Asset Prices and Business Cycles with Financial Shocks

| gradman

Nezefat, Mahdi, and Ctirad Slavik, “Asset Prices and Business Cycles with Financial Shocks,” American Finance Association, 75th Annual Meeting, Boston (2015).

Purpose:  This paper introduces a DSGE asset pricing model in which shocks to firm productivity and to firm financial constraints lead to asset price volatility.

Model:

  • Setup
    • two consumers (entrepreneurs and laborers)
    • two goods (a consumption good and a capital good)
    • infinite and discrete time, with two subperiods in each period
      • in subperiod 1, all entrepreneurs hire labor and produce using the same technology.
      • in subperiod 2, a fraction of entrepreneurs are randomly presented with investment opportunities (i.e. the ability to transform the consumption good one-to-one into capital, without adjustment costs).
        • Firms not investing in new projects can purchase equity in other firms.
    • Equity is the only asset traded in the market (incomplete markets).
    • Firms’ financial constraint (the financial friction) is that there is a limit on how much of each new project can be sold as equity.
      • This limit changes over time, which is a theoretical contribution of this model.
    • Entrepreneurs and laborers maximize the present value of their consumption subject to a budget constraint, and wages and return on equity are determined competitively, and markets clear.
  • Productivity and financial shocks:
    • Productivity shocks affect the wealth of all firms, changing how much they can spend on equity.
    • Financial shocks affect the funding of firms with investment projects, and determine how much equity is available to the market.
    • These two shocks directly influence the amount of equity traded and investors’ budget constraints, and so directly contribute to fluctuations in asset prices.

Results:

  • After calibrating the model to the U.S. economy, productivity shocks alone explain little of the observed volatility.
  • With both types of shocks, modeled asset price volatility is about 80% of the observed volatility of the stock market.
  • The model explains 70% of the observed equity premium.
  • This model also generates the volatility in investment that is observed in the data.
  • Unlike previous models, the equilibrium here is not Pareto optimal.  The government could increase all agents’ welfare by relaxing the financial constraints of entrepreneurs with investment projects by extending loans to them.