Shadow banks and macroeconomic instability

December 28, 2013

By Roland Meeks, Benjamin Nelson and Piergiorgio Alessandri

We develop a macroeconomic model in which commercial banks can offload risky loans onto a “shadow” banking sector and financial intermediaries trade in securitized assets. We analyze the responses of aggregate activity, credit supply and credit spreads to business cycle and financial shocks. We find that interactions and spillover effects between financial institutions affect credit dynamics, that high leverage in the shadow banking system heightens the economy’s vulnerability to aggregate disturbances, and that following a financial shock, a stabilization policy aimed solely at the securitization markets is relatively ineffective.

Not only does this paper include a financial sector, nowadays a must for any macro model looking at the recent sector, this model also includes securitization and shadow banking. The latter arises as a better way to leverage illiquid loans. Banks try to transfer risk to their shadow operations, but not explicitly because of regulation. In fact, there is no regulatory motive to shadow banking in this paper, something that would be much beyond its current complexity. This paper is an interesting modeling strategy trying to push the envelope further in integrating the financial sector in macro models.

Life Cycle Uncertainty and Portfolio Choice Puzzles

December 23, 2013

By Yongsung Chang, Jay Hong and Marios Karabarbounis

The standard theory of household portfolio choice is hard to reconcile with the following facts. (i) Despite a high rate of returns the average household holds a low share of risky assets (equity premium puzzle). (ii) The share of risky assets increases in age. (iii) The share of risky assets is disproportionately larger for richer households. We show that a simple life-cycle model with learning about earnings ability can successfully address all three puzzles. Young workers, on average asset poor, face larger uncertainty in their life-time labor income because they do have perfect knowledge of their ability in the market. They hedge this risk in human capital by investing in relatively safe financial assets. As earnings ability is gradually revealed over time, they take more risk in financial investment. When the labor income risks are calibrated to those observed in the Panel Study of Income Dynamics, our model with learning reproduces the investment profile we see in the Survey of Consumer Finances.

Often neglected in portfolio theory, labor income risk appears to be critical to understand portfolio choices over the life cycle. It not only the fact that younger people do not have the means to invest in financial assets, the paper here shows that the uncertainly about the path of future labor income is overwhelming at first and then vanishes as they learn it over time. It is only then that they can afford financial asset return risk.

Polarized business cycles

December 22, 2013

By Marina Azzimonti and Matthew Talbert

We are motivated by four stylized facts computed for emerging and developed economies: (i) business cycle movements are wider in emerging countries; (ii) economies in emerging countries experience greater economic policy uncertainty; (iii) emerging economies are more polarized and less politically stable; and (iv) economic policy uncertainty is positively related to political polarization. We show that a standard real business cycle (RBC) model augmented to incorporate political polarization, a ‘polarized business cycle’ (PBC) model, is consistent with these facts. Our main hypothesis is that fluctuations in economic variables are not only caused by innovations to productivity, as traditionally assumed in macroeconomic models, but also by shifts in political ideology. Switches between left-wing and right-wing governments generate uncertainty about the returns to private investment, and this affects real economic outcomes. Since emerging economies are more polarized than developed ones, the effects of political turnover are more pronounced. This translates into higher economic policy uncertainty and amplifies business cycles. We derive our results analytically by fully characterizing the long-run distribution of economic and fiscal variables. We then analyze the effect of a permanent increase in polarization on PBCs.

In a well-functioning government, public policies are close to optimal and fluctuate little over time. In a highly polarized government with power shifts, policy swings around wildly and has the potential to have more of an impact. The paper here looks at the effect on the business cycle and finds one way to rationalize the higher business cycle volatility found in emergent and developing economies. The point here is that it is the policy uncertainty that influences business decisions, in particular investment. This should resonate with those complaining about polarization in Washington.

Collateral requirements and asset prices

December 10, 2013

By Johannes Brumm, Michael Grill, Felix Kubler and Karl Schmedders

Many assets derive their value not only from future cash flows but also from their ability to serve as collateral. In this paper, we investigate this collateral value and its impact on asset returns in an infinite-horizon general equilibrium model with heterogeneous agents facing collateral constraints for borrowing. We document that borrowing against collateral substantially increases the return volatility of long-lived assets. Moreover, otherwise identical assets with different degrees of collateralizability exhibit substantially different return dynamics because their prices contain a sizable collateral premium that varies over time. This premium can be positive even for assets that never pay dividends.

Assets with collateral properties are in fashion these days, for understandable reasons. Yet, the pricing of these assets has not been much studied. This paper fills this void starting, of course, from a Lucas tree with interesting results for the moments of excess returns.

A comparison of numerical methods for the solution of continuous-time DSGE models

December 3, 2013

By Juan Carlos Parra-Alvarez

This paper evaluates the accuracy of a set of techniques that approximate the solution of continuous-time DSGE models. Using the neoclassical growth model I compare linear-quadratic, perturbation and projection methods. All techniques are applied to the HJB equation and the optimality conditions that define the general equilibrium of the economy. Two cases are studied depending on whether a closed form solution is available. I also analyze how different degrees of non-linearities affect the approximated solution. The results encourage the use of perturbations for reasonable values of the structural parameters of the model and suggest the use of projection methods when a high degree of accuracy is required.

Continuous-time DSGE models are not very popular but do have some interest applications. While there is an extensive literature looking at solution methods for discrete-time models that is looking a computing performance and precisions, that literature is much scarcer for the continuous-time kind. That paper is a good start.