FInancial and REal interdependencies: volatility, international openness and economic policies – FIRE

All our research project is based on three interrelated axes. During the first 18 months, contributions were made in each of these three areas.

Axis 1. Effects of bubbles and financial assets

We focused on valuing financial assets and rational bubbles. We focused on their ownership of volatility and their real effects. A particular analysis was devoted to the implications of heterogeneous behavior and financial friction. This latter part has been addressed by providing the appropriate microeconomic basis for financial frictions. We also explored the role of expectations on the existence of macroeconomic volatility.

Axis 2. Mechanisms for the Transmission of International Trade and

We studied the interaction between financial and real spheres in open economies. We focused mainly on the role of openness on asset valuation, bubbles and growth. Our objective was to examine the trade-offs between financial markets and commodity markets, the existence and spread of speculative bubbles, and the effects on growth of capital inflows through international financial markets. We also addressed the issue of banking crises and their international transmission through increased risk in the financial markets.

Axis 3. The role of monetary and fiscal policies

We sought to understand the role of monetary and fiscal policies when the economy is experiencing economic cycles and financial crises. One focused on their stabilizing virtues, but also on the optimality of these policies. We have focused particularly on economies characterized by high levels of public debt, as happens after a crisis. From this point of view, we have studied the links between debt level, growth and macroeconomic instability.

Axis1: The main results obtained concern the analysis of the links between financial markets and goods markets, in particular concerning the appearance of speculative bubbles. The impact of such bubbles on macroeconomic growth and volatility was analyzed. The role of expectations has been particularly examined.

Axis 2: The main results obtained concern the analysis of the international allocation of labor and capital. The consequences of these allocations in terms of the international transmission of speculative bubbles and the determination of exchange rates were particularly examined.

Axis 3: The main results concern the analysis of public policies (budgetary and monetary) and their impact on growth. Two axes were particularly examined: the first concerns the study of fiscal policies in the context of large public debts. Issues of sustainability and long-term impact were discussed. The second axis focused on the impact of taxation policies in the theoretical context of balanced government budget. Recent debates about the imposition of a golden rule on public finances necessitates questioning the impact of such policies on the expectations of agents.

Based on the results obtained during the first 18 months, the priority objective is to integrate axes 2 and 3 in order to propose an analysis of public policies and the impact of debt in an open economy. This must of course be done in coordination with the contributions of axis 1 insofar as the consideration of heterogeneous agents and financial constraints is crucial.

Axis 1: 14 papers on the specific themes of this axis have been published during the last 18 months.

Axis 2: 7 papers concerning the specific themes of this axis were published during the first 18 months of our project.

Axis 3: 8 papers concerning the specific themes of this axis have been published during the last 18 months.

In addition, a conference and two international workshops on all these themes were organized.

The current crisis was initially generated by a decrease of housing prices in the US. The subprime crisis had a global impact because toxic assets entered portfolios of private institutions. Today, we can note their financial and real effects, through the implications on the financial and real activities of many countries.

The second main point that we learn from the current crisis is that it started as a local phenomenon, but propagated quite quickly all around the world. Because we live in a globalized world and markets are interdependent, it facilitated the transmission of the crisis, which started locally in the US, to the other countries. In this sense this crisis appears as quite different to the previous crises that occurred in the second half of the 20th century and that were much more local as affecting a limited number of countries (e.g. the Asian crisis of the 2000’s). There are however some similarities with the Great Recession of the 30’s with the notable difference that the propagation has been much faster nowadays as a consequence of a much stronger international market integration.

The third main instruction concerns economic policies. While monetary and fiscal authorities first reacted using standards instruments and rules, there is now a consensus to conclude that we are in an exceptional economic situation, meaning that new economic policies should be considered. We can for instance have in mind the definition of new monetary rules or the design of fiscal policies with high levels of public debt.

These three important aspects require us to understand more deeply the interdependencies between the financial and real spheres of economies. The real effects of asset volatility and bubble bursting should be investigated in the presence or not of financial imperfections. The transmission mechanisms to a globalized economy should be examined taking into account both real and financial spheres. Of course, in this context, new monetary and fiscal policies need to be designed. In this perspective, this project that focuses on the financial and real interdependencies will be organized according to the following three parts:

Part 1 / Task 1. Real effects of bubbles and financial assets

We focus on the valuation of financial assets and rational bubbles. We are concerned in their volatility and their real effects. A special attempt will be devoted to the implications of heterogeneous behaviors and financial frictions. This last part is addressed providing appropriate microeconomic foundations of the financial frictions.

Part 2 / Task 2. Transmission mechanisms of international trade and openness

We study the interplay between the financial and real spheres in open economies. We especially focus on the role of openness on asset valuation, bubbles and growth. Our goal is to examine the arbitrages that take place between the financial and good markets, the existence and propagation of speculative bubbles and the effects of capital inflows through international financial markets on growth.

Part 3 / Task 3. The role of monetary and fiscal policies

We aim to design the role of monetary and fiscal policies when the economy experiences business cycles and financial crises. One focuses on their stabilizing virtues, but also on the optimality of such policies. We are in particular concerned with economies characterized by strong levels of public debt and exceptional events, as it happens following a crisis.