01a MacroMoneyFinance RealModels SimpleBasakCuoco

Modern Macro, Money, and
International Finance
Princeton Initiative 2023
Heterogenous Agents Real Model

Markus K. Brunnermeier
Princeton University
What is Macro-Finance?
 Macro: aggregate impact (resource allocation and constraint)
 Finance: risk allocation
financial/contracting frictions, heterogeneous agents
institutions, liquidity
 Monetary: inside money creation
 How to design Financial Sector, Gov. bonds, etc.

to achieve optional resource and risk allocation
 Topics include:
 Amplification, peculation of shocks, resilience, financial cycle
 Financial stability, spillovers, systemic risk measures
 (Un)conventional central bank policy and balance sheet, maturity structure, CBDC
 Capital flows
Macro-Finance & Related Fields
FINANCE
Public
Finance
Corporate
DD81, AG
MACRO Lucas HT
Finance
KM97
BGG99 BruSan, HK Asset
Aiyagari
Safe Pricing
HANK Asset I-Theory Merton
of Money FF
Woodford
Intermediary
KW
Finance
MONETARY
Heterogeneous Agents
 Lending-borrowing/insuring since agents are different
 Poor-rich  Rich-poor
 Productive  Less productive
 Less patient Limited direct lending
due to frictions
 More patient
 Less risk averse  More risk averse
 More optimistic  More pessimistic
 Friction psMRSs different even after transactions
 Wealth distribution matters! (net worth of subgroups)

 Financial sector is not a veil
Financial Frictions and Distortions
 Belief distortions
 Match “belief surveys”
 Incomplete markets
 “natural” leverage constraint (BruSan)
 Costly state verification (BGG) state 2
 + Leverage constraints
(no “liquidity creation”)
 Exogenous limit (Bewley/Ayagari) state 1
 Collateral constraints
 Next period’s price (KM) Debt limit
 Next periods volatility (VaR, JG) can depend on
prices/volatility
 Current price
Risk premia, price of risk
 Risk premia = price of risk * (endogenous + exogenous risk)
 Exogenous risk – shock from outside

 Endogenous risk
 Amplification: adverse feedback loops
 Multiple equilibria: Run, Sudden Stops
 Non-linearities are key for financial stability

 Around vs. away from steady state
Resilience Management
1. Push barrier/tipping point further away
- ex-ante investment
 Buffers, reserves, (specific) redundancies
 No overheating of the economy
 Like moving ahead without keeping tipping point at a distance
Tipping point/R-barrier
Sahm Rule: if , then unemployment jumps (after a shock)
2. Agility: react earlier to turn around (rigidity)

a. (Re)action (of CB) in timely fashion
 ex-post discretion vs. ex-ante rule (automatic algo) Tipping point/R-barrier
Large shock vs. a sequence of shocks
b. Expectations of others: Re-re-actions
9
Persistence & Resilience
 Even in standard real business cycle models,
temporary adverse shocks can have long-lasting effects
 Due to feedback effects, persistence is much
stronger in models with financial frictions
 Bernanke & Gertler (1989)
 Carlstrom & Fuerst (1997)
 Negative shocks to net worth exacerbate
frictions and lead to lower capital,
investment and net worth in future periods
Persistence Leads to Dynamic Amplification
 Static amplification occurs because fire-sales of capital
from productive sector to less productive sector depress asset prices
 Importance of market liquidity of physical capital
 Dynamic amplification occurs because a
temporary shock translates into a
persistent decline in output and asset prices
 Forward grow net worth via retained earnings
 Backward asset pricing
 Kiyotaki Moore (1997)

 Bernanke Gertler Gilchrist (1999)
“Single Shock Critique”
 Critique: After the shock all agents in the economy know that the economy will
deterministically return to the steady state.
 Length of slump is deterministic (and commonly known)
 No safety cushion needed
 In reality an adverse shock may be followed by additional adverse shocks

 Build-up extra safety cushion for an additional shock in a crisis
 Impulse response vs. volatility dynamics

Endogenous Volatility & Volatility Paradox
 Endogenous Risk/Volatility Dynamics in BruSan
 Beyond Impulse responses
 Input: constant volatility

 Output: endogenous risk
time-varying volatility
Stochastic
steady state
Precautionary savings
 Role for money/safe asset
Nonlinearities in crisis endogenous fait tails, skewness

 Volatility Paradox
 Low exogenous (measured) volatility leads to
high build-up of (hidden) endogenous volatility (Minksy)
Fan chart: Distributional Impulse Response Function
 Difference with and without a shock
Cts.-time Macro: Macro-Finance vs HANK
Agents: Heterogenous investor focus Heterogenous consumer focus
- Net worth distribution (often discrete) - Net worth distribution (often cts.)
Tradition: Finance (Merton) DSGE (Woodford)
PORTFOLIO AND CONSUMPTION CONSUMPTION CHOICE
CHOICE
Full/global dynamical system Transition dynamics back to steady state
- focused on non-linearities - Zero probability shock
away from steady state (crisis …)
- Length of recession is stochastic - Length of recession is deterministic
Money due to: Risk & financial frictions Price stickiness

Risk: Risk & financial frictions No aggregate risk (in HANK paper)
Price of risk: Idiosyncratic & aggregate risk
Assets: Capital, money, bonds with All assets are risk-free
different risk profile
- Risk-return trade-off - No risk-return trade-off
- Liquidity-return trade-off - Liquidity-return trade-off
- Flight to safety 16
Course Overview
Real Macro-Finance Models with Heterogeneous Agents
1. A Simple Real Macro-finance Model
2. Endogenous (Price of) Risk Dynamics
3. A Model with Jumps due to Sudden Stops/Runs
Money Models
4. A Simple Money Model
5. Cashless vs. Cash Economy and “The I Theory of Money”
6. Welfare Analysis & Optimal Policy
1. Fiscal, Monetary, and Macroprudential Policy
International Macro-Finance Models

7. International Financial Architecture
Digital Money
17
Simple Two Sector Model: Basak Cuoco (1998)
 Expert sector Household sector
A L A L
Net worth
Capital Debt Loans
𝑁𝑡
See Lecture Notes, Chapter 2 or

Handbook of Macroeconomics 2017, Chapter 18
18
Financial Frictions and Distortions
 Belief distortions
 Match “belief surveys”
 Incomplete markets
 Costly state verification (BGG)
state 2
 Exogenous limit (Bewley/Ayagari)
state 1
 Next period’s price(KM)
Debt limit
can depend on
 Next periods volatility (VaR, JG)
prices/volatility
 Current price
Two Sector Model Setup
Expert sector Household sector
Output: Output:
Consumption rate:
Investment rate:
Investment rate:
agent of type (expert, HH)
Friction: Can only issue

Risk-free debt
Equity, but most hold 20
Investment rate:
Investment rate:
Friction: Can only issue Log-utility in Basak Cuoco 1998
Risk-free debt
Investment rate:
Investment rate:

Risk-free debt
The Big Picture
𝜅 =1 allocation of
A L 𝜒 =1
accumu- Debt
physical assets
lation
Outside
… risk equity
y
ti lit
ackward equation Forward equation

a
vol
𝐴(𝜅) 𝐾
amplification
Φ (𝜄 ) − 𝛿
output 𝜄 capital
price of risk
precautionary
drift
drift growth
consumption + investment 𝜂 volatility
ith expectations
net worth
distribution 23
Solving MacroModels Step-by-Step
0. Postulate aggregates, price processes & obtain return processes
1. For given -ratio and SDF processes for each finance block
a. Real investment + Goods market clearing (static)
 Toolbox 1: Martingale Approach, HJB vs. Stochastic Maximum Principle Approach
b. Portfolio choice + Asset market clearing or
Asset allocation & risk allocation
 Toolbox 2: “price-taking social planner approach” – Fisher separation theorem
c. “Money evaluation equation”
 Toolbox 3: Change in numeraire to total wealth (including SDF)
2. Evolution of state variable (and ) forward equation
3. Value functions g-utility
backward equation
Lo
a. Value fcn. as fcn. of individual investment opportunities
 Special cases: log-utility, constant investment opportunities
b. Separating value fcn. into
c. Derive -ratio and prices of risks
4. Numerical model solution 24
a. Transform BSDE for separated value fcn. into PDE
0. Postulate Aggregates and Processes
 Individual capital evolution:
 Where is the individual cumulative capital purchase process

 Capital aggregation:
 Within sector :
 Across sectors:
Same Brownian
 Capital share:
 Net worth aggregation:

 Within sector :
 Across sectors:
 Wealth share:
 Value of capital stock:
Postulate 25
Basics of Ito Calculus
 Geometric Ito Process
 Stock goes up 32% or down 32% over a year.
256 trading days
 Ito’s Lemma:
, volatility of process is
 Ito product rule: stock price exchange rate
 Ito ratio rule:
27
The Big Picture
A L 𝜒 =1
accumu- Debt
physical assets
lation
Outside
… risk equity
y
ti lit

a
vol
𝐴(𝜅) 𝐾
amplification
Φ (𝜄 ) − 𝛿
output 𝜄 capital
price of risk
precautionary
drift
drift growth
ith expectations
net worth
distribution 30
backward equation
Lo
c. Derive -ratio and price of risk
1a. Individual Agent Choice of , ,
 Choice of is static problem (and separable) for each
 FOC: Tobin’sDividend Capital gains rate

 All agents yield For aggregate capital return,
Replace with
 Special functional form:
 Goods market clearing:
32
1a. Method 3: Martingale Approach – Cts. Time
s.t. + labor income/endow/taxes

given
 Portfolio Choice: Martingale Approach
 Let be the value of a “self-financing trading strategy”(reinvest
dividends)
 Theorem: follows a Martingale, i.e. drift .
 Let ,
 Recall
 By Ito product rule
volatility terms
 Expected return:
 For risk-free asset, i.e. :
33
1a. Optimal Portfolio Choice - back to our model
 Using for capital return (instead of generic asset A)
ut equity issuance
Dividend Capital gains rate

yield
 Recall
 portfolio share in risk-free bond (if negative = debt/short position)
 portfolio share in (physical) capital
 Asset markets clearing:

 Capital market
 Debt/bond market (by Walras Law)
34
backward equation
Lo
2. GE: Markov States and Equilibria
 Equilibrium is a map
Histories of shocks prices
net worth distribution
net worth share
 All agents maximize utility

 Choose: portfolio, consumption, technology
 All markets clear
 Consumption, capital, money, outside equity 36
Recall: Basics of Ito Calculus
 Geometric Ito Process
 Ito’s Lemma:
 Ito product rule:
 Ito ratio/quotation rule:
37
2. Law of Motion of Wealth Share
 Method 1: Using Ito’s quotation rule
 Ito ratio rule: Using portfolio

choice equation
 Method 2: Change of numeraire + Martingale (Lecture Notes)
38
3. Value functions backward equation
a. Value fcn. as fcn. Lofogindividual
-utility investment opportunities
The Big Picture
A L 𝜒 =1
accu- Debt
physical assets
mulation
Outside
… risk equity
y
ti lit

a
vol
𝐴(𝜅) 𝐾
amplification
Φ (𝜄 ) − 𝛿
output 𝜄 capital
price of risk
precautionary
drift
drift growth
ith expectations
net worth
distribution 40
3a. CRRA Value Function Applies separately for each type of agent
 Martingale Approach: works best in endowment economy
 Here: mix Martingale approach with value function (envelop condition)
 for individuals
 For CRRA/power utility
increase net worth by factor, optimal for all future states
increases by this factor -ratio is invariant in
 value function can be written as
 Investment opportunity/ “net worth multiplier”
 -function turns out to be independent of
41
 Change notation from -function to -process
3a. CRRA Value Function: relate to
 value function can be written as , that is
 by optimal consumption (if no corner solution)
Next step:
a) Special simple cases
b) replace with
something scale invariant 42
3a. CRRA Value Function: Special Case utility
 Ito for volatility term:

 For log utility :
for any
 Expected excess return:
 Recall
 Consumption choice:
 does not matter income and substitution effect cancel out
 Portfolio choice: myopic (no Mertonian hedging demand)

 Volatility of investment of opportunity/net worth multiplier
does not matter Myopic price of risk
43
L o g-utility
Recall: Market Clearing
 Output good market
⇒ 𝑞 𝑡 =𝑞 , ∀ 𝑡
 Hence
 Capital market
 Debt/bond market (by Walras Law)
45
4b. Model Solution
 Using , , for
 Using portfolio choice, goods & capital market clearing
from capital market clearing
 Goods & capital market clearing and -evolution

risk-free rate
46
Numerical example
𝑎=.11 , 𝜌 =5 % , 𝜎 =.1 ,Φ ( 𝜄 )=
log ( 𝜙𝜄+1 )
, 𝜙=10
47
𝜙
Observation of Basak-Cuoco Model
 fluctuates with macro shocks, since experts are levered
 Price of risk, i.e. Sharpe ratio, is
 Goes to as goes to zero

 Achieved via risk-free rate
 Rather than depressing price of risky asset,

 No endogenous risk
 No amplification
 No volatility effects
 in the long run HH-net worth share vanishes
 Way out:
 Different discount rates (KM) 48
 Switching types (BGG)
Desired Model Properties
 Normal regime: stable around steady state
 Experts are adequately capitalized
 Experts can absorb macro shock
 Endogenous risk and price of risk
 Fire-sales, liquidity spirals, fat tails
 Spillovers across assets and agents
 Market and funding liquidity connection
 SDF vs. cash-flow news
 Volatility paradox
 Financial innovation less stable economy
 (“Net worth trap” double-humped stationary distribution)
49
Modern Macro, Money, and
International Finance
Princeton Initiative 2023
Endogenous Risk Dynamics in
Real Macro Model with Heterogenous Agents
Markus K. Brunnermeier
Princeton University
Risk premia, price of risk
 Risk premia = price of risk * (endogenous + exogenous risk)
 Exogenous risk – shock from outside

 Endogenous risk
 Amplification: adverse feedback loops
 Multiple equilibria: Run, Sudden Stops
 Non-linearities are key for financial stability

 Around vs. away from steady state
BruSan 2017:
Two Type/Sector Model with Outside Equity Handbook of Macroeconomics,
Lecture Notes, Chatper 3
 Expert sector Household sector

A L A L
Debt Loans
Capital Net worth
𝑒 Outside Equity
𝑁 𝑡 equity Capital
𝑒
≥ 𝛼 𝜅𝑡
 Skin in the Game Constraint:

Experts must hold fraction of aggregate capital risk with
( never happens in equilibrium)
 Return on inside equity can differ from outside equity
 Issue outside equity at required return from HH 58
 In related model, He and Krishnamurthy 2013 impose that inside and
Financial Frictions and Distortions UPDATE!
state 2
 Skin in the game constraint Occasionally binding
 Retain certain fraction of risk equity constraint
 Incomplete markets state 1

 Costly state verification (BGG)
 Exogenous limit (Bewley/Ayagari)
 Next period’s price (KM)
 Next periods volatility (VaR, JG)

Two Type Model Setup
𝑒 h
 Output: 𝑎 ≥ 𝑎 Output:
 Consumption rate: Consumption rate:
 Investment rate: Investment rate:
𝑒 h
𝜌 ≥𝜌
 Risk-free debt
 Equity, but must hold
64
The Big Picture
𝜅 allocation of
A L 𝜒≥𝜒
accu- Debt
physical assets
mulation
Outside
… risk equity
y
ti lit

a
vol
𝐴(𝜅) 𝐾
amplification
Φ (𝜄 ) − 𝛿
output 𝜄 capital
price of risk
precautionary
drift
drift growth
ith expectations
net worth
distribution 66
2. GE: Markov States and Equilibria
 Equilibrium is a map
Histories of shocks prices
net worth distribution
net worth share
 All agents maximize utility

 Choose: portfolio, consumption, technology
 All markets clear
 Consumption, capital, money, outside equity 67
2. Law of Motion of Wealth Share
 Method 1: Using Ito’s quotation rule
 Recall
 + (lots of algebra)
 Method 2: Change of numeraire + Martingale Approach

 New numeraire: Total wealth in the economy,
 Apply Martingale Approach for value of ’s portfolio
 Simple algebra to obtain drift of :
Note that change of numeraire does not affect ratio !
68
2. Amplification Formula: Loss Spiral
 Recall
 By Ito’s Lemma on
 Total volatility
 Loss spiral
 Market illiquidity (price impact elasticity)
69
Solution
 Price of capital Amplification
𝑒 𝑒 𝑒 𝑒
𝜅 𝑡 <1 𝜅 𝑡 =1 𝜅 𝑡 <1 𝜅 𝑡 =1
n
regio
n
n
r eg i o
regio
n
al
r eg i o
Norm
is
al
Cris
Norm
is
Cris
Parameters:
71
Volatility Paradox
 Comparative Static w.r.t. .01,.05,.1
72
Risk Sharing via Outside Equity
 Comparative Static w.r.t. Risk sharing .1,.2, .5
(skin the game constraint)
73
Market Liquidity
 Comparative static w.r.t.
74
From & to Stationary Distribution
 Drift and Volatility of
𝑒 𝑒
𝜂 =𝛼 𝜅
“Steady state” ,
HHs’ short-sale constraint of HHs’ short-sale constraint of

capital binds, capital binds,
Case 1a
Case 1a
Case 2a
Case 2a
Case 1b
Case 1b
𝜂 𝜂
Experts’ skin in the game Experts’ skin in the game
constraint binds, 76
constraint binds, 76
5. Kolmogorov Forward Equation
 Given an initial distribution
the density diffusion follows PDE
 “Kolmogorov Forward Equation” is in physics referred to as

“Fokker-Planck Equation”
 Corollary: if stationary distribution exists, it satisfies the

ODE
77
5. Stationary Distribution
 Stationary distribution of
𝑒 𝑒
𝜂 =𝛼 𝜅
Experts’ skin in the game Perfect risk-sharing

constraint binds region (infeasible)
ll 79: Is the constraint always (not just occasionally) binding
a) yes 79
b) no, only for some parameters
5. Stationary Distribution
 Stationary distribution of
𝑒 𝑒
𝜂 =𝛼 𝜅
Experts’ skin in the game Perfect risk-sharing

constraint binds region (infeasible)
Poll 80: What happens for
a) experts take over the economy, 80
b) there is a steady state at
5. Fan chart and distributional impulse response
 … the theory to Bank of England’s empirical fan
charts
 Starts at , the median of stationary distribution
 Simulate a shock at quantile of original Brownian
shock () for a period of .
 Converges back to stationary distribution
81
5. Fan chart and distributional impulse response
 Starts at stationary distribution
 Simulate a shock at quantile of original Brownian
shock () for a period of .
82
5. Density Diffusion
 Starts at stationary distribution
 Simulate a shock at quantile of original Brownian shock ()
for a period of .
83
5.Density Diffusion Movies
84
5. Distributional Impulse Response
 Difference between path with and without shock
 Difference converges to zero in the long-run
𝜎 =0.15
85
Desired Model Properties
 Normal regime: stable around steady state
 Experts are adequately capitalized
 Experts can absorb macro shock
 Endogenous risk and price of risk
 Fire-sales, liquidity spirals, fat tails
 Spillovers across assets and agents
 Market and funding liquidity connection
 SDF vs. cash-flow news
 Volatility paradox
 Financial innovation less stable economy
 (“Net worth trap” double-humped stationary distribution)
87

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Modern Macro, Money, and

Heterogenous Agents Real Model

 How to design Financial Sector, Gov. bonds, etc.

 Friction psMRSs different even after transactions

 Wealth distribution matters! (net worth of subgroups)

 Exogenous risk – shock from outside

 Non-linearities are key for financial stability

2. Agility: react earlier to turn around (rigidity)

 Kiyotaki Moore (1997)

 In reality an adverse shock may be followed by additional adverse shocks

 Impulse response vs. volatility dynamics

 Input: constant volatility

Nonlinearities in crisis endogenous fait tails, skewness

Money due to: Risk & financial frictions Price stickiness

International Macro-Finance Models

See Lecture Notes, Chapter 2 or

agent of type (expert, HH)

Friction: Can only issue

Friction: Can only issue Log-utility in Basak Cuoco 1998

Friction: Can only issue

ackward equation Forward equation

 Where is the individual cumulative capital purchase process

 Net worth aggregation:

 Ito ratio rule:

ackward equation Forward equation

 FOC: Tobin’sDividend Capital gains rate

 Goods market clearing:

s.t. + labor income/endow/taxes

Dividend Capital gains rate

 Asset markets clearing:

net worth distribution

net worth share

 All agents maximize utility

 Ito product rule:

 Ito ratio/quotation rule:

 Ito ratio rule: Using portfolio

 Method 2: Change of numeraire + Martingale (Lecture Notes)

ackward equation Forward equation

 value function can be written as , that is

 by optimal consumption (if no corner solution)

 Ito for volatility term:

 Portfolio choice: myopic (no Mertonian hedging demand)

 Debt/bond market (by Walras Law)

 Using portfolio choice, goods & capital market clearing

from capital market clearing

 Goods & capital market clearing and -evolution

 Goes to as goes to zero

 Rather than depressing price of risky asset,

 Exogenous risk – shock from outside

 Non-linearities are key for financial stability

 Expert sector Household sector

 Skin in the Game Constraint:

 Incomplete markets state 1

 “natural” leverage constraint (BruSan)

 Next periods volatility (VaR, JG)

ackward equation Forward equation

net worth distribution

net worth share

 All agents maximize utility

 Method 2: Change of numeraire + Martingale Approach

HHs’ short-sale constraint of HHs’ short-sale constraint of

 “Kolmogorov Forward Equation” is in physics referred to as

 Corollary: if stationary distribution exists, it satisfies the

Experts’ skin in the game Perfect risk-sharing