Uninsurable Idiosyncratic Shocks Research Articles

CO-MOVEMENT OF STEADY-STATE GOVERNMENT DEBT AND HOUSEHOLD DEBT

To understand whether and how movements of government debt and household debt are related, stationary equilibrium government debt and household debt are characterized in a politico-economic model where office-seeking policymakers decide government debt and individual voters can borrow facing uninsurable idiosyncratic income shocks. An increase in uninsurable income risk unconditionally raises stationary equilibrium government debt and aggregate household debt together, while an increase in household-loan collateral value or population aging conditionally does so, entailing positive correlations between these two debts’ movements. In contrast, an increase in interest rate conditionally causes these two debts to move in the opposite directions.

Common Idiosyncratic Volatility and Carry Trade Returns

I provide new evidence that incomplete consumption risk sharing across countries is an important determinant of carry trade returns. I show that there is a strong co-movement in idiosyncratic volatilities over time, and that shocks to the common idiosyncratic volatility (CIV) factor, defined as the equally weighted average of the idiosyncratic volatilities in the cross-section, are priced. I find that high-interest rate currencies deliver low returns when the CIV increases, which are bad times for investors. Low-interest rate currencies provide a hedge by yielding positive returns. CIV shocks remain an empirically powerful risk factor in explaining the cross-section of carry trade returns after controlling for global foreign exchange (FX) volatility risk. Furthermore, CIV risk is correlated with cross-country income risk faced by households. My findings are consistent with a heterogeneous-agent model with persistent, uninsurable idiosyncratic shocks in consumption growth. The calibrated model quantitatively accounts for the cross-sectional differences in average returns across CIV-beta sorted portfolios for plausible market prices of CIV risk.

Capital Income Taxation with Portfolio Choice

This paper analyzes redistributional and macroeconomic effects of differential taxation of financial assets with a different risk levels. The redistributive effect stems from the fact that various households hold portfolios with a starkly different risk levels. In particular, poor households primarily save in safe assets, while rich households often invest a substantially higher share of their wealth in (risky) equity. At the same time, equity and safe assets are often taxed at different rates in many tax codes. This is primarily because investments in equity (which are relatively riskier) are taxed both as corporate and personal income, unlike debt, which is tax deductible for corporations. This paper firstly builds a simple theoretical two-period model which shows that the optimal tax wedge between risky and safe assets is increasing in the underlying wealth inequality. Furthermore, I build a quantitative model with a continuum of heterogeneous agents, parsimonious life-cycle, borrowing constraint, aggregate shocks and uninsurable idiosyncratic shocks, in which the government raises revenue by using linear taxes on risky and safe assets. Simulations of quantitative models shows that elimination of differential asset taxation leads to a welfare loss equivalent to a 0.3% permanent reduction in consumption. I find that the optimal tax wedge between taxes on equity and debt is higher than the one in the U.S. tax code.

Reducing residential mortgage default: Should policy act before or after home purchases?

We examine two possible approaches to reducing residential mortgage default using a dynamic model of heterogeneous infinitely-lived agents acting optimally subject to uninsurable idiosyncratic earnings shocks and systemic house price shocks. We find higher down payments are very effective in minimizing residential mortgage foreclosures, even in periods of house price declines and recessions. In contrast, the length of the credit exclusionary period for people who experience bankruptcy or foreclosure has a much smaller impact on mortgage defaults. Thus, it is much more effective to prevent mortgage default before the mortgage closes than to pressure homeowners not to default once they are in financial trouble. This also suggests a major aspect of credit scores and credit policy is non-productive and punitive, harming people in return for little societal gain.

Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Shocks

This paper studies optimal taxation in the standard incomplete markets model. We formulate a Ramsey problem and solve numerically for the optimal (time varying) paths of proportional capital and labor income taxes, (possibly negative) lump-sum transfers, and government debt. The solution maximizes welfare along the transition between an initial steady state, calibrated to replicate key features of the US economy, and an endogenously determined final steady state. We find that in the optimal (utilitarian) policy: (i) capital income taxes are front-loaded hitting the imposed upper bound of 100 percent for 33 years before decreasing to 45 percent in the long-run; (ii) labor income taxes are reduced to less than half of their initial level, from 28 percent to about 13 percent in the long-run; and (iii) the government accumulates assets over time reducing the debt-to-output ratio from 63 percent to o€€€17 percent in the long-run. This leads to an average welfare gain equivalent to a permanent 4.9 percent increase in consumption. Though distortive, taxes reduce the variance both cross-sectionally and over time of after-tax income, increasing welfare for both a redistributive and an insurance motive which we quantify.

THE WELFARE GAINS OF FINANCIAL LIBERALIZATION: CAPITAL ACCUMULATION AND HETEROGENEITY

Research has shown that, absent individual heterogeneity and under complete markets, the welfare impact of financial openness is quantitatively limited. Not only are inequalities in wealth and labor productivity a feature of most societies, but also financial markets suffer from many well-known frictions. This paper demonstrates that, when households face borrowing constraints and uninsurable idiosyncratic shocks to income, the welfare implications of financial liberalization are considerable. For instance, the average increase in welfare of a typical emerging market economy that switches from a closed capital market to perfect capital mobility is equivalent to a permanent increase in average consumption of roughly |$5.4\% $|⁠. This is about 3.9 times more than the welfare gains of the same policy under a complete markets environment without any individual heterogeneity. We show that individual heterogeneity accounts for two thirds of this additional increase in the average welfare gain; market incompleteness accounts for the remaining third. In our calibration, the median household in capital-scarce countries is in favor of international financial integration. However, if the pivotal voter is wealthy enough then such reform might not be implemented, since richer households have a vested interest in capital market closedness.

COSTLY INTERMEDIATION AND CONSUMPTION SMOOTHING

I. INTRODUCTION Financial intermediaries play an essential role in economies, transferring funds from agents who do not wish to use them immediately to those who do, improving the allocation of resources with consequences for efficiency and welfare. As Hahn (1971) pointed out, financial intermediation is not a costless activity: It uses real resources, such as labor and capital, and governments often tax such activity. This generates a wedge between the deposit and borrowing rates and consequently implies that households face different interest rates, depending on whether they are savers or borrowers. We construct a neoclassical growth model with costly intermediation, in order to analyze two positive questions: (1) What are the quantitative welfare implications of intermediation costs? (2) Are the welfare effects evenly distributed across individuals with different levels of wealth? Individuals in our neoclassical growth model face uninsurable idiosyncratic shocks to labor productivity, an endogenous borrowing limit, and costly intermediation. Households smooth consumption over time by making deposits at a financial intermediary in good times and running down credit balances or getting loans in bad times. Intermediation costs generate a wedge between loan and deposit rates, with interest payments on loans higher than the return on deposits. We assume that financial institutions provide all the intermediation, and therefore abstract from direct borrowing and lending between households. (1) As in Martins-da-Rocha and Vailakis (2010), the intermediary has a labor-intensive technology, maximizes profit, is remunerated by the marginal product of labor, and takes regulation as given. (2) See Hahn (1971), Diaz-Gimenez et al. (1992), and Mehra, Piguillem, and Prescott (2011) for similar approaches. Our goal is to analyze the effects of intermediation costs on agents' intertemporal ability to smooth consumption and insure against labor income shocks. As a consequence, we focus on unsecured consumption loans such as personal loans and credit card debt, and abstract from the effects of intermediation costs on entrepreneurship and productivity. Unsecured consumption loans, while only a subset of the total credit market, allow us to construct a direct measure of intermediation costs for our quantitative exercise. In addition, the fraction of unsecured credit over all credit in the data provides another dimension on which we can assess the performance of our model. We use our model to measure key statistics of the U.S. economy, including intermediation costs, and perform counterfactual experiments. Reducing intermediation costs leads to two effects. First, for a given interest rate, decreasing borrowing costs expands net borrowers' consumption possibility frontiers and even current savers may benefit (with positive probability they may need to borrow to smooth consumption in the future due to bad labor productivity shocks). Second, there is an indirect effect: lower intermediation costs imply an increase in the demand for loans, which raises the interest rate. This offsets part of the decrease in borrowing costs and also increases interest income, improving savers' welfare. Determining the net impact of these effects requires a quantitative analysis. We interpret a reduction in intermediation costs as an improvement in the financial intermediation technology or a reduction in taxes on financial transactions. The welfare analysis focuses on stationary equilibria and transitional dynamics. The transition is slow, and abstracting from it can lead to misleading welfare calculations. Also, mobility in wealth means that comparing, for instance, the agent with median wealth in two stationary equilibria may not involve the same household. We find three main quantitative results: First, intermediation costs have a large effect on welfare. For the U.S. economy, the average aggregate welfare gain of all agents from reducing intermediation costs from 3. …

Constrained Efficiency in the Neoclassical Growth Model With Uninsurable Idiosyncratic Shocks

We investigate the welfare properties of the one-sector neoclassical growth model with uninsurable idiosyncratic shocks. We focus on the notion of constrained efficiency used in the general equilibrium literature. Our characterization of constrained efficiency uses the first-order condition of a constrained planner's problem. This condition highlights the margins of relevance for whether capital is too high or too low: the factor composition of income of the (consumption-)poor. Using three calibrations commonly considered in the literature, we illustrate that there can be either over- or underaccumulation of capital in steady state and that the constrained optimum may or may not be consistent with a nondegenerate long-run distribution of wealth. For the calibration that roughly matches the income and wealth distribution, the constrained inefficiency of the market outcome is rather striking: it has much too low a steady-state capital stock.

Heterogeneous Agents and Uninsurable Idiosyncratic Employment Shocks in a Linearized Dynamic General Equilibrium Model

This paper proposes an analytical solution method for a dynamic general equilibrium model with heterogeneous agents and uninsurable idiosyncratic employment shocks. The solution method yields an approximate balanced growth path which depends on the unemployment rate and the unemployment risk, but which is independent of the ever-changing wealth distribution.

Constrained Efficiency in the Neoclassical Growth Model with Uninsurable Idiosyncractic Shocks

We investigate the welfare properties of the one-sector neoclassic growth model with uninsurable idiosyncratic shocks. We focus on the constrained efficiency notion of the general equilibrium literature, and we demonstrate constrained inefficiency for our model. We provide a characterization of constrained efficiency that uses the first-order condition of a constrained planner's problem that points to the margins of relevance for whether capital is too high or too low: the income composition of the (consumption-)poor. We calibrate our benchmark model parameters governing idiosyncratic risks to the U.S. earnings and wealth distribution, and for this distribution the income of the poor is mainly composed of labor earnings. We compute the constrained-efficient allocations - including transition dynamics - for our model economy, and we conclude that the long-run capital stock in a laissez-faire world is not only too low, but much too low. We also show that one can find parameterizations with different qualitative features: in one case, the steady-state capital stock is too high, and in another case no steady state exists.

Understanding the U.S. Distribution of Wealth

This article describes the current state of economic theory intended to explain the unequal distribution of wealth among U.S. households. The models reviewed are heterogeneous agent versions of standard neoclassical growth models with uninsurable idiosyncratic shocks to earnings. The models endogenously generate differences in asset holdings as a result of the household's desire to smooth consumption while earnings fluctuate. Both of the dominant types of models— dynastic and life cycle models—reproduce the U.S. wealth distribution poorly. The article describes several features recently proposed as additions to the theory based on changes in earnings, including business ownership, higher rates of return on high asset levels, random capital gains, government programs to guarantee a minimum level of consumption, and changes in health and marital status. None of these features has been fully analyzed yet, but they all seem to have potential to move the models in the right direction.

Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle

This paper studies asset prices and consumption patterns in an infinite horizon model with borrowing constraints and uninsurable idiosyncratic shocks to labor income. Calibration experiments demonstrate that idiosyncratic shocks to income are effectively smoothed through transactions in the securities market; consumption and asset prices are similar to those predicted in the representative agent model. This suggests that the equity premium puzzle is robust to several important sources of market incompleteness.

Heterogeneous agents in quantitative aggregate economic theory

Modern macroeconomics, with increasing frequency, is devoting attention to the fact that agents are heterogeneous, especially in their role as providers of labor input into production. These differences can take various forms: the skills for market production are different; some workers are and some are not engaged in market activity in any given period; people are at different stages of the life cycle; people are faced with uninsurable idiosyncratic shocks, perhaps combined with liquidity constraints; and so on. In some cases, the equilibrium still can be computed from a stand-in planner's problem. The most exciting recent development, however, is the dramatically expanded ability to compute equilibriums for interesting model economies for which that is not the case. Examples are given.