Comments on

Financial Innovations and Macroeconomic Volatility

by Urban Jermann and Vincenzo Quadrini

Giorgio PrimiceriNorthwestern University

November 17, 2006

Standard deviation of US GDP growth

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.4

0.5

0.6

0.7

0.8

0.9

1

1.1

1.2

1.3

Standard deviation of US GDP (HP filter)

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.8

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

This paper…

Financial structure of firms has become more volatileafter 1984

Model in which financial factors are key to generate fluctuations

Two financial frictions:Endogenous borrowing limit (limited commitment)Exogenous cost of paying out dividends

Main result

Model calibrated to US data pre and post-1984

Explain the Great Moderation as a consequence of firms’ greater financial flexibility

Outline of my Comments

1. Will tell you why this is a very nice paper

2. Comments on the empirical motivation

3. Comments on the theoretical framework

Why I think this is the right direction

A look at the Great Moderation from a different perspective

Why I think this is the right direction

A look at the Great Moderation from a different perspective

Justiniano and Primiceri (2005):Large scale DSGE model with time varying volatility of structural shocks

Why I think this is the right direction

A look at the Great Moderation from a different perspective

Justiniano and Primiceri (2005):Large scale DSGE model with time varying volatility of structural shocks

Reduction in volatility of GDP explained by a reduction in volatility of a shock to the real return on capital

Why I think this is the right direction

This shock is a “wedge” in the Euler Equation pricing the capital stock

Might proxy for un-modeled financial frictions (CKM, 2006)

Why I think this is the right direction

This shock is a “wedge” in the Euler Equation pricing the capital stock

Might proxy for un-modeled financial frictions (CKM, 2006)

Interpretation: Great Moderation comes from a reduction in financial frictions

Bingo!

Outline of my Comments

1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction

Outline of my Comments

1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction

2. Comments on the empirical motivation

A closer look at the empirical motivation of JQ

Decline in volatility of GDP in early 1980s is very sharp

Volatility of US GDP

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.8

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

A closer look at the empirical motivation of JQ

Decline in volatility of GDP in early 1980s is very sharp

This is the real puzzle

This is why the Monetary Policy hypothesis has received so much attention

A closer look at the empirical motivation of JQ

Decline in volatility of GDP in early 1980s is very sharp

This is the real puzzle

This is why the Monetary Policy hypothesis has received so much attention

Let’s have a look at the financial variables examined in JQ

Time varying SD of Debt Repurchase

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20051.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

Time varying SD of Equity Payout

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20050.7

0.8

0.9

1

1.1

1.2

1.3

1.4

1.5

1.6

Reduction in vol. of components of GDP

Which component of GDP has experienced the sharpest and most dramatic reduction in volatility?

Reduction in vol. of components of GDP

GDP

Consumption Investment

Non-durables

and servicesDurables

Reduction in vol. of components of GDP

GDP

Consumption Investment

Non-durables

and servicesDurables Non-residential Residential

Time varying SD of Non-Residential investment

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20054.2

4.4

4.6

4.8

5

5.2

5.4

Time varying SD of Equipment & Software

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

4.6

4.8

5

5.2

5.4

5.6

5.8

6

6.2

6.4

Time varying SD of Residential investment

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 20052

4

6

8

10

12

14

16

Reduction in vol. of components of GDP

GDP

Consumption Investment

Non-durables

and servicesDurables Non-residential Residential

Share of residential assets owned by HH

1950 1960 1970 1980 1990 2000 20100.5

0.55

0.6

0.65

0.7

0.75

0.8

0.85

0.9

0.95

1

What do we learn?

Household sector owns most of residential assets (85%)

Business sector owns most of non-residential assets

What do we learn?

Household sector owns most of residential assets (85%)

Business sector owns most of non-residential assets

Smooth change in volatility of firms’ financial structure is consistent with smooth change in volatility of non-residential investment!

What do we learn?

Household sector owns most of residential assets (85%)

Business sector owns most of non-residential assets

Smooth change in volatility of firms’ financial structure is consistent with smooth change in volatility of non-residential investment!

Shouldn’t we pay more attention to the household sectorto explain the Great Moderation?

Campbell and Hercowitz (2006)Mertens (2006)Guerron (2006)

Outline of my Comments

1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction

2. Comments on the empirical motivationChange in volatility of financial structure is too smoothHousehold sector seems to be key

Outline of my Comments

1. Will tell you why this is a very nice paperLarger scale models indicate this as a promising direction

2. Comments on the empirical motivationChange in volatility of financial structure is too smoothHousehold sector seems to be key

3. Comments on the theoretical framework

Theoretical issues: a closer look at the model

Key elements

Limited commitment Quadratic cost of paying out dividends

Theoretical issues: a closer look at the model

Key elements

Limited commitmentStrong micro-foundation

No role in the Great Moderation

Quadratic cost of paying out dividends

Theoretical issues: a closer look at the model

Key elements

Limited commitmentStrong micro-foundation

No role in the Great Moderation

Natural questions: Why do we need it?Can’t we write a simpler model?

Quadratic cost of paying out dividends

Theoretical issues: a closer look at the model

Key elements

Limited commitmentStrong micro-foundation

No role in the Great Moderation

Natural questions: Why do we need it?Can’t we write a simpler model?

Quadratic cost of paying out dividends

Crucial for the quantitative result!

Non-standard

Ad-hoc

Theoretical issues: a closer look at the model

Ad-hoc quadratic costs of paying out dividends

Shouldn’t we think of structural interpretations?

Signaling problemProgressive taxationRisk adverse entrepreneurs

Either non-symmetric cost or more appropriate interpretation for private equity

Outline of my Comments

1. Will tell you why this is a very nice paperLarger scale models indicates this as a promising direction

2. Comments on the empirical motivationIncrease in volatility of financial structure is too smoothHousehold sector seems to be important!

3. Comments on the theoretical frameworkWhat is the role of limited commitment?Quadratic adjustment costs of paying out dividends???