Research
Publications:
1. Solving the Feldstein-Horioka Puzzle with Financial Frictions, joint with Yan Bai, Econometrica, Vol. 78 (2), March 2010, 603–632.
Unlike the prediction of a frictionless open economy model, long-term average savings and investment rates are highly correlated across countries—a puzzle first identified by Feldstein and Horioka (1980). We quantitatively investigate the impact of two types of financial frictions on this correlation. One is limited enforcement, where contracts are enforced by the threat of default penalties. The other is limited spanning, where the only asset available is noncontingent bonds. We find that the calibrated model with both frictions produces a savings-investment correlation and a volume of capital flows close to the data. To solve the puzzle, the limited enforcement friction needs low default penalties under which capital flows are much lower than those in the data, and the limited spanning friction needs to exogenously restrict capital flows to the observed level. When combined, the two frictions interact to endogenously restrict capital flows and thereby solve the Feldstein–Horioka puzzle.
Technical Appendix
2. Financial Integration and International Risk Sharing, joint with Yan Bai, Journal of International Economics, Vol. 86 (1), January 2012, 17-32.
Conventional wisdom suggests that financial liberalization can help countries insure against idiosyncratic risk. There is little evidence, however, that countries have increased risk sharing despite widespread financial liberalization. We show that the key to understanding this puzzling observation is that conventional wisdom assumes frictionless international financial markets, while actual markets are far from frictionless: financial contracts are incomplete and contract enforceability is limited. When countries remove official capital controls, default risk is still present as an implicit barrier to capital flows. If default risk were eliminated, capital flows would be six times greater, and international risk sharing would increase substantially.
3. Duration of Sovereign Debt Renegotiation, joint with Yan Bai, Journal of International Economics, Vol. 86 (2), March 2012, 252-268.
In the period since 1990, sovereign debt renegotiations take an average of five years for bank loans but only one year for bonds. We provide an explanation for this finding by highlighting one key difference between bank loans and bonds: bank loans are rarely traded, while bonds are heavily traded on the secondary market. In our theory, the secondary market plays a crucial information revelation role in shortening renegotiations. Consider a dynamic bargaining game with incomplete information between a government and creditors. The creditors' reservation value is private information, and the government knows only its distribution. Delays in reaching agreements arise in equilibrium because the government uses costly delays to screen the creditors' reservation value. When the creditors trade on the secondary market, the market price conveys information about their reservation value, which lessens the information friction and reduces the renegotiation duration. We find that the secondary market tends to increase the renegotiation payoff of the government but decrease that of the creditors while increasing the total payoff. We then embed these renegotiation outcomes in a simple sovereign debt model to analyze the ex ante welfare implications. The secondary market has the potential to increase the government ex ante welfare when the information friction is severe.
4. Decentralized Borrowing and Centralized Default, joint with Yun Jung Kim, Journal of International Economics, Vol. 88 (1), Septermber 2012, 121-133.
In the past, foreign borrowing by developing countries was comprised almost entirely of government borrowing. Recently, private firms and individuals in developing countries borrow substantially from foreign lenders. It is often asserted that this surge in private sector borrowing generates overborrowing and leads to sovereign defaults in developing countries. This paper analyzes the impact of decentralized borrowing using a quantitative model in which private agents decide how much to borrow and the government decides whether to default. Relative to a model in which the government decides both borrowing and default, decentralized borrowing drives up aggregate credit costs and sovereign default risk, and reduces aggregate welfare. Private agents do not internalize the effect of their borrowing on economy-wide credit costs and tend to overborrow. Depending on the severity of default penalties, decentralized borrowing may lead to either too much or too little debt in equilibrium.
5. Firm Dynamics and Financial Development, joint with Cristina Arellano and Yan Bai, Journal of Monetary Economics, Vol. 59 (6), October 2012.
This paper studies the impact of cross-country variation in financial market development on firms' financing choices, growth and default using comprehensive firm-level datasets. We document that in less financially developed economies, small firms grow faster and have lower leverage ratios than large firms. As financial development improves, the differences in growth and leverage of small and large firms shrink, especially for entrant firms. We develop a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. We parameterize the model to the firms' financial structure in the data and show that financial restrictions can account for the majority of the difference in growth rates between firms across countries. The model also matches the data in that small and highly leveraged firms are more likely to default in less financially developed economies.
6. Comparative Advantage and the Welfare Impact of European Integration, joint with Andrei A. Levchenko, Economic Policy, Vol. 72, October 2012: 567-602.
This paper investigates the welfare gains from European trade integration, and the role of comparative advantage in determining the magnitude of those gains. We use a multi-sector Ricardian model implemented on 79 countries, and compare welfare in the 2000s to a counterfactual scenario in which Eastern European countries are closed to trade. For Western European countries, the mean welfare gain from trade integration with Eastern Europe is 0.16%, ranging from zero for Portugal to 0.4% for Austria. For East European countries, gains from trade are 9.23% at the mean, ranging from 2.85% for Russia to 20% for Estonia. For Eastern Europe, comparative advantage is a key determinant of the variation in the welfare gains: countries whose comparative advantage is most similar to Western Europe tend to gain less, while countries with technology most different from Western Europe gain the most.
7. The Global Labor Market Impact of Emerging Giants: a Quantitative Assessment, joint with Andrei Levchenko, IMF Economic Review, Vol 61(3), August 2013: 479-519.
This paper investigates both aggregate and distributional impacts of the trade integration of China, India, and Central and Eastern Europe in a quantitative multi-country multi-sector model, comparing outcomes with and without factor market frictions. Under perfect withincountry factor mobility, the gains to the rest of the world from trade integration of emerging giants are 0.37%, ranging from -0.37% for Honduras to 2.28% for Sri Lanka. Reallocation of factors across sectors contributes relatively little to the aggregate gains, but has large distributional e ects. The aggregate gains to the rest of the world are only 0.065 percentage points lower when neither capital nor labor can move across sectors within a country. On the other hand, the distributional e ects of the emerging giants' trade integration are an order of magnitude larger, with changes in real factor returns ranging from -5% to 5% across sectors in most countries. The workers and capital owners in emerging giants' comparative advantage sectors such as Textiles and Wearing Apparel experience greatest losses, while factor owners in Printing and Medical, Precision and Optical Instruments normally gain the most.
8. Structural Change in an Open Economy, joint with Tim Uy and Kei-Mu Yi, Journal of Monetary Economics, Vol 60(6), September 2013: 667-682.
We study the importance of international trade in structural change. Our framework has both productivity and trade cost shocks, and allows for non-unitary income and substitution elasticities. We calibrate our model to investigate South Korea's structural change between 1971 and 2005. We find that the shock processes, propagated through the model's two main transmission mechanisms, non-homothetic preferences and the open economy, explain virtually all of the evolution of agriculture and services labor shares, and the rising part of the hump-shape in manufacturing. Counterfactual exercises show that the role of the open economy is quantitatively important for explaining South Korea's structural change.
9. The Global Welfare Impact of China: Trade Integration and Technological Change, joint with Julian di Giovanni and Andrei A. Levchenko, American Economic Journal: Macroeconomics, Vol 6(3), January 2014:153-183.
This paper evaluates the global welfare impact of China's trade integration and technological change in a quantitative Ricardian-Heckscher-Ohlin model implemented on 75 countries. The model implies that the mean gain from trade with China is 0.13%, with a range from -0.27% to 0.80%. Countries in East Asia tend to gain the most, while many Textile- and Apparel-producing countries experience welfare losses. We then simulate two alternative productivity growth scenarios: a "balanced" one in which China's productivity grows at the same rate in each sector, and an "unbalanced" one in which China's comparative disadvantage sectors catch up disproportionately faster to the world productivity frontier. Contrary to a well-known conjecture by Samuelson (2004), the average country in the world experiences an order of magnitude larger welfare gains when China's growth is unbalanced.
10. Ricardian Productivity Differences and the Gains from Trade, joint with Andrei Levchenko, European Economic Review, Vol 65, January 2014: 45-65.
This paper evaluates the role of sectoral heterogeneity in determining the gains from trade. We first show analytically that in the presence of sectoral Ricardian comparative advantage, a one-sector sufficient statistic formula that uses total trade volumes as a share of total absorption systematically understates the true gains from trade. Greater relative sectoral productivity differences lead to larger disparities between the single- and the multi-sector formulas. Using data on overall and sectoral trade shares in a sample of 79 countries and 19 sectors we show that the multi-sector formula implies on average 30% higher gains from trade than the single-sector formula, and as much as 100% higher gains for some countries. We then set up and estimate a quantitative Ricardian-Heckscher-Ohlin model in which no version of the formula applies exactly, and compare a range of sufficient statistic formulas to the true gains in this model. Confirming the earlier results, formulas that do not take into account sectoral heterogeneity understate the true gains from trade in the model by as much as two-thirds. The most reliable results obtain in a formula that uses information on both sectoral trade shares and input-output linkages in the tradeable sector.
11. The Impact of Foreign Liabilities on Small Firms: Firm-Level Evidence from the Korean Crisis, joint with Yun Jung Kim and Linda L. Tesar, Journal of International Economics, Vol 97(2), November 2015: 209-230.
Using Korean firm-level data on publicly-listed and privately-held firms together with firm exit data, we find strong evidence of the balance-sheet effect for small firms at both the intensive and extensive margins. During the crisis, small firms with more short-term foreign debt are more likely to go bankrupt, and experience larger declines in sales conditional on survival. The extensive margin accounts for a large fraction of small firms’ adjustment during the crisis. Consistent with many studies in the literature, large firms with larger exposure to foreign debt paradoxically have better performance during the crisis at both the intensive and extensive margin.
12. The Evolution of Comparative Advantage: Measurement and Welfare Implications, joint with Andrei A. Levchenko, Journal of Monetary Economics, Vol 78, April 2016: 96-111.
Using novel estimates of sectoral total factor productivities for 72 countries across 5 decades we provide evidence of relative productivity convergence: productivity grew systematically faster in initially relatively less productive sectors. These changes have had a significant impact on trade volumes and patterns, and a non-negligible welfare impact. Had productivity in each country's manufacturing sector relative to the US remained the same as in the 1960s, trade volumes would be higher, cross-country export patterns more dissimilar, and intra-industry trade lower than in the data. Relative sectoral productivity convergence -- holding average growth fixed -- had a modest negative welfare impact.
13. What is a Sustainable Public Debt?, joint with Pablo D'Erasmo and Enrique G. Mendoza, Handbook of Macroeconomics II, January 2016.
14. Portfolio Rebalancing in General Equilibrium, joint with Miles S. Kimball, Matthew D. Shapiro, and Tyler Shumway, Journal of Financial Economics, Vol 135 (3), March 2020: 816-834.
This paper develops an overlapping generations model of optimal rebalancing where agents differ in age and risk tolerance. Equilibrium rebalancing is driven by a leverage effect that influences levered and unlevered agents in opposite directions, an aggregate risk tolerance effect that depends on the distribution of wealth, and an intertemporal hedging effect. After a negative macroeconomic shock, relatively risk-tolerant investors sell risky assets, while more risk-averse investors buy them. Owing to interactions of leverage and changing wealth, however, all agents have higher exposure to aggregate risk after a negative macroeconomic shock and lower exposure after a positive shock.
15. The Relationship between Debt and Output, joint with Yun Jung Kim, IMF Economic Review, 69, February 2021: 230-257.
We empirically investigate the dynamic relationship between debt and output in a panel of 72 countries over the period 1970--2014 using a vector autoregression (VAR). We document two puzzling empirical findings that contrast with what is predicted by a standard small open economy model by Aguiar and Gopinath (2007), where debt and output endogenously respond to total factor productivity (TFP) shocks. First, developing countries' debt falls after a positive output shock, while the model predicts a debt expansion. Second, output declines in developed and developing countries after a debt shock, while the model predicts higher output. The relationship between debt and output depends on the sector taking on debt (households, firms, or governments) and the source of financing (domestic versus external) and differs across countries with varying degrees of economic development or different exchange rate regimes.
17. Trade Integration, Global Value Chains, and Capital Accumulation, joint with Michael Sposi and Kei-Mu Yi, IMF Economic Review, 69, July 2021: 505-539.
Motivated by increasing trade and fragmentation of production across countries, accompanied by income convergence by many emerging economies, we build a dynamic two-country model featuring sequential, multi-stage production and capital accumulation. As trade costs decline over time, global-value-chain (GVC) trade expands across countries, particularly more in the faster growing country, consistent with the empirical pattern. Via Heckscher-Ohlin forces, GVC trade can generate back-and-forth feedback between comparative advantage and capital accumulation (growth). Moreover, GVC trade increases both steady-state and dynamic gains from trade.
18. Structural Change and Global Trade, joint with Logan Lewis, Ryan Monarch, and Michael Sposi, Journal of the European Economic Association, 20 (1), February 2022: 476-512.
Services, which are less traded than goods, rose from 55% of world expenditure in 1970 to 75% in 2015. Using a Ricardian trade model incorporating endogenous structural change, we quantify how this substantial shift in consumption has affected trade. Without structural change, we find that the world trade to GDP ratio would be 13 percentage points higher by 2015, about half the boost delivered from declining trade costs. In addition, a world without structural change would have had about 40% greater welfare gains from the trade integration over the past four decades. Absent further reductions in trade costs, ongoing structural change implies that world trade as a share of GDP would eventually decline. Going forward, higher income countries gain relatively more from reducing services trade costs than from reducing goods trade costs.
19. International Capital Flows: Public versus Private Flows in Developing and Developed Countries, joint with Yun Jung Kim, International Economic Review, 64 (10, February 2023: 225-260.
Empirically, total capital inflows are pro-cyclical in developed countries and counter-cyclical in developing countries. That said, private inflows are pro-cyclical and public inflows are counter-cyclical in both groups of countries. The dominance of private (public) inflows in developed (developing) countries drives the difference in total inflows. We rationalize these patterns using a dynamic stochastic two-sector model of a small open economy facing borrowing constraints. Private agents over-borrow because of the pecuniary externality arising from constraints. The government saves abroad to reduce aggregate debt, making the economy resilient to adverse shocks. Differences in borrowing constraints and shock processes across countries explain the empirical patterns of capital inflows.
20. A Macroeconomic Model of Healthcare Saturation, Inequality and the Output-Pandemia Tradeoff, joint with Enrique G. Mendoza, Eugenio Rojas, and Linda L. Tesar, 2022, IMF Economic Review, forthcoming. (Also available at NBER WP 28247)
COVID-19 became a global health emergency when it threatened the catastrophic collapse of health systems as demand for health goods and services and their relative prices surged. Governments responded with lockdowns and increases in transfers. Empirical evidence shows that lockdowns and healthcare saturation contribute to explain the cross-country variation in GDP drops even after controlling for COVID-19 cases and mortality. We explain this output-pandemia tradeoff as resulting from a shock to subsistence health demand that is larger at higher capital utilization in a model with entrepreneurs and workers. The health system moves closer to saturation as the gap between supply and subsistence narrows, which worsens consumption and income inequality. An externality distorts utilization, because firms do not internalize that lower utilization relaxes healthcare saturation. The optimal policy response includes lockdowns and transfers to workers. Quantitatively, strict lockdowns and large transfer hikes can be optimal and yield sizable welfare gains because they prevent a sharp rise in inequality. Welfare and output costs vary in response to small parameter changes or deviations from optimal policies. Weak lockdowns coupled with weak transfers programs are the worst alternative and yet are in line with what several emerging and least developed countries have implemented.
Papers Submitted or under Revision:
1. Deindustrialization and Industry Polarization, joint with Kei-Mu Yi and Michael Sposi, 2024, resubmitted to Econometrica.
We add to recent evidence on deindustrialization and document a new pattern: increasing industry polarization over time. We assess whether these new features of structural change can be explained by a dynamic open economy model with two primary driving forces, sector-biased productivity growth and sectoral trade integration. We calibrate the model to the same countries used to document our patterns. We find that sector-biased productivity growth is important for deindustrialization by reducing the relative price of manufacturing to services, and sectoral trade integration is important for industry polarization through increased specialization. The interaction of these two driving forces is also essential as increased trade openness transmits global technological change to each country's relative prices, sectoral specialization, and sectoral trade imbalances.
2. What Determines State Heterogeneity in Response to US Tariff Changes, joint with Ana Maria Santacreu and Michael Sposi, 2023, under revision for International Economic Review.
We develop a structural framework to identify the sources of cross-state heterogeneity in response to US tariff changes. We quantify the effects of unilaterally increasing US tariffs by 25 percentage points across sectors. Welfare changes range from -0.8 percent in Oregon to 2.1 percent in Montana. States gain more when their sectoral comparative advantage covaries negatively with that of the aggregate US. Consequently, ``preferred'' changes in tariffs vary systematically across states, indicating the importance of transfers in aligning state preferences over trade policy. Foreign retaliation substantially reduces the gains across states while perpetuating the cross-state variation.
3. Cross-Country Differences in Sectoral Output, Employment, and Income, joint with Michael Sposi, 2023, coming soon.
4. Fiscal Policy Analysis of Sovereign Debt, joint with Tamon Asonuma and Hyungseok Joo, 2024, coming soon.
5. Layoffs, Lemons and Temps, joint with Christopher L. House, February 2022, submitted.
We develop a dynamic equilibrium model of labor demand with adverse selection. Firms learn the quality of newly hired workers after a period of employment. Adverse selection makes it costly to hire new workers and to release productive workers. As a result, firms hoard labor and under-react to labor demand shocks. The adverse selection problem also creates a market for temporary workers. In equilibrium, firms hire a buffer stock of permanent workers and respond to changing business conditions by varying their temp workers. A hiring subsidy or tax can improve welfare by discouraging firms from hoarding too many productive workers.
6. Saving Europe?: The Unpleasant Arithmetic of Fiscal Austerity in Integrated Economies, joint with Linda Tesar and Enrique Mendoza, October 2014, submitted.
This paper studies the impact of tax adjustments to large debt shocks using a two-country Neoclassical model with endogenous capital utilization and a fully-specified tax system. Factor income tax hikes have large adverse effects on macro aggregates and welfare, and trigger strong cross-country externalities. Countries with large debt burdens become relatively less tax efficient and their tax adjustments provide significant gains for their trading partners. Quantitative analysis based on a calibration to European data shows that unilateral increases in capital taxes cannot restore fiscal solvency in the countries with larger debt burdens (GIIPS), because their dynamic Laffer curve peaks below the required revenue increase. Unilateral labor tax hikes can restore solvency, but with negative effects on the GIIPS equilibrium allocations and welfare, and nontrivial improvements in their trading partners (EU10). Strategic incentives are therefore strong, and the Nash solutions to one-shot tax competition games, in which both regions adjust taxes to offset their observed debt shocks, produce a highly distorting race to the bottom in capital taxes. In the absence of a cooperative solution or redistribution of the debt burden (i.e. debt haircuts), the GIIPS region attains higher welfare by moving to autarky.
Working Papers:
1. Leveling the Playing Field: Emerging Markets and Small Lenders, joint with Astghik Mkhitaryan and Zachary Stangebye, 2021, coming soon.
2. Global Input-Output Linkage, joint with Mike Sposi, work in progress.
Other publications:
External Rebalancing, Structural Adjustment,and Real Exchange Rates in Developing Asia, joint with Andrei Levchenko, in B. Ferrarini and D. Hummels (Eds.), Asia and Global Production Networks. Cheltenhan, UK: Edward Elgar. 2014: 215-248.
Real Interest Rates over the Long Run, joint with Kei-Mu Yi, Economic Policy Papers, Federal Reserve Bank of Minneapolis, September 2016, No. 16-10.
Understanding Global Trends in Long-Run Real Interest Rates, joint with Kei-Mu Yi, Economic Perspectives, Federal Reserve Bank of Chicago, 2017 (2).
Recent Developments in the Economics of Structural Change, co-editor with Michael Sposi and Kei-Mu Yi, International Library of Critical Writings in Economics Series, Cheltenham, UK: Edward Elgar Publishers, 2019.
The Dynamic Relationship between Global Debt and Output, joint with Yun Jung Kim, Chicago Fed Letter No 457, May 2021.
The Increasing Importance of Services Expenditures and the Dampening Effect on Global Trade, joint with Logan T. Lewis, Ryan Monarch, and Michael Sposi, Chicago Fed Letter No 456, April 2021.
What Is Driving U.S. Inflation amid a Global Inflation Surge, joint with Bart Hobijn, Russell Miles, and James Royal, Chicago Fed Letter No 470, August 2022.
The Recent Steepening of Phillips Curves, joint with Bart Hobijn, Russell Miles, and James Royal, Chicago Fed Letter No 475, January 2023.
Discussion of A North-South Model of Structural Change and Growth by Aristizabal Ramirez, Leahy, and Tesar, Journal of Monetary Economics, forthcoming.
The Labor Market Impact of COVID-19 on Asian Americans, joint with Chris de Mena and Suvy Qin, Economic Perspective, Federal Reserve Bank of Chicago, 2024 (1).
Book Review:
Emerging Markets: Resilience and Growth amid Global Turmoil, by M. Ayhan Kose and Eswar S. Prasad 2010. Journal of Economic Literature 2011 (December).
Preliminary Projects:
Factor Accumulation, Specialization, and Long Run Growth in China, joint with Kei-Mu Yi and Vivian Yue, coming soon!
Frictions in Chinese Firm Exporting, joint with Heiwai Tang and Xiaodong Zhu, coming soon!
Optimal Monetary Policy under Limited Commitment in Monetary Union, joint with Yan Bai, work in progress.