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

The Value of Constraints on Discretionary Government Policy

This paper investigates how institutional constraints discipline the behavior of discretionary governments subject to an expenditure bias. The focus is on constraints implemented in actual economies: monetary policy targets, limits on the deficit and debt ceilings. For a variety of aggregate shocks considered, the best policy is to impose a minimum primary surplus of about half a percent of output. Most welfare gains from constraining government behavior during normal times, which to a large extent is sufficient to discipline policy in adverse times. Monetary policy targets are not generally desirable as they hinder the ability of governments to smooth distortions. Allowing for the effective use of inflation during transitions is a key component of good institutional design. Debt ceilings are benign, but always dominated by deficit constraints. More pre-commitment to government actions is ineffective in curbing inefficiently high public expenditure.

Vocational Considerations and Trends in Social Security Disability

Along with health, Social Security Disability Insurance (SSDI) evaluates work-limiting disability by considering vocational factors including age, education, and past work experience. As the number of SSDI applicants and awards has increased, these vocational criteria are increasingly important to acceptances and denials. A unique state-level dataset allows us to estimate how these factors relate to the SSDI award process. These estimates are used to asses how changes to the demographic and occupational composition have contributed to awards trends. In our results, the prevalence of workers in their 50s are especially important. Further, increasing educational attainment lowers applications and vocational awards.

Nominal rigidities in debt and product markets

Standard models used for monetary policy analysis rely on sticky prices. Recently, the literature started to explore also nominal debt contracts. Focusing on mortgages, this paper compares the two channels of transmission within a common framework. The sticky price channel is dominant when shocks to the policy interest rate are temporary, the mortgage channel is important when the shocks are persistent. The first channel has significant aggregate effects but small redistributive effects. The opposite holds for the second channel. Using yield curve data decomposed into temporary and persistent components, the redistributive and aggregate consequences are found to be quantitatively comparable.

The Visible Hand: The Role of Government in China’s Long-Awaited Industrial Revolution

China is undergoing its long-awaited industrial revolution. There is no shortage of commentary and opinion on this dramatic period, but few have attempted to provide a coherent, in-depth, political economic framework that explains the fundamental mechanisms behind China’s rapid industrialization. This article reviews the New Stage Theory of economic development put forth by Wen (2016a). It illuminates the critical sequence of developmental stages since the reforms enacted by Deng Xiaoping in 1978: namely, small-scale commercialized agricultural production, proto-industrialization in the countryside, a formal industrial revolution based on mass production of labor-intensive light consumer goods, a sustainable “industrial trinity” boom in energy/motive power/infrastructure, and a second industrial revolution involving the mass production of heavy industrial goods. This developmental sequence follows essentially the same pattern as Great Britain’s Industrial Revolution, despite sharp differences in political and institutional conditions. One of the key conclusions exemplified by China’s economic rise is that the extent of industrialization is limited by the extent of the market. One of the key strategies behind the creation and nurturing of a continually growing market in China is based on this premise: The free market is a public good that is very costly for nations to create and support. Market creation requires a powerful “mercantilist” state and the correct sequence of developmental stages; China has been successfully accomplishing its industrialization through these stages, backed by measured, targeted reforms and direct participation from its central and local governments.

Near-Money Premiums, Monetary Policy, and the Integration of Money Markets: Lessons from Deregulation

The 1960s and 1970s witnessed rapid growth in the markets for new money market instruments, such as negotiable certificates of deposit (CDs) and Eurodollar deposits, as banks and investors sought ways around various regulations affecting funding markets. In this paper, we investigate the impacts of the deregulation and integration of the money markets. We find that the pricing and volume of negotiable CDs and Eurodollars issued were influenced by the availability of other short-term safe assets, especially Treasury bills. Banks appear to have issued these money market instruments as substitutes for other types of funding. The integration of money markets and ability of banks to raise funds using a greater variety of substitutable instruments has implications for monetary policy. We find that, when deregulation reduced money market segmentation, larger open market operations were required to produce a given change in the federal funds rate, but that the pass through of changes in the funds rate to other market rates was also greater.

Persistence of Shocks and the Reallocation of Labor

This paper proposes a theoretical and quantitative analysis of the reallocation of labor across firms in response to idiosyncratic shocks of different persistence. Creating and destroying jobs is costly and workers are paid a share of the value of the marginal worker. The model predicts that employment and labor costs react differently to transitory shocks and permanent shocks. Quantitative evaluation of the model on a panel of French firms shows the model’s performance. Modest adjustment costs are needed to reproduce observed job reallocation and inaction rates. Removing adjustment costs leads to productivity gains of 1% at the steady state. These gains are 50% larger in a economy with only transitory shocks and an order of magnitude lower in an economy with only permanent shocks. Bargaining dampens the reallocation of labor across firms, leading to larger efficiency losses from adjustment costs.

Effects of Credit Supply on Unemployment and Inequality

The Great Recession, which was preceded by the financial crisis, resulted in higher unemployment and inequality. We propose a simple model where firms producing varieties face labor-market frictions and credit constraints. In the model, tighter credit leads to lower output, lower number of vacancies, and higher directed-search unemployment. Where workers are more productive at higher levels of firm output, lower credit supply increases firm capital intensity, raises inequality by increasing the rental of capital relative to the wage, and has an ambiguous effect on welfare. At initial high levels of labor share in total costs tighter credit lowers welfare. This pattern reverses during an expansionary phase caused by higher credit availability.

Did the Founding of the Federal Reserve Affect the Vulnerability of the Interbank System to Contagion Risk?

As a result of legal restrictions on branch banking, an extensive interbank system developed in the United States during the nineteenth century to facilitate interregional payments and flows of liquidity and credit. Vast sums moved through the interbank system to meet seasonal and other demands, but the system also transmitted shocks during banking panics. The Federal Reserve was established in 1914 to reduce reliance on the interbank system and to correct other defects that caused banking system instability. Drawing on recent theoretical work on interbank networks, we examine how the Fed’s establishment affected the system’s resilience to solvency and liquidity shocks and whether those shocks might have been contagious. We find that the interbank system became more resilient to solvency shocks but less resilient to liquidity shocks as banks sharply reduced their liquidity after the Fed’s founding.The industry’s response illustrates how the introduction of a lender of last resort can alter private behavior in ways that increase the likelihood that the lender will be needed.

Disentangling the Wage Impacts of Offshoring on a Developing Country: Theory and Policy

Does a reduction in offshoring cost benefit workers in the world''s factories in developing countries? Using a parsimonious two-country model of offshoring we find very nuanced results. These include cases where wages monotonically improve, worsen, as well as where wages exhibit an inverted U-shaped relationship with the offshoring cost. We identify qualitative conditions under which these relationships hold. Since global welfare always rises with an improvement in offshoring technology, we find that there is a role for a wage tax or a minimum wage in the developing country. We derive the optimal levels of such policies.

Optimal Taxation, Marriage, Home Production, and Family Labor Supply

An empirical approach to optimal income taxation design is developed within an equilibrium collective marriage market model with imperfectly transferable utility. Taxes distort labour supply and time allocation decisions, as well as marriage market outcomes, and the within household decision process. Using data from the American Community Survey and American Time Use Survey, we structurally estimate our model and explore empirical design problems. We consider the optimal design problem when the planner is able to condition taxes on marital status, as in the U.S. tax code, but we allow the schedule for married couples to have an arbitrary form of tax jointness. Our results suggest that the optimal tax system for married couples is characterized by negative jointness, although the welfare gains from this jointness are shown to be quite modest.

Network Search: Climbing the Job Ladder Faster

We introduce an irregular network structure into a model of frictional, on-the-job search in which workers find jobs through their network connections or directly from firms. We show that jobs found through network search have wages that stochastically dominate those found through direct contact. In irregular networks, heterogeneity in the worker''s position within the network leads to heterogeneity in wage and employment dynamics: better-connected workers climb the job ladder faster. Despite this rich heterogeneity from the network structure, the mean-field approach allows the problem of our workers to be formulated tractably and recursively. We then calibrate a quantitative version of our mechanism, showing it is consistent with several empirical findings regarding networks and labor markets: jobs found through networks have higher wages and last longer. Finally, we present new evidence consistent with our model that job-to-job switches at higher rungs of the ladder are more likely to use networks.

Nonlinearities, Smoothing and Countercyclical Monetary Policy

Empirical analysis of the Fed’s monetary policy behavior suggests that the Fed smooths interest rates— that is, the Fed moves the federal funds rate target in several small steps instead of one large step with the same magnitude. We evaluate the effect of countercyclical policy by estimating a Vector Autoregression (VAR) with regime switching. Because the size of the policy shock is important in our model, we can evaluate the effect of smoothing the interest rate on the path of macro variables. Our model also allows for variation in transition probabilities across regimes, depending on the level of output growth. Thus, changes in the stance of monetary policy affect the macroeconomic variables in a nonlinear way, both directly and indirectly through the state of the economy. We also incorporate a factor summarizing overall sentiment into the VAR to determine if sentiment changes substantially around turning points and whether they are indeed important to understanding the effects of policy.

The Postwar Conquest of the Home Ownership Dream

Post-World War II witnessed the largest housing boom in recent history. This paper develops a quantitative equilibrium model of tenure choice to analyze the key determinants in the co-movement between home-ownership and house prices over the period 1940-1960. The parameterized model matches key features and is capable of accounting for the observed housing boom. The key driver in understanding this boom is an asymmetric productivity change that favors the goods sector relative to the construction sector. Other factors such as demographics, income risk, and government policy are important determinants of the homeownership rate but have small effect on house prices.

Estimating Border Effects: the Impact of Spatial Aggregation

Trade data are typically reported at the level of regions or countries and are therefore aggregates across space. In this paper, we investigate the sensitivity of standard gravity estimation to spatial aggregation. We build a model in which initially symmetric micro regions are combined to form aggregated macro regions. We then apply the model to the large literature on border effects in domestic and international trade. Our theory shows that larger countries are systematically associated with smaller border effects. The reason is that due to spatial frictions, aggregation across space increases the relative cost of trading within borders. The cost of trading across borders therefore appears relatively smaller. This mechanism leads to border effect heterogeneity and is independent of multilateral resistance effects in general equilibrium. Even if no border frictions exist at the micro level, gravity estimation on aggregate data can still produce large border effects. We test our theory on domestic and international trade flows at the level of U.S. states. Our results confirm the model’s predictions, with quantitatively large effects.

Revisiting Gertler-Gilchrist Evidence on the Behavior of Small and Large Firms

Gertler and Gilchrist (1994) provide seminal evidence for the prevailing view that adverse shocks are propagated via credit constraints: small firms are affected more during tight credit periods than large firms. Under this view, the deep recession that followed the 2008 financial crisis is often interpreted as the propagation of the initial “credit shock.” Following Gertler and Gilchrist (1994)’s methodology, we study the behavior of small and large firms during the episodes of credit disruption and extend the analysis to the 2008 financial crisis and NBER-dated recessions. We find that large firms'' short-term debt and sales contracted relatively more than those of small firms during the 2008 financial crisis and during most recessions since 1969. These results, which we show are robust to changes in the business cycle dating procedure, suggest that an alternative view may be needed to understand the prolonged recession following the 2008 financial crisis.

Local and Aggregate Fiscal Policy Multipliers

In this paper, we estimate the effect of defense spending on the U.S. macroeconomy since World War II. First, we construct a new panel dataset of state-level federal defense contracts. Second, we sum observations across states and, using the resulting time series, estimate the aggregate effect of defense spending on national income and employment via instrumental variables. Third, we estimate local multipliers using the state-level data, which measures the relative effect on economic activity due to relative differences in defense spending across states. Comparing the aggregate and local multiplier estimates, we find that the two deliver similar results, providing a case in which local multiplier estimates may be reliable indicators of the aggregate effects of fiscal policy. We also estimate spillovers using interstate commodity flow data and find some evidence of small positive spillovers, which explain part of the (small) difference between the estimated local and aggregate multipliers. Across a wide range of specifications, we estimate income and employment multipliers between zero and 0.5. We reconcile this result with the greater-than-one multipliers found in Nakamura and Steinsson (2014) by analyzing the impact of the Korean War episode in the estimation.

Measuring Openness to Trade

In this paper we derive a new measure of openness—trade potential index—that quantifies the potential gains from trade as a simple function of data. Using a standard multi-country trade model, we measure openness by a country’s potential welfare gain from moving to a world with frictionless trade. In this model, a country’s trade potential depends on only the trade elasticity and two observable statistics: the country’s home trade share and its income level. Quantitatively, poor countries have greater potential gains from trade relative to rich countries, while their welfare costs of autarky are similar. This leads us to infer that rich countries are more open to trade. Our trade potential index correlates strongly with estimates of trade costs, while both the welfare cost of autarky and the volume of trade correlate weakly with trade costs. Thus, our measure of openness is informative about the underlying trade frictions.

Terrorism, Trade and Welfare: Some Paradoxes and a Policy Conundrum

We present a standard trade model and show that terrorism can be trade inducing, starting from autarky. In addition, terrorism can be shown to be welfare augmenting for a group of nations. Finally, we present some qualitative conditions that identify when a nation’s trade volume may rise (or fall) in response to a greater incidence of terrorism. Our trade and welfare results point to potential difficulties in international coordination of counterterrorism policy because of terrorism’s differential impact across nations.

Trade and Terrorism: A Disaggregated Approach

This paper constructs a model of trade consequences of terrorism, where firms in trading nations face different costs arising from domestic and transnational terrorism. Using dyadic dataset in a gravity model, we test terrorism’s effects on overall trade, exports, and imports, while allowing for disaggregation by primary commodities and manufacturing goods. While terrorism has little or no influence on trade of primary products, terrorism reduces trade of manufactured goods. This novel finding pinpoints the avenue by which terrorism harms trade and suggests why previous studies that looked at all trade found modest impacts. Moreover, the detrimental effect of transnational terrorism on total manufactured trade, exports, and imports as well as on various classes of manufactured trade is substantially larger than that of domestic terrorism. Generally, this adverse impact is more pronounced for imports than for exports.

Incentive Compatibility as a Nonnegative Martingale

This paper considers a dynamic Mirrleesian economy and decomposes agents'''' lifetime incentive compatibility (IC) constraints into a sequence of temporal ones. We encode the frequency and severeness of these temporal IC constraints by their associated Lagrange multipliers,showing that the accumulation of the Lagrange multipliers on the consumption part is a nonnegative martingale. It is emphasized that, distinct from the extant literature, this martingale property is derived directly from the IC constraints and so is independent of the optimization of the social planning problem. We apply our fi nding to (i) the characterization of constrained efficient intertemporal wedges in the aggregate, and (ii) the extension of the so-called immiseration to an environment more general than the extant literature.

Long-term Unemployment: Attached and Mismatched?

In this paper, I quantify the contribution of occupation-specific shocks and skills to unemployment duration and its cyclical dynamics. I quantify specific skills using microdata on wages, estimating occupational switching cost as a function of the occupations'' difference in skills. The productivity shocks are consistent with job finding rates by occupation. For the period 1995-2013, the model captures 69.5% of long-term unemployment in the data, while a uniform finding rate delivers only 47.2%. In the Great Recession, the model predicts 72.9% of the long-term unemployment that existed in the data whereas a uniform finding rate would predict 57.8%.

International R&D Spillovers and Asset Prices

We provide new empirical evidence of a relationship between asset prices and trade- Induced international R&D spillovers; in particular, we find that pairs of countries that share more research and development exhibit more highly correlated stock market returns and less volatile exchange rates. We develop an endogenous growth model of innovation and international technology diffusion that accounts for these empirical findings. A calibrated version of the model matches several important asset pricing and quantity moments, which helps explain some of the classical quantity–price puzzles highlighted in the literature on international macroeconomics.

Interlocked Excecutives and Insider Board Members: an Empirical Analysis

This paper asked the question of whether the behavior and compensation of interlocked executives and non-independent board of directors are consistent with the hypothesis of governance problem or whether this problem is mitigated by implicit and market incentives. It then analyzes the role of independent board of directors. Empirically, we cannot reject the hypothesis that executives in companies with a large number of non-independent directors on the board receive the same expected compensation as other executives. In our model, every executive has an incentive to work. Placing more of non-independent directors on the board mitigates gross losses to the firm should any one of them shirk because they monitor each other. It also reduces the net benefits from shirking and increases the gross value of the firm from greater coordination (reflected in the firm’s equity value and thus impounded into its financial returns). Therefore having a greater non-independent director representation on the board create a more challenging signaling problem to solve thereby raising the risk premium. However, giving more votes on the board to non-independent executives fosters better executive working conditions, which in turn offsets the higher risk premium in pay by a lower certainty-equivalent wage in equilibrium. Thus, our estimates undergird a plausible explanation of how large shareholders determine the number of insiders on the board to maximize the expected value of their equity. We then conduct counterfactual policy experiment imposing 50% upper bound on the fraction of insiders on the board and another counterfactual imposing 40% quotas for women on the boards.

Why Are Exchange Rates So Smooth? A Household Finance Explanation

Empirical moments of asset prices and exchange rates imply that pricing kernels have to be almost perfectly correlated across countries. If they are not, observed real exchange rates are too smooth to be consistent with high Sharpe ratios in asset markets. However, the cross- country correlation of macro fundamentals is far from perfect. We reconcile these empirical facts in a two-country stochastic growth model with heterogeneous trading technologies for households and a home bias in consumption. In our model, only a small fraction of households actively participate in international risk sharing by frequently trading domestic and foreign equities. These active traders, who induce high cross-country correlation to the pricing kernels, are the marginal investors in foreign exchange markets. In a calibrated version of our model, we show that this mechanism can quantitatively account for the excess smoothness of exchange rates in the presence of highly volatile pricing kernels and weakly correlated macro fundamentals.

The Sufficient Statistic Approach: Predicting the Top of the Laffer Curve

We provide a formula for the tax rate at the top of the Laffer curve as a function of three elasticities. Our formula applies to static models and to steady states of dynamic models. One of the elasticities that enters our formula has been estimated in the elasticity of taxable income literature. We apply standard empirical methods from this literature to data produced by reforming the tax system in a model economy. We find that these standard methods underestimate the relevant elasticity in models with endogenous human capital accumulation.

Interbank Markets and Banking Crises: New Evidence on the Establishment and Impact of the Federal Reserve

This paper examines the impact of the Federal Reserve’s founding on seasonal pressures and contagion risk in the interbank system. Deposit flows among classes of banks were highly seasonal before 1914; amplitude and timing varied regionally. Panics interrupted normal flows as banks throughout the country sought funds from the central money markets simultaneously. Seasonal pressures and contagion risk in the system were lower by the 1920s, when the Fed provided seasonal liquidity and reserves. Panics returned in the 1930s, due in part to shocks from nonmember banks and because the Fed’s decentralized structure hampered a vigorous response to national crises.

Natural Resources and Global Misallocation

Are production factors allocated efficiently across countries? To differentiate misallocation from factor intensity differences, we provide a new methodology to estimate output shares of natural resources based solely on current rent flows data. With this methodology, we construct a new dataset of estimates for the output shares of natural resources for a large panel of countries. In sharp contrast with Caselli and Feyrer (2007), we find a significant and persistent degree of misallocation of physical capital. We also find a remarkable movement toward efficiency during last 35 years, associated with the elimination of interventionist policies and driven by domestic accumulation. Interestingly, when both physical and human capital can be reallocated, capital would often flow from poor to rich countries.

Explaining Cross-Cohort Differences in Life Cycle Earnings

College-educated workers entering the labor market in 1940 experienced a 4-fold increase in their labor earnings between the ages of 25 and 55; in contrast, the increase was 2.6-fold for those entering the market in 1980. For workers without a college education these figures are 3.6-fold and 1.5-fold, respectively. Why are earnings profiles flatter for recent cohorts? We build a parsimonious model of schooling and human capital accumulation on the job, and calibrate it to earnings statistics of workers from the 1940 cohort. The model accounts for 99 percent of the flattening of earnings profiles for workers with a college education between the 1940 and the 1980 cohorts (52 percent for workers without a college education). The flattening in our model results from a single exogenous factor: the increasing price of skills. The higher skill price induces (i) higher college enrollment for recent cohorts and thus a change in the educational composition of workers and (ii) higher human capital at the start of work life for college-educated workers in the recent cohorts, which implies lower earnings growth over the life cycle.

A Racial Inequality Trap

Why has the U.S. black/white earnings gap remained around 40 percent for nearly 40 years? This paper''''s answer consists of a model of skill accumulation and neighborhood formation featuring a trap: Initial racial inequality and racial preferences induce racial segregation and asymmetric skill accumulation choices that perpetuate racial inequality. Calibrated to match the U.S. distribution of race, house prices and earnings across neighborhoods, the model produces one-half of the observed racial earnings gap. Moving the economy from the trap to a racially integrated steady state implies a 15.6 percent welfare gain for black households and a 2.7 percent loss for white households.

Mortgages and Monetary Policy

Mortgages are long-term loans with nominal payments. Consequently, under incomplete asset markets, monetary policy can affect housing investment and the economy through the cost of new mortgage borrowing and real payments on outstanding debt. These channels, distinct from traditional real rate channels, are embedded in a general equilibrium model. The transmission mechanism is found to be stronger under adjustable- than fixed-rate mortgages. Further, monetary policy shocks affecting the level of the nominal yield curve have larger real effects than transitory shocks, affecting its slope. Persistently higher inflation gradually benefits homeowners under FRMs, but hurts them immediately under ARMs.


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