The macroprudential toolkit: effectiveness and interactions

January 26, 2021

By Stephen Millard, Margarita Rubio and Alexandra Varadi

We use a DSGE model with financial frictions, leverage limits on banks, loan to value (LTV) limits and debt‑service ratio (DSR) limits on mortgage borrowing to examine: i) the effects of different macroprudential policies on key macro aggregates; ii) their interaction with each other and with monetary policy; and iii) their effects on the volatility of key macroeconomic variables and on welfare. We find that capital requirements can nullify the effects of financial frictions and reduce the effects of shocks emanating from the financial sector on the real economy. LTV limits, on their own, are not sufficient to constrain household indebtedness in booms, though can be used with capital requirements to keep DSRs under control. Finally, DSR limits lead to a significant decrease in the volatility of lending, consumption and inflation, since they disconnect the housing market from the real economy. Overall, DSR limits are welfare improving relative to any other macroprudential tool.

This paper shows nicely that central banks have other useful tools in their hand to manage business cycles. This is only a first step though. One still needs to show that a policy maker can work with them efficiently and practically, for example that they can be changed in time for good effect. Also, when the economy is in something like a corner solution like now, do these tools still work (or work even better)?


Labor Market Informality and the Business Cycle

January 19, 2021

By Frédéric Lambert, Andrea Pescatori and Frederik Toscani

Labor market informality is a pervasive feature of most developing economies. Motivated by the empirical regularity that the labor informality rate falls with GDP per capita, both at business cycle frequency and in a cross-section of countries, and that the Okun’s coefficient falls with the level of labor informality, we build a small open-economy dynamic stochastic general equilibrium model with two sectors, formal and informal, which can replicate these key stylized facts. The model is calibrated to Colombia. The results show that labor market and tax reforms play an important role in changing the informality rate but also caution against over-optimism – with low GDP per capita, informality will always be relatively high as there is insufficient demand for formal goods. Quantitatively we find that higher productivity in the formal sector is key in explaining the difference between Colombia and countries with significantly lower informality. We use the model to study how labor informality and labor market frictions mediate the cyclical response of the economy to shocks, including commodity price shocks which are particularly relevant in Latin America. Informality is shown to play an important role as a shock absorber with the informal-formal margin limiting movements in the employed-unemployed margin.

Studying informal economies is tricky business because there is poor data, pretty much by definition. But Dynamic General Equilibrium models come in handy here, as they can work with limited data (no time series required) or even absent data (best guesses can fill in). Finally they allow to work through scenarios that have not (yet) been observed thanks to internal consistency. This paper is a nice example of this. It shows that informality is not only an issue of a weak state but also of low income. Also, informality has some benefits.

Rare disasters, the natural interest rate and monetary policy

January 13, 2021

By Alessandro Cantelmo

This paper evaluates the impact of rare disasters on the natural interest rate and macroeconomic conditions by simulating a nonlinear New-Keynesian model. The model is calibrated using data on natural disasters in OECD countries. From an ex-ante perspective, disaster risk behaves as a negative demand shock and lowers the natural rate and inflation, even if disasters hit only the supply side of the economy. These effects become larger and nonlinear if extreme natural disasters become more frequent, a scenario compatible with climate change projections. From an ex-post perspective, a disaster realization leads to temporarily higher natural rate and inflation if supply-side effects prevail. If agents’ risk aversion increases temporarily, disasters may generate larger demand effects and lead to a lower natural rate and inflation. If supply-side effects dominate, the central bank could mitigate output losses at the cost of temporarily higher inflation in the short run. Conversely, under strict inflation targeting, inflation is stabilized at the cost of larger output losses.

I mentioned several times on this blog that demographic aging is a source of declining interest rates. Now add climate change to the mix. As it looks like declining fertility may also come from climate change, the two shocks may reinforce each other in reducing interest rates. After a decade or two with interest rates kept low by policy, they may not be increasing that much once we get back to “normal” times.

How Important Is Health Inequality for Lifetime Earnings Inequality?

January 7, 2021

By Roozbeh Hosseini, Karen A. Kopecky and Kai Zhao

Using a dynamic panel approach, we provide empirical evidence that negative health shocks reduce earnings. The effect is primarily driven by the participation margin and is concentrated in less educated and poor health individuals. We build a dynamic, general equilibrium, lifecycle model that is consistent with these findings. In the model, individuals, whose health is risky and heterogeneous, choose to either work, or not work and apply for social security disability insurance (SSDI). Health impacts individuals’ productivity, SSDI access, disutility from work, mortality, and medical expenses. Calibrating the model to the United States, we find that health inequality is an important source of lifetime earnings inequality: nearly 29 percent of the variation in lifetime earnings at age 65 is due to the fact that Americans face risky and heterogeneous life-cycle health profiles. A decomposition exercise reveals that the primary reason why individuals in the United States in poor health have low lifetime earnings is because they have a high probability of obtaining SSDI benefits. In other words, the SSDI program is an important contributor to lifetime earnings inequality. Despite this, we show that it is ex ante welfare improving and, if anything, should be expanded.

Interesting paper with a potentially puzzling conclusion. SSDI increases inequality because its existence allows people to stop working when disabled, thus they have lower income (though one could ask if their income could have decreased further without SSDI). But SSDI is good because it provide insurances against having to work while disabled, i.e., a non-monetary component to welfare. Income is not everything.