International Business Cycle and Financial Intermediation

January 17, 2017

By Tamas Csabafi, Max Gillman and Ruthira Naraidoo

The world-wide financial crisis of 2007 to 2009 caused bankruptcy and bank failures in the US and many other parts such as Europe. Recent empirical evidence suggests that this simultaneous drop in output was strongest in countries with greater financial ties to the US economy with important cross border deposit and lending. This paper develops a two-country framework to allow for banking structures within an international real business cycle model. The banking structure across countries is modelled using the production approach to financial intermediation. We allow both countries. banks to be able to take deposits both locally and internationally. We analyze the transmission mechanism of both goods and banking sector productivity shocks. We show that goods total factor productivity (TFP) and bank TFP have different effects on the finance premium. Most countries have shown procyclic equity premium over their histories but with evidence that these are countercyclic during the Great Recession especially. The model has the ability to explain the countercyclical movements of credit spreads during major recession and financial crisis when goods TFP also affects banking productivity. This we model as a cross correlation of shocks to replicate the recent events during the crisis period. Importantly, the model can also explain business cycles facts and the countercyclical behaviour of the trade balance.

Opening up and economy brings obvious efficiency gains and allows for smoothing out domestic shocks. But it also opens up the domestic economy up to foreign shocks. The impact of foreign TFP shocks has long been discussed in the literature. This paper brings in the impact of of foreign finance shocks, something that was an obvious driver in the dissemination of the financial crisis from the US to some other countries. The story is likely not as simple as this paper makes it, but it is a nice contribution that attempts to take the banking sector seriously in the international business cycle literature.

Testing part of a DSGE model by Indirect Inference

December 21, 2016

By Patrick Minford, Michael Wickens and Yongdeng Xu

e propose a new type of test. Its aim is to test subsets of the structural equations of a DSGE model. The test draws on the statistical inference for limited information models and the use of indirect inference to test DSGE models. Using Monte Carlo experiments on two subsets of equations of the Smets-Wouters model we show that the model has accurate size and good power in small samples. In a test of the Smets-Wouters model on US Great Moderation data we reject the specification of the wage-price but not the expenditure sector, pointing to the first as the source of overall model rejection.

It is very easy for DSGE model to be rejected. That should be expected, as they are a simplification of the real world and they are disciplined in ways that does not lend to data fitting at any cost. But as every research question that deserves its own model that highlights what is needed to answer that question and leaves aside what appears to be marginal, it is of great use to see whether the particular model features the right ingredients. This paper shows a method that can help us here, testing only part of the model, the one we really care about, without having the neglected parts dragging the whole model down.

Opportunity to Move: Macroeconomic Effects of Relocation Subsidies

December 14, 2016

By Andrii Parkhomenko

The unemployment insurance system in the U.S. does not provide incentives to look for jobs outside local labor markets. In this paper I introduce relocation subsidies as a supplement to unemployment benefits, and study their effects on unemployment, productivity and welfare. I build a job search model with heterogeneous workers and multiple locations, in which migration is impeded by moving expenses, cross-location search frictions, borrowing constraints, and utility costs. I calibrate the model to the U.S. economy, and then introduce a subsidy that reimburses a part of the moving expenses to the unemployed and is financed by labor income taxes. During the Great Recession, a relocation subsidy that pays half of the moving expenses would lower unemployment rate by 0.36 percentage points (or 4.8%) and increase productivity by 1%. Importantly, the subsidies cost nothing to the taxpayer: the additional spending on the subsidies is offset by the reduction in spending on unemployment benefits. Unemployment insurance which combines unemployment benefits with relocation subsidies appears to be more effective than the insurance based on the benefits only.

I have followed and tried to contribute to the optimal unemployment insurance literature. It surprises me that no one, including myself, has looked at relocation subsidies. It seems like an obvious solution to spatial mismatch. Yes, some fiscal systems allow you to deduct moving expenses, but this is not tied to unemployment insurance benefits.

Quantitative Impact of Reducing Barriers to Skilled Labor Immigration: The Case of the US H-1B Visa

December 7, 2016

By Hyun Lee

In this paper, I develop a novel two-country general equilibrium model of immigration and return migration with incomplete markets and heterogeneous agents. I use the model to quantify the short-run and the long-run macroeconomic impacts of permanently doubling the US H-1B visa quota. In the short-run, I find huge endogenous increase in visa application by less talented skilled foreigners, which increases the probability of obtaining the H-1B visa by only 11 percentage points. In the long-run, US experiences a modest gain in output per capita. Most importantly, I find that there exists a sizable mass of US native skilled workers who—despite the decrease in their equilibrium wage—gain in welfare because of their accumulated capital holdings. Furthermore, I highlight the importance of including return migration in a quantitative model of international labor mobility by showing that shutting down return migration in my model results in overestimating the magnitude of the welfare changes by more than sixfold for certain cohorts.

The temporary visa question is a hot topic now, and this paper shows that looking at the answer in general equilibrium may lead to some outcomes you would not necessarily have thought about beforehand. Let us hope policymakers will look at the issue with some good thought.

Gender, Marriage, and Life Expectancy

November 29, 2016

By Margherita Borella, Mariacristina De Nardi and Fang Yang

Wages and life expectancy, as well as labor market outcomes, savings, and consumption, differ by gender and marital status. In this paper we compare the aggregate implications of two dynamic structural models. The first model is a standard, quantitative, life-cycle economy, in which people are only heterogenous by age and realized earnings shocks, and is calibrated using data on men, as typically done. The second model is one in which people are also heterogeneous by gender, marital status, wages, and life expectancy, and is calibrated using data for married and single men and women. We show that the standard life-cycle economy misses important aspects of aggregate savings, labor supply, earnings, and consumption. In contrast, the model with richer heterogeneity by gender, marital status, wage, and life expectancy matches the observed data well. We also show that the effects of changing life expectancy and the gender wage gap depend on marital status and gender, and that it is essential to not only model couples, but also the labor supply response of both men and women in a couple.

This seems like a fairly obvious point, and a point that needs to be made and is supported here by significant quantities.

Financial Regulation in a Quantitative Model of the Modern Banking System

November 29, 2016

By Tim Landvoigt and Juliane Begenau

This paper builds a quantitative general equilibrium model with commercial banks and shadow banks to study the unintended consequences of capital requirements. In particular, we investigate how the shadow banking system responds to capital regulation changes for traditional banks. A key feature of our model are defaultable bank liabilities that provide liquidity services to households. In case of default, commercial bank debt is fully insured and thus provides full liquidity services. In contrast, shadow banks are only randomly bailed out. Thus, shadow banks’ liquidity services also depend on their default rate. Commercial banks are subject to a capital requirement. Tightening the requirement from the status quo, leads households to substitute shadow bank liquidity for commercial bank liquidity and therefore to more shadow banking activity in the economy. But this relationship is non-monotonic due to an endogenous leverage constraint on shadow banks that limits their ability to deliver liquidity services. The basic trade-off of a higher requirement is between bank liquidity provision and stability. Calibrating the model to data from the Financial Accounts of the U.S., the optimal capital requirement is around 20%.

The more you regulate the banks, the more assets will leak into the shadow banking system that is muc more difficult to regulate. It is therefore impossible to have a completely safe banking system and there is an optimum level of regulation, which may actually depend on a lot of things, including some that vary with economic conditions. It is going to be difficult to find regulators and politicians with that kind of flexibility.

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.