Economic Response Research Articles

Climate actions, market beliefs, and monetary policy

This paper studies the role of expectations and monetary policy in the economy's response to climate actions. We show that in a stochastic environment, without the standard assumption of the perfect rationality of agents, there is more uncertainty regarding the path and the economic impact of a climate policy, with a potential threat to the ability of central banks to maintain price stability. Market beliefs and behavioral agents increase the trade-offs inherent to the chosen mitigation tool, with a carbon tax entailing more emissions uncertainty than in a rational expectations model and a cap-and-trade scheme implying a more pronounced pressure on allowance prices and inflation. The impact on price stability is worsened by delays in the implementation of stringent climate policies, the lack of confidence in the ability of central banks to keep inflation under control, and the adoption of monetary rules tied to expectations rather than current macroeconomic conditions. Central banks can implement successful stabilization policies that reduce the uncertainty surrounding the impact of climate actions and support the greening process while remaining within their mandate.

Fiscal policy and the monetary transmission mechanism

The economy's response to monetary policy depends on its fiscal backing. We present a novel decomposition of the equilibrium that links the wealth effect, i.e. the revaluation of households' financial and human wealth, to the fiscal response to monetary policy. When monetary policy has fiscal consequences, monetary variables affect the timing of aggregate output while fiscal variables shape its present value and the wealth effect. Consequently, a contractionary monetary policy reduces inflation only if followed by contractionary fiscal policy. The slope of the Phillips curve determines the importance of monetary-fiscal coordination for the effectiveness of monetary policy.

Individualism during Crises

Abstract Individualism has long been linked to economic growth. Using the COVID-19 pandemic, we show that such a culture can hamper the economy's response to crises, a period with heightened coordination frictions. Exploiting variation in U.S. counties' frontier experience, we show that more individualistic counties engage less in social distancing and charitable transfers and are less willing to receive COVID-19 vaccines. The effect of individualism is stronger where social distancing has higher externality and holds at the individual level when we exploit migrants for identification. Our results suggest that individualism can exacerbate collective action problems during economic downturns.

Dynamic Labor Reallocation with Heterogeneous Skills and Uninsured Idiosyncratic Risk

Occupational specificity of human capital motivates an important role of occupational reallocation for the economy's response to shocks and for the dynamics of inequality. We introduce occupational mobility, through a random choice model with dynamic value function optimization, into a multi-sector/multi-occupation Bewley-Aiyagari model with heterogeneous income risk, liquid and illiquid assets, price adjustment costs, and in which households differ by their occupation-specific skills. Labor income is a combination of endogenous occupational wages and idiosyncratic shock. Occupational reallocation and its impact on the economy depend on the transferability of workers' skills across occupations and occupational specialization of the production function. The model matches well the statistics on income and wealth inequality, and the patterns of occupational mobility. It provides a laboratory for studying the short- and long-run effects of occupational shocks, automation and task encroaching on income and wealth inequality. We apply the model to the pandemic recession by adding an SIR block with occupation-specific infection risk and a ZLB policy and study the impact of occupational and aggregate labor supply shocks. We find that occupational mobility may tame the effect of the shocks but amplifies earnings inequality, as compared to a model without mobility.

Search with Wage Posting under Sticky Prices

AbstractThis paper examines the implications of interacting pricing frictions, labor market frictions, and consumption risk by comparing variants of a New Keynesian model. The model variants make alternative assumptions about whether hiring and pricing decisions occur within the same firm or across different firms, and whether workers pool income. Each model implies the same contract is offered to workers, making model comparisons transparent. The economy's response to changes in unemployment benefits or persistently below‐target inflation depends on whether hiring and pricing decisions are integrated. The dynamics following technology or monetary shocks are shaped both by firm‐ and worker‐level assumptions.

Modelling the Reserve Bank of Australia's Policy Decisions and the Case for a Negative Cash Rate

AbstractTaylor's eponymous ‘rule’ models how central banks set policy rates in response to inflation and output. We estimate a Taylor rule for the Reserve Bank of Australia (RBA), modifying it to make it more realistic, while retaining its simplicity. The model implies that if the Bank responds to recent forecasts as it has on average since 1995, the cash rate could have briefly gone negative in 2020. But the RBA is wary of negative cash rates. There are grounds for caution; the economic outlook is particularly uncertain and the economy's response to negative rates is uncharted territory.

Components of Uncertainty

Uncertainty is acknowledged to be a source of economic fluctuations. But, does the type of uncertainty matter for the economy's response to an uncertainty shock? This paper offers a novel identification strategy to disentangle different types of uncertainty. It uses machine learning techniques to classify different types of news instead of specifying a set of keywords. It is found that, depending on its source, the effects of uncertainty on macroeconomic variable may differ. I find that both good (expansionary effect) and bad (contractionary effect) types of uncertainty exist.

COMPONENTS OF UNCERTAINTY

AbstractUncertainty is acknowledged to be a source of economic fluctuations. But, does the type of uncertainty matter for the economy's response to an uncertainty shock? This article offers a novel identification strategy to disentangle different types of uncertainty. It uses machine learning techniques to classify different types of news instead of specifying a set of keywords. The article finds that, depending on its source, the effects of uncertainty on a macroeconomic variable may differ. I find that both good (expansionary effect) and bad (contractionary effect) types of uncertainty exist.

Product Quality, Measured Inflation and Monetary Policy

This paper proposes a tractable New Keynesian (NK) economy with endogenous adjustment in product quality that nests the canonical framework. Endogenous quality choice reduces the slope of the traditional NK Phillips curve and amplifies the economy's response to productivity shocks. This leads to a less reactionary monetary policy where model misspecification of imperfectly observable quality adjustments matters more for macroeconomic stabilization than the mismeasurement of those adjustments. With no misperception of product quality by the monetary authority, the principles for optimal monetary policy are, nonetheless, unchanged as the quality extensions to the canonical NK model preserve divine coincidence.

Shocks to Transition Risk

We propose and implement a method to identify shocks to transition risk. We identify transition risk shocks as instances where a strong differential valuation of green versus brown firms coincides with significant information on climate change. For that purpose, we combine information from long-short equity portfolios sorted on firms' carbon footprints with information from textual analysis of newspaper archives. We find that shocks increasing transition risk (negative abnormal returns of brown firms) induce a decline in aggregate and sectoral industrial production. Moreover, they significantly affect financial stability, as measured by the excess bond premium or credit conditions more generally. Finally, we document a pronounced asymmetry in the economy's response to shocks increasing or decreasing transition risk.

Financial Development and Trade Liberalization

We investigate the extent to which frictions in financial markets affect the gains from trade liberalization. We study a small open economy populated with entrepreneurs heterogeneous in productivity and net worth who can trade internationally and are subject to financing constraints. We calibrate the model to match key features of Colombian plant-level data and use it to quantify the role of credit frictions in shaping the economy's response to trade liberalization. We find that frictions in financial markets slow down the response of capital and output in the aftermath of trade liberalization; in contrast, the dynamics of exports adjustment are largely independent of financial development. We document evidence consistent with these findings for the Colombian trade liberalization in the early 1990s.

Learning from Monetary and Fiscal Policy

We present a dynamic incomplete information model where monetary and fiscal policy instruments serve as endogenous signals for the private sector. We highlight a novel information channel of policy interactions, and show the general equilibrium (GE) information feedback between policies largely shapes the economy's response to policy shocks. We document a non-monotone signaling effect of policies with respect to the policy rule parameters. Our analysis shows the GE information feedback is quantitatively significant, and the model provides a unified explanation of the various policy impacts on inflation, the dynamics of survey expectations, and the missing inflation after the Great Recession.

THE EXPORT DETERMINANT OF SOCIO-ECONOMIC RESILIENCE IN FOREIGN ECONOMIC ACTIVITY

An undoubted advantage of the diversified economies is their less sensitivity to dynamics fluctuations of local sectors and shock destructions. A downturn in one industry can be compensated by growth in another. Formed in Soviet times significant industrial potential of Ukraine was not possible to implement only in the national economy. A significant part of Ukrainian manufacturing and extractive industries products was consumed by foreign consumers. Formed absolute and relative advantage in international trade ensured the enrichment of a limited set of stakeholders and have become the drivers of system economic crisis and the loss of Ukraine's ability to adsorb (to leap back) shock disturbance. The results of the analysis indicate the negative impact of resources specificity on the Ukraine's ability to ensure sustainable development. Proved the validity of conclusions about the negative effects of high exports concentration (low commodity diversification) on the economy's response from shock disturbances.

Risk Shocks, Risk Management and Investment

This paper studies the macroeconomic effects of shocks to idiosyncratic business risk in an economy with endogenously incomplete markets. I develop a model in which firms face idiosyncratic risk and obtain insurance from intermediaries through contracts akin to credit lines. Insurance is imperfect due to limited commitment in financial contracts. Although steady-state capital is higher than if firms were constrained to issue only standard equity, a rise in uncertainty about idiosyncratic business outcomes leads to an endogenous reduction in risk sharing. This deterioration in risk sharing results from a general-equilibrium shortage of pledgeable assets and implies that the economy's response to an increase in idiosyncratic business risk can be amplified by financial contracting rather than dampened. In a parametrized version of the model, a rise in idiosyncratic business risk generates a large increase in uncertainty about aggregate investment.

Fiscal Distress and Banking Performance: The Role of Macroprudential Regulation

Fiscal fragility can undermine a government's ability to honor its bank deposit insurance pledge and induces a positive correlation between sovereign default risk and financial (bank) default risk. We show that this positive relation is reversed if bank capital requirements in fiscally weak countries are allowed to adjust optimally. The resulting higher requirements buttress the banking system and support higher output and welfare relative to the case where macroprudential policy does not vary with the degree of fiscal stress. Fiscal tenuousness also exacerbates the effects of other risk shocks. Nonetheless, the economy's response can be mitigated if macroprudential policy is adjusted optimally. Our analysis implies that, on the basis of fiscal strength, fiscally weak countries would favor and fiscally strong countries would object to banking union.

The UK Economy: Forecast Summary

The UK economy is facing an unusual level of uncertainty because of Brexit. This uncertainty primarily stems from the yet to be defined relationship between the UK and the EU but also from the economy's response to the new framework once it emerges. The UK government's White Paper, which set out its preferences for that new relationship, has failed to unite the government or Parliament, leaving open an entire spectrum of possible outcomes.Our central forecast under a ‘soft Brexit’ scenario is that the economy will grow at a pace that is consistent with its potential. This translates to annual GDP growth of 1.4 per cent this year and 1.7 per cent next year, which is broadly unchanged from our previous forecast. The risks to our GDP growth forecast are wider than before and tilted to the downside.As before, we condition our forecast on a gentle path of monetary policy normalisation with the next 25 basis point rate increase this month. On the fiscal side, we recommend that the government maintains its current level of spending (as a share of GDP) and raises the quality of public services.

How Robust Are Popular Models of Nominal Frictions?

AbstractWe consider alternative combinations of nominal price and wage frictions in dynamic stochastic general equilibrium models fit to U.S. data. Since inflation was unanchored in the 1970s, we divide the data into early, middle, and late samples (1955–68, 1969–79, and 1983–2007, respectively). We find that prices are reoptimized more frequently and exhibit greater indexation to past inflation in the middle sample than in the other two samples, while wages are reoptimized with increasing frequency and display less evidence of indexation over time. Differences in price and wage setting across samples have important implications for the economy's response to key shocks.

Uncertainty Shocks in a Model of Effective Demand: Reply

de Groot, Richter, and Throckmorton, 2018 argue that the model in Basu and Bundick, 2017 can match the empirical evidence only because the model assumes an asymptote in the economy's response to an uncertainty shock. In this Reply, we provide new results showing that our model's ability to match the data does not rely either on assuming preferences that imply an asymptote nor on a particular value of the intertemporal elasticity of substitution. We demonstrate that shifting to preferences that are not vulnerable to the Comment's critique does not change our previous conclusions about the propagation of uncertainty shocks to macroeconomic outcomes.

Uncertainty Shocks in a Model of Effective Demand: Reply

de Groot, Richter, and Throckmorton (2018) argue that the model in Basu and Bundick (2017) can match the empirical evidence only because the model assumes an asymptote in the economy's response to an uncertainty shock. In this Reply, we provide new results showing that our model's ability to match the data does not rely either on assuming preferences that imply an asymptote nor on a particular value of the intertemporal elasticity of substitution. We demonstrate that shifting to preferences that are not vulnerable to the Comment's critique does not change our previous conclusions about the propagation of uncertainty shocks to macroeconomic outcomes.

Policy Paradoxes in the New Keynesian Model

Abstract The common sticky-prices New-Keynesian model behaves differently in a zero-lower bound environment. Fiscal and forward guidance multipliers can be very large. Positive supply shocks, such as an increase in productivity, will lower production, and increased price flexibility can exacerbate such a decline in output (as well as amplifying the effects of other shocks). These results are fragile and disappear under a plausible alternative to sticky prices (sticky information): Fiscal and monetary multipliers are smaller, positive supply shocks raise output, and greater price flexibility, in the sense of more frequent updating of information, moves the economy's response toward the neoclassical benchmark.