Search-Based Endogenous Illiquidity and the Macroeconomy

April 22, 2014

By Wei Cui and Sören Radde

We endogenize asset liquidity in a dynamic general equilibrium model with search frictions on asset markets. In the model, asset liquidity is tantamount to the ease of issuance and resaleability of private financial claims, which is driven by investors’ participation on the search market. Limited resaleability of private claims creates a role for liquid assets, such as government bonds or fiat money, to ease funding constraints. We show that liquidity and asset prices positively co-move. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, the hedging value of liquid assets increases. Our model is thus able to match the flight to liquidity observed during recessions. Finally, we show that investors’ search market participation is more intense in a constrained efficient economy.

From the latest NEP-DGE report, I have selected this paper because I did not know it was possible to obtain endogenous asset liquidity. Money search has shown us that demand for a very liquid asset can emerge, but it is only a dichotomous choice. In this paper, The liquid asset is always present, and the demand for the illiquid one varies, and as the market for theses illiquid ones is modeled as a search process, its liquidity depends on market participation. Liquidity is thus endogenous, and it matters.

Social Security and the Interactions Between Aggregate and Idiosyncratic Risk

April 9, 2014

By Daniel Harenberg and Alexander Ludwig

We ask whether a PAYG-financed social security system is welfare improving in an economy with idiosyncratic and aggregate risk. We argue that interactions between the two risks are important for this question. One is a direct interaction in the form of a countercyclical variance of idiosyncratic income risk. The other indirectly emerges over a household’s life-cycle because retirement savings contain the history of idiosyncratic and aggregate shocks. We show that this leads to risk interactions, even when risks are statistically independent. In our quantitative analysis, we find that introducing social security with a contribution rate of two percent leads to welfare gains of 2.2% of lifetime consumption in expectation, despite substantial crowding out of capital. This welfare gain stands in contrast to the welfare losses documented in the previous literature, which studies one risk in isolation. We show that jointly modeling both risks is crucial: 60% of the welfare benefits from insurance result from the interactions of risks.

This is an interesting paper that highlights that an important benefit of a social security system is not only coming from the insurance against lifecycle income risk, individual or aggregate, but majorly from the interaction of such indvidual and aggregate risks. And this paper does not even consider the advantage of insuring against longevity risk.

Uncertainty and the business cycle

March 30, 2014

Two important papers on the booming literature about uncertainty this week. They show that uncertainty matters a lot and can have lasting effects on the state fo the economy and the effectiveness of policy. This keeps silent, however, how policy can influence uncertainty. Interesting stuff that should prompt more work.

Uncertainty Traps

By Pablo Fajgelbaum, Edouard Schaal and Mathieu Taschereau-Dumouchel

We develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The unique equilibrium of this economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have nearly permanent effects on the level of activity. The economy is subject to an information externality but uncertainty traps remain even in the efficient allocation. We extend our framework to include additional features of standard business cycle models and show, in that context, that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions.

Really Uncertain Business Cycles

By Nicholas Bloom, Max Floetotto, Nir Jaimovich, Itay Saporta-Eksten and Stephen Terry

We propose uncertainty shocks as a new shock that drives business cycles. First, we demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of 2007-2009. Second, we quantify the impact of time-varying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. We find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, we show that increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.

Asset Prices in a Lifecycle Economy

March 19, 2014

By Roger Farmer

The representative agent model (RA) has dominated macroeconomics for the last thirty years. This model does a reasonably good job of explaining the co-movements of consumption, investment, GDP and employment during normal times. But it cannot easily explain movements in asset prices. Two facts are hard to understand 1) The return to equity is highly volatile and 2) The premium for holding equity, over a safe government bond, is large. This paper constructs a lifecycle model in which agents of different generations have different savings rates and different attitudes to risk and I use this model to account for both a high equity premium and a volatile stochastic discount factor. The model is persuasive, precisely because it explains so much with so few parameters, each of which is pinned down by a few simple facts.

While I do not think the model is as simple and has as few degrees of freedom as Roger Farmer makes it appear, it is quite powerful in resolving the excessive volatility and equity premium puzzles. We have learned that the life cycle matters for many economic issues, and this seems to be another one. While the life cycle is modeled in a very crude way here, it would interesting to see whether the quantitative results would still hold in a model that tracks life events with more granularity.

Optimal Taxation and Life Cycle Labor Supply Profile

March 16, 2014

By Michael Kuklik and Nikita Céspedes

The optimal capital income tax rate is 36 percent as reported by Conesa, Kitao, and Krueger (2009). This result is mainly driven by the market incompleteness as well as the endogenous labor supply in a life-cycle framework. We show that this model fails to account for the basic life-cycle features of the labor supply observed in the U.S. data. In this paper, we introduce into this model non-linear wages and inter-vivos transfers into this model in order to account for the life-cycle features of labor supply. The former makes hours of work highly persistent and helps to account for labor choices at the extensive margin over the life cycle. The latter allows us to account for labor choices early in life. The suggested model delivers an optimal capital income tax rate of 7.4 percent, which is significantly lower than what Conesa, Kitao, and Krueger (2009) found.

One more paper in an everexpanding literature on optimal capital income taxation. And once more, it shows how dramatically sensitive results are to modeling assumptions. Is this literature ever going to come to a conclusion? On one hand, this challenge makes it all the more exciting for the researcher, on the other hand, the lack of robustness of results is quite disheartening.

Can Intangible Capital Explain Cyclical Movements in the Labor Wedge?

March 5, 2014

By François Gourio and Leena Rudanko

Intangible capital is an important factor of production in modern economies that is generally neglected in business cycle analyses. We demonstrate that intangible capital can have a substantial impact on business cycle dynamics, especially if the intangible is complementary with production capacity. We focus on customer capital: the capital embodied in the relationships a firm has with its customers. Introducing customer capital into a standard real business cycle model generates a volatile and countercyclical labor wedge, due to a mismeasured marginal product of labor. We also provide new evidence on cyclical variation in selling effort to discipline the exercise.

There are now quite a few papers that look beyond the traditional production factors and their impact on the business cycle. This is probably the most concrete paper that looks at intangible capital, which is obviously difficult to measure, but which manifests itself in ways that can be related to data such as indicators of selling effort. It looks like theory is still ahead of measurement, though.

Optimal Tax Progressivity: An Analytical Framework

February 28, 2014

By Jonathan Heathcote, Kjetil Storesletten and Gianluca Violante

What shapes the optimal degree of progressivity of the tax and transfer system? On the one hand, a progressive tax system can counteract inequality in initial conditions and substitute for imperfect private insurance against idiosyncratic earnings risk. At the same time, progressivity reduces incentives to work and to invest in skills, and aggravates the externality associated with valued public expenditures. We develop a tractable equilibrium model that features all of these trade-offs. The analytical expressions we derive for social welfare deliver a transparent understanding of how preferences, technology, and market structure parameters influence the optimal degree of progressivity. A calibration for the U.S. economy indicates that endogenous skill investment, flexible labor supply, and the externality linked to valued government purchases play quantitatively similar roles in limiting desired progressivity.

This is an interesting paper for several reasons. First, it finds that progressivity is optimal without having any preference for equality. The welfare criterion is the expected utility of an agent born into this model economy, and this agent is purely selfish. Second, the paper nicely shows how various model features contribute to the progressivity. And third, but little exploited in the paper, it shows how some intrinsic features (outside of preferences) of an economy can lead to different degrees of progressivity.

Public Investment, Time to Build, and the Zero Lower Bound

February 10, 2014

By Hafedh Bouakez, Michel Guillard and Jordan Roulleau-Pasdeloup

Public investment represents a non-negligible fraction of total public expenditures. Yet, theoretical studies of the effects of public spending when the economy is stuck in a liquidity trap invariably assume that government expenditures are entirely wasteful. In this paper, we consider a new-Keynesian economy in which a fraction of government spending increases the stock of public capital-which is an external input in the production technology-subject to a time-to-build constraint. In this environment, an increase in public spending has two conflicting effects on current and expected inflation: a positive effect due to higher aggregate demand and a negative effect reflecting future declines in real marginal cost. We solve the model analytically both in normal times and when the zero lower bound (ZLB) on nominal interest rates binds. We show that under relatively short time-to-build delays, the spending multiplier at the ZLB decreases with the fraction of public investment in a stimulus plan. Conversely, when several quarters are required to build new public capital, this relationship is reversed. In the limiting case where a fiscal stimulus is entirely allocated to investment in public infrastructure, the spending multiplier at the ZLB is 4 to 5 times larger than in normal times when the time to build is 12 quarters.

It surprises Europeans that the US has not taken advantage of a deep recession and very low interest rates to renew its crumbling infrastructure. After all, this seems like a greate opportunity for some intertemporl substitution of government expenses. The key is likely in the American distate for public deficits. Yet, given that the stimulus money was decided anyway, why not focus on public infrastrucutre? This paper shows that the returns could have been very large. Unfortunately, I am not quite convinced of the results. Indeed, using a log-linearization in the context of a highly non-linear situation like the ZLB can yield misleading results. In addition, the log-linearization is taken around the deterministic steady-state, which is quite far from the ZLB under stochastics and the approximation error could be large even if there were no linearity issue.

News shocks and business cycles: bridging the gap from different methodologies

February 2, 2014

By Christoph Görtz and John Tsoukalas

An important disconnect in the news driven view of the business cycle formalized by Beaudry and Portier (2004), is the lack of agreement between different—VAR and DSGE—methodologies over the empirical plausibility of this view. We argue that this disconnect can be largely resolved once we augment a standard DSGE model with a financial channel that provides amplification to news shocks. Both methodologies suggest news shocks to the future growth prospects of the economy to be significant drivers of U.S. business cycles in the post-Greenspan era (1990-2011), explaining as much as 50% of the forecast error variance in hours worked in cyclical frequencies.

News shocks are interesting because they are forward-looking, compared to the other shocks in the literature that focus on current conditions. In retrospect, it is thus natural that forward-looking features of the economy, like the financial sector, need to be included in a model to properly account for news shocks. This is what this paper does.


January 29, 2014

There is now a new NEP report dedicated to economic growth. I encourage those interested in this topic to subscribe to it here. Note that while I have in the past featured growth models on NEP-DGE even when they were not DGE, I will stop doing so now.

And here are the calls for papers for the month:

Southern Workshop in Macroeconomics, Auckland, New Zealand, 7-8 March 2014

Tsinghua Workshop in Macroeconomics, Beijing, 30 May-1 June 2014.

Carnegie-Rochester-NYU Conference on Public Policy on “Monetary Policy: An Unprecedented Predicament”, Pittsburgh, 14-15 November, 2014

Paris Conference on Goods Markets, The Macroeconomy and Policy, Paris 15-16 May 2014.

First African Search and Matching Workshop, Marrakesh (Morocco) 21-23 May 2014.

Conference on Recent Developments in Macroeconomics, Mannheim (Germany), 23-24 June 2014.

Doctoral Workshop on Dynamic Macroeconomics, Strasbourg (France), 2-3 June 2014.

And let us not forget that the deadline is coming up for the Society for Economic Dynamics Annual Meeting, Toronto, 26-28 June 2014.


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