Political Distribution Risk and Business Cycles

January 16, 2018

By Thorsten Drautzburg, Jesus Fernandez-Villaverde and Pablo Guerron-Quintana


We argue that one important determinant of the variation in income shares is political risk. To that end, we document significant changes in the capital share after political events such as the introduction of right-to-work legislation in U.S. states and international events such as the Carnation Revolution in Portugal. These policy changes are often associated with significant fluctuations in output and asset prices. To quantify the importance of these political shocks for the U.S., we extend an otherwise standard neoclassical growth model. We model political shocks as exogenous changes in the bargaining power of workers in a labor market with search unemployment. We calibrate the model to the U.S. corporate non-financial business sector with a standard process for productivity. A one standard deviation redistribution shock reduces the capital share up 0.2 percentage point on impact and leads to a drop in output of 0.6 percent. Our calibration also implies that political distribution risk can explain 15 to 25% of the observed volatility of U.S. gross capital shares — and 35 to 45 percent of output volatility, depending on the elasticity of substitution between capital and labor. Eliminating political redistribution risk in the U.S. would raise the welfare of the representative household by 1.6 percent of steady state consumption.

I am actually surprised that political risk matters that little, at least for the US, seeing how politics can wreak havoc in other countries. Or maybe it is that bad politics is a steady state elsewhere, and thus it has an impact more on the levels than the fluctuations.


The Optimal Inflation Target and the Natural Rate of Interest

January 12, 2018

By Philippe Andrade, Jordi Galí, Hervé Le Bihan and Julien Matheron


We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-for-one: increases in the optimal inflation rate are generally lower than declines in the steady-state real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.

Economists are now fairly convinced that the real interest rate has declined, whatever the reason may be. In that context, some of the policy “constants” need to be reevaluated, as they may depend on the real interest rate. This paper is one important approach at this question for the inflation target using a New Keynesian model. Let’s see whether other approaches come to similar conclusions.

Inferring Inequality with Home Production

January 11, 2018

By Job Boerma and LoukasKarabarbounis


We revisit the causes, welfare consequences, and policy implications of the dispersion in households’ labor market outcomes using a model with uninsurable risk, incomplete asset markets, and a home production technology. Accounting for home production amplifies welfare-based differences across households meaning that inequality is larger than we thought. Using the optimality condition that households allocate more consumption to their more productive sector, we infer that the dispersion in home productivity across households is roughly three times as large as the dispersion in their wages. There is little scope for home production to offset differences that originate in the market sector because productivity differences in the home sector are large and the time input in home production does not covary with consumption expenditures and wages in the cross section of households. We conclude that the optimal tax system should feature more progressivity taking into account home production.

I am actually quite surprised by the result of this paper. I would have thought that those with poorer labor market outcomes would have a comparative advantage in home production, and this would decrease inequality once you take home production into account. It turns out I was dead-wrong.

Optimal Long-Run Inflation and the Informal Economy

December 27, 2017

By Claudio Cesaroni


This paper studies the optimal long-run rate of inflation in a two-sector model of the Lithuanian economy with informal production and price rigidity in the regular sector. The government issues no debt and is committed to follow a balanced budget rule. The informal sector is unregulated and untaxed and its existence limits the government’s ability to collect revenues through fiscal policy. Such environment provides therefore the basis for quantifying the possible existence of a public finance motive for inflation. The main results can be summarized as follows: First, there is a strong heterogeneity in the optimal inflation rate which depends on the tax rate that is endogenously adjusted to keep the budget balanced. Inflation can be as high as 6.77% when the capital tax rate is endogenous, but when labor income taxes are adjusted optimal policy calls for a rate of deflation such that the nominal interest rate hits the zero lower bound. Second, the optimal inflation rate is a non-decreasing function of the size of the informal economy and, in most cases, there is a positive relationship between the two. Finally, substantial deviations from zero inflation are observed even in presence of a plausible degree of price rigidity.

Seigniorage is a good source of government revenue and this paper shows that when you have a sizable informal sector, seigniorage becomes invaluable. The contribution of this paper is first to show how the tax mix is influential, how there seems to be some sort of Laffer curve (very loosely defined) in play, and that price rigidity matters. This paper should help countries with low tax morale.

Uncertainty Shocks and Firm Dynamics: Search and Monitoring in the Credit Market

December 23, 2017

By Thomas Brand, Marlène Isoré and Fabien Tripier


We develop a business cycle model with gross flows of firm creation and destruction. The credit market is characterized by two frictions. First, entrepreneurs undergo a costly search for intermediate funding to create a firm. Second, upon a match, a costly-state-verification contract is set up. When defaults occurs, banks monitor firms, seize their assets, and a fraction of financial relationships are severed. The model is estimated using Bayesian methods for the U.S. economy. Among other shocks, uncertainty in productivity turns out to be a major contributor to both macro-financial aggregates and firm dynamics.

This is an interesting that brings an additional layer to the financing part of the typical business cycle model. Entrepreneurs search and are subject to CSV. Also the model is estimated. It is not a surprise that in such a set-up second moments matter, but it worth emphasizing once more uncertainty is important.

Two papers on exchange rate policy

December 14, 2017

FX Intervention in the New Keynesian Model

By Zineddine Alla, Raphael A Espinoza and Atish R. Ghosh


We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

The Exchange Rate as an Instrument of Monetary Policy

By Jonas Heipertz, Ilian Mihov and Ana Maria Santacreu


Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

Lately, interesting papers seem to come in pairs in the weekly NEP-DGE reports. This time they are about exchange rate policy. The first one highlights that it can help with indeterminacy and multiplicity in monetary economies, and the second one shows that an optimal policy is mightily interesting and is not a corner solution.

Two papers on wealth taxation

December 8, 2017

Use It or Lose It: Efficiency Gains from Wealth Taxation

By Fatih Guvenen, Gueorgui Kambourov, Burhan Kuruscu, Sergio Ocampo-Diaz and Daphne Chen

This paper studies the quantitative implications of wealth taxation (as opposed to capital income taxation) in an incomplete markets model with return rate heterogeneity across individuals. The rate of return heterogeneity arises from the fact that some individuals have better entrepreneurial skills than others, allowing them to obtain a higher return on their wealth. With such heterogeneity, capital income and wealth taxes have different efficiency and distributional implications. Under capital income taxation, entrepreneurs who are more productive and, as a result, generate more income pay higher taxes. Under wealth taxation, on the other hand, entrepreneurs who have similar wealth levels pay similar taxes regardless of their productivity. Thus, in this environment, the tax burden shifts from productive entrepreneurs to unproductive ones if the capital income tax were replaced with a wealth tax. This reallocation increases aggregate productivity. Second, and at the same time, it increases wealth inequality in the population. To provide a quantitative assessment of these different effects, we build and simulate an overlapping generations model with individual-specific returns on capital income and with idiosyncratic shocks to labor income. Our results indicate that switching from a capital income tax to a wealth tax increases welfare by almost 8% through better allocation of capital. We also study optimal taxation in this environment and find that, relative to the benchmark, the optimal wealth tax increases welfare by 9.6% while the optimal capital income tax increases it by 6.3%.

Inheritance Taxation and Wealth Effects on the Labor Supply of Heirs

By Fabian Kindermann, Lukas Mayr and Dominik Sachs


Taxing bequests not only generates direct tax revenue, but can have a positive impact on the labor supply of heirs through wealth effects. This leads to an increase in future labor income tax revenue. How large is this effect? We use a state of the art life-cycle model that we calibrate to the German economy to answer this question. Our model successfully matches quasi-experimental evidence regarding the size of wealth effects on labor supply. Using this evidence directly for a back of the envelope calculation fails because (i) heirs anticipate the reduction in bequests through taxation and adjust their labor supply already prior to the actual act of bequeathing, and (ii) when bequest receipt is stochastic, even those who ex post end up not inheriting anything respond ex ante to a change in the expected size of bequests. We find that for each Euro of bequest tax revenue the government mechanically generates, it obtains an additional 9 Cents of labor income tax revenue (in net present value) through a higher labor supply of (non-)heirs.

A large crop of papers in this week’s NEP-DGE report yields two on an important topic of the day: estate (or inheritance) taxation. A lot of people need to be better informed before making law, and these paper are part of that bibliography.