Limited Asset Market Participation Research Articles

Do term premiums matter? Transmission via exchange rate dynamics

The macroeconomic effect of term premiums is a controversial issue both theoretically and quantitatively. In this paper, we explore the possibility that term premiums affect inflation and the real economy via exchange rate dynamics. For this purpose, we construct a small open economy model with limited asset market participation, focusing on the empirical observation that uncovered interest parity holds better for longer-term interest rate differentials. A quantitative exercise using Japanese and U.S. data shows that changes in term premiums, particularly those made by the central bank's bond purchases, have sizable effects on Japanese inflation rates via exchange rate dynamics.

When is government debt accumulation optimal in a liquidity trap?

When the government issues long-term bonds, the optimal time-consistent fiscal and monetary policy is to consolidate debt in a liquidity trap by increasing labor taxes aggressively. This prescription is at odds with large debt-financed fiscal expansions undertaken in the US during previous liquidity trap episodes. In this article, I show that accumulating debt turns optimal in a medium-scale model with sticky wages and limited asset market participation. In my model, the net disposable income of Rule-of-Thumb households is sensitive to tax variations and constitutes an additional constraint to fiscal policy. For plausible calibration, the discretionary policy maker chooses to curtail its tax increase and to beef up its spending stimulus. In long simulations, the volatility of taxes falls below the one of government spending, in line with empirical evidence. The debt increase in the liquidity trap is also consistent across maturities, both under discretion and commitment.

Correction to: Limited asset market participation and fiscal sustainability

Correction to: Limited asset market participation and fiscal sustainability

Limited asset market participation and fiscal sustainability

Limited asset market participation and fiscal sustainability

Risk Premiums, Nominal Rigidities, and Limited Asset Market Participation

AbstractRecent developments in the asset pricing literature show that a combination of technology and distributive shocks can rationalize observed risk premia when firm ownership is concentrated in the hands of few households. We find that distributive shocks are unnecessary when nominal price rigidity is taken into account. Our results are driven by the income redistribution associated to procyclical variations in profit margins when firms ownership is concentrated, prices are sticky, and technology shocks hit the economy. In this regard, standard DSGE models that allow for firm ownership concentration have the potential to replicate both business cycle facts and the moments of financial variables.

Equity premium and monetary policy in a model with limited asset market participation

We develop a dynamic stochastic general equilibrium model to examine how monetary policy shocks affect income inequality and the equity premium. The model features Ricardian and non-Ricardian households and shows that a monetary policy tightening causes an endogenous redistribution of income from non-Ricardians to Ricardians. Ricardians’ consumption comoves more strongly with asset returns, giving rise to high equity premia. We extend our model with several frictions and estimate it with generalized method of moments using US macroeconomic and financial data from 1960 to 2007. We find that the estimated model jointly matches the bond and equity premia. We complement our theoretical model with vector autoregression estimations and show that a tightening of US monetary policy increases equity premia.

A Note on Great Inflation, Robust Monetary Policy, and Limited Asset Market Participation

This note investigates how model uncertainty influences economic fluctuation in a two-agent New Keynesian (TANK) model. We reveal that, as the fraction of non-asset holders rises, the effects of the model uncertainty on the inflation rate become larger. This leads to large fluctuations of the inflation rate in response to the cost-push shock. Our results show that the fluctuation of the inflation rate can be high even when monetary policy is appropriate for the economy.

DISINFLATION, INEQUALITY, AND WELFARE IN A TANK MODEL

We investigate the redistributive and welfare effects of disinflation in a two‐agent New Keynesian model characterized by limited asset market participation and wealth inequality. We highlight two key mechanisms driving our long‐run results: (1) the cash in advance constraint on firms working capital; (2) dividends endogeneity. These two channels point in opposite directions. Lower inflation softens the cash in advance constraint and, by raising labor demand, lowers inequality. But disinflation also raises dividends and this increases inequality. The disinflation is always welfare‐improving for asset holders. We obtain ambiguous results for non‐asset holders, who suffer substantial consumption losses during the transition. (JEL E31, E5, D3, D6)

Do Term Premiums Matter? Transmission Via Exchange Rate Dynamics

The macroeconomic effect of term premiums is a controversial issue both theoretically and quantitatively. In this paper, we explore the possibility that term premiums affect inflation and the real economy via exchange rate dynamics. For this purpose, we construct a small open economy model with limited asset market participation, focusing on the empirical fact that uncovered interest parity (UIP) holds better for longer-term interest rate differentials. A quantitative exercise using Japanese and U.S. data shows that changes in term premiums of both Japanese and U.S. long-term yields have sizable effects on Japanese inflation rates via exchange rate dynamics.

LIMITED ASSET MARKET PARTICIPATION AND THE EURO AREA CRISIS: AN EMPIRICAL DSGE MODEL

We estimate a medium‐scale dynamic stochastic general equilibrium model for the Euro area with limited asset market participation (LAMP). Our results suggest that in the recent European Monetary Union years LAMP is particularly sizable (39% during 1993–2012) and important to understand business cycle features. The Bayes factor and the forecasting performance show that the LAMP model is preferred to its representative household counterpart. In the representative agent model the risk premium shock is the main driver of output volatility in order to match consumption correlation with output. In the LAMP model this role is played by the investment‐specific shock, because non‐Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments. We also detect the contractionary role of monetary policy shocks during the post‐2007 years. In this period consumption of non‐Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance. (JEL C11, C13, C32, E21, E32, E37)

Disinflation, Inequality and Welfare in a TANK Model

We investigate the redistributive and welfare effects of disinflation in a two-agent New Keynesian (TANK) model characterized by Limited Asset Market Participation (LAMP) and wealth inequality. We highlight two key mechanisms driving our long-run results: i) the cash in advance constraint on firms working capital (CIA); ii) dividends endogeneity. These two channels point in opposite directions. Lower inflation softens the CIA and, by raising labor demand, lowers inequality. But the disinflation also raises dividends and this increases inequality. The disinflation is al- ways welfare-improving for asset holders. We obtain ambiguous results for non-asset holders, who suffer substantial consumption losses during the transition.

Heterogeneity in an RBC Model with Durable Goods and Energy

This paper investigates the effects of total factor productivity and energy price shocks in a real business cycle (RBC) model with heterogeneous agents. It extends standard RBC models by including the distinction between durable goods and non-durable goods but also including energy in production of non-durable goods. Furthermore, we combine two sources of heterogeneity using idiosyncratic shocks in labor supply and limited asset market participation by a fixed proportion of agents. We study to what degree the empirically observed inequality in income and wealth can be explained by the provided framework. The model can predict the evolution of inequality in income and wealth, unlike traditional homogeneous macroeconomic models with a representative agent. We show that the distinction between non-durable and durable goods leads to a significant improvement in predicting most of the moments close to the one in observational data from Germany. Furthermore, we find that energy price shocks lead to decreasing inequalities, with respect to both income and wealth. In a brief policy analysis, we give an outlook about the effects of redistribution of income between classes of agents.

Limited Asset Market Participation and the Euro Area Crisis. An Empirical DSGE Model

We estimate a medium scale DSGE model for the Euro area with Limited Asset Market Participation (LAMP). Our results suggest that in the recent EMU years LAMP is particularly sizeable (393 during 1993-2012) and important to understand business cycle features. The Bayes factor and the forecasting performance show that the LAMP model is preferred to its representative household counterpart. In the RA model the risk premium shock is the main driver of output volatility in order to match consumption correlation with output. In the LAMP model this role is played by the investment-specific shock, because Non-Ricardian households introduce a Keynesian multiplier effect and raise the correlation between consumption and investments. We also detect contractionary role of monetary policy shocks during the post-2007 years. In this period consumption of Non-Ricardian households fell dramatically, but this outcome might have been avoided by a more aggressive policy stance.

Risk Premiums, Nominal Rigidities and Limited Asset Market Participation

Recent developments in the asset pricing literature show that a combination of technology and distributive shocks can rationalize observed risk premia when firm ownership is concentrated in the hands of few households. We find that distributive shocks are unnecessary when nominal price rigidity is taken into account. Our results are driven by the income redistribution associated to procyclical variations in profit margins when firms ownership is concentrated, prices are sticky and technology shocks hit the economy. In this regard, standard DSGE models that allow for firm ownership concentration have the potential to replicate both business cycle facts and the moments of financial variables.

Determinacy analysis in high order dynamic systems: The case of nominal rigidities and limited asset market participation

We show how to use Hurwitz polynomials to study the stability and uniqueness of Rational Expectation equilibria (REE) in Dynamic General Equilibrium models (DGE). We apply this method to a model characterized by sticky wages and prices and by limited asset market participation (LAMP). We prove analytically in a fourth-order dynamics system that, once nominal wage stickiness is taken into account, LAMP does not invalidate the Taylor Principle.

Reexamination of Fiscal Policy in a Small Open Economy: The Case of Korea

We empirically estimate the effects of expansionary fiscal policy in Korea to analyze the impacts of the fiscal policy with different exchange rate regime. First, we empirically estimate the Structural VAR to identify the transmission mechanism of major macroeconomic variables from government expenditure shocks in Korea. The government expenditure shocks increase consumption, investment, and GDP. At the same time net exports decrease and foreign exchange rates depreciate in the long run. Second, we set up a small open economy model with financial frictions and discuss the role of financial market frictions in generating a multiplier of government expenditure under PEG and flexible exchange regime. Extended the existing literature on fiscal policy by introducing limited asset market participation and external finance a la Bernanke et al. (1999) into the model. Shown that the multiplier can be larger than one under pegged exchange rate regime, while is smaller than one under flexible exchange rate regime.

Fiscal policy and liquidity traps with heterogeneous agents

This paper explores global dynamics in a monetary model with limited asset market participation and the zero lower bound on nominal interest rates. It is shown that a rise in government transfers to ‘non-Ricardian’ consumers financed by debt-based taxes to ‘Ricardian’ consumers is capable of escaping disinflationary paths typically convergent to a liquidity trap. Fiscal policy does not need to be unsustainable at the low inflation steady state to avoid liquidity traps, as argued in the context of the standard single representative agent setup.

Inflation bias and markup shocks in a LAMP model with strategic interaction of monetary and fiscal policy

This paper investigates the effects generated by limited asset market participation on optimal monetary and fiscal policy, where monetary and fiscal authorities are independent and play strategically. It shows that: (i) both the long run and the short run equilibrium require a departure from zero inflation rate; (ii) in response to a markup shock, fiscal policy becomes more aggressive as the fraction of liquidity constrained agents increases and price stability is no longer optimal even under Ramsey; (iii) overall, optimal discretionary policies imply welfare losses for Ricardians, while liquidity constrained consumers experience welfare gains with respect to Ramsey.

LIMITED ASSET MARKET PARTICIPATION, STICKY WAGES, AND MONETARY POLICY

A small amount of nominal wage stickiness makes limited asset market participation (LAMP) irrelevant for the design of monetary policy. Recent research argues that LAMP could invert the slope of the IS curve in otherwise standard New Keynesian models. This, in turn, implies that optimal monetary policy rules should be passive. We show that the so‐called inverted aggregate demand logic (IADL) relies on nominal wage flexibility. Outside of extreme parameterizations, wage stickiness prevents the inversion of the slope of the IS curve. Hence, LAMP does not generally alter the trade‐offs faced by a welfare maximizing Central Bank, and for this reason it does not fundamentally affect the design of optimal simple rules and optimal monetary policy. (JEL E21, E52)

Inflation Bias and Markup Shocks in a LAMP Model with Strategic Interaction of Monetary and Fiscal Policy

This paper investigates the effects generated by limited asset market participation on optimal monetary and fiscal policy, where monetary and fiscal authorities are independent and play strategically. It shows that: (i) both the long run and the short run equilibrium require a departure from zero inflation rate; (ii) in response to a markup shock, fiscal policy becomes more aggressive as the fraction of liquidity constrained agents increases and price stability is no longer optimal even under Ramsey; (iii) overall, optimal discretionary policies imply welfare losses for Ricardians, while liquidity constrained consumers experience welfare gains with respect to Ramsey.