Thomas Mertens
Vice President
Financial Research
Finance, Macroeconomics, and International finance
CV (pdf, 95.56 kb)
Profiles: Google Scholar | RePEc | SSRN | Personal website
Working Papers
Volatile Stock Markets: Equilibrium Computation and Policy Analysis
Unpublished manuscript | with Schneemeier | November 2011
Macroeconomic Drivers and the Pricing of Uncertainty, Inflation, and Bonds
2022-06 | with Bok and Williams | May 2022
abstract (+)This paper analyzes a new stylized fact: According to financial market prices, the correlation between uncertainty shocks, as measured by changes in the VIX, and changes in break-even inflation rates has declined and turned negative over the past quarter century. It rationalizes this uncertainty-inflation correlation within a standard New Keynesian model with a lower bound on interest rates combined with a decline in the natural rate of interest. With a lower natural rate, the likelihood of the lower bound binding increased and the effects of uncertainty on the economy became more pronounced. In such an environment, increases in uncertainty raise the possibility that the central bank will be unable to eliminate inflation shortfalls following negative demand shocks. As a result, the observed decline in the correlation between uncertainty and inflation expectations emerges. Average-inflation targeting policies can mitigate the longer-run effects of increases in uncertainty on the real economy.
A Risk-Based Theory of Exchange Rate Stabilization
2016-15 | with Hassan and Zhang | May 2020
abstract (+)We develop a novel, risk-based theory of the effects of exchange rate stabilization. In our model, the choice of exchange rate regime allows policymakers to make their currency, and by extension, the firms in their country, a safer investment for international investors. Policies that induce a country’s currency to appreciate when the marginal utility of international investors is high lower the required rate of return on the country’s currency and increase the world-market value of domestic firms. Applying this logic to exchange rate stabilizations, we find a small economy stabilizing its bilateral exchange rate relative to a larger economy can increase domestic capital accumulation, domestic wages, and even its share in world wealth. In the absence of policy coordination, small countries optimally choose to stabilize their exchange rates relative to the currency of the largest economy in the world, which endogenously emerges as the world’s “anchor currency.” Larger economies instead optimally choose to oat their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.
Published Articles (Refereed Journals and Volumes)
What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices
American Economic Review 111(8), August 2021, 2473-2505
abstract (+)This paper analyzes the effects of the lower bound for interest rates on the distributions of inflation and interest rates. In a New Keynesian model with a lower bound, two equilibria emerge: policy is mostly unconstrained in the “target equilibrium,” whereas policy is mostly constrained in the “liquidity trap equilibrium.” Using options data on interest rates and inflation, we find forecast densities consistent with the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. The lower bound has a sizable effect on the distribution of interest rates, but its impact on inflation is relatively modest.
Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates
In Chapter 3 in Strategies for Monetary Policy, ed. by John Cochrane and John Taylor | Stanford, CA: Hoover Institution, 2020. 103-172 | with Williams
Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates
American Economic Review Papers and Proceedings 109, May 2019, 427-432 | with Williams
abstract (+)This paper applies a New Keynesian model to analyze monetary policy in the presence of a low natural rate of interest and a lower bound on interest rates. Under standard inflation-targeting, inflation expectations will be anchored at a level below the inflation target. Two 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. Second, price-level targeting that raises inflation expectations when inflation is low can both anchor expectations at target and further reduce the effects of the lower bound on the economy.
Solving an Incomplete Markets Model with a Large Cross-Section of Agents
Journal of Economic Dynamics and Control 91, June 2018, 349-368 | 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
Current Recession Risk According to the Yield Curve
Economic Letter 2022-11 | May 9, 2022 | with Bauer
Effects of Asset Valuations on U.S. Wealth Distribution
Economic Letter 2021-24 | August 30, 2021 | with Diwan and Duzhak
Average-Inflation Targeting and the Effective Lower Bound
Economic Letter 2020-22 | August 10, 2020 | with Diwan and Leduc
Market Assessment of COVID-19
Economic Letter 2020-14 | May 28, 2020 | with Kwan
Zero Lower Bound Risk according to Option Prices
Economic Letter 2019-24 | September 23, 2019 | with Bauer
Did the Yield Curve Flip? Will the Economy Dip?
SF Fed Blog | Feb 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