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Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critical comment.

Recent Working Papers

Should the central bank issue e-money?

Should a central bank take over the provision of e-money, a circulable electronic liability? We discuss how e-money technology changes the tradeoff between public and private provision, and the tradeoff between e-money and a central bank's existing liabilities like bank notes and reserves. The tradeoffs depend on i) the technological setup of the e-money system (as a token or an account; centralized or decentralized); ii) the potential improvement in the implementation and transmission of monetary policy; iii) the risks to safety and privacy from cyber attacks; and iv) the uncertain impact on banks' efficiency and financial stability. The most compelling argument for central banks to issue e-money is to address competition problems in the banking sector.

The Founding of the Federal Reserve, the Great Depression and the Evolution of the U.S. Interbank Network

Financial network structure is an important determinant of systemic risk. This paper examines how the establishment of the Federal Reserve and Great Depression affected U.S. interbank network structure. Seeking liquidity sources, banks generally preferred to connect to Federal Reserve member banks in cities with Fed offices or clearinghouses. Overall network concentration declined initially as banks connected to Federal Reserve cities other than New York, but increased in the Depression. Banks that survived the Depression generally had higher percentages of connections to Federal Reserve cities and to correspondent banks that also survived.

Interbank Connections, Contagion and Bank Distress in the Great Depression

Liquidity shocks transmitted through interbank connections contributed to bank distress during the Great Depression. New data on interbank connections reveal that banks were much more likely to close when their correspondents closed. Further, after the Federal Reserve was established, banks’ management of cash and capital buffers was less responsive to network risk, suggesting that banks expected the Fed to reduce network risk. Because the Fed’s presence removed the incentives for the most systemically important banks to maintain capital and cash buffers that had protected against liquidity risk, it likely contributed to the banking system’s vulnerability to contagion during the Depression.

International Stock Comovements with Endogenous Clusters

We use an endogenous cluster factor model to examine international stock return comovements of country-industry portfolios. Our model allows country-industry portfolio comovements to be driven by a global and a cluster component, with the cluster membership endogenously determined. Results indicate that country-industry portfolios tend to cluster mainly within geographical areas that can include one or more countries. The cluster component was the main driver of country-industry portfolio returns for most of the sample, except from mid-2000 to mid-2010s when the global component had a more prominent role. At the end of the sample, a large cluster among European countries emerges.

The Baby Boomers and the Productivity Slowdown

The entry of baby boomers into the labor market in the 1970s slowed growth for physical and human capital per worker because young workers have little of both. Thus, the baby boom could have contributed to the 1970s productivity slowdown. I build and calibrate a model a la Huggett et al. (2011) with exogenous population and TFP to evaluate this theory. The baby boom accounts for 75% of the slowdown in the period 1964-69, 25% in 1970-74 and 2% in 1975-79. The retiring of baby boomers may cause a 2.8pp decline in productivity growth between 2020 and 2040, ceteris paribus.

The Nonlinear Effects of Uncertainty Shocks

We consider the effects of uncertainty shocks in a nonlinear VAR that allows uncertainty to have amplification effects. When uncertainty is relatively low, fluctuations in uncertainty have small, linear effects. In periods of high uncertainty, the effect of a further increase in uncertainty is magnified. We …find that uncertainty shocks in this environment have a more pronounced effect on real economic variables. We also conduct counterfactual experiments to determine the channels through which uncertainty acts. Uncertainty propagates through both the household consumption channel and through businesses delaying investment, providing substantial contributions to the decline in GDP observed after uncertainty shocks. Finally, we find evidence of the ability of systematic monetary policy to mitigate the adverse effects of uncertainty shocks.

Endogenous Debt Maturity: Liquidity Risk vs. Default Risk

We study the endogenous determination of corporate debt maturity in a setting with default risk. We assume that firms must access the bond market and they issue debt with a flexible structure (coupon, face value, and maturity). Initially, the firm is in a low growth/illiquid state that requires debt refinancing if it matures. Since lenders do not refinance projects with positive but small net present value, firms may be forced to default in the first phase. We call this liquidity risk. The technology is such that earnings can switch to a higher (but riskier) level. In this second phase firms have access to the equity market but they may default if this is the best option. We call this strategic default risk. In the model optimal maturity balances these two risks. We show that firms with poor prospects and firms in more unstable industries will choose shorter maturities even if it is feasible to issue longer debt. The model also offers predictions on how asset maturity, asset salability, and leverage influence maturity. Even though our model is extremely stylized we find that the predictions are roughly consistent with the evidence. Moreover, it offers some insights into the factors that determine the structure of the debt.

News, sovereign debt maturity, and default risk

Leading into a debt crisis, interest rate spreads on sovereign debt rise before the economy experiences a decline in productivity, suggesting that news may play an important role in these episodes. The empirical evidence also shows that a news shock has a significantly larger contemporaneous impact on sovereign credit spreads than a comparable shock to labor productivity. We develop a quantitative model of news and sovereign debt default with endogenous maturity choice that generates impulse responses very similar to the empirical estimates. The model allows us to interpret the empirical evidence and to identify key parameters. We find that, first, the increase in sovereign yield spreads around a debt crisis episode is due mostly to the lower expected productivity following a bad news shock, and not to the borrowing choices of the government. Second, a shorter debt maturity increases the chance that bad news shocks trigger a debt crisis. Third, an increase in the precision of news allows the government to improve its debt maturity management, especially during periods of high financial stress, and thus face lower spreads and default risk while holding the amount of debt constant.

Resource Curse or Blessing? Sovereign Risk in Resource-Rich Emerging Economies

In this paper we document the stylized facts about the relationship between international oil price swings, sovereign risk and macroeconomic performance of oil-exporting economies. We show that even though being a bigger oil producer decreases sovereign risk–because it increases a country’s ability to repay–having more oil reserves increases sovereign risk by making autarky more attractive. We develop a small open economy model of sovereign risk with incomplete international financial markets, in which optimal oil extraction and sovereign default interact. We use the model to understand the mechanisms behind the empirical facts, and show that it supports them.

Capital Gains Taxation and Investment Dynamics

This paper quantifies the long-run effects of reducing capital gains taxes on aggregate investment. We develop a dynamic general equilibrium model with heterogeneous firms, which face discrete capital gains tax rates based on their firm size. We calibrate our model by targeting important micro moments as well as the difference-in-differences estimate of the capital elasticity based on our institutional setting in Korea. We find that the firm-size reform that reduced the capital gains tax rates from 24 percent to 10 percent for the affected firms increased aggregate investment by 1.61 percent in the steady state, with the short-run effects overstating the effects by 1 percentage points. Additionally, a counterfactual analysis where we set the uniformly low tax rate of 10 percent reveals that aggregate investment rose by 6.89 percent in the long-run. We also find that general equilibrium effects through prices are substantial in our simulation. Taken together, our findings suggest that reducing capital gains tax rates would substantially increase investment in the short-term, and accounting for dynamic and general equilibrium responses is important for understanding the aggregate effects of capital gains taxes.

The Real Term Premium in a Stationary Economy with Segmented Asset Markets

This paper proposes an equilibrium model to explain the positive and sizable term premia observed in the data. We introduce a slow mean-reverting process of consumption growth and a segmented asset market mechanism with heterogeneous trading technology to otherwise a standard heterogeneous agent general equilibrium model. First, a slow mean-reverting consumption growth process implies that the expected consumption growth rate is only slightly countercyclical and the process can exhibit a near zero first-order autocorrelation as seen in the data. The very small countercyclicality of the expected consumption growth rate suggests that the long term bonds are risky and hence the term premia are positive. Second, the segmented asset market mechanism amplifies the size and the magnitude of term premia since the aggregate risk is concentrated into a small fraction of marginal traders who demand high risk premia. For sensitivity analysis, the role of each assumption is further investigated by taking each factor out one by one.

The Macroeconomic Consequences of Early Childhood Development Policies

To study long-run large-scale early childhood policies, this paper incorporates early childhood investments into a standard general-equilibrium (GE) heterogeneous-agent overlapping-generations model. After estimating it using US data, we show that an RCT evaluation of a short-run small-scale early childhood program in the model predicts effects on children's education and income that are similar to the empirical evidence. A long-run large-scale program, however, yields twice as large welfare gains, even after considering GE and taxation effects. Key to this difference is that investing in a child not only improves her skills but also creates a better parent for the next generation.

Superstar Economists: Coauthorship networks and research output

We study the impact of research collaborations in coauthorship networks on research output and how optimal funding can maximize it. Through the links in the collaboration network, researchers create spillovers not only to their direct coauthors but also to researchers indirectly linked to them. We characterize the equilibrium when agents collaborate in multiple and possibly overlapping projects. We bring our model to the data by analyzing the coauthorship network of economists registered in the RePEc Author Service. We rank the authors and research institutions according to their contribution to the aggregate research output and thus provide a novel ranking measure that explicitly takes into account the spillover effect generated in the coauthorship network. Moreover, we analyze funding instruments for individual researchers as well as research institutions and compare them with the economics funding program of the National Science Foundation. Our results indicate that, because current funding schemes do not take into account the availability of coauthorship network data, they are ill-designed to take advantage of the spillover effects generated in scientific knowledge production networks.

Reconciling Orthodox and Heterodox Views on Money and Banking

A wide range of heterodox theories claim that banks are special because they create money in the act of lending. Put another way, banks can create the funding they need ex nihilo, whereas all other agencies must first acquire the funding they need from other parties. Mainstream economic theory largely agrees with this assessment, but questions its theoretical and empirical relevance, preferring to view banks as one of many potentially important actors in the financial market. In this paper, I develop a formal economic model in an attempt to make these ideas precise. The model lends some support to both views on banking.

Assessing the Impact of Central Bank Digital Currency on Private Banks

I investigate the theoretical impact of central bank digital currency (CBDC) on a monopolistic banking sector. The framework combines the Diamond (1965) model of government debt with the Klein (1971) and Monti (1972) model of banking. There are two main results. First, the introduction of interest-bearing CBDC increases financial inclusion, diminishing the demand for physical cash. Second, while interest-bearing CBDC reduces monopoly profit, it need not disintermediate banks in any way. CBDC may, in fact, lead to an expansion of bank deposits if CBDCcompetition compels banks to raise their deposit rates.

Understanding Lowflation

Central banks are viewed as having a demonstrated ability to lower long-run inflation. Since the financial crisis, however, the central banks in some jurisdictions seem almost powerless to accomplish the opposite. In this article, we offer an explanation for why this may be the case. Because central banks have limited instruments, long-run inflation is ultimately determined by fiscal policy. Central bank control of long-run inflation therefore ultimately hinges on its ability to gain fiscal compliance with its objectives. This ability is shown to be inherently easier for a central bank determined to lower inflation than for a central bank determined to accomplish the opposite. Among other things, the analysis here suggests that for the central banks of advanced economies, any stated inflation target is more credibly viewed as a ceiling.

Fiscal Multipliers and Financial Crises

I study the macroeconomic effects of the US fiscal policy response to the Great Recession, accounting not only for standard tools such as government purchases and transfers but also for financial sector interventions such as bank recapitalizations and credit guarantees. A global solution to a quantitative model calibrated to the US allows me to study the state-dependent effects of different types of fiscal policies. I combine the model with data on the US fiscal policy response to find that the fall in aggregate consumption would have been twice as worse in the absence of that response with a cumulative loss of 14.5%. Transfers and bank recapitalizations yielded the largest fiscal multipliers at the height of the crisis through new transmission channels that arise from linkages between household and bank balance sheets.

Why did Rich Families Increase their Fertility? Inequality and Marketization of Child Care

A negative relationship between income and fertility has persisted for so long that its existence is often taken for granted. One economic theory builds on this relationship and argues that rising inequality leads to greater differential fertility between rich and poor. We show that the relationship between income and fertility has flattened between 1980 and 2010 in the US, a time of increasing inequality, as high income families increased their fertility. These facts challenge the standard theory. We propose that marketization of parental time costs can explain the changing relationship between income and fertility. We show this result both theoretically and quantitatively, after disciplining the model on US data. We explore implications of changing differential fertility for aggregate human capital. Additionally, policies, such as the minimum wage, that affect the cost of marketization, have a negative effect on the fertility and labor supply of high income women. We end by discussing the insights of this theory to the economics of marital sorting.

On the Benefits of Currency Reform

Money allows agents to achieve allocations that are not possible without it. How- ever, currency in most economies is a uniform object, and there may be incentive compatible allocations that cannot be implemented with a uniform currency. We show that currency reform, ie, changing the monetary base by replacing one currency with another, is a powerful tool that can enable a planner to achieve his desired allocation. Our monetary mechanism with currency reform is anonymous and features nonlinear pricing of consumption goods and future assets, as observed in practice. Our result suggests that currency reform is rarely seen in practice precisely because it is such a powerful tool and none but the most benevolent planner can be trusted to use it wisely.

Insurance and Inequality with Persistent Private Information

We study optimal insurance contracts for an agent with Markovian private information. Our main results characterize the implications of constrained efficiency for long-run welfare and inequality. Under minimal technical conditions, there is Absolute Immiseration: in the long run, the agent’s consumption and utility converge to their lower bounds. When types are persistent and utility is unbounded below, there is Relative Immiseration: low-type agents are immiserated at a faster rate than high-type agents, and “pathwise welfare inequality” grows without bound. These results extend and substantially generalize the hallmark findings from the classic literature with iid types, suggesting that the underlying forces are robust to a broad class of private information processes. The proofs rely on novel recursive techniques and martingale arguments. When the agent has CARA utility, we also analytically and numerically characterize the short-run properties of the optimal contract. Persistence gives rise to qualitat- ively novel short-run dynamics and allocative distortions (or “wedges”) and, quantitatively, induces less efficient risk-sharing. We compare properties of the wedges to their counterparts in the dynamic taxation literature.

The 2008 U.S. Auto Market Collapse

​New vehicle sales in the U.S. fell nearly 40 percent during the last recession, causing significant job losses and unprecedented government interventions in the auto industry. This paper explores two potential explanations for this decline: falling home values and falling households' income expectations. First, we establish that declining home values explain only a small portion of the observed reduction in vehicle sales. Using a county-level panel from the episode, we find: (1) A one-dollar fall in home values reduced new vehicle spending by about 0.9 cents; and (2) Falling home values explain approximately 19 percent of the aggregate vehicle spending decline. Next, examining state-level data from 1997-2016, we find: (3) The short-run responses of vehicle consumption to home value changes are larger in the 2005-2011 period relative to other years, but at longer horizons (e.g. 5 years), the responses are similar across the two sub-periods; and (4) The service flow from vehicles, as measured from miles traveled, responds very little to house price shocks. We also detail the sources of the differences between our findings (1) and (2) from existing research. Second, we establish that declining current and expected future income expectations played an important role in the auto market's collapse. We build a permanent income model augmented to include infrequent, repeated car buying. Our calibrated model matches the pre-recession distribution of auto vintages and exhibits a large vehicle sales decline in response to a moderate decline in expected permanent income. In response to the decline in permanent income, households delay replacing existing vehicles, allowing them smooth the effects of the income shock without significantly adjusting the service flow from their vehicles. Combining our negative results regarding housing wealth with our positive model-based findings, we interpret the auto market collapse as consistent with existing permanent income based approaches to durable goods consumption (e.g., Leahy and Zeira (2005)).

Imperfect Information Transmission from Banks to Investors: Macroeconomic Implications

We study the interaction of information transmission in loan-backed asset markets and screening effort in a general equilibrium framework. Originating banks can screen their borrowers, but can inform investors of their asset type only through an error-prone rating technology. The premium paid on highly rated assets emerges as the main determinant of screening effort. Because the rating technology is imperfect, this premium is insufficient to induce the efficient level of screening. However, the fact that banks know their asset quality and produce public information accordingly helps keep the premium high. Mandatory rating and mandatory ratings disclosure policies interfere with this decision margin, thereby reducing informativeness of high ratings, lowering the premium paid on them, and exacerbating the credit misallocation problem. Policies that work to increase accuracy and/or cost of rating technology can help restore efficiency. If, as in Skreta and Veldkamp (2009), we associate the expansion leading up to the recent financial crisis with declining rating accuracy, our model helps interpret several puzzling pre-crisis observations: laxer screening effort, intensified rating activity, ratings inflation, the decline in the premium paid on highly rated assets, and rising prevalence of triple-A ratings. The same model mechanism also helps explain the variation in default rates across asset classes documented in Cornaggia, Cornaggia, and Hund (2017).

A Search-Based Neoclassical Model of Capital Reallocation

As a form of investment, the importance of capital reallocation between …firms has been increasing over time, with the purchase of used capital accounting for 25% to 40% of …firms’ total investment nowadays. Cross-…firm reallocation of used capital also exhibits intriguing business-cycle properties, such as (i) the illiquidity of used capital is countercyclical (or the quantity of used capital reallocation across …rms is procyclical), (ii) the prices of used capital are procyclical and more so than those of new capital goods, and (iii) the dispersion of …firms' ’TFP or MPK (or the bene…t of capital reallocation) is countercyclical. We build a search-based neoclassical model to qualitatively and quantitatively explain these stylized facts. We show that search frictions in the capital market are essential for our empirical success but not sufficient—---fi…nancial frictions and endogenous movements in the distribution of …rm-level TFP (or MPK) and interactions between used-capital investment and new investment are also required to simultaneously explain these stylized facts, especially that prices of used capital are more volatile than that of new investment and the dispersion of …firm TFP is countercyclical.

Bank runs without sequential service

Banking models in the tradition of Diamond and Dybvig (1983) rely on sequential service to explain belief driven runs. But the run-like phenomena witnessed during the …nancial crisis of 2007–08 occurred in the wholesale shadow banking sector where sequential service is largely absent. This suggests that something other than sequential service is needed to help explain runs. We show that in the absence of sequential service runs can easily occur whenever bank-funded in- vestments are subject to increasing returns to scale consistent with available evidence. Our framework is used to understand and evalu- ate recent banking and money market regulations.

Financial Development and International Trade

This paper studies the industry-level and aggregate implications of fi nancial development on international trade. I set up a multi-industry general equilibrium model of international trade with heterogeneous fi rms subject to fi nancial frictions. Industries differ in capital-intensity, which leads to differences in external fi nance dependence. The model is parameterized to match key features of fi rm-level data. Financial development leads to substantial reallocation of international trade shares from labor- to capital-intensive industries, with minor effects at the aggregate-level. These fi ndings are consistent with estimates from cross-country industry-level and aggregate data.

Majority Voting in a Model of Means Testing

We study a model of endogenous means testing where households differ in their income and where the in-kind transfer received by each household declines linearly with income. Majority voting determines the two dimensions of public policy: the size of the welfare program and the means-testing rate. We establish the existence of a sequential majority voting equilibrium, when the households vote first on the size of the program and then on the means-testing rate. We show that the means-testing rate increases with the size of the program but the fraction and the identity of the households receiving the transfers are independent of the program size.

Sovereign Debt Restructurings

Sovereign debt crises generally involve debt restructurings characterized by a mix of face-value haircuts and debt maturity extensions. We present new evidence on maturity extensions in distressed restructurings and develop a new quantitative model of endogenous sovereign debt restructuring that captures important stylized facts of debt over the business cycle and during restructuring episodes, helping to identify key ingredients that generate maturity extensions. We also find that policy interventions implementing minimum haircuts and equalizing losses across holders of different maturities are welfare enhancing as they facilitate maturity extensions in restructurings. Methodologically, the use of dynamic discrete choice solution methods allows for smoother decision rules on default and debt portfolio choices, rendering the problem tractable.

Long-Term Finance and Investment with Frictional Asset Markets

This paper develops a theory of investment and maturity choices and studies its implications for the macroeconomy. The novel ingredient is an explicit secondary market with trading frictions which leads to a liquidity spread which increases with maturity and generates an upward sloping yield curve. As a result, trading frictions induce firms to borrow and invest at shorter horizons than in a frictionless benchmark. Economies with more severe frictions exhibit a steeper yield curve which further affects maturity and investment choices of rms. A model calibrated to match cross-country moments suggests that reductions in trading frictions-a new channel of financial development-can promote economic development. A policy intervention with government-backed financial intermediaries in the secondary market can improve liquidity and reduce the cost of long-term finance which promotes investment in longer-term projects and generates substantial welfare gains.

Explaining Intergenerational Mobility: The Role of Fertility and Family Transfers

Poor families have more children and transfer less resources to them. This suggests that family decisions about fertility and transfers dampen intergenerational mobility. To evaluate the quantitative importance of this mechanism, we extend the standard heterogeneous-agent life-cycle model with earnings risk and credit constraints to allow for endogenous fertility, family transfers, and education. The model, estimated to the US in the 2000s, implies that a counterfactual flat income-fertility profile would-through the equalization of initial conditions-increase intergenerational mobility by 7%. The impact of a counterfactual constant transfer per child is twice as large.

Retail Prices: New Evidence From Argentina

We create a new database of retail prices in Argentina with over 10 million observations per day. Our main novel finding is that, different from Kaplan, Menzio, Rudanko, and Trachter (2016), chains, rather than stores, explain most of the price variation in our data. We show this in three ways: (a) Even though chains have on average 158 stores, there are on average less than 2.5 unique prices per product by chain; (b) Among products that change prices in one store, the probability that other stores of the same chain also change the price of the same product in the same day is 2.4 times the probability for other stores of any chain; and (c) A formal variance decomposition shows that only 28% of the price dispersion (for the same product, day, and city) is explained by stores setting different prices within a chain. This finding is relevant for retail-pricing theories since there are significantly fewer chains than stores, which matters for the degree of competition in the market. This paper also studies the heterogeneity in price changes and price dispersion across product categories.


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