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Working Papers

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

Recent Working Papers

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 develop a quantitative model of endogenous sovereign debt maturity choice and restructuring that captures key stylized facts of debt over the business cycle and during restructuring episodes, including the variation of haircuts, maturity extensions and default duration found in the data. We also find that policy interventions implementing minimum haircuts and redistributing losses away from holders of short term debt improve the outcome of distressed debt restructurings and reduce the frequency of debt distress events. Methodologically, the use of dynamic discrete choice solution methods allows us to smooth 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 Income Inequality and 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 increase income inequality and 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 at income-fertility profile would-through the equalization of initial conditions-reduce intergenerational persistence and income inequality by about 10%. 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.

International Credit Markets and Global Business Cycles

This paper stresses a new channel through which global financial linkages contribute to the co-movement in economic activity across countries. We show in a two-country setting with borrowing constraints that international credit markets are subject to self-fulfilling variations in the world real interest rate. Those expectation-driven changes in the borrowing cost in turn act as global shocks that induce strong cross-country co-movements in both financial and real variables (such as asset prices, GDP, consumption, investment and employment). When firms around the world benefit from unexpectedly low debt repayments today, they borrow and invest more, which leads to excessive supply of collateral and of loanable funds at a low interest rate, thus fueling a boom in both home and foreign economies. As a consequence, business cycles are synchronized internationally. Such a stylized model thus offers one way to rationalize both the existence of world business-cycle factor documented by recent empirical studies through dynamic factor analysis and such a factor’s intimate link to global financial markets.

Long and Plosser Meet Bewley and Lucas

We develop a N-sector business cycle network model a la Long and Plosser (1983), featuring heterogenous money demand a la Bewley (1980) and Lucas (1980). Despite incomplete markets and a well-defined distribution of real money balances across heteroge- neous households, the enriched N-sector network model remains analytically tractable with closed-form solutions up to the aggregate level. Relying on the tractability, we establish several important results: (i) The economy’s input-output network linkages become en- dogenously time-varying over the business cycle—thanks to the influence of the endogenous distribution of money demand on cross-sector allocations of commodities. (ii) Despite flex- ible prices, money is neither neutral nor superneutral and transitory monetary injections can generate highly persistent effects on sectoral output, thanks to the time-varying distri- bution of money demand and its effect on input-output coefficients. (iii) Although money injection is distributed equally across households by design, the real effects are asymmetric across production sectors, e.g., the impact of money is strongest on downstream sectors that purchase intermediate goods from the rest of the economy, but weakest on upstream sectors that supply intermediate goods to the other sectors, in sharp contrast to the case of sectoral technology shocks and government spending shocks. Our model also shows that movements in the distribution of money demand could be an important source of the measured labor wedge documented by the business cycle accounting literature.

National and Regional Housing Vacancy: Insights Using Markov-switching Models

Abstract We examine housing vacancy rates over time and space using Markov-switching models. Our theoretical analysis extends a standard search and matching model for housing by incorporating regime-switching behavior and interregional spillovers. Such an approach is strongly supported by our empirical results. Our estimations allow us to examine differences in vacancy rates as well as explore the possibility of asymmetries within and across housing markets, depending on the state/regime of a given housing market. Estimated vacancy rates, conditional on the vacancy regime, vary across regions in all models. Models allowing for interregional effects tend to perform better than models lacking this feature. These models track vacancies well. Noteworthy is their performance during the Great Recession/Financial Crisis. The importance and diversity of interregional effects are demonstrated, and vacancies in a specific Census region are affected by vacancies in other regions. Moreover, the sizes of these effects depend on the vacancy state of the specific region.

Designing UISAs for Developing Countries

The benefits of implementing Unemployment Insurance Savings Accounts (UISAs) are studied in the presence of the multiple sources of information frictions often existing in developing countries. A benchmark incomplete markets economy is calibrated to Mexico in the early 2000s. The unconstrained optimal allocation would imply very large welfare gains relative to the benchmark economy (similar to an increase in consumption of 23% in every period). More importantly, in presence of multiple sources of information frictions, about half of those potential gains can be accrued through the implementation of UISAs with replacement rates between 40-50%, contribution rates between 10-15%, an initial liquidity transfer of about 20 quarters of average income, and higher payroll taxes to finance those initial stocks.

Trade in Commodities and Business Cycle Volatility

This paper studies the role of the patterns of production and international trade on the higher business cycle volatility of emerging economies. We study a multi-sector small open economy in which firms produce and trade commodities and manufactures. We estimate the model to match key cross-sectional differences across countries: emerging economies run trade surpluses in commodities and trade deficits in manufactures, while sectoral trade flows are balanced in developed economies. We find that these differences amplify the response of emerging economies to fluctuations in commodity prices. We show evidence consistent with these findings using cross-country data.

Regional Consumption Responses and the Aggregate Fiscal Multiplier

We use regional variation in the American Recovery and Reinvestment Act (2009-2012) to analyze the e ect of government spending on consumer spending. Our consumption data come from household-level retail purchases in Nielsen and auto purchases from Equifax credit balances. We estimate that a $1 increase in county-level government spending increases consumer spending by $0.18. We translate the regional consumption responses to an aggregate fiscal multiplier using a multi-region, New Keynesian model with heterogeneous agents and incomplete markets. Our model successfully generates the estimated positive local multiplier, a result that distinguishes our incomplete markets model from models with complete markets. The aggregate consumption multiplier is 0.4, which implies an output multiplier higher than one. The aggregate consumption multiplier is almost twice the local estimate because trade linkages propagate government spending across regions.

Offshoring Barriers, Regulatory Burden and National Welfare

We present a model which considers both regulatory burden of offshoring barriers and possible terms of trade gains from such barriers. Non-tariff barriers are shown to be unambiguously welfare-reducing, and tariff barriers raise welfare only when associated terms-of-trade gains exceed resulting regulatory burdens, in which case there is a positive optimal offshoring tax. Otherwise, free trade is optimal. Welfare reductions from an offshoring tax are more likely with several developed nations engaging in offshoring. We derive and characterize the Nash equilibrium in such a case.

Monetary Policy and Liquid Government Debt

We examine the conduct of monetary policy in a world where the supply of outside money is controlled by the fiscal authority-a scenario increasingly relevant for many developed economies today. Central bank control over the long-run inflation rate depends on whether fiscal policy is Ricardian or Non-Ricardian. The optimal monetary policy follows a generalized Friedman rule that eliminates the liquidity premium on scarce treasury debt. We derive conditions for determinacy under both fiscal regimes and show that they do not necessarily correspond to the Taylor principle. In addition, Non-Ricardian regimes may suffer from multiplicity of steady-states when the government runs persistent deficits.

Escaping the Middle-income Trap —A Cross-Country Analysis on the Patterns of Industrial Upgrading

With rapid industrial upgrading along the global value chain of manufactured goods, China has transformed, within one generation, from an impoverished agrarian society to a middle-income nation as well as the largest manufacturing powerhouse in the world. This article identifies the pattern of China’s industrial upgrading and compares it with those of other successfully industrialized economies and the failed ones. We find that (i) China (since 1978) followed essentially the same path of industrial upgrading as that of Japan and the “Asian Tigers.” These economies succeeded in catching up with the developed western world by going through three developmental stages sequentially; namely, a proto-industrialization in the rural areas, a first industrial revolution featuring mass production of labor-intensive light consumer goods, and then a second industrial revolution featuring mass production of the means of mass production (i.e., capital-intensive heavy industrial good s such as steel, machine tools, electronics, automobiles, communication and transport infrastructures). (ii) In contrast, economies stuck in the low-income trap or middle-income trap did not follow the above sequential stages of industrialization. For example, many Eastern European and Latin American countries after WWII jumped to the stage of heavy industrialization without fully developing their labor-intensive light industries, and thus stagnated in the middle-income trap. Also, there is a clear lack of proto-industrialization in the rural areas for many African economies that have remained in the low-income trap. We believe that laissez-faire and “free market” alone is unable to trigger industrial upgrading. Instead, correct government-led bottom-up industrial policies are the key to escaping the low- and middle-income traps.

An Empirical Investigation of Direct and Iterated Multistep Conditional Forecasts

When constructing unconditional point forecasts, both direct- and iterated-multistep (DMS and IMS) approaches are common. However, in the context of producing conditional forecasts, IMS approaches based on vector autoregressions (VAR) are far more common than simpler DMS models. This is despite the fact that there are theoretical reasons to believe that DMS models are more robust to misspecification than are IMS models. In the context of unconditional forecasts, Marcellino, Stock, and Watson (MSW, 2006) investigate the empirical relevance of these theories. In this paper, we extend that work to conditional forecasts. We do so based on linear bivariate and trivariate models estimated using a large dataset of macroeconomic time series. Over comparable samples, our results reinforce those in MSW: the IMS approach is typically a bit better than DMS with significant improvements only at longer horizons. In contrast, when we focus on the Great Moderation sample we find a marked improvement in the DMS approach relative to IMS. The distinction is particularly clear when we forecast nominal rather than real variables where the relative gains can be substantial.

The (Unintended?) Consequences of the Largest Liquidity Injection Ever

We study the design of lender of last resort interventions and show that the provision of long-term liquidity incentivizes purchases of high-yield short-term securities by banks. Using a unique security-level data set, we find that the European Central Bank's three-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds that could be pledged to obtain central bank liquidity. This "collateral trade" effect is large, as banks purchased short-term bonds equivalent to 10.6% of amounts outstanding. The steepening of peripheral sovereign yield curves after the policy announcement is consistent with the equilibrium effects of the collateral trade.

The Persistence of Financial Distress

Using recently available proprietary panel data, we show that while many (35%) US consumers experience financial distress at some point in the life cycle, most of the events of financial distress are primarily concentrated in a much smaller proportion of consumers in persistent trouble. Roughly 10% of consumers are distressed for more than a quarter of the life cycle, and less than 10% of borrowers account for half of all distress events. These facts can be largely accounted for in a straightforward extension of a workhorse model of defaultable debt that accommodates a simple form of heterogeneity in time preference but not otherwise.

Banking on the Boom, Tripped by the Bust: Banks and the World War I Agricultural Price Shock

Bank lending booms and asset price booms are often intertwined. Although a fundamental shock might trigger an asset boom, aggressive lending can push asset prices higher, leading to more lending, and so on. Such a dynamic seems to have characterized the agricultural land boom surrounding World War I. This paper examines i) how banks responded to the asset price boom and how they were affected by the bust; ii) how various banking regulations and policies influenced those effects; and iii) how bank lending contributed to rising farm land values in the boom, and how bank closures contributed to falling prices in the bust. We find that rising crop prices encouraged bank entry and balance sheet expansion in agriculture counties. State deposit insurance systems amplified the impact of rising crop prices on the size and risk of bank portfolios, while higher minimum capital requirements dampened the effects. Further, increases in county farm land values and mortgage debt were correlated with the number of local banks ex ante and increases in bank loans during the boom. When farm land prices collapsed, banks that had responded most aggressively to the asset boom had a higher probability of closing, while counties with more bank closures experienced larger declines in land prices than can be explained by falling crop prices alone.

Financing Ventures

The relationship between venture capital and growth is examined using an endogenous growth model incorporating dynamic contracts between entrepreneurs and venture capitalists. At each stage of financing, venture capitalists evaluate the viability of startups. If viable, VCs provide funding for the next stage. The success of a project depends on the amount of funding. The model is confronted with stylized facts about venture capital; viz., the average cash-on-cash multiple and statistics by funding round concerning the success rate, failure rate, investment rate, equity shares, and the value of an IPO. Raising capital gains taxation reduces growth and welfare.

Markup Cyclicality: A Tale of Two Models

Many models in the business cycle literature generate counter-cyclical price markups. This paper examines if the prominent models in the literature are consistent with the empirical findings of micro-level markup behavior in Hong (2016). In particular, I test the markup behavior of the following two models: (i) an oligopolistic competition model, and (ii) a New Keynesian model with heterogeneous price stickiness. First, I explore the Atkeson and Burstein (2008) model of oligopolistic competition, in which markups are an increasing function of firm market shares. Coupled with an exogenous uncertainty shock as in Bloom (2009), i.e. a second-moment shock to firm productivities in recessions, this model results in a countercyclical average markup, as in the data. However, in contrast with the data, this model predicts that smaller firms reduce their markups. Second, I calibrate both Calvo and menu cost models of price stickiness to match the empirical heterogeneity in price dura tions across small and large firms, as in Goldberg and Hellerstein (2011). I find that both models can match the average counter-cyclicality of markups in response to monetary shocks. Furthermore, since small firms adjust prices less frequently, they exhibit greater markup counter-cyclicality, consistent with the empirical patterns. Quantitatively, however, only the menu cost model, through its selection effect, can match the extent of the empirical heterogeneity in markup cyclicality. In addition, both sticky price models imply pro-cyclical markup behavior in response to productivity shocks.

Customer Capital, Markup Cyclicality, and Amplification

This paper studies the importance of firm-level price markup dynamics for business cycle fluctuations. The first part of the paper uses state-of-the-art IO techniques to measure the behavior of markups over the business cycle at the firm level. I find that markups are countercyclical with an average elasticity of -0.9 with respect to real GDP, in line with the earlier industry-level evidence. Importantly, I find substantial heterogeneity in markup cyclicality across firms, with small firms having significantly more countercyclical markups than large firms. In the second part of the paper, I develop a general equilibrium model that matches these empirical findings and explore its implications for business cycle dynamics. In particular, I embed customer capital (due to deep habits as in Ravn, Schmitt-Grohe, and Uribe 2006) into a standard Hopenhayn (1992) model of firm dynamics with entry and exit. A key feature of the model is that a firm's decision about markups becomes dynamic {firms accumulate customer capital in the periods of fast growth by charging low markups, and choose to exploit it by charging high markups in the downturns. In particular, during recessions, the endogenous higher exit probability for smaller firms implies that they place lower weight on future profits, leading them to charge higher markups. This mechanism serves to endogenously increase the dispersion of firm sales and employment in recessions, a property that is consistent with the data. I further show that the resulting input misallocation amplifies both the volatility and persistence of the exogenous productivity shocks driving the business cycle.

Optimal fiscal policy in overlapping generations models

In this paper, we explore the proposition that the optimal capital income tax is zero using an overlapping generations model. We prove that for a large class of preferences, the optimal capital income tax along the transition path and in steady state is non-zero. For a version of the model calibrated to the US economy, we find that the model could justify the observed rates of capital income taxation for an empirically reasonable intertemporal utility function and a robust demographic structure.

Unconventional monetary policy and long yields during QE1: Learning from the shorts

In November 2008, the Federal Reserve announced the first of a series of unconventional monetary policies, which would include asset purchases and forward guidance, to reduce long-term interest rates. We investigate the behavior of shorts, considered sophisticated investors, before and after FOMC announcements not fully anticipated in spot bond markets. Short interest in Treasury and agency securities declined prior to expansionary anouncements, indicating shorts anticipated these surprises, and declined further after these announcements. The failure of shorts to reinstitute their positions after the last purchase announcement confirms that the Fed convinced sophisticated investors that interest rates would remain low.

Mortgage Debt, Consumption, and Illiquid Housing Markets in the Great Recession

Using a model with housing search, endogenous credit constraints, and mortgage default, this paper accounts for the housing crash from 2006 to 2011 and its implications for aggregate and cross-sectional consumption during the Great Recession. Left tail shocks to labor market uncertainty and tighter down payment requirements emerge as the key drivers. An endogenous decline in housing liquidity amplifies the recession by increasing foreclosures, contracting credit, and depressing consumption. Balance sheets act as a transmission mechanism from housing to consumption that depends on gross portfolio positions and the leverage distribution. Low interest rate policies accelerate the recovery in housing and consumption.

Knowledge diffusion, trade and innovation across countries and sectors

We develop and quantify a multi-country and multi-sector endogenous growth model in which comparative advantage and the stock of knowledge are endogenously determined by innovation and knowledge diffusion. We quantify the effect of trade liberalization on innovation, comparative advantage and welfare in a framework that features intersectoral production and knowledge linkages that are consistent with the data. A reduction in trade frictions induces a reallocation of innovation and comparative advantage across sectors: innovation reallocates towards sectors that experience larger increases in comparative advantage, and comparative advantage reallocates towards sectors with stronger knowledge spillovers. Furthermore, knowledge spillovers amplify the effect of a trade liberalization as countries and sectors benefit from foreign technology. In contrast to standard one sector models of trade and innovation without knowledge spillovers, we find significant dynamic gains from trad e. These gains are mainly driven by innovation and knowledge diffusion across sectors and countries.

The exchange rate as an instrument of monetary policy

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.

The Aggregate and Relative Economic Effects of Medicaid and Medicare Expansions

Government-financed health care (GFHC) expenditures, through Medicare and Medicaid, have grown from roughly zero to over 7.5 percent of national income over the past 50 years. Recently, some advocates (e.g., the Council of Economic Advisers (2014)) have argued that an expansion of GFHC (in particular Medicaid) has large positive employment effects. Using quarterly data between 1976 and 2016, this paper estimates the impact of GFHC spending on the unemployment rate by using an instrumental variables strategy that exploits exogenous variation in Medicare spending. We find that an exogenous GFHC expansion either increases or has no effect on the unemployment rate. Although the unemployment rate responses using aggregate data are estimated imprecisely, they are considerably sharper when estimated using state-level data. We also show the so-called relative (or local) multiplier approach based on the state-level panel provides similar estimates to those based on aggregate data. Finally, we show how the absence of a negative effect of GFHC expansions on the unemployment rate may be due to the implications these policies have for taxes across states.

Modeling Time-Varying Uncertainty of Multiple-Horizon Forecast Errors

We develop uncertainty measures for point forecasts from surveys such as the Survey of Professional Forecasters, Blue Chip, or the Federal Open Market Committee''''s Summary of Economic Projections. At a given point of time, these surveys provide forecasts for macroeconomic variables at multiple horizons. To track time-varying uncertainty in the associated forecast errors, we derive a multiple-horizon specification of stochastic volatility. Compared to constant-variance approaches, our stochastic-volatility model improves the accuracy of uncertainty measures for survey forecasts.

Flight to What?— ---Dissecting Liquidity Shortages in the Financial Crisis

We endogenize the liquidity and the quality of private assets in a tractable incomplete-market model with heterogeneous agents. The model decomposes the convenience yield of government bond into a "liquidity premium" (flight to liquidity) and a "safety premium" (flight to quality) over the business cycle. When calibrated to match the U.S. aggregate output fluctuations and bond premiums, the model reveals that a sharp reduction in the quality, instead of the liquidity, of private assets was the culprit of the recent financial crisis, consistent with the perception that it was the subprime mortgage problem that triggered the Great Recession. Since the provision of public liquidity endogenously affects the provision of private liquidity, our model indicates that excessive injection of public liquidity during financial crisis can be welfare reducing under either conventional or unconventional policies. In particular, too much intervention for too long can depress capital investment.

Optimal Ramsey Capital Income Taxation—A Reappraisal

This paper addresses a long-standing problem in the optimal Ramsey capital taxation literature. The tractability of our model enables us to solve the Ramsey problem analytically along the entire transitional path. We show that the conventional wisdom on Ramsey tax policy and its underlying intuition and rationales do not hold in our model and may thus be misrepresented in the literature. We uncover a critical trade off for the Ramsey planner between aggregate allocative efficiency in terms of the modified golden rule and individual allocative efficiency in terms of self-insurance. Facing the trade-off, the Ramsey planner prefers issuing debt rather than taxing capital if possible. In particular, the planner always intends to supply enough bonds to relax individuals'' borrowing constraints to achieve the modified golden rule by crowding out capital. A capital tax is not the optimal tool to achieve aggregate allocative efficiency, despite possible over-accumulation of capital. Thus, the optimal capital tax can be zero, positive, or even negative, depending on the Ramsey planner''s ability to issue debt. The modified golden rule can fail to hold whenever the government encounters a debt limit. Finally, the planner''s desire to relax individuals'' borrowing constraints may lead to unlimited debt accumulation, resulting in a dynamic path featuring no steady state.

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