Optimal labor-market policy in recessions

December 22, 2011

By Philip Jung and Keith Kuster


The authors examine the optimal labor market-policy mix over the business cycle. In a search and matching model with risk-averse workers, endogenous hiring and separation, and unobservable search effort they first show how to decentralize the constrained-efficient allocation. This can be achieved by a combination of a production tax and three labor-market policy instruments, namely, a vacancy subsidy, a layoff tax and unemployment benefits. The authors derive analytical expressions for the optimal setting of each of these for the steady state and for the business cycle. Their propositions suggest that hiring subsidies, layoff taxes and the replacement rate of unemployment insurance should all rise in recessions. The authors find this confirmed in a calibration targeted to the U.S. economy.

Interesting piece that goes a long way to improve on the simplistic proposals out there. Interestingly, the government budget constraint is balanced every period, so one could even improve on this with some well-timed public borrowing.


Macroeconomics With Heterogeneity: A Practical Guide

December 16, 2011

By Fatih Guvenen


This article reviews macroeconomic models with heterogeneous households. A key question for the relevance of these models concerns the degree to which markets are complete. This is because the existence of complete markets imposes restrictions on (i) how much heterogeneity matters for aggregate phenomena and (ii) the types of cross-sectional distributions that can be obtained. The degree of market incompleteness, in turn, depends on two factors: (i) the richness of insurance opportunities provided by the economic environment and (ii) the nature and magnitude of idiosyncratic risks to be insured. First, I review a broad collection of empirical evidence—from econometric tests of “full insurance,” to quantitative and empirical analyses of the permanent income (“self insurance”) model that examine how it fits the facts about life cycle allocations, to studies that try to directly measure where economies place between these two benchmarks (“partial insurance”). The empirical evidence I survey reveals significant uncertainty in the profession regarding the magnitudes of idiosyncratic risks as well as whether or not these risks have increased since the 1970s. An important difficulty stems from the fact that inequality often arises from a mixture of idiosyncratic risk and fixed (or predictable) heterogeneity, making the two challenging to disentangle. I also discuss applications of incomplete markets models to trends in wealth, consumption, and earnings inequality both over the life cycle and over time, where this challenge is evident. Third, I discuss “approximate” aggregation—the finding that some incomplete markets models generate aggregate implications very similar to representative-agent models. What approximate aggregation does and does not imply is illustrated through several examples. Finally, I discuss some computational issues relevant for solving and calibrating such models and I provide a simple yet fully parallelizable global optimization algorithm that can be used to calibrate heterogeneous agent models.

This is an excellent survey that should be mandatory reading for anyone interested in modern macroeconomics. It nicely lays out what the agenda is at the frontier of research and what some of the stumbling blocks are. And it also highlights when the additional complexity of the heterogeneous approach is not really necessary and representative agents can do.

The Influence of Public Policy on Health, Wealth and Mortality

December 6, 2011

By John Karl Scholz and Ananth Seshadri


In this project we extend an augmented lifecycle model, incorporating a Grossman-style model of health capital, to enhance understanding of factors influencing consumption, wealth and health. We develop three primary results when using the model to explore the effects of stylized versions of Medicare and Social Security on wealth and longevity. First, our model calibration implies consumption and health are complements. As health depreciates with age, households will get less utility from consumption than would be in the case of a lifecycle model that does not endogenize health. Second, it appears that forward-looking households, when confronted by a substantially reduced safety net, will respond by reducing consumption and by reducing their health investment and therefore longevity. Third, there is a potentially important difference between short- and long-run responses to policy.

I selected this paper this week because of this very interesting result that in the absence of a safety net, people invest less in health. This seems like a vicious cycle: with more fragile health they would need even more a safety net, but its absence worsens the situation even more. This result also runs counter to the intuition we have about idiosyncratic income shocks: the less one is insured, the more one does something about it.