Essays in Macroeconomics with Frictions and Uncertainty Shocks

Title: Essays in Macroeconomics with Frictions and Uncertainty Shocks C1. Financial Effects of Credit Constrained Workers’ Unemployment C2. International Financial Business Cycles C3. Uncertainty, Collateral Constrained Borrower, and the Business Cycle Author: Taesu Kang Advisor: Fabio Ghironi This dissertation consists of three essays on macroeconomics with frictions and uncertainty shocks. The first essay is ”Collateral Constrained Workers’ Unemployment”. Financial market and labor market are closely interconnected each other in the sense that unemployed workers have difficulty not only in borrowing new loan but also in repaying outstanding loan. In addition, if unemployment entails loss from default and no new loan, credit constrained workers will accept lower wage to avoid the loss from losing job. In this paper, we try to investigate the role of the interaction between financial market and labor market over the business cycle. To do that, we assume credit constrained workers can borrow against their houses and repay outstanding loans only when they are employed. We also introduce labor search and matching framework into our model to consider unemployment and wage bargaining process explicitly. With this setup, we find that adverse housing preference shock leads to substantial negative impact on labor market by reducing the benefit from maintaining job. As a result, high unemployment significantly amplifies the business cycle by reducing supply of loan and increasing default. This result would be helpful to understand recent ”Great Recession” which was originated from the collapse of housing market and accompanied by high unemployment and default rate. The second essay is ”International Financial Business Cycles”. Recent international macroeconomics literature on global imbalances explains the U.S. persistent current account deficit and emerging countries’ surplus, i.e., the U.S. is the borrower. Little research has been done on the banking-sector level, where U.S. banks are lenders to banks in emerging countries. We build a two country framework where banks are explicitly modeled to investigate how lending in the banking sector can affect the international macroeconomy during the recent crisis. In steady state, banks in the developing country borrows from the U.S. banks. When the borrowers in the U.S. pay back less than contractually agreed and damage the balance sheet of the U.S. banks, with the presence of bank capital requirement constraint, U.S. banks raise lending rates and decrease the loans made to U.S. borrowers as well as banks in the developing country. The results are a sharp increase in the lending spread, a reduction in output and a depreciation in the real exchange rate of the developing country. They are the experience of many emerging Asian markets following the U.S. financial crisis starting in late 2007. Another feature of our model captures an empirical fact, documented by Devereux and Yetman (2010), that across different economies, countries with lower financial rating can suffer more when the lending country deleverages. The third essay is ”Uncertainty, Collateral Constrained Borrowers, and Business Cycle”. Standard RBC model fails to generate the co-movement of key macro variables under uncertainty shock because precautionary saving motive decreases consumption but increases investment and labor. To fill this gap, we build a DSGE model with collateral constrained borrowers who can borrow against housing and capital. In the model with modest risk aversion, we can generate the desired co-movement of key macro variables under uncertainty shock and the co-movement comes from the collateral constraint channel through drop in housing price. Under uncertainty shock, highly indebted borrowers sell collaterals to avoid uncertainty in future consumption. As a result, housing price goes down and it makes credit crunch to borrowers through collateral constraint channel. The negative effect of uncertainty shock is strengthened in the economy with higher indebted borrowers.