Unemployment (Fears), Precautionary Savings, and Aggregate Demand - PowerPoint PPT Presentation

Unemployment (Fears), Precautionary Savings, and Aggregate Demand Wouter J. Den Haan (LSE/CEPR/CFM) Pontus Rendahl (University of Cambridge/CEPR/CFM) Markus Riegler (LSE/CFM) November 4, 2015

Intro Model Model properties Business Cycles UI What we do Show that the interaction between 1 One friction in financial markets: incomplete risk sharing 2 Two frictions in labor markets : • sticky nominal wages : dW / dP < 1 • matching can • give rise to "aggregate demand" like propagation from supply shocks • lead to novel policy implication regarding unemployment insurance (UI)

Intro Model Model properties Business Cycles UI Interaction of two frictions key • Complete risk sharing = ⇒ Sticky nominal wages dampen effect shocks • Flexible nominal wages = ⇒ Incomplete risk sharing dampens effect shocks • Both shocks magnify effect shocks

Intro Model Model properties Business Cycles UI Key components behind these results • Aggregate risk • UI policy implications different without aggregate risk • Asset price volatility • Portfolio rebalancing towards liquid/unproductive asset during recession • Nonlinearities induced by standard matching framework

Intro Model Model properties Business Cycles UI Four cases 1 Complete markets and flexible wages 2 Complete markets and sticky wages 3 Incomplete markets and flexible wages 4 Benchmark: Incomplete markets and sticky wages

Intro Model Model properties Business Cycles UI Case 1: flexible wages & complete markets usual matching stuff: • productivity ↓ = ⇒ • expected future productivity ↓ = ⇒ • job creation ↓ = ⇒ • employment rate ↓ = ⇒ • unemployment rate ↑ = ⇒ • expected duration unemployment ↑

Intro Model Model properties Business Cycles UI Case 2: Sticky nominal wages & complete markets • productivity ↓ = ⇒ • Upward pressure on prices = ⇒ • downward pressure on real wages = ⇒ • nominal wage rigidity dampens shocks!

Intro Model Model properties Business Cycles UI Case 3: Flexible nominal wages & incomplete markets • productivity ↓ = ⇒ • investment in job creation ↓ = ⇒ • unemployment ↑ = ⇒ • idiosyncratic risk ↑ = ⇒ • precautionary savings ↑ = ⇒ • reduction in job creation is smaller = ⇒ • incomplete markets dampens shocks

Intro Model Model properties Business Cycles UI Case 4: Sticky nominal wages & incomplete markets • Incomplete markets: Precautionary savings ↑ when unemp ↑ = ⇒ • precautionary demand for money ↑ = ⇒ • downward pressure on P = ⇒ W / P ↑ (sticky W ) = ⇒ • job creation investment ↓ by more not by less! = ⇒ • unemployment rate ↑ = ⇒ • precautionary savings ↑ = ⇒ etc. • = ⇒ deflationary spiral Risk for unemployed = ⇒ procyclical W / P = ⇒ volatile asset prices

Intro Model Model properties Business Cycles UI Main results 1 Incomplete markets together with sticky wages amplify shocks, but on their own repress shocks 2 Increase in unemployment insurance from 50% to 55% = ⇒ everybody better off • not true in economy without aggregate risk

Intro Model Model properties Business Cycles UI Model: Key ingredients 1 Heterogeneous households and incomplete markets 2 Nominal wages do not respond 1-for-1 with P 3 Search frictions in the labor market 4 # jobs = # firms = # shares

Intro Model Model properties Business Cycles UI Existing firms • One-worker firms • Profits are given by D t = P t exp ( z t ) − W t � P t � ω P � z t � ω z z W t = P ω 0 z P • Key parameter is ω P ≤ 1 • Aactive firms do not make decisions

Intro Model Model properties Business Cycles UI Individual households • one-worker households • employed workers earn nominal wage ( 1 − τ t ) W t • unemployed earn µ ( 1 − τ t ) W t & search for jobs • idiosyncratic risk • exogenous job loss probability, δ • lower chance of getting a job in a recession • agents can save/invest in • unproductive asset: money, M i , t • productive asset: equity, q i , t ≥ 0 (i.e., firm ownership/jobs)

Intro Model Model properties Business Cycles UI Individual households     � M i , t + 1 + j � 1 − ζ    c 1 − γ − 1 i , t + j − 1 ∞     P t + j β j  + χ ∑ max E t     1 − γ 1 − ζ j = 0 with respect to P t c i , t + J t ( q i , t + 1 − ( 1 − δ ) q i , t ) + M i , t + 1 = ( 1 − τ t ) W t e i , t + µ ( 1 − τ t ) W t ( 1 − e i , t ) + D t q i , t + M i , t and q i , t + 1 ≥ 0

Intro Model Model properties Business Cycles UI First-order conditions �� c i , t + 1 �� � − γ � D t + 1 J t + ( 1 − δ ) J t + 1 = β E t P t c i , t P t + 1 P t + 1 � P t � � M i , t � − ζ c − γ c − γ i , t = β E t + χ i , t + 1 P t + 1 P t • Marked departure from literature: Individual MRS is used in both Euler equations • Inequality constraints ignored here

Intro Model Model properties Business Cycles UI Equity market equilibrium � h t + (( 1 − δ ) q i − q ( e i , q i , M i ; s t )) dF t ( e i , q i , M i ) ���� � �� � i ∈A − Equity creation Equity sold � = ( q ( e i , q i , M i ; s t ) − ( 1 − δ ) q i ) dF t ( e i , q i , M i ) , � �� � i ∈A + Equity bought with A − = { i : q ( e i , q i , M i ; s t ) − ( 1 − δ ) q i ≤ 0 } , A + = { i : q ( e i , q i , M i ; s t ) − ( 1 − δ ) q i ≥ 0 } , "go to equity supply derivation"

Intro Model Model properties Business Cycles UI Employment � � q t = i ∈A + q ( e i , q i , M i ; s t ) dF t ( e i , q i , M i ) + q ( e i , q i , M i ; s t ) dF t ( e i ∈A − = ( 1 − δ ) q t − 1 + h t

Intro Model Model properties Business Cycles UI Money market equilibrium • Equilibrium � ( M i − M ( e i , q i , M i ; s t )) dF t ( e i , q i , M i ) � �� � i ∈B − Money sold � = ( M ( e i , q i , M i ; s t ) − M i ) dF t ( e i , q i , M i ) , � �� � i ∈B + Money bought • Money supply, M , is constant in the benchmark economy.

Intro Model Model properties Business Cycles UI Government τ t q t W t = ( 1 − q t ) µ ( 1 − τ t ) W t ( 1 − q t ) τ t = µ q t + µ ( 1 − q t )

Intro Model Model properties Business Cycles UI Calibration • ω P : range of values � P t � ω P � z t � ω z z W t = ω 0 P z P • One-year post-displacement consumption drop is 34% (Kolsrud, Landais, Nilsson, & Spinnewijn 2015; Sweden) • Expected unemployment duration 3.57 quarters

Intro Model Model properties Business Cycles UI MODEL PROPERTIES

Intro Model Model properties Business Cycles UI Money holdings upon displacement 0.6 Cond. on expansion Cond. on recession 0.5 Money holdings 0.4 0.3 0.2 0.1 0 −1 0 1 2 3 4 5 6 7 8 Unemployment duration (quarters)

Intro Model Model properties Business Cycles UI Amount invested in liquid asset Employed in expansion 0.9 Unemployed in expansion 0.8 Employed in recession Unemployed in recession 0.7 0.6 Money demand 0.5 0.4 0.3 0.2 0.1 0 0 0.5 1 1.5 2 2.5 3 Real cash on hand

Intro Model Model properties Business Cycles UI BUSINESS CYCLES

Intro Model Model properties Business Cycles UI IRFs with sticky nominal wages Output and productivity (dashed line) Employment 0 0.5 0 −0.01 −0.5 −0.02 −1 Log deviation Ppt. deviation −0.03 −1.5 −0.04 −2 −0.05 −2.5 −0.06 −3 −0.07 Incompl. markets −3.5 Compl. markets −0.08 −4 0 10 20 30 40 50 0 10 20 30 40 50 Asset prices Price level 0 0.1 −0.1 0.05 −0.2 Log deviation Log deviation 0 −0.3 −0.4 −0.05 −0.5 −0.1 −0.6 −0.7 −0.15 0 10 20 30 40 50 0 10 20 30 40 50 Time (quarters) Time (quarters)

Intro Model Model properties Business Cycles UI IRFs with flexible nominal wages Output and productivity (dashed line) Employment 0 0.5 0 −0.01 −0.5 −0.02 Log deviation Ppt. deviation −1 −0.03 −1.5 −0.04 −2 −0.05 −2.5 −0.06 Incompl. markets −3 Compl. markets −0.07 −3.5 0 10 20 30 40 50 0 10 20 30 40 50 Asset prices Price level 0 0.15 −0.05 0.1 −0.1 −0.15 Log deviation Log deviation 0.05 −0.2 −0.25 0 −0.3 −0.35 −0.05 −0.4 −0.45 −0.1 0 10 20 30 40 50 0 10 20 30 40 50 Time (quarters) Time (quarters)

Intro Model Model properties Business Cycles UI UNEMPLOYMENT INSURANCE

Intro Model Model properties Business Cycles UI Unemployment Insurance Two unemployment insurance (UI) experiments 1 Compare economies with different replacement rates 2 Unexpectedly increase replacement rate and take into account transition Two ways to deal with effect on wages 1 wage rule not affected 2 wage rule is adjusted to keep same implied Nash bargaining weights

Intro Model Model properties Business Cycles UI Unemployment insurance Mechanism emphasized in the literature Replacement rate ↑ = ⇒ 1 Agents better insured = ⇒ savings ↓ = ⇒ employment ↓ 2 Through bargaining wage ↑ = ⇒ employment ↓ This also happens in our model too, but ...