We present a model of financial crises that stem from endogenous complexity . We conceptualize complexity as banks' uncertainty about the financial network of cross exposures. As conditions deteriorate, cross exposures generate the possibility of a domino effect of bankruptcies. As this happens, banks face an increasingly complex environment since they need to understand a greater fraction of the financial network to assess their own financial health. Complexity dramatically amplifies banks' perceived counterparty risk, and makes relatively healthy banks reluctant to buy risky assets. The model also features a novel complexity externality .

Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market‐wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty‐driven crises.

We propose that the limited financial development of emerging markets is a significant factor behind the large share of dollar‐denominated external debt present in these markets. We show that when financial constraints affect borrowing and lending between domestic agents, agents undervalue insuring against an exchange rate depreciation. Since more of this insurance is present when external debt is denominated in domestic currency rather than in dollars, this result implies that domestic agents choose excessive dollar debt. We also show that limited financial development reduces the incentives for foreign lenders to enter emerging markets. The retarded entry reinforces the underinsurance problem.

We develop a model of gross capital flows and analyze their role in global financial stability. In our model, consistent with the data, when a country experiences asset fire sales, foreign investments exit (fickleness), while domestic investments abroad return home (retrenchment). When countries have symmetric expected returns and financial development, the benefits of retrenchment dominate the costs of fickleness and gross flows increase fire-sale prices. Fickleness, however, creates a coordination problem since it encourages local policy makers to restrict capital inflows. When countries are asymmetric, capital flows are driven by additional mechanisms—reach for safety and reach for yield—that can destabilize the receiving country.

This article explores the consequences of extremely low real interest rates in a world with integrated but heterogeneous capital markets, nominal rigidities, and an effective lower bound [a zero lower bound (ZLB) for simplicity]. We establish four main results: (1) At the ZLB, creditor countries export their recession abroad, which we illustrate with a new Metzler diagram in quantities; (2) Beggar-thy-neighbour currency and trade wars provide stimulus to the undertaking country at the expense of other countries; (3) (Safe) public debt issuances and increases in government spending anywhere are expansionary everywhere; and (4) When there is a scarcity of safe assets, net issuers of these assets import the recession from abroad.

When firms face menu costs, the relation between their output and money is highly non-linear. At the aggregate level, however, this needs not be so. In this paper we study the dynamic behaviour of a menu-cost economy where firms are heterogeneous in the shocks they perceive, and the demands and adjustment costs they face. In this context we (i) generalize the Caplin and Spulber (1987) steady-state monetary-neutrality result; (ii) show that uniqueness of equilibria depends not only on the degree of strategic complementarities but also on the degree of dispersion of firms' positions in their price-cycle; (iii) characterize the path of output outside the steady state and show that as strategic complementarities become more important, expansions become longer and smoother than contractions; and (iv) show that the potential impact of monetary shocks is an increasing function of the distance of the economy from its steady state, but that an uninformed policy maker will have no effect on output on average.

In this paper we provide a framework to study the aggregate dynamic behavior of an economy where individual units follow (S, s) policies. We characterize structural and stochastic heterogeneities that ensure convergence of the economy's aggregate to that of its frictionless counterpart, determine the speed at which convergence takes place, and describe the transitional dynamics of this economy. In particular, we consider a dynamic economy where agents differ in their initial positions within their bands and face both stochastic and structural heterogeneity; where the former refers to the presence of (unit specific) idiosyncratic shocks, and the latter to differences in the widths of units' (S, s) bands and their response to aggregate shocks. We study the evolution of the economy's aggregate and the evolution of the difference between this aggregate and that of an economy without macroeconomic friction, where the latter pertains to a situation where individual units adjust with no delay to all shocks. We also examine the sensitivity of this difference to common shocks. For example, in the retail inventory problem the aggregate deviation and sensitivity to common shocks correspond to the aggregate inventory level and its sensitivity to aggregate demand shocks, respectively.

A Comment on the Economics of Labor Adjustment: Mind the Gap: Reply by Ricardo J. Caballero and Eduardo M.R.A. Engel. Published in volume 94, issue 4, pages 1238-1244 of American Economic Review, September 2004

The purpose of this paper is to provide empirical evidence helpful for distinguishing different types of externalities. We pursue this by extending the productionfunction framework of Robert E. Hall (1990) and Caballero and Lyons (1990, 1992) to exploit two key dimensions of the data: disaggregate input-output relationships and differences estimates emphasizing time-series versus cross-sectional aspects of the data. We obtain three main results. First, from the within estimates (using annual data), which emphasize the time-series properties common across sectors, we find a strong reduced-form relationship industry productivity and the activity level (input growth) of customers. In sharp contrast, supplier activity levels are insignificant. The second result derives from between estimates, which emphasize the cross-sectional dimension of the data. Here, we find the opposite is true: there is a strong reduced-form relationship industry productivity and the activity level of suppliers, but no relationship with customer activity levels. We interpret the first two results as suggesting that over shorter horizons the linkage an industry and its customers is pivotal in the transmission of external effects, while in the long run external effects are mostly related to intermediate goods linkages. The third result concerns the transition from short to long run. We find that as the number of periods over which the variables are averaged is incrementally increased from one year toward the full sample period (27 years), the significance of customers versus suppliers smoothly reverses itself. The remainder of the paper is organized in four sections. Section I presents the core model and the econometric methods for disentangling the external effects; Section II describes the data and estimation; Section III presents the main results; and our conclusions are presented in Section IV.

The secular decline in safe interest rates since the early 1980s has been the subject of considerable attention. In this short paper, we argue that it is important to consider the evolution of safe real rates in conjunction with three other first-order macroeconomic stylized facts: the relative constancy of the real return to productive capital, the decline in the labor share, and the decline and subsequent stabilization of the earnings yield. Through the lens of a simple accounting framework, these four facts offer suggestive insights into the economic forces that might be at work.