Eddie Gerba
Published: 2014
Total Pages: 99
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We establish a set of US stylized facts on prices, quantities and balance sheets, assess the consistency of the current generation of financial DSGE models to these, and provide guidance on the challenges ahead. We mainly find four aspects which future financial friction models should take into account. The first is the profound shift in household financing structure, both on the asset and liability side, which has meant that they have been left vulnerable. Second, the balance sheet of firms has become increasingly leveraged and coupled with more volatile and procyclical equity prices has meant that the balance sheet of firms has become increasingly procyclical and volatile since the 1990's. The current generation of FA models do capture some aspects of this but produce excessively smooth results. Third, it would be of interest for policy makers to find the optimal level/percentage of foreign ownership of the Federal debt at which the debt portfolio is diversified, but the future government budget constraint and its stabilisation capacity is not put in danger by over-exposure to international shocks. Lastly, models might be extended to include a regime-switching mechanism and explore the effects on model dynamics and model stability when the economy goes from a low volatility-low correlation state to a high volatility-high correlation state. A wider implication of our findings is that accumulation of stocks might alter agents risk preferences, production technologies, or beliefs to such a degree that the optimization problem that those agents face has transformed over time. The economy is effectively in a different state of nature, and agents may face different constraints. Future macroeconomic models need to take a different strategy to modeling the long-run ratios, since these have increased over the long-run, and this has had an effect on both the frequency and the amplitude of the business cycles.