Knowledge that Transforms

A large psychology literature argues that, due to selective memory recall, decision-makers’ forecasts of the future are overly influenced by the perceived news. We adopt the diagnostic expectations (DE) paradigm [Bordalo et al. (2018), Journal of Finance, 73, 199–227] to capture this feature of belief formation, develop a method to incorporate DE in business cycle models, and study the implications for aggregate dynamics. First, we address (1) the theoretical challenges associated with modelling the feedback between optimal actions and agents’ DE beliefs and (2) the time-inconsistencies that arise under distant memory (i.e. when news is perceived with respect to a more distant past than just the immediate one). Second, we show that under distant memory the interaction between actions and DE beliefs naturally generates repeated boom–bust cycles in response to a single initial shock. We also propose a portable solution method to study DE in dynamic stochastic general equilibrium models and use it to estimate a quantitative DE New Keynesian model. Both endogenous states and distant memory play a critical role in successfully replicating the boom–bust cycle observed in response to a monetary policy shock.

This paper shows that more highly concentrated labour markets experience more positive employment effects of the minimum wage. In the most concentrated labour markets, employment rises following a minimum wage increase. The paper establishes its main findings by studying the effects of local minimum wage increases on a key low-wage retail sector, and using data on labour market concentration that covers the entirety of the U.S. with fine spatial variation at the occupation level. The results carry over to the fast-food sector and the entire low-wage labour market and are robust to using proxies of labour market concentration available for a broader range of industries, such as the number of establishments and population density. A model of oligopsonistic competition can explain these effects: there is more room to increase wages in high-concentration areas where wages tend to be further below marginal productivity. These findings provide evidence supporting monopsonistic wage setting as an explanation for the near-zero minimum wage employment effect documented in prior work.

Reclassification risk is a major concern in health insurance where contracts are typically 1 year in length but health shocks often persist for much longer. While most health systems with private insurers pair short-run contracts with substantial pricing regulations to reduce reclassification risk, long-term contracts with one-sided insurer commitment have significant potential to reduce reclassification risk without the negative side effects of price regulation, such as adverse selection. We theoretically characterize optimal long-term insurance contracts with one-sided commitment, extending the literature in directions necessary for studying health insurance markets. We leverage this characterization to provide a simple algorithm for computing optimal contracts from primitives. We estimate key market fundamentals using data on all under-65 privately insured consumers in Utah. We find that dynamic contracts are very effective at reducing reclassification risk for consumers who arrive at the market in good health, but they are ineffective for consumers who come to the market in bad health, demonstrating that there is a role for the government insurance of pre-market health risks. Individuals with steeply rising income profiles find front-loading costly, and thus relatively prefer ACA-type exchanges. Switching costs enhance, while myopia moderately compromises, the performance of dynamic contracts.

In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. This article proposes a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we argue that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. We show that issuing debt to purchase reserves during good times allows the government to stabilize aggregate demand when sovereign spreads rise and rolling over the debt becomes more expensive. We provide empirical evidence consistent with the model’s predictions.

With “2020 hindsight,” the 2000s housing cycle is not a boom–bust but a boom–bust–rebound. Using a spatial equilibrium regression in which house prices are determined by income, amenities, urbanization, and supply, we show that long-run city-level fundamentals predict not only 1997–2019 price and rent growth but also the amplitude of the boom–bust–rebound. This evidence motivates our model of a cycle rooted in fundamentals. Households learn about fundamentals by observing “dividends” but become over-optimistic in the boom due to diagnostic expectations. A bust ensues when beliefs start to correct, exacerbated by a price–foreclosure spiral that drives prices below their long-run level. The rebound follows as prices converge to a path commensurate with higher fundamental growth. The estimated model explains the boom–bust–rebound with a single shock and accounts quantitatively for the dynamics of prices, rents, and foreclosures in cities with the largest cycles. We draw implications for asset cycles more generally.

This article studies the incentives for interim voluntary disclosure of verifiable information in probabilistic all-pay contests with two-sided incomplete information. Private information may concern marginal cost, valuations, and ability. Our main result says that, if the contest is uniformly asymmetric, then full revelation is the unique perfect Bayesian equilibrium outcome. This is so because the weakest type of the underdog reveals her type in an attempt to moderate the favourite, while the strongest type of the favourite tries to discourage the underdog—so that the contest unravels. This strong-form disclosure principle is robust with respect to correlation, partitional evidence, randomized disclosures, sequential moves, and continuous type spaces. Moreover, the assumption of uniform asymmetry is not needed when incomplete information is one-sided. However, the principle may break down when type distributions are too similar, contestants possess commitment power, or information is unverifiable. In fact, cheap talk will always be ignored, even if mediated by a trustworthy third party.

This paper studies commodity taxation in a model featuring heterogeneous consumers, imperfect competition, and tax salience. We derive new formulas for the incidence and marginal excess burden of commodity taxation highlighting interactions between tax salience and market structure. We estimate the necessary inputs to the formulas by using Nielsen Retail Scanner and Consumer Panel data covering grocery stores and households in the U.S. and detailed sales tax data. We estimate a large amount of pass-through of taxes onto consumer prices and find that households respond more to changes in prices than taxes. We also estimate significant heterogeneity in tax salience across households. We calibrate our new formulas using these results and conclude that essentially all of the incidence of sales taxes falls on consumers, and the marginal excess burden of taxation is larger than estimates based on standard formulas that ignore imperfect competition and tax salience.

Can taxes on consumption redistribute in developing countries? Contrary to consensus, we show that taxing consumption is progressive once we account for informal consumption. Using household expenditure surveys in 32 countries, we proxy for informal consumption using the type of store where purchases occur. We establish that the budget share spent in informal stores steeply declines with income, so that richer households pay a substantially larger share of their income in taxes. Our findings imply that the widespread policy of exempting food from taxation is hard to justify on equity grounds in low-income countries.

This paper studies a general model of matching with constraints. Observing that a stable matching typically does not exist, we focus on feasible, individually rational, and fair matchings. We characterize such matchings by fixed points of a certain function. Building on this result, we characterize the class of constraints on individual schools under which there exists a student-optimal fair matching, the matching that is the most preferred by every student among those satisfying the three desirable properties. We study the numerical relevance of our theory using data on government-organized daycare allocation.

We study the impact of widespread adoption of work-from-home (WFH) technology using an equilibrium model where people choose where to live, how to allocate their time between working at home and at the office, and how much space to use in production. Motivated by cross-sectional evidence on WFH, we model WFH as a complement to work at the office. Simulations of the model indicate that the pandemic induced a large change to the relative productivity of WFH that substantially increased home prices and will permanently affect incomes, income inequality, and city structure.