Discussion of Kiyotaki

1
Discussion of Kiyotaki MooreLiquidity,
Business Cycles, and Monetary Policy

• Gerhard Illing
• LMU Munich University/CESifo
• Banque de France Bundesbank conference
• June 2009

2
Central issues

• A role for liquid assets in a RBC model motivated
  by real frictions
• Strength Model response of output and asset
  prices to liquidity shocks Characterize
  aggregate fluctuations in an economy with real
  frictions role for monetary policy to smooth
  fluctuations
• Skepticism Does the model really help to
  understand the role of monetary policy in normal
  times or in times of stress?

3
Summary Model setup

• Economy with heterogeneous agents.
• Workers are passive (needed as tax base)
• Entrepreneurs have stochastic investment
  opportunities
• New capital needs to be funded need to issue
  equity
• Limited commitment
• Borrowing constraint Productive entrepreneurs
  can finance only a fraction ?lt1 with external
  funds
• Resale-ability constraint Only fraction flt1 of
  equity can be resold each period! ? Liquidity
  constraint

Motivates a role for fiat money with dominated
return Potentially productive entrepreneurs
prefer to hold a mix of liquid money and high
yielding, yet illiquid equity claims
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Summary The main insights

• Productive entrepreneurs invest every penny
  Binding liquidity constraint no money holding
• Unproductive entrepreneurs hold a portfolio mix
  with money and equity. Trade off
• Chance to become productive Money is most
  liquid asset to finance investment
• Risk to stay unproductive Equity holdings
  yield higher return.

• Beautiful fairy tale Elegant modeling of
  aggregate dynamics with heterogeneous agents
  explicit closed form solution Derives some
  Keynesian features (Feedback between goods and
  asset market Tobins Q) in a tractable dynamic
  general equilibrium model

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Summary The main insights

• What happens after a liquidity shock?
• f falls
• Productive entrepreneurs can get less funds by
  selling equity ? Equity less attractive among
  unproductive entrepreneurs
• Falling asset price, rising value of money
  (flight to liquidity, deflation)
• Falling investment
• Rising consumption decumulation of capital

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Summary The main insights

• Monetary policy? Open market operation Buy
  (sell) equity by issuing (withdraw) money
• Inefficiency of laissez-faire monetary economy
  Consumption is not smooth.
• Policy response after a negative shock on f
• Open market operation to increase the liquidity
  of the investing entrepreneurs, so
• Investments and asset prices can be insulated
  from the liquidity shock,
• Helps to smooth consumption!

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Comments

• Optimal monetary policy Implement Friedman rule
  to eliminate the frictions from liquidity
  constraints ? Implement first best outcome
• Trust in money (government) substitutes for lack
  of trust in entrepreneurs. Why?

• Problem 1 Model does not respect Lucas critique
• Frictions (Borrowing and Resale-ability
  constraints) do not respond to policy changes
• Moral hazard of entrepreneurs may be affected by
  policy Need to model the frictions from first
  principles to define the set of constrained
  efficient outcomes.
• Exogenous variations of ? and f Is a change in f
  simply a change in belief?
• Cheap route Ability to tax workers makes
  liquidity constraints of entrepreneurs non-binding

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Comments

• Problem 2 Model is biased towards favoring
  central bank intervention
• Frictions ?, f distort economy away from
  efficient outcome in just one direction
  under-accumulation!Central bank intervention
  helps to smooth/ overcome frictions. Does not
  capture a key element of current debate.

Model cannot address the notion of Fools Gold
(Overinvestment excessive risk taking) Allow
for possibility of Ponzi or Madoff games (fgt1?)
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Comments

• Alan Greenspan, Speech on Consumer Finance April
  2005 ? ?1 f?1
• With these advances in technology, lenders
  have taken advantage of credit-scoring models and
  other techniques for efficiently extending credit
  to a broader spectrum of consumers. Where once
  more-marginal applicants would simply have been
  denied credit, lenders are now able to quite
  efficiently judge the risk posed by individual
  applicants and to price that risk appropriately.
  These improvements have led to rapid growth in
  subprime mortgage lending

Are recent times of stress just a temporary
shock in the perception of f?
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Conclusion

• A compact, tractable framework to introduce a
  role for liquidity in standard RBC type models.
• Beautiful framework.
• But much more needs to be done!