CAPM - Asset A has variance of 5, returns are uncorrelated with income. Asset B has a variance of .5, and positively correlated with income. According to CAPM, which asset would an investor prefer?

They use a set of real and financial variables for the manufacturing sector to analyse the response of small and large firms to monetary policy. They find that small firms contracts substantially relative to large firms after tightening money and they account for a significantly disproportionate share of the manufacturing decline. These results support the importance of imperfect financial markets as large firm's borrowing increases after monetary tightening, where the small firm's borrowing declines sharply. Due to the fact small firms are likely to face larger barriers to outside finance than larger firms do.

Financial Imperfection - Gentler & Gilchrist

The theory of financial market imperfections predicts that the association between cash flow and investment will be stronger for firms that face greater barriers to external finance. Unless the association between current cash flow and future profitability is stronger for forms with less access to external finance. The difference in the cash flow - investment relationship between the two groups can be used to test the importance of financial market imperfections to investment.

Financial Market Imperfection Theory

Using panel data on individual manufacturing firms, we compare the investment behavior of rapidly growing firms that exhaust all of their internal finance with that of mature firms paying dividends. We find that q values remain very high for significant periods of time for firms paying no dividends, relative to those for mature firms. We also find that investment is more sensitive to cash flow for the group of firms that our model implies is most likely to face external finance constraints Supports Financial Market Imperfection Theory.

Financial Imperfection - Fazzari, Hubbard, and Peterson

The model states that economic output is a function of money or price "surprise". The model accounts for the empirically based trade off between output and prices represented by the Phillips curve, but the function breaks from the Phillips curve since only unanticipated price level changes lead to changes in output. The model accounts for empirically observed short-run correlations between output and prices, but maintains the neutrality of money (the absence of a price or money supply relationship with output and employment) in the long-run. The policy ineffectiveness proposition extends the model by arguing that, since people with rational expectations cannot be systematically surprised by monetary policy, monetary policy cannot be used to systematically influence the economy.

Lucas Model

Refers to the inability of an important class of economic models to explain the average premium of the returns on a well-diversified U.S. equity portfolio over U.S. Treasury Bills observed for more than 100 years. the investor returns on equities have been on average so much higher than returns on U.S. Treasury Bonds, that it is hard to explain why investors buy bonds, even after allowing for a reasonable amount of risk aversion. The intuitive notion that stocks are much riskier than bonds is not a sufficient explanation of the observation that the magnitude of the disparity between the two returns, the equity risk premium (ERP), is so great that it implies an implausibly high level of investor risk aversion that is fundamentally incompatible with other branches of economics, particularly macroeconomics and financial economics.

Equity-Premium Puzzle

An economic hypothesis holding that consumers are forward looking and so internalize the government's budget constraint when making their consumption decisions. This leads to the result that, for a given pattern of government spending, the method of financing that spending does not affect agents' consumption decisions, and thus, it does not change aggregate demand. Suppose that the government finances some extra spending through deficits; i.e. it chooses to tax later. According to the hypothesis, taxpayers will anticipate that they will have to pay higher taxes in future. As a result, they will save, rather than spend, the extra disposable income from the initial tax cut, leaving demand and output unchanged.

Barro ricardian equivalence

Hall's extension of PIH, in contrast, predicts that when output declines uneexpectedly, consumption declines only by the amount of the fall in permanent income; as a result, it is not expected to recover. RWH implies that change in consumption is unpredictable. Could not reject hypothesis that either lagged values of income or consumption could not predict the change in consumption.

Random Walk Hypothesis (Hall)

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