When money matters: liquidity shocks with real effects

1. When money matters: liquidity shocks with real effects John Driffill and Marcus Miller Birkbeck and University of Warwick

2. Abstract • In their ‘workhorse model of money and liquidity’, Kiyotaki and Moore (2008) show how tightening credit constraints can cut current investment and future aggregate supply. • Aggregate demand matches current supply, thanks to a flex-price ‘Pigou effect’ • Switching from a flex-price to a fix-price framework implies that demand failures can emerge after a liquidity shock. • Quantitative estimates by FRBNY using such a framework produce dramatic results: what about the analytics?

3. Diagram 1. Effect of a stochastic liquidity shock in US that lasts 10 quarters, Del Negro et al. (2009)

4. Macro Paradigm: Woodford’s Synthesis Interest and Prices (2003) • marked decisive shift in monetary economics from looking at the quantity of money to the cost of borrowing (i.e. from Friedman back to Wicksell • inspired by an over-arching vision: to create a new synthesis reconciling mainline macroeconomics with dynamic General Equilibrium (GE), as practised by RBC theorists in particular.

5. Hammond’s view of GE without credit constraints?

6. The Arrow Debreu paradigmat risk? • In the absence of collateral or other credible enforcement , Peter Hammond (1979) argued that, the ‘core’ of the inter-temporal GE model is not sub-game perfect. Further discussion tomorrow? • If this is true for Arrow-Debreu paradigm of GE, it is also true for the DSGE specialisation developed for macroeconomics. Does it matter?

7. Great Moderation has succumbed to credit crunch • US unemployment rate has doubled from 4.8 per cent to 9.8 percent • “the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-302” Eichengreen and O’Rourke (2009). • “The good news is that the policy response is very different” (zero interest rate, deficit spending, QE) • The bad news is that it lies outside the reach of DSGE • Can Kiyotaki and Moore (2008) model help?

8. KM(2008) framework • addresses the Hammond critique of DGE: firms cannot borrow at will - with real consequences for composition of output. • heterogeneous investors facing liquidity constraints • want to hold money as a precaution against a lack of finance for investment opportunity • need to add sticky wages/prices for liquidity shocks to have significant real effects; • otherwise the Pigou effect acts as automatic stabiliser!

9. Woodford’s synthesis: the New Paradigm

10. Kiyotaki and Moore(2008), but with sticky wages/prices as in FRBNY and Driffill/Miller

11. Fix price macro • 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.

12. Figure 3. Short-run determination of X and Y

13. Kiyotaki 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

14. Flex price to Fix price

15. Workers – not the focus of attention • Spend what they get • Rational and forward-looking, but impatient and credit constrained. • No borrowing • They can hold money and equity if they choose • Save nothing • Consumption equals wages

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

17. 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

18. Liquidity constraints – on investment • 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

19. Entrepreneur’s budget constraint • Budget: • p – price of money; q – equity price • λ – 1-depreciation rate • n equity held by entrepreneur • Objective - max exp U:

20. Production • CRS / C-D production function, capital and labour • KM: wage clears labour market • DM: fix money wage and price level – entrepreneurs keep the surplus

21. Investment and Net Demand Investment demand . Entrepreneurs’ income equals their demand (GM equilibrium)

22. Entrepreneur’s Portfolio Balance (AM)

23. KM (2008): liquidity driven expansion, ϕincreases, equity more liquid

24. DM (2010): liquidity driven contraction

25. Saddle Path Dynamics in fix price case: driven by Asset Market and Investment disequilibrium

26. Using AM and RI to get phase diagram

27. liquidity shock shifts E to E': with stock market fall leading to recession – or recovery if shock is to be reversed

28.  Figure 6. Numerical Results from DM simulation using FRBNY parameters

29. Calibration using FRBNY parameters (qtly) • 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]

30. Temporary and permanent liquidity shock

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

32. Figure 8. Tobin’s q and the capital stock between the wars

33. Figure 9. Bubble collapse preceding liquidity shock: like 1929

34. Credit crunch • With firms who want to invest more credit constrained - and workers income constrained - no Pigou effect to stimulate entrepreneurial consumption, a ‘credit crunch’ causes recession. • The antidote discussed by KM should work here too: Quantitative Easing as the government supplies liquidity in exchange for corporate securities.

35. Conclusion • 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

36. Current UK recession (blue) relative to earlier recessions(brown: 1930s, green and yellow: oil shocks)

37. Titanic sinking

38. Titanic

39. Queen Hermione imprisoned for sixteen years: then came reconciliation

40. Time for a change in Macro? • discredited and discarded in the stagflation that followed the oil price shocks of the 70s and 80s, the Keynesian paradigm of macroeconomic stabilisation has suffered in silence for many years. • but the new DSGE paradigm failed to predict the ‘credit crunch’ - or explain its effects. • Let’s briefly review recent fashions in macro