Optimal Policy with Informal Sector and Endogenous Savings

August 8, 2014

By Luz Adriana Flórez


This paper analyzes the effect of social security and lump sum layoff payment in an economy with an informal sector and savings, where the search effort is unobserved. I characterize the optimal consumption/search/non-participant strategy assuming that workers are risk averse and that formal jobs last forever. After including job destruction shocks I solve the model numerically, and focus on the effects of lump sum layoff and social security payments on workers’ decision to be formal, informal or non-participant. I find that severance payments protect formal workers against the unemployment risk. With severance payments workers do not over-accumulate to protect themselves against unemployment, instead they increase the search effort through the re-entitlement effects. In this respect my work resembles that of Coles (2006). I find that in the steady state a high severance payment increases the proportion of formal workers while reduces the proportion of informal workers and those who decide not to participate in the labor market. Even though the optimal policy with severance payment is generous, I find that in the steady state the unemployment rate is low and welfare improves.

In countries where the inromal sector is large, it is a challenge to run various services that rely on universal participation, such as unemployment insurance. There, finding ways to give the right incentives for joining the formal sector is important. This paper provides a nice discussion of this.

Childcare Subsidies and Household Labor Supply

August 7, 2014

By Nezih Guner, Remzi Kaygusuz and Gustavo Ventura


What would be the aggregate effects of adopting a more generous and universal childcare subsidy program in the U.S.? We answer this question in a life-cycle equilibrium model with joint labor-supply decisions of married households along extensive and intensive margins, heterogeneity in terms of the presence of children across households and skill losses of females associated to non-participation. We find that subsidies have substantial effects on female labor supply, which are largest at the bottom of the skill distribution. Fully subsidized childcare available to all households leads to long-run increases in the participation of married females and total hours worked by about 10.1% and 1.0%, respectively. There are large differences across households in welfare gains, as a small number of households – poorer households with children – gain significantly while others lose. Welfare gains of newborn households amount to 1.9%. Our findings are robust to differences among households in fertility and childcare expenditures.

There are plenty of empirical studies addressing the same question, but the big problem is that so many measures are endogenous (general equilibrium!), including factor prices that are important for labor supply decisions. This is why studies like this one are very important, as they highlight the channels through which public policies have an impact. What this paper shows is that matters are almost impossible for the empiricist: either there is a natural experiment with a small segment of the population, where the wages are not affected and the results thus miss something very important, or it is a nationwide experiment where wages are affected but they can also be affected by many other things.

Golden Rules for Wages

July 31, 2014

By Andrew Young and Hernando Zuleta


We consider a decentralized version of the neoclassical growth model where labor share is chosen by workers to maximize their long run (permanent) wages. In this framework, if the labor share increases relative to the competitive share, workers capture a larger share of a smaller total income in the steady-state. This is because the incentives to invest are lower and the steady-state capital to labor ratio is lower. We find that the “Golden Rule” labor share is equal to the elasticity of output with respect to labor. This is precisely what would obtain under the assumption of competitive factor markets. We also consider the model with two classes of workers: organized and unorganized. In this case, organized labor may choose a higher than competitive share and the difference is economically significant for plausible parameter values. Furthermore, relative to the Cobb-Douglas case, organized labor chooses a higher share for the empirically relevant case of an elasticity of substitution less than unity. We also analyze versions of the model with endogenous skill acquisition and capitalists with bargaining power.

This paper is a very nice illustration of who powerful general equilibrium effects can be. While the premise of the model is not very realistic (workers get to decide what share of income goes to them), the model shows nicely how first degree intuition can backfire spectacularly if you forget about the rest of the model.

Financial Crises in DSGE Models: The IMF’s MAPMOD

July 18, 2014

By Jaromir Benes, Michael Kumhof and Douglas Laxton

Financial Crises in DSGE Models: A Prototype Model


Financial Crises in DSGE Models: Selected Applications of MAPMOD


These two papers present MAPMOD, a new IMF model designed to study vulnerabilities associated with excessive credit expansions, and to support macroprudential policy analysis. In MAPMOD, bank loans create purchasing power that facilitates adjustments in the real economy. But excessively large and risky loans can impair balance sheets and sow the seeds of a financial crisis. Banks respond to losses through higher spreads and rapid credit cutbacks, with adverse effects for the real economy. These features allow the model to capture the basic facts of financial cycles. The first paper shows the theoretical structure, the second studies the simulation properties of MAPMOD. (This abstract is a merge of the abstracts of the two papers)

These papers provide an interesting look at the kind of models policy institutions devise nowadays to study the economy. What is particularly interesting here is that the model is flexible enough to integrate some unexpected behavior of the economy in the sense of a shock or friction that has not happened yet. If there is no history to draw from, theory needs to come to the rescue, and this can only happen with some serious structural modeling. Here, we have a nice demonstration of that.

Leverage Restrictions in a Business Cycle Model

July 11, 2014

By Lawrence Christiano and Daisuke Ikeda


We modify an otherwise standard medium-sized DSGE model, in order to study the macroeconomic effects of placing leverage restrictions on financial intermediaries. The financial intermediaries (‘bankers’) in the model must exert effort in order to earn high returns for their creditors. An agency problem arises because banker effort is not observable to creditors. The consequence of this agency problem is that leverage restrictions on banks generate a very substantial welfare gain in steady state. We discuss the economics of this gain. As a way of testing the model, we explore its implications for the dynamic effects of shocks.

This paper highlights how special the financial sector is and how putting (particular) restrictions on it can have significant positive impact. In this case, it all boils down to whether it is observable whether we can see how well the banker selects and monitors loans. As the banker use the funds of others, he is not getting the full returns from his efforts and does not try hard enough. And imagine if there where also some other perverse incentives in the model, like limited liability or a bonus pay system that would encourage investing in excessively risky projects.

Endogenous Wage Indexation and Aggregate Shocks

July 9, 2014

By: Julio Carrillo, Gert Peersman and Joris Wauters


Wage indexation practices have changed. Evidence on the U.S. for instance suggests that wages were heavily indexed to past inflation during the Great Inflation but not during the Great Moderation. However, most DSGE models assume fixed indexation parameters in wage setting, which might not be structural in the sense of Lucas (1976). This paper presents a New-Keynesian model in which workers, by maximizing their welfare, set their wage indexation rule in response to aggregate shocks and monetary policy. We find that workers index their wages to past inflation when technology and permanent inflation-target shocks drive output fluctuations; when aggregate demand shocks do, workers index to trend-inflation. In addition, workers’ choices do not coincide with the social planner’s choice, which may explain the observed changes in wage indexation in the post-WWII U.S. data.

Many are unhappy about the way macro models deal with price and wage rigidities, and properly understanding indexation is a neglected part of this reflection. This paper provides an interesting tack at this question. Critical here is the choice set of indexation rules. The relevant part of the paper is here:

[..] in periods in which wages are re-optimised, workers select an indexation rule among two different types: one based on past inflation, and the other one based on the inflation target of the Central Bank (i.e. trend inflation, which may vary). Workers then choose the rule associated with the highest expected utility, given the average length of the labor contract and the regime’s economic characteristics. Similar to Schmitt-Grohe and Uribe (2007), we solve the non-linear model to compute the welfare criterion of workers. The sum of all workers’ decisions determines the degree at which nominal wages are indexed to past inflation on average. We name this level the degree of aggregate indexation in the economy. We implement an algorithm that computes the equilibrium level for aggregate indexation, given the economic regime.

Optimal taxation with home production

July 8, 2014

By Conny Olovsson


Optimal taxes for Europe and the U.S. are derived in a realistically calibrated model in which agents buy consumption goods and services and use home capital and labor to produce household services. The optimal tax rate on services is substantially lower than the tax rate on goods. Specifically, the planner cannot tax home production directly and instead lowers the tax rate on market services to increase the relative price of home production. The optimal tax rate on the return to home capital is strictly positive and the welfare gains from switching to optimal taxes are large.

This paper makes a very simple, but often neglected point. If market services and home produced goods (say, restaurant meals and home-cooked meals) are substitutes, one needs to tax market services less than other goods. The intuition is simple: you want to avoid flight to the home production sector that cannot be taxed. Were they complements, then the taxes should be higher, so as to tax the otherwise untaxable. The paper quantifies all this and shows this is really important, especially once you factor in that households react to the tax environment.


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