When investors are unwilling to hold the economy's risk, a decline in the interest rate increases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. However, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.
Caballero, R. and A. Simsek (2018), "A Model of Fickle Capital Flows and Retrenchment"
We develop a model of gross capital flows that addresses the tension between their fickleness during foreign crises and retrenchment during local crises. In a symmetric environment with domestic crises, capital flows mitigate fire sales since fickle inflows exit the crisis location at weak prices whereas past outflows provide liquidity at higher valuations. However, due to the public good aspect of flows' liquidity services, local policymakers with financial stability concerns may restrict flows. Greater scarcity of safe assets and lower correlation between crises increase gross flows. With asymmetric locations, the model features reach-for-safety and reach-for-yield flows that can be destabilizing.
In Caballero and Simsek (2018), we develop a model of fickle capital flows and show that, when countries are similar, international flows create global liquidity and mitigate crises despite their fickleness. In this paper, we focus on the asymmetric situation of Emerging Markets (EM) exchanging flows with Developed Markets (DM) that feature lower returns but less frequent crises. Relatively high DM returns help to mitigate EM crises, by reducing fickle inflows, and by providing greater liquidity. The situation dramatically changes as the DM returns fall, as this increases the fickle inflows driven by reach for yield and exacerbates EM crises.
Iachan, F., P. Nenov, and A. Simsek (2017), "The Choice Channel of Financial Innovation"
Financial innovations in recent decades have expanded portfolio choice. We investigate how greater choice affects investors' savings. We establish a choice channel by which greater portfolio choice increases investors' (nonprecautionary) savings---by enabling them to earn the aggregate risk premium or to take speculative positions. We provide empirical evidence for this channel by examining the saving behavior of U.S. households since the 1980s. We also theoretically analyze the effect of choice on asset returns. Portfolio customization (access to risky assets other than the market portfolio) reduces the risk-free rate, whereas participation reduces the risk premium but typically increases the risk-free rate.
We propose a tractable model of bargaining with optimism. The distinguishing feature of our model is that the bargaining power is durable and changes only due to important events such as elections. Players know their current bargaining powers, but they can be optimistic that events will shift the bargaining power in their favor. We define congruence (in political negotiations, political capital) as the extent to which a party's current bargaining power translates into its expected payoff from bargaining. We show that durability increases congruence and plays a central role in understanding bargaining delays, as well as the finer bargaining details in political negotiations. Optimistic players delay the agreement if durability is expected to increase in the future. The applications of this durability effect include deadline and election effects, by which upcoming deadlines or elections lead to ex-ante gridlock. In political negotiations, political capital is highest in the immediate aftermath of the election, but it decreases as the next election approaches.
Acemoglu, D. and A. Simsek (2012), "Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading," working paper [slides]
A "folk theorem" maintains that competitive equilibria with asymmetric information are always (or generically) inefficient unless agents' consumption can be fully monitored by the principal (and specified in contracts). We critically evaluate these claims in the context of a general equilibrium economy with moral hazard. We allow agents' consumption to be partially monitored (e.g., employment contracts can specify how long a vacation agent takes, but not where she spends her vacation). We identify weak separability of agents' preferences between non-monitored consumption and effort as the necessary and sufficient condition for efficiency (e.g., weak separability implies how much the agent likes Bahamas vs. Hawaii is independent of her effort level). We also establish ε-efficiency when there are only small deviations from weak separability. These results delineate a range of benchmark environments under which general equilibrium has strong efficiency properties even though agents' consumption is not fully monitored.