July 3, 2021
By Stephie Fried, Kevin Novan and William Peterman
This paper explores how to recycle carbon tax revenue back to households to maximize welfare. Using a general equilibrium lifecycle model calibrated to reflect the heterogeneity in the U.S. economy, we find the optimal policy uses two thirds of carbon-tax revenue to reduce the distortionary tax on capital income while the remaining one third is used to increase the progressivity of the labor-income tax. The optimal policy attains higher welfare and more equality than the lump-sum rebate approach preferred by policymakers as well as the approach originally prescribed by economists — which called exclusively for reductions in distortionary taxes.
It turns out, it is really difficult to convince people about carbon taxes. They need to see direct benefits, while indirect, general equilibrium benefits are difficult to grasp. This is one of those cases where you need to see what is “politically feasible” instead of what is “economically best” or you are stuck with the status quo. Too bad, because here we have a great paper telling us how we could do the “economically best.”
June 29, 2021
By Volker Grossmann, Benjamin Larin and Thomas Steger
The housing wealth-to-income ratio has been increasing in most developed economies since the 1950s. We provide a novel theory to explain this long-term pattern. We show analytically that house prices grow in the steady state if i) the housing sector is more land-intensive than the non-housing sector. Despite growing house prices and housing wealth, the housing wealth-to income ratio is constant in steady state. We hence study the dynamics in the housing wealth-to-income ratio by computing transitions. The model is calibrated separately to the US, UK, France, and Germany. On average, we replicate 89 percent of the observed increase in the housing wealth-to-income ratio. The key for replicating the data is the differentiation between residential land as a non-reproducible factor and residential structure as reproducible factor. The transition process from the calibrated model points to two driving forces of an increasing housing wealth-to-income ratio: i) A long-lasting construction boom that brought about a pronounced build-up in the stock of structures and ii) an increase in the demand for residential land that resulted in surging residential land prices.
You heard the complaints that housing prices are increasing everywhere and that housing takes a too large portion of total expenses. And this is not a recent phenomenon. This paper lays out neatly a model with just the right ingredient to study this. The answer is powerful yet subtle: it is all in the dynamics.
June 27, 2021
By Diego Daruich and Raquel Fernández
The idea of universal basic income (UBI)—a set income that is given to all without any conditions—is making an important comeback but there is no real evidence regarding its long-term consequences. This paper provides a very inexpensive evaluation of such a policy by studying its dynamic consequences in a general equilibrium model with imperfect capital markets and labor market shocks, in which households make decisions about education, savings, labor supply, and with intergenerational linkages via skill formation. The steady state of the model is estimated to match US household data. We find that a UBI policy that gives all households a yearly income equivalent to the poverty line level has very different welfare implications for those alive when the policy is introduced relative to future generations. While a majority of adults (primarily older non-college workers) would vote in favor of introducing UBI, all future generations (operating behind the veil of ignorance) would prefer to live in an economy without UBI. The expense of the latter leads to lower skill formation and education, requiring even higher tax rates over time. Modeling automation as an increased probability of being hit by an “out-of-work” shock, the model is also used to provide insights on how the benefits of UBI change as the environment becomes riskier. The results suggest that UBI may be a useful transitional policy to help current individuals whose skills are more likely to become obsolete and are unprepared for the increased risk, while, simultaneously, education policies may be implemented to increase the likelihood that future cohorts remain productive and employed.
My own experience has been that it is extremely difficult to justify UBI, its financing is simply too distorting for its limited, untargeted benefits. This paper adds endogenous education to the mix actually finds some people that would like to enjoy UBI, but they make it worse for future generations (who of course do not have a vote). The paper also shows that UBI is not a cure-all that can replace all other policies. Targeted policies are still needed.
May 31, 2021
By Alan Finkelstein Shapiro and Gilbert Metcalf
We analyze the quantitative labor market and aggregate effects of a carbon tax in a framework with pollution externalities and equilibrium unemployment. Our model incorporates endogenous labor force participation and two margins of adjustment influenced by carbon taxes: firm creation and green production-technology adoption. A carbon-tax policy that reduces carbon emissions by 35 percent – roughly the emissions reductions that will be required under the Biden Administration’s new commitment under the Paris Agreement – and transfers the tax revenue to households generates mild positive long-run effects on consumption and output; a marginal increase in the unemployment and labor force participation rates; and an expansion in the number and fraction of firms that use green technologies. In the short term, the adjustment to higher carbon taxes is accompanied by gradual gains in output and consumption and a negligible expansion in unemployment. Critically, abstracting from endogenous firm entry and green-technology adoption implies that the same policy has substantial adverse short- and long-term effects on labor income, consumption, and output. Our findings highlight the importance of these margins for a comprehensive assessment of the labor market and aggregate effects of carbon taxes.
Interesting to see that a carbon tax does not entail any output loss, even in the short term. Why is it then such a hard sell?
May 26, 2021
By Jorge Miranda-Pinto and Gang Zhang
We show that, unlike any other recession after World War II, sectoral output comovement significantly increased during the Great Recession. On the other hand, trade credit supply, as measured by the ratio of account receivables to the total value of outputs, collapsed during the Great Recession. We show that sectoral comovement was larger for sectors connected through trade credit. We then develop a multisector model with occasionally binding credit constraints and endogenous supply of trade credit to explain these facts. The model shows that equilibrium trade credit reflects both the intermediate supplier’s and client’s bank lending conditions, and thus has asymmetric effects on sectoral outputs. When banking shocks are idiosyncratic, trade credit serves as a mitigation mechanism as firms are able to substitute bank loans for trade credit. However, when banking shocks are strongly correlated, trade credit amplifies the negative financial shock and generates the sharp increase in sectoral comovement observed during the Great Recession. We show that production network models with reduced form wedges are unable to generate this pattern, and that a model with endogenous trade credit amplifies the Great Recession in 18%.
The Great Recession was characterized by a large shock common to all sectors. I suspect we will see the same with the pandemic recession. The same mechanism seems at play: a shocks initially impacts several sectors, and it then filters to others sector, through credit in one recession and through supply chain disruptions in the other.
May 18, 2021
By Nils Gornemann, Keith Kuester and Makoto Nakajima
We build a New Keynesian business-cycle model with rich household heterogeneity. In the model, systematic monetary stabilization policy affects the distribution of income, income risks, and the demand for funds and supply of assets: the demand, because matching frictions render idiosyncratic labor-market risk endogenous; the supply, because markups, adjustment costs, and the tax system mean that the average profitability of firms is endogenous. Disagreement about systematic monetary stabilization policy is pronounced. The wealth rich or retired tend to favor inflation targeting. The wealth-poor working class, instead, favors unemployment-centric policy. One- and two-agent alternatives can show unanimous disapproval of inflation-centric policy, instead. We highlight how the political support for inflation-centric policy depends on wage setting, the tax system, and the portfolio that households have.
All the way back in 2012, I reported about a first paper by the same three authors tackling the issue of the heterogeneous impact of monetary policy. It is nice to see all the progress made since on this topic and how it relates to current events.
May 16, 2021
By Ed Westerhout, Lex Mijdam, Eduard Ponds and Jan Bonenkamp
In many countries, both pay-as-you-go (PAYG) and funding are used to finance pensions, although the balance between the two principles differs a lot between countries. Over the last decades, many countries made a gradual transition to more funding. In this paper, we develop an analytical framework that includes three models of pension design, allowing us to study the role of efficiency aspects, redistributional aspects and political-economy aspects. We subsequently analyze the impact of several trends (a permanent decline in the rate of return on financial markets, a decline in the average rate of economic growth, decreased output volatility and increased capital market volatility) on the optimal balance between PAYG and funding. We argue that it may be optimal to revise the gradual transition to more funding and to revive PAYG.
This paper is a really nice overview of the literature on pension system along with an interesting analysis that shows that optimal policy design changes as fundamentals change.
May 3, 2021
By Yvan Lenwiler and Athanasios Orphanides
Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank’s collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This can potentially induce sovereign debt crises and defaults that would not otherwise arise.
A strong case here for European Union bonds and thus for the ECB stopping to deal with national bonds. Or a good example of politics and economics getting into each others’ way.
April 29, 2021
By Angela Abbate and Dominik Thaler
Empirical research suggests that lower interest rates induce banks to take higher risks. We assess analytically what this risk-taking channel implies for optimal monetary policy in a tractable New Keynesian model. We show that this channel creates a motive for the planner to stabilize the real rate. This objective conflicts with the standard inflation stabilization objective. Optimal policy thus tolerates more inflation volatility. An inertial Taylor-type reaction function becomes optimal. We then quantify the significance of the risk-taking channel for monetary policy in an estimated medium-scale extension of the model. Ignoring the channel when designing policy entails non-negligible welfare costs (0.7% lifetime consumption equivalent).
Nobody said monetary policy was easy. Even when the central bank’s mandate has only one or two objectives, and thus one or two tools should be sufficient, it always turns out that there are implicitly more objectives. Or like in this case, tools are not narrowly focused and have other implications. Central banks really need more tools, call them unconventional if you want.
April 19, 2021
By Giovanni Pellegrino; Efrem Castelnuovo; Giovanni Caggiano
We employ a nonlinear VAR framework and a state-of-the-art identification strategy to document the large response of real activity to a financial uncertainty shock during and in the aftermath of the great recession. We replicate this evidence with an estimated DSGE framework featuring a concept of uncertainty comparable to that in our VAR. We then use the estimated framework to quantify the output loss due to the large uncertainty shock that materialized in 2008Q3. We find such a shock to be able to explain about 60% of the output loss in the 2008-2014 period. The same estimated model unveils the role successfully played by the Federal Reserve in limiting the output loss that would otherwise have occurred had monetary policy been conducted as in normal times. Finally, we show that the rule estimated during the great recession is able to deliver an economic outcome closer to the flexible price one than the rule describing the Federal Reserve’s conduct in normal times.
This is the first paper I see that convincingly shows the impact of Fed policy during the Great Recession. Interesting!