Advanced Topics in Macroeconomics: Information, Moral Hazard, and Financial Frictions (B ) Fall 2009 Laura Veldkamp and Gian Luca Clementi

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1 Advanced Macro Syllabus and Outline Advanced Topics in Macroeconomics: Information, Moral Hazard, and Financial Frictions (B ) Fall 2009 Laura Veldkamp and Gian Luca Clementi Laura Office: KMC 7 77 Gian Luca Office: KMC 7-71 Phone: (212) Phone: (212) lvedkam@stern.nyu.edu clem@nyu.edu Office Hours: By appointment (just send us an ) Classes: Mondays Wednesdays 2:30 4:00 in KMC Course Description The topic of the course is imperfect information, moral hazard, and financial frictions. The first half of the course is an introduction to information choice with applications to business cycles, monetary economics and finance. We will cover Bayesian learning, coordination games with heterogeneous information and rational inattention. The second half is about modeling moral hazard in dynamic economic models. If you did not believe that moral hazard matters, the events of the last couple of years should have convinced you! We ll start by introducing standard techniques used in the literature and then we ll consider recent applications to a variety of fields, such as firm dynamics, corporate finance, economic development,... (see below for a complete list). Prerequisites You are expected to have already taken the first year PhD sequences in microeconomics and macroecomomics.

2 Advanced Macro Syllabus and Outline 2 Coursework and Evaluation Class attendance and participation. Required. Homework. There will be regular problem sets. Exam/Project. For the first half of the class, there is no exam. Instead, you can choose between writing a 5-page research proposal or writing a referee report for one of the papers in the bibliography of the lecture notes (or some other related paper, with approval). For the second half of the class, there will be a take home exam. Your grade will be based on your performance on all of these deliverables, weighted as follows: Class Participation 10% Homework 40% Exam/Research Proposal/Referee Report 50% We will average the grades from the two halves of the course to give you one course grade at the end of the semester.

3 Sept. 9 through Oct. 21 Information Choice and Macroeconomics (Laura Veldkamp) Notes, slides, and problem sets will be posted on my personal webpage ( pages.stern.nyu.edu/~lveldkam/). The course schedule below lists articles that you should read before class these are the articles we ll cover in lecture. You ll get the most out of the class if you read these articles, at least briefly, in advance. There are other articles that you may want to read for background or that you can use for your referee report. These articles are listed as recommended reading in the syllabus and in the bibliography of the lecture notes. Topic 1 (September 9, 14). Introduction and overview. Why study information choice? Bayesian updating with normal variables. Measuring Information Flows. Entropy and mutual information. Comparing learning technologies. Read before class: Sims (2003) Recommended Reading: Brunnermeier (2001) Ch. 1.1, Cover and Thomas (1991), ch.s 2,10 Topic 2 (September 16, 21). Information choice in strategic games. Introduction to global games. The role of private and public information in coordination games. Strategic aspects of information choice. Applications to price-setting models. Avoiding multiple equilibria problems in information choice models. Read before class: Morris and Shin (1998), Morris and Shin (2002), Hellwig and Veldkamp (2009). Recommended Reading: Vives (2008) ch. 6.3, Amador and Weill (2007). Due at the start of class: Problem set #1 Topic 3 (September 23, 30). Information choice in price-setting. Models of inattentiveness and rational inattention that generate price inertia. Read before class: Maćkowiak and Wiederholt (2009), Reis (2006). Recommended Reading: Abel, Eberly, and Panageas (2007) Due at the start of class: Problem set #2 Topic 4 (October 5,7). Portfolio Choice. Extending the noisy rational expectations model to many assets. Handling correlated risks. Revisiting the choice of learning technologies and role of the timing of uncertainty resolution. Read before class: Grossman and Stiglitz (1980), Admati (1985), Van Nieuwerburgh

4 Advanced Macro Syllabus and Outline 4 and Veldkamp (2009) Recommended Reading: Brunnermeier, Gollier, and Parker (2007), Peng and Xiong (2005) Due at the start of class: Problem set #3 Topic 5 (October 12, 14). Investment and information acquisition. Returns to scale in a real investment model. Partial equilibrium models of portfolio choice. Information markets and hidden complementarities. Read before class: Wilson (1975), Veldkamp (2006). Recommended Reading: Peress (2004), Veldkamp and Wolfers (2007). Due at the start of class: Problem set #4 Topic 6 (October 19). Information-driven business cycles Can news about productivity explain business cycle fluctuations? Read before class: Lorenzoni (2009), Beaudry and Portier (2004) Recommended Reading: Lucas (1972), Jaimovich and Rebelo (2006) Due at the start of class: Problem set #5 Topic 7 (October 21). Applications and empirical validation. What to do with these tools? How to test models of information choice? Due Monday November 30: Research proposal or referee report. Oct. 26 through Dec 14 Moral Hazard and Macroeconomics (Gian Luca Clementi) Part I Theory Optimal Risk Sharing under Asymmetric Information Readings: Rogerson (1985), Townsend (1982), Green (1987), Thomas and Worrall (1990) Recursive Representation of Dynamic Principal Agent Problems Readings: Atkeson and Lucas (1992), Spear and Srivastava (1987)

5 Advanced Macro Syllabus and Outline 5 The APS Algorithm Readings: Abreu, Pearce, and Stacchetti (1990), Wang (1997) Part II Applications Consumption and Risk Sharing Readings: Rogerson (1985), Cole and Kocherlakota (2001), Abraham and Pavoni (2005), Abraham and Pavoni (2008), Attanasio and Pavoni (2009) Unemployment Insurance Readings: Shavell and Weiss (1979), Hopenhayn and Nicolini (1997), Pavoni (2009), Kocherlakota (2004a), Mitchell and Zhang (2007), Pavoni and Violante (2007) Firm Dynamics Readings: Albuquerque and Hopenhayn (2004), Clementi and Hopenhayn (2006), Quadrini (2003), Clementi, Cooley, and Di Giannatale (2009), Arellano, Bai, and Zhang (2009) Corporate Finance Readings: DeMarzo and Fishman (2007), Biais, Mariotti, Plantin, and Rochet (2007), Tchistyi (2005), Piskorski and Tchistyi (2006) International Finance Readings: Atkeson (1991), Albuquerque (2003), Mendoza, Quadrini, and Rios-Rull (2009) Business Cycle Readings: Bernanke and Gertler (1989), Gertler (1992), Cooley, Quadrini, and Marimon (2004), Smith and Wang (2006) Economic Development Readings: Caselli and Gennaioli (2003), Castro, Clementi, and MacDonald (2004), Erosa and Hidalgo Cabrillana (2008), Castro, Clementi, and MacDonald (2009) Money Readings: Jovanovic and Ueda (1997), Meh, Quadrini, and Terajima (2009), Jovanovic (2009) Taxation Readings: Mirrlees (1971), Golosov, Kocherlakota, and Tsyvinski (2003), Kocher-

6 Advanced Macro Syllabus and Outline 6 lakota (2004b), Kocherlakota (2009), Kocherlakota (2009), Albanesi and Sleet (2009) Background Reading On Contract Theory: Macho-Stadler and Perez-Castrillo (1997), Salanie (1997), Ljungqvist and Sargent (2000), Laffont and Martimort (2002), Bolton and Dewatripont (2005) On Dynamic Programming and Numerical Methods in Macroeconomics: Stokey and Lucas (1989), Ljungqvist and Sargent (2000), Adda and Cooper (2003), Judd (1998) References Abel, A., J. Eberly, and S. Panageas (2007): Optimal Inattention to the Stock Market, American Economic Review, 97(2), Abraham, A., and N. Pavoni (2005): The Efficient Allocation of Consumption under Moral Hazard and Hidden Access to the Credit Market, Journal of the European Economic Association, 3, (2008): Efficient Allocations with Moral Hazard and Hidden Borrowing and Lending: A Recursive Formulation, Review of Economic Dynamics, 11(4), Abreu, D., D. Pearce, and E. Stacchetti (1990): Toward a Theory of Discounted Repeated Games with Imperfect Monitoring, Econometrica, 58, Adda, J., and R. Cooper (2003): Dynamic Programming: Theory and Applications. MIT Press, Cambridge, MA. Admati, A. (1985): A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets, Econometrica, 53(3), Albanesi, S., and C. Sleet (2009): Dynamic Optimal Taxation with Private Information, Review of Economic Studies, 73(1), Albuquerque, R. (2003): The Composition of International Capital Flows: Risk Sharing Through Foreign Direct Investment, Journal of International Economics, 61(2), Albuquerque, R., and H. Hopenhayn (2004): Optimal Lending Contracts and Firm Dynamics, Review of Economic Studies, 71,

7 Advanced Macro Syllabus and Outline 7 Amador, M., and P.-O. Weill (2007): Learning from Private and Public Observations of Others Actions, Working Paper. Arellano, C., Y. Bai, and J. Zhang (2009): Firm Dynamics and Financial Development, NBER Working Paper No Atkeson, A. (1991): International Lending with Moral Hazard and Risk of Repudiation, Econometrica, 79, Atkeson, A., and R. Lucas (1992): On Efficient Distribution with Private Information, Review of Economic Studies, 59, Attanasio, O., and N. Pavoni (2009): Risk Sharing in Private Information models with Asset Accumulation: Explaining the Excess Smoothness of Consumption, University College London. Beaudry, P., and F. Portier (2004): Exploring Pigou s Theory of Cycles, Journal of Monetary Economics, 51(6), Bernanke, B., and M. Gertler (1989): Agency Costs, Net Worth and Business Fluctuations, American Economic Review, 79, Biais, B., T. Mariotti, G. Plantin, and J.-C. Rochet (2007): Dynamic Security Design: Convergence to Continous Time and Asset Pricing Implications, Review of Economic Studies, 74(2), Bolton, P., and M. Dewatripont (2005): Contract Theory. MIT Press, Cambridge, MA. Brunnermeier, M. (2001): Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis and Herding. Oxford University Press, first edn. Brunnermeier, M., C. Gollier, and J. Parker (2007): Optimal Beliefs, Asset Prices and the Preferences for Skewed Returns, American Economic Review, Papers and Proceedings, 97(2), Caselli, F., and N. Gennaioli (2003): Dynastic Management, NBER Working Paper No Castro, R., G. L. Clementi, and G. MacDonald (2004): Investor Protection, Optimal Incentives, and Economic Growth, Quarterly Journal of Economics, 119(3), (2009): Legal Institutions, Sectoral Heterogeneity, and Economic Development, Review of Economic Studies, 76(2), Clementi, G. L., T. Cooley, and S. Di Giannatale (2009): A Theory of Firm Decline, NBER Working Paper No

8 Advanced Macro Syllabus and Outline 8 Clementi, G. L., and H. A. Hopenhayn (2006): A Theory of Financing Constraints and Firm Dynamics, Quarterly Journal of Economics, 121(1), Cole, H., and N. Kocherlakota (2001): Efficient Allocations with Hidden Income and Hidden Storage, Review of Economic Studies, 68, Cooley, T., V. Quadrini, and R. Marimon (2004): Aggregate Consequences of Limted Contract Enforceability, Journal of Political Economy, 112(4), Cover, T., and J. Thomas (1991): Elements of Information Theory. John Wiley and Sons, New York, New York, first edn. DeMarzo, P., and M. Fishman (2007): Optimal Long-Term Financial Contracting, Review of Financial Studies, 20(6), Erosa, A., and A. Hidalgo Cabrillana (2008): On Finance as a Theory of TFP, Cross Industry Productivity Differences, and Economic Rents, International Economic Review, 49(2), Gertler, M. (1992): Financial Capacity and Output Fluctuations in an Economy with Multi-Period Financial Relationships, Review of Economic Studies, 59, Golosov, M., N. Kocherlakota, and A. Tsyvinski (2003): Optimal Indirect and Capital Taxation, Review of Economic Studies, 70, Green, E. (1987): Lending and the Smoothing of Uninsurable Income, in Contractual Arrangements for Intertemporal Trade. University of Minnesota Press, Minneapolis, MN. Grossman, S., and J. Stiglitz (1980): On the Impossibility of Informationally Efficient Markets, American Economic Review, 70(3), Hellwig, C., and L. Veldkamp (2009): Review of Economic Studies76, Hopenhayn, H. A., and J. P. Nicolini (1997): Optimal Unemployment Insurance, Journal of Political Economy, 105, Jaimovich, N., and S. Rebelo (2006): Can News About the Future Drive the Business Cycle?, Working Paper. Jovanovic, B. (2009): Nominal Shocks and Long Term Contracts, New York University. Jovanovic, B., and M. Ueda (1997): Contracts and Money, Journal of Political Economy, 105(4), Judd, K. (1998): Numerical Methods in Economics. MIT Press, Cambridge, MA.

9 Advanced Macro Syllabus and Outline 9 Kocherlakota, N. R. (2004a): Figuring out the Impact of Hidden Savings on Optimal Unemployment Insurance, Review of Economic Dynamics, 7(3), (2004b): Wedges and Taxes, American Economic Review, 94, (2009): Zero Expected Wealth Taxes: A Mirrlees Approach to Dynamic Optimal Taxation, Econometrica, 73(5), Laffont, J.-J., and D. Martimort (2002): The Theory of Incentives. Princeton University Press, Cambridge, MA. Ljungqvist, L., and T. J. Sargent (2000): Recursive Macroeconomic Theory. MIT Press, Cambridge, MA. Lorenzoni, G. (2009): A Theory of Demand Shocks, American Economic Review, forthcoming. Lucas, R. (1972): Expectations and the Neutrality of Money, Journal of Economic Theory, 4(2), Macho-Stadler, I., and D. Perez-Castrillo (1997): An Introduction to the Economics of Information - Incentives and Contracts. Oxford University Press, Oxford, UK. Maćkowiak, B., and M. Wiederholt (2009): Optimal Sticky Prices Under Rational Inattention, American Economic Review, 99(3), Meh, C., V. Quadrini, and Y. Terajima (2009): Real Effects of Price Stability with Endogenous Nominal Indexation, Working Paper , Bank of Canada. Mendoza, E., V. Quadrini, and V. Rios-Rull (2009): Financial Integration, Financial Deepness, and Global Imbalances, Journal of Political Economy, 117(3), Mirrlees, J. (1971): An Exploration in the Theory of Optimum Income Taxation, Review of Economic Studies, 38, Mitchell, M., and Y. Zhang (2007): Unemployment Insurance with Hidden Savings, University of Toronto. Morris, S., and H. Shin (1998): Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks, American Economic Review, 88(3), (2002): The Social Value of Public Information, American Economic Review, 92, Pavoni, N. (2009): Optimal Unemployment Insurance with Human Capital Depreciation and Duration Dependence, International Economic Review, 50(2),

10 Advanced Macro Syllabus and Outline 10 Pavoni, N., and G. Violante (2007): Optimal Welfare to Work Plans, Review of Economic Studies, 74, Peng, L., and W. Xiong (2005): Investor Attention, Overconfidence and Category Learning, Journal of Financial Economics, forthcoming. Peress, J. (2004): Wealth, Information Acquisition and Portfolio Choice, The Review of Financial Studies, 17(3), Piskorski, T., and A. Tchistyi (2006): Optimal Mortgage Design, Columbia GSB. Quadrini, V. (2003): Investment and Liquidation in Renegotian-proof Contracts with Moral Hazard, 51, Reis, R. (2006): Inattentive Producers, Review of Economic Studies, 73(3), Rogerson, W. (1985): Repeated Moral Hazard, Econometrica, 53, Salanie, B. (1997): The Economics of Contracts - A primer. MIT Press, Cambridge, MA. Shavell, S., and L. Weiss (1979): The Optimal Payment of Unemployment Insurance Benefits over Time, Journal of Political Economy, 87, Sims, C. (2003): Implications of Rational Inattention, Journal of Monetary Economics, 50(3), Smith, A., and C. Wang (2006): Dynamic Credit Relationships in General Equilibrium, Journal of Monetary Economics, 53(4), Spear, S., and S. Srivastava (1987): On Repeated Moral Hazard with Discounting, Review of Economic Studies, 54, Stokey, N. L., and R. J. Lucas (1989): Recursive Methods in Economic Dynamics. Harvard University Press, Cambridge, MA. Tchistyi, A. (2005): Security Design with Correlated Hidden Cash Flows: The Optimality of Performance Pricing, Working paper, Haas School of Business, UC Berkeley. Thomas, J., and T. Worrall (1990): Income Fluctuation and Asymmetric Information: An Example of a Repeated Principal-Agent Problem, Journal of Economic Theory, 51, Townsend, R. (1982): Optimal Multiperiod Contracts and the Gain from Enduring Relationships wunder Private Information, Journal of Political Economy, 90,

11 Advanced Macro Syllabus and Outline 11 Van Nieuwerburgh, S., and L. Veldkamp (2009): Information Immobility and the Home Bias Puzzle, Journal of Finance, 64(3), Veldkamp, L. (2006): Media Frenzies in Markets for Financial Information, American Economic Review, 96(3), Veldkamp, L., and J. Wolfers (2007): Aggregate Shocks or Aggregate Information? Costly Information and Business Cycle Comovement, Journal of Monetary Economics, 54, Vives, X. (2008): Information and learning in markets: The impact of market microstructure. forthcoming. Wang, C. (1997): Incentives, CEO Compensation, and Shareholder Wealth in a Dynamic Agency Model, Journal of Economic Theory, 76, Wilson, R. (1975): Informational Economies of Scale, Bell Journal of Economics, 6,