Inequality and Aggregate Demand

November 22, 2016

By Matthew Rognlie and Adrien Auclert

We explore the quantitative effects of transitory and persistent increases in income inequality on equilibrium interest rates and output. Our starting point is a Bewley-Huggett-Aiyagari model featuring rich heterogeneity and earnings dynamics as well as downward nominal wage rigidities. A temporary rise in inequality, if not accommodated by monetary policy, has an immediate effect on output that can be quantified using the empirical covariance between income and marginal propensities to consume. A permanent rise in inequality can lead to a permanent Keynesian recession, which is not fully offset by monetary policy due to a lower bound on interest rates. We show that the magnitude of the real interest rate fall and the severity of the steady-state slump can be approximated by simple formulas involving quantifiable elasticities and shares, together with two parameters that summarize the effect of idiosyncratic uncertainty and real interest rates on aggregate savings. For plausible parametrizations the rise in inequality can push the economy into a liquidity trap and create a deep recession. Capital investment and deficit-financed fiscal policy mitigate the fall in real interest rates and the severity of the slump.

The approach here is the reverse of what is usually done in such model: shock the heterogeneity to see what it implies for aggregates. The next step would be to identify what the origin of the shock is and then let the aggregates feed back to heterogeneity. General equilibrium in a sense. In any case, this one more testimony that heterogeneity and distribution matters bigly.

Confidence Cycles and Liquidity Hoarding

November 16, 2016

By Volha Audzei

Market confidence has proved to be an important factor during past crises. However, many existing general equilibrium models do not account for agents’ expectations, market volatility, or overly pessimistic investor forecasts. In this paper, we incorporate a model of the interbank market into a DSGE model, with the interbank market rate and the volume of lending depending on market confidence and the perception of counterparty risk. In our model, a credit crunch occurs if the perception of counterparty risk increases. Our results suggest that changes in market confidence can generate credit crunches and contribute to the depth of recessions. We then conduct an exercise to mimic some central bank policies: targeted and untargeted liquidity provision, and reduction of the policy rate. Our results indicate that policy actions have a limited effect on the supply of credit if they fail to influence agents’ expectations. Interestingly, a policy of a low policy rate worsens recessions due to its negative impact on banks’ revenues. Liquidity provision stimulates credit slightly, but its efficiency is undermined by liquidity hoarding.

One thing that the last financial crisis taught us is that the interbank market matters quite a bit. This paper takes a serious look at it, and in particular factors in heterogeneity in banks’ beliefs. My slightly related previous research (with the same conclusion about low interest rates and liquidity hoarding, but without the interbank market) showed me that heterogeneity matters a lot for credit markets. This paper confirms that.

The Heterogeneous Effects of Government Spending: It’s All About Taxes

November 14, 2016

By Axelle Ferrière and Gaston Navarro

Empirical work suggests that government spending generates large expansions of output and consumption. Most representative-agent models predict a moderate expansion of output, and a crowding-out of consumption. We reconcile these findings by taking into account the distribution of taxes. Using US data from 1913 to 2012, we provide evidence that government spending induces larger expansions in output and consumption when financed with more progressive taxes. We then develop a model with heterogeneous households and idiosyncratic risk, to show that a rise in government spending can be expansionary, both for output and consumption, only if financed with more progressive labor taxes. Key to our results is the model endogenous heterogeneity in households’ marginal propensities to consume and labor supply elasticities. In this respect, the distributional impact of fiscal policy is central to its aggregate effects.

Distribution matters big time when income taxes are more progressive. It makes total sense that the Ricardian Equivalence when you depart from linearity, but this paper shows it is significant.

Optimal monetary policy with heterogeneous agents

November 10, 2016

By Galo Nuño and Carlos Thomas

Incomplete markets models with heterogeneous agents are increasingly used for policy analysis. We propose a novel methodology for solving fully dynamic optimal policy problems in models of this kind, both under discretion and commitment. We illustrate our methodology by studying optimal monetary policy in an incomplete-markets model with non-contingent nominal assets and costly inflation. Under discretion, an inflationary bias arises from the central bank’s attempt to redistribute wealth towards debtor households, which have a higher marginal utility of net wealth. Under commitment, this inflationary force is countered over time by the incentive to prevent expectations of future inflation from being priced into new bond issuances; under certain conditions, long run inflation is zero as both effects cancel out asymptotically. For a plausible calibration, we find that the optimal commitment features first-order initial inflation followed by a gradual decline towards its (near zero) long-run value. Welfare losses from discretionary policy are first-order in magnitude, affecting both debtors and creditors.

This is an interesting paper for two reasons. First, it provides an new solution method. Second, the application yields substantial welfare costs for inflation. It would be really useful to see someone replicate this with another method to verify that the result is not driven by the method.

Band or Point Inflation Targeting? An Experimental Approach

October 24, 2016

BY Camille Cornand and Cheick Kader M’Baye

We conduct laboratory experiments with human subjects to test the rationale of adopting a band versus point inflation targeting regime. Within the standard New Keynesian model, we evaluate the macroeconomic performances of both regimes according to the strength of shocks affecting the economy. We find that when the economy faces small shocks, the average level of inflation as well as its volatility are significantly lower in a band targeting regime, while the output gap and interest rate levels and volatility are significantly lower in a point targeting regime with tolerance bands. However, when the economy faces large shocks, choosing the suitable inflation targeting regime is irrelevant because both regimes lead to comparable performances. These findings stand in contrast to those of the literature and question the relevance of clarifying a mid-point target within the bands, especially in emerging market economies more inclined to large and frequent shocks.

Interesting approach to use an experiment with live actors to test a model. I am not sure about its validity though, as outcomes are provided by the model, not endogenously through the interaction of the participants. And the model is extremely crude.

Monetary policy for a bubbly world

October 21, 2016

By Vladimir Asriyan, Luca Fornaro, Alberto Martin and Jaume Ventura

We propose a model of money, credit and bubbles, and use it to study the role of monetary policy in managing asset bubbles. In this model, bubbles pop up and burst, generating fluctuations in credit, investment and output. Two key insights emerge from the analysis. First, the growth rate of bubbles, which is driven by agents’ expectations, can be set in real or in nominal terms. This gives rise to a novel channel of monetary policy, as changes in the inflation rate affect the real growth rate of bubbles and their effect on economic activity. Crucially, this channel does not rely on contract incompleteness or price rigidities. Second, there is a natural limit on monetary policy’s ability to control bubbles: the zero-lower bound. When a bubble crashes, the economy may enter into a liquidity trap, a regime in which agents shift their portfolios away from bubbles – and the credit that they sustain – to money, reducing intermediation, investment and growth. We explore the implications of the model for the conduct of “conventional” and “unconventional” monetary policy, and we use the model to provide a broad interpretation of salient macroeconomic facts of the last two decades.

Intriguing paper. Of course, modeling bubbles is tricky business, and the policy prescription will depend on how you generate bubbles. But the message is clear, the monetary authority should receive a clearer mandate to care about financial stability beyond its worries about inflation, and the existence of bubbles adds more fuel to this idea.

What order? Perturbation methods for stochastic volatility asset pricing and business cycle models

October 19, 2016

By Oliver de Groot

When a DSGE model features stochastic volatility, is a third-order perturbation approximation sufficient? The answer is often no. A key parameter – the standard deviation of stochastic volatility innovations – does not appear in the coefficients of the decision rules of endogenous variables until a fourth- or sixth-order perturbation approximation (depending on the functional form of the stochastic volatility process). This paper shows analytically this general result and demonstrates, using three models, that important model moments can be imprecisely measured when the order of approximation is too low. i) In the Bansal-Yaron long-run risk model, the equity risk premium rises from 4.5% to 10% by going to sixth-order. ii) In a workhorse real business cycle model, the welfare cost of business cycles also rise when a fourth-order approximation properly accounts for the presence of stochastic volatility. iii) In a canonical New-Keynesian model, the risk-aversion parameter can be lowered while matching the term premium when a fourth-order approximation is used.

It is important to choose an approximation methods that reflects well for the exercise you are trying to perform. That said, there can also be other avenues, in particular with piecewise-linear and/or grid methods that can work better at potentially a lower cost. This paper highlights hat these are important considerations.