Knowledge that Transforms

This article studies the efficient allocation in an economy in which firms are connected through input–output linkages and must pay a fixed cost to produce. When economic conditions are poor, some firms might decide not to operate, thereby severing the links with their neighbours and changing the structure of the production network. Since producers benefit from having access to additional suppliers, nearby firms tend to operate, or not, together. As a result, the production network features clusters of operating firms, and the exit of a producer can create a cascade of firm shutdowns. While well-connected firms are better able to withstand shocks, they trigger larger cascades upon exit. The theory also predicts how the structure of the production network changes over the business cycle. As in the data, recessions are associated with more dispersed networks that feature fewer highly connected firms. In the calibrated economy, the endogenous reorganization of the network substantially dampens the impact of idiosyncratic shocks on aggregate fluctuations.

We propose a novel channel through which rising income inequality affects job creation and macroeconomic outcomes. High-income households save relatively more in stocks and bonds but less in bank deposits. A rising top income share thereby increases the relative financing cost for bank-dependent firms, which in turn create fewer jobs compared to other firms. Exploiting variation in top income shares across US states and an instrumental variable strategy, we provide evidence for this channel. We then build a general equilibrium macroeconomic model with heterogeneous households and heterogeneous firms and calibrate it to our empirical estimates. The model shows that the secular rise in top incomes accounts for 13% of the decline in the employment share of small firms since 1980. Through the new channel, rising inequality also reduces the labour share and aggregate output. Model experiments show that ignoring the link between inequality and job creation understates welfare effects of income redistribution.

A key question in labour market research is how the unemployment insurance system affects unemployment rates and labour market dynamics. We provide new answers to this old question by studying one of the largest unemployment insurance reforms in recent decades, the German Hartz reforms. On average, lower separation rates into unemployment account for 76% of declining unemployment after the reform, a fact unexplained by existing research focussing on job-finding rates. Exploiting institutional changes by age, employment duration, and wages, we establish a causal link between the reform and changes in labour market dynamics. Relying on the labour market theory, we generalize our empirical findings beyond the German case and establish separation rate changes as an important macroeconomic adjustment channel after unemployment insurance reforms. We derive analytically that the change of separation rates increases in proportion to average unemployment duration suggesting an equally important role for most other European labour markets.

Using a dynamic panel approach, we provide empirical evidence that negative health shocks significantly reduce earnings. The effect is primarily driven by the participation margin and is concentrated among the less educated and those in poor health. Next, we develop a life-cycle model of labour supply featuring risky and heterogeneous frailty profiles that affect individuals’ productivity, likelihood of access to social insurance, disutility from work, mortality, and medical expenses. Individuals can either work or not work and apply for social security disability insurance (SSDI/SSI). Eliminating health inequality in our model reduces the variance of log lifetime (accumulated) earnings by 28% at age 55. About 60% of this effect is due to the impact of poor health on the probability of obtaining SSDI/SSI benefits. Despite this, we show that eliminating the SSDI/SSI program reduces ex ante welfare.

We exploit Germany’s temporary three-percentage-point value-added tax (VAT) cut in the second half of 2020 to study the spending response to unconventional fiscal policy. We use survey and scanner data on household consumption expenditures and their perceived pass-through of the tax change into prices, and a HANK model to quantify the effects of this VAT policy. The survey and scanner data show that the temporary VAT reduction led to a relative increase in durable and, to a lesser extent, semi-durable spending for individuals with high perceived pass-through. According to the HANK model, the VAT policy increased total aggregate consumption spending by 4.4% on impact.

Environmental externalities—uncompensated damages imposed on others—lie at the root of climate change, pollution, deforestation and biodiversity loss. Empirical evidence is limited, however, as to how externalities drive private decision making. We study one such behaviour, illegal tropical forest fires, using 15 years of daily satellite data covering over 107,000 fires across Indonesia. Weather-induced variation in fire spread risk and variation in who owns surrounding land allow us to identify how far externalities influence the decision to use fire. Relative to when all spread risks are internalized, we find that firms overuse fire when surrounded by unleased government lands where property rights are weak. In contrast, and consistent with the Coase Theorem, firms treat risks to nearby private concessions similarly to risks to their own land. Government sanctions, concentrated on fires spreading to populated areas, also deter fires, consistent with Pigouvian deterrence.

We investigate optimal monetary and macroprudential policies in an open economy with aggregate demand externalities and an occasionally binding zero lower bound constraint. Our analysis highlights that the optimal policy balances output stabilization and capital flow management. When macroprudential policy is available, monetary policy stabilizes the output gap. By contrast, when macroprudential policy is not available, monetary policy is used prudentially. However, contrary to a widespread view, raising the interest rate is not necessarily the optimal prudential policy. Finally, we show that international spillovers operate through the world real rate, but macroprudential policies provide insulation from the adverse effects of foreign policies.

How do movements in the distributions of bank size and income affect the macroeconomy? To answer this question, we develop a dynamic general equilibrium model with heterogeneous financial intermediaries, incomplete markets, and aggregate uncertainty. We find that market incompleteness and uninsured idiosyncratic bank rate of return risk generate minimal concentration in the bank net worth distribution, leading to an “as-if” result, whereby the economy behaves as if it had a representative bank. However, introducing ex ante heterogeneity in the banks’ rates of return significantly raises concentration and amplifies real and financial fluctuations relative to the representative-bank case, as this increases a key sufficient statistic, the average marginal propensity to lend. We then extend the model with two empirically validated features of the banking sector—countercyclical return risk and deposit market power—and show that these amplify and dampen aggregate fluctuations, respectively. Finally, because in the model with ex ante heterogeneity the distribution of bank size is highly concentrated, shocks to the largest banks can account for almost all of the aggregate variation that is due to idiosyncratic risk, leading to granular banking and economic cycles. The failure of granular banks (“too big to fail”) produces sizeable macroeconomic crises.

We develop a satisficing model of choice in which the available alternatives differ in their inherent complexity. We assume—and experimentally validate—that complexity leads to errors in the perception of alternatives’ values. The model yields sharp predictions about the effect of complexity on choice probabilities, some of which qualitatively contrast with those of maximization-based choice models. We confirm the predictions of the satisficing model—and thus reject maximization—in a novel data set with information on hundreds of millions of real-world chess moves by highly experienced players. Looking beyond chess, our work offers a blueprint for incorporating complexity at the level of individual objects into models of choice and for detecting satisficing outside of the laboratory.

Firms are allowed to use aggregate data on market salaries to set pay, a practice known as salary benchmarking. Using national payroll data, we study firms that gain access to a tool that reveals market benchmarks for each job title. Using a difference-in-differences design, we find that the benchmark information reduces salary dispersion by 25%. Thus, salary dispersion must stem partly from aggregate uncertainty about the salaries offered by other firms. Our model formalizes how salary dispersion can arise even in competitive labour markets for identical workers when such uncertainty exists, and we discuss implications for an ongoing policy debate.