A productive capacity generates output and risks, both of which need to be absorbed by economic agents. If they are unable to do so, output and risk gaps emerge. Risk gaps close quickly: A decline in the interest rate increases the Sharpe ratio of the risky assets and equilibrates the risk markets. If the interest rate is constrained from below (or the policy response is slow), the risk markets are instead equilibrated via a decline in asset prices. However, the drop in asset prices also drags down aggregate demand and generates a recession, which further drags prices down, and so on. If economic agents are optimistic about the speed of recovery, a decline in asset prices leads to a large increase in the Sharpe ratio that stabilizes the drop. If they are pessimistic, the economy becomes highly susceptible to downward spirals due to the feedback between asset prices and aggregate demand. The fear of a recession with a downward price spiral also reduces the interest rate during the boom. When beliefs are heterogenous, optimists take too much risk from a social point of view since they do not internalize their positive effect on asset prices and aggregate demand during recessions. Macroprudential policy can improve outcomes, and is procyclical as the negative aggregate demand effect of prudential tightening is more easily offset by interest rate policy during booms than during recessions. Forward guidance policies are also effective, but their robustness weakens as agents become more pessimistic. Our model also illustrates that interest rate rigidities and speculation generate endogenous price volatility that exacerbates demand recessions.
Caballero, R. and A. Simsek (2017), "A Model of Fickle Capital Flows and Retrenchment"
We develop a global equilibrium model of capital flows that addresses the tension between their fickleness during foreign crises and retrenchment during local crises. In a symmetric world with a scarcity of safe assets, gross flows mitigate crises since the fickle flows exit the country at weak prices (or exchange rates) whereas retrenched flows are brought back at relatively high valuations. However, the fickleness of flows is not inconsequential as it induces local policymakers to tax capital flows despite their global liquidity provision benefits. If the system is heterogeneous, the model features reach-for-safety and reach-for-yield flows that can destabilize developed and emerging market economies, respectively.
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.