The Risk Channel of Unconventional Monetary Policy (Job Market Paper)
Abstract: This paper examines how unconventional monetary policy affects asset prices and macroeconomic conditions by reallocating risk in the economy. I consider an environment with two main ingredients: heterogeneity in risk tolerance and limited asset market participation. Risk-tolerant investors take leveraged positions, exposing the economy to balance sheet recessions. Limited asset market participation implies the balance sheet of the central bank is non-neutral. Unconventional monetary policy reduces the risk premium and endogenous volatility. During balance sheet recessions, asset purchases boost investment and growth. In contrast, during normal times, the expectation of future interventions reduces growth by its impact on savings. A commitment by the central bank to unwind its portfolio early, conditional on the recovery of leveraged institutions' balance sheet, reduces the risk premium by more than strategies involving holding its portfolio for longer. Asset purchases also have implications for the concentration of risk. Leveraged institutions respond to the policy by reducing risk-taking relatively more than risk-averse investors. As risk concentration falls, the probability of negative tail-events is reduced, enhancing financial stability.
Optimal Unconventional Monetary Policy: A Two-Period Example
Abstract: I study the optimal design of unconventional monetary policy in an environment with two frictions: limited asset market participation and a moral hazard in the financial sector that limits idiosyncratic risk sharing. I consider a two-period setting that allows for a sharp characterization of the optimal policy. I show that the optimal policy will always deviate from the full participation equilibrium, as the central bank faces a trade-off between correcting a pecuniary externality generated by the moral hazard problem and providing the appropriate exposure to risk to non-participants. Comparative statics exercises indicate the central bank should expand its balance sheet after negative shocks. Asset prices would vary less under the optimal policy compared to the laissez-faire equilibrium.
Research in Progress
Entrepreneurship and Idiosyncratic Risk Premium in Village Economies (joint with Robert M. Townsend)
Abstract: Data on the return of farm and non-farm business enterprises in Thailand indicates that idiosyncratic risk commands a positive price in equilibrium. We study the determination of the idiosyncratic risk premium and its implications in a life-cycle framework where entrepreneurs have limited insurance due to a moral hazard friction. We argue that the price of idiosyncratic risk is determined in the long-run by entrepreneur's savings behavior. In particular, an increase in the bequest motive will reduce the idiosyncratic premium, as it increases entrepreneur's risk bearing capacity. A reduction in uninsurable volatility reduces the premium only in the short-run, as it reverts to the original level in the long-run. The effects of idiosyncratic volatility on growth and the distribution of capital depends on the strength of a precautionary motive. For high levels of risk aversion, a reduction in uninsurable volatility reduces growth and it increases the concentration of capital on older households. We test the predictions using data from business enterprises in Thailand and structurally estimate the model to evaluate the impact of a financial innovation that increases the availability of insurance to entrepreneurs.
Fiscal Fragility (joint with Nicolas Caramp)
Abstract: We study how the level, maturity structure and asset composition of government debt affects the severity of crises and the effectiveness of stabilization policies. We consider a small modification of the basic New Keynesian model: we assume the government has access to distortionary taxation, but not to lump-sum taxes. In contrast to the pervasiveness of multiple equilibria in the New Keynesian literature, equilibrium is now unique. Second, both fiscal and monetary policies become less powerful in high debt economies, meaning both the fiscal multiplier and the response to changes in the monetary policy are attenuated. The level of debt also has implications for how the economy responds to shocks. In response to a preference shock that pushes the economy into a liquidity trap, high debt economies experience larger and more prolonged recessions. Moreover, the maturity structure and asset composition matters. Economies with the same level of debt, but a higher fraction of long-term debt will face a smaller recession in the liquidity trap experiment. An economy with a higher fraction of long-term indexed debt will have more effective stabilization policies and it will be less affected by the preference shock. Therefore, more indebted economies and economies that rely less on long-term or indexed debt are, in this sense, more fragile.