“Mom, Dad: I’m staying”. Initial labor market conditions, housing markets, and welfare

February 22, 2021

By Rodrigo Martínez-Mazza


Young individuals are currently living with their parents more than at any other point in time, while also spending more on housing. In this paper, I first show how labor market entry conditions affect housing tenure and affordability in the long term, by using the unemployment rate at the time of graduation as an exogenous shock to income. I perform this analysis across Europe for the last 25 years. Results indicate that a 1 pp increase in the unemployment rate at the time of graduation leads, one year after, to (1) a 1.50 pp increase in the probability of living with parents, (2) a 1.02 pp decrease in the probability of home-ownership and 0.45 pp decrease in renting, and (3) worse affordability. Second, I develop an OLG model to link income shocks for young agents with changes in housing tenure at the aggregate level. I allow for an outside option for landlords which can introduce rigidity into the rental market. Results show that if rental markets are rigid, an income shock to young agents will translate into a larger share of them living with their parents, worse affordability, and larger welfare losses. Finally, I perform a policy exercise based on the French housing aid system. I show that housing aid policies can help to recover welfare losses for young agents, by enabling them to afford to rent. Recognizing the right scenario for the implementation of these policies is key to ensure welfare gains concentrate on the targeted population.

I have so many questions about this paper, mainly about its generalization. Locational preferences are very strong in Europe, thus people tend to stay within the same town. Living with parents is then a possibility. This also constrains the potential jobs. Policies that address these frictions seem to have more potential, but also be more difficult to implement. That said, it looks like the current pandemic could also serve as a reset, as many have interpreted “work form home” as “work from parent’s home.” The post-pandemic equilibrium will not look like the one before because of this lock-in mechanism.


A Buffer-Stock Model for the Government: Balancing Stability and Sustainability

February 15, 2021

By Jean-Marc Fournier


A fiscal reaction function to debt and the cycle is built on a buffer-stock model for the government. This model inspired by the buffer-stock model of the consumer (Deaton 1991; Carroll 1997) includes a debt limit instead of the Intertemporal Budget Constraint (IBC). The IBC is weak (Bohn, 2007), a debt limit is more realistic as it reflects the risk of losing market access. This risk increases the welfare cost of fiscal stimulus at high debt. As a result, the higher the debt, the less governments should smooth the cycle. A larger reaction of interest rates to debt and higher hysteresis magnify this interaction between the debt level and the appropriate reaction to shocks. With very persistent shocks, the appropriate reaction to negative shocks in highly indebted countries can even be procyclical.

Economists keep explaining that the government budget is not like the budget of a firm or a household. Here is a paper that tries to model a government like a household that follows a classic buffer-stock rule. This difference is that here the government loses access to market at a particular debt limit, and the distance to this limit is the buffer stock. Assuming this limit is known and invariant, this changes quite a bit the ability of the government to conduct fiscal policy.

Two papers on monetary theory where the Friedman Rule is not optimal

February 12, 2021

Nominal Contracts and the Payment System

By Hakime Tomura


This paper introduces into an overlapping generations model the courts inability to distinguish different qualities of goods of the same kind. Given the recognizability of fiat money for the court, this friction leads to the use of nominal debt contracts as well as the use of fiat money as a means of payment in the goods market. This result holds without dynamic inefficiency or lack of double coincidence of wants. Instead, money is necessary because it is essential for credit. However, there can occur a shortage of real money balances for liability settlements, even if the money supply follows a Friedman rule. This problem can be resolved if the central bank can lend fiat money to agents elastically at a zero intraday interest rate within each period. Given the economy being dynamically efficient, this policy makes the money supply cease to be the nominal anchor for the price level. In this case, the monetary steady state becomes compatible with other nominal anchors than the money supply.

Liquidity Premium, Credit Costs, and Optimal Monetary Policy

By Sukjoon Lee


I study how monetary policy affects firms’ external financing decisions. More precisely, I study the transmission mechanism of monetary policy to credit costs in a general equilibrium macroeconomic model where firms issue corporate bonds or obtain bank loans, and corporate bonds are not just stores of value but also serve a liquidity role. The model shows that an increase in the nominal policy rate can lower the borrowing cost in the corporate bond market, while increasing that in the bank loan market, and I provide empirical evidence that supports this result. The model also predicts that a higher nominal policy rate induces firms to substitute corporate bonds for bank loans, which is supported by the existing empirical evidence. In the model, the Friedman rule is suboptimal so that keeping the cost of holding liquidity at a positive level is socially optimal. The optimal policy rate is an increasing function of the degree of corporate bond liquidity.

By chance, two interesting papers about monetary policy and the Friedman Rule in this week’s NEP-DGE report. Monetary theory is quite dizzying as small details can lead to dramatically different results. The details can be about what money actually is, how it is used, how credit is collateralized, etc. This is fascinating, but also difficult to keep up. Policy advice is so difficult, yet important.

The Welfare and Distributional Effects of Fiscal Volatility: A Quantitative Evaluation

February 2, 2021

By Rüdiger Bachmann, Jinhui Bai, Minjoon Lee and Fudong Zhang


This study explores the welfare and distributional effects of fiscal volatility using a neoclassical stochastic growth model with incomplete markets. In our model, households face uninsurable idiosyncratic risks in their labor income and discount factor processes, and we allow aggregate uncertainty to arise from both productivity and government purchases shocks. We calibrate our model to key features of the U.S. economy, before eliminating government purchases shocks. We then evaluate the distributional consequences of the elimination of fiscal volatility and find that, in our baseline case, welfare gains increase with private wealth holdings.

Fiscal policy has no role, how is this possible? Well, this is a standard result of the canonical real-business-cycle model, so it should not be a surprise. The difference here is that as markets are incomplete, government purchases could provide aggregate insurance that the economy needs. The government provides additional insurance through unemployment insurance and tax progressivity, but in this model, the sole source of fiscal policy volatility are the shocks to G. While G provides utility, its fluctuations are just contributing to general volatility, thus is should not be a surprise that shutting down its volatility is welfare improving. So, what is the point of the paper? One, the welfare cost is small. Two, the welfare cost is largest for the rich, an interesting departure of usual business cycle costs. This is because the after-tax return of capital fluctuations affect most the rich.