Reducing Government Debt in the Presence of Inequality


 Rolf Black
 1 years ago
 Views:
Transcription
1 Reducing Government Debt in the Presence of Inequality Sigrid Röhrs and Christoph Winter July 18, 2014 Abstract What are the welfare effects of government debt? In particular, what are the welfare consequences of government debt reductions? We answer these questions with the help of an incomplete markets economy with production. Households are subject to uninsurable income shocks. We make several contributions. First, when comparing stationary equilibria, we find that quantitatively sizable welfare gains can be achieved by reducing public debt, contrary to what the literature has suggested. Second, when we also consider the transition between stationary equilibria, we find that the welfare costs of a debt reduction outweigh the benefits of being in a stationary equilibrium with lower debt. Third, by targeting the skewed wealth and earnings distribution of the US economy in our calibration, we identify inequality as a major driver of the welfare effects. Our results have important implications for the design of debt reduction policies. Since the skewed wealth distribution generates a large fraction of borrowingconstrained households, the public debt reduction should be nonlinear, such that the tax burden is postponed into the future. Key words: Government Debt, Borrowing Limits, Incomplete Markets, Crowding Out JEL classification: E2, H6, D52 Acknowledgements: We would like to thank Alexander Bick, Timo Boppart, Nicola FuchsSchündeln, Wouter den Haan, John Hassler, Marcus Hagedorn, Kenneth Judd, Leo Kaas, Timothy Kehoe, Nobuhiro Kiyotaki, Felix Kübler, Alex Michaelides, Dirk Niepelt, Karl Schmedders, Kjetil Storesletten, Iván Werning as well as participants of various seminars and especially Fabrizio Zilibotti for many useful comments. Röhrs would like to thank the University of Zurich for financial support (Forschungskredit Nr ). Winter gratefully acknowledges financial support from the European Research Council (ERC Advanced Grant IPCDP ) and the National Centre of Competence in Research Financial Valuation and Risk Management (NCCR FINRISK). All remaining errors are our own. Parts of this project were previously circulated under the title Wealth Inequality and the Optimal Level of Government Debt. Goethe University Frankfurt, Chair of Macroeconomics and Development, Office HOF 3.42, Grüneburgplatz 1, D Frankfurt am Main (Germany), +49 (069) , (corresponding author) University of Zurich, Department of Economics, Office SOFG21, Schönberggasse 1, 8001 Zurich (Switzerland), +41 (044) ,
2 1 Introduction Many countries  including the United States  have experienced a dramatic surge in their public debt levels in the aftermath of the financial crisis. Drastic measures, including tax increases, need to be applied to bring government debt back to its precrisis level. 1 However, history has shown that austerity measures are very unpopular and that their political implementation is difficult. As suggested by Reinhart and Rogoff (2009), historically, many countries have chosen to default on their sovereign debt even at moderate debt/gdp ratios in order to avoid painful austerity policies. Motivated by these observations, we study the welfare effects of government debt. We conduct our analysis with the help of an incomplete markets framework in the tradition of Aiyagari (1994). Households are subject to idiosyncratic productivity shocks. These shocks are uninsurable because insurance markets are absent. Households can selfinsure against adverse shocks by accumulating precautionary savings or by borrowing. In our framework, borrowing is limited. This restricts the ability of households to selfinsure. This framework is ideal for our purposes for two reasons. First, government debt plays a nontrivial role if markets are incomplete and if borrowing is restricted. As it is wellknown from the seminal work by Woodford (1990) and Aiyagari and McGrattan (1998), government debt relaxes borrowing constraints and therefore helps to complete markets by facilitating precautionary saving. Issuing government debt might thus be an effective way to improve risksharing and aggregate welfare (Flodén, 2001, Shin, 2006, Albanesi, 2008). Second, the fact that markets are incomplete and risksharing is limited generates a nontrivial distribution of assets and consumption. One contribution of this project is to show that the degree of inequality implied by the model is crucial. Important papers discussing the welfare effects of government debt in an incomplete markets environment with production are Aiyagari and McGrattan (1998), Flodén (2001) and Desbonnet and Weitzenblum (2011). In order to generate a distribution of earnings and assets that resembles the skewed distributions of earnings and wealth in the US economy, we follow Castañeda, DíazGiménez, and RíosRull (2003) in our calibration of the stochastic process that governs the evolution of idiosyncratic earning shocks. We find that the debt/gdp ratio that leads to the highest stationary equilibrium welfare is negative, i.e. when the government holds assets, not debt. This result is remarkable, given that the previous literature, which uses the Aiyagari (1994) framework, most notably Aiyagari and McGrattan (1998), Flodén (2001) and Desbonnet and Weitzenblum (2011), has concluded that debt/gdp ratio that maximizes social welfare in a stationary state is positive, not negative. In order to fully appreciate our finding and to understand how our outcome is influenced by inequality, it is useful to consider the impact of borrowing constraints in greater detail. If borrowing constraints are binding, lowering government debt crowds in private capital. This is because households that face binding borrowing constraints will not decrease their savings onetoone in response to a decrease in debt, and the Ricardian Equivalence breaks down. This implies that the demand for private bonds will not meet the supply of private bonds issued by the firm. We say that public debt crowds in the capital stock, and therefore also production and output. As a result, the equilibrium interest rate that clears 1 See Chen and Imrohoroglu (2012) for an overview over several proposals to reduce government debt that are discussed for the US. 1
3 the private bond market will decrease, and the marginal product of labor will increase. Moreover, if taxation is distortionary instead of lumpsum, lower debt/gdp ratios are associated with even stronger positive effects on capital accumulation and output, since less government debt means lower taxes and therefore reduces the inefficiencies caused by distortionary taxes. To the extent that more capital and output translates into higher average consumption of goods and leisure, a lower debt/gdp ratio is welfareimproving. 2 Besides the impact on average consumption, the change in the interest rate and the wage rate resulting from crowding in and lower distortionary taxes give rise to other welfare effects in a world in which markets are incomplete and in which there is heterogeneity among households. Firstly, a lower interest rate makes selfinsurance more difficult for private households, since saving yields a lower return (Aiyagari and McGrattan, 1998). Put differently, the price of the riskless production factor (capital) decreases, while the price of the risky factor (labor) increases. Lower debt/gdp ratios therefore have a negative effect on aggregate welfare through this insurance effect. Changes in market clearing prices that affect welfare when markets are incomplete are also key in Gottardi, Kajii, and Nakajima (2010) and Davila et al. (2011). These papers analyze whether the laissezfaire outcome is constrained efficient if markets are incomplete. 3 Second, government debt also affects the distribution of consumption via the composition of income, because households that receive capital income lose and households that mainly rely on labor income win. This income composition counteracts the negative effect of the insurance channel on aggregate welfare, since the households that profit the most from the increase in wages are the consumptionpoor. Which of these three effects dominates the development of social (Utilitiarian) welfare depends crucially on the distribution of wealth and income. Since in the US, both wealth and income are very unequally distributed across the population, and because households that are consumptionpoor also hold no wealth or are even in debt, the positive welfare effects associated with lower debt/gdp ratios more than offset the insurance effect. Instead, Aiyagari and McGrattan (1998) and Flodén (2001) conclude that the opposing effects almost cancel out, leading to only weak overall welfare effects of government debt. In light of our results that lower debt/gdp ratios are welfareimproving when we consider stationary equilibria, the fact that debt reductions face so much political resistance is puzzling at the first glance. 4 It should be noted that so far we have ignored the costs that occur over the transition from a stationary equilibrium with a high debt/gdp ratio to the new one that is characterized by a low debt/gdp ratio. As a second contribution of our project, we therefore also incorporate the welfare effects of government debt reductions occurring over the transition into our analysis. We are interested in whether the losses occurring over the transition offset the benefits of being in a stationary equilibrium with a lower debt/gdp ratio. In particular, we want to understand how the curvature of the debt/gdp path and the time span affect these costs. Both curvature and time horizon are important policy parameters. For this reason, we focus on a small but realistic unanticipated reduction of the debt/gdp ratio from 0.66, 2 Using the terminology of Flodén (2001), this is the level effect. 3 Gottardi, Kajii, and Nakajima (2010) and Davila et al. (2011) find that, depending on the structure of uncertainty, constrained efficiency requires a higher level of capital compared to the competitive equilibrium outcome when markets are incomplete. 4 Protests can be fierce, as documented by Ponticelli and Voth (2011), who found that fiscal consolidation increase the likelihood of social unrest. 2
4 the longrun average of the US, to 0.6. This reduction is financed by increasing the (linear) personal income tax rate, therefore keeping the distortions on asset and labor supply constant. We find that the government can minimize transitional costs by following a concave debt/gdp path, where the reduction is slow initially and accelerates over time. Extending the time horizon during which the debt reduction is implemented further helps to reduce the transitional welfare costs. However, for all cases that we compute, we find that the transitional welfare costs associated with reducing government debt more than offset the longrun benefits of living in a stationary equilibrium with a lower debt/gdp ratio. In order to understand the determinants of the transitional welfare effects, it is again important to consider the role of inequality. When choosing the curvature of the debt/gdp path, the government faces the following tradeoff. On the one hand, a convex debt/gdp path offers the advantage of minimizing intertemporal distortions arising through asset income taxation. This is because a convex debt/gdp path implies that taxes are high at the beginning, when assets are predetermined. On the other hand, households who are initially at the borrowing constraint prefer a concave debt/gdp path, under which the tax burden is initially low and increasing over time. The fact that in our calibration, consistent with the US economy, a substantial fraction of the population holds no assets or is in debt, explains why the concave path is superior to a convex or a linear path. 5 Our results contribute to the literature by showing that inequality is important for welfare effects of government debt in the transition and in stationary equilibrium. The previous literature has largely ignored transitional welfare effects altogether (see e.g. Aiyagari and McGrattan, 1998 and Flodén, 2001). An exception is the work by Desbonnet and Weitzenblum (2011), who however do not match the large degree of wealth inequality observed in the data, which makes their stationary equilibrium results very different from ours. Moreover, they only study linear debt/gdp paths. Their focus is on computing the debt/gdp ratio that maximizes total (transitional plus stationary equilibrium) welfare, whereas we are interested in analyzing the welfare consequences of debt reduction policies. Our results about the importance of inequality for the transitional costs of debt reductions and inequality is consistent with the findings of D Erasmo and Mendoza (2012) who study the link between domestic inequality and the likelihood to default on domestic debt in an incomplete markets model similar to ours. They show that inequality increases the probability to default. In earlier work, Alesina and Perotti (1996) have established a link between inequality and social unrest. Apart from the aforementioned work by Aiyagari and McGrattan (1998) and Flodén (2001), our project is also related to other papers that study the impact of fiscal policy in quantitative models with incomplete markets. Domeij and Heathcote (2004) and Conesa, Kitao, and Krueger (2009) study the welfare effects of abolishing capital taxation. Açikgöz (2013) studies the long run characteristics of the optimal Ramsey policy under incomplete markets (including government debt). In line with our findings, he concludes debt/gdp that maximizes welfare in stationary equilibrium is negative. 5 As a special case, we also consider the policy where the government unexpectedly raises the asset income tax in the initial period only. We find that in this case, government debt reductions lead to an overall welfare gain, which is however much smaller than the associated increase in stationary equilibrium welfare, implying that the transitional phase is still welfare reducing. The reason is the existence of borrowing constraints, which prevent some poor households from immediately benefiting from the higher income lower debt/gdp will bring to them in the future. 3
5 Moreover, he finds that the debt/gdp ratio that maximizes overall welfare is positive, which confirms our results that the costs of debt reductions over the transition are large. In this project, we show that inequality is the important driver of the welfare effects of government debt, both in the transition as well as in stationary equilibrium. Ludwig and Krüger (2013) compute the optimal tax progressivity and education subsidies in a model with endogenous human capital formation. Heathcote (2005) analyses the impact of tax changes on aggregate consumption. Gomes, Michaelides, and Polkovnichenko (2013) quantify the crowding out effect on the capital stock of a 10 percent increase in government debt in an incomplete market economy with aggregate risk. Angeletos and Panousi (2009) and Challe and Ragot (2010) study the effects of changes in government expenditures in incomplete market models. Oh and Reis (2012) study the impact of government transfers. Gomes, Michaelides, and Polkovnichenko (2012) aim at quantifying the fiscal costs of the recent financial crisis in US. Desbonnet and Weitzenblum (2011) and Azzimonti, de Francisco, and Quadrini (2012) also exploit the fact that government debt facilitates selfinsurance, as we do in our work. The explicit characterization of the welfare consequences of debt reductions during transition and in stationary state is not the main objective of any of the aforementioned papers. The remainder of the paper is structured as follows. We present the baseline model in the next section. In section 3 we discuss the calibration of the model. Section 4 shows the quantitative results. Section 5 concludes. 2 The Baseline Model The economy we consider is a neoclassical growth model with incomplete markets where households face uninsurable income shocks, as in Aiyagari (1994). The economy consists of three sectors: households, firms and a government. In the following, we describe the three sectors in greater detail. We start by describing the bonds that households in our economy use to accumulate savings. 2.1 Supply and Demand for Bonds Households selfinsure against income fluctuations by saving in oneperiod riskfree bonds. Bonds are issued by firms and the government, as in Aiyagari and McGrattan (1998) and Flodén (2001). Bonds issued by firms are claims to physical capital. We abstract from aggregate risk, which implies that claims to physical capital and government bonds are perfect substitutes and thus yield the same return, r t. 6 Different from Aiyagari and McGrattan (1998) and Flodén (2001), we also allow households to borrow up to a certain limit. We view this as an important modification, given that the fraction of households that actually borrow in the data is substantial Household Sector The economy is populated by a continuum of exante identical, infinitely lived households with total mass of one. Households maximize their expected utility by making a series of consumption, c t, labor, 6 In Gomes, Michaelides, and Polkovnichenko (2012, 2013), government bonds and private capital are imperfect substitutes due to aggregate uncertainty. 7 Borrowing by households can be interpreted as bonds that are issued to other households ( IOUs ) or to the government. 4
6 l t, and savings, a t+1, choices subject to a budget constraint and a borrowing limit on assets. In period t = 0, before any uncertainty has realized, their expected utility is given by U({c t, 1 l t } t=1,2,... ) = E 0 t=0 β t u(c t, 1 l t ) where β is the subjective discount factor. The perperiod utility function, u(.), is assumed to be strictly increasing, strictly concave and continuously differentiable. Additionally, the first derivative is assumed to satisfy the following limiting (Inada) conditions: lim c(c, 1 l) c 0 =, lim c(c, 1 l) = 0 c lim 1 l(c, 1 l) l 0 = Household productivity is subject to a shock, ɛ, that follows a Markov process with transition matrix π(ɛ ɛ). A household faces the following perperiod budget constraint: c t + a t+1 = y t + a t where a t+1 denotes the bond holdings of a household. y t is the household s (aftertax) income. Notice that a t+1 may also be negative, in which case the household borrows. Borrowing is restricted: a t+1 a The fact that we impose an exogenous borrowing constraint that is tighter than the natural borrowing limit is important. With a natural borrowing constraint and lump sum taxes, government debt would be neutral (Ricardian equivalence holds). The tax system in our economy consists of proportional taxes on asset income, τ k,t, and labor income, τ l,t, and a lump sum transfer, χ t. Figure 1 in Golosov and Sargent (2012) suggests that affine taxes are a very good approximation to the US tax code. We conceptualize the tax rates as a baseline component equal to the labor income tax, τ t = τ l,t, and a premium on the asset income tax, ζ, such that τ k,t = ζτ t. This way of defining the tax rates will be useful later during our policy experiments where we change only the baseline component, τ t, keeping the premium on the asset income tax fixed. To focus on government debt and the timing of the (linear) taxes, we assume that transfers/output remains constant over time. Furthermore, we assume that only nonnegative asset income is taxed. In other words, there are no proportional subsidies if households are in debt. More precisely, we define the tax on asset income τ k,t, as follows: { τk,t if a 0 τ k,t (a) = 0 if a < 0 The aftertax interest rate is therefore given by r t = (1 τ k,t (a))r t. The aftertax wage rate is given by w t = (1 τ l,t )w t where w t is the price of labor in the economy. Aftertax income is thus given by: y t = w t ɛl t + r t a t + χ t 5
7 The optimization problem of a household is given by the following functional equation: { } W t (a, ɛ) = max c,l,a u(c, 1 l) + β ɛ π(ɛ ɛ)w t+1 (a, ɛ ) s.t. c + a = w t ɛl + (1 + r t )a + χ t (2) a a The household s problem is timedependent because we do not only study steadystates but also transitions between steadystates. 8 (1) 2.3 Firm Sector We assume that the aggregate production technology which is operated by a representative firm to produce output, Y t, using aggregate capital, K t, and aggregate labor, N t, as inputs is given as follows: Y t = F (K t, X t N t ) where X t denotes exogenous laboraugmenting technological progress. This technology is assumed to grow exogenously at a constant rate X t+1 = (1 + g)x t. For simplicity we normalize initial technology to X 0 = 1, such that: X t = (1 + g) t The presence of technological progress implies that households, on average, become richer over time. Technological progress thus increases the propensity of households to borrow. The aggregate production function, F, is assumed to have the standard properties, in particular constant returns to scale. This ensures that in competitive equilibrium, the number of firms is indeterminate and we can assume the existence of a representative firm, without loss of generality. 2.4 Government Sector The government has to finance government spending, G t, and the total transfers to households, T r t, by issuing new government bonds, B t+1, and levying taxes on positive asset and labor income. We assume that government spending/output is constant. Furthermore, the government services its debt, B t, and makes interest payments, r t B t. The government budget constraint is thus given by: G t + r t B t + T r t = B t+1 B t + τ l w t N t + τ k r t Â t (3) where Ât A t is the tax base for the asset income tax. As explained above taxes are only levied on positive financial income (no proportional transfers from the government for indebted people) and thus the tax base is defined as: Â t = adθ t (ɛ, a) a 0 8 Notice that as long we focus on transition between steadystates, the dynamic programming problem of the household falls into the class of stationary dynamic programming problems for which the principle of optimality is satisfied. We numerically show that our economy converges to a new steadystate. 6
8 where θ t (ɛ, a) denotes the distribution of households over income and asset states. Aggregate transfers have to equal the sum of all individual transfers: χ t dθ t (ɛ, a) = T r t 2.5 Competitive Equilibrium Using the characterization of the three sectors we can now define the competitive equilibrium. Definition 1. Competitive Equilibrium: Given a transition matrix π, a government policy {B t, τ t, G} t=0, and an initial distribution of the idiosyncratic productivity shocks and of the asset holdings θ 0 (ɛ, a) a recursive competitive equilibrium is defined by a law of motion Γ, factor prices {r t, w t } t=0, a sequence of value functions {W t } t=0 and a sequence of policy functions {c t, l t, a t} t=0 such that 1. Households solve the utility maximization problem as defined in equation (1). 2. Competitive firms maximize profits, such that factor prices are given by w t = F L (K t, X t N t ) (4) r t = F K (K t, X t N t ) δ (5) 3. The government budget constraint as defined in equation (3) holds. 4. Factor and goods markets have to clear: Labor market: N t = ɛl t dθ t (ɛ, a) Asset market: A t+1 = a tdθ t (ɛ, a) = K t+1 + B t+1 Goods market: c t dθ t (ɛ, a) + G t + I t = F (K t, X t N t ) where investment I is given by I K (1 δ)k 5. Rational expectations of households about the law of motion of the distribution of shocks and asset holdings, Γ reflect the true law of motion, as given by θ t+1 (a, ɛ) = Γ[θ t (a, ɛ)] (6) where θ t (a, ɛ) denotes the joint distribution of asset holdings and productivity shocks. 7
9 2.6 Welfare Measure In order to be able to compare the welfare effects of different government policies, we have to define a welfare criterion. Following the previous literature as for example, Aiyagari and McGrattan (1998) and Flodén (2001), we compute the aggregate value function: Ω t = W t (a, ɛ)dθ t (a, ɛ) This criterion can either be interpreted as (1) a Utilitarian social welfare function where every individual has the same weight for the planner, (2) a steadystate ex ante welfare of an average consumer before realizing income shocks and initial asset holdings or (3) the probability limit of the utility of an infinitely lived dynasty where households utilities are altruistically linked to each other. In order to facilitate the interpretation, we compute the average welfare change in consumption equivalent units, i.e. the consumption that needs to be given to each household in order to make households indifferent on average between two specific policies. 9 More details are provided in the Appendix. 3 Calibration We calibrate the model such that it is consistent with long run features of the US economy. The resulting allocation serves as a benchmark for our welfare calculations. The parameter values that result from our calibration procedure are shown in Table 1. Parameter values that are adopted from the existing literature are given in Table 2. In the following, we discuss the rationale behind our parameter choices in greater detail. 3.1 Utility Function and Production Technology We assume that preferences can be represented by a constant relative risk aversion utility function: u(c, 1 l) = (cη (1 l) 1 η ) 1 µ 1 µ µ determines the curvature of the utility function. We set µ to 2. This implies a coefficient of risk aversion of 1 µ + ηµ = 1.3, which is well in the range (between 1 and 3) commonly chosen in the literature. η denotes the share of consumption in the utility function. We calibrate η such that the average share of time worked is 0.3. This results in η = This choice implies an aggregate Frisch elasticity of This is broadly in line with the outcome of other macro models in which the Frisch elasticity of the overall population is considered, but an order of magnitude larger than the Frisch elasticity estimated using micro data from prime age workers More precisely, this measure provides the percentage increase in benchmark consumption at every date and state (with leisure at every date and state held fixed at benchmark values) that leads to the same welfare (under the benchmark policy) as under the new policy. 10 For our choice of the utility function, the Frisch elasticity is given by (1 µ + ηµ)/µ (T l)/ l, where T denotes the time endowment (normalized to 1 in our case) and l denotes the fraction of time spend at work, in our case The debate on whether micro and macro elasticities are consistent is ongoing. See Keane and Rogerson (2011) for a summary. 8
10 We assume that the aggregate technology is given by a CobbDouglas production function: F (K, XN) = K α (XN) 1 α Initial technology is normalized to X 0 = 1, such that X t = (1 + g) t. We set g = 0.02, which implies that our economy grows at a rate of 2 percent per year. The parameter α, which denotes the share of capital in total production, is set to 0.3. This implies a labor share of 0.7. The discount factor β is chosen such that the model reproduces a wealthoutput ratio of 3.1 (cf. Cooley and Prescott (1995) or Ábrahám and CárcelesPoveda (2010)). The resulting β is equal to The annual depreciation rate δ is set to 7 percent, which is a common value in the literature (see e.g. Trabandt and Uhlig (2009)). Table 1: Calibrated Parameter Values Parameter Value Target Data Model Discount factor, β 0.96 Capital to output ratio Weight of consumpt. in the util. funct., η 0.31 Average labor supply Borrowing constraint a 0.3 % of HH with no assets or debt Gov. spending/gdp, G 0.15 gov. budget constraint clearing Taxes and Government Debt Following Trabandt and Uhlig (2009), we set the labor income tax rate, τ l, to 0.28, and we set the asset income tax rate, τ k, to This implicitly defines the baseline component of our tax system τ l = τ = 0.28 and the premium on the asset income tax ζ = τ k τ = Lumpsum transfers/gdp, χ, are set to 0.083, also in accordance with Trabandt and Uhlig (2009). Similar values are reported by Mendoza, Razin, and Tesar (1994) for an earlier time period, as well. Following Aiyagari and McGrattan (1998), we use a debt/gdp ratio of Aiyagari and McGrattan (1998) calculate this figure as the average of the sum of US federal and state debt divided by gross domestic product over the postwar period. Table 2: Parameters Set Exogenously Parameter Value Capital s share, α 0.3 Growth rate, g 0.02 Debt/GDP, B 0.66 Labor tax, τ l 0.28 Capital tax, τ k 0.36 Transfers/GDP, χ Curvature µ 2 9
11 Finally, government spending/gdp, G, is set such that the government s budget constraint clears, given all other parameters. 3.3 Income Process We calibrate the vector of income states, s, and the transition matrix, Π, such that the distribution of earnings and net worth generated by the model are consistent with the data. Disciplining the model such that it is consistent with the skewed distribution of earnings and wealth observable in the US economy is key for assessing the welfaremaximizing government debt/gdp ratio. In particular, we are interested in the share of (consumption) poor households in the economy, who matter more in our Utilitarian welfare criterion, given the concavity of the utility function. In addition, matching inequality is also important in order to determine the factor income composition of the poor, which in turn determines whether poor households gain or lose from changes in government debt. We compute the distribution of earnings and net financial assets from the 2007 Survey of Consumer Finances (SCF) (see Table 3 and 4). We define net financial assets as net worth excluding housing and other durable goods, following Ábrahám and CárcelesPoveda (2010). Earnings are defined as labor earnings (wages and salaries) plus a fraction of business income before taxes, excluding government transfers. 12 This definition is close to the concept of earnings that is implied by our model as well. Table 3: Distributional Properties at Benchmark Stationary Economy Q1 Q2 Q3 Q4 Q5 Gini Net financial assets Data 1.60% 0.10% 1.64% 8.29% 91.57% 0.90 Baseline Economy 1.57% 0.88% 3.92% 7.23% 89.54% 0.83 Aiyagari/McGrattan s Economy 3.24% 10.07% 16.96% 25.71% 44.03% 0.41 Earnings Data 0.40% 3.19% 12.49% 23.33% 61.39% 0.62 Baseline Economy 0.00% 2.38% 12.58% 22.73% 62.31% 0.65 Aiyagari/McGrattan s Economy 1.21% 9.70% 16.18% 26.85% 46.07% 0.45 Remarks: Quintiles (Q1Q5) denote net financial assets (resp. earnings) of a group in percent of total net financial assets (resp. earnings). The entries in data are computed from the 2007 SCF. See main text for precise definitions. Notice that earnings can be negative due to the fact that labor earnings also contain part of the gains (or losses) of small enterprises. Table 3 and 4 show that both earnings and net financial assets are very unequally distributed in the data. The richest 20 percent of the population hold more than 90 percent of all financial assets, net of debt. The distribution of earnings is less skewed. Households in the top quintile earn around 60 percent 12 Unfortunately, it is not declared exactly in the SCF how much of the business income is actually labor and how much is capital income. We take business income from sole proprietorship or a farm to be labor earnings, whereas we define business income from other businesses or investments, net rent, trusts, or royalties as capital income. 10
12 Table 4: Upper Percentiles of Wealth Distribution at Benchmark upper 10% upper 5% upper 1% Net financial assets Data 79.64% 66.83% 39.09% Benchmark Calibration 70.58% 47.03% 13.53% Remarks: The table shows the percent of net financial assets held by the wealthiest 10% (upper 10%), 5% (upper 5%) and 1% (upper 1%). of the total earnings. It is well known that for a standard parameterization of the earnings process, incomplete markets models in the tradition of Aiyagari (1994) generate too little inequality compared to the data (see e.g. Quadrini and RíosRull (1997)). We follow Castañeda, DíazGiménez, and RíosRull (2003) and calibrate the vector of income states s and the transition matrix Π to match the Lorenz curves of US earnings and wealth as found in our analysis of the 2007 SCF. In the model, wealth inequality (and consumption inequality) are the result of households optimal decisions with respect to consumption and saving. Household use assets in order to smooth consumption over time and in order to save against uninsurable income shocks. Households decision making in turn depends on preference parameters and the specification of the earnings process. In our calibration, we modify the uninsurable income shocks such that the equilibrium asset allocation resembles the observable wealth inequality in the US 13 Tables 3 and 4 show that our calibration tracks the observable wealth and earnings distribution very closely, with the exception of the top decile of the wealth distribution. Here, our earnings process generates less inequality than the data, but much more than a standard AR(1) process. We find the following vector of income states: s = {0.055, 0.551, 1.195, 7.351} It should be noted that the highest income state is more than 130 times as high as the lowest income state. Furthermore, we get the following transition matrix for the income states: Π = As can be seen from the transition matrix, there is a 10 percent probability of moving from the highest income state today to the lowest income state tomorrow. This generates a strong saving motive for incomerich households, leading to the high degree of wealth inequality that we also observe in the data. The same mechanism is also present in the transition matrix found by Castañeda, DíazGiménez, and RíosRull (2003). 13 An alternative approach, which is due to Krusell and Smith (1998), would be to introduce preference heterogeneity. Krusell and Smith (1998) assume that some households are more patient than others, and thus also accumulate more savings. 11
13 3.4 Borrowing Limit We calibrate the adhoc borrowing limit to match the percentage of households with negative or zero financial assets in the 2007 SCF (24 percent). We find a borrowing limit of a = Results We are now ready to compute the welfare effects of reductions in government debt. We distinguish between transition (in the following also labeled as shortrun) and stationary equilibrium (in the following also labeled as longrun). We proceed in two steps. First, we analyze the welfare consequences of government debt reductions in stationary equilibrium. This is done by comparing stationary equilibria that are characterized by different debt/gdp ratios, keeping all other parameters constant. In order to keep the budget of the government balanced, we adjust taxes such that the relative distortions between capital and labor (ζ) remains constant. We find that in the longrun, debt reductions are associated with welfare gains. In a second step, we also incorporate the welfare effects that occur over the transition between a highdebt stationary equilibrium to a lowdebt equilibrium. We find that the costs of debt reductions occurring over the transition can be substantial, depending on the policy. The shortrun costs of debt reductions can easily outweigh the longrun gains. 4.1 Effects of Public Debt in Stationary Equilibrium In this section, we compute the longrun welfare maximizing debt/gdp ratio in our economy. Our analysis is motivated by the fact that in the textbook neoclassical model with lumpsum taxes, government debt is neutral and therefore has no impact on welfare. In a seminal paper, Aiyagari and McGrattan (1998) showed that in the presence of borrowing constraints and in the absence of complete markets, government debt has nontrivial welfare effects. Two quantitative results from their paper have been very influential for the following research. First, Aiyagari and McGrattan (1998) argue that the debt/gdp ratio that maximizes longrun welfare is around 2/3, which is also the historical average of debt/gdp in the US economy. Second, they also find that welfare effects of deviations from the longrun historical average are small. We show that these two conclusions drastically change in our calibration. In Figure 1, we plot the aggregate welfare changes for stationary equilibria for different public debt/gdp ratios, relative to the benchmark in which debt amounts to 2/3 of GDP. Figure 1 conveys a clear message: according to our calibration, stationary equilibria with lower debt/gdp ratios offer more aggregate welfare, compared to the benchmark. In our economy, the debt/gdp ratio maximizing longrun welfare is 0.8. Moreover, reducing debt/gdp relative to the longrun average results in large welfare gains, up to 0.6 percent of consumption per year for the average household in our economy. In the following, we analyze in greater detail the driving forces behind the longrun welfare effects of changes in government debt in an Aiyagari (1994) style incomplete markets model. In particular, we want to understand the driving forces that explain the differences between Aiyagari and McGrattan (1998) and our baseline calibration. The longrun welfare effects of government debt result from the interaction between public debt and private capital. The interplay between public debt and private capital accumulation is a consequence of 12
14 1 0.8 Our Model Aiyagari/McGrattan Welfare Change in Consumption Equivalents (in %) Public Debt/GDP Figure 1: Comparing Welfare Between Different Stationary Equilibria. In this exercise we plot the welfare change in consumption equivalent units implied by our baseline calibration (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa), relative to the benchmark in which public debt amounts to 2/3 of GDP (green diamond and vertical line). Two cases: (1) Our Baseline Economy (blue crosses);(2) Aiyagari and McGrattan s economy (black circles). the fact that the borrowing constraint a is exogenous and fixed. Because of this, an increase in government debt crowds out private capital accumulation by effectively relaxing the borrowing limit (Aiyagari and McGrattan), a fact which facilitates precautionary savings. Notice that not only households who are currently at the constraint profit from the effective relaxation of the borrowing limit, but also those households that fear to be constrained in the future. For our baseline calibration, the effect of public debt on private capital (private savings minus public debt) can be seen in Figure 2, where we depict assets (i.e. aggregate private savings) and the capital stock, relative to GDP. 14 Higher public debt/gdp ratios decrease capital. This means that the increase in assets demanded by households cannot compensate for the increase in asset supplied by the government. The reverse also holds. If government debt is reduced, the capital stock is crowded in. Households do not reduce their asset holdings as much as the government reduces its debt. As a result, the capital stock increases. If the capital stock in the baseline calibration is below its efficient level, crowding in of capital increases welfare, all other things equal. In a recent paper, Davila et al. (2011) show that in an environment in which markets are incomplete, inequality, in particular the nature of the income risk as well as the composition of income for the consumptionpoor, are important determinants for the constrained efficient capital stock. Davila et al. (2011) show that if the earnings process is calibrated as in Castañeda, DíazGiménez, and RíosRull (2003)  the method that we employ in this paper  the constrained efficient capital stock is much higher than its laissezfaire level. This finding is in line with our result that government debt reductions increase the private capital stock and raise welfare. 14 We study the relationship between public debt and borrowing limits in a separate paper, see Röhrs and Winter (2013). In the other project, we also allow for endogenous borrowing limits that result from a limited commitment problem. 13
15 Capital/Benchmark GDP Public Debt/GDP Assets/Benchmark GDP Public Debt/GDP 2 2 Income before taxes (GDP) Income after taxes Public Debt/GDP Public Debt/GDP Figure 2: Capital, Assets, Income Before Taxes, Income After Taxes. This figure shows the changes in selected aggregate economic variables (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa). In the benchmark public debt amounts to 2/3 of GDP (green diamond and vertical line). All variables relative to GDP in the benchmark. There are three channels, through which government debt reductions affect welfare in the longrun. which we describe each in greater detail in the following. 15 Level effect: Since government debt/gdp ratios lead to more private capital, they are associated with more production (see the lower panel in Figure 2). To the extent that more production translates into more consumption, crowdingin of private capital is welfareenhancing. In general, we expect the level effect to be nonlinear. Flodén (2001) finds that the level effect is concave around the benchmark debt/gdp ratio. Since we use a different calibration of the earnings process which is closer to Davila et al. (2011), we would expect that lower debt/gdp ratios (and hence more private capital), relative to the benchmark, are welfareenhancing for a while. We will get back to this point later. Insurance effect: A decrease in public debt means that households effectively face tighter borrowing 15 We adopt the labels of Flodén (2001), who distinguishes a level effect, an uncertainty effect and an inequality effect. By relabeling the inequality effect into income composition effect, we would like to stress the origin of inequality in the model, namely the fact the composition of income between households differs. 14
16 limits. Precautionary saving becomes more difficult. The economy accumulates more private capital. As a consequence, we observe a decrease in the interest rate r and an increase in the wage rate w (see Figure 3). This, by itself, makes it more difficult for households to selfinsure against adverse productivity shocks. Consequently, the fraction of households which are at the borrowing constraint, as plotted in Figure 4, rises. Interest Rate Public Debt/GDP Wage Rate Public Debt/GDP Figure 3: Interest Rate and Wage Rate. This figure shows the changes in equilibrium prices for capital and labor (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa). In the benchmark public debt amounts to 2/3 of GDP (green diamond and vertical line). In addition, a fall in the interest rate and an increase in the wage rate increases uncertainty in total income, all other things equal. This is because the weight of the uncertain income component, namely labor income is increased relative to capital income, which is certain in our economy. As a result, uncertainty about consumption is amplified as well, and households experience an exante welfare loss. Income composition effect: A reduction in government debt/gdp implies that the interest rate r falls, while the wage rate w increases. As a consequence, asset owners experience, on average, a loss in their income if there is more government debt, while those households who primarily depend on labor income, experience a gain. We call this the income composition effect. It is important to notice that the income composition effect would also exist if markets were complete and if idiosyncratic shocks were fully insurable. This distinguishes the income composition effect from the uncertainty channel that was previously outlined. In our environment, in which markets are incomplete, the impact of the income composition effect on aggregate welfare is even larger. This is because in our calibration, wealth is primarily held in order to selfinsure against uninsurable income fluctuations. Households who own little wealth, and thus depend heavily on their labor income, are those that have been hit by a sequence of bad shocks. These households are also consumptionpoor and thus matter more in the Utiliterian welfare criterion, given the concavity of the utility function. In sum, a reduction in government debt affects aggregate welfare in the longrun via a level effect, an insurance channel and through the composition of individual income. The impact of the level effect 15
17 20 Our Model Baseline using Aiyagari/McGrattan income process Fraction of Constrained Households (in %) Public Debt/GDP Figure 4: Fraction of Households at the Borrowing Constraint. This figure shows the changes in the fraction of constrained households (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa). In the benchmark public debt amounts to 2/3 of GDP (green diamond and vertical line). Two cases: Our Model (blue crosses); Baseline using Aiyagari/McGrattan income process (red squares). on aggregate welfare is ambiguous, depending on the efficient level of capital. The income composition effect implies that lower debt/gdp increase aggregate welfare, whereas the insurance effect implies that welfare decreases for lower debt/gdp ratios. The relative strength of each channel depends on the degree of wealth and income inequality in the economy. Why is the welfare function nonmonotone? Interestingly, the welfare function reveals that lowering debt/gdp beyond 0.8 does not increase welfare anymore. 16 At the first glance, this result is perhaps surprising, given that stationary equilibria with smaller debt/gdp ratios should ceteris paribus require lower tax rates, given that the debt service is smaller. We argue that the nonlinear interaction between the level effect, the insurance effect and the incomecomposition effect can explain the shape of the welfare function. The interaction between the insurance effect and the incomecomposition effect can be illustrated by analyzing in greater detail the welfare effects of different population subgroups. More specifically, we divide the population into three groups by applying the following definition: 1. Poor: Households with zero or negative assets. 2. Rich: Group of households who together own 70 percent of total assets. 3. Middle class: Households who do not belong to either of the previous categories. 16 Actually, welfare starts to decline for debt/gdp ratios below 1. Welfare effects from lowering debt/gdp ratios beyond 1 can be obtained from authors upon request. 16
18 The poor do not receive asset income and finance their consumption with labor income only. The rich instead depend primarily on capital income. Finally, the middle class receives income from both labor and capital income. We keep the definition constant in all of the following experiments. 40 Welfare 80 Group Size Welfare Change in Consumption Equivalents (in %) Public Debt/GDP Group Size in % of Total Population Poor Middle Class Rich Public Debt/GDP Figure 5: Group Size and Welfare Change of Wealth Groups. This figure shows the changes in group size and welfare of a group (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa). In the benchmark public debt amounts to 2/3 of GDP (green diamond and vertical line). Three groups: (1) the poor have no assets or are in debt (black circles), (2) the rich own 70% of assets as a group (red squares), (3) the middle class is the rest of the households that are neither rich nor poor (blue crosses). At the benchmark equilibrium with debt/gdp of 66 percent, around 25 percent of all households are poor according to our definition. About 2 percent are rich and the rest belongs to the middle class. The relative groupsizes are not invariant to changes in the debt/gdp ratio, as the first panel of Figure 5 makes apparent. The lower the debt/gdp ratios, the more the number of poor households grow, at the expense of the number of middleincome households. 17 Intuitively, lower debt/gdp ratios discourage saving through depressing interest rates. This illustrates the insurance effect: lower debt/gdp ratios hamper the ability of households to selfinsurance, and increase the fraction of households at the borrowing constraint. The groupspecific welfare functions are shown in the second panel of Figure 5. The betweengroup differences are enormous. In particular, the welfare function of the rich is almost exactly the mirror image of the welfare function of the poor: poor households gain in the longrun as we move to lower debt/gdp ratios, while rich households lose. This reflects the incomecomposition effect. Poor households, who by definition do not possess assets, profit from the higher wage rate that prevails at lower debt/gdp ratios. Rich households instead suffer from the decrease in the interest rate. The fact that welfare is not monotonically increasing for lower debt/gdp ratios can thus be partly explained by the counteracting forces of the insurance effect (which leads to an impoverishment of a large part of the population if debt is reduced) and the incomecomposition effect (which increases the 17 Reducing government debt thus increases wealth inequality (but reduces consumption inequality) in the longrun, a result that was already emphasized by Flodén (2001). 17
19 welfare of the poor). The Contribution of Inequality. In the following, we want to shed more light on the relative contribution of inequality in explaining the differences between the welfare effects of government debt in our baseline case relative to the seminal paper by Aiyagari and McGrattan (1998) Welfare Change in Consumption Equivalents (in %) Baseline Economy Baseline with 1) Aiyagari/McGrattan income process Baseline with 1) and 2) Aiyagari/McGrattan borrowing limit 0.8 Baseline with 1), 2) and 3) Aiyagari/McGrattan common tax rate on both factors Baseline with 1)3) and 4) Aiyagari/McGrattan risk aversion Aiyagari/McGrattan Public Debt/GDP Figure 6: Comparing Welfare in Different Economies. In this exercise we plot the welfare change in consumption equivalent units implied by our model (on the ordinate) for different stationary equilibria that differ with respect to the public debt/gdp ratio (on the abscissa), relative to the benchmark in which public debt amounts to 2/3 of GDP (yellow diamond and vertical line). We consecutively changed parameters for the baseline economy: 1) Aiyagari/McGrattan s income process (AR(1) process with persistence of ρ = 0.6 and variance of σ = 0.3); 2) Borrowing limit=0; 3) One common tax rate on capital and labor; 4) Aiyagari/McGrattan s risk aversion (µ = 1.5) As can be seen from Figure 6, using the AR(1) earnings process from Aiyagari and McGrattan (1998) instead of our calibration procedure substantially attenuates the welfare effects of government debt. Clearly, as Table 4 shows, altering the income process leads to a sharp drop in the level of inequality generated by our model. Notice that in this step, as well as in all other steps that follow, we recalibrate the economy to be consistent with all other targets of our baseline calibration. Another difference between our setup and the one of Aiyagari and McGrattan (1998) is that we allow for borrowing, while Aiyagari and McGrattan (1998) impose a zeroborrowing constraint. Prohibiting borrowing in our model additionally decreases wealth inequality (which is obvious, given that there are no households in debt anymore, see Table 5). Interestingly, Figure 6 shows that this measure further mutes the welfare effects of government debt. Figure 6 further reveals that changing the earnings process and imposing a tighter borrowing limit together accounts for almost half of the differences between our welfare function and the one computed by Aiyagari and McGrattan (1998). All other checks, such as implementing the riskaversion of Aiyagari and McGrattan (1998), their tax distortions etc., do not alter the welfare function substantially. 18 Importantly, Table 5 shows that changing these parameters 18 We also use a different growth rate and a different depreciation rate compared to Aiyagari and McGrattan (1998). This accounts for the gap between specification 4 and Aiyagari and McGrattan (1998). 18
20 Table 5: Distributional properties of baseline and other economies Q1 Q2 Q3 Q4 Q5 Gini Net financial assets Data 1.60% 0.10% 1.64% 8.29% 91.57% 0.9 Baseline Economy 1.57% 0.88% 3.92% 7.23% 89.54% 0.83 Baseline Economy with 1) 2.24% 9.63% 16.94% 26.08% 45.11% 0.43 Baseline with 1) and 2) 3.30% 10.15% 17.05% 25.70% 43.79% 0.41 Baseline with 1), 2) and 3) 3.60% 10.48% 17.23% 25.63% 43.06% 0.4 Baseline with 1)3) and 4) 3.53% 10.40% 17.17% 25.63% 43.28% 0.4 Aiyagari/McGrattan 3.24% 10.07% 16.96% 25.71% 44.03% 0.41 Earnings Data 0.40% 3.19% 12.49% 23.33% 61.39% 0.62 Baseline 0.00% 2.38% 12.58% 22.73% 62.31% 0.62 Baseline with 1) 2.88% 10.98% 16.82% 26.18% 43.15% 0.41 Baseline with 1) and 2) 2.96% 11.05% 16.84% 26.11% 43.04% 0.41 Baseline with 1), 2) and 3) 2.78% 10.87% 16.79% 26.22% 43.34% 0.41 Baseline with 1)3) and 4) 2.27% 10.49% 16.58% 26.40% 44.26% 0.43 Aiyagari/McGrattan 1.21% 9.70% 16.18% 26.85% 46.07% 0.45 * Quintiles (Q1Q5) denote wealth (resp. earnings) of a group in percent of total wealth (resp. earnings). ** Last column denotes percent of population with no or negative assets. 1) Aiyagari/McGrattan s income process used for this economy (AR(1) process with persistence of ρ = 0.6 and variance of σ = 0.3) 2) Borrowing limit=0 for this economy 3) One common tax rate on capital and labor (same value as in Aiyagari/McGrattan) for this economy 4) Aiyagari/McGrattan s risk aversion for this economy (µ = 1.5). does not influence inequality either. Hence, this confirms our result that accounting for inequality is particularly important when calculating the welfare effects of government debt. Decomposition of Total Welfare Change. We now decompose the total welfare effect of public debt in its subcomponents level, insurance and income composition effect, following Flodén (2001). We then use these subcomponents to better understand the role that the income process (and therefore also inequality) plays for the total welfare effects of government debt. In order to do so, we do this decomposition for our baseline calibration using two different earnings processes, once with our earnings process and once using the AR(1) process of Aiyagari and McGrattan (1998). We recalibrate the economy to be consistent with the targets of our baseline calibration. Figure 7 shows the results. The following interesting pattern are visible. First of all, the insurance and the income composition effect show the expected sign. The income composition effect is positive for lower debt/gdp ratios, implying that rich households lose but poor households win in the longrun if the government reduces its debt. The insurance effect is negative, because lower debt/gdp ratios make it more difficult for households to selfinsure. It is perhaps not surprising that both effects are weaker under the income process used by Aiyagari and McGrattan (1998), at least for debt/gdp ratios that are not too far away from the longrun average, given that the Aiyagari and McGrattan (1998) income process produces far less inequality. 19
Reducing Government Debt in the Presence of Inequality
Reducing Government Debt in the Presence of Inequality Sigrid Röhrs and Christoph Winter February 4, 214 Abstract What are the welfare consequences of debt reduction policies? In this paper, we answer
More informationReducing Government Debt in the Presence of Inequality
Reducing Government Debt in the Presence of Inequality Sigrid Röhrs and Christoph Winter February 25, 2016 Abstract What are the welfare effects of government debt? In particular, what are the welfare
More informationUninsured Entrepreneurial Risk and Public Debt Policies
Uninsured Entrepreneurial Risk and Public Debt Policies Sumudu Kankanamge a 1 a Paris School of Economics, CNRS, France Abstract This paper builds a stylized economy with both entrepreneurial and non entrepreneurial
More informationPublic debt and aggregate risk
Public debt and aggregate risk Audrey Desbonnet, LEDa, Université ParisDauphine, Sumudu Kankanamge, Toulouse School of Economics (GREMAQ). First draft: March 2006, This draft: April 2011. Abstract In
More information. In this case the leakage effect of tax increases is mitigated because some of the reduction in disposable income would have otherwise been saved.
Chapter 4 Review Questions. Explain how an increase in government spending and an equal increase in lump sum taxes can generate an increase in equilibrium output. Under what conditions will a balanced
More informationKeywords: Overlapping Generations Model, Tax Reform, Turkey
SIMULATING THE TURKISH TAX SYSTEM ADEM İLERİ Middle East Technical University Department of Economics aileri@metu.edu.tr PINAR DERİNGÜRE Middle East Technical University Department of Economics pderin@metu.edu.tr
More informationOptimal Taxation in a Limited Commitment Economy
Optimal Taxation in a Limited Commitment Economy forthcoming in the Review of Economic Studies Yena Park University of Pennsylvania JOB MARKET PAPER Abstract This paper studies optimal Ramsey taxation
More informationOptimal Consumption with Stochastic Income: Deviations from Certainty Equivalence
Optimal Consumption with Stochastic Income: Deviations from Certainty Equivalence Zeldes, QJE 1989 Background (Not in Paper) Income Uncertainty dates back to even earlier years, with the seminal work of
More informationUniversidad de Montevideo Macroeconomia II. The RamseyCassKoopmans Model
Universidad de Montevideo Macroeconomia II Danilo R. Trupkin Class Notes (very preliminar) The RamseyCassKoopmans Model 1 Introduction One shortcoming of the Solow model is that the saving rate is exogenous
More informationLecture 2 Dynamic Equilibrium Models : Finite Periods
Lecture 2 Dynamic Equilibrium Models : Finite Periods 1. Introduction In macroeconomics, we study the behavior of economywide aggregates e.g. GDP, savings, investment, employment and so on  and their
More informationOn the Consequences of Eliminating Capital Tax Differentials
On the Consequences of Eliminating Capital Tax Differentials Ctirad Slavík and Hakki Yazici February 19, 2014 Abstract In the United States structure and equipment capital are effectively taxed at different
More informationCurrent Accounts in Open Economies Obstfeld and Rogoff, Chapter 2
Current Accounts in Open Economies Obstfeld and Rogoff, Chapter 2 1 Consumption with many periods 1.1 Finite horizon of T Optimization problem maximize U t = u (c t ) + β (c t+1 ) + β 2 u (c t+2 ) +...
More informationMoney and Public Finance
Money and Public Finance By Mr. Letlet August 1 In this anxious market environment, people lose their rationality with some even spreading false information to create trading opportunities. The tales about
More information6. Budget Deficits and Fiscal Policy
Prof. Dr. Thomas Steger Advanced Macroeconomics II Lecture SS 2012 6. Budget Deficits and Fiscal Policy Introduction Ricardian equivalence Distorting taxes Debt crises Introduction (1) Ricardian equivalence
More informationFinancial Development and Macroeconomic Stability
Financial Development and Macroeconomic Stability Vincenzo Quadrini University of Southern California Urban Jermann Wharton School of the University of Pennsylvania January 31, 2005 VERY PRELIMINARY AND
More informationPublic debt and aggregate risk
Public debt and aggregate risk Audrey Desbonnet a 1 and Sumudu Kankanamge b 2 a University of Vienna, Austria. b Paris School of Economics, CNRS, France Abstract This paper assesses the longrun optimal
More informationOn the irrelevance of government debt when taxes are distortionary
On the irrelevance of government debt when taxes are distortionary Marco Bassetto a,b,, Narayana Kocherlakota c,b a Department of Economics, University of Minnesota, 271 19th Ave. S., Minneapolis, MN 55455,
More informationOn the Consequences of Eliminating Capital Tax Differentials
On the Consequences of Eliminating Capital Tax Differentials Ctirad Slavík and Hakki Yazici July 21, 2014 Abstract In the United States structure and equipment capital are effectively taxed at different
More informationDividend and Capital Gains Taxation under Incomplete Markets
Dividend and Capital Gains Taxation under Incomplete Markets Alexis Anagnostopoulos, Eva CárcelesPoveda,DanmoLin Stony Brook University; Stony Brook University; University of Maryland Received Date; Received
More informationOptimal fiscal policy under commitment
Abstract Optimal Fiscal and Monetary Policy with Commitment Mikhail Golosov and Aleh Tsyvinski 1 May 31, 2006 Forthcoming in New Palgrave Dictionary of Economics and Law Optimal fiscal and monetary policy
More informationOptimal Income Taxation: Mirrlees Meets Ramsey
Optimal Income Taxation: Mirrlees Meets Ramsey Jonathan Heathcote FRB Minneapolis Hitoshi Tsujiyama Goethe University Frankfurt Iowa State University, April 2014 The views expressed herein are those of
More informationECON20310 LECTURE SYNOPSIS REAL BUSINESS CYCLE
ECON20310 LECTURE SYNOPSIS REAL BUSINESS CYCLE YUAN TIAN This synopsis is designed merely for keep a record of the materials covered in lectures. Please refer to your own lecture notes for all proofs.
More informationwelfare costs of business cycles
welfare costs of business cycles Ayse Imrohoroglu From The New Palgrave Dictionary of Economics, Second Edition, 2008 Edited by Steven N. Durlauf and Lawrence E. Blume Abstract The welfare cost of business
More informationOptimal Income Taxation: Mirrlees Meets Ramsey
Optimal Income Taxation: Mirrlees Meets Ramsey Jonathan Heathcote FRB Minneapolis Hitoshi Tsujiyama Goethe University Frankfurt Ohio State University, April 17 2014 The views expressed herein are those
More informationThe Real Business Cycle Model
The Real Business Cycle Model Ester Faia Goethe University Frankfurt Nov 2015 Ester Faia (Goethe University Frankfurt) RBC Nov 2015 1 / 27 Introduction The RBC model explains the comovements in the uctuations
More informationDiscussion of Capital Injection, Monetary Policy, and Financial Accelerators
Discussion of Capital Injection, Monetary Policy, and Financial Accelerators Karl Walentin Sveriges Riksbank 1. Background This paper is part of the large literature that takes as its starting point the
More informationInsurance and Opportunities: The Welfare Implications of Rising Wage Dispersion
Insurance and Opportunities: The Welfare Implications of Rising Wage Dispersion Jonathan Heathcote, Kjetil Storesletten, and Giovanni L. Violante February 005 Abstract This paper analyzes the welfare effects
More informationLecture 3: Growth with Overlapping Generations (Acemoglu 2009, Chapter 9, adapted from Zilibotti)
Lecture 3: Growth with Overlapping Generations (Acemoglu 2009, Chapter 9, adapted from Zilibotti) Kjetil Storesletten September 10, 2013 Kjetil Storesletten () Lecture 3 September 10, 2013 1 / 44 Growth
More informationReal Business Cycles. Federal Reserve Bank of Minneapolis Research Department Staff Report 370. February 2006. Ellen R. McGrattan
Federal Reserve Bank of Minneapolis Research Department Staff Report 370 February 2006 Real Business Cycles Ellen R. McGrattan Federal Reserve Bank of Minneapolis and University of Minnesota Abstract:
More informationThe RBC methodology also comes down to two principles:
Chapter 5 Real business cycles 5.1 Real business cycles The most well known paper in the Real Business Cycles (RBC) literature is Kydland and Prescott (1982). That paper introduces both a specific theory
More informationNotes on Papers on Public Debt & Dynamic Public Finance
Notes on Papers on Public Debt & Dynamic Public Finance LucasStokey, JME 1983 Optimal public finance with stochastic G, allowing for rich structure of asset markets (including claims equivalent to statecontingent
More informationCapital Constraints, Lending over the Cycle and the Precautionary Motive: A Quantitative Exploration (Working Paper)
Capital Constraints, Lending over the Cycle and the Precautionary Motive: A Quantitative Exploration (Working Paper) Angus Armstrong and Monique Ebell National Institute of Economic and Social Research
More informationMargin Calls, Trading Costs and Asset Prices in Emerging Markets: The Financial Mechanics of the Sudden Stop Phenomenon
Discussion of Margin Calls, Trading Costs and Asset Prices in Emerging Markets: The Financial Mechanics of the Sudden Stop Phenomenon by Enrique Mendoza and Katherine Smith Fabrizio Perri NYUStern,NBERandCEPR
More informationLife Cycle Asset Allocation A Suitable Approach for Defined Contribution Pension Plans
Life Cycle Asset Allocation A Suitable Approach for Defined Contribution Pension Plans Challenges for defined contribution plans While Eastern Europe is a prominent example of the importance of defined
More informationMoney and Capital in an OLG Model
Money and Capital in an OLG Model D. Andolfatto June 2011 Environment Time is discrete and the horizon is infinite ( =1 2 ) At the beginning of time, there is an initial old population that lives (participates)
More informationUNIVERSITY OF OSLO DEPARTMENT OF ECONOMICS
UNIVERSITY OF OSLO DEPARTMENT OF ECONOMICS Exam: ECON4310 Intertemporal macroeconomics Date of exam: Thursday, November 27, 2008 Grades are given: December 19, 2008 Time for exam: 09:00 a.m. 12:00 noon
More informationCash in advance model
Chapter 4 Cash in advance model 4.1 Motivation In this lecture we will look at ways of introducing money into a neoclassical model and how these methods can be developed in an effort to try and explain
More informationIntergenerational Persistence of Earnings: The Role of Early and College Education
Intergenerational Persistence of Earnings: The Role of Early and College Education Diego Restuccia University of Toronto Carlos Urrutia Centro de Investigación Económica, ITAM Universidad Carlos III de
More informationOptimal Paternalism: Sin Taxes and Health Subsidies
Optimal Paternalism: Sin Taxes and Health Subsidies Thomas Aronsson and Linda Thunström Department of Economics, Umeå University SE  901 87 Umeå, Sweden April 2005 Abstract The starting point for this
More informationThe Impact of Government Debt and Taxation on Endogenous Growth in the Presence of a Debt Trigger
The Impact of Government Debt and Taxation on Endogenous Growth in the Presence of a Debt Trigger Gregory W. Huffman March, 2015 Abstract Relatively little is known about how government debt influences
More informationThe Japanese Saving Rate
The Japanese Saving Rate By KAIJI CHEN, AYŞE İMROHOROĞLU, AND SELAHATTIN İMROHOROĞLU* * Chen: Department of Economics, University of Oslo, Blindern, N0317 Oslo, Norway (email: kaijic@econ. uio.no); A.
More informationFurther Discussion of Temporary Payroll Tax Cut During Recession(s) Mark Bils and Pete Klenow, December 12, 2008
Further Discussion of Temporary Payroll Tax Cut During Recession(s) Mark Bils and Pete Klenow, December 12, 2008 We focus on three aspects of a cut in payroll taxes as a stabilizer in a recession: (1)
More informationInsurance and Opportunities: The Welfare Implications of Rising Wage Dispersion
JOINT USC ECONOMICS DEPARTMENT SEMINAR IN ECONOMICS DYNAMICS and USC FBE DEPT MACROECONOMICS AND INTERNATIONAL FINANCE WORKSHOP presented by Gianluca Violante FRIDAY, April 14, 006 3:30 pm  5:00 pm, Room:
More information4. Only one asset that can be used for production, and is available in xed supply in the aggregate (call it land).
Chapter 3 Credit and Business Cycles Here I present a model of the interaction between credit and business cycles. In representative agent models, remember, no lending takes place! The literature on the
More informationThis PDF is a selection from a published volume from the National Bureau of Economic Research
This PDF is a selection from a published volume from the National Bureau of Economic Research Volume Title: Fiscal Policy and Management in East Asia, NBEREASE, Volume 16 Volume Author/Editor: Takatoshi
More informationLecture 14 More on Real Business Cycles. Noah Williams
Lecture 14 More on Real Business Cycles Noah Williams University of Wisconsin  Madison Economics 312 Optimality Conditions Euler equation under uncertainty: u C (C t, 1 N t) = βe t [u C (C t+1, 1 N t+1)
More informationMacroeconomic and Distributional Effects of Social Security
Macroeconomic and Distributional Effects of Social Security Luisa Fuster 1 Universitat Pompeu Fabra and University of Toronto First draft: September 2002. This version: December 2002 1. Introduction Social
More informationMacroeconomics Lecture 1: The Solow Growth Model
Macroeconomics Lecture 1: The Solow Growth Model Richard G. Pierse 1 Introduction One of the most important longrun issues in macroeconomics is understanding growth. Why do economies grow and what determines
More informationA Theory of Capital Controls As Dynamic Terms of Trade Manipulation
A Theory of Capital Controls As Dynamic Terms of Trade Manipulation Arnaud Costinot Guido Lorenzoni Iván Werning Central Bank of Chile, November 2013 Tariffs and capital controls Tariffs: Intratemporal
More informationConsumption, Saving, and Investment, Part 1
Agenda Consumption, Saving, and, Part 1 Determinants of National Saving 51 52 Consumption and saving decisions : Desired consumption is the consumption amount desired by households Desired national saving
More informationIntermediate Macroeconomics: The Real Business Cycle Model
Intermediate Macroeconomics: The Real Business Cycle Model Eric Sims University of Notre Dame Fall 2012 1 Introduction Having developed an operational model of the economy, we want to ask ourselves the
More informationThe Provision of Public Universal Health Insurance: Impacts on Private Insurance, Asset Holdings and Welfare
The Provision of Public Universal Health Insurance: Impacts on Private Insurance, Asset Holdings and Welfare Minchung Hsu Junsang Lee GRIPS KDI November, 2011 Abstract This paper aims to investigate impacts
More informationWORKING PAPER NO. 1118 PRIVATE EQUITY PREMIUM IN A GENERAL EQUILIBRIUM MODEL OF UNINSURABLE INVESTMENT RISK
WORKING PAPER NO. 1118 PRIVATE EQUITY PREMIUM IN A GENERAL EQUILIBRIUM MODEL OF UNINSURABLE INVESTMENT RISK Francisco Covas Board of Governors of the Federal Reserve System and Shigeru Fujita Federal
More informationHuman Capital Risk, Contract Enforcement, and the Macroeconomy
Human Capital Risk, Contract Enforcement, and the Macroeconomy Tom Krebs University of Mannheim Moritz Kuhn University of Bonn Mark Wright UCLA and Chicago Fed General Issue: For many households (the young),
More informationMACROECONOMIC ANALYSIS OF VARIOUS PROPOSALS TO PROVIDE $500 BILLION IN TAX RELIEF
MACROECONOMIC ANALYSIS OF VARIOUS PROPOSALS TO PROVIDE $500 BILLION IN TAX RELIEF Prepared by the Staff of the JOINT COMMITTEE ON TAXATION March 1, 2005 JCX405 CONTENTS INTRODUCTION... 1 EXECUTIVE SUMMARY...
More informationMoral Hazard. Itay Goldstein. Wharton School, University of Pennsylvania
Moral Hazard Itay Goldstein Wharton School, University of Pennsylvania 1 PrincipalAgent Problem Basic problem in corporate finance: separation of ownership and control: o The owners of the firm are typically
More informationStriking it Richer: The Evolution of Top Incomes in the United States (Updated with 2009 and 2010 estimates)
Striking it Richer: The Evolution of Top Incomes in the United States (Updated with 2009 and 2010 estimates) Emmanuel Saez March 2, 2012 What s new for recent years? Great Recession 20072009 During the
More informationEndogenous Growth Theory
Chapter 3 Endogenous Growth Theory 3.1 OneSector Endogenous Growth Models 3.2 Twosector Endogenous Growth Model 3.3 Technological Change: Horizontal Innovations References: Aghion, P./ Howitt, P. (1992),
More informationNew Dynamic Public Finance. Mikhail Golosov (Yale, New Economic School, and NBER) Aleh Tsyvinski (Yale, New Economic School, and NBER)
New Dynamic Public Finance Mikhail Golosov (Yale, New Economic School, and NBER) Aleh Tsyvinski (Yale, New Economic School, and NBER) New Dynamic Public Finance is a recent literature that analyzes taxation
More informationGraduate Macro Theory II: The Real Business Cycle Model
Graduate Macro Theory II: The Real Business Cycle Model Eric Sims University of Notre Dame Spring 2011 1 Introduction This note describes the canonical real business cycle model. A couple of classic references
More informationAssessing welfare impacts of some debtconsolidation episodes in the European Union
Assessing welfare impacts of some debtconsolidation episodes in the European Union Miguel Viegas GOVCOPP, DEGEI, Universidade de Aveiro Ana Paula Ribeiro CEF.UP and Faculdade de Economia, Universidade
More informationThe Budget Deficit, Public Debt and Endogenous Growth
The Budget Deficit, Public Debt and Endogenous Growth Michael Bräuninger October 2002 Abstract This paper analyzes the effects of public debt on endogenous growth in an overlapping generations model. The
More informationMacroeconomic and Welfare Costs of U.S. Fiscal Imbalances
WP/12/38 Macroeconomic and Welfare Costs of U.S. Fiscal Imbalances Bertrand Gruss and José L. Torres 201 International Monetary Fund WP/12/38 IMF Working Paper Fiscal Affairs Department Macroeconomic and
More informationPractice Problems on the Capital Market
Practice Problems on the Capital Market 1 Define marginal product of capital (i.e., MPK). How can the MPK be shown graphically? The marginal product of capital (MPK) is the output produced per unit of
More informationcrowding out Crowding out at full employment
C000452 Crowding out refers to all the things which can go wrong when debtfinanced fiscal policy is used to affect output. While the initial focus was on the slope of the LM curve, now refers to a multiplicity
More informationSustainable Social Security: Four Options
Federal Reserve Bank of New York Staff Reports Sustainable Social Security: Four Options Sagiri Kitao Staff Report no. 505 July 2011 This paper presents preliminary findings and is being distributed to
More informationThe Elasticity of Taxable Income: A NonTechnical Summary
The Elasticity of Taxable Income: A NonTechnical Summary John Creedy The University of Melbourne Abstract This paper provides a nontechnical summary of the concept of the elasticity of taxable income,
More informationMaster Economics & Business Understanding the World Economy. Sample Essays and Exercices
Master Economics & Business Understanding the World Economy Sample Essays and Exercices Examples of short exercises 1. Decreasing Marginal Product of Capital and Depreciation Consider two sectors using
More informationA Simple Model of Price Dispersion *
Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper No. 112 http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0112.pdf A Simple Model of Price Dispersion
More informationThe Redistributive Benefits of Progressive Labor and Capital Income Taxation, or: How to Best Screw the Top 1%
The Redistributive Benefits of Progressive Labor and Capital Income Taxation, or: How to Best Screw the Top 1% Fabian Kindermann University of Würzburg and Netspar Dirk Krueger University of Pennsylvania,
More informationOptimal Social Insurance Design: UI Benefit Levels
Florian Scheuer 4/8/2014 Optimal Social Insurance Design: UI Benefit Levels 1 Overview optimal insurance design, application: UI benefit level Baily (JPubE 1978), generalized by Chetty (JPubE 2006) optimal
More information2. Real Business Cycle Theory (June 25, 2013)
Prof. Dr. Thomas Steger Advanced Macroeconomics II Lecture SS 13 2. Real Business Cycle Theory (June 25, 2013) Introduction Simplistic RBC Model Simple stochastic growth model Baseline RBC model Introduction
More informationVI. Real Business Cycles Models
VI. Real Business Cycles Models Introduction Business cycle research studies the causes and consequences of the recurrent expansions and contractions in aggregate economic activity that occur in most industrialized
More informationMicro and macro elasticities in a life cycle model with taxes
Journal of Economic Theory 144 (2009) 2277 2292 www.elsevier.com/locate/jet Micro and macro elasticities in a life cycle model with taxes Richard Rogerson, Johanna Wallenius Department of Economics, Arizona
More informationINTERNATIONAL COMPARISON OF INTEREST RATE GUARANTEES IN LIFE INSURANCE
INTERNATIONAL COMPARISON OF INTEREST RATE GUARANTEES IN LIFE INSURANCE J. DAVID CUMMINS, KRISTIAN R. MILTERSEN, AND SVEINARNE PERSSON Abstract. Interest rate guarantees seem to be included in life insurance
More informationThe Impact of Interlinked Insurance and Credit Contracts on Financial Market Deepening and Small Farm Productivity
The Impact of Interlinked Insurance and Credit Contracts on Financial Market Deepening and Small Farm Productivity June 2011 Summary Twin puzzles Ample evidence that uninsured risk depresses small holder
More informationUnemployment Insurance Generosity: A TransAtlantic Comparison
Unemployment Insurance Generosity: A TransAtlantic Comparison Stéphane Pallage (Département des sciences économiques, Université du Québec à Montréal) Lyle Scruggs (Department of Political Science, University
More informationInflation. Chapter 8. 8.1 Money Supply and Demand
Chapter 8 Inflation This chapter examines the causes and consequences of inflation. Sections 8.1 and 8.2 relate inflation to money supply and demand. Although the presentation differs somewhat from that
More informationThe Effect on Housing Prices of Changes in Mortgage Rates and Taxes
Preliminary. Comments welcome. The Effect on Housing Prices of Changes in Mortgage Rates and Taxes Lars E.O. Svensson SIFR The Institute for Financial Research, Swedish House of Finance, Stockholm School
More informationThis paper is not to be removed from the Examination Halls
This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON EC2065 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences, the Diplomas
More informationLeveraged purchases of government debt and deflation
Leveraged purchases of government debt and deflation R. Anton Braun Federal Reserve Bank of Atlanta Tomoyuki Nakajima Kyoto University October 5, 2011 Abstract We consider a model in which individuals
More informationDebt and the U.S. Economy
Debt and the U.S. Economy Kaiji Chen Ayşe İmrohoroğlu This Version: April 2012 Abstract Publicly held debt to GDP ratio in the U.S. has reached 68% in 2011 and is expected to continue rising. Many proposals
More informationSumming up ECON4310 Lecture. Asbjørn Rødseth. University of Oslo 27/
Summing up 4310 ECON4310 Lecture Asbjørn Rødseth University of Oslo 27/11 2013 Asbjørn Rødseth (University of Oslo) Summing up 4310 27/11 2013 1 / 20 Agenda Solow, Ramsey and Diamond Real Business Cycle
More informationTowards a Structuralist Interpretation of Saving, Investment and Current Account in Turkey
Towards a Structuralist Interpretation of Saving, Investment and Current Account in Turkey MURAT ÜNGÖR Central Bank of the Republic of Turkey http://www.muratungor.com/ April 2012 We live in the age of
More informationHealth Insurance and Tax Policy
REVISED USC FBE DEPT. MACROECONOMICS & INTERNATIONAL FINANCE WORKSHOP presented by Sagiri Kitao FRIDAY, Oct. 13, 2006 3:30 pm 5:00 pm, Room: HOH601K Health Insurance and Tax Policy Karsten Jeske Sagiri
More informationA Model of Financial Crises
A Model of Financial Crises Coordination Failure due to Bad Assets Keiichiro Kobayashi Research Institute of Economy, Trade and Industry (RIETI) Canon Institute for Global Studies (CIGS) Septempber 16,
More informationLending in Last Resort to Governments
Olivier Jeanne, Johns Hopkins University Indiana University, March 2015 Introduction Fiscal fundamentals in 2009: an international comparison Net debt/gdp (%) 40 50 60 70 80 90 100 110 120 US JAP UK EUR
More informationGENERAL EQUILIBRIUM WITH BANKS AND THE FACTORINTENSITY CONDITION
GENERAL EQUILIBRIUM WITH BANKS AND THE FACTORINTENSITY CONDITION Emanuel R. Leão Pedro R. Leão Junho 2008 WP nº 2008/63 DOCUMENTO DE TRABALHO WORKING PAPER General Equilibrium with Banks and the FactorIntensity
More informationHello, my name is Olga Michasova and I present the work The generalized model of economic growth with human capital accumulation.
Hello, my name is Olga Michasova and I present the work The generalized model of economic growth with human capital accumulation. 1 Without any doubts human capital is a key factor of economic growth because
More informationU.S. Tax Policy and Health Insurance Demand: Can a Regressive Policy Improve Welfare?
U.S. Tax Policy and Health Insurance Demand: Can a Regressive Policy Improve Welfare? Karsten Jeske Sagiri Kitao March 22, 2007 Abstract The U.S. tax policy on health insurance is regressive because it
More informationMA Advanced Macroeconomics: 7. The Real Business Cycle Model
MA Advanced Macroeconomics: 7. The Real Business Cycle Model Karl Whelan School of Economics, UCD Spring 2015 Karl Whelan (UCD) Real Business Cycles Spring 2015 1 / 38 Working Through A DSGE Model We have
More information1 Uncertainty and Preferences
In this chapter, we present the theory of consumer preferences on risky outcomes. The theory is then applied to study the demand for insurance. Consider the following story. John wants to mail a package
More informationPractice Problems on Current Account
Practice Problems on Current Account 1 List de categories of credit items and debit items that appear in a country s current account. What is the current account balance? What is the relationship between
More information3 The Standard Real Business Cycle (RBC) Model. Optimal growth model + Labor decisions
Franck Portier TSE Macro II 2921 Chapter 3 Real Business Cycles 36 3 The Standard Real Business Cycle (RBC) Model Perfectly competitive economy Optimal growth model + Labor decisions 2 types of agents
More informationProductivity Gains From Unemployment Insurance
Productivity Gains From Unemployment Insurance Daron Acemoglu Department of Economics M.I.T. Robert Shimer Department of Economics Princeton September 1999 Abstract This paper argues that unemployment
More informationNotes  Gruber, Public Finance Chapter 20.3 A calculation that finds the optimal income tax in a simple model: Gruber and Saez (2002).
Notes  Gruber, Public Finance Chapter 20.3 A calculation that finds the optimal income tax in a simple model: Gruber and Saez (2002). Description of the model. This is a special case of a Mirrlees model.
More informationUnraveling versus Unraveling: A Memo on Competitive Equilibriums and Trade in Insurance Markets
Unraveling versus Unraveling: A Memo on Competitive Equilibriums and Trade in Insurance Markets Nathaniel Hendren January, 2014 Abstract Both Akerlof (1970) and Rothschild and Stiglitz (1976) show that
More informationLecture notes for Choice Under Uncertainty
Lecture notes for Choice Under Uncertainty 1. Introduction In this lecture we examine the theory of decisionmaking under uncertainty and its application to the demand for insurance. The undergraduate
More informationHeterogeneous firms and dynamic gains from trade
Heterogeneous firms and dynamic gains from trade Julian Emami Namini Department of Economics, University of DuisburgEssen, Campus Essen, Germany Email: emami@vwl.uniessen.de 14th March 2005 Abstract
More informationSocial Security and Risk Sharing
Social Security and Risk Sharing Piero Gottardi Department of Economics, University of Venice Felix Kubler Department of Economics, Universität Mannheim June 14, 2006 Abstract In this paper we identify
More information