Working Papers




  1. Monetary Policy and Rational Asset Bubbles Redux, with Pengfei Wang, and Zhouxiang Shen, PDF, January 2018.


Abstract: We show that Galí's (2014) counterintuitive results are driven by his choice of a backward-looking sunspot solution around a stable bubbly steady state. Under adaptive learning, such a steady state and the associated sunspot solutions under optimal monetary policy are not E-stable. When deriving the unique forward-looking minimum stable variable (MSV) solution around a bubbly steady state, we obtain results that are consistent with the conventional views. Such a steady state and the associated MSV solution are E-stable.



  1. Macro-Financial Volatility under Dispersed Information, with Jieran Wu and Eric Young, PDF, March 2017.


Abstract: We provide a production-based asset pricing model under dispersed information. In the log-linearized equilibrium system, aggregate output and equity prices depend on the higher-order beliefs about average forecasts of aggregate demand and individual stochastic discount factors, respectively. We prove that the presence of dispersed information reduces aggregate output volatility under very general information structures, provided agents are informationally small. On the other hand, equity volatility can be arbitrarily high when the volatility of the idiosyncratic shock approaches infinity. We show our analytical results using the frequency-domain techniques. As a methodological contribution, we illustrate how a two-step spectral factorization method can be used to obtain closed-form solutions if the signal extraction problem involves more shocks than signals, applicable to a large class of models with information frictions.


  1. Asset Bubbles and Monetary Policy, with Pengfei Wang and Feng Dong, PDF, January 2017.


Abstract: We provide an infinite-horizon model of rational asset bubbles in a Dynamic New Keynesian framework. Entrepreneurs are heterogeneous in investment efficiency and face credit constraints. They can trade land as an asset, which also serves collateral to borrow from banks with reserve requirements. Land commands a liquidity premium and a land bubble can emerge. Monetary policy can affect the condition for the existence of a bubble, its steady-state size, and its dynamics including the initial size. The `leaning against the wind' interest rate policy will reduce the bubble volatility, but it may come at the cost of raising the inflation volatility. Whether monetary policy should respond to asset bubbles depends on the particular interest rate rule adopted by the central bank and on the exogenous shocks hitting the economy.


  1. Asset Bubbles and Foreign Interest Rate Shocks, with Pengfei Wang and Jing Zhou, PDF, November 2016


Abstract: We provide an infinite-horizon general equilibrium model of a small open economy with both domestic and international financial market frictions. Firms face credit constraints and use a bubble asset (land) as collateral to borrow. A land bubble can provide liquidity and relax credit constraints. Low foreign interest rates are conducive to bubble formation. A rise in foreign interest rate can cause the collapse of the asset bubble and a sudden stop. Asset bubbles provide an important amplification mechanism.



  1. Saving China’s Stock Market, with Yi Huang and Pengfei Wang, PDF, August 2016  VoxEU


Abstract: What are the economic benefits and costs of preventing a stock market meltdown during the summer of 2015 by the Chinese government intervention? We answer this question by estimating the value creation for the stocks purchased by the government between the period starting with the market crash in mid-June and the market recovery in September. We find that the government intervention increased the value of the rescued firms with a net benefit between RMB 2,464 and 3,402 billion, which is about 5% of the Chinese GDP in 2014. The value creation came from the increased stock demand by the government, the reduced default probabilities, and the increased liquidity.



  1. Oil Driven Stock Price Momentum, with Dayong Huang, PDF, May 2016


Abstract: Stocks with high exposure to oil price movements perform well when oil price rises and poorly when oil price falls. This oil driven stock price momentum differs from the conventional stock price momentum and it is related to firms’ profitability. Daily oil price movement measures the state of the economy at high frequency and exposures to oil price movement estimated with daily data can be significant in forecasting future returns.



  1. Dynamic Contracts with Learning Under Ambiguity, with Shaolin Ji and Li Li, PDF, March 2016.


Abstract: We study a continuous-time principal-agent problem with learning under ambiguity. The agent takes hidden actions to affect project output. The project quality is unknown to both the principal and the agent. The agent faces ambiguity about mean output, but the principal does not. We show that incentives are delayed due to ambiguity. While belief manipulation due to learning about unknown quality causes wages and pay-performance sensitivity to be front-loaded, ambiguity smooths wages and causes the drift and volatility of wages to decline more slowly over time. When the level of ambiguity is sufficiently large, the principal fully insures the agent by allowing the agent to shirk forever.



Abstract: Credit booms often cause economic expansions. But some credit booms end in financial crises and others do not. This paper presents a dynamic macroeconomic model with adverse selection in the financial market to address this issue. Entrepreneurs can take short-term collateralized debt and trade long-term assets to finance investment. Funding liquidity can erode market liquidity. High funding liquidity discourages firms from selling their good long-term assets since these good assets have to subsidize lemons when there is information asymmetry. This can cause a liquidity dry-up in the market for long-term assets and even a market breakdown, resulting in a financial crisis. Multiple equilibria can coexist. Credit booms combined with changes in beliefs can cause equilibrium regime shifts, leading to an economic crisis or expansion.


  1. Does Calvo Meet Rotemberg at the Zero Lower Bound? PDF, with Phuong V. Ngo, October 2014


Abstract: This paper compares the Calvo model with the Rotemberg model in a fully nonlinear dynamic new Keynesian framework with an occasionally binding zero lower bound (ZLB) on nominal interest rates. Although the two models are equivalent to a first-order approximation, they generate very different results regarding the policy functions and the government spending multiplier based on nonlinear solutions. The multiplier in the Calvo model is less than one for low persistence of the government spending shock and rises above one as the persistence increases, but eventually decreases with the persistence and falls below one for sufficiently high persistence. In addition, the multiplier increases with the duration of the ZLB. By contrast, the multiplier in the Rotemberg model is less than one and decreases with the persistence. Surprisingly, it also decreases with the duration of the ZLB.




  1. Liquidity Premia, Price-Rent Dynamics, and Business Cycles, PDF, with Pengfei Wang and Tao Zha, February, 2014


Abstract: In the U.S. economy over the past twenty five years, house prices exhibit fluctuations considerably larger than house rents.  These price-rent dynamics tend to move together with business cycles and have a predictive power for house returns over the long horizon.  We develop and estimate a dynamic general equilibrium model to account for these facts and offer structural interpretations.  The model's transmission mechanism transforms a very small persistent shock to the stochastic discount factor into a large price-rent ratio fluctuation.  The same shock generates the comovement between the price-rent ratio and output.  Moreover, the rent-price ratio predicts the house return over the long horizon.




  1. Ambiguity Aversion and Variance Premium, PDF, with Bin Wei and Hao Zhou, March 2012.


Abstract: This paper offers an ambiguity-based interpretation of variance premium---the difference between risk-neutral and objective expectations of market return variance---as a compounding effect of both belief distortion and variance differential regarding the uncertain economic regimes. Our approach endogenously generates variance premium without imposing exogenous stochastic volatility or jumps in consumption process. Such a framework can reasonably match the mean variance premium as well as the mean equity premium, equity volatility, and the mean risk-free rate in the data. We find that about 96 percent of the mean variance premium can be attributed to ambiguity aversion. Applying the model to historical consumption data, we find that variance premium mostly captures depressions, deep recessions, and financial panics, with a post war peak in 2009.



  1. Credit Risk and Business Cycles, with Pengfei Wang, PDF, August 2010.


Abstract: We incorporate long-term defaultable corporate bonds and credit risk in a dynamic stochastic general equilibrium business cycle model. Credit risk amplifies aggregate technology shocks. The debt-capital ratio provides a new state variable and its endogenous movements provide a propagation mechanism. The model can match the persistence and volatility of output growth as well as the mean equity premium and the mean risk-free rate as in the data. The model implied credit spreads are countercyclical and forecast future economic activities because they affect firm investment through Tobin's Q. They also forecast future stock returns through changes in the market price of risk. Finally, we show that shocks to the credit markets are transmitted to the real economy through Tobin's Q.



The following papers are outdated and need revisions. But they are still cited by a few papers.


1.     Stationary Equilibria of Economies with a Continuum of Heterogeneous Consumers, PDF, 2002


2.     Managerial Preferences,  Corporate Governance, and Financial Structure, PDF, with Hong Liu, March 2006


3.     Experimentation under Uninsurable Idiosyncratic Risk: An Application to Entrepreneurial Survival, PDF, with Neng Wang, May 2007


Abstract: We propose an analytically tractable continuous-time model of experimentation in which a risk-averse entrepreneur cannot fully diversify the idiosyncratic risk from his business investment. He makes consumption/savings and business exit decisions jointly, while learning about the unknown quality of the project over time. Using the closed-form solutions, we show that (i) the entrepreneur may stay in business even though the project's net present value (NPV) is negative; (ii) entrepreneurial risk aversion erodes option value and lowers private project value so that a sufficiently risk-averse entrepreneur may exit even when the NPV is positive; (iii) a more risk-averse or a more pessimistic entrepreneur exits earlier; and (iv) the model can generate a positive relation between wealth and entrepreneurial survival duration from undiversifiable idiosyncratic risk without liquidity constraints.


4.     Corporate Tax Policy and Long-Run Capital Formation: The Role of Irreversibility and Fixed Costs, PDF, May 2008.

Abstract: This paper presents an analytically tractable continuous-time general equilibrium model with investment irreversibility and fixed adjustment costs. In the model, there is a continuum of firms that are subject to idiosyncratic shocks to capital. Although the presence of investment frictions lowers consumer welfare, it may raise or reduce the long-run average capital stock, depending on the degree of idiosyncratic uncertainty. An increase in this uncertainty may raise equilibrium aggregate capital, but reduce welfare. An unexpected permanent change in the corporate income tax rate affects the investment trigger and target values, and hence the size and rate of capital adjustment. Following this tax policy, the percentage changes in equilibrium quantities are larger when fixed adjustment costs are larger. These changes are significantly smaller in a general equilibrium model than in a partial equilibrium model.