Policy Trade-Offs in Building Resilience to Natural Disasters: The Case of St. Lucia

April 17, 2019

BY Alessandro Cantelmo; Leo Bonato; Giovanni Melina; Gonzalo Salinas


Resilience to climate change and natural disasters hinges on two fundamental elements: financial protection —insurance and self-insurance— and structural protection —investment in adaptation. Using a dynamic general equilibrium model calibrated to the St. Lucia’s economy, this paper shows that both strategies considerably reduce the output loss from natural disasters and studies the conditions under which each of the two strategies provides the best protection. While structural protection normally delivers a larger payoff because of its direct dampening effect on the cost of disasters, financial protection is superior when liquidity constraints limit the ability of the government to rebuild public capital promptly. The estimated trade-off is very sensitive to the efficiency of public investment.

This paper shows how far DGE modelling has strayed from studying business cycles in the US. This one is about studying climate change and natural disasters in a Caribbean island-state. D(S)GE is very broadly applicable and should be used more to study questions like these that have concrete policy applications.


The Intergenerational Incidence of Green Tax Reform

April 10, 2019

By Sebastian Rausch and Hidemichi Yonezawa


We examine the lifetime incidence and intergenerational distributional effects of an economywide carbon tax swap using a numerical dynamic general equilibrium model with overlapping generations of the U.S. economy. We highlight various fundamental choices in policy design including (1) the level of the initial carbon tax, (2) the growth rate of the carbon tax trajectory of over time, and (3) alternative ways for revenue recycling. Without revenue recycling, we find that generations born before the tax is introduced experience smaller welfare losses, or even gain, relative to future generations. For sufficiently low growth rates of the tax trajectory, the impacts for distant future generations decrease over time. For future generations born after the introduction of the tax, the negative welfare impacts are the smallest (largest) when revenues are recycled through lowering pre-existing capital income taxes (through per-capita lump-sum rebates). For generations born before the tax is introduced, we find that lump-sum rebates favor very old generations and labor (capital) income tax recycling favors very young generations (generations of intermediate age).

Now that carbon taxes are taking a foothold, the question arises what to do with the revenue. The politically expedient way is to provide a lump-sum rebate, which may make sense if you are trying to sell the main point of the carbon tax to politicians and the general public: pricing pollution. But one can do better and this paper shows that there are stark differences across generations on both fronts, the tax itself and its benefits. This is one of those cases where you have to choose between a complex, optimal schedule and a simple, easy-to-sell policy.

Environmental Policy Instrument Choice and International Trade

March 29, 2019

By J. Scott Holladay, Mohammed Mohsin and Shreekar Pradhan


We develop a dynamic stochastic general equilibrium model to understand how environmental policy instrument choice affects trade. We extend the existing literature by employing an open economy model to evaluate three environmental policy instruments: cap-and-trade, pollution taxes, and an emissions intensity standard in the face of two types of exogenous shocks. We calibrate the model to Canadian data and simulate productivity and import price shocks. We evaluate the evolution of key macroeconomic variables, including the trade balance in response to the shocks under each policy instrument. Our findings for the evolution of output and emissions under a productivity shock are consistent with previous closed economy models. Our open economy framework allows us to find that a cap-and-trade policy dampens the international trade effects of the business cycle relative to an emissions tax or intensity standard. Under an import shock, pollution taxes and intensity targets are as effective as cap-and-trade policies in reducing variance in consumption and employment. The cap-and-trade policy limits the intensity of the import competition shock suggesting that particular policy instrument might serve as a barrier to trade.

While it is not the principal purpose of environmental policy, it is nice to know that it does not amplify business cycles. But I suspect that it matters how pollution enters the model. In this case, it is through a production loss. What if it where through a utility loss or a death probability increase (change in discount rate)? I suspect there is a reasonable specification that could reverse the result. I want to see a paper that proves me wrong.

Behavioural economics is useful also in macroeconomics : the role of animal spirits

March 27, 2019

By Paul de Grauwe and Yuemei Ji


Dynamic stochastic general equilibrium models are still dominant in mainstream macroeconomics, but they are only able to explain business cycle fluctuations as the result of exogenous shocks. This paper uses concepts from behavioural economics and discusses a New Keynesian macroeconomic model that generates endogenous business cycle fluctuations driven by animal spirits. Our discussion includes two applications. One is on the optimal level of inflation targeting under a zero lower bound constraint. The other is on the role of animal spirits in explaining the synchronization of business cycles across countries.

I guess this is more an issue of semantics, but animal spirits still need to be triggered by something, however small that may be, and this something is still exogenous to the model, right? The dream of having a fully endogenous model is a pipe dream.

Inequality, Portfolio Choice and the Great Recession

March 25, 2019

By Heejeong Kim


What drives sharp declines in aggregate quantities over the Great Recession? I study this question by building a dynamic stochastic overlapping generations economy where households hold both low-return liquid and high-return illiquid assets. In this environment, I consider shocks to aggregate TFP that occur alongside a rise in risk of a further economic downturn. Importantly, a higher probability of an economic disaster is consistent with the recent evidence finding a decline in households’ expected income growth over the Great Recession. I also show that a rise in disaster risk explains the rise in savings rates, seen in the micro data over the Great Recession. When calibrated to reproduce the distribution of wealth as well as the frequency and severity of disasters reported in Barro (2006), a rise in disaster risk, and an empirically consistent fall in TFP, explains around 70 percent of the decline in aggregate consumption and more than 50 percent of the decline in investment over the Great Recession. Comparing my model to an economy without illiquid assets, I find that household variation in the liquidity of wealth plays a key role in amplifying the effect of a rise in disaster risk.

I am not sure the risk of disaster increased, rather it is the subjective probability of a disaster that increased. When the Great Recession hit, very few in that generation had experienced a deep recession. An economic disaster was simply not on the radar, despite the gold nuts’ best efforts. Just like now it is unfathomable to have interest rates that are close to zero. Economics memories are surprisingly short. In any case, these kind of changes, whether they are subjective or not, matter, as this paper shows.

Don’t Tax Capital — Optimal Ramsey Taxation in Heterogeneous Agent Economies with Quasi-Linear Preferences

March 21, 2019

By YiLi Chien and Yi Wen


We build a tractable infinite-horizon Aiyagari-type model with quasi-linear preferences to address a set of long-standing issues in the optimal Ramsey taxation literature. The tractability of our model enables us to analytically prove the existence of Ramsey steady states and establish several strong and novel results: (i) Depending on the government’s capacity to issue debts, there can exist different types of Ramsey steady state and their existence depends critically on model parameter values. (ii) The optimal capital tax is exclusively zero in a Ramsey steady state regardless of the modified golden rule and government debt limits. (iii) Along the transition path toward a Ramsey steady state, optimal capital tax depends positively on the elasticity of intertemporal substitution. (iv) When a Ramsey steady state (featuring a non-binding government debt limit) does not exist but is erroneously assumed to exist, the modified golden rule always “holds” and the implied “optimal” long-run capital tax is strictly positive, reminiscent of the result obtained by Aiyagari (1995). (v) Whether the modified golden rule holds depends critically on the government’s capacity to issue debts, but has no bearing on the planner’s long-run capital tax scheme. (vi) The optimal debt-to-GDP ratio in the absence of a binding debt limit, however, is determined by a positive wedge times the modified-golden-rule saving rate; the wedge is decreasing in the strength of the individual self-insurance position and approaches zero when the idiosyncratic risk vanishes or markets are complete. The key insight behind our results is the Ramsey planner’s ultimate concern for self-insurance. Since taxing capital in the steady state permanently hinders individuals’ self-insurance positions, the Ramsey planner prefers (i) issuing debt rather than imposing a steady-state capital tax to correct the capital-overaccumulation problem under precautionary saving motives, and (ii) taxing capital only in the short run regardless of its debt positions. Thus, in sharp contrast to Aiyagari’s argument, permanent capital taxation is not the optimal tool to achieve aggregate allocative efficiency despite overaccumulation of capital, and the modified golden rule can fail to hold in a Ramsey equilibrium whenever the government encounters a debt-limit.

The literature on optimal capital taxation seems endless with conclusions getting reversed frequently, like whether eggs are healthy or not. This is another, but important, contribution that maybe will get us closer to resolution.

The Distributional Effects of Conventional Monetary Policy and Quantitative Easing: Evidence from an Estimated DSGE Model

March 18, 2019

By Stefan Hohberger, Romanos Priftis and Lukas Vogel


This paper compares the distributional effects of conventional monetary policy and quantitative easing (QE) within an estimated open-economy DSGE model of the euro area. The model includes two groups of households: (i) wealthier households, who own financial assets and can smooth consumption over time, and (ii) poorer households, who only receive labor and transfer income and live “hand to mouth.” We compare the impact of policy shocks on constructed measures of income and wealth inequality (net disposable income, net asset position, and relative per-capita income). Except for the short term, expansionary conventional policy and QE shocks tend to mitigate income and wealth inequality between the two population groups.

This is an interesting result that absolves central banks from the criticism that their unconventional policies exacerbate inequality. However, I am afraid that the heterogeneity in this model is much too simple to be convincing. Indeed, their are really two representative agents in here: one who saves and one who does not. inequality is much more granular than that, and multidimensional. But one has to start somewhere.