Financial Factors in EconomicFinancial Factors in Economic Fluctuations

Lawrence ChristianoLawrence ChristianoRoberto Motto

Massimo RostagnoMassimo Rostagno

What we doI t t fi i l f i ti i t t d d ilib i• Integrate financial frictions into a standard equilibrium model and estimate the model using Euro Area and US data.

– Asymmetric information and costly state verification (Townsend (1978), Bernanke-Gertler-Gilchrist (1999))

– Endogenous determination of financial liabilities, like M1 and M3 (Chari-Christiano-Eichenbaum (1995))

• Decompose 14 aggregate data series into shocks and propagation mechanisms:

– A new shock, a ‘risk’ shock

– A new source of propagation: non-state contingent nominal rates of interest.

Outline

• Sketch the basic ingredients of the model.

• Results

Standard Model

Firmsconsumption

Investment goods1 1 f,t Investment goodsYt 0

1Yjt

f,t djf,

, 1 ≤ f,t ,

Yjt tKjtztljt

1−

Supply labor Rent capitalother t

oilautK̄t Gt Ct It,t

≤ Yt.

HouseholdsK̄ 1 K̄ G I I Backyard capital accumulation:

E Rt1k

Kt1 1 − Kt Gi,t, It, It−1

u 1rk 1 P ′

Backyard capital accumulation:

uc,t Etc,tuc,t1t1

t1 Rt1k

ut1rt1 1 − Pk ′,t1Pk ′,t

Financial SectorA t• Assets:– Working capital loans– Loans to entrepreneurs for purchasing capital– Loans to entrepreneurs for purchasing capital

• Liabilities:– Provide utility to households– Neoclassical bank production function

• Results: – features on the liability side of banks do not addfeatures on the liability side of banks do not add

shocks or propagation to business cycle dynamics

– Features on the asset side do– Features on the asset side do matter…particularly ‘loans to entrepreneurs’

EntrepreneurEntrepreneur

• Buys capital from capital producers usingBuys capital from capital producers using own resources and loans from bank

• Rents capital to intermediate good dproducers.

Banks Households EntrepreneursBanks, Households, Entrepreneurs

entrepreneur~F,t, E 1

entrepreneur

entrepreneur

HouseholdsBank

entrepreneur

Bank

entrepreneurentrepreneur

Standard debt contract

Economic Impact of Risk ShockEconomic Impact of Risk Shock

l l di t ib ti

1

lognormal distribution: 20 percent jump in standard deviation

0.7

0.8

0.9

σσ *1.2

Larger number of entrepreneurs in lefttail problem for bank

0.4

0.5

0.6

dens

ity Banks must raise interest rate on entrepreneur

Entrepreneur borrows less

0 1

0.2

0.3

Entrepreneur borrows less

Entrepreneur buys less capital, investment drops, economy tanks

0.5 1 1.5 2 2.5 3 3.5 4

0.1

idiosyncratic shock

Risk Shocks and NewsRisk Shocks and News

• Finding:Finding:

Economic effects of risk shocks operate– Economic effects of risk shocks operate primarily via advance information, or news.

Risk Shock and NewsRisk Shock and News

• Assume iid Wold innovation in log tAssume

A t h d i f ti b t

logt logt−1 iid, Wold innovation in log t

ut

• Agents have advance information about pieces of ut

ut t0 t−1

1 . . . t−88

t−ii ~iid, E t−i

i 2 i2

t−ii ~piece of ut observed at time t − i

Monetary PolicyMonetary Policy

• Nominal rate of interest function of:Nominal rate of interest function of:

A ti i t d l l f i fl ti d h– Anticipated level of inflation and change.– Slowly moving inflation target.

f f– Deviation of output growth from ss path.– Growth of credit in case of EA. – Monetary policy shock.

Estimation• EA and US data covering 1985Q1-2008Q2

Δ log per capita stock market indextPt

GDP deflator inflationt

logper capita hourst

Δ log per capita credittPt

Δ logper capita GDPt

Δ log Hourly compensationtPt

Xt

Δ logper capita investmentt

Δ log per capita M1 t

Pt

Δ log per capita M3 tPtt

Δ logper capita consumptiont

Risk Spreadt

Rtlong − Rt

e

Rte

Δ logPIt)Δ logreal oil pricet

Δ log per capita Bank Reserves tP

• Standard Bayesian methodsΔ log Pt

Summary of results• Risk shocks:

– important source of fluctuationsimportant source of fluctuations.– news on the risk shock important.

• Assumption of state non contingent interest rates has• Assumption of state non-contingent interest rates has an important impact on shock propagation.

M d d d i id• Money demand and inside money:

– relatively unimportant as a source of shocks– modest contribution to forecast ability

• Out-of-Sample evidence suggests the model deservesOut of Sample evidence suggests the model deserves to be taken seriously.

Risk ShocksRisk Shocks

• ImportantImportant

Wh th i t t?• Why are they important?

• What shock do they displace, and why?

Figure: Year-over-year GDP Growth Rate - Data (black) versus what data would have been with only the risk shock

US

Risk shock important

EA

Variance Decomposition of Financial Shocks, US Data

risk shock, trisk shock, t

Output19

I t t fInvestment

38

Important for output and investment

Consumption5

Very important for Risk Spread97

R l V l f St k M k t

Very important for financial variables

Real Value of Stock Market80

Although the data like signals on standard technology shocks they prefer signals on riskshocks, they prefer signals on risk.

Why Risk Shock is so Importanty p• A. Our econometric estimator ‘thinks’

risk spread ~ risk shock.p

• B In the data: the risk spread is stronglyB. In the data: the risk spread is strongly negatively correlated with output.

• C. In the model: bad risk shock generates a response that resembles a recessiona response that resembles a recession.

• A+B+C suggests risk shock important• A+B+C suggests risk shock important.

Correlation (risk spread(t),output(t-j)), HP filtered data, 95% Confidence Interval

The risk spread is significantly negatively correlated with output and leads a little.

Notes: Risk spread is measured by the difference between the yield on the lowest rated corporate bond (Baa) and the highest ratedcorporate bond (Aaa). Bond data were obtained from the St. Louis Fed website. GDP data were obtained from Balke and Gordon(1986). Filtered output data were scaled so that their standard deviation coincide with that of the spread data.

Another Reason the Risk Shock is so Important

Positive shock to risk triggers what looks• Positive shock to risk triggers what looks like a recession

US, Impulse Response to Riskiness Shock (contemporaneous)

Credit procyclical risk spread countercyclical

0.05

Output Investment

0Consumption

Credit procyclical, risk spread countercyclical

0 1

-0.05

0

perc

ent

-0.2

0

0.2

perc

ent

-0.05

perc

ent

-0.15

-0.1

-0.6

-0.4p

-0.1

p

0

Real Net Worth

100

Premium (Annual Rate)

-0 5

Total Loans (Real)Risk spread (AR)

-2

-1

perc

ent

50

100

basi

s po

ints

-1.5

-1

0.5

perc

ent

10 20 30

-3

10 20 300

b

10 20 30-2.5

-2

What Shock Does the Risk Shock Displace, and why?

Th i k h k d t f th• The risk shock crowds out some of the role of the marginal efficiency of i t t h kinvestment shock.

Business Cycle FrequenciesModel risk shock, t survival, t marginal efficiency of investment, it

OutputBaseline 19 2 22CEE-SW na na 46CEE SW na na 46

InvestmentBaseline 38 5.2 53CEE-SW na na 91

ConsumptionBaseline 5 1 2CEE-SW na na 3

External Finance Premiumli 9 3 0

Risk shock appears to crowd out the marginal efficiency of investment shockBaseline 97 3 0

CEE-SW na na naReal Value of Stock Market

marginal efficiency of investment shock

Baseline 80 10 2CEE-SW na na na

Why does Risk Crowd out yMarginal Efficiency of

I t t?Investment?Price of capital

Supply shifter:marginal efficiencyPrice of capital marginal efficiencyof investment, i,t

Demand shifters:risk shock, t;wealth shock wealth shock, t

Quantity of capital

• Marginal efficiency of investment shockMarginal efficiency of investment shock can account well for the surge in investment and output in the 1990s asinvestment and output in the 1990s, as long as the stock market is not included in the analysisthe analysis.

Wh th t k k t i i l d d th• When the stock market is included, then explanatory power shifts to financial

k t h kmarket shocks.

Variance Decomposition of Inside Money Shocks

Business Cycle Frequenciesy qBank demand for excess reserves, t Bank technology shock, xt

b Household money demand shock, t

Output0 0 5 00 0.5 0

Investment0 0 0

ConsumptionConsumption0 1 0

Risk spread0 0 00 0 0

Real value of stock market0 0 0

Contribution to variance: trivial

Out of Sample RMSEs• There is not a loss of forecasting power with

the additional complications of the model.

• The model does well on everything, exceptThe model does well on everything, except the risk spread.

• Calculations for 1,2,…,12 ahead forecasts:First date of forecast 2001Q3– First date of forecast, 2001Q3

– DSGE models re-estimated every other quarter– BVAR re-estimated each quarter (standard– BVAR re-estimated each quarter (standard

Minnesota priors).

Other support for the modelOther support for the model• Model predicted default rates positively

correlated with measures of default in the data.

0.0235 4Default Probability (lhs)

Expected Default Probability, NFC (rhs)

0.0185

2

0.0085

0.0135

1990Q1 1993Q1 1996Q1 1999Q1 2002Q1 2005Q1 2008Q10

Our Measure of Idiosyncratic Risk versus Bloom et alRisk, versus Bloom, et al

0.51.15Series1Series4Ri ki Sh k (3 t MA)

0 4

1.05

Riskiness Shock (3-quarter MA)Cross-firms Sale Growth Spread (3-quarter MA)

0.4

0.95

0.3

0.85

0.75

0.20.651981Q2 1986Q2 1991Q2 1996Q2 2001Q2 2006Q2

Conclusion• Incorporating financial frictions changes inference

about the sources of shocks and of propagationrisk shock– risk shock.

– New nominal rigidity: nominal non-state contingent interest rate

• Models with financial frictions can be used to ask i t ti li tiinteresting policy questions:– When there is an increase in risk spreads, how

should monetary policy respond?y p y p– How should monetary policy be structured to avoid

excess asset market volatility?What are the pro’s and con’s of ‘unconventional– What are the pro s and con s of unconventional monetary policy’?