Disciplined Systematic Global Macro Views

There is the right work taking place in macroeconomics since the financial crisis. The forefront of this intensive research is to try and incorporate finance variables into macro-models. In a recently available model in a paper called “Risk Shocks” by Christiano, Rostagno, and Motto, the authors take the typical monetary dynamic general equilibrium model and put in a financial accelerator mechanism. The goal is to observe how financial shocks such as what were observed in 2008 will spill-over to the overall macro economy. The intuition is relatively obvious, but the link between financial and credit effects and GDP has often not been completely modeled straight. Capital is spent based on an expected return but this comeback is uncertain.

You don’t know the pay-off when an investment is manufactured and this uncertainty makes investing risky. Entrepreneurs borrow money through a personal debt contract but these debts contracts change in price because the expected pay-off changes. When risk is high, there is certainly high quality for a credit which is harder to acquire. When risk is low, credit is cheap and easy to obtain. The risk associated with credit can be shocked by lots of factors which cause counter-cyclical credit spreads and pro-cyclical investment.

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The shocks to risk include the value of the currency markets, credit to non-financial firms, credit spreads, and the slope of the word structure. Running simulations using this type of model, the writers find that fluctuations in financial risk can account for about 60% of the growth rate in aggregate US output. The implication is extremely important. Policy-makers should get worried about what is happening in financial marketplaces. Credit spreads and financing availability are important like the overall rate of interest just. Clearly, the focus by central banks on systemic risk is beginning to address this pressing issue, but the mandate of the Fed is for controlled inflation and full employment and is not seeking to solve problems in the financial markets.

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