Monetary Policy over the Lifecycle

September 23, 2021

By Anton Braun and Daisuke Ikeda

A tighter monetary policy is generally associated with higher real interest rates on deposits and loans, weaker performance of equities and real estate, and slower growth in employment and wages. How does a household’s exposure to monetary policy vary with its age? The size and composition of both household income and asset portfolios exhibit large variation over the lifecycle in Japanese data. We formulate an overlapping generations model that reproduces these observations and use it to analyze how household responses to monetary policy shocks vary over the lifecycle. Both the signs and the magnitudes of the responses of a household’s net worth, disposable income and consumption depend on its age.

I wonder whether these results carry over for an aging economy, especially as there may be general equilibrium effects that may amplify or reduce the implications.

The Neoclassical Model and the Welfare Costs of Selection

September 16, 2021

By Fabrice Collard and Omar Licandro

This paper embeds firm dynamics into the Neoclassical model and provides a simple framework to solve for the transitional dynamics of economies moving towards more selection. As in the Neoclassical model, markets are perfectly competitive, there is only one good and two production factors (capital and labor). At equilibrium, aggregate technology is Neoclassical, but the average quality of capital and the depreciation rate are both endogenous and positively related to selection. At steady state, output per capita and welfare both raise with selection. However, the selection process generates transitional welfare losses that may reduce in around 60% long term (consumption equivalent) welfare gains. The same property is shown to be true in a standard general equilibrium model with entry and fixed production costs.

The selection mechanism is important in any economy, and this paper shows this is indeed the case. Selection, however, does not always work that well: sometimes, the most efficient firms do not survive. This is the crux of a lot of the less developed economies. But even for developed ones, selection leads to some degree of market power, which can be welfare decreasing.

No country is an island: International cooperation and climate change

September 14, 2021

By Ferrari Massimo and Pagliari Maria Sole

In this paper we explore the cross-country implications of climate-related mitigation policies. Specifically, we set up a two-country, two-sector (brown vs green) DSGE model with negative production externalities stemming from carbon-dioxide emissions. We estimate the model using US and euro area data and we characterize welfare-enhancing equilibria under alternative containment policies. Three main policy implications emerge: i) fiscal policy should focus on reducing emissions by levying taxes on polluting production activities; ii) monetary policy should look through environmental objectives while standing ready to support the economy when the costs of the environmental transition materialize; iii) international cooperation is crucial to obtain a Pareto improvement under the proposed policies. We finally find that the objective of reducing emissions by 50%, which is compatible with the Paris agreement’s goal of limiting global warming to below 2 degrees Celsius with respect to pre-industrial levels, would not be attainable in absence of international cooperation even with the support of monetary policy.

nice paper that highlights the importance of dynamic general equilibrium and transition costs for claimte change response. It shows that it is possible to reach climate goals and both fiscal and monetary tools are required. And, of course, international cooperation.

The Long-Term Effects of Capital Requirements

September 6, 2021

By Gianni De Nicolo, Nataliya Klimenko, Sebastian Pfeil and Jean-Charles Rochet

We build a stylized dynamic general equilibrium model with financial frictions to analyze costs and benefits of capital requirements in the short-term and long-term. We show that since increasing capital requirements limits the aggregate loan supply, the equilibrium loan rate spread increases, which raises bank profitability and the market-to-book value of bank capital. Hence, banks build up larger capital buffers which (i) lowers the public losses in case of a systemic crisis and (ii) restores the banking sector’s lending capacity after the short-term credit crunch induced by tighter regulation. We confirm our model’s dynamic implications in a panel VAR estimation, which suggests that bank lending has even increased in the long-run after the implementation of Basel III capital regulation.

People have been afraid that implicit or explicit tightening of capital requirements would hinder lending in Basel III. But with less risk in banks, their ability to raise funds and lend improves. It is cool such model predictions from before Basel III can be seen in real live, this was true out-of-sample forecasting.

Monetary Policy and the Persistent Aggregate Effects of Wealth Redistribution

September 3, 2021

By Martin Kuncl and Alexander Ueberfeldt

We identify a sizable wealth redistribution channel which creates a monetary policy trade-off whereby short-term economic stimulus is followed by persistently lower output over the medium term. This trade-off is stronger in economies with more nominal household debt but weakened by a more aggressive monetary policy stance and underprice-level targeting. Given this trade-off, low-for-long episodes can lead to persistently depressed output. The medium-term implications of the wealth redistribution channel rely on the presence of labor supply heterogeneity, which we show both analytically and in the context of an estimated New Keynesian general equilibrium model with household heterogeneity.

Monetary policy cannot ignore distributional effects any more. Especially when they have aggregate affects, and as this paper shows, long-term aggregate effects. This is making the conduct of policy really difficult. Having more instruments would come in handy…

Emigration and Fiscal Austerity in a Depression

August 18, 2021

By Guilherme Bandeira, Jordi Caballe and Eugenia Vella

This paper studies the role of emigration in a deep recession when the government implements fiscal consolidation. We build a small open economy New Keynesian model with search and matching frictions, emigration of the labour force, and fiscal details. Our simulations for the austerity mix during the Greek Depression show that fiscal austerity accounts for one third of the output drop and more than 10% of migration outflows, whereas the rest is attributed to the macroeconomic environment. A counterfactual without migration underestimates the fall in output by one fifth. The model also sheds light on the two-way relation between emigration and austerity. Labour income tax hikes induce prolonged migration outflows, while spending cuts exert only a small effect on emigration which can be positive or negative depending on opposite demand and wealth effects. On the flip side, emigration increases the required tax hike and time to meet a given debt target due to endogenous revenue leakage. For tax hikes, emigration acts as an absorber of the austerity shock by diluting the output costs per resident through shrinking population. Yet, in terms of unemployment, temporary gains are reversed over time due to the distortionary effects of taxes on employment.

There is some literature on the effect of tax hikes on emigration. There is some, but it is not as bad as some make it sound. This paper goes further with its analysis of the recent Greek austerity: it also considers the budget cuts and debt targets. Those appear to have a negligible impact on emigration, but emigration has a larger impact on debt service, as the same debt needs to be carried by fewer people.

Does It Matter How Central Banks Accumulate Reserves? Evidence from Sovereign Spreads

August 14, 2021

By César Sosa-Padilla and Federico Sturzenegger

There has been substantial research on the benefits of accumulating foreign reserves, but less on the relative merits of how these reserves are accumulated. In this paper we explore whether the form of accumulation affects country risk. We first present a model of endogenous sovereign debt defaults, where we show that reserve accumulation through the issuance of debt contingent on local output reduces spreads in a way that reserve accumulation with foreign borrowing does not. We confirm this model prediction when taking the theory to the data. These results suggest that attention should be placed on the way reserves are accumulated, a distinction that has important practical implications. In particular, our results call into question the benefits of programs of reserves strengthening through external debt such as those typically implemented by multilateral organizations.

Indeed, in this day and age of sophisticated financial instruments, one should be able to do better than issuing debt denominated in US dollars. If shareholders are willing to take reduced dividends in downturns, there should be a market for sovereign debt tied to contingencies. That should work as long as statistical agencies can maintain their independence, which can be a hurdle, though.

Distributional Effects of Emission Pricing in a Carbon-Intensive Economy: The Case of Poland

August 8, 2021

By Marek Antosiewicz; J. Rodrigo Fuentes; Piotr Lewandowski; Jan Witajewski-Baltvilks

In this paper, we assess the distributional impact of introducing a carbon tax in Poland. We apply a two-step simulation procedure. First, we evaluate the economy-wide effects with a dynamic general equilibrium model. Second, we use a microsimulation model based on household budget survey data to assess the effects on various income groups and on inequality. We introduce a new adjustment channel related to employment changes, which is qualitatively different from price and behavioural effects, and is quantitatively important. We find that the overall distributional effect of a carbon tax is largely driven by how the revenue is spent: distributing the revenues from a carbon tax as lump-sum transfers to households reduces income inequality, while spending the revenues on a reduction of labour taxation increases inequality. These results could be relevant for other coal-producing countries, such as South Africa, Germany, or Australia.

Another paper on the carbon tax, and again it leaves unsatisfied. I am a big fan of carbon taxes, and it seems trivial to think that redistribution will depend on how the revenues are spent. What is really interesting is that Poland is currently very much dependent on coal for heating at the household level. The costs to convert to other technologies are substantial, hence the tax needs to be very high to have a bite. The household response will be much more complex than a microsimulation can yield because you are not talking about a small variation around existing allocations. This is going to be massive, and the resistance will be huge.

Recycling Carbon Tax Revenue to Maximize Welfare

July 3, 2021

By Stephie Fried, Kevin Novan and William Peterman

This paper explores how to recycle carbon tax revenue back to households to maximize welfare. Using a general equilibrium lifecycle model calibrated to reflect the heterogeneity in the U.S. economy, we find the optimal policy uses two thirds of carbon-tax revenue to reduce the distortionary tax on capital income while the remaining one third is used to increase the progressivity of the labor-income tax. The optimal policy attains higher welfare and more equality than the lump-sum rebate approach preferred by policymakers as well as the approach originally prescribed by economists — which called exclusively for reductions in distortionary taxes.

It turns out, it is really difficult to convince people about carbon taxes. They need to see direct benefits, while indirect, general equilibrium benefits are difficult to grasp. This is one of those cases where you need to see what is “politically feasible” instead of what is “economically best” or you are stuck with the status quo. Too bad, because here we have a great paper telling us how we could do the “economically best.”

Das House Kapital

June 29, 2021

By Volker Grossmann, Benjamin Larin and Thomas Steger

The housing wealth-to-income ratio has been increasing in most developed economies since the 1950s. We provide a novel theory to explain this long-term pattern. We show analytically that house prices grow in the steady state if i) the housing sector is more land-intensive than the non-housing sector. Despite growing house prices and housing wealth, the housing wealth-to income ratio is constant in steady state. We hence study the dynamics in the housing wealth-to-income ratio by computing transitions. The model is calibrated separately to the US, UK, France, and Germany. On average, we replicate 89 percent of the observed increase in the housing wealth-to-income ratio. The key for replicating the data is the differentiation between residential land as a non-reproducible factor and residential structure as reproducible factor. The transition process from the calibrated model points to two driving forces of an increasing housing wealth-to-income ratio: i) A long-lasting construction boom that brought about a pronounced build-up in the stock of structures and ii) an increase in the demand for residential land that resulted in surging residential land prices.

You heard the complaints that housing prices are increasing everywhere and that housing takes a too large portion of total expenses. And this is not a recent phenomenon. This paper lays out neatly a model with just the right ingredient to study this. The answer is powerful yet subtle: it is all in the dynamics.