Human Capital Risk, Contract Enforcement, and the Macroeconomy

August 26, 2015

By Tom Krebs, Moritz Kuhn and Mark Wright

We use data from the Survey of Consumer Finance and Survey of Income Program Participation to show that young households with children are under-insured against the risk that an adult member of the household dies. We develop a tractable macroeconomic model with human capital risk, age-dependent returns to human capital investment, and endogenous borrowing constraints due to the limited pledgeability of human capital. We show analytically that, consistent with the life insurance data, in equilibrium young households are borrowing constrained and under-insured. A calibrated version of the model can quantitatively account for the life-cycle variation of life-insurance holdings, financial wealth, earnings, and consumption inequality observed in the US data. Our analysis implies that a reform that makes consumer bankruptcy more costly, like the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, leads to a substantial increase in the volume of both credit and insurance.

Young adults are under-insured because they are optimistic about the risks they face. This paper shows that their in an important other reason: they face a large future income risk they cannot insure because they are borrowing constraint. As they have current low income, but much better prospects if they build human capital, they want to borrow and spend on consumption, human capital accumulation, and insurance. As they cannot borrow enough, insurance is the principal loser. This could be alleviated by changing legislation by making bankruptcy more costly and thus making credit more enforceable.

What We Don’t Know Doesn’t Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

August 14, 2015

By Yulei Luo, Jun Nie, Gaowang Wang and Eric Young

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

Pretty neat paper that shows that the permanent income hypothesis is more powerful that what you would think. And we need to worry less about incomplete markets than what we previously thought.

The Ins and Outs of Selling Houses

August 11, 2015

By Rachel Ngai and Kevin Sheedy

The number of houses for sale is as volatile as sales volume and much more volatile than house prices, yet it has received relatively little attention. What drives volatility in the number of houses for sale? Is it due to changes in the difficulty of selling houses or changes in the incentive to put houses up for sale? This paper presents evidence that both inflows and outflows are important using a variance decomposition. It then uses a search-and-matching model with both the decision of when to agree a sale (outflows) and the decision of when to put a house up for sale (inflows) to understand the behaviour of sales, listings, and prices in the housing market. Quantitatively, the model does a much better job of matching relative volatility and correlations between housing-market variables than those that abstract from the inflow decision.

The paper makes and valid and important point: The decision to put a house on the market is highly strategic and neglected in the literature. And it turns out it matters greatly. And of course expectations matter a lot, and it would be great to integrate differ models of expectation formation in this line of work. Real estate is prone to bubbles, so this matters.

Coordinating Business Cycles

August 7, 2015

By Mathieu Taschereau-Dumouchel and Edouard Schaal

We develop a quantitative theory of business cycles with coordination failures. Because of a standard aggregate demand externality, firms want to coordinate production. The presence of a non-convex capacity decision generates multiple equilibria under complete information. We use a global game approach to show that, under incomplete information, the multiplicity of equilibria disappears to give rise to a unique equilibrium with two stable steady states. The economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. In our calibration, the coordination channel improves on the neoclassical growth model in terms of business cycle asymmetries and skewness. The model also accounts for features of the 2007- 2009 recession and its aftermath. Government spending is harmful in general as the coordination problem magnifies the crowding out. It can, however, increase welfare — without nominal rigidities — when the economy is about to transition to the bad steady state. Simple subsidies implement the efficient allocation.

This is an interesting way to approach coordination failures and how to narrow down the set of possible equilibria. And for those who feel that the fundamentals were right in the economy, at least on the real side, this model can provide an explanation why a deep and long recession still resulted from a financial shock. The paper ignores completely, though, the impact of very low real interest rates, like the Fed has been pursuing. I wonder whether this model is telling us this policy is a good way to get to the better equilibrium. It should certainly help with coordination.

Cross-border Banking, Spillover Effects and International Business Cycles

August 5, 2015

By Alexandre Kopoin

This paper studies the link between cross-border banking activities and the international propagation of real and financial shocks. We develop a two-country DSGE model with a bank capital channel and a financial accelerator, in which banks grant loans to domestic as well as to foreign firms. The model economy is calibrated to data from the U.S. and Canada. Our results suggest that following a positive technology shock and a tightening of home monetary policy, the existence of cross-border banking activities tends to amplify the transmission channel in both the domestic and the foreign country. However, cross-border banking activities tend to weaken the impact of shocks on foreign and home consumption because of the cross-border saving possibility between the two countries. Finally, our simulations suggest that under cross-border banking, correlations between macroeconomic variables of both countries become greater than in the absence of international banking activities. Overall, our results show sizable spillover effects of cross-border banking on macroeconomic dynamics and suggest cross border banking is an important source of the synchronization of business cycles between the U.S. and Canada.

If you open an economy, it should allow for opportunities to smooth economic fluctuations. It also opens it to shocks from abroad. This paper shows that this analysis becomes more subtle once you factor in cross-border banking. And it does so in interesting ways, as the channels of increasing synchronization of business cycles are so far not well understood.