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Financial Frictions, Asset Prices, and the Great Recession Zhen Huo and Jos e-V ctor R os-Rull Yale University, University of Pennsylvania, UCL, CAERP Einaudi Institute for Economics and Finance Sunday 12 th March, 2017 First

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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 12th March, 2017

First Version April 2013

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 1/59

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We have had a Great Recession

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 2/59

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Facts on the last recession: output, unemp, cons, inv

2002 2004 2006 2008 2010 2012 2014 2016 −8 −6 −4 −2 2 4 6 8

Real output

2002 2004 2006 2008 2010 2012 2014 2016 4 5 6 7 8 9 10

Unemployment rate

2002 2004 2006 2008 2010 2012 2014 2016 −10 −8 −6 −4 −2 2 4 6 8

Consumption

2002 2004 2006 2008 2010 2012 2014 2016 −40 −30 −20 −10 10 20 30

Investment

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

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Facts on the last recession: wealth, mortg, houses, pr h

2002 2004 2006 2008 2010 2012 2014 2016 3.8 4 4.2 4.4 4.6 4.8 5

Net worth to output

2002 2004 2006 2008 2010 2012 2014 2016 0.5 0.55 0.6 0.65 0.7 0.75

Mortgage debt to output

2002 2004 2006 2008 2010 2012 2014 2016 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9

Housing value to output

2002 2004 2006 2008 2010 2012 2014 2016 150 160 170 180 190 200 210 220 230

Housing price index

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 4/59

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Facts on the last recession: productivity and labor quality

2002 2004 2006 2008 2010 2012 2014 2016 −4 −3 −2 −1 1 2 3 4 5 6

TFP: measured with total hours

2002 2004 2006 2008 2010 2012 2014 2016 −8 −6 −4 −2 2 4 6

Labor productivity

2002 2004 2006 2008 2010 2012 2014 2016 −1 −0.8 −0.6 −0.4 −0.2 0.2 0.4 0.6 0.8

Labor force quality

2009 2010 2011 2012 2013 2014 2015 −4.5 −4 −3.5 −3 −2.5 −2 −1.5 −1 −0.5 0.5

TFP: measured with total hours TFP: measured with total labor inputs

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 5/59

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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

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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

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Findings: The answer is yes, provided there are (from +to-)

1

Real frictions that difficult the switch from production of consumption goods to exports or investment.

2

Houses with prices amenable to falling as they did in the data.

3

Frictions in the goods markets that generate movements in measured GDP.

4

Households that differ in job prospects.

5

Some labor market frictions that limit wage adjustments.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 8/59

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Findings: The Recession that we generate

  • Shares most of the features of the Great Recession:

1

A large decline in output, employment, consumption and investment.

2

Large reductions in assets (housing and stocks) prices.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 9/59

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Model

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 10/59

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The Model Characteristics: Steady State

Enhanced Aiyagari Economy:

1

Multisector: Tradables and nontradables.

2

Houses (land) that need to be purchased to be enjoyed.

3

Endogenous productivity movements (frictions in goods markets).

4

Various job market frictions.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 11/59

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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. cN = IN c

1 ρ

Ni di

ρ = cNi Iρ

N

Households have to search for varieties, its number is a choice. IN = d Ψd(Qg)

Ψd(Qg): Probability (per search unit) of finding a variety (goods market frictions).

Households also like tradables and housing and dislike goods searching u [cA(cN Iρ

N, cT ), h, d]

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 12/59

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Households: Endowments and Wealth

Household skill type is ǫ, follows a Markov chain Γǫ,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 δǫ

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

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SLIDE 14

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

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SLIDE 15

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 = NN + NT . Same job finding probability across types: Φe =

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

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Assets markets: Financial assets and houses

Total housing H is in fixed supply. Negative financial assets (b′ < 0) are (undefaultable) mortgages.

Its interest rate is predetermined:

1 1+r∗ − ς, if b < 0.

Mortgages have to be collateralized by housing: if b < 0 then |b| ≤ [1 − λ] ph h

  • 1

1 + r∗ − ς

  • 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. R(b) =

  • 1 + r,

if b ≥ 0 1, if b < 0.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 16/59

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SLIDE 17

Households’ problem

V (ǫ, e, a) = max

cN,i,cT ,IN,h,d u(cA, h, d)+

β

  • ǫ′,e′,θ′

Πθ

θ,θ′ Πw e′|e,ǫ Πε ǫ,ǫ′ V [ǫ′, e′, a′(b, h)]

s.t. IN picN,i + cT + phh + b = a + 1e=1wǫ + 1e=0 w BC a′(b, h) = phh + R(b)b AA b ≥ −λ ph h

  • 1

1 + r∗ − ς

  • FC

IN = d Ψd[Qg] SC

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 17/59

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SLIDE 18

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 Ψf[Qg]

  • c[pi(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

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SLIDE 19

Nontradable firms’ problem

ΩN(k, n) = max

i,v,pi ℓ1,ℓ2

Ψf[Qg]pi

  • c(pi, ǫ, e, a) dx − wℓ − i − κv

+

  • θ′

Πθ

θ,θ′ ΩN(k′, n′)

1 + r∗ subject to ℓ2 ≥ Ψf[Qg]

  • f ℓ[c(pi, x), k, ℓ1]d(x, S)

D DC ℓ1 + ℓ2 = nǫ SL k′ = (1 − δk)k + i − φN(k, i) LMK n′ = [1 − δn]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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Tradable firms’ are competitive and have adjustment costs

  • Its output is used for exports, investment, and (part of) consumption.
  • Decreasing returns.

ΩT (k, n) = max

i,v F T (k, ℓ) − wℓ − i − κv − φT,n(n′, n)

+

  • θ′

Πθ

θ,θ′ ΩT (k′, n′)

1 + r∗ subject to k′ = (1 − δk)k + i − φT,k(k, i) ℓ = nǫ n′ = [1 − δn]n + v

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 20/59

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Mutual fund

Financial wealth in the economy is L+ =

  • b>0

b(ǫ, e, a) dx Mortgages in the economy are L− =

  • b<0

−b(ǫ, e, a) dx Net foreign asset position of the country (the mutual fund owns all firms) B = L+ −

  • ΩN − πN + ΩT − πT +

1 1 + r∗ L−

  • The realized rate of return is

1 + r = ΩN + ΩT + (1 + r∗)B + L− L+

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 21/59

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The Financial Shocks

We now pose simultaneous (MIT) shocks to the Financial system: Both to

1

Loan to value ratio. λ

2

Markup on loans ζ

Solve for the transition We have to take care of wages dynamics. They are determined via the following formula logw − logw = εw

  • logY − logY
  • [Gornemann, Kuester, and Nakajima(2012)].

Solving the transition implies solving for sequences for home prices, wages, nontradable prices. We assume the transition is completed in T periods.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 22/59

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Mapping the Model to Data

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 23/59

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Functional forms

Preferences u(cA, h, d) = 1 1 − σc

  • cA − ξd

d1+γ 1 + γ 1−σc + v(h) where there is an Armington aggregator for consumption cA =

  • ω (cNIρ

N)

η−1 η

+ (1 − ω)c

η−1 η

T

  • η

η−1

and houses are inferior goods as a proxy for segmentation of housing markets v(h) =      ξh log(h), if h < h1

ξh 1−σh h1−σh,

if h1 ≤ h ≤ h2. ξh ¯ h − h, if h > h2.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 24/59

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Housing Utility Function

Housing utility function Engel Curve: consumption vs housing

1 2 3 4 5 −1.2 −1 −0.8 −0.6 −0.4 −0.2 0.2 0.4

Housing Housing utility

1 2 3 4 5 6 7 8 2.5 3 3.5 4 4.5 5

Consumption Housing

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 25/59

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Functional forms

Production function F N(k, ℓ1, ℓ2) = zN kα0 ℓα1

1

ℓα2

2 ,

F T (k, ℓ) = zT kθ0ℓθ1 Capital adjustment cost in the nontradable goods sector φN(i, k) = ψ 2 i k − δk 2 k Capital and employment adjustment cost in the tradable goods sector φT,k(i, k) = ψ 2 i k − δk 2 k, φT,n(n′, n) = ψ 2 n′ n − 1 2 n Matching technology M(D, T) = νDµT 1−µ

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 26/59

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Exogenously determined parameters

Parameter Value Risk aversion for consumption, σc 2.0 Satiation level for housing, h 5.0 Curvature of shopping, γ 1.5 Elasticity of substitution bw tradables and nontradables, η 0.80 Price markup, ρ 1.1 Loan to value ratio, λ 0.80 Interest rate for international bonds, r∗ 4% Note: model period is half a quarter

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 27/59

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Endogenously determined parameters: aggregate

Target Value Parameter Value Wealth to output ratio 4.00 β 0.97 Housing value to output ratio 1.70 ξh 0.54 Debt to output ratio 0.40 ǫ4 37.41 Fraction of housing held by bottom 70% 0.25

  • h1

1.48 Fraction of housing held by bottom 80% 0.39

  • h2

4.22 Fraction of housing held by bottom 90% 0.58 σh 2.92 Share of tradables 0.30 ω 0.98 Occupancy Rate 0.81 ν 0.81 Capital to output ratio 2.00 δk 0.01 Labor Share in nontradables 0.64 α0 0.27 α1 = α2 —— α1 0.36 Labor Share in tradables 0.66 θ1 0.66 Vacancy cost to output ratio 0.02 κ 0.42 Home production to lowest earning ratio 0.50 w 0.07 Units Parameters Output 1 zN 0.93 Relative price of nontradables 1 zT 0.48 Market tightness in goods markets 1 ξd 0.03

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 28/59

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Endogenously determined parameters: cross-section

Lorenz

Target Value Parameter Value Job duration for type 1 1.5 year δ1

n

0.083 Job duration for type 3 5 year δ3

n

0.025 Job duration for type 4 5 year δ4

n

0.025 Unemployment rate 6% δ2

n

0.048 Wealth Gini index 0.82 Πǫ

1,4

0.0007 Earnings Gini index 0.64 Πǫ

4,1

0.0058 Earning autocorrelation 0.91 Πǫ

1,1

0.9656 Earning stdev 0.20 Πǫ

2,2

0.9770

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 29/59

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SLIDE 30

Lorenz Curve

Return

Networth Housing

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Model Data

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Model Data Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 30/59

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SLIDE 31

Dynamic Parameter I

Real wage rule: log wt

Pt − log w P = ϕw

log Y ∗

t − log Y

  • Choose ϕw = 0.55: match correlation between real output and real wage

Consistent with the movement during the Great Recession

2002 2004 2006 2008 2010 2012 2014 −8 −6 −4 −2 2 4 6 8 Real output Real wage Approx wage: ϕw = 0.30 Approx wage: ϕw = 0.55 Approx wage: ϕw = 0.80

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 31/59

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Dynamic Parameter II

Summary of Dynamic Parameters

Parameter Value Target Adjustment cost, ψ 1.60 Decrease in investment: 30% DRS in tradables, θ0 0.21 Increase in tradable sector: 4% Goods market matching elasticity in, µ 0.80 Decrease in TFP: 1.5% Wage elasticity, ϕw 0.55 Ratio of wage to output change: 0.55

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 32/59

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SLIDE 33

Experiments: once and for all set of surprises

1

Baseline Over three months the down payment changes from 20% to 40% The borrowing interest rate’s surcharge goes from zero to 0.5%

2

Decomposition: with only down payment or interest rate change

3

Role of asset price: constant housing price

4

Role of frictions: wage elasticity, matching frictions and adj costs

5

Allowing default: a larger drop of housing price

6

Credit cycle

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 33/59

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SLIDE 34

Long Run Properties

  • Typically like in all [Aiyagari(1994)] - [Bewley(1986)] -

[Huggett(1993)] - [Imrohoro˘ glu(1989)] type models, in the long run

  • utput and wealth end up being higher.
  • But in our economies the transition is associated to a recession.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 34/59

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SLIDE 35

Experiment 1: Baseline

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline

Real output

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline

Unemployment

1 2 3 4 5 6 7 8 9 10 −7 −6 −5 −4 −3 −2 −1

Baseline

Consumption

1 2 3 4 5 6 7 8 9 10 −30 −25 −20 −15 −10 −5 5

Baseline

Investment

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 35/59

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SLIDE 36

Experiment 1: Baseline

1 2 3 4 5 6 7 8 9 10 −8 −7 −6 −5 −4 −3 −2 −1

Baseline

Wealth

1 2 3 4 5 6 7 8 9 10 −35 −30 −25 −20 −15 −10 −5

Baseline

Debt

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline

Housing price

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 36/59

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SLIDE 37

Experiment 1: Baseline

1 2 3 4 5 6 7 8 9 10 −1.5 −1 −0.5

Baseline

TFP with total hours

1 2 3 4 5 6 7 8 9 10 −1.5 −1 −0.5

Baseline

Labor Productivity

1 2 3 4 5 6 7 8 9 10 0.2 0.4 0.6 0.8 1 1.2 1.4

Baseline

Labor quality

1 2 3 4 5 6 7 8 9 10 −2.5 −2 −1.5 −1 −0.5

Baseline

TFP with total labor inputs

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 37/59

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SLIDE 38

Another Experiment: Constant Housing Prices

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5 0.5

Baseline Constant housing price

1 2 3 4 5 6 7 8 9 10 5.5 6 6.5 7 7.5 8 8.5 9

Baseline Constant housing price

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 −0.2 0.2

Baseline Constant housing price

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline Constant housing price

TFP Housing price

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 38/59

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SLIDE 39

Experiment 5: Allowing Households Holding no Housing

30% of households hold zero houses in the United States Change preference slightly to match this moment v(h) =        ξh log(h + h), if h < h1,

ξh 1−σh

  • h + ξ1

h

1−σh + ξ2

h,

if h1 ≤ h ≤ h2, ξ3

h

  • h

2 − (h − h)2 + ξ4 h,

if h > h2. Similar aggregate response, but richer cross-sectional implications

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 39/59

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SLIDE 40

Experiment 5: Aggregate Response

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline Extension: allowing no housing

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline Extension: allowing no housing

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.5 −1 −0.5

Baseline Extension: allowing no housing

1 2 3 4 5 6 7 8 9 10 −20 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline Extension: allowing no housing

TFP Housing price

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 40/59

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SLIDE 41

Experiment 5: Cross-Sectional Effects

10 20 30 40 50 60 70 80 90 100 −60 −50 −40 −30 −20 −10

Wealth

10 20 30 40 50 60 70 80 90 100 −16 −14 −12 −10 −8 −6 −4 −2 2 4

Consumption

  • This agrees with the evidence in [Petev, Pistaferri, and Eksten(2012)] and

[Parker and Vissing-Jorgensen(2009)]

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 41/59

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SLIDE 42

Experiment 6: Allowing Default

Borrowing interest rate’s surcharge goes from zero to 1%. Housing price drops more than 20%, and agents may be underwater. Allow borrowers to default, but savers suffer from the capital loss.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 42/59

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SLIDE 43

Experiment 6: Allowing Default

Total saving in financial wealth in the economy is L+,t =

  • b>0

bt(ǫ, e, a) dx Mortgages in the economy are L−,t =

  • b<0

−bt(ǫ, e, a) dx Net foreign asset position of the country Bt = L+,t −

  • ΩN

t − πN t + ΩT t − πT t +

1 1 + r∗ L−,t

  • The realized rate of return in next period is

1 + rt+1 = ΩN

t+1 + ΩT t+1 + (1 + r∗)Bt

L+ −

  • b<0 Iph,t+1ht(ǫ,e,a)+bt(ǫ,e,a)>0[ph,t+1ht(ǫ, e, a) + bt(ǫ, e, a)] dx

L+

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 43/59

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SLIDE 44

Experiment 6: Allowing Default

1 2 3 4 5 6 7 8 9 10 −4.5 −4 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline Allow default

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9 9.5 10

Baseline Allow default

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −2.5 −2 −1.5 −1 −0.5

Baseline Allow default

1 2 3 4 5 6 7 8 9 10 −25 −20 −15 −10 −5

Baseline Allow default

TFP Housing price

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 44/59

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SLIDE 45

Experiment 7: Credit Cycle

1 2 3 4 5 6 7 8 9 10 0.55 0.6 0.65 0.7 0.75 0.8 0.85

Loan to value ratio λ

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SLIDE 46

Experiment 7: Credit Cycle

1 2 3 4 5 6 7 8 9 10 −2.5 −2 −1.5 −1 −0.5 0.5 1 1.5 1 2 3 4 5 6 7 8 9 10 4.5 5 5.5 6 6.5 7 7.5 8

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.2 −1 −0.8 −0.6 −0.4 −0.2 0.2 0.4 0.6 0.8 1 2 3 4 5 6 7 8 9 10 −5 5 10 15 20

TFP Housing price

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SLIDE 47

Conclusions

We have a recession generated purely by increased difficulties to borrow on the part of households The recession comes together with

TFP loses Drop in Housing prices (movements too sharp because of lack of house frictions) Drop in Stock Market

The literature is trying hard to get this ([Midrigan and Philippon(2011)],

[Guerrieri and Lorenzoni(2009)]) with limited success.

Still ways to go:

Foreclosures; slow housing frictions; Long term Mortgages. Slow expanding export industries. Model of banking cycles.

Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 47/59

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SLIDE 48

Thank you very much

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SLIDE 49

American Time Use Survey Data on Shopping Time

5.2 5.4 5.6 5.8 6 6.2 2003 2006 2009 2012 Year Total Shopping Time Trend 1.6 1.8 2 2.2 2.4 2003 2006 2009 2012 Year Shopping time on services Trend

Total shopping time Shopping time on services

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SLIDE 50

The working of financial shocks that hit the production side

[Bernanke and Gertler(1989)], [Bernanke, Gertler, and Gilchrist(1999)]

Firms cannot borrow as much. Not all good projects will be undertaken. Cash rich firms expand at the expense of cash poor firms. In fact there is some of this in the data: Since 2007 employment of the young

firms went down by 24.5% and in 2012 it was at the historically lowest level.

Firms make themselves vulnerable by being close to their credit limit to improve their bargaining position over wages

[Monacelli, Quadrini, and Trigari(2011)]

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SLIDE 51

Why was there a financial shock? (what was the trigger?)

Increased variance in the cross-sectional returns of firms [Bloom(2009)],

[Bloom et al.(2011)Bloom, Floetotto, Jaimovich, and Saporta] [Arellano, Bai, and Kehoe(2012)], [Christiano, Motto, and Rostagno(2014)] [Dyrda(2015)].

Straight shocks to credit constraints [Jermann and Quadrini(2012)],

[Perri and Quadrini(2011)], [Macera(2015)].

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SLIDE 52

What have we learned

It is hard to get a large recession only from the product side and only from lower investment. The largest success (to my knowledge) ([Arellano, Bai, and Kehoe(2012)]) works by having the financial shocks increase the probability of default and inducing firms to pursue very conservative use of inputs despite their almost normal productivity. Still it is hard to have a reduction of marginal cash to create a large recession ([Zetlin-Jones and Shourideh(2012)]). It may have played a larger role in the expansion of new firms

([Dyrda(2015)])

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SLIDE 53

References

Aiyagari, S. Rao. 1994. “Uninsured Idiosyncratic Risk and Aggregate Saving.” Quarterly Journal of Economics 109 (3):659–684. Arellano, Cristina, Yan Bai, and Patrick J. Kehoe. 2012. “Financial Frictions and Fluctuations in Volatility.” Federal Reserve Bank of Minneapolis Research Department Sta Report. Bernanke, B. and M. Gertler. 1989. “Agency Costs, Net Worth, and Business Fluctuations.” American Economic Review 79 (1):14–31. Bernanke, Ben S., Mark Gertler, and Simon Gilchrist. 1999. “The financial accelerator in a quantitative business cycle framework.” In Handbook of Macroeconomics, Handbook of Macroeconomics, vol. 1, edited by J. B. Taylor and M. Woodford, chap. 21. Elsevier, 1341–1393. URL https://ideas.repec.org/h/eee/macchp/1-21.html. Bewley, Truman. 1986. “Stationary Monetary Equilibrium with a Continuum of Independently Fluctuating Consumers.” In Contributions to Mathematical Economics in Honor of G´ erard Debreu, edited by Werner Hildenbrand and Andreu Mas-Colell. Amsterdam: North Holland. Bloom, Nicholas. 2009. “The Impact of Uncertainty Shocks.” Econometrica 77 (3):623–685. URL http://ideas.repec.org/a/ecm/emetrp/v77y2009i3p623-685.html. Bloom, Nicholas, Max Floetotto, Nir Jaimovich, and Itay Saporta. 2011. “Really Uncertain Business Cycles.” Mimeo Stanford University. Christiano, Lawrence, Roberto Motto, and Massimo Rostagno. 2014. “Risk Shocks.” American Economic Review 104 (1):37–65. Dyrda, Sebastian. 2015. “Fluctuations in uncertainty, efficient borrowing constraints and firm dynamics.” Huo & R´ ıos-Rull, Yale, Penn, UCL, CAERP Financial Frictions, Asset Prices, & the Great Recession EIEF 53/59

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SLIDE 54

Equilibrium

An equilibrium is a set of decision rules and values for households, firms’ values and decision rules, and a set aggregate variables of aggregate states, such that: Households’ and firms’ policy functions and value functions solve the corresponding program problems. Aggregate searching consistence D =

  • d(ǫ, e, a) dx,

Nontradable prices satisfies p = pi(KN, NN) dx, Housing market clears

  • h(ǫ, e, a) dx = H.

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SLIDE 55

Equilibrium

Average separation probability and labor force quality δn =

  • ǫ δn(ǫ)n(ǫ)

N , ǫ =

  • ǫ ǫn(ǫ)

N Rate of return to the mutual fund satisfies 1 + r = ΩN + ΩT + (1 + r∗)B +

  • b<0 b(x)
  • b>0 b(x)

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SLIDE 56

Experiment 2 : Only λ or r Change

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline Only λ change Only r change

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline Only λ change Only r change

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 −0.2 0.2

Baseline Only λ change Only r change

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline Only λ change Only r change

TFP Housing price

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SLIDE 57

Experiment 4.1: Wage Elasticity

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline High wage elasticity: ϕw = 1.0

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline High wage elasticity: ϕw = 1.0

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 −0.2

Baseline High wage elasticity: ϕw = 1.0

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline High wage elasticity: ϕw = 1.0

TFP Housing price

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SLIDE 58

Experiment 4.2: Adjustment Cost

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline Low adjustment cost

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline Low adjustment cost

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −2 −1.8 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 −0.2

Baseline Low adjustment cost

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline Low adjustment cost

TFP Housing price

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SLIDE 59

Experiment 4.3: Goods Market Frictions

1 2 3 4 5 6 7 8 9 10 −3.5 −3 −2.5 −2 −1.5 −1 −0.5

Baseline Low matching elasticity: µ = 0.05

1 2 3 4 5 6 7 8 9 10 6 6.5 7 7.5 8 8.5 9

Baseline Low matching elasticity: µ = 0.05

Real output Unemployment rate

1 2 3 4 5 6 7 8 9 10 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 −0.2 0.2 0.4

Baseline Low matching elasticity: µ = 0.05

1 2 3 4 5 6 7 8 9 10 −18 −16 −14 −12 −10 −8 −6 −4 −2

Baseline Low matching elasticity: µ = 0.05

TFP Housing price

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