Redistributive consequences of financial crises and bank bailouts

In the project we will develop a novel model of economy with heterogeneous agents and rich financial sector. We will first study, in a theoretical setup, the links between financial sector disturbances and stabilization policies and preexisting inequality in wealth, income and portfolio heterogeneity. This model will further be developed to a quantitative heterogeneous agent New Keynesian (HANK). Our model will feature realistic income processes and asset positions of households. We will use this setup to explore the effectiveness and redistributive consequences of various policy interventions intended to mitigate consequences of financial crises. Namely, bank bailouts and purchases of distressed assets affect households in different parts of the wealth distribution in a different way. These widely deployed relief programs usually come at a cost that eventually has to be covered by taxation, burden of which falls disproportionately on some households. It is not clear ex ante what types of stabilization programs are more effective and what determines their effectiveness. 

This broad research agenda will be operationalized in two studies: a stylized theoretical study and a quantitative study. From the perspective of policy relevance, verifying two hypotheses is of paramount importance.

• Hypothesis 1: Financial sector shocks, as well as policies intended to mitigate them, affect inequality. It was demonstrated empirically for monetary policy shocks, but theory remains underdeveloped for financial sector shocks. Our objective is to provide a theoretical account of the channels relating disturbances in financial sector and the distribution of household incomes and wealth. As an auxiliary hypothesis, we postulate that the macroeconomic effects of financial shocks depend on the joint distribution of wealth, income and assets in the economy. A negative covariance between MPCs and net nominal asset position and a positive covariance between MPCs and household level income growth as a consequence of interest rate cut work in the same way. We expect to find a similar set of theoretical predictions to be true in a context of financial shocks
• Hypothesis 2: The joint distribution of wealth, income and assets in the economy drives which of instruments -- bank bailouts or direct transfers to the households -- are more effective in raising aggregate demand. This hypothesis is related to H1. If banking crises eventually depress wages of households with low MPCs, bank bailouts might be more powerful than equally costly direct transfers to the poor household. If households exposed to a sharp decline in asset prices are wealthy hand-to-mouth, they will have high MPCs and relief programs focused on purchases of distressed assets might be especially potent. Without a calibrated model it is impossible to say which one of these scenarios is the one closest to reality.

Summarizing, the proposed study provides an innovative way to analyze the effects of financial shocks and financial market interventions. From the academic perspective, it addresses policy relevant problems and builds on previous findings in the field. Furthermore, the aim of the proposed study is to develop a tool than can be later on utilized to address further research questions. From the technical perspective, building a model that features a rich asset structure, a meaningful income and wealth heterogeneity and microfounded frictional financial sector is a challenge. It requires a sophisticated solution algorithm and developing this set of skills will be beneficial during the subsequent stages of the academic career. As a project result, we hope to provide policy recommendations, which could guide decisions of policymakers who are concerned about inequality and are facing a financial crisis.