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Philippe Bacchetta

 

Liquidity and Risk in Macroeconomic Models

Domaine: ERC Advanced Grant

Acronyme: LIQRISK

Durée: à confirmer

Budget total: 2.070.570 EUR 

 

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Philippe Bacchetta, Département d'économétrie et d'économie politique, Faculté des HEC

 

Abstract

The proposal is motivated by the objective to introduce financial realities into macroeconomic models. The objective is to introduce leverage and liquidity in standard dynamic general equilibrium models and analyze their macroeconomic implications. The proposal is divided into two subprojects. The first deals with leverage and market liquidity in developed financial economies. The second examines the demand for liquid assets by emerging countries and its global implications.

In the first subproject, the proposal breaks new ground in the understanding of the dynamics of risk and in explaining some important features of the recent crisis. The project particularly emphasizes the role of self-fulfilling changes in expectations that can lead to sudden large shifts in risk. This can take the form of a financial panic with a big drop in asset prices. Such panics become much more severe when taking place against the backdrop of leveraged institutions that are in weak financial health. The framework that we develop can account for the main features of the current crisis, both during the panic and pre-panic stages of the crisis.

Moreover, the project has broader implications as it highlights the possibility of self-fulfilling joint shifts in risk and volatility of risk that can naturally occur in any market (assets, goods, labor) where demand depends on risk. Various extensions will investigate the empirical implications as well as the implications for international capital flows, exchange rates, macroeconomic activity and policy recommendations.

In the second subproject, the objective is to formalize and analyze different degrees of liquidity in international capital flows. While liquidity has been widely analyzed in microeconomic or partial equilibrium models, it has proven challenging to incorporate this feature into dynamic general equilibrium macroeconomic models. The project will innovate in finding ways to model liquidity in dynamic open economy models. This will allow a better understanding of the recent pattern in international capital flows where less developed countries lend to richer economies. It will also shed light on the evolution of global imbalances before and after the crisis.
 

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