Macroprudential and Monetary Policies: Implications for Financial Stability and Welfare

October 30, 2013

By José Carrasco-Gallego and Margarita Rubio

In this paper, we analyse the implications of macroprudential and monetary policies for business cycles, welfare, and .nancial stability. We consider a dynamic stochastic general equilibrium (DSGE) model with housing and collateral constraints. A macroprudential rule on the loan-to-value ratio (LTV), which responds to output and house price deviations, interacts with a traditional Taylor rule for monetary policy. From a positive perspective, introducing a macroprudential tool mitigates the effects of booms in the economy by restricting credit. However, monetary and macroprudential policies may enter in conflict when shocks come from the supply-side of the economy. From a normative point of view, results show that the introduction of this macroprudential measure is welfare improving. Then, we calculate the combination of policy parameters that maximizes welfare and find that the optimal LTV rule should respond relatively more aggressively to house prices than to output deviations. Finally, we study the efficiency of the policy mix. We propose a tool that includes not only the variability of output and inflation but also the variability of borrowing, to capture the effects of policies on financial stability: a three-dimensional policy frontier (3DPF). We find that both policies acting together unambiguously improve the stability of the system.

As much as capital requirements for banks should vary over the business cycle, this paper argues that the loan-to-value ratio for commercial loans should also be a policy variable. That makes good sense if it were otherwise constant, as it is admittedly often modelled. But lenders do adjust it according to circumstances, and the question therefore should be whether there is still room for a policy-maker to intervene and adjust it in its own way. Due to moral hazard in the banking sector, a strong point for intervention can be made for capital requirements. I am not sure where the market inefficiency would be that would call for intervention on the loan-to-value ratio.

External Habit in a Production Economy

October 21, 2013

Andrew Y. Chen

A unified framework for understanding asset prices and aggregate fluctuations is critical for understanding both issues. I show that a real business cycle model with external habit preferences and capital adjustment costs provides one such framework. The estimated model matches the first two moments of the equity premium and risk-free rate, return and dividend predictability regressions, and the second moments of output, consumption, and investment. The model also endogenizes a key mechanism of consumption-based asset pricing models. In order to address the Shiller volatility puzzle, external habit, long-run risk, and disaster models require the assumption that the volatility of marginal utility is countercyclical. In the model, this countercyclical volatility arises endogenously. Production makes precautionary savings effects show up in consumption. These effects lead to countercyclical consumption volatility and countercyclical volatility of marginal utility. External habit amplifies this channel and makes it quantitatively significant.

Another paper that comes to the conclusion that habit persistence is an essential part of any model that wants to reflect both business cycles and asset prices. Modelers may want to may that a standard feature.

Transitional Dynamics and Long-run Optimal Taxation Under Incomplete Markets

October 12, 2013

By Ömer Tuğrul Açıkgöz

Aiyagari (1995) showed that long-run optimal fiscal policy features a positive tax rate on capital income in Bewley-type economies with heterogeneous agents and incomplete markets. However, determining the magnitude of the optimal capital income tax rate was considered to be prohibitively difficult due to the need to compute the optimal tax rates along the transition path. This paper shows that, in this class of models, long-run optimal fiscal policy and the corresponding allocation can be studied independently of the initial conditions and the transition path. Numerical methods based on this finding are used on a model calibrated to the U.S. economy. I find that the observed average capital income tax rate in the U.S. is too high, the average labor income tax rate and the debt-to-GDP ratio are too low, compared to the long-run optimal levels. The implications of these findings for the existing literature on the optimal quantity of debt and constrained efficiency are also discussed.

The results of this paper will upset people across the political spectrum. First, the public debt to GDP ratio should be much higher than currently in the US. This is because the public debt allows households to overcome their borrowing constraints, thus the best is for the government to borrow up to the natural borrowing limit (which is not the debt ceiling). Second, labor income taxes should be higher, because this finances the debt and reduces the volatility of household income. Third, capital income taxes should be lower, as this favors the accumulation of precautionary savings. The paper also highlights that policies that are welfare-maximizing in the long run can leads to significantly dominated outcomes in the short-run. This also shows that as so often in the optimal tax literature, optimal policy is difficult to find and results can easily be reversed by changing some aspect of the model. The future will tell whether this analysis will be robust.

Open-Market Operations, Asset Distributions, and Endogenous Market Segmentation

October 8, 2013

By Babak Mahmoudi

This paper investigates the long-run effects of open-market operations on the distributions of assets and prices in the economy. It offers a theoretical framework to incorporate multiple asset holdings in a tractable heterogeneous-agent model, in which the central bank implements policies by changing the supply of nominal bond and money. This model features competitive search, which produces distributions of money and bond holdings as well as price dispersion among submarkets. At a high enough bond supply, the equilibrium shows segmentation in the asset market; only households with good income shocks participate in the bond market. When deciding whether to participate in the asset market, households compare liquidity services provided by money with returns on bond. Segmentation in the asset market is generated endogenously without assuming any rigidities or frictions in the asset market. In an equilibrium with a segmented asset market, open-market operations affect households’ participation decisions and, therefore, have real effects on the distribution of assets and prices in the economy. Numerical exercises show that the central bank can improve welfare by purchasing bonds and supplying money when the asset market is segmented.

Pretty neat paper, as it endogenizes the market segmentation that is typically hard-coded in models. In addition, it looks at how policy influences this limited participation, and it matters for the influence of monetary policy on outcomes. Indeed, monetary policy acts first on those agents who are participating in markets, and if their number and composition changes as a consequence of policy, it may amplify or dilute the policy. Here, with appropriate policy, its impact is amplified.

Was Stalin Necessary for Russia’s Economic Development?

October 6, 2013

By Anton Cheremukhin, Mikhail Golosov, Sergei Guriev and Aleh Tsyvinski

This paper studies structural transformation of Soviet Russia in 1928-1940 from an agrarian to an industrial economy through the lens of a two-sector neoclassical growth model. We construct a large dataset that covers Soviet Russia during 1928-1940 and Tsarist Russia during 1885-1913. We use a two-sector growth model to compute sectoral TFPs as well as distortions and wedges in the capital, labor and product markets. We find that most wedges substantially increased in 1928-1935 and then fell in 1936-1940 relative to their 1885-1913 levels, while TFP remained generally below pre-WWI trends. Under the neoclassical growth model, projections of these estimated wedges imply that Stalin’s economic policies led to welfare loss of -24 percent of consumption in 1928-1940, but a +16 percent welfare gain after 1941. A representative consumer born at the start of Stalin’s policies in 1928 experiences a reduction in welfare of -1 percent of consumption, a number that does not take into account additional costs of political repression during this time period. We provide three additional counterfactuals: comparison with Japan, comparison with the New Economic Policy (NEP), and assuming alternative post-1940 growth scenarios.

I would not have thought it possible to make a welfare analysis of the first decades of the Soviet regime. Data is spotty or likely manipulated, and the economy is distorted in ways that are difficult to measure or model. Still, the authors use here all they can find to come up with strong results. If Stalin was manipulating the data, the outcome would have been much better. One cannot help thinking that TFP may have been endogenous in this context. The mission being full employment, one does not necessarily employ the best technologies. I am sure this paper will spark much more research on the topic.