Financial Frictions, Asset Prices, and the Great Recession Zhen Huo - PowerPoint PPT Presentation

Financial Frictions, Asset Prices, and the Great Recession Zhen Huo and Jos´ e-V´ ıctor R´ ıos-Rull University of Minnesota, Federal Reserve Bank of Minneapolis, CAERP, CEPR, NBER University of Mannheim Sept 24, 2013 Very Preliminary . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 1 / 65

Facts on the last recession: I 6 10 4 9 2 8 0 7 −2 6 −4 5 −6 −8 4 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 Real output Unemployment 6 30 4 20 2 10 0 0 −2 −10 −4 −20 −6 −30 −8 −10 −40 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 . . . . . . . Consumption Investment .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 2 / 65 Note : Except for unemployment, figures show percentage deviation from a linear trend.

Facts on the last recession: II 5 0.8 4.8 0.75 4.6 0.7 4.4 4.2 0.65 4 0.6 3.8 0.55 3.6 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 Debt to output Wealth to output 1.8 230 1.7 220 1.6 210 1.5 200 1.4 190 1.3 180 1.2 170 1.1 1 160 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 . . . . . . . Housing price index Housing value to output .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 3 / 65

Facts on the last recession: III 3 4 2 3 1 2 0 1 −1 0 −2 −1 −3 −2 −4 −3 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 TFP with total hours Labor productivity 4 0.8 3 0.6 2 0.4 0.2 1 0 0 −0.2 −1 −0.4 −2 −0.6 −3 −0.8 −4 −1 −5 2004 2006 2008 2010 2012 2004 2006 2008 2010 2012 . . . . . . . Labor quality TFP with total labor inputs .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 4 / 65 Note : Figures show percentage deviation from a linear trend.

Summary of the facts Large decline in main aggregate variables. Households deleveraging process: private debt and housing price plunged. Total factor productivity dropped, but labor productivity and labor quality increased. . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 5 / 65

Objective of this project To explore the quantitative properties of environments where recessions are caused by worse financial conditions faced by households. These environments have . . Real frictions that make difficult to switch from production of consumption goods 1 to exports or investment. . . Households differing in wealth and job market prospects. 2 . . A financial system used widely by households to buy houses which are inferior 3 goods and not wanted by the super-rich. . . Asset prices respond to market conditions. 4 . . Frictions in the goods market generate movements in measured TFP. 5 . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 6 / 65

Ingredients of this project It is a small open Aiyagari/Krusell-Smith economy with a housing market and a stock market. Borrowing has to be collateralized by the value of housing. The financial terms available are the financial conditions and are subject to shocks. Like in Huo & Rios-Rull(13) there are goods market frictions that generate TFP losses, job market frictions, and adjustment costs to move into tradable production. . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 7 / 65

Findings A recession can be triggered by financial shocks to households. It shares most of the features of the Great Recession. Insufficient reductions in assets (housing and stocks) prices. For now!! . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 8 / 65

The Model . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 9 / 65

Households: Preferences Continuum of households that live forever ( β ), are subject to uninsurable idiosyncratic and aggregate shocks. Hholds care about quantities and number of varieties of nontradables. (∫ I N ) ρ 1 c N = c Ni di ρ 0 [∫ I N ] ρ 1 ▶ Under equal consumption of each variety: c N I ρ N = c Ni di ρ 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. 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 (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 10 / 65

Households: Endowments and Wealth Household skill type is ϵ , follows a Markov chain Γ ϵ,ϵ ′ . 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 ϵ 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 (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 11 / 65

Production: two sectors tradables and nontradables. Tradables . ▶ Measure one of competitive firms. ▶ (Large) Adjustment costs to both capital and labor. ▶ Its output is used for exports, investment, and (part of) consumption. ▶ F T ( k , ℓ ) may have decreasing returns. Nontradables ▶ Measure one of monopolistic firms each one producing a different variety. ▶ Each firm/variety has a measure one of locations, each location has its own production function F N ( k , ℓ 1 , ℓ 2 ) . ⋆ ℓ 1 Committed to the location. (Sales staff) ⋆ ℓ 2 Can be reallocated within the period. (Production Staff ) ▶ Locations may or may not be filled (get a customer). They produce only for consumption. ▶ Firms post prices before the location is filled. . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 12 / 65

Goods markets • Perfect competition and frictionless markets for tradables. • Search frictions in the markets for nontradables: Households look for varieties. M ( D , 1). Market tightness is Q g = 1 CRS matching function D . Random search. There is no possibility of attracting more customers with lower prices (we are working on a paper where there is shopping and searching simultaneously). ▶ The probability that a shopper finds a firm-variety: Ψ d ( Q g ) = M D ▶ The probability that a firm finds a shopper is the measure of filled locations or of consumers buying the good: Ψ f ( Q g ) = M 1 = M ( D , 1). . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 13 / 65

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 determined via the following formula ( ) log w − log w = ε w log Y − log Y It simplifies things. Gornemann, Kuester, and Nakajima (2012). . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 14 / 65

Assets markets: Financial assets and houses Total housing H is in fixed supply. Negative financial assets ( b ′ < 0) are (undefaultable) mortgages. ▶ Its interest rate 1 q is predetermined at borrowing time, { 1 , if b ≥ 0 q ( θ, b ′ ) = 1 1+ r ∗ − ς ( θ ) , if b < 0 ▶ Mortgages have to be collateralized by housing q ( θ, b ) b ≥ − λ ( θ ) p h ( S ) h Positive financial assets ( b > 0) are shares of a mutual fund. ▶ Its return is stochastic. Possible Capital gains and loses. ▶ The return is { 1 + r ( S , S ′ ) , if b ≥ 0 R ( S , S ′ , b ) = 1 , if b < 0 . . . . . . . . .. . .. . .. . .. . ,. .. . .. . .. . Huo & R´ ıos-Rull (UMN, Mpls Fed, CAERP) Financial Frictions & Great Recessions University of Mannheim 15 / 65