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

Dt

=

Pt exp (zt) − Wt Wt

=

ω0 zt z ωz z Pt P ωP P

• Key parameter is ωP ≤ 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 − τt) Wt
• unemployed earn µ (1 − τt) Wt & 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, Mi,t
• productive asset: equity, qi,t ≥ 0 (i.e., firm ownership/jobs)

Intro Model Model properties Business Cycles UI

Individual households

max Et   

∞

∑

j=0

βj     c1−γ

i,t+j − 1

1 − γ   + χ Mi,t+1+j

Pt+j

1−ζ

− 1

1 − ζ       with respect to Ptci,t + Jt (qi,t+1 − (1 − δ) qi,t) + Mi,t+1

= (1 − τt) Wtei,t + µ (1 − τt) Wt (1 − ei,t) + Dtqi,t + Mi,t

and qi,t+1 ≥ 0

Intro Model Model properties Business Cycles UI

First-order conditions

Jt Pt

= βEt

ci,t+1 ci,t −γ Dt+1 Pt+1

+ (1 − δ) Jt+1

Pt+1

• c−γ

i,t = βEt

Pt Pt+1 c−γ

i,t+1

• + χ

Mi,t Pt −ζ

• 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

ht

• Equity creation

+

• i∈A−

((1 − δ) qi − q (ei, qi, Mi; st))

• Equity sold

dFt (ei, qi, Mi)

=

• i∈A+

(q (ei, qi, Mi; st) − (1 − δ) qi)

• Equity bought

dFt (ei, qi, Mi) , with

A− = {i : q(ei, qi, Mi; st) − (1 − δ)qi ≤ 0}, A+ = {i : q(ei, qi, Mi; st) − (1 − δ)qi ≥ 0},

"go to equity supply derivation"

Intro Model Model properties Business Cycles UI

Employment

qt

=

• i∈A+q (ei, qi, Mi; st) dFt (ei, qi, Mi) +
• i∈A−

q (ei, qi, Mi; st) dFt (e

= (1 − δ) qt−1 + ht

Intro Model Model properties Business Cycles UI

Money market equilibrium

• Equilibrium
• i∈B−

(Mi − M (ei, qi, Mi; st))

• Money sold

dFt (ei, qi, Mi)

=

• i∈B+

(M (ei, qi, Mi; st) − Mi)

• Money bought

dFt (ei, qi, Mi) ,

• Money supply, M, is constant in the benchmark economy.

Intro Model Model properties Business Cycles UI

Government

τtqtWt

= (1 − qt) µ (1 − τt) Wt

τt

=

µ

(1 − qt)

qt + µ (1 − qt)

Intro Model Model properties Business Cycles UI

Calibration

• ωP : range of values

Wt = ω0 zt z ωz z Pt P ωP 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

−1 1 2 3 4 5 6 7 8 0.1 0.2 0.3 0.4 0.5 0.6

Unemployment duration (quarters) Money holdings

• Cond. on expansion
• Cond. on recession

Intro Model Model properties Business Cycles UI

Amount invested in liquid asset

0.5 1 1.5 2 2.5 3 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Real cash on hand Money demand

Employed in expansion Unemployed in expansion Employed in recession Unemployed in recession

Intro Model Model properties Business Cycles UI

BUSINESS CYCLES

Intro Model Model properties Business Cycles UI

IRFs with sticky nominal wages

10 20 30 40 50 −0.08 −0.07 −0.06 −0.05 −0.04 −0.03 −0.02 −0.01

Log deviation Output and productivity (dashed line)

• Incompl. markets
• Compl. markets

10 20 30 40 50 −4 −3.5 −3 −2.5 −2 −1.5 −1 −0.5 0.5

• Ppt. deviation

Employment

10 20 30 40 50 −0.7 −0.6 −0.5 −0.4 −0.3 −0.2 −0.1

Log deviation Time (quarters) Asset prices

10 20 30 40 50 −0.15 −0.1 −0.05 0.05 0.1

Time (quarters) Log deviation Price level

Intro Model Model properties Business Cycles UI

IRFs with flexible nominal wages

10 20 30 40 50 −0.07 −0.06 −0.05 −0.04 −0.03 −0.02 −0.01

Log deviation Output and productivity (dashed line)

• Incompl. markets
• Compl. markets

10 20 30 40 50 −3.5 −3 −2.5 −2 −1.5 −1 −0.5 0.5

• Ppt. deviation

Employment

10 20 30 40 50 −0.45 −0.4 −0.35 −0.3 −0.25 −0.2 −0.15 −0.1 −0.05

Log deviation Time (quarters) Asset prices

10 20 30 40 50 −0.1 −0.05 0.05 0.1 0.15

Time (quarters) Log deviation Price level

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 ...

Intro Model Model properties Business Cycles UI

Mean employment rate and higher UI

... there is a strong countervailing effect arising from aggregate uncertainty: Replacement rate ↑ =

⇒

1 Asset prices less volatile =

⇒ demand equity ↑ = ⇒

employment ↑

2 Employment is concave in equity prices, J =

⇒

E [employment] ↑ when SD [J] ↓

Intro Model Model properties Business Cycles UI

UI and employment

0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.85 0.86 0.87 0.88 0.89 0.9 0.91

Employment level ωP=0.7, µ does not affect wages

Intro Model Model properties Business Cycles UI

Switch to alternative UI policy

1 Replacement rate increases from 0.5 to 0.55 2 Switch is unexpected 3 Switch is permanent 4 Agents take transition into account

Intro Model Model properties Business Cycles UI

Average welfare effect of change in UI

0.35 0.4 0.45 0.5 0.55 0.6 0.65 −1.5 −1 −0.5 0.5 1 1.5

ωP=0.7, µ affects wages

Intro Model Model properties Business Cycles UI

Who likes/dislikes higher UI?

0.5 1 1.5 2 0.5 1 1.5

Real cash−on−hand Welfare gain µ=0.55, ω0 unchanged

EE UU UE EU 0.5 1 1.5 2 0.5 1 1.5

Real cash−on−hand µ=0.55, ω0 increases

Intro Model Model properties Business Cycles UI

Concluding comments

• With incomplete markets and sticky nominal wages, a decline in

productivity sets off a self-reinforcing aggregate demand effect

• This happens despite the fact that both incomplete markets as

well as sticky nominal wages — in isolation — repress propagation.

• One of the core components of this mechanism is the missing

market for unemployment insurance.

• A rise in UI generosity can therefore increase average

employment and raise welfare for all agents — even the asset-rich employed

Intro Model Model properties Business Cycles UI

Creation of new jobs/firms/equity

• number of new firms created:

ht = ψvη

t u1−η t

• vacancy yield:

ht vt

= ψ

vt ut η−1

Intro Model Model properties Business Cycles UI

Supply of new equity

• Matching function
• zero-profit condition

= ⇒

ht = ψ ψ κ Jt Pt η/(1−η) ut

Intro Model Model properties Business Cycles UI

Creation of new jobs/firms/equity

• zero-profit condition =

⇒ vacancies as a function of Jt/Pt:

κ = ψ vt ut η−1 Jt Pt

• supply of new equity (job/firm creation):

ht = ψ ψ κ Jt Pt η/(1−η) ut "back to main"

Intro Model Model properties Business Cycles UI

Euro Area

2000 2002 2004 2006 2008 2010 2012 2014 0.85 0.9 0.95 1 1.05 1.1 A: Price level (*) 2000 2002 2004 2006 2008 2010 2012 2014 0.85 0.9 0.95 1 1.05 1.1 1.15 B: Price level (*) and nominal wage (+)

Intro Model Model properties Business Cycles UI

Euro Area

2000 2002 2004 2006 2008 2010 2012 2014 0.85 0.9 0.95 1 1.05 1.1 1.15 B: Price level (*) and nominal wage (+) 2000 2002 2004 2006 2008 2010 2012 2014 0.85 0.9 0.95 1 1.05 1.1 C: Price level (*) and nominal unit labor cost (o) time

Intro Model Model properties Business Cycles UI

Unemployment duration

2 4 6 8 10 12 14 16 18 20 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4

Duration of unemployment spell (quarters) Frequency

• Cond. on expansion
• Cond. on recession

Intro Model Model properties Business Cycles UI

Equity holdings upon displacement

−1 1 2 3 4 5 6 7 8 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Unemployment duration (quarters) Equity holdings

• Cond. on expansion
• Cond. on recession

Intro Model Model properties Business Cycles UI

Portfolio choice: fraction in liquid asset

0.5 1 1.5 2 2.5 3 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 real cash on hand share of money in portfolio employed in boom unemployed in boom employed in recession unemployed in recession

Intro Model Model properties Business Cycles UI

Technical challenges

• Even rep-agent version not trivial to solve accurately
• non-linearity matching function matters
• sufficiently volatile employment =

⇒

• volatile surplus
• volatile equity prices
• "go to accuracy graph rep-agent model"
• Adding moderate aggregate uncertainty to model

is not a small change

• substantial changes in means
• volatile surplus and asset prices
• multiplicity

Intro Model Model properties Business Cycles UI

Log employment level

50 100 150 200 250 300 350 400 450 500

• 0.26
• 0.24
• 0.22
• 0.2
• 0.18
• 0.16
• 0.14
• 0.12
• 0.1
• 0.08

2-nd order perturbation 5th-order projections method

"back to main"

Intro Model Model properties Business Cycles UI

Increase in UI & transition dynamics

• Increase in UI first period of recession
• No change in wage rule =

⇒

• equity less risky =

⇒ average employment ↑

• less deflationary spiral =

⇒ recession less deep = ⇒ employment ↑

• Change in wage rule =

⇒

• the same as above +
• profits ↓ =

⇒ average employment ↓

Intro Model Model properties Business Cycles UI

Switch to higher level of unemployment benefits

10 20 30 40 50 60 0.85 0.86 0.87 0.88 0.89 0.9 0.91

Employment Time (quarters)

µ=0.5 µ=0.55 µ=0.55, ω0 increases