Sebastian Di Tella | Macro Paper Warehouse

Aggregation, Liquidity, and Asset Prices with Incomplete Markets

This manuscript builds a tractable theory of asset pricing and household consumption behavior starting from the two-account incomplete-markets model of Kaplan and Violante (2014, 2022) – designed to match realistic, heterogeneous household-level consumption and asset-holding patterns, including large fractions of “wealthy hand-to-mouth” households – and extends it with aggregate shocks in a way that still permits a closed-form solution. The key move is to assume idiosyncratic risk speeds up whenever the representative-agent valuation ratio for aggregate output is low (a stylized version of the empirically documented countercyclical skewness of labor-income shocks); under this assumption, the aggregate value of each asset type equals its value in the corresponding frictionless representative-agent economy multiplied by a constant, asset-specific “liquidity factor” that is invariant to the process and history of aggregate shocks and can be recovered from the model’s steady state alone. Liquid assets carry a larger liquidity factor than illiquid ones because they additionally insure households against running out of funds before their next trading opportunity – a mechanism the authors show reproduces the “wealthy hand-to-mouth” pattern even for households with substantial wealth. Translated into expected returns, this produces liquidity premia that move inversely with valuation ratios, while risk premia and other second-moment properties of asset prices are unchanged from the representative-agent benchmark. Calibrating the model’s few sufficient-statistic moments to U.S. data, the authors argue the evidence points to small average risk premia and large, volatile liquidity premia: the model can quantitatively account for the gap between the high risk-free rate implied by low-EIS representative-agent models and the low return on Treasury bills, for why aggregate consumption Euler equations fit well for a zero-beta stock portfolio but poorly for Treasury bills, and for most of the predictability of excess stock returns.

Risk Premia and the Real Effects of Money

This paper proposes a flexible-price theory of the role of money in an economy with incomplete idiosyncratic risk sharing. When the idiosyncratic risk premium on capital rises – for instance, in a downturn – money provides a safe store of value that improves risk sharing but, precisely because it is safe and effectively in positive net supply, also keeps the real interest rate from falling as much as it would in a moneyless economy, which reduces investment. In a simple AK growth model with log utility over consumption and real money balances, money turns out to be fully neutral and superneutral, and Ricardian equivalence holds – yet the presence of money still has large real effects on investment, because it changes the risk-sharing arrangement agents can achieve. The competitive equilibrium is not efficient: investment is too high relative to the planner’s allocation when idiosyncratic risk is low, and too low when idiosyncratic risk is high, because money provides too little insurance in the first case and too much in the second. Correcting this requires a tax or subsidy on capital, not a change in monetary policy – money’s real effects survive even in the cashless limit where actual currency holdings shrink to zero, and they are robust to modeling money via cash-in-advance instead of money-in-the-utility. The paper also argues its mechanism is complementary to, but distinct from, the zero-lower-bound channel in sticky-price New Keynesian models: introducing money does create a floor on nominal rates, but it also raises the “natural” real interest rate itself, so it is possible for the natural rate to be negative without money and positive once money is introduced – meaning the ZLB need not bind even though money still depresses investment through this separate, flexible-price channel.

Risk Premium Shocks Can Create Inefficient Recessions

This paper proposes a flexible-price model of business cycles driven by spikes in uninsurable idiosyncratic risk, built by adding one friction – entrepreneurs’ inability to insure the idiosyncratic risk in their own production – to an otherwise standard neoclassical growth model with workers and entrepreneurs. When aggregate shocks raise idiosyncratic risk, entrepreneurs demand a risk premium to compensate for bearing it, which shows up as a countercyclical wedge that effectively taxes both labour and capital; but because capital is a long-duration store of value, a concurrent precautionary-saving motive lowers interest rates and offsets the risk premium’s drag on investment demand, while labour, having no such store-of-value role, is left depressed by the risk premium alone. The paper derives a sufficient statistic showing that, calibrated to U.S. data, these two offsetting forces on capital roughly cancel, so risk shocks act almost purely as a tax on labour – generating recessions in which employment, consumption, and investment decline together, quantitatively broadly consistent with U.S. business-cycle facts. This competitive-equilibrium response is shown to be inefficient: because individual agents take interest rates and the market price of risk as given, they do not internalize that their own consumption choices affect aggregate idiosyncratic risk sharing, so a fall in aggregate consumption during a downturn worsens risk sharing and pushes risk premiums higher still, in a self-reinforcing spiral. A constrained-efficient planner who faces the same limits on idiosyncratic risk sharing responds very differently – lowering labour taxes and raising capital taxes during downturns, which stimulates employment and raises consumption on impact rather than letting it fall – so that optimal policy calls for subsidizing employment and consumption, not investment, during recessions.

The Zero-Beta Interest Rate

This paper proposes and measures the zero-beta rate — the expected return on a portfolio of stocks with zero market beta, constructed to be orthogonal to the SDF innovations spanned by standard factors — as the correct intertemporal price of consumption, and argues that safe interest rates (Treasury bill yields) are not. Using 130 stock portfolios (81 sorted on combinations of beta, size, value, investment, and profitability; 49 industry portfolios) and GMM estimation with five macro instruments (T-bill yield, inflation, term spread, excess bond premium, and the U6 unemployment rate) over January 1973 to December 2020, the paper estimates the zero-beta rate to average 8.3% per year in real terms with a standard deviation of 9.3%, producing a spread of roughly 7.6% per year over the expected real Treasury bill yield. The paper then shows that this zero-beta rate fits the aggregate consumption Euler equation remarkably well: the macro instruments that best predict the real return of the zero-beta portfolio are nearly proportional to those that predict real consumption growth, a non-mechanical result that survives when the sample is restricted to exclude COVID. Statistical Euler equation tests (Stock-Wright [2000] weak-instrument-robust GMM) reject the Euler equation for all IES values when applied to the Treasury bill, fail to reject it for any IES value when applied to the volatile market return (weak identification), but fail to reject it only for IES below 0.5 (risk aversion above 2) when applied to the zero-beta rate — providing identification from the intermediate predictability of the zero-beta portfolio. Monetary policy shock regressions using Romer-Romer and Nakamura-Steinsson shocks further show that an unexpected monetary tightening raises the real Treasury bill yield but lowers the real zero-beta rate, consistent with the Euler equation’s prediction that the intertemporal price should fall when expected consumption growth falls. Finally, the high level and volatility of the zero-beta rate implies that the entire variation of the price-dividend ratio of a consumption claim can be attributed to variation in the zero-beta rate without requiring time-varying equity risk premia — resolving the equity premium puzzle and Campbell’s [1991] excess volatility puzzle simultaneously, at the cost of an unexplained convenience spread on safe assets.