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 We model policy uncertainty by assuming that the reform may be either repealed or made permanent with some probability at a predetermined date.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.

Time Preferences over the Life Cycle and Household Saving Puzzles

March 29, 2021

By Wataru Kureishi; Hannah Paule-Paludkiewicz; Hitoshi Tsujiyama; Midori Wakabayashi


Most economic models assume that time preferences are stable over time, but the evidence on their long-term stability is lacking. We study whether and how time preferences change over the life cycle, exploiting representative long-term panel data. We provide new evidence that discount rates decrease with age and the decline is remarkably linear over the life cycle. Decreasing discounting helps a canonical life-cycle model to explain the household saving puzzles of undersaving when young and oversaving after retirement. Relative to the model with constant discounting, the model’s fit to consumption and asset data profiles improves by 40% and 30%, respectively.

If one thinks that discounting has to do with survival probabilities, one is sorely mistaken, apparently. Note that a discount rate that declines over a life time is consistent with aging economies having lower interest rates. The implications from the paper are interesting.

Risk shocks and divergence between the Euro area and the US in the aftermath of the Great Recession

March 22, 2021

By Thomas Brand and Fabien Tripier


Highly synchronized during the Great Recession of 2008-2009, the Euro area and the US have diverged in the period that followed. To explain this divergence, we provide a structural interpretation of these episodes through the estimation for both economies of a business cycle model with financial frictions and risk shocks, measured as the volatility of idiosyncratic uncertainty in the financial sector. Our results show that risk shocks have stimulated US growth in the aftermath of the Great Recession and have been the main driver of the double-dip recession in the Euro area. They play a positive role in the Euro area only after 2015. Risk shocks therefore seem well suited to account for the consequences of the sovereign debt crisis in Europe and the subsequent positive effects of unconventional monetary policies, notably the ECB’s Asset Purchase Programme (APP).

This shows how the Great Recession was different form previous recessions: risk was the major factor, and it mattered foremost in the subsequent recovery (or lack thereof). If every new recession now requires a new type of shock, we will be in constant need of rethinking the economic models (soon after, a pandemic hits…).

Imperfect Banking Competition and Macroeconomic Volatility: A DSGE Framework

March 15, 2021

By Jiaqi Li


This paper studies the impact of imperfect banking competition on aggregate fluctuations using a DSGE framework that features a Cournot banking sector. The paper highlights a new propagation mechanism of imperfect banking competition that operates via the dynamics of the expected marginal product of capital. Since capital is partly financed by bank loans, a higher expected return on capital implies that firms are more willing to borrow to invest in capital, making their capital and thus loan demand more inelastic. Market power enables banks to take advantage of the lower loan demand elasticity by charging a higher loan rate markup. Given that different shocks affect the dynamics of the expected return on capital differently, this paper finds that while the loan rate markup after a contractionary monetary policy shock increases and thus amplifies aggregate fluctuations, the impact of imperfect banking competition after a productivity shock is less clear and depends on the persistence of the shock.

Banking regulators worry about mergers and acquisitions of banks a lot, because of the “too big to fail” problem and local competition issues. This paper takes a macro view to competition issues and shows that lack of competition is something to worry about. The next question is: how can you measure whether there is enough competition? For example, are the six large banks dominating the Canadian market sufficiently competitive?

Sovereign default and imperfect tax enforcement

March 8, 2021

By Francesco Pappadà and Yanos Zylberberg


The effect of fiscal policy on default risk is mitigated by the response of tax compliance. To explore the consequences of this stylized fact, we build a model of sovereign debt with limited commitment and imperfect tax enforcement. Fiscal policy persistently affects the size of the informal economy, which impacts future fiscal revenues and default risk. The interaction of imperfect tax enforcement and limited commitment strongly constrains the dynamics of optimal fiscal policy and leads to costly uctuations in consumption.

This sounds obvious, but needs reinforcing. If a state has weak enforcement of taxation, it is more at risk of default because the tax base shrinks right when it is most needed. Fund tax agencies well, it is worth it!

Universal Basic Income in Developing Countries: Pitfalls and Alternatives

March 1, 2021

By Pedro Cavalcanti Ferreira, Marcel Cortes, Peruffo and André Cordeiro Valério


This article studies the short -and long-term effects of Universal Basic Income programs – a uniform transfer to every individual in society – in the context of a developing economy and compares this policy with other schemes that condition the transfer on household characteristics such as income and education. We construct a dynastic heterogeneous-agent model, featuring uninsurable idiosyncratic risk, investment in physical and human capital, and choice of labor effort. We calibrate the model to Brazilian data and introduce a UBI transfer equivalent to roughly 4.5% of average household income. We find that, over the short run, this policy alleviates poverty and increases welfare, especially for the poor. Over time, however, income falls and poverty and inequality increase as fewer people stay in school, labor supply decreases, and savings fall. We then explore the consequences of an equivalent transfer that is both subject to means testing and requires recipients to enroll their children in school. This policy outperforms the UBI in several dimensions, increasing overall income, reducing poverty and inequality, and improving welfare. This result is robust to varying the magnitude of the cash transfer. We then investigate which aspects of the CCT make it so effective, and find that the schooling conditionality is crucial in ensuring its long- and even short- run success.

It is very rare to find a well-thought-out and quantitative evaluation of universal basic income, and I can speak from experience. This one is really well done and looks at good alternatives. An important contribution to the UBI discussion.

“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.