The Macroeconomic Effects of a Carbon Tax to Meet the U.S. Paris Agreement Target: The Role of Firm Creation and Technology Adoption

May 31, 2021

By Alan Finkelstein Shapiro and Gilbert Metcalf

We analyze the quantitative labor market and aggregate effects of a carbon tax in a framework with pollution externalities and equilibrium unemployment. Our model incorporates endogenous labor force participation and two margins of adjustment influenced by carbon taxes: firm creation and green production-technology adoption. A carbon-tax policy that reduces carbon emissions by 35 percent – roughly the emissions reductions that will be required under the Biden Administration’s new commitment under the Paris Agreement – and transfers the tax revenue to households generates mild positive long-run effects on consumption and output; a marginal increase in the unemployment and labor force participation rates; and an expansion in the number and fraction of firms that use green technologies. In the short term, the adjustment to higher carbon taxes is accompanied by gradual gains in output and consumption and a negligible expansion in unemployment. Critically, abstracting from endogenous firm entry and green-technology adoption implies that the same policy has substantial adverse short- and long-term effects on labor income, consumption, and output. Our findings highlight the importance of these margins for a comprehensive assessment of the labor market and aggregate effects of carbon taxes.

Interesting to see that a carbon tax does not entail any output loss, even in the short term. Why is it then such a hard sell?

Trade Credit and Sectoral Comovement during the Great Recession

May 26, 2021

By Jorge Miranda-Pinto and Gang Zhang

We show that, unlike any other recession after World War II, sectoral output comovement significantly increased during the Great Recession. On the other hand, trade credit supply, as measured by the ratio of account receivables to the total value of outputs, collapsed during the Great Recession. We show that sectoral comovement was larger for sectors connected through trade credit. We then develop a multisector model with occasionally binding credit constraints and endogenous supply of trade credit to explain these facts. The model shows that equilibrium trade credit reflects both the intermediate supplier’s and client’s bank lending conditions, and thus has asymmetric effects on sectoral outputs. When banking shocks are idiosyncratic, trade credit serves as a mitigation mechanism as firms are able to substitute bank loans for trade credit. However, when banking shocks are strongly correlated, trade credit amplifies the negative financial shock and generates the sharp increase in sectoral comovement observed during the Great Recession. We show that production network models with reduced form wedges are unable to generate this pattern, and that a model with endogenous trade credit amplifies the Great Recession in 18%.

The Great Recession was characterized by a large shock common to all sectors. I suspect we will see the same with the pandemic recession. The same mechanism seems at play: a shocks initially impacts several sectors, and it then filters to others sector, through credit in one recession and through supply chain disruptions in the other.

Doves for the Rich, Hawks for the Poor? Distributional Consequences of Systematic Monetary Policy

May 18, 2021

By Nils Gornemann, Keith Kuester and Makoto Nakajima

We build a New Keynesian business-cycle model with rich household heterogeneity. In the model, systematic monetary stabilization policy affects the distribution of income, income risks, and the demand for funds and supply of assets: the demand, because matching frictions render idiosyncratic labor-market risk endogenous; the supply, because markups, adjustment costs, and the tax system mean that the average profitability of firms is endogenous. Disagreement about systematic monetary stabilization policy is pronounced. The wealth rich or retired tend to favor inflation targeting. The wealth-poor working class, instead, favors unemployment-centric policy. One- and two-agent alternatives can show unanimous disapproval of inflation-centric policy, instead. We highlight how the political support for inflation-centric policy depends on wage setting, the tax system, and the portfolio that households have.

All the way back in 2012, I reported about a first paper by the same three authors tackling the issue of the heterogeneous impact of monetary policy. It is nice to see all the progress made since on this topic and how it relates to current events.

Should we Revive PAYG? On the Optimal Pension System in View of Current Economic Trends

May 16, 2021

By Ed Westerhout, Lex Mijdam, Eduard Ponds and Jan Bonenkamp

In many countries, both pay-as-you-go (PAYG) and funding are used to finance pensions, although the balance between the two principles differs a lot between countries. Over the last decades, many countries made a gradual transition to more funding. In this paper, we develop an analytical framework that includes three models of pension design, allowing us to study the role of efficiency aspects, redistributional aspects and political-economy aspects. We subsequently analyze the impact of several trends (a permanent decline in the rate of return on financial markets, a decline in the average rate of economic growth, decreased output volatility and increased capital market volatility) on the optimal balance between PAYG and funding. We argue that it may be optimal to revise the gradual transition to more funding and to revive PAYG.

This paper is a really nice overview of the literature on pension system along with an interesting analysis that shows that optimal policy design changes as fundamentals change.

Collateral Framework: Liquidity Premia and Multiple Equilibria

May 3, 2021

By Yvan Lenwiler and Athanasios Orphanides

Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank’s collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This can potentially induce sovereign debt crises and defaults that would not otherwise arise.

A strong case here for European Union bonds and thus for the ECB stopping to deal with national bonds. Or a good example of politics and economics getting into each others’ way.