Uncertainty Shocks and Balance Sheet Recessions (Job Market Paper) Download
This paper investigates the origin and propagation of balance sheet recessions in a continuous-time general equilibrium model with financial frictions. I first show that in standard models driven by TFP shocks, the balance sheet channel completely disappears when agents are allowed to write contracts contingent on the aggregate state of the economy. Financial frictions still affect the economy, but optimal contracts separate leverage from aggregate risk sharing, eliminating the excessive risk taking that drives the balance sheet channel. Balance sheets therefore play no role in the transmission and amplification of aggregate shocks. Motivated by this neutrality result, I consider alternative structural shocks. I show that uncertainty shocks can drive balance sheet recessions, with depressed growth and asset prices, and trigger a “flight to quality” event, with low interest rates and high risk-premia. Uncertainty shocks create an endogenous hedging motive, inducing agents to take on aggregate risk even when contracts can be written on the aggregate state of the economy. Finally, I explore the implications for optimal financial regulation.
Dynamic Moral Hazard with Re-Contracting (PDF coming soon)
I study a continuous-time moral hazard problem where the agent’s private benefits are purely pecuniary. When the agent can commit to a long-term contract that can monitor his consumption, the first best can be achieved. I then explore the implications of lack of commitment to long-term contracts, and introduce a notion of competitive re-contracting. The agent can make a take-it or leave-it offer to the principal, who cannot commit to refuse a mutually beneficial offer. I characterize the optimal contract as the solution of a constrained portfolio problem.
Moral Hazard and the Balance Sheet Channel (PDF coming soon)
This paper uses a standard continuous-time growth model to study the interaction between moral hazard and the balance sheet channel. I allow agents to write contracts on all observable variables. I find that a balance sheet channel arises only when the private action exposes the agent’s private benefit to aggregate risk. The contract can deter the agent from taking the inefficient private action by overexposing him to aggregate risk. This creates a tradeoff between aggregate and idiosyncratic risk sharing. The resulting overexposure to aggregate risk drives a balance sheet amplification channel. In contrast, when moral hazard does not affect the exposure to aggregate risk of the agent’s private benefit, the balance sheet channel vanishes.
Research in Progress
Optimal Financial Regulation
I study optimal financial regulation in a model of financial crises. The financial friction is derived from a moral hazard problem with limited commitment, and balance sheet recessions are driven by uncertainty shocks. I consider alternative policy tools.
What is the Value of Commitment during a Liquidity Trap? (with Juan Passadore and Su Wang)
When the zero lower bound on nominal interest rates is binding, the central bank can still stimulate the economy by committing to keep interest rates low after the liquidity trap in order to create inflation and an output boom in the future. Without commitment, the central bank would revert to an optimal policy right after the liquidity trap, eliminating this policy tool. However, to the extent that the economy remains weak and at risk of falling back into a liquidity trap, the central bank might find it optimal to keep interest rates low for purely forward looking motives. We explore how this affects the value of commitment during liquidity traps.