Production, Collateral and the Risk-Free Rate

Geoffrey Dunbar

No 448, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper, I examine the implications of collateral constraints in a production economy and demonstrate that collateral constraints may have a role to play in resolving two outstanding puzzles: the risk-free rate puzzle and the total factor productivity puzzle. The first puzzle, as noted by Mehra and Prescott (1985), Weil (1989) and others is simply that it is difficult to obtain plausible values of the risk-free real interest rate in production economies without assuming implausibly high values of risk-aversion. This paper demonstrates that the risk-free real interest is related to idiosyncratic productivity risk through the collateral constraint and that a low risk-free real interest rate can be obtained for small, and plausible, values of risk-aversion. The second puzzle is more recent - namely why has the risk-free real interest rate fallen while measured total factor productivity has risen during the 1990's in the United States? The argument put forth here is that the level and persistence of idiosyncratic productivity risk is related to measured aggregate total factor productivity and the risk-free real interest rate via the collateral constraint. Hence, increases in aggregate total factor productivity that occur in conjunction with decreases in the risk-free real interest rate may simply reflect unanticipated increases in the level (or persistence) of idiosyncratic productivity risk

Keywords: Collateral; Risk-Free Rate; Wealth Heterogeneity; TFP; Equity Premium (search for similar items in EconPapers)
JEL-codes: E43 E44 G21 (search for similar items in EconPapers)
Date: 2006
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed006:448

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