"Information Heterogeneity in the Macroeconomy" with Ponpoje Porapakkarm. This paper considers the role that information heterogeneity can play in generating wealth inequality. We solve a model where households face both aggregate and idiosyncratic shocks to returns and wages under two assumptions about information – fully-informed (FI) economies have agents who observe all states while partially-informed (PI) economies have agents that must rely on the Kalman filter to extract estimates of the states based on observed prices. We find that the PI economy has higher aggregate activity (output, consumption, investment) and larger fluctuations in output and investment. Quantitatively, we find that the most important factor is the gap between the PI agents’ beliefs about the state of the world today and the true state; the other two factors, the heterogeneity of forecasts tomorrow and the higher risk faced by PI agents, generate only small changes in behavior.

Programs for FI Economy and PI Economy

"A Note on Sunspots with Heterogeneous Agents" with Daniel R. Carroll. This paper studies sunspot fluctuations in a model with heterogeneous households. We find that wealth inequality reduces the degree of increasing returns needed to produce indeterminacy, while wage inequality increases it. When the model is calibrated to match the joint distribution of hours, income, and wealth the required degree of increasing returns to scale is still much too high to be supported empirically (although smaller than similar homogeneous agent economies). We also find that the model robustly predicts only one sunspot, despite having 1242 predetermined state variables.

Federal Reserve Bank of Cleveland Working Paper No 09-06.

"Personal Bankruptcy and the Insurance of Labor Income Risk" with Kartik Athreya and Xuan S. Tam. Recent research [Livshits, MacGee, and Tertilt (2007), Chatterjee et al. (2007)] has found that the relatively lenient US bankruptcy code is likely to improve ex ante welfare relative to more strict forms of debt forgiveness. The welfare gains come from improved consumption insurance provided by the option to not repay debt in some circumstances. However, all instances where the literature finds a beneficial role for bankruptcy have been ones with large and transitory shocks directly to household consumption expenditures. It is clear therefore that involuntary reductions in net worth are sufficient to justify US personal bankruptcy. The availability of default will be reflected in the pricing on consumer debt, and so will affect households' ability to smooth consumption across dates and states-of-nature. It is therefore important to observe that a significant fraction of risks to lifetime household resources are not those coming from expenses, but rather from persistent shocks to labor income. We investigate the extent to which personal bankruptcy alters the ability of households to insure labor income risk. Our main finding is that the personal bankruptcy option very generally hinders the ability of households to protect themselves against labor income risk. From a policy perspective, our results suggest that given the rarity and nature of expense shocks relative to the prevalence and importance of labor income risk, the US bankruptcy system may be fairly costly.

Old Version: Federal Reserve Bank of Richmond Working Paper No 09-11. "Are Harsh Punishments for Default Really Better?"

"Sticky Information Diffusion and the Inertial Behavior of Durables Consumption" with Yulei Luo. This paper examines the implications of two types of sticky information diffusion: finite information-processing capacity (called rational inattention or RI) and sticky expectations (henceforth SE) for the joint dynamics of non-durables and durables consumption at both individual and aggregate levels. Specifically, we show that both RI and SE can improve the model's predictions at the aggregate level: (1) They reduce the relative volatility of non- durables to durables consumption and (2) they increase the first-order serial correlation of expenditures on durables. In particular, we show that both hypotheses may provide a potential explanation for Mankiw (1982)'s puzzle. Furthermore, we show that SE can better characterize the inertial behavior at the individual level (infrequent and lumpy purchases on durables). Finally, we show that allowing for heterogeneity in channel capacity can endogenize SE and thus makes the model with heterogenous capacity better explain the data at both individual and aggregate levels.

"Robust Control, Informational Frictions, and International Consumption Correlations" with Yulei Luo and Jun Nie. In this paper we examine how two types of information imperfection, robustness (RB) and finite information-processing capacity (called rational inattention or RI), affect international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by introducing heterogenous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. We also show that RI affects international consumption correlations via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noises that reduces the correlations. Both changes bring the model more in line with the data.

Federal Reserve Bank of Kansas City Working Paper 10-16.

"Loan Guarantees for Consumer Credit Markets" with Kartik Athreya and Xuan S. Tam. This paper studies the consequences of the introduction of loan guarantee programs for unsecured (defaultable) consumer debt. Under symmetric information, we find that loan guarantees can improve welfare only if they are not too generous. We also find that allocations and default rates are quite sensitive to the size of qualifying loans. As a result, even seemingly modest loan guarantee programs can transfer resources in significant amounts from all households to the lifetime poor. Relative to symmetric information, under asymmetric information the welfare gains are larger (losses are smaller). Our paper therefore provides some insight into why, despite a priori reasons to expect net benefits, we do not observe these programs in practice -- if too generous they act primarily as redistribution from skilled to unskilled and from nondefaulters to defaulters. More limited guarantees, contingent on the arrival of an expenditure shock, allows more generous programs to benefit all types.

Federal Reserve Bank of Richmond Working Paper 11-06.

"Long-Run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention" with Yulei Luo. We study the portfolio decision of a household with limited information-processing capacity in a setting with recursive utility, which has two key features. First, intertemporal substitution and risk aversion are disentangled. Second, the household has a preference for the timing of the resolution of uncertainty. We find that rational inattention combined with a preference for early resolution of uncertainty leads to a significant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that RI increases the implied equity premium because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of nontraded labor income.

"Signal Extraction and Rational Inattention" with Yulei Luo. In this paper we examine the implications of two theories of informational frictions, signal extraction (SE) and rational inattention (RI), for optimal decisions and economic dynamics within the linear-quadratic-Gaussian (LQG) setting. We first show that if the variance of the noise and channel capacity are fixed exogenously in the SE and RI problems, respectively, the two environments lead to different policy and welfare implications. We also find that if the signal-to-noise ratio in the SE problem is fixed, the two theories generate the same policy implications in the univariate case, but different policy implications in the multivariate case. These results are robust to the presence of correlation between structural shocks and noise shocks and the presence of risk-sensitive preferences. Thus, while RI provides a microfoundation for the imprecise observations and noise in the SE problem it is difficult to specify the structure of the noise in the SE problem in a manner consistent with the efficiency conditions from RI.

"Financial Crises and Macro-Prudential Policies" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. Stochastic general equilibrium models of small open economies with occasionally binding financial frictions are capable of mimicking both the business cycles and the crisis events associated with the sudden stop in access to credit markets (Mendoza, 2010). In this paper we study the inefficiencies associated with borrowing decisions in a two-sector small open production economy. We find that this economy is much more likely to display "under-borrowing" rather than "over-borrowing" in normal times. As a result, macro-prudential policies (i.e. Tobin taxes or economy-wide controls on capital inflows) are costly in welfare terms in our economy. Moreover, we show that macro-prudential policies aimed at minimizing the probability of the crisis event might be welfare-reducing in production economies. Our analysis shows that there is a much larger scope for welfare gains from policy interventions during financial crises. That is to say that, within our modeling approach, ex post or crisis-management policies dominate ex ante or macro-prudential ones. (Updated and expanded version of "Revisiting Overborrowing and its Policy Implications.")

"Monetary and Macro-Prudential Policies: An Integrated Analysis" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. This paper studies the interaction between monetary and macro-prudential policies in a simple model with both nominal and financial frictions. The nominal friction gives rise to conventional monetary policy objectives emphasized in the New Keynesian literature. The financial friction, in the form of an occasionally binding collateral constraint, gives rise to a financial stability objective. We study how rules developed for the nominal rigidity perform in a model that also has the financial friction. We then study how two alternative macro-prudential regimes perform. The first is a macroprudential adjusted monetary policy. The second is a two-part rule–a standard Taylor rule and a tax rule on the amount that the economy borrows. There are threemain findings. First, in the economy with a nominal rigidity and a financial friction, a relatively accommodative monetary policy may be welfare improving, suggesting a role for positive inflation. By the same taken, we find that there may be a trade off between macroeconomic and financial stability with a relatively aggressive monetary policy. Second, macro-prudential policy is most effective in our model (from a welfare ranking point of view) when it is designed in terms of macroprudential augmented interest rate rules rather than through an independent tax rule on debt. Third, independent macro-prudential tax policies rules can be welfare reducing when monetary policy is accommodative and welfare increasing when it is aggressive toward inflation as in this case it helps to address the possible trade off between macroeconomic and financial stability. An important caveat to these results is that they depend on both the model specification and the parameter values adopted. They are therefore illustrative of the complex interactions at play rather than definitive.

"Model Uncertainty and Intertemporal Tax Smoothing" with Yulei Luo and Jun Nie. In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and debt structure in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB. Furthermore, we show that introducing RB can improve the model’s predictions by generating (i) the observed relative volatility of the changes in tax rates to government spending and (ii) the observed comovement between government deficits and spending, and (iii) more consistent behavior of government budget deficits.

Federal Reserve Bank of Kansas City Working Paper 12-1.

"Robust Policymaking in the Face of Sudden Stops". This paper considers policies to deal with Sudden Stops -- declines in aggregate activity that are magnified by a binding collateral constraint -- that occasionally occur in emerging market economies. Households and/or the government are assumed to face model uncertainty and desire robustness against alternative models. Welfare gains are small if the government trusts its model of household expectations, whether those expectations are altered by model uncertainty or not; in contrast, welfare losses are large if the government is uncertain about the household's probability model.

Prepared for November 2011 Carnegie-NYU-Rochester Conference on Public Policy.