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Article

Earnings Inequality in Latin America: A Three-Decade Retrospective  

Manuel Fernández and Gabriela Serrano

Latin American countries have some of the highest levels of income inequality in the world. However, earnings inequality have significantly changed over time, increasing during the 1980s and 1990s, declining sharply in the 2000s, and stagnating or even increasing in some countries since 2015. Macroeconomic instability in the region in the 1980s and early 1990s, as well as the introduction of structural reforms like trade, capital, and financial liberalization, affected the patterns of relative demand and relative earnings across skill-demographic groups in the 1990s, increasing inequality. Significant gains in educational attainment, the demographic transition, and rising female labor force participation changed the skill-demographic composition of labor supply, pushing the education and experience premiums downward, but this was not enough to counteract demand-side trends. At the turn of the 21st century, improved external conditions, driven by China’s massive increase in demand for commodities, boosted economies across Latin America, which began to grow rapidly. Growth was accompanied by a positive shift in the relative demand for less-educated workers, stronger labor institutions, rising minimum wages, and declining labor informality, a confluence of factors that reduced earnings inequality. In the aftermath of the global financial crisis, particularly after the end of the commodities price boom in 2014, economic growth decelerated, and the pace of inequality decline stagnated. There is extensive literature documenting and trying to explain the causes of recent earnings inequality dynamics in Latin America. This literature is examined in terms of themes, methodological approaches, and key findings. The focus is on earnings inequality and how developments in labor markets have shaped it.

Article

Foreign Exchange Intervention  

Helen Popper

The practice of central bank foreign exchange intervention for a time ran ahead of either compelling theoretical explanations of its use or persuasive empirical evidence of its effectiveness. Research accelerated when the emerging economy crises of the 1990s and the early 2000s brought fresh data in the form of urgent experimentation with foreign exchange intervention and related policies, and the financial crisis of 2008 propelled serious treatment of financial frictions into models of intervention. Current foreign exchange intervention models combine financial frictions with relevant externalities: with the aggregate demand and pecuniary externalities that inform macroeconomic models more broadly, and with the trade-related learning externalities that are particularly relevant for developing and emerging economies. These models characteristically allow for normative evaluation of the use of foreign exchange intervention, although most (but not all) do so from a single economy perspective. Empirical advances reflect the advantages of more variation in the use of foreign exchange intervention, better data, and novel econometric approaches to addressing endogeneity. Foreign exchange intervention is now widely viewed as influencing exchange rates at least to some extent, and sustained one-sided intervention; and its corresponding reserve accumulation appear to play a role in moderating exchange rate fluctuations and in reducing the likelihood of damaging consequences of financial crises. Key avenues for future research include sorting out which frictions and externalities matter most, and where foreign exchange intervention—and perhaps international cooperation—properly fits (if at all) into the blend of policies that might appropriately address the externalities.

Article

Immigration and International Trade  

Katharina Erhardt and Andrea Lassmann

International trade involves the movement of goods across borders, while immigration pertains to the movement of people across national boundaries. These two phenomena are strongly correlated. To some extent, the similarity between barriers to trade and migration explains this correlation, with distance being a crucial factor in both trade and migration. Geographically closer countries tend to engage in both trade and migration because of closer cultural connections. Immigration is itself also an important determinant of trade flows. Migrant networks play a vital role in reducing trade barriers by improving information sharing and facilitating business connections. This, in turn, leads to an increase in both exports and imports between countries. As trade increasingly relies on efficient firm and supplier matching, particularly within global supply chains, the influence of migrant networks becomes more significant. Finally, immigration also drives demand for goods and services from migrants’ home countries. Migrants often maintain strong ties to their home countries and prefer consuming products and services from those regions. This preference fosters increased bilateral trade flows between the home country and the country of immigration. In summary, international trade and immigration are closely linked, and understanding the interplay between international trade and immigration is crucial for comprehending the dynamics of the global economy.

Article

Macroprudential Policies and Global Finance  

Stijn Claessens, Aaron Mehrotra, and Ilhyock Shim

Macroprudential policy involves using mainly prudential but sometimes also monetary and fiscal tools to reduce systemic risk and achieve financial stability. It is motivated by externalities associated with the buildup of systemic risk over time due to strategic complementarities, fire sales and credit crunches related to a generalized sell-off of assets, and strong cross-institutional interconnectedness. Macroprudential tools apply to both banks and nonbank financial institutions and to different classes of borrowers to the extent that they come with systemic risks. Both advanced economies (AEs) and emerging market economies (EMEs) have steadily increased their use of macroprudential measures since the mid-1990s. Empirical evidence suggests that tighter macroprudential policy has improved banking system resilience and that tools such as lower caps on loan-to-value or debt service ratios have helped reduce housing credit and price growth. Evidence shows that while tightening macroprudential policy is generally effective, relaxing it is less so. By moderating fluctuations in general bank credit, housing/household credit, or house prices, macroprudential policy tends to reduce the severity and likelihood of future crises as well as the volatility of growth, but recent studies also show that it slows output growth. As financial globalization progresses, macroprudential policy may become less effective due to regulatory arbitrage and cross-border leakages, especially in financially more open AEs and EMEs, also given the limited scope for international coordination and the lack of an internationally agreed-upon macroprudential framework. To deal with the associated externally driven risks, many EMEs use foreign exchange (FX)-related macroprudential tools, e.g., FX liability-based reserve requirements, limits on currency mismatch or FX positions, and FX liquidity requirements. In EMEs, FX intervention can also play a macroprudential role. In contrast, AEs rarely use such instruments but use macroprudential capital buffers more actively than EMEs. Recent evidence suggests both positive and negative international spillover effects of these and other macroprudential policies. These and other findings point to the need to build formal models that have a macro-financial stability framework (MFSF) at their core. The framework incorporates the relevant policy tools, their individual effects, and interactions, and captures the channels of financial risk-taking and their implications for global and domestic financial conditions. Such an MFSF includes monetary policy to ensure macroeconomic stability and assist with financial stability, fiscal policy to guarantee fiscal sustainability and limit cyclical economic fluctuations, and macroprudential policy to complement monetary and fiscal policies by strengthening the resilience of the financial system and limiting the buildup of financial imbalances. Research is underway to develop such models, but considerable scope for further work in this area exists.

Article

Trade Liberalization and Informal Labor Markets  

Lourenço S. Paz and Jennifer P. Poole

In recent decades, economic reforms and technological advances have profoundly altered the way employers do business—for instance, the nature of employment relationships, the skills firms demand, and the goods and services they produce and export. In many developing economies, these changes took place concurrently with a substantive rise in work outside of the formal economy. According to International Labour Organization estimates, informal employment can be as high as 88% of total employment in India, almost 50% in Brazil, and around 35% of employment in South Africa. Such informal employment is typically associated with lower wages, lower productivity, poorer working conditions, weaker employment protections, and fewer job benefits and amenities, and these informal workers are often poorer and more vulnerable than their counterparts in the formalized economy. Informal jobs are a consequence of labor market policies—like severance payments or social security contributions—that make the noncompliant informal job cheaper for the employer than a compliant formal job. Each model has a different benefit (or lack of punishment) for employing formal workers, and a distinct mechanism through which international trade shocks alter the benefit-cost of these types of jobs, which in turn results in a change in the informality share. The empirical literature concerning international trade and formality largely points to an unambiguous increase in informal employment in the aftermath of increased import competition. Interestingly, increased access to foreign markets, via liberalization of major trading partners, offers strongly positive implications for formal employment opportunities, decreasing informality. Such effects are moderated by the de facto enforcement of labor regulations. Expansions toward the formal economy and away from informal wage employment in the aftermath of increased access to foreign markets are smaller in strictly enforced areas of the country.

Article

International Trade and Labor Markets  

Greg Wright

China's entry into the World Trade Organization in 2001 rapidly integrated tens of millions of low-skilled workers into the global labor market, establishing a new center for low-wage goods manufacturing and offering a distinct opportunity to test models of international trade. Recent literature has found that the impact of this “China shock” has been uneven across regions within countries. Theoretically, region-specific labor market outcomes emerge only when there are internal barriers to factor mobility within a country, suggesting these barriers were underestimated prior to the extensive empirical research sparked by the China shock. Since workers with limited formal education and those outside the 25-39 age range are considerably less mobile than others, these workers have experienced more negative outcomes due to exposure to import competition in recent decades. Most notably, these workers have suffered the bulk of workforce displacement and attendant social ills resulting from China's rise as a global economic power.

Article

Tariffs and the Macroeconomy  

Xiangtao Meng, Katheryn N. Russ, and Sanjay R. Singh

For hundreds of years, policymakers and academics have puzzled over how to add up the effects of trade and trade barriers on economic activity. The literature is vast. Trade theory generally focuses on the question of whether trade or trade barriers, like tariffs, make people and firms better off using models of the real economy operating at full employment and a net-zero trade balance. They yield powerful fundamental intuition but are not well equipped to address issues such as capital accumulation, the role of exchange rate depreciation, monetary policy, intertemporal optimization by consumers, or current account deficits, which permeate policy debates over tariffs. The literature on open-economy macroeconomics provides additional tools to address some of these issues, but neither literature has yet been able to answer definitively the question of what impact tariffs have on infant industries, current account deficits, unemployment, or inequality, which remain open empirical questions. Trade economists have only begun to understand how multiproduct retailers affect who ultimately pays tariffs and still are struggling to meaningfully model unemployment in a tractable way conducive to fast or uniform application to policy analysis, while macro approaches overlook sectoral complexity. The field’s understanding of the importance of endogenous capital investment is growing, but it has not internalized the importance of the same intertemporal trade-offs between savings and consumption for assessing the distributional impacts of trade on households. Dispersion across assessments of the impacts of the U.S.–China trade war illustrates the frontiers that economists face assessing the macroeconomic impacts of tariffs.

Article

International Trade and the Environment: Three Remaining Empirical Challenges  

Jevan Cherniwchan and M. Scott Taylor

Considerable progress has been made in understanding the relationship between international trade and the environment since Gene Grossman and Alan Krueger published their now seminal working paper examining the potential environmental effects of the North American Free Trade Agreement in 1991. Their work articulated a simple framework through which international trade and economic growth could affect the environment by impacting: the scale of economic activity (the scale effect), the composition of production across industries (the composition effect), or the emission intensity of individual industries (the technique effect). GK provided preliminary evidence of the relative magnitudes of the scale, composition and technique effects, and reached a striking conclusion: international trade would not necessarily harm the environment. Much of the subsequent literature examining the effects of international trade and the environment has adopted Grossman and Krueger’s simple framework and builds directly from their initial foray into the area. We now have better empirical evidence of the relationship between economic growth and environmental quality, of how environmental regulations affect international trade and investment flows, and of the relative magnitudes of the scale, composition and technique effects. Yet, the need for further progress remains along three key fronts. First, despite significant advances in our understanding of how economic growth affects environmental quality, evidence of the interaction between international trade, economic growth, and environmental outcomes remains scarce. Second, while a growing body of evidence suggests that environmental regulations significantly alter trade flows, it is still unclear if these policies have a larger or smaller effect than traditional determinants of comparative advantage. Third, although it is clear the technique effect is the primary driver of changes in pollution, evidence as to how trade has contributed to the technique effect is limited. Addressing these Three Remaining Challenges is necessary for assessing whether Grossman and Krueger’s conclusion that international trade need not necessarily harm the environment still holds today.

Article

Sparse Grids for Dynamic Economic Models  

Johannes Brumm, Christopher Krause, Andreas Schaab, and Simon Scheidegger

Solving dynamic economic models that capture salient real-world heterogeneity and nonlinearity requires the approximation of high-dimensional functions. As their dimensionality increases, compute time and storage requirements grow exponentially. Sparse grids alleviate this curse of dimensionality by substantially reducing the number of interpolation nodes, that is, grid points needed to achieve a desired level of accuracy. The construction principle of sparse grids is to extend univariate interpolation formulae to the multivariate case by choosing linear combinations of tensor products in a way that reduces the number of grid points by orders of magnitude relative to a full tensor-product grid and doing so without substantially increasing interpolation errors. The most popular versions of sparse grids used in economics are (dimension-adaptive) Smolyak sparse grids that use global polynomial basis functions, and (spatially adaptive) sparse grids with local basis functions. The former can economize on the number of interpolation nodes for sufficiently smooth functions, while the latter can also handle non-smooth functions with locally distinct behavior such as kinks. In economics, sparse grids are particularly useful for interpolating the policy and value functions of dynamic models with state spaces between two and several dozen dimensions, depending on the application. In discrete-time models, sparse grid interpolation can be embedded in standard time iteration or value function iteration algorithms. In continuous-time models, sparse grids can be embedded in finite-difference methods for solving partial differential equations like Hamilton-Jacobi-Bellman equations. In both cases, local adaptivity, as well as spatial adaptivity, can add a second layer of sparsity to the fundamental sparse-grid construction. Beyond these salient use-cases in economics, sparse grids can also accelerate other computational tasks that arise in high-dimensional settings, including regression, classification, density estimation, quadrature, and uncertainty quantification.

Article

Trade Shocks and Labor-Market Adjustment  

John McLaren

When international trade increases, either because of a country’s lowering its trade barriers, a trade agreement, or productivity surges in a trade partner, the surge of imports can cause dislocation and lowered incomes for workers in the import-competing industry or the surrounding local economy. Trade economists long used static approaches to analyze these effects on workers, assuming either that workers can adjust instantly and costlessly, or (less often) that they cannot adjust at all. In practice, however, workers incur costs to adjust, and the adjustment takes time. An explosion of research, mostly since about 2008, has explored dynamic worker adjustment through change of industry, change of occupation, change of location, change of labor-force participation, adjustment to change in income, and change in marital status or family structure. Some of these studies estimate rich structural models of worker behavior, allowing for such factors as sector-specific or occupation-specific human capital to accrue over time, which can be imperfectly transferable across industries or occupations. Some allow for unobserved heterogeneity across workers, which creates substantial technical challenges. Some allow for life-cycle effects, where adjustment costs vary with age, and others allow adjustment costs to vary by gender. Others simplify the worker’s problem to embed it in a rich general equilibrium framework. Some key results include: (a) Switching either industry or occupation tends to be very costly; usually more than a year’s average wages on average. (b) Given that moving costs change over time and workers are able to time their moves, realized costs are much lower, but the result is gradual adjustment, with a move to a new steady state that typically takes several years. (c) Idiosyncratic shocks to moving costs are quantitatively important, so that otherwise-identical workers often are seen moving in opposite directions at the same time. These shocks create a large role for option value, so that even if real wages in an industry are permanently lowered by a trade shock, a worker initially in that industry can benefit. This softens or reverses estimates of worker losses from, for example, the China shock. (d) Switching costs vary greatly by occupation, and can be very different for blue-collar and white-collar workers, for young and old workers, and for men and women. (e) Simple theories suggest that a shock results in wage overshooting, where the gap in wages between highly affected industries and others opens up and then shrinks over time, but evidence from Brazil shows that at least in some cases the wage differentials widen over time. (f) Some workers adjust through family changes. Evidence from Denmark shows that some women workers hit by import shocks withdraw from the labor market at least temporarily to marry and have children, unlike men. Promising directions at the frontier include more work on longitudinal data; the role of capital adjustment; savings, risk aversion and the adjustment of trade deficits; responses in educational attainment; and much more exploration of the effects on family.