Seminar presented by Markus Brunnermeier

Last Monday (9/13), the Department of Economics at Rutgers University held a highly participated seminar in which Markus K. Brunnermeier presented his latest work on “A Macroeconomic Model with Financial Sector” (written together with Yuliy Sannikov). Even though, the time available was too little to get into the necessary detail, some important and interesting ideas were introduced.

With the liquidity and credit crunch of 2007-09 in mind, they created a macroeconomic model to replicate some of the potential consequences that frictions in the financial sector can have in the economy. To do this, they used recursive methods, instead of log-linear approximations, because they believe that crises with high volatility (as the current one) are non-linear and hence, the log-linear approximations fail to show those effects.

To introduce such frictions, they introduced heterogeneous agents and leverage in the model. There are two types of agents: experts (who have a superior ability to manage assets) and households (that are less productive asset managers). In their model, the former borrows from the latter.

Furthermore, they allow the agents to lever their investment, which leads to an amplification of the shocks and therefore, to a more instable system. This happens because the agents lever too much and have a too risky portfolio, which in turn leads to excessive borrowing, leverage, volatility and maturity mismatch. This way, the experts generate an externality on the real sector of the economy (mostly on the labor market) because they do not correctly account for the costs of adverse economic conditions that result from crises.

This last result leads the authors to recommend that the financial regulators, in order to solve these problems, should try to internalize these externalities.