Ebook Asset Prices and Business Cycles with Financial Frictions
The excess volatility puzzle (Shiller, 1981, and LeRoy and Porter, 1981) and the equity premium puzzle (Mehra and Prescott, 1985) are two fundamental challenges to theoretical models that have been developed in the finance and macroeconomics literature. Building a production economy model that would satisfactorily account for both high aggregate stock market volatility and the behavior of aggregate quantities has proven to be difficult and no consensus model has arisen. In this paper we build a model in which variations in firms’ ability to raise external capital to take profitable projects lead to asset price volatility. We calibrate the model to the U.S. data and find that it generates about 80% of the observed aggregate stock market volatility. At the same time, the model generates time-series properties of aggregate quantities that match the macroeconomic data.
Our model closely resembles the model described in Kiyotaki and Moore (2008). It is a dynamic stochastic general equilibrium model with heterogeneous entrepreneurs, who face a real and a financial friction. The real friction restricts entrepreneurs’ access to new projects. In every period only a fraction of entrepreneurs find new profitable projects. Following the literature, we assume that the arrival of profitable projects is i.i.d. over time and over entrepreneurs, see e.g. Angeletos (2007) and Kocherlakota (2009). We model an entrepreneur’s ability to start a profitable project as his ability to produce new capital goods one-to-one from the general consumption good. Entrepreneurs who cannot produce capital are willing to buy claims to returns of other entrepreneurs’ projects to replace their depreciated capital. We call these claims equity. Markets are incomplete and equity is the only financial asset that is traded in the economy. The financial friction restricts new issuance of equity. We assume that entrepreneurs can only leverage a fraction of the returns of the newly produced capital, i.e. sell only a fraction of the new project as equity. On its own, this friction is standard in the literature. The novel feature of our model is that the ratio of outside to total financing of projects changes over time.
The interactions between these two frictions and the time variation in the financial friction play an important role in the ability of our model to explain the asset price volatility. Assuming that all entrepreneurs in the economy can produce new capital goods would imply that the price of equity is constant at the cost at which capital is produced, i.e. at price one. No entrepreneur would be willing to pay a higher price. Assuming heterogeneity in entrepreneurs’ ability to produce new capital in the absence of the financial friction would imply that the price of equity is always one as well. If the price was higher, an entrepreneur with the ability to produce new capital would find it profitable to increase his investment in the project. He then would sell equity to the newly installed capital at a price that exceeds the costs. However, if the fraction of entrepreneurs that can produce new capital goods and the leverage ratio are relatively low, the price of equity will be greater than one. In that case, fluctuations in the leverage ratio result in fluctuations in the price of equity. The intuition behind this result is as follows. If the leverage ratio decreases, entrepreneurs with the ability to produce new capital goods decrease their investment and their supply of new equity. This decrease in supply increases the value of existing assets and therefore the price of equity will increase. A similar logic applies for an increase in the leverage ratio. Consequently, as the leverage ratio fluctuates over time so does the price of equity.
We calibrate the model and find that it generates about 80% of the quarterly volatility in asset prices relative to the Dow Jones Total Stock Market Index. On the annual basis, our benchmark model generates about 85% of the asset return volatility relative to the value weighted market return. We construct a shadow risk free rate and find that our model generates an annual equity premium of 1.6%. Finally, we find that time variation in the financial friction contributes significantly to the volatility of investment, but not to the volatility of output.
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