Demographics and the Decline in Firm Entry: Lessons from a Life-Cycle Model

November 27, 2020

By Oke Röhe and Nikolai Stähler

Since the mid-1970s, firm entry rates in the United States have declined significantly. This also holds for other OECD countries over the past years. At the same time, these economies experienced a gradual process of population aging. Applying a tractable life-cycle model with endogenous firm dynamics, we show that falling US firm entry rates can be explained by demographic transition. Specifically, our model simulations suggest that aging can account for up to one third of the observed decrease in US firm entry rates. In addition to the negative effects of a slowdown in working-age population growth on firm entry, our analysis points out that an increase in longevity may also be an important factor contributing to the decline in business dynamism, weighing on both firm entry and exit rates.

Yet another illustration of how transformative population aging can be. See a few more mentioned on this blog.

Higher education funding, welfare and inequality in equilibrium

November 24, 2020

By Gustavo Mellior

This paper analyses theoretically and quantitatively the effect that different higher education funding policies have on welfare (on aggregate and at the individual level) and wealth inequality. A heterogeneous agent model in continuous time, which has uninsurable income risk and endogenous educational choice is used to evaluate five different higher education financing schemes. Educational investments can be self financed, supported by government guaranteed student loans – that may come with or without income contingent support – or be covered by the public sector. When educational costs are small, differences in outcomes amongst systems are negligible. On the other hand, when these costs rise to realistic levels we see that there can be large gains in welfare and significant drops in inequality by moving to a system with more public sector support. This support can come in the form of tuition subsidies and/or income contingent student loans. However, as the cost of education and the share of debtors in society gets larger, it is preferable to increase public support in the form of tuition subsidies. The reason is that there is a pecuniary externality of debt that gets magnified when student loans become excessive. While I identify large steady state welfare gains from more public sector financing, I show that the transition costs can be large enough to justify the status quo.

A timely paper that brings some rationality into a debate that seems overly political and/or emotional. It shows that some systems are better than others, but that changing the system to a better one may not be worth it. That last point is often overlooked.

Dissecting Trade and Business Cycle Co-movement

November 21, 2020

By Paul Hilhak Ko

International business cycles have become highly synchronized across countries in the past three decades, yet there is a lack of consensus on whether this is due to an increase in the correlation of country-specific shocks or due to increased economic integration. To understand this empirical phenomenon, I develop a multi-country real business cycle model with international trade that captures several potential explanations: shocks to productivity, demand, leisure, investment, sectoral expenditures, and trade- linkages. By matching the data exactly with the endogenous outcomes of the model, shocks fully account for the data such as GDP and trade shares. Calibrating the model to a panel of developed (G7) countries during 1992-2014, I find that trade-linkage shocks, which capture the increased economic integration and volatility of trade flows, are essential in synchronizing international business cycles. In contrast, other correlated country-specific shocks play relatively minor roles. This suggests that trade shocks through economic integration have been the primary driver of the co-movement of international business cycles. Furthermore, I use my model to address the trade co-movement puzzle, which states that international real business cycle models should be predicting a much stronger link between trade and cross-country GDP correlations. Once I account for the trade-linkage shocks, the model predicts a strong link between trade and business cycle co-movement. This finding suggests that incorporating the dynamics of trade shocks is crucial when studying international business cycles.

I started my career with international RBC models, but soon left the field because I saw little left to say and some fundamental flaws in the models that could not be addressed. Well, as for other puzzles in Economics, you just give it a few decades and eventually this become interesting again, and the literature manages to gnaw at the puzzles. This paper shows nicely where this literature is now and what it can contribute again.

The Effect of Wealth on Worker Productivity

November 6, 2020

By Jan Eeckhout; Alireza Sepahsalari

We propose a theory that analyzes how a workers’ asset holdings affect their job productivity. In a labor market with uninsurable risk, workers choose to direct their search to jobs that trade off productivity and wages against unemployment risk. Workers with low asset holdings have a precautionary job search motive, they direct their search to low productivity jobs because those offer a low risk at the cost of low productivity and a low wage. We show that such sorting occurs under a condition closely related to Decreasing Relative Risk Aversion and that the presence of consumption smoothing can reconcile the directed search model with negative duration dependence on wages, a robust empirical regularity that the canonical directed search model cannot rationalize. We calibrate the infinite horizon economy and find that this mechanism is quantitatively important. We evaluate a tax financed unemployment insurance (UI) scheme and how it affects welfare. Aggregate welfare is inverted U-shaped in benefits: the insurance effect UI dominates the incentive effects for low levels of benefits and vice versa for high benefits. Also, when UI increases, total production falls in the economy while worker productivity increases. Finally, we compare a one-off severance payment with per period benefits and find that per period benefits generate superior welfare.

This is an interesting twist in the optimal unemployment insurance literature. Wealth does not only affect job taking decision, but also productivity or effort on the job. In this model this happens by sorting into jobs with different productivities. This conveniently fixes some issues with the theoretical literature, such as the relationship between unemployment duration and wages.