Capital Utilization and Search Unemployment in Dynamic General Equilibrium

October 30, 2018

By Ian King and Frank Frank Stähler

We present a dynamic general equilibrium model in which both unemployment and capital utilization are determined endogenously in an environment with directed search frictions. The model allows for proportions of both labor and capital to be idle in equilibrium, where the degree of capital utilization determines its depreciation. We show that, under certain conditions, multiple steady state equilibria exist. In stable equilibria, both unemployment and capital utilization rates decline as productivity increases.

Getting endogenous idleness for two factors of production is tricky, and this paper makes a good attempt at this. I am intrigued by the result of multiple equilibria though, in particular whether it is only valid locally. What I have in mind is the observation that less productive economies seem to have a lot of idle capital and people, at least compared to developed ones.


What inflation measure should a currency union target?

October 29, 2018

By William Barnett, Chan Wang, Xue Wang and Liyuan Wu

What is the appropriate inflation target for a currency union, when conducting monetary policy: core inflation or headline inflation? We answer the question in a two-country New Keynesian model with an energy sector. We derive the welfare loss function and find that optimal monetary policy should target output gaps, the terms of trade gap, the Prouder Price Index inflation rates, and the real marginal cost gaps. We use the welfare loss function to evaluate two alternative Taylor-type monetary policy rules. We find that the choice of preferred policy rule depends on the shocks. Specifically, when productivity shocks hit the economy, the policymaker should follow the headline inflation Taylor rule, while the core inflation Taylor rule should be followed when a negative energy endowment shock hits the economy.

Thus, the monetary policy target depends on the state of the economy. To me, this sounds like having this kind of target is a bad idea, as you do not learn the state of the economy in real time. This idea of have a target was to have some real-time statistic to set policy with, after all.

Equilibrium foreign currency mortgages

October 26, 2018

By Marcin Kolasa

This paper proposes a novel explanation for why foreign currency denominated loans to households have become so popular in some emerging economies. Our argument is based on what we call the debt limit channel, which arises when multi-period contracts are offered to financially constrained borrowers against collateral that is established on newly acquired assets. Whenever the difference between domestic and foreign interest rates is positive, this effect biases borrowers’ choices towards foreign currency, even if the exchange rate is known to depreciate as implied by the interest parity condition. We demonstrate in a simple macroeconomic framework that the debt limit channel is quantitatively important and can result in dollarization of debt also when borrowing in foreign currency is risky. We next use a small open economy DSGE model and show that, if first-order effects related to the debt limit channel are neutralized by appropriate adjustment in debt contracts, the equilibrium share of foreign currency loans is small.

I think the point of the paper is that mortgage holders in countries with a currency that depreciates (and thus has a higher interest rate) borrow in a foreign currency so that they can borrow more. This is reminiscent of balloon mortgages in the US. Do the borrowers really know what they are getting into? Do the lenders realize that the borrowers are likely facing difficulties?

Inheritance Taxation and Wealth Effects on the Labor Supply of Heirs

October 25, 2018

By Fabian Kindermann, Lukas Mayr and Dominik Sachs

The taxation of bequests 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 on top of direct bequest tax revenue. We first show in a theoretical model that a simple back-of-the-envelope calculation, based on existing estimates for the reduction in earnings after wealth transfers, fails: the marginal propensity to earn out of unearned income is not a sufficient statistic for the calculation of this effect because (i) heirs anticipate the reduction in net bequests and adjust their labor supply already prior to inheriting, and (ii) when bequest receipt is stochastic, even those who ex post end up not inheriting anything respond ex ante to the implied change in their distribution of net bequests. We quantitatively elaborate the size of the overall revenue effect due to labor supply changes of heirs by using a state of the art life-cycle model that we calibrate to the German economy. Besides the joint distribution of income and inheritances, quasi-experimental evidence regarding the size of wealth effects on labor supply is a key target for this calibration. 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 higher labor supply of (non-) heirs.

This paper makes an interesting point in the debate on estate taxation: the labor supply of potential heirs is elastic to the expected inheritance. This is a unique case where increasing a tax rate also increases GDP! It is, however, not clear what the impact on welfare is, as household need to do more precautionary savings and enjoy less leisure. Too bad the paper is silent on this.

The Elasticity of Intergenerational Substitution, Parental Altruism, and Fertility Choice

October 24, 2018

By Juan Carlos Córdoba and Marla Ripoll

Dynastic models common in macroeconomics use a single parameter to control the willingness of individuals to substitute consumption both intertemporally, or across periods, and intergenerationally, or across parents and their children. This paper defines the concept of elasticity of intergenerational substitution (EGS), and extends a standard dynastic model in order to disentangle the EGS from the EIS, or elasticity of intertemporal substitution. A calibrated version of the model lends strong support to the notion that the EGS is significantly larger than one. In contrast, estimates of the EIS suggests that it is at most one. What disciplines the identification is the need to match empirically plausible fertility rates for the US.

This has flavors of hyperbolic discounting, but intergenerational and for the elasticity of substitution. This could have important implications as we evaluate policies that span generations.

A New Keynesian Model with Wealth in the Utility Function

October 20, 2018

By Pascal Michaillat and Emmanuel Saez

This paper extends the New Keynesian model by introducing wealth, in the form of government bonds, into the utility function. The extension modifies the Euler equation: in steady state the real interest rate is negatively related to consumption instead of being constant, equal to the time discount rate. Thus, when the marginal utility of wealth is large enough, the dynamical system representing the equilibrium is a source not only in normal times but also at the zero lower bound. This property eliminates the zero-lower-bound anomalies of the New Keynesian model, such as explosive output and inflation, and forward-guidance puzzle.

I have to confess that I have a hard time with the innovative assumption of this paper. Do people really really care about their wealth beyond what it brings in terms of future consumption? OK, wealth brings status, but does this matter this much? And is this status wealth in government bonds? I would have thought that to rather be in oversized housed, expensive cars and golden toilets.

Aggregate Effects of Minimum Wage Regulation at the Zero Lower Bound

October 20, 2018

By Andrew Glover

The Fair Minimum Wage Act of 2007 increased the U.S. nominal minimum wage by 41 percent immediately prior to nominal interest rates hitting the Zero Lower Bound in 2008. I study the interaction of these two events in an extension of the sticky-price New Keynesian model. The minimum wage dampens the contractionary effects of the ZLB by preventing rapid wage deflation, halting the deflationary spiral caused by low aggregate demand. For sufficiently persistent ZLB shocks, the minimum wage generates infinite output gains relative to flexible wages, while GDP losses are reduced by half in a calibrated economy. Increasing the minimum wage at the ZLB is expansionary: accumulated output gains are more than 15 percent in the calibrated economy.

Interesting. I can believe that increasing the minimum wage is expansionary, after all the beneficiaries have a very high propensity to consume. And this becomes particularly important when you hit the ZLB, as policy options are running out. I would not have expected this to that effective a policy.

Education policy and intergenerational transfers in equilibrium

October 17, 2018

By Brant Abbott, Giovanni Gallipoli, Costas Meghir and Giovanni L. Violante

This paper examines the equilibrium effects of alternative financial aid policies intended to promote college participation. We build an overlapping generations life cycle model with education, labor supply, and consumption/saving decisions. Cognitive and non-cognitive skills of children depend on the cognitive skills and education of parents, and affect education choice and labor market outcomes. Driven by both altruism and paternalism, parents make transfers to their children which can be used to fund education, supplementing grants, loans and the labor supply of the children themselves during college. The crowding out of parental transfers by government programs is sizable and thus cannot be ignored when designing policy. The current system of federal aid is valuable: removing either grants or loans would each reduce output by 2% and welfare by 3% in the long-run. An expansion of aid towards ability-tested grants would be markedly superior to either an expansion of student loans or a labor tax cut. This result is, in part, due to the complementarity between parental education and ability in the production of skills of future generations.

The best way to finance is an important issue and this paper shows that it matters. It also demonstrates that education should not be free, but its cost in the end should be tailored to the financial abilities of the parents. The worst outcome is if the government is not involved at all, and this even if student ability is correlated with parental wealth.

Redistributing the Gains From Trade Through Progressive Taxation

October 17, 2018

By Spencer Lyon and Michael Waugh

Should a nation’s tax system become more progressive as it opens to trade? Does opening to trade change the benefits of a progressive tax system? We answer these question within a standard incomplete markets model with frictional labor markets and Ricardian trade. Consistent with empirical evidence, adverse shocks to comparative advantage lead to labor income loses for import-competition-exposed workers; with incomplete markets, these workers are imperfectly insured and experience welfare losses. A progressive tax system is valuable as it substitutes for imperfect insurance and redistributes the gains from trade. However, it also reduces the incentives to work and for labor to reallocate away from comparatively disadvantaged locations. We find that progressivity should increase with openness to trade and that progressivity is an important tool to mitigate the negative consequences of globalization.

This is an interesting take on how to address the losers from globalization. But when you think a little about it, this is like tax progressivity helping to redistribute income during a recession, except that in the latter case you also have to tool of public deficits.

Corporate Tax Cuts and the Decline of the Labor Share

October 14, 2018

By Baris Kaymak and Immo Schott

We document a strong empirical connection between corporate taxation and the labor’s share of income in the manufacturing sector across OECD countries. The estimates indicate that the decline in corporate taxes is, on average, associated with 40% of the observed decline in labor’s share. We then present a model of industry dynamics where firms differ in their capital intensity as well as their productivity. A drop in the corporate tax rate reduces the labor share by shifting the distribution of production towards capital intensive firms. Industry con- centration rises as a result, and firm entry falls, consistent with the US experience documented in Kehrig and Vincent (2017) and Autor et al. (2017). Calibration of the model to the US economy indicates that corporate tax cuts explain at least a third of the decline in labor’s share in the US manufacturing industry.

The secular(?) decline in the labor income share is cause for a a lot of speculation, especially as it seems to happens in several countries simultaneously. This paper presents an interesting take at this question: it is to a good part due to declining corporate tax rates and the ensuing market concentration. The narrative makes sense and the numbers seem to back it up well.