Twenty-sixth Annual Conference on Macroeconomics

April 8 and 9, 2011
Daron Acemoglu of MIT and Michael Woodford of Columbia University, Organizers

Andreas Fuster and Ben Hebert, Harvard University, and David Laibson, Harvard University and NBER
Natural Expectations, Macroeconomic Dynamics, and Asset Pricing

How does an economy behave if fundamentals are truly hump-shaped, exhibiting momentum in the short run and partial mean reversion in the long run, and agents do not know that fundamentals are hump-shaped and thus base their beliefs on parsimonious models that they fit to the data? A class of parsimonious models engenders qualitatively similar biases and generates empirically observed patterns in asset prices and macroeconomic dynamics. First, parsimonious models will robustly pick up the short-term momentum in fundamentals but will generally fail to fully capture the long-run mean reversion. Therefore, beliefs will be characterized by endogenous extrapolation bias and pro-cyclical excess optimism. Second, asset prices will be highly volatile and will exhibit partial mean reversion - that is, overreaction. Excess returns will be negatively predicted by lagged excess returns, P/E ratios, and consumption growth. Third, real economic activity will have amplified cycles. For example, consumption growth will be negatively auto-correlated in the medium run. Fourth, the equity premium will be large. Agents will perceive that equities are very risky when in fact long-run equity returns will co-vary only weakly with long-run consumption growth. If agents had rational expectations, then the equity premium would be close to zero. Fifth, sophisticated agents - those who are assumed to know the true model - will hold far more equity than investors who use parsimonious models. Moreover, sophisticated agents will follow a counter-cyclical asset allocation policy. Fuster, Hebert, and Laibson confirm these predicted effects in U.S. data.

Klaus Adam, University of Mannheim; Pei Kuang, Frankfurt University; and Albert Marcet, London School of Economics
House Prices and the Current Account

Adam, Kuang, and Marcet assert that a simple, open economy asset pricing model can account for the house price and current account dynamics in the G7 over the years 2001-8. Their model features rational households, but assumes that households entertain subjective beliefs about price behavior and update them using Bayes's rule. The resulting beliefs dynamics considerably propagate economic shocks and crucially contribute to replicating the empirical evidence. Belief dynamics can temporarily delink house prices from fundamentals, so that low interest rates can fuel a house price boom. House price booms, however, are not necessarily synchronized across countries and the model correctly predicts the heterogeneous response of house prices across the G7, following the fall in real interest rates at the beginning of the millennium. The response to interest rates depends sensitively on agents' beliefs at the time of the interest rate reduction, which are a function of the prior history of disturbances hitting the economy. According to the model, the U.S. house price boom could have been largely avoided, if real interest rates had decreased by less after the year 2000.

Markus K. Brunnermeier, Princeton University and NBER; Gary B. Gorton, Yale University and NBER; and Arvind Krishnamurthy, Northwestern University and NBER
Risk Topography

Brunnermeier, Gorton, and Krishnamurthy conceptualize and design a risk topography that outlines a data acquisition and dissemination process which informs policymakers, researchers, and market participants about systemic risk. The authors emphasize that systemic risk cannot be detected based on measuring cash instruments, such as balance sheet items and income statement items. Typically, such risk builds up in the background before materializing in a crisis, and it is determined by market participants' response to various shocks. The researchers propose that regulators elicit from market participants their (partial equilibrium) risk, as well as their liquidity sensitivities with respect to major risk factors and liquidity scenarios. Using this panel data set, general equilibrium responses and economy-wide system effects can be calibrated .

Deniz Igan, Prachi Mishra, and Thierry Tressel, International Monetary Fund
A Fistful of Dollars: Lobbying and the Financial Crisis

Has lobbying by financial institutions contributed to the financial crisis? Igan, Mishra, and Tressel use detailed information on financial institutions' lobbying and mortgage lending activities to answer this question. They find that lobbying was associated with more risk-taking during 2000-7 and with worse outcomes in 2008. In particular, lenders lobbying more intensively on issues related to mortgage lending and securitization: 1) originated mortgages with higher loan-to-income ratios; 2) securitized a faster growing proportion of their loans; and 3) had faster growing originations of mortgages. Moreover, delinquency rates in 2008 were higher in areas where lobbying lenders' mortgage lending grew faster. These lenders also experienced negative abnormal stock returns during the rescue of Bear Stearns and the collapse of Lehman Brothers, but positive abnormal returns when the bailout was announced. Finally, the authors find a higher bailout probability for lobbying lenders. These findings suggest that lending by politically active lenders played a role in accumulation of risks and thus contributed to the financial crisis.

Gianluca Benigno, London School of Economics; Pierpaolo Benigno, Luiss Guido Carli and NBER; and Salvatore Nistico, Universita di Roma, La Sapienza
Risk, Monetary Policy, and The Exchange Rate

Benigno, Benigno, and Nistico provide new empirical evidence on the importance of time-varying uncertainty for the exchange rate and the excess return in currency markets. Following an increase in monetary policy uncertainty, the dollar exchange rate appreciates in the medium run, while an increase in the volatility of productivity leads to a dollar depreciation. The authors propose a general-equilibrium theory of exchange rate determination based on the interaction between monetary policy and time-varying uncertainty aimed at understanding these regularities. In the model, the behavior of the exchange rate following nominal and real volatility shocks is consistent with the empirical evidence. Furthermore, they show that risk factors and interest-rate smoothing are important in accounting for the negative coefficient in the UIP regression.

Jordi Gali, CREI and NBER; Frank Smets, European Central Bank; and Raf Wouters, National Bank of Belgium
Unemployment in an Estimated New Keynesian Model

Gali, Smets, and Wouters develop a reformulated version of the Smets-Wouters (2007) framework that embeds the theory of unemployment proposed in Gali (2011a,b). They estimate the resulting model using postwar U.S. data, while treating the unemployment rate as an additional observable variable. Their approach overcomes the lack of identification of wage markup and labor supply shocks highlighted by Chari, Kehoe, and McGrattan (2008) in their criticism of New Keynesian models, and allows them to estimate a "correct" measure of the output gap. In addition, the estimated model can be used to analyze the sources of unemployment fluctuations.

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