Can large trade shocks cause crises? The case of the Soviet-Finnish trade collapse
joint with Markus Haavio and Juha Kilponen

We study macroeconomic consequences of a major trade disruption using the example of the FinnishSoviet trade collapse in 1991. This is a rare case of a well-identified large trade shock in a developed economy. We find that the shock had a significant effect on Finnish output. While the direct trade channel effect was rather moderate, the shock led to significant tightening of financial conditions. It was therefore endogenously amplified due to the propagation through the domestic financial sector. Even so, the trade collapse was insufficient to generate an all-out economic crisis. It can account for only a part of the Finnish Great Depression (1990 - 1993). The crisis was triggered and prolonged by the meltdown of the overheated financial and banking sectors since 1989. We show that the financial system remaineda major independent source of shocks throughout the depression.
Latest version, June 2019

Media coverage: YLE TV1 (in Finnish)

Paradise lost? A brief history of DSGE macroeconomics

Since the Global Financial Crisis, academic economists and policymakers have had to deal with uncomfortable questions about the quality of their models and the state of macroeconomics as a profession. This note offers a summary of this discussion, focusing on the Dynamic Stochastic General Equilibrium (DSGE) framework and its underpinnings. This class of models reflects both theoretical advances and perennial modeling challenges. While DSGE modeling developed in times of scarce micro data and limited computational resources, it has much room for improvement given progress along these dimensions and advances in other branches of economics. Key tasks on the to-do-list for model improvement include the modeling on the financial sector, departures from the representative agent and rationality, as well as clarification of the empirical relevance of the Lucas critique. The framework is likely to remain a major research and policy tool, although its limitations call for greater robustness, validation and open recognition of uncertainty in drawing real-life quantitative conclusions.
Latest version, November 2018

Bond Finance, Bank Credit, and Aggregate Fluctuations in an Open Economy
joint with Roberto Chang and Andrés Fernández Martin
Journal of Monetary Economics, January 2017
Carnegie-Rochester-NYU Conference Series on Public Policy:
"Globalization in the Aftermath of the Crisis", April 8-9, 2016

Corporate sectors in emerging market economies have noticeably increased their reliance on foreign financing, presumably reflecting low global interest rates. The evidence also shows a rebalancing from bank loans towards bonds. To study these developments, we develop a dynamic open economy model where these modes of finance are determined endogenously. The model replicates the stylized facts following a drop in world interest rates; in particular, rebalancing towards bonds occurs because bank credit becomes relatively more expensive, reflecting the scarcity of bank equity. More generally, the model is suitable for studying the interactions between modes of finance and the macroeconomy.
Final version, November 2016
NBER Working Paper version, June 2016
Online Appendix

Interest Rates, Leverage, and Business Cycles in Emerging Economies:
The Role of Financial Frictions
joint with Andrés Fernández Martin
American Economic Journal: Macroeconomics, July 2015

Countercyclical country interest rates have been shown to be an important characteristic of business cycles in emerging markets. In this paper we provide a microfounded rationale for this pattern by linking interest rate spreads to the dynamics of corporate leverage. For this purpose we embed a financial accelerator into a business cycle model of a small open economy and estimate it on a novel panel dataset for emerging economies that merges macroeconomic and financial data. The model accounts well for the empirically observed countercyclicality of interest rates and leverage, as well as for other stylized facts.

Final version, March 2014
Additional materials
Old version, June 2012

Finanssisyklit taloustieteellisessä kirjallisuudessa. Kirjallisuuskatsaus
(Financial cycles. A literature review)
joint with Karlo Kauko

Vuosikymmenten tauon jälkeen rahoitusmarkkinat ovat jälleen makrotaloustieteen keskeinen tutkimuskohde. Finanssisyklit ovat uusi käsite, jonka merkitys on vakiintumassa. Nämä syklit vaikuttavat etenkin luottokantoihin ja kiinteistöjen hintoihin. Ne ovat pitkäaikaisempia kuin tuotantoon ja työllisyyteen vaikuttavat suhdannevaihtelut. Globaalit finanssisyklit ovat ehkä selvimmin havaittavissa osake- ja varsinkin osakejohdannaismarkkinoilla. Pääosa kirjallisuudesta on voimakkaan empiriapainotteista, ja sen tavoitteena on pikemminkin kuvailla finanssisyklejä kuin testata niiden olemassaoloa. Mitään yleisesti hyväksyttyä valtavirtateoriaa finanssisyklejä aiheuttavasta mekanismista ei ole, mutta syyksi on esitetty muun muassa endogeenista riskinottohalukkuuden vaihtelua ja pankkien strategisesti motivoitua toinen toistensa jäljittelyä. Suomessa finanssisyklin voimakkaimmat nousuvaihteet koettiin 1980- ja 1990-lukujen lopulla, lähimenneisyyden pahin suhdannekuoppa 1990-luvun alussa.

Open Economies, Interest Rates, and Revealed Preferences

We apply the weak axiom of revealed preferences (WARP) in the context of a two-period model of current account determination. According to this argument, certain changes in net exports and net foreign asset positions should be precluded. In particular, a country which initially ran a trade deficit (was a net debtor), should remain in deficit (remain a net debtor) after the exogenously given interest rate drops. Similarly, a country running a trade surplus (or is a net lender) should remain so if the interest rate goes up. The argument holds for both in endowment economy as well as in a model with production. Our methodology involves solving for the key problem, i.e. isolating the substitution effect from the income and wealth effects which are due to changes in GDP, investment and net factor income from abroad.

Coming soon!

Incomplete Markets, Optimal Portfolios, and International Consumption Correlations

In this paper, we revisit the consumption correlation as well as the Backus-Smith puzzles by inspecting the role of financial markets.
Relative to the existing literature, we introduce explicit international trade in stocks and bonds in an otherwise standard
model of international business cycles. The results show that markets with symmetric trade in stocks allow for a high degree of risk sharing and closely mimic the Arrow-Debreu economy despite being formally incomplete. Risk sharing decreases in asymmetric stock and nominal bond markets, but is still higher than in a single commodity bond economy. The results, therefore, cast doubt on the explanation of the two puzzles based on highly restricted asset trade and large degree of market incompleteness. We also provide empirical evidence that output net of investment and government spending tends to be less correlated across countries than consumption, much less than output itself. This constitutes a new form of the consumption correlation puzzle. The puzzle can be accounted for in the presence of high home bias and low elasticities of substitution between domestic and foreign baskets.