Report

Teaser, summary, work performed and final results

Periodic Reporting for period 2 - MACROPMF (Macroeconomic Dynamics with Product Market Frictions)

Teaser

Aggregate demand has substantially fallen in developed economies during the Great Recession between 2008 and 2010, and has recovered slowly since then. Weak aggregate demand has been suggested as a major cause behind the unusual slow recovery of GDP and employment after the...

Summary

Aggregate demand has substantially fallen in developed economies during the Great Recession between 2008 and 2010, and has recovered slowly since then. Weak aggregate demand has been suggested as a major cause behind the unusual slow recovery of GDP and employment after the recession. Crucially, low levels of interest rates in the current recession have made impossible for policy authorities to stimulate demand through the standard channel, i.e. lowering the interest rate. This inability has created the need to come up with new and unconventional policy instruments to stimulate demand (e.g. quantitative easing by central banks, tax cuts and rebates by fiscal authorities). Several policies, both fiscal and monetary, have been proposed and to some extent implemented, to stimulate household demand. Unfortunately, there is scarce empirical and theoretical guidance on how to engineer these alternative policies so to maximize their effectiveness.

The project aims at addressing this issue by pursuing three main objectives: (1) an empirical analysis of household demand behavior over the business cycle and in response to shocks; (2) a model based study of the implication of household demand behavior for firm pricing; (3) an analysis of the role of frictions in the product markets for the transmission of monetary and fiscal policy.

This project aims to achieve these objectives by studying the determinants of household demand, taking advantage of the recent availability of micro data on household shopping behavior in the U.S. from 2004 to 2014. The aim is to integrate micro- and macro-economics, both theoretically and empirically, to a greater extent than has been done in the past in order to quantify the relevance of product market frictions for firm price setting and the cyclical behavior of demand. The questions we address are: How does aggregate household demand expand in a boom and contract in a recession? Does expansion in demand occur through higher expenditure on the same items or through the household buying more (new) goods? Does contraction in demand occur through lower expenditure on the same items or through the household buying fewer goods? Answering these questions is crucial to understand the transmission of shocks and policy interventions on aggregate demand, and the feedback from demand to firms investment decisions. For instance, if aggregate demand falls in a recession because households experiment fewer new goods then firms might have fewer incentives to innovate and launch new products in a recession, amplifying the effects of the recession on employment. As households do not take into account that their experimenting for new products feedbacks onto firms decisions to innovate, a policy intervention by the government that stimulates household demand may be highly effective on employment.

Moreover, the transmission of microeconomic and macroeconomic shocks to firms’ price and demand in product markets is the cornerstone of a large volume of macroeconomic literature as it determines aggregate inflation. If households\' addition/removal of products from the consumption basket is a key determinant of aggregate demand, then firms have a scope to retain/attract customers when setting their price. Product market frictions, by reducing the ability of demand to relocate across different suppliers, affect firms’ optimal price setting and, therefore, the pass-through of shocks to inflation. Therefore, we study the implications of these product market frictions for price and demand dynamics.

Work performed

\"The PI and his team have been working on an empirical analysis of household search behavior in the product markets (objective 1) in the working paper “Consumption Expenditure Flows”. Implementing this part of the project has required powerful workstations and dedicated RAs to manage and elaborate the large set of micro data on shopping behavior of a representative panel of US households (Nielsen Homescan). Given the ambitious target and big data analysis, this project is still work in progress. We are at the stage where empirical results have been collected, a structural model has been developed and a preliminary draft has been produced. Our results provide novel insights on the dynamics of aggregate demand. We find that a large share of the fall of household consumption in the Great Recession is due to households buying fewer products, in large part driven by households adding fewer new products to their consumption basket than in normal times. We also find that fiscal stimulus, such as the one implemented by the U.S. government through the Economic Stimulus Act of 2008, are very effective at stimulating household expenditure in experimentation for new products. We are now disseminating the results of this analysis to collect feedbacks before sending the paper to a scientific journal. Preliminary results from this analysis have been presented at a workshop co-financed and co-organized in June 2017 (“Macroeconomic Issues After the Crisis”), at the SAM Conference in Bristol in March 2017, at the Bank de France in November 2018. The PI has already been invited to present this paper in the plenary session of the 26th CEPR European Summer Symposium in International Macroeconomics, and plans to further present this work in international high level conferences in the coming months.

The PI and his team have developed a model to study the implication of household search behavior for firm pricing (objective 2) in the working paper “Price Dynamics with Customer Markets”. In such paper, we estimate the price elasticity of the extensive margin of demand and build a micro-founded model to measure the importance of such elasticity for firm pricing. We find that firms pass-through costs shocks incompletely to prices in order to preserve their customer base. During the reporting period we have presented this work at international conferences (CEPR-IO 2016, Barcelona GSE Summer Forum 2016), central banks (Federal Reserve of Chicago) and universities (CEMFI). This paper has been accepted for publication at a leading scientific journal, “The International Economic Review”.

The PI and his team have pursued an analysis of the role of product market frictions for the transmission of monetary policy (objective 3) with the paper “Ambiguous Policy Announcements” where we highlight a novel channel through which monetary policy announcements can affect the economy, namely the interaction between household wealth inequality, heterogeneity in inflation expectations, and nominal price rigidities in product markets. We show that inflation expectations have increased more in wealthier European countries in response to the announcement of Forward Guidance by the ECB in July 2013. We argue that this differential response of inflation expectations across households of different wealth reduces the ability of monetary policy announcements to stimulate household demand and, given price rigidities, output. An important policy implication of this study is that fiscal policy can enhance the effectiveness of monetary policy announcements in stimulating demand by reducing wealth inequality before such announcements. Results from this project have been presented at several international conferences (CEPR-ESSIM 2016, Banking, Monetary Policy, and Macroeconomic Performance - University of Frankfurt, SED 2016 meeting - Toulouse, EABCN 2017 Meeting on \"\"Recent Developments in Monetary Policy Research”, \"\"The New Macroeconomics of A\"

Final results

The project “Price Dynamics with Customer Markets” has already been accepted for publication at the “International Economic Review” and will be published within the next 6 months. The PI expects to publish also the two other projects, “Consumption Expenditure Flows” and “Ambiguous Policy Announcements”, in leading scientific journals.
Further progress will be made on the project “Consumption Expenditure Flows” before submitting it to a journal. In particular, during the next months the results of the project will be illustrated to the scientific community and comments will be collected. Addressing those comments will require further work both on the data analysis and on the economic model.

Moreover, a few more papers are likely to be written as a byproduct of these papers. First, we plan to study the spillovers of households\' experimenting for new products onto firms\' incentive to innovate. Innovation and investment in R&D by firms is at the cornerstone of economic growth. Our study opens new unexplored avenues in the study of the determinants of economic growth. If households experiment less for new products in a recession, then firms have incentives to launch fewer new products in a recession, exacerbating the fall in output and the welfare consequences of the recession. To the extent that households experimentation is inefficiently low in a recession, there is room and scope for policy to stimulate it. We plan to investigate the relevance of this channel for economic growth and policy.

Second, in our study we have found substantial heterogeneity in the response of households\' consumption expenditure to fiscal stimulus. How much of the increase in consumption expenditure translates into an increase in actual consumption by households depends on the response of prices by firms. By using a matched households-firms dataset, we plan to investigate if households whose consumption expenditure is more sensitive to fiscal stimulus are matched to firms whose price is more responsive, so that the effect of the stimulus on actual consumption is mitigated, or are instead matched to firms whose price is less responsive, so that the effect of the stimulus on consumption consumption is amplified. Addressing this question is of great importance for policymakers aimed at designing effective instruments to stimulate household demand.

Website & more info

More info: https://sites.google.com/site/gigipaciello/home/erc.