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Capital, Aggregate Fluctuations and Idiosyncratic Risk

Student: Kanof`ev Vadim

Supervisor: Udara Peiris

Faculty: International College of Economics and Finance

Educational Programme: Master

Final Grade: 10

Year of Graduation: 2014

<p>Macroeconomic models typically consider the effect of aggregate shocks on economic variables such as aggregate savings and output growth. The role that idiosyncratic risk may play in generating aggregate fluctuations is usually ignored. However, there are evidences that support that persistence of idiosyncratic shocks in the economy increases over time.</p><p>It is a widely known fact that distributions of the capital and production have positive skew. Thus in the economy most of the firms have small or intermediate size, however most of goods are produced by large ones. For example, in the U.S. in 2013 sales of top 10 companies exceeded 13% of total GDP, sales of the first 50 companies were over 35% of the GDP. Therefore productivity and, as a result, sales of individual firms from the top of the list play a considerable role in the aggregate behavior of the economy. Hence, idiosyncratic shocks to these companies can lead to a sufficient changes in the aggregate output.</p><p>Irvine and Schuh (2002) consider empirical data for the U.S. economy and show that after 1984 the economy was subject to the following stylized facts:</p><p>- Firm-level production volatility has considerably risen.</p><p>- Volatility of aggregate output on contrary significantly decreased.</p><p>- Covariance between firms and between industries declined.</p><p>If we assume that the micro-structure of the economy (firm-level volatility and inter-firm correlations) is an exogenous parameter, arises a very interesting question concerning the mechanism of reduction of the aggregate fluctuations in such an environment. There are different views on this issue: Stock and Watson (2003) argue that this result can be achieved through improvement of the inventory management and the proper monetary policy. Dynan et al. (2006) show that the aggregate volatility reduction may be caused by the financial innovations (e.g. development of loan markets etc.). We examine how this result can be obtained through the regulation of the investment strategies. Specifically, we consider how at the economy, where firms experience independent and identically distributed productivity shocks, different investment rules can be used in order to minimize volatility of the aggregate production.</p><p>We want to determine long-term effects of a short-term investment decisions driving by the current firm productivities. In such an economy savings will be a function of only a current state of nature and rate of return, therefore each period investments would not depend on the expectations on the future path of the economy. For this purpose we choose an Overlapping Generations model as a baseline because it exhibits all the underline features. We consider the OLG growth model of Polemarchakis and Dutta (1992), which describes an economy with a population of firms that experience independent and identically distributed productivity shocks. If investment decisions are made before the realization of productivity, the limit economy converges to the risk-less one with constant aggregate production. However if new investments can be reallocated ex-post, aggregate productivity in general is not a constant because of the persistence of sunk production of less efficient firms that use the capital that was accumulated during previous periods. Their result leaves open the question of the stationarity of such an economy: in fact, in general it will not be stationary. Our innovation is consideration of the proportional capital allocation rules, when firms receive new capital according to some invertible continuous function of its productivity. This distribution of the capital leads to vanishing of the aggregate fluctuations, whereas the aggregate level of the output exceeds the one obtained under ex-ante capital allocation.</p><p>Firstly, we present the baseline model and study aggregate outputs under different investment rules. Then we examine different classes of the proportional allocation rules and find optimal shapes of capital distribution functions within each of them. Finally we consider the dynamic properties of the economy under different investment rules and discuss which ones are more preferable. As a result we show that when the capital does not fully depreciate, the highest equilibrium production level and rate of convergence are exhibited under linear and logarithmic proportional allocations.</p>

Full text (added June 10, 2014) (371.32 Kb)

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