Fi i l F t i E i Fl t tiFinancial Factors in Economic Fluctuations

L Ch i tiLawrence ChristianoRoberto Motto

M i R tMassimo Rostagno

What we doI t t fi i l f i ti i t t d d ilib i• Integrate financial frictions into standard equilibrium model and estimate the model using Euro Area and US data.

– Asymmetric information and costly state verification (Townsend (1978), Bernanke-Gertler-Gilchrist (1999))

– Endogenous determination of financial liabilities, like M1 and M3 (Chari-Christiano-Eichenbaum (1995))

• Decompose 14 aggregate data series into shocks and propagation mechanisms:

– A new shock, a ‘risk’ shock

– A new source of propagation: non-state contingent nominal rates of interest.

Outline

• Describe the basic ingredients of the d lmodel.

• Results

Standard Model ‘Marginal Efficiency of Investment’

Firmsconsumption

Investment goods1 1 f,t

Investment

Investment goodsYt 0

1Yjt

f,t djf,

, 1 ≤ f,t ,

Yjt tKjtztljt

1−

Supply labor Rent capitalother t

oilautKt Gt Ct It,t

≤ Yt.

HouseholdsK 1 K G I I Backyard capital accumulation:

E Rt1k

Kt1 1 − Kt Gi,t, It, It−1

u 1rk 1 P ′

Backyard capital accumulation:

uc,t Etc,tuc,t1t1

t1 Rt1k

ut1rt1 1 − Pk ′,t1Pk ′,t

Standard Model

Firms

Labor

LK

Market for Physical

Labor market C I

Capital

household

Financing• In the standard model already have borrowing by firms forIn the standard model, already have borrowing by firms for

working capital. – will now have banks intermediate this borrowing between

households and firms.

• In standard model, ‘putting capital to work’ is completely straightforward and is done by households They just rentstraightforward and is done by households. They just rent capital into a homogeneous capital market.

• Now: ‘putting capital to work’ involves a special kind of creativity that only some households – entrepreneurs – have.– Entrepreneurs finance the acquisition of capital in part by t ep e eu s a ce t e acqu s t o o cap ta pa t by

themselves, and in part by borrowing from regular ‘households’.– Conflict of interest, because there is asymmetric information

about the payoff from capital.Standard sharing contract between entrepreneur and household– Standard sharing contract between entrepreneur and household not feasible.

Financial Frictions with Physical K

Firms

Labor

LK

Entrepreneurs

Labor market

Capital Producers

C I

Producers

Entrepreneurssell their K

household

sell their Kto capital producers

Financial Frictions with Physical K

Firms

Labor

Entrepreneurs

Labor market

Capital Producers

K’Producers

household banksLoans

Extension to Incorporate Financial FrictionsFinancial Frictions

• General idea:

– Asset Side of Bank Balance Sheets: • Short term financing of working capital• Financing of physical capital (subject to CSV)

– Liability Side of Bank Balance Sheets:• Assets that provide various degrees of

transactions services.• ‘Time deposits’ to help finance capitalTime deposits to help finance capital.

Assets and Liabilities, Financial System

Assets LiabilitiesReservesReserves

Working capital loans to firms Household demand depositsg p pFirm demand deposits

Loans to entrepreneurs to purchase capital Savings depositsTime deposits

– Technology for producing transactions services:– (Chari-Christiano-Eichenbaum (1995)):

HouseholdsPreferences:• Preferences:

Etj∑

l0

lc,tluCtl − bCtl−1 − Lhj,tl

1L

1 L

−

1cPtlCtlMtl

1−tl 1cPtlCtl

Dtlh

1−tl1− 1cPtlCtlDtl

m b

tl1−q

1 − ,

• Features:H bit f ti i ti diff ti t d L b

1 − q

– Habit formation in consumption, differentiated Labor – Monopolistic supplier of specialized labor input (EHL)– Enjoy deposits services of two bank assets– Hold time deposits– Access to 10-year bond, with gross return

exogenous shock which can capture any failure of the model to match Rtℵ compared with data on 10-year bond returns

tℵ 1

Rtℵ

Banks Households EntrepreneursAccounts for about 30% of GDP

Banks, Households, Entrepreneurs

entrepreneur~F,t, E 1

entrepreneur

entrepreneur

HouseholdsBank

entrepreneur

Bank

entrepreneurentrepreneur

Standard debt contract

• Net worth of an entrepreneur who goes to e o o a e ep e eu o goes othe bank to receive a loan in period t:

nt

value of capital after production

Pk ′,t1 − Kt

earnings from capital after utilization costs

rtkKt −Bt−1

Zt−1 t

An entrepreneur who bought capital in t-1 experienced an idiosyncratic shock, .

This log-normal shock has mean unity across all entrepreneurs, .

~ F,t

An entrepreneur’s shock can only be observed by lender by paying a monitoring cost.

Under standard debt contract, entrepreneur either pays the interest rate on the debt,or (if is too low) declares bankruptcy, in which case he/she is monitored and loses everything to the bank.

Accelerator and Debt Deflation Effects• Net worth, averaged across entrepreneurs:

Nt Pk ′ t1 − Kt rtkKt − Bt−1

Zt−1 tt

Source of standard ‘accelerator effects’

k ,t t t t

source of ‘Fisher deflation effects’

t 1 t

• Shocks that raise output tend to be amplified if the shock also raises capital values and entrepreneurial income (‘accelerator effects’))

• Shocks that reduce the price level hurt entrepreneurial net worth and depress output (‘Fisher deflation effect’)

• Finding based on estimated model of US and EA (CMR):– Financial frictions magnify output effect of shocks that raise Y

and Pand P.– Financial frictions have little impact on shocks that move Y and P

in opposite directions.

Five Adjustments to Standard DSGE Model for CSV Financial Frictions

D h h ld i l i f i l• Drop: household intertemporal equation for capital.

• Add: characterization of the loan contracts that can beAdd: characterization of the loan contracts that can be offered in equilibrium (zero profit condition for banks).

• Add: efficiency condition associated withAdd: efficiency condition associated with entrepreneurial choice of contract.

• Add: Law of motion for entrepreneurial net worth• Add: Law of motion for entrepreneurial net worth (source of accelerator and Fisher debt-deflation effects).

• Introduce: bankruptcy costs in the resource constraint.

Risk Shock and NewsRisk Shock and News

• Assume iid i i t i ti t Assume

A t h d i f ti b t

t 1t−1 iid, univariate innovation to t

ut

• Agents have advance information about pieces of ut

ut t0 t−1

1 . . . t−88

t−ii ~iid, E t−i

i 2 i2

t−ii ~piece of ut observed at time t − i

Economic Impact of Risk ShockEconomic Impact of Risk Shock

l l di t ib ti

1

lognormal distribution: 20 percent jump in standard deviation

0.7

0.8

0.9

σσ *1.2

Larger number of entrepreneurs in lefttail problem for bank

0.4

0.5

0.6

dens

ity Banks must raise interest rate on entrepreneur

Entrepreneur borrows less

0 1

0.2

0.3

Entrepreneur borrows less

Entrepreneur buys less capital, investment drops, economy tanks

0.5 1 1.5 2 2.5 3 3.5 4

0.1

idiosyncratic shock

Monetary PolicyMonetary Policy Monetary policy rule: Monetary policy rule:

Rte iR t−1

e 1 − i Re Et t1 − t

target

GDP 1 − iy

4Re log GDPtz∗GDPt−1

1 − idRe t − t−1

1 b l Bt1 1 1 − ib

4Re log Bt1z∗Bt

1400Re t,

Monetary policy shock:t ~ white noise

Inflation target:

ttarget t−1

target ttarget, E t

target 2 ,

0.965, 0.00035

Monetary PolicyMonetary Policy

• Nominal rate of interest function of:Nominal rate of interest function of:

A ti i t d l l f i fl ti d h– Anticipated level of inflation and change.– Slowly moving inflation target.

f f– Deviation of output growth from ss path.– Growth of credit in case of EA. – Monetary policy shock.

Estimation• EA and US data covering 1985Q1-2008Q2

Δ log per capita stock market indextPt

GDP deflator inflationt

logper capita hourst

Δ log per capita credittPt

Δ logper capita GDPt

Δ log Hourly compensationtPt

Xt

Δ logper capita investmentt

Δ log per capita M1 t

Pt

Δ log per capita M3 tPtt

Δ logper capita consumptiont

Risk Spreadt

Rtlong − Rt

e

Rte

Δ logPIt)Δ logreal oil pricet

Δ log per capita Bank Reserves tP

• Standard Bayesian methodsΔ log Pt

Key Result• Risk shocks:

important so rce of fl ct ations– important source of fluctuations.

• Out-of-Sample evidence suggests the p ggmodel deserves to be taken seriously.

Risk ShocksRisk Shocks

• ImportantImportant

Wh th i t t?• Why are they important?

• What shock do they displace, and why?

Figure: Year-over-year GDP Growth Rate - Data (black) versus what data would have been with only the risk shock

US

Risk shock important

EA

Variance Decomposition, US DataVariance Decomposition, US DataPercent Variance Due to Risk Shock, t

Business Cycle Frequencies (8 32 quarters) Low Frequencies (cycles longer than 8 years)Business Cycle Frequencies (8-32 quarters) Low Frequencies (cycles longer than 8 years)Output

30 47InvestmentInvestment

57 64Consumption

4 274 27Risk Spread

96 95Real Value of Stock MarketReal Value of Stock Market

83 74

•Not surprisingly in view of earlier chart more important in the lower frequenciesNot surprisingly in view of earlier chart, more important in the lower frequencies,for output, consumption, investment

•Very important for financial variables

Why Risk Shock is so Importanty p• A. Our econometric estimator ‘thinks’

risk spread ~ risk shock.p

• B In the data: the risk spread is stronglyB. In the data: the risk spread is strongly negatively correlated with output.

• C. In the model: bad risk shock generates a response that resembles a recessiona response that resembles a recession.

• A+B+C suggests risk shock important• A+B+C suggests risk shock important.

Correlation (risk spread(t),output(t-j)), HP filtered data, 95% Confidence Interval

The risk spread is significantly negatively correlated with output and leads a little.

Notes: Risk spread is measured by the difference between the yield on the lowest rated corporate bond (Baa) and the highest ratedcorporate bond (Aaa). Bond data were obtained from the St. Louis Fed website. GDP data were obtained from Balke and Gordon(1986). Filtered output data were scaled so that their standard deviation coincide with that of the spread data.

Another Reason the Risk Shock is so Important

Positive shock to risk triggers what looks• Positive shock to risk triggers what looks like a recession

Dynamic response to contemporaneous and 8 period lagged news about risk, σt

-0 06

-0.04

Output

0.1

0.2Investment

-0 04

-0.02

Consumption

-0.14

-0.12

-0.1

-0.08

0.06

perc

ent

-0.4

-0.3

-0.2

-0.1

0

perc

ent

-0.1

-0.08

-0.06

-0.04

perc

ent

-0.18

-0.16

contemporaneous shock8 ‐ quarter in advance signal

-0.6

-0.5 -0.12

q g

1

-0.5

0

0.5Real Net Worth

80

100

120

Risk Spread (Annual Rate)

1

-0.5

Total Credit (Real)

-3

-2.5

-2

-1.5

-1

perc

ent

20

40

60

basi

s po

ints

-2

-1.5

-1

perc

ent

2 4 6 8 10 12 14 16

-3.5

2 4 6 8 10 12 14 16

0

2 4 6 8 10 12 14 16

-2.5

Dynamic response to contemporaneous and 8 period lagged news about risk, σt

-0.06

-0.04

Output

0

0.1

0.2Investment

-0 04

-0.02

Consumption

-0.14

-0.12

-0.1

-0.08

0.06

perc

ent

-0.4

-0.3

-0.2

-0.1

0

perc

ent

-0.1

-0.08

-0.06

0.04

perc

ent

-0.18

-0.16

contemporaneous shock8 ‐ quarter in advance signal

-0.6

-0.5 -0.12

q g

-1

-0.5

0

0.5Real Net Worth

80

100

120

s

Risk Spread (Annual Rate)

-1

-0.5

Total Credit (Real)

3 5

-3

-2.5

-2

-1.5

1

perc

ent

20

40

60

basi

s po

ints

2 5

-2

-1.5

1

perc

ent

2 4 6 8 10 12 14 16

-3.5

2 4 6 8 10 12 14 16

0

2 4 6 8 10 12 14 16

-2.5

Response to signal about risk 8 quarters in future

What Shock Does the Risk Shock Displace, and why?

Th i k h k d t f th• The risk shock crowds out some of the role of the marginal efficiency of i t t h kinvestment shock.

B i C l F iBusiness Cycle FrequenciesModel Risk shock, t marginal efficiency of investment shock, i,t

OutputOutputBaseline 30 14CEE-SW na 44

InvestmentBaseline 57 34CEE-SW na 87

Risk shock appears to crowd out the marginal efficiency of investment shock

CEE-SW na 87

marginal efficiency of investment shock

Why does Risk Crowd out yMarginal Efficiency of

I t t?Investment?Price of capitalPrice of capital

Demand shifters:risk shock, t;wealth shock wealth shock, t

Quantity of capital

Why does Risk Crowd out yMarginal Efficiency of

I t t?Investment?Price of capital

Supply shifter:marginal efficiencyPrice of capital marginal efficiencyof investment, i,t

Demand shifters:risk shock, t;wealth shock wealth shock, t

Quantity of capital

• Marginal efficiency of investment shockMarginal efficiency of investment shock can account well for the surge in investment and output in the 1990s asinvestment and output in the 1990s, as long as the stock market is not included in the analysisthe analysis.

Wh th t k k t i i l d d th• When the stock market is included, then explanatory power shifts to financial

k t h kmarket shocks.

‘Out of Sample Evidence’

• Out of sample forecasting performance• Out of sample forecasting performance good.

• Predictions for aggregate bankruptcy rate goodgood.

Correlates well with Bloom evidence on• Correlates well with Bloom evidence on cross-sectional uncertainty.

Other support for the modelOther support for the model• Model predicted default rates positively

correlated with measures of default in the data.

0.0235 4Default Probability (lhs)

Expected Default Probability, NFC (rhs)

0.0185

2

0.0085

0.0135

1990Q1 1993Q1 1996Q1 1999Q1 2002Q1 2005Q1 2008Q10

Our Measure of Idiosyncratic Risk versus Bloom et alRisk, versus Bloom, et al

0.51.15Series1Series4Ri ki Sh k (3 t MA)

0 4

1.05

Riskiness Shock (3-quarter MA)Cross-firms Sale Growth Spread (3-quarter MA)

0.4

0.95

0.3

0.85

0.75

0.20.651981Q2 1986Q2 1991Q2 1996Q2 2001Q2 2006Q2

A Policy ExperimentA Policy Experiment….

How Should Policy Respond to the Ri k S d?Risk Spread?

• Taylor’s recommendation:Taylor s recommendation:

R e y Risky rate Risk free rate Rt te yt − Risky ratet − Risk free ratet

1

• Evaluate this proposal by comparing

1

Evaluate this proposal by comparing performance of economy with and

against Ramsey-optimal 1

0 against Ramsey optimal benchmark. 0

Get a recession, just like in earlier graphearlier graph

Taylor suggestion creates a boomIs it too much?Is it too much?

Taylor’s suggestion overstimulatesTaylor s suggestion overstimulates

Conclusion• Incorporating financial frictions changes• Incorporating financial frictions changes

inference about the sources of shocks:– risk shock.

• Models with financial frictions can be used to ask interesting policy questions:ask interesting policy questions:

– When there is an increase in risk spreads, howWhen there is an increase in risk spreads, how should monetary policy respond?

How should monetary policy be structured to– How should monetary policy be structured to avoid excess asset market volatility?

– What are the pro’s and con’s of ‘unconventional monetary policy’?