Research Statement Abeer Reza Carleton University November 2, 2012

Prior to the 2008 recession, workhorse neoclassical or new-Keynesian models that informed policy in governments and central banks around the world seldom considered financial markets. The Modigliani and Miller (1958) theorem was largely interpreted to imply that financial or credit market conditions have no effect on the real economy. The 2008 recession, however, made it abundantly clear that financial markets are an important channel through which shocks to the economy are transmitted and propagated, and may themselves originate recessions. In my research, I aim to understand the linkage between real and financial sectors, and how financial frictions affect the responses of important economic variables to different shocks in dynamic stochastic general equilibrium (DSGE) models.

Current Research In my job market paper, titled “Search Frictions, Bank Leverage, and Gross Loan Flows”, I develop a full-fledged banking model that serves both as a transmission channel for shocks, as well as a point of origin for recessions. During the 2008 recession, erosion in bank equity led to an increase in gross loan destruction, a reduction in net loan flows, and a countercyclical rise in interest rate spreads. This paper develops a search-theoretic banking model in a DSGE framework that can simultaneously explain movements in interest rate spreads and gross loan creation and destruction flows, while keeping the model useful for aggregate policy analysis. I introduce a banking sector featuring an explicit bank leverage ratio channel, endogenous match separation, and bank loans that vary in both extensive and intensive margins to a standard New Keynesian framework, and use the model to study responses to two types of financial shocks one that originates within the banking sector, and one 1

that works through the bank leverage channel, along with traditional shocks to technology and interest rates. First, I find that search frictions generate a counter-cyclical interest rate spread by varying bank loans in both extensive and intensive margins, which amplifies and propagates recessions generated by all negative shocks considered. Endogenous match separation and the bank leverage channel both contribute to generating a counter-cyclical interest spread. Second, I compare model generated responses to financial shocks with empirical responses estimated using a factor-augmented variance auto-regression (FAVAR) framework and identified using sign restrictions. I find that the shock that works through the bank leverage channel, rather than one that originates within the banking sector, generates responses to loan destruction and net loan flows that are consistent with evidence. This implies that the 2008 crisis involved more than just a simple supply-side reduction in bank loans. In the first chapter of my dissertation, titled “Financial Frictions, Labour Search and Investment Shocks”, I study how financial frictions affect the transmission of investmentspecific technology shocks, and its implication for the consumption co-movement puzzle identified in the literature. Recent research on the source of economic fluctuations in post-war US find that investment-specific shocks, that affect the efficiency through which investment spending is transformed to productive capital, are an important driving force for business cycles. In most models that include investment shocks, however, consumption falls on impact. This contradicts observed business cycle co-movements where consumption, output and investment move together. This paper shows that introducing financial frictions alongside endogenous capacity utilization in a new-Keynesian model can produce co-movement of consumption. By attenuating investment responses to supply shocks, the Bernanke et al. (1999) ”financial accelerator” mechanism reduces intertemporal substitution towards savings and allows consumption to rise on impact. Search frictions in the labour market introduce a wedge between the marginal product of labour and wages through Nash bargaining, which also contribute to generating co-movement. In the absence of wage rigidity, however, search frictions alone are not enough to reduce the sensitivity of consumption response to labour market elasticities. A version of this paper has received a revision and resubmission request from Economics Letters. In a joint work with my supervisor, Hashmat Khan, titled “House Prices and Government Spending Shocks”, I study the transmission of government spending shocks in the presence

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of borrowing constraints as in Iacoviello (2005). This paper uses a structural vector autoregression (SVAR) method to show that house prices in the U.S. increase after a positive government spending shock, even when anticipation effects have been taken into account. We highlight that in a broad class of DSGE models with housing and collateralized borrowing, house prices fall after a positive government spending shock. While the focus of previous literature has been on generating a positive response of consumption in a model economy, the counterfactual response of house prices poses a new challenge in understanding the transmission of fiscal policy. This issue is especially relevant when using these models to address policy issues related to house prices and consumption which have come to fore in the aftermath of the Great Recession of 2008.

Future Research Currently, I am working on extending the search-theoretic banking model developed for my job market paper to address an important issue related to the financial crisis. By including household lending and allowing banks to fund mortgage loans, I hope to study the effect of supply-side funding availability on housing dynamics. In particular, it would be interesting to see the effect of bank loan availability on house prices. Iacoviello and Neri (2010) estimate a two-sector model with borrowing constraints on mortgage lending using Bayesian techniques on U.S. data and finds that house price increases prior to the sub-prime crisis were driven by the fact that productivity growth in the housing sector did not keep up with productivity growth in the non-housing sector. Their study therefore provides a strictly real side story to the rise in house prices prior to the sub-prime crisis. However, Brunnermeier (2009) notes that the crisis was instigated through an increase in the availability of loans. In particular, financial innovation is thought to have contributed to the rise in house prices. It would, therefore, be interesting to see whether a secular rise in match efficiency between banks and mortgage borrowers can generate a rise in house prices seen in recent history. By estimating the model, we can further ask whether there is empirical support to the story that financial innovation (or misperception of financial innovation) has led to a rise in house prices.

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References Bernanke, B. S., Gertler, M. and Gilchrist, S.: 1999, The financial accelerator in a quantitative business cycle framework, in J. B. Taylor and M. Woodford (eds), Handbook of Macroeconomics, Vol. 1 of Handbook of Macroeconomics, Elsevier, chapter 21, pp. 1341– 1393. Brunnermeier, M. K.: 2009, Deciphering the liquidity and credit crunch 2007-2008, Journal of Economic Perspectives 23(1), 77–100. Iacoviello, M.: 2005, House prices, borrowing constraints, and monetary policy in the business cycle, American Economic Review 95(3), 739–764. Iacoviello, M. and Neri, S.: 2010, Housing market spillovers: Evidence from an estimated dsge model, American Economic Journal: Macroeconomics 2(2), 125–64. Modigliani, F. and Miller, M.: 1958, The cost of capital, corporation finance and the theory of investment, The American Economic Review 48(3), 261–297.

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