Comments on The Great Escape? A Quantitative Evaluation of the Fed's Non-Standard Policies

1. Comments onThe Great Escape? A Quantitative Evaluation ofthe Fed's Non-Standard Policies Luis F. Cespedes Central Bank of Chile October 2010

2. Main questions of the paper • What are the potential effects of the non-standard open market operations undertaken by the Fed in the recent global financial crisis? • Answer of the paper: The effects can be large, especially at the ZLB. • Moreover, the authors argue that they were key to avoid a Great Depression-style collapse. • Very nice paper.

3. The Model • They extend the model of Kiyotaki and Moore (2008) which features differences in liquidity across assets. • Non-standard open market operations in private assets conducted by the government are relevant. • In each period a fraction of the entrepreneurs receives an investment opportunity. • The arrival of such opportunity is randomly distributed across entrepreneurs through time.

4. The Model • Because not all entrepreneurs can invest in each period, there is a need to transfer resources from those who do not have an investment opportunity to those who do. • To finance investment entrepreneurs sell equity claims to the future returns from the newly produced capital.

5. The Model • A crucial feature of the model (KM 2008) is that, because the investing entrepreneur cannot precommit to work throughout its life, he is able to pledge only a fraction q of future returns from the new capital. • As the investing entrepreneur can only issue new equity up to fraction of his investment, he faces a borrowing constraint.

6. The Model • Because of the borrowing constraint, the investing entrepreneur needs to finance investment partly by selling his holding of liquid assets and equity of the other agents. • The other key feature of the model is that the existing equity (the claim to the return of the existing capital stock) cannot be sold as quickly as liquid assets. • Specifically, they assume that, in any given period t, an agent can sell only a fraction ftof his equity holding (resaleability constraint).

7. The Model • Liquid assets are hold only if q and f are low enough. • Rate of return of liquid assets is low, less than return on equity. • Nevertheless, entrepreneurs hold liquid assets in their portfolio because in the event they receive an investment opportunity they will be liquidity constraint and liquid assets “are more liquid” than equity.

8. The Model • A shock to f reduces resaleability of equity which reduces the amount investing entrepreneurs can uses as downpayment which reduces investment. • Also, lower resaleability reduces the price of equity: “flight to liquidity” • This increases the size of the required downpayment which feedbacks into the economy… • Government can exchange liquid assets for equity, increasing liquidity in the economy and mitigating the effects of the negative shock.

9. The Government • The government sets the nominal interest rate according to a rule: • The intervention is modeled as a swap of liquid (real bonds) for illiquid assets. • Where

10. The Model • The rest of the model is somehow standard: • Entrepreneurs. • The Government. • Capital Goods Producers. • Final Good Producers. • Intermediate Goods Producers. • Workers.

11. Calibration: One Key Variable • Liquidity share: f

12. Results • Non-standard policy can have large effects under price and wage rigidity. • This is particularly true at zero interest rates. • Model economy generates a collapse of the same order as the Great Depression in the absence of non-standard government policies.

13. Comments • What was the original shock? Decline in real estate values? (deterioration in entrepreneurs (financial intermediaries) balance sheets?) • This is important because it determines which constraints are more relevant. • But also because reduces the dependency of the results on price and wage rigidity. • Obviously the initial shock may have “triggered” additional shocks (uncertainty, resaleability, etc)

14. Comments • Given the way in which the resaleability shock is constructed may include other type of shocks that are different in nature (quality of capital for example) and future policy actions.

15. Comments • In KM (2008) an important driver of the non output losses under flexible prices was due to income effect on entrepreneurs of price decline. It seems that here too. • Under flexible prices, does the central bank follows a Taylor rule? (remember than under flexibles prices money matters in this model) • Non conventional actions could have made announcements of “lower interest rates” for a long period of time more credible.

16. Comments • The non conventional policies had different dimensions (expanded discount window operations, direct lending in high grade credit markets, equity injections), is the one trillion a measure of the intervention that wants to be evaluated? • Related with the previous point, the “great escape” may have worked not only through other channels but also may include other actors (fiscal policy?) • Need more information on calibration. Consumption share of entrepreneurs with respect to consumption of workers.

17. October 2010 The Changing International Transmission of Financial Shocks: Evidencie from a Classical Time-Varying FAVAREickmeier, Lemke & Marcellino Luis F. Céspedes Central Bank of Chile

18. Introduction - Very good paper - Very interesting in using the methodology in three aspect: - Factor Augmented framework, to reduce large amount of information related with financial aspects. - Time varying framework, to measure variations in the impact of FCI on relevant variables. - Use of the New FCI published by Hatzius et al 2010, allows to take into account new finance indicators and measure new effects than previous measurements could not do.

19. The goals of the paper are interesting and key. • How large is the impact of US financial shocks on the major advanced countries, and have their size and transmission changed over time? • Through what channels are US financial shocks both domestically and internationally transmitted, and can we identify changes in the transmission mechanism over time? • How strongly were the major advanced economies affected by the global financial crisis and through which channels?

20. The paper • How large is the impact of US financial shocks on the major advanced countries, and have their size and transmission changed over time? • Positive US financial shocks have a considerable positive impact on the nine countries under analysis. • The transmission to GDP growth in the euro-area countries and in Japan has increased gradually since the 1980s.

21. The paper • Through what channels are US financial shocks both domestically and internationally transmitted, and can we identify changes in the transmission mechanism over time? • US: Evidence indicates that FCI shocks raise credit and equity and house prices. They increase investment and consumption. Particularly in the period 1987-2007. • Two hypothesis: monetary policy or structural changes in financial markets. • Trade channel: imports in most countries increase. • Exchange rate: depreciate in Japan and Germany and appreciate for the rest.

22. Comments What about terms of trade? Authors argue that it is questionable whether exchange rates and terms of trade played an important role for the international transmission of US financial shocks. Therefore, trade reactions can probably be explained with trade openness rather than with relative price movements. Would like to see the complete impulse response of imports and exports. Relative price movements may have a more reduced impact on impact but may be relevant in medium term horizons. .

23. The paper • How strongly were the major advanced economies affected by the global financial crisis and through which channels? • Exceptionally deep recent worldwide recession was mostly due to a large negative US financial shock combined with a strong propagation of that shock. • The transmission of the global financial crisis was unusual in a number of respects. In most countries including the US the GDP response to a same-size FCI shock was not particularly large by historical standards. • Germany, Japan and Spain are exceptions in the sense that their GDPs were much more strongly hit by US financial shocks over the 2008-2009 crisis than ever before. • Initial conditions matter…

24. Comments • What are these financial shocks? Preferences, expected productivity, uncertainty, monetary policy shocks? • Depending on the nature of the shock, monetary policy reaction is likely to be different (monetary policy is different if shock is due to expected productivity or some aggregate demand driver shock) • Given that there are different “shocks” behind the FCI shocks, differences across time could be related to changes in the shocks configurations rather than changes in transmission mechanisms. • Transmission of financial shocks from the US to the rest of the world. Could it be the other way around? Global uncertainty shocks or emerging market shocks that generates flight to quality may affect financial conditions in the US. Maybe less relevant for the group of countries considered in the sample. But maybe important in the recent global financial crisis.

25. Comments • If financial variables included in the FCI are forward looking you may be identifying expected changes in variables under study. • Financial globalization also may imply changes in the way in which financial variables are combined within the FCI. • Regarding the transmission mechanisms and the different responses across countries there are conjectures but no clear evidence. • The variance share explained by FCI shocks is closely related to the time varying FCI shock volatility. Episodes of uncertainty (Bloom 2009) have significant impact on output dynamics across countries. • FCI may be affected by policy changes.