Working Papers





1.      Fiscal Stimulus under Average Inflation Targeting, with Zheng Liu and Dongling Su, PDF, November 2022


Abstract: The stimulus effects of expansionary fiscal policy under average inflation targeting (AIT) depends on both monetary and fiscal policy regimes. AIT features an inflation makeup under the monetary regime, but not under the fiscal regime. In normal times, AIT amplifies the short-run fiscal multipliers under both regimes while mitigating the cumulative multiplies due to intertemporal substitution. In a zero-lower-bound (ZLB) period, AIT reduces fiscal multipliers under a monetary regime by shortening the duration of the ZLB through expected inflation makeup. Under the fiscal regime, AIT has a nonlinear effect on fiscal multipliers because of the absence of inflation makeup and the presence of a nominal wealth effect.


2.      Linear Quadratic Approximation of Rationally Inattentive Control Problems, PDF. February 2022


Abstract: This paper proposes a linear quadratic approximation approach to dynamic nonlinear rationally inattentive control problems with multiple states and multiple controls. An efficient toolbox to implement this approach is provided. Applying this toolbox to four economic examples demonstrates that rational inattention can help explain the comovement puzzle in the macroeconomics literature.


3.      Robust Rationally Inattentive Discrete Choice, with Lars Hansen and Hao Xing, PDF, February 2022


Abstract: We introduce robustness to the rational inattention model with Shannon mutual information costs in a discrete choice setting when the decision maker is concerned about model misspecification/ambiguity. We provide necessary and sufficient conditions for the robust solution and develop numerical methods to solve it. We show that the decision maker slants their beliefs pessimistically toward worse outcomes. As a result, their choice behavior can be qualitatively different from that in the standard rational inattention model with risk aversion. We apply our model to three consumer problems and show that tests based on misspecified models can lead to type I errors.



4.      Capital Return Jumps and Wealth Distribution, with Jess Benhabib and Wei Cui, PDF, November 2021.


Abstract: The distributions of wealth in the US and many other countries are

strikingly concentrated on the top and skewed to the right. To explain the income and wealth inequality, we provide a tractable heterogeneous-agent model with incomplete markets in continuous time. We separate illiquid capital assets from liquid bond assets and introduce capital return jump risks. Under recursive utility, we derive optimal consumption and wealth in closed form and show that the stationary wealth distribution has an exponential right tail. Our calibrated model can match the income and wealth distributions in the US data including the extreme right tail. We also study the effect of taxes on the distribution of wealth.


5.      Fiscal and Monetary Policy Interactions in a Model with Low Interest Rates, with Dongling Su, PDF, February 2021.


Abstract: We provide a dynamic new Keynesian model in which entrepreneurs face uninsurable idiosyncratic investment risk and credit constraints. Government bonds provide liquidity service and raise net worth. Multiple steady states with positive values of public debt can be supported for a given permanent deficit-to-output ratio. The steady-state interest rates are less than economic growth and public debt contains a bubble component. We analyze the determinacy regions of policy parameter space and find that a large set of monetary and fiscal policy parameters can achieve debt and inflation stability given persistent fiscal deficits.


6.      Robust Financial Contracting and Investment, PDF, with Aifan Ling and Neng Wang, Jaunary 2021.


Abstract: We study how investors' preferences for robustness influence corporate investment, financing, and compensation decisions and valuation in a financial contracting model with agency. We characterize the robust contract and show that early liquidation can be optimal when investors are sufficiently ambiguity averse. We implement the robust contract by debt, equity, cash, and a financial derivative asset. The derivative is used to hedge against the investors' concern that the entrepreneur may be overly optimistic. Our calibrated model generates sizable equity premium and credit spread, and implies that ambiguity aversion lowers Tobin's q, the average investment, and investment volatility. The entrepreneur values the project at an internal rate of return of 3.5% per annum higher than investors do.


7.      Dynamic Discrete Choice under Rational Inattention, PDF, with Hao Xing, May 2020.


Abstract: We adopt the posterior-based approach to study dynamic discrete choice problems under rational inattention. We provide necessary and sufficient

conditions to characterize the solution for general uniformly posterior-separable cost functions. We propose an efficient algorithm to solve these conditions and apply our model to explain phenomena such as perceptual distance, status quo bias, confirmation bias, and belief polarization. A key condition for our approach to work is the concavity of the difference between the generalized entropy of the current posterior and the discounted generalized entropy of the prior beliefs about the future states.


8.      Multivariate LQG Control under Rational Inattention in Continuous Time. February 2019


Abstract: I propose a multivariate linear-quadratic-Gaussian control framework with rational inattention in continuous time. I propose a three-step solution procedure. The critical step is to transform the problem into a rate distortion problem and derive a semidefinite programming representation. I provide generalized reverse water-filling solutions for some special cases and characterize the optimal signal dimension. I apply my approach to study a consumption/saving problem and illustrate two pitfalls in the literature.




  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 firmsí 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.



  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.