Macroeconomic Implications of Capital Markets Frictions with Heterogeneous Agents

University Of Southern California, Los Angeles CA

Investigators

Abstract

This proposal includes three research projects that study the macroeconomic implications of capital markets frictions in economies with heterogeneous agents. The first project explores the link between the process of financial globalization and the ongoing global financial crisis. The second project explores how capital markets liberalization affects the international business cycle. The third project proposes a new framework to study sovereign defaults on domestic debt. The three projects are linked by the common theme of studying how frictions in capital markets affect macroeconomic performance using models in which agents' heterogeneity plays a critical role. The urgent need to understand the mechanisms behind the current global financial crisis makes the general intellectual merit of pursuing these projects and their potential broader impact self evident. It is clear that the crisis originated in the buildup of high levels of leverage in the private and public sectors of the U.S. economy. The driving forces behind the high leverage are much less clear. The projects included in this proposal aim to shed some light on this issue and to consider their policy implications. In the first project the PI's pose the hypothesis that the buildup of leverage was caused by the process of international financial integration. The debt buildup results from the higher ability to insure away individual risk that U.S. agents enjoy relative to the rest of the world thanks to more developed financial markets. As a result, financial integration leads to a reduction of the real interest rate, a large drop in the U.S. net foreign asset position, and a surge in debt relative to the value of asset holdings for U.S. agents. The heterogeneous agents setup also allows the project to examine how the familiar Fisherian debt-deflation channel triggered by a credit shock can have cross-sectional implications. In particular, a credit shock that first affects only the most highly leveraged agents, can be transmitted to other agents once asset prices begin to decline in response to the initial shock. The second project is motivated by the observation that as the process of financial globalization moved forward, business cycle volatility of output fell for the majority of OECD countries. The PI's study and estimate using structural Bayesian methods a model with financial markets frictions and credit shocks. The estimated model generates a decline in the volatility of output and a higher cross-country co-movement after capital markets liberalization. A key ingredient to generate this result is the way credit shocks are propagated to the real sectors of the domestic and foreign countries. The third project examines a striking empirical regularity showing that countries viewed as capable of defaulting on external debt, have also a record of defaulting explicitly on domestic debt obligations. Rogoff and Reinhart (2008) refer to this phenomenon as a key item in the `forgotten history of domestic debt' which has been largely ignored in the literature. The PI's put forward the hypothesis that domestic sovereign default can be explained if we take into account the heterogeneity of agents in terms of their position in the wealth distribution. If a benevolent government trades off the adverse consequences of economy-wide tax hikes that will harm proportionally more the poor against the option of defaulting on domestic public debt that is held proportionally more by the rich, the government may prefer the latter.