Universal Basic Income in Developing Countries: Pitfalls and Alternatives

March 1, 2021

By Pedro Cavalcanti Ferreira, Marcel Cortes, Peruffo and André Cordeiro Valério

http://d.repec.org/n?u=RePEc:fgv:epgewp:821&r=dge

This article studies the short -and long-term effects of Universal Basic Income programs – a uniform transfer to every individual in society – in the context of a developing economy and compares this policy with other schemes that condition the transfer on household characteristics such as income and education. We construct a dynastic heterogeneous-agent model, featuring uninsurable idiosyncratic risk, investment in physical and human capital, and choice of labor effort. We calibrate the model to Brazilian data and introduce a UBI transfer equivalent to roughly 4.5% of average household income. We find that, over the short run, this policy alleviates poverty and increases welfare, especially for the poor. Over time, however, income falls and poverty and inequality increase as fewer people stay in school, labor supply decreases, and savings fall. We then explore the consequences of an equivalent transfer that is both subject to means testing and requires recipients to enroll their children in school. This policy outperforms the UBI in several dimensions, increasing overall income, reducing poverty and inequality, and improving welfare. This result is robust to varying the magnitude of the cash transfer. We then investigate which aspects of the CCT make it so effective, and find that the schooling conditionality is crucial in ensuring its long- and even short- run success.

It is very rare to find a well-thought-out and quantitative evaluation of universal basic income, and I can speak from experience. This one is really well done and looks at good alternatives. An important contribution to the UBI discussion.


“Mom, Dad: I’m staying”. Initial labor market conditions, housing markets, and welfare

February 22, 2021

By Rodrigo Martínez-Mazza

http://d.repec.org/n?u=RePEc:ieb:wpaper:doc2020-14&r=dge

Young individuals are currently living with their parents more than at any other point in time, while also spending more on housing. In this paper, I first show how labor market entry conditions affect housing tenure and affordability in the long term, by using the unemployment rate at the time of graduation as an exogenous shock to income. I perform this analysis across Europe for the last 25 years. Results indicate that a 1 pp increase in the unemployment rate at the time of graduation leads, one year after, to (1) a 1.50 pp increase in the probability of living with parents, (2) a 1.02 pp decrease in the probability of home-ownership and 0.45 pp decrease in renting, and (3) worse affordability. Second, I develop an OLG model to link income shocks for young agents with changes in housing tenure at the aggregate level. I allow for an outside option for landlords which can introduce rigidity into the rental market. Results show that if rental markets are rigid, an income shock to young agents will translate into a larger share of them living with their parents, worse affordability, and larger welfare losses. Finally, I perform a policy exercise based on the French housing aid system. I show that housing aid policies can help to recover welfare losses for young agents, by enabling them to afford to rent. Recognizing the right scenario for the implementation of these policies is key to ensure welfare gains concentrate on the targeted population.

I have so many questions about this paper, mainly about its generalization. Locational preferences are very strong in Europe, thus people tend to stay within the same town. Living with parents is then a possibility. This also constrains the potential jobs. Policies that address these frictions seem to have more potential, but also be more difficult to implement. That said, it looks like the current pandemic could also serve as a reset, as many have interpreted “work form home” as “work from parent’s home.” The post-pandemic equilibrium will not look like the one before because of this lock-in mechanism.


A Buffer-Stock Model for the Government: Balancing Stability and Sustainability

February 15, 2021

By Jean-Marc Fournier

http://d.repec.org/n?u=RePEc:imf:imfwpa:2019/159&r=dge

A fiscal reaction function to debt and the cycle is built on a buffer-stock model for the government. This model inspired by the buffer-stock model of the consumer (Deaton 1991; Carroll 1997) includes a debt limit instead of the Intertemporal Budget Constraint (IBC). The IBC is weak (Bohn, 2007), a debt limit is more realistic as it reflects the risk of losing market access. This risk increases the welfare cost of fiscal stimulus at high debt. As a result, the higher the debt, the less governments should smooth the cycle. A larger reaction of interest rates to debt and higher hysteresis magnify this interaction between the debt level and the appropriate reaction to shocks. With very persistent shocks, the appropriate reaction to negative shocks in highly indebted countries can even be procyclical.

Economists keep explaining that the government budget is not like the budget of a firm or a household. Here is a paper that tries to model a government like a household that follows a classic buffer-stock rule. This difference is that here the government loses access to market at a particular debt limit, and the distance to this limit is the buffer stock. Assuming this limit is known and invariant, this changes quite a bit the ability of the government to conduct fiscal policy.


Two papers on monetary theory where the Friedman Rule is not optimal

February 12, 2021

Nominal Contracts and the Payment System

By Hakime Tomura

http://d.repec.org/n?u=RePEc:wap:wpaper:1923&r=dge

This paper introduces into an overlapping generations model the courts inability to distinguish different qualities of goods of the same kind. Given the recognizability of fiat money for the court, this friction leads to the use of nominal debt contracts as well as the use of fiat money as a means of payment in the goods market. This result holds without dynamic inefficiency or lack of double coincidence of wants. Instead, money is necessary because it is essential for credit. However, there can occur a shortage of real money balances for liability settlements, even if the money supply follows a Friedman rule. This problem can be resolved if the central bank can lend fiat money to agents elastically at a zero intraday interest rate within each period. Given the economy being dynamically efficient, this policy makes the money supply cease to be the nominal anchor for the price level. In this case, the monetary steady state becomes compatible with other nominal anchors than the money supply.


Liquidity Premium, Credit Costs, and Optimal Monetary Policy

By Sukjoon Lee

http://d.repec.org/n?u=RePEc:pra:mprapa:104825&r=dge

I study how monetary policy affects firms’ external financing decisions. More precisely, I study the transmission mechanism of monetary policy to credit costs in a general equilibrium macroeconomic model where firms issue corporate bonds or obtain bank loans, and corporate bonds are not just stores of value but also serve a liquidity role. The model shows that an increase in the nominal policy rate can lower the borrowing cost in the corporate bond market, while increasing that in the bank loan market, and I provide empirical evidence that supports this result. The model also predicts that a higher nominal policy rate induces firms to substitute corporate bonds for bank loans, which is supported by the existing empirical evidence. In the model, the Friedman rule is suboptimal so that keeping the cost of holding liquidity at a positive level is socially optimal. The optimal policy rate is an increasing function of the degree of corporate bond liquidity.


By chance, two interesting papers about monetary policy and the Friedman Rule in this week’s NEP-DGE report. Monetary theory is quite dizzying as small details can lead to dramatically different results. The details can be about what money actually is, how it is used, how credit is collateralized, etc. This is fascinating, but also difficult to keep up. Policy advice is so difficult, yet important.


The Welfare and Distributional Effects of Fiscal Volatility: A Quantitative Evaluation

February 2, 2021

By Rüdiger Bachmann, Jinhui Bai, Minjoon Lee and Fudong Zhang

http://d.repec.org/n?u=RePEc:ris:wsuwpa:2020_002&r=dge

This study explores the welfare and distributional effects of fiscal volatility using a neoclassical stochastic growth model with incomplete markets. In our model, households face uninsurable idiosyncratic risks in their labor income and discount factor processes, and we allow aggregate uncertainty to arise from both productivity and government purchases shocks. We calibrate our model to key features of the U.S. economy, before eliminating government purchases shocks. We then evaluate the distributional consequences of the elimination of fiscal volatility and find that, in our baseline case, welfare gains increase with private wealth holdings.

Fiscal policy has no role, how is this possible? Well, this is a standard result of the canonical real-business-cycle model, so it should not be a surprise. The difference here is that as markets are incomplete, government purchases could provide aggregate insurance that the economy needs. The government provides additional insurance through unemployment insurance and tax progressivity, but in this model, the sole source of fiscal policy volatility are the shocks to G. While G provides utility, its fluctuations are just contributing to general volatility, thus is should not be a surprise that shutting down its volatility is welfare improving. So, what is the point of the paper? One, the welfare cost is small. Two, the welfare cost is largest for the rich, an interesting departure of usual business cycle costs. This is because the after-tax return of capital fluctuations affect most the rich.


The macroprudential toolkit: effectiveness and interactions

January 26, 2021

By Stephen Millard, Margarita Rubio and Alexandra Varadi

http://d.repec.org/n?u=RePEc:boe:boeewp:0902&r=dge

We use a DSGE model with financial frictions, leverage limits on banks, loan to value (LTV) limits and debt‑service ratio (DSR) limits on mortgage borrowing to examine: i) the effects of different macroprudential policies on key macro aggregates; ii) their interaction with each other and with monetary policy; and iii) their effects on the volatility of key macroeconomic variables and on welfare. We find that capital requirements can nullify the effects of financial frictions and reduce the effects of shocks emanating from the financial sector on the real economy. LTV limits, on their own, are not sufficient to constrain household indebtedness in booms, though can be used with capital requirements to keep DSRs under control. Finally, DSR limits lead to a significant decrease in the volatility of lending, consumption and inflation, since they disconnect the housing market from the real economy. Overall, DSR limits are welfare improving relative to any other macroprudential tool.

This paper shows nicely that central banks have other useful tools in their hand to manage business cycles. This is only a first step though. One still needs to show that a policy maker can work with them efficiently and practically, for example that they can be changed in time for good effect. Also, when the economy is in something like a corner solution like now, do these tools still work (or work even better)?


Labor Market Informality and the Business Cycle

January 19, 2021

By Frédéric Lambert, Andrea Pescatori and Frederik Toscani

http://d.repec.org/n?u=RePEc:imf:imfwpa:2020/256&r=dge

Labor market informality is a pervasive feature of most developing economies. Motivated by the empirical regularity that the labor informality rate falls with GDP per capita, both at business cycle frequency and in a cross-section of countries, and that the Okun’s coefficient falls with the level of labor informality, we build a small open-economy dynamic stochastic general equilibrium model with two sectors, formal and informal, which can replicate these key stylized facts. The model is calibrated to Colombia. The results show that labor market and tax reforms play an important role in changing the informality rate but also caution against over-optimism – with low GDP per capita, informality will always be relatively high as there is insufficient demand for formal goods. Quantitatively we find that higher productivity in the formal sector is key in explaining the difference between Colombia and countries with significantly lower informality. We use the model to study how labor informality and labor market frictions mediate the cyclical response of the economy to shocks, including commodity price shocks which are particularly relevant in Latin America. Informality is shown to play an important role as a shock absorber with the informal-formal margin limiting movements in the employed-unemployed margin.

Studying informal economies is tricky business because there is poor data, pretty much by definition. But Dynamic General Equilibrium models come in handy here, as they can work with limited data (no time series required) or even absent data (best guesses can fill in). Finally they allow to work through scenarios that have not (yet) been observed thanks to internal consistency. This paper is a nice example of this. It shows that informality is not only an issue of a weak state but also of low income. Also, informality has some benefits.


Rare disasters, the natural interest rate and monetary policy

January 13, 2021

By Alessandro Cantelmo

http://d.repec.org/n?u=RePEc:bdi:wptemi:td_1309_20&r=dge

This paper evaluates the impact of rare disasters on the natural interest rate and macroeconomic conditions by simulating a nonlinear New-Keynesian model. The model is calibrated using data on natural disasters in OECD countries. From an ex-ante perspective, disaster risk behaves as a negative demand shock and lowers the natural rate and inflation, even if disasters hit only the supply side of the economy. These effects become larger and nonlinear if extreme natural disasters become more frequent, a scenario compatible with climate change projections. From an ex-post perspective, a disaster realization leads to temporarily higher natural rate and inflation if supply-side effects prevail. If agents’ risk aversion increases temporarily, disasters may generate larger demand effects and lead to a lower natural rate and inflation. If supply-side effects dominate, the central bank could mitigate output losses at the cost of temporarily higher inflation in the short run. Conversely, under strict inflation targeting, inflation is stabilized at the cost of larger output losses.

I mentioned several times on this blog that demographic aging is a source of declining interest rates. Now add climate change to the mix. As it looks like declining fertility may also come from climate change, the two shocks may reinforce each other in reducing interest rates. After a decade or two with interest rates kept low by policy, they may not be increasing that much once we get back to “normal” times.


How Important Is Health Inequality for Lifetime Earnings Inequality?

January 7, 2021

By Roozbeh Hosseini, Karen A. Kopecky and Kai Zhao

http://d.repec.org/n?u=RePEc:uct:uconnp:2020-20&r=dge

Using a dynamic panel approach, we provide empirical evidence that negative health shocks reduce earnings. The effect is primarily driven by the participation margin and is concentrated in less educated and poor health individuals. We build a dynamic, general equilibrium, lifecycle model that is consistent with these findings. In the model, individuals, whose health is risky and heterogeneous, choose to either work, or not work and apply for social security disability insurance (SSDI). Health impacts individuals’ productivity, SSDI access, disutility from work, mortality, and medical expenses. Calibrating the model to the United States, we find that health inequality is an important source of lifetime earnings inequality: nearly 29 percent of the variation in lifetime earnings at age 65 is due to the fact that Americans face risky and heterogeneous life-cycle health profiles. A decomposition exercise reveals that the primary reason why individuals in the United States in poor health have low lifetime earnings is because they have a high probability of obtaining SSDI benefits. In other words, the SSDI program is an important contributor to lifetime earnings inequality. Despite this, we show that it is ex ante welfare improving and, if anything, should be expanded.

Interesting paper with a potentially puzzling conclusion. SSDI increases inequality because its existence allows people to stop working when disabled, thus they have lower income (though one could ask if their income could have decreased further without SSDI). But SSDI is good because it provide insurances against having to work while disabled, i.e., a non-monetary component to welfare. Income is not everything.


Consumer Credit With Over-Optimistic Borrowers

December 21, 2020

By Florian Exler, Igor Livshits, James MacGee and Michèle Tertilt

http://d.repec.org/n?u=RePEc:bon:boncrc:crctr224_2020_245&r=dge (paper is the first on the list once you click on this link)

There is active debate over whether borrowers’ cognitive biases create a need for regulation to limit the misuse of credit. To tackle this question, we incorporate overoptimistic borrowers into an incomplete markets model with consumer bankruptcy. Lenders price loans, forming beliefs—type scores—about borrowers’ types. Since over-optimistic borrowers face worse income risk but incorrectly believe they are rational, both types behave identically. This gives rise to a tractable theory of type scoring as lenders cannot screen borrower types. Since rationals default less often, the partial pooling of borrowers generates cross-subsidization whereby over-optimists face lower than actuarially fair interest rates. Over-optimists make financial mistakes: they borrow too much and default too late. We calibrate the model to the US and quantitatively evaluate several policies to address these frictions: reducing the cost of default, increasing borrowing costs, imposing debt limits, and providing financial literacy education. While some policies lower debt and filings, they do not reduce over-borrowing. Financial literacy education can eliminate financial mistakes, but it also reduces behavioral borrowers’ welfare by ending cross-subsidization. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.

Borrowing is a form of leveraging your assets. The better the prospects, the more you should leverage. The problem is with those who misread the prospects and are over-optimistic. And if you cannot identify those, it is actually pretty difficult to correct for these biases without reducing overall welfare.