Does Inattentiveness Matter for DSGE Modelling? An Empirical Investigation

January 12, 2022

By Jenyu Chou, Joshy Easaw and Patrick Minford

The purpose of this paper is to investigate the empirical performance of the standard New Keynesian dynamic stochastic general equilibrium (DSGE) model in its usual form with full-information rational expectations and compare it with versions assuming inattentiveness- namely sticky information and imperfect information data revision. Using a Bayesian estimation approach on US quarterly data (both realtime and survey) from 1969 to 2015, we find that the model with sticky information fits best and is the only one that can generate the delayed responses observed in the data. The imperfect information data revision model is improved fits better when survey data is used in place of real-time data, suggesting that it contains extra information.

This looks like a very interesting question. Given all the attention to news shocks and their proven relevance, it must matter how people digest information. However, we you think about inattention, one is inattentive to small things and attentive to large ones. This must imply that the relationship is highly non-linear. But it looks like the model is linear. Thus, I not not know what to make of the results, all the more that there is Calvo-pricing, which basically implies lack of attention.

Financial Constraints, Sectoral Heterogeneity, and the Cyclicality of Investment

January 4, 2022

By Cooper Howes

While investment in most sectors declines in response to a contractionary monetary policy shock, investment in the manufacturing sector increases. Using manually digitized aggregate income and balance sheet data for the universe of U.S. manufacturing firms, I show this increase is driven by the types of firms that are least likely to be financially constrained. A two-sector New Keynesian model with financial frictions can match these facts; unconstrained firms are able to take advantage of the decline in the user cost of capital caused by the monetary contraction, while constrained firms are forced to cut back.

I must confess I was not aware of this fact that manufacturing investment is countercyclical. This paper demonstrates also a nice automatic stabilizer from that sector. I wonder, though, whether the size of manufacturing matters in this regard, as a larger sector would not be able to take as easily advantage of lower capital costs.

The impact of U.S. employer-sponsored insurance in the 20th century

December 31, 2021

By Vegard Nygaard and Gajendran Raveendranathan

The introduction of employer-sponsored insurance (ESI) in the 1940s led to the largest decline in the uninsurance rate in U.S. history. To study the fiscal and welfare implications of this insurance expansion, we endogenize the selection of workers into jobs with and without ESI in a general equilibrium life-cycle model where consumers face idiosyncratic health shocks. Our model rationalizes non-targeted empirical patterns related to ESI coverage between 1940 and 2010 and in recent cross-sectional data. ESI leads to moderate welfare gains in the short run (0.5 percent of lifetime consumption for the average consumer) but zero gains or even moderate losses in the long run. The reason is that the health insurance benefit provided by ESI dominates in the short run but the tax increase required to offset ESI tax exemptions dominates in the long run. We substantiate these welfare estimates by showing that our model rationalizes both the level and rise in total ESI tax exemptions. Finally, we show that tax-financed universal health insurance — considered among policymakers in the 1930s — would have led to significantly higher welfare gains.

The fact the the employment-based health insurance model in the United States is suboptimal is not deniable. The contribution of this paper is that first that it does not contribute much of anything in well-being, and second that it quantifies how much better a simple tax-based health-insurance model would improve things, without even getting into why health care is so expensive in the United States.

Unintended Effects From the Expansion of the Non-Contributory Health System in Peru

December 24, 2021

By Jonas Nauerz and Jose Torres

Over the last two decades, the Peruvian government has made great efforts to improve access to health care by significantly augmenting the coverage of the non-contributory public health care system Seguro Integral de Salud (SIS). This expansion has a positive impact on welfare and public health indicators, as it limits the risk of catastrophic health-related costs for previously uninsured individuals and allows for the appropriate treatment of illnesses. However, it also entails some unintended consequences for informality, tax revenues, and GDP, since a few formal agents are paying for a service that the majority of (informal) agents receive for free. In this paper, we use a general equilibrium model calibrated for Peru to simulate the expansion of SIS to quantify the unintended effects. We find that overall welfare increases, but informality rises by 2.7 percent, while tax revenues and output decrease by roughly 0.1 percent. Given the extent of the expansion in eligibility, the economic relevance of these results seems negligible. However, this occurs because the expansion of coverage was mostly funded by reducing the spending per insured person. In fact, we find larger costs if public spending is increased to improve the quality of service given universal coverage.

This is a nice example of a “non-traditional” use of a DSGE model, in particular for a question where data is bad (if there is nay) and plain empirical research would not cut it. If fact, even if there were good data, they would not be reliable to run through some of the scenarios that are presented here. As a bonus, interesting results, where I wonder whether they can be generalized to economies with less disparity in incomes. Indeed, it is my understanding that the rich can pay for the healthcare of the (informal) poor is because their incomes are so much higher and subsidizing the poor is cheap.

No Regret Fiscal Reforms

December 20, 2021

By Pierre-Édouard Collignon

How should fiscal policy react to shocks ex-post while preserving incentives to work and save ex-ante? The standard solution involves a commitment to a contingent policy, whereby the initial government sets all the policies for all future states of the world. Contingent policies are unrealistic. As an alternative, I introduce ”No Regret Fiscal Reforms”: the government has the discretion to change its fiscal policy provided households do not regret their past decisions. Hence flexibility is provided and incentives to work and save are preserved. Such reforms can be achieved by changing taxes on both capital and labor such that wealth effects exactly compensate substitution effects. In a representative agent framework, I study how a benevolent government uses No Regret fiscal reforms and I make comparisons to the optimal contingent policy. Both approaches yield very similar policies and allocations but No Regret reforms entail a small welfare loss. Second, I consider robustness to Near-Rational Expectations i.e the government is uncertain of the households’ beliefs about the distribution of shocks and implements a policy robust to this uncertainty. No Regret fiscal reforms are fully robust to this departure from rational expectations. Finally, I characterize No Regret fiscal reforms with wealth and skill heterogeneity.

The idea here is that households’ decisions are not influenced by what the government does. In other words, households are completely insured against the government’s actions. Fine, but isn’t the role of government to have an impact on household decisions, that is, be relevant? I am confused.

The Murder-Suicide of the Rentier: Population Aging and the Risk Premium

December 18, 2021

By Joseph Kopecky and Alan Taylor

Population aging has been linked to global declines in real interest rates. A similar trend is seen for equity risk premia, which are on the rise. An existing literature can explain part of the declining trend in safe rates using demographics, but has no mechanism to speak to trends in relative returns on different assets. We calibrate a heterogeneous agent life-cycle model with equity markets and aggregate risk, and we show that aging demographics can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing the return premium attached to risky assets. This is because the life-cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue to push the risk free rate further into negative territory, while the equity risk premium remains elevated.

One more paper I highlight about the consequences of aging on asset markets. There is now a substantial body of literature that shows the inevitable changes in returns, yet I see nothing translated into actual recommendations to investors. Where is the disconnect? Or am I not looking at the right place?

Welfare Costs of Exchange Rate Fluctuations: Evidence from the 1972 Okinawa Reversion

December 3, 2021

By Kazuko Kano and Takashi Kano

The main tenet of the New Keynesian (NK) paradigm is that price dispersion caused by nominal price stickiness is the primary source of allocative inefficiency. This study empirically evaluates the welfare implications of NK models by observing how internal and external price dispersion responds to two types of large aggregate shocks: high inflation and sharp currency depreciation. For this purpose, we consider the history of US military deployment on a small southern island in Japan called Okinawa following the Pacific War. We investigate unique data variations in micro-level retail prices surveyed in Okinawa and mainland Japan before and after the Okinawan reversion to Japanese sovereignty in May of 1972. By considering the Okinawan experience of three currency regimes during the high inflation period of the early 1970s as valid quasi-natural experiments, we identify statistically significant deteriorations of currency misalignment associated with the sudden exogenous large USD depreciation versus the JPY following the Nixon Shock. Furthermore, we observe that these massive aggregate shocks left the average absolute size of price changes mostly unchanged, but significantly increased the average frequency of price changes in Okinawa. Because a calibrated small open-economy menu cost model fits these empirical findings better than the Calvo model, the welfare costs of exchange rate fluctuations may be more elusive than suggested by the open-economy NK literature.

This is actually a very cool natural experiment. Even more amazing, it shows that one can still find detailed data for such events that happened fifty years ago.

Democracy or Optimal Policy: Income Tax Decisions without Commitment

November 27, 2021

By Youngsoo Jang

How do differences in the government’s political and commitment structure affect the aggregate economy, inequality, and welfare? I analyze this question, using a calibrated Aiyagari’s (1994) economy with wealth effects of labor supply wherein a flat tax rate and transfers are endogenously determined according to its political and commitment structure. I compare four economies: a baseline economy, an economy with the optimal tax with commitment in all steady states, an economy with the optimal tax without commitment, and a political economy with sequential voting. I obtain two main findings. First, the commitment structure shifts the government’s weighting between redistribution and efficiency. A lack of commitment leads the government to pursue a more redistributive policy at the expense of efficiency. Second, given a lack of commitment, the political economy with voting yields greater welfare than the economy with the time-consistent optimal policy. In the latter case, a lack of commitment hinders the government from implementing a more frugal policy desirable in the long run; instead, it cares more for low-income and wealth households, resulting in a substantial efficient loss. However, in the political economy with voting, the government considers only the interests of the median voter, who is middle class and reluctant to bear larger distortions from a higher tax rate and larger transfers. These findings imply that in terms of welfare, policies targeting the middle class would possibly be better than those exquisitely designed for the general public.

That institutional design matters for policy setting in nothing new, including for Aiyagari models. It easy to imagine why: you change the welfare function between a voting equilibrium and one based on average welfare, for example. This paper shows that the ability of the government to commit matters as well.

Green technology policies versus carbon pricing. An intergenerational perspective

November 22, 2021

By Sebastian Rausch and Hidemichi Yonezawa

Technology policy is the most widespread form of climate policy and is often preferred over seemingly efficient carbon pricing. We propose a new explanation for this observation: gains that predominantly accrue to households with large capital assets and that influence majority decisions in favor of technology policy. We study climate policy choices in an overlapping generations model with heterogeneous energy technologies and distortionary income taxation. Compared to carbon pricing, green technology policy leads to a pronounced capital subsidy effect that benefits most of the current generations but burdens future generations. Based on majority voting which disregards future generations, green technology policies are favored over a carbon tax. Smart “polluter-pays” financing of green technology policies enables obtaining the support of current generations while realizing efficiency gains for future generations.

Interesting explanation on why it is so difficult to convince people and politicians about carbon taxes.

An Economy of Neural Networks: Learning from Heterogeneous Experiences

November 19, 2021

By Artem Kuriksha

This paper proposes a new way to model behavioral agents in dynamic macro-financial environments. Agents are described as neural networks and learn policies from idiosyncratic past experiences. I investigate the feedback between irrationality and past outcomes in an economy with heterogeneous shocks similar to Aiyagari (1994). In the model, the rational expectations assumption is seriously violated because learning of a decision rule for savings is unstable. Agents who fall into learning traps save either excessively or save nothing, which provides a candidate explanation for several empirical puzzles about wealth distribution. Neural network agents have a higher average MPC and exhibit excess sensitivity of consumption. Learning can negatively affect intergenerational mobility.

This is an interesting approach to a old problem. There is an learning literature out there that has shown that rational expectations are not necessarily a convergence outcome, and this is another example of that. But there is also a literature that shows that markets can help a lot in getting to the “right” equilibrium. This is a field that is studied enough.