when money matters: liquidity shocks with real effects john driffill and marcus miller birkbeck and...
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When money matters: liquidity shocks with real effects
John Driffill and Marcus Miller
Birkbeck and University of Warwick
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Abstract• In their ‘workhorse model of money and liquidity’,
Kiyotaki and Moore (2008) show how tightening credit constraints can cut current investment and future aggregate supply.
• Aggregate demand matches current supply, thanks to a flex-price ‘Pigou effect’
• Switching from a flex-price to a fix-price framework implies that demand failures can emerge after a liquidity shock.
• Quantitative estimates by FRBNY using such a framework produce dramatic results: what about the analytics?
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Diagram 1. Effect of a stochastic liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009)
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Macro Paradigm: Woodford’s Synthesis Interest and Prices (2003)
• marked decisive shift in monetary economics from
looking at the quantity of money to the cost of
borrowing (i.e. from Friedman back to Wicksell
• inspired by an over-arching vision: to create a new
synthesis reconciling mainline macroeconomics with
dynamic General Equilibrium (GE), as practised by
RBC theorists in particular.
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Hammond’s view of GE without credit constraints?
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The Arrow Debreu paradigm at risk?
• In the absence of collateral or other credible
enforcement , Peter Hammond (1979) argued that, the
‘core’ of the inter-temporal GE model is not sub-game
perfect. Further discussion tomorrow?
• If this is true for Arrow-Debreu paradigm of GE, it is also
true for the DSGE specialisation developed for
macroeconomics. Does it matter?
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Great Moderation has succumbed to credit crunch
• US unemployment rate has doubled from 4.8 per cent to
9.8 percent
• “the world is currently undergoing an economic shock
every bit as big as the Great Depression shock of 1929-
302” Eichengreen and O’Rourke (2009).
• “The good news is that the policy response is very
different” (zero interest rate, deficit spending, QE)
• The bad news is that it lies outside the reach of DSGE
• Can Kiyotaki and Moore (2008) model help?
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KM(2008) framework
• addresses the Hammond critique of DGE: firms cannot borrow at will - with real consequences for composition of output.
• heterogeneous investors facing liquidity constraints
• want to hold money as a precaution against a lack of finance for investment opportunity
• need to add sticky wages/prices for liquidity shocks to have significant real effects;
• otherwise the Pigou effect acts as automatic stabiliser!
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Woodford’s synthesis: the New Paradigm
Supply conditions
Goods market
Money market
RBC (representative agent with RE)
Productive efficiency (Flex-price, FE)
Inter-temporal optimisation (Euler equation)
Efficient contracts (money an epiphenomenon)
Keynesian Orthodoxy
Fix-price,UE (Phillips curve)
Agg. Demand (IS)
Liquidity Preference (LM)
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Kiyotaki and Moore(2008), but with sticky wages/prices as in FRBNY and Driffill/Miller
Supply conditions
Goods market
Money market
RBC (representative agent with RE)
Productive efficiency (Flex-price, FE)
Inter-temporal optimisation subject to
Efficient contracts (money an epiphenomenon)
Keynesian Orthodoxy
Fix-price,UE (Phillips curve)
(credit constraints) Agg. Demand (IS)
Liquidity Preference (LM)
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Fix price macro
• If prices are inflexible downward, there will be no Pigou
effect to stabilise aggregate demand in the face of a fall
of investment
• A fall in demand will contract employment if the real
wage is determined by bargaining, as argued for the UK
in Layard and Nickell, Alan Manning.
• Graphical representation follows of how liquidity
contraction can cut income conditional on K and q.
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45°
L
wage bill (w*L)
X
‘workers spend what they earn;
entrepreneurs earn what they
spend’
Marginal Product of Labour
Aggregate Demand
Bargaining Wage
w*
X
Xf
real wage rate
L
D(X;q,K,)
μ
E
E*
D
D*
Net Output (X = r(Y)K)
Net Output (X=r(Y)K)
Figure 3. Short-run determination of X and Y
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Kiyotaki and Moore (2008): “Liquidity, Business Cycles, and Monetary Policy”
• Assets involved:
• Money and equity
• Money is liquid
• Equity is not (completely) liquid – only a fraction of holdings can be sold each period– only a fraction of newly produced capital goods can
be financed by issuing new equity
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Flex price to Fix price
Planes of stationarity
IR, Investment for Replacement I=(1-λ)K
AM, Asset Market equilibrium
GM, Goods Market equilibrium
Other variables
Dynamics of adjustment
Otherwise, Capital adjusts
out of equil, Share prices adjust
out of equil, Prices move
n/a
Variable determined
K q p M, φ
Nature State variable Jump Jump exogenous Notes Two unstable and one stable eigenvectors In 3 dimensional p,q,K space, with one state variable,K.
Planes of stationarity
IR, Investment for Replacement I=(1-λ)K
AM, Asset Market equilibrium
Change of status (Goods Market not in equil)
Other variables as before
Dynamics of adjustment
Otherwise, Capital adjusts
out of equil, Share prices adjust
n/a n/a
Variable determined K q p M, φ Nature State variable Jump exogenous exogenous Note One unstable and one stable eigenvectors In 2 dimensional q,K space, with one state variable,K.
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Workers – not the focus of attention
• Spend what they get
• Rational and forward-looking, but impatient and credit
constrained.
• No borrowing
• They can hold money and equity if they choose
• Save nothing
• Consumption equals wages
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Investment
Entrepreneurs can only finance investment using
money, selling existing equity claims to others,
raising equity on new capital, and spending out of
current income
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Entrepreneurs – play central role, manage production and invest and hold assets
• May (prob π) or may not (prob 1-π) have an idea for a profitable investment
• Those with no ideas (no investment)– Consume – Save in form of money and equity holdings
• Those with an idea (Investors)– Buy new capital goods– Issue equity against them– Use money, other equity holdings, and current income
to finance investment
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Liquidity constraints – on investment
• Entrepreneurs can raise equity against up to a fraction θ of new investment.
• They can sell off a fraction φt of pre-existing equity (theirs and others) nt
• Money is perfectly liquid
1 (1 ) (1 )t t t tn i n
1 0tm
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Entrepreneur’s budget constraint
• Budget:
• p – price of money; q – equity price
• λ – 1-depreciation rate
• n equity held by entrepreneur
• Objective - max exp U:
1 1( ) ( )t i t t t t t t t t tc i q n i n p m m r n
log( )s tt s
s t
E c
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Production
• CRS / C-D production function, capital and labour
• KM: wage clears labour market
• DM: fix money wage and price level – entrepreneurs keep the surplus
1t t t ty A k l
t t t t ty w l r k
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Investment and Net Demand
(1 )1 1
t t t t t t
t t Rt t t
r q K p Mq I
q K
( ) 1
( ) 11
t t t
t t t t t tRt t
r x qr x K I K p M
q
Investment demand
Entrepreneurs’ income equals their demand (GM equilibrium)
1
1R t
t
.
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Entrepreneur’s Portfolio Balance (AM)
1 1 1
1 1 1 1
1 1 1 1 1 1
1 1 1 1 1 1 1
/ /(1 )
/ (1 ) /
(1 )
t t t t tt s
t t t t
Rt t t t t t t t
t R st t t t t t t
r q q p pE
r q N p M
p p r q q qE
r q q N p M
1 (1 )st t t t tN I K K
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q
Equity Price
K
AM
E
Capital Stock
RI'GM
K*
Zero net investment
ΔK/Δt = 0
Asset price stationary
Δq/Δt = 0
GM'
AM'
RI
Δp/Δt = 0
Note that, at E’, the price level is lower than at E; 3D dynamics
E'
KM (2008): liquidity driven expansion, ϕincreases, equity more liquid
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q
Equity Price
K
AM
E'
Capital Stock
RI'
K*
Zero net investment
ΔK/Δt = 0
Asset price stationary
Δq/Δt = 0
GM
AM'
RI
Fixed price, 2D dynamics with respect to AM and RI, GM not applicable: output is demand determined
E
Y
DM (2010): liquidity driven contraction
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Saddle Path Dynamics in fix price case: driven by Asset Market and Investment disequilibrium
q
Equity Price
K
AM
E
Capital Stock
RI
K*
Zero net investment
ΔK/Δt = 0
Asset price stationary
Δq/Δt = 0
Note: Goods Markets has excess supply
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Using AM and RI to get phase diagram
q
Equity Price
K
AM
E
Capital Stock
RI
SU
K*
K Zero net investment
ΔK/Δt = 0
Asset price stationary
Δq/Δt = 0 U
S
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liquidity shock shifts E to E': with stock market fall leading to recession – or recovery if shock is to be
reversed
q
K
E
K**
U'
D
K*
E'
U'
L
A
A
I
P
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Figure 6. Numerical Results from DM simulation using FRBNY parameters
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Calibration using FRBNY parameters (qtly)
• φ = 0.13 (fraction of existing assets an entrepreneur can sell);
• discount factor β = 0.99;
• fraction of new capital against which an entrepreneur can raise equity, θ = 0.13;
• probability of an entrepreneur having an idea for an investment, π = 0.075;
• the quarterly survival rate of the capital stock λ = 0.975
• [ our base case steady state: q = 1.12, r = 0.0374,
• Mp/K =0.1171, K = 152.5, y =17.26]
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Temporary and permanent liquidity shock
t
Y
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Table 2. Impact effects of a 20% cut in ϕ for different lengths of time
Short (2 years) Long (8 years) Permanent
q -1.25% -2.86% -3.57%
r -10.90% -12.23% -12.50%
X -10.27% -11.48% -11.73%
y -18.65% -20.54% -20.92%
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Figure 8. Tobin’s q and the capital stock between the wars
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Figure 9. Bubble collapse preceding liquidity shock: like 1929
q
K
U
E
K**
U
E'
D
K*
U'
U'B
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Credit crunch
• With firms who want to invest more credit constrained -
and workers income constrained - no Pigou effect to
stimulate entrepreneurial consumption, a ‘credit crunch’
causes recession.
• The antidote discussed by KM should work here too:
Quantitative Easing as the government supplies
liquidity in exchange for corporate securities.
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Conclusion• Switching from a flex-price to a fix-price framework
means that demand failures can emerge after a liquidity shock.
• AM and RI offer simple analytical treatment of impact and dynamic effects.
• Adding bubble might help explain the origin of the shock- it’s when the bubble bursts
• Need to add financial intermediaries to get to the heart of the matter
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Current UK recession (blue) relative to earlier recessions(brown: 1930s, green and yellow: oil shocks)
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Titanic sinking
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Titanic
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Queen Hermione imprisoned for sixteen years: then came reconciliation
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Time for a change in Macro?
• discredited and discarded in the stagflation that followed
the oil price shocks of the 70s and 80s, the Keynesian
paradigm of macroeconomic stabilisation has suffered
in silence for many years.
• but the new DSGE paradigm failed to predict the ‘credit
crunch’ - or explain its effects.
• Let’s briefly review recent fashions in macro