nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2006‒09‒30
twenty papers chosen by
Christian Zimmermann
University of Connecticut

  1. On the Consequences of Demographic Change for Rates of Returns to Capital, and the Distribution of Wealth and Welfare By Dirk Krueger; Alexander Ludwig
  2. The Effects of Labor Market Policies in an Economy with an Informal Sector By James Albrecht; Lucas Navarro; Susan Vroman
  3. Investment-Specific Technology Shocks in a Small Open Economy By Mulraine, Millan L. B.
  4. Skill Acquisition, Credit Constraints, and Trade By Tatyana Chesnokova; Kala Krishna
  5. Procyclicality, collateral values and financial stability By Prasanna Gai; Peter Kondor; Nicholas Vause
  6. Hiring Freeze and Bankruptcy in Unemployment Dynamics By Pietro Garibaldi
  7. Bank capital, asset prices and monetary policy By David Aikman; Matthias Paustian
  8. The Welfare Enhancing Effects of a Selfish Government in the Presence of Uninsurable, Idiosyncratic Risk By R. Anton Braun; Harald Uhlig
  9. Future Targets and Multiple Equilibria By Ashok S Guha; Brishti Guha
  10. The danger of inflating expectations of macroeconomic stability: heuristic switching in an overlapping generations monetary model By Alex Brazier; Richard Harrison; Mervyn King; Tony Yates
  11. Accounting for the Rise in Consumer Bankruptcies By Igor Livshits; James MacGee; Michele Tertilt
  12. Career progression and formal versus on-the-job training By Jerome Adda; Christian Dustmann; Costas Meghir; Jean-Marc Robin
  13. Real Exchange Rate Dynamics With Endogenous Distribution Costs By Mulraine, Millan L. B.
  14. Shadow Sorting By Tito Boeri; Pietro Garibaldi
  15. On Irreversible Investment By Xia Su; Frank Riedel
  16. LUCAS COUNTER EXAMPLE REVISITED By Effrosyni Diamantoudi; Licun Xue
  17. Comparing Average and Marginal Tax Rates Under the FairTax and the Current System of Federal Taxation By Laurence J. Kotlikoff; David Rapson
  18. The determinants of household debt and balance sheets in the United Kingdom By Merxe Tudela; Garry Young
  19. New models of old(?) payment questions By Ricardo de Oliveira Cavalcanti; Neil Wallace
  20. A review of static and dynamic models of labour supply and labour market transitions By Michal Myck; Howard Reed

  1. By: Dirk Krueger (University of Frankfurt, CEPR, CFS, MEA, and NBER); Alexander Ludwig (University of Mannheim and MEA,)
    Abstract: This paper employs a multi-country large scale Overlapping Generations model with uninsurable labor productivity and mortality risk to quantify the impact of the demographic transition towards an older population in industrialized countries on world-wide rates of return, international capital flows and the distribution of wealth and welfare in the OECD. We find that for the U.S. as an open economy, rates of return are predicted to decline by 86 basis points between 2005 and 2080 and wages increase by about 4.1%. If the U.S. were a closed economy, rates of return would decline and wages increase by less. This is due to the fact that other regions in the OECD will age even more rapidly; therefore the U.S. is “importing” the more severe demographic transition from the rest of the OECD in the form of larger factor price changes. In terms of welfare, our model suggests that young agents with little assets and currently low labor productivity gain, up to 1% in consumption, from higher wages associated with population aging. Older, asset-rich households tend to lose, because of the predicted decline in real returns to capital.
    Keywords: Population Aging, International Capital Flows, Distribution of Welfare
    JEL: E17 E25 D33 C68
    Date: 2006–08–07
  2. By: James Albrecht; Lucas Navarro; Susan Vroman (Department of Economics, Georgetown University)
    Abstract: In many economies, there is substantial economic activity in the informal labor market, beyond the reach of government policy. Labor market policies, which by definition apply only to the formal-sector can have important spillover effects on the informal sector. The relative sizes of the informal and formal sectors adjust, the skill composition of the workforce in the two sectors changes, etc. In this paper, we build an equilibrium search and matching model to analyze the effects of labor market policies in an economy with an informal sector. Our model extends Mortensen and Pissarides (1994) by allowing for ex ante worker heterogeneity with respect to formal-sector productivity. We analyze the effects of labor market policy on informal- and formal-sector output, on the division of the workforce into unemployment, informal-sector employment and formal-sector employment, and on wages. Finally, our model allows us to examine the distributional implications of labor market policy; specifically, we analyze how labor market policy affects the distributions of wages and productivities across formal-sector matches. Classification-JEL Codes: E26, J64, J65, O17
    Keywords: search, matching, informal sector
  3. By: Mulraine, Millan L. B.
    Abstract: In this paper we examine the behavioral responses of key macroeconomic variables in Canada to exogenous innovations to investment specific technology. This is done by developing a stylized international real business cycle model which is simulated to explore its ability to shed new light on the dynamic behavior of the standard small open economy. The results indicate that this model can quantitatively replicate the key dynamic features of the post-war Canadian economy, and thus shocks to investment-specific technology can be considered an important propagation mechanism for studying and understanding modern macroeconomic dynamics in small open economies. Moreover, when the model was augmented with an endogenous utilization rate it was able to generate the counter-cyclical behavior of the external accounts - without appealing to an adjustment cost parameter and/or a propagation mechanism whose volatility and persistence are artificially low.
    Keywords: Endogenous rate of time preference; Investment-specific shocks; Relative price of investment goods
    JEL: E32 F41 E37
    Date: 2005–01
  4. By: Tatyana Chesnokova; Kala Krishna
    Abstract: This paper looks at the effect of credit constraints on skill acquisition when agents have heterogeneous abilities and wealth. We use a two factor general equilibrium model and assume credit markets are absent. We explore the effects of trade on factor earnings as well as the evolution of the distribution of income in small and large economies. Our work suggests that developed countries need to ensure access to education when liberalizing trade to ensure they reap the potential gains from trade.
    JEL: F16 O15 O16
    Date: 2006–08
  5. By: Prasanna Gai; Peter Kondor; Nicholas Vause
    Abstract: This paper analyses how the risk-sharing capacity of the financial system varies over the business cycle, leading to procyclical fragility. We show how financial imperfections contribute to underinsurance by entrepreneurs, generating an externality that leads to the build-up of systematic risk during upturns. Increased asset price uncertainty emerges as a symptom of the sectoral concentration that builds up during booms. The liquidity of the collateral asset is shown to play a key role in amplifying the financial cycle. The welfare costs of financial stability, in terms of the efficiency costs due to financial frictions and the volatility costs due to amplification, are also illustrated.
  6. By: Pietro Garibaldi
    Abstract: This paper proposes a matching model that distinguishes between job creation by existing firms and job creation by firm entrants. The paper argues that vacancy posting and job destruction on the extensive margin, i.e. from firms that enter and exit the labour market, represents a potentially viable mechanism for understanding the cyclical properties of vacancies and unemployment. The model features both hiring freeze and bankruptcies, where the former represents a sudden shut down of vacancy posting at the firm level with labour downsizing governed by natural turnover. A bankrupt firm, conversely, shut down its vacancies and lay offs its stock of workers. Recent research in macroeconomics has shown that a calibration of the Mortensen and Pissarides matching model account for 10 percent of the cyclical variability of the vacancy unemployment ratio displayed by U.S. data. A calibration of the model that explicitly considers hiring freeze and bankruptcy can account for 20 to 35 percent of the variability displayed by the data.
    Keywords: unemployment dynamics, matching models
    JEL: J30
    Date: 2006
  7. By: David Aikman; Matthias Paustian
    Abstract: We study a general equilibrium model in which informational frictions impede entrepreneurs' ability to borrow and banks' ability to intermediate funds. These financial market frictions are embedded in an otherwise-standard dynamic New Keynesian model. We find that exogenous shocks have an amplified and more persistent effect on output and investment, relative to the case of perfect capital markets. The chief contribution of the paper is to analyse how these financial sector imperfections - in particular, those relating to the banking sector - modify our understanding of optimal monetary policy. Our main finding is that optimal monetary policy tolerates only a very small amount of inflation volatility. Given that similar results have been reported for models that abstract from banks, we conclude that assigning a non-trivial role for banks need not materially affect the properties of optimal monetary policy.
  8. By: R. Anton Braun; Harald Uhlig
    Abstract: This paper poses the following question: Is it possible to improve welfare by increasing taxes and throwing away the revenues? This paper demonstrates that the answer to this question is “yes.” We show that there may be welfare gains from taxing capital income even when the additional capital income tax revenues are wasted or consumed by a selfish government. Previous literature has assumed that government expenditures are exogenous or productive, or allowed for redistribution of tax revenue either via lump-sum transfers, unemployment compensation or other redistributive schemes. In our model a selfish government taxes capital above a given threshold and then consumes the proceeds. This raises the before-tax real return on capital and and thereby enhances the ability of agents to self-insure when they are long-term unemployed and have low savings. Since all agents have positive probability of finding themselves in that state there are cases where all agents prefer a selfish government to no government at all.
    Keywords: capital income tax, selfish government, welfare improvement, redistribution
    JEL: H20 H21 H23 D31 D33 E21 E62
    Date: 2006–09
  9. By: Ashok S Guha (Jawaharlal Nehru University); Brishti Guha (School of Economics and Social Sciences, Singapore Management University)
    Abstract: Multiple Pareto-rankable equilibria may obtain in an overlapping generations model where consumers save to reach a fixed target. Existence and uniqueness conditions are discussed. The model displays excess consumption sensitivity to current income and perfect old-age insurance.
    Keywords: Multiple equilibria, saving, overlapping generations, excess sensitivity.
    JEL: E21 D91
    Date: 2005–10
  10. By: Alex Brazier; Richard Harrison; Mervyn King; Tony Yates
    Abstract: The volatility of inflation and output has fallen in most advanced economies in the 1990s and 2000s. We use a monetary overlapping generations model to discuss the cause and durability of this macroeconomic change. In that model, agents' decision rules require them to make forecasts of future inflation, which, because of shocks to productivity, is uncertain. Agents make forecasts of inflation using two rules of thumb or 'heuristics'. One is based on lagged inflation, the other on an inflation target announced by the central bank. They switch between those heuristics based on an imperfect assessment of how each has performed in the past. The way the economy propagates productivity shocks into inflation depends on the proportion of agents using each. Movements in that proportion generate fluctuations in small sample measures of economic volatility. We use this simple model of heuristic switching to contrast the performance of monetary policy rules. We find that, relative to the rule that would be optimal under rational expectations, a rule that responds to both productivity shocks and inflation expectations better stabilises the economy but does not prevent agents switching between heuristics. Finally, we study the impact of introducing an explicit inflation target, which can be used by agents as a simple heuristic, into an economy that did not previously have one. Depending on the heuristics agents have access to before the introduction of the target, this can result in reduced inflation volatility.
  11. By: Igor Livshits (University of Western Ontario); James MacGee (University of Western Ontario); Michele Tertilt (Stanford University)
    Abstract: Personal bankruptcies in the United States have increased dramatically, rising from 1.4 per thousand working age population in 1970 to 8.5 in 2002. We use a heterogeneous agent life-cycle model with competitive financial intermediaries who can observe households' earnings, age and current asset holdings to evaluate several commonly offered explanations. We find that increased uncertainty (income shocks, expense uncertainty) cannot quantitatively account for the rise in bankruptcies. Instead, stories related to a change in the credit market environment are more plausible. In particular, we find that a combination of a decrease in the transactions cost of lending and a decline in the cost of bankruptcy does a good job in accounting for the rise in consumer bankruptcy. We also argue that the abolition of usury laws and other legal changes are unimportant.
    Keywords: consumer bankruptcy; uncertainty; credit markets; stigma
    JEL: E21 E44 G18 K35
    Date: 2006
  12. By: Jerome Adda (Institute for Fiscal Studies and University College London); Christian Dustmann (Institute for Fiscal Studies and University College London); Costas Meghir (Institute for Fiscal Studies and University College London); Jean-Marc Robin (Institute for Fiscal Studies and EUREQua, University of Paris 1)
    Abstract: We develop a dynamic discrete choice model of training choice, employment and wage growth, allowing for job mobility, in a world where wages depend on firm-worker matches, as well as experience and tenure and jobs take time to locate. We estimate this model on a large administrative panel data set which traces labour market transitions, mobility across firms and wages from the end of statutory schooling. We use the model to evaluate the life-cycle return to apprenticeship training and find that on average the costs outweigh the benefits; however for those who choose to train the returns are positive. We then use our model to consider the long-term lifecycle effects of two reforms: One is the introduction of an Earned Income Tax Credit in Germany, and the other is a reform to Unemployment Insurance. In both reforms we find very significant impacts of the policy on training choices and on the value of realised matches, demonstrating the importance of considering such longer term implications.
    Date: 2006–08
  13. By: Mulraine, Millan L. B.
    Abstract: The importance of distribution costs in generating the deviations from the law of one price has been well documented. In this paper we show that a two-country flexible price dynamic general equilibrium model driven by exogenous innovations to technology, and with a localized distribution services sector can replicate the key dynamic features of the real exchange rate. In doing so, the paper identifies the importance of two key channels for real exchange rate dynamics. That is, we show: (i) that shocks in the real sector are important contributors to movements in the real exchange rate, and (ii) that the endogenous wedge created by distribution costs of traded goods is a significant source of fluctuation for the real exchange rate, and the overall macro-economy as a whole. The evidence presented here demonstrates that this model - without any nominal rigidities, can account for up to 89% of the relative volatility in the real exchange rate.
    Keywords: Distribution costs; Real exchange rate dynamics; Law of one price
    JEL: E32 F41 E37
    Date: 2006–09
  14. By: Tito Boeri; Pietro Garibaldi
    Abstract: This paper investigates the border between formal employment, shadow employment, and unemployment in an equilibrium model of the labor market with market frictions. From the labor demand side, firms optimally create legal or shadow employment through a mechanism that is akin to tax evasion. From the labor supply side, heterogeneous workers sort across the two sectors, with high productivity workers entering the legal sector. Such worker sorting appears fully consistent with most empirical evidence on shadow employment. The model sheds also light on the "shadow puzzle", the increasing size of the shadow economy in OECD countries in spite of improvements in technologies detecting tax and social security evasion. Shadow employment is correlated with unemployment, and it is tolerated because the repression of shadow activity increases unemployment. The model implies that shadow wage gaps should be lower in depressed labor markets and that deregulation of labor markets is accompanied by a decline in the average skills of the workforce in both legal and shadow sectors. Based on micro data on two countries with a sizeable shadow economy, Italy and Braziil, we find empirical support to these implications of the model. The paper suggests also that policies aimed at reducing the shadow economy are likely to increase unemployment.
    Keywords: Unemployment, Matching, Shadow Activity.
    JEL: J30
    Date: 2006
  15. By: Xia Su; Frank Riedel
    Abstract: This paper develops a general theory of irreversible investment of a single firm that chooses a dynamic capacity expansion plan in an uncertain environment. The model is set up free of any distributional or any parametric assumptions and hence encompasses all the existing models. As the first contribution, a general existence and uniqueness result is provided for the optimal investment policy. Based upon an alternative approach developed previously to dynamic programming problems, we derive the optimal base capacity policy such that the firm always keeps the capacity at or above the base capacity. The critical base capacity is explicitly constructed and characterized via a stochastic backward equation. This method allows qualitative insights into the nature of the optimal investment under irreversibility. It is demonstrated that the marginal profit is indeed equal to the user cost of capital in free intervals where investment occurs in an absolutely continuous way at strictly positive rates. However, the equality is maintained only in expectation on average in blocked intervals where no investment occurs. Whenever the uncertainty is generated by a diffusion, the investment is singular with respect to Lebesgue measure. In contrast to the deterministic and Brownian motion case where lump sum investment takes place only at time zero, the firm responses in general more frequently in jumps to shocks. Nevertheless, lump sum investments are shown to be possible only at information surprises which is defined as unpredictable stopping time or unanticipated information jump even at the predictable time. Furthermore, general monotone comparative statics results are derived for the relevant ingredients of the model. Finally, explicit solutions are derived for infinite time horizon, a separable operating profit function of Cobb--Douglas type and an exponential Levy process modelled economic shock.
    Keywords: Sequential Irreversible Investment, Capacity Expansion, Singular Control Problem, Levy Processes
    JEL: C61 D81 E22 G11
    Date: 2006–06
  16. By: Effrosyni Diamantoudi; Licun Xue
    Abstract: We revisit Lucas’(1968) counter example for the existence of von Neumann and Morgenstern (1944) stable set (solution) for coalitional games. We show that when we endow the agents with foresight, particularly, when we replace von Neumann and Morgenstern’s (1944) dominance relation with the indirect dominance relations introduced by Harsanyi (1974), Lucas’s example admits a stable set.
    JEL: C71
    Date: 2006–09
  17. By: Laurence J. Kotlikoff; David Rapson
    Abstract: Abstract Building on Gokhale, Kotlikoff, and Sluchynsky's (2002) study of Americans' incentives to work full or part time, this paper uses ESPlanner, a life-cycle financial planning program, in conjunction with detailed modeling of transfer programs to determine a) total marginal net tax rates on current labor supply, b) total net marginal tax rates on life-cycle labor supply, c) total net marginal tax rates on saving, and d) the tax-arbitrage opportunities available from contributing to retirement accounts. In seeking to provide the most comprehensive analysis to date of fiscal incentives, the paper incorporates federal and state personal income taxes, the FICA payroll tax, federal and state corporate income taxes, federal and state sales and excise taxes, Social Security benefits, Medicare benefits, Medicaid benefits, Foods Stamps, welfare (TAFCD) benefits, and other transfer program benefits. The paper offers four main takeaways. First, thanks to the incredible complexity of the U.S. fiscal system, it's impossible for anyone to understand her incentive to work, save, or contribute to retirement accounts absent highly advanced computer technology and software. Second, the U.S. fiscal system provides most households with very strong reasons to limit their labor supply and saving. Third, the system offers very high-income young and middle aged households as well as most older households tremendous opportunities to arbitrage the tax system by contributing to retirement accounts. Fourth, the patterns by age and income of marginal net tax rates on earnings, marginal net tax rates on saving, and tax-arbitrage opportunities can be summarized with one word -- bizarre.
    JEL: H21 H24
    Date: 2006–09
  18. By: Merxe Tudela; Garry Young
    Abstract: Household indebtedness has grown sharply in the United Kingdom in recent years. This paper proposes a framework for understanding this based on a model in which households are assumed to plan their lifetime spending rationally, allowing for bequests to future generations. The model is set up to be consistent with both aggregate and disaggregated balance sheet positions as revealed in the British Household Panel Survey. The paper goes on to outline the effect on debt and balance sheets of changes in interest rates, house prices, preferences and retirement income.
  19. By: Ricardo de Oliveira Cavalcanti (EPGE/FGV); Neil Wallace
    Date: 2006–09
  20. By: Michal Myck (Institute for Fiscal Studies); Howard Reed (Institute for Fiscal Studies)
    Abstract: This paper aims to review the techniques and methods which have been developed by researchers to study labour supply and employment, unemployment and inactivity in the labour market. Progress in labour supply modelling in the last thirty years or so has been considerable. Firstly, the theory of labour supply has become much more sophisiticated; simple static-period models of the budget constraint and the hours decision have been augmented with new developments such as intertemporal optimisation, explicit treatment of the participation decision as distinct from the hours decision, and search theory. Secondly, the econometric techniques available to estimate these more advanced models on the data have expanded massively, along with increases in the amount and quality of data available and huge improvements in computing power. In this report we aim to provide a comprehensive survey of the state of the art in the field of labour supply estimation.
    Date: 2006–08

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