Two papers on exchange rate policy

December 14, 2017

FX Intervention in the New Keynesian Model

By Zineddine Alla, Raphael A Espinoza and Atish R. Ghosh

We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

The Exchange Rate as an Instrument of Monetary Policy

By Jonas Heipertz, Ilian Mihov and Ana Maria Santacreu

Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

Lately, interesting papers seem to come in pairs in the weekly NEP-DGE reports. This time they are about exchange rate policy. The first one highlights that it can help with indeterminacy and multiplicity in monetary economies, and the second one shows that an optimal policy is mightily interesting and is not a corner solution.


Two papers on wealth taxation

December 8, 2017

Use It or Lose It: Efficiency Gains from Wealth Taxation

By Fatih Guvenen, Gueorgui Kambourov, Burhan Kuruscu, Sergio Ocampo-Diaz and Daphne Chen

This paper studies the quantitative implications of wealth taxation (as opposed to capital income taxation) in an incomplete markets model with return rate heterogeneity across individuals. The rate of return heterogeneity arises from the fact that some individuals have better entrepreneurial skills than others, allowing them to obtain a higher return on their wealth. With such heterogeneity, capital income and wealth taxes have different efficiency and distributional implications. Under capital income taxation, entrepreneurs who are more productive and, as a result, generate more income pay higher taxes. Under wealth taxation, on the other hand, entrepreneurs who have similar wealth levels pay similar taxes regardless of their productivity. Thus, in this environment, the tax burden shifts from productive entrepreneurs to unproductive ones if the capital income tax were replaced with a wealth tax. This reallocation increases aggregate productivity. Second, and at the same time, it increases wealth inequality in the population. To provide a quantitative assessment of these different effects, we build and simulate an overlapping generations model with individual-specific returns on capital income and with idiosyncratic shocks to labor income. Our results indicate that switching from a capital income tax to a wealth tax increases welfare by almost 8% through better allocation of capital. We also study optimal taxation in this environment and find that, relative to the benchmark, the optimal wealth tax increases welfare by 9.6% while the optimal capital income tax increases it by 6.3%.

Inheritance Taxation and Wealth Effects on the Labor Supply of Heirs

By Fabian Kindermann, Lukas Mayr and Dominik Sachs

Taxing bequests not only generates direct tax revenue, but can have a positive impact on the labor supply of heirs through wealth effects. This leads to an increase in future labor income tax revenue. How large is this effect? We use a state of the art life-cycle model that we calibrate to the German economy to answer this question. Our model successfully matches quasi-experimental evidence regarding the size of wealth effects on labor supply. Using this evidence directly for a back of the envelope calculation fails because (i) heirs anticipate the reduction in bequests through taxation and adjust their labor supply already prior to the actual act of bequeathing, and (ii) when bequest receipt is stochastic, even those who ex post end up not inheriting anything respond ex ante to a change in the expected size of bequests. We find that for each Euro of bequest tax revenue the government mechanically generates, it obtains an additional 9 Cents of labor income tax revenue (in net present value) through a higher labor supply of (non-)heirs.

A large crop of papers in this week’s NEP-DGE report yields two on an important topic of the day: estate (or inheritance) taxation. A lot of people need to be better informed before making law, and these paper are part of that bibliography.

Macroeconomic Fluctuations with HANK & SAM: an Analytical Approach

December 8, 2017

By Morten Ravn and Vincent Sterk

New Keynesian models with unemployment and incomplete markets are rapidly becoming a new workhorse model in macroeconomics. Such models typically require heavy computational methods which may obscure intuition and overlook equilibria. We present a tractable version which can be characterized analytically. Our results highlight that – due the interaction between incomplete markets, sticky prices and endogenous unemployment risk – productivity shocks may have radically different effects than in traditional NK models, that the Taylor principle may fail, and that pessimistic beliefs may be self-fulfilling and move the economy into temporary episodes of low demand and high unemployment, as well as into a long-lasting “unemployment trap”. At the Zero Lower Bound, the presence of endogenous unemployment risk can create inflation and overturn paradoxical properties of the model. We further study financial asset prices and show that non-negligible risk premia emerge.

There is so much going on in this paper I cannot summarize it. Just read it.

Is Something Really Wrong with Macroeconomics?

November 29, 2017

By Ricardo Reis

While there is much that is wrong with macroeconomics today, most critiques of the state of macroeconomics are off target. Current macroeconomic research is not mindless DSGE modelling filled with ridiculous assumptions and oblivious of data. Rather, young macroeconomists are doing vibrant, varied, and exciting work, getting jobs, and being published. Macroeconomics informs economic policy only moderately and not more nor all that differently than other fields in economics. Monetary policy has benefitted significantly from this advice in keeping inflation under control and preventing a new Great Depression. Macroeconomic forecasts perform poorly in absolute terms and given the size of the challenge probably always will. But relative to the level of aggregation, the time horizon, and the amount of funding, they are not so obviously worse than those in other fields. What is most wrong with macroeconomics today is perhaps that there is too little discussion of which models to teach and too little investment in graduate-level textbooks.

What he says. To which I would add that more investment in undergraduate education and some vulgarization would be most welcome, too, given the common misconceptions about macroeconomics.

Capital Specificity, the Distribution of Marginal Products and Aggregate Productivity

November 22, 2017

By Andrea Lanteri and Pamela Medina

This paper studies the role of capital specificity and investment irreversibility on the distribution of marginal products of capital and aggregate TFP. We use a methodology new to the misallocation literature, based on the study of “mobility” across quantiles of a distribution. In a panel of Peruvian firms, we show that persistent dispersion in marginal products is explained to an important extent by the persistence of low marginal products. That is, by unproductive firms that take a long time to downsize. Using a quantitative general-equilibrium model of firm dynamics with idiosyncratic shocks, calibrated to match key features of our data, we argue that the persistence of low marginal products suggests that irreversibility frictions are large. Moreover, it is inconsistent with theories of misallocation based only on financing constraints.

Misallocation is a big topic these days, but little is known about the underlying frictions. This paper makes progress on this front with what looks to me a case of the sunk cost fallacy. Attachment to capital that “still works” prevents significant productivity improvements.

The Lifetime Costs of Bad Health

November 17, 2017

By Mariacristina De Nardi, Svetlana Pashchenko and Ponpoje Porapakkarm

Health shocks are an important source of risk. People in bad health work less, earn less, face higher medical expenses, die earlier, and accumulate much less wealth compared to those in good health. Importantly, the dynamics of health are much richer than those implied by a low-order Markov process. We first show that these dynamics can be parsimoniously captured by a combination of some lag-dependence and ex-ante heterogeneity, or health types. We then study the effects of health shocks in a structural life-cycle model with incomplete markets. Our estimated model reproduces the observed inequality in economic outcomes by health status, including the income-health and wealth-health gradients. Our model has several implications concerning the pecuniary and non-pecuniary effects of health shocks over the life-cycle. The (monetary) lifetime costs of bad health are very concentrated and highly unequally distributed across health types, with the largest component of these costs being the loss in labor earnings. The non-pecuniary effects of health are very important along two dimensions. First, individuals value good health mostly because it extends life expectancy. Second, health uncertainty substantially increases lifetime inequality by affecting the variation in lifespans.

This paper has already received quite a bit of attention, but I still want to highlight it this week. Indeed, imagine a new type of insurance that would insure you against being born with bad genes. There is nothing you can do about bad genes (yet), and you carry that weight your whole life (which may be shorter). This paper allows you to quantify the payout in the gene lottery. Presumably, the lucky ones would have to pay in.

Labor Market Liquidity

November 10, 2017

By Korie Amberger and Jan Eeckhout

Labor market liquidity (flows to and from employment) have decreased sharply in the US in the last decades while the unemployment rate has remained constant; and across developed economies, there are also huge differences in flows. This poses very different risk profiles for workers: low labor market liquidity makes employment more attractive (higher job security) and unemployment less so (lower reemployment security). In this paper we ask which regime offers better insurance and higher welfare: job security or reemployment security? Except for very high levels of labor market liquidity, we find that welfare for a given asset level is increasing in liquidity for both the unemployed and employed. To avoid being borrowing constrained in an illiquid labor market, unemployed workers dissave more slowly, and the employed increase their savings, whose value is affected by equilibrium prices (wages and the interest rate). However, allowing capital markets to readjust generates higher aggregate welfare as flows decrease, completely through improved job security and asset accumulation for the low-skilled employed. The aggregate welfare gains from lower liquidity are sizable, 1.4% of consumption when comparing across countries. Optimal Unemployment Insurance (UI) is around 40% in the benchmark US economy and is increasing with lower labor market liquidity. A skill-specific optimal policy heavily favors the less wealthy low skilled but less so in a more illiquid labor market. Finally, we find lower flows decrease wealth inequality.

What is the better labor market? A US-like one with high turnover and no job security, or a European-style with life-long jobs and long-term unemployment? This paper shows the former seems to dominate, as the high turnover acts like an insurance mechanism that requires less unemployment insurance and pushes people to save more, both of of which contribute to positive general equilibrium effects. The model could have added more incentive effects and they would have reinforced the result, like the fact that in a fluid labor market workers need more to stay productive to survive or that job maching will end up better if more matches are tried.