The Macroeconomic Stabilization Of Tariff Shocks: What Is The Optimal Monetary Response?

June 29, 2020

By Paul Bergin and Giancarlo Corsetti

In the wake of Brexit and the Trump tariff war, central banks have had to reconsider the role of monetary policy in managing the economic effects of tariff shocks, which may induce a slowdown while raising inflation. This paper studies the optimal monetary policy responses using a New Keynesian model that includes elements from the trade literature, including global value chains in production, firm dynamics, and comparative advantage between two traded sectors. We find that, in response to a symmetric tariff war, the optimal policy response is generally expansionary: central banks stabilize the output gap at the expense of further aggravating short-run inflation—contrary to the prescription of the standard Taylor rule. In response to a tariff imposed unilaterally by a trading partner, it is optimal to engineer currency depreciation up to offsetting the effects of tariffs on relative prices, without completely redressing the effects of the tariff on the broader set of macroeconomic aggregates.

It is hard to find a good economic justification for a tariff war. Thus, the role of the central bank is in a sense to patch up the mistakes of the government (which calls into question the independence of the central bank). But this is imperfect, and the tariff war still leaves marks. And it makes the core goals of the central bank more difficult to achieve as it is distracted.

Two papers on the demographics of wealth and the real interest rate decline

June 23, 2020

Intergenerational wealth inequality: the role of demographics

By António Antunes and Valerio Ercolani

During the last three decades in the US, the older part of the population has become significantly richer, in contrast with the younger part, which has not. We show that demographics account for a significant part of this intergenerational wealth gap rise. In particular, we develop a general equilibrium model with an OLG structure which is able to mimic the wealth distribution of the household sector in the late 1980s, conditional on its age structure. Inputting the observed rise of life expectancy and the fall in population growth rate into the model generates an increase in wealth inequality across age groups which is between one third and one half of that actually observed. Furthermore, the demographic factors help explain the change of the wealth concentration conditional on the age structure; for example, they account for more than one third of the rise of the share of the elderly within the top 5% wealthiest households. Finally, consistent with a stronger life-cycle motive and an increase of the capital-labor ratio, the model produces an interest rate fall of 1 percentage point.

Demographics and the natural interest rate in the euro area

By Marcin Bielecki, Michał Brzoza-Brzezina and Marcin Kolasa

We investigate the impact of demographics on the natural rate of interest (NRI) in the euro area, with a particular focus on the role played by economic openness, migrations and pension system design. To this end, we construct a life-cycle model and calibrate it to match the life-cycle profiles from HFCS data. We show that population aging contributes significantly to the decline in the NRI, explaining about two-thirds of its secular decline between 1985 and 2030. Openness to international capital flows has not been important in driving the EA real interest rate so far, but will become a significant factor preventing its further decline in the coming decades, when aging in Europe accelerates relative to the rest of the world. Of two possible pension reforms, only an increase in the retirement age can revert the downward trend on the equilibrium interest rate while a fall in the replacement rate would make its fall even deeper. The demographic pressure on the Eurozone NRI can be alleviated by increased immigration, but only to a small extent and with a substantial lag.

The game of various generations blaming each other for their lot can take a backseat. Simple demographics account for a lot of what they are arguing about. And, as argued before on this blog, real interest rates are decreasing, and this has nothing to do with policy.

Savings externalities and wealth inequality

June 20, 2020

By Konstantinos Angelopoulos, Spyridon Lazarakis and James Malley

Incomplete markets models imply heterogeneous household savings behaviour which in turn generates pecuniary externalities via the interest rate. Conditional on differences in the processes determining household earnings for distinct groups in the population, these savings externalities may contribute to inequality. Working with an open economy heterogenous agent model, where the interest rate only partially responds to domestic asset supply, we find that differences in the earnings processes of British households with university and non-university educated heads entail savings externalities that increase wealth inequality between the groups and within the group of the non-university educated households. We further find that while the inefficiency effects of these externalities are quantitatively small, the distributional effects are sizeable.

Models with heterogeneous agents have become the bread and butter of Stochastic Dynamic General Equilibrium analysis. Yet relatively few of them have heterogeneous income processes, even though they look very promising in studying inequalities. This paper demonstrates that this type of heterogeneity is also successful at replicating little studied dimensions of inequality, such as within-group inequality. Use income process heterogeneity more!

Unemployment insurance, Recalls and Experience Rating

June 10, 2020

By Julien Albertini, Xaivier Fairise and Anthony Terriau

In the US, almost half of unemployment spells end through recall. In this paper, we show that the probability of being recalled is much higher among unemployment benefit recipients than nonrecipients. We argue that a large part of the observed difference in recall shares is accounted for by the design of the unemployment insurance financing scheme characterized by an experience rating system. We develop a search and matching model with different unemployment insurance status, endogenous separations, recalls and new hires. We quantify what would have been the labor market under alternative financing scheme. In the absence of the experience rating, the hiring and separations would have been higher in the long run and more volatile. Experience rating system contributes significantly to the difference in recalls between the recipients and the nonrecipients.

The results is driven by the facts that the unemployment insurance tax that the firm pays depends on how much its fired employees draw from the unemployment insurance. Recalling them stops the increase in tax, and that seems to be a sufficient incentive. Will this work in the current crisis as well? I am not that sure, as compared to other recessions, a lot more firms are expected to go bankrupt. And in such cases, there is no way the incentive will work.