Current works and working papers

 

We develop a model of the Financial Stability Fund (Fund), which can be set by a union of sovereign countries. The Fund can improve the countries’ ability to share risks, and borrow and lend, with respect to the standard instrument used to smooth fluctuations: sovereign debt financing. Efficiency gains arise from the ability of the Fund to offer long-term contingent financial contracts, subject to limited enforcement (LE) and moral hazard (MH) constraints.  By contrast, standard sovereign debt contracts are uncontingent and subject to untimely debt roll-overs and default risk. We quantitatively compare the constrained-efficient Fund economy with the incomplete markets economy with default. In particular, we characterize how (implicit) interest rates and asset holdings differ, as well as how both economies react differently to the same productivity and government expenditure shocks. In our economies, calibrated to the euro area ‘stressed countries’, substantial welfare gains are achieved, particularly in times of crisis. Our theory provides a basis for the design of a Fund beyond the current scope of the European Stability Mechanism (ESM), and a theoretical and quantitative framework to assess alternative risk-sharing (shock-absorbing) facilities, as well as, proposals to deal with the euro area ‘debt-overhang problem’. Read more

We extend the envelope theorem, the Euler equation, and the Bellman equation to dynamic optimization problems where binding constraints can give rise to non-differentiable value functions and multiplicity of Lagrange multipliers. The envelope theorem — an extension of Milgrom and Segal’s (2002) theorem — establishes a relation between the Euler and the Bellman equation. We show that solutions and multipliers of the Bellman equation may fail to satisfy the Euler equations of the infinite-horizon problem.  In standard dynamic programming the failure of Euler equations results in inconsistent multipliers, but not in non-optimal outcomes. However, in dynamic optimisation problems with forward-looking constraints (e.g., Marcet and Marimon (2019))  this failure can result in inconsistent promises and non-optimal outcomes. We introduce an envelope selection condition which guarantees that solutions generated from the Bellman equation satisfy the Euler equations with or without forward-looking constraints.  A recursive  method of solving dynamic optimisation problems with non-differentiable value function involves expanding the co-state to account for the envelope selection condition. Read more

 

In an overlapping generations economy with incomplete insurance markets, the introduction of an employment fund – akin to the one introduced in Austria in 2003, also known as ‘Austrian backpack’– can enhance production efficiency and social welfare. It complements the two classical systems of public insurance: pay-as-you-go pensions and unemployment insurance (UI). We show this in a calibrated dynamic general equilibrium model with heterogeneous agents of the Spanish economy (2014). A ‘backpack’ (BP) employment fund is an individual (across jobs) transferable fund, which earns the economy interest rate as a return and is financed with a payroll tax (a BP tax). The worker can use the fund if he or she becomes unemployed or retires. To complement the existing Spanish pension and UI systems with a welfare maximising 19% BP tax would raise welfare by 1.3% of average consumption at the new steady state, and would be preferred to the status quo by most economic and demographic groups. Our model also provides a framework where other reforms – e.g. a partial, or complete, substitution of current unsustainable pension systems – can be quantitatively assessed.Read more

We study the introduction, and possible design, of a European Unemployment Insurance System (EUIS) using a multi-country dynamic general equilibrium model with labour market frictions. Our calibration provides a novel diagnosis of European labour markets, revealing the key parameters – in particular, job-separation and job-arrival rates – that explain their different performance in terms of unemployment (or employment) and its persistence. We show that there are small welfare gains from insuring against country-specific cyclical fluctuations in unemployment expenditures. However, we find that there are substantial gains from reforming currently suboptimal unemployment benefit systems. In spite of country differences, it is possible to unanimously agree on a (minimal) EUIS, which countries can complement by additional national benefits. The EUIS features an unlimited duration of eligibility, which eliminates the risk of not finding a job before the receipt of benefits ends, and a low replacement rate of 10%, which stabilizes incentives to work. Country-specific payroll taxes eliminate cross-country persistent transfers. The resulting tax differences across countries may be the best statistic of their structural labour market differences, in terms of job creation and destruction, providing clear incentives for reform. Read more

 

 

 

In standard dynamic optimisation problems the failure of Euler equations results in inconsistent multipliers, but not in non-optimal outcomes. However, in problems with forward-looking constraints this failure can result in inconsistent promises and non-optimal outcomes. We also show how the inconsistency problem can be resolved by an envelope selection condition and a minimal extension of the co-state. We extend the theory of recursive contracts of Marcet and Marimon (1998, 2017) to the case where the value function is non-differentiable, resolving a problem pointed out in Messner and Pavoni (2004).[/expand]

We develop a theory of self-confirming crises in which lenders charge high interest rates because they wrongly believe that lower rates would further increase their losses. In a directed search economy, this misperception can persist because at the equilibrium there is no evidence that can confute it, preventing the constrained-efficient outcome. A policy maker with the same beliefs as lenders will find it optimal to offer a subsidy contingent on losses to induce low interest rates. As a by-product, this policy generates new information for the market that may disprove misperceptions and make superfluous the implementation of any subsidy. We provide new micro-evidence suggesting that the 2009 TALF intervention in the market of newly generated ABS was an example of the optimal policy in our model. Read more

This eBook provides an overview of the findings and proposals of the Horizon 2020 ADEMU research project (June 2015 to May 2018), which aimed at reassessing the fiscal and monetary framework of the European Economic and Monetary Union in the wake of the euro crisis.

Two core principles of economics are that welfare can be enhanced with stronger commitment to individual arrangements (contracts) and with more competition. However, in the presence of search frictions, commitment may deter entry with consequent reduction in the reallocation of human resources. We study these tradeoffs when there are different degrees of commitment in a model with on-the-job search. Since the degree of commitment depends on the organizational structure of a firm, we contrast the equilibrium of an industry where firms are organized in the form of partnerships with the equilibrium where firms are public companies. We show that in the equilibrium with public companies there is more investment in high return but uncertain activities (risk-taking), higher productivity (value added per employee) and greater income dispersion (inequality). These predictions are consistent with the observed evolution of the financial sector where the switch from partnerships to public companies has been especially important in the decades that preceded the 21st Century financial crisis. Read more