Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

We study the trading dynamics in an asset market where the quality of assets is private information of the owner and finding a counterparty takes time. When trading of a financial asset ceases in equilibrium as a response to an adverse shock to asset quality, a large player can resurrect the market by purchasing bad assets which involves financial losses. The equilibrium response to such a policy is intricate as it creates an announcement effect: a mere announcement of intervening at a later point in time can cause markets to function again. This effect leads to a gradual recovery in trading volume, with asset prices converging non-monotonically to their normal values. The optimal policy is to intervene immediately at a minimal scale when markets are deemed important and losses are small. As losses increase and the importance of the market declines, the optimal intervention is delayed and it can be desirable to rely more on the announcement effect by increasing the size of the intervention. Search frictions are important for all these results. They compound adverse selection, making a market more fragile with respect to a classic lemons problem. They dampen the announcement effect and cause the optimal policy to be more aggressive, leading to an earlier intervention at a larger scale.Trading Dynamics, Adverse Selection, Search, Intervention in Asset Markets, Announcement Effect

Liquidity, Redistribution, and the Welfare Cost of Inflation

This paper studies the long run welfare costs of inflation in a micro-founded model with trading frictions and costly liquidity management. Agents face uninsurable idiosyncratic uncertainty regarding trading opportunities in a decentralized goods market and must pay a fixed cost to rebalance their liquidity holdings in a centralized liquidity market. By endogenizing the participation decision in the liquidity market, this model endogenizes the responses of velocity, output, the degree of market segmentation, as well as the distribution of money. We find that, compared to the traditional estimates based on a representative agent model, the welfare costs of inflation are significantly smaller due to distributional effects of inflation. The welfare cost of increasing inflation from 0% to 10% is 0.62% of income for the U.S. economy and 0.20% of income for the Canadian economy. Furthermore, the welfare cost is generally non-linear in the rate of inflation, depending on the endogenous responses of the liquidity market participation to inflation and liquidity management costs.Inflation: costs and benefits

Uncertainty, Inflation, and Welfare

This paper studies the welfare costs and the redistributive effects of inflation in the presence of idiosyncratic liquidity risk, in a micro-founded search-theoretical monetary model. We calibrate the model to match the empirical aggregate money demand and the distribution of money holdings across households, and study the effects of inflation under the implied degree of market incompleteness. We show that in the presence of imperfect insurance the estimated long-run welfare costs of inflation are on average 40% smaller compared to a complete markets, representative agent economy, and that inflation induces important redistributive effects across households. For example, the welfare gains of reducing inflation from 10% to 0% is 0.59% of income. Furthermore, we estimate that the long-run welfare gains of reducing the typical current inflation target of 2 to 1 percent to be 0.06% of income.Inflation: costs and benefits; Monetary policy framework

Financial Intermediation, Liquidity and Inflation

This paper develops a search-theoretic model to study the interaction between banking and monetary policy and how this interaction affects the allocation and welfare. Regarding how banking affects the welfare costs of inflation: First, we find that, with banking, inflation generates smaller welfare costs. Second, we show that, lowering inflation improves welfare not just by reducing consumption/production distortions, but also by avoiding intermediation costs. Therefore, understanding the nature of intermediation cost is critical for accurately assessing the welfare gain of lowering the inflation target. Regarding how monetary policy affects the welfare effects of banking: First, banking always improves efficiency of production, but the banking technology has to be efficient to improve welfare (especially in low inflation economy). Second, welfare effects of banking depend on monetary policy. For low inflation, banking is not active. For high inflation, banking is active and improves welfare. For moderate inflation, banking is active but reduces welfare. Owing to general equilibrium feedback, banking is supported in equilibrium even though welfare is higher without banking.Monetary policy framework

Innovation and Growth with Financial, and Other, Frictions

The generation and implementation of ideas, or knowledge, is crucial for economic performance. We study this process in a model of endogenous growth with frictions. Productivity increases with knowledge, which advances via innovation, and with the exchange of ideas from those who generate them to those best able to implement them (technology transfer). But frictions in this market, including search, bargaining, and commitment problems, impede exchange and thus slow growth. We characterize optimal policies to subsidize research and trade in ideas, given both knowledge and search externalities. We discuss the roles of liquidity and financial institutions, and show two ways in which intermediation can enhance efficiency and innovation. First, intermediation allows us to finance more transactions with fewer assets. Second, it ameliorates certain bargaining problems, by allowing entrepreneurs to undo otherwise sunk investments in liquidity. We also discuss some evidence, suggesting that technology transfer is a significant source of innovation and showing how it is affected by credit considerations.Economic models; Potential output; Productivity

Innovation and growth with financial, and other, frictions

The generation and implementation of ideas, or knowledge, is crucial for economic performance. We study this process in a model of endogenous growth with frictions. Productivity increases with knowledge, which advances via innovation, and with the exchange of ideas from those who generate them to those best able to implement them (technology transfer). But frictions in this market, including search, bargaining, and commitment problems, impede exchange and thus slow growth. We characterize optimal policies to subsidize research and trade in ideas, given both knowledge and search externalities. We discuss the roles of liquidity and financial institutions, and show two ways in which intermediation can enhance efficiency and innovation. First, intermediation allows us to finance more transactions with fewer assets. Second, it ameliorates certain bargaining problems, by allowing entrepreneurs to undo otherwise sunk investments in liquidity. We also discuss some evidence, suggesting that technology transfer is a significant source of innovation and showing how it is affected by credit considerations.

Liquidity Provision and Collateral Haircuts in Payments Systems

Central banks play a pivotal role in well-functioning payments systems by providing liquidity via collateralized lending. This article discusses the role of collateral and haircut policy in central bank lending, as well as the distinguishing features of the central bank’s policy relative to private sector practices. It presents a model that explicitly incorporates the unique role of central banks in the payments system and argues that central banks must consider how their haircut policies affect the relative price and liquidity of assets, the market’s asset allocation, and the likelihood of participants to default. Furthermore, under extraordinary circumstances, there is a rationale for the central bank to temporarily reduce haircuts or broaden the list of eligible collateral to mitigate the shortage of liquidity in the market.

A Model of Tiered Settlement Networks

This paper develops a model of settlement system to study the endogenous structure of settlement networks, and the welfare consequences of clearing agent failure. The equilibrium degree of tiering is endogenously determined by the cost structure and the information structure. The degree of tiering is decreasing in the fixed cost of operating the second-tier network and the availability of public credit history. Furthermore, the welfare effects of clearing agent failure can be decomposed into operational inefficiency and the loss of private information.Payment, clearing, and settlement systems