How Should Financial Intermediation Services be Taxed?

November 24, 2010

By Ben Lockwood

This paper considers the optimal taxation of savings intermediation and payment services in a dynamic general equilibrium setting, when the government can also use consumption and income taxes. When payment services are used in strict proportion to final consumption, and the cost of intermediation services is fixed and the same across firms, the optimal taxes are generally indeterminate. But, when firms differ exogenously in the cost of intermediation services, the tax on savings intermediation should be zero. Also, when household time and payment services are substitutes in transactions, the optimal tax rate on payment services is determined by the returns to scale in the conditional demand for payment services, and is generally different to the optimal rate on consumption goods. In particular, with constant returns to scale, payment services should be untaxed. These results can be understood as applications of the Diamond-Mirrlees production efficiency theorem. Finally, as an extension, we endogenize intermediation, in the form of monitoring, and show that it may be oversupplied in equilibrium when banks have monopoly power, justifying a Pigouvian tax in this case

There is much talk now about taxing banks in various ways. This model add to the usual taxes one on payment services and another on interest spreads. The paper goes through various scenarios, but the general sense is that these taxes should be small if not zero. And indeed, they would add frictions and wedges that are detrimental to welfare. But note that these taxes are different from a Tobin tax.


Optimal Monetary and Fiscal Policies In a Search-theoretic Model of Money and Unemployment

November 20, 2010

By Pedro Gomis-Porqueras, Benoît, Julien and Chengsi Wang

In this paper we study the optimal monetary and fiscal policies of a general equilibrium model of unemployment and money with search frictions both in labor and goods markets as in Berentsen, Menzio and Wright (2010). We abstract from revenue-raising motives to focus on the welfare-enhancing properties of optimal policies. We show that some of the inefficiencies in the Berentsen, Menzio and Wright (2010) framework can be restored with appropriate fiscal policies. In particular, when lump sum monetary transfers are possible, a production subsidy financed by money printing can increase output in the decentralized market and a vacancy subsidy financed by a dividend tax even when the Hosios’ rule does not hold.

Money search is making great strides in becoming a useful tool for policy since the Lagos-Wright model came out. The recent BMW paper started with embedding a labor search market with a money search market, and this paper builds and expands on this by looking very closely at optimal policies and finds in particular that active monetary monetary policy can even have positive long-run effects. Imagine that: money is not neutral in the long run in a neo-classical model!

Hayashi meets Kiyotaki and Moore: a theory of capital adjustment costs

November 16, 2010

By Pengfei Wang and Yi Wen

Firm-level investment is lumpy and volatile but aggregate investment is much smoother and highly serially correlated. These different patterns of investment behavior have been viewed as indicating convex adjustment costs at the aggregate level but non-convex adjustment costs at the firm level. This paper shows that financial frictions in the form of collateralized borrowing at the firm level (Kiyotaki and Moore, 1997) can give rise to convex adjustment costs at the aggregate level yet at the same time generate lumpiness in plant-level investment. In particular, our model can (i) derive aggregate capital adjustment cost functions identical to those assumed by Hayashi (1982) and (ii) explain the weak empirical relationship between Tobin’s Q and plant-level investment. Although aggregate adjustment cost functions can be derived from microfoundations, they are subject to the Lucas critique because parameters in such functions may not be structural and policy invariant.

Capital adjustment cost functions are liberally used in business cycles models to reduce excessive investment volatility, yet little thought has been given to their specification. This paper should help in getting an appropriate specification from microfoundations. But, as the authors note, this is still a reduced form, and thus the specification and its calibration may need to change with policy or other states.

Winners and Losers in House Markets

November 5, 2010

By Nobuhiro Kiyotaki, Alexander Michaelides and Kalin Nikolov

This paper is a quantitatively-oriented theoretical study of the interaction between housing prices, aggregate production, and household behavior over a lifetime. We develop a life-cycle model of a production economy in which land and capital are used to build residential and commercial real estates. We find that, in an economy where the share of land in the value of real estates is large, housing prices react more to an exogenous change in expected productivity or the world interest rate, causing a large redistribution between net buyers and net sellers of houses. Changing financing constraints, however, has limited effects on housing prices.

There as been much talk about how the relaxation of borrowing constraints on US markets has driven up house prices. This paper shows that at least theoretically this need not be so, and the interest rates and productivity growth are much more important. Theory, of course, can only cover fundamentals, and bubbles may add to house prices, and those bubbles may be linked to these financing conditions. In the long run, though, bubbles are largely irrelevant, and this model indicates we should stop worrying about mortgage down-payments.