Research Database

We show that optimal monetary and fiscal policies are time consistent for a class of economies often used in applied work, economies appealing because they are consistent with the growth facts. We establish our results in two steps. We first show that for this class of economies, the Friedman rule of setting nominal interest rates to zero is optimal under commitment. We then show that optimal policies are time consistent if the Friedman rule is optimal. For our benchmark economy in which the time consistency problem is most severe, the converse also holds: if optimal policies are time consistent, then the Friedman rule is optimal.

This paper studies the impact of cross-country variation in financial market development on firms’ financing choices and growth rates using comprehensive firm-level datasets. We document that in less financially developed economies, small firms grow faster and have lower debt to asset ratios than large firms. We then develop a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. We parameterize the model to the firms’ financial structure in the data and show that financial restrictions can account for the majority of the difference in growth rates between firms of different sizes across countries.

Between 2007 and 2013, U.S. households experienced a large and persistent decline in net worth. The objective of this paper is to study the business cycle implications of such a decline. We first develop a tractable monetary model in which households face idiosyncratic unemployment risk that they can partially self-insure using savings. A low level of liquid household wealth opens the door to self-fullfilling fluctuations: if wealth-poor households expect high unemployment, they have a strong precautionary incentive to cut spending, which can make the expectation of high unemployment a reality. Monetary policy, because of the zero lower bound, cannot rule out such expectations-driven recessions. In contrast, when wealth is sufficiently high, an aggressive monetary policy can keep the economy at full employment. Finally, we document that during the U.S. Great Recession wealth-poor households increased saving more sharply than richer households, pointing towards the importance of the precautionary channel over this period.

We use a simple random growth model to study the role of changing dynamics of family firms in shaping the evolution of top wealth shares in the United States over the course of the past century. Our model generates a time path for top wealth shares. The path is remarkably similar to those found by Saez and Zucman (2016) and Gomez (2019) when the volatility of idiosyncratic shocks to the value of family firms is similar to that found for public firms by Herskovic, Kelly, Lustig, and Van Nieuwerburgh (2016). We also show that consideration of family firms contributes not only to overall wealth inequality but also to considerable upward and downward mobility of families within the distribution of wealth. We interpret our results as indicating that improving our understanding of how families found new firms and eventually diversify their wealth is central to improving our understanding of the distribution of great wealth and its evolution over time.

This paper by Baxter and Kouparitsas is an ambitious attempt to explore which variables are robust in explaining the correlations of bilateral GDP between countries at business cycle frequencies. Most of the variables turned out to be fragile. The main contribution is to show that countries with large amounts of bilateral trade tend to have robustly higher business cycle correlations. Another interesting finding is that neither currency unions nor industrial structure are robustly related to business cycle correlations.

It is well documented that on average, stock prices drop by less than the value of the dividend on ex-dividend days. This has commonly been attributed to the effect of tax clienteles. We use data from the Hong Kong stock market where neither dividends nor capital gains are taxed. As in the U.S.A. the average stock price drop is less than the value of the dividend; specifically, in Hong Kong the average dividend was HK $0.12 and the average price drop was HK $0.06. We are able to account for this both theoretically and empirically through market microstructure based arguments.

During the financial crisis, life insurers sold long-term policies at deep discounts relative to actuarial value. The average markup was as low as −19 percent for annuities and −57 percent for life insurance. This extraordinary pricing behavior was due to financial and product market frictions, interacting with statutory reserve regulation that allowed life insurers to record far less than a dollar of reserve per dollar of future insurance liability. We identify the shadow cost of capital through exogenous variation in required reserves across different types of policies. The shadow cost was $0.96 per dollar of statutory capital for the average company in November 2008.

There is an old wisdom that reductions in tariffs force changes on producers that lead to costless, or nearly so, increases in productivity. We construct a technology-ladder model that captures this wisdom. As in other technology-ladder models, time spent in research helps propel an industry up a technology-ladder. In contrast to the literature, we include another activity that plays a role in determining an industry's position on the technology-ladder: attempts to obstruct the research program of rivals (through regulations, for example). In this world, reductions in tariffs between countries lead producers to spend more time in research and less in obstruction of rivals.

We study the U.S. sugar manufacturing cartel that was created during the New Deal. This was a legal-cartel that lasted 40 years (1934-74). As a legal-cartel, the industry was assured widespread adherence to domestic and import sales quotas (given it had access to government enforcement powers). But it also meant accepting government-sponsored cartel-provisions. These provisions significantly distorted production at each factory and also where the industry was located. These distortions were reflected in, for example, a declining industry recovery rate, that is, the pounds of white sugar produced per ton of beets. It declined from about 310 pounds in 1934 to 240 pounds in 1974. The cartel provisions also distorted the location of industry. For example, it kept production in California and the Far West. Since the cartel ended in 1974, California's share of sugar production has dropped dramatically.

How big are the welfare losses from severe economic downturns, such as the U.S. Great Recession? How are those losses distributed across the population? In this paper we answer these questions using a canonical business cycle model featuring household income and wealth heterogeneity that matches micro data from the Panel Study of Income Dynamics (PSID). We document how these losses are distributed across households and how they are affected by social insurance policies. We find that the welfare cost of losing one’s job in a severe recession ranges from 2% of lifetime consumption for the wealthiest households to 5% for low-wealth households. The cost increases to approximately 8% for low-wealth households if unemployment insurance benefits are cut from 50% to 10%. The fact that welfare losses fall with wealth, and that in our model (as in the data) a large fraction of households has very low wealth, implies that the impact of a severe recession, once aggregated across all households, is very significant (2.2% of lifetime consumption). We finally show that a more generous unemployment insurance system unequivocally helps low-wealth job losers, but hurts households that keep their job, even in a version of the model in which output is partly demand determined, and therefore unemployment insurance stabilizes aggregate demand and output.

We present a 2-country model with heterogeneous agents in which changes in a country’s monetary policy affect real interest rates, relative prices of traded and nontraded goods and real exchange rates. Nontransitory real effects of monetary policy stem solely from a friction (country-specific reserve requirements) that generates separate demands for a country’s money and bonds. Without violating the classical assumptions of individual rationality and flexible prices, the model’s implications seem qualitatively in accord with the U.S. experience of the 1980s: a monetary policy tightening leading to a rise in the real interest rate and to an initial rise in the real value of the dollar which is subsequently reversed. In the model a monetary policy change leads to different welfare effects for agents born at different times, living in different countries, or participating on different sides of a market. The welfare of some agents can be affected more by relative price changes than by real interest rate changes.

This paper presents a dynamic, stochastic general equilibrium study of the causes of the international Great Depression. We use a fully articulated model to assess the relative contributions of deflation/monetary shocks, which are the most commonly cited shocks for the Depression, and productivity shocks. We find that productivity is the dominant shock, accounting for about 2/3 of the Depression, with the monetary shock accounting for about 1/3. The main reason deflation doesn’t account for more of the Depression is because there is no systematic relationship between deflation and output during this period. Our finding that a persistent productivity shock is the key factor stands in contrast to the conventional view that a continuing sequence of unexpected deflation shocks was the major cause of the Depression. We also explore what factors might be causing the productivity shocks. We find some evidence that they are largely related to industrial activity, rather than agricultural activity, and that they are correlated with real exchange rates and non-deflationary shocks to the financial sector.

No abstract available.

Applied general equilibrium models with imperfect competition and economies of scale have been extensively used for analyzing international trade and development policy issues. They offer a natural framework for testing the empirical relevance of propositions from the industrial organization and new trade theoretical literature. This paper warns model builders and users that considerable caution is needed in interpreting the results and deriving strong policy conclusions from these models: in this generation of applied general equilibrium models, nonuniqueness of equilibria is not a theoretical curiosum, but a potentially serious problem. Disregarding this may lead to dramatically wrong policy appraisals.

This paper quantitatively tests the “new trade theory” based on product differentiation, increasing returns, and imperfect competition. We employ a standard model, which allows both changes in the distribution of income among industrialized countries, emphasized by Helpman and Krugman (1985), and nonhomothetic preferences, emphasized by Markusen (1986), to effect trade directions and volumes. In addition, we generalize the model to allow changes in relative prices to have large effects. We test the model by calibrating it to 1990 data and then “backcasting” to 1961 to see what changes in crucial variables between 1961 and 1990 are predicted by the theory. The results show that, although the model is capable of explaining much of the increased concentration of trade among industrialized countries, it is not capable of explaining the enormous increase in the ratio of trade to income. Our analysis suggests that it is policy changes, rather than the elements emphasized in the new trade theory, that have been the most significant determinants of the increase in trade volume.

The magnitude of and heterogeneity in systematic earnings risk has important implications for various theories in macro, labor, and financial economics. Using administrative data, we document how the aggregate risk exposure of individual earnings to GDP and stock returns varies across gender, age, the worker’s earnings level, and industry. Aggregate risk exposure is U-shaped with respect to the earnings level. In the middle of the earnings distribution, aggregate risk exposure is higher for males, younger workers, and those in construction and durable manufacturing. At the top of the earnings distribution, aggregate risk exposure is higher for older workers and those in finance. Workers in larger employers are less exposed to aggregate risk, but they are more exposed to a common factor in employer-level earnings, especially at the top of the earnings distribution. Within an employer, higher-paid workers have higher exposure to employer-level risk than lower-paid workers.

Inflation expectations have recently received increased interest because of the uncertainty created by the Federal Reserve’s unprecedented reaction to the Great Recession. The effect of this reaction on the real economy is also an important topic. In this paper I use various surveys to produce a term structure of inflation expectations – inflation expectations at any horizon from 3 to 120 months – and an associated term structure of real interest rates. Inflation expectations extracted from this model track actual (ex-post) realizations of inflation quite well, and in terms of forecast accuracy they are at par with or superior to some popular alternatives obtained from financial variables. Looking at the period 2008–2013, I conclude that the unconventional policies of the Federal Reserve kept long-run inflation expectations anchored and provided a large level of monetary stimulus to the economy.

This paper argues that the comovement between inflation and economic activity is an important determinant of real interest rates over time and across countries. First, we show that for advanced economies, periods with more procyclical inflation are associated with lower real rates, but only when there is no risk of default on government debt. Second, we present a model of nominal sovereign debt with domestic risk-averse lenders. With procyclical inflation, nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. In the absence of default risk, procyclical inflation yields lower real rates. However, procyclicality implies that the government needs to make larger (real) payments when the economy deteriorates, which could increase default risk and trigger an increase in real rates. The patterns of real rates predicted by the model are quantitatively consistent with those documented in the data.

This paper studies optimal taxation of earnings when the degree of tax progressivity is allowed to vary with age. The setting is an overlapping-generations model that incorporates irreversible skill investment, flexible labor supply, ex-ante heterogeneity in the disutility of work and the cost of skill acquisition, partially insurable wage risk, and a life cycle productivity profile. An analytically tractable version of the model without intertemporal trade is used to characterize and quantify the salient trade-offs in tax design. The key results are that progressivity should be U-shaped in age and that the average marginal tax rate should be increasing and concave in age. These findings are confirmed in a version of the model with borrowing and saving that we solve numerically.

In standard approaches to monetary policy, interest rate rules often lead to indeterminacy. Sophisticated policies, which depend on the history of private actions and can differ on and off the equilibrium path, can eliminate indeterminacy and uniquely implement any desired competitive equilibrium. Two types of sophisticated policies illustrate our approach. Both use interest rates as the policy instrument along the equilibrium path. But when agents deviate from that path, the regime switches, in one example to money; in the other, to a hybrid rule. Both lead to unique implementation, while pure interest rate rules do not. We argue that adherence to the Taylor principle is neither necessary nor sufficient for unique implementation with pure interest rate rules but is sufficient with hybrid rules. Our results are robust to imperfect information and may provide a rationale for empirical work on monetary policy rules and determinacy.