Carlos Eugênio da Costa

On the Optimality of the Friedman Rule with Heterogeneous Agents and Nonlinear Income Taxation

We study the optimal inflation tax in an economy with heterogeneous agents subject to nonlinear taxation of labor income. We find that the Friedman rule is Pareto efficient when combined with a nondecreasing labor income tax. In addition, the optimum for a utilitarian social welfare function lies on this region of the Pareto frontier. The welfare costs from inflation are bounded below by the area under the demand curve.

A NOTE ON THE FORWARD AND THE EQUITY PREMIUM PUZZLES: TWO SYMPTOMS OF THE SAME ILLNESS?

We build a stochastic discount factor—SDF— using information on US domestic financial data only, and provide evidence that it accounts for foreign markets stylized facts that escape SDF’s generated by consumption based models. By interpreting our SDF as the projection of the pricing kernel from a fully specified model in the space of returns, our results indicate that a model that accounts for the behavior of domestic assets goes a long way toward accounting for the behavior of foreign assets prices. In our tests, we address predictability, a defining feature of the Forward Premium Puzzle—FPP— by using instruments that are known to forecast excess returns in the moments restrictions associated with Euler equations both in the equity and the foreign markets.

Adverse Selection and Risk Aversion in Capital Markets

We generalize Boadway and Keens model of adverse selection in capital markets to allow for risk aversion on the part of entrepreneurs. We use the new model to analyze two types of policies. We first consider policies that would allow entrepreneurs to use a greater fraction of their total wealth in financing their projects, thus allowing them to reduce reliance on debt or equity finance by outside investors. We show that such policies may not be welfare-improving, because they expose entrepreneurs to more downside risk. This result highlights the importance of allowing for risk aversion, since policies that aim at alleviating inefficiencies associated with adverse selection may increase risk exposure and ultimately reduce welfare. We then consider how the tax treatment of losses affects social welfare. We show that if a society places a high value on distributional equity or if entrepreneurs are sufficiently risk-averse, a full-loss-offset system may be desirable even when there is excessive investment.

Forward-premium puzzle: is it time to abandon the usual regression?

ABSTRACT The forward premium puzzle is usually evidenced by the rejection of the null hypothesis in the uncovered interest parity (UIP) regression. Because this parity need only hold in a risk-neutral world, a risk adjustment term is missing from the equation if speculation in foreign exchange markets is risky. We deal with this issue following the literature which assumes that discounted returns on foreign government bonds are log-normal, so we can linearize the Euler pricing equations (in level) and obtain a modified UIP system for which the risk adjustment term is obtained by applying to the pricing kernel-based relations a generalized autoregressive conditional heteroscedasticity-in-mean model. However, here we innovate by adopting a methodology which differs from all these related works. We construct and use a stochastic discount factor that does not depend on a specific model, by residing in the space of returns which we extract from the data by simply imposing the orthogonality restrictions represented by the Euler equations. So, we devise a purely statistical pricing kernel that performs well in in-sample level equations. Somewhat disappointingly, the risk premium inclusion in the conventional regression changes neither the significance nor the magnitude of the forecasting power of the forward premium for most currencies we study. The contrasting performance of the tests in level and in logs suggests that linearization may be to blame.

Comment on "A Theory of Involuntary Unrequited International Transfers"

Incorporating mutual dislikes between two countries that have been at war is an important move toward understanding postwar behavior. Kemp and Shimomura (2003) have shown that, when this feature is added to a trade model, involuntary unrequited international transfers may have paradoxical effects on each country’s welfare: increasing transfers from the defeated nation to the victor may reduce the welfare of the victor. I show that the conditions required for this paradoxical result also imply that the countries are satiated in equilibrium and social welfare may be increased by a unilateral reduction in own consumption. Thus the results can hold only under conditions in which a country would want to sabotage its own consumption or refuse donations from any other country: a situation that does not seem to characterize any historical event to date. One may easily grasp what lies behind such results through the following simple example. Consider the case of a single good, x, and let the two agents (countries) be indexed by a and b, with preferences that are altruistic toward each other, and represented by the utility aggregators and , where , a a b a b b b b a b a a i U (x , u ) p x d u U (x , u ) p x d u u , b, represents the utility experienced by agent i. Hatred, in this i p a model, amounts to assuming that and are negative. a b d dIncorporating mutual dislikes between two countries that have been at war is an important move toward understanding postwar behavior. Kemp and Shimomura (2003) have shown that, when this feature is added to a trade model, involuntary unrequited international transfers may have paradoxical effects on each country’s welfare: increasing transfers from the defeated nation to the victor may reduce the welfare of the victor. I show that the conditions required for this paradoxical result also imply that the countries are satiated in equilibrium and social welfare may be increased by a unilateral reduction in own consumption. Thus the results can hold only under conditions in which a country would want to sabotage its own consumption or refuse donations from any other country: a situation that does not seem to characterize any historical event to date. One may easily grasp what lies behind such results through the following simple example. Consider the case of a single good, x, and let the two agents (countries) be indexed by a and b, with preferences that are altruistic toward each other, and represented by the utility aggregators and , where , a a b a b b b b a b a a i U (x , u ) p x d u U (x , u ) p x d u u , b, represents the utility experienced by agent i. Hatred, in this i p a model, amounts to assuming that and are negative. a b d d