Optimal Long-Run Inflation and the Informal Economy

By Claudio Cesaroni

http://d.repec.org/n?u=RePEc:lie:wpaper:46&r=dge

This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government’s ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-decreasing function of the size of the informal economy and, in most cases, there is a positive relationship between the two. Finally, substantial deviations from zero inflation are observed even in presence of a plausible degree of price rigidity.

Seigniorage is a good source of government revenue and this paper shows that when you have a sizable informal sector, seigniorage becomes invaluable. The contribution of this paper is first to show how the tax mix is influential, how there seems to be some sort of Laffer curve (very loosely defined) in play, and that price rigidity matters. This paper should help countries with low tax morale.

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Uncertainty Shocks and Firm Dynamics: Search and Monitoring in the Credit Market

By Thomas Brand, Marlène Isoré and Fabien Tripier

http://d.repec.org/n?u=RePEc:cpm:docweb:1707&r=dge

We develop a business cycle model with gross flows of firm creation and destruction. The credit market is characterized by two frictions. First, entrepreneurs undergo a costly search for intermediate funding to create a firm. Second, upon a match, a costly-state-verification contract is set up. When defaults occurs, banks monitor firms, seize their assets, and a fraction of financial relationships are severed. The model is estimated using Bayesian methods for the U.S. economy. Among other shocks, uncertainty in productivity turns out to be a major contributor to both macro-financial aggregates and firm dynamics.

This is an interesting that brings an additional layer to the financing part of the typical business cycle model. Entrepreneurs search and are subject to CSV. Also the model is estimated. It is not a surprise that in such a set-up second moments matter, but it worth emphasizing once more uncertainty is important.

Two papers on exchange rate policy

FX Intervention in the New Keynesian Model

By Zineddine Alla, Raphael A Espinoza and Atish R. Ghosh

http://d.repec.org/n?u=RePEc:imf:imfwpa:17/207&r=dge

We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

The Exchange Rate as an Instrument of Monetary Policy

By Jonas Heipertz, Ilian Mihov and Ana Maria Santacreu

http://d.repec.org/n?u=RePEc:fip:fedlwp:2017-028&r=dge

Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

Lately, interesting papers seem to come in pairs in the weekly NEP-DGE reports. This time they are about exchange rate policy. The first one highlights that it can help with indeterminacy and multiplicity in monetary economies, and the second one shows that an optimal policy is mightily interesting and is not a corner solution.

Two papers on wealth taxation

Use It or Lose It: Efficiency Gains from Wealth Taxation

By Fatih Guvenen, Gueorgui Kambourov, Burhan Kuruscu, Sergio Ocampo-Diaz and Daphne Chen

This paper studies the quantitative implications of wealth taxation (as opposed to capital income taxation) in an incomplete markets model with return rate heterogeneity across individuals. The rate of return heterogeneity arises from the fact that some individuals have better entrepreneurial skills than others, allowing them to obtain a higher return on their wealth. With such heterogeneity, capital income and wealth taxes have different efficiency and distributional implications. Under capital income taxation, entrepreneurs who are more productive and, as a result, generate more income pay higher taxes. Under wealth taxation, on the other hand, entrepreneurs who have similar wealth levels pay similar taxes regardless of their productivity. Thus, in this environment, the tax burden shifts from productive entrepreneurs to unproductive ones if the capital income tax were replaced with a wealth tax. This reallocation increases aggregate productivity. Second, and at the same time, it increases wealth inequality in the population. To provide a quantitative assessment of these different effects, we build and simulate an overlapping generations model with individual-specific returns on capital income and with idiosyncratic shocks to labor income. Our results indicate that switching from a capital income tax to a wealth tax increases welfare by almost 8% through better allocation of capital. We also study optimal taxation in this environment and find that, relative to the benchmark, the optimal wealth tax increases welfare by 9.6% while the optimal capital income tax increases it by 6.3%.

Inheritance Taxation and Wealth Effects on the Labor Supply of Heirs

By Fabian Kindermann, Lukas Mayr and Dominik Sachs

http://d.repec.org/n?u=RePEc:red:sed017:1046&r=dge

Taxing bequests not only generates direct tax revenue, but can have a positive impact on the labor supply of heirs through wealth effects. This leads to an increase in future labor income tax revenue. How large is this effect? We use a state of the art life-cycle model that we calibrate to the German economy to answer this question. Our model successfully matches quasi-experimental evidence regarding the size of wealth effects on labor supply. Using this evidence directly for a back of the envelope calculation fails because (i) heirs anticipate the reduction in bequests through taxation and adjust their labor supply already prior to the actual act of bequeathing, and (ii) when bequest receipt is stochastic, even those who ex post end up not inheriting anything respond ex ante to a change in the expected size of bequests. We find that for each Euro of bequest tax revenue the government mechanically generates, it obtains an additional 9 Cents of labor income tax revenue (in net present value) through a higher labor supply of (non-)heirs.

A large crop of papers in this week’s NEP-DGE report yields two on an important topic of the day: estate (or inheritance) taxation. A lot of people need to be better informed before making law, and these paper are part of that bibliography.

Macroeconomic Fluctuations with HANK & SAM: an Analytical Approach

By Morten Ravn and Vincent Sterk

http://d.repec.org/n?u=RePEc:red:sed017:1067&r=dge

New Keynesian models with unemployment and incomplete markets are rapidly becoming a new workhorse model in macroeconomics. Such models typically require heavy computational methods which may obscure intuition and overlook equilibria. We present a tractable version which can be characterized analytically. Our results highlight that – due the interaction between incomplete markets, sticky prices and endogenous unemployment risk – productivity shocks may have radically different effects than in traditional NK models, that the Taylor principle may fail, and that pessimistic beliefs may be self-fulfilling and move the economy into temporary episodes of low demand and high unemployment, as well as into a long-lasting “unemployment trap”. At the Zero Lower Bound, the presence of endogenous unemployment risk can create inflation and overturn paradoxical properties of the model. We further study financial asset prices and show that non-negligible risk premia emerge.

There is so much going on in this paper I cannot summarize it. Just read it.