Collateral Constraints and Noisy Fluctuations [download pdf]
Collateral constraints on firm-level investment introduce a potentially powerful two-way feedback between the financial market and the real economy. On one hand, real economic activity forms the basis for asset dividends. On the other hand, asset prices affect collateral value, which in turn determines the ability of firms to invest. In this paper I show how this two-way feedback can generate significant expectations-driven fluctuations in asset prices and macroeconomic outcomes when information is dispersed. In particular, I study the implications of this two-way feedback within a micro-founded business-cycle economy in which agents are imperfectly, and heterogeneously, informed about the underlying economic fundamentals. I then show how tighter collateral constraints mitigate the impact of productivity shocks on equilibrium output and asset prices, but amplify the impact of "noise", by which I mean common errors in expectations. Noise can thus be an important source of asset-price volatility and business-cycle fluctuations when collateral constraints are tight.
Dispersed Information over the Business Cycle: Optimal Fiscal and Monetary Policy (with George-Marios Angeletos) [download pdf]
We study how the heterogeneity of information affects the design of optimal fiscal and monetary policy over the business cycle. We do so within a model that features a standard Dixit-Stiglitz monopolistic competition structure, introduces dispersed private information about the underlying aggregate productivity shock, and allows this information to be imperfectly aggregated through certain prices and macroeconomic indicators. Our key findings are the following: (i) If we take the information structure as fixed, the optimal fiscal policy only removes the monopolistic distortion and the optimal monetary policy merely replicates flexible price allocations, much alike the standard case in which information is homogeneous. (ii) Unlike that case, however, replicating flexible-price allocations is not synonymous to targeting price stability. Rather, it involves trading off some price volatility for less output volatility. (iii) Once we take into account the endogeneity of information, both fiscal and monetary policies can affect the speed of learning through prices and macroeconomic indicators. (iv) Typically, this implies that the optimal policies are countercyclical.
Predatory Trading and Credit Freeze [download pdf]
This paper studies how predatory trading affects the ability of banks and large trading institutions to raise capital in times of temporary financial distress, in an environment in which traders are asymmetrically informed about each others' balance sheets. Predatory trading is a strategy in which a trader can profit by trading against another trader's position, driving an otherwise solvent but distressed trader into insolvency. The predator, however, must be sufficiently informed of the distressed trader's balance sheet in order to exploit this position. I find that when a distressed trader is more informed than other traders about its own balances, searching for extra capital from lenders can become a signal of financial need, thereby opening the door for predatory trading and possible insolvency. Thus, a trader who would otherwise seek to recapitalize is reluctant to search for extra capital in the presence of potential predators. Predatory trading may therefore make it exceedingly difficult for banks and financial institutions to raise credit in times of temporary financial distress.
Animal Spirits (with George-Marios Angeletos) [download pdf]
[previous title: Sentiments]
This paper develops a novel theoretical framework for studying the self-fulfilling nature of short-run fluctuations. In our theory, the economy features fluctuations that are orthogonal to the underlying technologies, preferences, and other fundamentals, and that help capture the informal notions of "animal spirits," "market sentiments", "demand shocks", and the like. Unlike common wisdom or prior work, these seemingly arbitrary fluctuations are neither the product of irrationality nor the symptom of equilibrium determinacy. Rather, they rest only on imperfect communication and obtain in an otherwise canonical, unique-equilibrium, rational-expectations economy, similar to the neoclassical backbone of most modern macro models. What is more, these fluctuations can also be consistent with a notion of constrained efficiency that leaves no room for conventional stabilization policies. A new paradigm thus emerges---one whose positive aspects have a strong Keynesian flavor, but whose micro-foundations are squarely Neoclassical, and whose policy implications are unsettlingly anti-Keynesian.
The Social Value of Information over the Business Cycle (with George-Marios Angeletos and Luigi Iovino) [pdf coming soon!]
What are the welfare effects of enhanced dissemination of public information? This paper tackles this question within the context of a micro-founded business-cycle model that features dispersed information about underlying shocks to aggregate productivity and monopoly power (“mark-up shocks”). Unlike previous work, we find that the degree of strategic complementarity among firms is not central to answering this question. Instead, we show that the answer to this question rests on the nature of the underlying shocks. We establish this in two steps. First, in line with previous work, we consider the case that information is purely exogenous. In this case, we show that more public information about the aggregate productivity shocks unambiguously increases welfare, whereas more public information about the aggregate mark-up shocks unambiguously decreases welfare. Next, we take into account the fact that most of the information collected and publicized by central bankers and other government agencies regards, not the underlying shocks themselves, but rather various statistics of economic activity, such as the aggregate level of prices and real output. In this case, we show that the publication of more precise statistics improves welfare when the business cycle is driven by productivity shocks, but reduces welfare when the business cycle is driven by mark-up shocks.