Optimal monetary policy with the risk-taking channel

April 29, 2021

By Angela Abbate and Dominik Thaler


Empirical research suggests that lower interest rates induce banks to take higher risks. We assess analytically what this risk-taking channel implies for optimal monetary policy in a tractable New Keynesian model. We show that this channel creates a motive for the planner to stabilize the real rate. This objective conflicts with the standard inflation stabilization objective. Optimal policy thus tolerates more inflation volatility. An inertial Taylor-type reaction function becomes optimal. We then quantify the significance of the risk-taking channel for monetary policy in an estimated medium-scale extension of the model. Ignoring the channel when designing policy entails non-negligible welfare costs (0.7% lifetime consumption equivalent).

Nobody said monetary policy was easy. Even when the central bank’s mandate has only one or two objectives, and thus one or two tools should be sufficient, it always turns out that there are implicitly more objectives. Or like in this case, tools are not narrowly focused and have other implications. Central banks really need more tools, call them unconventional if you want.

Uncertainty and Monetary Policy during the Great Recession

April 19, 2021

By Giovanni Pellegrino; Efrem Castelnuovo; Giovanni Caggiano


We employ a nonlinear VAR framework and a state-of-the-art identification strategy to document the large response of real activity to a financial uncertainty shock during and in the aftermath of the great recession. We replicate this evidence with an estimated DSGE framework featuring a concept of uncertainty comparable to that in our VAR. We then use the estimated framework to quantify the output loss due to the large uncertainty shock that materialized in 2008Q3. We find such a shock to be able to explain about 60% of the output loss in the 2008-2014 period. The same estimated model unveils the role successfully played by the Federal Reserve in limiting the output loss that would otherwise have occurred had monetary policy been conducted as in normal times. Finally, we show that the rule estimated during the great recession is able to deliver an economic outcome closer to the flexible price one than the rule describing the Federal Reserve’s conduct in normal times.

This is the first paper I see that convincingly shows the impact of Fed policy during the Great Recession. Interesting!

Capital Tax Reforms With Policy Uncertainty

April 12, 2021

By Arpad Abraham, Pavel Brendler and Eva Carceles


One important feature of capital tax reforms is uncertainty regarding their duration. We use the Bush Tax cuts as the leading example to illustrate how uncertainty about reform duration may affect the economy’s path and erode political support for the reform. We model policy uncertainty by assuming that the reform may be either repealed or made permanent with some probability at a predetermined date. We show that policy uncertainty is a critical ingredient that can explain why the Bush tax cuts had no economically significant effect on investment, as confirmed empirically by Yagan (2015). While the permanent reform leads to positive aggregate welfare gains on impact, policy uncertainty may reverse this result. These observations hold both in a model with a representative firm and heterogeneous firms, but adding firm heterogeneity generates an interesting implication. In contrast to the permanent reform, policy uncertainty increases the TPF since it dampens investment by mature, less productive firms.

This is a point that seems obvious, yet often overlooked. This paper nicely demonstrates it: policy uncertainty matters, especially for policies that influence forward-looking behavior.

Globalization, Trade Imbalances, and Labor Market Adjustment

April 5, 2021

By Rafael Dix-Carneiro, João Paulo Pessoa, Ricardo Reyes-Heroles and Sharon Traiberman


We study the role of global trade imbalances in shaping the adjustment dynamics in response to trade shocks. We build and estimate a general equilibrium, multicountry, multisector model of trade with two key ingredients: 1) consumption-saving decisions in each country commanded by representative households, leading to endogenous trade imbalances, and 2) labor market frictions across and within sectors, leading to unemployment dynamics and sluggish transitions to shocks. We use the estimated model to study the behavior of labor markets in response to globalization shocks, including shocks to technology, trade costs, and intertemporal preferences (savings gluts). We find that modeling trade imbalances changes both qualitatively and quantitatively the short- and long-run implications of globalization shocks for labor reallocation and unemployment dynamics. In a series of empirical applications, we study the labor market effects of shocks accrued to the global economy, their implications for the gains from trade, and we revisit the “China Shock” through the lens of our model. We show that the U.S. enjoys a 2.2 percent gain in response to globalization shocks. These gains would have been 73 percent larger in the absence of the global savings glut, but they would have been 40 percent smaller in a balanced-trade world.

Determining the benefits of trade is more subtle than people have been arguing before, as a rich debate about trade war justifications has shown. This is why it is important to be thoroughly in quantifying the impact of globalization. This is an excellent contribution to this literature.