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Working Paper Archives

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

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 and welfare implications of reducing import tariffs on capital and intermediate inputs. We document that financially underdeveloped economies feature a slower aggregate response following trade liberalization. We set up a quantitative general equilibrium model with heterogeneous firms subject to collateral constraints and estimate it to match salient features from Colombian plant-level data. Our model explains a substantial fraction of the differences in the empirical responses of GDP, consumption, and capital across economies with different levels of financial development. Slow adjustment due to collateral constraints reduces welfare gains from trade liberalization.

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.

Credit and Liquidity Policies during Large Crises

We compare firms’ financials during the Great Financial Crisis (GFC) and COVID-19. While the two crises featured similar increases in credit spreads, debt and liquid assets decreased during the GFC, but increased during COVID-19. In the cross section, leverage was the main determinant of credit spreads and investment during the GFC, but liquidity was more important during COVID-19. We augment a quantitative model of firm capital structure with a motive to hold liquid assets. The GFC resembled a combination of productivity and financial shocks, while COVID-19 also featured liquidity shocks. We study the state-dependent effects of credit and liquidity policies.

Enduring Relationships in an Economy with Capital and Private Information

We study efficient risk sharing in a model where agents operate linear production technologies with private information about idiosyncratic productivity. Capital is the sole factor of production, and accumulable. We establish a time-invariant, one-to-one mapping between the capital allocated to an agent and his lifetime utility entitlement. The mapping implies properties that are distinct from those in models with private information about endowments. In contrast to the latter, the value of the risk-sharing arrangement in our model always remains above the autarky value. There is no need for long-term commitment. Further, in our model, there are no net expected transfers each period across individuals. This allows us to decentralize the efficient allocation into one-period insurance contracts that do not require long-term commitment on the part of the principal or agent. Furthermore, while the efficient allocation implies an increasing dispersion of lifetime utility entitlements and consumption, this need not lead to declines in individual consumption as in the endowment model. When technology is sufficiently productive, all individuals experience consumption growth.

Should Capital Be Taxed?

We design an infinite-horizon heterogeneous-agents and incomplete-markets model to demonstrate analytically that in the absence of any redistributional effects of government policies, optimal capital tax is zero despite capital overaccumulation under precautionary savings and borrowing constraints. Our result indicates that public debt is a better tool than capital taxation to restore aggregate productive efficiency.

Eggs in One Basket: Security and Convenience of Digital Currencies

Digital currencies store balances in anonymous electronic addresses. We analyze the trade-offs between safety and convenience of aggregating balances in addresses, electronic wallets and banks. In our model agents balance the risk of theft of a large account with the cost to safeguarding a large number of passwords of many small accounts. Account custodians (banks, wallets and other payment service providers) have different objectives and tradeoffs on these dimensions; we analyze the welfare effects of differing industry structures and interdependencies, and in particular the consequences of "password aggregation" programs which in effect consolidate risks across accounts.

FRED-SD: A Real-Time Database for State-Level Data with Forecasting Applications

We construct a real-time dataset (FRED-SD) with vintage data for the U.S. states that can be used to forecast both state-level and national-level variables. Our dataset includes approximately 28 variables per state, including labor market, production, and housing variables. We conduct two sets of real-time forecasting exercises. The first forecasts state-level labor-market variables using five different models and different levels of industrially-disaggregated data. The second forecasts a national-level variable exploiting the cross-section of state data. The state-forecasting experiments suggest that large models with industrially-disaggregated data tend to have higher predictive ability for industrially-diversified states. For national-level data, we find that forecasting and aggregating state-level data can outperform a random walk but not an autoregression. We compare these real-time data experiments with forecasting experiments using final-vintage data and find very different results. Because these final-vintage results are obtained with revised data that would not have been available at the time the forecasts would have been made, we conclude that the use of real-time data is essential for drawing proper conclusions about state-level forecasting models.

Collaboration in Bipartite Networks, with an Application to Coauthorship Networks

This paper studies the impact of collaboration on research output. First, we build a micro founded model for scientific knowledge production, where collaboration between researchers is represented by a bipartite network. The equilibrium of the game incorporates both the complementarity effect between collaborating researchers and the substitutability effect between concurrent projects of the same researcher. Next, we develop a Bayesian MCMC procedure to estimate the structural parameters, taking into account the endogenous matching of researchers and projects. Finally, we illustrate the empirical relevance of the model by analyzing the coauthorship network of economists registered in the RePEc Author Service.

The Role of Establishment Size in the City-Size Earnings Premium in Spain

Both large establishments and large cities are known to offer workers an earnings premium. In this paper, we show that these two premia are closely linked by documenting a new fact: when workers move to a large city, they also move to larger establishments. We then ask how much of the city- size earnings premium can be attributed to transitions to larger and better-paying establishments. Using administrative data from Spain, we find that 38 percent of the city-size earnings premium can be explained by establishment-size composition. Most of the gains from the transition to larger establishments realize in the short-term upon moving to the large city. Establishment size explains 29 percent of the short-term gains, but only 5 percent of the medium-term gains that accrue as workers gain experience in the large city. The small contribution to the medium-term gains is due to two facts: first, within large cities workers transition to large establishments only slightly faster than in smaller cities; second, the relationship between earnings and establishment size is weaker in large cities.

Forecasting Low Frequency Macroeconomic Events with High Frequency Data

High-frequency financial and economic indicators are usually time-aggregated before computing forecasts of macroeconomic events, such as recessions. We propose a mixed-frequency alternative that delivers high-frequency probability forecasts (including their confidence bands) for low-frequency events. The new approach is compared with single-frequency alternatives using loss functions for rare-event forecasting. We find: (i) the weekly-sampled spread improves over the monthly-sampled to predict NBER recessions, (ii) the predictive content of financial variables is supplementary to economic activity for forecasts of vulnerability events, and (iii) a weekly activity index can date the 2020 business cycle peak in real-time using a mixed-frequency filtering.

Convergence to Rational Expectations in Learning Models: A Note of Caution

This paper illustrates a challenge in analyzing the learning algorithms resulting in second-order difference equations. We show in a simple monetary model that the learning dynamics do not converge to the rational expectations monetary steady state. We then show that to guarantee convergence, the gain parameter used in the learning rule has to be restricted based on economic fundamentals in the monetary model.

Monetary Policy and Economic Performance since the Financial Crisis

We review the macroeconomic performance over the period since the Global Financial Crisis and the challenges in the pursuit of the Federal Reserve’s dual mandate. We characterize the use of forward guidance and balance sheet policies after the federal funds rate reached the effective lower bound. We also review the evidence on the efficacy of these tools and consider whether policymakers might have used them more forcefully. Finally, we examine the post-crisis experience of other major central banks with these policy tools.

Home Production and Leisure During the COVID-19 Recession

Between the months of February and April of 2020, average weekly market hours dropped by 6.25, meanwhile 35% of commuting workers reported switching to remote work arrangements. In this paper, we examine implications of these changes for the time allocation of different households, and on aggregate. We estimate that home production activity increased by 2.1 hours a week, or 34% of lost market hours, whereas leisure activity increased by 3.8 hours a week. The monthly value of home production increased by $30.83 billion – that is 10.5% of the concurrent $292.61 billion drop in monthly GDP. Although market hours declined the most for single, less educated individuals, the lost market hours were absorbed into home production the most by married individuals with children.

Labor Market Policies During an Epidemic

We study the positive and normative implications of labor market policies that counteract the economic fallout from containment measures 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 it leaves room for social assistance to workers who face inevitable job loss.

Job Applications and Labor Market Flows

Job applications have risen over time yet job-finding rates remain unchanged. Meanwhile, separations have declined. We argue that increased applications raise the probability of a good match rather than the probability of job-finding. Using a search model with multiple applications and costly information, we show that when applications increase, firms invest in identifying good matches, reducing separations. Concurrently, increased congestion and selectivity over which offer to accept temper increases in job-finding rates. Our framework contains testable implications for changes in offers, acceptances, reservation wages, applicants per vacancy, and tenure, objects that enable it to generate the trends in unemployment flows.

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. 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 and the actual changes in the nominal interest rate and inflation during the Volcker disinflation, nearly 60 percent of all households would prefer to avoid the disinflation. This share depends negatively on the liquidity value of money, positively on the average duration of nominal borrowing, and positively on the short-run increase in the real interest rate.

The Geography of Business Dynamism and Skill Biased Technical Change

This paper seeks to explain several key components of the growing regional disparities in the U.S. since 1980: big cities saw a larger increase in the relative wages and 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. With the introduction of a new skill-biased, high fixed cost but low marginal cost technology, firms endogenously adopt more in big cities, cities that offer abundant amenities for high-skilled workers and cities that are more productive in using high-skilled labor. Differences in technology adoption account for the regional divergence in the relative wages and supply of skilled workers and in business dynamism. I document that firms in big cities invest more intensively in Information and Communication Technology, consistent with patterns of technology adoption in the model.


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