Dynamic Indeterminacy and Welfare in Credit Economies (joint with Zach Bethune and Tai-Wei Hu)
We characterize the equilibrium set and constrained-efficient allocations of a pure credit economy with limited commitment under both pairwise and centralized meetings. We show that the set of equilibria derived under "not-too-tight" solvency constraints (Alvarez and Jermann, 2000; Gu et al., 2013b) is of measure zero in the whole set of Perfect Bayesian Equilibria. There exist a continuum of endogenous credit cycles of any periodicity and a continuum of sunspot equilibria, irrespective of the assumed trading mechanism. Moreover, any equilibrium allocation of the corresponding monetary economy is an equilibrium allocation of the pure credit economy but the reverse is not true. On the normative side, we establish conditions under which the Second Welfare Theorem of Alvarez and Jermann (2000) fails to apply, i.e., constrained-efficient allocations cannot be implemented with "not-too-tight" solvency constraints.
Competing for Order Flow in OTC markets (joint with Ben Lester and Pierre-Olivier Weill)
We develop a model of a two-sided asset market with the following characteristics: (i) Trades are intermediated by dealers and are bilateral; (ii) Dealers compete to attract order flow by posting the terms at which they execute trades, which can include prices, quantities, and execution times; (iii) Investors direct their orders toward dealers that offer the most attractive terms of trade. Equilibrium outcomes have the following properties. First, investors face a trade-off between trading costs and speeds of execution. Second, the asset market is endogenously segmented in the sense that investors with different asset valuations and different asset holdings will trade at different speeds and different costs. Third, dealers' implicit bargaining powers are endogenous and typically vary across submarkets. As an example, under a Leontief technology to match investors and dealers, per unit trading costs decrease with the size of the trade, in accordance with the evidence from the market for corporate bonds. Finally, we obtain a rich set of comparative statics both analytically, by studying a limiting economy where trading frictions are small, and numerically. For instance, we find that the relationship between trading costs and dealers' bargaining power can be hump-shaped.
Financial Frictions, The Housing Market, and Unemployment (joint with Bill Branch and Nicolas Petrosky-Nadeau)
We develop a two-sector search-matching model of the labor market with imperfect mobility of workers, augmented to incorporate a housing market and a frictional goods market. Homeowners use home equity as collateral to finance idiosyncratic consumption opportunities. A financial innovation that raises the acceptability of homes as collateral raises house prices and reduces unemployment. It also triggers a reallocation of workers, with the direction of the change depending on firms' market power in the goods market. A calibrated version of the model under adaptive learning can account for house prices, sectoral labor flows, and unemployment rate changes over 1996-2010.
Limelight on Dark Markets: Theory and Experimental Evidence on Liquidity and Information (Joint with Aleksander Berentsen and Mike McBride)
We investigate how informational frictions affect trading in OTC markets in theory and in a laboratory setting. Subjects, matched pairwise at random, trade divisible commodities that have different private values for a divisible asset with a common value. We compare a bargaining game with complete information with a bargaining game where agents can produce fraudulent assets at some cost and are privately informed about the quality of their assets. The threat of fraud strongly reduces the subjects' ability to exploit the gains from trade, and it reduces significantly both the size of the trade and the acceptability of the asset.