An Over-the-Counter Approach to the FOREX Market

May 27, 2015

By Athanasios Geromichalos and Kuk Mo Jung

The FOREX market is an over-the-counter market (in fact, the largest in the world) characterized by bilateral trade, intermediation, and significant bid-ask spreads. The existing international macroeconomics literature has failed to account for these stylized facts largely due to the fact that it models the FOREX as a standard Walrasian market, therefore overlooking some important institutional details of this market. In this paper, we build on recent developments in monetary theory and finance to construct a dynamic general equilibrium model of intermediation in the FOREX market. A key concept in our approach is that immediate trade between ultimate buyers and sellers of foreign currencies is obstructed by search frictions (e.g., due to geographic dispersion). We use our framework to compute standard measures of FOREX market liquidity, such as bid-ask spreads and trade volume, and to study how these measures are affected both by macroeconomic fundamentals and the FOREX market microstructure. We also show that the FOREX market microstructure critically affects the volume of international trade and, consequently, welfare. Hence, our paper highlights that modeling the FOREX as a frictionless Walrasian market is not without loss of generality.

The foreign exchange market is modelled in an incredibly naive way, incredible given the size of the market. And despite its size, there are sizable frictions and many missing bilateral markets. This paper is an important step n the direction of modelling the microfoundations of this market to better understand how issues in intermediation can have macroeconomic, even global, implications.


Optimal Savings for Retirement: The Role of Individual Accounts

May 19, 2015

By Julia Le Bland and Almuth Scholl

We employ a life-cycle model with income risk to analyze how tax-deferred individual accounts affect households’ savings for retirement. We consider voluntary accounts as opposed to mandatory accounts with minimum contribution rates. We contrast add-on accounts with carve-out accounts that partly replace social security contributions. Quantitative results suggest that making add-on accounts mandatory has adverse welfare effects across income groups. Carve-out accounts generate positive welfare across all income groups but gains are lower for low income earners. Default investment rules in individual accounts have a modest impact on welfare.

As soon as you are mandating something, you are going to reduce welfare unless you overcome some sort of short-sightedness or there is a general equilibrium effect that warrants intervention. I see neither in this model, so it must be that replacing part of social security with a mandatory individual account allows to replace a mandate by a less bad one.

Large Firm Dynamics and the Business Cycle

May 17, 2015

By Vasco Carvalho and Basile Grassi

Do large firm dynamics drive the business cycle? We answer this question by developing a quantitative theory of aggregate fluctuations caused by firm-level disturbances alone. We show that a standard heterogeneous firm dynamics setup already contains in it a theory of the business cycle, without appealing to aggregate shocks. We offer a complete analytical characterization of the law of motion of the aggregate state in this class of models – the firm size distribution – and show that the resulting closed form solutions imply aggregate output and productivity dynamics which are: (i) persistent, (ii) volatile and (iii) exhibit time-varying second moments. We explore the key role of moments of the firm size distribution – and, in particular, the role of large firm dynamics – in shaping aggregate fluctuations, theoretically, quantitatively and in the data.

The message of this paper: the distribution of firms changes over time, it matters and can create fluctuations that are consistent to what we assume for a typical business cycle model. In other words, we could be endogenizing here all the way to the firm-level the aggregate shocks we always rely on.

Wage inequality

May 12, 2015

By Ken Burdett, Carlos Carrillo-Tudela and Melvyn Coles

The objective of this paper is to study why are some workers paid more than others. To do so we construct and quantitatively assess an equilibrium search model with on-the-job search, general human capital accumulation and two sided heterogeneity. In the model workers differ in abilities and firms differ in their productivities. The model generates a simple (log) wage variance decomposition that is used to measure the importance of firm and worker productivity differentials, frictional wage dispersion and workers’ sorting dynamics. We calibrate the model using a sample of young workers for the UK. We show that heterogeneity among firms generates a lot of wage inequality. Among low skilled workers job ladder effects are small, most of the impact of experience on wages is due to learning-by-doing. High skilled workers are much more mobile. Job ladder effects have sizeable impact.

To all enthusiasts of diff-in-diff or diff-in-diff-in-diff empirical studies: adding a little bit of theory goes a log way in identifying and understanding what you are trying to measure, let alone how to set up the empirical strategy. This paper is perfect example of that. In particular it allows to tie back the measurements directly to concepts we know from theory, instead of having a usually vague idea that they are consistent with some theory (“the signs are correct”). Finally, this paper is not only a nice empirical exercise, it also yields some pretty interesting results.

The zero lower bound and parameter bias in an estimated DSGE model

May 5, 2015

By Yasuo Hirose and Atsushi Inoue

This paper examines how and to what extent parameter estimates can be biased in a dynamic stochastic general equilibrium (DSGE) model that omits the zero lower bound (ZLB) constraint on the nominal interest rate. Our Monte Carlo experiments using a standard sticky-price DSGE model show that no significant bias is detected in parameter estimates and that the estimated impulse response functions are quite similar to the true ones. However, as the probability of hitting the ZLB increases, the parameter bias becomes larger and therefore leads to substantial differences between the estimated and true impulse responses. It is also demonstrated that the model missing the ZLB causes biased estimates of structural shocks even with the virtually unbiased parameters.

The zero lower bound will have a lasting and profound effect on business cycle research. First, because it happened and this eventuality was not much considered previously. Second, because the assumption of symmetry around a steady-state is not defensible any more and linearization cannot be justified. And third, because the data is also “tainted” and one needs to be extra-careful in dealing with it now. This paper is a good example of this third point.

Remittances and Macroeconomic Volatility in African Countries

May 1, 2015

By Ahmat Jidoud

This paper investigates the channels through which remittances affect macroeconomic volatility in African countries using a dynamic stochastic general equilibrium (DSGE) model augmented with financial frictions. Empirical results indicate that remittances–as a share of GDP–have a significant smoothing impact on output volatility but their impact on consumption volatility is somewhat small. Furthermore, remittances are found to absorb a substantial amount of GDP shocks in these countries. An investigation of the theoretical channels shows that the stabilization impact of remittances essentially hinges on two channels: (i) the size of the negative wealth effect on labor supply induced by remittances and, (ii) the strength of financial frictions and the ability of remittances to alleviate these frictions.

This is a rare paper that applies DSGE methods to Africa. It also addresses an important question, as African economies are extremely volatile and suffer from large frictions, to the point that the volatility of consumption is higher than that of output. Finally, remittances have become more much larger over the years as a share of GDP, and thus offer potentially interesting ways to insure against domestic fluctuations.