Does rental housing market stabilize the economy? A micro and macro perspective.

September 26, 2017

By Michal Rubaszek and Margarita Rubio

The size of the rental housing market in most countries around the globe is low. In this article we claim that this may be detrimental for macroeconomic stability. Toward this aim we, determine the reasons behind rental market underdevelopment by conducting an original survey among a representative group of 1005 Poles, a country that is characterized by high homeownership ratio. We find that households’ preferences are strongly influenced by economic and psychological factors. Next, we propose a DSGE model in which households satisfy housing needs both by owning and renting. We use it to show that reforms enhancing the rental housing market contribute to macroeconomic stability. This micro-macro approach allows us to dig into the causes of rental market underdevelopment and design appropriate policy recommendations.

I have been puzzled that in economies with more risk, people were owning their homes rather than renting them. The reason of my puzzlement was that owning makes you less mobile, as you are tied to an illiquid asset whose value correlates strongly with local economic conditions (which may be the reason to move away). This paper seems to resolve this through reverse causation: where rental rates are higher, economies are more stable as a result. To make this happen in general equilibrium, though, the choice of residential status has then to be at least partly exogenous of economic considerations.


Modelling a complex world: Improving macro-models

September 22, 2017

By Warwick J. McKibbin and Andrew Stoeckel

Macro models have come under criticism for their ability to understand or predict major economic events such as the global financial crisis and its aftermath. Some of that criticism is warranted; but, in our view, much is not. This paper contributes to the debate over the adequacy of benchmark DSGE models by showing how three extensions, which are features that have characterized the global economy since the early 2000s, are necessary to improve our understanding of global shocks and policy insights. The three extensions are to acknowledge and model the entire global economy and the linkage through trade and capital flows; to allow for a wider range of relative price variability by moving to multiple sector models rather than a single good model; and to allow for changes in risk perceptions which propagate through financial markets and adjustments in the real economy. These extensions add some complexity to large scale macromodels, but without them policy models can oversimplify things, allowing misinterpretations of shocks and therefore costly policy mistakes to occur. Using oversimplified models to explain a complex world makes it more likely there will be “puzzles”. The usefulness of these extensions is demonstrated in two ways; first, by briefly revisiting some historical shocks to show how outcomes can be interpreted that make sense within a more complex DSGE framework; then, by making a contemporary assessment of the implications from the proposed large fiscal stimulus and the bans on immigration by the Trump administration which have both sectoral and macroeconomic implications that interact.

A frequent criticism of DSGE models is that the simplest model cannot address all sorts of empirical regularities (“puzzles”) that often can be dealt with through appropriate extensions of the model. I think this paper is trying to make the point that some of those extensions should be systematically added to the canonical DSGE model. I do not think I can agree with that. First, adding all sorts of bells and whistles to a model makes it very difficult to understand. As a researcher we should strive to understand why something happens, not just observe that it happens. Models are abstractions of the reality that keep just what is needed to understand the empirical phenomenon. Of course, one can debate whether the assumption of the model are right, and this is what peer review, for example, is supposed to do. Second, having a too complex model makes it difficult to solve. A model that goes after a simple question and need a cluster to run is not a good model. Say you what to study the impact of unemployment insurance extension. Having trade and capital flow linkage in a global economy is then going to be of second or third order importance. Stay with the simplest possible model that can answer your research question.

Optimal Ramsey Capital Income Taxation —A Reappraisal

September 21, 2017

By YiLi Chien and Yi Wen

This paper addresses a long-standing problem in the optimal Ramsey capital taxation literature. The tractability of our model enables us to solve the Ramsey problem analytically along the entire transitional path. We show that the conventional wisdom on Ramsey tax policy and its underlying intuition and rationales do not hold in our model and may thus be misrepresented in the literature. We uncover a critical trade off for the Ramsey planner between aggregate allocative efficiency in terms of the modified golden rule and individual allocative efficiency in terms of self-insurance. Facing the trade off, the Ramsey planner prefers issuing debt rather than taxing capital if possible. In particular, the planner always intends to supply enough bonds to relax individuals’ borrowing constraints and through which to achieve the modified golden rule by crowding out capital. Capital tax is not the vital tool to achieve aggregate allocative efficiency despite possible over-accumulation of capital. Thus the optimal capital tax can be zero, positive, or even negative, depending on the Ramsey planner’s ability to issue debt. The modified golden rule can fail to hold whenever the government encounters a debt limit. Finally, the desire to relax individuals’ borrowing constraints by the planner may lead to unlimited debt accumulation, resulting in a dynamic path featuring no steady state.

This is an important contribution in the seemingly endless debate about capital income taxation. Here, the paper refocuses the issue on the ability of the government to issue debt. In particular, it shows that you cannot simultaneously impose debt limits on a government while hoping to achieve aggregate allocative efficiency. Whether you want to tax or even subsidize capital income would then depend on interest burden and labor income tax.

Are consistent expectations better than rational expectations?

September 21, 2017

By Elliot Aurissergues

In this paper, I argue that agents may prefer learning a misspecified model instead of learning the rational expectation model. I consider an economy with two types of agent. Fundamentalists learn a model where endogenous variables depend on relevant exogenous variables whereas followers learn a model where endogenous variables are function of their lagged values. A Fundamentalist is like a DSGE econometrician and a follower is like a VAR econometrician. If followers (resp. fundamentalists) give more accurate forecasts, a fraction of fundamentalists (resp. followers) switch to the follower model. I apply this algorithm in a linear model. Results are mixed for rational expectations. Followers may dominate in the long run when there are strategic complementarities and high persistence of exogenous variables. When additional issues are introduced, like structural breaks or unobservable exogenous variable, followers can have a significant edge on fundamentalists. I apply the algorithm in three economic models a cobweb model, an asset price model and a simple macroeconomic model.

This horse race is a bit different from the ones focusing on the forecasting ability of statistical and micro-founded models. Here it is about how well agents following each strategy do in a fictitious world. It turns out “fundamentalists” do not do too well when the model changes on them. The critical aspect here is whether they are really blind to what is happening here. Says for example that suddenly a government loses the ability to borrow. A real-world fundamentalist would be able to reevaluate with this information. In this paper, though, he continues with a model that is obviously misspecified and only over time realizes that there is a new constraint. What is the more likely scenario?

Financial Regulation and Shadow Banking: A Small-Scale DSGE Perspective

September 13, 2017

By Patrick Fève and Olivier Pierrard

In this paper, we revisit the role of regulation in a small-scale dynamic stochastic general equilibrium (DSGE) model with interacting traditional and shadow banks. We estimate the model on US data and we show that shadow banking interferes with macro-prudential policies. More precisely, asymmetric regulation causes a leak towards shadow banking which weakens the expected stabilizing effect. A counterfactual experiment shows that a regulation of the whole banking sector would have reduced investment fluctuations by 10% between 2005 and 2015. Our results therefore suggest to base regulation on the economic functions of financial institutions rather than on their legal forms.

Regulators and banks play a cat and mouse game, and I wonder whether to adopt a rule like “if it looks like a bank, regulate as a bank” would work. But this is a good attempt at tackling the shadow banking sector, which is difficult to track properly both in real life and as a modeler.

Goods and Factor Market Integration: A Quantitative Assessment of the EU Enlargement

September 7, 2017

By Lorenzo Caliendo, Luca David Opromolla, Fernando Parro and Alessandro Sforza

The economic effects from labor market integration are crucially affected by the extent to which countries are open to trade. In this paper we build a multi-country dynamic general equilibrium model with trade in goods and labor mobility across countries to study and quantify the economic effects of trade and labor market integration. In our model trade is costly and features households of different skills and nationalities facing costly forward-looking relocation decisions. We use the EU Labour Force Survey to construct migration flows by skill and nationality across 17 countries for the period 2002-2007. We then exploit the timing variation of the 2004 EU enlargement to estimate the elasticity of migration flows to labor mobility costs, and to identify the change in labor mobility costs associated to the actual change in policy. We apply our model and use these estimates, as well as the observed changes in tariffs, to quantify the effects from the EU enlargement. We find that new member state countries are the largest winners from the EU enlargement, and in particular unskilled labor. We find smaller welfare gains for EU-15 countries. However, in the absence of changes to trade policy, the EU-15 would have been worse off after the enlargement. We study even further the interaction effects between trade and migration policies and the role of different mechanisms in shaping our results. Our results highlight the importance of trade for the quantification of the welfare and migration effects from labor market integration.

Trade in goods and movement of labor are substitutes. Opening trade and labor may thus introduce complex interactions. This paper tries to sort that out in general equilibrium, and it turns out everyone wins, although not necessarily a lot.

Banking Panics and Output Dynamics

September 1, 2017

By Daniel Sanches

This paper develops a dynamic general equilibrium model with an essential role for an illiquid banking system to investigate output dynamics in the event of a banking crisis. In particular, it considers the ex-post efficient policy response to a banking crisis as part of the dynamic equilibrium analysis. It is shown that the trajectory of real output following a panic episode crucially depends on the cost of converting long-term assets into liquid funds. For small values of the liquidation cost, the recession associated with a banking panic is protracted as a result of the premature liquidation of a large fraction of productive banking assets to respond to a panic. For intermediate values, the recession is more severe but short-lived. For relatively large values, the contemporaneous decline in real output in the event of a panic is substantial but followed by a vigorous rebound in real activity above the long-run level.

Hmm, Daniel Sanches is onto something here. Could the high level of financial development be the reason it took so long for the United States to get out of the last banking crisis? Eyeballing the graphs, it looks like the total cost of a banking crisis recession is higher if liquidation is less costly. That seems to be a surprising and counter-intuitive result, as large financial frictions seem to be better. And I wonder whether the steady-state effect of liquidation costs is stronger than the cyclical effect. So many questions…