Financial Frictions and the Macroeconomy
Paper Session
Tuesday, Jan. 5, 2021 10:00 AM - 12:00 PM (EST)
- Chair: Florian Madison, Claremont McKenna College
Doubling Down on Debt: Limited Liability as a Financial Friction
Abstract
We investigate how a combination of limited liability and preexisting debt distort firms’ real investment and equity payout decisions (e.g. equity buybacks). We find that preexisting debt induces equity holders to ``double-sell'' cash flows in default, distorting real investment and leading to excessively high leverage. This mechanism, which relies on the ability of equity holders to issue new debt with claims to the bankruptcy value of the firm, tends to induce firms to overinvest even in the presence of default costs. Allowing equity payouts financed by newly issued debt mitigates investment distortions ex-post, but may exacerbate them ex-ante. In a repeated version of the model, we show that the ex-post incentives to double-sell cash flows leads to ex-ante inefficient real investment where low-leverage firms underinvest and high-leverage firms overinvest. Finally, we provide empirical evidence consistent with predictions of our model.Who Bears the Welfare Costs of Monopoly? The Case of the Credit Card Industry
Abstract
How are the welfare costs from monopoly distributed across U.S. households? We answer thisquestion for the U.S. credit card industry, which is highly concentrated, charges interest rates that
are 3.4 to 8.8 percentage points above perfectly competitive pricing, and has repeatedly lost antitrust
lawsuits. We depart from existing competitive models by integrating oligopolistic lenders into a het-
erogeneous agent, defaultable debt framework. Our model accounts for 20 to 50 percent of the spreads
observed in the data. Welfare gains from competitive reforms in the 1970s are equivalent to a one-time
transfer worth between 0.24 and 1.66 percent of GDP. Along the transition path, 93 percent of indi-
viduals are better off. Poor households benefit from increased consumption smoothing, while rich
households benefit from higher general equilibrium interest rates on savings. Transitioning from 1970
to 2016 levels of competition yields welfare gains equivalent to a one-time transfer worth between
1.87 and 3.20 percent of GDP. Lastly, homogeneous interest rate caps in 2016 deliver limited welfare
gains.
Bubble-driven Financial Cycles and Macroeconomic Policies
Abstract
The run-up of financial bubbles followed by financial crashes is a frequent phenomena in modern economies. The building up of the bubble as well as its crash usually sets a number of amplification mechanisms linked to the presence of financial frictions and spillovers effects in the real economy.We model financial bubbles generated in the banking sector and test several macroprudential measures, including countercyclical capital requirements, to mitigate the growth of a bubble and the adverse effects after its burst. We formalize the processes of bubble creation and asset price inflation to provide a setting for the analysis of monetary policy and efficacy of regulatory instruments. Specifically, we consider a real (or rational) trigger of the bubble (financial innovation) and an (irrational or behavioral) extrapolation of past loan growth into the future asset price. We assume that learning by agents determined by the signal-to-noise ratio of their available information (Kalman gain) in the model gives rise to endogenously driven waves of optimism (pessimism) which lead to sustained credit booms (bursts) whenever agents observe increasing (decreasing) fundamental values. We show that our model is able to quantitatively capture the historical U.S. credit market cycles especially the negative skewness and the large support of the empirical distribution which reflect the presence of occasional credit market run-ups and reversals.
We test several measures on whether they can effectively reduce the impact of a financial bubble, which is robust to variations of the Kalman gain. We find that a countercyclical capital requirement proves to be the most effective measure to prevent a bubble from growing. This lies in its nature of increasing costs which counteract the fall in monitoring need following a financial innovation. We thereby provide a comprehensive rationale for the use of countercyclical capital buffers as introduced in Basel III.
Tracing the Sources of Fiscal Multipliers
Abstract
We investigate the impact of fiscal expansions on firm investment through corporate lending by exploiting highly granular Colombian data during 2004-2015. For identification, we focus on firms that have multiple banking relationships and trace the entire loan history across lenders as they change their stock of government bonds. Further, we conduct a localized RDD approach and compare the lending behavior of: (i) banks that barely met and missed the criteria of being a primary dealer, and (ii) barely winners and losers at government auctions. We argue that the lending strategy of banks within the vicinity of the cutoff point is very similar ex ante and can reveal crowding-out effects when confronting liquidity shortages. Our results indicate that during a period of 10 months, a 1 percentage point (pp) increase in banks’ bonds-to-assets ratio decreases loans by up to 0.42%. Consistently, our RDD results show that primary dealers reduce their credit to corporates by 10.8% compared to non-primary dealers. As a result, a one standard deviation increase in firms’ exposure to lenders with high bond holdings leads to a decline in liabilities, investment, profits, and wages by up to 1.3%, 10.8%, 2.3%, and 5.4%. Our findings are grounded in a quantitative default model with financial and real sectors. It shows that increased government spending limits the amount of available funds to firms and raises sovereign risk. Primary dealers then pass on these costs to local firms. Essentially, the heightened cost of credit lowers private investment.Quantifying the Macroeconomic Impact of Credit Expansions
Abstract
This project explores, both theoretically and empirically, what are the effects of credit market conditions on the real economy. The literature has emphasized several channels though which changes in credit conditions affect economy activity, and there is a debate about their relative importance. The goal of our paper is to discriminate between these channels, by using a quasi-natural experiment and a quantitative model. Empirically, we exploit the deregulation of the US banking sector in the 1980s, which we interpret as an improvement in credit market conditions. We find this lowers the interest rate on loans, increases lending to households and businesses, boosts employment, output, wages and labor productivity, stimulates firm entry and job creation. Motivated by these findings, we seek to understand what is the mechanism through which better credit affects economic activity. To that end, we build a quantitative model in which credit market frictions can affect the real economy through several channels. First, better credit market conditions stimulate aggregate demand from households and consequently GDP. Second, more favorable credit market conditions affect the production sector by (1) increasing capital investment for incumbent firms and (2) stimulating new firms' entry. To parameterize the model, we leverage the bank deregulation quasi-natural experiment and use the identified moments in the data as targets in the estimation. We then use quantitative the model to discriminate between the relative importance of the aforementioned channels.JEL Classifications
- E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit