Inflation and Welfare in Long-Run Equilibrium with Firm Dynamics

November 29, 2009

By Alexandre Janiak and Paulo Santos Monteiro

We analyze the welfare cost of inflation in a model with cash-in-advance constraints and an endogenous distribution of establishments’ productivities. Inflation distorts aggregate productivity through firm entry dynamics. The model is calibrated to the United States economy and the long-run equilibrium properties are compared at low and high inflation. We find that, when the period over which the cash-in-advance constraint is binding is one quarter, an annual inflation rate of 10 percent leads to a decrease in the steady-state average productivity of roughly 0.5 percent compared to the optimum’s steady-state. This decrease in productivity is not innocuous: it leads to a doubling of the welfare cost of inflation.

It has been very difficult to find substantial costs for inflation, in a large part because it is difficult to make money matter in significant ways in a microfounded model. This attempt is different in that the welfare cost comes from productivity losses through the firm entry and distribution. The resulting impact of money and inflation is indirect yet important.

Portfolio inertia and the equity premium

November 22, 2009

By Christopher Gust and David López-Salido

We develop a DSGE model in which aggregate shocks induce endogenous movements in risk. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. We show that the model can account for the mean returns on equity and the risk-free rate, and generates countercyclical movements in the equity premium that help explain the response of stock prices to monetary shocks. The model is consistent with empirical evidence documenting that unanticipated changes in monetary policy have important effects on equity prices through changes in risk.

Yet another attempt to solve the equity premium puzzle while obtaining a reasonable risk free rate. So many explanation have been thrown at the wall, finally a explanation that will stick?

Credit Constraints and the Persistence of Unemployment

November 17, 2009

By Nicolas Dromel, Elie Kolakez and Etienne Lehmann

In this paper, we argue that credit market imperfections impact not only the level of unemployment, but also its persistence. For this purpose, we first develop a theoretical model based on the equilibrium matching framework of Mortensen and Pissarides (1999) and Pissarides (2000) where we introduce credit constraints. We show these credit constraints not only increase steady-state unemployment, but also slow down the transitional dynamics. We then provide an empirical illustration based on a country panel dataset of 20 OECD countries. Our results suggest that credit market imperfections significantly increase the persistence of unemployment.

This paper combines (imperfect) credit markets and labor market frictions. The innovation is that entrepreneurs need to borrow to create jobs, but can do so only up to a fraction of pledgeable assets. The consequences that unemployment level and persistence are dependent on the sophistication of credit markets. While this is empirically consistent, is this a credible model of entrepreneurship and job creation?

Housing and Debt Over the Life Cycle and Over the Business Cycle

November 9, 2009

By Matteo Iacoviello and Marina Pavan

We present an equilibrium life-cycle model of housing where nonconvex adjustment costs lead households to adjust their housing choice infrequently and by large amounts when they do so. In the cross-sectional dimension, the model matches the wealth distribution, the age profiles of consumption, homeownership, and mortgage debt, and data on the frequency of housing adjustment. In the time-series dimension, the model accounts for the procyclicality and volatility of housing investment, and for the procyclical behavior of household debt. We use a calibrated version of our model to ask the following question: what are the consequences for aggregate volatility of an increase in household income risk and a decrease in downpayment requirements? We distinguish between an early period, the 1950s through the 1970s, when household income risk was relatively small and loan-to-value ratios were low, and a late period, the 1980s through today, with high household income risk and high loan-to-value ratios. In the early period, precautionary saving is small, wealth-poor people are close to their maximum borrowing limit, and housing investment, homeownership and household debt closely track aggregate productivity. In the late period, precautionary saving is larger, wealth-poor people borrow less than the maximum and become more cautious in response to aggregate shocks. As a consequence, the correlation between debt and economic activity on the one hand, and the sensitivity of housing investment to aggregate shocks on the other, are lower, as is found the data. Quantitatively, our model can explain: (one) 45 percent of the reduction in the volatility of household investment; (two) the decline in the correlation between household debt and economic activity; (three) about 10 percent of the reduction in the volatility of GDP.

This is an innovative model that tries to address issues that go beyond the the housing market: how can innovation in the financing of housing explain the evolution of the volatility of GDP, the volatility of housing investment and the relationship of household debt and economic activity? These issues have previously only been addressed with models where households invest and borrow some generic asset. Housing is different, because of its life-cycle aspect and its lumpiness, and this appears to matter.

About overborrowing

November 1, 2009

Two somewhat related papers this week.

Overborrowing and systemic externalities in the business cycle

by Javier Bianchi

Credit constraints that link a private agent’s debt to market-determined prices embody a credit externality that drives a wedge between competitive and constrained socially optimal equilibria, inducing private agents to overborrow. The externality arises because agents fail to internalize the debt-deflation effects of additional borrowing when negative income shocks trigger the credit constraint. We quantify the effects of this inefficiency in a two-sector dynamic stochastic general equilibrium model of a small open economy calibrated to emerging markets. The credit externality increases the probability of financial crises by a factor of seven and causes the maximum drop in consumption to increase by 10 percentage points.

Rising indebtedness and hyperbolic discounting: a welfare analysis

by Makoto Nakajima

Is the observed rapid increase in consumer debt over the last three decades good news for consumers? This paper quantitatively studies macroeconomic and welfare implications of relaxing borrowing constraints when consumers exhibit a hyperbolic discounting preference. In particular, the author constructs a calibrated general equilibrium life-cycle model with uninsured idiosyncratic earnings shocks and a quasi-hyperbolic discounting preference and examines the effect of relaxation of the borrowing constraint which generates increased indebtedness. The model can capture the two contrasting views associated with increased indebtedness: the positive view, which links increased indebtedness to financial sector development and better insurance, and the negative view, which associates increased indebtedness with consumers’ over-borrowing. He finds that while there is a welfare gain as large as 0.4 percent of flow consumption from a relaxed borrowing constraint, which is consistent with the observed increase in aggregate debt between 1980 and 2000 in the model with standard exponential discounting consumers, there is a welfare loss of 0.2 percent in the model with hyperbolic discounting consumers. This result holds in spite of the observational similarity of the two models; the macroeconomic implications of a relaxed borrowing constraint are similar between the two models. Cross-sectionally, although consumers of high and low productivity gain and medium productivity consumers suffer due to a relaxed borrowing constraint in both models, the welfare gain of low-productivity consumers is substantially reduced (and becomes negative in the case of strong hyperbolic discounting) in the hyperbolic discounting model due to the welfare loss from over-borrowing. Finally, the author finds that the optimal (social welfare maximizing) borrowing limit is 15 percent of average income, which is substantially lower than both the optimal level implied by the exponential discounting model (37 percent) and the level of the U.S. economy in 2000 implied by the model (29 percent).

The Bianchi paper shows that agents overborrow and this has negative consequences on the economy because of a larger risk of financial crises. The Nakajima paper argues that the observed increase in borrowing may be due to overborrowing due to hyperbolic discounting and financial innovation and the negative welfare effect of hyperbolic discounting dominates. Should one restrain consumer borrowing even if standard model indicate that completing markets should be welfare improving?


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