Working Papers

 

 

Abstract: We present an estimated dynamic stochastic general equilibrium model of stock market bubbles and business cycles using Bayesian methods. Bubbles emerge through a positive feedback loop mechanism supported by self-fulfilling beliefs. We identify a sentiment shock which drives the movements of bubbles and is transmitted to the real economy through endogenous credit constraints. This shock explains more than 96 percent of the stock market volatility and about 25 to 45 percent of the variations in investment and output. It is the driving force behind the comovements between stock prices and macroeconomic quantities. Historical decomposition of shocks shows that the sentiment shock is the dominant force for accounting for the internet bubbles and the Great Recession.

 

 

 

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.

 

 

 

Abstract: This paper introduces endogenous credit constraints in a search model of unemployment. These constraints generate multiple equilibria supported by self-fulfilling beliefs. A stock market bubble exists through a positive feedback loop mechanism. The collapse of the bubble tightens the credit constraints, causing firms to reduce investment and hirings. Unemployed workers are hard to find jobs generating high and persistent unemployment.

 

 

 

Abstract: This paper develops a macroeconomic model with a banking sector in which banks face endogenous borrowing constraints. There is no uncertainty about economic fundamentals. Banking bubbles can emerge through a positive feedback loop mechanism. Changes in household confidence can cause the collapse of bubbles, resulting in a financial crisis. Credit policy can mitigate economic downturns but also incur an efficiency loss. Bank capital requirements can prevent the formation of banking bubbles by limiting leverage. But a too restrictive requirement leads to less lending and hence less production.

 

 

Abstract: Bubbles are often on productive assets and occur in a sector of the economy. In addition, their occurence is often accompanied with credit booms. Incorporating these features, we provide a two-sector endogenous growth model with credit-driven bubbles. Bubbles have a credit easing effect by relaxing collateral constraints and improving investment efficiency. Sectoral bubbles also have a capital reallocation effect in the sense that bubbles in a sector attract more capital to be allocated to that sector. Their impact on economic growth depends on the interplay between these two effects.

 

 

Abstract: We provide an infinite-horizon model of a production economy with credit-driven stock price bubbles, in which firms meet stochastic investment opportunities and face credit constraints. Capital is not only an input for production, but also serves as collateral. We show that bubbles on this reproducible asset may arise, which relax collateral constraints and improve investment efficiency. The collapse of bubbles leads to a recession and a stock market crash. We show that there is a credit policy that can eliminate the bubble on firm assets and can achieve the efficient allocation.

 

 

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.

 

 

Abstract: This paper challenges the traditional view of the corporate tax as taxing corporate capital rather than the act of incorporating. Our model has no capital. Entrepreneurs pay to go public to diversify their risk. In discouraging incorporation, the tax keeps more entrepreneurs private and exposed to more risk. The tax falls primarily on high-skilled entrepreneurs and to a lesser extent on labor, who experience less demand for their services. The wage reduction also induces marginal entrepreneurs to set up shop and experience more risk. Hence, the answer to the title's question is that the corporate tax taxes risk-sharing.

 

 

 

Abstract: This paper studies the impact of corporate tax policy on the economy in the presence of both convex and nonconvex capital adjustment costs in a dynamic general equilibrium model. We show that corporate tax policy generates both intensive and extensive margin effects via the channel of marginal Q. Its impact is determined largely by the strength of the extensive margin effect, which in turn depends on the cross-sectional distribution of firms. Depending on the initial distribution of firms, the economy displays asymmetric responses to tax changes. We also show that an anticipated decrease in the future corporate income tax rate raises investment and adjustment rate immediately, while an anticipated increase in the future investment tax credit reduces investment and adjustment rate initially. Our general equilibrium analysis demonstrates that a partial equilibrium analysis of tax policy can be quite misleading both quantitatively and qualitatively.

 

 

Abstract: We present an analytically tractable dynamic stochastic general equilibrium model that incorporates micro-level fixed and convex adjustment costs. We provide an explicit characterization of equilibrium dynamics by a system of nonlinear stochastic difference equations. We provide general conditions under which our model features investment lumpiness at the microeconomic level, but aggregate dynamics are isomorphic to those in a Q-theory model without fixed costs. This theoretical result is independent of the specification of the fixed cost distribution and also holds true when firms face persistent idiosyncratic productivity shocks.

 

Abstract: In this paper we present a recursive method for the computation of dynamic competitive equilibria in models with heterogeneous agents and market frictions. This method is based on a convergent operator over an expanded set of state variables. The fixed point of this operator defines the set of all Markovian equilibria. We study approximation properties of the operator as well as the convergence of the moments of simulated sample paths. We apply our numerical algorithm to two growth models, an overlapping generations economy with money, and an asset pricing model with financial frictions.

 

Abstract: We study an investor's optimal consumption and portfolio choice problem when he is confronted with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is especially strong when the submodel with a low Bayesian probability delivers a much smaller continuation value. Unlike in the Bayesian framework, the hedging demand against model uncertainty may cause the investor's stock allocation to decrease sharply given a small doubt of return predictability, even though the predictive variable is large. Adopting the Bayesian strategy can lead to sizable welfare costs for an ambiguity-averse investor, especially when he has a strong prior of return predictability.

 

Abstract: This paper provides a dynamic rational expectations equilibrium model in which investors have heterogeneous information and investment opportunities. Informed investors privately receive advance information that is useful for predicting future earnings but is unrelated to current earnings. This information is immediately partially incorporated into prices, and thus stock prices may move in ways unrelated to current fundamentals. Investors' speculative and rebalancing trades in response to advance information generate short-run momentum, mimicking an underreaction pattern. When this information materializes, the stock price reverts back to its long-run mean, mimicking an overreaction pattern.

 

 

 

 

Abstract: Empirical and experimental evidence documents that money illusion is persistent and widespread. This paper incorporates money illusion into a stochastic continuous-time monetary model of endogenous growth. We model an agent’s money illusion behavior by assuming that he maximizes nonstandard utility derived from both nominal and real quantities. Money illusion affects an agent’s perception of the growth and riskiness of real wealth and distorts his consumption/savings decisions. It influences long-run growth via this channel. We show that the welfare cost of money illusion is negligible, whereas its impact on long-run growth is noticeable even if the degree of money illusion is low. Monetary policy can eliminate this cost by correcting the distortions on a money-illusioned agent’s consumption/savings decisions.

 

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

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.

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.