Essays on Macroeconomics and International Finance

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Leon-Diaz, John Jairo
Aruoba, Boragan
My doctoral research contributes to the fields of macroeconomics and international finance. Within macroeconomics, I have explored the role of financial frictions in shaping macroeconomic outcomes following a recession. I have studied the dissonance between the rapid improvement in financial conditions and the sluggish recovery in investment observed in the aftermath of the Great Recession. In related research I also analyze the fast improvement in financial conditions and analyze the existence of a positive feedback between asset prices and leverage through the lens of liquidity shocks. Within international finance, I have an empirical and theoretical interest in the analysis of capital flows. My research in this area has focused on the role of domestic investors in preventing economies from experiencing the largely-documented pervasive effects of net sudden stops in capital flows, and its determinants. Chapter 1. The rapid improvement in financial conditions and the sluggish recovery of physical investment in the aftermath of the Great Recession are difficult to reconcile with the predictions of existing models that link impaired access to credit and investment. I propose a tractable model that solves this puzzle by exploiting the role of customer markets in shaping the persistent effects of financial shocks on investment decisions. In my model, firms react to a negative financial shock by reducing expenditures in sales-related activities and increasing prices to restore internal liquidity, at the expense of customer accumulation. Once financial conditions start reverting to normal levels, the firm postpones investment due to a shortage of customers relative to its existing production capacity and the need to first rebuild its customer base. This mechanism can capture two important features of the data: First, the slow recovery of investment despite improving financial conditions, and second, the positive correlation between financial conditions and investment observed during downturns and the weakening of this correlation observed during upturns. Chapter 2. I assess how the inclusion of complementary sources of liquidity can have sizeable reinforcing effects during a crisis and in its aftermath. In this paper, I allow for the possibility to finance investment projects either by selling existing capital units or by borrowing using the units not sold as collateral. The main characteristic of this model is that capital is heterogeneous and composed by units of different quality, which are only observed by the owner. The asymmetric information on capital quality makes both, the asset prices at which investors can sell their assets and the loan-to-value (i.e. leverage) ratio at which they can borrow to be endogenously determined. The simultaneity in the determination of asset prices and leverage lead to the existence of liquidity spirals. For instance, a negative exogenous shock that reduces leverage creates a fall in the funds available to finance capital purchases (i.e. a decline in demand). It also increases the supply for assets in the market, since entrepreneurs require selling more units to finance the same amount of investment. These two effects create unambiguously a fall in prices. The fall in prices reinforces the initial fall in loan-to-values since lenders expect the quality of units used as collateral to be lower. This mechanism explains why alternative sources of liquidity fall rapidly during downturns, and why liquidity can recover faster during upturns. Chapter 3. This paper, which is joint work with Eduardo Cavallo and Alejandro Izquierdo, explores the determinants behind the decision of domestic investor to adjust their asset position in response to a variation in gross capital inflows and avoid episodes of net sudden stops. We present evidence that while sudden stops in gross inflows are associated with global conditions, domestic factors such as the degree of domestic liability dollarization, economic growth and institutional background are important to prevent these episodes in becoming net sudden stops. We also extend the concept of “Prevented Sudden Stops” and differentiate “Delayed” from “Purely Prevented” episodes. A purely prevented episode is one in which there is not a sudden stop in any of the quarters for which there was a sudden stop in gross inflows. A delayed episode is one in which there is at least one quarter in which there was both a sudden stop in gross inflows and a net sudden stop. We want to analyze how this classification can affect the extent to which economic growth and domestic liability dollarization can still account for the offsetting behavior of domestic investors.