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

Regional Consumption Responses and the Aggregate Fiscal Multiplier

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

Offshoring Barriers, Regulatory Burden and National Welfare

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

Monetary Policy and Liquid Government Debt

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

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

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

An Empirical Investigation of Direct and Iterated Multistep Conditional Forecasts

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

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

The design of lender-of-last-resort interventions can exacerbate the bank-sovereign nexus. During sovereign crises, central bank provision of long-term liquidity incentivizes banks to purchase high-yield eligible collateral securities matching the maturity of the central bank loans. Using unique security-level data, we find that the European Central Bank's 3-year Long-Term Refinancing Operation caused Portuguese banks to purchase short-term domestic government bonds, equivalent to 10.6% of amounts outstanding, and pledge them to obtain central bank liquidity. The steepening of eurozone peripheral sovereign yield curves right after the policy announcement is consistent with the equilibrium effects of this "collateral trade."

The Persistence of Financial Distress

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

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

How do banks respond to asset booms? This paper examines i) how U.S. banks responded to the World War I farmland boom; ii) the impact of regulation; and iii) how bank closures exacerbated the post-war bust. The boom encouraged new bank formation and balance sheet expansion (especially by new banks). Deposit insurance amplified the impact of rising crop prices on bank portfolios, while higher minimum capital requirements dampened the effects. Banks that responded most aggressively to the asset boom had a higher probability of closing in the bust, and counties with more bank closures experienced larger declines in land prices.

Financing Ventures

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

Markup Cyclicality: A Tale of Two Models

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

Customer Capital, Markup Cyclicality, and Amplification

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

Optimal fiscal policy in overlapping generations models

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

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

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

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

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

Knowledge diffusion, trade and innovation across countries and sectors

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

The exchange rate as an instrument of monetary policy

Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

The Aggregate and Relative Economic Effects of Medicaid and Medicare Expansions

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

Modeling Time-Varying Uncertainty of Multiple-Horizon Forecast Errors

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

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

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

Optimal Ramsey Capital Income Taxation—A Reappraisal

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

Money, Banking and Financial Markets

The fact that money, banking, and financial markets interact in important ways seems self-evident. The theoretical nature of this interaction, however, has not been fully explored. To this end, we integrate the Diamond (1997) model of banking and financial markets with the Lagos and Wright (2005) dynamic model of monetary exchange--a union that bears a framework in which fractional reserve banks emerge in equilibrium, where bank assets are funded with liabilities made demandable for government money, where the terms of bank deposit contracts are constrained by the liquidity insurance available in financial markets, where banks are subject to runs, and where a central bank has a meaningful role to play, both in terms of inflation policy and as a lender of last resort. The model provides a rationale for nominal deposit contracts combined with a central bank lender-of-last-resort facility to promote efficient liquidity insurance and a panic-free banking system.

Debt and Stabilization Policy: Evidence from a Euro Area FAVAR

The Euro-area poses a unique problem in evaluating policy: a currency union with a shared monetary policy and country-specific fiscal policy. Analysis can be further complicated if high levels of public debt affect the performance of stabilization policy. We construct a framework capable of handling these issues with an application to Euro-Area data. In order to incorporate multiple macroeconomic series from each country but, simultaneously, treat country-specific fiscal policy, we develop a hierarchical factor-augmented VAR with zero restrictions on the loadings that yield country-level factors. Monetary policy, then, responds to area-wide conditions but fiscal policy responds only to its country level conditions. We find that there is broad quantitative variation in different countries'''' responses to area-wide monetary policy and both qualitative and quantitative variation in responses to country-specific fiscal policy. Moreover, we find that debt conditions do not diminish the effectiveness of policy in a significant manner, suggesting that any negative effects must come through other channels.

Corporate Income Tax, Legal Form of Organization, and Employment

A dynamic stochastic occupational choice model with heterogeneous agents is developed to evaluate the impact of a corporate income tax reduction on employment. In this framework, the key margin is the endogenous entrepreneurial choice of the legal form of organization (LFO). A reduction in the corporate income tax burden encourages adoption of the C corporation legal form, which reduces capital constraints on firms. Improved capital re-allocation increases overall productive efficiency in the economy and therefore expands the labor market. Relative to the benchmark economy, a corporate income tax cut can reduce the non-employment rate by up to 7 percent.

The response of multinationals’ foreign exchange rate

We use intraday data to estimate the daily foreign exchange exposure of U.S. multinationals and show that macroeconomic news affects these firms’ foreign exchange exposure. News creates a substantial shift in the joint distribution of stock and exchange rate returns that has both a transitory and a persistent component. For example, a positive domestic demand surprise, as reflected in higher-than-expected nonfarm payroll, increases the value of the low-exposure domestic activities and results in a persistent decrease in foreign exchange exposure.

Optimal Monetary Policy under Negative Interest Rate

In responding to the extremely weak global economy after the financial crisis in 2008, many industrial nations have been considering or have already implemented negative nominal interest rate policy. This situation raises two important questions for monetary theories: (i) Given the widely held doctrine of the zero lower bound on nominal interest rate, how is a negative interest rate (NIR) policy possible? (ii) Will NIR be effective in stimulating aggregate demand? (iii) Are there any new theoretical issues emerging under NIR policies? This article builds a model to show that (i) money injections can remain effective even when the nominal bank lending rate has reached zero or become negative; (ii) it is a good policy to keep the nominal interest rate as low as possible by purchasing government bonds with money; and (iii) the conventional wisdom on the notion of the liquidity trap and the Fisherian decomposition between the nominal and real interest rate can be invalid.

Truncated Firm Productivity Distributions and Trade Margins

A standard theoretical prediction is that average exports are independent of tariff rates when the underlying distribution of firm productivities is assumed to be the widely-used Pareto distribution. Assuming that the underlying distribution has no upper bound is undoubtedly inaccurate and produces theoretical results at odds with empirical results. In contrast, we show that upper-truncation of the Pareto distribution makes average exports rise with trade liberalization. This result is derived analytically, and is supported by simulations. We extend our analysis to the cases of lognormal and Fréchet distributions, which are also frequently used by trade economists. Our findings for lognormal and Fréchet distributions are qualitatively similar to the findings using the truncated Pareto.

Terms-of-Trade and Counterterrorism Externalities

This paper investigates the interplay of trade and terrorism externalities under free trade between a developed nation that exports a manufactured good to and imports a primary product from a developing nation. A terrorist organization targets both nations and reduces its attacks in response to a nation’s defensive counterterrorism efforts, while transferring some of its attacks abroad. Terms-of-trade considerations lead the developed nation to raise its counterterrorism level beyond the “small-country” level, thus compounding its overprovision of these measures. By contrast, the developing nation limits its defensive countermeasures below that of the small-country level. This asymmetry is a novel finding. The analysis is extended to include proactive countermeasures to weaken the terrorist group. Again, the developed country raises its efforts owing to the terms-of-trade externality, which now opposes the underprovision associated with proactive efforts. A sec ond extension allows for several developing-country exporters of the primary product.

Nominal GDP Targeting With Heterogeneous Labor Supply

We study nominal GDP targeting as optimal monetary policy in a model with a credit market friction following Azariadis, Bullard, Singh and Suda (2016), henceforth ABSS. As in ABSS, the macroeconomy we study has considerable income inequality which gives rise to a large private sector credit market. Households participating in this market use non-state contingent nominal contracts (NSCNC). We extend the ABSS framework to allow for endogenous and heterogeneous household labor supply among credit market participant households. We show that nominal GDP targeting continues to characterize optimal monetary policy in this setting. Optimal monetary policy repairs the distortion caused by the credit market friction and so leaves heterogeneous households supplying their desired amount of labor, a type of “divine coincidence” result. We also analyze the case when there is an aging population. We interpret these findings in light of the recent debate in monetary policy concerning labor force participation.

Airport Noise in Atlanta: The Inequality of Sound

We examine how changes in the geographic concentrations of Hispanic and African-American populations are correlated with changes in probabilities of airport noise, in Atlanta, during 2003 and 2012. We estimate ordered probit and locally weighted ordered probit regressions for three different noise categories to determine the correlations between these two demographic groups and the aircraft noise levels experienced by people in individual houses that sold. Then we determine the average coefficient for all houses sold in each Census block group, and we plot each year’s coefficients for each block group against the percentiles of the minority population. While the absolute level of noise has declined over the geographic area considered in 2012 compared with 2003, we find that the distribution of noise coefficients among Hispanics and blacks became more inequitable in 2012 compared with 2003. At least two potential mechanisms could generate these correlations. Due to residential mobility, income and preferences could combine to produce a concentration of minorities in certain neighborhoods. Or, perhaps noisier flight paths are imposed upon higher minority neighborhoods as a result of discrimination. Our findings contribute to the broader literature on environmental justice, even though we cannot definitively infer the mechanisms at work.

Optimal Taxes Under Private Information: The Role of Inflation

We consider an overlapping generation framework with search and private information to study optimal taxation. Agents sequentially trade in markets that are characterized by different frictions and trading protocols. In frictional decentralized markets, agents receive shocks that determine if they are going to be consumers or producers. Shocks are private information. Mechanism design is used to solve for the constrained optimal allocation. We then study whether a government can replicate the constrained optimal allocation with an array of policy instruments including fiat money. We show that if the government has a full set of non-linear taxes, then lump-sum taxes and inflation are irrelevant for the allocation. However, if the government is constrained to use linear taxes, then using the inflation tax is optimal even if lump-sum taxes are available.


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