Consumption Volatility Research Articles

Costly financial intermediation and excess consumption volatility

This paper documents the cyclical properties of financial intermediation costs and uses their dynamics to explain excess consumption volatility (ECV) differences across countries in a dynamic stochastic general equilibrium framework with housing market. I find that financial development levels have a limited role in explaining ECVs. Instead, the volatility of financial sectors plays the determinative role. Consistent with the data, the model finds higher ECVs in emerging countries. The paper also shows that if the US had the same intermediation cost structure as Turkey, deteriorations in the production and consumption following a financial shock would increase threefold.

The Macroeconomic Effects of Progressive Taxes and Welfare

We analyze the positive and normative effects of a progressive tax on wages in a nonlinear New Keynesian DSGE model in the presence of demand and technology shocks. The non-linearity allows us to disentangle the effects of the progressive tax on the volatility and the level of macroeconomic variables, for both intertemporally optimizing (Ricardian) and non-Ricardian (rule-of-thumb) households. We find that the interaction of the two household types is of crucial importance. When only Ricardian households are considered, progressive taxes increase welfare (compared to at taxes) in the presence of technology shocks. Aggregate welfare falls, however, when rule-of-thumb households are added to the analysis. The progressive tax increases the welfare of the latter household by lowering its consumption volatility, but this is overcompensated for by the destabilization of Ricardian household consumption. Under demand shocks, progressive taxes reduce the welfare of both household types, with the welfare of rule-of-thumb households falling despite a decline in their consumption volatility. The reason is a lower average consumption level which is related to the changed curvature of the marginal cost function.

Fiscal Policy in Oil‐exporting Countries: The Roles of Oil Funds and Institutional Quality

AbstractOil‐exporting countries face challenges in the conduct of fiscal policy owing to volatile oil revenues, especially in countries with weak institutions. Many oil exporters have established oil funds to delink government expenditure from oil revenues; however, their effectiveness remains unresolved. This paper examines the roles of oil funds and institutional quality in reducing fiscal procyclicality and macroeconomic volatility in 42 oil‐exporting countries from 1960 to 2014 using panel vector autoregression techniques. The results show that oil funds are effective in reducing fiscal procyclicality in countries with high institutional quality. There is also a reduction in the procyclical bias in those with low institutional quality but the statistical evidence is weak. Nevertheless, oil funds are associated with reduced volatility of government consumption and the real exchange rate in countries with low institutional quality. These findings give credence to the macroeconomic stabilization role of oil funds but also reinforce the importance of good institutions.

Aid Volatility and Real Business Cycles in a Developing Open Economy

This article analyzes the impact of the unpredictability of foreign aid on macroeconomic fluctuations in the recipient country. I build a small open‐economy business cycle model that accounts for foreign aid shocks, with no preference shocks. The model is calibrated to reflect the structural empirical regularities of Cote d'Ivoire, a typical aid‐dependent developing country. The parameters of the exogenous shocks are estimated using Bayesian methods and time series data for Cote d'Ivoire. The model produces business cycle patterns that are consistent with the data and key stylized facts. Specifically, the excess volatility of consumption with respect to output is successfully replicated. The results suggest that the unpredictability of foreign aid contributes to explain the volatility of business cycles in the recipient economy and has negative welfare effects.

Expectations-driven cycles in the housing market

This paper explores the transmission of “news shocks” in a model of the housing market and shows that anticipated signals or beliefs of future macroeconomic developments can generate boom-bust cycles in the housing market and lead to business cycle fluctuations. Anticipated monetary policy and inflationary shocks that turn out to be wrong can also lead to subsequent macroeconomic recessions. Credit frictions also play an important role in generating boom-bust cycle dynamics in the housing market. In particular, favorable credit conditions that are expected to be reversed in the near future generate an housing boom. The active use of the loan-to-value ratio as a policy tool aimed at dampening the severity of expectations-driven cycles effectively reduces the volatility of household debt, aggregate consumption and GDP.

Universal banking, asymmetric information and the stock market

This paper aims to explore the role of the universal banking system in contributing to the stock market bust in the wake of the financial crisis 2008–2009 when bankers might have incentive to hide information from shareholders. We set up a stylized model of consumption smoothing involving universal banks that undertake both investment and commercial banking activities. Banks have private information about the outcome of a project that it funds. In the wake of bad news about the project, the banker has an incentive to sell lemon shares in a secondary market with the pretence of a liquidity crunch. Our model shows that such an incentive results in (i) a sharp discounting of stock prices, (ii) greater loan demand (iii) higher fraction of bank ownership of the borrowing firms, and (iv) heightened consumption risk resulting in precautionary savings by households. The magnitude of these effects depends on the market's perception about the preponderance of lemons in the stock market. A credible punishment scheme implemented by the government in the form of fines may moderate the stock market decline and consumption volatility due to information friction. However, it imposes a deadweight loss on private citizens because of a fall in all banks' expected profit. On the other hand, a “ring-fenced” banking arrangement along the way suggested by the Vickers Commission may entail a first order welfare loss due to the lack of diversification opportunities.

Working Capital in a Closed Economy Real Business Cycle Model

One challenge in real business cycle (RBC) models is their performance in matching non-targeted data moments. In small open economy environment, exogenous interest rate has been widely used to bring additional volatility through the working capital. The role of working capital channel in a simple closed economy has not been explicitly investigated though. This paper explores the impacts of working capital on the business cycle statistics in a closed economy RBC framework. I illustrate that working capital on both inputs decreases the volatilities of consumption and output, whereas its impact on relative volatilities and first order autocorrelations is ambiguous. Working capital drives the correlation between consumption and output to a reasonable range. Moreover, when the working capital is only on one of the inputs, business cycle implications are more complicated. I also show that level of working capital is crucial for the degree of procyclicality of interest rate. The asymmetric effects of this channel on the business cycle moments suggest that it can be used in order to improve the performance of closed economy RBC models.

Optimal fiscal management of commodity price shocks

This paper analyzes how low-income countries should optimally respond, through fiscal policy, to commodity price shocks. The model accounts for imperfect access to world capital markets and a variety of externalities associated with public infrastructure, including utility benefits, a direct complementarity effect with private investment, and reduced distribution costs. However, public capital is also subject to congestion and absorption constraints, with the latter affecting the efficiency of infrastructure investment. The optimal windfall allocation rule between spending today and asset accumulation is determined so as to minimize a social loss function defined in terms of the volatility of private consumption and either the nonresource primary fiscal balance or a more general index of macroeconomic stability, which accounts for the volatility of the real exchange rate.

Has the Increased Attachment of Women to the Labor Market Changed a Family's Ability to Smooth Income Shocks?

An increase in a married woman's attachment to the labor market affected her family's ability to smooth unexpected income shocks. Between 1970 and 1990, the sharp rise in labor market attachment provided an increasingly important channel for smoothing shocks to spousal income. As the participation rate stabilized, this contribution to smoothing evened out. In the Great Recession, both spouses received negative income shocks, and access to transfer income became the main insurance mechanism. Volatility of consumption followed volatility of family income trends but at a lower magnitude. Families' ability to weather income shocks didn't change during the 1970-2010 period.

Commodities, Financialization, and Heterogeneous Agents

The term 'financialization' describes the phenomenon that commodity contracts are traded for purely financial reasons and not for motives rooted in the real economy. Recently, financialization has been made responsible for causing adverse welfare effects especially for low-income and low-wealth agents, who have to spend a large share of their income for commodity consumption and cannot participate in financial markets. In this paper we study the effect of financial speculation on commodity prices in a heterogeneous agent production economy with an agricultural and an industrial producer, a financial speculator, and a commodity consumer. While access to financial markets is always beneficial for the participating agents, since it allows them to reduce their consumption volatility, it has a decisive effect with respect to overall welfare effects who can trade with whom (but not so much what types of instruments can be traded).

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything -- Visual Version

The equity risk premium puzzle is that the return on equities has far exceeded the average return on short-term risk-free debt and cannot be explained by conventional representative-agent consumption based equilibrium models. We review a few attempts done over the years to explain this anomaly:1. Inclusion of highly unlikely events with low probability (Ugly state along with Good and Bad), or market crashes, recently also termed as Black Swans.2. Slow moving habit, or time-varying subsistence level, added to the basic power utility function.3. Allowing for a separation of the inter-temporal elasticity of substitution and risk aversion, combined with consumption and dividend growth rates modeled as containing a small persistent expected growth rate component and a fluctuating volatility which captures time varying economic uncertainty.We explore whether a fusion of the above approaches supplemented with better methods to handle the below reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences:1. Unlimited ability of individuals to invest as compared to their ability to consume.2. Lack of an objective measuring stick of value which gives rise to heterogeneous preferences and beliefs.3. Unintended consequences due to the dynamic nature of social systems, where changes can be observed and decisions effected by participants to influence the system.4. Relaxation of the transversality condition to avoid the formation of asset price bubbles.5. How durable is durable? Since nothing lasts forever, accounting for durable goods to create a comprehensive measure of consumption volatility .The world we live in produces fascinating phenomenon despite (or perhaps, due to) being a hotchpotch of varying doses of the above elements. The rationale for a unified theory is that beauty can emerge from chaos since the best test for a stew is its taste.

Integrated HVAC management and optimal scheduling of smart appliances for community peak load reduction

Of the total electricity-generating capacity in the United States, 20% is dedicated to meet peak loads. Strategies to mitigate volatility in energy consumption have the potential to reduce the need for this surplus capacity. Here we investigate the potential for residential consumers to lower community-level peak demand through home energy management systems. We focus on the combination of air-conditioning use with the operation of time-shiftable appliances in the southern U.S. A centralized model predictive control (MPC) scheme minimizes peak air-conditioning (A/C) energy use by altering the thermostat set-points in individual homes. We simultaneously schedule the operation of time-shiftable appliances to further reduce the community peak load. The scheduling problem is formulated as a mixed-integer linear program (MILP) aimed at minimizing peak load under constraints that reflect the start times and allowed delays of individual appliances (e.g. dishwashers, washing machines, dryers) in each house. Using sample data collected from residential homes and consumer survey data located in Austin, TX, USA we show that the proposed integrated control and scheduling approach can minimize the peak load for the neighborhood by leveraging the physical differences and individual preferences between houses. On average, our framework is able to reduce the daily peak load for the group of houses by 25.5% (18.2kW) when compared with the load for individually controlled thermostat settings and appliance start times.

Real Economic Shocks and Sovereign Credit Risk

AbstractWe provide new empirical evidence that U.S. expected growth and consumption volatility are closely related to the strong comovement in sovereign spreads. We rationalize these findings in an equilibrium model with recursive utility for credit default swap (CDS) spreads. The framework links a reduced-form default process with country-specific sensitivity to expected growth and macroeconomic uncertainty. Exploiting the high-frequency information in the CDS term structure across 38 countries, we estimate the model and find parameters consistent with preference for early resolution of uncertainty. Our results confirm the existence of time-varying risk premia in sovereign spreads as compensation for exposure to common U.S. macroeconomic risk.

Consumption Volatility, Liquidity Constraints and Household Welfare

We evaluate the impact of increased income uncertainty and financial liberalisation in the US on consumption volatility and household welfare. We estimate Euler equations and measure the volatility of unpredictable changes in consumption as the squared residuals. We directly control for liquidity constraints using Survey of Consumer Finances data on access to credit, and document that despite the increase in household debt between 1983 and 2007, there was no decline in the proportion of liquidity constrained households. Consumption volatility increased significantly over this period, especially for liquidity constrained households, indicating substantial welfare losses.

Variations in energy use and output growth dynamics: An assessment for intertemporal and contemporaneous relationship

Departing from the prior literature on the energy consumption-economic growth linkages, this paper aims to quantify the asymmetric impact of unpredictable variations in energy use on GDP (gross domestic product) volatility across the high- and low-volatility regimes in the United Kingdom. For this purpose, the paper utilizes quarterly and monthly data on energy consumption and real GDP, covering the period from 1960 to 2013. To obtain the regime-dependent conditional volatility series, we estimate the two-state Markov regime switching ARCH model. We find significant evidence of the presence of regime shifting in behaviour of both underlying volatility series. By estimating the Markov regime switching model, we find that not only the current (contemporaneous) but also the past (intertemporal) volatility shocks in energy utilization are significant in explaining the output dynamics. Yet, we show that the impact of energy consumption volatility is quite asymmetric, depending on the intensiveness of volatility. Specifically, we show that although the effect of energy consumption volatility on GDP volatility is statistically insignificant in the low-volatility regime, in the high-volatility regime, it appears highly significant. From a policy perspective, our findings suggest that controlling unwanted variations in energy usage would be useful in stabilizing real sector of the economy.

Can Fiscal Decentralization Alleviate Government Consumption Volatility?

This paper assesses the effect of fiscal decentralization on government consumption volatility using data for 97 developed and developing countries from 1971 to 2010. The results suggest that a higher degree of fiscal decentralization leads to lower government consumption volatility. This result holds for the sub-sample of advanced economies, while it is not confirmed for those less-developed. This mechanism seems to work mainly through a lower volatility of the non-discretionary spending, which typically belongs to the central government’s policy. We also confirm existing findings according to which country size lowers government spending volatility. Thus, given a minimum level of development, fiscal decentralization reforms can reduce spending volatility by distributing power to sub-central governments, particularly in smaller countries which are usually more prone to volatility.

SOE and Chinese Real Business Cycle

Chinese real business cycle (RBC) exhibits a unique pattern, which is characterized by moderate consumption volatility, substantially low investment volatility, and acyclical trade balance. These features are quite different from business cycles in other emerging markets and cannot be explained by existing emerging market RBC theories. Motivated by the facts that China undertook dramatic and persistent reform on state-owned enterprises (SOE) in the last 30 years, we construct a full-fledged general equilibrium model with SOE sector and show that the model does a fairly good job in accounting for the above features. The two main driving forces are: (1) shock to the share of downstream SOE in manufacturing sectors and (2) shock to upstream SOE's monopolistic position. These two shocks can explain 85 percent of output volatility, 79 percent of consumption volatility, 72 percent of investment volatility, and 57 percent of the volatility of trade balance-to-output ratio. Relatively speaking, standard shocks such as permanent productivity shock, credit shocks, country risk premium shocks, and preference shocks are less important in explaining Chinese economic fluctuations. Our results show that Chinese RBC may be affected substantially by domestic policies.

Trade Finance Affects Trade Dynamics

Existent literature is by no means conclusive on the effects of trade finance on trade and the economy. We propose a suitable framework to explore the linkages between international trade and finance based on an international real business cycle model where firms require external finance to import and can be financially constrained. We find that credit shocks do affect the dynamic properties of the economy and they have the potential to cause significant deviations in trade and economic performance. The trade-to-GDP ratio falls following a negative credit shock, as the shock reduces the capability of firms to purchase foreign intermediate goods, thereby reducing efficiency and production. However, it forces a demand substitution towards domestic intermediate goods that limits GDP deterioration. We also find that financially developed countries trade more, are richer and more stable in terms of GDP and consumption, consistent with the empirical evidence. Finally, the model sheds light on persistent contradictions between theoretical business-cycle and their empirical counterparts, namely, the consumption/output anomaly and the volatility of consumption, imports and terms of trade relative to GDP.

On the Pure-Exporters of Developing Economies

Pure-exporters, firms that export most of their products, produce sizable amounts of GDPs in many developing economies. Since pure-exporters are mainly independent from the domestic market conditions, the granular nature of the economy, following Gabaix (2011), paves the way for considering these special exporters. This paper, using firm level data from WBES 2006-2015 for 135 developing economies, first, discovers characteristics of pure-exporters that are different from the regular exporters. Pure-exporters are found to be larger, mostly dependent on one main product, concentrated in several sectors and have higher labor share but lower labor productivity. On the other side, the firms in the countries with higher aggregate pure-exporter activities have higher labor productivity. Finally, it proposes cross-country evidence on the relationship between the pure-exporters and business cycle fluctuations. The pure-exporter activities are found to negative relationship with volatilities of GDP and consumption, and a positive relationship with the inflation. These results can be useful in understanding the implications of policies on the pure-exporter subsidies in many developing countries.

Debt, Recovery Rates and the Greek Dilemma

Most discussions of the Greek debt overhang have focussed on the implications for Greece. We show that when additional funds released to the debtor (Greece), via debt restructuring, are used efficiently in pursuit of a practicable business plan, then both debtor and creditor can benefit. We examine a dynamic two country model calibrated to Greek and German economies and support two-steady states, one with endogenous default and one without, depending on creditors expectations. In the default steady state, debt forgiveness lowers the volatility of both German and Greek consumption whereas demanding higher recovery rates has the opposite effect.