Doubts about the Model and Optimal Policy

August 31, 2020

By Anastasios Karantounias

This paper analyzes optimal policy in setups where both the leader and the follower have doubts about the probability model of uncertainty. I illustrate the methodology in two environments: a) an industry populated with a large firm and many small firms in a competitive fringe, where both types of firms doubt the probability model of demand shocks, and b) a general equilibrium economy, where a policymaker taxes linearly the labor income of a representative household in order to finance an exogenous stream of stochastic spending shocks. The policymaker can distrust the probability model of spending shocks more, the same, or less than the household. Whenever there are doubts about the model, cautious agents form endogenous worst-case beliefs by assigning high probability on low profitability or low-utility events. There are two forces that shape optimal policy results: the manipulation of the endogenous beliefs of the follower to the benefit of the leader, and the discrepancy (if any) in the pessimistic beliefs between the leader and the follower. Depending on the application, the leader may amplify or mitigate the worst-case beliefs of the follower.

What happens when both the policymaker and the policy “follower” are not sure of what is going on? What if either is trying to manipulate the other? As you can expect this become really complex really quickly, but it is also really important.

Climate Finance Intermediation: Interest Spread Effects in a Climate Policy Model

August 27, 2020

By Kai Lessmann and Matthias Kalkuhl

Interest rates are central determinants of saving and investment decisions. Costly financial intermediation distort these price signals by creating a spread between the interest rates on deposits and loans with substantial effects on the supply of funds and the demand for credit. This study investigates how interest rate spreads affect climate policy in its ambition to shift capital from polluting to low-carbon sectors of the economy. To this end, we introduce financial intermediation costs in a dynamic general equilibrium climate policy model. We find that costly financial intermediation affects carbon emissions in various ways through a number of different channels. For low to moderate interest rate spreads, carbon emissions increase by up to 7 percent, in particular, because of lower investments into the capital intensive clean energy sector. For very high interest rate spreads, emissions fall because lower economic growth reduces carbon emissions. If a certain temperature target should be met, carbon prices have to be adjusted upwards by up to one third under the presence of capital market frictions.

The financial sector is here to grease the wheels of the savings-to-investment engine. But there is still friction, and the consequences can be dramatic as illustrated in this paper. Now imagine if there were no financial sector: a model without a financial sector would find a “perfect” outcome, and the real world would show very inefficient investment. Glad this paper is bridging that.

Macroeconomic effects of tariffs shocks: the role of the effective lower bound and the labour market

August 20, 2020

By Pascal Jacquinot, Matija Lozej and Massimiliano Pisani

We simulate a version of the EAGLE, a New Keynesian multi-country model of the world economy, to assess the macroeconomic effects of US tariffs imposed on one country member of the euro area (EA), and the rest of the world (RW). The model is augmented with an endogenous effective lower bound (ELB) on the monetary policy rate of the EA and country-specific labour markets with search-and-matching frictions. Our main results are as follows. First, tariffs produce recessionary effects in each country. Second, if the ELB holds, then the tariff has recessionary effects on the whole EA, even if it is imposed on one EA country and the RW. Third, if the ELB holds and the real wage is flexible in the EA country subject to the tariff, or if there are segmented labour markets with directed search within each country, then the recessionary effects on the whole EA are amplified in the short run. Fourth, if the elasticity of substitution among tradables is low, then the tariff has recessionary effects on the whole EA also when the ELB does not hold.

The abstract does not do justice to the paper. This is a four-country model: US, a Euro country (Germany), the rest of the Euro zone, and the rest of the world. The US imposes a new import tariff on the Euro country and the rest of the world (but not the rest of the Euro zone), and the Euro-zone policy response is constrained by a lower bound on the policy rate. The tariff lowers GDP everywhere and increases unemployment everywhere, with the Euro country most affected, of course. The policy constraint matters. Without it, the rest of the Euro-zone would actually gain.

Dynamic General Equilibrium modelling of tiny countries

August 11, 2020

Fiscal Policy Multipliers in Small States

By Ali Alichi, Ippei Shibata and Kadir Tanyeri

Government debt in many small states has risen beyond sustainable levels and some governments are considering fiscal consolidation. This paper estimates fiscal policy multipliers for small states using two distinct models: an empirical forecast error model with data from 23 small states across the world; and a Dynamic Stochastic General Equilibrium (DSGE) model calibrated to a hypothetical small state’s economy. The results suggest that fiscal policy using government current primary spending is ineffective, but using government investment is very potent in small states in affecting the level of their GDP over the medium term. These results are robust to different model specifications and characteristics of small states. Inability to affect GDP using current primary spending could be frustrating for policymakers when an expansionary policy is needed, but encouraging at the current juncture when many governments are considering fiscal consolidation. For the short term, however, multipliers for government current primary spending are larger and affected by imports as share of GDP, level of government debt, and position of the economy in the business cycle, among other factors.

Policy Trade-Offs in Building Resilience to Natural Disasters: The Case of St. Lucia

By Alessandro Cantelmo, Leo Bonato, Giovanni Melina and Gonzalo Salinas

Resilience to climate change and natural disasters hinges on two fundamental elements: financial protection —insurance and self-insurance— and structural protection —investment in adaptation. Using a dynamic general equilibrium model calibrated to the St. Lucia’s economy, this paper shows that both strategies considerably reduce the output loss from natural disasters and studies the conditions under which each of the two strategies provides the best protection. While structural protection normally delivers a larger payoff because of its direct dampening effect on the cost of disasters, financial protection is superior when liquidity constraints limit the ability of the government to rebuild public capital promptly. The estimated trade-off is very sensitive to the efficiency of public investment.

I have always been fascinated with tiny countries (think: Caribbean states) and how they can operate. This week’s crop of the NEP-DGE report has by coincidence two papers about such countries. The first looks at an “average” tiny country and how fiscal multipliers work in various circumstances, while the second one studies specifically St. Lucia (population 182K). The advantage of DSGE modelling is that it can work in a data-poor environment. No need for long time series, and guesses can make do if data is missing entirely. In fact, long-term averages are often sufficient.