Three papers on macroeconomics with financial frictions

Chapter 1: Financial frictions amplify the portfolio balance effect of QE. A costly state verification friction increases output growth by between 0.13 - 0.41 percentage points and increases inflation between 6 - 18 basis points more than the model without the friction. I find that overall that the Federal Reserve’s second round of Large-Scale Asset Purchases (LSAPII) boosts output between 0.51% - 1.62%, which is the equivalent of a 83 - 278 basis point cut in the Federal Funds rate. Investors who arbitrage between long term government debt and corporate debt create a Portfolio Balance Channel in that the effects of QE spill over to the overall cost of corporate borrowing. This long term maturity preference of investors increases output growth by between 0.4 and 1.27% points, and inflation between 20 and 64 annualized basis points more than the model without this channel. Chapter 2: From 2000-2006 US house prices and mortgage credit grew substantially. Simultaneously, the relative cost of mortgage credit fell – particularly for privately securitized mortgages – suggesting the importance of credit supply factors. This chapter explores two candidate (credit supply) shocks: an increase in the inflow of global savings into the US, and innovations in the securitization of mortgage credit. I model a two-layered mortgage market. This generates a novel balance sheet effect: changes in aggregate mortgage credit quantity are linked to changes in mortgage spreads via the interaction of financially constrained commercial banks and mortgage securitizers. Innovation in securitization matches mortgage credit market dynamics by directly relaxing the securitizers’ financial constraint. Conversely, the inflow of global savings leads to a counter-factual increase of mortgage spreads through the balance sheet effect. Chapter 3: In this chapter I show that the existence of unregulated financial institutions (“shadow banks”) generates overborrowing (relative to the socially optimal level) in competitive equilibrium. This is because borrowers fail to internalize that an additional unit of borrowing, when the financial sector is well functioning, has adverse effects on the credit conditions they will face if a crisis arises. The social planner therefore has a motive to intervene to reduce borrowing in good times so as to limit the severity of a crisis. The discretionary planner’s optimal allocation can be decentralized either using borrower based instruments or via regulation of financial intermediaries. The optimal regulation of commercial banks is pro-cyclical.