The Macroeconomic Stabilization Of Tariff Shocks: What Is The Optimal Monetary Response?

June 29, 2020

By Paul Bergin and Giancarlo Corsetti

In the wake of Brexit and the Trump tariff war, central banks have had to reconsider the role of monetary policy in managing the economic effects of tariff shocks, which may induce a slowdown while raising inflation. This paper studies the optimal monetary policy responses using a New Keynesian model that includes elements from the trade literature, including global value chains in production, firm dynamics, and comparative advantage between two traded sectors. We find that, in response to a symmetric tariff war, the optimal policy response is generally expansionary: central banks stabilize the output gap at the expense of further aggravating short-run inflation—contrary to the prescription of the standard Taylor rule. In response to a tariff imposed unilaterally by a trading partner, it is optimal to engineer currency depreciation up to offsetting the effects of tariffs on relative prices, without completely redressing the effects of the tariff on the broader set of macroeconomic aggregates.

It is hard to find a good economic justification for a tariff war. Thus, the role of the central bank is in a sense to patch up the mistakes of the government (which calls into question the independence of the central bank). But this is imperfect, and the tariff war still leaves marks. And it makes the core goals of the central bank more difficult to achieve as it is distracted.

Two papers on the demographics of wealth and the real interest rate decline

June 23, 2020

Intergenerational wealth inequality: the role of demographics

By António Antunes and Valerio Ercolani

During the last three decades in the US, the older part of the population has become significantly richer, in contrast with the younger part, which has not. We show that demographics account for a significant part of this intergenerational wealth gap rise. In particular, we develop a general equilibrium model with an OLG structure which is able to mimic the wealth distribution of the household sector in the late 1980s, conditional on its age structure. Inputting the observed rise of life expectancy and the fall in population growth rate into the model generates an increase in wealth inequality across age groups which is between one third and one half of that actually observed. Furthermore, the demographic factors help explain the change of the wealth concentration conditional on the age structure; for example, they account for more than one third of the rise of the share of the elderly within the top 5% wealthiest households. Finally, consistent with a stronger life-cycle motive and an increase of the capital-labor ratio, the model produces an interest rate fall of 1 percentage point.

Demographics and the natural interest rate in the euro area

By Marcin Bielecki, Michał Brzoza-Brzezina and Marcin Kolasa

We investigate the impact of demographics on the natural rate of interest (NRI) in the euro area, with a particular focus on the role played by economic openness, migrations and pension system design. To this end, we construct a life-cycle model and calibrate it to match the life-cycle profiles from HFCS data. We show that population aging contributes significantly to the decline in the NRI, explaining about two-thirds of its secular decline between 1985 and 2030. Openness to international capital flows has not been important in driving the EA real interest rate so far, but will become a significant factor preventing its further decline in the coming decades, when aging in Europe accelerates relative to the rest of the world. Of two possible pension reforms, only an increase in the retirement age can revert the downward trend on the equilibrium interest rate while a fall in the replacement rate would make its fall even deeper. The demographic pressure on the Eurozone NRI can be alleviated by increased immigration, but only to a small extent and with a substantial lag.

The game of various generations blaming each other for their lot can take a backseat. Simple demographics account for a lot of what they are arguing about. And, as argued before on this blog, real interest rates are decreasing, and this has nothing to do with policy.

Savings externalities and wealth inequality

June 20, 2020

By Konstantinos Angelopoulos, Spyridon Lazarakis and James Malley

Incomplete markets models imply heterogeneous household savings behaviour which in turn generates pecuniary externalities via the interest rate. Conditional on differences in the processes determining household earnings for distinct groups in the population, these savings externalities may contribute to inequality. Working with an open economy heterogenous agent model, where the interest rate only partially responds to domestic asset supply, we find that differences in the earnings processes of British households with university and non-university educated heads entail savings externalities that increase wealth inequality between the groups and within the group of the non-university educated households. We further find that while the inefficiency effects of these externalities are quantitatively small, the distributional effects are sizeable.

Models with heterogeneous agents have become the bread and butter of Stochastic Dynamic General Equilibrium analysis. Yet relatively few of them have heterogeneous income processes, even though they look very promising in studying inequalities. This paper demonstrates that this type of heterogeneity is also successful at replicating little studied dimensions of inequality, such as within-group inequality. Use income process heterogeneity more!

Unemployment insurance, Recalls and Experience Rating

June 10, 2020

By Julien Albertini, Xaivier Fairise and Anthony Terriau

In the US, almost half of unemployment spells end through recall. In this paper, we show that the probability of being recalled is much higher among unemployment benefit recipients than nonrecipients. We argue that a large part of the observed difference in recall shares is accounted for by the design of the unemployment insurance financing scheme characterized by an experience rating system. We develop a search and matching model with different unemployment insurance status, endogenous separations, recalls and new hires. We quantify what would have been the labor market under alternative financing scheme. In the absence of the experience rating, the hiring and separations would have been higher in the long run and more volatile. Experience rating system contributes significantly to the difference in recalls between the recipients and the nonrecipients.

The results is driven by the facts that the unemployment insurance tax that the firm pays depends on how much its fired employees draw from the unemployment insurance. Recalling them stops the increase in tax, and that seems to be a sufficient incentive. Will this work in the current crisis as well? I am not that sure, as compared to other recessions, a lot more firms are expected to go bankrupt. And in such cases, there is no way the incentive will work.

A Plucking Model of Business Cycles

May 29, 2020

By Stéphane Dupraz, Emi Nakamura and Jón Steinsson

In standard models, economic activity fluctuates symmetrically around a “natural rate” and stabilization policies can dampen these fluctuations but do not affect the average level of activity. An alternative view–labeled the “plucking model” by Milton Friedman–is that economic fluctuations are drops below the economy’s full potential ceiling. If this view is correct, stabilization policy, by dampening these fluctuations, can raise the average level of activity. We show that the dynamics of the unemployment rate in the US display a striking asymmetry that strongly favors the plucking model: increases in unemployment are followed by decreases of similar amplitude, while the amplitude of the increase is not related to the amplitude of the previous decrease. We develop a microfounded plucking model of the business cycle. The source of asymmetry in our model is downward nominal wage rigidity, which we embed in an explicit search model of the labor market. Our search framework implies that downward nominal wage rigidity is consistent with optimizing behavior and equilibrium. In our plucking model, stabilization policy lowers average unemployment and thereby yields sizable welfare gains.

Interesting take at business cycle asymmetries, and one that makes a much better use of “potential GDP” than other models.

Can Pandemic-Induced Job Uncertainty Stimulate Automation?

May 27, 2020

By Sylvain Leduc and Zheng Liu

The COVID-19 pandemic has raised concerns about the future of work. The pandemic may become recurrent, necessitating repeated adoptions of social distancing measures (voluntary or mandatory), creating substantial uncertainty about worker productivity. But robots are not susceptible to the virus. Thus, pandemic-induced job uncertainty may boost the incentive for automation. However, elevated uncertainty also reduces aggregate demand and reduces the value of new investment in automation. We assess the importance of automation in driving business cycle dynamics following an increase in job uncertainty in a quantitative New Keynesian DSGE framework. We find that, all else being equal, job uncertainty does stimulate automation, and increased automation helps mitigate the negative impact of uncertainty on aggregate demand.

Are the robots going to take over? It all depends how you define a robot, at least in this kind of modelling. Leduc and Liu view them as perfect substitutes for labor without its imperfections, such as catching a virus. However, robots can also catch a virus, be poorly qualified for particular jobs, or be difficult to move to another location. In other words, they face the same kind of frictions that are valid for the human workforce. With this in mind, they are not a miracle solution, and there is substantial uncertainty from investing in them.

Dynamic Beveridge Curve Accounting

May 11, 2020

By Hie Joo Ahn and Leland Crane

We develop a dynamic decomposition of the empirical Beveridge curve, i.e., the level of vacancies conditional on unemployment. Using a standard model, we show that three factors can shift the Beveridge curve: reduced-form matching efficiency, changes in the job separation rate, and out-of-steady-state dynamics. We find that the shift in the Beveridge curve during and after the Great Recession was due to all three factors, and each factor taken separately had a large effect. Comparing the pre-2010 period to the post-2010 period, a fall in matching efficiency and out-of-steady-state dynamics both pushed the curve upward, while the changes in the separations rate pushed the curve downward. The net effect was the observed upward shift in vacancies given unemployment. In previous recessions changes in matching efficiency were relatively unimportant, while dynamics and the separations rate had more impact. Thus, the unusual feature of the Great Recession was the deterioration in matching efficiency, while separations and dynamics have played significant, partially offsetting roles in most downturns. The importance of these latter two margins contrasts with much of the literature, which abstracts from one or both of them. We show that these factors affect the slope of the empirical Beveridge curve, an important quantity in recent welfare analyses estimating the natural rate of unemployment.

This is a pretty clever use of a standard model to decompose the Beveridge Curve, i.e., the dynamics of unemployment and vacancies. I would not have thought that matching efficiency would be have been an issue in the Great Recession, given that the underlying issue was financial.

Dollar invoicing, global value chains, and the business cycle dynamics of international trade

May 6, 2020

By David Cook and Nikhil Patel

Recent literature has highlighted that international trade is mostly priced in a few key vehicle currencies, and is increasingly dominated by intermediate goods and global value chains (GVCs). Taking these features into account, this paper reexamines the business cycle dynamics of international trade and its relationship with monetary policy and exchange rates. Using a three country dynamic stochastic general equilibrium (DSGE) framework, it finds key differences between the response of final goods and GVC trade to both internal and external shocks. In particular, the model shows that in response to a dollar appreciation triggered by a US interest rate increase, direct bilateral trade between non-US countries contracts more than global value chain oriented trade which feeds US final demand. We use granular data on GVC at the sector level to document empirical evidence in favor of this prediction.

Few people may appreciate that, but this papers brings back memories from my dissertation and shortly thereafter. Back then, I was working on international real business cycles and wrote separate papers on asymmetries (with a three-country model), exchange rate fluctuations, and the importance of intermediate goods. How things have evolved since, now papers integrate all three without difficulty! Nice!

Health versus Wealth: On the Distributional Effects of Controlling a Pandemic

April 27, 2020

By Andrew Glover, Jonathan Heathcote, Dirk Krueger and José-Víctor Ríos-Rull

To slow the spread of COVID-19, many countries are shutting down non-essential sectors of the economy. Older individuals have the most to gain from slowing virus diffusion. Younger workers in sectors that are shuttered have the most to lose. In this paper, we build a model in which economic activity and disease progression are jointly determined. Individuals differ by age (young and retired), by sector (basic and luxury), and by health status. Disease transmission occurs in the workplace, in consumption activities, at home, and in hospitals. We study the optimal economic mitigation policy of a utilitarian government that can redistribute across individuals, but where such redistribution is costly. We show that optimal redistribution and mitigation policies interact, and reflect a compromise between the strongly diverging preferred policy paths of different subgroups of the population. We find that the shutdown in place on April 12 is too extensive, but that a partial shutdown should remain in place through July.

Among the hundreds of papers already written on COvid-19, a few stand out, and this is one of the select few. Proper confinement design is an important question, especially as it has very strong distributional consequences. Here, the best tools of trade are applied to understand the consequences of the current confinement policies. Of course, the paper was produced in record time and you could argue about some choices, but this draft shows clearly that a more nuanced approach is warranted. History will tells us whether this is right.

The Murder-Suicide of the Rentier: Population Aging and the Risk Premium

April 20, 2020

By Joseph Kopecky and Alan Taylor

Population aging has been linked to global declines in interest rates. A similar trend shows that equity risk premia are on the rise. An existing literature can explain part of the decline in the trend in safe rates using demographics, but has no mechanism to speak to trends in relative asset prices. We calibrate a heterogeneous agent life-cycle model with equity markets, showing that this demographic channel can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing premium attached to risky assets. This is because the life cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated.

To continue on the theme mentioned here two weeks ago, population aging is crucial for some many economic outcomes. This paper adds to it. However, I am starting to wonder whether the current pandemic is going to make those changes less drastic as it will lead to less pronounced aging of the population.