Tuesday, October 11, 2011

New Research

. Tuesday, October 11, 2011

On the Network Topology of Variance Decompositions: Measuring the Connectedness of Financial Firms Francis X. Diebold, Kamil Yilmaz
NBER Working Paper No. 17490
We propose several connectedness measures built from pieces of variance decompositions, and we argue that they provide natural and insightful measures of connectedness among financial asset returns and volatilities. We also show that variance decompositions define weighted, directed networks, so that our connectedness measures are intimately-related to key measures of connectedness used in the network literature. Building on these insights, we track both average and daily time-varying connectedness of major U.S. financial institutions' stock return volatilities in recent years, including during the financial crisis of 2007-2008.
This is important work, and I know that several regulators and central banks (including the Bank of England) are starting to take this sort of modeling -- weighted, directed networks -- very seriously. When you're trying to track sources of systemic weakness you really need to know what the system looks like. The problem isn't just "too big too fail", it's also about which firms are tightly connected to many other firms. These two will often correlate, but not always and not perfectly, so knowing the difference is important.

The Stock Market Crash of 2008 Caused the Great Recession: Theory and Evidence Roger Farmer
NBER Working Paper No. 17479
This paper argues that the stock market crash of 2008, triggered by a collapse in house prices, caused the Great Recession. The paper has three parts. First, it provides evidence of a high correlation between the value of the stock market and the unemployment rate in U.S. data since 1929. Second, it compares a new model of the economy developed in recent papers and books by Farmer, with a classical model and with a textbook Keynesian approach. Third, it provides evidence that fiscal stimulus will not permanently restore full employment. In Farmer's model, as in the Keynesian model, employment is demand determined. But aggregate demand depends on wealth, not on income.
I think some of this gets to my confusion about Keynesianism from a few days back. I think the last sentence particularly drives at what I was saying before: if the monetary multiplier is low because of expectations, then how can the fiscal multiplier be high under the same set of expectations? It makes more sense (to me) for behavior to be conditioned by wealth more than income, particularly if the income is temporary. I clearly need to become more familiar with Farmer's work.

And here's a near-complete preprint of Herb Gintis' most recent book, The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences. Via one of Phil Arena's commenters.


New Research
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