Lien Laureys, Mr. Roland Meeks, and Boromeus Wanengkirtyo
We reconsider the design of welfare-optimal monetary policy when financing frictions impair the supply of bank credit, and when the objectives set for monetary policy must be simple enough to be implementable and allow for effective accountability. We show that a flexible inflation targeting approach that places weight on stabilizing inflation, a measure of resource utilization, and a financial variable produces welfare benefits that are almost indistinguishable from fully-optimal Ramsey policy. The macro-financial trade-off in our estimated model of the euro area turns out to be modest, implying that the effects of financial frictions can be ameliorated at little cost in terms of inflation. A range of different financial objectives and policy preferences lead to similar conclusions.
Luis Franjo, Nathalie Pouokam, and Francesco Turino
In this paper we build a model of occupational choice with informal production and progressive income taxation. We calibrate the model to the Brazilian economy to evaluate the impact of removing financial frictions on informality. We find that financial deepening leads to a drop in the size of the informal sector (from 37 percent to 22 percent of official GDP), to an increase in measured TFP (by 4 percent), to an increase in official GDP (by 27 percent), to a decrease in tax evasion (by 17 percent) and to an increase in fiscal revenues (by 15 percent). When assessing the response of this policy at different levels of financial development, we find a non-linear relationship between the credit-to-GDP ratio on the one hand, and either the size of the informal economy, or GDP per capita on the other hand. We test these features with cross-country data and find evidence in favor of both types of non-linearity. We also investigate changes in the income tax progressitivity as an alternative policy and find it to be more effective in countries with a medium to high level of financial markets development.
Benjamin Carton, Emilio Fernández Corugedo, and Mr. Benjamin L Hunt
This paper uses a multi-region, forward-looking, DSGE model to estimate the macroeconomic impact of a tax reform that replaces a corporate income tax (CIT) with a destination-based cash-flow tax (DBCFT). Two key channels are at play. The first channel is the shift from an income tax to a cash-flow tax. This channel induces the corporate sector to invest more, boosting long-run potential output, GDP and consumption, but crowding out consumption in the short run as households save to build up the capital stock. The second channel is the shift from a taxable base that comprises domestic and foreign revenues, to one where only domestic revenues enter. This leads to an appreciation of the currency to offset the competitiveness boost afforded by the tax and maintain domestic investment-saving equilibrium. The paper demonstrates that spillover effects from the tax reform are positive in the long run as other countries’ exports benefit from additional investment in the country undertaking the reform and other countries’ domestic demand benefits from improved terms of trade. The paper also shows that there are substantial benefits when all countries undertake the reform. Finally, the paper demonstrates that in the presence of financial frictions, corporate debt declines under the tax reform as firms are no longer able to deduct interest expenses from their profits. In this case, the tax shifting results in an increase in the corporate risk premia, a near-term decline in output, and a smaller long-run increase in GDP.
We study the effect of external financing constraint on job creation in emerging markets and
developing countries (EMDC) at the firm level by looking at a specific transmission channel
- the working capital channel. We develop a simple model to illustrate how the need for
working capital financing of a firm affects the link between financial constraint and the firm's
job creation. We show that the effect of relaxing financial constraint on job creation is greater
the smaller the firm scale and the more labor-intensive its production structure. We use the
World Bank Enterprise Surveys data to test the main predictions of the model, and find
strong evidence for the working capital channel of external finance on firm employment.
This paper studies private investment in India against the backdrop of a significant investment
decline over the past decade. We analyze the potential causes of weaker investment at the firm
level, using both firm-level financial statements and a novel dataset on firms’ investment project
decisions, and find that financial frictions have played a role in the slowdown. Firms with higher
financial leverage invest less, as do firms with lower earnings relative to their interest expenses.
Consistent with the notion of credit constraints leading to pro-cyclical investment, we also find
that firms with higher leverage are (i) less likely to undertake new investment projects, (ii) less
likely to complete investment projects once begun, and (iii) undertake shorter-term investment
This paper develops a Dynamic Stochastic General Equilibrium (DSGE) model with a
financial accelerator which captures key features of low-income countries (LICs). The
predominance of supply shocks in LICs poses distinct challenges for policymakers, given the
negative correlation between inflation and the output gap in the case of supply shocks. Our
results suggest that: (1) in the face of a supply-side shock, the most desirable interest rate rule
involves simply targeting current inflation and smoothing the policy interest rate; and (2)
ignoring financial frictions when evaluating policy rules can be particularly problematic in
LICs, where financial frictions loom especially large.
Zineddine Alla, Mr. Raphael A Espinoza, and Mr. Atish R. Ghosh
This paper analyzes the use of unconventional policy instruments in New Keynesian setups in which the ‘divine coincidence’ breaks down. The paper discusses the role of a second instrument and its coordination with conventional interest rate policy, and presents theoretical results on equilibrium determinacy, the inflation bias, the stabilization bias, and the optimal central banker’s preferences when both instruments are available. We show that the use of an unconventional instrument can help reduce the zone of equilibrium indeterminacy and the volatility of the economy. However, in some circumstances, committing not to use the second instrument may be welfare improving (a result akin to Rogoff (1985a) example of counterproductive coordination). We further show that the optimal central banker should be both aggressive against inflation, and interventionist in using the unconventional policy instrument. As long as price setting depends on expectations about the future, there are gains from establishing credibility by using any instrument that affects these expectations.