Mikhail I. Dmitriev

Collateral Constraints and State-Contingent Contracts

It is commonly assumed that binding collateral constraints amplify the impact of aggregate shocks on the economy. However, we show that when firms can hedge against aggregate risk with state-contingent lending contracts, binding collateral constraints no longer amplify shocks relative to the basic New Keynesian model. We embed state-contingent lending contracts in a quantitative business cycle model in the spirit of Kiyotaki and Moore (1997) and Iacoviello (2005) and find that in general equilibrium unconstrained lenders sell insurance against aggregate risk to constrained borrowers. The provision of insurance against aggregate risk prevents the usual tightening of collateral constraints during downturns and leads to relatively mild recessions.

The optimal design of a fiscal union

We study cooperative and non-cooperative fiscal policy in a multi-country model where asset markets are segmented and countries face terms of trade externalities. We show that the optimal form of fiscal cooperation, or fiscal union, is defined by the Armington elasticity of substitution between the products of different countries. We prove that members of a fiscal union should: (1) harmonize tax rates when the Armington elasticity is low in order to ameliorate terms of trade externalities; and (2) send fiscal transfers across countries when the Armington elasticity is high in order to improve risk-sharing. For standard calibrations, the welfare gains from tax harmonization are as high as 0.3% of permanent consumption for countries both inside and outside of a currency union. The welfare gains from fiscal transfers are close to zero for countries outside of a currency union, but rise to between 0.5% (France) and 3.6% (Greece) of permanent consumption for countries inside a currency union.

Price Stability In Small Open Economies

We study the conduct of monetary policy in a continuum of small open economies. We solve the model globally in closed form without restricting the elasticity of substitution between home and foreign goods to one. Using this global closed-form solution, we give an exact characterization of optimal monetary policy and welfare with and without international policy cooperation. We consider the cases of internationally complete asset markets and financial autarky, producer currency pricing and local currency pricing. Under producer currency pricing, it is always optimal to mimic the flexible-price equilibrium through a policy of price stability. Under local currency pricing, policy should fix the exchange rate. Even if substitutability differs from one, the continuum of small open economies implies that the share of each countrys output in the world consumption basket (and therefore the impact of the countrys monopoly power) is negligible. This removes the incentive to deviate from price stability under producer currency pricing or a fixed exchange rate under local currency pricing. There are no gains from international monetary cooperation in all cases examined. Our results stand in contrast to those in the literature on optimal monetary policy for large open economies, where strategic interactions drive optimal policy away from price stability or fixed exchange rates, and gains from cooperation are present, when substitutability differs from one.

Risk Aversion, Uninsurable Idiosyncratic Risk, and the Financial Accelerator

This paper studies the role of non-diversified risk and risk aversion for business cycles in a model with agency frictions. We extend the Bernanke, Gertler and Gilchrist(1999) financial accelerator framework where entrepreneurs are risk neutral to the case of entrepreneurs with constant-relative-risk-aversion preferences. In the presence of risk aversion, non-diversified idiosyncratic risk stabilizes business cycle fluctuations, especially in response to financial shocks.We extend the Bernanke, Gertler and Gilchrist (1999) financial accelerator model with risk-neutral entrepreneurs to entrepreneurs with CRRA preferences. The optimal contract is identical to debt when there is no default, while when there is default entrepreneurs retain a part of their assets. In partial equilibrium, leverage becomes more sensitive to fluctuations in expected returns to capital when entrepreneurs are risk averse. In general equilibrium, this higher sensitivity tends to stabilize business cycle fluctuations . The response of output to “risk shocks” — shocks to the variance of unobserved idiosyncratic productivity — or shocks to the wealth distribution between households and entrepreneurs is 60 to 70 percent smaller when entrepreneurs are risk averse than when they are risk neutral. However, technology and monetary shocks have quantitatively similar effects on key macro variables, although about 20 percent smaller with risk aversion.