Working Papers
2023
January 27, 2023
How Do Adaptive Learning Expectations Rationalize Stronger Monetary Policy Response in Brazil?
Description: This paper estimates a standard Dynamic Stochastic General Equilibrium (DSGE) model that includes a wage and price Phillip's curves with different expectation formation processes for Brazil and the USA. Other than the standard rational expectation process, we also use a limited rationality process, the adaptive learning model. In this context, we show that the separate inclusion of a labor market in the model helps to anchor inflation even in a situation of adaptive expectations, a positive output gap and inflation above target. The estimation results show that the adaptive learning model does a better job in fitting the data in both Brazil and the USA. In addition, the estimation shows that expectations are more backward-looking and started to drift away sooner in 2021 in Brazil than in the USA. We then conduct optimal policy exercises that prescribe early monetary policy tightening in the context of positive output gaps and inflation far above the central bank target.
January 27, 2023
Tax Distortions from Inflation: What are They? How to Deal with Them?
Description: Expected inflation has few real effects in purely private economies, but this is not the case when the tax system is not neutral with respect to inflation. In practice, tax systems are not neutral—though some have attempted to be so in the past—and this paper provides a comprehensive overview of the most relevant non-neutralities drawing both on existing literature and showing new illustrations and evidence of the effects. The paper shows, for example, how taxing inflationary gains can have tremendous impact on effective tax rates—even at relatively low rates of inflation. It also shows how partial adjustment—for only some types of incomes—can create additional distortions. A new empirical analysis reveals how the erosion of the value of depreciation allowances through inflation affects investment. Finally the paper discusses policy options to address such non-neutralities.
January 20, 2023
Macroprudential Policies in Response to External Financial Shocks
Description: This paper examines how countries use Macroprudential Policies (MaPs) to respond to external shocks such as US monetary policy surprises or fluctuations in capital flows. Constructing a model of a small open economy with financial frictions and a MaP authority that adjusts loan to value (LTV) ratio limits on borrowers and capital adequacy ratio (CAR) limits on banks, we show that using MaPs where stochastic external financial shocks are present entails a trade-off between macro-financial volatility and GDP growth. The terms of the trade-off are a function of a few country characteristics that amplify financial channels of external monetary shocks. Estimating MaP reaction functions for a panel of 41 countries in the period 2000–2017, we find that countercyclical macroprudential policy in response to surprise US monetary tightening is more likely for countries with net short currency mismatches (that is, foreign currency denominated liabilities larger than foreign currency denominated assets), consistent with the model’s predictions. The paper also finds that domestic credit and interest rates are more insulated from US monetary tightening for countries that employ MaPs countercyclically.
January 20, 2023
A Market for Brown Assets To Make Finance Green
Description: This paper proposes a market solution to enhance the role of the financial sector in the green transition. Developing a secondary market for “brown exposures” can allow banks to dispose more quickly of stranded assets thereby increasing their capacity to finance green investments. Furthermore, newly created instruments – the brown assets backed securities (B-ABS) - can expand the diversification opportunities for specialized green investors and, thus, attract additional resources for new green investments. The experience of the secondary market for non-performing loans suggests that targeted policy and regulatory measures can simultaneously support the development of the secondary market for brown assets and green finance.
January 20, 2023
Understanding Post-COVID Inflation Dynamics
Description: We propose a macroeconomic model with a nonlinear Phillips curve that has a flat slope when inflationary pressures are subdued and steepens when inflationary pressures are elevated. The nonlinear Phillips curve in our model arises due to a quasi-kinked demand schedule for goods produced by firms. Our model can jointly account for the modest decline in inflation during the Great Recession and the surge in inflation during the Post-Covid period. Because our model implies a stronger transmission of shocks when inflation is high, it generates conditional heteroskedasticity in inflation and inflation risk. Hence, our model can generate more sizeable inflation surges due to cost-push and demand shocks than a standard linearized model. Finally, our model implies that the central bank faces a more severe trade-off between inflation and output stabilization when inflation is high.
January 20, 2023
To Demand or Not to Demand: On Quantifying the Future Appetite for CBDC
Description: We set up a model of banks, the central bank, the payment system, and the surrounding private sector economic environment. It is a structural, choice-theoretic model which is deeply rooted in data. We use the model to conduct a structural counterfactual that introduces a Central Bank Digital Currency (CBDC) which is optionally interest-bearing. The model can be used to provide estimates of the emerging CBDC-in-total-money shares, the drop of deposit rate spreads to policy rates, the impact on reserve needs, the implied rotation of profits away from banks toward central banks, and the extent to which monetary policy pass-through may become stronger. We obtain upper bound estimates for the CBDC-in-money shares of about 25 percent and 20 percent, respectively for the U.S. and euro area, when CBDC would be remunerated at the policy rates and be perceived as “deposit-like” by the public. Actual take-up may likely be below such upper bound estimates. The model codes—to replicate all results and to apply them to other countries—are made available along with the paper.
January 18, 2023
Central Banks as Dollar Lenders of Last Resort: Implications for Regulation and Reserve Holdings
Description: This paper explores how non-U.S. central banks behave when firms in their economies engage in currency mismatch, borrowing more heavily in dollars than justified by their operating exposures. We begin by documenting that, in a panel of 53 countries, central bank holdings of dollar reserves are significantly correlated with the dollar-denominated bank borrowing of their non-financial corporate sectors, controlling for a number of known covariates of reserve accumulation. We then build a model in which the central bank can deal with private-sector mismatch, and the associated risk of a domestic financial crisis, in two ways: (i) by imposing ex ante financial regulations such as bank capital requirements; or (ii) by building a stockpile of dollar reserves that allow it to serve as an ex post dollar lender of last resort. The model highlights a novel externality: individual central banks may tend to over-accumulate dollar reserves, relative to what a global planner would choose. This is because individual central banks do not internalize that their hoarding of reserves exacerbates a global scarcity of dollar-denominated safe assets, which lowers dollar interest rates and encourages firms to increase the currency mismatch of their liabilities. Relative to the decentralized outcome, a global planner may prefer stricter financial regulation (e.g., higher bank capital requirements) and reduced holdings of dollar reserves.
January 13, 2023
Trade Policy Implications of a Changing World: Tariffs and Import Market Power
Description: Economic theory suggests that countries’ tariff commitments in trade agreements reflect their import market power at the time of negotiations. However, as countries grow, their market power in different sectors can change in unforeseen ways and their commitments may no longer reflect changed economic conditions. Using a newly built dataset of pre-Uruguay Round applied tariffs and relying on the theoretical framework of the terms-of-trade motive for trade agreements, we estimate hypothetical tariff commitments under current levels of market power and compare them with actual tariff commitments. We find that lower tariff commitments required to reflect current economic conditions would amount to a reduction in annual tariff costs of up to $26.4 billion – equivalent to nearly 10% of global tariff costs. Our results reveal substantial heterogeneity between countries and sectors. The sectors with the largest potential tariff cost reductions are vehicles (HS 87) and machinery and appliances (HS 84-85). Product-level tariff reductions would range from 0 to 18.5 percentage points and are on average largest for China. In the past, the GATT/WTO system has updated tariff commitments through periodic rounds of negotiations, and our findings support the revival of the WTO's negotiation function in this area.
January 13, 2023
Supporting Sustainable Financing and Access to Finance in Armenia
Description: In Armenia, both external and domestic financing face challenges. Armenia’s share of inward foreign direct investment (FDI) in private external financing has declined significantly over the past decade. Access to domestic finance in Armenia is also moderate and masks important disparities. Against this background, this paper analyses the determinants of inward FDI and examines the impediments to increasing access to domestic finance. The paper confirms empirically that governance-related structural factors have a significant impact on inward FDI. Similar structural factors, informality and poor accounting practices are reported among major challenges for increasing access to finance for firms in Armenia. This paper finds that to improve financing in Armenia include: implementing structural reforms to improve the business environment, maintaining prudent macroeconomic policies, strengthening financial reporting, and improving financial inclusion through reduced informality in the economy.
January 13, 2023
How Effective were Job-Retention Schemes during the COVID-19 Pandemic? A Microsimulation Approach for European Countries
Description: The COVID-19 pandemic had posed a dramatic impact on labor markets across Europe. Forceful fiscal responses have prevented an otherwise sharper contraction. Many countries introduced or expanded job-retention schemes to preserve jobs and support households. This paper uses a microsimulation approach (EUROMOD) and household data to assess the effectiveness of those schemes in stabilizing household income during the pandemic across European countries. Empirical evidence shows that job-retention schemes were effective in stabilizing income and, along with other measures, absorbed nearly 80 percent of market income shocks—almost doubling the extent of the automatic stabilization of the pre-pandemic tax and benefit systems. The large effects are related to the widespread use and scaling up of those schemes and a deep but short-lived disruption to labor markets during the pandemic. Along with other fiscal support measures, job-retention schemes helped mitigate the rise in the unemployment rate, by about 3 percentage points, and income inequality during the pandemic. Our results show that job-retention schemes were largely targeted, in which households more vulnerable to income losses, such as lower-income families, youth, and low-skilled workers, are able to stabilize their income.