Motivation

Summary

Comments

Comments on “Adverse Selection, Uncertainty
Shocks and Business Cycles” by Daisuke Ikeda
Keiichiro Kobayashi
Institute of Economic Research, Hitotsubashi University

Nov 27, 2011

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Motivation

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Motivation1: To understand the great recession

I Candidates for the cause of great recession:

Risk shock: Christiano et al,Financial shock (interest rate spread) : Hall, Gilchrist et al,
I Marginal Eﬃciecy of Investment (MEI) shocks (investment
good to capital good): Justiniano, et alII

I This paper aims to provide microfoundation of ﬁnancial shockand MEI shock ⇒ Uncertainty shock

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Motivation

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Motivation 2: To develop a computable GE model withadverse selection

Two ﬁnancial frictions to consider
I Ex ante private information =⇒ Adverse selection νt .
I Ex post diversion of resources =⇒ Moral hazard ϕ.

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Summary
Partial Equilibrium model
Financial contract between Entrepreneur and Financier
1. Adverse selection
Entrepreneur has net worth Nn and private information p.
The project yields p1 R with probability p. p ∼ F (p), whereF (p) is publicly known.
2. Moral hazardEntrepreneur can divert ϕ of gross revenue ex post.
3. Zero proﬁts for banks
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Equilibrium conditions

1. Truth telling constraint ⇐= Adverse selection
2. No diversion constraint ⇐= Moral Hazard
3. Entrepreneurs’ participation constraint
4. Zero proﬁts for banks (⇐⇒ Condition is independent of net
worth of borrowers)

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Characterization of equilibrium
I Threshold p∗ does not depend on net worth
I The amounts of loan (Bn (p)) and repayment (Xn (p)) arelinear in net worth
I Risky entrepreneurs can borrow and pay more in theequilibrium contract (Riskier entrepreneurs have smaller
expected repayment)
I Intermediaries oﬀer loans to more entrepreneurs as the returns

earned by entrepreneurs get higher.

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General Equilibrium Models
Consumption good ⇒ Capital good ⇒ Consumption good
Model 1 – Adverse selection in the demand of capital
I Entrepreneurs buy capital good and rent it out for competitive

production of consumption goods
I Capital good producers are in the competitive market

Model 2 – Adverse selection in the supply of capital
I Entrepreneurs buy consumption goods and produce capital

goods
I They sell capital goods in the competitive market
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Simulation Results
I In response to uncertainty shocks, comovements are

reproduced
I In Model 2 net worth increase in response to uncertainty shock

or MEI shock (because there is no CEE adjustment cost)
I Countercyclical markup in wages and capital utilization rates

are crucial for comovement.
I CEE adjustment costs makes humpshaped and persistent

responses.
I CEE adjustment costs is crucial for predictive power ofexternal ﬁnance premium.
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Extensions
I Uncertainty shock (vt ) is qualitatively equivalent to risk shockin CMR()ŝt = −χ1,r N̂t − q̂t − K̂t+1 − χ2,r Et ur,t+1 ,()ŝt = −χ1 N̂t − q̂t − K̂t+1 − χ2 vt .
I Unrealized uncertainty shock has similar eﬀect as realized

uncertainty shock()ŝt = −χ1 N̂t − q̂t − K̂t+1 − χ2 vt + χ4 ηt .

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General Comment

I Tractable model of adverse selection in the DSGE framework(⇔ Kurlat 2010, Bigio 2010)
I One period ﬁnancial contract in DSGE model:CF 1997
BGG 1999
I CMR 2010 (Risk shock)I Hirakata Sudo Ueda 2009
I Kato 2006 (Holmstrom-Tirole type)II

I This model is equivalent to BGG if vt = 0.

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Comment 1
Similarity between Risk shock and Uncertainty shock
I Risk Shock: σt

BGG framework: Costly State Veriﬁcation
Ex post idiosyncratic shock on project: ln ωt ∼ N (µ, σ)
I In BGG model, σ is constant
I In CMR model, it is time variant → Risk shockII

I Uncertainty shock: vt

This paper: Adverse selection + Moral hazard
I Ex ante idiosyncratic shock on project: p ∼ U [pevt , 1]
I v follows v = ρ v
ttv t−1 + ϵt .
I

The aggregate eﬀect of risk shock and uncertainty shock are similar
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Comment 1 (continued)

Risk shock v.s. Uncertainty shock
I Incorporating adverse selection into DSGE model
I Eﬀect on macroeconomic dynamics
I Microfoundation for ﬁnancial shocks (interest rate spread)I

Is it “micro” foundation?

I Can introduce additional features, e.g., Knightian uncertainty(Fukuda 2008)12 / 17

Motivation

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Comment 2
Shocks on investment (i.e., MEI shock or ﬁnancial shock):main driving force of business cycle?
I This paper

Shocks on investment ⇐ Financial frictions
I Shocks on investment = the main driving force (Justiniano etal.)
II Justiniano et al.

If M P L = M RS investment shock cannot reproduce
comovement
I Sticky prices and wages make M P L ̸= M RS and investment
shocks generate comovementsI

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Comment 2 (continued)
I Labor wedge arguments (Chari et al., Shimer)

Labor wedge 1 − τt = M RS/M P L
Changes in labor wedge can reproduce business cycles
I Shocks on τ may be the driving force of business cycles
tIISearch friction in the labor market
Frictions on working capital ﬁnancing (Jermann and Quadrini
2006, Mendoza 2010)
I Nominal wage rigidities + productivity shockIII

Nominal wage rigidities + investment shock

I Investment may ﬂuctuate in response to shocks on search

friction and/or working capital ﬁnancing
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Comment 3

DSGE model + Large shock = Great recession?
I What is the cause of uncertainty shocks (or risk shocks)?
I We may not need to know the cause of shock foranalysis of mechanism of propagation
I assessment of (unconventional) policy
I

I We need to know the cause of large shock for prevention ofrecurrence of ﬁnancial crisis.

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Comment 3 (continued)
Stylized pattern of ﬁnancial crisis (Reinhart and Rogoﬀ)
I Financial liberalization or ﬁnancial innovation / Capital inﬂowbonanza
I Asset price bubble and overleverage
I Banking crisis
I Inﬂation / Government debt crisis (external and/or domestic)

Cause of ﬁnancial crisis
I DSGE literature: Large shock to a normal economy
I RR imply: Small shock to an overleveraged economy
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Minor comment

Moral hazard shock
I What is the eﬀect of shocks to ϕ?

ϕt = (1 − ρ)ϕ + ρϕt + ϵt
I Is it equivalent to net worth shock?

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