Zheng Liu

Senior Research Advisor and Director

Center for Pacific Basin Studies

Macro, Money, Chinese Economy

Zheng.Liu (at) sf.frb.org

CV (pdf, 54.48 kb)

Working Papers

A Theory of Housing Demand Shocks

2019-09 | With Wang and Zha | March 2019

abstract (+)

Aggregate housing demand shocks are an important source of house price fluctuations in the standard macroeconomic models, and through the collateral channel, they drive macroeconomic fluctuations. These reduced-form shocks, however, fail to generate a highly volatile price-to-rent ratio that comoves with the house price observed in the data (the “price-rent puzzle”). We build a tractable heterogeneous-agent model that provides a microeconomic foundation for housing demand shocks. The model predicts that a credit supply shock can generate large comovements between the house price and the price-to-rent ratio. We provide empirical evidence from cross-country and cross-MSA data to support this theoretical prediction.

Optimal Capital Account Liberalization in China

2018-10 | With Spiegel and Zhang | May 2019

abstract (+)

China maintains tight controls over its capital account. Its current policy regime also features financial repression, under which banks are required to extend funds to state-owned enterprises (SOEs) at favorable terms, despite their lower productivity than private firms. We incorporate these features into a general equilibrium model. We find that capital account liberalization under financial repression incurs a tradeoff between aggregate productivity and inter-temporal allocative efficiency. Along a transition path with a declining SOE share, welfare-maximizing policy calls for rapid removal of financial repression, but gradual liberalization of the capital account.

Interest-Rate Liberalization and Capital Misallocations

2017-15 | With Wang and Xu | July 2017

abstract (+)

We study the consequences of interest-rate liberalization in a two-sector general equilibrium model of China. The model captures a key feature of China’s distorted financial system: state-owned enterprises (SOEs) have greater incentive to expand production and easier access to credit than private firms. In this second-best environment, liberalizing interest rate controls improves capital allocations within each sector, but exacerbates misallocations across sectors. Under calibrated parameters, interest-rate liberalization may reduce aggregate productivity and welfare, unless other policy reforms are also implemented to alleviate SOEs’ distorted incentives or improve private firms’ credit access.

Published Articles (Refereed Journals and Volumes)

The Weak Job Recovery in a Macro Model of Search and Recruiting Intensity

Forthcoming in American Economic Journal: Macroeconomics | With Leduc

abstract (+)

We show that cyclical fluctuations in search intensity and recruiting intensity are quantitatively important for explaining the weak job recovery from the Great Recession. We demonstrate this result using an estimated labor search model that features endogenous search and recruiting intensity. Since the textbook model with free entry implies constant recruiting intensity, we introduce a cost of vacancy creation, so that firms respond to aggregate shocks by adjusting both vacancies and recruiting intensity. Fluctuations in search and recruiting intensity driven by shocks to productivity and the discount factor help bridge the gap between the actual and model-predicted job filling rate.

supplement (+)

wp2016-09_appendix.pdf – Supplemental appendix
Leduc-Liu-replication-files.zip – Replication files

Reserve Requirements and Optimal Chinese Stabilization Policy

Forthcoming in Journal of Monetary Economics | With Chang, Spiegel, and Zhang

abstract (+)

China’s central bank frequently adjusts reserve requirements for macroeconomic stabilization. We evaluate the effectiveness of such policy in a two-sector DSGE model. A heavy-industry sector–proxied as state-owned enterprises (SOEs)–is financed through government-guaranteed bank loans subject to reserve requirements, while more productive private firms rely on unregulated off-balance sheet financing. Increasing reserve requirements reallocates resources towards private firms, raising both aggregate productivity and SOE bankruptcies. Optimal reserve requirement adjustments complement money supply adjustments in improving macroeconomic stability and welfare. However, gains are greater under sector-specific shocks, which call for resource reallocation, than under aggregate shocks.

supplement (+)

wp2016-10_appendix.pdf – Supplement
CLSZ_rep_code.zip – Replication code

Breaking the “Iron Rice Bowl:” Evidence of Precautionary Savings from the Chinese State-Owned Enterprises Reform

Journal of Monetary Economics 94, 2018, 94-113 | With He, Huang, and Zhu

abstract (+)

China’s large-scale reform of state-owned enterprises (SOE) in the late 1990s provides a natural experiment for estimating precautionary savings. Before the reform, SOE workers enjoyed similar job security as government employees. The reform caused massive SOE layoffs, but government employees kept their “iron rice bowl.” The changes in the relative unemployment risks for SOE workers provide a clean identification of income uncertainty. With self-selection biases mitigated by focusing on government assigned jobs, precautionary savings account for about 40 percent of SOE households’ wealth accumulation. Moreover, demographic groups more vulnerable to the reform also accumulated more precautionary wealth.

Dollar Appreciation and Asian Economies

Vox China, 2017 | With Spiegel and Tai

abstract (+)

The sharp appreciation of the U.S. dollar between mid-2014 and mid-2015 raised concerns in the U.S. and its major trading partners. Zheng Liu, Mark Spiegel, and Andrew Tai from the San Francisco Fed evaluate the impact of dollar appreciation on economic conditions in the United States and its three major Asian trading partners: South Korea, Japan, and China.

Measuring the Effects of Dollar Appreciation on Asia: A FAVAR Approach

Journal of International Money and Finance 74, June 2017, 353-370 | With Spiegel and Tai

abstract (+)

Exchange rate shocks have mixed effects on economic activity in both theory and empirical VAR models. In this paper, we extend the empirical literature by considering the implications of a positive shock to the U.S. dollar in a factor-augmented vector autoregression (FAVAR) model for the U.S. and three large Asian economies: Korea, Japan and China. The FAVAR framework allows us to represent a country’s aggregate economic activity by a latent factor, generated from a broad set of underlying observable economic indicators. To control for global conditions, we also include in the FAVAR a ‘‘global conditions index,” which is another latent factor generated from the economic indicators of major trading partners. We find that a dollar appreciation shock reduces economic activity and inflation not only for the U.S. economy, but also for all three Asian economies. This result, which is robust to a number of alternative specifications, suggests that in spite of their disparate economic structures and policy regimes, the dollar appreciation shock affects the Asian economies primarily through its impact on U.S. aggregate demand; and this demand channel dominates the expenditure-switching channel that affects a country’s export competitiveness.

Uncertainty Shocks Are Aggregate Demand Shocks

Journal of Monetary Economics 82, September 2016, 20-35 | With Leduc

abstract (+)

Search frictions in the labor market give rise to a new option-value channel through which uncertainty affects aggregate economic activity, and the effects of which are reinforced by the presence of nominal rigidities. With these features, an increase in uncertainty resembles an aggregate demand shock because it increases unemployment and lowers inflation. Using a new empirical measure of uncertainty based on the Michigan survey and a VAR model, we show that these theoretical patterns are consistent with US data. Using a calibrated DSGE model, we show that combining search frictions and nominal rigidities can match the qualitative VAR pattern and account for about 70 percent of the empirical increase in unemployment following an uncertainty shock.

supplement (+)

wp12-10bk_appendix.pdf – Supplemental Appendix

Land Prices and Unemployment

Journal of Monetary Economics 80, June 2016, 86-105 | With Miao and Zha

abstract (+)

We integrate the housing market and the labor market in a dynamic general equilibrium model with credit and search frictions. We argue that the labor channel, combined with the standard credit channel, provides a strong transmission mechanism that can deliver a potential solution to the Shimer (2005) puzzle. The model is confronted with U.S. macroeconomic time series. The estimation results account for two prominent facts observed in the data. First, land prices and unemployment move in opposite directions over the business cycle. Second, a shock that moves land prices also generates the observed large volatility of unemployment.

Capital Controls and Optimal Chinese Monetary Policy

Journal of Monetary Economics 74, September 2015, 1-15 | With Chang and Spiegel

abstract (+)

China’s external policies, including capital controls, managed exchange rates, and sterilized interventions, constrain its monetary policy options for maintaining macro- economic stability following external shocks. We study optimal monetary policy in a dynamic stochastic general equilibrium (DSGE) model that incorporates these “Chinese characteristics”. The model highlights a monetary policy tradeoff between domestic price stability and costly sterilization. The same DSGE framework allows us to evaluate the welfare implications of alternative liberalization policies. Capital account and exchange rate liberalization would have allowed the Chinese central bank to better stabilize the external shocks experienced during the global financial crisis.

supplement (+)

CLS_Erratum.pdf – Erratum
wp2012-13supplement_replication_files.zip – data for replication (276 kb)

Optimal Monetary Poilicy and Capital Account Restrictions in a Small Open Economy

IMF Economic Review 63, September 2015, 298-324 | With Spiegel

abstract (+)

Declines in interest rates in advanced economies during the global financial crisis resulted in surges in capital flows to emerging market economies and triggered advocacy of capital control policies. The paper evaluates the effectiveness for macroeconomic stabilization and the welfare implications of the use of capital account policies in a monetary DSGE model of a small open economy. The model features incomplete markets, imperfect asset substitutability, and nominal rigidities. In this environment, policymakers can respond to fluctuations in capital flows through capital account policies such as sterilized interventions and taxing capital inflows, in addition to conventional monetary policy. The welfare analysis suggests that optimal sterilization and capital controls are complementary policies.

Temptation and Self-Control: Some Evidence and Applications

Journal of Money, Credit and Banking 47(4), June 2015, 581-615 | With Huang and Zhu

abstract (+)

This paper studies the empirical relevance of temptation and self-control using household-level data from the Consumer Expenditure Survey. We construct an infinite-horizon consumption-savings model that allows, but does not require, temptation and self-control in preferences. In the presence of temptation, a wealth–consumption ratio, in addition to consumption growth, becomes a determinant of the asset-pricing kernel, and the importance of this additional pricing factor depends on the strength of temptation. To identify the presence of temptation, we exploit an implication of the theory that a more tempted individual should be more likely to hold commitment assets such as individual retirement account (IRA) or 401(k) accounts. Our estimation provides empirical support for temptation preferences. Based on our estimates, we explore some quantitative implications of this class of preferences for capital accumulation in a neoclassical growth model and the welfare cost of the business cycle.

Discussion of Notarpietro and Siviero

Journal of Money, Credit and Banking 47 (S1), April 2015, 411-417

Credit Constraints and Self-Fulfilling Business Cycles

American Economic Journal: Macroeconomics 6(1), January 2014, 32-69 | With Wang

abstract (+)

We argue that credit constraints not only amplify fundamental shocks, they can also lead to self-fulfilling business cycles. We study a model with heterogeneous firms, in which imperfect contract enforcement implies that productive firms face binding credit constraints, with the borrowing capacity limited by expected equity value. A drop in equity value tightens credit constraints and reallocates resources from productive to unproductive firms. Such reallocation reduces aggregate productivity, further depresses equity value, generating a financial multiplier. Aggregate dynamics are isomorphic to those in a representative-agent economy with increasing returns. For sufficiently tight credit constraints, the model generates self-fulfilling business cycles.

The Transmission of Productivity Shocks: What Do We Learn about DSGE Modeling?

Annales d’Economie et de Statistique (Annals of Economics and Statistics) 109/110, June 2013, 283-304 | With Phaneuf

abstract (+)

Nominal rigidities are known to be important for the transmission of monetary policy. We argue that nominal rigidities are important also for the transmission of technology shocks, especially for explaining their effects on hours and real wages. Evidence suggests that a positive technology shock leads to a short-run decline in labor hours and a gradual rise in real wages. We examine the ability of an RBC model augmented with real frictions, a pure sticky-price model, a pure sticky-wage model, and a model combining sticky prices and sticky wages in accounting for this evidence. For each model, we examine the implications of the Frisch elasticity of hours and the extent of monetary policy accommodation for the results. We show that both sticky prices and sticky nominal wages are important for explaining the observed effects of technology shocks on labor market variables. This finding is robust and it holds with a small Frisch elasticity of hours and a relatively high frequency of price re-optimization that are consistent with microeconomic evidence

Land-Price Dynamics and Macroeconomic Fluctuations

Econometrica 81(3), May 2013, 1147-1184 | With Wang and Zha

abstract (+)

We argue that positive co-movements between land prices and business investment are a driving force behind the broad impact of land-price dynamics on the macroeconomy. We develop an economic mechanism that captures the co-movements by incorporating two key features into a DSGE model: We introduce land as a collateral asset in firms’ credit constraints, and we identify a shock that drives most of the observed fluctuations in land prices. Our estimates imply that these two features combine to generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through the joint dynamics of land prices and business investment.

Should the Central Bank Be Concerned about Housing Prices?

Macroeconomic Dynamics 17, January 2013, 29-53 | With Jeske

abstract (+)

Housing is an important component of the consumption basket. Since both rental prices and goods prices are sticky, the literature suggests that optimal monetary policy should stabilize both types of prices, with the optimal weight on rental inflation proportional to the housing expenditure share. In a two-sector DSGE model with sticky rental prices and goods prices, however, we find that the optimal weight on rental inflation in the Taylor rule is small—much smaller than that implied by the housing expenditure share. We show that the asymmetry in policy responses to rent inflation versus goods inflation stems from the asymmetry in factor intensity between the two sectors.

supplement (+)

wp10-05bk.pdf – Working paper version, FRBSF WP2010-05

Sources of Macroeconomic Fluctuations: A Regime-Switching DSGE Approach

Quantitative Economics 2(2), July 2011, 251-301 | With Waggoner and Zha

abstract (+)

We examine the sources of macroeconomic fluctuations by estimating a variety of richly parameterized DSGE models within a unified framework that incorporates regime switching both in shock variances and in the inflation target. We propose an efficient methodology for estimating regime-switching DSGE models. Our counterfactual exercises show that changes in the inflation target are not the main driving force of high inflation in the 1970s. The model that best fits the U.S. time-series data is the one with synchronized shifts in shock variances across two regimes, and the fit does not rely on strong nominal rigidities. We provide evidence that a shock to the capital depreciation rate, which resembles a financial shock, plays a crucial role in accounting for macroeconomic fluctuations.

supplement (+)

wp09-01bk.pdf – Working paper version, FRBSF WP2009-01

Asymmetric Expectation Effects of Regime Shifts in Monetary Policy

Review of Economic Dynamics 12, April 2009, 284-303 | With Waggoner and Zha

abstract (+)

This paper addresses two substantive issues: (1) Does the magnitude of the expectation effect of regime switching in monetary policy depend on a particular policy regime? (2) Under which regime is the expectation effect quantitatively important? Using two canonical DSGE models, we show that there exists asymmetry in the expectation effect across regimes. The expectation effect under the dovish policy regime is quantitatively more important than that under the hawkish regime. These results suggest that the possibility of regime shifts in monetary policy can have important effects on rational agents’ expectation formation and on equilibrium dynamics. They offer a theoretical explanation for the empirical possibility that a policy shift from the dovish regime to the hawkish regime may not be the main source of substantial reductions in the volatilities of inflation and output.

Learning, Adaptive Expectations, and Technology Shocks

The Economic Journal 119, March 2009, 377-405 | With Huang and Zha

abstract (+)

This study explores the macroeconomic implications of adaptive expectations in a standard growth model. We show that the self-confirming equilibrium under adaptive expectations is the same as the steady-state rational expectations equilibrium for all admissible parameter values, but that dynamics around the steady state are substantially different between the two equilibria. The differences are driven mainly by the dampened wealth effect and the strengthened intertemporal substitution effect, not by escapes emphasized by Williams (2003). Consequently, adaptive expectations can be an important source of frictions that amplify and propagate technology shocks and seem promising for generating plausible labor market dynamics.

Gains from International Monetary Policy Coordination: Does It Pay to Be Different?

Journal of Economic Dynamics and Control 32(7), July 2008, 2,085-2,117 | With Pappa

abstract (+)

In a two country world where each country has a traded and a nontraded sector and each sector has sticky prices, optimal independent policy in general cannot replicate the natural-rate allocations. There are potential welfare gains from coordination since the planner under a cooperating regime internalizes a terms-of-trade externality that independent policymakers overlook. If the countries have symmetric trading structures, however, the gains from coordination are quantitatively small. With asymmetric trading structures, the gains can be sizable since, in addition to internalizing the terms-of-trade externality, the planner optimally engineers a terms-of-trade bias that favors thecountry with a larger traded sector.

Investment-Specific Technological Change, Skill Accumulation, and Wage Inequality

Review of Economic Dynamics 11(2), April 2008, 314-334 | With He

abstract (+)

Wage inequality between education groups in the United States has increased substantially since the early 1980s. The relative number of college-educated workers has also increased dramatically in the postwar period. This paper presents a unified framework where the dynamics of both skill accumulation and wage inequality arise as an equilibrium outcome driven by measured investment-specific technological change. Working through equipment-skill complementarity and endogenous skill accumulation, the model does well in capturing the steady growth in the relative quantity of skilled labor during the postwar period and the substantial rise in wage inequality after the early 1980s. Based on the calibrated model, we examine the quantitative effects of some hypothetical tax-policy reforms on skill accumulation, wage inequality, and welfare.

Technology Shocks and Labor Market Dynamics: Some Evidence and Theory

Journal of Monetary Economics 54(8), November 2007, 2,534-2,553 | With Phaneuf

abstract (+)

A positive technology shock may lead to a rise or a fall in per capita hours, depending on how hours enter the empirical VAR model. We provide evidence that, independent of how hours enter the VAR, a positive technology shock leads to a weak response in nominal wage inflation, a modest decline in price inflation, and a modest rise in the real wage in the short run and a permanent rise in the long run. We then examine the ability of several competing theories to account for this VAR evidence. Our preferred model features sticky prices, sticky nominal wages, and habit formation. The same model also does well in accounting for the labor market evidence in the post-Volcker period.

Business Cycles with Staggered Prices and International Trade in Intermediate Inputs

Journal of Monetary Economics 54(4), May 2007, 1,271-1,289 | With Huang

abstract (+)

International trade in intermediate inputs and, increasingly, in goods produced at multiple stages of processing has been widely studied in the real trade literature. We assess the role of this feature of modern world trade in accounting for some stylized facts about international business cycles. Our model with staggered prices and trade in intermediates across four stages of processing does well in explaining the observed international correlations in aggregate quantities, and it performs much better than a single-stage model with no trade in intermediates. The model in itself does not provide a full account of the cyclical behavior of the real exchange rate, but, compared to the single-stage model, it moves in the right direction.

Sellers’ Local Currency Pricing or Buyers’ Local Currency Pricing: Does It Matter for International Welfare Analysis?

Journal of Economic Dynamics and Control 30(7), July 2006, 1,183-1,213 | With Huang

abstract (+)

We study international transmissions and welfare implications of monetary shocks in a two-country world with multiple stages of production and multiple border-crossings of intermediate goods. This empirically relevant feature is important, as it has opposite implications for two external spillover effects of a unilateral monetary expansion. If all production and trade are assumed to occur in a single stage, the conflict-of-interest terms-of-trade effect tends to dominate the common-interest efficiency-improvement effect for reasonable parameter values, so that the international welfare effects would depend in general on the underlying assumptions about the currencies of price setting. The stretch of production and trade across multiple stages of processing magnifies the efficiency-improvement effect and dampens the terms-of-trade effect. Thus, a monetary expansion can be mutually beneficial regardless of its source or the pricing assumptions.

Inflation Targeting: What Inflation Rate to Target?

Journal of Monetary Economics 52(8), November 2005, 1,435-1,462 | With Huang

abstract (+)

In an economy with nominal rigidities in both an intermediate good sector and a finished good sector, and thus with a natural distinction between CPI and PPI inflation rates, a benevolent central bank faces a tradeoff between stabilizing the two measures of inflation, a final output gap and, unique to our model, a real marginal cost gap in the intermediate sector, so that optimal monetary policy is second-best. We discuss how to implement the optimal policy with minimal information requirement and evaluate the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. A main finding is that a simple hybrid rule under which the short-term interest rate responds to CPI inflation and PPI inflation results in a welfare level close to the optimum, whereas policy rules that ignore PPI inflation or PPI sector shocks can result in significant welfare losses.

Does Trade Openness Matter for Aggregate Instability?

Journal of Economic Dynamics and Control 29(7), July 2005, 1,165-1,192 | With De Fiore

abstract (+)

This paper presents a cash-in-advance model of a small open economy and shows that whether an inflation-targeting interest rate rule introduces aggregate instability depends in general on the degree of openness to international trade. This result emerges regardless of whether prices are sticky or flexible. In a closed economy, as the monetary authority responds to movements in inflation, the resulting changes in interest rates affect aggregate consumption through an intertemporal substitution effect and an inflation tax effect. In a small open economy, this policy also induces changes in the terms of trade, which, depending on the degree of openness, can generate counteracting effects on consumption. As a consequence, the implications of interest rate rules on macroeconomic stability in an open economy differ from those in a closed economy.

Why Does the Cyclical Behavior of Real Wages Change Over Time?

American Economic Review 94(4), September 2004, 836-856 | With Huang and Phaneuf

abstract (+)

The cyclical behavior of real wages has evolved from mildly countercyclical during the interwar period to modestly procyclical in the postwar era. This paper presents a general equilibrium business-cycle model that helps explain the evolution. In the model, changes in the real wage cyclicality arise from interactions between nominal wage and price rigidities and an evolving input-output structure.

Input-Output Structure and Nominal Rigidity: The Persistence Problem Revisited

Macroeconomic Dynamics 8(2), April 2004, 188-206 | With Huang

abstract (+)

This paper revisits an important issue concerning the persistent real effect of a shock to monetary policy. Although recent sentiment has shifted away from price stickiness toward wage stickiness in explaining persistence, the present paper shows that introducing an input output structure tends to make the former an equally important monetary transmission mechanism. Under staggered wage setting, the well-known relative-wage effect is the only source of endogenous sluggishness in wage, and thus price, adjustments, regardless of whether there is an intermediate input. Under staggered price setting, relative wages are constant, but the presence of an intermediate input creates a real-wage effect that prevents nominal wages from deviating too much from a sticky intermediate-input price. Meanwhile, stickiness in the intermediate-input price translates directly into sluggishness in marginal-cost movement. This reinforces the endogenous rigidity in the nominal wages and makes firms pricing decisions even more rigid. Thus, although it makes no difference in output dynamics under staggered wage setting, the input output structure improves the ability of staggered price setting in generating persistence. As a consequence, the conventional wisdom on the equivalence of price and wage staggering may continue to hold for some reasonable parameter values.

Staggered Price-Setting, Staggered Wage-Setting, and Business Cycle Persistence

Journal of Monetary Economics 49(2), March 2002, 405-433 | With Huang

Production Chains and General Equilibrium Aggregate Dynamics

Journal of Monetary Economics 48(2), October 2001, 437-462 | With Huang

Seasonal Cycles, Business Cycles, and Monetary Policy

Journal of Monetary Economics 46(2), October 2000, 441-464

FRBSF Publications

Other Works

Youth Labor Force Participation Continues To Fall, but It Might Be for a Good Reason

The Regional Economist , January 2015, 12-13 | With Kudlyak and Canon