The Brexit Vote, Productivity Growth and Macroeconomic Adjustments in the United Kingdom

September 29, 2019

By Ben Broadbent, Federico Di Pace, Thomas Drechsel, Richard Harrison and Silvana Tenreyro

http://d.repec.org/n?u=RePEc:cfm:wpaper:1916&r=dge”

The UK economy has experienced significant macroeconomic adjustments following the 2016 referendum on its withdrawal from the European Union. This paper develops and estimates a small open economy model with tradable and non-tradable sectors to characterise these adjustments. We demonstrate that many of the effects of the referendum result can be conceptualised as news about a future slowdown in productivity growth in the tradable sector. Simulations show that the responses of the model economy to such news are consistent with key patterns in UK data. While overall economic growth slows, an immediate permanent fall in the relative price of non-tradable output (the real exchange rate) induces a temporary ‘sweet spot’ for tradable producers before the slowdown in tradable sector productivity associated with Brexit occurs. Resources are reallocated towards the tradable sector, tradable output growth rises and net exports increase. These developments reverse after the productivity decline in the tradable sector materialises. The negative news about tradable sector productivity also leads to a decline in domestic interest rates relative to world interest rates and to a reduction in investment growth, while employment remains relatively stable. As a by-product of our analysis, we provide a quantitative analysis of the UK business cycle.

Note that this paper deals with just one shock that Brexit entails: anticipated lower productivity in the tradable sector. There can be more, such as a sectoral reallocation, changes in labor force composition, government spending, and others. This is still a very useful benchmark.

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Dynamic Programming with State-Dependent Discounting

September 25, 2019

By John Stachurski and Junnan Zhang

http://d.repec.org/n?u=RePEc:arx:papers:1908.08800&r=dge

This paper extends the core results of discrete time infinite horizon dynamic programming theory to the case of state-dependent discounting. The traditional constant-discount condition requires that the discount factor of the controller is strictly less than one. Here we replace the constant factor with a discount factor process and require, in essence, that the process is strictly less than one on average in the long run. We prove that, under this condition, the standard optimality results can be recovered, including Bellman’s principle of optimality, convergence of value function iteration and convergence of policy function iteration. We also show that the condition cannot be weakened in many standard settings. The dynamic programming framework considered in the paper is general enough to contain features such as recursive preferences. Several applications are discussed.

I guess everyone was thinking dynamic programming would work with variable discounting, but it is nice that this paper firmly establishes it works when the discount rate is state-dependent. One may now apply this without guilt.


Exchange Rate Pass-Through: A Competitive Search Approach

September 22, 2019

By Beverly Lapham and Ayman Mnasri

http://d.repec.org/n?u=RePEc:qed:wpaper:1418&r=dge

We develop an open economy monetary model with heterogeneous households which is characterized by incomplete pass-through of exchange rate movements to import prices. Partial pass-through arises in our environment due to the presence of competitive search in international goods’ markets. Under competitive search, agents choose a sub-market in which to exchange goods, where different sub-markets are characterized by different price and trading probability combinations. Preference and policy shocks which induce exchange rate movements cause households to choose a different sub-market for their purchases of traded goods–an extensive margin response. These responses mitigate the direct effect of nominal exchange rate changes on equilibrium traded goods’ prices, thereby generating incomplete exchange rate pass-through to goods’ prices. In the calibrated model, exchange rate pass-through due to foreign shocks ranges between 19% and 62%, which is in the range of import price pass-through estimates for developed economies. Due to risk aversion by households, the magnitude of pass-through depends on the size and direction of the initial shock, making the model consistent with the observed phenomenon of asymmetric pass-through. Importantly, by incorporating household heterogeneity, we are able to examine the role of precautionary savings in affecting pass-through, characterize how pass-through varies across different types of households, and examine the distributional effects of exchange rate movements.

I have always wondered why there is incomplete pass-through. Of course, you can assume various psychological factors, but that is too easy. This paper shows that incomplete pass-through can be the result of complete rationality: markets are segmented, and moving between markets in response to shocks is costly.


Credit, Default, and Optimal Health Insurance

September 1, 2019

By Youngsoo Jang

http://d.repec.org/n?u=RePEc:pra:mprapa:95397&r=dge

How do defaults and bankruptcies affect optimal health insurance policy? I answer this question using a life-cycle model of health investment with the option to default on emergency room (ER) bills and financial debts. I calibrate the model for the U.S. economy and compare the optimal health insurance in the baseline economy with that in an economy with no option to default. With no option to default, the optimal health insurance is similar to the health insurance system in the baseline economy. In contrast, with the option to default, the optimal health insurance system (i) expands the eligibility of Medicaid to 22 percent of the working-age population, (ii) replaces 72 percent of employer-based health insurance with a private individual health insurance plus a progressive subsidy, and (iii) reforms the private individual health insurance market by improving coverage rates and preventing price discrimination against people with pre-existing conditions. This result implies that with the option to default, households rely on bankruptcies and defaults on ER bills as implicit health insurance. More redistributive healthcare reforms can improve welfare by reducing the dependence on this implicit health insurance and changing households’ medical spending behavior to be more preventative.

It sounds trivial, but it needs to be pointed out. Medical debt is like limited liability if people can default on it. In such cases, there is the temptation to take excessive risk, is this case by neglecting on preventive care. The solution is not to forbid default, but rather to provide actual insurance.