To be or not to be informal?: A Structural Simulation

September 24, 2012

By José P. Mauricio Vargas

The paper presents estimations of the informal economy size in Bolivia from an application of a Dynamic General Equilibrium Model. The parameter estimation is performed using maximum likelihood method to obtain, as an intermediate result, a latent variable estimation of the informal economy size. This procedure is new, as the estimate of the size of the informal economy using a dynamic structural model represents an alternative study area to latent variable models which assume relationships without a strong support in theory (MIMIC models). The results suggest that the size of the informal economy represents 60% of Bolivian GDP in 2010 and that the trend has been decreasing in the last decade. In addition, we simulated four alternative policies to reduce the size of the underground economy. Some of them allow to identify surprising response mechanisms which allows to analyze the flow of workers from the informal sector into the formal sector and vice versa. The research, besides quantifying the informal economy size, tries to provide a tool and methodology for evaluating alternative policy scenarios related to fiscal policy and labor mobility in a framework of an economy with a large informal sector and evasion.

This paper is a very interesting application of a structure DSGE model to measure a phenomenon that is otherwise very difficult to evaluate: the informal economy, which is not measured by definition. Drawing a model that geberates a informal sector and then estimating it with observable data can lead to interesting results that should be more reliable than traditional methods which, for example, rely solely on money or electricity demand.


Sovereign Defaults and Banking Crises

September 16, 2012

By Cesar Sosa-Padilla

Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers that lend to both the government and the corporate sector. When these bankers are highly exposed to government debt a default triggers a banking crisis which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to Argentina’s 2001 default episode the model produces default on equilibrium with a frequency in line with actual default frequencies, and when it happens credit experiences a sharp contraction which generates an output drop similar in magnitude to the one observed in the data. Moreover, the model also matches several moments of the cyclical dynamics of macroeconomic aggregates.

Interesting paper that deals with the joint crises of sovereign debt and the banking sector. While it focusses on Argentina, the perennial candidate for sovereign default, I wonder how much this paper also applies to the current situation in Europe. In this paper, banks decide to hold sovereign debt despite the demonstrated rsik of default. In Europe, banks are still holding sovereign debt after years of headlines about potential default, the only deifference being it has not happened (yet) except for a haircut in Greece.

Optimal Taxation in a Limited Commitment Economy

September 11, 2012

By Yena Park

This paper studies optimal Ramsey taxation when risk sharing in private insurance markets is imperfect due to limited enforcement. In a limited commitment economy, there are externalities associated with capital and labor because individuals do not take into account that their labor and saving decisions affect aggregate supply, wages and thus the value of autarky. Due to these externalities, the Ramsey government has an additional goal, which is to internalize the externalities of labor and capital to improve risk sharing, in addition to its usual goal – minimizing distortions when financing government expenditures. These two goals drive capital and labor taxes in opposite directions. By balancing these conflicting goals, the steady-state optimal capital income taxes are levied only to remove the negative externality of the capital, and optimal labor income taxes are set to meet the budgetary needs of the government in the long run, despite positive externalities of labor.

This paper studies an interesting aspect of capital under limited commitment and thus imperfect insurance: this leads to higher accumulation of capital. But having more aggregate capital also improves autarky wages and thus uncentives to leave the insurance contract. Thus, you want to tax capital to bring it back to the efficient level. Yet, there is also the standard Ramsey result that capital should not be taxed.

Home Production and the Optimal Rate of Unemployment Insurance

September 5, 2012

By Temel Taşkın

In this paper, we incorporate home production into a quantitative model of unemployment and show that realistic levels of home production have a significant impact on the optimal unemployment insurance rate. Motivated by recently documented empirical facts, we augment an incomplete markets model of unemployment with a home production technology, which allows unemployed workers to use their extra non-market time as partial insurance against the drop in income due to unemployment. In the benchmark model, we find that the optimal replacement rate in the presence of home production is roughly 40% of wages, which is 40% lower than the no home production model’s optimal replacement rate of 65%. The 40% optimal rate is also close to the estimated rate in practice. The fact that home production makes a significant difference in the optimal unemployment insurance rate is robust to a variety of parameterizations and alternative model environments.

Having worked with this type of models, I may show some bias in selecting this paper this week. It is quite natural to think that unemployment insurance should be less generous once you take into account the fact that the unemployed worker does more than doing nothing with his new free time. The contribution here is to quantify the effect, and that is quite difficult as home production is poorly measured. This means also that significant robustness exercises are necessary. While those shown do not show much chnage in the results, more needs to be done to convince me. That includes working with a lower benchmark replacement rate, as the effective rate in the United States it quite lower than the rate when eligible.