Financial Market Frictions, Beliefs, and the Macroeconomy; An Application to the Case of China
Lead Research Organisation:
UNIVERSITY COLLEGE LONDON
Department Name: Economics
Abstract
Project 1: "Limited Commitment and the Effects of Monetary Policy"
In this project, we will study how financial frictions affected by beliefs of market participants, and the implication for monetary policy (such as a change in interest rates on productivity and growth). The expansionary monetary policy (higher money supply growth or easier lending conditions) in China after 2011 did not have the same expansionary effects on inflation and output as in the previous years. We will study how the presence of a particular type of frictions, limited commitment, significantly affects the impact of monetary policy and can explain the different effects observed in recent years. This study could shed light on the conduct of monetary policy, which will depend on the beliefs in the credit market and the firm size-productivity distribution.
Project 2: "Search-and-matching for Liquidity in Financial Markets and Government Policies"
According to World Bank data, between 2000 and 2013 in China, the quantity of money (M2) grew at a yearly rate of 16.2%: in the same period, the average yearly inflation rate was 2.4%, and the average yearly real GDP growth rate 8.7%. This means that, even after taking into account the high real GDP growth, the inflation rate in China has been systematically lower than what one would expect on the basis of the money supply growth rate.
Chinese financial markets are still not fully developed, and many privately issued assets are not very liquid. As a result, besides the transaction motive, economic agents' hold money also because of liquidity needs. The purpose of this project is to study how the higher liquidity needs (due to the low liquidity of the financial markets) affect the relations between monetary policy, inflation and economic growth, when beliefs about liquidity affect market participations. We will apply the study to understand the Chinese practice mentioned in the beginning, and discuss whether it is sustainable.
We will study these issues by introducing asset liquidity frictions in an otherwise standard macroeconomic framework. In contrast to exogenous asset liquidity, expressed by a fixed fraction of assets sellable in a given period, endogenous asset liquidity is micro-founded and suitable for policy analysis.
Project 3: "Long Run Herd Behaviour and Volatility Clustering in Financial Markets"
In the third project, we turn to another form of financial frictions, asymmetric information.
Financial markets are crucial for good investment decisions. The ability of prices to aggregate dispersed information is fundamental for an efficient allocation of resources. We will study the informational efficiency of the Chinese financial markets through the use of novel financial markets models, with a specific focus on learning and herding. We will also study why asset prices exhibit time-varying volatility and the extent to which this is related to herd behaviour. We will then estimate the models using transactions data for the Chinese stock exchanges obtained from Wind Info. The structural estimation will allow us to quantify the drivers of herding and asset prices' time-varying volatility and their effect on market efficiency.
In this project, we will study how financial frictions affected by beliefs of market participants, and the implication for monetary policy (such as a change in interest rates on productivity and growth). The expansionary monetary policy (higher money supply growth or easier lending conditions) in China after 2011 did not have the same expansionary effects on inflation and output as in the previous years. We will study how the presence of a particular type of frictions, limited commitment, significantly affects the impact of monetary policy and can explain the different effects observed in recent years. This study could shed light on the conduct of monetary policy, which will depend on the beliefs in the credit market and the firm size-productivity distribution.
Project 2: "Search-and-matching for Liquidity in Financial Markets and Government Policies"
According to World Bank data, between 2000 and 2013 in China, the quantity of money (M2) grew at a yearly rate of 16.2%: in the same period, the average yearly inflation rate was 2.4%, and the average yearly real GDP growth rate 8.7%. This means that, even after taking into account the high real GDP growth, the inflation rate in China has been systematically lower than what one would expect on the basis of the money supply growth rate.
Chinese financial markets are still not fully developed, and many privately issued assets are not very liquid. As a result, besides the transaction motive, economic agents' hold money also because of liquidity needs. The purpose of this project is to study how the higher liquidity needs (due to the low liquidity of the financial markets) affect the relations between monetary policy, inflation and economic growth, when beliefs about liquidity affect market participations. We will apply the study to understand the Chinese practice mentioned in the beginning, and discuss whether it is sustainable.
We will study these issues by introducing asset liquidity frictions in an otherwise standard macroeconomic framework. In contrast to exogenous asset liquidity, expressed by a fixed fraction of assets sellable in a given period, endogenous asset liquidity is micro-founded and suitable for policy analysis.
Project 3: "Long Run Herd Behaviour and Volatility Clustering in Financial Markets"
In the third project, we turn to another form of financial frictions, asymmetric information.
Financial markets are crucial for good investment decisions. The ability of prices to aggregate dispersed information is fundamental for an efficient allocation of resources. We will study the informational efficiency of the Chinese financial markets through the use of novel financial markets models, with a specific focus on learning and herding. We will also study why asset prices exhibit time-varying volatility and the extent to which this is related to herd behaviour. We will then estimate the models using transactions data for the Chinese stock exchanges obtained from Wind Info. The structural estimation will allow us to quantify the drivers of herding and asset prices' time-varying volatility and their effect on market efficiency.
Planned Impact
Our research will be of interest to academics, policy makers, and financial markets professionals.
To reach the academic community, we will present our projects at various stages of development in seminars, workshops and conferences. We will aim to publish our work in the very top scientific journals both in economics and in finance, so researchers who are interested in our work can further build upon the published work.
To reach policy makers, we will also try to publish preliminary versions of our work in working paper series such as the IMF Working Papers, the FED Staff Reports and the ECB Working Papers. In fact, we have already regularly done so in the past, see, e.g., Cui W. and Soeren Radde, 2016, "Search-based Endogenous Asset Liquidity and the Macroeconomy," ECB WP1917; Cipriani M. and Guarino A., 2012 , "Estimating a structural model of herd behavior in financial markets," Staff Reports 561, Federal Reserve Bank of New York. An important task of the overall project is to show how policy should react when financial markets can be shaped by variations in beliefs.
We plan to organize at least two two-day conferences for academics and policy makers on the theme of financial markets and growth in China: one in London and one in Shanghai (for example, Shanghai Jiaotong University, where the principle investigator has already established long-term relationship). The conference will bring together scholars and policy makers from the UK and China to share knowledge and facilitate communication. We plan to invite industry experts in Chinese financial markets. Such events can increase the industry impact of our research, and, on the other hand, result in useful feedback on our work from practitioners.
Professionals in the private sector will be interested in using our techniques in their work. They could benefit from understanding the linkage between the Chinese macroeconomy and its financial markets in a structural way. We will make our computer codes publicly available and will aim to make our methods widely known by participating in events with a broader audience than just academics and policy makers. In the past, the co-investigator has written for magazines for financial professionals, such as Collier Capital Magazine. The principle-investigator will work with the co-investigator on generating reports on Chinese financial markets to the general publics in the UK and China.
We would also like to mention that UCL has a consolidated record in engaging with users. For instance, the seminar and teaching activities of CEMMAP (UCL based centre funded by the ESRC) typically reach a variety of users. In addition, from October 2017 we will establish a new Centre for Finance (CfF) within the Department of Economics (Antonio Guarino will be the director and Wei Cui a research fellow); we will also use the activities of the CfF to reach a variety of users.
Finally, we would like to make our research visible to an even larger audience by creating a blog on "China: Financial Markets and the Macroeconomy", which could potentially benefit their investment decisions and understanding of government policies in China. We will solicit experts interested in the Chinese economy, and, more in general, in developing economies, to contribute to the blog. We will also use other blogs, such as the Federal Reserve Bank of New York Blog ("Libertystreet Economics"), the LSE blog ("Usappblog") and the IFS bog ("Microeconomic Initiatives"), where we have already been invited to present our work.
To reach the academic community, we will present our projects at various stages of development in seminars, workshops and conferences. We will aim to publish our work in the very top scientific journals both in economics and in finance, so researchers who are interested in our work can further build upon the published work.
To reach policy makers, we will also try to publish preliminary versions of our work in working paper series such as the IMF Working Papers, the FED Staff Reports and the ECB Working Papers. In fact, we have already regularly done so in the past, see, e.g., Cui W. and Soeren Radde, 2016, "Search-based Endogenous Asset Liquidity and the Macroeconomy," ECB WP1917; Cipriani M. and Guarino A., 2012 , "Estimating a structural model of herd behavior in financial markets," Staff Reports 561, Federal Reserve Bank of New York. An important task of the overall project is to show how policy should react when financial markets can be shaped by variations in beliefs.
We plan to organize at least two two-day conferences for academics and policy makers on the theme of financial markets and growth in China: one in London and one in Shanghai (for example, Shanghai Jiaotong University, where the principle investigator has already established long-term relationship). The conference will bring together scholars and policy makers from the UK and China to share knowledge and facilitate communication. We plan to invite industry experts in Chinese financial markets. Such events can increase the industry impact of our research, and, on the other hand, result in useful feedback on our work from practitioners.
Professionals in the private sector will be interested in using our techniques in their work. They could benefit from understanding the linkage between the Chinese macroeconomy and its financial markets in a structural way. We will make our computer codes publicly available and will aim to make our methods widely known by participating in events with a broader audience than just academics and policy makers. In the past, the co-investigator has written for magazines for financial professionals, such as Collier Capital Magazine. The principle-investigator will work with the co-investigator on generating reports on Chinese financial markets to the general publics in the UK and China.
We would also like to mention that UCL has a consolidated record in engaging with users. For instance, the seminar and teaching activities of CEMMAP (UCL based centre funded by the ESRC) typically reach a variety of users. In addition, from October 2017 we will establish a new Centre for Finance (CfF) within the Department of Economics (Antonio Guarino will be the director and Wei Cui a research fellow); we will also use the activities of the CfF to reach a variety of users.
Finally, we would like to make our research visible to an even larger audience by creating a blog on "China: Financial Markets and the Macroeconomy", which could potentially benefit their investment decisions and understanding of government policies in China. We will solicit experts interested in the Chinese economy, and, more in general, in developing economies, to contribute to the blog. We will also use other blogs, such as the Federal Reserve Bank of New York Blog ("Libertystreet Economics"), the LSE blog ("Usappblog") and the IFS bog ("Microeconomic Initiatives"), where we have already been invited to present our work.
Organisations
- UNIVERSITY COLLEGE LONDON (Lead Research Organisation)
- Bank of Canada (Collaboration)
- London School of Economics and Political Science (University of London) (Collaboration)
- University of Wisconsin-Madison (Collaboration)
- Shandong University (Collaboration)
- Shanghai Jiao Tong University (Collaboration)
- University of Hong Kong (Collaboration)
People |
ORCID iD |
| Wei Cui (Principal Investigator) | |
| Antonio Guarino (Co-Investigator) |
Publications
Cui W
(2021)
Endogenous Liquidity and Capital Reallocation
in SSRN Electronic Journal
Cui W
(2022)
Endogenous Liquidity and Capital Reallocation
Cui W
(2024)
Risk-taking with Financing Constraints
in SSRN E Journal
Cui W
(2025)
Endogenous Liquidity and Capital Reallocation
in Journal of Political Economy
Cui W.
(2025)
Risk-taking, Leverage and Sentiment
| Description | -- Research Summary -- Despite the significant disruptions caused by the pandemic and childcare duties, we completed three research papers as planned. One of these papers has been published in a top-five general-interest economic journal, another is currently under review at a similar journal, and the third is in the submission process. Our research has also fostered new collaborations and expanded research networks across the United States, Canada, and China. Below, we summarize our key findings and outline directions for future exploration. -- The Role of Leverage and Interest Rate Policies in Risk-Taking -- Our first study examines how leverage and interest rate policies influence firms' risk-taking behavior. We identify a nuanced relationship where firms' liquidity constraints-stemming from limited commitment to project implementation-affect their risk appetite. The impact of interest rate cuts on risk-taking is not uniform. When firms face low debt-servicing costs, lower interest rates discourage risk-taking as firms prefer safer investments to preserve wealth. Conversely, when debt-servicing costs are high, lower interest rates encourage risk-taking as firms seek higher returns. This results in a non-monotonic, hump-shaped relationship between interest rates and both firm return volatility and aggregate productivity. Our calibrated model suggests that an optimal interest rate exists, shaped by credit constraints and return correlations. Additionally, financial regulations targeting asset pledgeability and the interconnectedness of firms' risky projects can significantly influence the effectiveness of interest rate policies. This paper is currently under review at a top-five general-interest economic journal. -- Liquidity in Financial Markets and Capital Reallocation -- Our second study explores liquidity in financial markets and its effects on reallocating productive capital. We uncover long-term and cyclical patterns in capital reallocation, finding that full capital sales increase during economic expansions while partial sales decline. To analyze these dynamics, we developed a novel model where firms initially acquire capital in centralized primary markets before trading in decentralized secondary markets as new information-such as idiosyncratic productivity shocks-emerges. Our findings reveal that higher trend inflation and inflation expectations raise liquidity costs, reducing full sales and increasing partial sales. Additionally, credit shocks influence the balance between full and partial sales, generating capital reallocation and inflation dynamics that align with real-world business cycles. Our research highlights the crucial role of monetary policy in managing the balance between primary and secondary markets. Inflationary policies can either stimulate or contract investment, employment, and output depending on market expectations and bargaining power. This paper has been published in the Journal of Political Economy, one of the top-five general-interest economic journals. -- Sentiment-Driven Risk-Taking in Chinese Financial Markets -- In our third study, we analyze sentiment data from major Chinese stock market forums and other Chinese financial data. We find that higher market sentiment leads to increased risk-taking and a preference for equity financing over-borrowing. Our quantitative model suggests that elevated sentiment and optimistic beliefs drive firms to take on more risk while reducing aggregate savings, mirroring herding behavior that may not be socially optimal. Additionally, the model raises questions about policymakers' ability to intervene in sentiment-driven fluctuations, warranting further research. Future studies will explore how firms' expectations influence risk-taking behavior. This paper is expected to be completed and submitted to a top-five general-interest economic journal later this year. -- Personal Development -- Through this research, I have developed new technical skills in handling medium- and large-scale macroeconomic models with numerical integrations. Additionally, I have gained deeper insights into Chinese financial market sentiments, stock market performance, and firm-level data in the United States. Firstly, our investigation delves into the influence of leverage and interest rate policies on risk-taking behaviours. We discovered a nuanced relationship between liquidity constraints stemming from limited firm commitment to project implementation and their propensity for risk-taking. The impact of interest rate cuts on risk-taking varies depending on firms' debt-servicing costs. Lower interest rates discourage risk-taking when debt-servicing costs are low, as firms prioritize safer investments to secure wealth. However, when debt-servicing costs are high, lower interest rates amplify the inclination towards risk-taking to achieve higher average returns on wealth. This results in a non-monotonic, hump-shaped relationship between interest rates and firm-return volatility on an aggregate level. Our calibrated model suggests that the optimal real interest rate should consider return spillover measures, advocating for low interest rates to enhance allocation efficiency. Additionally, the model indicates an optimal policy mix of interest rates and leverage concerning risk spillover, which outperforms individual interest rate or leverage policies. This prompts further inquiries into the impact of policy mixes on industries or sectors with intricate interlinkages. Secondly, we explored liquidity in financial markets and its effect on reallocating productive capital. Our research uncovered long-run and cyclical patterns in capital reallocation, with full capital sales increasing during economic expansions and decreasing during partial sales. We constructed a novel model economy where firms initially acquire capital in centralized primary markets before trading it in decentralized secondary markets following new information, such as idiosyncratic productivity shocks. The model revealed that higher trend inflation and inflation expectation raises liquidity costs, reducing full sales and increasing partial sales. Credit shocks further influence the mix between full and partial sales, generating reallocation and inflation dynamics mirroring real-world business cycles. Our findings underscore the critical role of monetary policy in balancing the dynamics between primary and secondary markets, where inflationary policies can either stimulate or contract investment, employment, and output based on market expectations and bargaining power. Thirdly, we utilized sentiment data from leading Chinese stock market forums alongside other Chinese financial data, and we show that higher sentiments lead to more risk-taking behaviour and outside financing through the stock market (instead of borrowing). Our quantitative model indicates that higher sentiments and positive beliefs lead to increased risk-taking and reduced firms' savings in the aggregate, resembling herding behaviour, which may not be socially optimal. The model suggests uncertainty regarding policymakers' intervention in sentiment levels, which warrants further exploration. Additionally, we aim to analyse firms' expectation-driven risk-taking behaviour in future research endeavours. As a final remark, I have personally developed new research skills in handling medium- and large-scale macro models with numerical integrations. Furthermore, I have gained a deeper understanding of Chinese financial market sentiments, stock market performance, and micro-level firm data in the United States. |
| Exploitation Route | 1. Academic Contribution: Our research expands the traditional analysis of financial frictions, investment, beliefs, and productivity by examining how external financial conditions influence risk-taking and capital reallocation. In particular, we emphasize the crucial role of debt servicing costs in shaping firms' risk-taking decisions. This perspective allows researchers to more directly connect financial conditions to innovation and economic growth while assessing the impact of government policies. Additionally, our models are highly tractable, even with endogenous belief variations, making them easily adaptable for future studies that incorporate additional economic factors. 2. Policy and Practical Implications: Our findings-such as the non-monotonic relationship between leverage, interest rates, risk-taking, and productivity-offer valuable insights for ongoing policy discussions, particularly regarding the UK's recent slowdown in productivity growth. Other key takeaways, including the effects of interest rates on productivity distribution and the policy response to shifting market beliefs, provide fresh perspectives on monetary and financial regulation debates. Furthermore, our approach to integrating sentiment data into a macroeconomic model may be particularly useful for policymakers and financial analysts seeking to better understand and predict market movements. |
| Sectors | Education Financial Services and Management Consultancy Government Democracy and Justice Other |
| URL | https://www.youtube.com/watch?v=6d4JicdAqXQ |
| Description | One research paper has been included in the Bank of Canada working paper series. Please check the following website maintained by the government of Canada. https://publications.gc.ca/collections/collection_2022/banque-bank-canada/FB3-5-2022-27-eng.pdf This paper has been presented in various non-academic institutions, including regional Federal Reserve banks in the US. Recently, it was accepted for publication in a top-five general-interest economic journal (Journal of Political Economy). Another research paper (the effect of liquidity on risk-taking) has been presented at numerous academic and policy institutions, as well as various conferences, one of which was attended by staff members from many European national central banks and the ECB. This paper has stimulated discussion about the role of low interest rates in encouraging or discouraging risk-taking/innovation. |
| First Year Of Impact | 2022 |
| Sector | Education,Government, Democracy and Justice |
| Impact Types | Policy & public services |
| Title | Replication Data for: "Endogenous Liquidity and Capital Reallocation" |
| Description | This is the replication package for "Endogenous Liquidity and Capital Reallocation," accepted in 2024 by the Journal of Political Economy. |
| Type Of Material | Database/Collection of data |
| Year Produced | 2024 |
| Provided To Others? | Yes |
| Impact | As of 13 Mar, 2025, the open-source research dataset, database, and model have been downloaded 8,561 times, compared to 1,388 times of another (more theoretical) paper I published in the Journal of Political Economy in 2024. |
| URL | https://dataverse.harvard.edu/citation?persistentId=doi:10.7910/DVN/EKVBZG |
| Description | Collaboration on research on limited commitment, risk-taking, and monetary policy |
| Organisation | Shandong University |
| Country | China |
| Sector | Academic/University |
| PI Contribution | We provide our expertise and intellectual input in building the model of one paper. |
| Collaborator Contribution | Renbin Zhang from Shandong University provides intellectual input and designs numerical methods. |
| Impact | We have two finished papers focusing on financial frictions (based on limited commitment) and risk-taking behaviours. We show how monetary policy may have a non-monotone effect on firm risk-taking and productivity growth. The second paper incorporates survey data about Chinese financial markets. These data contain useful information about investors' beliefs. |
| Start Year | 2020 |
| Description | Collaboration on research on search-and-matching in capital markets, liquidity, and monetary policy |
| Organisation | Bank of Canada |
| Department | Funds Management Department |
| Country | Canada |
| Sector | Public |
| PI Contribution | We provide our expertise and intellectual input in building the model and designing numerical methods for one paper. |
| Collaborator Contribution | Yu Zhu from the Bank of Canada provideed intellectual input, analyzes the data, and designs numerical methods. He is now a professor at Renmin University of China. |
| Impact | We have one finished paper focusing on search-and-matching and liquidity in the secondary capital markets. We show how inflation is linked with new investment and secondary capital spending. The research paper has been accepted by the Journal of Political Economy, one of the top 5 general-interest journals in economics. We plan to have follow-up papers on this topic. |
| Start Year | 2019 |
| Description | Collaboration on research on search-and-matching in capital markets, liquidity, and monetary policy |
| Organisation | University of Wisconsin-Madison |
| Country | United States |
| Sector | Academic/University |
| PI Contribution | We provide our expertise and intellectual input in building the model and designing numerical methods for one research paper. |
| Collaborator Contribution | Prof Randall Wright from the University of Wisconsin Madison provided intellectual input in building the model and very generous input in delivering the research paper. He also presented the paper at many conferences and workshops. Please check the YouTube video link I put in the "key finding" section. |
| Impact | We have one finished paper focusing on search-and-matching and liquidity in the secondary capital markets. We show how inflation is linked with new investment and secondary capital spending. The research paper has been accepted by the Journal of Political Economy, one of the top 5 general-interest journals in economics. We plan to have follow-up papers on this topic. |
| Start Year | 2020 |
| Description | HKU-UCL-ESRC Summer Workshop: Recent Research on Expectations in Macroeconomics and Finance |
| Organisation | University of Hong Kong |
| Country | Hong Kong |
| Sector | Academic/University |
| PI Contribution | We invited distinguished economists (including one of previous editor at Journal of Finance) and covered accommodation costs. |
| Collaborator Contribution | For invited speakers, the partner provided transportation for the workshop, and they covered the cost of lunches, dinners, and coffee/tea. |
| Impact | We now have a good connection with HKU Business School. This is one of the top business schools in the world. A researcher at HKU and I have started another research project thanks to this joint workshop. In future research output (not a direct output of this award), we should thank the generous ESRC funding support for linking us. Through the conference programme, we understand better the frontier research on financial markets, beliefs, and the macroeconomy. In particular, the discussions about optimism and pessimism and the effects on monetary policy is helpful to all participants. Further fiscal and monetary policy topics shed light on the conduct of policy with financial market frictions and trade frictions. The participants agreed to further exchange ideas in future workshops that may be organized elsewhere. |
| Start Year | 2023 |
| Description | Joint annual conference on macroeconomics and financial markets with Shanghai Jiao Tong University |
| Organisation | Shanghai Jiao Tong University |
| Country | China |
| Sector | Academic/University |
| PI Contribution | We started an annual conference in Shanghai in 2019 on macroeconomics and financial markets, with an emphasis on beliefs. The conference invites a senior economist and a group of junior economists for facilitating discussions. We invite some conference participants and we cover their travel costs. We also cover conference dinners. |
| Collaborator Contribution | The partner contributes to booking hotel accommodations, coffees, and lunches for all conference participants. The partner also invited some other speakers and cover their cost of transportation and accommodations. |
| Impact | The conference facilitates lively discussion on financial markets and macroeconomics in different countries. We plan to hold this conference every year. We also broadcast ESRC and of course UCL at the same time. Shanghai Jiao Tong University is arguably one of the top 5 universities in China. Please see the website here for further reference. http://macro-finance-workshop.weebly.com/ |
| Start Year | 2019 |
| Description | Joint workshops on macroeconomics and financial markets with LSE |
| Organisation | London School of Economics and Political Science (University of London) |
| Country | United Kingdom |
| Sector | Academic/University |
| PI Contribution | The team organized three workshops on recent research on macroeconomics and financial markets, with an application to the Chinese economy. The workshop invited many economists working in related areas, all based in the UK (so there is less concern about travel restrictions in 2022). |
| Collaborator Contribution | Shengxing Zhang from LSE (visiting UCL) invited distinguished Economists from many higher education institutions, including Princeton University, the University of Cambridge, LSE, Queen Mary, and many others. Provided generous feedback and comments to the research of our team and workshop participants. We rotate the organization between LSE and UCL. |
| Impact | The workshop provides lively discussion on financial markets and macroeconomics in the US, the UK, and China. We planned to hold this type of workshop more often in the UK, given that many countries still had travel restrictions in 2022. We also broadcast ESRC and, of course, UCL at the same time. |
| Start Year | 2022 |