Credit Constraints, Productivity Shocks and Consumption Volatility in Emerging Economies

September 30, 2013

By Rudrani Bhattacharya and Ila Patnaik

How does access to credit impact consumption volatility? Theory and evidence from advanced economies suggests that greater household access to finance smooths consumption. Evidence from emerging markets, where consumption is usually more volatile than income, indicates that financial reform further increases the volatility of consumption relative to output. We address this puzzle in the framework of an emerging economy model in which households face shocks to trend growth rate, and a fraction of them are credit constrained. Unconstrained households can respond to shocks to trend growth by raising current consumption more than rise in current income. Financial reform increases the share of such households, leading to greater relative consumption volatility. Calibration of the model for pre and post financial reform in India provides support for the model’s key predictions.

The relative volatility of consumption to output is higher in less developed economies, which can be rationalized with less developed financial markets. When consumption is more volatile than output, as it is the case for the least developed economies, that becomes more difficult to explain. The issue is slightly different in this paper. As financial markets become more complete, consumption becomes relatively more volatile. The paper explains this in two ways: first the type of shocks is different, as they pertain to the trend growth rate. This has important implication for permanent income volatility. Second there is a composition effect as the number of financially constraint household is reduced, and thus more can borrow against future income and increase consumption. The combination of the two therefore increases the relative volatility of consumption, which eventually should fall back to the numbers we know from the most advanced economies once the composition effect vanishes and trend growth becomes more stable.


Productivity insurance: the role of unemployment benefits in a multi-sector model

September 28, 2013

By David Fuller, Marianna Kudlyak and Damba Lkhagvasuren

We construct a multi-sector search and matching model where the unemployed receive idiosyncratic productivity shocks that make working in certain sectors more productive than in the others. Agents must decide which sector to search in and face moving costs when leaving their current sector for another. In this environment, unemployment is associated with an additional risk: low future wages if mobility costs preclude search in the appropriate sector. This introduces a new role for unemployment benefits—productivity insurance while unemployed. Analytically, we characterize two competing effects of benefits on productivity, a moral hazard effect and a consumption effect. In a stylized quantitative analysis, we show that the consumption effect dominates, so that unemployment benefits increase per-worker productivity. We also analyze the welfare-maximizing benefit level and find that it decreases as moving costs increase.

While moral hazard issues make unemployment insurance less attractive, the argument pushed by Acemoglu and Shimer that an unemployment insurance scheme allows workers to search for better matches becomes important here. The difference here is that instead of waiting for a stochastic process to deliver a good match, here workers can choose to move between sectors, sectors being defined loosely, such as location, industry, or occupation. A crucial parameter is then the cost of moving which can have a major impact on the average productivity in the economy.

Housing and Tax Policy

September 26, 2013

By Sami Alpanda and Sarah Zubairy

In this paper, we investigate the effects of housing-related tax policy measures on macroeconomic aggregates using a dynamic general-equilibrium model. The model features borrowing and lending across heterogeneous households, financial frictions in the form of collateral constraints tied to house prices, and a rental housing market alongside owner-occupied housing. Using our model, we analyze the effects of changes in housing-related tax policy measures on the level of output, tax revenue and household debt, along with other macroeconomic aggregates. The tax policies we consider are (i) increasing property tax rates, (ii) eliminating the mortgage interest deduction, (iii) eliminating the depreciation allowance for rental income, (iv) instituting taxation of imputed rental income from owner-occupied housing and (v) eliminating the property tax deduction. We find that among these fiscal tools, eliminating the mortgage interest deduction would be the most effective in raising tax revenue, and in reducing household debt, per unit of output lost. On the other hand, eliminating the depreciation allowance for rental income would be the least effective. Our experiments also highlight the differential welfare impact of each tax policy on savers, borrowers and renters.

This is a paper I would have liked to write, had I the time. Fiscal policy leads to massive distortions on the housing and real estate markets, and it is not clear that these are needed. Once further aspect that is not considered here is that investing in your own house is very poor diversification in the light of the high correlation between the local unemployment rate and housing prices. I am a reluctant house owner…

Evaluating Quantitative Easing: A DSGE Approach

September 15, 2013

By Matteo Falagiarda

This paper develops a simple Dynamic Stochastic General Equilibrium (DSGE) model capable of evaluating the effect of large purchases of treasuries by central banks. The model exhibits imperfect asset substitutability between government bonds of different maturities and a feedback from the term structure to the macroeconomy. Both are generated through the introduction of portfolio adjustment frictions. As a result, the model is able to isolate the portfolio rebalancing channel of Quantitative Easing (QE). This theoretical framework is employed to evaluate the impact on yields and the macroeconomy of large purchases of medium- and long-term treasuries recently carried out in the US and UK. The results from the calibrated model suggest that large asset purchases of government assets had stimulating effects in terms of lower long-term yields, and higher output and inflation. The size of the effects is nevertheless sensitive to the speed of the exit strategy chosen by monetary authorities.

While it is relatively easy to talk informally about the effects of the quantitative easing program, doing it formally in a model that takes into account the general equilibrium effects on prices, and especially the yield curve, is quite difficult. Matteo Falagiarda finds an interesting ways to do it and manages to come up with some quantitative answers that highlights that the exit strategy is crucial. We will see how that will turn out to be.

Top Incomes, Rising Inequality, and Welfare

September 11, 2013

By Kevin Lansing and Agnieszka Markiewicz

This paper develops a general-equilibrium production model of skill-biased technological change that approximates the dramatic upward shift in the share of total income going to the top decile of U.S. households since 1980. Under realistic assumptions, we show that all agents in the economy can benefit from the technology change, provided that the observed rise in U.S. redistributive transfers over this period is taken into account. We show that the increase in capital’s share of total income and the presence of capital-entrepreneurial skill complementarity are two key features that help support the wages of ordinary workers as the new technology diffuses.

Interesting paper about a topic much discussed in mainstream media. But, for once, it uses theory and modelling to understand the rise of top incomes, provides an explanation of where it may come from, offers a welfare evaluation for different groups of the population and gives encouraging policy implications. This is how the public debate about top incomes should be.

A Monetary Theory with Non-degenerate Distributions

September 9, 2013

By Guido Menzio, Shouyong Shi and Hongfei Sun

We construct and analyze a tractable search model of money with a non-degenerate distribution of money holdings. Analytical tractability comes from modeling decentralized exchange as directed search, which makes the monetary steady state block recursive. By adapting lattice-theoretic techniques, we characterize individuals’ policy and value functions, and show that these functions satisfy the standard conditions of optimization. We prove that a unique monetary steady state exists and provide conditions under which the steady-state distribution of buyers over money balances is non-degenerate. Moreover, we analyze the properties of this distribution.

There are now several ways in which one can add non-degenerate distributions of money holdings to money search models, and all appear to be reasonably tractable. These are important theoretical developments, as they considerably expand the horizon of the questions that can be asked with money search model. It will be interesting to see what this literature will be able to bring in the next years. The Lagos-Wright model has certainly triggered quite a rush, we will see how this one fares.