Monetary Economics

Members of the NBER's Monetary Economics Program Meeting met in Cambridge November 2. Faculty Research Fellow Gabriel Chodorow-Reich of Harvard University and Research Associate Simon Gilchrist of New York University organized the meeting. These researchers' papers were presented and discussed:

George-Marios Angeletos, MIT and NBER, and Zhen Huo, Yale University

Myopia and Anchoring (NBER Working Paper No. 24545)

Angeletos and Huo consider a stationary setting featuring forward-looking behavior, strategic complementarity, and incomplete information. They obtain an observational equivalence result that recasts the aggregate dynamics of this setting as that of a representative-agent model featuring two distortions-- myopia -- as in models with imperfect foresight and anchoring of the current outcome to the past outcome, as in models with habit persistence and adjustment costs. The researchers further show that the as-if distortions are larger when the general-equilibrium feedback, or the strategic complementarity, is stronger. These results offer a fresh perspective on the observable implications of informational frictions, build a useful bridge to the DSGE literature, and help reduce an uncomfortable gap between the prevailing structural interpretations of the macroeconomic time series and the related microeconomic evidence. Finally, an empirical evaluation is offered in the context of inflation, wherein it is shown how the results can rationalize existing estimates of the Hybrid NKPC while also matching survey evidence on expectations.

Ben S. Bernanke, Brookings Institution

The Real Effects of the Financial Crisis

Economists both failed to predict the global financial crisis and underestimated its consequences for the broader economy. Focusing on the second of these failures, Bernanke makes two contributions. First, he review research since the crisis on the role of credit factors in the decisions of households, firms, and financial intermediaries and in macroeconomic modeling. The research provides broad support for the view that credit-market developments deserve greater attention from macroeconomists, not only for analyzing the economic effects of financial crises but in the study of ordinary business cycles as well. Second, Bernanke provides new evidence on the channels by which the recent financial crisis depressed economic activity in the United States. Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, he finds that the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit. This finding helps to justify the government's extraordinary efforts to stem the panic in order to avoid greater damage to the real economy.

Atif R. Mian, Princeton University and NBER, and Amir Sufi, University of Chicago and NBER

Credit Supply and Housing Speculation (NBER Working Paper No. 24823)

Credit supply expansion fuels housing speculation, generating a boom and bust in house prices. Mian and Sufi show that U.S. zip codes more exposed to the 2003 acceleration of the private label mortgage securitization (PLS) market witnessed a sudden and large increase in mortgage originations and house prices from 2003 to 2006, followed by a collapse in house prices from 2006 to 2010. During the boom, cities with higher PLS-market exposure were more likely to see a large increase in house prices despite substantial new construction -- these cities experienced a severe bust after 2006. Most of the marginal home-buyers brought into the housing market by the acceleration of the PLS market were short-term buyers or "flippers." These marginal buyers had lower credit scores and higher ex post default rates. Speculation by such home-buyers contributed to a large rise in transaction volume from 2003 to 2006, and helped trigger the mortgage default crisis in 2007.

Olivier Coibion, University of Texas at Austin and NBER; Yuriy Gorodnichenko, University of California, Berkeley and NBER; and Tiziano Ropele, Bank of Italy

Inflation Expectations and Firm Decisions: New Causal Evidence (slides)

Coibion, Gorodnichenko, and Ropele use a unique design feature of a survey of Italian firms to study the causal effect of inflation expectations on firms' economic decisions. In the survey, a randomly chosen subset of firms is repeatedly treated with information about recent inflation (or the European Central Bank's inflation target) whereas other firms are not. This information treatment generates exogenous variation in inflation expectations. The researchers find that higher inflation expectations on the part of firms leads them to raise their prices, increase their utilization of credit, and reduce their employment. However, when policy interest rates are fixed, demand effects are stronger, leading firms to raise their prices more and no longer reduce their employment.

David W. Berger and Konstantin Milbradt, Northwestern University and NBER; Fabrice Tourre, Copenhagen Business School; and Joseph S. Vavra, University of Chicago and NBER

Mortgage Prepayment and Path-Dependent Effects of Monetary Policy (NBER Working Paper No. 25157)

How much ability does the Fed have to stimulate the economy by cutting interest rates? Berger, Milbradt, Tourre, and Vavra argue that the presence of substantial household debt in fixed-rate prepayable mortgages means that this question cannot be answered by looking only at how far current rates are from zero. Using a household model of mortgage prepayment with endogenous mortgage pricing, wealth distributions and consumption matched to detailed loan-level evidence on the relationship between prepayment and rate incentives, the researchers argue that the ability to stimulate the economy by cutting rates depends not just on the level of current interest rates but also on their previous path: 1) Holding current rates constant, monetary policy is less effective if previous rates were low. 2) Monetary policy "reloads" stimulative power slowly after raising rates. 3) The strength of monetary policy via the mortgage prepayment channel has been amplified by the 30-year secular decline in mortgage rates. All three conclusions imply that even if the Fed raises rates substantially before the next recession arrives, it will likely have less ammunition available for stimulus than in recent recessions.

Francesco D'Acunto, Boston College; Daniel Hoang, Karlsruhe Institute of Technology; Maritta Paloviita, Bank of Finland; and Michael Weber, University of Chicago and NBER

Human Frictions to the Transmission of Economic Policy

Intertemporal substitution is at the heart of modern macroeconomics and finance as well as economic policymaking, but a large fraction of a representative population - those below the top of the distribution by cognitive abilities (IQ) - do not change their consumption propensities with their inflation expectations. Low-IQ men are also less than half as sensitive to interest-rate changes when making borrowing decisions. Low-IQ men account for more than 50% of the individuals and 50% of the labor income in our sample, which includes unique merged administrative data on cognitive abilities, economic expectations, consumption and borrowing plans, as well as total loan amounts from Finland. Heterogeneity in education, income, other expectations, and financial constraints do not explain these results. Limited cognitive abilities are human frictions in the transmission and effectiveness of economic policy and inform research on heterogeneous agents in macroeconomics and finance.

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