Sunday, August 19, 2012

Princeton Initiative: Macro, Money and Finance

I just made my flight reservations to and from Newark to attend the Princeton Initiative on Macro, Money and Finance in September. I'm not sure which professor nominated me for the workshop, but I'm sure glad they did. The program looks really exciting. I'll hear lectures from professors whose papers I have read. The description of the initiative is:
Following the Princeton tradition of incorporating financial frictions in macroeconomic models - scholars like Ben Bernanke come to mind - this camp brings together top 2nd year Ph.D. students who wish to write a Ph.D. thesis at the intersections between Macroeconomics and Finance. The recent experience starting with the run-up of imbalances and bubbles in the first decade of the 21st century, followed by a severe financial crisis that ultimately led to the Great Recession, calls for new frameworks to study macro-prudential policy tools and to design a new international financial architecture. The aim of this meeting is to bridge the gap between modern finance and macroeconomics and expose the best students from across the country to macroeconomic models with financial frictions and /or non-standard expectations.
We have an assigned pre-reading, "Macroeconomics with Financial Frictions: A Survey" by Brunnermeier,  Eisenbach, and Sannikov. Here is an excerpt from the intro:

In a frictionless economy, funds are liquid and can flow to the most profi table project or to the person who values the funds most. Di fferences in productivity, patience, risk aversion or optimism determine fund flows, but for the aggregate output only the total capital and labor matter. Productive agents hold most of the productive capital and issue claims to less productive individuals. In other words, in a setting without financial frictions it is not important whether funds are in the hands of productive or less productive agents and the economy can be studied with a single representative agent in mind. In contrast, with financial frictions, liquidity considerations become important and the wealth distribution matters. External funding is typically more expensive than internal funding through retained earnings. Incentives problems dictate that productive agents issue to a large extent claims in the form of debt since they ensure that the agent exerts su fficient eff ort. However, debt claims come with some severe drawbacks: an adverse shock wipes out large fraction of the levered borrowers net worth, limiting this risk bearing capacity in the future. 
Hence, a temporary adverse shock is very persistent since it can take a long time until productive agents can rebuild their net worth through retained earnings. Besides persistence, amplifi cation is the second macroeconomic implication we cover in this survey. An initial shock is ampli ed if productive agents are forced to re-sell their capital. Since re-sales depress the price of capital, the net worth of productive agents suff ers even further (loss spiral). In addition, margins and haircuts might rise (loan-to-value ratios might fall) forcing productive agents to lower their leverage ratio (margin spiral). Moreover, a dynamic amplifi cation e ffect can kick in. The persistence of a temporary shock lowers future asset prices, which in turn feed back to lower contemporaneous asset prices, eroding productive agents' net worth even further and leading to more re-sales. 
The ampli cation eff ects can lead to rich volatility dynamics and explain the inherent instability of the fi nancial system. Even when the exogenous risk is small, endogenous risk resulting from interactions in the system can be sizable...(1-2).
There are a number of different ways to microfound financial frictions, and Brunnermeier et al survey a good variety. Some implications are surprising, like: "In certain environments the issuance of additional government bonds can even lead to a 'crowding-in eff ect' and be welfare enhancing. As (idiosyncratic) uncertainty increases, the welfare improving eff ect of higher government debt also increases. Note that unlike the stan-
dard (New-) Keynesian argument this reasoning does not rely on price stickiness and a zero lower bound on nominal interest rates" (3).

I'm looking forward to working through some of these models, thinking about the set-ups and implications more carefully, and bringing my questions to Princeton.

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