Do Banking Shocks Matter for the U.S. Economy?

Recent financial turmoil and existing empirical evidence suggest that adverse shocks to the financial intermediary (FI) sector cause substantial economic downturns. The quantitative significance of these shocks to the U.S. business cycle, however, has not received much attention up to now. To determine the importance of these shocks, we estimate a sticky-price dynamic stochastic general equilibrium model with what we describe as chained credit contracts. In this model, credit- constrained FIs intermediate funds from investors to credit-constrained entrepreneurs through two types of credit contract. Using Bayesian estimation, we extract the shocks to the FIs' net worth. The shocks are cyclical, typically negative during a recession, such as the one that began in 2007. Their effects are persistent, lowering economic activity for several quarters after the recessionary trough. According to the variance decomposition, shocks to the FI sector are a main source of the spread variations, explaining 39% of the FIs' borrowing spread and 23% of the entrepreneurial borrowing spread. At the same time, these shocks play an important but not dominant role for investment, accounting for 15% of its variations.Monetary Policy, Financial Accelerators, Financial Intermediaries, Chained Credit Contracts

The Effects of Monetary Policy Commitment: Evidence from Time- varying Parameter VAR Analysis

In this paper, we explore the effects of the Bank of Japan's ( BOJ's) policy commitment under zero interest rates on the economy, by considering the transmission channel of altering private-sector expectations. To that end, we carry out a structural vector autoregression analysis on macroeconomic variables and private-sector expectations variables, using a time-varying parameters estimation technique with stochastic volatility. We show empirical evidence on two points. First, the BOJ's policy commitment regarding the future course of short-term interest rates, associated with only a small reduction in policy interest rates, succeeded in altering private-sector expectations. Second, the BOJ's policy commitment alone, nevertheless, was not sufficient to restore the previous trends in prices and output.Policy commitment, policy duration effect, expectations management, Bayesian estimation, time-varying parameter vector autoregression with stochastic volatility

Some Alternative Perspectives on Macroeconomic Theory and Some Policy Implications

An initial version of this paper was presented at a meeting of the Euro50 group in Paris on 20, November, 2009. It has benefitted from comments by David Laidler and Axel Leijonhufvud, neither of whom necessarily agree with all of its contents.

Booms and Busts in Asset Prices

We show how low-frequency boom and bust cycles in asset prices can emerge from Bayesian learning by investors. Investors rationally maximize infinite horizon utility but hold subjective priors about the asset return process that we allow to differ infinitesimally from the rational expectations prior. Bayesian updating of return beliefs then gives rise to self-reinforcing return optimism that results in an asset price boom. The boom endogenously comes to an end because return optimism causes investors to make optimistic plans about future consumption. The latter reduces the demand for assets that allow to intertemporally transfer resources. Once returns fall short of expectations, investors revise return expectations downward and set in motion a self-reinforcing price bust. In line with available survey data, the learning model predicts return optimism to comove positively with market valuation. In addition, the learning model replicates the low frequency behavior of the U.S. price dividend ratio over the period 1926-2006.

Productivity and Fiscal Policy in Japan: Short Term Forecasts from the Standard Growth Model

Japan is facing severe fiscal challenges. The aging of the population is projected to raise total pension and health expenditures. There is already a huge debt to output ratio which is the highest in advanced economies. In this paper we ask `if the consumption tax rate is raised to 15%, will there be a primary surplus, and what factors are important in achieving a fiscal balance?' Using the standard growth model 's simulations as `modern back-of-the-envelope' calculations, the quantitative findings indicate the critical need to contain government expenditures. Even an annual growth rate of 3% in GDP over the next 20 years may be insufficient to turn consistent primary surpluses, combined with a new consumption tax rate of 15%, unless prudent expenditure policies are implemented.Primary Balance, Fiscal Policy, Productivity, Growth Theory

Can Cross-Border Financial Markets Create Endogenously Good Collateral in a Crisis?

In this paper, we explore whether markets can create endogenously good collateral in a crisis by analyzing a simple exchange economy where a country-specific catastrophic shock is shared between two countries. To see this possibility, we examine whether the equilibrium achieved by the time-0 complete markets with solvency constraints can be recovered in the dynamically complete markets with collateral constraints. This paper demonstrates that it is possible to recover the time-0 equilibrium outcome in a sequential manner when pricing errors occur randomly in evaluating Lucas trees at a catastrophic event. Such stochastic components may be interpreted as a policy initiative to create good collateral and yield constrained efficient outcomes at crisis periods.Solvency Constraints, Collateral Constraints, Dynamic Optimal Contract, Catastrophic Shocks

Accelerated Investment and Credit Risk under a Low Interest Rate Environment: A Real Options Approach

Empirical studies have found that a low interest rate environment accelerates firmsf investment and debt financing, leading to subsequent balance sheet problems in many countries in recent years. We examine the mechanism whereby firmfs debt financing and investment become more accelerated and the credit risk rises under a low interest rate environment from the perspective of a real options model. We find that firms tend to increase debt financing and investment not only under strong expectations of continued low interest rates but also when there are expectations of future interest rate increases, and such behavior causes higher credit risk. We also find that when future interest rate rises are expected, the investment decisions vary depending on how firms incorporate the possibility of future interest rises. Specifically, myopic firms make glast-minute investmentsh based on concerns over future interest rate hikes and this behavior increases their credit risk. In contrast, economically rational firms choose to decrease their investments, carefully considering the likelihood of future interest rate hikes.Low interest rate environment, Investment behavior, Credit risk, Real options model, Corporate finance, Time-inconsistent discount rate, Behavioral economics

Exorbitant Privilege and Exorbitant Duty

We update and improve the Gourinchas and Rey (2007a) dataset of the historical evolution of US external assets and liabilities at market value since 1952 to include the recent crisis period. We find strong evidence of a sizeable excess return of gross assets over gross liabilities. The center country of the International Monetary System enjoys an gexorbitant privilegeh that significantly weakens its external constraint. In exchange for this gexorbitant privilegeh we document that the US provides insurance to the rest of the world, especially in times of global stress. This gexorbitant dutyh is the other side of the coin. During the 2007-2009 global financial crisis, payments from the US to the rest of the world amounted to 19 percent of US GDP. We present a stylized model that accounts for these facts.

The Future of Central Banking: A Lesson from United States History

This paper is being prepared for the 2010 international conference of the Institute for Monetary and Economic Studies of the Bank of Japan, gThe Future of Central Banking under Globalization,h to be held May 26-27, 2010, in Tokyo. I am grateful to Marvin Goodfriend for helpful discussions.