Permanent Increase In Consumption Research Articles

Welfare gains from market insurance: The case of Mexican oil price risk

Mexico has a long-standing practice of hedging oil price risk through the purchase of put options. We examine the resulting welfare gains using a standard sovereign default model calibrated to Mexican data. We show that hedging increases welfare by reducing income volatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent to a permanent increase in consumption of 0.44 percent with 90 percent of these gains stemming from lower risk spreads.

Interest Rate Uncertainty and Sovereign Default Risk

Fluctuations in sovereign bond yields display a large global component which is associated with a rise in uncertainty. We build a model of sovereign default in which shocks to the level and to the volatility of the world interest rate help to account for this phenomenon. We calibrate the model parameters to Argentine data and estimate a process for the world interest rate using US treasuries data. Time variation in the world interest rate interacts with default incentives and its effect on borrowing and sovereign spreads is state contingent. We find that shocks to the level and volatility of the world interest rate (i.e. uncertainty shocks) cause the model to predict an average sovereign spread that is 280 basis points larger and 200 basis points more volatile than a model with a constant world interest rate. The model also predicts that countries will prefer a longer maturity for their debt when facing a time-varying world interest rate. The welfare gains from eliminating uncertainty about the world interest rate amount up to a permanent increase in consumption of 1 percent.

Inflation and innovation with a cash-in-advance constraint on human capital accumulation

This note explores a novel channel – a cash-in-advance (CIA) constraint on endogenous human capital investment – through which monetary policy impacts growth and welfare in a scale-invariant Schumpeterian growth model. We find the following. An increase in the nominal interest rate leads to a decrease in human capital investment, which in turn reduces long-run growth and welfare. Calibration shows that long-run growth increases 0.61% by reducing the nominal interest rate from 9.9% (the sample mean of the U.S.) to 0%. The corresponding welfare gain is equivalent to a permanent increase in consumption of 15.98%. The growth and welfare effects depend on the strength of the CIA constraint on human capital investment. Our study has strong policy implications for developing countries where out-of-pocket money may be important for schooling.

Inflation and fertility in a Schumpeterian growth model: Theory and evidence

This study explores a novel channel for monetary policy to impact growth and welfare—through fertility choice. In a scale-invariant Schumpeterian growth model with endogenous fertility and a cash-in-advance constraint on consumption, we find a positive effect of an increase in the nominal interest rate on fertility. The increase in fertility decreases labor supplied to production and R&D, which in turn decreases long-run growth. Calibration shows that long-run growth increases 0.12% by reducing the nominal interest rate from 9.6% to 0%, and the welfare gain is equivalent to a permanent increase in consumption of 3.14%. As an empirical test, we build panel data for 12 advanced countries during 2000–2014. We use the degree of central bank independence and money growth as the instruments for inflation. We find that the effect of inflation on population growth is positive and significant in instrumental variables estimation. Our results remain robust to using birth rate or fertility rate as the dependent variable. An increase in annual inflation of 1 percentage point would bring an increase of 0.06 percentage point in the annual growth of the total population. Our empirical findings provide support for our theory.

Welfare Gains from Market Insurance: The Case of Mexican Oil Price Risk

Over the past two decades, Mexico has hedged oil price risk through the purchase of putoptions. We examine the resulting welfare gains using a standard sovereign default modelcalibrated to Mexican data. We show that hedging increases welfare by reducing incomevolatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent toa permanent increase in consumption of 0.44 percent with 90 percent of these gainsstemming from lower risk spreads.

Welfare Gains from Market Insurance: The Case of Mexican Oil Price Risk

Over the past two decades, Mexico has hedged oil price risk through the purchase of put options. We examine the resulting welfare gains using a standard sovereign default model calibrated to Mexican data. We show that hedging increases welfare by reducing income volatility and reducing risk spreads on sovereign debt. We find welfare gains equivalent to a permanent increase in consumption of 0.44 percent with 90 percent of these gains stemming from lower risk spreads.

HUMAN CAPITAL AND INNOVATION IN A MONETARY SCHUMPETERIAN GROWTH MODEL

This study explores the growth and welfare effects of monetary policy in a scale-invariant Schumpeterian growth model with endogenous human capital accumulation. We model money demand via a cash-in-advance (CIA) constraint on research and development (R&D) investment. Our results can be summarized as follows. We find that an increase in the nominal interest rate leads to a decrease in R&D and human capital investment, which, in turn, reduces the long-run growth rates of technology and output. This result stands in stark contrast to the case of exogenous human capital accumulation in which the long-run growth rates of technology and output are independent of the nominal interest rate. Simulating the transitional dynamics, we find that the additional long-run growth effect under endogenous human capital accumulation amplifies the welfare effect of monetary policy. Decreasing the nominal interest rate from 10% to 0% leads to a welfare gain that is equivalent to a permanent increase in consumption of 2.82% (2.38%) under endogenous (exogenous) human capital accumulation.

THE OPTIMAL TAXATION OF ASSET INCOME WHEN GOVERNMENT CONSUMPTION IS ENDOGENOUS: THEORY, ESTIMATION AND WELFARE

This paper derives the Ramsey optimal fiscal policy for taxing asset income in a model where government expenditure is a function of net output or the inputs that produce it. Extending work by Kenneth L. Judd, I demonstrate that the canonical result that the optimal tax on capital income is zero in the medium to long term is a special case of a more general model. Employing a vector error correction model to estimate the relationship between government consumption and net output or the factor inputs that generate it for the United States between 1948Q1 and 2015Q4, I demonstrate that this special case is empirically implausible, and show how a cointegrating vector can be used to determine the optimal tax schedule. I simulate a version of the model using the empirical estimates to measure the welfare implications of changing the tax rate on asset income, and contrast these results with those generated in a version of the model where government consumption is purely exogenous. The shifting pattern of welfare measurements confirms the theoretical results. I calculate that the prevailing effective tax rate on net asset income in the United States between 1970 and 2014 averaged 0.449. Hence abolishing the tax completely does generate welfare improvements, though only by the equivalent of between 1.103% and 1.616% permanent increase in consumption—well under half the implied welfare benefit when the endogeneity of the government consumption is ignored. The maximum welfare improvement from shifting part of the burden of tax from capital to labor is the equivalent of a permanent increase in consumption of between only 1.491% and 1.858%, and is attained when the tax rate on asset income is lowered to between 0.148 and 0.186. Allowing the tax rate to vary over time raises the maximum welfare benefit to 1.865%. All the results are very robust to a wide range of elasticities of labor supply. (JEL E62, H21, H50)

The impact of weather insurance on consumption, investment, and welfare

I develop and estimate a dynamic stochastic optimization model to assess the impact of weather insurance on the consumption, investment, and welfare of farmers in developing countries. Weather insurance has the potential to provide large welfare gains, equivalent to a permanent increase in consumption of almost 17%. Moreover, it can allow for the adoption of riskier but more productive seeds, further enhancing welfare. The interplay with other uninsured risks, the presence of liquidity constraints, basis risk, and loading factor on the insurance premium may account for the low take‐up that is often empirically observed. Weather insurance welfare technology adoption G22 O12 O13 O16 O33 Q14

Growth Uncertainty And Risksharing

We propose a new methodology to evaluate the gains from global risksharing that is closely connected to the empirical growth literature. We obtain estimates of residual risk (growth uncertainty) at various horizons from regressions of country-specific deviations from world growth on a wide set of variables in the information set. Since this residual risk can be entirely hedged, we use it to obtain a measure of welfare gain that can be achieved by a representative country. We find that nations can reap very large benefits from engaging in such risksharing arrangements. Using post-war data, the gain for a 35-year horizon, corresponding to an equivalent permanent increase in consumption, is 6.6% when based on a set of 49 countries, and 1.5% when based on 21 OECD countries. Using historical data from 1870 to 1990, we find that the potential gain for a 120-year horizon ranges from 4.9% for a small set of rich countries to 16.5% for a broad set of 24 countries.

The Impact of Weather Insurance on Consumption, Investment, and Welfare

I develop and estimate a dynamic stochastic optimization model to assess the impact of weather insurance on the consumption, investment, and welfare of farmers in developing countries. Weather insurance has the potential to provide large welfare gains, equivalent to a permanent increase in consumption by almost 17%. Moreover, it can allow for the adoption of riskier but more-productive seeds, further enhancing welfare. The low take-up that is often empirically observed is likely to be due to high insurance premium, basis risk, and the interplay with other uninsured risks.

The Impact of Weather Insurance on Consumption, Investment, and Welfare

Weather variations crucially affect the wellbeing of farmers in developing countries. I develop and estimate a dynamic stochastic optimization model to assess the impact of weather insurance on the consumption, investment, and welfare for farmers in developing countries. The parameters of the model are pinned down with a combination of calibration and structural estimation using data from Malawi. Contrary to some past work, I find that weather insurance has the potential to provide substantial welfare gains equivalent to almost a 17% permanent increase in consumption. These gains can be magnified especially for the poorest households by contemporaneously extending credit to finance the additional desired investment. In an extension of the model I also show that weather insurance can allow for the adoption of riskier but more-productive improved seeds, further boosting farmers' welfare. Finally, I explore the extent to which the interplay with other uninsured risks, the presence of basis risk, and a loading factor on the insurance premium may lower the welfare gains from weather insurance, and lead to low take-up as is often observed empirically.

Gains from financial integration in the European Union: Evidence for new and old members

We estimate the benefits of financial integration resulting from international risk sharing among the 25 EU countries. Under full risk sharing, country-specific output shocks are diversified across the EU members and output volatility of an individual country is not reflected in its consumption. The gains from risk sharing are expressed as the utility equivalent of a permanent increase in consumption. We report positive potential welfare gains for all the EU countries if they move toward full risk sharing. Ten country-members who joined the Union in 2004 would potentially obtain much higher gains than the longer-standing 15 members.

Gains from Financial Integration in the European Union: Evidence for New and Old Members

We estimate potential welfare gains from financial integration and corresponding better insurance against country-specific shocks to output (risk sharing) for the twenty-five European Union countries. Using theoretical utility-based measures we express the gains from risk sharing as the utility equivalent of a permanent increase in consumption. We report positive potential welfare gains for all the EU countries if they move toward full risk sharing. Ten country-members who joined the Union in 2004 have more volatile or counter-cyclical consumption and output and would obtain much higher potential gains than the longer-standing fifteen members.

Growth uncertainty and risksharing

We propose a new methodology to evaluate the gains from global risksharing that is closely connected to the empirical growth literature. We obtain estimates of diversifiable growth uncertainty at various horizons from regressions of country-specific deviations from world growth on a wide set of variables in the information set. This is used to obtain a measure of the welfare gain from risksharing for a representative country. We find large benefits from risksharing. The gain for a 35-year horizon, corresponding to a welfare equivalent permanent increase in consumption, is 6.6% when based on a set of 49 countries, and 1.5% when based on 21 OECD countries.