Monetary policy shocks in a DSGE model with a shadow banking system

February 21, 2011

By Fabio Verona, Manuel M. F. Martins and Inês Drumond

This paper is motivated by the recent financial crisis and addresses whether a “too low for too long” interest rate policy may generate a boom-bust cycle. We suggest a model in which a microfounded shadow banking sector is included in an otherwise state-of-the-art DSGE model. When faced with perverse incentives, financial intermediaries within the shadow banking sector can divert a fraction of stockholders’ profits for their own benefits and extend credit at a discounted rate. The model predicts that long periods of accommodative monetary policy do create the preconditions for, but do not cause per se, a boom-bust cycle. Rather, it is the combination of a persistent monetary ease with microeconomic distortions in the financial system that causes a boom-bust.

Thus the Fed can maintain low interest rates as long as the financial sector is efficiently regulated. Are we there?


Competitive Equilibria with Production and Limited Commitment

February 13, 2011

By Árpád Ábrahám and Eva Cárceles-Poveda

This paper studies a production economy with aggregate uncertainty where consumers have limited commitment on their financial liabilities. Markets are endogenously incomplete due to the fact that the borrowing constraints are determined endogenously. We first show that, if competitive financial intermediaries are allowed to set the borrowing limits, then the ones that prevent default will be an equilibrium outcome. The equilibrium allocations in this economy are not constrained efficient due to the fact that intermediaries do not internalize the adverse effects of capital on default incentives. We also isolate and quantify this new source of inefficiency by comparing the competitive equilibrium allocations to the constrained efficient ones both qualitatively and quantitatively. We tend to observe higher capital accumulation in the competitive equilibrium, implying that agents may enjoy higher (average) welfare in the long run than in the constrained efficient allocation.

This is an interesting model of economic fluctuations under limited commitment and endogenous borrowing limits. In particular it highlights how unregulated lending markets do internalize default incentives, and thus lead to suboptimal outcomes.

Marginal abatement cost curves and the budgetary impact of CO2 taxation in Portugal

February 7, 2011

By Alfredo Marvão Pereira and Rui M. Pereira

The objective of this paper is to study CO2 taxation in its dual role as a climate and a fiscal policy instrument. It develops marginal abatement cost curves for CO2 emissions associated with CO2 taxation using a dynamic general equilibrium model of the Portuguese economy which highlights the mechanisms of endogenous growth and includes a detailed modeling of the public sector. It also considers a pair of complementary cost curves corresponding to the impact of CO2 taxes on GDP and on the public budget. Simulation results show that a tax of 17.00 Euros per tCO2 has the technical capacity to limit emissions growth to 62.6 Mt CO2 in 2020, consistent with the existing climate policy target for Portugal. In turn, changes in tax revenues together with reductions in public spending, lead to a decline of 2.7% in the public debt. These desirable outcomes, however, come at the cost of a 0.7% reduction in GDP relative to steady state baseline levels. In general, we find that stricter emission targets imply greater equilibrium CO2 tax levels and larger GDP losses, although these are accompanied by greater reductions in public debt. Finally, the paper highlights the importance of public spending behavior when projecting the net impact of CO2 taxes on public revenue and the public account and in the designing of policies to promote fiscal consolidation.

Dynamic general equilibrium is not only about macroeconomics. It is also very well suited to the study on environmental problems, one because of the dynamics and two because environmental economics is all about effects of one market on another. One could also add that uncertainty can be important. This paper is a very good example of this, as it mixes macroeconomics aspects of taxation and climate policy.

Life-Cycle Labor Search with Stochastic Match Quality

February 3, 2011

By Julen Esteban-Pretel and Junichi Fujimoto

Unemployment, job finding, and job separation rates exhibit patterns of decline as worker age increases in the U.S. We build and numerically simulate a search and matching model of the labor market that incorporates a life-cycle structure to account for these empirical facts. The model features random match quality, which, with positive probability, is not revealed until production takes place. We show that the model, calibrated to U.S. data, is able to reproduce the empirical patterns of unemployment and job transition rates over the entire life-cycle. Both decreasing distance to retirement as a worker ages, and ex ante unknown match quality, are essential in delivering these results. We then explore, both analytically and numerically, the efficiency implications of the model.

Labor search models are getting ever closer to replicate the intricate dynamics of the labor market. Here, it is shown that they can follow labor market flows through the life cycle without needing too much complexity.