The main aim of our research is to model and estimate the dynamics of an open economy where financial frictions play a crucial role in determining the price of assets, the evolution of financial bubbles and the exchange rate pass-through of export prices. It also aims at identifying the early warning system to adopt in order to prevent financial crises and the monetary and fiscal policies to employ in this environment. Our motivations are twofold: 1) the increasing interest shown for financial frictions by both the economic literature and policy making conflicts with the insufficient attention paid to their effects on asset price dynamics and on the design of monetary and fiscal policies; 2) the literature has neglected the possibility to conceive financial frictions as an organizing explanatory principle of the way the financial sphere affects the real side of the economic system and, in this way, the whole economy¿s dynamics. We will start to overcome these shortcomings by adopting a unifying micro-macro approach, which conceives financial frictions as a key element of economic dynamics, because of its ability to: a) explain asset pricing, including sovereign debt, and the presence of bubbly assets in macroeconomic equilibrium; b) identify the elements which may provide early predictions of financial crises; c) design of optimal monetary and fiscal policies. We will provide sound foundations to our approach by employing: i) ex-ante data collection and evaluation, to derive the empirical stylized facts on financial frictions, asset pricing and macroeconomic dynamics to be replicated by our models; ii) ex-post model evaluation, to be carried out by estimating through Bayesian techniques the developments of our dynamic models and by employing marginal likelihoods to evaluate their fitting abilities; iii) identification and design of the policy prescriptions suggested by our analysis.
Recent investigations on the effects of financial frictions remained confined to specialized and segmented fields of research. Even though our project is strongly related to the developments of the literature, and shares with them the main methodological and analytical tools, it aims at providing a unifying and multidimensional perspective, linking micro and macro issues, which we conceive as key to understand the way the financial sector dynamics affects the business cycle. Besides this general remark, our research aims to improve our knowledge of several issues, from the modelling of asset price formation to macroeconomic risks in both public-bond and private-loans markets, from asset price bubbles to early indicators of financial crises, to the policies able to control the dynamics of an open and imperfect economy. The specific innovative elements of our project can be summarized as follows.
1. We will show that, under an extended-APT framework and financial frictions, expected returns have a K+1 factor representation, where the K factors drive the ¿beta SDF¿ (the given SDF, that is linear in a set of observed factors) and the additional factor is the "alpha SDF", i.e., the term that makes the beta SDF admissible. This representation will also be useful for taking our theory to the data.
2. The consideration of sovereign risk will fill the existing theoretical void on risky economy with non-zero probability of default, not only in the banking sector, but also in both private and public behavior, as that risk generates a premium that bears important implications in both public-bond and private-loans markets.
3. We will calculate and compare the country specific dynamic multipliers of financially equivalent fiscal policies affecting government consumption, transfers and investments, on the expenditure side, and direct and indirect consumption taxes, on the revenue side.
4. We will evaluate the empirical validity of the sovereign risk channel hypothesis.
5. We aim to show that, when the bubble is small, the credit demand channel may prevail but, as the bubble size increases, the other two channels may lead to a recession. If the weight attached to asset prices in the interest rate rule is too big, a lean against the wind policy may increase volatility and produce an excessive reaction of the real rate.
6. We will focus on the cross-sectional dimension of banking institutions, exploring the relationship between the risk-taking channel and credit booms (Gambacorta, 2009) to understand whether the risk-perception of banks can represent an early signal of growing financial risks leading to distress.
7. We will characterize the response of firms export decisions to exchange rates on the intensive and extensive margins, allowing this to vary across firms, depending on exposure to financial frictions.
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