Essays on finance and macroeconomics

Abstract

This thesis studies the role of the financial system in the amplification and propagation of business cycles. Chapter 1 studies the origin and propagation of balance sheet recessions. I first show that in standard models driven by TFP shocks, the balance sheet channel disappears when agents are allowed to write contracts on the aggregate state of the economy. In contrast, I show how uncertainty shocks can drive balance sheet recessions with depressed asset prices and growth, and trigger a "flight to quality" event with low interest rates and high risk-premia. Uncertainty shocks create an endogenous hedging motive that induces financial intermediaries to take on a disproportionate fraction of aggregate risk, even when contracts can be written on the aggregate state of the economy. Finally, I explore some implications for financial regulation. Chapter 2 studies a tractable model of dynamic moral hazard with purely pecuniary private benefits. The agent can trade a productive asset and secretly divert funds to a private account and use them to "recontract": at any time he can offer a new continuation contract to the principal, who accepts if the new contract is attractive. The main result is that the optimal contract can be characterized as the solution to a standard portfolio problem with a simple "skin in the game" constraint. The setting places few restrictions on preferences and the distribution of shocks, distinguishes between (observable) aggregate shocks and (unobservable) idiosyncratic shocks, and takes arbitrary general equilibrium prices as given. This makes the results easily applicable to many macro and financial applications. Chapter 3 explores under what conditions the presence of moral hazard can create a balance sheet amplification channel. If the private action of the agent exposes him to aggregate risk through his unobserved private benefit, the optimal contract will try to over-expose him to aggregate risk to deter him from misbehaving. This creates a tradeoff between aggregate and idiosyncratic risk-sharing. More productive agents naturally want to leverage more and therefore have larger incentives to distort their aggregate risk-sharing in order to reduce their exposure to idiosyncratic risk. In equilibrium, therefore, more productive agents take on a disproportionate fraction of aggregate risk, creating a balance sheet channel.