Macro-finance Model Research Articles

Cournot Fire Sales

In standard Walrasian macro-finance models, pecuniary externalities due to fire sales lead to excessive borrowing and insufficient liquidity holdings. We investigate whether imperfect competition (Cournot) improves welfare through internalizing the externality and find that this is far from guaranteed. Cournot competition can overcorrect the inefficiently high borrowing in a standard model of levered real investment. In contrast, Cournot competition can exacerbate the inefficiently low liquidity in a standard model of financial portfolio choice. Implications for welfare and regulation are therefore sector-specific, depending both on the nature of the shocks and the competitiveness of the industry.

Does Communicating a Numerical Inflation Target Anchor Inflation Expectations? Evidence & Bond Market Implications

High-frequency empirical evidence suggests that inflation expectations in the United States became better anchored after the Federal Reserve began communicating a numerical inflation target. Using an event-study approach, we find that forward measures of inflation compensation became unresponsive to news about current inflation after the adoption of an explicit inflation target. In contrast, we find that forward measures of nominal compensation in Japan continued to drift with news about current inflation, even after the Bank of Japan adopted a numerical inflation target. These empirical findings have implications for the term structure of interest rates in the United States. In a calibrated macro-finance model, we show that the apparent anchoring of inflation expectations implies lower term premiums in longer-term bond yields and decreases the slope of the yield curve.

Equilibrium Implications of Interest Rate Smoothing

We introduce a macro-finance model in which monetary authorities adjust the money supply by targeting not only output and inflation but also the slope of the yield curve. We study the impact of McCallum-type rules on capital growth, the volatility of interest rates, the spread between long- and short-term rates, the persistence of monetary shocks and equity volatility. Our model supports the Federal Reserve’s choice to incorporate financial data in their policy decisions and expand the monetary base to decrease the nominal interest rate spread at the cost of lower expected long-term growth.

The Macroeconomics of Shadow Banking

ABSTRACTWe build a macrofinance model of shadow banking—the transformation of risky assets into securities that are money‐like in quiet times but become illiquid when uncertainty spikes. Shadow banking economizes on scarce collateral, expanding liquidity provision, boosting asset prices and growth, but also building up fragility. A rise in uncertainty raises shadow banking spreads, forcing financial institutions to switch to collateral‐intensive funding. Shadow banking collapses, liquidity provision shrinks, liquidity premia and discount rates rise, asset prices and investment fall. The model generates slow recoveries, collateral runs, and flight‐to‐quality effects, and it sheds light on Large‐Scale Asset Purchases, Operation Twist, and other interventions.

The real effects of capital controls: Firm-level evidence from a policy experiment

This paper evaluates the effects of capital controls on firm-level stock returns and real investment using data from Brazil. On average, there is a statistically significant drop in cumulative abnormal returns consistent with an increase in the cost of capital for Brazilian firms following capital control announcements. Large firms and the largest exporting firms appear less negatively affected compared to external-finance-dependent firms, and capital controls on equity inflows have a more negative announcement effect on equity returns than those on debt inflows. Overall, the findings have implications for macro-finance models that abstract from heterogeneity at the firm level to examine the optimality of capital control taxation.

Modelling Sovereign Credit Spreads with International Macro-Factors: The Case of Brazil 199882009

This paper develops a macro-finance model of the Brazilian economy and its sovereign debt markets that allows for domestic and international macroeconomic influences as well as swings in investor confidence. It finds significant evidence of common trends in the US and Brazilian economies and bond markets as well as spillover effects from US inflation and business cycles to the Brazilian economy. The US Fed Funds rate influences Brazilian sovereign spreads, as do Brazilian inflation and policy rates. The Brazilian confidence factor dominates the behavior of the spreads during periods of crisis and we find that it also has a powerful effect on the level and volatility of macroeconomic variables. These results suggest that the macro-finance approach could throw light upon the behavior of other economies that are troubled by sovereign risk.

Credit-Loans Non-Local Transactions and Surface-Like Waves

This paper describes waves of Credit-Loans macro financial transactions on economic space. We use agent’s risk ratings as their coordinates and describe evolution of macro financial variables by transactions between agents. Aggregations of agent’s financial variables with risk coordinates x on economic space define macro financial variables as function of x. Aggregations of financial transactions between agents at point x and y determine functions of two variables (x,y) on economic space. As example we study Credit transactions provided from agents at point x to agents at point y and thus amount of Loans received by agents at point y from agents at point x at moment t during time term dt. We model evolution of macro transactions by hydrodynamic-like equations. Agents fill macro financial domain on economic space that is bounded by minimum risk ratings of most secure and maximum risk ratings of most risky agents. Economic and financial shocks can disturb steady borders of macro domain and cause perturbations of financial transactions. Such disturbances can generate waves that can propagate along risk borders alike to surface waves in fluids. As example, we describe simple model interactions between two financial transactions by hydrodynamic like equations in a closed form. We introduce notions of “financial accelerations” and their potentials that establish steady state distributions of financial transactions on economic space. For this model in linear approximation we describe surface-like waves and show that perturbations induced by financial surface-like waves can exponentially grow up inside macro domain and induce financial instabilities in a low risk area. Description of possible steady state distributions of financial transactions and surface-like waves on economic space might be important for macro-finance modeling and policy-making.

Continuous Time Macro-Finance, Financial Transactions and Waves

This paper describes continuous time macro-finance via dynamics of financial transactions between economic agents. Risk ratings of agents play role of their coordinates x on economic space. Financial variables of agents like Investment or Assets, Profits or Credits allow describe corresponding macro financial variables. Aggregates of financial variables of all agents allocated near x define macro variables as functions of time and x. Integrals of financial variables over economic space equal common variables of entire macro-finance as functions of time only. Financial transactions between agents define evolution of their financial variables. Aggregates of financial transactions between agents allocated at points x and y define macro transactions that describe financial action-at-a-distance between points x and y. Dynamics of macro transactions define evolution of macro financial variables. To model macro financial transactions and their mutual interactions we obtain hydrodynamic-like equations. For simple model of interactions between two macro transactions like Assets-Liabilities and Income-on-Assets we derive hydrodynamic-like equations in a closed form. That allows model relations between two macro transactions in a self-consistent manner. For that model we derive wave equations on perturbations of macro transactions and study simple solutions and consequences. Existence and diversities of financial waves in simple models clarifies importance of wave processes for macro-finance modeling.

Macro-Finance*

Macro-finance addresses the link between asset prices and economic fluctuations. Many models reflect the same rough idea: the market’s ability to bear risk is greater in good times, and less in bad times. Models achieve this similar result by quite different mechanisms. I contrast their strengths and weaknesses. I highlight directions for future research, including additional facts to be matched, and limitations of the models that should prod future theoretical work. I describe how macro-finance models can fundamentally alter macroeconomics, by putting time-varying risk premiums and risk-bearing capacity at the center of recessions rather than variation in the interest rate and intertemporal substitution.

The term structure of returns: Facts and theory

We summarize and extend the new literature on the term structure of equity. Short-term equity claims, or dividend strips, have higher average returns and Sharpe ratios than the aggregate stock market. The returns on short-term dividend claims are risky as measured by volatility, but safe as measured by market beta. These facts are hard to reconcile with traditional macro-finance models and we provide an overview of new models that can reproduce some of these facts. We relate our evidence on dividend strips to facts about other asset classes such as nominal and corporate bonds, volatility, and housing. We discuss the broader economic implications of our findings by linking the term structure of returns to real economic decisions such as hiring and investment. We conclude with an outline of empirical and theoretical extensions that we consider interesting avenues for future research.

Forecasting Financial Returns with a Structural Macroeconomic Model

This paper investigates the ability of a fully structural macro-finance model to forecast long-term financial returns. We estimate a Dynamic Stochastic General Equilibrium (DSGE) model that describes the dynamics of the U.S. economy. The model includes government bond and stock market returns, which allows us to describe bond and stock risk premia. We first show that these risk premia are fundamentally related to other shocks in the economy. Second, the DSGE model reproduces the mean reversion in the term structure of risks for bond and stock returns. It also generates long-term forecasts of financial returns that outperform unrestricted VAR models.

The Financial Channel of Uncertainty Shock Transmission

This paper presents a macrofinance model with uncertainty shocks. Entrepreneurs in this economy need to pose collateral to obtain finance, and they can default when collateral value becomes too low. I show that by allowing default, the payoff of a collateralized loan contract resembles that of a short put option. An uncertainty shock causes a spike in lending haircut, which amounts to a credit crunch. This reduces the capital of the entrepreneurs and starts a recession. The model shows that temporary uncertainty shocks can generate persistent recessions in a bare-bone RBC model even if all the agents are risk-neutral.

Financial Contracting As Behavior Towards Risk: The Corporate Finance of Business Cycles

This paper describes an equilibrium macro finance model where contracts are the mechanism by which differentially risk averse bondholders and stockholders resolve a conflict of interest problem and confront the risks associated with future operating decisions and financing decisions of a representative firm/economy. In resolving this conflict of interest problem the interrelated covenants in the financial contract shape certain stylized financial facts of business cycles ignored in Classical and Keynesian models. The model set-up includes 2 agents (bondholders and stockholders); 2 decisions (production-investment decisions generating operating income and operating risk) and (financial decisions generating financial risk); and 2 no-arbitrage equilibrium conditions (market value equals economic book value for both bonds and stocks). In this 2x2x2 set-up contract constrained managers of the representative firm make production-investment decisions that conform to the risk aversion of stockholders as reflected in stock prices, and then use financing decisions to offset any effect of a change in operating risk on the market valuation of bonds. In this model managers work for both stockholders and bondholders. Preliminary evidence from the U.S. non-financial corporate sector does not reject the predictions of the model. A similar form of risk and return sharing is shown to occur between more risk averse mature and experienced workers with seniority and less risk averse young apprentice workers.

Limited Stock Market Participation and Goods Market Frictions: A Potential Resolution for Puzzles in International Finance

The popular assumption based on complete markets that the log of real exchange rate growth equals the difference between the logs of home and foreign IMRSs imposes a tight restriction on explaining the joint behavior of asset prices, exchange rates, and international risk sharing. We study asset prices, exchange rates, and consumption dynamics in a general equilibrium two-country macro-finance model that features both asset-market and goods-market frictions. For the asset-market friction, we consider limited stock market participation a la Guvenen (2009). In addition, we follow Corsetti, Dedola, and Leduc (2008) to model frictions to international trade such as non-traded goods and distribution cost. We provide analysis of the model linearized to the second order, by implementing the method proposed by Devereux and Sutherland (2010) to overcome the indeterminacy issues with portfolio choice. The model generates a high price of risk, smooth exchange rates, and makes substantial progress towards explaining the empirically observed low consumption growth correlation between countries. We find that distribution cost plays a central role for reducing international consumption co-movement while also amplifying risk premia.

New Look on Macro-Finance Modeling

This paper gives new look on finance theory and develops parallels between modeling macro-finance as multi-agent systems on economic space and description of multi-particle systems. We treat economic agents alike to “economic particles” – as simple units of macro-finance system. Risk ratings of economic agents play role of their coordinates on economic space. Financial variables of economic agents and of entire economics are defined as functions of time and coordinates on economic space. We describe macro-finance system alike to hydrodynamics and for simple model of possible mutual dependence between Demand on Investment and Interest Rate derive hydrodynamic-like equations in a closed form. For perturbations of financial variables we derive wave equations. Financial perturbation waves on economic space can propagate with exponential growth of amplitude and can cause time fluctuations of financial variables and financial crises.

Estimating dynamic equilibrium models using mixed frequency macro and financial data

We provide a framework for inference in dynamic equilibrium models including financial market data at daily frequency, along with macro series at standard lower frequency. Our formulation of the macro-finance model in continuous time conveniently accounts for the difference in observation frequency. We suggest the use of martingale estimating functions (MEF) to infer the structural parameters of the model directly through a nonlinear scheme. This method is compared to regression-based methods and the generalized method of moments (GMM). We illustrate our approaches by estimating various versions of the AK-Vasicek model with mean-reverting interest rates. We provide asymptotic theory and Monte Carlo evidence on the small sample behavior of the estimators and report empirical estimates using 30 years of US macro and financial data.

Log, Stock and Two Simple Lotteries

This work studies the problem of decision-making under risk by agents whose information processing abilities may be limited. The constructed theoretical framework grounds on findings from economic laboratory experiments, incorporates existing neuroscience knowledge, and is implemented using information-theoretic formalism. Activation of the above information-processing constraints distorts the subjective perception of the objective stochastic environment the agent operates in, and the constrained-optimal decision-making requires appropriate adjustments. In the selected application, a general equilibrium macro-finance model, such biases of subjective perspective as overconfidence, pessimism and categorization thus emerge endogenously. The theoretical implications receive empirical support in a mutually consistent way: according to (cross-checked) calibrations, they allow us to reverse-engineer and rationalize the phenomena known as the equity premium/risk-free rate puzzles; as well as contribute to the understanding of such regularities as the portfolio underdiversification puzzle, style investing and the non-monotone pricing kernel puzzle. On the other hand, these results also help rationalize, by formulating certain optimizing foundations behind, the experimental evidence that underlies the Allais paradox and that is systematized in, e.g., the (cumulative) prospect theory.

The Term Structure of Returns: Facts and Theory

We summarize and extend the new literature on the term structure of equity. Short-term equity claims, or dividend strips, have on average significantly higher returns than the aggregate stock market. The returns on short-term dividend claims are risky as measured by volatility, but safe as measured by market beta. These facts are hard to reconcile with traditional macro-finance models and we provide an overview of new models that can reproduce some of these facts. We relate our evidence on dividend strips to facts about other asset classes such as nominal and corporate bonds, volatility, and housing. We conclude by discussing the broader economic implications by linking the term structure of returns to real economic decisions such as hiring and investment.

Editors’ Introduction

Editors’ Introduction

Exponential-Affine Approximations of Macro-Finance Models with Nonlinear Habits

We propose a first-order approximation technique to solve a general class of discrete-time dynamic models with endogenous and state-dependent risk, and we provide simple analytical expressions for generalized equilibrium term structures of asset prices. We apply this technique to two endowment economies with Campbell-Cochrane habits as well as a more complex version that features a production economy and nominal rigidities. The proposed essentially-affine approximation performs similarly to global solution methods and outperforms alternative affine approximation methods. The approximation maintains a high quality at short as well as long horizons, and it preserves the main properties of the stochastic discount factor, including its martingale component and the maximal risk-return tradeoff.