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Work in Progress

Aggregation, Liquidity, and Asset Prices in Incomplete Markets

with Ben Hebert and Pablo Kurlat.

We analytically characterize asset-pricing and consumption behavior in two-account heterogeneous-agent models with aggregate risk. We show that trading frictions can simultaneously explain (1) household-level consumption behavior such as high marginal propensities to consume, (2) a zero-beta rate on equities that satisfies an aggregate consumption Euler equation, (3) a return on safe assets that does not, and (4) a flat securities market line. The return of equities is well explained by aggregate consumption, while the return of safe assets reflects a large and volatile liquidity premium.

The Zero-Beta Interest Rate

with Ben Hebert, Pablo Kurlat, and Qitong Wang.
We use equity returns to construct a time-varying measure of the interest rate that we call the zero-beta rate: the expected return of a stock portfolio orthogonal to the stochastic discount factor. The zero-beta rate is high and volatile. In contrast to safe rates, the zero-beta rate fits the aggregate consumption Euler equation remarkably well, both unconditionally and conditional on monetary shocks, and can explain the level and volatility of asset prices. We claim that the zero-beta rate is the correct intertemporal price.

Risk Markups

with Cedomir Malgieri and Christopher Tonetti.

Optimal policy in an economy with misallocation depends on the origin of markups. We develop a model of heterogeneous markups generated by uninsurable persistent idiosyncratic risk. Entrepreneurs hire labor trading off expected profits against risk. Markups arise as compensation for risk and create misallocation. We microfound incomplete risk sharing with moral hazard and hidden trade. The constrained-efficient allocation can be implemented with a uniform labor subsidy (or tax) and does not affect TFP. The subsidy equals the product of (1) the aggregate markup and (2) workers’ consumption share divided by their Pareto weight. It is uniform because targeted subsidies can be exploited by entrepreneurs’ hidden actions—the boundary of the firm is not invariant to policy. The markup component reflects inefficient risk premia and the consumption-share component reflects inefficient precautionary saving. In the long-run the optimal policy is a tax with a take-home rate equal to workers’ consumption divided by labor income.


Risk Premium Shocks Can Create Inefficient Recessions

Di Tella and Hall (2021), Review of Economic Studies (accepted).

We develop a simple flexible-price model of business cycles driven by spikes in risk premiums. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively plausible recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient—output, employment, and consumption fall too much during recessions, compared to the constrained-efficient allocation. Optimal policy involves stimulating employment and consumption during recessions.

Optimal Asset Management Contracts with Hidden Savings

Di Tella and Sannikov (2021), Econometrica, 89(3):1099-1139.

We characterize optimal asset management contracts in a classic portfolio-investment setting. When the agent has access to hidden savings, his incentives to misbehave depend on his precautionary saving motive. The contract dynamically distorts the agent’s access to capital to manipulate his precautionary saving motive and reduce incentives for misbehavior. We provide a sufficient condition for the validity of the first-order approach which holds in the optimal contract: global incentive compatibility is ensured if the agent’s precautionary saving motive weakens after bad outcomes. We extend our results to incorporate market risk, hidden investment, and renegotiation.

Why are Banks Exposed to Monetary Policy?

Di Tella and Kurlat (2021), AEJ:Macro, 13(4): 295-340.

We propose a model of banks’ exposure to movements in interest rates and their role in the transmission of monetary shocks. Since bank deposits provide liquidity, higher interest rates allow banks to earn larger spreads on deposits. Therefore, if risk aversion is higher than one, banks’ optimal dynamic hedging strategy is to take losses when interest rates rise. This risk exposure can be achieved by a traditional maturity-mismatched balance sheet, and amplifies the effects of monetary shocks on the cost of liquidity. The model can match the level, time pattern, and cross-sectional pattern of banks’ maturity mismatch.

Risk Premia and the Real Effects of Money

Di Tella (2020), American Economic Review, 110(7):1995-2040.

This paper proposes a flexible-price theory of the role of money in an economy with incomplete idiosyncratic risk sharing. When the risk premium goes up, money provides a safe store of value that prevents interest rates from falling, reducing investment. Investment is too high during booms when risk is low, and too low during slumps when risk is high. Monetary policy cannot correct this—money is superneutral and Ricardian equivalence holds. The optimal allocation requires the Friedman rule and a tax/subsidy on capital. The real effects of money survive even in the cashless limit.

Optimal Regulation of Financial Intermediaries

Di Tella (2019), American Economic Review, 109(1):271-313.

I characterize the optimal financial regulation policy in an economy where financial intermediaries trade capital assets on behalf of households, but must retain an equity stake to align incentives. Financial regulation is necessary because intermediaries cannot be excluded from privately trading in capital markets. They don’t internalize that high asset prices force everyone to bear more risk. The socially optimal allocation can be implemented with a tax on asset holdings. I derive a sufficient statistic for the externality in terms of observable variables, valid for heterogeneous intermediaries and asset classes, and arbitrary aggregate shocks. I use market data on leverage and volatility of intermediaries’ equity to measure the externality, which co-moves with the business cycle.

Uncertainty Shocks and Balance Sheet Recessions

Di Tella (2017), Journal of Political Economy, 125(6):2038-2081.

This paper investigates the origin and propagation of balance sheet recessions in a general equilibrium model with financial frictions. I first show that in standard models driven by TFP shocks, the balance sheet channel completely disappears when agents are allowed to write contracts on the aggregate state of the economy. Optimal contracts sever the link between leverage and aggregate risk sharing, eliminating the concentration of aggregate risk that drives balance sheet recessions. I then show how the type of aggregate shock that hits the economy can help explain the concentration of aggregate risk. In particular, I show that uncertainty shocks can drive balance sheet recessions and “flight to quality” events, even when contracts can be written on the aggregate state of the economy. Finally, I explore implications for financial regulation.