Thomas Mertens, Senior Research Advisor, Federal Reserve Bank of San Francisco

Thomas Mertens

Senior Research Advisor

Financial Research

Finance, Macroeconomics, Computational methods

thomas.mertens (at)

CV (pdf, 95.56 kb)

Working Papers
Hide this section
Volatile Stock Markets: Equilibrium Computation and Policy Analysis

Unpublished manuscript | With Schneemeier | November 2011

Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates

2019-01 | With Williams | January 2019

abstract (+)
This paper applies a standard New Keynesian model to analyze the effects of monetary policy in the presence of a low natural rate of interest and a lower bound on interest rates. Under a standard inflation-targeting approach, inflation expectations will be anchored at a level below the inflation target, which in turn exacerbates the deleterious effects of the lower bound on the economy. Two key themes emerge from our analysis. First, the central bank can mitigate this problem of a downward bias in inflation expectations by following an average-inflation targeting framework that aims for above-target inflation during periods when policy is unconstrained. Second, a dynamic strategy such as price-level targeting that raises inflation expectations when inflation is low can both anchor expectations at the target level and potentially further reduce the effects of the lower bound on the economy.
What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices

2018-03 | With Williams | August 2018

abstract (+)
This paper analyzes the effects of the lower bound for interest rates on the distributions of expectations for future inflation and interest rates. We use a stylized model economy where the policy instrument is subject to a lower bound to motivate the empirical analysis. Two equilibria emerge: In the “target equilibrium,” policy is unconstrained most or all of the time, whereas in the “liquidity trap equilibrium,” policy is mostly or always constrained. We use options data on future interest rates and inflation to study whether the decrease in the natural rate of interest leads to forecast densities consistent with the theoretical model. We develop a lower bound indicator that captures the effects of the lower bound on the distribution of interest rates. Qualitatively, we find that evidence is largely consistent with the theoretical predictions in the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. Quantitatively, while the lower bound has a sizable effect on the distribution of future interest rates, its impact on forecast densities for inflation is relatively modest.
Currency Manipulation

2016-15 | With Hassan and Zhang | December 2016

abstract (+)
We propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country’s currency to appreciate in bad times lower its risk premium in international markets and, as a result, lower the country’s risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country (“currency stabilization”), we find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country.
Published Articles (Refereed Journals and Volumes)
Hide this section
Solving an Incomplete Markets Model with a Large Cross-Section of Agents

Forthcoming in Journal of Economic Dynamics and Control | With Judd

abstract (+)
This paper shows that perturbation methods can be applied to a DSGE model with incomplete markets and a finite but arbitrarily large number of heterogeneous agents. We develop a simple but general solution technique that handles many state and choice variables for each agent and thus has an extremely high-dimensional state space. The method is based on perturbations around a point at which the solution is known. The novel idea is to exploit the symmetry of the problem to overcome the curse of dimensionality. We use the analysis to demonstrate the impact of heterogeneity on macroeconomic quantities and the pricing of risk. Furthermore, we set our technique apart from standard methods used in the literature.
The Social Cost of Near-Rational Investment

American Economic Review 107(4), April 2017, 1059-1103 | With Hassan

abstract (+)
We show that the stock market may fail to aggregate information even if it appears to be efficient, and that the resulting decrease in the information content of prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors when forming expectations about future productivity. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When prices reflect less information, the conditional variance of stock returns rises, causing an increase in uncertainty and costly distortions in consumption, capital accumulation, and labor supply.
Not So Disconnected: Exchange Rates and the Capital Stock

Journal of International Economics, July 2016 | With Hassan and Zhang

abstract (+)
We investigate the link between stochastic properties of exchange rates and differences in capital-output ratios across industrialized countries. To this end, we endogenize capital accumulation within a standard model of exchange rate determination with nontraded goods. The model predicts that currencies of countries that are more “systemic” for the world economy (countries that face particularly volatile shocks or account for a large share of world GDP) appreciate when the price of traded goods in world markets is high. These currencies are better hedges against consumption risk faced by international investors because they appreciate in “bad” states of the world. As a consequence, more systemic countries face a lower cost of capital and accumulate more capital per worker. We estimate our model using data from seven industrialized countries with freely floating exchange rate regimes between 1984 and 2010 and show that cross-country variation in the stochastic properties of exchange rates accounts for 72% of the cross-country variation in capital-output ratios. In this sense, the stochastic properties of exchange rates map to fundamentals in the way predicted by the model.
Information Aggregation in a Dynamic Stochastic General Equilibrium Model

In NBER Macroeconomics Annual 2014, 29, ed. by Parker and Woodford | National Bureau of Economic Research, 2015. 159-207 | With Hassan

abstract (+)
We introduce the information microstructure of a canonical noisy rational expectations model (Hellwig, 1980) into the framework of a conventional real business cycle model. Each household receives a private signal about future productivity. In equilibrium, the stock price serves to aggregate and transmit this information. We find that dispersed information about future productivity affects the quantitative properties of our real business cycle model in three dimensions. First, households’ ability to learn about the future affects their consumption-savings decision. The equity premium falls and the risk-free interest rate rises when the stock price perfectly reveals innovations to future productivity. Second, when noise trader demand shocks limit the stock market’s capacity to aggregate information, households hold heterogeneous expectations in equilibrium. However, for a reasonable size of noise trader demand shocks the model cannot generate the kind of disagreement observed in the data. Third, even moderate heterogeneity in the equilibrium expectations held by households has a sizable effect on the level of all economic aggregates and on the correlations and standard deviations produced by the model. For example, the correlation between consumption and investment growth is 0.29 when households have no information about the future, but 0.41 when information is dispersed.
Fraud Deterrence in Dynamic Mirrleesian Economies

Journal of Monetary Economics 60(2), March 2013, 139-151 | With Armenter

abstract (+)
Insurance schemes rely on legal consequences to deter fraud and tax evasion. This observation guides us to introduce random state verification in a dynamic economy with private information. With some probability, an agent’s skill becomes known to the planner who prescribes punishments to misreporting agents. Deferring consumption can ease the provision of incentives creating a motive for subsidizing savings. In an infinite horizon economy, the constrained-efficient allocation converges to high consumption, full insurance, and no labor distortions for any positive probability of state verification.
Market Sentiment: A Tragedy of the Commons

American Economic Review Papers and Proceedings 101(3), May 2011, 402-405 | With Hassan

abstract (+)
We present a model in which investors decide whether or to what degree they want to allow their behavior to be influenced by “market sentiment.” Investors who choose to insulate their decisions from market sentiment earn higher expected returns, but incur a small mental cost. We show that if information is moderately dispersed across investors, even a very small mental cost may result in a significant amount of sentiment in equilibrium: Individuals who choose to be swayed by sentiment increase uncertainty about the future and make it less costly for others to be swayed by sentiment as well.
Consumer Finance Protection

In Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, ed. by Acharya, Cooley, Richardson, and Walter | Hoboken, NJ: NYU Stern School of Business and John Wiley & Sons, 2011. 73-84 | With others

Central Bank Independence and the Role of the Fed

In Real-Time Solutions for Financial Reform, ed. by Acharya, Cooley, Richardson, and Walter | New York: NYU Stern Working Group on Financial Reform, 2009 | With others

Consumer Finance Protection Agency: Is There a Need?

In Real-Time Solutions for Financial Reform, ed. by Acharya, Cooley, Richardson, and Walter | New York: NYU Stern Working Group on Financial Reform, 2009 | With others

FRBSF Publications
Hide this section
Did the Yield Curve Flip? Will the Economy Dip?

SF Fed Blog | 2019 | With Bauer

Information in the Yield Curve about Future Recessions

Economic Letter 2018-20 | August 27, 2018 | With Bauer

Economic Forecasts with the Yield Curve

Economic Letter 2018-07 | March 5, 2018 | With Bauer

Valuation Ratios for Households and Businesses

Economic Letter 2018-01 | January 8, 2018 | With Shultz and Tubbs

China’s Exchange Rate Policies and U.S. Financial Markets

Economic Letter 2017-28 | October 2, 2017 | With Shultz

Has the Dollar Become More Sensitive to Interest Rates?

Economic Letter 2017-18 | June 26, 2017 | With Fernald and Shultz