Valuation Risk and Asset Pricing

December 23, 2012

By Rui Albuquerque, Martin S. Eichenbaum and Sergio Rebelo

Standard representative-agent models have difficulty in accounting for the weak correlation between stock returns and measurable fundamentals, such as consumption and output growth. This failing underlies virtually all modern asset-pricing puzzles. The correlation puzzle arises because these models load all uncertainty onto the supply side of the economy. We propose a simple theory of asset pricing in which demand shocks play a central role. These shocks give rise to valuation risk that allows the model to account for key asset pricing moments, such as the equity premium, the bond term premium, and the weak correlation between stock returns and fundamentals.

One may want to criticize that it is easy to explain more moments by adding more shocks, but the preferences shocks here (to time preference) are disciplined by the return on risk-free bonds. This works because the shocks are aggregate, which thus opens the question why preference shocks would be coordinated in such a way. Is there some fundamental that allows such coordination? Or, if the aggregate shock is a summary of the shift in the distribution of individual preferences, is this a valid approximation? I hope this paper will trigger research along those lines, as its results are quite intriguing.


Understanding the distributional impact of long-run inflation

December 18, 2012

By Gabriele Camera and YiLi Chien

The impact of fully anticipated inflation is systematically studied in heterogeneous agent economies with an endogenous labor supply and portfolio choices. In stationary equilibrium, inflation nonlinearly alters the endogenous distributions of income, wealth, and consumption. Small departures from zero inflation have the strongest impact. Three features determine how inflation impacts distributions and welfare: financial structure, shock persistence, and labor supply elasticity. When agents can self-insure only with money, inflation reduces wealth inequality but may raise consumption inequality. Otherwise, inflation reduces consumption inequality but may raise wealth inequality. Given persistent shocks and an inelastic labor supply, inflation may raise average welfare.

The idea that inflation has a distributional impact is not new, as it dates back to the work of Richard Cantillon in the early 18th century and more recently to the limited participation literature (for example). The difference here is that inflation is fully anticipated, there is production with endogenous labor supply, and different financial structures are studied. And while long-run inflation reduces wealth inequality, it is welfare-reducing because it increases consumption inequality.

Analyzing the Effects of Insuring Health Risks: On the Trade-off between Short Run Insurance Benefits vs. Long Run Incentive Costs

December 13, 2012

By Harold Cole, Soojin Kim and Dirk Krueger

This paper constructs a dynamic model of health insurance to evaluate the short- and long run effects of policies that prevent firms from conditioning wages on health conditions of their workers, and that prevent health insurance companies from charging individuals with adverse health conditions higher insurance premia. Our study is motivated by recent US legislation that has tightened regulations on wage discrimination against workers with poorer health status (Americans with Disability Act of 2009, ADA, and ADA Amendments Act of 2008, ADAAA) and that will prohibit health insurance companies from charging different premiums for workers of different health status starting in 2014 (Patient Protection and Affordable Care Act, PPACA). In the model, a trade-off arises between the static gains from better insurance against poor health induced by these policies and their adverse dynamic incentive effects on household efforts to lead a healthy life. Using household panel data from the PSID we estimate and calibrate the model and then use it to evaluate the static and dynamic consequences of no-wage discrimination and no-prior conditions laws for the evolution of the cross-sectional health and consumption distribution of a cohort of households, as well as ex-ante lifetime utility of a typical member of this cohort. In our quantitative analysis we find that although a combination of both policies is effective in providing full consumption insurance period by period, it is suboptimal to introduce both policies jointly since such policy innovation induces a more rapid deterioration of the cohort health distribution over time. This is due to the fact that combination of both laws severely undermines the incentives to lead healthier lives. The resulting negative effects on health outcomes in society more than offset the static gains from better consumption insurance so that expected discounted lifetime utility is lower under both policies, relative to only implementing wage nondiscrimination legislation.

Beyond being an interesting topic, this paper shows nicely how the tools of DSGE models can efficiently be applied beyond macroeconomics. If there are expectations and general equilibrium effects, this is the way to go.

The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery

December 8, 2012

By Stephanie Schmitt-Grohé and Martín Uribe

The great contraction of 2008 pushed the U.S. economy into a protracted liquidity trap (i.e., a long period with zero nominal interest rates and inflationary expectations below target). In addition, the recovery was jobless (i.e., output growth recovered but unemployment lingered). This paper presents a model that captures these three facts. The key elements of the model are downward nominal wage rigidity, a Taylor-type interest-rate feedback rule, the zero bound on nominal rates, and a confidence shock. Lack-of-confidence shocks play a central role in generating jobless recoveries, for fundamental shocks, such as disturbances to the natural rate, are shown to generate recessions featuring recoveries with job growth. The paper considers a monetary policy that can lift the economy out of the slump. Specifically, it shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment.

While this is a nice example of how a relatively simple model with the right ingredients can yields results that seems difficult to obtain with standard models, this paper is not convincing to me. First, it cannot explain previous jobless recoveries, as I think at least one ingredient is missing in every case. Second, I think we saw plenty of example of downward flexibility in nominal wages during the last recession, for example with furloughs. Third, as Reinhard and Rogoff have shown, recoveries from financial crises are very protracted and few of them have all the ingredients of this model (for example such low interest rates).

And three more calls for papers

December 6, 2012

This is high season for calls for papers. Here are more:

Special issue of the Review of Economic Dynamics on Money, Credit, and Financial Frictions.

A conference in Amsterdam on the Role of Financial Intermediaries in Monetary Policy Transmission.

And in Beijing the Tsinghua Workshop in Macroeconomics