Economist's View

"Immigration and National Wages: Clarifying the Theory and the Empirics"

Gianmarco I.P. Ottaviano and Giovanni Peri on immigration and wages:

Immigration and National Wages: Clarifying the Theory and the Empirics, Gianmarco I.P. Ottaviano, Giovanni Peri. NBER WP No. 14188,
Issued in July 2008 [open link]: Abstract This paper estimates the effects of immigration on wages of native workers at the national U.S. level. Following Borjas (2003) we focus on national labor markets for workers of different skills and we enrich his methodology and refine previous estimates. We emphasize that a production function framework is needed to combine workers of different skills in order to evaluate the competition as well as cross-skill complementary effects of immigrants on wages. We also emphasize the importance (and estimate the value) of the elasticity of substitution between workers with at most a high school degree and those without one. Since the two groups turn out to be close substitutes, this strongly dilutes the effects of competition between immigrants and workers with no degree. We then estimate the substitutability between natives and immigrants and we find a small but significant degree of imperfect substitution which further decreases the competitive effect of immigrants. Finally, we account for the short run and long run adjustment of capital in response to immigration. Using our estimates and Census data we find that immigration (1990-2006) had small negative effects in the short run on native workers with no high school degree (-0.7%) and on average wages (-0.4%) while it had small positive effects on native workers with no high school degree (+0.3%) and on average native wages (+0.6%) in the long run. These results are perfectly in line with the estimated aggregate elasticities in the labor literature since Katz and Murphy (1992). We also find a wage effect of new immigrants on previous immigrants in the order of negative 6%.

Real-Time Assessment of the Economy

Ben Bernanke gave a speech today at a Boston Fed conference on inflation and the Phillip's curve. Part of the speech discusses the difficulties with real-time policymaking, and those remarks are repeated below. To complement the discussion, I also included an academic paper by S. Boragan Aruoba, Francis X. Diebold, and Chiara Scotti that develops "a framework for high-frequency business conditions assessment" that is an attempt to provide a solution to this problem. The paper is, essentially, a call to action on this problem and it attempts to lead the way by providing the methodology for obtaining real time assessments of economic conditions, and by providing an illustrative example (see the graph below). This is probably geekier than I realize:

Outstanding Issues in the Analysis of Inflation, by Ben S. Bernanke, FRB: ...Forecasting and controlling inflation are, of course, central to the process of making monetary policy. In this respect, policymakers are fortunate to be able to build on an intellectual foundation provided by extensive research and practical experience. Nonetheless, much remains to be learned about both inflation forecasting and inflation control. In the spirit of this conference, my remarks this evening will highlight some key areas where additional research could help to provide a still-firmer foundation for monetary policymaking.

...I will briefly touch on four topics of particular interest for policymakers:  commodity prices and inflation, the role of labor costs in the price-setting process, issues arising from the necessity of making policy in real time, and the determinants and effects of changes in inflation expectations. ...

"Macroeconomic Theory For a World of Imperfect Knowledge"

This paper by Roman Frydman and Michael Goldberg

Macroeconomic Theory For a World of Imperfect Knowledge, by Roman Frydman and Michael D. Goldberg

extends and further explains the arguments in their book, Imperfect Knowledge Economics: Exchange Rates and Risk. More particularly, the paper looks at problems that arise in contemporary macroeconomic models when the causal mechanism that underpins change is fully specified in advance (i.e., when it is assumed that the economy can only change in unforeseeable ways). The approach in the paper is intended to surmount these difficulties, and to show how allowing for unforeseeable events may give economists new insight into areas such how risk fluctuates over time in financial markets.

Here's one small part of the paper:

Modern macroeconomics constructs models of aggregate outcomes on the basis of mathematical representations of individual decision making, with market participants’ forecasting behavior lying at the heart of the interaction between the two levels of analysis. Individuals’ forecasts play a key role in how they make decisions, and markets aggregate those decisions into prices. The causal mechanisms behind both individual decisions and aggregate outcomes, therefore, depend on market participants’ understanding of the economy and how they use this knowledge to forecast the future.

By focusing on the central role of forecasting for understanding the connection between micro and macro outcomes, economists have achieved important insights. For example, building on the path-breaking work of Phelps (1968, 1970), Lucas (1976) sharply criticized econometric policy analysis that, based on Keynesian aggregate models, examined the effects of changes in tax rates, money supply, or other “policy” variables on market outcomes. This analysis presumed that the same structure – the set of causal variables and the parameters that relate them to those variables – would continue to represent adequately the causal mechanism after a change in policy. The main point of the “Lucas critique” was the untenability of that premise. He argued that changes in policy variables would alter the way market participants forecast the future – and hence their decision-making. In general, this change on the individual level would also alter the causal mechanism driving market outcomes.

Lucas offered a seemingly straightforward remedy to this fundamental difficulty. He presumed that the Rational Expectations Hypothesis (REH) would enable economists to model exactly how policy changes would affect market participants’ forecasts and aggregate outcomes. REH postulates that the economist’s aggregate model precisely represents the causal mechanism driving individuals’ forecasts and their revisions. By constraining the predictions on the individual and aggregate levels to be one and the same, REH is thought to offer a “scientific” way to predict both the micro and macro effects of policy changes. In embracing REH-based models, economists have merely replaced Keynesian policy analysis with another mechanistic approach to evaluating the consequences of policy changes.

To be sure, the Lucas critique of Keynesian models does not depend on REH: it requires only that policy changes influence forecasting strategies significantly enough to alter the causal mechanism driving market outcomes. What has been largely overlooked, however, is that Lucas’s critical arguments point to a fundamental difficulty inherent in the entire modern research program in macroeconomics. After all, while policy changes undoubtedly play a role in market participants’ alteration of their forecasting strategies, so do many other factors.2

In fact, even if one were to limit the analysis solely to policy changes, the solution that Lucas proposes is facile: REH supposes that individuals revise their forecasting strategies in mechanical ways that can be precisely specified in advance. However, in capitalist economies, individuals are strongly motivated to search for genuinely new ways to forecast the future and deploy their resources. The social context, including the institutions within which individuals make decisions, also changes in unforeseeable ways. But when the social context or how market participants’ forecast future outcomes changes, so too does the causal mechanism underpinning market outcomes. Thus, change in capitalist economies is to a significant extent non-routine, for it does not follow pre-existing rules and procedures. The premise of IKE is that leaving macroeconomic models open to such change is crucial for understanding outcomes in real-world markets.

[The paper is fairly long, but even if you only make it through the first few pages you'll have a pretty good idea of what the paper is about.]

The Social Effects of Unexpected Income

People who believe consumption is driven, in part, by the consumption of neighbors and friends will like these results [open link]. The source of the data is:

the Dutch Postcode Lottery (PCL). Each week, this lottery allocates a prize to participants in a randomly chosen postcode (containing 19 households on average). About one third of the Dutch population participates in the lottery. A participant wins €12,500 per ticket. In addition, one of the participants wins a BMW. From an experimental design perspective, the lottery provides PCL participants in the winning code with an unexpected temporary income shock equal on average to about eight months of income, while leaving all other households’ incomes unchanged.

How does winning the lottery impact on consumption of neighbors?:

Turning to social effects, we detect statistically significant effects of neighbors’ lottery winnings on car consumption and exterior home renovations. For example, PCL nonparticipants who live in winning codes are more likely to acquire a new car in the six months after the lottery win than nonparticipants living in nonwinning codes. Further, we find that nonwinning households who live next door to PCL winners are significantly more likely to purchase a car in the six months after the lottery than nonwinning households located elsewhere, and that nonwinning households living in postcodes where a large number of households won the PCL are more likely to start a major exterior home renovation in the six months since the lottery than nonwinning households located elsewhere.

"Who Gentrifies Low-Income Neighborhoods?"

This examines the distributional impacts of gentrification. The results may not be what you expect:

Who Gentrifies Low-Income Neighborhoods?, by Terra McKinnish, Randall Walsh, and Kirk White NBER Working Paper No. 14036 May 2008 JEL No. J15,J60,R23 [Open Link]: Abstract This paper uses confidential Census data, specifically the 1990 and 2000 Census Long Form data, to study the demographic processes underlying the gentrification of low-income urban neighborhoods during the 1990's. In contrast to previous studies, the analysis is conducted at the more refined census-tract level with a narrower definition of gentrification and more closely matched comparison neighborhoods. The analysis is also richly disaggregated by demographic characteristic, uncovering differential patterns by race, education, age and family structure that would not have emerged in the more aggregate analysis in previous studies. The results provide no evidence of displacement of low-income non-white households in gentrifying neighborhoods. The bulk of the increase in average family income in gentrifying neighborhoods is attributed to black high school graduates and white college graduates. The disproportionate retention and income gains of the former and the disproportionate in-migration of the latter are distinguishing characteristics of gentrifying U.S. urban neighborhoods in the 1990's.

I. Introduction

"Concern, and anger, over gentrification has grown in communities across the country as housing rental and sales prices have soared .… there are numerous reports of resident displacement from neighborhoods long ignored that now attract higher-income households."¹ -2006 Urban Institute Report

Over the past several decades, there has been substantial gentrification of low-income neighborhoods in many U.S. urban areas. These neighborhoods typically experience large increases in household income and housing prices. Some laud the revitalization of decayed neighborhoods and others criticize the displacement of low-income, often minority, households.

The distribution of benefits from neighborhood change is a crucial policy issue. Since 1974 the U.S. Department of Housing and Urban Development (HUD) has allocated nearly $120 Billion in Community Development Block Grants.² These grants, that are intended to benefit low and moderate-income individuals by eliminating slums or blight and addressing urgent community development needs, have been allocated to more than 1000 U.S. cities. While public investment in neighborhood revitalization is ubiquitous, the consequences of neighborhood gentrification for low-income and minority individuals remain an open question.

Menu Costs and Phillips Curves: The CalvoPlus Model and Intermediate Inputs

Awhile back, I posted a summary of a paper by Golosov and Lucas. The paper is important because it raises questions about the ability of New Keynesian models to explain fluctuations in real output. As I stated at the time:

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

And since we believe nominal shocks matter for real GDP - there is empirical evidence in support of that claim - the fact that nominal shocks (think monetary policy) aren't able to explain much of the movement in output in the class of theoretical macroeconomic models used to assess policy and learn about the economy is a problem.

As a review, here's part of the introduction and conclusion from the Golosov and Lucas paper:

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2 [open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

Under menu costs, any individual price will be constant most of the time and then occasionally jump to a new level. Thus the center of the model will be the firm's pricing decision to reprice or not to do so. Many New Keynesian models do not examine this decision but instead rely on a simplifying assumption proposed by Calvo (1983) that the waiting time between repricing dates is selected at random from an exponential distribution: Firms choose the size of price changes but not their timing.

As many others are, we are skeptical that the Calvo model provides a serviceable approximation to behavior under menu costs.[1] One reason is that the assumption of a constant repricing rate cannot fit the fact that repricing is more frequent in high-inflation environments. But a second, more important, reason was discovered by Caplin and Spulber (1987), who constructed a theoretical example of an economy with menu costs in which only a small fraction of firms reprice yet changes in money growth are neutral. In their example, there is a stationary distribution of firms' relative prices, and as a monetary expansion proceeds, the firms at the low end of this distribution reprice to the high end. The repricing rate is very low—prices are very "sticky"—but no price stickiness can be seen at the aggregate level. The key to the example is that the firms that change price are not selected at random but are rather those firms whose prices are most out of line.

The Caplin and Spulber example is well designed to exhibit this selection effect, but it is unrealistic in too many respects to be implemented quantitatively. In this paper we capture the selection effect in a new model of menu cost pricing, designed so that it can be realistically calibrated...

Our main finding is that even though monetary shocks have almost no impact on the rate at which firms change prices, the shocks' real effects are dramatically less persistent than in an otherwise comparable economy with time-dependent price adjustment. Simulations of the model's responses to a one-time impulse of inflation show small and transient effects on real output and employment..., in contrast to much larger and more persistent responses of the same model with Calvo pricing. ... In the menu cost model, a positive aggregate shock induces the lowest-priced firms to increase prices. At the same time, it offsets negative idiosyncratic shocks, and some firms that would otherwise have decreased prices choose to wait. As a result, the lowest-priced firms do most of the adjusting, their adjustments are large and positive, and the economywide price level increases quickly to reflect the aggregate shock. In the Calvo setting, in contrast, firms get the opportunity to reprice randomly, many firms reprice even though they were already close to their desired price, and the average response of prices to the shock is much smaller. It takes longer for the monetary shock to be reflected in prices, and impulse responses become more persistent. ...

VII.      Conclusions ... In summary, the model we proposed and calibrated to microeconomic evidence on U.S. pricing behavior ... does not appear to be consistent with large real effects of monetary instability. These results seem to us another confirmation of the insight provided by the much simpler example of Caplin and Spulber (1987) that even when most prices remain unchanged from one day to the next, nominal shocks can be nearly neutral...

But not so fast. The paper below develops a multi-sector "CalvoPlus Model" that maintains the mathematical simplicity of the Calvo approach, but allows state dependent pricing. In particular, in the standard Calvo model of price rigidity, firms are allowed to change prices with probability a, and prices remain fixed with probability 1-a (with the parameter a chosen based upon empirical results on the average frequency of price changes). Essentially, with probability a the cost of changing the price in a given period is zero, and with probability 1-a, the cost to change price is infinite. The CalvoPlus model changes this so that with probability a, the cost of changing a price is very low, and with probability 1-a the cost is high, but not infinite (the high-low costs vary across sectors). This introduces an element of state dependency because if a price is far enough away from its optimal value, it may be worthwhile to pay the high cost to change it since the benefit of changing the price would be even larger than the cost. It introduces heterogeneity due to the multi-sector set up (the degree of non-neutrality goes up as the number of sectors is increased, and the model is calibrated so that around 75% of price changes occur in the low cost states).

However, allowing heterogeneity across sectors in the frequency and size of price changes by itself is not enough to allow the model to generate non-neutralities large enough to be consistent with actual fluctuations in real GDP. Thus, the model also adds a second change, the introduction of intermediate inputs. As the authors note, "Intuitively, in the model with intermediate inputs, firms that change their price soon after a shock to nominal aggregate demand choose to adjust less than they otherwise would because the prices of many of their inputs have not yet responded to the shock." In the model, the price of these inputs depends directly upon the price of other goods in the economy (they are "strategic complements"). Because intermediate input prices adjust sluggishly, an increase in aggregate demand of 1%  increases input costs by less than 1%, and prices do not rise by as much as they would if intermediate inputs were not present (i.e. if input costs were completely flexible). This extra price sluggishness results in larger real effects and doubles the degree of non-neutrality in the model (i.e. the output movements attributable to CalvoPlus pricing and to the presence of intermediate inputs are about equal, and total around 25% of the total variation).

Here's part of the introduction to the paper (it's been keeping me occupied today):

Monetary Non-Neutrality in a Multi-Sector Menu Cost Model, by Emi Nakamura and Jon Steinsson, NBER WP 14001, May 2008: [Open Link] 1 Introduction Much applied work in monetary economics relies on models in which nominal rigidities are the key friction that generates monetary non-neutrality. The workhorse models in this literature - e.g., the Calvo (1983) model and the Taylor (1980) model - make the simplifying assumption that the timing of price changes is independent of firms' incentives to change prices. It has been recognized at least since Caplin and Spulber (1987) that models based on this assumption can yield very different conclusions about monetary non-neutrality than models in which nominal rigidities arise due to a fixed cost of changing prices (see...). Golosov and Lucas (2007) calibrate a menu cost model based on newly available micro-data on the frequency and size of price changes and conclude that nominal rigidities due to menu costs yield monetary non-neutrality that is "small and transient".

Given the importance of nominal rigidities as a source of monetary non-neutrality in most models that analyze the transmission of monetary policy, this conclusion poses a serious challenge for monetary economics. If realistically modeled nominal rigidity yields monetary non-neutrality that is small and transient, much of our understanding of the transmission of monetary policy is called into question. It is therefore of great importance for monetary economics to assess whether the implications of highly stylized menu cost models hold up in a richer, more realistic setting. ...

In this paper, we ... extend a simple benchmark menu cost model to include two features for which there exists particularly clear empirical evidence: 1) Heterogeneity across sectors in the frequency and size of price changes; 2) Intermediate inputs. We show that when we subject our model to calibrated nominal shocks it generates fluctuations in real output that can account for 26% of the U.S. business cycle.[1] This result of our model accords well with empirical evidence on the importance of nominal shocks for business cycle fluctuations.

Shapiro and Watson (1988) attribute 28% of the variation in output at short horizons to nominal shocks. In contrast, the Golosov and Lucas model generates fluctuations of real output that can account for only roughly 2% of the U.S. business cycle. Roughly half of the difference in monetary non-neutrality in our model relative to the model of Golosov and Lucas (2007) is due to the introduction of heterogeneity in the frequency of price change; the remaining half is due to the introduction of intermediate inputs. ...

Monetary Policy at the Zero Interest Rate Bound

If Bernanke believes his own research, and if the zero interest rate bound begins to come into play, we should expect to hear lots of discussion from FOMC members about the future course of monetary policy. Here are a few excerpts from papers on the topic of "Monetary Policy Alternatives as the Zero Bound":

Bernanke, Reinhart, and Sack:

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment (2004): Non-technical summary ...[S]uccess over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound on interest rates. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely instead on “non-standard” policy alternatives. ...

In this paper, we apply the tools of modern empirical finance to the recent experiences of the United States and Japan to provide evidence on the potential effectiveness of various nonstandard policies. Following Bernanke and Reinhart (2004), we group these policy alternatives into three classes: (1) using communications policies to shape public expectations about the future course of interest rates; (2) increasing the size of the central bank’s balance sheet, or “quantitative easing”; and (3) changing the composition of the central bank’s balance sheet through, for example, the targeted purchases of long-term bonds as a means of reducing the long-term interest rate. We describe how these policies might work and discuss relevant existing evidence. ...

Our results provide some grounds for optimism about the likely efficacy of nonstandard policies. In particular, we confirm a potentially important role for central bank communications to try to shape public expectations of future policy actions. Like Gürkaynak, Sack, and Swanson (2004), we find that the Federal Reserve’s monetary policy decisions have two distinct effects on asset prices. These factors represent, respectively, (1) the unexpected change in the current setting of the federal funds rate, and (2) the change in market expectations about the trajectory of the funds rate over the next year that is not explained by the current policy action. In the United States, the second factor, in particular, appears strongly linked to Fed policy statements, probably reflecting the importance of communication by the central bank. If central bank “talk” affects policy expectations, then policymakers retain some leverage over long-term yields, even if the current policy rate is at or near zero.

We also find evidence supporting the view that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.

"Highly Predictable Volume Leads to Highly Predictable Returns"

In the paper described below, the "attention-grabbing" hypothesis plays a key role:

A specific story involving irrational or cognitively constrained investors is the "attention-grabbing" hypothesis... According to this hypothesis, individual investors both have limited attention, and rarely sell short. When a stock which they currently do not own grabs their attention, these individual investors are more likely to buy the stock (compared to a stock which does not grab their attention). Institutional investors are less attention constrained....

Do these investors cause an "announcement premium" by rushing to buy stocks that are in the news?:

Stocks Rise Around Earnings Announcements, by Matt Nesvisky. NBER Digest: It has long been observed that when firms announce their quarterly earnings, as they are required to do, considerable price volatility and increases in trading volume are evident. In addition, in the days around earnings announcements, stock prices usually rise. In The Earnings Announcement Premium and Trading Volume..., Owen Lamont and Andrea Frazzini explore why these phenomena occur. ...

In general, of course, stocks tend to rise on high volume and to decline on low volume, but Lamont and Frazzini say that whether this happens because of the interpretation of the announcements or because of irrational or random traders is uncertain. What may well be in play is that certain earnings announcements simply "grab attention," with the result that individual investors are motivated to buy in.

The researchers focus on this "attention-grabbing" hypothesis, because stocks that make news - whether good, bad, or neutral -- have both high volume and high net buying by individuals. Lamont and Frazzini note that arbitrageurs might be expected to eliminate this anomaly, but this would require substantially increased trading activity, which is costly. In addition, the highly idiosyncratic volatility around earnings announcements could deter traders who, for whatever reason, cannot sufficiently diversify. If idiosyncratic risk is somehow preventing arbitrage activity, then in this limited sense the premium may be viewed as a reward for bearing risk. Lamont and Frazzini see evidence that ... arbitrageurs are trading on the anomaly, but simply have not yet eliminated it. Whatever the case, because earnings announcements occur frequently and regularly and generate substantial volume, they provide a good opportunity for testing ... whether predictable volume generates predictable returns. ...

The researchers demonstrate that the strategy of buying every stock expected to announce within the coming month and shorting every stock not expected to announce yields a return of over 60 basis points per month. The announcement premium is thus substantial, particularly among large cap securities, lasts about four weeks, and is evident in samples going back to 1927. At the same time, stocks with the largest predicted volume increases in announcement months ... tend to have higher subsequent premiums. These stocks also tend to have the highest imputed buying around announcement dates by small investors.

Lamont and Frazzini add that the evidence increasingly shows that individual investors seem to make uninformed trading decisions. In line with the attention-grabbing hypothesis, ... small-investor buys ... soar on announcement day. ... One explanation for these phenomena is that some securities attract small attention-constrained investors around earnings announcement dates. Since such investors rarely sell short, the predictable rise in volume boosts prices around announcement dates, thus generating a seasonal component in the stock's expected return.

These results fit with the broader research on the connection between trading activity and prices. Elements such as liquidity, information flow, heterogeneous beliefs, and short sale constraints arguably are all important in understanding this connection. Lamont and Frazzini's findings impose an additional requirement on any theory attempting to connect volume and prices. Any hypothesis, the researchers assert, must now explain why highly predictable volume leads to highly predictable returns. Their ... explanation is uninformed or irrational demand by individual investors, coupled with imperfect arbitrage by informed traders.

Price Rigidity

New Keynesian models rely upon price and wage rigidity to generate movements in macroeconomic variables that match, approximately, movements in actual variables over time. In order to match the movements in actual data, a particular degree of price/wage rigidity must be assumed. Thus, it is important that estimates of the actual degree of price and wage rigidity match the degree of rigidity imposed upon these models.

What does the evidence say about prices? When econometricians look at aggregated prices, they tend to find a great deal of stickiness, enough to justify the degree assumed in the models. However, when disaggregated prices are examined, prices appear to be much more flexible. For example, this is from "Reference Prices and Nominal Rigidities," by Martin Eichenbaum, Nir Jaimovich, and Sergio Rebelo, March 2008:

[T]he recent literature ... uses micro data sets to measure the frequency of price changes. The seminal article by Bils and Klenow (2004) argues that prices are quite flexible. Using monthly CPI data, they find that median duration of prices is 4.3 months. This estimate has became a litmus test for the plausibility of monetary models. In contrast, Nakamura and Steinsson (2007) focus on non-sale prices and argue that these prices are quite inertial. When sales are excluded, prices change on average every 8 to 11 months.

Kehoe and Midrigan (2007) also examine the impact of sales on price inertia. They use an algorithm to define sales prices that they apply to weekly supermarket scanner data. They find that, when sales observations are excluded, prices change once every 4.5 months. When sales are included, prices change every 3 weeks.

So there is quite a bit of variation in the estimates of stickiness derived from disaggregated data, and even more variation when more aggregate prices are examined. As the paper notes, whether or not sales are included in the price data is a key issue for the results from disaggregated data:

Excluding 'sales prices' from the data has a major impact on inference about price inertia. Not surprisingly, there is an ongoing debate in the literature about how to define a sale and whether one should treat 'regular' and 'sales' prices asymmetrically.

The paper makes a contribution to this debate by using the concept of "reference prices":

An advantage of working with 'reference prices' is that we do not need to take a stand on what sales are or whether they are special events that should be disregarded by macroeconomists.

But that is not the only reason to use this concept. They find that although disaggregated prices are quite flexible, they are flexible around an inflexible reference point, and that inflexibility can produce substantial nominal rigidities:

We argue that our evidence is inconsistent with the three most widely used pricing models in macroeconomics: flexible price models, standard menu cost models, and Calvo-style pricing models. There is, however, a simple pricing rule that is consistent with our evidence. This rule can be described as follows. Prices do not generally change unless costs change. For any given good the nominal reference price is on average a particular markup over nominal reference cost. The retailer sets the frequency with which they reset the reference price so as to keep the actual markup within plus/minus twenty percent of the desired markup over reference cost. ... With this rule reference prices can exhibit substantial nominal rigidities even though weekly prices change frequently.

Maybe pictures will help - the variability of the prices and the inflexibility of the reference points are both evident. This is two of the 60,000 prices they examine:

And, finally, the conclusion:

We present evidence that is consistent with the view that nominal rigidities are important. However, these rigidities do not take the form of sticky prices, i.e. prices that remain constant over time. Instead, nominal rigidities take the form of inertia in reference prices and costs. Weekly prices and costs fluctuate around reference values which tend to remain constant over extended periods of time.

Reference prices are particularly inertial and have an average duration of roughly one year. So, nominal rigidities are present in our data, even though prices and cost change very frequently, roughly once every two weeks. We document the relation between prices and costs and argue that our findings pose a challenge to the most commonly pricing models used in macroeconomics.

The challenge is not to the idea that wage and price rigidity cause unintended price dispersion and resource misallocations that bring about short-run variation in the macroeconomy present in the New Keynesian framework. The challenge is to the particular form of price and wage rigidity that has been imposed upon New Keynesian models (e.g. the Calvo rule). The pricing rules have always been a weak part of these models, they are often imposed rather than derived from first principles, so perhaps this will motivate progress on this front.

[One final note. This is part of the debate described in the post on the natural rate of unemployment. If prices are sticky, then shocks can move the economy away from its long-run  optimal (equilibrium) path, and this opens up the possibility for monetary or fiscal policy to intervene and make people better off by redirecting the economy back to its long-run optimum. But if prices are perfectly flexible (or close enough, and there are no other rigidities, including information problems), then all movements are changes in the equilibrium path for the economy rather than deviations from it. In this case there is nothing for policymakers to do since any change in output would take the economy away from its optimal level making people worse rather than better off. However, the results in this paper are consistent with the idea that policy intervention can provide positive benefits.]

The Natural Rate of Unemployment

In the post below this one, Tim Duy talks about what the Fed will do. However, others are more worried about what the Fed ought to do, and Willem Buiter suggests that perhaps a rate increase is needed.

So let me argue against the types of interventionist policies I have been advocating, and present an argument that supports Willem Buiter. One of the keys is his contention that the natural rate of unemployment has been rising:

The natural rate of unemployment in the US is rising: the Fed should consider raising rates, by Willem Buiter: ...The latest labour market figures show a large fall in employment and an even larger fall in labour supply, resulting in an actual decline in the unemployment rate to 4.8%. There is also evidence to support the view that the natural (equilibrium) rate of unemployment in the US is increasing. The combination of a declining actual unemployment rate and a rising natural unemployment rate means that there are now higher domestic inflationary pressures associated with any observed level of employment and unemployment than before. ...

It makes economic sense that the US natural rate of unemployment is increasing, if only because of compositional changes in the labour force that are reducing, on average, its quality and employability. The post-9/11 imposition of additional obstacles to the immigration of skilled labour are one factor reducing labour force flexibility. So is the long-standing decline in the numeracy and literacy standards of the high-school graduates.

At the same time, the need for greater changes in the mix of skills and in the geographical and industrial distribution of employment associated with globalisation and accelerating technological change, have raised the degree of flexibility required to maintain the same amount of labour market pressure. The US is not responding, except defensively by threatening a retreat into protectionism. With mismatch unemployment and frictional unemployment rising, the natural rate of unemployment is rising in the US.

We can look at the evidence for a higher natural rate of unemployment also from the perspective of the path of potential output. Underlying total factor productivity growth in the US appears to be slowing down and with it the trend growth rate of potential output, raising the output gap corresponding to any level of observed output.

The reduction in labour supply is highly unlikely to reflect the so-called discouraged worker effect. ... The recession ... is far too young to have created an increase in discouraged worker disengagement from the labour force.

So with inflation too high and the natural rate of unemployment rising, the Fed should be thinking of hiking rates, not lowering them further.

Whether you believe Buiter's reasoning or not (see below for estimates of the factors that appear to change the natural rate), there is evidence from the academic journals that the natural rate of unemployment is highly variable over time. For example, consider this article by Thomas King and James Morley from the March, 2007 edition of the Journal of Monetary Economics:

In search of the natural rate of unemployment, by Thomas B. King and James Morley, JME, March 2007: ...1. Introduction The natural rate of unemployment is the long-run equilibrium in the labor market, and economists often appeal to it as a proxy for broader macroeconomic equilibrium. A measure of the natural rate is therefore potentially useful... In this paper, we present an estimate of the natural rate...

Our approach to estimating the natural rate [relies]... on the following definition given in Phelps (1994, p. 1):

[The 'natural rate of unemployment' is defined as] the current equilibrium steady-state rate, given the current capital stock and any other state variables. (It is the unemployment rate that, if it were the actual rate at the moment, would make the current rate of change of the associated equilibrium unemployment rate path equal zero.) In [this] theory, then, the equilibrium path of the unemployment rate is driven by a natural rate that is a variable of the system rather than a constant or a forcing function of time. The endogenous natural rate becomes the moving target that the equilibrium path constantly pursues.

Under this definition, which is closely related to Friedman's (1968) idea of the natural rate as the value “ground out by the Walrasian system,” the unemployment rate is determined by a stable dynamic process and, in the absence of exogenous shocks, converges to a unique steady-state equilibrium. Importantly, this equilibrium is itself endogenous, determined by technological, institutional, and demographic factors, and is therefore not necessarily constant over time. ...

We ... estimate the natural rate under Phelps's definition as the time-varying steady state of the unemployment rate. ... In contrast to many previous studies, our results suggest that the natural rate is quite volatile and support the idea that most macroeconomic activity reflects movements in long-run equilibrium, not from equilibrium. Indeed, movements in the natural rate account for over half of the variation in the post-War US unemployment rate. ...

To examine our estimated natural rate further, we consider whether it relates to a number of variables that economic theory suggests may be relevant. Consistent with recent search-based models of equilibrium unemployment, the most important determinants are unemployment benefits, labor productivity, real wages, and sectoral shifts in the labor market, with sectoral shifts having the largest estimated impact. Also, consistent with the short-run Phillips Curve, there is a strong negative relationship between inflation and the corresponding measure of cyclical unemployment.

Here is a picture of their estimate (actual unemployment is the faded line):

Here's the estimated Phillips curve:

And here's the bottom line:

7. Conclusion ...The results ... provide further support to the already large body of literature validating the existence of the short-run Phillips Curve. ... However, the results also clearly suggest that any tradeoff between cyclical unemployment and inflation is an issue of secondary importance when compared to the effects of movements in the natural rate itself. If one views unemployment at the natural rate as evidence of a market-clearing outcome, it must be inferred that shifts in labor-market equilibrium constitute the bulk of the variation in the unemployment rate. Thus, while movements away from the steady state are governed by a strong Phillips Curve relationship, a sizeable proportion of macroeconomic activity is governed by changes in the steady state, even over short horizons. To the extent that achievement of equilibrium in the labor market proxies for broader macroeconomic efficiency, this finding suggests that business cycles primarily reflect market-clearing adjustments to exogenously changing conditions.

With regard to macroeconomic policy, if the goal is to maintain the economy at full employment, the results in this paper yield a frustrating conclusion: the natural rate is a quickly moving target. If the economy responds slowly and uncertainly to monetary shocks, policymakers will have a hard time predicting the effects of policy. In order to do so accurately, one needs not only a model describing the response of economic variables to monetary changes, but also a model describing the behavior of the natural rate over time. From the analysis in this paper, relevant variables for such a model include changes in sectoral composition, unemployment benefits, and, to a lesser extent, productivity growth and real wages. ...

Again, this is not the only view -- there is a lot more evidence on both sides of the issue. From my reading of the evidence, I do not believe that a passive policy response to current conditions is warranted (and, given the current problems in the economy, I certainly don't think an increase in the target rate is needed to bring the real interest rate up to its natural level). The point is that it is possible to make a case for the view that much of the variation we see in the macroeconomy is an equilibrium response - and hence there is no need for policy intervention other than to control inflation - rather than a deviation from the equilibrium path that can be corrected through monetary and fiscal policy.

I hold the New Keynesian view that fluctuations we see are predominantly deviations from the equilibrium path rather than the Real Business Cycle view that fluctuations are mostly changes in equilibrium. Much of the split you hear from analysts - some advocating an aggressive policy response and others taking a hands off let it correct itself perspective - is due to this difference in beliefs about whether fluctuations are variations in equilibrium or deviations from equilibrium.

Why don't we know which it is? The simplest way to think about it is that we have one series, the unemployment rate, and we want to extract two pieces of information from it, trend movements in unemployment and the cycles in unemployment around the trend. However, we can't get two pieces of information from a single series without making identifying assumptions, and the assumptions that are made - all of which are defensible - change the answer that you get in terms of what is trend and what is cycle. There's a little more to it than this, but that's the heart of the problem.

Borjas, Grogger, and Hanson: Immigrant and Native Complementarity

George Borjas, Jeffrey Grogger, and Gordon Hanson have a new paper, and it's not good news for the Ottaviano and Peri result that immigration can cause native wages to increase due to strong complementarities between native and immigrant labor:

Immigrant-Native Complementarity Revisited, by George Borjas: I’ve often been asked what I think about the Ottaviano-Peri finding that there are strong complementarities between comparably skilled immigrants and natives—complementarities that lead them to conclude that immigration raises wages for many natives.

I’ve always been a little skeptical of the Ottaviano-Peri evidence. ... Here’s the abstract to our new paper:

What is Political Economics?

Alberto Alesina describes political economics:

Political Economy, by Alberto F. Alesina, NBER Reporter: The Political Economy Program is new at the NBER, and thus needs an introduction. What is political economics? And, why has the NBER chosen to have a program in it?

The best way to answer is to set back the clock to the mid-1980s. This was a time of great turmoil and transformation in the American economy. President Reagan was in the middle of his "revolution": there were large deficits, taxes were being cut, and the economy was being deregulated. Continental Europe, in contrast, was entering a long period of sclerosis: some countries in Europe (but not all) had accumulated debt that was rising towards wartime levels. The need for structural reforms and liberalization in Europe was evident, but they were delayed. A dozen European countries were heading towards uncharted territories of monetary, and some sort of political, union. Latin America was in the midst of a huge debt crisis and a "lost decade", with very high or even hyperinflations, foreign debt defaults, and large budget deficits. Unavoidable policy reforms were delayed, increasing the economic costs and leading to crisis. The Soviet Bloc was about to collapse; when it did, it opened a Pandora's box of politico-economic questions.

It was increasingly difficult to fit all of these complexities and varieties of experiences into traditional model of economic policy in which benevolent social planners maximize the utility of a representative individual. Some economists started exploring how political forces affected the choice of policies, paying special attention to distributive conflicts and political institutions, which are absent in representative agent models.

Measuring Pure Inflation

Here are Ricardo Reis and Mark Watson who will tell you what they have done and why it matters. This is interesting work:

Relative Goods' Prices and Pure Inflation, by Ricardo Reis and Mark W. Watson, NBER WP 13615, November 2007 [open link]: ABSTRACT This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three components: idiosyncratic relative-price changes, aggregate relative-price changes, and changes in the unit of account. The model identifies a measure of "pure" inflation: the common component in goods' inflation rates that has an equiproportional effect on all prices and is uncorrelated with relative price changes at all dates. The estimates of pure inflation and of the aggregate relative-price components allow us to re-examine three classic macro-correlations. First, we find that pure inflation accounts for 15-20% of the variability in overall inflation, so that most changes in inflation are associated with changes in goods' relative prices. Second, we find that the Phillips correlation between inflation and measures of real activity essentially disappears once we control for goods' relative-price changes. Third, we find that, at business-cycle frequencies, the correlation between inflation and money is close to zero, while the correlation with nominal interest rates is around 0.5, confirming previous findings on the link between monetary policy and inflation.

...

6. What have we done and why does it matter? In this paper, we ... used different estimation techniques and specifications to robustly estimate pure inflation, and proposed a simple method to compute macroeconomic correlations while controlling for goods’ relative price changes.

Our first finding was that pure inflation can differ markedly from other conventional measures of inflation, like the PCE deflator or its core version. It is smoother, less volatile, and in particular in the 1990s, its ups-and-downs are quite different from those in other measures of inflation. This should be useful to economic historians since it provides an alternative account of the movements in inflation in the last half-century. Relative to existing measure of inflation, pure inflation has the virtue of separating absolute from relative-price changes, which is a crucial distinction in economic theory. Moreover, pure inflation matches more closely the concept that many economists seem to have in mind when discussing aggregate movements in prices and monetary policy (typically based on intuition that comes from a one-good world).

Fed Plans to Increase Transparency

The Fed is moving to increase transparency:

Fed Plans Transparency Steps, by Greg Ip, WSJ: Federal Reserve officials are nearing consensus on several steps to make their deliberations more transparent to the public, but are likely to defer one of Chairman Ben Bernanke's longstanding goals: an explicit inflation target.

The centerpiece of their new communications steps would be the release of economic forecasts of policy makers four times a year, instead of the current two times, with additional detail and background... Moreover, the horizon for those forecasts would be extended to three years from two.

The ... Fed had hoped to finalize them by this month. But the fallout of the market turmoil that erupted in August has complicated the agenda of next week's meeting of the policy-making Federal Open Market Committee and it may defer decisions on its communications policy to a later meeting. ...

While the idea of setting an inflation target hasn't been shelved, officials say it needs more discussion. ... For Mr. Bernanke, deferral of an inflation target represents a setback, but he can chalk up a tactical victory for forging a consensus on other steps. ...

At his nomination hearing in 2005, Mr. Bernanke restated his preference for a target while promising "extensive discussion and consultation" and "no precipitate steps." ...

The FOMC as a whole is still not ready to take the step. One concern is that Congress, having taken a more populist turn since Democrats took power in 2006, could perceive a target as subordinating the Fed's responsibility for employment, despite Mr. Bernanke's insistence to the contrary. Another is that officials don't think the current system is broken.

At present, the FOMC meets eight times a year, and at two of its meetings, members submit forecasts for the current and next year on growth, inflation and unemployment that are included in a report to Congress. The "central tendency" of those forecasts -- a range that excludes the extreme projections -- garners the most attention. ...

At present, the post-meeting FOMC statement and the minutes aren't expected to be altered significantly.

A recent paper by Orphanides and Wieland is related to the release of the economic forecasts more often and with more detail. According to this paper from a recent conference at the St. Louis Fed, the "midpoints of the central tendencies" used as "proxies for the modal forecasts of FOMC" are better at explaining policy decisions and deviations from the Taylor rule than data on actual economic conditions. Simply put, if you want to understand the Fed's policy decisions, look at the FOMC forecasts, not the actual data on the economy available at the time:

Economic Projections and Rules-of-Thumb for Monetary Policy, by Athanasios Orphanides and Volker Wieland, October 2007: Abstract Monetary policy analysts often rely on rules-of-thumb, such as the Taylor rule, to describe historical monetary policy decisions and to compare current policy to historical norms. Analysis along these lines also permits evaluation of episodes where policy may have deviated from a simple policy rule... One interesting question is whether such rules-of-thumb should draw on policymaker forecasts of economic conditions or recent outcomes of key variables such as inflation and unemployment. ... We investigate this proposition in the context of FOMC policy decisions over the past 20 years using publicly available FOMC projections from the biannual monetary policy reports to the Congress (Humphrey-Hawkins reports). Our results indicate that FOMC decisions can indeed be predominantly explained in terms of the FOMC's own projections rather than recent economic outcomes. Thus, a forecast-based rule-of-thumb better characterizes FOMC decision-making. We also confirm that many of the apparent deviations of the federal funds rate from an outcome-based Taylor-style rule may be considered systematic responses to information contained in FOMC projections.

John Taylor's Contributions to Monetary Theory and Policy

Papers from the Dallas Fed Conference held to honor of John Taylor's contributions to monetary theory and policy:

Golosov and Lucas: Menu Costs and Phillips Curves

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2
[open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

"Is The 'Surge' Working? Some New Facts"

This NBER paper by MIT's Michael Greenstone reinforces Paul Krugman's message (in the post below this one) that the "smart money" is betting against Iraq's survival. According to this analysis of the Iraqi state bond market, since the Surge began there has been "a 40% increase in the market's expectation that Iraq will default. This finding suggests that to date the Surge is failing to pave the way toward a stable Iraq and may in fact be undermining it." Here's the abstract, introduction, and conclusion the paper:

Is The 'Surge' Working? Some New Facts, by Michael Greenstone, SSRN, September 14, 2007: Abstract There is a paucity of facts about the effects of the recent military Surge on conditions in Iraq and whether it is paving the way for a stable Iraq. Selective, anecdotal and incomplete analyses abound. Policy makers and defense planners must decide which measures of success or failure are most important, but until now few, if any, systematic analyses were available on which to base those decisions. This paper applies modern statistical techniques to a new data file derived from more than a dozen of the most reliable and widely-cited sources to assess the Surge's impact on three key dimensions: the functioning of the Iraqi state (including civilian casualties); military casualties; and financial markets' assessment of Iraq's future. The new and unusually rigorous findings presented here should help inform current evaluations of the Surge and provide a basis for better decision making about future strategy.

The analysis reveals mixed evidence on the Surge's effect on key trends in Iraq. The security situation has improved insofar as civilian fatalities have declined without any concurrent increase in casualties among coalition and Iraqi troops. However, other areas, such as oil production and the number of trained Iraqi Security Forces have shown no improvement or declined. Evaluating such conflicting indicators is challenging.

There is, however, another way to assess the Surge. This paper shows how data from world financial markets can be used to shed light on the central question of whether the Surge has increased or diminished the prospect of today's Iraq surviving into the future. In particular, I examine the price of Iraqi state bonds, which the Iraqi government is currently servicing, on world financial markets. After the Surge, there is a sharp decline in the price of those bonds, relative to alternative bonds. The decline signaled a 40% increase in the market's expectation that Iraq will default. This finding suggests that to date the Surge is failing to pave the way toward a stable Iraq and may in fact be undermining it.

Olivier Blanchard and Jordi Gali: The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?

Why did the economy respond differently to oil price shocks in the 2000s as compared to the 1970s?:

The Macroeconomic Effects of Oil Shocks. Why are the 2000s So Different from the 1970s?, by Olivier J. Blanchard and Jordi Gali, NBER WP 13368, September 2007 [open link]: Abstract We characterize the macroeconomic performance of a set of industrialized economies in the aftermath of the oil price shocks of the 1970s and of the last decade, focusing on the differences across episodes. We examine four different hypotheses for the mild effects on inflation and economic activity of the recent increase in the price of oil: (a) good luck (i.e. lack of concurrent adverse shocks), (b) smaller share of oil in production, (c) more flexible labor markets, and (d) improvements in monetary policy. We conclude that all four have played an important role.

Goldin and Katz: Long-Run Changes in the U.S. Wage Structure: Narrowing, Widening, Polarizing

This paper by Claudia Goldin and Lawrence F. Katz documents the sources of the growing disparity in economic outcomes in recent decades. They find that "the majority of the increase in wage inequality since 1980 has come from rising educational wage differentials, particularly rising returns to post-secondary schooling." But the reason is interesting. They find it's not because of an increase in the growth of demand for skilled workers, i.e. from an increase in demand driven by skill-based technical change. Instead, "the growth of the supply of skills slowed considerably after 1980 and the wage structure, in consequence, widened. The slowdown in the relative supply of skills of the working population came about largely from the slowdown in the growth in the educational attainment of U.S. natives for cohorts born since around 1950."

This is the introduction and (part of) the conclusion to the paper:

Long-Run Changes in the U.S. Wage Structure: Narrowing, Widening, Polarizing, Claudia Goldin and Lawrence F. Katz, September 2007: From the close of World War II to 1970 ... America enjoyed widespread prosperity. Not only did the nation grow rapidly, all parts of the income distribution expanded at fairly similar rates. America was “growing together.” But in the mid-1970s, economic growth slowed. By the early 1980s the wage structure began a period of widening that has lasted until the present day. Even though productivity growth surged again starting in the mid-1990s, the benefits of economic growth have been concentrated at the top end of the distribution.[1] America has been “growing apart.”

Click on figure to enlarge

The “growing together” and “growing apart” patterns are shown in Figure 1, which compares real income growth across the family income distribution for the postwar period before and after 1973. For the pre-1973 period, real income growth was fastest near the bottom of the income distribution and slowest near the top, making the changes modestly equalizing. In sharp contrast, for 1973 to 2005 family incomes virtually stagnated for the lowest quintile but grew more than three times as rapidly for the top 5 percent as for the middle group.

CEO Pay: The Outrage Constraint

Here's more from the paper by Robert Gordon and Ian Dew-Becker, "Unresolved Issues  in the Rise of American Inequality." This section addresses whether the principle agent model of CEO pay is valid, i.e. whether the best interests of boards of directors, CEOs, and shareholders are in alignment and finds "a substantial amount of evidence that the principal-agent setting cannot explain the salient facts about CEO pay." This important because, according to this evidence, the manner in which CEO pay is set is inconsistent with the best interests of shareholders:

6.4 Firm‐Level Models of CEO Pay The Gabaix and Landier model can be thought of as a general equilibrium model of CEO pay. It involves firms that are differentiated only by size and does not consider any sort of bargaining. However, there is an extensive literature that studies exactly how CEO compensation is set, in particular, the interactions between CEOs, boards of directors, and shareholders (see Murphy (1999), for a survey of this literature). The classic principal-agent model treats directors as chosen by shareholders, and then studies the optimal contracts they set up for CEOs. This framework requires that boards have only the shareholders' interests in mind. As we have discussed above, this assumption seems at best implausible.

Bebchuk and Fried (2004) provide a substantial amount of evidence that the principal-agent setting cannot explain the salient facts about CEO pay.[14] They propose an alternative model in which CEOs have control over boards of directors and are mainly restricted by an "outrage constraint" where shareholders retaliate if they perceive executive compensation to be excessive. Weisbach's (2007) review notes a number of especially convincing pieces of evidence that the Bebchuk-Fried model is superior to the principal-agent model. Specifically, they provide evidence that CEO contracts are far from optimal, that CEOs control directors, and that directors put substantial effort into disguising the size of CEO compensation packages. Their proposal obviously has been met with some criticism, notably in the Chicago Law Review with articles by Bebchuk, Fried, Walker (2002), and Murphy (2002).

The key assumption that directors are independent turns out to be highly questionable. To start, their pay is far from negligible-an average of $152,000 per year in the top 200 firms. While directors also usually own stock in the companies they oversee, presumably the amount they stand to gain from good governance is smaller than the salary they would lose if they were not renominated. Moreover, directors receive substantial non-salary benefits in the form of perks, or in business directed to their own firms. Also, as we have noted before, if a CEO is also on the boards of any of his directors, there are ample opportunities for tit-for-tat relationships.

Bebchuk and Fried also provide compelling evidence that CEO contracts are in no sense optimal.

Gordon and Dew-Becker: Unresolved Issues in the Rise of American Inequality

Whenever one discusses inequality and CEO pay, the results from a paper by Gabaix and Landier inevitably come up as rebuttal to the idea that CEO pay is unjustified in the sense of being disconnected from underlying economic fundamentals. Here's a summary of their work from Tyler Cowen (repeats part of this post):

A Contrarian Look at Whether U.S. Chief Executives Are Overpaid, by Tyler Cowen, Economic Scene, NY Times: ...Not surprisingly, many people think ... American executives are overpaid. ...

But in a new paper "Why Has C.E.O. Pay Increased So Much?," the economists Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Stern School of Business at New York University ... suggest that the higher salaries for chief executives can largely be explained by increases in the value of the stock market. Viewed as a whole, these salaries are a result of competitive pressures rather than the exploitation of shareholders.

Their core argument is simple. If we look at recent history, compensation for executives has risen with the market capitalization of the largest companies. For instance, from 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional sixfold matching increase (the correlation coefficients are 0.93 and 0.97, respectively; 1.0 would be a perfect match). ...

[T]he debate over chief executives' salaries has moved a step forward. Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. ...

But a new paper by Robert Gordon and Ian Dew-Becker ("Unresolved Issues  in the Rise of American Inequality") challenges these results:

6.3 The Conflict among Hypotheses ...[I]t is worth considering the simple equilibrium explanation of Gabaix and Landier (2006) that executive pay moves in proportion to market capitalization.

"More Inequality, Less Social Mobility"

There's been discussion of inequality and social mobility lately, e.g. Tyler Cowen says:

Here is the latest, by Emmanuel Saez and co-authors... Here is one key sentence:

...we find that short-term and long-term mobility among all workers has been quite stable since the 1950s.

...In [Saez'] view a constant level of mobility means that no force is offsetting ongoing inequality. ... I believe he would likely read his own paper as support for ... concern with income inequality. He would not read his work as reason to dismiss the mobility issue. My view differs, as I worry about mobility -- can a hard-working person get ahead? -- but I do not worry about inequality per se, nor do I require of mobility that it overturn a particular level of inequality.

There may be a connection between mobility and inequality. Dan Andrews and Andrew Leigh find that countries that are more unequal are also countries where social mobility is lower:

More Inequality, Less Social Mobility by Andrew Leigh: Dan Andrews and I have a short paper out on the relationship between inequality and intergenerational mobility (aka social mobility). By contrast with the view that inequality is offset by more income mobility across generations, it turns out that in more unequal countries it is actually harder to move from rags to riches (or vice-versa). ...

We’re pretty sure that we’re the first to test for a statistically significant relationship between the two variables, but our results do accord with other studies that have shown that there is less intergenerational mobility in the US than in the Scandinavian countries.

Here's the abstract, introduction, and conclusion to the paper:

More Inequality, Less Social Mobility, by Dan Andrews and Andrew Leigh: Abstract We investigate the relationship between inequality and intergenerational mobility. Proxying fathers' earnings with using detailed occupational data, we find that sons who grew up in countries that were more unequal in the 1970s were less likely to have experienced social mobility by the late-1990s.

Glenn Rudebusch and John Williams: Using the Yield Curve to Forecast Recessions

The WSJ Economics blog notes this paper from the San Francisco Fed on the usefulness of the yield curve as an indicator of coming recessions. It may be more useful than we thought:

Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve, by Glenn D. Rudebusch and John C. Williams, July 2007: Abstract We show that professional forecasters have essentially no ability to predict future recessions a few quarters ahead. This is particularly puzzling because, for at least the past two decades, researchers have provided much evidence that the yield curve, specifically the spread between long- and short-term interest rates, does contain useful information at that forecast horizon for predicting aggregate economic activity and, especially, for signalling future recessions. We document this puzzle and suggest that forecasters have generally placed too little weight on yield curve information when projecting declines in the aggregate economy.

Here's more from the introduction:

1. Introduction The word "recession" conjures a variety of fears -- for workers who suffer job losses, for investors who endure asset price declines, for entrepreneurs who risk bankruptcy. Recessions are periods of greater dislocation and anxiety, higher unemployment and suicide rates, and lower output and profits. In the United States, recessions have become less frequent and less severe in the past two decades; however, non-recessionary episodes have also become more stable, so in relative terms, as the market sensitivity in the epigraph suggests, recessions appear to many to be as perilous as before. Therefore, any ability to predict recessions remains highly profitable to investors and very useful to policymakers and other economic agents. Accordingly, there remains a keen and widespread interest in predicting recessions, and our paper examines what economic forecasters know about the likely occurrence of a recession and, most importantly, when do they know it.

David Card on Immigration and U.S. Cities

David Card on "How Immigration Affects U.S. Cities". Here is the abstract, introduction, and conclusion:

How Immigration Affects U.S. Cities, by David Card, June 2007 [via]: Abstract In the past 25 years immigration has re-emerged as a driving force in the size and composition of U.S. cities. This paper describes the effects of immigration on overall population growth and the skill composition of cities, focusing on the connection between immigrant inflows and the relative number of less-skilled workers in the local population. The labor market impacts of immigrant arrivals can be offset by outflows of natives and earlier generations of immigrants. Empirically, however, these offsetting flows are small, so most cities with higher rates of immigration have experienced overall population growth and a rising share of the less-skilled. These supply shifts are associated with a modest widening of the wage gap between more- and less-skilled natives, coupled with a positive effect on average native wages. Beyond the labor market, immigrant arrivals also affect rents and housing prices, government revenues and expenses, and the composition of neighborhoods and schools. The effect on rents is the same magnitude as the effect on average wages, implying that the average “rent burden” (the ratio of rents to incomes) is roughly constant. The local fiscal effects of increased immigration also appear to be relatively small. The neighborhood and school externalities posed by the presence of low-income and minority families may be larger, and may be a key factor in understanding native reactions to immigration.

Introduction The U.S. is once again becoming a country of immigrants. Immigrant arrivals – currently running about 1.25 million people per year – account for 40% of population growth nationally, and a much larger share in some regions.[1] The effects of these inflows are controversial, in part because of their sheer size and in part because of their composition. Something like 35-40% of new arrivals are undocumented immigrants from Mexico and Central America with low education and limited English skills (Passel, 2005). Although another quarter of immigrants – from countries like India and China – are highly skilled, critics of current immigration policy often emphasize the presumed negative effects of lower-skilled people in the overall economy (e.g., Rector, Kim and Watkins, 2007). Moreover, even the most highly skilled immigrants are predominately non-white, contributing to the growing presence of visible minorities in the U.S. population.

Michael Woodford: Globalization and Monetary Control

Another paper from Michael Woodford. In this one, he asks if globalization means that the Fed will lose the ability to influence inflation:

Globalization and Monetary Control, by Michael Woodford, NBER WP 13329, August 2007: Abstract It has recently become popular to argue that globalization has had or will soon have dramatic consequences for the nature of the monetary transmission mechanism, and it is sometimes suggested that this could threaten the ability of national central banks to control inflation within their borders, at least in the absence of coordination of policy with other central banks. In this paper, I consider three possible mechanisms through which it might be feared that globalization can undermine the ability of monetary policy to control inflation... These three fears relate to potential changes in the form of the three structural equations of a basic model of the monetary transmission mechanism: the LM equation, the IS equation, and the AS equation respectively.

What are the three factors that potentially change the IS, LM, and AS curves?

On the one hand, it might be thought that in a globalized world, it is "global liquidity" that should determine world interest rates rather than the supply of liquidity by a single central bank (especially a small one); thus one might fear that a small central bank will no longer have any instrument with which to shift the LM curve. Alternatively, it might be thought that changes in the balance between investment and saving in one country should matter little for the common world level of real interest rates, so that the "IS curve" should become perfectly horizontal even if the LM curve could be shifted. It might then be feared that loss of control over domestic real interest rates would eliminate any leverage of domestic monetary policy over domestic spending or inflation. Or as still another possibility, it might be thought that inflation should cease to depend on economic slack in one country alone (especially a small one), but rather upon "global slack"; in this case the AS curve would become horizontal, implying that even if domestic monetary policy can be effectively used to control domestic aggregate demand, this might not allow any control over domestic inflation.

And he finds that:

I take up each of these possibilities, by discussing the effects of openness (of goods markets, of factor markets, and of financial markets) on each of these three parts of a "new Keynesian" model of the monetary transmission mechanism. I first consider each argument in the context of a canonical open-economy monetary model..., and show that openness need not have any of the kinds of effects that I have just proposed. In each case, I also consider possible variants of the standard model in which the effects of globalization might be more extreme. These cases are not always intended to be regarded as especially realistic, but are taken up in an effort to determine if there are conditions under which the fear of globalization would be justified. Yet I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation.

It is true that, in a globalized economy, foreign developments will be among the sources of economic disturbances to which it will be appropriate for a central bank to respond, in order for it to achieve its stabilization goals. But there is little reason to fear that the capacity of national central banks to stabilize domestic inflation, without having to rely upon coordinated action with other central banks, will be weakened by increasing openness of national economies.

Does Immigration Cause Lower Prices?

According to this paper that is forthcoming in the Journal of Political Economy, "a one percentage point increase in the ratio of immigrants to natives in a city decreases prices by 0.5 percentage points on average":

Study: Immigration can lower prices of consumer products, EurakAlert: An important new study examines how immigration influences the prices of consumer goods. The study, forthcoming in the Journal of Political Economy, challenges the predictions of the perfectly competitive model – that an increase in demand leads to higher prices. Instead, the study finds that immigration can lower the prices of food, clothing, furniture, and appliances and have a significant moderating effect on inflation.

Immigration to Israel from the Former Soviet Union (FSU) increased dramatically in 1990, growing from about 1,500 immigrants a month in October 1989 to about 35,000 a month in December 1990.

Using the large variation in the number of new immigrants across Israeli cities (e.g., some Arab towns reported no new immigrants from the FSU), Saul Lach (Hebrew University of Jerusalem and the Centre for Economic Policy Research), compared the relative size of the FSU immigrant population with monthly, store-level prices for 915 products. These products were sold in more than 1,800 retail stores in 52 Israeli cities during 1990.

Controlling not only for native population size and overall city size, as larger cities may have more competitive markets, but also for