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

International trade and labor reallocation: misclassification errors, mobility, and switching costs

Over the last few decades, international trade has increased at a rapid pace, altering domestic production and labor demand in different sectors of the economy. A growing literature studies the heterogeneous effects of trade shocks on workers’ employment and on welfare when reallocation decisions are costly. The estimated effects critically depend on data on workers’ reallocation patterns, which is typically plagued with coding errors. In this paper, I study the consequences of misclassification errors for estimates of the labor market effects of international trade and show that structural parameter values and the estimated employment and welfare effects are biased when the analysis uses uncorrected data. I develop an econometric framework to jointly estimate misclassification probabilities, corrected mobility matrices, and structural parameters in a unified way. Under different model specifications, I compare how the estimated effects of a trade shock differ on whether the analysis uses correct mobility measures and parameters. The results show that estimated employment and welfare effects of a trade shock are substantially different, raising an important warning for quantitative exercises using mobility data with coding errors.

Paving the Road for Replications: Experimental Results from an Online Research Bibliography

Are users of a bibliographic database interested in learning about replications? Can they be induced to learn? To answer these questions, we performed an experiment at the online research bibliography, RePEc (Research Papers in Economics). RePEc is the main research bibliography for pre-prints and published papers in economics. Using randomized stratification, we allocated 324 replications and their corresponding original studies to clusters. We then drew from those clusters to construct treatment and control groups. Brightly colored tabs were added to the relevant webpages to alert visitors to the existence of a replication study. We then monitored traffic over three phases lasting several months: a) no treatment, b) treatment on one group, c) treatment on both groups. Our estimates indicate that this intervention generated an average click-through-rate (CTR) of 1.6%, resulting in a 13% increase in the visits to replication webpages, though only the former estimate was statistically significant.

Evergreening

We develop a simple model of relationship lending where lenders have incentives for evergreening loans by offering better terms to less productive and more indebted firms. We detect such lending behavior using loan-level supervisory data for the United States. Low-capitalized banks systematically distort firms’ risk assessments to window-dress their balance sheets. To avoid further reductions in their capital ratios, such banks extend relatively more credit to underreported borrowers. We incorporate the theoretical mechanism into a dynamic heterogeneous-firm model to show that evergreening affects aggregate outcomes, resulting in lower interest rates, higher levels of debt, and lower productivity.

The Impact of Juvenile Conviction on Human Capital and Labor Market Outcomes

This article documents the long-term relationship among juvenile conviction, occupation choices, employment, wages, and recidivism. Using data from NLSY97, we document that youths who are convicted at or before age 17 have lower full-time employment rate and lower wage growth rate even after 10 years into the labor market. Merging the NSLY97 with occupational characteristics data from O*NET, we show that youths with a juvenile conviction are less likely to be employed in occupations that have a higher on-the-job (OTJ) training requirement and these high OTJ occupations have higher wage and wage growth. The accumulated occupation-specific work experience, general experience, and education are important to explain the gaps in wage and recidivism between youths with and without a juvenile conviction. Our results highlight the important role of occupation choices as a human capital investment vehicle through which juvenile crimes have a long-term impact on wages and recidivism.

Dynamic Gains from Trade Agreements with Intellectual Property Provisions

I develop a quantitative multi-country trade model of innovation and technology licensing to study the short- and long-term effects of trade agreements with intellectual property (IP) provisions. A trade agreement involves determining the level of tariffs and IP protection as Nash bargaining between a developed and a developing country. The agreement increases welfare, innovation, and growth in the long-run. However, gains accrue differently across countries along the transition. Developing countries experience short-run losses, as they now pay higher licensing prices. An agreement designed by a politically-motivated government could mitigate these losses, but at the expense of lower growth and welfare.

Financial Frictions and International Trade

This paper reviews recent studies on the impact of financial frictions on international trade. We first present evidence on the relation between measures of access to external finance and export decisions. We then present an analytical framework to analyze the impact of financial frictions on firms' export decisions. Finally, we review recent applications of this framework to investigate the impact of financial frictions on international trade dynamics across firms, industries, and in the aggregate. We discuss related empirical, theoretical, and quantitative studies throughout.

Effects of Defensive and Proactive Measures on Competition Between Terrorist Groups

A two-stage game investigates how counterterrorism measures affect within-country competition between two rival terrorist groups. Although such competition is commonplace (e.g., al-Nusra Front and Free Syria Army; Revolutionary Armed Forces of Colombia and the National Liberation Army; and al-Fatah and Hamas), there is no theoretical treatment of how proactive and defensive measures influence this interaction. Previous studies on rival terrorist groups are solely empirical concerning group survival, outbidding, and terrorism level, while ignoring the role that government countermeasures exert on the rival groups’ terrorism. In a theoretical framework, alternative counterterrorism actions have diverse impacts on the level of terrorism depending on relative group sizes and government-targeting decisions. In the two-stage game, optimal counterterrorism policy rules are displayed in terms of how governments target symmetric and asymmetric terrorist groups. Comparative statics show how parameter changes affect Nash or subgame perfect equilibrium outcomes.

A Quantitative Analysis of Tariffs across U.S. States

We develop a quantitative framework to assess the cross-state implications of a U.S. trade policy change: a unilateral increase in the import tariff from 2 to 25 across all goods-producing sectors. Although the U.S. gains overall from the tariff increase, we find the impact differs starkly across locations. Changes in real consumption (welfare) range from as high as 3.8% in Wyoming to $-0.3% in Florida, depending mainly on how exposed states are to differentially-impacted sectors. As a result, the "preferred'' tariff rate varies greatly across states. Foreign retaliation in trade policy substantially reduces the welfare gains across states, while perpetuating the cross-state variation in those gains. The presence of internal trade frictions amplifies the welfare impacts of changes in trade policy.

The Local-Spillover Decomposition of an Aggregate Causal Effect

This paper presents a method to decompose the causal effect of government defense spending into: (i) a local (or direct) effect, and (ii) a spillover (or indirect) effect. Each effect is measured as a multiplier: the unit change in output of a one unit change in government spending. We apply this method to study the effect of U.S. defense spending on output using regional panel data. We estimate a positive local multiplier and a negative spillover multiplier. By construction, the sum of the local and spillover multipliers provides an estimate of the aggregate multiplier. The aggregate multiplier is close to zero and precisely estimated. We show that enlisting disaggregate data improves the precision of aggregate effect estimates, relative to using aggregate time series alone. Our paper provides a template for researchers to conduct inference about local, spillover and aggregate causal effects in a unified framework.

The Impact of Health and Economic Policies on the Spread of COVID-19 and Economic Activity

This paper empirically investigates the causal linkages between COVID-19 spread, government health containment and economic support policies, and economic activity in the U.S. up to the introduction of vaccines in early 2021. We model their joint dynamics as generated by a structural vector autoregression and estimate it using U.S. state-level data. We identify structural shocks to the variables by making assumptions on their short-run relation consistent with salient epidemiological and economic features of COVID-19. We isolate the direct impact of COVID-19 spread and policy responses on economic activity by controlling for demand fluctuations using disaggregate exports data. We find that health containment and economic support policies are highly effective at curbing the spread of COVID-19 without leading to a long-term contraction of economic activity.

The Allocation of Immigrant Talent: Macroeconomic Implications for the U.S. and Across Countries

We quantify the barriers to the economic integration of immigrants using an occupational choice model with natives and immigrants of multiple types subject to wedges that distort their allocations. We show that key parameters, including wedges, can be estimated to match the distribution of employment and earnings across individuals and occupations. We find sizable output gains from removing immigrant wedges in the U.S., accounting for 7 percent of immigrants' overall economic contribution. These gains arise from increased labor force participation and from reallocation from manual toward cognitive jobs. We show that the model-implied elasticities are consistent with empirical estimates and that immigrant wedges affect the impact of alternative immigration policies. Finally, we use harmonized microdata across 19 economies and find substantial cross-country differences in the estimated immigrant wedges. Differences in immigrant labor force participation and the correlation between wedges and productivities account for the heterogeneous gains from removing the wedges.

The Alpha Beta Gamma of the Labor Market

Using a large panel dataset of US workers, we calibrate a search-theoretic model of the labor market, where workers are heterogeneous with respect to the parameters governing their employment transitions. We first approximate heterogeneity with a discrete number of latent types, and then calibrate type-specific parameters by matching type-specific moments. Heterogeneity is well approximated by 3 types: αs, βs and γs. Workers of type α find employment quickly because they have large gains from trade, and stick to their jobs because their productivity is similar across jobs. Workers of type γ find employment slowly because they have small gains from trade, and are unlikely to stick to their job because they keep searching for jobs in the right tail of the productivity distribution. During the Great Recession, the magnitude and persistence of aggregate unemployment is caused by γs, who are vulnerable to shocks and, once displaced, they cycle through multiple unemployment spells before finding stable employment.

Are Unconditional Lump-sum Transfers a Good Idea?

The role of unconditional lump-sum transfers in improving social welfare in heterogenous agent models has not been thoroughly understood in the literature. We adopt an analytically tractable Aiyagari-type model to study the distinctive role of unconditional lump-sum transfers in reducing consumption inequality due to ex-post uninsurable income risk under borrowing constraints. Our results show that in the presence of ex-post heterogeneity and in the absence of wealth inequality, unconditional lump-sum transfers are not a desirable tool for reducing consumption inequality---the Ramsey planner opts to rely solely on public debt and a linear labor tax (in the absence of a lump-sum tax) to mitigate income risk without the need for lump-sum transfers, in contrast to the result obtained by Werning (2007), Azzimonti and Yared (2017), and Bhandari, Evans, Golosov, and Sargent (2017) in models with ex-ante heterogeneity.

The Poverty of Macroeconomics --- What the Chemical Revolution Tells Us about Neoclassical Production Function

Quantitative macroeconomics is often portrayed as a science—because of its intensive use of high-powered mathematics—with the possible limitation of being unable to conduct controlled experiments. To qualify as a science, however, theories in that discipline must meet a minimum number of criteria: (i) It has explanatory power to explain phenomena; (ii) it has predictive power to yield quantifiable and falsifiable statements about new phenomenon; and (iii) it has operational power to change the world. A scientific theory consists of axioms and working hypotheses that facilitate the derivation of contestable statements from the axioms.2 Hence, simply laying out a list of contradictions between a theory’s implications and the data is often insufficient to disqualify a theory as science; it may have just challenged its working hypotheses, not its axioms. But, challenging a theory’s working hypotheses is a crucial step to improve or falsify a theory. This is why Isaac Newton spent so much effort in his Principia Mathematica to deal with the law of motion under air friction. This article discusses one of the working hypotheses of the Arrow-Debreu paradigm and its dynamic stochastic general equilibrium reincarnation in quantitative macroeconomics—the supply curve and its embodiment in the neoclassical production function. The supply curve is a much stronger pillar than the demand curve in holding up the Arrow-Debreu paradigm, but we argue in this article that the neoclassical production function embodying the supply curve is full of cracks. More specifically, we show that the neoclassical production function is not quantifiable as a working hypothesis to support the Arrow-Debreu DSGE model, unlike the chemical reaction equations based on Lavoisier’s oxygen theory of combustion. The neoclassical production function relies on the unobservable and unmeasurable Solow residual to explain the quantity of output produced at the firm, industry, or national level, and the hypothetical factors of production (capital and labor) are much like “fire, air, water, and earth” in the ancient Greek theory of the universe. Because the working hypotheses of quantitative macroeconomics are not themselves quantifiable, the neoclassical theory is not yet a science. And this explains the lack of power for DSGE models to predict the 2008 Financial Crisis and the inability of economic theory to change the world by engineering or recreating economic prosperity in developing countries.

Industrial Connectedness and Business Cycle Comovements

While aggregate shocks account for most business cycle fluctuations, sectoral shocks have become relatively more important since the 1980s. Previous studies show that sectoral shocks propagate through industry supply chains. Typically, sectors are defined by similarities in function and/or market. While some industries have supply chains within their own sector (vertical), others have supply chains across a number of sectors (horizontal). Similarity in these supply chain characteristics appear to be a determining factor in how industries comove. Using industrial production data of 82 four-digit NAICS industries over the period 1972 to 2019, this comovement is analyzed in a panel Markov-switching model incorporating a number of features relevant for sub-national analysis: (i)industry-specific trends that differentiate cyclical downturns from secular declines; (ii) a national-level business cycle; and (iii) factors that represent industrial comovement. While national-level shocks are typically still the most important driver of cyclical fluctuations, endogenously clustering by industry comovement highlights the role of sectoral shocks.

Supply and demand shifts of shorts before Fed announcements during QE1–QE3

Cohen, Diether, and Malloy (Journal of Finance, 2007), find that shifts in the demand curve predict negative stock returns. We use their approach to examine changes in supply and demand at the time of FOMC announcements. We show that shifts in the demand for borrowing Treasuries and agencies predict quantitative easing. A reduction in the quantity demanded at all points along the demand curve predicts expansionary quantitative easing announcements.

Tests of Conditional Predictive Ability: Existence, Size, and Power

We investigate a test of conditional predictive ability described in Giacomini and White (2006; Econometrica). Our main goal is simply to demonstrate existence of the null hypothesis and, in doing so, clarify just how unlikely it is for this hypothesis to hold. We do so using a simple example of point forecasting under quadratic loss. We then provide simulation evidence on the size and power of the test. While the test can be accurately sized we find that power is typically low.

Raising College Access and Completion: How Much Can Free College Help?

Free college proposals have become increasingly popular in many countries of the world. To evaluate their potential effects, we develop and estimate a dynamic model of college enrollment, performance, and graduation. A central piece of the model, student effort, has a direct effect on class completion, and an indirect effect in mitigating the risk of not completing a class or not remaining in college. We estimate the model using rich, student-level administrative data from Colombia, and use the estimates to simulate free college programs that differ in eligibility requirements. Among these, universal free college expands enrollment the most, but it does not affect graduation rates and has the highest per-graduate cost. Performance-based free college, in contrast, delivers a slightly lower enrollment expansion yet a greater graduation rate at a lower per-graduate cost. Relative to universal free college, performance-based free college places greater risk on students, but precisely for this reason leads them to better outcomes. Nonetheless, even performance-based free college fails to deliver a large increase in graduation rate, suggesting that additional, complementary policies might be required to elicit the large effort increase needed to raise graduation rates.

Investors and Housing Affordability

This paper studies the impact of a new class of investors on the dynamics of U.S. housing affordability after the Financial Crisis. Using a novel instrumental variable and processing 85 million housing transactions, we find that investors' purchases increase the price-to-income ratio, especially in the bottom price-tier, the entry point for first-time buyers. Investors cause a short-run reduction in the vacancy rate of owner-occupied units and a medium-run positive response of construction. These equilibrium responses mitigate the effect on affordability. The effects on price-to-income and price-to-rent ratios depend on the housing supply elasticity. In highly elastic areas investors affect rents more than prices, whereas in areas that are highly inelastic investors have the opposite effect.

Optimal Management of an Epidemic: Lockdown, Vaccine and Value of Life

This paper analyzes the optimal management of a pandemic (stay-at-home and vaccination policies) in a dynamic model. The optimal lockdown policies respond to the spread of the virus with significant restrictions to employment, followed by partial loosening before the peak of the epidemic. Upon the availability of a vaccine, the optimal vaccination policy has an almost bang-bang property, despite the loss of immunity of the vaccinated: vaccinate at the highest possible rate, and then rapidly converge to the steady state. The model illustrates interesting trade-offs as it implies that lower hospital capacity requires flattening the infection curve and hence a more stringent lockdown, but lower vaccination possibilities (both the likelihood of a vaccine and the vaccination rate) push the optimal lockdown policy in the opposite direction, even before the arrival of vaccine. The model implies that the “dollar” value of a vaccine decreases rapidly as time passes with the reinfection rate being an important determinant of the monetary value. The value that society assigns to averting deaths is a major driver of the optimal policy. The sensitivity analysis shows that even for reasonable bounds of the economic and epidemiological parameters, the timing and the magnitude of the optimal policy varies substantially.

Rural-Urban Migration and House Prices in China

This paper uses a dynamic competitive spatial equilibrium framework to evaluate the contribution of rural-urban migration induced by structural transformation to the behavior of Chinese housing markets. In the model, technological progress drives workers facing heterogeneous mobility costs to migrate from the rural agricultural sector to the higher paying urban manufacturing sector. Upon arrival to the city, workers purchase housing using long-term mortgages. Quantitatively, the model fits cross-sectional house price behavior across a representative sample of Chinese cities between 2003 and 2015. The model is then used to evaluate how changes to city migration policies and land supply regulations affect the speed of urbanization and house price appreciation. The analysis indicates that making migration policy more egalitarian or land policy more uniform would promote urbanization but also would contribute to larger house price dispersion

Finance and Inequality: A Tale of Two Tails

We estimate the effects that the different financial deregulations in the U.S. have had on the country's income distribution. We find that the different reforms have moved inequality in drastically different directions. On the one hand, during the late 1970s and early 1980s, the removal of intra- and inter-state branching restrictions and the elimination of state-varying rates ceilings decreased inequality, as they mostly enhanced the incomes of workers in the lower tail of the income distribution. On the other hand, the repeal of the Glass-Steagall Act in 1999 substantially increased inequality, as it mostly –and by large amounts-- increased the incomes of workers in the upper tail of the distribution. To explore the mechanisms underlying the different effects, we also examine the responses within and across individuals in different age groups and compare finance vs non-finance workers. Our findings indicated that models based solely on capital skill complementarities (CSC) are insufficient because they would imply similar responses to all reforms. We construct a model that emphasizes the endogenous changes in the heterogeneous access (and choices) of households' financial products. The model naturally explains how the different deregulations impacted the opposite tails of the income distribution by capturing the changes in the financial markets available to households of different incomes and characteristics.

More Stories of Unconventional Monetary Policy

This article extends the work of Fawley and Neely (2013) to describe how major central banks have evolved unconventional monetary policies to encourage real activity and maintain stable inflation rates from 2013 through 2019. By 2013, central banks were moving from lump-sum asset purchase programs to continuing asset purchase programs, which are conditioned on economic conditions, careful communication strategies, bank lending programs with incentives and negative interest rates. This article reviews how central banks tailored their unconventional monetary methods to their various challenges and the structures of their respective economies.

The Consequences of Bretton Woods Impediments to International Capital Mobility and the Value of Geopolitical Stability

This paper quantifies the positive and normative effects of capital controls on international economic activity under The Bretton Woods international financial system. We develop a three-region world economic model consisting of the U.S., Western Europe, and the Rest of the World. The model allows us to quantify the impact of these controls through an open economy general equilibrium capital flows accounting framework. We find these controls had large effects. Counterfactuals show that world output would have been 6% larger had the controls not been implemented. We show that the controls led to much higher welfare for the rest of the world, moderately higher welfare for Europe, but much lower welfare for the U.S. We interpret the large U.S. welfare loss as an estimate of the implicit value to the U.S. of preventing capital flight from other countries and thus promoting economic and political stability in ally and developing countries.

Wage Setting Under Targeted Search

When setting initial compensation, some firms set a fixed, non-negotiable wage while others bargain. In this paper we propose a parsimonious search and matching model with two sided heterogeneity, where the choice of wage-setting protocol, wages, search intensity, and degree of randomness in matching are endogenous. We find that posting and bargaining coexist as wage-setting protocols if there is sufficient heterogeneity in match quality, search costs, or market tightness and that labor market tightness and relative costs of search play a key role in the optimal choice of the wage-setting mechanism. Finally, we show that bargaining prevalence is positively correlated with wages, residual wage dispersion, and labor market tightness, both in the model and in the data.

Fiscal Dominance

Who prevails when fiscal and monetary authorities disagree about the value of public expenditure and how much to discount the future? When the fiscal authority sets debt as its main policy instrument it achieves fiscal dominance, rendering the preferences of the central bank, and thus its independence, irrelevant. When the central bank sets the nominal interest rate it renders fiscal impatience (its debt bias) irrelevant, but still faces its expenditure bias. I find that the expenditure bias has a major impact on welfare through higher public spending, while the effect on other policies is relatively minor. In contrast, the debt bias affects debt, deficits and inflation, but has a minor impact on expenditure and welfare. I also find that the central bank can do little to overcome the negative impact of the fiscal authority's expenditure bias, though there are still gains from properly designing the central bank.

Technology adoption, mortality, and population dynamics

We develop a quantitative theory of mortality trends and population dynamics. We emphasize diseases as causes of death and individuals' decisions to reduce their mortality by adopting, at some cost, a modern health-related technology. Adoption confers a dynamic externality: Adoption becomes cheaper as more individuals acquire the modern technology. Our model generates an S-shaped diffusion curve, whose shape dictates the pace of mortality reduction in each country. We use the model to explain the gradual decline of mortality in Western Europe in the 19th and 20th centuries as well as the rapid decline in poor countries since 1960. Unlike a Malthusian theory of population, our model accounts for the well-known historical disconnect between mortality decline and economic takeoff and its recent equivalents: cross-country mortality convergence despite lack of income convergence and mortality miracles, i.e., declining mortality in countries with declining income. Our model is also consistent with the observed acceleration in world population, which cannot be explained solely by declining fertility à la Becker.

No Credit, No Gain: Trade Liberalization Dynamics, Production Inputs, and Financial Development

We study the role of financial development on the aggregate implications of reducing import tariffs on capital and intermediate inputs. We document empirically that financially underdeveloped economies feature a slower aggregate response following trade liberalization. To quantify these effects, we set up a general equilibrium model with heterogeneous firms subject to collateral constraints and estimate it using Colombian plant-level data. We find that low financial development substantially limited the gains from trade liberalization in Colombia in the early 1990s. More broadly, we find that low financial development substantially limits both the aggregate and welfare gains from tariff reductions.

Time-Inconsistent Optimal Quantity of Debt

A key property of the Aiyagari-type heterogeneous-agent models is that the equilibrium interest rate of public debt lies below the time discount rate. This fundamental property, however, implies that the Ramsey planner's fiscal policy may be time-inconsistent because the forward-looking planner would have a dominant incentive to issue plenty of debt such that all households are fully self-insured against idiosyncratic risk. But such a full self-insurance allocation may be paradoxical because, to achieve it, the optimal labor tax rate may approach 100% and aggregate consumption may approach zero. This is puzzling from an intuitive perspective because near the point of full self-insurance the marginal gains of increasing debt should be less than the marginal costs of financing the debt under distortionary taxes. We show that this puzzling behavior originates from the assumption that the planner must commit to future plans at time zero. Under such a full commitment, the Ramsey planner opts to exploit the low interest cost of borrowing to front-load consumption by sacrificing future consumption in the long run because future utilities are heavily discounted compared to the inverse of the interest rate on government bonds. We demonstrate our points analytically using a tractable heterogeneous-agents model featuring non-linear preferences and a well-defined distribution of household wealth.

Firms as Learning Environments: Implications for Earnings Dynamics and Job Search

This paper demonstrates that heterogeneity in firms’ promotion of human capital accumulation is an important determinant of life-cycle earnings inequality. I use administrative micro data from Germany to show that different establishments offer systematically different earnings growth rates for their workers. This observation suggests that that the increase in inequality over the life cycle reflects not only inherent worker variation, but also differences in the firms that workers happen to match with over their lifetimes. To quantify this channel, I develop a life-cycle search model with heterogeneous workers and firms. In the model, a worker’s earnings can grow through both human capital accumulation and labor market competition channels. Human capital growth depends on both the worker’s ability and the firm’s learning environment. I find that heterogeneity in firm learning environments accounts for 40% of the increase in cross-sectional earnings variance over the life cycle, and that this mechanism is especially important for young workers. I then show that differences in labor market histories partially shape the worker-specific income profiles estimated by reduced-form statistical earnings processes. Finally, because young workers do not fully internalize the benefits of matching to high-growth firms, changes to the structure of unemployment insurance policies can incentivize these workers to search for better matches.


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