Monetary Economics

Members of the NBER's Monetary Economics Program met in Federal Reserve Bank of New York on March 1-2. Faculty Research Fellows Amir Kermani of University of California at Berkeley and Jennifer La'O of Columbia University organized the meeting. These researchers' papers were presented and discussed:

Itamar Drechsler, New York University and NBER; Alexi Savov, New York University and NBER; and Philipp Schnabl, New York University and NBER

Banking on Deposits: Maturity Transformation without Interest Rate Risk

Drechsler, Savov, and Schnabl show that in stark contrast to conventional wisdom maturity transformation does not expose banks to significant interest rate risk. Aggregate net interest margins have been near-constant from 1955 to 2015, despite substantial maturity mismatch and wide variation in interest rates. They argue that this is due to banks' market power in deposit markets. Market power allows banks to pay deposit rates that are low and relatively insensitive to interest rate changes, but it also requires them to pay large operating costs. This makes deposits resemble fixed-rate liabilities. Banks hedge them by investing in long-term assets whose interest payments are also relatively insensitive to interest rate changes. Consistent with this view, the researchers find that banks match the interest rate sensitivities of their expenses and income one for one. This relationship is robust to instrumenting for expense sensitivity using geographic variation in market power. Also consistent, they find that banks with lower expense sensitivity hold assets with substantially longer duration. The researchers' results provide a novel explanation for the coexistence of deposit-taking and maturity transformation.

Julian Kozlowski, New York University; Laura Veldkamp, New York University and NBER; and Venky Venkateswaran, New York University and NBER

The Tail that Keeps the Riskless Rate Low (NBER Working Paper No. 24362)

Riskless interest rates fell in the wake of the financial crisis and have remained low. Kozlowski, Veldkamp, and Venkateswaran explore a simple explanation: This recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed, perceived tail risk remains high, generates a demand for riskless, liquid assets, and continues to depress the riskless rate. The researchers embed this mechanism in a simple production economy with liquidity constraints and use observable macro data, along with standard econometric tools, to discipline beliefs about the distribution of aggregate shocks. When agents observe an extreme, adverse realization, they re-estimate the distribution and attach a higher probability to such events recurring. As a result, even transitory shocks have persistent effects because, once observed, the shock stays forever in the agents' data set. The researchers show that their belief revision mechanism can help explain the persistent nature of the fall in the risk-free rates.

Chen Lian, MIT, and Yueran Ma, Harvard University

Anatomy of Corporate Borrowing Constraints

A common perspective in macro-finance analyses links firms' borrowing constraints to the liquidation value of physical assets firms pledge as collateral. Lian and Ma empirically investigate borrowing by non-financial firms in the U.S. They find that 20% of corporate debt by value is collateralized by specific physical assets ("asset-based lending" in creditor parlance), while 80% is based predominantly on cash flows from firms' operations ("cash flow-based lending"). In this setting, a standard form of borrowing constraint restricts a firm's total debt as a function of cash flows measured using operating earnings ("earnings-based borrowing constraints," or EBCs). The features of corporate borrowing illuminate how financial variables affect firms' borrowing constraints and outcomes on the margin. First, with cash flow-based lending, cash flows in the form of operating earnings directly relax EBCs, and enable firms to both borrow and invest more. Second, as corporate borrowing overall does not rely heavily on physical assets such as real estate, firms could be less vulnerable to collateral damage from asset price shocks, and fire sale amplifications may be mitigated. In the Great Recession, for example, property value declines did not trigger a deleveraging cycle among major U.S. non-financial firms due to collateral damage. Finally, results in the U.S. contrast with those in Japan, where corporate borrowing historically emphasizes physical assets.

Francisco J. Buera, Washington University in St. Louis, and Sudipto Karmakar, Banco de Portugal

Real Effects of Financial Distress: The Role of Heterogeneity

What are the heterogeneous effects of financial shocks on firms' behavior? Buera and Karmakar evaluate and answer this question from both an empirical and a theoretical perspective. Using micro data from Portugal during the sovereign debt crisis, starting in 2010, they document that highly leveraged firms and firms that had a larger share of short-term debt on their balance sheets contracted more in the aftermath of a financial shock. The researchers use a standard model to analyze the conditions under which leverage and debt maturity determine the sensitivity of firms' investment decisions to financial shocks. They show that the presence of long-term investment projects and frictions to the issuance of long-term debt are needed for the model to rationalize the empirical findings. The researchers conclude that the differential responses of firms to a financial shock do not provide unambiguous information to identify these shocks. Rather, they argue that this information should be use to test for the relevance of important model assumptions.

Anmol P. Bhandari, University of Minnesota; David Evans, University of Oregon; Mikhail Golosov, University of Chicago and NBER; and Thomas J. Sargent, New York University and NBER

Inequality, Business Cycles and Monetary-Fiscal Policy

Bhandari, Evans, Golosov, and Sargent study monetary and fiscal policy in a heterogeneous agents model with incomplete markets and nominal rigidities. They develop numerical techniques that allow them to approximate Ramsey plans in economies with substantial heterogeneity. In a calibrated model that captures features of income inequality in the U.S., the researchers study optimal responses of nominal interest rates and labor tax rates to productivity and cost-push shocks. Optimal policy responses are an order of magnitude larger than in a representative agent economy, and for cost-push shocks are of opposite signs. Taylor rules poorly approximate optimal nominal interest rates.

Emmanuel Farhi, Harvard University and NBER, and David Baqaee, London School of Economics

Productivity and Misallocation in General Equilibrium (NBER Working Paper No. 24007)

Farhi and Baqaee provide a general non-parametric formula for aggregating microeconomic shocks in general equilibrium economies with distortions such as taxes, markups, frictions to resource reallocation, and nominal rigidities. They show that the macroeconomic impact of a shock can be boiled down into two components: its "pure" technology effect, and its effect on allocative efficiency arising from the reallocation of resources (measured via changes in factor income shares). The researchers derive a formula showing how these two components are determined by structural microeconomic parameters such as elasticities of substitution, returns to scale, factor mobility, and network linkages. Overall, their results generalize those of Solow (1957) and Hulten (1978) to economies with distortions. To demonstrate their empirical relevance, the researchers pursue different applications, focusing on markup distortions. They operationalize their non-parametric results and show that improvements in allocative efficiency account for about 50% of measured TFP growth over the period 1997-2015. They also implement their structural results and conclude that eliminating markups would raise TFP by about 40%, increasing the economy-wide cost of monopoly distortions by two orders of magnitude compared to the famous 0.1% estimate by Harberger (1954).

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