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This paper provides a model to explain the role of international reserves in reducing the likelihood of sovereign debt crises. The setup features a government making optimal choices of debt and reserves in an environment in which self-fulfilling rollover crises a-là Cole-Kehoe and external default a-là Eaton-Gersovitz coexist. This allows for both fundamental and market-sentiment driven debt crises. Self-fulfilling crises arise because of a lender's coordination problem when multiple equilibria are feasible. Conditional on the country's Net Foreign Asset position, additional reserves make the sovereign more willing to service its debt even when no new borrowing is possible, which enlarges the set of states in which repayment is the government's dominant strategy and this in turn reduces the set of states that admit a self-fulfilling crisis. From an ex-ante perspective, reserves reduce the probability of crises in the future and which lowers current sovereign spreads. The result depends on the existence of roll-over risk and debt not being limited to one period debt. This paper advances existing models by accounting not only for the self-insurance role of reserves against self-fulfilling crises but also for their part in reducing the probability of such events. These findings are in line with the empirical literature on vulnerability measures to sovereign debt crises that shows the connection between international reserves, the probability of debt crises and sovereign spreads. Quantitatively the model can explain 60% of Mexico's international reserves holdings, while accounting for key cyclical facts, showing the relevance of the proposed mechanism.
Optimal v. Simple Financial Policy Rules in an Equilibrium Model of Credit Booms and Crashes
with Enrique G. Mendoza
We evaluate the effectiveness of optimal versus simple financial policy rules in a model of a small open economy with production, liability dollarization and “unconventional shocks” in the form of global liquidity shifts and news about future fundamentals. In our model, both tradable and nontradable goods are produced using intermediate goods traded in world markets. Debt is denominated in units of tradables, and a collateral constraint limits debt to a fraction of the market value of total income. The optimal policy has a macroprudential or ex-ante component: a debt tax levied at date t only when the collateral constraint is not currently binding but may do so at t+1, as well as an ex-post component: sectoral production taxes/subsidies used when the collateral constraint binds. The optimal policy, although complex, is very effective at reducing the magnitude and severity of financial crises. Simple policies can be effective but need to be constructed carefully otherwise they can be welfare reducing.
Fighting for the Best, Losing with the Rest: On the Desirability of Competition in Financial Markets
with Daniel Wills
The Jumpstart Our Business Startups (JOBS) act of 2012 aims at increasing funding access for young firms by easing securities regulation. Motivated by this, we ask if there is a role for the regulation of the market of funds for firms that lack collateral and have a large uncertainty about their ability to generate profits. To answer that we characterize optimal financial contracts in a competitive environment with risk, adverse selection and limited liability. We find that competition among financial intermediaries always forces them to fund projects with negative expected returns both from a private and from a social perspective. Intermediaries use steep payoff schedules to screen entrepreneurs, but limited liability implies this can only be done by giving more to all entrepreneurs. In equilibrium, competition for the best entrepreneurs forces intermediaries to offer better terms to all customers, there is cross subsidization among entrepreneurs and intermediation profits are nil. The three main features of our framework (competition, adverse selection and limited liability) are necessary in order to get the inefficient laissez-faire outcome and a role for financial regulation. Our result remains robust when firms can collateralize some portion of the credit as long as there is still an unsecured fraction.
Optimal Capital Taxes and Entrepreneurial Choice: New vs Old Money
with Ali Shourideh and Daniel Wills (Work in progress)
We characterize optimal business and labor income tax schedules in an environment in which agents can choose to be entrepreneurs or workers. Agents privately observe their skill for each occupation and also privately decide the corresponding investment and effort intensities. The different nature of the incentive structure in each sector results in a distortion of the occupational choice margin, and the resulting sector-specific tax schedules are different from what they would be in a world without sector mobility. In the case where workers supply hours inelastically, a Rawlsian planner always sets the marginal tax on labor income higher than the marginal tax on operating profits. In this setting consumption is not equalized among workers.
Mathematics Institute PhD level (Summer 2013, 2014 and 2015)
Monetary and Fiscal Policy (Spring 2016), Money and Banking (Fall 2015), International Finance (Fall 2014), Introduction to Macroeconomics (Spring 2014), Microeconomic Theory I PhD level (Fall 2013-2012), Intermediate Microeconomics (Spring 2013)