Are asset price data informative about news shocks? A DSGE perspective

August 22, 2018

By Nikolay Iskrev

Standard economic intuition suggests that asset prices are more sensitive to news than other economic aggregates. This has led many researchers to conclude that asset price data would be very useful for the estimation of business cycle models containing news shocks. This paper shows how to formally evaluate the information content of observed variables with respect to unobserved shocks in structural macroeconomic models. The proposed methodology is applied to two different real business cycle models with news shocks. The contribution of asset prices is found to be relatively small. The methodology is general and can be used to measure the informational importance of observables with respect to latent variables in DSGE models. Thus, it provides a framework for systematic treatment of such issues, which are usually discussed in an informal manner in the literature.

Interesting, if only to highlight that the stock market has relatively little additional information, compared to official statistics, about the state of the economy.


Euro Area unemployment insurance at the time of zero nominal interest rates

August 18, 2018

By Guillaume Claveres and Jan Stráský

The discussion about a fiscal stabilisation capacity as a way of providing more fiscal integration in the euro area has strengthened in the aftermath of the European sovereign debt crisis. Among the instruments that can be used for temporary macroeconomic stabilisation in the presence of both asymmetric and area-wide shocks, a euro area unemployment insurance scheme has attracted increased attention. We build a two-region DSGE model with supply, demand and labour market frictions and introduce in it an area-wide unemployment insurance scheme that is entitled to borrow in financial markets. The model is calibrated to the euro area core and periphery data. For a country-specific negative demand shock hitting the periphery, we find the scheme to reduce the drop in Periphery output by about one fifth and the drop in union output by about a third. The scheme is effective when some households are cut from financial markets, and even more so when the national government also loses market access.

More evidence that supranational insurance against business-cycle events is beneficial, here coupled with active financial market participation by the insurance scheme.

The Aggregate Consequences of Tax Evasion

August 3, 2018

By Alessandro Di Nola, Georgi Kocharkov, Almuth Scholl and Anna-Mariia Tkhir

There is a sizable overall tax gap in the U.S., albeit tax non-compliance differs sharply across income types. While only small percentages of wages and salaries are underreported, the estimated misreporting rate of self-employment business income is substantial. This paper studies how tax evasion in the self-employment sector affects aggregate outcomes and welfare. We develop a dynamic general equilibrium model with incomplete markets in which heterogeneous agents choose between being a worker or self-employed. Self-employed agents may hide a share of their business income but face the risk of being detected by the tax authority. Our model replicates important quantitative features of the U.S. economy in terms of income, wealth, self-employment, and tax evasion. Our quantitative ndings suggest that tax evasion leads to a larger self-employment sector but it depresses the average size and productivity of self-employed businesses. Tax evasion generates positive aggregate welfare effects because it acts as a subsidy for the self-employed. Workers, however, suffer from substantial welfare losses.

Interesting that there is an overall welfare benefit from tax evasion. But this could be done better by having some formal tax benefit from entrepreneurship.

On the optimal design of a Financial Stability Fund

August 1, 2018

By Arpad Abraham, Eva Carceles-Poveda, Yan Liu and Ramon Marimon

A Financial Stability Fund set by a union of sovereign countries can improve countries’ ability to share risks, borrow and lend, with respect to the standard instrument used to smooth fluctuations: sovereign debt financing. Efficiency gains arise from the ability of the fund to offer long-term contingent financial contracts, subject to limited enforcement (LE) and moral hazard (MH) constraints. In contrast, standard sovereign debt contracts are uncontingent and subject to untimely debt roll-overs and default risk. We develop a model of the Financial Stability Fund (Fund) as a long-term partnership with LE and MH constraints. We quantitatively compare the constrained-efficient Fund economy with the incomplete markets economy with default. In particular, we characterize how (implicit) interest rates and asset holdings differ, as well as how both economies react differently to the same productivity and government expenditure shocks. In our economies, “calibrated” to the euro area “stressed countries”, substantial efficiency gains are achieved by establishing a well-designed Financial Stability Fund; this is particularly true in times of crisis. Our theory provides a basis for the design of a Fund – for example, beyond the current scope of the European Stability Mechanism (ESM) – and a theoretical and quantitative framework to assess alternative risk-sharing (shock-absorbing) facilities, as well as proposals to deal with the euro area “debt overhang problem.”

This is an important paper in literature that studies how countries can insure themselves against shocks, under the assumption that markets are currently incomplete or not perfect and that business cycles are costly. It essentially boils down to designing complex securities in a way that very large players can supply them. The political ramifications are daunting.