CAREER: Frictional Financial Markets, Crises and Policies

Financial markets institutions are key determinants of the allocation of risk and capital, both within and across countries. This project consists of three main research questions that explore the economic consequences of financial market imperfections and the role of policy in improving these outcomes. The first area focuses on understanding why firms linked in a production network tend to borrow and lend to each other, and the implications of these inter-firms financial relations for macroeconomic stability. The second area examines optimality criteria for the management of the balance sheet of a monetary authority, in the context of the recent waves of asset purchases pursued by central banks around the world. The third area studies the reasons why, over the past decade, key economic indicators have signaled an increase in barriers to capital mobility across countries. The educational component of the project convenes a workshop with graduate students to teach frontier methods for the analysis of frictional financial markets in open and closed economies. The findings from these research projects will have broad implications for US macroeconomic policy.

This research focuses on three areas. The first area studies the macroeconomics implications of trade credit relationships. In most countries, transactions between firms in a production network typically involve the issuance of an IOU rather than a spot payment. These trade-credit bills are a key instruments for liquidity management, and changes in their availability or terms have major effects on firms' performance. The first project in this area develops a macroeconomic model of trade credit relationships and uses the framework to measure how these links affect the propagation of financial shocks. The second project explores the role of self-fulfilling expectations in explaining sudden freezes of the inter-firms network of payments. The second area focuses on positive and normative aspects of "unconventional" monetary and fiscal policies carried out by several countries after 2008. The first project in this area develops optimality criteria for the management of foreign reserves by a small open economy, while the second project focuses on the management of the balance sheet for a central bank that engages in quantitative easing. The third area aims at understanding the deviations from covered interest parity we have observed for several currencies after 2008. This research shows that a sizable component of the observed deviations from covered interest parity is due to the widening of the bid-ask spreads demanded by dealers in currency markets rather than an arbitrage opportunity, and it proposes a model to interpret this finding.