Finance and Economics Discussion Series: 2013-47 Screen Reader version ^{♣}

Abstract:

I study the effects of credit tightening in an economy with uninsured idiosyncratic investment risk. In the model, entrepreneurs require an equity premium because collateral constraints limit insurance. After collateral constraints tighten, the equity premium and the riskiness of consumption rise
and the risk-free interest rate falls. I show that, both immediately after the shock and in the long run, the equity premium and the riskiness of consumption increase more than they would if the risk-free rate were constant. Indeed, the long-run increase in the riskiness of consumption growth is
purely a general-equilibrium effect: if the risk-free rate were constant (as in a small open economy), an endogenous decrease in risk-taking by entrepreneurs would, in the long run, completely offset the decrease in their ability to diversify. I also show that the credit shock leads to a decrease
in aggregate capital if the elasticity of intertemporal substitution is sufficiently high. Finally, I show that, due to a general-equilibrium effect, there is no "overshooting" in the equity premium: in response to a permanent decrease in firms' ability to pledge their future income, the equity
premium immediately jumps to its new steady-state level and remains constant thereafter, even as aggregate capital adjusts over time. However, if idiosyncratic uncertainty is sufficiently low, credit tightening has no short- or long-run effects on aggregate capital, the equity premium, or the
riskiness of consumption. Thus my paper highlights how investment risk affects the economy's response to a credit crunch.

Keywords: Incomplete markets, idiosyncratic risk, business cycles, risk-free rates

JEL codes: D52, E44, G11, O16

This paper studies the short- and long-run effects of a shift from loose credit for firms to tight credit in an economy with uninsured investment risk. I focus on a general-equilibrium link between firms: financial claims issued by one firm can (directly or indirectly) be the asset of another firm. The debtor firm seeks to finance an investment. The creditor firm (which owns the debt perhaps in the form of a bank deposit) holds the other firm's debt in order to finance future investments or as a buffer against a bad shock to its own profitability.

When a firm faces tighter credit conditions, it seeks to decrease its borrowing: in part because it can no longer borrow as much against a given investment and in part because, with tighter credit, some investments are not worth pursuing and hence do not generate collateral. If many firms face tighter credit conditions, they will all seek to decrease their borrowing at the same time. Hence there will be fewer stores of value for other firms to hold.

To explore this linkage between firms and how it affects the economy's response to a credit crunch, I develop a tractable dynamic, general-equilibrium model in which collateral constraints limit the ability of entrepreneurs to hedge idiosyncratic risk. The model illustrates the interaction between idiosyncratic investment risk and limited commitment. In contrast, many papers on uninsured investment risk, including Angeletos (2007), Angeletos and Panousi (2009), Angeletos and Panousi (2011), and Panousi (2012), abstract from borrowing constraints, while many papers on shocks to collateral constraints, including Buera and Moll (2012) and Midrigan and Xu (2012), abstract from uninsured investment risk.

Thus, the paper's main contribution is to characterize the short- and long-run effects of credit tightening in a general-equilibrium model with uninsured investment risk. I emphasize the role of an endogenous decrease in the risk-free rate in determining the effects of credit tightening on capital accumulation, consumption riskiness, and the equity premium.

*Preview of the model and results*. In the model, firms are run by entrepreneurs and the output of each firm is subject to an idiosyncratic shock. Entrepreneurs can issue state-contingent assets of any maturity, but the set of financial contracts available to an
entrepreneur is constrained because, in the event of default, creditors' recovery is limited. This limited-enforcement problem gives rise to collateral constraints. Due to these collateral constraints, taking advantage of investment opportunities requires forgoing insurance. Thus, entrepreneurs
require a (private) equity premium.

The shock that I study takes the form of a decrease in creditors' recovery in the event of default. I begin by studying the economy's long-run response. When collateral constraints tighten, entrepreneurs are forced to retain a greater share of their profits. As each entrepreneur shifts to self-financing, he reduces the quantity of financial assets that can be owned by other entrepreneurs to insure against their bad idiosyncratic shocks. This has important general-equilibrium effects: the risk-free rate falls and consumption growth becomes riskier. The equity premium rises, for two reasons: first, credit tightening reduces the share of (risky) profits that entrepreneurs can sell to diversified investors; and, second, because the risk-free rate falls, hedging is more expensive. Correspondingly, the risk-adjusted return to saving falls. This gives rise to an income effect and a substitution effect, and thus aggregate capital decreases if and only if the elasticity of intertemporal substitution is sufficiently large.

I show that if the risk-free rate were constant, as in a small open economy, the economy's response would be qualitatively different. In particular, because the risk-free rate would not fall as entrepreneurs shift to self-financing, the decrease in firms' ability to borrow would lead entrepreneurs to scale back risk-taking. This endogenous decrease in risk-taking would be so large that, in the long run, the riskiness of consumption growth would be unchanged - even though credit tightening mechanically reduces the share of profits that entrepreneurs can sell to diversified investors. The equity premium would still rise, because, for a given investment, an entrepreneur has to bear more risk. However, because entrepreneurs would accumulate safe financial assets, they would be better hedged. Hence, the equity premium would not rise as much as it does when the risk-free rate is endogenous.

This highlights the general-equilibrium effects of the endogenous decrease in the risk-free rate after a shock to collateral constraints. In the long run, the increase in the equity premium is higher than it would be if the interest rate were constant. Moreover, the increase in the riskiness of consumption growth can be accounted for by the decrease in the risk-free rate.

This analysis of the long-run response to credit tightening begs the question of how the economy responds in the short run. I show that there is no "overshooting" in the equity premium: in response to a permanent decrease in firms' ability to pledge their future income, the equity premium immediately jumps to its new steady-state level and remains constant thereafter, even as aggregate capital adjusts over time. One corollary of this result is that if idiosyncratic uncertainty is sufficiently low, credit tightening has no short- or long-run effects on aggregate capital, the equity premium, or the riskiness of consumption. I also show that the absence of overshooting is a general-equilibrium effect. Finally, in the case where the elasticity of intertemporal substitution is equal to one, I show that, in the short run, the increase in the equity premium and the riskiness of consumption caused by credit tightening are larger than they would be if the risk-free rate were unaffected by credit tightening.

My paper builds on the literature on uninsured investment risk, including Angeletos (2007), Angeletos and Panousi (2009), Angeletos and Panousi (2011), and Panousi (2012). These papers study how aggregate capital is affected by idiosyncratic investment risk using models in which entrepreneurs can trade only a risk-free bond. These papers ignore borrowing constraints (except for the "natural" borrowing constraint that consumption need always be positive) and, like Aiyagari (1994) and Guerrieri and Lorenzoni (2011), which use similar models of uninsured labor-income risk, ignore the micro-foundations for incomplete markets. In contrast, I explicitly incorporate a limited-enforcement problem that gives rise to collateral constraints.

Even though my paper features collateral constraints and state-contingent debt, some of the economic forces at work in Angeletos (2007) are similar and one of my results - that aggregate capital decreases when firms' ability to pledge their income decreases if and only if the elasticity of intertemporal substitution is greater than one - appears very similar to the main result of Angeletos (2007); in Angeletos (2007), aggregate capital is lower without state-contingent debt than with complete markets if and only if the elasticity of substitution is above a related threshold. However, it is not the case that my model nests Angeletos (2007), or vice versa. In my model, even when firms cannot pledge any future profits, the zero correlation between idiosyncratic productivity and the payment to outside investors is an endogenous, general-equilibrium outcome: in partial equilibrium, the entrepreneurs in my model could hedge, even when they cannot pledge any future income, by receiving, for example, a minimum salary from investors regardless of the realized shock. Thus, even when firms cannot pledge any future profits, the correlation between idiosyncratic productivity and the payment to outside investors is zero only because no entrepreneur can supply the assets that other entrepreneurs can use to hedge; that is, the risk-free rate must be sufficiently low such that entrepreneurs are willing to forgo insurance. In contrast, in Angeletos (2007), the correlation between idiosyncratic productivity and the payment to outside investors is exogenous. One advantage of my approach is that, in my paper, idiosyncratic productivity risk and the level of financial development can vary independently; in contrast, in Angeletos and Panousi (2011), idiosyncratic productivity risk and financial development are one and the same.

Two papers that emphasize idiosyncratic risk and borrowing constraints are Covas (2006) and Guerrieri and Lorenzoni (2011). Covas (2006) studies the effects of idiosyncratic investment risk on steady-state aggregate capital in a calibrated Bewley-type model of entrepreneurs with an ad-hoc (as opposed to "natural") borrowing constraint. In the paper's simulations, Covas (2006) often finds that, with uninsured investment risk and borrowing constraints, steady-state aggregate capital is higher than under complete markets. Covas (2006) attributes these results, in part, to precautionary saving. That is, uninsured investment risk and borrowing constraints increase the hedging demand for the safe asset, depressing the risk-free rate and thus making the risky entrepreneurial investment more attractive. However, as highlighted in my paper, this decrease in the risk-free rate also increases the cost of hedging, making risky entrepreneurial investment less attractive. In Covas (2006), it is not clear why the former effect tends to dominate the latter effect. Guerrieri and Lorenzoni (2011), like my paper, studies the short-run effects of a shock to borrowing constraints in the presence of idiosyncratic risk. Unlike my paper, Guerrieri and Lorenzoni (2011) focus on uninsured labor income risk in a Bewley-type model, rather than uninsured investment income risk in a model with collateral constraints on investment. In Guerrieri and Lorenzoni (2011), as in my paper, a credit crunch leads to a decrease in the risk-free rate, providing an example of a shock that can lead to a negative real risk-free rate and potentially a binding zero-lower-bound on the nominal risk-free rate. Eggertsson and Krugman (2012) explore a similar point in a simple, tractable model of consumers who borrow and lend due to heterogeneity in impatience to consume.

This paper also contributes to a growing literature that studies the short-run macroeconomic response to shocks that limit firms' ability to pledge their profits to outside investors. Some papers in this literature, including Jermann and Quadrini (2011), Kahn and Thomas (2010) and Buera and Moll (2012), study shocks to parameters, such as outside investors' recovery rate in bankruptcy, that directly enter into firms' collateral constraints. Other papers, including Christiano, Motto and Rostagno (2010), Gilchrist, Sim and Zakrajsek (2010), and Arellano, Bai and Kehoe (2010), study shocks to idiosyncratic and aggregate uncertainty in the presence of financial constraints.

Jermann and Quadrini (2011), like this paper, examines the short-run effects of credit tightening. However, their results rely on two particular assumptions: (i) an ad-hoc cost of changing the payout to equityholders; and (ii) tax benefits of debt. If there are no ad-hoc costs to changing dividends and no tax benefits of debt, shocks to firms' ability to borrow would not affect the real economy. In my paper, in contrast, there are no financial constraints beyond those that arise endogenously from the firms' limited enforcement problem, and entrepreneurs' financial decisions are driven by the investment risk they face. Kahn and Thomas (2011), in a calibrated DSGE model, study how fixed costs of capital adjustment affect the economy's response to a decrease in firms' ability to borrow. In Kahn and Thomas (2011), idiosyncratic investment risk is important, but for a different reason than in my paper. In Kahn and Thomas (2011), equityholders are fully diversified, and idiosyncratic uncertainty matters only because responding to shocks may trigger fixed costs of adjustment. In my paper, as in Angeletos (2007), idiosyncratic uncertainty matters because entrepreneurs are undiversified owners of the equity of their firms. Also, like Jermann and Quadrini (2011), Kahn and Thomas (2011) features ad-hoc financial frictions, such as the inability of widely held firms to issue equity.

Buera and Moll (2012), like this paper, analytically characterizes the short-run response to a collateral-constraints shock and emphasizes the effect of endogenous changes to the risk-free rate. However, the firm's problem and the economy's response to a credit crunch in Buera and Moll (2012) are different than in my paper. Buera and Moll (2012) assume that each firm's productivity is known with certainty at the time of investment and financial contracting; financial frictions limit the transfer of wealth from low-productivity firms to high-productivity firms and there is no uninsured investment risk. In contrast, in my model, each firm's productivity is unknown at the time of investment and financial contracting, but the distribution of next-period productivity is the same for each firm. As a result, in my model, financial frictions do not give rise to misallocation across firms, but there is uninsured investment risk.

Unsurprisingly, the economy's response to a collateral-constraints shock in my paper is qualitatively different than the economy's response in Buera and Moll (2012). For example, Buera and Moll (2012) focus on the investment wedge, defined as the tax on investment in a representative-agent
economy that would make the Euler equation hold, as in Chari, Kehoe and McGrattan (2007).^{1} One of Buera and Moll (2012)'s main results is that, with
idiosyncratic productivity shocks, the investment wedge is equal to zero and is unaffected by changes in firms' ability to borrow. Although Buera and Moll (2012)'s investment wedge is not the focus of my paper, I find that, comparing across steady states, Buera and Moll (2012)'s entrepreneurial
investment wedge is generally non-zero, has a sign that depends on the elasticity of intertemporal substitution, and increases in absolute value when firms' ability to borrow decreases.

A number of calibration papers in this literature also abstract from uninsured idiosyncratic investment risk by assuming that tomorrow's productivity is revealed before today's investment and financial-contracting decisions. Midrigan and Xu (2012) study a shock to collateral constraints in a calibration that matches Korean establishment-level data. Buera and Shin (2010) study the effects of capital liberalization and a decrease in idiosyncratic taxes in a calibration that matches six emerging-market growth-acceleration episodes. Bassetto, Cagetti and DeNardi (2010) study a variety of financial shocks in a calibration that matches the U.S. firm-size distribution. Like my paper, these papers study both short-run dynamics and long-run effects.

It bears noting that, although my paper differs in important ways from these papers, many of these papers also emphasize the general-equilibrium effects of endogenous changes to the risk-free rate. For example, in the literature on collateral constraints, Midrigan and Xu (2012) find that steady-state TFP losses due to financial frictions are about 50 percent larger in a closed economy than in a small open economy. Similarly, Buera and Shin (2010) find that reducing idiosyncratic distortions leads to a much larger increase in TFP when accompanied by a capital-account liberalization that results in an exogenous increase in the interest rate. In the literature on uninsured investment risk, Panousi (2012) shows that the effect of capital taxation on capital accumulation is theoretically ambiguous, a surprising result that emerges because capital taxation leads to an increase in the risk-free rate and this in turn leads to a decrease in the equity premium.

Time is discrete, indexed by There is a continuum of infinitely-lived entrepreneurs, indexed by . Each entrepreneur runs a firm. There is only one good, used for both capital and consumption.

*Technology*. In period , firm has a history of
idiosyncratic productivity shocks
and invests in the
production technology. In period , the firm learns productivity
. The firm then hires labor
. The total output produced in period is:

Productivity is independently and identically distributed over and .

Denote the cumulative distribution function over productivities by . I normalize the expected productivity to be equal to one.

*Financial markets.* The firm can access financial markets by trading state-contingent promises that pay out conditional on the realization of productivity. At history , the firm sells a portfolio of Arrow-Debreu securities that represent a promise to pay
next period. Note that the promised payment
may depend on the realization of
. Because the shocks are idiosyncratic, the proceeds from this sale, in equilibrium, are
, where is the risk-free interest
rate between periods and and the expectation is taken with respect to
productivity
.

Although the promises are state-contingent, markets are incomplete because entrepreneurs can renege on payment. In particular, if an entrepreneur reneges, the most that creditors can seize is a fraction of the firm's output net of labor costs. This setup nests no ability to borrow ( ) and complete financial markets ( ). When a firm reneges, the unmet portion of the firm's debt is erased. (When the firm is allowed to issue promises due in more than one period, all future promises by the firm are also erased). Given this, the firms repay in period if and only if:

By allowing state-contingent promises, I am able to focus exclusively on a single financial friction, the possibility of reneging.The path of is deterministic but potentially time varying. Moreover, there exists a such that if .

*Preferences.* I assume that entrepreneurs have Epstein-Zin preferences with constant elasticity of intertemporal substitution and constant relative risk aversion. That is, associated with a stochastic consumption stream
is a stochastic utility stream that satisfies the following recursion:

and

Note that denotes the coefficient of relative risk aversion and
denotes the elasticity of intertemporal substitution. As in Angeletos (2007), allowing
permits the forces that operate in this economy to be more clearly elucidated while also nesting the frequently made assumption that
.
The supply of labor is inelastic and, in aggregate, equals . I normalize

*Budgets.* An entrepreneur's budget constraint at state is:

I assume that workers are hand-to-mouth consumers, who live in financial autarky and each period consume their wage.

*Equilibrium.* The initial condition of the economy is given by the distribution of
across firms. An equilibrium is a deterministic interest-rate and wage sequence
, collections of state-contingent plans for entrepreneurs
and paths for aggregate levels of debt consumption , capital , output and labor such that:

- the plans maximize the utility of each entrepreneur;
- the bond-market clears: for all ;
- the labor-market clears: for all ;
- aggregate quantities are determined by individual policies: , , , and

In the model, profits and labor demand for each entrepreneur are linear in the physical capital owned by the entrepreneur, due to constant returns to scale in technology and the ability to adjust labor demand according to the realization of idiosyncratic productivity:

and

where
and
.
Thus, the firm's problem can be written recursively as:

subject to

and, for each ,

In period , the entrepreneur chooses how much to consume, , and its capital . These choices determine, through the budget constraint (4.2), the expected value of next-period wealth. The firm also chooses a mapping from next-period productivity to next-period wealth, , that must satisfy the budget constraint (4.2) and the limited-enforcement constraints (4.3).

The (private) equity premium is . When this equity premium is positive, the firm faces a three-way tradeoff between insurance, the timing of consumption, and taking advantage of its investment opportunity. On the one hand, increasing capital increases expected next-period wealth, as shown in (4.2). On the other hand, for any state of the world for which (4.3) is binding, an increase in capital requires an increase in the amount of next-period period wealth that must be allocated to that state at the expense of either current consumption or the next-period wealth allocated to other states.

If is weakly concave, which I will verify below, then the period- wealth level will feature some constant level of wealth for every state below a threshold , and for every state greater than this threshold, wealth will be determined by (4.3). That is, will be equal to the greater of a fixed salary or the minimum wealth level consistent with repayment. I denote the fixed salary by , so that

Using this intuition, firms' optimal decisions for given prices can be characterized in closed form.

Equation (4.9) shows how the limited-enforcement problem interferes with insurance and the optimal timing of consumption. In period , the financial constraint (4.3) binds for all productivity realizations above a threshold , which is uniquely determined by: For productivity realizations below the threshold , there is full insurance: that is, for all . Moreover, for these low productivity realizations, the consumption growth rate is undistorted in the following sense: an entrepreneur at history is indifferent between (i) an additional unit of consumption next period in states with ; or (ii) units of consumption in period

In contrast, for productivity realizations for which the financial constraint does bind, insurance is limited: that is, is strictly increasing in for . Moreover, for these high productivity realizations, the consumption growth rate is "too high": the entrepreneur would prefer units of consumption in period rather than an additional unit of consumption next period in states with .

Correspondingly, when financial constraints bind with positive probability, entrepreneurs require an expected return on physical capital greater than the risk-free rate. The first-order conditions of (4.8) imply that the equity premium is:

Consider an entrepreneur in period with history . At the margin, increasing capital by one unit requires an entrepreneur to hold units of additional wealth next period in any state with in order to satisfy the financial constraint for that state. To do so, the entrepreneur must hold less wealth in states with .

Because shocks are i.i.d. across firms, the period- market-clearing wage is determined by . We can then define aggregate capital income in period as By Lemma 1, an entrepreneur's consumption, investment and minimum payoff are linear in his wealth, making the distribution of wealth irrelevant for calculating aggregates. This permits the following recursive characterization of general-equilibrium dynamics:

Note that this system is recursive in In particular, given , the market-clearing condition (4.14) can be used to determine . Next, equations (4.11) and (4.12) can be used to calculate and . Then the first-order conditions of (4.8) determine and , which in turn imply . Finally, (4.13) determines .

A steady state is a fixed point of the dynamic system (4.11)-(4.14) with and .

I make the following assumption, as in Angeletos (2007).

*Assumption 1*.

Assumption 1 implies that . An example of technology that satisfies Assumption 1 is Cobb-Douglas technology.

*(b) If a steady state exists, it is unique. In steady state
where satisfies:*

Hereafter, I will confine attention to economies which have a unique steady state. This is guaranteed by Assumption 2.

*Assumption 2*. *If*
, then
, where is determined by
.

The threshold in Assumption 2 is uniquely determined by preference parameters and , the distribution of idiosyncratic productivity , and the ability of firms to borrow . The threshold does not depend on the production function . It can be shown that and that is increasing in and and decreasing in .

The characterization of the economy's steady state in Proposition 3 immediately leads to the following result.

*(a) a decrease in the minimum payoff and an increase in the riskiness of consumption; that is, the growth rate of idiosyncratic consumption with
second-order stochastically dominates the growth rate of idiosyncratic consumption with
if and only if
;*

*(b) a decrease in the interest rate, R;*

*(c) an increase in the (private) equity premium,
;*

*(d) a decrease in aggregate capital if and only if the elasticity of intertemporal substitution is greater than one.*

*These changes will be strict if financial constraints bind in the new steady state.*

More specifically, consider the steady states associated with and , with , and suppose , so that financial constraints bind with positive probability in the steady state. Denote the productivity threshold above which financial constraints bind in the steady state by . Then there will be a cutoff productivity such that: for any productivity , the consumption growth rate in the steady state is lower than the consumption growth rate in the steady state; for any productivity , the opposite holds. Hence, it follows that a decrease in leads to a simple increase in risk in the distribution of consumption growth.

According to (5.2), this increase in the riskiness of consumption leads to a decrease in aggregate capital if and only if the elasticity of intertemporal substitution is greater than one. This is because credit tightening leads to a decrease in the risk-adjusted return to saving, giving rise to opposing income and substitution effects; when the EIS is higher, the substitution effect is stronger.

Using Assumption 1 and (4.10), the equity premium can be written as:

Thus, in the general-equilibrium steady state:

With a shift from to , for each additional unit of investment, an entrepreneur has to retain a greater share of the upside risk. Moreover, bearing the risk associated with entrepreneurial investment is even less attractive in the steady state than in the steady state, because, in the steady state, the interest rate is lower and it is more expensive to hedge. Hence, as (5.5) shows, a decrease in leads to an increase in the equity premium.

In the remainder of this section, I will examine how the economy would react differently to a decrease in if the risk-free rate were held constant, as in a small open economy.

To obtain a clearer understanding of Proposition 4, define a small-open-economy equilibrium as equivalent to the closed-economy equilibrium defined above, except that the bond-market clearing condition is replaced with an exogenously given interest rate.

Using the budget constraint (4.2) and Lemma 1, define the optimal debt policy as:

The aggregate dynamics in the small-open economy will satisfy:

as well as the optimality condition (4.13) and the first-order conditions of (4.8). A small-open-economy steady state is a fixed point of this system with and .

*(a) There exists
such that a small-open-economy steady state exists if and only if
.*

*(b) If a steady state exists, it is unique and entrepreneurs are not perfectly insured.*

The next result shows how a small-open economy would respond to a decrease in .

*(a) no change in the riskiness of consumption growth; the steady-state consumption growth rate
is unchanged;*

*(b) a decrease in net leverage,
, and expected profits per unit wealth,
;*

*(c) an increase in the equity premium (and hence a decrease in aggregate capital).*

Clearly, with a constant interest rate, no change in the riskiness of consumption after a decrease in firms' ability to pledge is consistent with (5.8): the certainty-equivalent of the wealth growth rate is unchanged; the interest rate is unchanged; and the minimum payoff is unchanged. Intuitively, it is the interest rate that controls how costly it is for entrepreneurs to hedge idiosyncratic risk.

The response of the equity premium to a decrease in firms' ability to borrow, holding the interest rate constant, can then be seen from (5.4). Because the riskiness of consumption is unchanged, is unchanged: shifting one unit of consumption from low-productivity states to high-productivity states is equally unattractive before and after the decrease in firms' ability to borrow. Nonetheless, mechanically, for each unit of physical capital that an entrepreneur holds, more consumption must be shifted from low-productivity states to high-productivity states. Correspondingly, the equity premium increases. Hence, aggregate capital decreases unambiguously.

Proposition 6 explains why the risk-free rate falls in a closed economy in response to a decrease in . Consider a small, open economy with and suppose that, in the initial steady state, its current account was in balance. In this small open economy, a decrease in leads to a persistent current-account surplus. The decrease in leverage, , has a mechanical component and an endogenous one. Mechanically, the decrease in means that, for high realizations of next-period productivity, the share of next-period profits pledged must decrease, in order to satisfy the limited-enforcement constraint. In addition, the decrease in leads to an endogenous decrease in expected profits per unit wealth, . Thus, a decrease in in the small open economy leads to a decrease in net leverage, which explains why, in the closed economy, the interest rate must fall in response to a decrease in .

The next proposition is the complement to Proposition 6: that is, Proposition 7 examines how a small-open economy is affected by changes in the risk-free rate.

*(a) a decrease in the minimum payoff and an increase in the riskiness of consumption growth;*

*(b) an increase in net leverage,
, and expected profits per unit wealth,
;*

*(c) an increase in the equity premium.*

As before, the response of the equity premium to a decrease in the interest rate, holding all other exogenous variables constant, can be seen from (5.4). Because the riskiness of consumption increases, decreases: shifting one unit of consumption from low-productivity states to high-productivity states is more painful than before the decrease in the interest rate. Thus, even though there is no change in the amount, per unit of physical capital, of wealth that must be shifted from low-productivity states to high-productivity states, reducing insurance is more painful because of the decrease in the risk-free rate.

In this section, I study how the economy responds in the *short run* to the decrease in firms' ability to borrow. In the preceding analysis of the long-run response, I showed that a decrease in firms' ability to borrow leads to an increase in the equity premium and the
riskiness of consumption. I also showed that steady-state aggregate capital may increase or decrease in response to a decrease in firms' ability to borrow, depending on the elasticity of intertemporal substitution. These results raise a number of questions about the short-run dynamics. For example,
one might conjecture that if entrepreneurs accumulate wealth over time in response to credit tightening, then there will be overshooting in the equity premium: the equity premium would shoot up at first, but this initial increase would be partially reversed over time.

Thus, in this section, I fully characterize the transition dynamics of the equity premium and the riskiness of consumption for any path for . It turns out that, due to a general-equilibrium effect, the equity premium and one measure of consumption riskiness do not display any over- or under-shooting in response to a decrease in firms' ability to borrow.

In this section, I explicitly denote the dependence of steady-state variables on the share of profits that firms are able to pledge in the long run; for example, is steady state aggregate capital when .

Another implication of Proposition 8 is that, at time , the future path for firms' ability to borrow, , does not affect the period- equity premium or the coefficient of variation of period- consumption, although it may affect period- aggregate capital and consumption.

The absence of overshooting described in Proposition 8 is a general-equilibrium effect. The equity premium, given in (5.4), is greater when idiosyncratic consumption is riskier; that is, when is more risky. Thus, the equity premium can overshoot (or undershoot) after a permanent shock only if the riskiness of consumption varies with aggregate capital. However, in the closed economy studied here, this is not possible. Consider a shock to aggregate capital, all else equal: if in response to the shock, entrepreneurs sought to take more risk by increasing leverage, this would lead to an increase in the supply of financial assets, leading entrepreneurs to hedge more and thus contradicting the premise that the aggregate wealth shock leads to more risk taking.

It is interesting to consider the short-run dynamics of the risk-free rate and whether the equity premium and consumption riskiness increase more in the short-run than they would if the interest-rate were fixed. I address this questions for the special case in which the elasticity of intertemporal substitution is equal to one. With an EIS equal to one, the path for aggregate capital is unaffected by the path for collateral constraints and idiosyncratic uncertainty.

*(a) The path for aggregate quantities
is unique and converges monotonically to the unique steady state, with
and
.*

*(b) Compare two economies, H and L, that are identical in their initial conditions and exogenous parameters, except that
Then
and the period- equity premium in economy L is
greater than it would be if the period- risk-free rate in economy L were exogenous and equal to
.*

A number of recent papers have studied the short- and long-run effects of shocks to collateral constraints in models that abstract from uninsured investment risk. At the same time, other papers have studied uninsured investment risk while ignoring borrowing constraints. In this paper, I characterized the economy's response to a shock to collateral constraints in a model with uninsured risk. In the model, credit tightening leads to an increase in the equity premium and the riskiness of consumption. I showed that, both immediately after the shock and in the long run, the equity premium and the riskiness of consumption increase more than they would if the risk-free rate were constant. Indeed, the long-run increase in the riskiness of consumption growth was shown to be a purely general-equilibrium effect: if the risk-free rate were constant (as in a small open economy), an endogenous decrease in risk-taking by entrepreneurs would, in the long run, completely offset the decrease in their ability to diversify. I also showed that the credit shock leads to a decrease in aggregate capital if the elasticity of intertemporal substitution is sufficiently high. Finally, I demonstrated that, due to a general-equilibrium effect, there is no "overshooting" in the equity premium: in response to a permanent decrease in firms' ability to pledge their future income, the equity premium immediately jumps to its new steady-state level and remains constant thereafter, even as aggregate capital adjusts over time. Because the results highlight how changes in the risk-free rate affect risk-taking and the equity premium, it would be useful to extend the model to understand the implications of uninsured investment risk for monetary policy and the optimal level of government debt.

**Appendix A: Proofs**

**Proof of Lemma 1**

Define

subject to (4.2) and (4.3). Using (7.1), we can write (4.1) as:

Conjecture the following solution:

where , , , and are time-varying but deterministic coefficients to be determined.

From (7.3), we have that

subject to

Dividing the first-order condition with respect to by the first-order condition with respect to , one obtains:

where is defined by

This, together with the linearity of (7.5), implies that the solutions and to (7.4)-(7.5) are linear in and that is linear in . In particular, we have , where is given by (4.7). Moreover, re-arranging (7.6), one obtains (4.10).

Substituting for into (7.2), one obtains:

Due to homotheticity, the solution of this problem will be of the formThe envelope condition is:

Taking the first-order condition, using the envelope condition, and rearranging, one obtains:

Forward iteration of (7.8) implies (4.6).

Finally, to verify (7.3), one must confirm that

Substituting from , where is defined as in 4.7, one has Dividing both sides by and using the envelope condition (7.7), one obtains (7.8).**Proof of Proposition 3**

From assumption 1, one obtains Setting in (4.12), one obtains the steady-state condition:

Hence, in steady state, and (5.1) holds. If , there is a unique that satisfies (5.1). If , there may be more than one that satisfies (5.1). However, consider and , where and both satisfy (5.1). If , then almost everywhere.

Using (4.7) and (7.8), one can write:

Then, setting in (7.10), one obtains

From (7.11), observe that if . If , then . Hence, if , there exists such that if .

Using (4.14), (7.9) and (7.11), one obtains (5.2). Next, using (4.2) , (7.6) and (7.11) , one obtains (5.3). Note that . If , then: ; ; and, from (5.3), . If , then: ; ; and from, (5.3), .

**Proof of Proposition 4**

I will compare the steady states corresponding to two different values for firms' ability to borrow: and .

Suppose that . Denoting explicitly the dependence of steady-state policies on and using (5.1), one obtains that This result, together with (5.5), implies that .

Next, I will show that a decrease in generates a mean-preserving spread in . Note that, in steady state, is the growth rate of idiosyncratic wealth and the growth rate of idiosyncratic consumption. Denote by the cumulative distribution function of . Observe that . Furthermore,

Thus, a decrease in generates a mean-preserving spread in . This implies that . Then, from (5.2), we have that if and only if . Finally, (5.3) and imply that .**Proof of Lemma 5**

In this proof, I will assume that is a continuous random variable and that has positive support over . However, the more general proof is very similar.

In a small open economy, and are uniquely determined by the steady-state condition and (5.3), which is a partial-equilibrium steady-state condition. Define a function by , where the domain of is . Observe that: ; ; is continuous; and is strictly decreasing in . Write (5.3) as:

Note that: ; ; and is strictly decreasing in . Thus, associated with any there is a unique value for and a unique value for that satisfy and (5.3). Then (4.10) determines the unique value of aggregate capital.

From (7.11), observe that if , where .

**Proof of Proposition 6**

From (7.12), one observes that and do not depend on . Hence, a decrease in leads to a decrease in and has no effect on . (5.4) implies that a decrease in leads to an increase in

**Proof of Proposition 7**

From (7.12), we see that a decrease in leads to an increase in and thus a decrease in . Hence, a decrease in leads to an increase in and a decrease in . (5.4) implies that a decrease in leads to an increase in Because decreases and increases, one obtains that a decrease in leads to a simple increase in risk in .

**Proof of Proposition 8**

As in the main text, I explicitly denote the dependence of steady-state variables on the share of profits that firms are able to pledge in the long run; for example, is steady state aggregate capital when .

Financial market clearing implies:

which determines a unique value for with Then, from 5.4, we have .Next, observe that

and hence the distribution of (conditional on period- information and unconditionally) is equal to the distribution of .

**Proof of Proposition 9**

Proof of Part (a). From (4.6) and the assumption that , one observes that for all . Then, from (4.14), one obtains that . Moreover, from (4.12), we have that steady state capital satisfies and that the growth rate of aggregate capital is given by , so that convergence is monotonic.

Proof of Part (b). Propositions 4 and 8 imply that . From part (a), we have that and hence .

Finally, consider an economy in which firms' ability to borrow is given by
but the period- interest rate
is exogenous and equal to
. Suppose, by contradiction, that the period- equity premium in
this hypothetical economy were greater than the period- equity premium in economy . Then, because
, we have that period- aggregate capital in this
economy is less than period- aggregate capital in economy Because
aggregate capital in period- is identical in the hypothetical economy and in economy , this implies that period- net leverage in the hypothetical economy is less than period- net leverage in economy , which is given by
. Equation (5.4) then implies that the period- equity premium in the hypothetical economy is greater than the period- equity premium in economy , a contradiction.

* Federal Reserve Board. I thank Vasia Panousi, Alp Simsek, Francisco Vazquez-Grande and various seminar participants for helpful comments. I am particularly grateful to George-Marios Angeletos, Ricardo Caballero, Guido Lorenzoni and Iván Werning for
their advice and encouragement. Any views expressed here are those of the author and need not represent the views of the Federal Reserve Board or its staff. Contact: [email protected] Return to Text

1. More specifically, they define the entrepreneurial investment wedge as the tax on investment in a representative-agent economy that would make the Euler equation hold for the aggregate consumption of firm owners. Return to
Text

2. It is without loss of generality to restrict attention to one-period promises. To see this, note that, if firms traded promises due in up to
periods in the future, a firm could replicate the cash flows from any set of multi-period promises by making a one-period promise in period- (due in period-) with a face value equal to the total expected value of the period- through period- promises, discounted to period using the spot-rate curve derived from
. The entrepreneur would not renege on this set of one-period promises if the entrepreneur would not renege on the original set of multi-period promises.
Rampini and Viswanathan (2010) make a similar point in a partial-equilibrium setting with a constant risk-free rate and a constant ability of firms to borrow against capital. Return to Text

3. In the case of standard expected utility, for productivity realizations below the threshold
, the consumption growth rate of entrepreneur is equal to
, reflecting the usual tradeoff between consuming
additional goods next period or one additional good today. Return to Text

4. The entrepreneur is indifferent between a decrease in period- consumption and a decrease (with equal expected value) in consumption in any states
with
. Return to Text

5. Note that if , there is a unique that satisfies (5.1). If , there may be more than one that satisfies (5.1); however, if
and
both satisfy (5.1), it will be the case that
almost everywhere. See the proof of Proposition 3 for more detail.
Return to Text

6. If , then there are multiple steady-state equilibria, but each features the same aggregate capital and perfect consumption insurance.
Return to Text

7. More specifically, the distribution of
represents a simple increase in risk relative to the distribution of
, as implied by Proposition 8. Moreover, the distribution of
represents a simple increase in risk relative to the distribution that would occur in economy if the period- risk-free rate were exogenous and equal to
. Return to Text