Also, recent financial crises indicate that a significant decline in house prices can reduce confidence of economic agents and cause bank runs and a fire sale. Accordingly, this dissertation investigates the role of housing on the household's attitudes toward risk and derives the closed-form expressions for risk aversion with generalized recursive preferences. This chapter finds that including housing in the utility function lowers risk aversion because housing partially absorbs aggregate shocks to consumption and labor.

This dissertation consists of three essays that examine the role of sovereign debt in the economy. The first of the essays explores the question of optimal debt through liquidity and finds that as long as debt is below a sustainability threshold, increasing debt is beneficial. Increasing debt levels encourages buyers to enter the market improving liquidity and lowering yields. The result is built by combining two strands of literature, market thinness and default probabilities in a unified search-theoretic model of over the counter traded debt. The model also predicts that liquidity and yields in smaller countries that are not able to issue much debt, suffer more from shocks to income. A panel VAR with data on Eurozone countries confirms this prediction. In the second chapter I present a search theoretic model of over-the-counter debt with quantitative easing that explains why interest rates fall more in some countries than others. The study is motivated by our finding that the higher rated a Eurozone country was, the more yields fell. Since the central banks purchase similar amounts in each Eurozone country, it cannot explain the difference in impact on yields. We explain the differential through two channels. Firstly, in markets for highly rated bonds, there are more preferred habitat investors and subsequently fewer sellers. Sellers therefore have a higher bargaining power and can negotiate a higher price. Those preferred habitat investors' have a less elastic demand for bonds, and wil continue to buy them even though it becomes harder to find sellers and their bargaining power diminishes. This excess demand due to market tightness has an additional positive impact on the price. Finally, central bank purchases initially improve liquidity, especially in high risk countries where the measure of buyers is small, but as it tapers the purchases, liquidity is reduced well below pre-purchase levels especially in those countries, that is the cost of quantitative easing. We estimate the share of preferred habitat investors in each Eurozone country from the ECB's Securities and Holdings Statistics and confirm the differential impact on yields with a panel VAR and an event study. The third chapter examines credit ratings and their impact on sovereign debt crises and yields. The results show that credit ratings are poor predictors of sovereign debt crises. A parsimonious model of fundamentals is better at predicting Emerging Market debt crises than credit ratings. Furthermore, rating changes tend to lag events significantly. Investors should therefore ignore rating changes given that they do not contain new information. Estimating the impact of rating changes on yields, we find evidence of contrary, yields react especially strongly to downgrades of non-investment grade debt. This can be due to regulatory constraints where a downgrade reduces the value of debt as a collateral.