Why does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion with Gianluca Rinaldi, 2021
We build a new model integrating a work-horse New Keynesian model a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.
Doubling Down on Debt: Limited Liability as a Financial Friction, with Jesse Perla and Michal Szkup, 2021
We investigate how a combination of limited liability and preexisting debt distort firms’ investment and equity payout decisions. We show that equity holders have incentives to ``double-sell'' cash flows in default, leading to overinvestment, provided that the firm has preexisting debt and the ability to issue new claims to the bankruptcy value of the firm. In a repeated version of the model, we show that the inability to commit to not double-sell cash flows leads to heterogeneous investment distortions, where high leverage firms tend to overinvest but low leverage firms tend to underinvest. Permitting equity payouts financed by new debt mitigates overinvestment for high leverage firms, but raises bankruptcy rates and exacerbates low leverage firms' tendency to underinvest---as the anticipation of equity payouts from future debt raises their cost of debt issuance. Finally, we provide empirical evidence consistent with the model.
A Model of Politics and the Central Bank, with Wioletta Dziuda, 2020
We present a two-period model examining how the central bank and the elected executive jointly shape economic outcomes, political selection, and accountability of the executive. The central bank is apolitical, minimizing a quadratic per-period loss function in inflation and unemployment, and trading off inflation and unemployment along an expectational Phillips curve. The elected government's quality shifts unemployment for any given level of inflation. After observing first-period unemployment, fully rational voter-households optimally choose between the incumbent, whose quality remains constant, versus a challenger of unknown quality. This simple setup allows us to derive a rich set of conclusions. First, an inflation-averse central bank increases incumbency advantage, or the likelihood that below-average incumbents are reelected. As a result, incumbents prefer more inflation-averse central banks than the social planner, rationalizing the political success of inflation-targeting central banks in practice. Second, in contrast to models without political selection, by increasing incumbency advantage an inflation-averse central bank raises long-term unemployment and can lower unemployment variability. Third, the adverse unemployment effects of inflation-averse central banks are compounded when the incumbent must also exert costly effort.