Liquidity, the Aggregate Economy and Public Policy

Princeton University, Princeton NJ

Investigators

Abstract

Abstract The recent financial crisis calls for a workhorse framework to analyze the interaction between the financial system and aggregate economic activities, and to give guidance for public policy. Although there is an extensive literature examining the implications of financial frictions for the aggregate economy, many important issues remain outstanding. The proposed project with John Moore plans to continue our long-term research in order to address questions such as: (1) Through what mechanism do shocks to the financial system lead to a financial crisis? How does a crisis spread both across markets and across countries? Does contagion occur mainly through prices (e.g. a fall in the value of collateral assets), or mainly through chains of credit and default? (2) What are the sources of financial instability, even during periods of stable inflation? Has it to do with contractual incompleteness (such as lack of indexation in debt contracts), or to do with the limited participation of small firms and households in asset markets? What is the externality that may rationalize government interventions? (3) How should government intervene? How and when should monetary and fiscal policies ameliorate financial crises? Does this role for government connect to the central bank's role as lender of last resort? Throughout the PI's investigation, the key departure from a standard framework is limited commitment: the agent cannot precommit to repay in the future unless the debt is secured by tangible and intangible collateral. Anticipating the possibility of future defaults, the lender limits credit according to the collateral value - the borrower faces a borrowing constraint. Another relatively under-studied aspect of limited commitment (at least in the macro literature) is limited resaleability. After the lender provides a loan to a borrower, can the lender sell her loan to new lenders in case she is short of funds? For the loan to be resaleable, the borrower has to commit to repay multilaterally, to both the original and new lenders. When the borrowing constraint is sufficiently tight, the PI plans to show that instruments with multilateral commitment (broad money) may circulate despite a low rate of return, facilitating to achieve a better resource allocation. In such an economy, shocks to resaleability can lead to a recession through a flight to liquidity. The PI plans to explore the effect of government policies that change the mix of assets held by private agents.