LAURA CASTILLO-MARTÍNEZ
WORKING PAPERS
Sudden Stops, Productivity, and the Exchange Rate
November 2024 [pdf] [online appendix] Reject & Resubmit at American Economic Review
Following a sudden stop, real exchange rates can adjust through a nominal exchange rate depreciation, lower domestic prices, or a combination of both. This paper makes three contributions to understand how the type of adjustment shapes the response of macroeconomic variables, in particular productivity, to such an episode. First, using Spanish micro data during two episodes, it documents that in a currency union unproductive firms exit more than in a floating regime. Second, it proposes a small open economy DSGE model featuring firm selection, variable markups and elastic labor supply to rationalize this finding. The model nests three mechanisms through which a sudden stop affects productivity: a pro-competitive, a cost, and a demand channel. While only the former operates when the nominal exchange rate adjusts, all three are active under a currency union. The model delivers general conditions under which the positive impact of the demand channel on productivity dominates. Third, it validates the model’s aggregate predictions against a wider set of economies. In particular, it shows that the decline in productivity after a sudden stop is increasing in the flexibility of the exchange rate.
Frictionless Inflation with Miguel Bandeira and Shiyuan Wang
October 2024 [pdf] [online appendix]
This paper investigates the relationship between menu costs of price adjustment at the micro level and aggregate inflation dynamics. For that purpose, it introduces a measure of frictionless inflation that estimates counterfactual inflation in the absence of menu costs. The measure is based on a novel smoother for a state-space representation that describes pricing dynamics at the micro level as implied by a random menu cost model. Combining the smoother with rich micro price data underlying the UK CPI, we produce a measure of frictionless inflation for the UK at a monthly frequency from 1997 to 2018. The analysis of that measure yields three main findings: (i) menu costs matter for aggregate inflation dynamics, but their importance decreased over time; (ii) the response of frictionless inflation to a monetary policy shock is at odds with the monetary transmission mechanism from the basic new Keynesian model and (iii) frictionless inflation contains useful information to forecast CPI inflation.
How Do Central Banks Control Inflation? A Guide For the Perplexed with Ricardo Reis
July 2024 [pdf] [online appendix] Revise & Resubmit at Journal of Economic Literature, 3rd round
Central banks have a primary goal of price stability. They pursue it using tools that include the interest they pay on reserves, the size and the composition of their balance sheet, and the dividends they distribute. We describe the economic theories that justify the central bank’s ability to control inflation and discuss their relative effectiveness, in light of both theory and the historical record. We present alternative approaches as consistent with each other, as opposed to conflicting ideological camps. While interest-rate setting is often superior, having both a monetarist pillar and fiscal support is essential, and at times pegging the exchange rate or monetizing the debt is inevitable.
Financial Frictions and Firm Exit with Gideon Bornstein
Awarded NSF Grant (co-PI with Gideon Bornstein)
September 2023 [pdf]
This paper studies the role of financial frictions in firm exit behavior and develops a model to assess the costs of inefficient firm exit. Using European firm-level data, we document a positive relationship between firm-level exit and leverage, controlling for non-financial firm characteristics. We find that this relationship is significantly stronger during recessions. We then construct a firm dynamics model with financial frictions. The model endogenously delivers a stronger relationship between firm exit and leverage during recessions. We show that the correlation between firm exit and a firm's financial condition prior to exit is informative of the degree of financial frictions in the economy. Using a calibrated version of the model, we assess the costs of inefficient firm exit due to financial frictions and study the effectiveness of different government interventions during recessions.
WORK IN PROGRESS
SS for SS: State-Space Methods for Lumpy Economies with Isaac Baley and Miguel Bandeira
This paper introduces a general statistical framework to study aggregate shock propagation in a dynamic (S,s) economy. The proposed framework enables researchers to combine micro and macro data to estimate all the parameters in this economy by maximum likelihood or Bayesian methods, estimate the cross-sectional distributions latent states over time, estimate impulse responses to aggregate shocks of any function of the cross-sectional distribution of lumpy variables given any initial distribution of state gaps and to forecast any function of the cross-sectional distribution of lumpy variables.