This thesis studies the interaction between the financial sector and the real economy. Chapter 1 analyzes how lending cuts by banks affect firms. I identify an exogenous lending cut by a large German bank and examine the growth of firms and counties dependent on this bank. Firms directly exposed to reduced bank lending grew more slowly. On average, firms suffered when many other firms in their county experienced decreased bank lending, because of lower aggregate demand and agglomeration spillovers. The effects of the lending cut persisted after lending had resumed. Innovation and productivity fell, consistent with the persistent effects. Chapter 2 investigates the effect of house prices on household borrowing using administrative mortgage data from the UK. The chapter develops an empirical approach that exploits individual house price variation coming from the timing of refinancing events around the Great Recession. There is a clear and robust effect of house prices on borrowing. The effect can largely be explained by households using the value of their house as collateral. Chapter 3 focuses on financial institutions. How changes in bank size affect the real economy is an important question in the design of financial regulation. This chapter studies a natural experiment from postwar West Germany. Reforms by the Allied occupiers led to increases in the size of a number of banks. I estimate the effect of increased bank size on the growth of firms. The results suggest that firms did not benefit when their banks became larger. The findings are inconsistent with theories that argue the real economy benefits from increases in bank size. There is evidence that big banks are worse at processing soft information and take more risks. Big banks receive more mentions in the media, which could be an incentive for banks to become big.

This thesis contains two theoretical essays on reciprocity and one that analyzes the effects of perception biases on learning and decision-making. In the first chapter, I propose a new theory of intention-based reciprocity that addresses the question of when a mutually beneficial action is kind. When both benefit from the action, a player’s motive is unclear: he may be perceived as kind for improving the other player’s payoff, or as self-interested and not-kind for improving his own. I use trust as an intuitive mechanism to solve this ambiguity. Whenever a player puts himself in a vulnerable position by taking such an action, he can be perceived as kind. In contrast, if this action makes him better off than his alternative actions do, even if it is met by the most selfish response, he cannot be kind. My model explains why papers in the literature fail to find (much) positive reciprocity when players can reward and punish. The second chapter extends my theory of reciprocity to incomplete information. I outline how reciprocity can give rise to pay-what-you-want pricing schemes. In the classic bilateral trade setting, I show that sequential interactions can be more efficient than normal form mechanisms when some people are motivated by reciprocity. Reciprocity creates incentives for information sharing. The last chapter is co-authored with Manuel Staab. We study the effects of perception biases and incorrect priors on learning behavior, and the welfare ranking of information experiments. We find that both types of biases by themselves reduce expected utility in a model where payoff relevant actions also generate informative signals, i.e. when actions constitute information experiments. However, experiments can be affected to different degrees by these biases. We provide necessary and sufficient conditions for when any binary ranking of action profiles can be reversed. Building on these findings, we show that an agent can be better off suffering from both biases rather than just one.

This thesis proposes a comprehensive framework that allows analysis of preference-sensitive well-being and inequality. It draws together complementary aspects of attempts to operationalise a more inclusive and multidimensional definition of well-being, through subjective well-being measurement, social welfare theory, and multidimensional indices of well-being and inequality. Theoretical proposals and empirical strategies are put forward, with illustrations using data from the British Household Panel Survey. Chapter 1 examines the underlying structure of subjective well-being, and the relationship between these subjective components of well-being and commonly targeted objective well-being indicators. A key finding is that subjective well-being follows a time-consistent dual structure of underlying ‘life satisfaction’ and ‘emotional well-being’ components. Additionally, the ‘life satisfaction’ component appears more strongly associated than the ‘emotional well-being’ component to changes in objective indicators of well-being. The ‘preference index approach’, the central proposal of the thesis, is introduced in Chapter 2. Preference comparisons are inspected at the individual and subgroup level, and a preference-sensitive index of multidimensional well-being is proposed. The chapter then uses the results of Chapter 1 to support the use of longitudinal life satisfaction regression to estimate the heterogeneous preferences between objective dimensions of life. Chapter 3 illustrates the properties of the preference index approach in terms of multidimensional inequality analysis. The main contribution is the incorporation of preference inequality as well as distributional inequality, and the ability to quantify their interdependent contributions to overall inequality in multidimensional well-being.

The ‘Great Recession’ has brought about a justified critique of the neoclassical economic model. It is within the context of this shock to the mainstream that the economic orthodoxy can be queried. The calls for a new economic paradigm request the mainstream’s acceptance of heterodox ideas creating a pluralist approach to economic theory, research and teaching. Following the shock of the financial crisis, UK government economic institutions indeed appear more pluralist than before the crisis. The Bank of England’s One Bank Research Agenda (2015) aims to remove its institutional ‘group think’ to incorporate different economic perspectives to better allow its efficient monitoring of the UK economy. Her Majesty’s Revenue and Customs have embraced pluralist economics, Senior Ministerial Advisors within HMRC learn Behavioural Economics, the work of Hyman Minsky, Jesus de Soto and Fredrich Hayek alongside neoclassical economics and fiscal sociology to gain a thorough understanding of economic phenomena. Andy Haldane, Director of Financial Stability at the Bank of England, has called for a pluralist economic methodology and in 2010, Conservative MPs proposed a Financial Services Bill based on the work of Hayek. Given this willingness for Policy at least to accept a pluralist economic approach, alternative economic theories must be evaluated to determine their relevance. Calls for a pluralist economic paradigm do not simply seek to replace one orthodoxy with another or indeed abandon entirely neoclassical economics. A pluralist economic paradigm is one where numerous explanations of economic phenomena are considered and policy is based on the most appropriate rather than the default. The thesis contributes to knowledge by providing an evaluation of Hayek’s theory of the trade cycle using a testable model and both reduced form and structural analysis, this is the first time this has been explicitly done addressing the shortfall in the literature identified in Kuehn (2013). Furthermore the thesis provides a consideration of the relevance of Hayek’s theory of the trade cycle for the UK addressing this gap in the Austrian Empirical Literature. The chosen analysis of a variety of models and tests also contributes to the Austrian methodological literature providing a comprehensive approach to the evaluation of Hayek’s theory. The UK data used for the empirical evaluation does not feature in any of the reviewed literature and thus its use represents a further contribution toward the UK gap in the Austrian Econometric Literature. An empirical evaluation of Hayek’s theory of the trade cycle using UK timeseries data contributes to the pluralist debate by determining the relevance of the theory for future policy consideration. A testable model of Hayek’s theory is developed and examined with various econometric tests to determine the support present in the data. Primarily Vector-Auto Regression, Vector Error Correction and Granger Causality Tests were used in the evaluation alongside Finite-Distributed Lag Models and an initial statistical evaluation of the theory and data. Within the calls for pluralism all empirical evaluation is conducted in a manner acceptable to the majority of Hayekian economists, yet utilising standard econometric tests to provide a persuasive and universally accessible evaluation of the theory. Whilst some evidence for Hayek’s theory of the trade cycle is found, the results show strong support for individual components of the theory, but limited support for the central tenet of the Theory, that of the unsustainable boom sowing the seeds of its own destruction. Yet, evidence is found for the predicted effects of the interest rate and of predicted endogenous turning points in the data, which are seen by several Austrian economists to be unique features of Hayek’s theory. A replication study of a key empirical study supporting Hayek’s theory with US timeseries data is also conducted with UK data, finding less support for the theory than its US counterpart. Given the calls for a pluralist economic paradigm, perhaps it is time to isolate the valid components of Hayek’s theory and incorporate them with other heterodox and orthodox theories. After all a true pluralist paradigm does not mean the primacy of a single approach.

Most of the literature which has considered the small sample bias of limited information estimators in simultaneous equation models has done so in the context of the static rather than the dynamic simultaneous equations model (DSEM). Therefore, an analysis of the performance of estimators in the general dynamic simultaneous equations case is timely and this is what is provided in this paper. By introducing an asymptotic expansion for the estimation errors of estimators, we are able to obtain bias approximations to order T−1. Following this we constructed bias corrected estimators by using the estimated bias approximation to reduce the bias. As an alternative, the use of the non-parametric bootstrap as a bias correction procedure was also examined. In Chapter 2, we analyse the Two Stage Least Squares ( 2SLS ) Estimator in the general DSEM. Based on the result in Chapter 2, Chapter 3 compared the Fuller modification of the limited information maximum likelihood estimator (FLIML) with the 2SLS estimator. The bias approximation and reduction in the pth-order dynamic reduced form are analysed in Chapter 4. The results indicate that FLIML gives much less biased estimates than the 2SLS estimation in the general DSEM. We have also observed that the bias correction method based on the estimated bias approximation to order T−1 provides almost unbiased estimates and it does not lead to an inflation of the mean squared errors compared with the associated uncorrected estimators. We suggest that the corrected estimators, based upon the O(T−1), should be used to reduce the bias of the original estimators in small samples. Alternatively, the numerical results show that the bootstrap method leads to an effective reduction of the bias and an inflation of MSE, however this reduction is not as effective as the first one.

This thesis studies the emergence of, and the interaction between, inequality in earnings and inequality in wealth, when labour markets are frictional. Chapter 1 investigates the implications of search frictions and human-capital accumulation for the equilibrium distribution of wages when firms invest optimally in match-specific productivity. Optimal investment choice is incorporated in a framework along the lines of (Burdett et al., 2011) and equilibrium is characterised. The effect of the rate of human capital accumulation on equilibrium dispersion of firm productivities and wages is analysed in a numerically solved version of the model. Chapter 2 studies the empirical relationship between wealth and two labour market outcomes - re-employment wages and unemployment durations. The analysis complements a closely related literature by exploiting new data from the Survey of Income and Program Participation. As in prior studies, negative relationship between net worth and hazard rates to employment is documented. In disagreement with prior studies, the relationship between re-employment wages and net worth is found to be non-monotonic and it is argued that prior findings likely result from misspecification. The implications of the relationship serve as a motivation for the third chapter. Chapter 3 (joint with Melvyn Coles) presents a model of the consumption-leisure tradeoff for risk-averse workers when labour markets are frictional. Optimal behaviour is that of a life-cycle consumer - work when young and save for retirement (non-participation) later - planning retirement efficiently. The analysis has highly tractable implications for wealth dynamics which emphasise life-cycle motives, labour-market decisions, persistent differentials in ability and heterogeneity in initial wealth. The model's empirical relevance is assessed; it is demonstrated that it provides an empirically convincing explanation for much of the between-households inequality in wealth.

This thesis uses the techniques of macroeconomic theory to answer three questions. It is divided in three chapters each focusing on one of these questions. The first chapter investigates the appropriate labor market policy response to two fundamental changes in the economy. I introduce unemployment benefits financed by a proportional payroll tax within a model of directed search on the job. I show that there exists a unique positive level of unemployment benefit which maximizes welfare of individuals. The optimal unemployment benefit level is hump-shaped as a function of the level of idiosyncratic risk. At empirically relevant levels of idiosyncratic risk, a much less generous system than in the economy without uncertainty emerges. Furthermore, the welfare costs of deviating from the optimal level are substantial, and accompanied by high unemployment rates. I also find that while the optimal generosity of the unemployment insurance system declines monotonically with the amount of aggregate risk in the economy, the welfare costs of deviating from the optimal system are rather small. Chapter two develops a small open economy model with both staggered nominal prices and wages. Then, performances of some alternative simple policy rules are compared by using the welfare loss criterion. It is shown that, firstly, the performance of domestic inflation-targeting or wage inflation-targeting is better than both CPI inflation-targeting and pegged exchange rate. Second, although the performance of simple rules depends on the degree of stickiness in prices and wages, wage inflationtargeting performs better than domestic inflation-targeting for a wide combination of wage and price stickiness. In chapter three, I develop a model with uninsurable capital-income risk and incomplete markets, and investigate the cyclical properties of the equity premium. Although the model abstracts from some common features of the business cycle model, it can generate a sizable and countercyclical equity premium. Moreover, the model generates relatively more volatile consumption, investment, and equity premium than under complete markets.

This study examines how fluctuations in the supply of credit and financial constraints affect capital structure. It is one of the first studies to do so and its methodology is inspired by the recent studies of Faulkender & Petersen (2006) and Bougheas et al. (2006). It examines the economy of Japan, a perfect testing ground for this theory due to the extreme credit supply fluctuations that have occurred during the past years. Furthermore under this new perspective of capital structure theory two more hypotheses are tested. A “horse race” test between the two predominant theories of capital structure, the trade-off and the pecking order hypothesis, is run. The methodology utilised to perform this test is similar to that derived by Shyam-Sunder & Myers (1999). Finally the role of trade credit, a factor overlooked by the majority of previous capital structure studies, is investigated through the use of a similar methodology as that utilised by Mateut et al. (2006). The results of this panel data study, applied in a large sample of public and private firms, clearly indicate that fluctuations in the supply of credit affect capital structure and also that Japanese firms face financial constraints. The pecking order hypothesis is proven to be the winner of the “horse race” test and trade credit is found to be a significant factor of capital structure and more specifically a substitute to bank credit. These findings should be taken into consideration by future research and even perhaps lead into the creation of a new theory of capital structure

Does innovation increase or decrease with more competition when innovation follows a memory process? This thesis provides a theoretical model which analyzes the innovation and competition relationship assuming that innovation follows a memory process, i.e. the current probability of innovation success depends on previous periods’ innovation successes. I find innovation increases with more product market competition, even under the Schumpeterian context where inventions are not completely appropriable. Assuming the probability to innovate increases with past innovations; a follower firm has large incentives to innovate, even in a highly competitive environment, since the memory obtained after innovating increases its probability to innovate again and become a leader. Therefore, industries will be most of the time neck-and-neck where firms innovate to escape from competition. I test this theoretical finding using the same dataset of Aghion et al. (2005). I find ambiguous results for the innovation-competition relationship. I show that the instrumental variables used by Aghion et al. (2005) are not exogenous and the empirical model is not stable over time. I, therefore, build a database of 220 U.S. industries to analyze the innovationcompetition relationship. As in my theoretical model, I find that innovation increases with more product market competition when innovation follows a memory process. However, when the innovation process is memoryless, I find that more competition decreases the level of innovation when industries already have a high level of competition

This thesis applies game theory to study optimal toehold bidding strategies during takeover competition, the problem of optimal design of voting rules and the design of package bidding mechanism to implement the core allocations. It documents three different research questions that are all related to auction theory. Chapter 2 develops a two-stage takeover game to explain toehold puzzle in the context of takeover. Potential bidders are allowed to acquire target shares in the open market, subject to some limitations. This pre-bid ownership is known as a toehold. Purchasing a toehold prior to making any takeover offer looks like a profitable strategy given substantial takeover premiums. However actual toehold bidding has decreased since 1980s and now is not common. Its time-series patter is centred on either zero or a large value. Chapter 2 develops a two-stage takeover game. In the first stage of this two-stage game, each bidder simultaneously acquires a toehold. In the second stage, bidders observe acquired toehold sizes, and process this information to update their beliefs about rival's private valuation. Then each bidder competes to win the target under a sealed-bid second-price auction. Different from previous toehold puzzle literature focusing on toehold bidding costs in the form of target managerial entrenchment, this chapter develops a two-stage takeover game and points another possible toehold bidding cost - the opportunity loss of a profitable resale. Chapter 2 finds that, under some conditions, there exists a partial pooling Bayesian equilibrium, in which low-value bidders optimally avoid any toehold, while high-value bidders pool their decisions at one size. The equilibrium toehold acquisition strategies coincide with the bimodal distribution of the actual toehold purchasing behaviour. Chapter 3 studies the problem of optimal design of voting rules when each agent faces binary choice. The designer is allowed to use any type of non-transferable penalty on individuals in order to elicit agents' private valuations. And each agent's private valuation is assumed to be independently distributed. Early work showed that the simple majority rule has good normative properties in the situation of binary choice. However, their results relay on the assumption that agents' preferences have equal intensities. Chapter 3 shows that, under reasonable assumptions, the simple majority is the best voting mechanism in terms of utilitarian efficiency, even if voters' preferences are comparable and may have varying intensities. At equilibrium, the mechanism optimally assigns zero penalty to every voter. In other words, the designer does not extract private information from any agent in the society, because the expected penalty cost of eliciting private information to select the better alternative is too high. Chapter 4 presents a package bidding mechanism whose subgame perfect equilibrium outcomes coincide with the core of an underlying strictly convex transferable utility game. It adopts the concept of core as a competitive standard, which enables the mechanism to avoid the well-known weaknesses of VCG mechanism. In this mechanism, only core allocations generate subgame perfect equilibrium payoffs, because non-core allocations provide arbitrage opportunities for some players. By the strict convexity assumption, the implementation of the core is achieved in terms of expectation.