Periodic Reporting for period 4 - MICROTOMACROANDBACK (Micro Heterogeneity and Macroeconomic Policy)
Reporting period: 2022-05-01 to 2023-10-31
How does the economy respond to a change in monetary policy? How does an increase in government spending affect output, consumption, and employment? How should the government design transfer programs to stabilize the economy in recessions? The recent global crises (i.e. the Global Financial Crisis, the COVID-19 Pandemic) have renewed interest in these questions and revealed the serious shortcomings of the prevailing paradigm at the heart of macroeconomics. The field of macro has been dominated for the past several decades by representative-agent dynamic stochastic general equilibrium (DSGE) models–models whose main elements are derived from microeconomic theory, but that are inconsistent with vast empirical micro evidence on consumer behavior. We can do better.
The objective of this project is to provide answers to those pressing questions and to help policymakers and academics design better policies for warding off and managing future crises. In particular, the project seeks to better understand the interplay between inequality and monetary and fiscal policies. Understanding the two-way feedback between the two will help guide economies to having stable and inclusive growth.
The objective of this project is to provide answers to those pressing questions and to help policymakers and academics design better policies for warding off and managing future crises. In particular, the project seeks to better understand the interplay between inequality and monetary and fiscal policies. Understanding the two-way feedback between the two will help guide economies to having stable and inclusive growth.
The project has produced many successes that will be useful for both the scientific community and the broader society. I developed a new computational methodology to facilitate answering the substantive questions outlined in the overall goals of the project. The methodology is broadly applicable and is already being used by other economic researchers to address pressing policy-relevant economic questions (it is further discussed in the next section).
The first research output is focused on the effects of monetary policy. “Forward Guidance” was published as lead article in the Journal of Monetary Economics and currently has 121 Google Scholar citations. That article studies the effect of forward guidance (unconventional monetary policy) in a heterogeneous-agent New Keynesian model. The paper shows the theoretically, inequality could either amplify or dampen the effects of forward guidance, when the model is calibrated to match realistic levels of nominal rigidities, forward guidance is not a powerful tool for stabilization.
On the fiscal policy side, I wrote the paper “The Fiscal Multiplier” which has been circulated as an NBER Working Paper. The paper was the first to quantify the size of the fiscal multiplier in the presence of significant household heterogeneity and in a model with a uniquely determined price level, which predicts a unique equilibrium in response to a stimulus. Further, it provided the first analysis of transfer multipliers, which is an important objective as many stimulus policies take the form of transfers and not an increase in spending. This enterprise provides much more meaningful answers than in a complete markets environment, since the welfare gains of high MPC (poor) households may outweigh the losses of low MPC (rich) households. The paper has been presented at leading international conferences (e.g. Minnesota Macro and NBER EFG), and research institutions, including Princeton, Columbia, NYU, and Minnesota. The framework was used for the policy piece "Corona Policy According to HANK" to study the monetary and fiscal policy response in the Euro area to the COVID-19 pandemic, published in VoxEU.
The project also produced the paper "The Curious Incidence of Monetary Policy Shocks Across the Income Distribution," which is "revise and resubmit" at the American Economic Journal: Macroeconomics." In that paper we use high-frequency German administrative data to study the effects of monetary policy on income and employment across the earnings distribution. Earnings growth at the bottom of the distribution is substantially more elastic to changes in monetary policy. This unequal incidence is driven by differences in the response of employment risk across the distribution: job loss is more countercyclical for lower-earnings households.
“The Housing Boom and Bust: Model Meets Evidence” was published as lead article in the Journal of Political Economy and currently has 626 Google Scholar citations. This paper investigates the causes of the boom and bust in house prices in the US in the 2000s. The paper finds that shifts in beliefs about future house price appreciation were the key driver of price movements. In contrast, credit relaxation was important for movements in home ownership and mortgage defaults.
“Household Heterogeneity and the Transmission of Foreign Shocks” was published in the Journal of International Economics and currently has 63 Google Scholar citations. This paper studies the effect of a sudden stop in capital flows on a small open economy with heterogeneity in housing assets and mortgage debt. It is the first to combine the small open economy framework of Gali-Monacelli with the heterogenous agent framework of Bewley-Imrohoroglu-Huggett-Aiyagari. It has opened up an exciting new area of research of heterogeneous agent international macro.
The final output, "Consumer Bankruptcy as Aggregate Demand Management," has been ciruclated as a working paper and presented at leading international conferences and top universities (e.g. Princeton, Stanford, Columbia, and Brown). The paper develops a framework to quantify automatic stabilizers over the business cycle. In addition, it shows that consumer bankruptcy meets the definition of an automatic stabilizer.
The first research output is focused on the effects of monetary policy. “Forward Guidance” was published as lead article in the Journal of Monetary Economics and currently has 121 Google Scholar citations. That article studies the effect of forward guidance (unconventional monetary policy) in a heterogeneous-agent New Keynesian model. The paper shows the theoretically, inequality could either amplify or dampen the effects of forward guidance, when the model is calibrated to match realistic levels of nominal rigidities, forward guidance is not a powerful tool for stabilization.
On the fiscal policy side, I wrote the paper “The Fiscal Multiplier” which has been circulated as an NBER Working Paper. The paper was the first to quantify the size of the fiscal multiplier in the presence of significant household heterogeneity and in a model with a uniquely determined price level, which predicts a unique equilibrium in response to a stimulus. Further, it provided the first analysis of transfer multipliers, which is an important objective as many stimulus policies take the form of transfers and not an increase in spending. This enterprise provides much more meaningful answers than in a complete markets environment, since the welfare gains of high MPC (poor) households may outweigh the losses of low MPC (rich) households. The paper has been presented at leading international conferences (e.g. Minnesota Macro and NBER EFG), and research institutions, including Princeton, Columbia, NYU, and Minnesota. The framework was used for the policy piece "Corona Policy According to HANK" to study the monetary and fiscal policy response in the Euro area to the COVID-19 pandemic, published in VoxEU.
The project also produced the paper "The Curious Incidence of Monetary Policy Shocks Across the Income Distribution," which is "revise and resubmit" at the American Economic Journal: Macroeconomics." In that paper we use high-frequency German administrative data to study the effects of monetary policy on income and employment across the earnings distribution. Earnings growth at the bottom of the distribution is substantially more elastic to changes in monetary policy. This unequal incidence is driven by differences in the response of employment risk across the distribution: job loss is more countercyclical for lower-earnings households.
“The Housing Boom and Bust: Model Meets Evidence” was published as lead article in the Journal of Political Economy and currently has 626 Google Scholar citations. This paper investigates the causes of the boom and bust in house prices in the US in the 2000s. The paper finds that shifts in beliefs about future house price appreciation were the key driver of price movements. In contrast, credit relaxation was important for movements in home ownership and mortgage defaults.
“Household Heterogeneity and the Transmission of Foreign Shocks” was published in the Journal of International Economics and currently has 63 Google Scholar citations. This paper studies the effect of a sudden stop in capital flows on a small open economy with heterogeneity in housing assets and mortgage debt. It is the first to combine the small open economy framework of Gali-Monacelli with the heterogenous agent framework of Bewley-Imrohoroglu-Huggett-Aiyagari. It has opened up an exciting new area of research of heterogeneous agent international macro.
The final output, "Consumer Bankruptcy as Aggregate Demand Management," has been ciruclated as a working paper and presented at leading international conferences and top universities (e.g. Princeton, Stanford, Columbia, and Brown). The paper develops a framework to quantify automatic stabilizers over the business cycle. In addition, it shows that consumer bankruptcy meets the definition of an automatic stabilizer.
In the publication, “Exploiting MIT Shocks in Heterogeneous Agent Economies: The Impulse Response as a Numerical Derivative,” my co-authors and I made a breakthrough in the computation of heterogeneous-agent models. Models with heterogeneous agents are notoriously difficult to solve because of the large state space implied by the model. This means solving the models numerically suffer from the "curse of dimensionality" common in computational problems. We developed a methodology that significantly reduces the problem's dimensionality, breaking the curse of dimensionality for a wide class of models and applications. The key insight of the paper is that solving for a perfect foresight impulse response of the model to an unexpected shock (an "MIT shock") is sufficient to linearize the model in sequence space (as opposed to standard perturbation methods that are recursive). The innovation is already taking off, spurning follow-up work from other researchers, who developed a functional matrix notation, a fast computational algorithm, and a software package to implement the innovation we pioneered. While the literature has fully embraced our linearization procedure, our methodology also provided tests for non-linearities so that researchers can detect when linear solutions are inappropriate for the question at hand. This breakthrough was unexpected. While part of the project did plan to develop new computational techniques to solve heterogeneous-agent models, this technique for linearization was not one of the project's expected outcomes.