Recent Developments in Business Cycle Theory: News, Expectations and Demand Shocks

This paper surveys some recent work in the theory of business cycles, which emphasizes the role of public news and consumer expectations as driving forces behind short-run aggregate fluctuations. The paper uses a simple two period model to introduce and discuss three issues regarding this class of models: (1) what is the role of nominal rigidities, (2) what are the testable implications of these models, (3) what are their implications for monetary policy.

Inefficient Credit Booms

This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.

A Theory of Demand Shocks

This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. Agents are hit by heterogeneous productivity shocks, they observe their own productivity and a noisy public signal regarding aggregate productivity. The shock to this public signal, or "news shock," has the features of an aggregate demand shock: it increases output, employment and inflation in the short run and has no effects in the long run. The dynamics of the economy following an aggregate productivity shock are also affected by the presence of imperfect information: after a productivity shock output adjusts gradually to its higher long-run level, and there is a temporary negative effect on inflation and employment. A calibrated version of the model is able to generate realistic amounts of short-run volatility due to demand shocks, in line with existing time-series evidence. The paper also develops a simple method to solve forward-looking models with dispersed information.

News Shocks and Optimal Monetary Policy

This paper studies monetary policy in a model where output fluctuations are caused by shocks to public beliefs on the economy's fundamentals. I ask whether monetary policy can offset the effect of these shocks and whether this offsetting is socially desirable. I consider an environment with dispersed information and two aggregate shocks: a productivity shock and a "news shock" which affects aggregate beliefs. Neither the central bank nor individual agents can distinguish the two shocks when they hit the economy. The main results are: (1) despite the lack of superior information an appropriate monetary policy rule can change the economy's response to the two shocks; (2) monetary policy can achieve full aggregate stabilization, that is, it can induce a path for aggregate output that is identical to that which would arise under full information; (3) however, full aggregate stabilization is typically not optimal. The fact that monetary policy can tackle the two shocks separately is due to two crucial ingredients. First, agents are forward looking. Second, current fundamental shocks will become public information in the future and the central bank will be able to respond to them at that time. By announcing its response to future information, the central bank can influence the expected real interest rate faced by agents with different beliefs and, thus, induce an optimal use of the information dispersed in the economy.

Liquidity and Trading Dynamics

How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.

Bubbles and Self-Enforcing Debt

We characterize equilibria with endogenous debt constraints for a general equilibrium economy with limited commitment in which the only consequence of default is losing the ability to borrow in future periods. First, we show that equilibrium debt limits must satisfy a simple condition that allows agents to exactly roll over existing debt period by period. Second, we provide an equivalence result, whereby the resulting set of equilibrium allocations with self-enforcing private debt is equivalent to the allocations that are sustained with unbacked public debt or rational bubbles; for the latter, there exist well known existence and characterization results. In contrast to the classic result by Bulow and Rogoff (AER 1989), positive levels of debt are sustainable in our environment because the interest rate is sufficiently low to provide repayment incentives.

Financial Frictions, Investment and Tobin's q

We develop a model of investment with financial constraints and use it to investigate the relation between investment and Tobin’s q. A firm is financed partly by insiders, who control its assets, and partly by outside investors. When insiders’ wealth is scarce, they earn a rate of return higher than the market rate of return, i.e. insiders earn a quasi-rent on invested capital. This rent is priced into the value of the firm, so Tobin’s q is driven by two forces: changes in the value of invested capital, and changes in the value of the insiders’ future rents. The second effect weakens the correlation between q and investment. We calibrate the model and show that, thanks to this effect, the model can generate realistic correlations between investment, q and cash flowFinancial constraints, Tobin's q, limited enforcement, investment, optimal capital structure

Financial Frictions, Investment and Tobin's q

We develop a model of investment with financial constraints and use it to investigate the relation between investment and Tobin's q. A firm is financed partly by insiders, who control its assets, and partly by outside investors. When their wealth is scarce, insiders earn a rate of return higher than the market rate of return, i.e., they receive a quasi-rent on invested capital. This rent is priced into the value of the firm, so Tobin's q is driven by two forces: changes in the value of invested capital, and changes in the value of the insiders' future rents per unit of capital. This weakens the correlation between q and investment, relative to the frictionless benchmark. We present a calibrated version of the model, which, due to this effect, generates realistic correlations between investment, q, and cash flow.

Credit Crises, Precautionary Savings, and the Liquidity Trap

We study the effects of a credit crunch on consumer spending in a heterogeneous-agent incomplete-market model. After an unexpected permanent tightening in consumers’ borrowing capacity, some consumers are forced to deleverage and others increase their precautionary savings. This depresses interest rates, especially in the short run, and generates an output drop, even with flexible prices. The output drop is larger with nominal rigidities, if the zero lower bound prevents the interest rate from adjusting downwards. Adding durable goods to the model, households take larger debt positions and the output response may be larger.

Reductions of the dispersionless 2D Toda hierarchy and their Hamiltonian structures

We study finite-dimensional reductions of the dispersionless 2D Toda hierarchy showing that the consistency conditions for such reductions are given by a system of radial Loewner equations. We then construct their Hamiltonian structures, following an approach proposed by Ferapontov.Comment: 15 page