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When money matters: liquidity shocks with real effects . John Driffill and Marcus Miller Birkbeck and University of Warwick. Financial boom… ( Note: US GDP is about $14 trillion).

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When money matters liquidity shocks with real effects

When money matters: liquidity shocks with real effects

John Driffill and Marcus Miller

Birkbeck and University of Warwick


Financial boom note us gdp is about 14 trillion

Financial boom…(Note: US GDP is about $14 trillion)


When money matters liquidity shocks with real effects

Followed by bust: UK recession (dark blue) relative to earlier recessions(dark brown is 1930s; green and yellow follow oil shocks; light brown follows bursting of housing bubble:)


Call for integration of financial factors into real models
Call for integration of financial factors into real models

  • In ‘The Great Moderation, the Great Panic and the Great Contraction’ Charlie Bean (2009) calls for further research on financial factors as an urgent priority.

  • In fact, Kiyotaki and Moore (2008) have developed a ‘workhorse model of money and liquidity’ where liquidity constraints can affect investment and the economy.

  • With flex-prices and full employment, their focus is on the supply side.

  • Simulations of such a model by FRBNY- in conjunction with Kiyotaki - in a fix-price environment produce dramatic results for liquidity shocks for aggregate demand.


Background growth and investment
Background: growth and investment

  • Before considering how financial factors may affect investment, we look at three real models of capital accumulation

  • The simplified Solow model of growth

  • Neoclassical optimising model

  • Tobin’s q –theory of investment

  • Reference

  • Acemoglou, Daron. Introduction to Modern Economic Growth. Princeton Univ Press


When money matters liquidity shocks with real effects

Effect of a liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009) – with analytical equivalent from Driffill and Miller (2010)

DM


When money matters liquidity shocks with real effects

y

y, output per head

Shading shows depreciation

c, consumption per head

k° = 0

k(o)

  • k*

k, capital per head

k  k*


Neoclassical growth model high marginal productivity of capital encourages savings
Neoclassical growth model: Del Negro et al. (2009) high marginal productivity of capital encourages savings

c, consumption per head

c° = 0

c

y, output per head

k° = 0

k(o)

  • k*

k, capital per head

  • f´(k * )=θ


The q theory of investment and saddle path stability
The q-theory of Investment Del Negro et al. (2009) and Saddle-Path stability


Dynamics of k and q phase diagram
Dynamics of K and q: Del Negro et al. (2009) phase diagram

Asset price stationary

q°= 0

Equity Price

q

K°= 0

U

Zero net investment

S

E

S

U

Capital Stock

K

K(0)

K*


Kiyotaki and moore 2008 liquidity business cycles and monetary policy
Kiyotaki Del Negro et al. (2009) 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


Workers not the focus of attention
Workers – not the focus of attention Del Negro et al. (2009)

  • Rational and forward-looking, but credit constrained (no borrowing)

  • Do not have ‘ideas’ for investment

  • Can hold money and equity if they choose

  • But choose to spend all they get on consumption and save nothing

  • So consumption equals wages


Entrepreneurs play central role manage production and invest and hold assets
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


Investment
Investment invest and hold assets

Entrepreneurs can only finance investment using money, selling existing equity claims to others, raising equity on new capital, and spending out of current income


Liquidity constraints on investment
Liquidity constraints on investment invest and hold assets

  • Entrepreneurs can raise equity against up to a fraction θof new investment.

  • They can sell off a fraction φt of pre-existing equity (theirs and others) nt

  • Money is perfectly liquid


Entrepreneur s budget constraint
Entrepreneur’s budget constraint invest and hold assets

  • Budget:

  • p – price of money; q – equity price

  • λ – 1-depreciation rate

  • n equity held by entrepreneur

  • Objective - max exp U:


Production
Production invest and hold assets

  • CRS / C-D production function, capital and labour

  • KM: wage clears labour market

  • DM: fix money wage and price level – entrepreneurs keep the surplus


Investment and aggregate net demand
Investment and Aggregate (Net) Demand invest and hold assets

Investment demand

.

Entrepreneurs’ income equals their demand (GM equilibrium)



Basic structure of km model
Basic structure of KM model invest and hold assets

  • 3 equations :Investment Demand, Aggregate Demand (C+I) and Portfolio Balance, between money and shares.

  • 3 unknowns: price level, Tobin’s q, and K.

  • Two regimes :

  • Flex-price: full employment via Pigou effect determines the price level.

  • Fix-price: agg demand determines employment.

  • What about K and q?


Stationary conditions for k and q
Stationary conditions for K and q. invest and hold assets

  • The Investment equation and Portfolio Balance determine evolution of K and q.

  • Stationarity for K is when all capital spending is for Replacement Investment, on upward sloping RI schedule in K,q space.

  • Stationarity for q, is on downward sloping AM equilibrium schedule where there are no capital gains.


Using am and ri to get phase diagram
Using AM and RI to get phase diagram invest and hold assets


Flex price comparative statics as in km 2008 increases liquidity driven expansion
Flex-price comparative statics as in KM (2008): invest and hold assetsφ increases, liquidity driven expansion,



Fix price comparative statics dm 2010 tightening liquidity shifts ri and am to left
Fix price comparative statics DM (2010): tightening liquidity shifts RI and AM to left


Dynamics stock market fall leading to recession or recovery if shock is to be reversed
Dynamics: stock market fall leading to recession – or recovery if shock is to be reversed


Linearised fix price model
Linearised fix-price model: recovery if shock is to be reversed


Fix price macro
Fix price macro recovery if shock is to be reversed

  • 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.


Figure 3 short run determination of x and y
Figure 3. Short-run determination of X and Y recovery if shock is to be reversed


Calibration using frbny parameters qtly
Calibration using FRBNY parameters (qtly) recovery if shock is to be reversed

  • 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]




Table 2 impact effects of a 20 cut in for different lengths of time
Table 2. Impact effects of a 20% cut in ϕ parameters for different lengths of time




Conclusion
Conclusion 1929

  • 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


References
References 1929

  • Acemoglou, Daron. Introduction to Modern Economic Growth. Princeton Univ Press

  • Del Negro, Marco, GautiEggertsson, Andrea Ferrero and NobuhiroKiyotaki (2009). ‘The Great Escape? A Quantitative Evaluation of the Fed's Non-Standard Policies.’ FRBNY working paper.

  • Dale, Spencer (2010), ‘QE – one year on’, speech a CIMF and MMF conference at Cambridge on 12th March.

  • Driffill, John and Marcus Miller(2010) ‘When money matters: liquidity shocks with real effects’

  • Kiyotaki, Nobuhiro and John Moore (2008)‘Liquidity, Business Cycles, and Monetary Policy’