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Working Paper Series

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Working papers disseminate economic research relevant not only to the tasks and functions of the Bank of Lithuania and of the European System of Central Banks but also appealing more broadly to the academic community in economics and finance. They present, discuss and analyse the results of original and academically rigorous theoretical and/or empirical research. Working papers constitute the basis for publications in leading academic journals, making contributions to the existing literature in the fields of economics and finance. They encourage collaboration between the researchers of the Bank of Lithuania and other central banks, Lithuanian and foreign universities and research institutes.

Papers are only available in English.

No 133
2025-04-14

Optimal Fiscal Policy under Endogenous Disaster Risk: How to Avoid Wars?

  • Abstract

    We examine the role of government investment in defense capital as a deterrence tool. Using an optimal fiscal policy framework with endogenous disaster risk, we allow for an endogenous determination of geopolitical risk and defense capacity, which we discipline using the Geopolitical Risk Index. We show both analytically and quantitatively that financing defense primarily through debt, rather than taxation, is optimal. Debt issuance mitigates present tax distortions but exacerbates them in the future, especially in wartime. However, since additional defense capital deters future wars, the expected tax distortions decline as well, making debt financing a welfare-improving strategy. Quantitatively, the optimal defense financing in the presence of heightened risk involves a twice higher share of debt and backloading of tax distortions compared to other types of government spending.


    Keywords: Optimal Fiscal Policy, Incomplete Markets, Endogenous Disaster Risk.

    JEL codes: E62, D52, E60

No 132
2025-03-24

Strategic trading with uncertain market depth

  • Abstract

    We study a model of strategic informed traders submitting market orders together with noise traders where an uncertainty over the overall participation of strategic and noise traders leads to an uncertainty over market depth. Our analysis compares the main case with such uncertainty with the benchmark case without it. When liquidity is driven by informed trading (noise trading), expected trading volume is higher (lower) and expected price informativeness is lower (higher) in the main case compared with the benchmark case. We also analyze the effects of random variation of the aggregate participation, which confound the effects of market expansion and thereby possibly lead to higher expected trading volume and lower expected price informativeness following market expansion. Further, these results can explain a negative volume-volatility relation and a negative impact of transparency reforms on price informativeness.


    Keywords: Market depth, liquidity, trading volume, price informativeness

    JEL codes: D82; G14

No 131
2025-02-06

Earnings Inequality and Risk over Two Decades of Economic Development in Lithuania

  • Abstract

    Using Social Security records between 2000 and 2020, we provide a comprehensive analysis of
    labor earnings inequality and its dynamics over the course of Lithuania’s economic development.
    Since 2000, there has been a substantial decline in earnings inequality, largely driven by the rapid
    growth of earnings at the bottom of the distribution, while earnings volatility has hardly changed.
    Importantly, we estimate a relatively high sensitivity of earnings growth to changes in real GDP,
    which declines with the level of permanent income. Additionally, we find that the idiosyncratic
    earnings risk of individuals at the bottom of the permanent income distribution is less sensitive to
    aggregate growth than that of individuals in the top half. Taken together, our findings underscore
    that analyzing earnings risk is critical to properly understanding the dynamics of inequality and
    designing effective policies to address it.


    Keywords: Income inequality, income risk, income mobility, administrative data

    JEL codes: D31, E24, J31

No 130
2025-01-28

Forecasting with the help of survey information

  • Abstract

    In this paper we propose a parsimonious way of combining survey expectations with empirical models to produce forecasts. We do so by augmenting a traditional vector autoregression model with forecasts for different variables and horizons from the ECB Survey of Professional Forecasters. The additional information improves estimation efficiency while maintaining a treatable model. In terms of forecasting performance, the gains from adding survey forecasts are greater at the one and two year ahead horizons, while they are limited at shorter horizons (below one year). Larger gains are found in terms of density performance than in terms of point. Forecasts of real GDP growth benefit the most from survey information, whereas inflation forecasts are improved the least. This latter result is partially driven by the very poor performance of SPF during the 2022 high inflation period. Forecasts for unemployment also benefit from including expectations for GDP and inflation, although not during the COVID pandemic period.

    Keywords: Expectations, Forecasting, Judgement, Survey of Professional Forecasters

    JEL codes: C32, C33, C51, D84, E37