Fire Sales and Endogenous Volatility ( Job Market Paper)

After the collapse of  the housing bubble in 2007, severe fire sales of assets in the financial sector are accompanied by a rise in the volatility of bank asset returns. To account for their co-movements, I develop a model that highlights the interaction between the financial health of banks and the volatility of their asset returns. The novel feature of the model is that the volatility of asset returns is endogenously generated by the banks’ risk taking behavior.  The risk taking by banks imposes a negative externality on the payoffs of other banks because given the lower valuation of risky assets by secondary market buyers, the liquidation of risky assets depresses the secondary market price of assets. Combining with limited liability, the model can give rise to a vicious feedback loop between a collective risk taking behavior of the banking sector and fire sales of assets. A standard liquidity requirement is shown to have ambiguous effects in stabilizing the financial system depending on the secondary market liquidity. The model suggests a room for counter-cyclical macroprudential policy to improve financial stability.

The Impact of Uncertainty Shocks on the Firm’s Customer Base

I study the interaction between uncertainty shocks and product market frictions and propose a new transmission mechanism through which uncertainty shocks negatively affect the real economy. Empirical evidence indicates that fluctuations in idiosyncratic uncertainty have negative impacts on the firm’s investment in customer capital. Based on this observation, I incorporate customer capital investment into the firm’s problem. Similar to the investment in physical capital, the firm needs to spend resources to acquire new customers and to maintain its existing customer base. Product market friction arises because the firm’s revenue is now jointly determined by its production and its customer base. When the firm receives a low TFP, its customers could be potentially better-off terminating the relationships with the firm and switch to their outside options. To maintain its customer base, the firm has to lower its price. The loss due to customer base maintenance is high especially when its productivity is low. Therefore uncertainty shocks would dampen the firm’s profitability and discourage firm investments.

The Imperfect Credibility of the Central Bank

The paper studies the optimal monetary policy when central banks have imperfect credibility. Contrary to the binary “commitment vs. discretion” commitment setting, central bankers in this model are able to commit to the optimal plans they formulate, but only over some finite (random) horizons due to their temptation to renege on the plans. The horizon of a central bank regime is closely related to the probability households assign on whether the current central banker will commit to what he promised. In another word, the probability can be interpreted as a measure of central bank credibility. This paper assumes that the central bank credibility depends negatively on the past inflations. Therefore, in addition to the traditional inflation output tradeoff, the central bank would contemplate on the impact of inflation on its future credibility and the social welfare as well. The main finding is that a central bank would enhance its credibility directly through a more “conservative” inflation policy. Moreover, a high sensitivity of credibility to past inflations contributes to a deeper and longer recession in the presence of a cost-push shock.