Essays in Macroeconomics and Finance

Abstract

This thesis contains three chapters in macroeconomics and finance. In the first chapter, co-authored with Pierfrancesco Mei, we propose a theory of shallow thinking to capture people’s limited understanding of the long causal chains involved in shock propagation. We cast general equilibrium as a system of causal relations in a directed cyclic graph. Estimation from our qualitative survey suggests that, on average, people understand only about 2.6 steps of propagation, overlooking much of the graph and significantly deviating from rational expectations. Our theory implies that longer causal chains have diminishing influence on beliefs. Applying shallow thinking to a New Keynesian model with active monetary policy reconciles several puzzles about long-term interest rates and inflation: (i) long-term interest rates underreact to cost-push shocks but overreact to monetary policy shocks; (ii) inflation expectations negatively predict bond excess returns; (iii) news about future cost-push shocks triggers inflation; and (iv) more persistent cost-push shocks lead to higher inflation. Notably, (iii) and (iv) contradict the predictions of rational expectations. In a real business cycle model, relative to rational expectations, shallow thinking amplifies and prolongs output fluctuations from productivity shocks and predicts negative future stock excess returns. In the second chapter, co-authored with Xu Lu, we argue that institutional portfolio rebalancing across asset classes plays a key role in transmitting monetary shocks to equity markets. All else equal, around FOMC announcements, a stock with 10% higher ownership by institutions that routinely rebalance loses an additional 3.7 basis points following a 10-basis-point surprise rate hike. Our cross-sectional approach links this return difference to the aggregate stock market reaction through the price elasticities of both the aggregate market and individual stocks. We find that portfolio rebalancing accounts for roughly one-third to two-thirds of the aggregate stock market reaction attributed to changes in expected excess returns. In the third chapter, I investigate the determinants of demand elasticities and distortions across industries, acknowledging that firms’ demand and pricings are interdependent in input-output networks. I propose a modeling approach of competition in markups, which micro-founds demand elasticities and markups via “network Lerner indexes” based on the network structure of the economy in general equilibrium. At the equilibrium, each firm’s markup depends on four industry-level network statistics—cycle, substitution in production, substitution in consumption, and impact on consumer price, in addition to its market share. Empirical analysis of Compustat firms from 1997 to 2019 confirms the theory predictions. Taking into account the sectoral heterogeneity explains about three times more variations in markups. Under the theory-predicted markups, the loss in total factor productivity due to misallocation is about 13% over the sample period, which is four times larger than the implied loss that ignores sectoral heterogeneity.