Monetary Economics

November 9, 2012
Guido Lorenzoni and Jonathan Parker, Northwestern University, Organizers

Emmanuel Farhi, Harvard University and NBER, and Ivan Werning, MIT and NBER

Fiscal Unions

Farhi and Werning study cross-country insurance for members of a currency union in an open economy model with nominal price and wage rigidities. They provide two results that build the case for the creation of a fiscal union within a currency union. First, they show that if financial markets are incomplete, the value of gaining access to any given level of insurance is greater for countries that are members of a currency union. Second, they show that even if financial markets are complete, private insurance is inefficiently low. A role emerges for government intervention in macro insurance to both guarantee its existence and to influence its operation. The efficient insurance arrangement can be implemented by contingent transfers within a fiscal union. The benefits of such a fiscal union are larger, the bigger the asymmetric shocks affecting the members of the currency union, the more persistent these shocks, and the less open the member economies.

Itamar Drechsler, New York University; Thomas Drechsel and David Marques-Ibanez, European Central Bank; and Philipp Schnabl, New York University and NBER

Who Borrows from the Lender of Last Resort? Evidence from the European Financial Crisis

Drechsler, Drechsel, Ibanez, and Schnabl document a strong divergence among banks in the take-up of implicit subsidies from the European Central Bank (ECB) over the financial crisis, as banks with high levels of ECB borrowing also used increasingly risky collateral. They propose four potential explanations for this divergence: 1) illiquidity, 2) insolvency,(3) political economy, and 4) differences in private valuations. They test these explanations using a novel dataset that includes detailed information on all borrowing and collateral pledged with the ECB from 2008 to 2011 and data on holdings from the European bank stress tests. Their results strongly support the insolvency explanation, both outside the Periphery countries, where it appears to be the main driver, and within the Periphery, where it seems that illiquidity, and possibly political economy, are also at work.

Susanto Basu, Boston College and NBER

Productivity and the Welfare of Nations

Basu shows that the welfare of a country' s infinitely-lived representative consumer is summarized, to a first order, by total factor productivity and by the capital stock per capita. These variables suffice to calculate welfare changes within a country, as well as welfare differences across countries. The result holds regardless of the type of production technology and the degree of product market competition. It applies to open economies as well, if total factor productivity is constructed using domestic absorption instead of gross domestic product as the measure of output. It also requires that total factor productivity be constructed with prices and quantities as perceived by consumers, not firms. Thus, factor shares need to be calculated using aftertax wages and rental rates; typically they will sum to less than one. These results are used to calculate welfare gaps and growth rates in a sample of developed countries with high-quality total factor productivity and capital data. Under realistic scenarios, the United Kingdom and Spain had the highest growth rates of welfare during the sample period 1985-2005, but the United States had the highest level of welfare.

Stefano Eusepi, Federal Reserve Bank of New York, and Bruce Preston, Monash University and NBER

Fiscal Foundations of Inflation: Imperfect Knowledge

Eusepi and Preston propose a theory of the fiscal foundations of inflation based on imperfect knowledge. Their theory is similar in spirit, but distinct from, unpleasant monetarist arithmetic and the fiscal theory of the price level. Because of uncertainty about the actual conduct of current and future monetary and fiscal policy, details of fiscal policy, such as the average scale and composition of the public debt, matter for in‡flation. As a result, fiscal policy constrains the efficacy of monetary policy. Heavily indebted economies with moderate maturity debt structures require aggressive monetary policy to anchor inflation expectations. The model predicts that the great moderation period would not have been so moderate, had fiscal policy been characterized by a scale and composition of public debt now witnessed in some advanced economies in the aftermath of the U.S. financial crisis. Conditional on having elevated levels of the public debt, issuing debt with maturities greater than 15 years substantially improves inflation control.

Chao He and Yu Zhu, University of Wisconsin, Madison, and Randall Wright, University of Wisconsin, Madison and NBER

Housing and Liquidity

In addition to providing utility, and possibly capital gains, housing facilitates credit transactions when home equity serves as collateral. He, Wright, and Zhu document big increases in home-equity loans coinciding with the U.S. house-price boom, and theysuggest a connection: when it is used as collateral, housing bears a liquidity premium. Because liquidity is endogenous, and depends to some extent on beliefs, even when fundamentals are deterministic and time-invariant, equilibrium house prices can display complicated patterns, including cyclic, chaotic, and stochastic trajectories. Some equilibrium price paths look a lot like bubbles. The framework is tractable, yet captures several salient features of housing markets qualitatively, and to some extent quantitatively. The authors examine various mechanisms for determining the terms of trade and different ways of specifying credit restrictions. They also study the impact of monetary policy on housing markets,

Rodney Ramcharan, Stephane Verani, and Skander Van Den Heuvel, Federal Reserve Board

From Wall Street to Main Street: The Impact of the Financial Crisis on Consumer Credit Supply

Ramcharan, Verani, and Van Den Heuvel studies how the collapse of the asset backed securities (ABS) market during the financial crisis of 2007-9 affected the supply of credit to the broader economy. They use a new dataset that describes unique interbank relationships within the credit union industry, which is important for consumer finance. They find that ABS-related losses at correspondent credit unions are associated with a large contraction in the supply of consumer credit and a hoarding of cash among downstream credit unions. They also find that this contraction in credit supply was concentrated among downstream credit unions that began the crisis with lower capital asset ratios, and that it may have amplified the initial decline in house prices. These results suggest that capital regulation might shape the ability of financial institutions to transmit securities price volatility onto the real economy.