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Lunch Seminar: Guido Lorenzoni - Northwestern University
Tuesday 18 June 2019, 01:00pm - 02:00pm

Risk Sharing Externalities joint with Luigi Bocola

Abstract:

Macroeconomic models with a financial accelerator mechanism are built around two main ingredients: a collateral constraint and incomplete financial markets. The first ingredient implies that shocks affecting the balance sheet of some agents affect their investment decisions, while the second ingredient guarantees that the same agents cannot hedge these shocks. A commonly held view in the literature is that both ingredients are necessary for the model to produce amplified responses to aggregate shocks. In this paper we revisit this view. In particular, we focus on a general equilibrium spillover, by which a reduction of the net worth of financially constrained agents lowers incomes and consumption levels in the rest of economy. The presence of the spillover makes hedging costly for the financially constrained agents and leads to amplification even in presence of complete financial markets. Numerical simulations show that this force is quantitatively relevant, as under plausible calibrations the competitive equilibrium with complete markets features a similar degree of amplification as the one with incomplete markets. The same spillover also implies that the competitive equilibrium is constrained inefficient and provides a rationale for financial regulation that reduces the exposure of financial institutions to aggregate risk.

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