Research Papers

Eurosclerosis and International Business Cycles ( Download PDF) w/ Juanyi Jenny Xu  This paper incorporates search frictions with endogenous job creation and destruction into a two country dynamic stochastic general equilibrium model to explain two macroeconomic facts. First, since the 1980’s, European unemployment rates have risen substantially above USA levels. Second, European business cycle have lagged the USA business cycle during the period of the Great Moderation. In the model, more generous unemployment benefits and greater firing costs can endogenously generate higher unemployment. These same policies will also create labor market frictions which slow the response of the economy to business cycle conditions.

Labor Mobility and Exchange Rate Regime in Open Economies (Download PDF) w/ Haichao Fan and Juanyi Jenny Xu and In this model, we study the impact of labor mobility on the choice of exchange rate regime in an open economy New Keynesian model with competitive labor markets . When we focus on demand shocks, we find results which are very similar to the standard Mundell optimal currency area result (fixed exchange rates are more costly the less mobile is labor) but with a quite different logic. Unlike the traditional case where labor mobility acts as a safety valve for unemployed workers, we explicitly consider the welfare effects of labor transfers in the face of worker preferences toward locational stability. We find that fixed exchange rates tend to transfer labor to high demand regions without taking full account of the costs of moving workers that prefer to stay at home. When we focus on supply shocks, however, we note there are cases where the optimal currency area logic is reversed. Fixed exchange rates can prevent highly mobile economies from fully realizing the efficiencies of moving workers to low cost production areas. Thus, areas with high inter-regional labor mobility benefit most from exchange rate flexibility.

Currency Boards when Interest Rates are Zero  (Download PDF ) Iw/ James Yetman In a fixed exchange rate system, any expectation that the peg may be abandoned will normally be reflected in an interest rate differential between instruments denominated in domestic and anchor currencies: the possibility of a revaluation will drive domestic interest rates below those in the anchor currency, for example. However, when interest rates are close to the zero lower bound, there is limited scope for exchange rate expectations to be reflected in interest rate differentials. Here we introduce a new mechanism, based on the central bank balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. An expectation of exchange rate appreciation will cause foreign exchange reserves to swell, increasing the cost to policymakers of allowing an appreciation and therefore lowering the likelihood of the fixed exchange rate being abandoned. Under normal circumstances, this channel reinforces the equilibrating effect of interest rate differentials. When interest rates cannot adjust only this channel operates, implying that much larger changes in reserves are required to equilibrate currency markets. We develop a simple model to illustrate these arguments and find support for the predictions of the model using data for Hong Kong, the world’s largest economy with a currency board.

New Keynesian Exchange Rate Pass-Through (Download PDF ) w/ Woon Gyu Choi Using an optimization model of price setting in line with the New Keynesian Phillips curve literature, this paper constructs a structural equation to estimate the rate at which exchange rates pass-through to import prices in the U.S. We estimate the structural equation using GMM for consistent estimates of exchange rate pass-through and price stickiness. Our estimation results suggest that local currency pricing dominates producer currency pricing. We also find a substantial forward-looking element to the adjustment of import prices. The estimate of price stickiness in import prices is comparable to existing estimates of domestic price stickiness.

Do Markups Have Betas?  The First Order Effects of Sticky Prices (Download PDF) Measures of financial market risk associated with high expected returns on risky assets are strong predictors of the labor share of income. I explain this as the logical outcome of risk-averse monopolistic firms pre-setting prices and taking into account the risk to their profits when they choose markups. A simple version of such a theory generates a statistical model which can demonstrate the impact of aggregate/systemic risk on average markups. When the conditional CAPM model is used as a measure of risk, we find that risk aversion leads to an increase in average markups of between 1 and 2%. This finding is confirmed with a panel of one-digit industry level data and a variety of conditional CAPM models of risk. The findings here demonstrate that the first order impact of aggregate fluctuations on economic efficiency can be associated with quantitatively significant welfare impacts.

Robust Control and the Small Open Economy  (Download pdf file  ) This paper examines the properties of business cycles in a small open economy in which consumers choose plans that are robust to potential model mis-specification. Faced with a range of potential correct specifications of the distribution of future shocks, households choose plans that are optimal under the worst case specification. Linear approximations to these robust plans are solved for using robust control methods. The robust plans has a number of important effects on the equilibrium response of the small open economy to business cycle shocks. First, the equilibrium is stationary. In a standard linear quadratic model of an open economy facing an exogenous interest rates, consumption will follow a random walk. Second, consumption plans robust to model mis-specification allow for greater response of consumption to temporary income shocks. In a model calibrated to match the features of the economy of Great Britain, the greater volatility of consumption leads to a counter-cyclical trade balance matching the data.