Essays on Macroeconomics and Financial Frictions

Abstract

A central question in macroeconomics is how financial frictions—factors that limit agents’ ability to borrow and secure financing—affect real economic outcomes. This dissertation investigates these frictions along three dimensions. First, it examines how earnings-based covenants (EBCs)—a clause in debt contracts limiting a firm’s borrowing capacity to a multiple of its earnings—lead firms to reduce intangible investment in the short run, yet ultimately lower borrowing costs and boost investment. Second, it explores how the strictness of financial covenants—beyond EBCs—shapes firms’ investment responses to unexpected changes in interest rates. Finally, it assesses whether non-bank financial intermediaries (NBFIs), such as Exchange-Traded Funds (ETFs), amplify or dampen global capital flow volatility and financial instability.

Motivated by the empirical fact that EBCs are prevalent among U.S. nonfinancial public firms, the first chapter, “Earnings-based Covenants and Intangible Investment,” studies how these covenants affect corporate intangible investment uses a combination of theoretical modeling, empirical methods, and quantitative analysis. Under current accounting rules, intangible investment must be expensed in the period it is incurred, while tangible investment is capitalized. This means that higher intangible investment reduces a firm’s current earnings. Consequently, firms may cut back on intangible investment to avoid violating EBCs in the short term. In the data, I find that firms subject to EBCs significantly reduce their intangible investments compared to firms not bound by these covenants when they are concerned about potential violations. I do not find such a pattern for tangible investment. However, this result does not imply that EBCs are bad for firms. EBCs protect lenders by acting as an early intervention mechanism, lowering ex-ante borrowing costs and potentially increasing investment. To assess the macro-level impact of EBCs, I develop a quantitative dynamic model with heterogeneous firms that captures these competing forces. The calibrated model reveals that EBCs on net lead to higher intangible capital and output by lowering borrowing costs. Meanwhile, excluding intangible investment from accounting earnings would lead to further gains in both investment and output.

The second chapter, “Transmission of Monetary Policy Shocks: The Role of Financial Covenants,” empirically studies how the strictness of financial covenants affects firms’ investment responses to monetary policy shocks. Using lender-specific financial shocks, which are arguably independent of borrowers’ fundamentals, I find that investment of borrowers with loan contracts containing stricter financial covenants is significantly more (less) responsive to contractionary (expansionary) monetary policy shocks than for borrowers with looser covenants. These findings are not driven by variation across borrowers in default risk, suggesting that financial covenants may serve as an important mechanism through which shocks to lenders can affect monetary policy transmission.

Chapter 3, “NBFIs and the Cyclicality of Global Portfolio Investment,” coauthored with Katharina Bergant and Damien Puy, studies the macroeconomic implications of NBFIs, such as ETFs, in emerging markets. International capital flows are increasingly intermediated by non-bank financial institutions. Focusing on the rise of passive investment vehicles, we examine whether the presence of ETFs makes capital flows to emerging markets more volatile, as well as the potential macroeconomic implications for countries receiving these flows. We find that ETFs are indeed two to three times as sensitive to global uncertainty shocks as traditional mutual funds. However, we find no evidence that countries with a higher share of ETFs in their investor base experience stronger adverse macroeconomic effects, such as lower returns, higher sensitivity of overall portfolio inflows, or higher exchange rate volatility.