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Liquidity and Risk in Macroeconomic Models

Final Report Summary - LIQRISK (Liquidity and Risk in Macroeconomic Models)

The recent financial crisis has illustrated various shortcomings in macroeconomic theories. This project explores two different avenues in two distinct subprojects. The first subproject focuses on the heart of the recent financial crisis and the Great Recession. It asks several related questions. First, how can we explain the explosion of risk perception, measured by the VIX? Second, why did this risk perception increase simultaneously in most countries? Third, why were business cycles so correlated around the world during the Great Recession? The first part of this subproject deals with risk panics and shows a mechanism under which such panics can occur. It develops a simple and general framework where risk about the future asset price depends on uncertainty about future risk. This dynamic mapping of risk into itself gives rise to the possibility of multiple equilibria and can generate risk panics. Moreover, in a panic, risk beliefs may be coordinated around a macro fundamental that becomes a sudden focal point of the market. I also investigate the potential international contagion of risk panics, as well as policy implications. This research has been published with two papers in the American Economics Review and one paper in the Journal of International Economics.

In the other part of this subproject, I focus on the real sector and the puzzling degree of international comovements during the Great Recession. Rather than extending the work of risk panics in financial markets I take a different track, while still focusing on self-fulfilling panics. Indeed, panics could be observed at the level of consumers and firms that were not necessarily strongly exposed to financial markets. Consequently, I developed a two-country model that allows for self-fulfilling business cycle panics through shifts in aggregate demand. I show that a business cycle panic will necessarily be synchronized across countries as long as there is a minimum level of economic integration. Moreover, I show that several factors generated particular vulnerability to such a global panic in 2008: tight credit, the zero lower bound, unresponsive fiscal policy and increased economic integration. This paper is being published in the American Economic Journal: Macroeconomics. Further related work analyzes self-fulfilling sovereign debt crises and the role of monetary policy in this context.

In the second subproject, I examine the macroeconomic implications of a demand for liquid assets by firms and by consumers. A first perspective is to consider a two-country model where firms in a less developed country suffer from credit constraints and have a demand for liquid assets, while in the developed country firms are unconstrained. I examine the implications for capital flows in this asymmetric setup. I find that an increase in growth in the most constrained country implies an increase in saving and in investment, as well as in net capital outflows. This depresses the world interest rate and stimulates the other economy. These developments are consistent with the episode of global imbalances and the increase in corporate saving. I extend the analysis by looking at policy issues and by introducing a central bank. I find that a rapidly growing economy has a higher welfare without capital mobility. In another paper I introduce the real exchange rate and study the optimal exchange rate policy in this context. I find that it is optimal for the central bank to let the real exchange initially depreciate and subsequently appreciate. These papers are already published in the Journal of the European Economic Association, the American Economic Journal: Macroeconomics and in the IMF Economic Review. Further work analyzes the accumulation of corporate cash and the role of liquid assets in a liquidity trap.