Labor Market Reform and the Cost of Business Cycles

February 28, 2015

By Tom Krebs and Martin Scheffel

This paper studies the effect of labor market reform on the welfare cost of business cycles. Motivated by the German labor market reforms of 2003-2005, the so-called Hartz reforms, the paper focuses on two labor market institutions: the unemployment insurance system determining search incentives and the system of job placement services affecting matching efficiency. The paper develops a tractable search model with idiosyncratic labor market risk and risk-averse workers, and derives a closed-form solution for the welfare cost of business cycles as a function of the various parameters of interest. An improvement in job placement services leads to a reduction in the welfare cost of business cycles, but a change in unemployment benefit generosity has in general an ambiguous effect. A quantitative analysis based on a calibrated version of the model suggests that the German labor market reforms of 2003-2005 reduced the non-cyclical unemployment rate by 3 percentage points and reduced the welfare cost of business cycles by 30 percent.

Labor market reform exercise are rarely assessed on how they impact welfare. It is OK to see what they do to, say, the unemployment rate, but economic well-being is more than that, the average level of things. This paper is a step in the right direction. It takes as a starting point that business cycles are costly in terms of welfare. Then it shows that some policies from the Hartz reforms where efficient in reducing that cost, but for others it is not that clear at all.

Modeling Labor Markets in Macroeconomics: Search and Matching

February 25, 2015

By Michael Krause and Thomas Lubik

We present and discuss the simple search and matching model of the labor market against the background of developments in modern macroeconomics. We derive a simple representation of the model in a general equilibrium context and how the model can be used to analyze various policy issues in labor markets and monetary policy.

A very nice introduction to the topic, good for anyone who wants to learn about the topic, read up one some of its major developments, or assign it to students.

Technology and Intergenerational Persistence: Theory and Some Evidence

February 10, 2015

By Brant Abbott and Giovanni Gallipoli

We develop and estimate an equilibrium model of intergenerational earnings persistence based on skill complementarity in production. We show that when a worker’s productivity is relatively independent of co-workers’ skills (i.e., skills are substitutable) parental investments in a child’s human capital have a stronger impact on the child’s future earnings. This leads to higher earnings’ persistence across generations. Observed patterns of geographic variation in intergenerational income persistence, both across countries and within the US, appear to be consistent with this hypothesis. We show that differences in skill substitutability may account for up to 1/5 of cross-country variation in intergenerational earnings persistence. We also find that public policies which equalize skills are more desirable in places where skills are more complementary in production. Thus cross-country differences in production arrangements provide a rationale for the observed concurrence of proactive government policies and increased economic mobility. When accounting for this indirect effect, the model explains an even larger share of cross-country differences in mobility, up to 1/3 of the total. As a by-product of this analysis we provide the first set of estimates of skill substitutability in different industries.

While the emphasis of the paper is on the international differences in intergenerational persistence, I wonder what it implies for its change through time. I believe, for example, that there is more persistence in the United States than before, and I think that jobs are more complementary that substitutable than before. Wouldn’t that contradict the results of the paper? Maybe there is another mechanism in the time dimension for the US: how borrowing or liquidity constraints are blocking access to education for some.

The Statistical Implications of Common Identifying Restrictions for DSGE Models

February 5, 2015

By Stephen Morris

I reveal identification failures in a well-known dynamic stochastic general equilibrium (DSGE) model, and study the statistical implications of common identifying restrictions. First, I provide a fully analytical methodology for determining all observationally equivalent values of the structural parameters in any parameter space. I show that either parameter admissibility or sign restrictions may yield global identification for some parameter realizations, but not for others. Second, I derive a “plug-in” maximum likelihood estimator, which requires no numerical search. I use this tool to demonstrate that the idiosyncratic identifying restriction directly impinges on both the location and distribution of the small-sample MLE, and compute correctly sized confidence intervals.

While this paper looks at the identification for a specific paper, An and Schorfheide (2007), it highlights an issue of much broader reach. Specifically, when estimating a typical DSGE model, the identification of parameter values may only be local and not necessarily global. But this can be fixed with identifying restrictions, which have an impact on the estimator.

Precautionary Saving and Aggregate Demand

February 4, 2015

By Edouard Challe, Julien Matheron, Xavier Ragot and Juan F. Rubio-Ramirez

We formulate and estimate a tractable macroeconomic model with time-varying precautionary savings. We argue that the latter affect aggregate fluctuations via two main channels: a stabilizing aggregate supply effect working through the supply of capital; and a destabilizing aggregate demand effect generated by a feedback loop between unemployment risk and consumption demand. Using the estimated model to measure the contribution of precautionary savings to the propagation of recent recessions, we find strong aggregate demand effects during the Great Recession and the 1990–1991 recession. In contrast, the supply effect at least offset the demand effect during the 2001 recession.

One much-neglected aspect of the recent recession is how households suddenly started saving more. This paper puts such behavior in the heart of the model and gets interesting results from it. Beyond the headline that the demand effects of precautionary savings were most important in the Great Recession, the model is also interesting because it has a lot of potential in explaining distributional aspects of recessions. Could it even explain long-term trends in the distribution of assets? Probably not without more institutional detail.