In these essays, I study the interplay of monetary policy with agent heterogeneity in economies with frictional markets. While accounting for the heterogeneity observed at the micro level, I investigate the implications of having persistent differences in firms and households' balance sheets and their consequences for business cycle fluctuations in monetary economies during both normal times and in times of economic distress.
In the first chapter, “Debt Overhang, Monetary Policy, and Economic Recoveries After Large Recessions”, I explore why conventional monetary policy was so ineffective in mitigating the severity of the 2007 U.S. recession and unsuccessful thereafter in stimulating aggregate demand. Linking firm-level data with predictions from a model, I show that accounting for individual firms’ debt structures is crucial in explaining why business investment fell so dramatically through the recession and remained low for several years, despite the Federal Reserve repeatedly cutting its target interest rate until conventional policy tools were exhausted. Using a sample of publicly traded firms, I establish that firms with greater long-term debt exposure experienced larger contractions and slower recoveries in their investment expenditure. Next, I show that debt overhang episodes were unusually prevalent over the years following the onset of the recession, and particularly so among firms relying more heavily on long-maturing debt. To understand these microeconomic observations and their implications for aggregates, I develop a New Keynesian model where heterogeneous firms finance investment using defaultable nominal long-term debt and where the central bank faces an explicit zero lower bound constraint. There, the greater a firm’s leverage, the higher its likelihood of experiencing a debt overhang episode following a large aggregate shock. Moreover, the severity of debt overhang problems, and their consequences for the distribution and level of aggregate investment, compounds with (1) an increased real value of debt, i.e., debt deflation, and (2) the monetary authority’s inability to restore inflation once nominal interest rates reach the zero lower bound. Together, firms’ long maturity debt positions and the binding zero lower bound are critical in transmitting the consequences of a deep recession into a remarkably anemic recovery in aggregate investment.
In chapters two and three, I focus on understanding the redistributive implications of monetary policy in economies in which money is an essential asset. In this second chapter, “More Money for Some: Monetary Policy Meets a Rich and Persistent Household Wealth Distribution”, I study the implications of a having a non-degenerate distribution of money for the conduct of monetary policy through open market operations, while explicitly accounting for the persistent differences in assets and portfolios observed in the data. To do so, I build a general equilibrium search-theoretic model of money where frictions in decentralized trading render money essential. There, households save using both cash and illiquid short-term government bonds. Money and bonds are supplied by a unified fiscal and monetary authority, which manages the provision of public liquidity by means of open market operations. Both assets are valuable for agents as they can use money to obtain goods in decentralized market trades and bonds to partially self-insure against idiosyncratic liquidity shocks. I study the properties of the stationary equilibrium and show that individuals’ inability to re-balance their portfolios right after experiencing a liquidity shock is the main driver of the observed heterogeneity in asset holdings and prices. Comparing stationary equilibria arising with different provisions of liquidity, I analyze the relationship between liquidity, interest rates, and output. Preliminary results suggest that expansionary open market operations are successful in driving both higher nominal interest rates and increased economic activity.
In the third chapter, “Non-Degenerate and Persistent Distributions in Search-Theoretic Models of Money”, I revisit traditional questions in the monetary policy literature associated to the welfare cost of inflation and the short-run effects of changes in monetary policy in a context where persistent heterogeneity is fundamental for a sluggish transmission of monetary changes. These questions have been studied using standard money search models, that despite the usefulness of assuming quasi-linear preferences tractability purposes, prevent us of giving any insight on the distributional consequences of policies or additional frictions, something that might seem overly simplifying in an environment in which heterogeneity is a direct byproduct of decentralized trading. In this paper, I relax the quasi-linearity assumption in the Lagos-Wright environment and propose a numerical method to compute the stationary equilibrium and the stochastic equilibrium of the model. As opposed to other solution methods, the solution of stationary equilibrium does not require to simulate many agents over several periods and does not depend on non-parametric estimation techniques. The solution strategy presented here relies on non-linear methods and can be easily extended to higher dimensions in a fast and robust manner. Importantly, this approach can be paired with a backward induction scheme to solve the stochastic equilibrium of the model. Using these new methods, I revisit previous results in the literature associated with the welfare cost of inflation, and the short-run effects of changes in monetary policy in a context where persistent heterogeneity is fundamental for a sluggish transmission of monetary changes.