Volume V111 • No.3 • Fall 2014 FROM THE LAB UC Santa Barbara | Laboratory for Aggregate Economics and Finance IN THIS ISSUE: Proceedings of the On Money as a Medium of Exchange: KW at 25! conference held in August 2014. 5th Advances in Macro-Finance Tepper-LAEF conference held in September 2014. IN THE NEXT ISSUE: Policy Analysis in the Post Great Recession Era conference held in October 2014. Ambiguity and Robustness in Economics conference held in March 2015. 3 Director’s Message Finn Kydland On Money as a Medium of Exchange: KW at 25! 5th Advances in Macro-Finance Tepper-LAEF 4 Conference Participants 14 Conference Participants Presentation Summaries Presentation Summaries. Note: speakers are highlighted in author listings. Note: speakers are highlighted in author listings. 5 Central Bank Purchases of Private Assets 14 Misspecified Recovery Stephen Williamson Jaroslav Borovicka, Lars Peter Hansen and Jose Scheinkman 5 Dynamic Indeterminacy and Welfare in Credit Economies 15 Dynamic Dispersed Information and the Credit Zach Bethune, Tai-Wei Hu and Guillaume Rocheteau Spread Puzzle 6 A Mechanism Design Approach to Financial Frictions Elias Albagli, Christian Hellwig and Aleh Tsyvinski Nobuhiro Kiyotaki 15 Optimal Debt and Profitability in the Tradeoff Theory 7 Monetary Policy with Asset-Backed Money Andrew Abel David Andolfatto, Aleksander Berentsen and Christopher Waller 16 Agency Conflicts Around the World 7 Search Theoretical Models of Money and Finance: Erwan Morellec, Boris Nikolov and Norman Schurhoff An Integrated Approach 16 Investor Sophistication and Capital Income Inequality Alberto Trejos and Randall Wright Marcin Kacperczyk, Jaromir Nosal and Luminita Stevens 8 Money and Credit Redux Financial Distress and Endogenous Uncertainty Randall Wright, Chao Gu and Fabrizio Mattesini 17 François Gourio 9 Short-Run Dynamics in a Search-Theoretic Model of Monetary Exchange 18 Taxing Atlas: Using Firm Data to Derive Optimal Income Jonathan Chiu and Miguel Molico Tax Rates Laurence Ales, Andrés Bellofatto and Jessie Wang 9 A Search-Theoretic Model of the Term Premium Athanasios Geromichalos, Lucas Herrenbrueck 19 Technological Specialization and Corporate Diversification and Kevin Salyer Fernando Anjos and Cesare Fracassi 10 Rehypothecation David Andolfatto, Fernando Martin and Shengxing Zhang 11 Heterogeneity in Decentralized Asset Markets Julian Hugonnier, Benjamin Lester and Pierre-Olivier Weill 11 Asset pricing in a monetary model with dealers Fabrizio Mattesini and Ed Nosal 12 Sorting in the Interbank Money Market Morten Bech and Cyril Monnet 13 Non-neutrality of Money in Dispersion: Hume Revisited Gu Jin and Tao Zhu UC Santa Barbara Laboratory for Aggregate Economics & Finance 2 | From the Lab FALL 2014 Director’s Message Finn Kydland This issue covers two anniversaries. One is the 5th-anniversary conference on Advances in Macro-Finance. When we started this series of annual conferences, we were not aware of any other conference even remotely like it. These days it’s more common to see conferences combining these two areas, which we regard as very much interrelated. The conferences are organized in co-operation with Carnegie Mellon’s Tepper School of Business. This last one took place in Pittsburgh. In the tradition of doing two in Pittsburgh, one in Santa Barbara, and so on, the next one, scheduled for middle of September 2015, will be held in Santa Barbara. Part of the format has been, to the extent possible, to pair authors to discussants with different backgrounds (macroeconomics and finance), with senior academics discussing the work of junior colleagues. An important anniversary was that related to money as a medium of exchange. Twenty- five years ago, Nobu Kiyotaki and Randy Wright published a paper that introduced a new approach, based on search theory, into monetary economics. In this approach, agents in the model trade with each other, and not simply against their budget lines. This framework allows one to ask how they trade - using barter, commodity or fiat money, secured or unsecured credit, etc. Over the last twenty-five years much progress has been made in the area, applying and extending the original model on many dimensions. This conference provided an opportunity to look back at what has been done, and to look forward to where monetary economics is likely go. Organizers of the conference were Ricardo Lagos, NYU, and Peter Rupert, UCSB. The macro-finance conference focused on research on the relationship between asset prices and macroeconomic fundamentals. Topics included, but were not limited to, production economies; exotic preferences; time variation in expected returns; learning; and the pricing of currencies, commodities and sovereign debt. The conference organizers were Brent Glover and Ariel Zetlin-Jones, both assistant professors at Carnegie Mellon University. Laboratory for Aggregate Economics and Finance Finn Kydland, DIRECTOR Peter Rupert, ASSOCIATE DIRECTOR Carmen Earle, BUSINESS MANAGER 2112 North Hall University of California, Santa Barbara Santa Barbara, CA 93106-9215 U.S.A. Phone: (805) 893-2258 Fax: (805) 893-8830 Email: [email protected] www.laef.ucsb.edu Special thanks for their accurate and concise summaries of the presentations go to Economics graduate students Ben Griffy, Austin Jones, Desen Lin and Xintong Yang of UCSB and Emilio Bisetti, Musab Kurnaz of Carnegie Mellon University. Thanks also to UCSB Instructional Development — Artworks for newsletter design and production, and Photo Services for the conference photos. FALL 2014 FROM THE LAB | 3 On Money as a Medium of Exchange: KW at 25! AUGUST 6-8, 2014 CONFERENCE PARTICIPANTS Morten Bech — Bank for International Settlement Miguel Molico — Bank of Canada Valerie Bencivenga — University of Texas, Austin Cyril Monnet — University of Bern and SZ Gerzensee Aleksander Berentsen — University of Basel Ed Nosal — Federal Reserve Bank of Chicago Zachary Bethune — University of California, Santa Barbara Munpyung O — University of Nevada, Las Vegas Jonathan Chiu — Bank of Canada Guillaume Rocheteau — University of California, Irvine Athanasios Geromichalos — University of California, Davis Alberto Trejos — INCAE-Costa Rica Lucas Herrenbrueck — University of California, Davis Christopher Waller — Federal Reserve Bank of St. Louis Tai-Wei Hu — Northwestern University Makoto Watanabe — VU University Amsterdam Gu Jin — Hong Kong University of Science and Technology Stephen Williamson — Washington University, St. Louis Benoit Julien — University of New South Wales Randall Wright — University of Wisconsin, Madison Nobuhiro Kiyotaki — Princeton University Cathy Zhang — Purdue University Benjamin Lester — Federal Reserve Bank of Philadelphia Shengxing Zhang — New York University Fernando Martin — Federal Reserve Bank of St. Louis 4 | FROM THE LAB FALL 2014 Central Bank Purchases of Private Assets increase, so households can borrow more and banks can increase Stephen D. Williamson the size of their balance sheets. In addition, if the cost of faking for either the household or the bank is low, their respective incentive In this paper, Williamson characterizes the effect that constraints will be more likely to bind. By lowering the interest government purchases of mortgage-backed securities might rate, conventional monetary policy can serve to aggravate these have on the incentives for households and banks to exchange incentive constraints and force households and banks to take mortgages. He allows both households and banks to fake the a larger haircut in order to be ensure that they are not faking quality of their assets (their house in the case of the individuals, their mortgages. Quantitative easing, however, may either be and mortgages in the case of the banks), and sees the extent to neutral or beneficial, depending upon the state of the economy. which these activities change when the government institutes By purchasing longer-term securities (mortgage-backed securities a program to purchase mortgages. He first explores how in this case), the central bank can increase the aggregate collateral behavior changes in response to conventional monetary policy, in the economy and increase overall welfare for the case in which before moving to private asset purchases. He shows that while both incentive constraints bind. Of interest, these purchases government activity may cause more agents in the economy to actually increase the likelihood that households and banks fake fake the quality of their collateral (houses or mortgages), these (or take a larger haircut) the quality of their collateral. However, policies can still be welfare improving by increasing the quantity by increasing overall collateral, the central bank offsets this effect of collateral in the economy. and increases welfare. Williamson adapts the model of Lagos and Wright (2005) The audience seemed concerned about whether or not this to address the change in behavior due to changes in monetary actually reflected financial markets. Williamson agreed that there policy. Time is discrete, and each time period is divided into two might be some concerns about the assumption and what kinds of sub-periods, a “centralized” market (CM), and a “decentralized” things the banks can see. Audience members were also confused market (DM). In the economy, there are a set of buyers and by the presence of three nominal assets, to which Williamson sellers; the buyers purchase goods from sellers in the DM and noted that they are only setting the interest rate and the rest is often require either currency