"Money Creation, Reserve Requirements, and Seigniorage" with Joseph H. Haslag. In this paper, we examine the impact that changes in the rate of money creation and reserve requirements have on real seigniorage revenue. We consider two additional features that differ from previous analyses. First, the model economies grow endogenously, and that growth depends on the accumulation of intermediated capital. Second, agents have two means of financing; one is bank deposits against which reserves must be held, and the other is a nonbank intermediary. Thus, growth-rate effects and financing-substitution effects are both present, and one can assess the quantitiative importance of each factor. Published, Review of Economic Dynamics 1(3), pp. 677-98.

Federal Reserve Bank of Dallas Working Paper 98-01 (older version)


"Unemployment Insurance and Capital Accumulation." In this paper, I examine a model economy with production, search, and unemployment insurance. The introduction of capital into the economy of Wang and Williamson (J. Monetary Econom. 49(7)(2001)1337) generates the result that optimal replacement ratios are always zero. The result arises from the decline in aggregate activity caused by unemployment insurance: both capital and labor inputs to production fall when benefits rise. Unlike most of the literature, I compute explicitly the cost of the transition path; agents are made better off by switching to a steady state with no unemployment insurance, but the welfare gain is approximately cut in half. Only the very poor and unemployed suffer welfare losses along the transition path. I then briefly investigate the implications of negative replacement ratios. Published, Journal of Monetary Economics 51(8), pp. 1683-710.


"Generalized Quasi-Geometric Discounting." This paper derives the ‘generalized Euler equation’ for an agent with multi-period deviations from geometric discounting. The functional equation that describes optimal consumption-savings decisions involves manipulation of future selves and indirect manipulation of more distant selves through intervening selves. Published, Economics Letters 96(3), pp. 343-50.


"The Wealth Distribution and the Demand for Status" with Yulei Luo. Standard economic theories of asset markets assume that assets are valued entirely for the consumption streams they can finance. This paper examines the introduction of the demand for status (as a function of wealth) into a model of uninsurable idiosyncratic risk – the ’spirit of capitalism’ assumption. We find that soc preferences lead to less inequality in wealth; placing wealth into the utility function leads to a shrinking wealth distribution. The drop in wealth concentration is smaller if the utility function implies status is a luxury good, but no parametrization leads to higher wealth Gini coefficients than the benchmark case. We then consider the consequences of revenue-neutral tax reforms with and without soc preferences, finding that they make little difference for this policy experiment. Published, Macroeconomic Dynamics 13(S1), pp. 1-30 (lead article).


"Unsecured Credit Markets Are Not Insurance Markets" with Kartik Athreya and Xuan S. Tam. We study the extent to which unsecured credit markets have altered the transmission of increased income risk to consumption variability over the past several decades. We find that unsecured credit markets pass through increased income risk to consumption, irrespective of bankruptcy policy and the information possessed by lenders. If risk sharing has indeed improved over this period, the reasons do not therefore lie in the unsecured credit market. Published, Journal of Monetary Economics 56(1) pp. 83-103.


"The Stationary Distribution of Wealth under Progressive Taxation" with Daniel R. Carroll. This paper considers the long-run distribution of capital holdings in a model with complete asset markets and progressive taxation. Households are assumed to be heterogeneous in their labor market productivity. We show that this model is capable of producing a nondegenerate determinate wealth distribution. However, it also predicts that capital and labor income will be negatively correlated. These results are robust to the introduction of elastic labor supply and borrowing constraints. Published, Review of Economic Dynamics 12(3), pp. 469-78.


"Rational Inattention and Aggregate Fluctuations" with Yulei Luo. This paper introduces the rational inattention hypothesis (RI) -- that agents process information subject to finite channel constraints -- into a stochastic growth model with permanent technology shocks. We find that RI raises consumption volatility relative to output by introducing an endogenous demand shock. Furthermore, it is shown that incorporating RI can provide an additional internal propagation mechanism (measured by the impulse response function and the autocorrelation function of output growth) and generate higher variance of forecastable movements in output. However, we find that RI cannot resolve these puzzles in the RBC literature -- weak internal propagation and low variance of forecastable movements in output, even with what appears to be a very low capacity channel. Finally, we show that in a model where general equilibrium effects are absent and idiosyncratic shocks cannot be distinguished from aggregate ones, RI has strong propagational effects. Published, BE Journal of Macroeconomics (Contributions) 9(1), Article 14.


"Solving the Incomplete Markets Model with Aggregate Uncertainty Using the Krusell-Smith Algorithm and Non-Stochastic Simulations." This article describes the approach to computing the version of the stochastic growth model with idiosyncratic and aggregate risk that relies on collapsing the aggregate state space down to a small number of moments used to forecast future prices. One innovation relative to most of the literature is the use of a nonstochastic simulation routine. Published, Journal of Economic Dynamics and Control 34(1), pp. 36-41.

Program Files: Programs


"Asset Pricing under Information-Processing Constraints" with Yulei Luo. This note shows that limited information processing has the potential to increase the equity premium because it introduces persistence and excess volatility into consumption growth. Published, Economics Letters 107(1), pp. 26-29.


"Risk-sensitive Consumption and Savings under Rational Inattention" with Yulei Luo. This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI). We first solve the model explicitly and show that RI increases precautionary savings by interacting with income uncertainty and risk-sensitivity. Given the closed-form solutions, we find that the RI model displays a wide range of observational equivalence properties, implying that consumption and savings data cannot distinguish between risk-sensitivity, robustness, or the discount factor, in any combination. We then show that the welfare costs from RI are larger for risk-sensitive households than any other observationally-equivalent settings. Published, American Economic Journal: Macroeconomics 2(4), pp. 281-325.


"The Long Run Effects of Changes in Tax Progressivity" with Daniel R. Carroll. This paper compares the steady state outcomes of revenue-neutral changes to the progressivity of the tax schedule. Our economy features heterogeneous households who differ in their preferences and permanent labor productivities, but it does not have idiosyncratic risk. We find that increases in the progressivity of the tax schedule are associated with long-run distributions with greater aggregate income, wealth, and labor input. Average hours generally declines as the tax schedule becomes more progressive implying that the economy substitutes away from less productive workers toward more productive workers. Finally, as progressivity increases, income inequality is reduced and wealth inequality rises. Many of these results are qualitatively different than those found in models with idiosyncratic risk, and therefore suggest closer attention should be paid to modeling the insurance opportunities of households. Published, Journal of Economic Dynamics and Control 35(9), pp. 1451-1473.

Older Version Federal Reserve Bank of Cleveland Working Paper No 09-13: "The Long Run Effects of Changes in Tax Progressivity"


"Revisiting Overborrowing and its Policy Implications" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. This paper analyzes quantitatively the extent to which there is overborrowing (i.e., inefficient borrowing) in a business cycle model for emerging market economies with production and an occasionally binding credit constraint. The main finding of the analysis is that overborrowing is not a robust feature of this class of model economies: it depends on the structure of the economy and its parametrization. Specifically, we find underborrowing in a production economy with our baseline calibration, but overborrowing with more impatient agents and more volatile shocks. Endowment economies display overborrowing regardless of parameter values, but they do not allow for policy intervention when the constraint binds (in crisis times). Quantitatively, the welfare gains from implementing the constrained-efficient allocation are always larger near crisis times than in normal ones. In production economies, they are one order of magnitude larger than in endowment economies both in crisis and normal times. This suggests that the scope for economy-wide macro-prudential policy interventions (e.g. prudential taxation of capital flows and capital controls) is weak in this class of models. Central Bank of Chile Working Paper No 582. Published in Céspedes, Luis Felipe, Robert Chang, and Diego Saravia (eds.), Monetary Policy under Financial Turbulence, Central Bank of Chile, pp. 145-185.

Related VoxEU article: "Are Macro-Prudential Policies Really Prudent?"


"A Quantitative Theory of Information and Unsecured Credit" with Kartik Athreya and Xuan S. Tam. Over the past three decades six striking features of aggregates in the unsecured credit market have been documented: (1) rising personal bankruptcy rates, (2) rising dispersion in unsecured interest rates across borrowing households, (3) the emergence of a discount for borrowers with good credit ratings, (4) a reduction in average interest rates paid by borrowers, (5) an increase in aggregate debt relative to income, and (6) an increase in the amount of debt discharged in bankruptcy relative to income. The main contribution of this paper is to suggest that improvements in the ability of lenders to observe borrower characteristics can help account for a substantial proportion of most, though not all, of these observations. A central aspect of our findings is that the power of signaling is likely to be weaker when it is non-pecuniary costs, rather than the persistent component of income, that are unobservable. From a welfare perspective, our main finding is that model agents prefer to inhabit settings with more information, ex ante, even though better information can rule out outcomes that some groups might find beneficial ex post. Published, American Economic Journal: Macroeconomics 4(3), pp. 153-183.


"Robustness, Information-Processing Constraints, and the Current Account in Small Open Economies" with Yulei Luo and Jun Nie. We examine the effects of two types of informational frictions, robustness (RB) and finite information-processing capacity (called rational inattention or RI) on the current account, in an otherwise standard intertemporal current account (ICA) model. We show that the interaction of RB and RI improves the model's predictions for the joint dynamics of the current account and income: (i) the contemporaneous correlation between the current account and income, and (ii) the volatility and persistence of the current account in small open emerging and developed economies. In addition, we show that the two informational frictions better explain consumption dynamics in small open economies: the impulse response of consumption to income shocks and the relative volatility of consumption growth to income growth. Published, Journal of International Economics 88(1), pp. 104-120.

Older Version Federal Reserve Bank of Kansas City Working Paper 10-17: "Robustness, Information-Processing Constraints, and the Current Account in Small Open Economies"


"Robust Policymaking in the Face of Sudden Stops". This paper considers tax policies to deal with Sudden Stops -- declines in aggregate activity that are magnified by a binding collateral constraint -- that occasionally occur in emerging market economies. Households and/or the government are assumed to face model uncertainty and desire robustness against alternative models. Welfare gains from optimal taxation are small if the government trusts its model of household expectations, whether those expectations are altered by model uncertainty or not; in contrast, welfare losses are large if the government is uncertain about the household's probability model. Published, Journal of Monetary Economics 59(5), pp. 512-527.


"Financial Crises and Macro-Prudential Policies" with Gianluca Benigno, Huigang Chen, Christopher Otrok, and Alessandro Rebucci. In this paper we study a two-sector production small open economy subject to an occasionally binding borrowing constraint that gives rise to the possibility of a financial crisis endogenously. In this class of models, the scope for policy intervention arises because of a pecuniary externality associated with the presence of a key market price in the borrowing constraint. Our main result is that the interaction between agents' behavior in crisis and normal times is crucial for the normative implications of this class of models. In contrast to the related literature, we find that our model economy borrows less than socially efficient rather than more in normal times (i.e., it displays "under-borrowing" rather "over-borrowing" in normal times) and yet achieves a lower probability of hitting the crisis. This is because by allocating productive resources across sectors more efficiently during crisis times a social planner can make the crisis less costly, thus lowering the social value of precautionary saving. While our findings call for both ex ante and ex post policy interventions relative to the crisis event, our analysis shows that welfare gains of ex-post policies are quantitatively much larger than those of ex ante policies. As a result, adopting only ex ante interventions such as macro-prudential policies or capital controls may be costly in welfare terms. For example, a small macro-prudential tax on debt that lowers the probability of a crisis to zero is welfare-reducing in our model because it also lowers average consumption. Published, Journal of International Economics 89(2), pp. 453-470.


"Model Uncertainty, State Uncertainty, and State-Space Models" with Yulei Luo and Jun Nie. State-space models have been increasingly used to study macroeconomic and financial problems. A state-space representation consists of two equations, a measurement equation which links the observed variables to unobserved state variables and a transition equation describing the dynamics of the state variables. In this paper, we show that a classic linear-quadratic macroeconomic framework which incorporates two new assumptions can be analytically solved and explicitly mapped to a state-space representation. The two assumptions we consider are the model uncertainty due to concerns for model misspecification (robustness) and the state uncertainty due to limited information constraints (rational inattention). We show that the state-space representation of the observable and unobservable can be used to quantify the key parameters on the degree of model uncertainty. We provide examples on how this framework can be used to study a range of interesting questions in macroeconomics and international economics. Published in Wu, Shu and Yong Zeng (eds.), State Space Models: Applications in Finance and Economics, Springer Press, pp. 91-112.

Also available as Federal Reserve Bank of Kansas City Working Paper 12-2.


"Signal Extraction and Rational Inattention" with Yulei Luo. In this paper we examine the implications of two theories of informational frictions, signal extraction (SE) and rational inattention (RI), for optimal decisions and economic dynamics within the linear-quadratic-Gaussian (LQG) setting. We first show that if the variance of the noise and channel capacity are fixed exogenously in the SE and RI problems, respectively, the two environments lead to different policy and welfare implications. We also find that if the signal-to-noise ratio in the SE problem is fixed, the two theories generate the same policy implications in the univariate case, but different policy implications in the multivariate case. These results are robust to the presence of correlation between structural shocks and noise shocks and the presence of risk-sensitive preferences. Thus, while RI provides a microfoundation for the imprecise observations and noise in the SE problem it is difficult to specify the structure of the noise in the SE problem in a manner consistent with the efficiency conditions from RI. Published, Economic Inquiry 52(2), pp. 811-829.


"Robust Control, Informational Frictions, and International Consumption Correlations" with Yulei Luo and Jun Nie. In this paper we examine the effects of model misspecification (robustness or RB) on international consumption correlations in an otherwise standard small open economy model with endogenous capital accumulation. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to productivity shocks across countries facing different macroeconomic uncertainty. In addition, we show that RB can also improve the model's predictions in three other moments of consumption dynamics: the relative volatility of consumption to income, the persistence of consumption, and the correlation between consumption and output. After calibrating the RB parameter using the detection error probabilities, we show that the model can explain the observed international consumption correlations as well as the other consumption moments quantitatively. Finally, we show that the main conclusions of our benchmark model do not change in an extension in which the agent cannot observe the state perfectly due to finite information-processing capacity. Published, European Economic Review 67(1), pp. 1-27 (lead article).

Older version available as Federal Reserve Bank of Kansas City Working Paper 10-16.


"Labor Market Upheaval, Default Regulations, and Consumer Debt" with Kartik Athreya, Juan M. Sánchez, and Xuan S. Tam. In 2005, bankruptcy laws were reformed signi cantly, making personal bankruptcy substantially more costly to file than before. Shortly after, the US began to experience its most severe recession in seventy years. While personal bankruptcy rates rose, they rose only modestly given the severity of the rise in unemployment, perhaps as a consequence of the reform. Moreover, in the subsequent recovery, households have been widely viewed as "develeraging" (Mian and Sufi (2011), Krugman and Eggertson (2012)), an interpretation consistent with the largest reduction in the volume of unsecured debt in the past three decades. In this paper, we aim to measure the role jointly played by recent bankruptcy reforms and labor market risks during the Great Recession in accounting for the use of consumer credit and debt default. We use a setting that features high-frequency life-cycle consumption-savings decisions, defaultable debt, search frictions, and aggregate risk. Our results suggest that the 2005 bankruptcy reform likely prevented a substantial increase in bankruptcy filings, but had only limited effect on the observed path of delinquencies. Thus, the reform appears to have "worked." We also find that fluctuations in the job separation rate observed over the Great Recession did not significantly affect the dynamics of default; all of the work is done, instead, by the large decline in the job-finding rate. Conditionally accepted, Review of Economic Dynamics.

Federal Reserve Bank of St. Louis Working Paper 2014-002A.

Link to WSJ Blog Article.


"Model Uncertainty and Intertemporal Tax Smoothing" with Yulei Luo and Jun Nie. In this paper we examine how model uncertainty due to the preference for robustness (RB) affects optimal taxation and the evolution of debt in the Barro tax-smoothing model (1979). We first study how the government spending shocks are absorbed in the short run by varying taxes or through debt under RB. Furthermore, we show that introducing RB improves the model's predictions by generating (i) the observed relative volatility of the changes in tax rates to government spending, (ii) the observed comovement between government de cits and spending, and (iii) more consistent behavior of government budget de cits in the US economy. Finally, we show that RB can also improve the model's predictions in the presence of multiple shocks. Forthcoming, Journal of Economic Dynamics and Control.

Older Version Available as Federal Reserve Bank of Kansas City Working Paper 12-1.


"Slow Information Diffusion and the Inertial Behavior of Durables Consumption" with Yulei Luo and Jun Nie. This paper studies the aggregate dynamics of durable and nondurable consumption under slow information diffusion (SID) due to noisy observations and learning within the permanent income framework. We show that SID can significantly improve the model’s predictions on the joint behavior of income, durable consumption, and nondurable consumption at the aggregate level. Specifically, we find that SID can significantly improve the model’s predictions for: (i) smoothness in durable and nondurable consumption, (ii) autocorrelation of durable consumption, and (iii) contemporaneous correlation between durable and nondurable consumption. Forthcoming, Journal of the European Economic Association.

Older Version "Federal Reserve Bank of Kansas City Working Paper 12-11"


"Long-Run Consumption Risk and Asset Allocation under Recursive Utility and Rational Inattention" with Yulei Luo. We study the portfolio decision of a household with limited information-processing capacity (rational inattention or RI) in a setting with recursive utility. We nd that rational inattention combined with a preference for early resolution of uncertainty could lead to a signi cant drop in the share of portfolios held in risky assets, even when the departure from standard expected utility with rational expectations is small. In addition, we show that the equilibrium equity premium increases with the degree of inattention because inattentive investors with recursive utility face greater long-run risk and thus require higher compensation in equilibrium. Our results are robust to the presence of correlation between the equity return and the RI-induced noise and the presence of non-tradable labor income. Forthcoming, Journal of Money, Credit, and Banking.