Essays in Macroeconomics

Abstract

This dissertation consists of three chapters. The first chapter studies the origin of the German labor market "miracle". I develop a search and matching model with multi-worker firms and a two-tier unemployment insurance system to explore the role of the 2005 unemployment insurance reform (the Hartz IV reform) in reducing the cyclical volatility of German employment. Lower long-term unemployment benefits reduce firms' incentives to cut employment during downturns, and render adjustment along the intensive margin relatively more important. Calibrating my model to German pre-reform data, I find that the reform reduced the volatility of employment by 68% and was the main reason behind the mild response of the German labor market to the Great Recession. A short-time work policy, praised as the key to the German "miracle," played a minor role. I also find that the reform raised an average worker's welfare by 1.18%. In the second chapter, written jointly with Aysa Dordzhieva, we study the inertia in sovereign credit ratings. We document that in the run-up to the European debt crisis sovereign credit ratings of Italy, Portugal and Spain displayed a higher degree of inertia. We suggest that the observed inertia in sovereign ratings was the result of the optimal behavior of credit rating agencies, and it might have helped to prevent a severe banking crisis. We build a sovereign default model with a credit rating agency (CRA) that maximizes the accuracy of its credit ratings. CRA receives private information about country's fundamentals and chooses whether to update its rating or not. We assume that a rating downgrade triggers a banking crisis in the near future irrespective of the government's default decision. We show that under certain conditions it is optimal for CRA not to downgrade even if it gets a negative signal and the probability of default goes up. Finally, the third chapter proposes a theory of the direct pass-through of sovereign default risk to firms that can generate the co-movement of sovereign and corporate spreads. I develop a model of sovereign default and bailout in an economy with productivity shocks. A key feature of the model is that the probability that the firm is going to be bailed out is endogenous and non-monotonic in the level of output. The bailout is more likely when the output is high. It is also more likely when the output is low and the government has a strong incentive to borrow: instead of repaying the debt, the government can default and bail out the firm. When the output is in the medium range, the probability of bailout is lower because the government is rich enough not to default but is not rich enough to be able to repay its debt and afford costly bailout. Since the firm internalizes this when it makes its investment decision, it takes more risk by buying more capital when the probability of bailout is higher and hence faces lower bond prices. This non-monotonicity in the firm's capital decision implies that the government and the firm's bond prices move together as long as the level of output is not too high.