Information frictions in macro-finance

Abstract

I study how economic conditions and strategic incentives affect belief formation of rational agents with a limited information processing capacity. I study the impact of cognitive and information frictions on individual risk taking, investment and portfolio choice, and their implications on aggregate macroeconomic fluctuations. In my first chapter "Rational Overoptimism and Moral hazard in Credit Booms" I develop a framework in which over optimism in credit booms originates from rational decisions of managers. Because of moral hazard, managers pay too little attention to the aggregate conditions that generate risk, leading them to over borrow and over invest during booms. Periods of low risk premia predict higher default rates, higher probability of crises and systematic negative banks excess returns, in line with existing evidence. I document a negative relation between the convexity of CEO's compensation and their information on a larger sample of firms, which is consistent with my theory. My model implies that compensation regulation can play an important role in macro prudential policy. In my second chapter "Biased Surveys" Rosen Valchev and I improve on the standard tests for the FIRE hypothesis by allowing for both public and private information, and find new interesting results. First, we propose a new empirical strategy that can accommodate this richer information structure, and find that the true degree of information rigidity is about a third higher than previously estimated. Second, we find that individual forecasts over-react to private information but under-react to public information. We show that this is consistent with a theory of strategic diversification incentives in forecast reporting, where forecasters are rational but report a biased measure of their true expectations. This has two effects. First, it generates what looks like behavioral “over-reaction” in expectations, and second biases the information rigidity estimate further downward. Overall, our results caution against the use of survey of forecasts as a direct measure of expectations, and suggest that the true underlying beliefs are rational, but suffer from a much larger degree of imperfect information than previously thought. This has particularly profound implications for monetary policy, where inflation expectations play a key role. I explore further how economic incentives shape beliefs in my third chapter "International Trade and Portfolio Diversification". I show that information choice can explain the puzzling positive relation between bilateral investment and trade across countries. I present a model of endogenous information with both investment in assets and income from trade. While standard model of risk-hedging would require agents to invest in non-trading countries to diversify income risk, I show that limited information capacity and preferences for early resolution of uncertainty reverse this result. The intuition is that investors collect more information on trading partners to reduce income uncertainty, and therefore perceive their equity as less risky. I find that allowing for information choice reduces the role of risk hedging on portfolio decisions. I test my model’s implied relation between trade and attention in the data and find robust empirical support.