24 research outputs found
Endogenous Market Turbulence
In this paper I study a nonlinear feedback trading model which can generate stable, unstable, turbulent or chaotic asset returns depending on market conditions. The dynamics are driven by the stochastic price impact of net order flow (inverse market liquidity). If price impact grows beyond exogenous threshold values, liquidity dries up and asset returns become turbulent. In the absence of fundamental factors, the occurrence of turbulence and chaos is entirely endogenous. The results highlight the critical role of maintaining stable market-making conditions for averting “liquidity black holes”
Fear of Floating and Social Welfare
This paper studies the welfare implications of financial stability and inflation stabilization as distinct monetary policy objectives. Introducing asymmetric aversion to exchange rate depreciation in the Barro-Gordon model mitigates inflation bias due to credibility problems. The net welfare impact of fear of floating depends on the economy’s recent track record, the credibility of monetary policy, and the central bank’s discount factor. It is shown that fear of floating is more appropriate for financially fragile developing countries with imperfectly credible monetary policy than for advanced economies
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On strategic default and liquidity risk
How does the uncertain provision of external finance affect investment projects' default probability and liquidity risk? In this paper, I study the strategic interaction between many creditors and a single borrower in the context of a two-period investment project requiring external credit. Loans mature in one period but the project requires two periods to complete. The key working assumptions are that creditors are risk-averse and that any uncertainty is common knowledge: information about the fundamentals can be incomplete but not asymmetric. Mixed and perfect Bayesian strategies are used to compute the equilibrium probabilities of default and early liquidation. The impact of the maturity structure on default and liquidity risk is a function of the underlying structural and stochastic parameters and investors' beliefs about the state of fundamentals. The implications for banking regulation are assessed under fixed and variable loan rates. An open range of fundamentals is derived outside of which default and liquidity risk are either zero or one. The cyclical properties of default and liquidity risk are shown to depend sensitively on the relative cost of early liquidation to the borrower and the creditors, hence also on the regulatory policy stance
Optimal Monetary Policy with a Convex Phillips Curve
This paper shows that convexity of the short-run Phillips curve is a source of positive inflation bias even when policymakers target the natural unemployment rate, that is when they operate with prudent discretion, and their loss function is symmetric. Optimal monetary policy also induces positive co-movement between average inflation, average unemployment and inflation variability---suggesting a new motive for inflation stabilization policy---and positively skewed unemployment distributions. The reduced form model is applied to the post-disinflation period (1986-2006) in developed countries and its properties are illustrated numerically for the United States.