Financial Factors in Economic Fluctuations. Lawrence Christiano Roberto Motto Massimo Rostagno

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1 Financial Factors in Economic Fluctuations Lawrence Christiano Roberto Motto Massimo Rostagno

2 Background Much progress made on constructing and estimating models that fit quarterly data well (Smets-Wouters, others). In practice the models abstract from details of financial markets and interaction with real economy. A common presumption: asset markets passively reflect fluctuations in standard shocks and contribute little to propagation.

3 What we do Integrate financial frictions into a standard DSGE model and estimate the model using EA and US data. Finding: integration of financial frictions changes inference about the shocks and propagation mechanisms governing economic fluctuations. Identify a new shock, a risk shock Identify a new propagation mechanism.

4 Outline Sketch the basic ingredients of the model. Present 5 results that motivate our conclusion

5 Standard Model consumption Firms Y t 0 1 Yjt 1 f,t dj Y jt t K jt z t l jt 1 f,t, 1 f,t, Investment goods Supply labor other t oil a u t K t G t C t I t,t Y t. Rent capital Households Backyard capital accumulation: K t 1 1 K t G i,t,i t,i t 1 Savers and investors are the same: NO FRICTIONS! k R u c,t E t c,t u t 1 c,t 1 t 1 k R t 1 u k t 1r t 1 1 P k,t 1 P k,t

6 Extension to Incorporate Financial Frictions General idea: Borrowing for two purposes: Short term financing of working capital Longer-term financing of capital. Bank financing: Issue assets that provide various degrees of transactions services to finance short term bank assets Issue time deposits to finance longer-term loans.

7 Banks Financial system assets and liabilities: Technology for producing transactions services:

8 Preferences: E tj l c,t l u C t l bc t l 1 L l 0 Households 1 c P t l C t l 1 t l 1 c P t l C t l M t l Dh t l 1 h L j,t l 1 L 1 t l 1 1 c P t l C t l D m t l b Features: Habit formation in consumption, differentiated Labor Monopolistic supplier of specialized labor input (EHL) Enjoy deposits services of two bank assets Hold time deposits Access to 10-year bond, with gross return exogenous shock which can capture any failure of the model to match R t t t l 1 q 1 q, 1 compared with data on 10-year bond returns Rt

9 Preferences: E tj l c,t l u C t l bc t l 1 L l 0 Households 1 c P t l C t l 1 t l 1 c P t l C t l M t l Dh t l 1 h L j,t l 1 L 1 t l 1 1 c P t l C t l D m t l b Features: Habit formation in consumption, differentiated Labor Monopolistic supplier of specialized labor input (EHL) Enjoy deposits services of two bank assets Hold time deposits Access to 10-year bond, with gross return t l 1 q 1 q, exogenous shock designed to capture any failure of the model to match R t long t long 1 compared with data on 10 year bond returns R t long

10 Monetary Policy Monetary policy rule: R t e i R e t 1 1 i target R e E t t 1 t 1 i y 4R e log GDP t z GDP t 1 1 i d R e t t 1 Monetary policy shock: Inflation target: 1 i b 4R e log t target B t 1 z B t 1 400R e t, t ~ white noise target t 1 target target 2 t, E t, 0.965,

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14 V t 1 real earnings on capital (rent plus capital gains) t nominal rate of interest t 1 t real debt to banks t 1 e Net Worth t 1 V t 1 W t 1 e 1 W t 1

15 Source of accelerator effects V t 1 real earnings on capital (rent plus capital gains) t nominal rate of interest t 1 t real debt to banks t 1 e Net Worth t 1 V t 1 W t 1 e 1 W t 1

16 V t 1 real earnings on capital (rent plus capital gains) t nominal rate of interest t 1 t real debt to banks t 1 e Net Worth t 1 V t 1 W t 1 e Source 1 W of Fisher t 1 deflation effect

17 V t 1 real earnings on capital (rent plus capital gains) t nominal rate of interest t 1 t real debt to banks t 1 e Net Worth t 1 V t 1 W t 1 e 1 W t 1

18 Prediction of financial friction model: Shocks that drive output and price in the same direction ( demand ) accelerated by financial frictions. Fisher and earnings effects reinforce each other. Shocks that drive output and price in opposite directions ( supply ) not much affected by financial frictions. Fisher and earnings effects cancel each other.

19 Risk Shock and News Assume t 1 t 1 iid, univariate innovation to t ut Agents have advance information about pieces of u t u t t t 1... t 8 i t i i ~iid, E t i 2 2 i i t i ~piece of u t observed at time t i

20 Estimation EA and US data covering 1985Q1-2007Q2 log N t 1 P t t log per capita hours t log per capita credit t P t log per capita GDP t log Wt P t log per capita I t X t log per capita M1t P t, log per capita M3t P t log per capita consumption t External Finance Premium t R t long R t e Standard Bayesian methods (e.g., SW) We remove sample means from data and set steady state of X to zero in estimation. R t e logp I,t logreal oil price t log per capita Bank Reserves t P t

21 Summary of results Risk shocks are an important source of fluctuations. News on the risk shocks is important. The Fisher debt-deflation channel has a substantial impact on propagation. Shocks to money demand and mechanism of producing inside money relatively unimportant. Out-of-Sample RMSEs of the model achieve the high standards set by SW.

22 Risk Shocks are Important Actual data versus what actual data would have been if there were only risk Shocks: Note: (1) as suggested by the picture, risk shocks are relatively important at the lower frequencies (2) We find that they are the single most important source of low frequency fluctuation in the EA, and a close second (after permanent tech shocks) in the US

23 Markup Banking tech Capital tech Money demand Government Permanent tech Gamma shock Temporary tech Monetary policy Risk, contemp Signals on risk Risk and signals Discount rate Marginal eff of I Price of oil Long rate error Table: Variance Decomposition, HP filtered data, EA x shock output consumption investment hours inflation labor productivity interest rate f x b g z policy signal and signal c i oil long measurement error inflation target all shocks

24 It s the signals! Table: Variance Decomposition, HP filtered data, EA x shock output consumption investment hours inflation labor productivity interest rate f x b g z policy signal and signal c i oil long measurement error inflation target all shocks

25 It s the signals! Table: Variance Decomposition, HP filtered data, EA x shock output consumption investment hours inflation labor productivity interest rate f x b g z policy signal and signal c i oil long measurement error inflation target all shocks

26 Markup Banking tech Capital tech Money demand Government Permanent tech Gamma shock Temporary tech Monetary policy Risk, contemp Signals on risk Risk and signals Discount rate Marginal eff of I Price of oil Error in long rate Table: Variance Decomposition, HP filtered data, EA x shock stock market credit spread term structure real M1 real M3 f x b g z policy signal and signal c i oil long measurement error inflation target all shocks

27 Markup Banking tech Capital tech Money demand Government Permanent tech Gamma shock Temporary tech Monetary policy Risk, contemp Signals on risk Risk and signals Discount rate Marginal eff of I Price of oil Error in long rate Table: Variance Decomposition, HP filtered data, EA x shock stock market credit spread term structure real M1 real M3 f x b g z policy signal and signal c i oil long measurement error inflation target all shocks

28 Markup Banking tech Capital tech Money demand Government Permanent tech Gamma shock Temporary tech Monetary policy Risk, contemp Signals on risk Risk and signals Discount rate Marginal eff of I Price of oil Error in long rate Signal matters! Table: Variance Decomposition, HP filtered data, EA shock stock market credit spread term structure real M1 real M3 f x b g z policy signal and signal c i oil long measurement error inflation target all shocks x

29 Importance of Risk Signals p News Specification on Risk and Marginal Likelihood (EA data) p t 1 t 1 t 0 t 1 t 2... t p log, marginal likelihood odds ( exp(difference in log likelihood from baseline)) 8 (baseline)

30 Why is Risk Shock so Important? According to the model, external finance premium is primarily risk shock. To look for evidence that risk might be important, look at dynamics of external finance premium and gdp. External finance premium is a negative leading indicator

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32 Why is Risk Shock so Important?: A second reason Our data set includes the stock market Output, stock market, investment all procyclical (surge together in late 1990s) This is predicted by risk shock.

33 Impact on Propagation Effects of monetary shocks on gdp amplified by BGG financial frictions because P and Y go in same direction. Effects of technology shocks on gdp mitigated by BGG financial frictions because P and Y go in opposite directions.

34 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, except the risk premium.

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36 Conclusion Incorporating financial frictions changes inference about the sources of shocks and of propagation. Models with financial frictions can be used to ask interesting policy questions: When there is an increase in risk spreads, how should monetary policy respond?