Research

WORKING PAPERS

Risky Business Cycles [NBER WP] [NBER Summer Institute Slides] (with Susanto Basu, Ryan Chahrour, and Rosen Valchev) R&R at the Journal of Political Economy

We identify a shock that explains the bulk of fluctuations in the equity risk premium, and show that the shock also explains a large fraction of the business-cycle comovements of output, consumption, employment, and investment. Recessions induced by the shock are associated with reallocation away from full-time labor positions, and towards part-time and flexible contract workers. We develop a novel real model with labor market frictions and fluctuations in risk appetite, where a “flight-to-safety” reallocation from riskier to safer factors of production precipitates a recession that can explain the data, since the safer factors offer lower marginal products in equilibrium. 

Managing Expectations with Exchange Rate Policy (with Pierre De Leo and Luca Gemmi) 

Should exchange rate policy communication be transparent or intentionally opaque? We show that it depends on whether expectations depart from rationality. We develop a macroeconomic model in which agents overreact to their private information about fundamentals and use the exchange rate as a public signal to learn about the private information of others. In this environment, central bank communication surrounding foreign exchange (FX) interventions can influence the information content of the ex- change rate and can be used to “manage expectations.” While FX interventions that are publicly announced provide additional information about fundamentals, secret FX inter- ventions instead alter the informational content of the exchange rate. If the overreaction bias is strong enough, it is optimal to intervene secretly to limit the informativeness of the exchange rate. Our model rationalizes observed practices in exchange rate policies such as managed floats and the opacity surrounding FX interventions. 

PUBLICATIONS

Using survey data, we document that predictable exchange rate forecast errors are responsible for the uncovered-interest-parity (UIP) puzzle and its reversal at longer horizons. We develop a general-equilibrium model based on shock misperception and over-extrapolative beliefs that reconciles these and other major exchange rate puzzles. These beliefs distortions generate both under- and over-reaction of expectations that account for the predictability of forecast errors about interest rates, exchange rates, and other macroeconomic indicators. In the model, forecast errors are endogenous to monetary policy and explain the change in the behavior of UIP deviations that emerged after the global financial crisis. Our findings point to an important role of beliefs distortions in exchange rate dynamics.

Do the benefits of central bank transparency depend on the structure of financial markets? We address this question in a two-country model with dispersed information among price-setting firms. The volatility of the real exchange rate is non-monotonic in the precision of public communications. Despite this non-monotonicity, under complete markets, greater provision of public information always improves welfare and full transparency is optimal. By contrast, under incomplete markets, more accurate public signals can decrease welfare by exacerbating the cost of cross-country demand imbalances. If the trade elasticity is low, optimal public announcements are intentionally imprecise.

Default recovery rates in the US are highly volatile and pro-cyclical. We show that state-of-the-art models with a Bernanke-Gertler-Gilchrist financial accelerator mechanism imply that recovery rates are flat over the cycle. We propose a model where financially-constrained entrepreneurs face an idiosyncratic cost of redeploying liquidated capital. The resulting endogenous liquidation costs magnify the effect of the financial accelerator. We fit the model to US data and find that it explains a substantial amount of variation in recovery rates, including their sharp contraction at the onset of the Great Recession.  Our mechanism delivers a more flexible relationship between credit spreads and macroeconomic variables and leads to novel policy implications about the effectiveness of subsidies for liquidated assets.

In models with financial frictions, state-contingent contracts stabilize the business cycle relative to contracts with predetermined repayments. We show that this finding depends on whether predetermined repayments are set in real or nominal terms. State-contingent contracts may amplify supply-driven recessions compared to contracts set in nominal terms.

We develop a tractable model to study jointly the role of non-diversifiable risk and financial frictions for business cycles. Non-diversifiable risk induces strong precautionary motives, which reduce the exposure of entrepreneurs to aggregate disturbances ex-ante, and make it easier to increase leverage ex-post. In general equilibrium, these precautionary motives dampen fluctuations in asset prices and risk premia, thus making the economy more resilient to financial shocks. We provide microeconomic evidence consistent with the model’s predictions about firm behavior. 

Real exchange rates are highly volatile and persistent. I provide a novel structural explanation for these facts using a model with dispersed information among firms. When producers face strategic complementarities in price-setting, uncertainty about competitors’ beliefs results in sluggish price adjustment that can generate large and long-lived real exchange rate movements. I estimate the model using data from the US and Euro Area, and show that it successfully explains the unconditional volatility and persistence of the real exchange rate. The model also accounts for the persistent and hump-shaped real exchange rate behavior conditional on nominal disturbances documented by a structural VAR. About 50% of this persistence is due to the inertial dynamics of higher-order beliefs.