"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?"


"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.


"Monetary and Macro-Prudential Policies: An Integrated Analysis" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. This paper studies monetary and macro-prudential policies in a simple model with both a nominal rigidity and a financial friction that give rise to price and financial stability objectives. We find that lowering the degree of nominal rigidity or increasing the strength of the interest rate response to inflation is always welfare increasing in the model, despite a tradeoff between price and financial stability that we document. Even though crises become more severe as the economy moves toward price flexibility, the cost of the nominal rigidity is always higher than the cost of the financial friction in welfare terms in the model. We also find that macro-prudential policy implemented by augmenting traditional monetary policy with a reaction to debt is always welfare increasing despite making crises more severe. In contrast, implementing macro-prudential policy with a separate tax on debt is always welfare decreasing despite making crises relatively less severe. The key difference lies in the behaviour of the nominal exchange rate, that is more depreciated in the economy with the tax on debt and increases the initial debt burden.


"Capital Controls or Exchange Rate Policy? A Pecuniary Externality Perspective" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. In the aftermath of the global financial crisis, a new policy paradigm has emerged in which old-fashioned policies such as capital controls and other government distor- tions have become part of the standard policy toolkit (the so-called macro-prudential policies). On the wave of this seemingly unanimous policy consensus, a new strand of theoretical literature contends that capital controls are welfare enhancing and can be justified rigorously because of second-best considerations. Within the same theoretical framework adopted in this fast-growing literature, we show that a credible commitment to support the exchange rate in crisis times always welfare-dominates prudential capital controls as it can achieve the first best unconstrained allocation. In this benchmark economy, prudential capital controls are optimal only when the set of policy tools is restricted so that they are the only policy instrument available.

CEPR Discussion Paper 9936

Older Version Federal Reserve Bank of St. Louis Working Paper 2012-025A.


"Optimal Policy for Macro-Financial Stability" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. In this paper we study whether policy makers should wait to intervene until a financial crisis strikes or rather act in a preemptive manner. We study this question in a relatively simple dynamic stochastic general equilibrium model in which crises are endogenous events induced by the presence of an occasionally binding borrowing constraint as in Mendoza (2010). First, we show that the same set of taxes that replicates the constrained social planner allocation could be used optimally by a Ramsey planner to achieve the first best unconstrained equilibrium: in both cases without any precautionary intervention. Second, we show that the extent to which policymakers should intervene in a preemptive manner depends critically on the set of policy tools available and what these instruments can achieve when a crisis strikes. For example, in the context of our model, we find that, if the policy tools is constrained so that the first best cannot be achieved and the policy maker has access to only one tax instrument, it is always desirable to intervene before the crisis regardless of the instrument used. If however the policy maker has access to two instruments, it is optimal to act only during crisis times. Third and finally, we propose a computational algorithm to solve Markov-Perfect optimal policy for problems in which the policy function is not differentiable.

Federal Reserve Bank of St. Louis Working Paper 2012-041A.


"Bankruptcy and Delinquency in a Model of Unsecured Debt" with Kartik Athreya, Juan M. Sánchez, and Xuan S. Tam. The two channels of default on unsecured consumer debt are (i) bankruptcy, which legally grants partial or complete removal of unsecured debt under certain circumstances, and (ii) delinquency, informal default via nonpayment. In the United States, both channels are used routinely. This paper introduces a model of unsecured consumer credit in the presence of both bankruptcy and delinquency and presents three new findings: First, with respect to the choice between bankruptcy and delinquency, labor income shocks matter. Specifically, we find delinquency is readily used by borrowers with the worst labor market outcomes, even those with relatively minor levels of debt. In contrast, bankruptcy is used by households with relatively high debts, but whose long-run earnings prospects are high enough to make interest rate penalties from delinquency too large. Second, financial distress is persistent, in the sense that households in poor financial conditions stay in that state for several quarters. Third, in broad terms, bankruptcy and delinquency are “substitutes,” with bankruptcy increasing as delinquency costs rise.

Older version available as Federal Reserve Bank of St. Louis Working Paper 2012-042A.


"Consumption, Market Price of Risk, and Wealth Accumulation under Induced Uncertainty" with Yulei Luo. In this paper we examine implications of model uncertainty due to robustness (RB) for con- sumption and saving and the market price of uncertainty under limited information-processing capacity (rational inattention or RI). We first solve the robust permanent income models with inattentive consumers and show that RI by itself creates an additional demand for robustness that leads to higher "induced uncertainty" facing consumers. Second, we explore how the in- duced uncertainty composed of (i) model uncertainty due to RB and (ii) state uncertainty due to RI, affects consumption-saving decisions and the market price of uncertainty. We find that induced uncertainty can better explain the observed market price of uncertainty -- low atten- tion increases the e ect of model misspecification. We also show the observational equivalence between RB and risk-sensitivity (RS) in environment.


"Regulatory Intensity, Crash Risk, and the Business Cycle" with Bo Sun and Xuan S. Tam. Regulatory investigations affect information in financial markets through two channels: (i) investigations detect financial manipulation and reveal hidden negative information;(ii) regulatory investigations impose adverse consequences for executives involved in manipulation and deter managerial incentives to manipulate ex ante. More- over, regulatory intensity varies over time, depending on the aggregate state of the economy. We propose a model to study the implications of cyclical regulatory intensity for stock market dynamics, and show that countercyclicality in financial regulation can lead to countercyclicality in crash risk in the stock markets. We also provide evidence that a strong relation between stock crash risk and the business cycle exists in the data. In addition, our model illustrates a unifying mechanism that contributes to a number of stylized facts including gradual booms and sudden crashes in the financial markets, increased crash risk, and countercyclical stock volatility.


"What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilbrium" with Yulei Luo and Gaowang Wang. This paper derives the general equilibrium effects of rational inattention (Sims 2003) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the Permanent Income Hypothesis (PIH) arises in equilibrium, as in models with full information-rational expectations, due to a balancing of precautionary savings and impatience. We then show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.


"Portfolio Choice with Information Processing Limits" with Altantsetseg Batchuluun and Yulei Luo. In this paper, we examine the joint consumption-portfolio decision of an agent with limited information-processing capacity (rational inattention or RI) in the sense of Sims (2003) within a non-linear-quadratic (non-LQ) setting. Our model predicts that, as processing capacity falls, agents choose to hold less of their savings in the form of risky assets on average; however, they still choose to hold substantial risky assets with some positive probability. Low capacity causes households to act as if they are more risk averse and more willing to substitute consumption intertemporally.