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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

Labor Market Policies During an Epidemic

We study the effects and welfare implications of labor market policies that counteract the economic fall out from containment policies during an epidemic. We incorporate a standard epidemiological model into an equilibrium search model of the labor market to compare unemployment insurance (UI) expansions and payroll subsidies. In isolation, payroll subsidies that preserve match capital and enable a swift economic recovery are preferred over a cost-equivalent UI expansion. When considered jointly, however, a cost-equivalent optimal mix allocates 20 percent of the budget to payroll subsidies and 80 percent to UI. The two policies are complementary, catering to different rungs of the productivity ladder. The small share of payroll subsidies is sufficient to preserve high-productivity jobs, but leaves room for social assistance to workers who face inevitable job loss.

Job Applications and Labor Market Flows

Unemployment inflows have declined sharply since the 1980s while unemployment outflows have remained mostly steady despite a rise in workers' applications over time. Using a random search model of multiple applications with costly information, we show how rising applications incentivize more firms to acquire information, improving the realized distribution of match qualities. Higher concentrations of high productivity matches reduce the incidence of endogenous separations, causing unemployment inflow rates to fall. Quantitatively, our model replicates the relative change in inflow and outflow rates as well as the decline in acceptance rates, job offers and the rise in reservation wages.

Managing a New Policy Framework: Paul Volcker, the St. Louis Fed, and the 1979-82 War on Inflation

In October 1979, Federal Reserve Chairman Paul Volcker persuaded his FOMC colleagues to adopt a new policy framework that i) accepted responsibility for controlling inflation and ii) implemented new operating procedures to control the growth of monetary aggregates in an effort to restore price stability. These moves were strongly supported by monetarist-oriented economists, including the leadership and staff of the Federal Reserve Bank of St. Louis. The next three years saw inflation peak and then fall sharply, but also two recessions and considerable volatility in interest rates and money supply growth rates. This article reviews the episode through the lens of speeches and FOMC meeting statements of Volcker and St. Louis Fed president Lawrence Roos, and articles by Roos’ staff. The FOMC adopted monetarist principles to establish the Fed’s anti-inflation credibility but Volcker was willing to accept deviations of money growth from the FOMC’s targets, unlike Roos, who viewed the targets as sacrosanct. The FOMC abandoned monetary aggregates in October 1982, but preserved the Fed’s commitment to price stability. The episode illustrates how Volcker used a change in operating procedures to alter policy fundamentally, and later adapt the procedures to changed circumstances without abandoning the foundational features of the policy.

Inequality in the Welfare Costs of Disinflation

We use an incomplete markets economy to quantify the distribution of welfare gains and losses of the US "Volcker" disinflation. In the long run households prefer low inflation, but disinflation requires a transition period and a redistribution from net nominal borrowers to net nominal savers. Even with perfectly flexible prices, welfare costs may be significant for households with nominal liabilities. When calibrated to match the micro and macro moments of the early 1980s high inflation environment, almost half of all borrowers (14 percent of all households) would prefer to avoid the redistribution and equilibrium effects of the disinflation. This share depends negatively on the liquidity value of money and positively on the average duration of nominal borrowing.

The Geography of Business Dynamism and Skill Biased Technical Change

This paper seeks to explain three key components of the growing regional disparities in the U.S. since 1980, referred to as the Great Divergence by Moretti (2012). Namely, big cities saw a larger increase in the relative wages of skilled workers, a larger increase in the relative supply of skilled workers, and a smaller decline in business dynamism. These trends can be explained by differences across cities in the extent to which firms adopt new skill-biased technologies. In response to the introduction of a new skill-biased, high fixed cost but low marginal cost technology, firms endogenously adopt more in big cities, in cities that offer abundant amenities for high-skilled workers and in cities that are more productive in using high-skilled labor. The differences in adoption can account for the increasing relationship between skill intensity and city size, the divergence of the city size wage premium by skill group and the changing cross sectional patterns of business dynamism. I document a new fact that firms in big cities invest more in Information and Communication Technology per employee than firms in small cities,consistent with patterns of technology adoption in the model.

Hot Money for a Cold Economy

What is the theoretical justification for taxing unspent money transfers in a recession? To examine this question, I study a model economy where fiat money is necessary as a medium of exchange and, incidentally, serves as a store of value. This latter property is shown to open the door to business cycles and depressions driven entirely by speculation. Unconditional money transfers do not guarantee escape from a psychologically-induced depression. I demonstrate how money transfers subject to a short expiration date do eliminate speculative equilibria. This hot money policy compares favorably to negative interest rate policy because the latter taxes all money savings whereas the former only threatens to tax gifted money.

On the Essentiality of Credit and Banking at the Friedman Rule

We investigate the essentiality of credit and banking in a microfounded monetary model in which agents face heterogeneous idiosyncratic time preference shocks. Three main results arise from our analysis. First, the constrained-efficient allocation is unattainable without banks. Second, financial intermediation can improve the equilibrium allocation even at the Friedman rule because it relaxes the liquidity constraints of impatient borrowers. Third, changes in credit conditions are not necessarily neutral in a monetary equilibrium at the Friedman rule. If the debt limit is sufficiently low, money and credit are perfect substitutes and tightening the debt limit is neutral. As the debt limit increases, however, patient agents always hold money but impatient agents prefer not to since it is costly for them to do so given they are facing a positive shadow rate. Borrowing instead is costless when interest rates are zero and increasing the debt limit improves the allocation.

Seigniorage and Sovereign Default: The Response of Emerging Markets to COVID-19

Monetary policy affects the tradeoffs faced by governments in sovereign default models. In the absence of lump-sum taxation, governments rely on both distortionary taxes and seigniorage to finance expenditure. Furthermore, monetary policy adds a time-consistency problem in debt choice, which may mitigate or exacerbate the incentives to accumulate debt. A deterioration of the terms-of-trade leads to an increase in sovereign-default risk and inflation, and a reduction in growth, which are consistent with the empirical evidence for emerging economies. An unanticipated shock resembling the COVID-19 pandemic generates a significant currency depreciation, increased inflation, and distress in government finances.

A New Daily Federal Funds Rate Series and History of the Federal Funds Market, 1928-1954

This article describes the origins and development of the federal funds market from its inception in the 1920s to the early 1950s. We present a newly digitized daily data series on the federal funds rate from April 1928 through June 1954. We compare the behavior of the funds rate with other money market interest rates and the Federal Reserve discount rate. Our federal funds rate series will enhance the ability of researchers to study an eventful period in U.S. financial history and to better understand how monetary policy was transmitted to banking and financial markets. For the 1920s and 1930s, our series is the best available measure of the overnight risk-free interest rate, better than the call money rate which many studies have used for that purpose. For the 1940s-1950s, our series provides new information about the transition away from wartime interest-rate pegs culminating in the 1951 Treasury-Federal Reserve Accord.

Counterterrorism Policy: Spillovers, Regime Stability, and Corner Solutions

This paper takes a unique approach to the scenario where a resident terrorist group in a (fragile) developing nation poses a terrorism threat at home and abroad. The host developing nation’s proactive countermeasures against the resident terrorist group not only limits terrorism at home and abroad, but also bolsters regime stability at home. A two-stage game is presented in which the developed country takes a leadership role to institute a tax-subsidy combination to discourage (encourage) proactive measures at home (abroad) in stage 1. Stage 2 involves both nations’ counterterrorism choices under alternative stage-1 public-policy packages. Unlike the extant literature, we explore corner and interior solutions in both stages based on the terrorists’ targeting preferences and the host nation’s regime-stability preferences. Surprisingly, the developed nation may profit from policy packages that reduce global counterterrorism while raising global terrorism. This outcome and others involve engineered counterterrorism burden shifting.

A Local-Spillover Decomposition of the Causal Effect of U.S. Defense Spending Shocks

This paper decomposes the causal effect of government defense spending into: (i) a local (or direct) effect, and (ii) a spillover (or indirect) effect. Using state-level defense spending data, we show that a negative cross-state spillover effect explains the existing simultaneous findings of a low aggregate multiplier and a high local multiplier. We show that enlisting disaggregate data improves the precision of aggregate effect estimates, relative to using aggregate time series alone. Moreover, we compare two-step efficient GMM with two alternative moment weighting approaches used in existing research.

Endogenous Social Distancing in an Epidemic

I present a model where work implies social interactions and the spread of a disease is described by an SIR-type framework where both susceptible and infectious are asymptomatic. Upon the outbreak of a disease a lower contact rate can be achieved at the cost of lower consumption. Individuals do not internalize the effects of their decisions on the evolution of the epidemic while the planner does. Specifically, the planner internalizes that a low contact rate early in the epidemic implies a low stock of infectious in the future; and a low stock of infectious in the future permits an increase in the contact rate without risking additional infections. Since a low contact rate is associated with low consumption, the planner effectively substitutes consumption early in the epidemic for consumption later. The individual's response does not, hence the planner obtains a flatter infection curve than that generated by the individual's' response, even though the planner's objective is not to ``flatten the curve.''

Shadow Bank Runs

Short-term debt is commonly used to fund illiquid assets. A conventional view asserts that such arrangements are run-prone in part because redemptions must be processed on a first-come, first-served basis. This sequential service protocol, however, appears absent in the wholesale banking sector---and yet, shadow banks appear vulnerable to runs. We explain how banking arrangements that fund fixed-cost operations using short-term debt can be run-prone even in the absence of sequential service. Interventions designed to eliminate run risk may or may not improve depositor welfare. We describe how optimal policies vary under different conditions and compare these to recent policy interventions by the Security and Exchange Commission and the Federal Reserve. We conclude that the conventional view concerning the societal benefits of liquidity transformation and its recommendations for prudential policy extend far beyond their application to depository institutions.

Measuring Labor Supply and Demand Shocks during COVID-19

We measure labor demand and supply shocks at the sector level around the COVID-19 outbreak by estimating a Bayesian structural vector autoregression on monthly statistics of hours worked and real wages. Most sectors were subject to historically large negative labor supply and demand shocks in March and April, with substantial heterogeneity in the size of shocks across sectors. Our estimates suggest that two-thirds of the drop in the aggregate growth rate of hours in March and April 2020 are attributable to labor supply. We validate our estimates of supply shocks by showing that they are correlated with sectoral measures of telework.

International Trade of Essential Goods During a Pandemic

This paper studies the role of international trade of essential goods during a pandemic. We consider a multi-country, multi-sector model with essential and non-essential goods. Essential goods provide utility relative to a reference consumption level, and a pandemic consists of an increase in this reference level. Each country produces domestic varieties of both types of goods using capital and labor subject to sectoral adjustment costs, and all varieties are traded internationally subject to trade barriers. We study the role of international trade of essential goods in mitigating or amplifying the impact of a pandemic. We find that the effects depend crucially on the countries' trade imbalances in essential goods. Net importers of these goods are relatively worse off during a pandemic than net exporters. The welfare losses of net importers are lower in a world with high trade barriers, while the reverse is the case for net exporters. Yet, once a pandemic arrives, net exporters of essential goods benefit from an increase in trade barriers, while net importers benefit from a decrease in them. These findings are consistent with preliminary evidence on changes in trade barriers across countries during the COVID-19 pandemic.

Scarring Body and Mind: The Long-Term Belief-Scarring Effects of COVID-19

The largest economic cost of the COVID-19 pandemic could arise if it changed behavior long after the immediate health crisis is resolved. A common explanation for such a long-lived effect is the scarring of beliefs. We show how to quantify the extent of such belief changes and determine their impact on future economic outcomes. We find that the long-run effect of the COVID crisis depends crucially on whether bankruptcies and changes in habit make existing capital obsolete. A policy that avoided most permanent separation of workers from capital could generate a much larger benefit than originally thought, that could easily be 180% of annual GDP, in present value.

Maturity Structure and Liquidity Risk

This paper studies the optimal maturity structure for government debt when markets for liquidity insurance are incomplete or non-competitive. There is no fiscal risk. Government debt in the model solves a dynamic inefficiency. Issuing debt in short and long maturities solves a liquidity insurance problem, but optimal yield curve policy is only possible if long-duration debt is rendered illiquid. Optimal policy is implementable through treasury operations only--adjustments in the primary deficit are not necessary.

Are Government Bonds Net Wealth or a Liability? ---Optimal Debt and Taxes in an OLG Model with Uninsurable Income Risk

The rapidly growing national debt in the U.S. since the 1970s has alarmed and intrigued the academic world. Consequently, the concept of dynamic (in)efficiency in an overlapping generations (OLG) world and the importance of the heterogeneous-agents and incomplete markets (HAIM) hypothesis to justify a high debt-to-GDP ratio have been extensively studied. Two important consensus emerge from this literature: (i) The optimal quantity of public debt is positive—due to insufficient private liquidity to support private saving and investment (see, e.g., Barro (1974), Woodford (1990), and Aiyagari and McGrattan (1998)); (ii) the optimal capital tax is positive—because of precautionary saving and the consequent failure of the modified golden rule (see, e.g., Aiyagari (1995)). But these two consensus views are seldom derived jointly in the same model, so the dynamic relationship between optimal debt and optimal taxation remains unclear in HAIM models, especially considering that the optimal quantity of debt must be judged by the golden-rule saving rate and any debt must be financed by future taxes. We use a primal Ramsey approach to analytically characterize optimal debt and tax policy in an OLG-HAIM model. We show that since precautionary saving and oversaving are not necessarily the same thing, they have different policy implications—the Ramsey planner opts to issue bonds to crowd out private savings if and only if a competitive equilibrium is dynamically inefficient regardless of precautionary savings. In other words, optimal debt can be negative even if households cannot insure themselves against idiosyncratic risk under borrowing constraints. The sign and magnitude of the optimal quantity of debt in turn dictate the sign and magnitude of optimal taxes as well as the priority order of tax tools such as a labor tax vs. a capital tax.

Fiscal Policy during a Pandemic

I study the effects of the 2019-20 coronavirus outbreak in the United States and subsequent fiscal policy response in a nonlinear DSGE model. The pandemic is a shock to the utility of contact-intensive services that propagates to other sectors via general equilibrium, triggering a deep recession. I use a calibrated version of the model to analyze different types of fiscal policies. I find that UI benefits are the most effective tool to stabilize income for borrowers, who are the hardest hit, while savers may favor unconditional transfers. Liquidity assistance programs are effective if the policy objective is to stabilize employment in the affected sector. I also study the effects of the $2 trillion CARES Act of 2020.

FRED-QD: A Quarterly Database for Macroeconomic Research

In this paper we present and describe a large quarterly frequency, macroeconomic database. The data provided are closely modeled to that used in Stock and Watson (2012a). As in our previous work on FRED-MD, our goal is simply to provide a publicly available source of macroeconomic “big data” that is updated in real time using the FRED database. We show that factors extracted from this data set exhibit similar behavior to those extracted from the original Stock and Watson data set. The dominant factors are shown to be insensitive to outliers, but outliers do affect the relative influence of the series as indicated by leverage scores. We then investigate the role unit root tests play in the choice of transformation codes with an emphasis on identifying instances in which the unit root-based codes differ from those already used in the literature. Finally, we show that factors extracted from our data set are useful for forecasting a range of macroeconomic series and that the choice of transformation codes can contribute substantially to the accuracy of these forecasts.

The 2008 U.S. Auto Market Collapse

New vehicle sales in the U.S. fell nearly 40 percent during the past recession, causing significant job losses and unprecedented government interventions in the auto industry. This paper explores three potential explanations for this decline: increasing oil prices, falling home values, and falling household income expectations. First, we use the historical macroeconomic relationship between oil prices and vehicle sales to show that the oil price spike explains roughly 15 percent of the auto sales decline between 2007 and 2009. Second, we establish that declining home values explain only a small portion of the observed reduction in household new vehicle sales. Using a county-level panel from the episode, we find (1) a one-dollar fall in home values reduced household new vehicle spending by 0.5 to 0.7 cents and overall new vehicle spending by 0.9 to 1.2 cents and (2) falling home values explain between 16 and 19 percent of the overall new vehicle spending decline. Next, examining state-level data for 1997-2016, we find (3) the short-run responses of new 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 by 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. Third, we establish that declining current and expected future income expectations potentially 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 the liquid-wealth-to-income ratio, and exhibits a large vehicle sales decline in response to a mild decline in expected permanent income due to a transitory slowdown in income growth. In response to the shock, households delay replacing existing vehicles, allowing them to smooth the effects of the income shock without significantly adjusting the service flow from their vehicles. Augmenting our model with a richer set of household expectations allows us to match 65 percent of the overall new vehicle spending decline (i.e. roughly the portion of the decline not explained by oil prices and falling home values). Combining our negative results regarding housing wealth and oil prices with our positive model-based findings, we interpret the auto market collapse as consistent with existing permanent income based approaches to durable goods purchases (e.g., Leahy and Zeira (2005)).

A Comparison of Fed "Tightening" Episodes since the 1980s

Deciding to undertake a series of tightening actions present unique challenges for Federal Reserve policymakers. These challenges are both political and economic. Using a variety of economic and financial market metrics, this article examines how the economy and financial markets evolved in response to the five tightening episodes enacted by the FOMC since 1983. The primary aim is to compare the most-recent episode, from December 2015 to December 2018, with the previous four episodes. The findings in this article indicate that the current episode bears some resemblance to previous Fed tightening episodes, but also differs in several key dimensions. For example, in the first four episodes, the data show the FOMC was generally tightening into a strengthening economy with building price pressures. In contrast, in the fifth episode the FOMC began its tightening regime during a deceleration in economic activity and with headline and core inflation remaining well below the FOMC’s 2 percent inflation target. Moreover, both short- and long-term inflation expectations were drifting lower. These developments helped explain why there was a one-year gap between the first and second increases in the federal funds target rate in the most-recent episode. Another key difference is that in three of the first four episodes, the FOMC continued to tighten after the yield curve inverted; a recession then followed shortly thereafter. However, in the final episode, the FOMC ended its tightening policy about eight months before the yield curve inverted. It remains to be seen if a recession follows this inversion.

Optimal Fiscal Policies under Market Failures

The aggregate capital stock in a nation can be overaccumulated for many different reasons. This paper studies which policy or policy mix is more effective in achieving the socially optimal (golden rule) level of aggregate capital stock in an infinite-horizon heterogeneous-agents incomplete-markets economy where capital is over-accumulated for two distinct reasons: (i) precautionary savings and (ii) production externalities. By solving the Ramsey problem analytically along the entire transitional path, we show that public debt and capital taxation play very distinct roles in dealing with the overaccumulation problem. The Ramsey planner opts neither to use a capital tax to correct the overaccumulation problem if it is caused solely by precautionary saving---regardless of the feasibility of public debt---nor use debt (financed by consumption tax) to correct the overaccumulation problem if it is caused solely by pollution---regardless of the feasibility of a capital tax. The key is that the modified golden rule has two margins: an intratemporal margin pertaining to the marginal product of capital (MPK) and an intertemporal margin pertaining to the time discount rate. To achieve the MGR, the Ramsey planner needs to equate not only the private MPK with the social MPK but also the interest rate with the time discount rate---neither of which is equalized in a competitive equilibrium. Yet public debt and a capital tax are each effective only in calibrating one of the two margins, respectively, but not both.

The Closing of a Major Airport: Immediate and Longer-Term Housing Market Effects

The closing of a busy airport has large effects on noise and economic activity. Using a unique dataset, we examine the effects of closing Denver’s Stapleton Airport on nearby housing markets. We find evidence of immediate anticipatory price effects upon announcement, but no price changes at closing likely because closing was widely anticipated. Further, after airport closure, high income and white households moved into these locations and developers upgraded the quality of houses being built. Finally, post-closing, these demographic and housing stock changes had substantial effects on housing prices, even after restricting the sample to pre-existing housing.

The Determination of Public Debt under both Aggregate and Idiosyncratic Uncertainty

We use an analytically tractable model to show that the Ramsey planner's decisions to finance stochastic public expenditures under uninsurable idiosyncratic risk implies a departure from tax smoothing. In the absence of state-contingent bonds the government's attempt to balance the competing incentives between tax smoothing and individual consumption smoothing---even at the cost of extra tax distortion---implies a bounded stochastic unit root component in optimal taxes. Nonetheless, a sufficiently high average level of public debt to support individuals’ self-insurance position is welfare improving, consistent with the strictly positive quantity of government debt observed throughout human history.

Predicting Benchmarked US State Employment Data in Real Time

US payroll employment data come from a survey of nonfarm business establishments and are therefore subject to revisions. While the revisions are generally small at the national level, they can be large enough at the state level to substantially alter assessments of current economic conditions. Researchers and policymakers must therefore exercise caution in interpreting state employment data until they are “benchmarked” against administrative data on the universe of workers some 5 to 16 months after the reference period. This paper develops and tests a state space model that predicts benchmarked US state employment data in realtime. The model has two distinct features: 1) an explicit model of the data revision process and 2) a dynamic factor model that incorporates realtime information from other state-level labor market indicators. We find that across the 50 US states, the model reduces the average size of benchmark revisions by about 9 percent. When we optimally average the model’s predictions with those of existing models, we find that we can reduce the average size of the revisions by about 15 percent.

Policy Interventions in Sovereign Debt Restructurings

The wave of sovereign defaults in the early 1980s and the string of debt crises in the decades that followed have fostered proposals involving policy interventions in sovereign debt restructurings. A key question about these proposals that has proved hard to handle is how they in influence the behavior of creditors and debtors. We address such challenge by incorporating these policy proposals into a quantitative model in the tradition of Eaton and Gersovitz (1981) that includes renegotiation in sovereign debt restructurings. Critically, the model also endogenizes the choice of debt maturity, an essential aspect of sovereign defaults and restructurings. We evaluate several policy interventions, and we identify the crucial features that matter to improve the outcome of distressed debt restructurings and reduce the frequency of debt distress events.

A Theory of Economic Unions: A Comment

Gino Gancia, Giacomo Ponzetto and Jaume Ventura have written an extremely interesting paper on a topic that is very timely for the global economy. In this article, I will first argue that GPV have succeeded in formalizing their hypothesis, and that while providing very suggestive analytical results, additional work can and should be done with the model, especially with regards to relative changes in the relative weights of incumbent countries. Second, I will comment on the potential insights if the rest of the world is modeled more realistically. Third, I will call for extending the baseline model to incorporate additional aspects beyond trade, such as investment and immigration flows, which appear to be relevant for the story of the European Union and its discontents. Four, I will add my non-European perspective on using the model to understand the story of the European Union.

Tax Progressivity, Economic Booms, and Trickle-Up Economics

We propose a method to decompose changes in the tax structure into orthogonal components measuring the level and progressivity of taxes. While our focus is on the progessivity results, we find that the level shock is similar to standard tax shocks found in the empirical literature in that a rise in the level is contractionary. We find that an increase in tax progressivity sets off an economic boom. When tax progressivity increases, those at the bottom of the income distribution experience an increase in disposable income; these consumers have a high marginal propensity to consume, and this increase in income results in a consumption boom which expands the overall economy. This overall economic expansion benefits those at the top of the income distribution as well, and the income and capital gains they experience as a result of the economic boom more than offset the losses they experienced due to the increase in tax progressivity. The net result is that an increase in progressivity leads to an increase in inequality, not a decrease as conventional wisdom would suggest. We interpret these results as evidence in favor of trickle up, not trickle down, economics.

Crises in the Housing Market: Causes, Consequences, and Policy Lessons

The global financial crisis of the past decade has shaken the research and policy worlds out of their belief that housing markets are mostly benign and immaterial for understanding economic cycles. Instead, a growing consensus recognizes the central role that housing plays in shaping economic activity, particularly during large boom and bust episodes. This article discusses the latest research regarding the causes, consequences, and policy implications of housing crises with a broad focus that includes empirical and structural analysis, insights from the 2000's experience in the United States, and perspectives from around the globe. Even with the significant degree of heterogeneity in legal environments, institutions, and economic fundamentals over time and across countries, several common themes emerge to guide current and future thinking in this area.


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