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Financial Innovations and Macroeconomic Volatility
by Urban Jermann and Vincenzo Quadrini
Giorgio PrimiceriNorthwestern University
November 17, 2006
Standard deviation of US GDP growth
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
Standard deviation of US GDP (HP filter)
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.8
1
1.2
1.4
1.6
1.8
2
2.2
2.4
2.6
This paper…
Financial structure of firms has become more volatileafter 1984
Model in which financial factors are key to generate fluctuations
Two financial frictions:Endogenous borrowing limit (limited commitment)Exogenous cost of paying out dividends
Main result
Model calibrated to US data pre and post-1984
Explain the Great Moderation as a consequence of firms’ greater financial flexibility
Outline of my Comments
1. Will tell you why this is a very nice paper
2. Comments on the empirical motivation
3. Comments on the theoretical framework
Why I think this is the right direction
A look at the Great Moderation from a different perspective
Why I think this is the right direction
A look at the Great Moderation from a different perspective
Justiniano and Primiceri (2005):Large scale DSGE model with time varying volatility of structural shocks
Why I think this is the right direction
A look at the Great Moderation from a different perspective
Justiniano and Primiceri (2005):Large scale DSGE model with time varying volatility of structural shocks
Reduction in volatility of GDP explained by a reduction in volatility of a shock to the real return on capital
Why I think this is the right direction
This shock is a “wedge” in the Euler Equation pricing the capital stock
Might proxy for un-modeled financial frictions (CKM, 2006)
Why I think this is the right direction
This shock is a “wedge” in the Euler Equation pricing the capital stock
Might proxy for un-modeled financial frictions (CKM, 2006)
Interpretation: Great Moderation comes from a reduction in financial frictions
Bingo!
Outline of my Comments
1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction
Outline of my Comments
1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction
2. Comments on the empirical motivation
A closer look at the empirical motivation of JQ
Decline in volatility of GDP in early 1980s is very sharp
Volatility of US GDP
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.8
1
1.2
1.4
1.6
1.8
2
2.2
2.4
2.6
A closer look at the empirical motivation of JQ
Decline in volatility of GDP in early 1980s is very sharp
This is the real puzzle
This is why the Monetary Policy hypothesis has received so much attention
A closer look at the empirical motivation of JQ
Decline in volatility of GDP in early 1980s is very sharp
This is the real puzzle
This is why the Monetary Policy hypothesis has received so much attention
Let’s have a look at the financial variables examined in JQ
Time varying SD of Debt Repurchase
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20051.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
Time varying SD of Equity Payout
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
Reduction in vol. of components of GDP
Which component of GDP has experienced the sharpest and most dramatic reduction in volatility?
Reduction in vol. of components of GDP
GDP
Consumption Investment
Non-durables
and servicesDurables
Reduction in vol. of components of GDP
GDP
Consumption Investment
Non-durables
and servicesDurables Non-residential Residential
Time varying SD of Non-Residential investment
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20054.2
4.4
4.6
4.8
5
5.2
5.4
Time varying SD of Equipment & Software
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
4.6
4.8
5
5.2
5.4
5.6
5.8
6
6.2
6.4
Time varying SD of Residential investment
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20052
4
6
8
10
12
14
16
Reduction in vol. of components of GDP
GDP
Consumption Investment
Non-durables
and servicesDurables Non-residential Residential
Share of residential assets owned by HH
1950 1960 1970 1980 1990 2000 20100.5
0.55
0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
What do we learn?
Household sector owns most of residential assets (85%)
Business sector owns most of non-residential assets
What do we learn?
Household sector owns most of residential assets (85%)
Business sector owns most of non-residential assets
Smooth change in volatility of firms’ financial structure is consistent with smooth change in volatility of non-residential investment!
What do we learn?
Household sector owns most of residential assets (85%)
Business sector owns most of non-residential assets
Smooth change in volatility of firms’ financial structure is consistent with smooth change in volatility of non-residential investment!
Shouldn’t we pay more attention to the household sectorto explain the Great Moderation?
Campbell and Hercowitz (2006)Mertens (2006)Guerron (2006)
Outline of my Comments
1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction
2. Comments on the empirical motivationChange in volatility of financial structure is too smoothHousehold sector seems to be key
Outline of my Comments
1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction
2. Comments on the empirical motivationChange in volatility of financial structure is too smoothHousehold sector seems to be key
3. Comments on the theoretical framework
Theoretical issues: a closer look at the model
Key elements
Limited commitment Quadratic cost of paying out dividends
Theoretical issues: a closer look at the model
Key elements
Limited commitmentStrong micro-foundation
No role in the Great Moderation
Quadratic cost of paying out dividends
Theoretical issues: a closer look at the model
Key elements
Limited commitmentStrong micro-foundation
No role in the Great Moderation
Natural questions: Why do we need it?Can’t we write a simpler model?
Quadratic cost of paying out dividends
Theoretical issues: a closer look at the model
Key elements
Limited commitmentStrong micro-foundation
No role in the Great Moderation
Natural questions: Why do we need it?Can’t we write a simpler model?
Quadratic cost of paying out dividends
Crucial for the quantitative result!
Non-standard
Ad-hoc
Theoretical issues: a closer look at the model
Ad-hoc quadratic costs of paying out dividends
Shouldn’t we think of structural interpretations?
Signaling problemProgressive taxationRisk adverse entrepreneurs
Either non-symmetric cost or more appropriate interpretation for private equity
Outline of my Comments
1. Will tell you why this is a very nice paperLarger scale models indicates this as a promising direction
2. Comments on the empirical motivationIncrease in volatility of financial structure is too smoothHousehold sector seems to be important!
3. Comments on the theoretical frameworkWhat is the role of limited commitment?Quadratic adjustment costs of paying out dividends???