April 12, 2015
By Gabriele Camera and Jaehong Kim
The directed search model (Peters, 1984) is static; its dynamic extensions typically restrict strategies, often assuming price or match commitments. We lift such restrictions to study equilibrium when search can be directed over time, without constraints and at no cost. In equilibrium trade frictions arise endogenously, and price commitments, if they do exist, are self-enforcing. In contrast to the typical model, there exists a continuum of equilibria that exhibit trade frictions. These equilibria support any price above the static price, including monopoly pricing in arbitrarily large markets. Dispersion in posted prices can naturally arise as temporary or permanent phenomenon despite the absence of pre-existing heterogeneity.
I think directed search holds much promise, foremost because we all search with some direction, not randomly. This paper also shows that directed search can get to many of the stylized facts that hard (but not impossible) to achieve with random search models, such as price dispersion, multiple equilibria, and endogenous frictions. I most intrigued by self-enforcing price commitments: This is like reputation, and to get that endogenously is not obvious.
April 9, 2015
By Satyajit Chatterjeeand Burcu Eyigungor
We present a model of long-duration collateralized debt with risk of default. Applied to the housing market, it can match the homeownership rate, the average foreclosure rate, and the lower tail of the distribution of home-equity ratios across homeowners prior to the recent crisis. We stress the role of favorable tax treatment of housing in matching these facts. We then use the model to account for the foreclosure crisis in terms of three shocks: overbuilding, financial frictions, and foreclosure delays. The financial friction shock accounts for much of the decline in house prices, while the foreclosure delays account for most of the rise in foreclosures. The scale of the foreclosure crisis might have been smaller if mortgage interest payments were not tax deductible. Temporarily higher inflation might have lowered the foreclosure rate as well.
This paper is a perfect example of good use of DSGE and micro-foundations: an important question, careful modeling that addresses that question, replication of data, and alternative policy scenarios.
April 7, 2015
By Michael Funke, Petar Mihaylovski and Haibin Zhu
The paper sheds light on the interplay between monetary policy, the commercial banking sector and the shadow banking sector in mainland China by means of a nonlinear stochastic general equilibrium (DSGE) model with occasionally binding constraints. In particular, we analyze the impacts of interest rate liberalization on monetary policy transmission as well as the dynamics of the parallel shadow banking sector. Comparison of various interest rate liberalization scenarios reveals that monetary policy results in increased feed-through to the lending and investment under complete liberalization. Furthermore, tighter regulation of interest rates in the commercial banking sector in China leads to an increase in loans provided by the shadow banking sector.
China is special, and the Chinese financial sector extra-special, with a heavy regulated and nudged official banking sector and an over-sized shadow banking system. How to conduct monetary policy in such an environment is a challenge, and so is understanding how undoing some of the constraints is going to impact all sectors. This paper is a nice attempt at tackling this.
March 29, 2015
By Franz Hamann, Jesús Bejarano and Diego Rodriguez
The sudden collapse of oil prices poses a challenge to inflation targeting central banks in oil exporting economies. This paper illustrates that challenge and conducts a quantitative assessment of the impact of permanent changes in oil prices in a small and open economy, in which oil represents an important fraction of its exports. We calibrate and estimate a variety of real and monetary dynamic stochastic general equilibrium models using Colombian historical data. We find that, in these artificial economies the macroeconomic effects can be large but vary depending on the structure of the economy. The main channels through which the shock passes to the economy come from the increased country risk premium, the real exchange rate depreciation, the sectoral reallocation of resources from nontradables to tradables and the sluggish adjustment of prices. Contrary to the conventional findings in the literature of the financial accelerator mechanism for single-good closed economies, in multiple-goods small open economies the financial accelerator does not play a significant role in magnifying macroeconomic fluctuations. The sectoral reallocation from nontradable to tradables diminishes the financial amplification mechanism.
This paper essentially argues that there is no reason for central banks in oil exporting countries to panic when the oil price drops. Let the real exchange rate do its magic, let the economy adjust, and target the inflation rate of non-tradables, and you will be fine. If the oil price remains very low, though, this is a different matter, but there is little a central bank can do in terms of long terms structural adjustment or major changes in permanent income anyway
March 26, 2015
By Jun Nie, Yulei Luo, Gaowang Wang and Eric Young
This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003,2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that,under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.
What I take away from this paper is that general equilibrium effects are impressive. Here we have an environment where economic agents suffer from incomplete information, which should make that the permanent income hypothesis should fail, yet interest rates put them right back on track. One could say that it is not new that prices reveal information that markets participants do not know individually. However, the added difficulty here is that for the hypothesis to hold under complete information, said interest rate needs to align with time preferences. So it is not obvious that things still fall into place once you remove information.
March 23, 2015
By Patrick Kehoe, Virgiliu Midrigan and Elena Pastorino
In the Great Contraction, regions of the United States that experienced the largest change in household debt to income ratios also experienced the largest drops in output and employment. Such output drops not only occurred for firms that sell primarily to a local region but also for regional establishments of nation-wide firms that sell highly traded goods to both the rest of the United States and abroad. These patterns are difficult to reconcile with standard models of financial frictions in which tightened financial constraints mainly affect firms’ ability to borrow. We develop a Bewley-Huggett-Aiyagari incomplete market model with search and matching frictions of the Diamond-Mortenson-Pissarides type that generates such patterns. Critically, we allow for human capital acquisition by employed individuals, which generates realistic wage-tenure profiles. We show that with such upward sloping wage profiles, an unanticipated tightening of borrowing constraints leads consumers to value less the prospect of consumption when employed and, thus, to find employment relatively less attractive. In equilibrium, firms anticipate this behavior by consumers and consequently reduce the number of vacancies they post. The key result is that in equilibrium the tightening of borrowing constraints generates a path of increased unemployment that lingers, as consumers slowly adjust their asset positions given the tighter constraints, and seemingly `sticky’ wages, despite wages being continually renegotiated.
Interesting paper that offers an explanation why the drop in the labor force participation rate accelerated during the recession. The question is then whether those who are more responsive to these debt constraint effects are going to return to the labor market once the economy is back to normal. This is not obvious as the persistence of the effects likely very high if this channel is indeed as important as the authors argue.