“Liquidity Scarcity, Project Selection and Volatility” (Job Market Paper)
The severe contraction that followed the Subprime Crisis highlighted the exposure of the real sector to financial markets and to the volatility in credit conditions. Unreliability in future funding influences the way in which firms choose their exposure to real and financial risks when investing in projects, demanding credit commitments and holding other assets. The present paper studies the behavior of project choice in an environment with financial frictions and liquidity scarcity and its consequences for the aggregate behavior of the economy. I focus on responses to fluctuations in the external supply of liquidity and in the liquidity created by the entrepreneurial projects themselves. When shocks occur to external liquidity sources, such as changes in the cash-flows that support mortgage-backed securities or other non-corporate assets, these are transmitted across different sectors of the economy. The anticipation of these shocks and its reflection in asset prices influence project selection and change the pattern of fluctuations. Likewise, the anticipation of variations in the internal liquidity of firms resulting from shocks to their productivity changes their choice of projects. For moderate liquidity scarcity, this effect is shown to lead to the dampening of these underlying productivity shocks; while for more severe shortages, amplification follows.
“Constrained Optimality and Taxation in a Dynamic Hidden Information Economy” [New draft soon. January 2011 version.]
I study the characterization of the constrained optimal allocation in an economy with hidden dynamic endowment shocks, in which agents are also able to trade bonds unobservably. Production is monitorable and might be controlled or distorted by a planner, which indirectly affects prices on the unobservable trades. The constrained optimal allocation can be implemented in a simple decentralized way, which takes the form of a bond market economy with taxes. Conditions under which the untaxed economy is sub-optimal are identified, with the sign of a welfare improving deviation depending on the covariance of marginal utility and asset holdings in the cross-section of agents. A necessary condition for an optimal tax rule is also derived.
Work in progress:
“A transaction-based theory of money and banking” (joint with Abhijit V. Banerjee and Eric S. Maskin) [notes available upon request]
We study an environment in which money is essential for all transactions, while banks undertake lending activity and provide liquidity insurance to customers, as in Diamond-Dybvig (1983). Prices are flexible, but given the importance of the timing of transactions and the essential role of money in their intermediation, banks need to keep monetary reserves and investment is constrained below its first-best level. This creates an inefficiency that monetary policy has the potential to address. We proceed by investigating the consequences of different policies that target the underlying friction.