Essays on macroeconomic instability and financial frictions

Abstract

This dissertation comprises three chapters, examining how macroeconomic instability and financial constraints impact economic efficiency and market behavior. Each chapter discusses different aspects of this relationship: first, by analyzing how inflation affects financial development and informality; second, by exploring central bank interventions in the presence of noisy trading; and third, by examining how financial frictions and external debt influence export performance and capital formation. The first chapter studies the impact of high inflation on household savings, aggregate capital, and informality. Using a large panel of countries, I document that high inflation is correlated with greater informality and lower financial development, even after controlling for GDP per capita. Financial development is measured by banks' assets, total credit to the private sector, and the market capitalization of listed companies as a percentage of GDP. To investigate the underlying economic mechanism that may rationalize these observations, I extend the Aiyagari model to incorporate a second sector representing the informal economy, where households must hold cash to purchase goods. With higher inflation, households set aside more cash for transactions in informal markets to counterbalance the decline in the real return on money. This reduces their disposable income and decreases savings in interest-bearing assets, which tightens the financial sector and restricts credit flows to formal firms. It is well documented that these firms are comparatively more capital-intensive than informal firms and rely more heavily on external financing. Thus, the relative cost of producing formal goods will increase, and their relative price and informality will be higher. In the quantitative part of the article, I calibrate the model to match moments from a representative Latin American economy. The findings indicate that an increase in steady-state annual inflation from 10% to 90% is related to a decline in steady-state capital by 8% and a growth in informality as a percentage of GDP by 14%. An effective public policy should avoid using inflation as a means of taxing the informal sector, as this approach expands the sector's size, leading to a less efficient economy in goods production. In the second chapter, I focus on a central bank that seeks to profit from trading against irrational, noisy traders, but cannot directly observe their positions as they blend in with those of rational traders who are also going against the noise. The optimal strategy for the Central Bank is to trade against the remaining noise partially, but this results in an inefficiently small position size. With complete information, targeting the actual noise is optimal for higher expected profits. If the Central Bank had a prior on the net open position limit of rational traders, it would target more than the remaining observable noise. I demonstrate that the Central Bank can learn to distinguish between actual noise and rational traders by adjusting the prior for multiple periods, calculating the sample variance of the observable noise, and comparing it to the actual noise variance. Finally, if rational traders have better information than the Central Bank on the future real exchange rate, intervening in the market may result in negative expected profits, so total inaction may be recommendable. In the third chapter, I document that the increase in prices, rather than quantities, is driving the increase in the value of Argentina's goods exports in this century. I also show the country's poor performance in capital formation, the low value of its market capitalization, and the tendency of consumers to save and firms to borrow in foreign currency. These three forces could help explain why Argentina is not exporting more. To understand the mechanisms, I built a model in which financial constraints and external debt would keep the economy closer to the same economy without these constraints. Moreover, this constrained economy allows multiple equilibria, which could open the door to optimal policy intervention. The critical channel driving the results is the low capital creation arising from high real exchange rates and the balance-sheet effect, affecting future consumers' wages through a decrease in the installed capital and its price, which forces the economy to appreciate in the future to compensate for that drop in income and keep the balance of payments in equilibrium. An economy ``trapped" in a bad pace will initially export more due to its high real exchange rate. However, it will eventually be forced out of the international market due to insufficient capital.