Improved Matching, Directed Search, and Bargaining in the Credit Card Market

February 21, 2018

By Gajendran Raveendranathan

http://d.repec.org/n?u=RePEc:mcm:deptwp:2018-05&r=dge

I build a model of revolving credit in which consumers face idiosyncratic earnings risk, and credit card firms direct their search to consumers. Upon a match, they bargain over borrowing limits and borrowing interest rates — fixed for the duration of the match. Using the model, I show that improved matching between consumers and credit card firms, calibrated to match the rise in the population with credit cards, accounts for the rise in revolving credit and consumer bankruptcies in the United States. I also provide empirical evidence consistent with the two key features in my model: directed search and bargaining. The lifetime consumption gains from improved matching are 3.55 percent— substantially larger than those previously estimated by alternative explanations for the rise in revolving credit and consumer bankruptcies (0.03-0.57 percent). Finally, I analyze how the credit card firm’s bargaining power impacts the welfare of introducing stricter bankruptcy laws.

That is going to surprise a few: the higher credit card debt and default are actually welfare improving. Or at least if they are the consequence of better matching and bargaining. Which means that one should not necessarily worry if the credit card market should more defaults.

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Dealing with Misspecification in DSGE Models: A Survey

February 10, 2018

By Alessia Paccagnini

http://d.repec.org/n?u=RePEc:pra:mprapa:82914&r=dge

Dynamic Stochastic General Equilibrium (DSGE) models are the main tool used in Academia and in Central Banks to evaluate the business cycle for policy and forecasting analyses. Despite the recent advances in improving the fit of DSGE models to the data, the misspecification issue still remains. The aim of this survey is to shed light on the different forms of misspecification in DSGE modeling and how the researcher can identify the sources. In addition, some remedies to face with misspecification are discussed.

I have occasionally pointed out on this blog various misspecification issues in the estimation of DSGE models. This handy survey addresses a lot of such worries with some remedies.


What’s News in International Business Cycles

February 7, 2018

By Daniele Siena

http://d.repec.org/n?u=RePEc:red:sed017:1206&r=dge

The role of news shocks in international business cycles is first evaluated using a structural factor-augmented VAR model (FAVAR). An international FAVAR model is shown to be necessary to recover the correct news shocks in open economies, except the US, without incurring in the ‘non-fundamentalness’ problem. Then, a standard two-country, two-good real business cycle model, featuring news shocks, investment adjustment costs and variable wealth elasticity of the labor supply is used to match and explain the empirical evidence. News shocks are only marginal drivers of international business cycles synchronization.

There is plenty of literature, including some relayed on this blog, that shows that news shocks are important in explaining business cycles. Why that suddenly vanishes once you look at the international dimension is interesting. This is certainly not the first time in the history of studying business cycles that this happens. I wonder what the disturbing mechanism is this time.


Political Distribution Risk and Business Cycles

January 16, 2018

By Thorsten Drautzburg, Jesus Fernandez-Villaverde and Pablo Guerron-Quintana

http://d.repec.org/n?u=RePEc:red:sed017:1201&r=dge

We argue that one important determinant of the variation in income shares is political risk. To that end, we document significant changes in the capital share after political events such as the introduction of right-to-work legislation in U.S. states and international events such as the Carnation Revolution in Portugal. These policy changes are often associated with significant fluctuations in output and asset prices. To quantify the importance of these political shocks for the U.S., we extend an otherwise standard neoclassical growth model. We model political shocks as exogenous changes in the bargaining power of workers in a labor market with search unemployment. We calibrate the model to the U.S. corporate non-financial business sector with a standard process for productivity. A one standard deviation redistribution shock reduces the capital share up 0.2 percentage point on impact and leads to a drop in output of 0.6 percent. Our calibration also implies that political distribution risk can explain 15 to 25% of the observed volatility of U.S. gross capital shares — and 35 to 45 percent of output volatility, depending on the elasticity of substitution between capital and labor. Eliminating political redistribution risk in the U.S. would raise the welfare of the representative household by 1.6 percent of steady state consumption.

I am actually surprised that political risk matters that little, at least for the US, seeing how politics can wreak havoc in other countries. Or maybe it is that bad politics is a steady state elsewhere, and thus it has an impact more on the levels than the fluctuations.


The Optimal Inflation Target and the Natural Rate of Interest

January 12, 2018

By Philippe Andrade, Jordi Galí, Hervé Le Bihan and Julien Matheron

http://d.repec.org/n?u=RePEc:bge:wpaper:1009&r=dge

We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

Economists are now fairly convinced that the real interest rate has declined, whatever the reason may be. In that context, some of the policy “constants” need to be reevaluated, as they may depend on the real interest rate. This paper is one important approach at this question for the inflation target using a New Keynesian model. Let’s see whether other approaches come to similar conclusions.


Inferring Inequality with Home Production

January 11, 2018

By Job Boerma and LoukasKarabarbounis

http://d.repec.org/n?u=RePEc:fip:fedmwp:746&r=dge

We revisit the causes, welfare consequences, and policy implications of the dispersion in households’ labor market outcomes using a model with uninsurable risk, incomplete asset markets, and a home production technology. Accounting for home production amplifies welfare-based differences across households meaning that inequality is larger than we thought. Using the optimality condition that households allocate more consumption to their more productive sector, we infer that the dispersion in home productivity across households is roughly three times as large as the dispersion in their wages. There is little scope for home production to offset differences that originate in the market sector because productivity differences in the home sector are large and the time input in home production does not covary with consumption expenditures and wages in the cross section of households. We conclude that the optimal tax system should feature more progressivity taking into account home production.

I am actually quite surprised by the result of this paper. I would have thought that those with poorer labor market outcomes would have a comparative advantage in home production, and this would decrease inequality once you take home production into account. It turns out I was dead-wrong.


Optimal Long-Run Inflation and the Informal Economy

December 27, 2017

By Claudio Cesaroni

http://d.repec.org/n?u=RePEc:lie:wpaper:46&r=dge

This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government’s ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-decreasing function of the size of the informal economy and, in most cases, there is a positive relationship between the two. Finally, substantial deviations from zero inflation are observed even in presence of a plausible degree of price rigidity.

Seigniorage is a good source of government revenue and this paper shows that when you have a sizable informal sector, seigniorage becomes invaluable. The contribution of this paper is first to show how the tax mix is influential, how there seems to be some sort of Laffer curve (very loosely defined) in play, and that price rigidity matters. This paper should help countries with low tax morale.