Financial Frictions, Asset Prices, and the Great Recession Zhen Huo and Jos´ e-V´ ıctor R´ ıos-Rull Yale University, University of Pennsylvania, UCL, CAERP Einaudi Institute for Economics and Finance Sunday 12 th March, 2017 First Version April 2013 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 1 / 59
We have had a Great Recession Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 2 / 59
Facts on the last recession: output, unemp, cons, inv 8 10 Real output Unemployment rate 6 9 4 8 2 0 7 −2 6 −4 5 −6 −8 4 2002 2004 2006 2008 2010 2012 2014 2016 2002 2004 2006 2008 2010 2012 2014 2016 8 30 Consumption Investment 6 20 4 10 2 0 0 −2 −10 −4 −20 −6 −30 −8 −10 −40 2002 2004 2006 2008 2010 2012 2014 2016 2002 2004 2006 2008 2010 2012 2014 2016 Note : Except for unemployment, figures show percentage deviation from a linear trend. Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 3 / 59
Facts on the last recession: wealth, mortg, houses, pr h 5 0.75 Net worth to output Mortgage debt to output 4.8 0.7 4.6 0.65 4.4 0.6 4.2 0.55 4 3.8 0.5 2002 2004 2006 2008 2010 2012 2014 2016 2002 2004 2006 2008 2010 2012 2014 2016 1.9 230 Housing value to output Housing price index 1.8 220 1.7 210 1.6 200 1.5 190 1.4 180 1.3 170 1.2 160 1.1 150 2002 2004 2006 2008 2010 2012 2014 2016 2002 2004 2006 2008 2010 2012 2014 2016 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 4 / 59
Facts on the last recession: productivity and labor quality 6 6 TFP: measured with total hours Labor productivity 5 4 4 2 3 2 0 1 −2 0 −1 −4 −2 −6 −3 −4 −8 2002 2004 2006 2008 2010 2012 2014 2016 2002 2004 2006 2008 2010 2012 2014 2016 0.8 0.5 Labor force quality TFP: measured with total hours TFP: measured with total labor inputs 0 0.6 −0.5 0.4 −1 0.2 −1.5 0 −2 −0.2 −2.5 −0.4 −3 −0.6 −3.5 −0.8 −4 −1 −4.5 2002 2004 2006 2008 2010 2012 2014 2016 2009 2010 2011 2012 2013 2014 2015 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 5 / 59
Culprit: Financial Shocks? When looking for triggers of the Great Recession some form of financial breakdown comes out in most popular explanations. Financing difficulties contribute to cut spending both of firms and households. Most of the action occurs via a demand reduction. Yet models have a hard time to deliver this. Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 6 / 59
This paper Explores recessions that are triggered by shocks to households’ ability to borrow. What are the theoretical elements needed In the context of a modern macro model Production with Savings A lot of wealth Heterogeneity so that the financial frictions are not imposed Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 7 / 59
Findings: The answer is yes, provided there are (from +to-) Real frictions that difficult the switch from production of consumption 1 goods to exports or investment. Houses with prices amenable to falling as they did in the data. 2 Frictions in the goods markets that generate movements in measured 3 GDP. Households that differ in job prospects. 4 Some labor market frictions that limit wage adjustments. 5 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 8 / 59
Findings: The Recession that we generate Shares most of the features of the Great Recession: • A large decline in output, employment, consumption and investment. 1 Large reductions in assets (housing and stocks) prices. 2 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 9 / 59
Model Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 10 / 59
The Model Characteristics: Steady State Enhanced Aiyagari Economy: Multisector: Tradables and nontradables. 1 Houses (land) that need to be purchased to be enjoyed. 2 Endogenous productivity movements (frictions in goods markets). 3 Various job market frictions. 4 Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 11 / 59
Households: Preferences Continuum of households that live forever ( β ), are subject to uninsurable idiosyncratic. H’holds care about quantities and number of varieties of nontradables. �� I N � ρ 1 = c Ni I ρ ρ c N = c Ni di N 0 Households have to search for varieties, its number is a choice . I N = d Ψ d ( Q g ) Ψ d ( Q g ) : Probability (per search unit) of finding a variety (goods market frictions). Households also like tradables and housing and dislike goods searching u [ c A ( c N I ρ N , c T ) , h, d ] Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 12 / 59
Households: Endowments and Wealth Household skill type is ǫ , follows a Markov chain Γ ǫ,ǫ ′ . Moves slowly and accommodates opportunities to get rich. Households either have a job e = 1 or not e = 0 . Type-dependent exogenous job destruction rate δ ǫ n . Job finding rate is type independent and depends on job creation by firms (workers are rationed, it is like no matching function in labor market but hiring costs) ([Fang and Nie(2013)] ) . Households have assets a . These assets can be allocated to (frictionless) houses and/or to financial assets with a collateral constraint. The poor will have some housing wealth and a mortgage, the rich houses and shares of the economy’s mutual fund. Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 13 / 59
Goods markets Search frictions in the markets for nontradables: Households look for varieties. Random search. Richer people consume and search more. Cuts in consumption cut search which cuts productivity. Perfect competition and frictionless markets for tradables. Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 14 / 59
Labor market Workers are rationed. Firms hire as many workers as they wish paying hiring costs. (like a vacancy filling probability of 1, with hiring costs). Employment: N = N N + N T . Same job finding probability across types: Φ e = V 1 − N . Wages are exogenous (set to some aggregate target). Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 15 / 59
Assets markets: Financial assets and houses Total housing H is in fixed supply. Negative financial assets ( b ′ < 0 ) are (undefaultable) mortgages. 1 Its interest rate is predetermined: 1+ r ∗ − ς, if b < 0 . Mortgages have to be collateralized by housing: if b < 0 then � � 1 | b | ≤ [1 − λ ] 1 + r ∗ − ς p h h Positive financial assets ( b > 0 ) are shares of a mutual fund. Its return, r , is determined ex-post (it matters when we hit the economy with shocks). Possible capital gains and loses. � 1 + r, if b ≥ 0 R ( b ) = 1 , if b < 0 . Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 16 / 59
Households’ problem V ( ǫ, e, a ) = c N,i ,c T , I N ,h,d u ( c A , h, d )+ max � Π θ θ,θ ′ Π w e ′ | e,ǫ Π ε ǫ,ǫ ′ V [ ǫ ′ , e ′ , a ′ ( b, h )] β s.t. ǫ ′ ,e ′ ,θ ′ � I N p i c N,i + c T + p h h + b = a + 1 e =1 wǫ + 1 e =0 w BC 0 a ′ ( b, h ) = p h h + R ( b ) b AA � � 1 FC b ≥ − λ p h h 1 + r ∗ − ς I N = d Ψ d [ Q g ] SC Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 17 / 59
Nontradables: Monopolistic Competition by Varieties Each firm/variety has any locations each. Some inputs are location specific. Others (type 2 labor) are not. Prices are posted before location is filled The demand function is given by � Ψ f [ Q g ] c [ p i ( ǫ, e, a ) , x ] d ( x, S ) The firm has to make sure that it can satisfy the demand at all locations. Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 18 / 59
Nontradable firms’ problem � Ω N ( k, n ) = max Ψ f [ Q g ] p i c ( p i , ǫ, e, a ) dx − wℓ − i − κv i,v,p i ℓ 1 ,ℓ 2 � θ,θ ′ Ω N ( k ′ , n ′ ) Π θ + 1 + r ∗ θ ′ subject to � f ℓ [ c ( p i , x ) , k, ℓ 1 ] d ( x, S ) ℓ 2 ≥ Ψ f [ Q g ] DC D ℓ 1 + ℓ 2 = nǫ SL k ′ = (1 − δ k ) k + i − φ N ( k, i ) LMK n ′ = [1 − δ n ] n + v LML Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 19 / 59
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