Financial crashes were followed by deep recessions in the Sudden Stops of emerging economies. An equilibrium business cycle model with a collateral constraint explains this phenomenon as a result of ...the amplification and asymmetry that the constraint induces in the responses of macro-aggregates to shocks. Leverage rises during expansions, and when it rises enough it triggers the constraint, causing a Fisherian deflation that reduces credit and the price and quantity of collateral assets. Output and factor allocations fall because access to working capital financing is also reduced. Precautionary saving makes Sudden Stops low probability events nested within normal cycles, as observed in the data.
Collateral constraints widely used in models of financial crises feature a pecuniary externality: Agents do not internalize how borrowing decisions made in “good times” affect collateral prices ...during a crisis. We show that under commitment the optimal financial regulator’s plans are time inconsistent and study time-consistent policy. Quantitatively, this policy reduces sharply the frequency and magnitude of crises, removes fat tails from the distribution of asset returns, and increases social welfare. In contrast, constant debt taxes are ineffective and can be welfare reducing, while an optimized “macroprudential Taylor rule” is effective but less so than the optimal time-consistent policy.
How big (small?) are fiscal multipliers? Ilzetzki, Ethan; Mendoza, Enrique G.; Végh, Carlos A.
Journal of monetary economics,
03/2013, Volume:
60, Issue:
2
Journal Article
Peer reviewed
Open access
Contributing to the debate on the macroeconomic effects of fiscal stimuli, we show that the impact of government expenditure shocks depends crucially on key country characteristics, such as the level ...of development, exchange rate regime, openness to trade, and public indebtedness. Based on a novel quarterly dataset of government expenditure in 44 countries, we find that (i) the output effect of an increase in government consumption is larger in industrial than in developing countries; (ii) the fiscal multiplier is relatively large in economies operating under predetermined exchange rates but is zero in economies operating under flexible exchange rates; (iii) fiscal multipliers in open economies are smaller than in closed economies; (iv) fiscal multipliers in high-debt countries are negative.
► We estimate the fiscal multiplier using an SVAR with a new quarterly database. ► The fiscal multiplier is larger in industrial than in developing countries. ► The fiscal multiplier is larger under fixed than under flexible exchange rates. ► Fiscal multipliers in open economies are smaller than in closed economies. ► Fiscal multipliers in high-debt countries are negative.
We study optimal macroprudential policy in a model in which unconventional shocks, in the form of news about future fundamentals and regime changes in world interest rates, interact with collateral ...constraints in driving the dynamics of financial crises. These shocks strengthen incentives to borrow in good times (i.e. when “good news” about future fundamentals coincide with a low-world-interest-rate regime), thereby increasing vulnerability to crises and enlarging the pecuniary externality due to the collateral constraints. Quantitatively, an optimal schedule of macroprudential debt taxes can lower the frequency and magnitude of financial crises, but the policy is complex because it features significant variation across interest-rate regimes and news realizations.
•We investigate the macroprudential policy design with news and interest rate shocks.•Good news and low interest rate raise the vulnerability to financial crises.•Macroprudential policy requires significant variation across states.
Global financial imbalances can result from financial integration when countries differ in financial markets development. Countries with more advanced financial markets accumulate foreign liabilities ...in a gradual, long‐lasting process. Differences in financial development also affect the composition of foreign portfolios: countries with negative net foreign asset positions maintain positive net holdings of nondiversifiable equity and foreign direct investment. Three observations motivate our analysis: (1) financial development varies widely even among industrial countries, with the United States on top; (2) the secular decline in the U.S. net foreign asset position started in the early 1980s, together with a gradual process of international financial integration; (3) the portfolio composition of U.S. net foreign assets features increased holdings of risky assets and a large increase in debt.
Why are episodes of sovereign default accompanied by deep recessions? The existing literature cannot answer this question. On one hand, sovereign default models treat income fluctuations as an ...exogenous endowment process with ad hoc default costs. On the other hand, emerging markets business cycle models abstract from modeling default and treat default risk as part of an exogenous interest rate on working capital. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing, and default triggers an efficiency loss as these inputs are replaced by imperfect substitutes, because both firms and the government are excluded from credit markets. Default is an optimal decision of a benevolent planner for whom, even after internalizing the adverse effects of default on economic activity, financial autarky has a higher payoff than debt repayment. The model explains the main features of observed cyclical dynamics around defaults, countercyclical spreads, high debt ratios, and key long-run business cycle moments.
Financial innovation and overconfidence about the risk of new financial products were key factors behind the 2008 U.S. credit crisis. We show that a model with a collateral constraint in which ...learning about the risk of a new financial environment interacts with Fisherian amplification produces a boom–bust cycle in debt, asset prices and consumption. Early realizations of a high-borrowing-ability regime turn agents optimistic about the persistence probability of this regime. Conversely, the first realization of a low-borrowing-ability regime turns agents unduly pessimistic. The model predicts large increases in household debt, land prices and excess returns during 1998–2006 followed by a collapse.
•Financial innovation and overconfidence about asset values and the riskiness of new financial products were important factors behind the U.S. credit crisis.•Recent crisis was preceded by two key facts: First, increases in household credit, residential land prices, and leverage ratios.•Second, financial innovation of a scope and magnitude unseen since the aftermath of the Great Depression.•We propose a model where collateral constraints and learning about riskiness of a new financial regime interact to produce amplification.•The model predicts big surges in household debt, land prices and excess returns during 1998-2006 followed by a collapse.
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