"Frictions in Financial and Labor Markets": A Summary of the 35th Annual Economic Policy Conference

Manuelli, Rodolfo, Peralta-Alva, Adrian, Federal Reserve Bank of St. Louis Review

This article contains synopses of the papers presented at the 35th Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis held October 21-22, 2010. The conference theme was "Frictions in Financial and Labor Markets." Leading participants in this field presented their research and commentary.

Federal Reserve Bank of St. Louis Review, July/August 2011, 93(4), pp. 273-92.

The Thirty-Fifth Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis was held October 21-22, 2010. The papers presented at the conference covered a variety of approaches and topics within the general theme of frictions in financial and labor markets. One group of papers directly addresses the question of the impact of frictions in financial markets--defined as a departure from the complete market, perfectly competitive Arrow-Debreu equilibrium--on economic performance. In "Quantifying the Impact of Financial Development on Economic Development," Greenwood, Sanchez, and Wang study the impact of increases in the relative (to the rest of the economy) efficiency of financial intermediaries in output and total factor productivity (TFP). For a calibrated version of their model they conclude that financial frictions can account for large changes in output and measured TFP. A somewhat different conclusion is reached by Midrigan and Xu in "Finance and Misallocation: Evidence from Plant-Level Data." In that paper, the authors study a different financial friction--a borrowing limit--and find that when the model must match the observed distribution of the growth rate of the output of individual firms, the contribution of market imperfections to TFP is rather small.

In "Middlemen in Limit-Order Markets," Jovanovic and Menkveld analyze the role of middlemen in asset markets who are assumed to have superior information and, hence, potentially improve the allocation of resources as they can "direct" each asset to its best use. They find that, depending on the distribution of information of potential asset traders, the presence of middlemen can either increase or decrease efficiency. They also confront the model with data that are consistent with the introduction of middlemen but their results are ambiguous. The last paper that most directly discusses the role of financial frictions is "Financial Markets and Unemployment," by Monacelli, Quadrini, and Trigari. They study a situation in which firms and workers bargain for wages but the total surplus--the object to be divided--decreases in relation to the amount of debt carried by the firm. They show that, in response to a positive productivity shock, firms will choose to borrow more since this lowers their current surplus and thus the wage demands of their workers.

A second set of papers looks at the role of search frictions in labor and goods markets. In "Joint-Search Theory: New Opportunities and New Frictions," Guler, Guvenen, and Violante consider the employment-search problem of a couple. They show that, in the absence of a market that permits perfect risk-sharing, location decisions and employment decisions are related and, due to the costs of separation from one's partner, some workers would reject job offers that appear to be above their reservation wage. A similar idea--searching for a price in this case--drives the price dispersion results in "Equilibrium Price Dispersion and Rigidity: A New Monetarist Approach," by Head, Liu, Menzio, and Wright. They show that when individuals differ in their ability to search for the lowest price, (i) the optimal pricing policy of a firm involves periods of price stickiness (when average prices are changing) and (ii) price dispersion may occur in equilibrium even when there is no inflation.

Finally, two papers deal with the effect of frictions on income distribution. In "Intergenerational Redistribution in the Great Recession," Glover, Heathcote, Krueger, and Rios-Rull study how a recession--not unlike the recent one in the United States--influences the welfare of different generations. They show that (i) asset prices will likely fall more than warranted by fundamentals and (ii) this has a negative effect on relatively older households. At the other end of the spectrum, younger households see their labor income drop but are able to purchase some assets (from the older generations) at bargain prices. Their welfare does not decrease as much as that of the older cohorts and, in some cases, it may increase. In "Social Security, Benefit Claiming, and Labor Force Participation: A Quantitative General Equilibrium Approach," Imrohoroglu and Kitao consider the quantitative implications of three alternative Social Security reforms: reductions in benefits, increases in normal retirement age, and increases in the earliest retirement age. They find that these proposals will have long-run positive effects. Even though this is not the focus of their paper, it seems that such changes could hurt current retirees and individuals close to retirement.

Overall, the research at the conference succeeded in focusing attention of academic economists and policymakers alike on the role of frictions in the economy.

INDIVIDUAL CONTRIBUTIONS

In the following sections we briefly describe the essential elements of the individual conference papers. The aim is not to provide a complete description of the environment and results, but rather to convey the major methodological and factual contributions of the research. In some cases, our analysis goes beyond the conference version of the paper and tries to draw inferences relevant for policymakers.

QUANTIFYING THE IMPACT OF FINANCIAL DEVELOPMENT ON ECONOMIC DEVELOPMENT

How do changes in the productivity of the financial intermediary sector affect the level of output? This is the question studied by Greenwood, Sanchez, and Wang. In their model, financial intermediaries exist because they better detect misreporting by firms.

The main theoretical finding is that increases in the efficiency of financial intermediaries (relative to the rest of the economy) increase output through two channels. First, the set of firms that receive funding shrinks and includes more high-productivity firms. Second, the size of the loan that each firm receives--which in all cases falls short of the perfect information level--increases for the most-productive firms and decreases for the least-productive.

Greenwood, Sanchez, and Wang calibrate their model to match the relevant data for the United States and use it to predict the impact on a given country's output level if it adopted Luxembourg's financial system. The basic model does an excellent job matching the cross-country evidence and suggests that large gains are possible with efficiency-increasing developments in the financial intermediary sector.

The Model

The production function of a firm is given by

y = x[theta][k.sup.[alpha][l.sup.1-[alpha]],

where x is an aggregate productivity shock (common to all firms), [theta] (which can take two values [[theta].sub.1] < [[theta].sub.2]) is a firm-specific shock, and k and l are, respectively, capital and labor. The key assumption is that although the type of firm is public knowledge (i.e., the set [tau] = ([[theta].sub.1], [[theta].sub.2]) is known), the particular realization of [theta] is not.

Since firms need to borrow funds to purchase capital, they contract with a financial intermediary. The distinguishing feature of this intermediary is its access to a monitoring technology. Greenwood, Sanchez, and Wang describe the properties of this monitoring technology in terms of the probability of detecting a cheater--a firm that claims to have received a low-productivity draw, [[theta].sub.1], when in fact it enjoys high productivity, [[theta].sub.2]--as a function

[P.sub.ij]([l.sub.mj], k, z),

where [P.sub.ij]([l.sub.mj], k, z) is the probability of detecting fraud when a firm announces that its productivity is [[theta].sub.j] when in fact it is [[theta].sub.i]. This probability increases the number of workers assigned to monitoring, [l.sub.mj], as well as the productivity of the financial sector, z. It decreases with the size of the loan, capturing the idea that larger (and more complex) loans are more difficult to monitor.

Greenwood, Sanchez, and Wang analyze the optimal contract between financial intermediaries and firms. They find that

(i) the set of projects that is financed--that is, the set of [tau] = ([[theta].sub.1], [[theta].sub.2]) that gets loans--shrinks as the relative efficiency of the financial sector increases (i.e., as z/x increases). Moreover, this "shrinkage" is associated with increases in the average efficiency of the funded firms;

(ii) as the efficiency of the financial intermediaries increase, some low-return firms fail to obtain funding, while high-return firms receive larger loans. This increases output and measured TFP; and

(iii) increases in financial intermediary efficiency result in higher wages.

Quantitative Results

Greenwood, Sanchez, and Wang consider alternative measures of intermediation costs (interest rate spreads, the capital-to-output ratio, or overhead costs) and calibrate the model using U.S. data on firm size distribution and output per worker. Then they use the model to ask some counterfactual questions about the United States--a mature economy in which increases in productivity in finance match overall increases in productivity--and Taiwan--a developing country that has experienced a significant increase in the relative productivity of its financial sector. They find that

(i) in the United States, about 30 percent of the growth in output per capita in the 1974-2004 period (from $22,352 to $41,208) can be attributed to productivity improvements in the financial sector, z.

Stated differently, had the level of productivity of financial intermediaries remained at its 1974 level, output per capita would have grown from $22,352 to $33,656. The difference is accounted for by the banking sector; and

(ii) in Taiwan, over the same period about 50 percent of the increase in output was due to improvements in z.

Greenwood, Sanchez, and Wang also use the model to understand the contribution of changes in the efficiency of finance on the cross-sectional distribution of output levels. To this end, they assume that the model holds; in addition, with data on interest rate spreads and output per capita, they estimate, for each country j, the levels of aggregate productivity, [x.sup.j], and financial sector productivity, [z.sup.j], that are consistent with the evidence. Since there is no obvious real-world analog of the parameter z, they regress the value of [z.sup.j] for country j on a measure of financial development (the ratio of private credit to gross domestic product [GDP]) and find that the correlation is high. This suggests that their identification procedure captures actual changes in efficiency.

With a parameterized model for a sample of over 40 countries, they find that the United States has the highest level of productivity outside the financial sector (i.e., the highest level of x J), while Luxembourg has the highest level of financial sector efficiency (highest level of [z.sup.j]). Then they ask …

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Publication information: Article title: "Frictions in Financial and Labor Markets": A Summary of the 35th Annual Economic Policy Conference. Contributors: Manuelli, Rodolfo - Author, Peralta-Alva, Adrian - Author. Journal title: Federal Reserve Bank of St. Louis Review. Volume: 93. Issue: 4 Publication date: July-August 2011. Page number: 273+. © 1998 Federal Reserve Bank of St. Louis. COPYRIGHT 2011 Gale Group.

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