Dissecting Trade and Business Cycle Co-movement

November 21, 2020

By Paul Hilhak Ko


International business cycles have become highly synchronized across countries in the past three decades, yet there is a lack of consensus on whether this is due to an increase in the correlation of country-specific shocks or due to increased economic integration. To understand this empirical phenomenon, I develop a multi-country real business cycle model with international trade that captures several potential explanations: shocks to productivity, demand, leisure, investment, sectoral expenditures, and trade- linkages. By matching the data exactly with the endogenous outcomes of the model, shocks fully account for the data such as GDP and trade shares. Calibrating the model to a panel of developed (G7) countries during 1992-2014, I find that trade-linkage shocks, which capture the increased economic integration and volatility of trade flows, are essential in synchronizing international business cycles. In contrast, other correlated country-specific shocks play relatively minor roles. This suggests that trade shocks through economic integration have been the primary driver of the co-movement of international business cycles. Furthermore, I use my model to address the trade co-movement puzzle, which states that international real business cycle models should be predicting a much stronger link between trade and cross-country GDP correlations. Once I account for the trade-linkage shocks, the model predicts a strong link between trade and business cycle co-movement. This finding suggests that incorporating the dynamics of trade shocks is crucial when studying international business cycles.

I started my career with international RBC models, but soon left the field because I saw little left to say and some fundamental flaws in the models that could not be addressed. Well, as for other puzzles in Economics, you just give it a few decades and eventually this become interesting again, and the literature manages to gnaw at the puzzles. This paper shows nicely where this literature is now and what it can contribute again.

The Effect of Wealth on Worker Productivity

November 6, 2020

By Jan Eeckhout; Alireza Sepahsalari


We propose a theory that analyzes how a workers’ asset holdings affect their job productivity. In a labor market with uninsurable risk, workers choose to direct their search to jobs that trade off productivity and wages against unemployment risk. Workers with low asset holdings have a precautionary job search motive, they direct their search to low productivity jobs because those offer a low risk at the cost of low productivity and a low wage. We show that such sorting occurs under a condition closely related to Decreasing Relative Risk Aversion and that the presence of consumption smoothing can reconcile the directed search model with negative duration dependence on wages, a robust empirical regularity that the canonical directed search model cannot rationalize. We calibrate the infinite horizon economy and find that this mechanism is quantitatively important. We evaluate a tax financed unemployment insurance (UI) scheme and how it affects welfare. Aggregate welfare is inverted U-shaped in benefits: the insurance effect UI dominates the incentive effects for low levels of benefits and vice versa for high benefits. Also, when UI increases, total production falls in the economy while worker productivity increases. Finally, we compare a one-off severance payment with per period benefits and find that per period benefits generate superior welfare.

This is an interesting twist in the optimal unemployment insurance literature. Wealth does not only affect job taking decision, but also productivity or effort on the job. In this model this happens by sorting into jobs with different productivities. This conveniently fixes some issues with the theoretical literature, such as the relationship between unemployment duration and wages.

DSGE Models Used by Policymakers: A Survey

October 28, 2020

By Takeshi Yagihashi


The paper conducts a comprehensive survey on the current state of the dynamic stochastic general equilibrium (DSGE) models developed by policy institutions, including central banks, government agencies, and international organizations around the world. Our main sample consists of 84 models developed by 58 institutions, and many of them were developed or updated after the 2008 financial crisis. We first document the evolution of macroeconomic models used for policy purpose, and then provide summary statistics on the models by type of institution, region, and number of authors of the publication. We find that there is a steady increase in the development of DSGE models by policy institutions. While central banks have been the main users of DSGE models, more government agencies in Europe have been actively developing their own DSGE models in the years following the 2008 Global Financial Crisis. We also find that some institutions have multiple DSGE models serving different purposes. Next, we narrow our focus to a subset of 42 models that are owned and actively used by policy institutions, and conduct a model comparison based on five key model features. Although the models share common basic structures, there are large variations in parameter values and modelling strategies, some of which do not necessarily reflect the findings of the empirical literature. Finally, we create a score card for each model depending on whether the model incorporated recent empirical findings on the five model features. Two models have a score of 4 out of 5, and the overall average is 2.21. In conclusion, there is a greater need for future DSGE policy models to adopt more recent findings in the empirical literature.

There is widely held belief that DSGE models are not used in policymaking. This is far from the truth, and this papers gives a nice compilation of some of the uses in ministries, central banks, and international organizations. As I have shown several times on this blog, they are incredibly powerful for understanding scenarios, especially when one faces a historically new situation, when there is a lack of data, or when one needs to disentangle several shocks.

The limits to robust monetary policy in a small open economy with learning agents

October 26, 2020

By André Marine Charlotte and Dai Meixing


We study the impact of adaptive learning for the design of a robust monetary policy using a small open-economy New Keynesian model. We find that slightly departing from rational expectations substantially changes the way the central bank deals with model misspecification. Learning induces an intertemporal trade-off for the central bank, i.e., stabilizing inflation (output gap) today or stabilizing it tomorrow. The central bank should optimally anchoring private agents expectations in the short term in exchange of easier future intratemporal trade-offs. Compared to the rational expectations equilibrium, the possibility to conduct robust monetary policy is limited in a small open economy under learning for any exchange rate pass-through level and any degree of trade openness. The misspecification that can be introduced into all equations of the model is lower in a small open economy, and approaches zero at high speed as the learning gain rises.

Central banking is hard: so much is endogenous and based on expectations and incomplete information. This paper shows that if there is learning in play, this is doubly difficult. And still, in this model there is complete certainty about interest rates. Imagine when that is not the case.

Uncertainty and Monetary Policy during Extreme Events

October 23, 2020

By Giovanni Pellegrino, Efrem Castelnuovo and Giovanni Caggiano


How damaging are uncertainty shocks during extreme events such as the great recession and the Covid-19 outbreak? Can monetary policy limit output losses in such situations? We use a nonlinear VAR framework to document the large response of real activity to a financial uncertainty shock during the great recession. We replicate this evidence with an estimated DSGE framework featuring a concept of uncertainty comparable to that in our VAR. We employ the DSGE model to quantify the impact on real activity of an uncertainty shock under different Taylor rules estimated with normal times vs. great recession data (the latter associated with a stronger response to output). We find that the uncertainty shock-induced output loss experienced during the 2007-09 recession could have been twice as large if policymakers had not responded aggressively to the abrupt drop in output in 2008Q3. Finally, we use our estimated DSGE framework to simulate different paths of uncertainty associated to different hypothesis on the evolution of the coronavirus pandemic. We find that: i) Covid-19-induced uncertainty could lead to an output loss twice as large as that of the great recession; ii) aggressive monetary policy moves could reduce such loss by about 50%.

Thus, public policy can be effective at alleviating (partially) large shocks that hit an economy, in particular by being flexible to react to uncertain events. That seems a good description of what fiscal and monetary policy can do. And the main thing monetary policy should do. Fiscal policy can have other goals, too.

A Structural Model of the Labor Market to Understand Gender Gaps among Marginalized Roma Communities

October 19, 2020

By Mauricio Salazar-Saenz and Monica Robayo


This paper constructs and estimates a household-level search model to analyze Roma spouses’ utility maximization for leisure, home production, and work. The paper aims to explain labor market gender gaps in a marginalized Roma population with low labor market participation rates (males 53 percent and females 17 percent). The analysis uses data from the 2017 Regional Roma Survey for six Western Balkan countries. The simulation results show that the main source for gender differentials in the labor market is the unequal opportunities in favor of males — not gender preferences or differences in home production productivity. Therefore, most of the gender differences in the labor market can be closed by providing wives the same labor market conditions as husbands. Counterfactual policy experiments show that policies that increase the frequency of receiving a job offer, decrease the frequency of laying off workers, and reduce search increase Roma husbands’ labor participation. Policies that equalize wages induces more wives to join the labor market and husbands to withdraw from it. This outcome signals that the wage gap is the dimension that deters the greatest number of Roma wives from joining the labor market.

There are two reasons I highlight this particular paper this week. The first is the rather unusual topic that actually fits very well for the modelling strategy. DSGE models are actually great tools in unusual setups where data or information may be lacking. Theory does wonders in such situations! The second reason is that I love how the paper is written. Each paragraph is introduced by one sentence in bold that summarizes it. Great for quick reading and getting additional details when you want them.

Monetary policy under imperfect information and consumer confidence

September 28, 2020

By Jan-Niklas Brenneisen


Although it is generally accepted that consumer confidence measures are informative signals about the state of the economy, theoretical macroeconomic models designed for the analysis of monetary policy typically do not provide a role for them. I develop a framework with asymmetric information in which the efficacy of monetary policy can be improved, when the imperfectly informed central banks include confidence measures in their information set. The beneficial welfare effects are quantitatively substantial in both a stylized New Keynesian model with optimal monetary policy and an estimated medium-scale DSGE model.

Policymakers take consumer confidence into account as long as it provides some additional information. In a typical model, consumer expectations do not, as they are formed on the same information set as that of the policymaker. In this paper, households have some private information, and thus their behavior is informative to the policymaker. Is that realistic? Difficult to say. Policymakers are well-informed and I suspect they ponder their decisions more than households. But the private sector still may know things that have not yet made it into the official statistics. Anyway, this paper is an interesting way to study this question.

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.