Working Papers
Working Papers
Excessive sales of real assets, while an essential feature of many canonical models of inefficient credit booms, are absent in many busts following credit booms. I show that credit booms and their implied volatility can be ex-ante constrained inefficient in the absence of any liquidation markets, not because of excessive liquidation of existing assets but due to insufficient creation of new ones: credit booms are constrained inefficient because credit supply is too low during the downturn. Constrained inefficiency can arise because ex-ante, higher level of initial credit has a negative pecuniary externality on future entrepreneurs through the future loan rate, whenever both entrepreneurs and intermediaries are financially constrained in the bad future state. I demonstrate that the absence of contingent debt is important for constrained inefficiency and show that contingent forward contracts can lead to Pareto improvement. An ex-ante excessive level of credit requires a low enough level of initial intermediaries' net worth. Macro-prudential policies, e.g., countercyclical capital buffers, that increase intermediaries' leverage in downturns can induce an excessive level of credit to the private sector ex-ante.
It is challenging for the existing models of fire sales to explain the simultaneous collapse in the price and trade volume of subprime mortgage-backed securities (MBS) during the Financial Crisis of 2007-2008. I show that this combination can naturally arise even in the absence of asymmetric information and even when informed capital is not scarce. With decentralized trade and endogenous participation, buyers’ decisions to wait to trade at an even lower price in the future can become strategic complements. Complementarity arises, if buying capacity is more than forced selling needs and selling pressures are expected to increase over time. This complementarity makes decentralized markets prone to coordination failures: buyers' waiting to trade at a lower price in the future can lead to a collapse in the current price and trade volume. Fire sales can have larger price impact in more liquid markets. Fire sales may also be inefficient.
How can low consumer spending cause an inefficient recession or recovery? We propose a theory, in which aggregate demand shortages are the result of aggregate demand externalities stemming from financial frictions rather than nominal rigidities. In our theory, an economy can be demand constrained when, i) consumption goods and assets used as saving vehicles are \textit{not} perfect substitutes, ii) productivity in the consumption goods sector can be improved or maintained via investment, and iii) external financing of this investment is subject to a tight enough borrowing constraint. In a demand-constrained equilibrium, a saving tax can increase consumption, investment, employment, output, and welfare. A tighter firms' borrowing constraint implies more severe aggregate demand shortages in a demand-constrained equilibrium. We use stylized extensions of our benchmark model to show how financial shocks can create demand-constrained recessions. Our theory suggests that fiscal rather than monetary policy might become the primary policy tool to restore the efficiency under certain conditions. Demand management policies might be necessary over a long period of time. The "potential", i.e., the constrained efficient allocation, may depend on both supply and demand factors.
What do low and declining rates imply about fiscal sustainability? I show that government bond becomes a safe asset when government default significantly reduces the returns to other assets. A more systemic government debt can compress not only the level but the changes in government bond yields. When government bond is a safe asset, it can have an upward-sloping demand curve for intermediate levels of borrowing and up to an inflection point. This happens because more borrowing increases aggregate risk and demand for safety, while government bond remains the relatively safer asset. The existence of an upward-sloping demand curve depends on the reversed hazard rate of the distribution of future tax revenues. These results suggest more caution in interpreting the currently low real rates because the price of a safe asset and its default risk can comove positively before government borrowing rates start rising again as debt levels surpass the inflection point.
This paper studies a novel type of misallocation of credit between investments of varying liquidity. One type of investment is more liquid, i.e., its return is more pledgeable, and the other is more productive; examples of liquid type may include low productivity large firms, firms with more tangible assets as in the construction and real estate sectors, and state-owned firms. Low liquidities of both investment types imply that the allocation of credit is constrained inefficient and that there is overinvestment in the liquid type. Constrained inefficient equilibria feature non-positive, i.e., one less than or equal the economy's growth rate, and yet also feature too high interest rate, too much investment and too little consumption. Financial development can reduce long-term welfare and output in a constrained inefficient equilibrium if it raises the liquidity of the liquid type. This implies that policies such as development of corporate bond markets, mortgage guarantees, securitization, and policies which facilitate collateral seizure by creditors may not be beneficial when there is overinvestment in liquid assets. I show a maximum liquid asset ratio or a simple debt tax can achieve constrained efficiency. Introducing government bonds can make Pareto improvement whenever it does not raise the interest rate.
We develop the implications of the stock–flow matching model for unemployment, vacancies, and worker flows. Workers and jobs are heterogeneous, so most worker–job pairs cannot profitably match, leading to the coexistence of unemployment and vacancies. Productivity shocks cause fluctuations in the number of jobs, which in turn cause fluctuations in other labor market variables. We derive exact expressions for employment and for worker transition rates in a finite economy and analyze their limiting behavior in a large economy. A calibrated version of the model is consistent with the observed co-movement and volatility of labor market variables.
We study empirically the link between lending (both formal and informal) and firm productivity. We do so by matching a Chinese privately-owned enterprises (POE) survey including rich information on firm financing with the Chinese Industrial Survey (CIS) data which features detailed firm balance sheet information. We find a coexistence of both formal and informal lending in a substantial fraction of POEs (hybrid group) which are large and more productive than others. While collateral constraints are crucial in declining formal lending to relatively small and unproductive firms, political connection plays an important role in preventing credit-constrained big firms from obtaining enough formal finance, which suggests significant misallocation for the hybrid firms.