Political Distribution Risk and Business Cycles

January 16, 2018

By Thorsten Drautzburg, Jesus Fernandez-Villaverde and Pablo Guerron-Quintana

http://d.repec.org/n?u=RePEc:red:sed017:1201&r=dge

We argue that one important determinant of the variation in income shares is political risk. To that end, we document significant changes in the capital share after political events such as the introduction of right-to-work legislation in U.S. states and international events such as the Carnation Revolution in Portugal. These policy changes are often associated with significant fluctuations in output and asset prices. To quantify the importance of these political shocks for the U.S., we extend an otherwise standard neoclassical growth model. We model political shocks as exogenous changes in the bargaining power of workers in a labor market with search unemployment. We calibrate the model to the U.S. corporate non-financial business sector with a standard process for productivity. A one standard deviation redistribution shock reduces the capital share up 0.2 percentage point on impact and leads to a drop in output of 0.6 percent. Our calibration also implies that political distribution risk can explain 15 to 25% of the observed volatility of U.S. gross capital shares — and 35 to 45 percent of output volatility, depending on the elasticity of substitution between capital and labor. Eliminating political redistribution risk in the U.S. would raise the welfare of the representative household by 1.6 percent of steady state consumption.

I am actually surprised that political risk matters that little, at least for the US, seeing how politics can wreak havoc in other countries. Or maybe it is that bad politics is a steady state elsewhere, and thus it has an impact more on the levels than the fluctuations.

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The Optimal Inflation Target and the Natural Rate of Interest

January 12, 2018

By Philippe Andrade, Jordi Galí, Hervé Le Bihan and Julien Matheron

http://d.repec.org/n?u=RePEc:bge:wpaper:1009&r=dge

We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

Economists are now fairly convinced that the real interest rate has declined, whatever the reason may be. In that context, some of the policy “constants” need to be reevaluated, as they may depend on the real interest rate. This paper is one important approach at this question for the inflation target using a New Keynesian model. Let’s see whether other approaches come to similar conclusions.


Inferring Inequality with Home Production

January 11, 2018

By Job Boerma and LoukasKarabarbounis

http://d.repec.org/n?u=RePEc:fip:fedmwp:746&r=dge

We revisit the causes, welfare consequences, and policy implications of the dispersion in households’ labor market outcomes using a model with uninsurable risk, incomplete asset markets, and a home production technology. Accounting for home production amplifies welfare-based differences across households meaning that inequality is larger than we thought. Using the optimality condition that households allocate more consumption to their more productive sector, we infer that the dispersion in home productivity across households is roughly three times as large as the dispersion in their wages. There is little scope for home production to offset differences that originate in the market sector because productivity differences in the home sector are large and the time input in home production does not covary with consumption expenditures and wages in the cross section of households. We conclude that the optimal tax system should feature more progressivity taking into account home production.

I am actually quite surprised by the result of this paper. I would have thought that those with poorer labor market outcomes would have a comparative advantage in home production, and this would decrease inequality once you take home production into account. It turns out I was dead-wrong.