Aggregate Demand Externalities Research Articles

Aggregate Demand Externality and Self-Fulfilling Default Cycles

Aggregate Demand Externality and Self-Fulfilling Default Cycles

Aggregate Demand Externality and Self-Fulfilling Default Cycles

Aggregate Demand Externality and Self-Fulfilling Default Cycles

Equity Home Bias in a Capital Market Union

I study the social efficiency and aggregate effects of equity home bias using a general equilibrium model with nominal rigidities and a fixed exchange rate. I find that the source of home bias is key for analyzing the wedge between equilibrium and socially optimal levels of home bias. Surprisingly, when home bias is due to labor income hedging effects, stock positions tend to be approximately efficient despite the aggregate demand externalities induced by the rigidities. On the other hand, home stock positions are excessive when home bias is due to financial frictions or biased expectations. The key theoretical results hold numerically well in a more general quantitative model.

Aggregate demand externalities, income distribution, and wealth inequality

We study a two-class model of growth and the distribution of income and wealth at the intersection of contemporary work in classical political economy and post-Keynesian economics. The key insight is that aggregate demand is an externality for individual firms: this generates a strategic complementarity in production and results in equilibrium underutilization of the economy’s productive capacity, as well as hysteresis in real output. Underutilization also affects the functional distribution of income and the distribution of wealth: both the wage share and the workers’ wealth share would be higher at full capacity. Consequently, fiscal allocation policy that achieves full utilization also attains a higher labor share and a more equitable distribution of wealth; while demand shocks have permanent level effects. Extensions look at hysteresis in the employment rate and growth. These findings are useful as an organizing framework for thinking through the lackluster economic record of the so-called Neoliberal era, the sluggish recovery of most advanced economies following the Great Recession, and the importance of fiscal policy in countering large shocks such as the Covid-19 pandemic.

Capital Controls: Theory and Evidence

This paper synthesizes recent advances in the theoretical and empirical literature on capital controls. We start by observing that international capital flows have both benefits and costs, but some of these are not internalized by individual actors and thus constitute externalities. The theoretical literature has identified pecuniary externalities and aggregate demand externalities that respectively contribute to financial instability and recessions. These externalities provide a natural rationale for countercyclical capital controls that lean against boom and bust cycles in international capital flows. The empirical literature has developed several measures of capital controls to capture different aspects of capital account openness. We evaluate the strengths and weaknesses of different measures and provide an overview of the empirical findings on the effectiveness of capital controls in addressing the externalities identified by the theory literature, that is, in reducing financial fragility and enhancing macroeconomic stability. We also discuss strategies to deal with the endogeneity of capital controls in such statistical exercises. We conclude by providing an overview of the historical and current debates on the role of capital controls in macroeconomic management and their relationship to the academic literature. (JEL D62, F32, F33, F38, F44)

Beauty Contests and the Term Structure

Abstract A novel decomposition highlights the scope for information to influence the term structure of interest rates. Based on the law of total covariance, we show that real term premia in macroeconomic models contain a component that depends on covariances of realised stochastic discount factors and a component that depends on covariances of expectations of those stochastic discount factors. The covariance of expectations is typically low in macrofinance models, which contributes to the real term premia implied by the models being at least an order of magnitude too small, a result that is unchanged even if we introduce aggregate demand externalities combined with shocks to higher-order beliefs. We argue that generating realistic term premia requires there to be strategic complementarities in the formation of expectations. A quantitative model, in which beliefs are formed in a beauty contest, can explain a significant proportion of observed term premia, when estimated using data on expectations of productivity growth from the Survey of Professional Forecasters.

Unemployment Insurance in Macroeconomic Stabilization

Does the generosity of unemployment insurance (UI) have a role to play in macroeconomic stabilization? When inefficient fluctuations arise from nominal rigidities and constraints on monetary policy, I demonstrate that it does, owing to the interaction between UI and aggregate demand. From a positive perspective, a marginal increase in UI generosity affects output and employment through a redistribution effect on aggregate demand. From a normative perspective, two forces determine optimal generosity beyond the classic trade-off between insurance and incentives: an aggregate demand externality and an effect of low aggregate demand on the social cost of disincentives. The aggregate demand externality summarizes the welfare impact of the redistribution effect when the economy is slack; both are governed by the difference in marginal propensities to consume between the unemployed and employed. Quantitatively, a calibrated model with search frictions, incomplete markets, and a binding zero lower bound suggests that the 2008–13 UI benefit extensions in the U.S. had important stabilization effects through these channels. Compared to counterfactual benefit durations capped at 9 months in the calibrated model, the extensions to 22 months prevent a 2-5 percentage point rise in the unemployment rate and generate a strict Pareto improvement.

Aggregate Demand Externalities, Income Distribution, and Wealth Inequality

We study a two-class model of growth and the distribution of income and wealth at the intersection of contemporary work in classical political economy and post-Keynesian economics. The key insight is that aggregate demand is an externality for individual firms: this generates a strategic complementarity in production and results in equilibrium underutilization of the economy's productive capacity, as well as hysteresis in real output. Underutilization also affects the functional distribution of income and the distribution of wealth: both the wage share and the workers' wealth share would be higher at full capacity. Consequently, fiscal allocation policy that achieves full utilization also attains a higher labor share and a more equitable distribution of wealth; while demand shocks have permanent level effects. Extensions look at hysteresis in the employment rate and growth. These findings are useful as an organizing framework for thinking through the lackluster economic record of the so-called Neoliberal era, the sluggish recovery of most advanced economies following the Great Recession, and the importance of fiscal policy in countering large shocks such as the Covid-19 pandemic.

Optimal Policy Under Dollar Pricing

Recent empirical evidence shows that most international prices are sticky in dollars. This paper studies the optimal policy implications of this fact in the context of an open economy model, allowing for an arbitrary structure of asset markets, general preferences and technologies, time-or state-dependent price setting, a rich set of shocks, and endogenous currency choice. We show that although monetary policy is less efficient and cannot implement the flexible-price allocation, inflation targeting remains robustly optimal in non-U.S. economies. The implementation of this non-cooperative policy results in a “global monetary cycle” with other countries partially pegging their exchange rates to the dollar and importing the monetary stance of the U.S. In spite of the aggregate demand externality, capital controls cannot unilaterally improve the allocation and are useful only when coordinated across countries. The optimal U.S. policy, on the other hand, deviates from inflation targeting to take advantage of its effects on global product and asset markets, generating negative spillovers on the rest of the world. International cooperation benefits other countries by improving global demand for dollar-invoiced goods, but may be hard to sustain because it is not in the self-interest of the U.S. At the same time, countries can still gain from local forms of policy coordination — such as forming a currency union like the Eurozone.

Macroprudential Policies in a Low Interest Rate Environment

AbstractIn this paper, we analyze the use of macroprudential policies in a low interest rate environment, where an occasionally binding zero lower bound (ZLB) constraint gives rise to aggregate demand externalities. We study this issue by using a dynamic stochastic general equilibrium (DSGE) model with financial frictions and a monetary policy rule that is subject to the ZLB. We find that, in a low interest rate environment, the occasionally binding ZLB creates additional scope for macroprudential intervention. When the interest rate is high and the two policies can perfectly coordinate, the optimal policy prescriptions behave as if they were independent. This is, however, no more the case, when the interest rate is low and/or when monetary policy and macroprudential policy cannot be perfectly coordinating. This more complex policy environment calls for more policy coordination.

Optimal Monetary Policy Under Dollar Pricing

Recent empirical evidence shows that most international prices are sticky in dollars. This paper studies the optimal policy implications of this fact in the context of an open economy model, allowing for an arbitrary structure of asset markets, general preferences and technologies, time- or state-dependent price setting, a rich set of shocks, and endogenous currency choice. We show that although monetary policy is less efficient and cannot implement the flexible-price allocation, inflation targeting remains robustly optimal in non-U.S. economies. The implementation of this non-cooperative policy results in a monetary cycle with other countries partially pegging their exchange rates to the dollar and importing the monetary stance of the U.S. In spite of the aggregate demand externality, capital controls cannot unilaterally improve the allocation and are useful only when coordinated across countries. The optimal U.S. policy, on the other hand, deviates from inflation targeting to take advantage of its effects on global product and asset markets, generating negative spillovers on the rest of the world. International cooperation benefits other countries by improving global demand for dollar-invoiced goods, but may be hard to sustain because it is not in the self-interest of the U.S. At the same time, countries can still gain from local forms of policy coordination -- such as forming a currency union like the Eurozone.

Corporate finance, monetary policy, and aggregate demand

I study how heterogeneity of financial frictions and monopolistic competition influence the pass through of the nominal interest rate to the real lending rate, its transmission into investment, and corporate cash holdings. Firms finance stochastic investment opportunities with either bank-issued credit or money. The market structure generates an aggregate demand externality which doubles transmission at the a policy rate of 4.8% and magnifies the effects of financial frictions on investment. In line with empirical evidence, the cash-to-sales ratio increases with the extent of financial constraints, and rises with the intensity of competition for financially constrained firms. Financial constraints raise firms’ sensitivity to monetary policy; and a mean-preserving spread of financial frictions reduces investment and output, strengthens transmission, and reduces the external share of finance.

Capital Controls: A Survey of the New Literature

This paper reviews selected post-Global Financial Crisis theoretical and empirical contributions on capital controls and identifies three theoretical motives for the use of capital controls: pecuniary externalities in models of financial crises, aggregate demand externalities in new-Keynesian models of the business cycle, and terms of trade manipulation in open economy models with pricing power. Pecuniary and demand externalities offer the most compelling case for the adoption of capital controls, but macroprudential policy can also address the same distortions. So capital controls generally are not the only instrument that can do the job. If evaluated through the lenses of the new theories, the empirical evidence reviewed suggests that capital controls can have the intended effects, even though the extant literature is inconclusive as to whether the effects documented amount to a net gain or loss in welfare terms. Terms of trade manipulation also provides a clear cut theoretical case for the use of capital controls, but this motive is less compelling because of the spillover and coordination issues inherent with the use of control on capital flows for this purpose. Perhaps not surprisingly, only a handful of countries have used capital controls in a countercyclical manner, while many adopted macroprudential policies. This suggests that capital control policy might entail additional costs other than increased financing costs, such as signaling the bad quality of future policies, leakages, and spillovers.

Liquidity traps, capital flows

Motivated by debates surrounding international capital flows during the Great Recession, we conduct a positive and normative analysis of capital flows when a region of the global economy experiences a liquidity trap. Capital flows reduce inefficient output fluctuations in this region by inducing exchange rate movements that reallocate expenditure towards the goods it produces. Restricting capital mobility hampers such an adjustment. From a global perspective, constrained efficiency entails subsidizing capital flows to address an aggregate demand externality associated with exchange rate movements. Absent cooperation, however, dynamic terms-of-trade manipulation motives drive countries to inefficiently restrict capital flows, impeding aggregate demand stabilization.

Law and Macroeconomics as Aggregate Demand Externalities: An Application to Optimal Tort Law

This paper presents one method for introducing macroeconomic concerns into the standard microeconomic models of law, using the canonical economic model of tort law as an example. When an economy suffers from inadequate aggregate demand, expendi-tures on precautions to avoid injuries have aggregate demand externalities. In addition to reducing damages from injury, expenditures on precautions raise incomes for the sellers of precautions (e.g., car brake mechanics). With higher incomes, the sellers, in turn, con-sume and invest more. This multiplier effect of the original expenditure on total spending and output can be modelled as an aggregate demand externality and incorporated into the standard economic models of law. When I introduce aggregate demand externalities into the seminal economic model of tort law, we come to very different conclusions than is standard. Specifically, the strict liability rule and the Hand Rule for negligence both pro-duce inefficient outcomes with respect to expenditures on precaution and activity levels. Instead, negligence rules with more stringent standards of care than the Hand Rule be-come more efficient. If standards of care get too high, however, then an enhanced negligence rule no longer yields a better outcome than strict liability or the Hand Rule. Optimal tort law therefore looks very different when we introduce aggregate demand ex-ternalities. If efficient tort law changes when we introduce macroeconomic effects, then we can presume that our law and microeconomic conclusions regarding other areas of law will change as well.

Moral Hazard Misconceptions: The Case of the Greenspan Put

Policy discussions on financial regulation tend to assume that whenever a corrective policy is used ex post to ameliorate the effects of a crisis, there are negative side effects in terms of moral hazard ex ante. This paper shows that this is not a general theoretical prediction, focusing on the case of monetary policy interventions ex post. In particular, we show that if the central bank does not intervene by monetary easing following a crisis, an aggregate demand externality makes borrowing ex ante inefficient. If instead the central bank follows the optimal discretionary policy and intervenes to stabilize asset prices and real activity, we show examples in which the aggregate demand externality disappears, reducing the need for ex ante intervention.

Aggregate Demand and the Dynamics of Unemployment

We introduce an aggregate demand externality into the Mortensen-Pissarides model of equilibrium unemployment. Because firms care about the demand for their products, an increase in unemployment lowers the incentives to post vacancies which further increases unemployment. This positive feedback creates a coordination problem among firms and leads to multiple equilibria. We show, however, that the multiplicity disappears when enough heterogeneity is introduced in the model. In this case, the unique equilibrium still exhibits interesting dynamic properties. In particular, the importance of the aggregate demand channel grows with the size and duration of shocks, and multiple stationary points in the dynamics of unemployment can exist. We calibrate the model to the U.S. economy and show that the mechanism generates additional volatility and persistence in labor market variables, in line with the data. In particular, the model can generate deep, long-lasting unemployment crises.

A Theory of Macroprudential Policies in the Presence of Nominal Rigidities

We propose a theory of monetary policy and macroprudential interventions in financial markets. We focus on economies with nominal rigidities in goods and labor markets and subject to constraints on monetary policy, such as the zero lower bound or fixed exchange rates. We identify an aggregate demand externality that can be corrected by macroprudential interventions in financial markets. Ex post, the distribution of wealth across agents affects aggregate demand and output. Ex ante, however, these effects are not internalized in private financial decisions. We provide a simple formula for the required financial interventions that depends on a small number of measurable sufficient statistics. We also characterize optimal monetary policy. We extend our framework to incorporate pecuniary externalities, providing a unified approach to both externalities. Finally, we provide a number of applications which illustrate the relevance of our theory. [web URL: http://onlinelibrary.wiley.com/doi/10.3982/ECTA11883/abstract]

Coordinating Business Cycles

We develop a quantitative theory of business cycles with coordination failures. Because of a standard aggregate demand externality, firms want to coordinate production. The presence of a non-convex capacity decision generates multiple equilibria under complete information. We use a global game approach to show that, under incomplete information, the multiplicity of equilibria disappears to give rise to a unique equilibrium with two stable steady states. The economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. In our calibration, the coordination channel improves on the neoclassical growth model in terms of business cycle asymmetries and skewness. The model also accounts for features of the 20072009 recession and its aftermath. Government spending is harmful in general as the coordination problem magnifies the crowding out. It can, however, increase welfare — without nominal rigidities — when the economy is about to transition to the bad steady state. Simple subsidies implement the efficient allocation.

Liquidity Trap and Excessive Leverage

We investigate the role of macroprudential policies in mitigating liquidity traps. When constrained households engage in deleveraging, the interest rate needs to fall to induce unconstrained households to pick up the decline in aggregate demand. If the fall in the interest rate is limited by the zero lower bound, aggregate demand is insufficient and the economy enters a liquidity trap. In this environment, households' ex ante leverage and insurance decisions are associated with aggregate demand externalities. Welfare can be improved with macroprudential policies targeted toward reducing leverage. Interest rate policy is inferior to macroprudential policies in dealing with excessive leverage. (JEL D14, E23, E32, E43, E52, E61, E62)