Financial frictions seem to play a major role in generating movements in aggregate prices and quantities. The first two parts of this project are motivated by the fact that models without financial frictions have a hard time accounting for the behavior of real exchange rates, a key variable in international economics. These parts of the project examine specific frictions discussed in the literature and assess their ability to better account for the observations. The third part develops a new quantitative model of the business cycle that formalizes the commonly held view that monetary contractions operating through a credit channel disproportionately affect small firms. The fourth project uses a panel data set to document how the behavior of small and large firms differ over the business cycle.
A model that generates substantial time-varying risk is needed to explain the movements in interest rates and exchange rates. The challenge is to generate such risk without making variables like interest rates counterfactually volatile and without putting substantial time-varying risk in the underlying fundamentals, for which there is scant evidence. This project attempts to meet this challenge with a monetary general equilibrium model that generates time-varying risk premia as a result of endogenous market segmentation arising from fixed costs. The model generates time-varying risk since, as the shocks vary, so do the fraction and quantity of trades by active agents in the asset market. The project studies the financial friction caused by the difficulty of enforcing contracts between sovereign nations involving large transfers of resources at one date and state which are backed only by promises to pay at later dates and states. Theoretically, this friction breaks the tight link between real exchange rates and relative consumption present in frictionless models by introducing a stochastic wedge between the real exchange rate and the ratio of marginal utilities. The project will investigate the quantitative role of this friction and contrast it with the iceberg shipping cost friction recently championed by Obstfeld and Rogoff.
The project develops a new quantitative model of the business cycle. A large empirical literature has argued that in business cycle downturns, and particularly after monetary contractions, small firms contract disproportionately. This literature has emphasized the credit channel for monetary policy in which monetary contractions lead firms, in the aggregate, to reduce their use of bank loans. Larger firms are less affected by monetary contractions because they can access markets for commercial paper and other forms of debt as well as equity. Panel data on the patterns of large and small firms over the cycle are used to discipline the analysis. Guided by this new theory, the project studies the patterns of small and large firms over the cycle. The Census Bureau has approved a separate proposal asking for access to an extensive, detailed collection of data at the plant and firm level available at the Census data centers.
Broader Impacts: This proposal will help policymakers design monetary policy, regulatory policy for the banking and financial services industry, and policy aimed at new and small firms. The research will be disseminated to policymakers in easily digestible formats and presented at policy conferences.
