Working Papers

Finance and Economics Discussion Series 2015-031. Washington: Board of Governors of the Federal Reserve System

We present a model in which endogenous liquidity generates a feedback loop between secondary market liquidity and firm’s financing decisions in primary markets. The model features two key frictions: a costly state verification problem in primary markets, and search frictions in over-the-counter secondary markets. Our concept of liquidity depends endogenously on illiquid assets put up for sale by impatient investors relative to the resources available for buying those assets. The endogenous nature of liquidity creates a feedback loop as issuance in primary markets affects secondary market liquidity, and vice versa through liquidity premia. We show that the privately optimal allocations are inefficient because investors and firms fail to internalize how their respective behavior affects secondary market liquidity. These inefficiencies are established analytically through a set of wedge expressions for key efficiency margins. Our analysis provides a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy.

Mortgage subsidies are expected to help borrowers, as house-price subsidies help home buyers. In contrast, in this paper, I show that when debt is used to finance asset purchases, debt subsidies can actually harm borrowers. I decompose the welfare effect of mortgage subsidies for these agents in terms of quantifiable expressions, and estimate the effect using data for the U.S. I demonstrate that mortgage subsidies hurt borrowers who take shorter-term loans, use low loan-to-values, or invest in regions where the elasticity of supply is constrained. For instance, a 100 basis point reduction in mortgage rates in California, for the median borrower with a 15-year mortgage, is estimated to reduce his welfare by 220 basis points of the house value.

“A Dynamic Model of Leverage and Interest Rates”. (available upon request)

I study a dynamic model where both leverage and interest rates are determined in equilibrium. The model considers risk neutral agents, or equivalently agents with an infinite elasticity of inter-temporal substitution. In this setting without financial frictions the risk-free rate is given by the discount rate of agents. However, I show that the introduction of collateral constraints creates a wedge between the equilibrium risk-free rate and agents’ rate of discount. The collateral constraint limits arbitrage and some agents enjoy risk-adjusted returns that are higher than the equilibrium risk-free rate. In a dynamic setting the possibility of enjoying these excess returns in the future makes agents willing to lend today at lower risk-free rates relative to their rate of preferences. Excess returns are expected to be larger when leverage is expected to be lower, so a more severe expected collapse in leverage increases the wedge between the rate of preferences and the equilibrium risk-free rate, i.e. reduces the risk-free rate. At the same time, the model predicts that this will increase risk premiums on debts that default when leverage is expected to be low.

“A Discrete-Time Macroeconomic Model with a Financial Sector”, with Kieran Walsh[slides]

“The Effect of Banks’ Financial Position on Credit Growth: Evidence from OECD Countries”Appendix. [slides]

This paper presents empirical evidence on the effect of banks’ financial position on credit growth using a sample of 29 OECD countries. The failure of the exogeneity assumption of explanatory variables is addressed using dynamic panel type instruments. The empirical results show that among capital, profits and liquidity at the end of the previous year, capital is the most important predictor of credit growth in the current year. The relationship between capital and credit growth is non-linear. Point estimates from the preferred econometric specification imply that at the sample mean a one standard deviation increase (decrease) is associated with an increase (decrease) of 0.8 (0.3) percentage points in credit growth upon impact and 1.6 (0.6) percentage points in the long-run.

“Market Liquidity, Investment and Unconventional Monetary Policy”, with David M. Arseneau and Alexandros P. Vardoulakis. [slides]

 Publications by Topic

Exchange Rates

“Exchange Rate and Foreign Investment Limits of Pension Funds” (with Kevin Cowan and Jorge Selaive), Financial Stability Report, Second Semester 2007, Central Bank of Chile, 2008. Extended English version Working Paper 433 Central Bank of Chile, 2007.

Micro Level Prices

“Dynamics of Price Adjustment: Evidence from Micro Level data for Chile” (with Juan Pablo Medina and Claudio Soto), Journal Economia Chilena, Vol. 10(2), pgs. 5-26, 2007. Available in English as Working Paper 432 Central Bank of Chile, 2007.

Higher Education

“Variability of Occupational Earnings” (with Bernardo Lara and Patricio Meller), In: P. Meller (ed.) Carreras Universitarias: Rentabilidad, Selectividad y Discriminacion, Uqbar Editores, 2010.

“Are Universities the Best Alternative for a Professional Degree? Chilean Evidence” (with Patricio Meller), El Trimestre Economico, 2008 (in Spanish). Reprinted In: P. Meller (ed.) Carreras Universitarias: Rentabilidad, Selectividad y Discriminacion, Uqbar Editores, 2010.

“New Methodology for a Ranking of Chilean Universities” (with Patricio Meller), Quality in Education, N°25, December, pp. 55-77, 2006.

“International Comparisons of the stock of professionals and the relative position of Chile” (with Patricio Meller), In: J. J. Brunner and P. Meller (eds.) Oferta y Demanda de profesionales y tecnicos en Chile: El Rol de la Informacion Publica, Ril, 2004.

Country Studies

“Economic Perspective of Korea” (with Andres Liberman and Patricio Meller), In: Roads to Development, Ministry of Foreign Relations, Chile, 2009.

“The Governmental Petroleum Fund of Norway” (with Luis Felipe Cespedes), Journal Economia Chilena, Vol. 91(1), pgs. 71-78, 2006.