Aggregate fluctuations, financial constraints and risk sharing

Summary. Private information and costly state verification often result in credit rationing in models with smooth investment, affecting both loan size and total investment. The optimal contract is derived in a dynamic stochastic growth model with capital for two types of models: one with symmetric information and the other with asymmetric information and costly state verification. When all information is observed costlessly, the equilibrium optimal contract provides complete insurance to risk-averse savers against aggregate fluctuations. When information is asymmetric and there is costly state verification, the equilibrium optimal contract provides only partial insurance against aggregate shocks. The extent of insurance is measured by the marginal rate of transformation of consumption between borrowers and lenders which is closely linked to the user cost of capital. The deadweight monitoring costs create a wedge between a borrower's cost of capital and a lender's stochastic discount factor, with two results: (i) fluctuations in the user cost of capital provides a mechanism by which aggregate shocks can be␣propagated; (ii) the distribution of capital's share of output among borrowers, lenders, and monitoring costs varies even if capital's share is constant. Capital market frictions not only amplify aggregate fluctuations but also generate cross-sectional fluctuations that may not be observable in aggregate data. Received: November 17, 1997; revised version: April 20, 1998     

Securitization of mortgage debt,domestic lending,and international risk sharing

Abstract Securitization makes mortgage‐related risks internationally tradeable and thus contributes considerably to the international diversification of macroeconomic risk: in the years 2003–2008, the increase in international cross‐holdings of securitized mortgage debt has lowered industrialized countries’ conditional consumption volatility (relative to the United States) by about 10–15 percentage points. We turn to the role of domestic credit in explaining this result. Domestic credit leads to better international risk sharing only if debt is securitized and traded internationally. Conversely, the risk‐sharing benefits from securitization seem to evaporate if credit dries up – as it did in the recent financial crisis.     

The cyclicality of consumption,wages and employment of the public sector in the euro area

This study empirically examines the business cycle behaviour of public consumption and its main components, the public wage bill (including its breakdown into compensation per employee and public employment) and intermediate consumption, in the euro area aggregate, euro area countries and a group of selected non-euro area Organization for Economic Co-operation and Development (OECD) countries (Denmark, Sweden, the UK, Japan and the US). It looks across a large number of variables and methods, using annual data from 1960 to 2005. It finds robust evidence supporting that public consumption, wages and employment co-move with the business cycle in a pro-cyclical manner with 1–2 year lags, notably for the euro area aggregate and euro area countries. The findings reflect mainly the correlation between cyclical developments, but also point to an important role of pro-cyclical discretionary fiscal policies.     

Regional consumption dynamics and risk sharing in Italy

In this paper, we propose a new method for investigating consumption insurance. Differently from the existing literature, we use error correcting VAR models in order to capture simultaneously the occurrence of risk sharing against permanent and transitory shocks. The proposed method is applied to the case of Italian regions. Empirical results obtained over the 1960–2001 period reveal that contrary to previous findings, Italian regions seem to shield against permanent shocks other than transitory ones. Although some biases are detected in the allocation process of resources, deviations from full consumption insurance are not as relevant as claimed in the previous literature on the Italian regions.     

Deleveraging,deflation and depreciation in the euro area

During the post-crisis period, economic performance has been highly heterogenous across the euro area. While some economies rebounded quickly after the 2009 output collapse, others are undergoing a protracted further decline as part of an extensive deleveraging process. At the same time, inflation has been subdued throughout the whole of the euro area and intra-euro-area exchange rates have hardly moved. We interpret these facts through the lens of a two-country model of a currency union. We find that deleveraging in one country generates deflationary spillovers which cannot be contained by monetary policy, as it becomes constrained by the zero lower bound. As a result, the real exchange rate response becomes muted, and the output collapse—concentrated in the deleveraging economies.     

Inflation and inflation uncertainty in the euro area

This article estimates a time-varying AR-GARCH model of inflation producing measures of inflation uncertainty for the euro area, and investigates their linkages in a VAR framework, also allowing for the possible impact of the policy regime change associated with the start of EMU in 1999. The main findings are as follows. Steady-state inflation and inflation uncertainty have declined steadily since the inception of EMU, whilst short-run uncertainty has stabilised. A sequential dummy procedure provides further evidence of a structural break coinciding with the introduction of the euro and resulting in lower long-run uncertainty. It also appears that the direction of causality has been reversed, and that in the euro period the Friedman-Ball link is empirically supported, consistently with the idea that the ECB can achieve lower inflation uncertainty by lowering the inflation rate.     

Growth accounting for the euro area

This article is concerned with the estimation of euro area potential output growth and its decomposition according to the sources of growth. The growth accounting exercise is based on a multivariate structural time series model which combines the decomposition of total output according to the production function approach with price and wage equations that embody Phillips-type relationships linking inflation and nominal wage dynamics to the output gap and cyclical unemployment, respectively. Assuming a Cobb?CDouglas technology with constant returns to scale, potential output results from the combination of the trend levels of total factor productivity (TFP) and factor inputs, capital and labour (hours worked), which is decomposed into labour intensity (average hours worked), the employment rate, the participation rate and population of working age. The nominal variables (prices and wages) play an essential role in defining the trend levels of the components of potential output, as the latter should pose no inflationary pressures on prices and wages. The structural model is further extended to allow for the estimation of potential output growth and the decomposition according to the sources of growth at different horizons (long run, medium run and short run); in particular, we propose and evaluate a model-based approach to the extraction of the low-pass component of potential output growth at different cut-off frequencies. The approach has two important advantages: the signal extraction filters have an automatic adaptation property at the boundaries of the sample period, so that the real-time estimates do not suffer from what is often referred to as the ??end-of-sample bias??. Secondly, it is possible to assess the uncertainty of potential output growth estimates with different degrees of smoothness.     

Optimal risk sharing and borrowing constraints in a continuous-time model with limited commitment

We study a continuous-time version of the optimal risk-sharing problem with one-sided commitment. In the optimal contract, the agent?s consumption is a time-invariant, strictly increasing function of a single state variable: the maximal level of the agent?s income realized to date. We characterize this function in terms of the agent?s outside option value function and the discounted amount of time in which the agent?s income process is expected to reach a new to-date maximum. Under constant relative risk aversion we solve the model in closed-form: optimal consumption of the agent equals a constant fraction of his maximal income realized to date. In the complete-markets implementation of the optimal contract, the Alvarez–Jermann solvency constraints take the form of a simple borrowing constraint familiar from the Bewley–Aiyagari incomplete-markets models.     

New technologies and productivity growth in the euro area

This paper provides an overview of the available evidence on the importance of information and communication technologies (ICT) for developments in average labour productivity (ALP) growth in the euro area. The contribution of ICT to ALP growth is found to have increased both in terms of production and investment over the 1990s (up to 2001). However, there is no evidence of significant positive spillover effects from the use of ICT on ALP growth. This implies that there is no reason to believe that potential output growth in the euro area has increased significantly in recent years on account of new technologies. Comparing developments in the euro area and the United States, it appears, however, that ICT capital cannot account for much of the difference in ALP developments over the 1990s. This suggests that cyclical developments and, in particular, the structure of the economy are more important for explaining the difference in performance.First version received: March 2002/Final version received: May 2003We thank Bart van Ark, Neale Kennedy, Gerard Korteweg, Ad van Riet, Marcel Timmer, two anonymous referees and participants at the 17th Congress of the European Economic Association, Venice August 2002 for their comments. All errors and omissions remain ours, of course. We thank Erikos Velissaratos for his help in acquiring data on investment in ICT and Colin Webb for providing us with the OECD STAN database. This paper represents the views of the authors and does not necessarily reflect the views of the European Central Bank, the European Commission or their staff.     

Money velocity and asset prices in the euro area

Monetary growth in the euro area has exceeded its target since several years. At the same time, the money demand function seems to be increasingly unstable if more recent data are used. If the link between money balances and the macroeconomy is fragile, the rationale of monetary aggregates in the ECB strategy has to be doubted. In fact, a rise in the income elasticity after 2001 can be observed, and may reflect the exclusion of real and financial wealth in conventional specifications of money demand. This presumption is explored by means of a cointegration analysis. To separate income from wealth effects, the specification in terms of money velocity is preferred. Evidence for the presence of wealth in the long run relationship is provided. In particular, both stock and house prices have exerted a negative impact on velocity after 2001 and lead to almost identical equilibrium errors. The extended error correction model is stable over the entire sample period and survive a battery of specification tests.

Non-linearities in euro area inflation persistence

This paper investigates the nature of inflation dynamics with a special focus on inflation persistence. Using data from euro area member-states we estimate dynamic non-linear panel models addressing in detail econometric issues concerning unobserved heterogeneity, genuine state dependence, and the initial conditions problem. After controlling for observed and unobserved heterogeneity, our results suggest that the degree of inflation persistence is genuine and varies depending on whether the inflation rate is too high, within the range of ECB's target of price stability, too low or negative. This implies that policies to stabilize inflation in the short run will have longer-run effects.     

Externalities, consumption constraints and regular economies

We consider a general model of pure exchange economies with consumption externalities. Households may have different consumption sets and each consumption set is described by a function called the possibility function. Utility and possibility functions depend on the consumptions of all households. Showing by means of an example that basic assumptions are not enough to guarantee generic regularity, we provide sufficient conditions for generic regularity in the space of endowments and possibility functions.     

Exchange rate uncertainty and import prices in the euro area

This paper analyzes the effects of exchange rate uncertainty on the pricing behavior of import firms in the euro area. Uncertainty is measured via the volatility of the structural shocks to the exchange rate in a nonlinear vector‐autoregressive model framework and is an important determinant of import prices. An increase in exchange rate uncertainty is associated with a fall in prices on average, which suggests that the exchange rate risk is borne by the importers. Controlling for the origin of imports (within or outside the euro area) is important for assessing the impact of exchange rate movements on prices.     

Uncertainty and employment dynamics in the euro area and the US

In this paper we investigate the local and foreign effects of uncertainty shocks on unemployment in two large economic regions, the United States (US) and the euro area (EA). We deploy a Bayesian Markov-switching structural vector autoregressive model identified via heteroscedasticity. Two alternative specifications are considered with the shocks of interest being labelled as “US (or EA) demand uncertainty” and “US (or EA) financial market uncertainty”. We reach similar conclusions using both specifications: (i) US shocks have an effect on both the local and foreign labour markets while euro area shocks are much less influential; (ii) the US labour market tends to react and absorb shocks more quickly than the labour market in the euro area does. As economic theory predicts, the reaction to uncertainty shocks points to possible market imperfections that are region specific.     

Differences in exchange rate pass-through in the euro area

This paper focuses on the pass-through of exchange rate changes into the prices of imports made by euro area countries originating outside the area. Using data on import unit values for 13 different product categories for each country, we estimate industry-specific rates of pass-through across and within countries for all euro members. In the short-run, pass-through rates differ across industries and countries and are less than one. In the long-run neither full pass-through nor equality of pass-through rates across industries and countries can be rejected. Differences exist across euro area countries in the degree that a common exchange rate movement gets transmitted into consumer prices and costs of production indices. Most of these differences in transmission rates are due to the distinct degree of openness of each country to non-euro area imports rather than to the heterogeneity in the structure of imports.     

Wealth effects on money demand in the euro area

We investigate the determinants of money demand (M3) in the euro area, considering that this variable remains an important co-determinant of monetary policy making by the European Central Bank. Regressing the real stock of M3 on real GDP, interest rates and wealth variables (real housing and stock prices) within an error-correction framework provides evidence of positive wealth effects on money demand in the long run. Correcting for this wealth effect, money demand in the euro area has grown almost exactly in line with the official reference value of 4 1/2% per annum. This article builds on research that was conducted in preparation of the annual OECD Economic Survey of the euro area and reported in Boone et al. (2004). The authors thank their colleagues in the Economics Department and the European Central Bank and two anonymous referees for their valuable comments. The authors assume full responsibility for any remaining errors and omissions. The opinions expressed in this article do not necessarily represent those of the OECD or its member countries     

Interest rate reaction functions for the euro area

Estimating interest rate reaction functions for the euro area is still hampered by the short time span since the conduct of a single monetary policy. This is why estimates of union-wide reaction functions are usually based on historical pre-EMU data. In this paper we circumvent the common use of aggregated data before 1999 by estimating interest rate reaction functions based on a panel including actual EMU Member States. We find that exploiting the cross-section dimension of a multi-country panel and accounting for cross-country heterogeneity in advance of the single monetary policy improves the ability of historical reaction functions to describe actual interest rate dynamics. We retrieve a panel reaction function which is employed for evaluating interest rate setting since 1999.     

Inflation (mis)perceptions in the euro area

There has been a growing interest on inflation perceptions in the euro area, in particular, following the euro cash changeover. It has been pointed out that a gap emerged between observed and perceived inflation since the introduction of the euro notes and coins. Such a statement relies on the fact that inflation perceptions, measured by the well-known balance statistic from the European Commission’s consumer survey, hiked after January 2002 and remained high thereafter, as opposed to the observed inflation, which has remained fairly stable. In this paper, we discuss the measurement of inflation perceptions, by comparing the balance statistic with a refined alternative measure, which is computed using the probability method. We argue that the balance statistic should be used carefully, as it can lead to misleading conclusions. In fact, we find no evidence, both for euro area and individual countries, of the breakdown in the relationship between observed and perceived inflation, as measured by the proposed alternative measure, at the time of the euro cash changeover.     

Monetary policy and systemic risk-taking in the euro area banking sector

Available empirical evidence on the significance of the (micro) risk-taking channel of monetary policy is not enough to indicate a threat to financial stability. Evidence of risk-taking with systemic risk implications is necessary. Statistical measures that capture systemic risk in all its forms within a structural factor-augmented vector autoregressive model suggest that conventional and unconventional monetary policies have resulted in systemic risk-taking in the euro area banking sector. Systemic risk has taken the form of an increase in the banking sector’s vulnerability via contagion and interconnectedness. Banks’ balance sheets, however, do not account for the full transmission from (micro) risk taking to systemic risk-taking. The main policy implication is that a persistently accommodative monetary policy may drive a monetary authority with a price stability mandate to consider a possible trade-off with financial stability. At a minimum, coordination between monetary and macro-prudential policies requires serious consideration.