The societal benefits of a financial transaction tax

November 19, 2014

By Aleksander Berentsen, Samuel Huber and Alessandro Marchesiani

We investigate the positive and normative implications of a tax on financial market transactions in a dynamic general equilibrium model, where agents face idiosyncratic liquidity shocks and financial trading is essential. Our main finding is that agents’ portfolio choices display a pecuniary externality which results in too much trading. We calibrate the model to U.S. data and find an optimal tax rate of 2.5 percent. Imposing this tax reduces trading in financial markets by 30 percent.

It is difficult to think why a Tobin tax would make sense in a standard DSGE model. The paper above takes into account that people have two types of assets, liquid and illiquid ones. Naturally, they would like to minimize the amount of liquid assets they carry around as they typically have lower returns. The authors point out that having liquid assets provides, however, a positive externality onto the economy. One way to entice people to hold more of them is to make conversions between liquid and illiquid assets more costly, the Tobin tax. And the welfare benefit seems to be quite substantial.


The Impact of Consumer Credit Access on Unemployment

November 18, 2014

By Kyle Herkenhoff

Unemployed households’ access to unsecured revolving credit (credit cards) nearly quadrupled from about 12 percent to about 45 percent over the last three decades. This paper analyzes how this large increase in revolving credit has impacted the business cycle. The paper develops a general equilibrium business cycle model with search in both the labor market and in the credit market. This generates a very rich and empirically plausible level of heterogeneity in work and credit histories while at the same time permitting a tractable model solution. Calibrating to the observed path of credit use between 1974 and 2012, I find that the large growth in credit access leads to deeper and longer recessions as well as moderately slower recoveries. Relative to an economy with credit fixed at 1970s levels, employment reaches its trough about 1 quarter later and remains depressed by up to .8 percentage points three years after the typical recession in this time period (e.g. employment is depressed by 2.8% rather than 2%). The mechanism is that when borrowing opportunities are easy to find, households optimally search for better-paying but harder-to-find jobs knowing that if the job search fails they can obtain credit to smooth consumption. Despite longer recessions and slower recoveries, increased credit card use enhances welfare by reducing consumption volatility and improving job-match quality.

It was seem at first counterintuitive that higher credit card debt, longer recession and more unemployment are welfare-enhancing, but it looks like matches are so much better in the search process that the outcome turns out to be better. And this despite the high credit card interest rates. This reminds me how entrepreneurship can be a driver for growth despite the high failure rate. As long as there is some mechanism in place that allows to capture at least some of the risk, taking risks is a good strategy.

Limited Asset Market Participation and the Optimal Fiscal and Monetary Policies

November 11, 2014

By Lorenzo Menna and Patrizio Tirelli

In the workhorse DSGE model, the optimal steady state inflation rate is near to zero or slightly negative and inflation is almost completely stabilized along the business cycle (Schmitt-Grohé and Uribe, 2011). We reconsider the issue, allowing for agent heterogeneity in the access to the market for interest bearing assets. We show that inflation reduces inequality and that LAMP can justify relatively high optimal inflation rates. When we calibrate the share of constrained agents to fit the wealth Gini index for the US, the optimal inflation rate is well above 2%. The optimal response to shocks is also affected. Rather than using public debt to smooth tax distortions, the Ramsey planner front loads tax rates and reduces public debt variations in order to limit the redistributive effects of debt service payments.

Intriguing paper that, for once, does not rely on downward nominal price rigidities to justify positive inflation. It also implies that a little dose of debt monetization is to some extent justified. This has to get a few people thinking.

Dynamic Prediction Pools: An Investigation of Financial Frictions and Forecasting Performance

November 5, 2014

By Marco Del Negro, Raiden Hasegawa and Frank Schorfheide

We provide a novel methodology for estimating time-varying weights in linear prediction pools, which we call Dynamic Pools, and use it to investigate the relative forecasting performance of DSGE models with and without financial frictions for output growth and inflation from 1992 to 2011. We find strong evidence of time variation in the pool’s weights, reflecting the fact that the DSGE model with financial frictions produces superior forecasts in periods of financial distress but does not perform as well in tranquil periods. The dynamic pool’s weights react in a timely fashion to changes in the environment, leading to real-time forecast improvements relative to other methods of density forecast combination, such as Bayesian Model Averaging, optimal (static) pools, and equal weights. We show how a policymaker dealing with model uncertainty could have used a dynamic pools to perform a counterfactual exercise (responding to the gap in labor market conditions) in the immediate aftermath of the Lehman crisis.

Much work has be done in recent years to estimate DSGE model for forecasting purposes. Despite the fact that they are designed for these purposes, they turn out to be surprisingly useful. This paper continues in this line of research and shows that in fact DSGE models are most useful when other model are most likely to fail: when things are out of the ordinary. In hindsight this makes absolute sense. This is when you get out of the comfort zone of small fluctuations around a trend and theory can help you determine how agent react to event that are out of the sample. It turns out that instead of ditching DSGE models during the last crisis, as many have advocated, we should have used them even more than usual!