2013

1309

Disastrous Disappointments: Asset-Pricing with Disaster Risk and Disappointment Aversion
Jim Dolmas
Abstract: In this paper, I combine disappointment aversion, as employed by Routledge and Zin [28] and Campanale, Castro and Clementi [9], with rare disasters in the spirit of Rietz [27], Barro [4], Gourio [16], Gabaix [15] and others. I find that, when the model’s representative agent is endowed with an empirically plausible degree of disappointment aversion, a rare disaster model can produce moments of asset returns that match the data reasonably well, using disaster probabilities and disaster sizes much smaller than have been employed previously in the literature. This is good news. Quantifying the disaster risk faced by any one country is inherently difficult with limited time series data. And, it is open to debate whether the disaster risk relevant to, say, US investors is well-approximated by the sizable risks found by Barro [4] and co-authors [6, 7, 26] in cross-country data. On the other hand, we have evidence (see [30], [8], or [11]) that individuals tend to over-weight bad or disappointing outcomes, relative to the outcomes’ weights under expected utility. Recognizing aversion to disappointment means that disaster risks need not be nearly as large as suggested by the cross-country evidence for a rare disaster model to produce average equity premia and risk-free rates that match the data. I illustrate the interaction between disaster risk and disappointment aversion both analytically and in the context of a simple Rietz-like model of asset-pricing with rare disasters. I then analyze a richer model, in the spirit of Barro [4], with a distribution of disaster sizes, Epstein-Zin preferences, and partial default (in the event of a disaster) on the economy’s ‘risk-free’ asset. For small elasticities of intertemporal substitution, the model is able to match almost exactly the means and standard deviations of the equity return and risk-free rate, for disaster risks one-half or one-fourth the estimated sizes from Barro [4]. For larger elasticities of intertemporal substitution, the model’s fit is less satisfactory, though it fails in a direction not often viewed as problematic—it under-predicts the volatility of the riskfree rate. Even so, apart from that failing, the results are broadly similar to those obtained by Gourio [16], but with disaster risks one-half or onefourth as large.

1308

A Closer Look at Potential Distortions in State RGDP: The Case of the Texas Energy Sector
Keith Phillips, Raul Hernandez and Benjamin Scheiner
Published as: Phillips, Keith, Raul Hernandez and Benjamin Scheiner (2014), "A Closer Look at Potential Distortions in State Real Gross Domestic Product: the Case of the Texas Energy Sector," Journal of Economic and Social Measurement 39 (1-2): 105-119.
Abstract: Surprisingly, from 1997 to 2010 Texas RGDP in oil and gas extraction was strongly negatively correlated with oil prices and with factors of production such as employment and the drilling rig count. It also had a slight negative correlation with physical production of oil and gas. In Texas the oil and gas sector is large and volatile enough to have a significant influence on overall RGDP growth so that when oil prices spike up (down) Texas RGDP generally weakens (strengths), which is in contrast to other indicators such as state job growth and real personal income. In this paper we investigate several potential sources of why RGDP in oil and gas extraction has a negative correlation with factors of production and units of output. We then use several different approximations of RGDP in oil and gas extraction to see which seems to be a good substitute for the current estimates produced by the BEA. We find that a measure based on changes in Texas physical production of oil and gas results in an estimate of total state RGDP that is more highly correlated with Texas job growth and closer to the correlation of these measures nationally.

1307

Tobin LIVES: Integrating Evolving Credit Market Architecture into Flow of Funds Based Macro-models
John Duca and John Muellbauer
Published as: Duca, John and John Muellbauer (2014), "Tobin LIVES: Integrating Evolving Credit Market Architecture into Flow of Funds Based Macro-models," in A Flow of Funds Perspective on the Financial Crisis, Volume II: Macroeconomic Imbalances and Risks to Financial Stability, ed. Bernard Winkler, Ad van Riet and Peter Bull (New York: Palgrave MacMillian), 11-39.
Abstract: After the global financial crisis, there is greater awareness of the need to understand the interactions between the financial sector and the real economy and hence the potential for financial instability. Data from the financial flow of funds, previously relatively neglected, are now seen as crucial to the data monitoring carried out by central banks. This paper revisits earlier efforts to understand financial-real linkages, such those of Tobin and the Yale School, and proposes a modeling framework for analysing the household flow of funds jointly with consumption. The consumption function incorporates household income, portfolios of assets and debt held at the end of the previous period, credit availability, and asset prices and interest rates. In a general equilibrium setting, these all have to be endogenised and since households make consumption and housing purchase decisions jointly with portfolio decisions, there is much to be gained in modeling a household sub-system of equations. Major evolutionary structural change – namely the evolving credit architecture facing households – is handled by our ‘Latent Interactive Variable Equation System’. A by-product is improved understanding of the secular decline in US saving rate, as well as of the household financial accelerator. Moreover, the models discussed in this paper offer new ways of interpreting data on credit, money and asset prices, which are crucial for central banks.

1306

Immigrants in the U.S. Labor Market
Pia M. Orrenius and Madeline Zavodny
Published as: Orrenius, Pia M. and Madeline Zavodny (2014), "Immigrants in the U.S. Labor Market," in Undecided Nation: Political Gridlock and the Immigration Crisis, ed. Tony Payan and Erika de la Garza (Switzerland: Springer), 189-207.
Abstract: Immigrants supply skills that are in relatively short supply in the U.S. labor market and account for almost half of labor force growth since the mid-1990s. Migrant inflows have been concentrated at the low and high ends of the skill distribution. Large-scale unauthorized immigration has fueled growth of the low-skill labor force, which has had modest adverse fiscal and labor market effects on taxpayers and U.S.-born workers. High-skilled immigration has been beneficial in most every way, fueling innovation and spurring entrepreneurship in the high tech sector. Highly skilled immigrants have had a positive fiscal impact, contributing more in tax payments than they use in public services. Immigration reform appears to be on the horizon, and policies such as a legalization initiative, a guest-worker program and more permanent visas for high-skilled workers would likely be an improvement over the status quo.

1305

Spurious Seasonal Patterns and Excess Smoothness in the BLS Local Area Unemployment
Keith R. Phillips and Jianguo Wang
Published as: Phillips, Keith and Jianguo Wang (2014), "A note on spurious seasonal patterns and other distortions in the BLS local area unemployment statistics," Journal of Economic and Social Measurement 39 (3): 145-152.
Abstract: State level unemployment statistics are some of the most important and widely used data sources for local analysts and public officials to gauge the health of their state’s economy. We find statistically significant seasonal patterns in the state level seasonally adjusted Local Area Unemployment Statistics (LAUS) released by the U.S. Bureau of Labor Statistics (BLS). We find that the pro-rata factors used in the benchmarking process can invoke spurious seasonal patterns in this data. We also find that the Henderson 13 filter used by the BLS to smooth the seasonally adjusted data may reduce monthly volatility too much in the sense that the aggregated state data is much smoother than the independently estimated national data. To reduce these problems, we suggest that the BLS use seasonally adjusted data when benchmarking regions to national totals.

1304

Monetary Policy, the Tax Code, and the Real Effects of Energy Shocks
William T. Gavin, Benjamin D. Keen and Finn E. Kydland
Published as: Gavin, William T., Benjamin D. Keen and Finn E. Kydland (2015), "Monetary Policy, the Tax Code, and the Real Effects of Energy Shocks," Review of Economic Dynamics 18 (3): 694-707.
Abstract: This paper develops a monetary model with taxes to account for the apparently asymmetric and time-varying effects of energy shocks on output and hours worked in post-World War II U.S. data. In our model, the real effects of an energy shock are amplified when the monetary authority responds to that shock by changing its inflation objective. Specifically, higher inflation raises households’ nominal capital gains taxes since those taxes are not indexed to inflation. The increase in taxes behaves as a negative wealth effect and generates an immediate decline in output, investment, and hours worked. The large drop in investment then causes a gradual but very persistent decline in the capital stock. That protracted decline in the capital stock is associated with an extended period of low productivity growth and high inflation. Those real effects from the increase in nominal capital gains taxes are magnified by the tax on nominal interest income, which is also not indexed to inflation. A prolonged period of higher inflation and lower productivity growth following a negative energy shock is consistent with the stagflation of the 1970s. The negative effects, however, subsided greatly after 1980 because the Volcker disinflation policy prevented the Fed from accommodating negative energy shocks with higher inflation.

1303

The Long–run Macroeconomic Impacts of Fuel Subsidies
Michael Plante
Published as: Plante, Michael (2014), "The Long–run Macroeconomic Impacts of Fuel Subsidies," Journal of Development Economics 107: 129-143.
Abstract: Many developing and emerging market countries have subsidies on fuel products. Using a small open economy model with a non-traded sector I show how these subsidies impact the steady state levels of macroeconomic aggregates such as consumption, labor supply, and aggregate welfare. These subsidies can lead to crowding out of non-oil consumption, inefficient inter-sectoral allocations of labor, and other distortions in macroeconomic variables. Across steady states aggregate welfare is reduced by these subsidies. This result holds for a country with no oil production and for a net exporter of oil. The distortions in relative prices introduced by the subsidy create most of the welfare losses. How the subsidy is financed is of secondary importance. Aggregate welfare is significantly higher if the subsidies are replaced by lump-sum transfers of equal value.

1302

The Prospect of Higher Taxes and Weak Job Growth During the Recovery from The Great Recession: Macro versus Micro Frisch Elasticities
Carlos E.J.M. Zarazaga
Abstract: Labor input growth during the recovery of the U.S. economy from the Great Recession of 2008–2009 has been considerably lower than expected. A number of scholars have attributed this disappointing outcome to the prospect of higher taxes, induced by the fiscal imbalances that will materialize in coming decades under current policies. The paper examines this fiscal sentiment hypothesis from the perspective of a neoclassical growth model, under the assumption that the typical household's preferences can be represented by a utility function that implies a constant intertemporal (Frisch) elasticity of substitution for aggregate hours of work, and for a hypothetical tax regime that incorporates the Congressional Budget Office'’s assessment of the U.S. fiscal situation. The paper finds that the empirical relevance of the fiscal sentiment hypothesis depends on whether this Frisch elasticity of labor supply is closer to the relatively large values needed to account for the observed volatility of labor input at business cycle frequencies, than to the lower values estimated by microeconomic and quasi–experimental studies.

1301

Fiscal Sentiment and the Weak Recovery from the Great Recession: A Quantitative Exploration
Finn E. Kydland and Carlos E. J. M. Zarazaga
Abstract: The U.S. economy isn'’t recovering from the deep Great Recession of 2008–2009 with the strength predicted by models that incorporate a variety of shocks and frictions in the basic analytical framework of the neoclassical growth model. It has been argued that the counterfactual predictions shouldn’'t be attributed to inherent features of that framework, but to the omission from the analysis of the prospects of an imminent switch to a higher taxes regime prompted by the unprecedented fiscal challenges faced by the U.S. economy in peacetime. The paper explores quantitatively this fiscal sentiment hypothesis. The main finding is that the hypothesis can account for a substantial fraction of the decline in investment and labor input in the aftermath of the Great Recession, relative to their pre–recession trends. These results require, however, a quali…cation: The perceived higher taxes must fall almost exclusively on capital income.

Globalization Institute Working Papers

Globalization Institute No. 166

Database of Global Economic Indicators (DGEI): A Methodological Note 
Valerie Grossman, Adrienne Mack and Enrique Martínez-García
Published as: Valerie Grossman, Adrienne Mack and Enrique Martínez-García (2014), "A New Database of Global Economic Indicators," Journal of Economics and Social Measurement 39 (3): 163-197. 
Abstract: The Database of Global Economic Indicators (DGEI) from the Federal Reserve Bank of Dallas is aimed at standardizing and disseminating world economic indicators for policy analysis and scholarly work on the role of globalization. The purpose of DGEI is to offer a broad perspective on how economic developments around the world influence the U.S. economy with a wide selection of indicators. DGEI is automated within an Excel-VBA and E-views framework for the processing and aggregation of multiple country time series. It includes a core sample of 40 countries with available indicators and broad coverage. Country groupings include rest of the world (ex. the U.S.) aggregates and subgroups of countries by development attainment and trade openness. The indicators currently tracked include real GDP, industrial production (IP), Purchasing Managers’ Index (PMI), merchandise exports and imports, headline CPI, CPI (ex. food and energy), PPI/WPI inflation, nominal and real exchange rates, and official/policy interest rates. All series are monthly, with the exception of real GDP which is reported at a quarterly frequency. Aggregation is based on trade shares with the U.S. The Globalization and Monetary Policy Institute publishes the aggregate indicators as well as additional country detail on its website with an accompanying slideshow on Global Economic Conditions. This note provides a technical description of the methodology implemented to construct the DGEI.

Globalization Institute No. 165

Monitoring Housing Markets for Episodes of Exuberance: An Application of the Phillips et al. (2012, 2013) GSADF Test on the Dallas Fed International House Price Database 
Efthymios Pavlidis, Alisa Yusupova, Ivan Paya, David Peel, Enrique Martínez-García, Adrienne Mack and Valerie Grossman
Abstract: The detection of explosive behavior in house prices and the implementation of early warning diagnosis tests are of great importance for policy-making. This paper applies the GSADF test developed by Phillips et al. (2012) and Phillips et al. (2013), a novel procedure for testing, detection and date-stamping of explosive behavior, to the data from the Dallas Fed International House Price Database documented in Mack and Martínez-García (2011). We discuss the use of the GSADF test to monitor international housing markets. We assess the international boom and bust cycle experienced during the past 15 years through this lens— with special attention to the United States, the United Kingdom, and Spain. Our empirical results suggest that these three countries experienced a period of exuberance in housing prices during the late 90s and the first half of the 2000s that cannot be attributed solely to the behavior of fundamentals. Looking at all 22 countries covered in the International House Price Database, we detect a pattern of synchronized explosive behavior during the last international house boom-bust episode not seen before.

Globalization Institute No. 162

Debt, Inflation and Growth Robust Estimation of Long-Run Effects in Dynamic Panel Data Models 
Alexander Chudik, Kamiar Mohaddes, Hashem Pesaran and Mehdi Raissi
Abstract: This paper investigates the long-run effects of public debt and inflation on economic growth. Our contribution is both theoretical and empirical. On the theoretical side, we develop a cross-sectionally augmented distributed lag (CS-DL) approach to the estimation of long-run effects in dynamic heterogeneous panel data models with cross-sectionally dependent errors. The relative merits of the CS-DL approach and other existing approaches in the literature are discussed and illustrated with small sample evidence obtained by means of Monte Carlo simulations. On the empirical side, using data on a sample of 40 countries over the 1965-2010 period, we find significant negative long-run effects of public debt and inflation on growth. Our results indicate that, if the debt to GDP ratio is raised and this increase turns out to be permanent, then it will have negative effects on economic growth in the long run. But if the increase is temporary then there are no long-run growth effects so long as debt to GDP is brought back to its normal level. We do not find a universally applicable threshold effect in the relationship between public debt and growth. We only find statistically significant threshold effects in the case of countries with rising debt to GDP ratios.

Globalization Institute No. 160

U.S. Business Cycles, Monetary Policy and the External Finance Premium 
Enrique Martínez-García
Published as: Martínez-García, Enrique (2014), "U.S. Business Cycles, Monetary Policy and the External Finance Premium," in Advances in Non-linear Economic Modeling: Theory and Applications, ed. Frauke Schleer-van Gellecom (Berlin: Springer), 41-114. 
Abstract: I investigate a model of the U.S. economy with nominal rigidities and a financial accelerator mechanism à la Bernanke et al. (1999). I calculate total factor productivity and monetary policy deviations for the U.S. and quantitatively explore the ability of the model to account for the cyclical patterns of GDP (excluding government), investment, consumption, the share of hours worked, inflation and the quarterly interest rate spread between the Baa corporate bond yield and the 20-year Treasury bill rate during the Great Moderation. I show that the magnitude and cyclicality of the external finance premium depend nonlinearly on the degree of price stickiness (or lack thereof) in the Bernanke et al. (1999) model and on the specification of both the target Taylor (1993) rate for policy and the exogenous monetary shock process. The strong countercyclicality of the external finance premium induces substitution away from consumption and into investment in periods where output grows above its long-run trend as the premium tends to fall below its steady state and financing investment becomes temporarily cheaper. The less frequently prices change in this environment, the more accentuated the fluctuations of the external finance premium are and the more dominant they become on the dynamics of investment, hours worked and output. However, these features—the countercyclicality and large volatility of the spread—are counterfactual and appear to be a key impediment limiting the ability of the model to account for the U.S. data over the Great Moderation period.

Globalization Institute No. 153

Large Panel Data Models with Cross-Sectional Dependence: A Survey 
Alexander Chudik and M. Hashem Pesaran
Published as: Chudik, Alexander and M. Hashem Pesaran (2015), "Large Panel Data Models with Cross-Sectional Dependence: A Survey," in The Oxford Handbook of Panel Data, ed. Badi H. Baltagi (New York: Oxford University Press), 3-45. 
Abstract: This paper provides an overview of the recent literature on estimation and inference in large panel data models with cross-sectional dependence. It reviews panel data models with strictly exogenous regressors as well as dynamic models with weakly exogenous regressors. The paper begins with a review of the concepts of weak and strong cross-sectional dependence, and discusses the exponent of cross-sectional dependence that characterizes the different degrees of cross-sectional dependence. It considers a number of alternative estimators for static and dynamic panel data models, distinguishing between factor and spatial models of cross-sectional dependence. The paper also provides an overview of tests of independence and weak cross-sectional dependence.

Globalization Institute No. 146

Common Correlated Effects Estimation of Heterogeneous Dynamic Panel Data Models with Weakly Exogenous Regressors 
Supplement 
Alexander Chudik and M. Hashem Pesaran
Published as: Chudik, Alexander and M. Hashem Pesaran (2015), "Common Correlated Effects Estimation of Heterogeneous Dynamic Panel Data Models with Weakly Exogenous Regressors," Journal of Econometrics 188 (2): 393-420. 
Abstract: This paper extends the Common Correlated Effects (CCE) approach developed by Pesaran (2006) to heterogeneous panel data models with lagged dependent variable and/or weakly exogenous regressors. We show that the CCE mean group estimator continues to be valid but the following two conditions must be satisfied to deal with the dynamics: a sufficient number of lags of cross section averages must be included in individual equations of the panel, and the number of cross section averages must be at least as large as the number of unobserved common factors. We establish consistency rates, derive the asymptotic distribution, suggest using co-variates to deal with the effects of multiple unobserved common factors, and consider jackknife and recursive de-meaning bias correction procedures to mitigate the small sample time series bias. Theoretical findings are accompanied by extensive Monte Carlo experiments, which show that the proposed estimators perform well so long as the time series dimension of the panel is sufficiently large.

Globalization Institute No. 139

Trade Barriers and the Relative Price Tradables 
Michael Sposi
Published as: Sposi, Michael (2015), "Trade Barriers and the Relative Price of Tradables," Journal of International Economics 92 (2): 398-411. 
Abstract: In this paper I quantitatively address the role of trade barriers in explaining why prices of services relative to tradables are positively correlated with levels of development across countries. I argue that trade barriers play a crucial role in shaping the cross-country pattern of specialization across many heterogenous tradable goods. The pattern of specialization feeds into cross-country productivity differences in the tradables sector and is reflected in the relative price of services. I show that the existing pattern of specialization implies that the tradables-sector productivity gap between rich and poor countries is more than 80 percent larger than it would be under free trade. In turn, removing trade barriers would eliminate 64 percent of the disparity in the relative price of services between rich and poor countries, without systematically altering the cross-country pattern of the absolute price of tradables.

Globalization Institute No. 138

Spatial Considerations on the PPP Debate 
Michele Ca'Zorzi and Alexander Chudik
Abstract: This paper studies the influence of aggregating across space when (i) testing the PPP theory or more generally pair-wise cointegration and (ii) evaluating the PPP puzzle. Our contribution is threefold: we show that aggregating foreign data and applying an ADF test may lead to erroneously reject the PPP hypothesis. We then show, on the basis of theoretical arguments as well as Monte Carlo experiments, that a sizable bias in the estimates of half-life deviations to PPP may be due to the effect of aggregation across space. We finally illustrate empirically the importance of spatial considerations when estimating the speed of price convergence among euro area countries.

Globalization Institute No. 137

Distribution Capital and the Short- and Long-Run Import Demand Elasticity 
Mario J. Crucini and J. Scott Davis
Published as: Crucini, Mario J. and J. Scott Davis (2016), "Distribution Capital and the Short- and Long-Run Import Demand Elasticity," Journal of International Economics 100: 203-219. 
Abstract: International business-cycle models assume that home and foreign goods are poor substitutes. International trade models assume they are close substitutes. This paper constructs a model where this discrepancy is due to frictions in distribution. Imports need to be combined with a local non-traded input, distribution capital, which is slow to adjust. As a result, imported and domestic goods appear as poor substitutes in the short run. In the long run this non-traded input can be reallocated, and quantities can shift following a change in relative prices. Thus the observed substitutability between home and foreign goods gets larger as time passes.

Globalization Institute No. 136

The GVAR Approach and the Dominance of the U.S. Economy 
Alexander Chudik and Vanessa Smith
Abstract: This paper extends the recent literature about global macroeconomic modelling by allowing the presence of a globally dominant economy. Our contribution is both theoretical and empirical. From a theoretical standpoint, we follow Chudik and Pesaran (2011 and 2012) to derive the GVAR approach as an approximation to two Infinite-Dimensional VAR (IVAR) models featuring nonstationary variables: one corresponding to the world consisting of several small open economies (benchmark model), and one corresponding to the world featuring a dominant economy (extended model). It is established that in the presence of a dominant economy, restrictions implied by the asymptotic analysis of a system without a dominant economy are no longer valid. The theoretical framework is then brought to the data by estimating both versions of the GVAR model featuring 33 countries for the period 1979(Q2)–2003(Q4). We found some support for the extended version of the GVAR model, allowing the US to be the dominant player in the world economy.

Globalization Institute No. 135

International Trade Price Stickiness and Exchange Rate Pass-through in Micro Data: A Case Study on U.S.–China Trade 
Mina Kim, Deokwoo Nam, Jian Wang and Jason Wu
Abstract: Price-setting behavior of exporters and exchange rate pass-through (ERPT) are crucial issues in international macroeconomics. This paper studies these topics, using a novel dataset of goods-level US-China trade prices collected by the US Bureau of Labor Statistics. We document that the duration of U.S.–China trade prices has declined almost 30 percent since China began appreciating its currency in 2005. A benchmark menu cost model that is calibrated to the data can replicate the documented decrease in price stickiness. We also estimate ERPT of RMB appreciation into U.S. import prices between 2005 and 2008. The lifelong ERPT is close to one for prices that have at least one change, while the pass-through is less than half when all goods are included. The difference in pass-through rates is a result of about one third of the goods never experiencing a price change.