C05: Heterogeneity, financial frictions and macroeconomic stabilization

For a time after the Great Moderation of the 1980s, macroeconomic crises were considered the realm of less-developed or emerging-market economies. No longer. Two decades of severe recessions have put—and continue to put—into sharp relief that also advanced economies require monetary and fiscal policies that aim to stabilize economic activity in the face of shocks. At the same time, our understanding of the effects (and ultimately, effectiveness) of such policies has to account for the fact that the micro- and macroeconomic environment in which these policies operate has changed fundamentally, and will keep changing.

On the household side, missing financial markets turn heterogeneity in income, wealth and portfolios into a first-order issue for macroeconomic stabilization policies. The reason is that such policies have distributional impacts on labor versus capital income, and across different asset classes, such as liquid nominal assets versus illiquid long-term assets (housing, say). Incomplete markets mean that these distributional impacts shape the aggregate effectiveness of the macroeconomic stabilization policies and their welfare properties. We aim to explore the effects of three important changes in the environment for industrialized economies. First, faced with aging societies, the generosity of government-provided retirement benefits has fallen in several economies. This has not only raised the need for private provision for retirement, but also changed households’ exposure to the distributional effects of stabilization policies. In this context, we aim to understand how the aging of society affects the transmission of fiscal stabilization policies. Second, the changing nature of earnings risk and large shifts in the wealth distribution make differences in — and differential responses of — household portfolios over various strata of the population an important aspect to take into account when thinking about business-cycle policies. Our goal is to study how household portfolio decisions and macroeconomic policies affect the long-term growth prospects of the economy through the decisions of individuals to start businesses and their capacity to expand these. Third, the extent of redistribution through the tax and welfare system may also change who wins and who looses from systematic monetary stabilization policies. In particular, countries that join a currency union give up the ability to stabilize employment and incomes through monetary policy. We will study the gains and losses from entering a currency union when considering heterogeneity in households’ portfolios and the redistribution that is implicit in the tax code.

On the firm side, there is substantial heterogeneity in the exposure to recessions. Once more, frictions in financial markets are a key driver of this heterogeneity. Some firms face the threat of default—and particularly so in a downturn—while others will gain business in a recession. Financial frictions on the side of firms can further amplify the effects of business-cycle shocks if the frictions hamper the efficient allocation of resources across firms. In this context, our goal is to study the distributional effects of macroeconomic policy interventions on firm-level investment and employment. We aim to investigate the transmission of stabilization policy when financial constraints, and in particular the presence of long- term debt, shape firm-level investment and employment. In addition, we aim to document and study the distributional labor market effects of stabilization policies. Heterogeneous exposure of firms to recessions means a reallocation of workers across firms. Next to the effect that reallocation has on aggregate productivity, heterogeneous employment responses can be informative about the underlying transmission channels. In addition, heterogeneous firm exposure translates into workers being exposed to firm-specific unemployment risk. Such heterogeneous risk in turn can amplify downturns if disproportionately many of the highly-exposed workers are financially constrained.

Overall, the project aims to spell out the implications that heterogeneity in the exposure of households and firms to the business cycle (through income or wealth) may have for monetary and fiscal stabilization policy. Considering each sector separately as well as their interaction, the project will contribute to a better understanding of the effectiveness of particular stabilization policies and their effects in the cross section of households and firms.