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This paper undertakes a quantitative investigation of the effects of anticipated inflation on the distribution of household wealth and welfare. Consumer Finance Data on household financial wealth suggests that about a third of the US population holds all its financial assets in transaction accounts. The remaining two-third of the US population holds most of their financial assets outside transaction accounts. To account for this evidence, I introduce a portfolio choice in a standard incomplete markets model with heterogeneous agents. I calibrate the model economy to SCF 2010 US data and use this environment to study the distributive effects of changes in anticipated inflation. An increase in anticipated inflation leads households to reshuffle their portfolio towards real assets. This crowding-in of supply for real assets lowers equilibrium interest rates and thereby redistributes wealth from creditors to borrowers. Because borrowers have a higher marginal utility, this redistribution improves aggregate welfare. First, this paper shows that inflation acts not only a regressive consumption tax as in Erosa and Ventura (2002), but also as a progressive tax. Second, this paper shows that the welfare cost of inflation are even lower than the estimates computed by Lucas (2000) and Ireland (2009). Finally, this paper offers insights into why deflationary environments should be avoided.
We study the life cycle of portfolio allocation following for 15 years a large random sample of Norwegian households using error-free data on all components of households’ investments drawn from the Tax Registry. Both, participation in the stock market and the portfolio share in stocks, have important life cycle patterns. Participation is limited at all ages but follows a hump-shaped profile which peaks around retirement; the share invested in stocks among the participants is high and flat for the young but investors start reducing it as retirement comes into sight. Our data suggest a double adjustment as people age: a rebalancing of the portfolio away from stocks as they approach retirement, and stock market exit after retirement. Existing calibrated life cycle models can account for the first behavior but not the second. We show that incorporating in these models a reasonable per period participation cost can generate limited participation among the young but not enough exit from the stock market among the elderly. Adding also a small probability of a large loss when investing in stocks, produces a joint pattern of participation and of the risky asset share that resembles the one observed in the data. A structural estimation of the relevant parameters that target simultaneously the portfolio, participation and asset accumulation age profiles of the model reveals that the parameter combination that fits the data best is one with a relatively large risk aversion, small participation cost and a yearly large loss probability in line with the frequency of stock market crashes in Norway.
n this paper we analyze an economy with two heterogeneous investors who both exhibit misspecified filtering models for the unobservable expected growth rate of the aggregated dividend. A key result of our analysis with respect to long-run investor survival is that there are degrees of model misspecification on the part of one investor for which there is no compensation by the other investor's deficiency. The main finding with respect to the asset pricing properties of our model is that the two dimensions of asset pricing and survival are basically independent. In scenarios when the investors are more similar with respect to their expected consumption shares, return volatilities can nevertheless be higher than in cases when they are very different.
We analyze the macroeconomic implications of increasing the top marginal income tax rate using a dynamic general equilibrium framework with heterogeneous agents and a fiscal structure resembling the actual U.S. tax system. The wealth and income distributions generated by our model replicate the empirical ones. In two policy experiments, we increase the statutory top marginal tax rate from 35 to 70 percent and redistribute the additional tax revenue among households, either by decreasing all other marginal tax rates or by paying out a lump-sum transfer to all households. We find that increasing the top marginal tax rate decreases inequality in both wealth and income but also leads to a contraction of the aggregate economy. This is primarily driven by the negative effects that the tax change has on top income earners. The aggregate gain in welfare is sizable in both experiments mainly due to a higher degree of distributional equality.
There is a growing debate about complementing the European Monetary Union by a more comprehensive fiscal union. Against this background, this paper emphasizes that there is a trade-off in designing a system of fiscal transfers ("fiscal capacity") in a union between members of different size. A system cannot guarantee symmetric treatment of members and simultaneously ensure a balanced budget. We compute hypothetical transfers for the Eurozone members from 2001 to 2012 to illustrate this trade-off. Interestingly, a symmetric system that treats shocks in small and large countries symmetrically would have produced large budgetary surpluses in 2009, the worst year of the financial crisis.
The Federal Reserve’s muddled mandate to attain simultaneously the incompatible goals of maximum employment and price stability invites short-term-oriented discretionary policymaking inconsistent with the systematic approach needed for monetary policy to contribute best to the economy over time. Fear of liftoff—the reluctance to start the process of policy normalization after the end of a recession—serves as an example. Causes of the problem are discussed, drawing on public choice and cognitive psychology perspectives. The Federal Reserve could adopt a framework that relies on a simple policy rule subject to periodic reviews and adaptation. Replacing meeting-by-meeting discretion with a simple policy rule would eschew discretion in favor of systematic policy. Periodic review of the rule would allow the Federal Reserve the flexibility to account for and occasionally adapt to the evolving understanding of the economy. Congressional legislation could guide the Federal Reserve in this direction. However the Federal Reserve may be best placed to select the simple rule and could embrace this improvement on its own, within its current mandate, with the publication of a simple rule along the lines of its statement of longer-run goals.
This paper investigates the effect of a change in informational environment of borrowers on the organizational design of bank lending. We use micro-data from a large multinational bank and exploit the sudden introduction of a credit registry, an information-sharing mechanism across banks, for a subset of borrowers. Using within borrower and loan officer variation in a difference-in-difference empirical design, we show that expansion of credit registry led to an improvement in allocation of credit to affected
borrowers. There was a concurrent change in the organizational structure of the bank that involved a dramatic increase in delegation of lending decisions of affected borrowers to loan officers. We also find a significant expansion in scope of activities of loan officers who deal primarily with affected borrowers, as well as of their superiors. There is suggestive evidence that larger banks in the economy were better able to implement similar changes as our bank. We argue that these patterns can be understood within the framework of incentive-based and information cost processing theories. Our findings could help rationalize why improvements in the information environment of borrowers may be altering the landscape of lending by moving decisions outside the boundaries of financial intermediaries.
This chapter outlines the conditions under which accounting-based smoothing can be beneficial for policyholders who hold with-profit or participating payout life annuities (PLAs). We use a realistically-calibrated model of PLAs to explore how alternative accounting techniques influence policyholder welfare as well as insurer profitability and stability. We find that accounting smoothing of participating life annuities is favorable to consumers and insurers, as it mitigates the impact of short-term volatility and enhances the utility of these long-term annuity contracts.
We investigate the determinants of firms’ implicit insurance to employees, using a difference-in-difference approach: we rely on differences between family and non-family firms to identify the supply of insurance, and exploit variation in unemployment insurance across and within countries to gauge workers’ demand for insurance. Using a firm-level panel from 41 countries, we find that family firms feature more stable employment, greater wage flexibility and lower labor cost than non-family ones. Employment stability in family firms is greater, and the wage discount larger, in countries with more generous public unemployment insurance: private and public provision of employment insurance are substitutes.
We propose a multivariate dynamic intensity peaks-over-threshold model to capture extreme events in a multivariate time series of returns. The random occurrence of extreme events exceeding a threshold is modeled by means of a multivariate dynamic intensity model allowing for feedback effects between the individual processes. We propose alternative specifications of the multivariate intensity process using autoregressive conditional intensity and Hawkes-type specifications. Likewise, temporal clustering of the size of exceedances is captured by an autoregressive multiplicative error model based on a generalized Pareto distribution. We allow for spillovers between both the intensity processes and the process of marks. The model is applied to jointly model extreme returns in the daily returns of three major stock indexes. We find strong empirical support for a temporal clustering of both the occurrence of extremes and the size of exceedances. Moreover, significant feedback effects between both types of processes are observed. Backtesting Value-at-Risk (VaR) and Expected Shortfall (ES) forecasts show that the proposed model does not only produce a good in-sample fit but also reliable out-of-sample predictions. We show that the inclusion of temporal clustering of the size of exceedances and feedback with the intensity thereof results in better forecasts of VaR and ES.
Expectations of Sterling returning to Gold have been disregarded in empirical work on the US dollar – Sterling exchange rate in the early 1920s. We incorporate such considerations in a PPP model of the exchange rate, letting the probability of a return to gold follow a logistic function. We draw several conclusions: (i) the PPP model works well from spring 1919 to spring 1925; (ii) wholesale prices outperform consumer prices; (iii) allowing for a return to gold leads to a higher speed of adjustment of the exchange rate to PPP; (iv) interest rate differentials and the relative monetary base are crucial determinants of the expected return to gold; (v) the probability of a return to Gold peaked at about 72% in late 1924 and but fell to about 60% in early 1925; and (vi) our preferred model does not support the Keynes’ view that Sterling was overvalued after the return to gold.
Since the 1970s, the overarching view in the literature has been that a Phillips curve relationship did not exist in Ireland prior to the 1979 exchange rate break with Sterling. It was argued that, as a small open economy, prices were determined externally. To test this relationship, we study the determination of inflation between 1926 and 2012, a longer sample period than any previously used. We find that the difference between unemployment and the NAIRU is a significant determinant of inflation both in the full sample and in the subsamples spanning the periods before and after the Sterling parity link.
In this paper we assemble an annual data set on broad and narrow money, prices, real economic activity and interest rates in Ireland from a variety of sources for the period 1933-2012. We discuss in detail how the data set is constructed and what assumptions we have made to do so. Furthermore, we estimate a simple SVAR model to provide some empirical evidence on the behaviour of these time series. Money supply shocks appear to be the most important drivers of both money and prices. Interest rate shocks, which capture monetary policy, play an important role driving output and, of course, interest rates. The GDP shocks, which raise prices, seem of less importance.
We model education as an investment in human capital that, like other investments, is appropriately evaluated in a framework that accounts for risk as well as return. In contrast to dominant wage-premia approach to calculating the returns to education, but which implicitly ignores risk, we evaluate the returns by treating the value of human capital as the price of a non-tradable risky asset. We do so using a lifecycle framework that incorporates risk preferences and earnings risk, as well as a progressive income tax and social insurance system. Our baseline estimate is that a college degree provides a $440K dollar increase in annual certainty-equivalent consumption. Although significantly smaller than traditional estimates of the value of education, these returns are still large enough to offset both the direct and indirect cost of college education for a large range of plausible preference parameters. Importantly, however, we find that accounting for risk reverses the finding from the education wage-premia literature regarding the trends in the returns to education. In particular, we find that the risk-adjusted gains from college completion actually decreased rather than increased in the recent period. Overall, our results show the importance of earnings risks in assessing the value of education.
We examine how U.S. monetary policy affects the international activities of U.S. Banks. We access a rarely studied US bank‐level dataset to assess at a quarterly frequency how changes in the U.S. Federal funds rate (before the crisis) and quantitative easing (after the onset of the crisis) affects changes in cross‐border claims by U.S. banks across countries, maturities and sectors, and also affects changes in claims by their foreign affiliates. We find robust evidence consistent with the existence of a potent global bank lending channel. In response to changes in U.S. monetary conditions, U.S. banks strongly adjust their cross‐border claims in both the pre and post‐crisis period. However, we also find that U.S. bank affiliate claims respond mainly to host country monetary conditions.
No. And not only for the reason you think. In a world with multiple inefficiencies the single policy tool the central bank has control over will not undo all inefficiencies; this is well understood. We argue that the world is better characterized by multiple inefficiencies and multiple policy makers with various objectives. Asking the policy question only in terms of optimal monetary policy effectively turns the central bank into the residual claimant of all policy and gives the other policymakers a free hand in pursuing their own goals. This further worsens the tradeoffs faced by the central bank. The optimal monetary policy literature and the optimal simple rules often labeled flexible inflation targeting assign all of the cyclical policymaking duties to central banks. This distorts the policy discussion and narrows the policy choices to a suboptimal set. We highlight this issue and call for a broader thinking of optimal policies.
We examine firms’ simultaneous choice of investment, debt financing and liquidity in a large sample of US corporates between 1980 and 2014. We partition the sample according to the firms’ financial constraints and their needs to hedge against future shortfalls in operating income. In contrast to earlier work, our joint estimation approach shows that cash flows affect the corporate decisions of unconstrained firms more strongly than those of constrained firms. Investment-cash flow sensitivities are particularly intense for unconstrained firms with high hedging needs. Investment opportunities (as proxied by Q), however, play a larger role for constrained firms with the effects being strongest in case of low hedging needs. Interestingly, constrained firms with low hedging needs are found to employ more debt to finance their investment opportunities and build up significant cash holdings at the same time. Our results hence indicate overinvestment behavior for unconstrained firms but no underinvestment for constrained firms if they have low hedging needs.
We develop a dynamic recursive model where political and economic decisions interact, to study how excessive debt-GDP ratios affect political sustainability of prudent fiscal policies. Rent seeking groups make political decisions – to cooperate (or not) – on the allocation of fiscal budgets (including rents) and issuance of sovereign debt. A classic commons problem triggers collective fiscal impatience and excessive debt issuing, leading to a vicious circle of high borrowing costs and sovereign default. We analytically characterize debt-GDP thresholds that foster cooperation among rent seeking groups and avoid default. Our analysis and application helps in understanding the politico-economic sustainability of sovereign rescues, emphasizing the need for fiscal targets and possible debt haircuts. We provide a calibrated example that quantifies the threshold debt-GDP ratio at 137%, remarkably close to the target set for private sector involvement in the case of Greece.
In 2000 Italy replaced its traditional system of severance pay for public employees with a new system. Under the old regime, severance pay was proportional to the final salary before retirement; under the new regime it is proportional to lifetime earnings. This reform entails substantial losses for future generations of public employees, in the range of €20,000-30,000, depending on seniority. Using a difference-in-difference framework, we estimate the impact of this unanticipated change in lifetime resources, on the current consumption and wealth accumulation of employees affected by the reform. In line with theoretical simulations, we find that each euro reduction in severance pay reduces the average propensity to consume by 3 cents and increases the wealth-income ratio by 0.32. The response is stronger for younger workers and for households where both spouses are public sector employees.
We examine the inter-linkages between financial factors and real economic activity. We review the main theoretical approaches that allow financial frictions to be embedded into general equilibrium models. We outline, from a policy perspective, the most recent empirical papers focusing on the propagation of exogenous shocks to the economy, with a particular emphasis on works dealing with time variation of parameters and other types of nonlinearities. We then present an application to the analysis of the changing transmission of financial shocks in the euro area. Results show that the effects of a financial shock are time-varying and contingent on the state of the economy. They are of negligible importance in normal times but they greatly matter in conditions of stress.