"FCI-plot: Central Bank Communication Through Financial Conditions", with Ricardo Caballero, 2025
This paper examines how central banks can improve monetary policy effectiveness through enhanced communication with financial markets. We motivate our analysis with eight empirical facts that highlight the key role of volatile financial conditions in policy transmission, the pervasiveness of disagreements between the markets and the central bank, and the limitations of traditional interest rate projections for conveying policy intentions. We develop a theoretical framework consistent with these facts and investigate its implications for policy communication. Our model reveals that market participants' uncertainty about the central bank's desired financial conditions creates the possibility of misunderstandings ("tantrums") and amplifies the effects of noise trading on financial conditions. We show that directly communicating the central bank's expected financial conditions path (FCI-plot), eliminates tantrums and recruits arbitrageurs to insulate financial conditions from noise. In contrast, communicating expected interest rates alone fails to achieve these benefits. We also demonstrate that a scenario-based FCI-plot communication enhances the recruitment effect. This occurs when market participants disagree with the central bank regarding near-term scenario probabilities and seek to understand the central bank's "reaction function." Overall, FCI-plot communication enables an "agree-to-disagree" equilibrium where markets help implement the central bank's objectives despite differing views.
"FCI-star," with Ricardo Caballero and Tomas Caravello, 2025
Monetary policy transmits through financial conditions rather than the policy interest rate. Financial Conditions Indices (FCI) quantify the effect of financial conditions on future output and summarize whether "market-based policy" is tight or loose. Despite the key transmission role of financial conditions and the availability of FCIs that quantify this transmission, the current monetary policy framework remains anchored around the policy interest rate, as exemplified by the focus on r* in policy discussions. In this paper, we introduce and empirically estimate FCI*, the analogue of r*, within a framework in which financial conditions along with demand shocks drive economic activity with some inertia. Conceptually, FCI* is the level of FCI that closes the expected output gap (in this sense, our concept is the analogue of the r* interpreted as a neutral rate). Therefore, FCI gaps---the differences between the observed FCI and the FCI*---are related to output gaps. This feature enables us to infer the latent FCI* from the observed FCI and the estimated output gaps. We operationalize this idea by empirically estimating a two-equation macroeconometric model via the Kalman Filter using quarterly data from 1990Q2 to 2024Q4. Our main finding is that FCI* primarily reflects macroeconomic developments, specifically the estimated output gaps, rather than financial market developments. This finding has two important implications. First, the FCI* does not necessarily track the observed FCI, with large gaps emerging especially in recessions. Second, FCI* provides a more stable guide to monetary policy than the (neutral) r*, because the latter is influenced by financial market developments such as persistent shifts in asset valuations. Additionally, we find that the FCI gaps provide a more accurate guide to the effective monetary policy stance compared to the interest rate gaps.
"Financial Conditions Targeting," with Ricardo Caballero and Tomas Caravello, 2024
We present evidence that noisy financial flows influence financial conditions and macroeconomic activity. How should monetary policy respond to this noise? We develop a model where it is optimal for the central bank to target and (partially) stabilize financial conditions beyond their direct effect on output gaps, even though stable financial conditions are not a social objective per se. In our model, noise affects both financial conditions and macroeconomic activity, and arbitrageurs are reluctant to trade against noise due to aggregate return volatility. Our main result shows that Financial Conditions Index (FCI) targeting---announcing a (soft) FCI target and striving to maintain the actual FCI close to the target---triggers an endogeneous return volatility-reducing feedback loop that stabilizes the output gap. This improvement occurs because the policy allows arbitrageurs to absorb noise more effectively. We also demonstrate that FCI targeting is strictly superior to traditional interest rate forward guidance. Finally, we extend recent policy counterfactual methods to incorporate our model's endogenous risk reduction mechanism and apply it to U.S. data. Our estimates indicate that FCI targeting could have reduced the variance of the output gap, inflation, and interest rates by 36%, 2%, and 6%, respectively, and decreased the conditional variance of the FCI by 55%. When compared with interest rate forward guidance, it would have reduced output gap variance by 21%. The stabilizing role of FCI targeting is particularly salient during the period from 2000Q1 to 2007Q4, a period dominated by financial noise shocks.
"Türkiye's Homemade Crises", with Hakan Kara, 2025
Türkiye's response to post-pandemic inflation is a cautionary tale of how political pressure for low interest rates can trap policymakers in increasingly destabilizing policy sequences. While central banks worldwide raised interest rates to combat inflation in 2021-2023, Turkish authorities pursued the opposite strategy: cutting real rates to deeply negative levels while implementing an array of financial engineering tools, FX interventions, and financial repression policies to stabilize markets. The centerpiece was a novel FX-protected deposit scheme (KKM) that guaranteed depositors against currency depreciation, effectively shifting exchange rate risk to the government balance sheet. We provide a detailed account of this policy experiment and develop a theoretical model that captures the key mechanisms, with a focus on understanding how KKM functions and creates vulnerabilities. While using FX reserves temporarily stabilizes the exchange rate, their depletion exposes the country to sudden stops that trigger more severe currency crises. KKM provides partial relief by effectively raising rates for savers while maintaining low rates for borrowers, with government absorbing the difference. However, KKM creates vulnerability to a self-fulfilling currency and sovereign debt crisis, which explains various additional policies adopted at the time, including capital flow management, financial repression, and an eventual return to orthodox monetary policy. Türkiye's experience yields important lessons for central banks under political pressure to maintain low rates and once again highlights that there is no sustainable substitute for conventional monetary policy instrument independence.
"Stock Market Wealth and Entrepreneurship," with Gabriel Chodorow-Reich, Plamen Nenov, and Vitor Santos, 2024
We use data on stock portfolios of Norwegian households to show that stock market wealth increases entrepreneurship by relaxing financial constraints. Our research design isolates idiosyncratic variation in household-level stock market returns. An increase in stock market wealth increases the propensity to start a firm, with the response concentrated in households with moderate levels of financial wealth, for whom a 20 percent increase in wealth due to a positive stock return increases the likelihood to start a firm by about 20%, and in years when the aggregate stock market return in Norway is high. We develop a method to study the effect of wealth on firm outcomes that corrects for the bias introduced by selection into entrepreneurship. Higher wealth causally increases firm profitability, an indication that it relaxes would-be entrepreneurs’ financial constraints. Consistent with this interpretation, the pass-through from stock wealth into equity in the new firm is one-for-one.
"A Monetary Policy Asset Pricing Model," with Ricardo Caballero, 2023
We propose a model where the central bank's ("the Fed's") interpretation of macroeconomic needs drives aggregate asset prices. The Fed affects macroeconomic activity with a lag by altering aggregate asset prices. Its objective is to align future aggregate demand and supply (in expectation). We reverse engineer the aggregate asset price that implements the Fed's objective ("pystar") and derive several implications: (i) the Fed's beliefs about future macroeconomic needs (aggregate demand and supply) drive aggregate asset prices, while standard financial forces determine relative asset prices; (ii) more precise news about future aggregate demand makes output less volatile but increases asset price volatility; (iii) with aggregate demand inertia, the Fed overshoots asset prices in response to current output gaps; (iv) inflation is negatively correlated with aggregate asset prices, regardless of its source (aggregate demand or supply); and (v) belief disagreements between the central bank and the market generate a policy risk premium and potential "behind-the-curve" asset price dynamics.
"Prudential Monetary Policy," with Ricardo Caballero, 2020
[PDF--alternative to the Dropbox link] [slides]
Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors' balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP "gets in all the cracks" or not depends on the constraints faced by shadow banks.
Older Working Papers
"Durability, Deadline, and Election Effects in Bargaining," with Muhamet Yildiz, 2016
We propose a tractable model of bargaining with optimism. The distinguishing feature of our model is that the bargaining power is durable and changes only due to important events such as elections. Players know their current bargaining powers, but they can be optimistic that events will shift the bargaining power in their favor. We define congruence (in political negotiations, political capital) as the extent to which a party's current bargaining power translates into its expected payoff from bargaining. We show that durability increases congruence and plays a central role in understanding bargaining delays, as well as the finer bargaining details in political negotiations. Optimistic players delay the agreement if durability is expected to increase in the future. The applications of this durability effect include deadline and election effects, by which upcoming deadlines or elections lead to ex-ante gridlock. In political negotiations, political capital is highest in the immediate aftermath of the election, but it decreases as the next election approaches.
"Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading," with Daron Acemoglu, 2012
[slides]
A "folk theorem" maintains that competitive equilibria with asymmetric information are always (or generically) inefficient unless agents' consumption can be fully monitored by the principal (and specified in contracts). We critically evaluate these claims in the context of a general equilibrium economy with moral hazard. We allow agents' consumption to be partially monitored (e.g., employment contracts can specify how long a vacation agent takes, but not where she spends her vacation). We identify weak separability of agents' preferences between non-monitored consumption and effort as the necessary and sufficient condition for efficiency (e.g., weak separability implies how much the agent likes Bahamas vs. Hawaii is independent of her effort level). We also establish ε-efficiency when there are only small deviations from weak separability. These results delineate a range of benchmark environments under which general equilibrium has strong efficiency properties even though agents' consumption is not fully monitored.
Research on the Turkish Economy
"Türkiye'nin Enflasyon Tercihleri," with Refet Gürkaynak, Sang Seok Lee, and Burçin Kısacıkoğlu, 2022
"An Economic Look at the Village Institutes," 2006, an old term paper that I wrote as a student for an MIT course on economic history