Adverse Selection and the Accelerator

This paper reexamines the relationship between financial market imperfections and economic instability. I present a model in which financial accelerator effects come from adverse selection in credit markets. Unlike other models of the financial accelerator, the model I present has the potential to stabilize the economy rather than destabilize it. The stabilizing forces in the dynamic model are closely related to forces that cause overinvestment in static models. Consequently, the stabilizing properties of the model are not specific to adverse selection but rather are present in any environment in which credit market distortions cause overinvestment. When investment projects are equity financed, or when contracts are written optimally, the only equilibria that emerge are stabilizer equilibria. Thus, stabilizing outcomes are more robust in this model. Finally, the empirical distinction between accelerator equilibria and stabilizer equilibria is subtle. Many statistics used to test for financial accelerators are observationally equivalent in stabilizer equilibria.subliminal extant Smith economagic gmm

Durable Goods and Conformity

Is the variety of products supplied in markets a reflection of the diversity of consumers' preferences? In this paper, we argue that the distribution of durable goods offered in markets tends to be compressed relative to the distribution of consumers' underlying preferences. In particular, there are strong incentives for conformity in markets for durable goods. The reason for conformity is natural: durables (for example houses) are traded and as a result, demand for these goods is influenced by their resale value. Agents may like one product, but purchase another because of resale concerns. We show that (1) there is a tendency to conform to the average preference; (2) conformity depends primarily on the number of people with extreme preferences; (3) conformity increases with increases in durability, patience, and the likelihood of trade; and (4) equilibrium conformity is not necessarily optimal. Surprisingly, there tends to be too little conformity in equilibrium. Conformity also creates a demand for rental markets. Renting does not necessarily decrease conformity however. Instead, renting tends to exaggerate conformity in the owner-occupied market.

An sS Model with Adverse Selection

We present a model of the market for used cars in which agents face a fixed cost of adjustment, the magnitude of which depend on the degree of adverse selection in the secondary market. We find that, unlike typical models, the sS bands in our model contract as the variance of the shock process increases. We also analyze a dynamic version of the model in which agents are allowed to make decisions that are conditional of the age of a used car. We find that, as a car ages, the lemons problem tends to decline in importance, and the sS bands contract.

Phased-In Tax Cuts and Economic Activity

Phased-in tax reductions are a common feature of tax legislation. This paper uses a dynamic general equilibrium model to quantify the effects of delaying tax cuts. According to the analysis of the model, the phased-in tax cuts of the 2001 tax law substantially reduced employment, output, and investment during the phase-in period. In contrast, the immediate tax cuts of the 2003 tax law provided significant incentives for immediate production and investment. The paper argues that the rules and accounting procedures used by Congress for formulating tax policy have a significant impact in shaping the details of tax policy and led to the phase-ins, sunsets, and temporary tax changes in both the 2001 and 2003 tax laws.Fiscal Policy, Tax Policy

Sticky Price Models and Durable Goods

This paper shows that there are striking implications that stem from including durable goods in otherwise conventional sticky price models. The behavior of these models depends heavily on whether durable goods are present and whether these goods have sticky prices. If long-lived durables have sticky prices, then even small durables sectors can cause the model to behave as though most prices were sticky. Conversely, if durable goods prices are flexible then the model exhibits unwelcome behavior. Flexibly priced durables contract during periods of economic expansion. The tendency towards negative comovement is very robust and can be so strong as to dominate the aggregate behavior of the model. In an instructive limiting case, money has no effects on aggregate output even though most prices in the model are sticky.Sticky prices, Durables, Comovement, Neutrality

Do Flexible Durable Goods Prices Undermine Sticky Price Models?

Multi-sector sticky price models have surprising implications when durable goods have flexible prices. While in actual data the production of virtually all durables exhibits strong negative responses to monetary contractions, in dynamic general equilibrium models a monetary contraction causes the output of flexibly priced durables to expand. Indeed, in the polar case in which only nondurables have sticky prices, the negative comovement of durable and nondurable production exactly offsets and the behavior of aggregate output mimics that of a model with fully flexible prices. While this neutrality' result is special, the comovement problem' -- the perverse response of flexibly priced durables to monetary policy shocks -- is highly robust. When some durables prices are flexible and others sticky, the comovement problem still applies strongly to the subset of durables with flexible prices. We argue that new housing construction might be best characterized as a flexible price industry for which the comovement problem is relevant. The underlying reason for the comovement problem is the combination of a naturally high intertemporal elasticity of substitution for the purchases of durables and temporarily low marginal costs associated with economic contractions.

Fixed Costs and Long-Lived Investments

Neoclassical investment models predict that firms should make frequent, small adjustments to their capital stocks. Microeconomic evidence, however, shows just the opposite -- firms make infrequent, large adjustments to their capital stocks. In response, researchers have developed models with fixed costs of adjustment to explain the data. While these models generate the observed firm-level investment behavior, it is not clear that the aggregate behavior of these models differs importantly from the aggregate behavior of neoclassical models. This is important since most of our existing understanding of investment is based on models without fixed costs. Moreover, models with fixed costs have non-degenerate, time-varying distributions of capital holdings across firms, making the models extremely difficult to analyze. This paper shows that, for sufficiently long-lived capital, (1) the cross-sectional distribution of capital holdings has virtually no bearing on the equilibrium and (2) the aggregate behavior of the fixed-cost model is virtually identical to that of the neoclassical model. The findings are due to a near infinite elasticity of investment timing for long-lived capital goods -- a feature that fixed-cost models and neoclassical models share. The analysis shows that the so-called "irrelevance results" obtained in recent numerical studies of fixed-cost models are not parametric special cases but instead reflect fundamental properties of long-lived investments.

Hydrolysis of Dihydrouridine and Related Compounds

Dihydrouridine is absent from the tRNA of almost all hyperthermophiles and most Archaea but is ubiquitous in the tRNA of Eubacteria and Eukaryotes. In order to investigate whether this could be due to instability, the rate of ring opening of dihydrouridine was measured between 25 and 120 C. The dihydrouridine ring is stable at 25 C, but the half-life at 100 C and pH 7 is 9.1 h, which is comparable to the doubling time of hyperthermophiles. This suggests an explanation for the absence of dihydrouridine from the tRNA of hyperthermophiles. The rates of ring opening of dihydrouracil, dihydrothymine, and 1-N-methyldihydrouracil were measured at 100 C and pH 6-9, as were the equilibrium constants for ring closure of the ureido acids to the dihydrouracils. The pH rate profiles for ring opening and ring closing were calculated from the data. Possible roles for dihydrouracils in the pre-RNA world are discussed

Managing Markets for Toxic Assets

We present a model in which banks trade toxic assets to raise funds for investment. The toxic assets generate an adverse selection problem and, as a consequence, the interbank asset market provides insufficient liquidity to finance investment. While the best investments are fully funded, socially efficient projects with modest payoffs are not. Investment is inefficiently low because acquiring funding requires banks to sell high-quality assets for less than their "fair" value. We then consider whether equity injections and asset purchases can improve market outcomes. Equity injections do not improve liquidity and may be counterproductive as a policy for increasing investment. By allowing banks to fund investments without having to sell high-quality assets, equity injections reduce the number of high-quality assets traded and further contaminate the interbank market. Paradoxically, if equity injections are directed to firms with the greatest liquidity needs, the contamination effect causes investment to fall. In contrast, asset purchase programs, like the Public-Private Investment Program, often have favorable impacts on liquidity, investment and welfare.