Endowment Shocks Research Articles

Sequential trading with coarse contingencies

We consider a dynamic pure exchange economy in which agents have a coarse perception of the future, and awareness emerges gradually over time. We make the key assumption that awareness of a shock to agents' endowments emerges before the shock hits, so agents can adapt by purchasing (or selling) insurance. We provide an irrelevance theorem showing that, under suitable conditions, unawareness matters if and only if it concerns aggregate shocks. In particular, if the unforeseen endowment shocks are purely idiosyncratic, there is no loss of efficiency with respect to the economy with perfect foresight. Building on this result, we show three key implications of unforeseen aggregate shocks: the possibility of non-comonotonic consumption allocations, a systematic bias in asset prices that gives rise to opportunities for intertemporal arbitrage, and the potential of unexpected default due to the agents' inability to repay (roll over) prior debt.

The Transmission of Commodity Price Super-Cycles

Abstract We examine two key channels through which commodity price super-cycles affect the economy: a wealth channel, through which higher commodity prices increase domestic demand, and a cost channel, through which they induce wage increases. By exploiting regional variation in exposure to commodity price shocks and administrative firm-level data from Brazil, we empirically disentangle these transmission channels. We introduce a dynamic model with heterogeneous firms and workers to further quantify the mechanisms and evaluate welfare. A counterfactual economy in which commodity booms are purely endowment shocks experiences only 30% of the intersectoral labour reallocation between tradables and nontradables, and 40% of the within-tradable labour reallocation between domestic and exported production. Finally, the consumption-equivalent welfare gain of a commodity super-cycle is twice as large in the counterfactual economy.

Reverse migration and exports at extensive margin: case of a small dependent economy.

We analyse the implications of reverse migration on export quality upgrading by the origin country. Other than a favourable endowment shock by raising the native country's labour supply, reverse migration cause loss of remittances from unskilled emigrants and capital investments made by skilled emigrants. Resulting loss of national income and correspondingly domestic demand affect local factor prices and consequently the competitiveness of exports, when the economy produces non-traded goods. In a competitive general equilibrium model of a small open economy, we establish that reverse migration of unskilled workers will cause upgrading of quality of the skill-based export good only if higher qualities require more capital relative to skilled labour. Reverse migration of skilled workers has just the opposite effect. Lower contribution to capital investment thereby lower capital stock and lower repatriation of returns to such investment further magnify such effects. Finally, the results are robust to a more generalised demand structure.

Trust and trustworthiness after negative random shocks

We experimentally investigate the effect of a negative endowment shock that can cause inequality in a trust game. Our goal is to assess whether different causes of inequality have different effects on trust and trustworthiness. In our trust game, we vary whether there is inequality (in favor of the second mover) or not and whether the inequality results from a random negative shock (i.e., the outcome of a die roll) or exists from the outset. Our findings suggest that inequality causes first-movers to send more of their endowment and second-movers to return more. However, we do not find support for the hypothesis that the cause of the inequality matters. Behavior after the occurrence of a random shock is not significantly different from the behavior in treatments where the inequality exists from the outset. Our results highlight the need to be cautious when interpreting the effects on trust and trustworthiness of negative random shocks in the field (such as natural disasters). Our results suggest that these effects are primarily driven by the inequality caused by the shock and not by any of the additional characteristics of the shock, like saliency or uncertainty.

A Theory of Foreign Exchange Interventions

We develop a theory of foreign exchange interventions in the presence of limited capital mobility. We study a real small open economy subject to global liquidity and endowment shocks. Home and foreign bond markets are segmented and intermediaries have a limited capacity to arbitrage between both bond markets. As a result, the central bank can manipulate the spread across markets by managing its portfolio. We show that the planning problem can be entirely framed in terms of the spreads. Crucially, spreads are inherently costly, over and above the standard costs from distorting households’ consumption profiles. The extra term is exactly given by the carry trade profits of foreign intermediaries, is convex in the spread - as more foreign intermediaries become active carry traders - and increasing in the openness of the capital account - as foreign intermediaries find it easier to take larger positions. Optimal interventions lean against the wind for global liquidity shocks and implement a zero spread against endowment shocks. Importantly, interventions should be small, frequent and rely on forward guidance of future interventions. The effectiveness of interventions increases if they are pre-announced and the policy is more credible. Finally, we model a world equilibrium with two types of small open economies: advanced economies, with a strong desire to save; and emerging markets, who intervene to avoid currency appreciation. In the Nash equilibrium, emerging markets engage in “reserve wars,” leading to substantial reserve over-accumulation and too depressed world interest rates. Simple coordination rules, like committing to replicating zero spreads, are shown to be strict Pareto improvements for reasonable calibrations.

The Impact of Endowment Shocks on Payouts

ABSTRACTUniversities’ endowment management practices have come under scrutiny by politicians and commentators who note that universities are tax-exempt, and do not want taxpayers subsidizing institutions only to have them accumulate wealth without advancing the public good. Defenders of university endowment policies argue that, to the contrary, managers do not hoard endowment wealth for its own sake, but rather use endowments to smooth university spending over time. A critical question in this context is how the amounts that universities pay out from their endowments respond to shocks to the values of their endowments. Specifically, if universities reduce payouts in response to negative shocks more than they increase payouts in response to positive shocks, then their behavior is consistent with the notion that endowment managers care more about maintaining the value of their endowments than smoothing expenditures. We investigate this issue using panel data on the payout behavior of over 700 universities during the period 1987 to 2009, and find that payouts are affected symmetrically by positive and negative shocks. While we make no attempt to argue that current payout policies are optimal for universities or for society, our findings do indicate that fears that universities are abusing their tax-exempt status by hoarding their endowments may be misplaced.

The Social Value of Asymmetric Information Revisited

We consider probabilistic information acquisition in the canonical Grossman-Stiglitz pure-exchange economy. In contrast to the previous literature, we show that costly information acquisition in financial markets can be welfare-improving. In particular, when risk-sharing incentives are weak and information quality is moderate, the welfare benefit can be very significant for speculators who provide liquidity. We show that marginal welfare can be decomposed into a positive probability-choice effect and a negative informed-trading effect. When the latter effect dominates, which occurs when risk-sharing incentives are strong, only the no-information equilibrium is Pareto-optimal. Otherwise, heterogenous endowment shocks and the Hirshleifer effect allow for a continuum of Pareto optimal equilibria. This suggests that regulatory efforts to alter the amount of informed trading may be unnecessary.

Unique monetary equilibrium with inflation in a stationary Bewley–Aiyagari model

We prove the existence and uniqueness of a stationary monetary equilibrium in a Bewley–Aiyagari model with idiosyncratic shocks. This is an exchange economy with an infinite horizon and one consumption good, and with each agent facing idiosyncratic endowment shocks at each period; the agents may trade their endowments for the only asset, fiat money. The government increases the money supply at a constant growth rate that induces inflation in a stationary monetary equilibrium. We identify the necessary and sufficient condition for a stationary monetary equilibrium (where money has a positive value and the aggregate real balance is constant over time) to exist, and, when it exists, we show that it is unique. The argument for uniqueness is based on a new monotonicity result for the average optimal consumption.

What inflation measure should a currency union target?

What is the appropriate inflation target for the monetary policymaker in a currency union, core inflation or headline inflation? We answer the question in a two-country New Keynesian model with an energy sector. We derive the welfare loss function and find that optimal monetary policy should target output gaps, the terms of trade gap, the Producer Price Index inflation rates, and the real marginal cost gaps. We use the welfare loss function to evaluate two alternative Taylor-type monetary policy rules. We find that the choice of preferred policy rule depends on the shocks. Specifically, when productivity shocks hit the economy, the monetary policymaker should follow the headline inflation Taylor rule, while the core inflation Taylor rule should be followed when a negative energy endowment shock hits the economy. In our extended model in which a representative energy producer in the home country inputs domestic non-energy consumption goods to produce energy to meet the union-wide demands, we also find that the core inflation Taylor rule should be followed when a negative energy productivity shock occurs. In addition, whichever monetary policy rule the monetary policymaker chooses, the welfare level of home households is always lower than that of foreign households following a negative energy productivity shock.

Risk sharing contracts with private information and one-sided commitment

In a repeated unobserved endowment economy in which agents negotiate long-term contracts with a financial intermediary, we study the risk sharing implications of the interaction between incentive compatibility constraints (due to private information) and participation constraints (due to one-sided commitment). In particular, we assume that after a default episode, agents consume their endowment and remain in autarky forever. We find that once they are away from autarky today, if the probability of drawing the highest possible endowment shock is sufficiently small, the optimal contract prevents agents from reaching autarky tomorrow and, thus, from being “impoverished.” Moreover, an invariant cross-sectional distribution of lifetime utilities (or values) exists. A numerical example shows that the mass of agents living in autarky can be zero in the limit.

When Are Financial Markets Perfectly Competitive?

We study competitiveness of financial markets in a one-period model, in which traders speculate on private information and hedge endowment shocks. Developing and fully characterizing a new measure of market competitiveness, we find that market becomes perfectly competitive if and only if the number of traders approaches infinity and speculation becomes negligible relative to hedging. While perfect competition – the key assumption for rational expectations equilibrium – is a strong condition, we show when it can be made innocuous and when it cannot. We discuss further implications of market competitiveness for the measurement of liquidity and the real-world financial market design.

Information and Competition with Symmetry

This paper investigates the strategic foundations for rational expectations equilibrium. In the model, risk-averse traders with two signals — private information and endowment shocks — submit demand schedules to trade a risky asset. Traders are divided into groups. Within groups, traders share common signals; signals are different across different groups. Either traders become price takers or the price becomes fully revealing, but not both, as the number of competitors per group goes to infinity. As the number of groups goes to infinity, neither price taking nor fully revealing prices are obtained. Measuring competition by the quantity traded as a fraction of that traded by a price-taker, we show that optimal exercise of market power has opposite implications for competition and price informativeness.

Indeterminacy in stochastic overlapping generations models: real effects in the long run

Indeterminate equilibria are known to exist for overlapping generations models, though recent research has been limited to deterministic settings in which all equilibria converge to a steady state in the long run. This paper analyzes stochastic overlapping generations models with three-period-lived representative consumers and adopts a novel computational algorithm to numerically approximate the entire set of competitive equilibria. In a stochastic setting with incomplete markets, indeterminacy has real effects in the long run. Our numerical simulations reveal that indeterminacy is an order of magnitude more important than endowment shocks in explaining long-run consumption and asset price volatility.

Market Size Matters: A Model of Excess Volatility in Large Markets

We present a model of excess volatility based on speculation and equilibrium multiplicity. Each trader has two distinct motives to trade: (i) speculation based on noisy signals, and (ii) hedging against endowment shocks. The key to equilibrium multiplicity is the self-fulfilling nature of information aggregation: if individuals trade relatively more on the basis of speculation rather than hedging, then prices reveal more information on payoff risk which in turn justifies less need for hedging. We first show that multiplicity arises only in large markets where aggregate shocks in prices are sufficiently more important than idiosyncratic shocks. We then show that (i) in a given equilibrium, excess volatility increases with payoff volatility, (ii) comparing across different equilibria, excess volatility is negatively associated with liquidity, trading volume, and social welfare. We also show that an increase in market size either creates high-volatility equilibria or eliminates low-volatility equilibria. Among other things, the model predicts that given two assets identical in their fundamental properties, the one that attracts more traders overtime is more likely to experience a jump in excess volatility. The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2639539

Efficiency and Distortions in a Production Economy with Heterogeneous Beliefs

In a production economy, in which agents have heterogeneous beliefs and a social planner has incomplete knowledge about which beliefs are correct, we introduce the concept of Incomplete Knowledge (IK) efficiency. IK-inefficient allocations can be improved upon without taking a stand on which belief, among a whole set of reasonable beliefs, is correct. We show that competitive equilibrium under heterogeneous beliefs is always IK-inefficient, and decompose this inefficiency into investment and speculative distortions. Overinvestment occurs in economies in which agents’ elasticity of intertemporal substitution is high, whereas underinvestment arises when their elasticity is low. Using the IK concept to define mispricing, we show that equilibrium mispricing never arises intratermporally, but that intertemporal mispricing is generically present in economies with rich state spaces and heterogeneous beliefs. Finally, we argue that investment distortions may be easier to address by a social planner than speculative distortions in economies with idiosyncratic endowment shocks, and also show that transaction taxes may be welfare decreasing in such economies.

Tradability of Output, Business Cycles, and Asset Prices

I examine the effect of a firm’s tradability, the proportion of output that is exported abroad, on its stock returns. There are three novel empirical findings: (1) firms with higher tradability have more cyclical asset returns; (2) firms with higher tradability have more cyclical earnings growth; (3) returns of a portfolio long on firms with the highest tradability and short on firms with the lowest tradability can predict the real exchange rate. The empirical patterns are consistent with the relative price adjustment of tradable and non-tradable goods to business cycles driven by endowment shocks.

Tradability of Output, Business Cycles, and Asset Prices

I examine the effect of a firm's tradability, the proportion of output that is exported abroad, on its stock returns. There are three novel empirical findings: (1) firms with higher tradability have more cyclical asset returns; (2) firms with higher tradability have more cyclical earnings growth; (3) returns of a portfolio long on firms with the highest tradability and short on firms with the lowest tradability can predict the real exchange rate. The empirical patterns are consistent with the relative price adjustment of tradable and non-tradable goods to business cycles driven by endowment shocks.

Equilibrium Asset Pricing with Both Liquid and Illiquid Markets

I study a general equilibrium model in which investors face endowment risk and trade two correlated assets; one asset is traded on a liquid market whereas the other is traded on an illiquid over-the-counter (OTC) market. Endowment shocks not only make prices drop, they also make the OTC asset more difficult to sell, creating an endogenous liquidity risk. This liquidity risk increases the risk premium of both the OTC asset and liquid asset. Furthermore, the OTC market frictions increase the trading volume and the cross-sectional dispersion of ownership in the liquid market. Finally, if the economy starts with only the OTC market, then I explain how opening a correlated liquid market can increase or decrease the OTC price depending on the illiquidity level. The model's predictions can help explain several empirical findings.

Efficiency and Lack of Commitment in an Overlapping Generations Model with Endowment Shocks

This paper considers a pure exchange stochastic overlapping generations model in which, on each date, an economy faces an aggregate endowment shock. On each date, a young agent and an old agent simultaneously decide how much of their respective endowments to transfer to the other agent; however, a young agent cannot make promises about how much he or she will give when old. In this sense, an economy faces a limited commitment constraint. This paper characterizes an efficient intergenerational risk sharing allocation that satisfies a limited commitment constraint, and also studies the role of money and history in a stochastic overlapping generations economy.

How University Endowments Respond to Financial Market Shocks: Evidence and Implications

Endowment payouts have become an increasingly important component of universities' revenues in recent decades. We study how universities respond to financial shocks to endowments and thus shed light on a number of existing models of endowment behavior. Endowments actively reduce payouts relative to their stated payout policies following negative, but not positive, shocks. This asymmetric behavior is consistent with “endowment hoarding,” especially among endowments whose current value is close to the benchmark value at the start of the university president's tenure. We also document the effect of negative endowment shocks on university operations, such as personnel cuts. (JEL G35, I22, I23)