Optimal Dynamic Capital Requirements and Implementable Capital Buffer Rules

September 22, 2020

By Matthew B. Canzoneri; Behzad T. Diba; Luca Guerrieri; Arsenii Mishin


We build a quantitatively relevant macroeconomic model with endogenous risk-taking. In our model, deposit insurance and limited liability can lead banks to make risky loans that are socially inefficient. This excessive risk-taking can be triggered by aggregate or sectoral shocks that reduce the return on safer loans. Excessive risk-taking can be avoided by raising bank capital requirements, but unnecessarily tight requirements lower welfare by limiting liquidity producing bank deposits. Consequently, optimal capital requirements are dynamic (or state contingent). We provide examples in which a Ramsey planner would raise capital requirements: (1) during a downturn caused by a TFP shock; (2) during an expansion caused by an investment-specific shock; and (3) during an increase in market volatility that has little effect on the business cycle. In practice, the economy is driven by a constellation of shocks, and the Ramsey policy is probably beyond the policymaker’s ken; so, we also consider implementable policy rules. Some rules can mimic the optimal policy rather well but are not robust to all the calibrations we consider. Basel III guidance calls for increasing capital requirements when the credit to GDP ratio rises, and relaxing them when it falls; this rule does not perform well. In fact, slightly elevated static capital requirements generally do about as well as any implementable rule.

Having toyed with this topic, all I can say is that this is an impressive effort on an important question. The analysis of cyclical capital requirements has long been hampered by inadequate modeling, in part due to difficulties working with these models. This one is really good.

Structuring Mortgages for Macroeconomic Stability

September 14, 2020

By John Y. Campbell, Nuno Clara and João F. Cocco


We study mortgage design features aimed at stabilizing the macroeconomy. We model overlapping generations of mortgage borrowers and an infinitely lived risk-averse representative mortgage lender. Mortgages are priced using an equilibrium pricing kernel derived from the lender’s endogenous consumption. We consider an adjustable-rate mortgage (ARM) with an option that during recessions allows borrowers to pay only interest on their loan and extend its maturity. We find that this maturity extension option stabilizes consumption growth over the business cycle, shifts defaults to expansions, and is welfare enhancing. The cyclical properties of the maturity extension ARM are attractive to a risk-averse lender so the mortgage can be provided at a relatively low cost.


Consumption and Income Inequality across Generations

September 7, 2020

By Giovanni Gallipoli, Hamish Low and Aruni Mitra


We characterize the joint evolution of cross-sectional inequality in earnings, other sources of income and consumption across generations in the U.S. To account for cross-sectional dispersion, we estimate a model of intergenerational persistence and separately identify the influences of parental factors and of idiosyncratic life-cycle components. We find evidence of family persistence in earnings, consumption and saving behaviours, and marital sorting patterns. However, the quantitative contribution of idiosyncratic heterogeneity to cross-sectional inequality is significantly larger than parental effects. Our estimates imply that intergenerational persistence is not high enough to induce further large increases in inequality over time and across generations.

Let me rephrase this fascinating paper. Within a family, there is an important degree of persistence in various economic behaviors across generations: earnings, savings and consumption correlate highly. In addition, there is assortitative mating: high earners tend to marry high earners, etc. We also observe that inequality has increased. Is this due to this inter-generational persistence. While this persistence is strong, it is not strong enough to influence aggregate inequality. Other forces drive that.

Doubts about the Model and Optimal Policy

August 31, 2020

By Anastasios Karantounias


This paper analyzes optimal policy in setups where both the leader and the follower have doubts about the probability model of uncertainty. I illustrate the methodology in two environments: a) an industry populated with a large firm and many small firms in a competitive fringe, where both types of firms doubt the probability model of demand shocks, and b) a general equilibrium economy, where a policymaker taxes linearly the labor income of a representative household in order to finance an exogenous stream of stochastic spending shocks. The policymaker can distrust the probability model of spending shocks more, the same, or less than the household. Whenever there are doubts about the model, cautious agents form endogenous worst-case beliefs by assigning high probability on low profitability or low-utility events. There are two forces that shape optimal policy results: the manipulation of the endogenous beliefs of the follower to the benefit of the leader, and the discrepancy (if any) in the pessimistic beliefs between the leader and the follower. Depending on the application, the leader may amplify or mitigate the worst-case beliefs of the follower.

What happens when both the policymaker and the policy “follower” are not sure of what is going on? What if either is trying to manipulate the other? As you can expect this become really complex really quickly, but it is also really important.

Climate Finance Intermediation: Interest Spread Effects in a Climate Policy Model

August 27, 2020

By Kai Lessmann and Matthias Kalkuhl


Interest rates are central determinants of saving and investment decisions. Costly financial intermediation distort these price signals by creating a spread between the interest rates on deposits and loans with substantial effects on the supply of funds and the demand for credit. This study investigates how interest rate spreads affect climate policy in its ambition to shift capital from polluting to low-carbon sectors of the economy. To this end, we introduce financial intermediation costs in a dynamic general equilibrium climate policy model. We find that costly financial intermediation affects carbon emissions in various ways through a number of different channels. For low to moderate interest rate spreads, carbon emissions increase by up to 7 percent, in particular, because of lower investments into the capital intensive clean energy sector. For very high interest rate spreads, emissions fall because lower economic growth reduces carbon emissions. If a certain temperature target should be met, carbon prices have to be adjusted upwards by up to one third under the presence of capital market frictions.

The financial sector is here to grease the wheels of the savings-to-investment engine. But there is still friction, and the consequences can be dramatic as illustrated in this paper. Now imagine if there were no financial sector: a model without a financial sector would find a “perfect” outcome, and the real world would show very inefficient investment. Glad this paper is bridging that.

Macroeconomic effects of tariffs shocks: the role of the effective lower bound and the labour market

August 20, 2020

By Pascal Jacquinot, Matija Lozej and Massimiliano Pisani


We simulate a version of the EAGLE, a New Keynesian multi-country model of the world economy, to assess the macroeconomic effects of US tariffs imposed on one country member of the euro area (EA), and the rest of the world (RW). The model is augmented with an endogenous effective lower bound (ELB) on the monetary policy rate of the EA and country-specific labour markets with search-and-matching frictions. Our main results are as follows. First, tariffs produce recessionary effects in each country. Second, if the ELB holds, then the tariff has recessionary effects on the whole EA, even if it is imposed on one EA country and the RW. Third, if the ELB holds and the real wage is flexible in the EA country subject to the tariff, or if there are segmented labour markets with directed search within each country, then the recessionary effects on the whole EA are amplified in the short run. Fourth, if the elasticity of substitution among tradables is low, then the tariff has recessionary effects on the whole EA also when the ELB does not hold.

The abstract does not do justice to the paper. This is a four-country model: US, a Euro country (Germany), the rest of the Euro zone, and the rest of the world. The US imposes a new import tariff on the Euro country and the rest of the world (but not the rest of the Euro zone), and the Euro-zone policy response is constrained by a lower bound on the policy rate. The tariff lowers GDP everywhere and increases unemployment everywhere, with the Euro country most affected, of course. The policy constraint matters. Without it, the rest of the Euro-zone would actually gain.

Dynamic General Equilibrium modelling of tiny countries

August 11, 2020

Fiscal Policy Multipliers in Small States

By Ali Alichi, Ippei Shibata and Kadir Tanyeri


Government debt in many small states has risen beyond sustainable levels and some governments are considering fiscal consolidation. This paper estimates fiscal policy multipliers for small states using two distinct models: an empirical forecast error model with data from 23 small states across the world; and a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to a hypothetical small state’s economy. The results suggest that fiscal policy using government current primary spending is ineffective, but using government investment is very potent in small states in affecting the level of their GDP over the medium term. These results are robust to different model specifications and characteristics of small states. Inability to affect GDP using current primary spending could be frustrating for policymakers when an expansionary policy is needed, but encouraging at the current juncture when many governments are considering fiscal consolidation. For the short term, however, multipliers for government current primary spending are larger and affected by imports as share of GDP, level of government debt, and position of the economy in the business cycle, among other factors.

Policy Trade-Offs in Building Resilience to Natural Disasters: The Case of St. Lucia

By Alessandro Cantelmo, Leo Bonato, Giovanni Melina and Gonzalo Salinas


Resilience to climate change and natural disasters hinges on two fundamental elements: financial protection —insurance and self-insurance— and structural protection —investment in adaptation. Using a dynamic general equilibrium model calibrated to the St. Lucia’s economy, this paper shows that both strategies considerably reduce the output loss from natural disasters and studies the conditions under which each of the two strategies provides the best protection. While structural protection normally delivers a larger payoff because of its direct dampening effect on the cost of disasters, financial protection is superior when liquidity constraints limit the ability of the government to rebuild public capital promptly. The estimated trade-off is very sensitive to the efficiency of public investment.

I have always been fascinated with tiny countries (think: Caribbean states) and how they can operate. This week’s crop of the NEP-DGE report has by coincidence two papers about such countries. The first looks at an “average” tiny country and how fiscal multipliers work in various circumstances, while the second one studies specifically St. Lucia (population 182K). The advantage of DSGE modelling is that it can work in a data-poor environment. No need for long time series, and guesses can make do if data is missing entirely. In fact, long-term averages are often sufficient.

The role of demographics and migration for the future of economic growth in China

July 28, 2020

By Juan Carlos Conesa and Yan Wang


China’s real GDP has been growing by almost 10 percent a year for the last three decades. For how long should we expect this spectacularly high growth to continue? We evaluate in a quantitative two sector model with segmented labor markets and financial frictions the prospects for China’s future growth under different policy scenarios. In our model the high growth rate observed in China since the early 1990s is fueled by the large increase in urban labor supply, because of rural-urban migration, and the emergence of private enterprises that absorb those migrant workers. Our simulations suggest that the rapid aging of its population will significantly decelerate urban labor force and economic growth starting around 2040. In a counterfactual exercise we show that substantial relaxation of labor market segmentation and financial constraints faced by private enterprises cannot compensate for that deceleration.

Mainland China has a series of demographic time bombs waiting to explode: aging, sex imbalance, shrinking of population, many internal migrants with little rights. This paper addresses some of those. China is ahead of challenging times.

Housing prices and credit constraints in competitive search

July 24, 2020

By Juan Pablo Rincón-Zapatero, Maria Belen Jerez Garcia-Vaquero and Antonia Diaz Rodriguez


We embed a competitive search model of the real estate market into a heterogeneous agent setting where households face credit constraints and idiosyncratic turnover shocks. Households can accumulate a risk-free asset to build a down payment and to smooth non-housing consumption.There is an inelastic supply of identical homes. The model is “block recursive”. In equilibrium wealthier home buyers sort into submarkets with higher prices and shorter buying times. We identify a novel amplification mechanism, arising from sorting, by which demand shocks can substantially affect housing prices. In particular, lowering down payment requirements induces entry of new buyers in the market and higher asset accumulation by current searchers, as these agents target more expensive (less congested) submarkets. This affects the distribution of prices and trading probabilities, and thereby the wealth distribution. Our quantitative results suggest that the effects on the long-run level and dispersion of housing prices can be significant.

Nice paper that highlights how general equilibrium effects are important and can annihilate the intended effect of a policy. For example, making it easier to get a mortgage may just increase house prices with no change in house ownership.

Immigration, Legal Status and Fiscal Impact

July 22, 2020

By Andri Chassamboulli and Xiangbo Liu


How do legal and illegal immigrants affect the fiscal balance and welfare of natives in the host country? To answer this question we develop a general equilibrium model with search frictions in the labor market that accounts for both the direct net contribution of immigrants to the fiscal balance and their indirect fiscal effects through their labor market impact. We calibrate the model to the US economy and find that legal immigrants increase native welfare, mainly due to their positive direct net contribution to the fiscal balance. On the other hand, illegal immigrants’ positive welfare impact stems mainly from their positive effect on job creation, which helps improve the fiscal balance, but also increases income to natives and in turn consumption. A legalization program leads to a fiscal gain and increases native welfare and it is more beneficial to the host country’s citizens than a purely restrictive immigration policy that reduces the illegal immigrant population.

There you have it: both legal and illegal immigration are beneficial to the economy in general and the natives in particular.