
on Dynamic General Equilibrium 
By:  Giovanni L. Violante; Per Krusell; Andreas Hornstein 
Abstract:  Standard search and matching models of equilibrium unemployment, once properly calibrated, can generate only a small amount of frictional wage dispersion, i.e., wage differerentials among exante similar workers induced purely by search frictions. We derive this result for a specific measure of wage dispersion  the ratio between the average wage and the lowest (reservation) wage paid. We show that in a large class of search and matching models this statistic (the "meanmin ratio") can be obtained in closed form as a function of observable variables (i.e., interest rate, value of leisure, and statistics of labor market turnover). Looking at various independent data sources suggests that, empirically, residual wage dispersion (i.e., inequality among observationally similar workers) exceeds the model's prediction by a factor of 20. We discuss three extensions of the model (risk aversion, volatile wages during employment, and onthejob search) and find that, in their simplest version, they can improve its performance, but only modestly. We conclude that either frictions account for a tiny fraction of residual wage dispersion, or the standard model needs to be augmented to confront the data. 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedrwp:0607&r=dge 
By:  Giovanni L. Violante; Per Krusell; Andreas Hornstein 
Abstract:  In this Technical Appendix to Hornstein, Krusell, and Violante (2006) (HKV, 2006, hereafter) we provide a detailed characterization of the search model with (1) wage shocks during employment and (2) onthejob search outlined in Sections 6 and 7 of that paper, and we derive all of the results that are only stated in HKV (2006). In particular, we derive the expressions for our preferred measure of frictional wage inequality: the ratio of average wages to the reservation wage, or, the 'meanmin' wage ratio. 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedrwp:0608&r=dge 
By:  Claustre Bajona; Timothy J. Kehoe 
Abstract:  This paper contrasts the properties of dynamic HeckscherOhlin models with overlapping generations with those of models with infinitely lived consumers. In both environments, if capital is mobile across countries, factor price equalization occurs after the initial period. In general, however, the properties of equilibria differ drastically across environments: With infinitely lived consumers, we find that factor prices equalize in any steady state or cycle and that, in general, there is positive trade in any steady state or cycle. With overlapping generations, in contrast, we construct examples with steady states and cycles in which factor prices are not equalized, and we find that any equilibrium that converges to a steady state or cycle with factor price equalization has no trade after a finite number of periods. 
JEL:  F11 F43 O15 O41 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12566&r=dge 
By:  Enrique G. Mendoza 
Abstract:  The current account reversals, large recessions, and price collapses that define Sudden Stops contradict the predictions of a large class of models in which the current account is a vehicle for consumption smoothing and investment financing. This paper shows that the quantitative predictions of a business cycle model with collateral constraints are consistent with the key features of Sudden Stops. Standard shocks to imported input prices, the world interest rate, and productivity trigger collateral constraints on debt and working capital when borrowing levels are high relative to asset values, and these highleverage states are endogenous outcomes. In these situations, Irving Fisher's debtdeflation mechanism causes Sudden Stops as the deflation of Tobin's Q leads to a spiraling decline in the prices and holdings of collateral assets. This has immediate effects on output and factor demands because collapsing collateral values cut access to working capital. In contrast with previous findings, collateral constraints induce significant amplification in the responses of macroaggregates to shocks. Because of precautionary saving, Sudden Stops are infrequent events nested within normal cycles in the long run, but they remain a positive probability event. 
JEL:  D52 E44 F32 F41 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12564&r=dge 
By:  Szilárd Benk; Max Gillman; Michal Kejak 
Abstract:  The explanation of velocity has been based in substitution and income effects, since Keynes’s (1923) interest rate explanation and Friedman’s (1956) application of the permanent income hypothesis to money demand. Modern real business cycle theory relies on a goods productivity shocks to mimic the data’s procyclic velocity feature, as in Friedman’s explanation, while finding money shocks unimportant and not integrating financial innovation explanations. This paper sets the model within endogenous growth and adds credit shocks. It models velocity more closely, with significant roles for money shocks and credit shocks, along with the goods productivity shocks. Endogenous growth is key to the construction of the money and credit shocks since they have similar effects on velocity, through substitution effects from changes in the nominal interest rate and in the cost of financial intermediation, but opposite effects upon growth, through permanent income effects that are absent with exogenous growth. 
Keywords:  Velocity, business cycle, credit shocks, endogenous growth. 
JEL:  E13 E32 E44 
Date:  2006–09 
URL:  http://d.repec.org/n?u=RePEc:san:cdmacp:0604&r=dge 
By:  Stijn Van Nieuwerburgh; PierreOlivier Weill 
Abstract:  We investigate the 30 year increase in the level and dispersion of house prices across U.S. metropolitan areas in a calibrated dynamic general equilibrium island model. The model is based on two main assumptions: households flow in and out metropolitan areas in response to local wage shocks, and the housing supply cannot adjust instantly because of regulatory constraints. Feeding in our model the 30 year increase in crosssectional wage dispersion that we document based on metropolitanlevel data, we generate the observed increase in house price level and dispersion. In equilibrium, workers flow towards exceptionally productive metropolitan areas and drive house prices up. The calibration also reveals that, while a baseline level of regulation is important, a tightening of regulation by itself cannot account for the increase in house price level and dispersion: in equilibrium, workers flow out of tightly regulated towards less regulated metropolitan areas, undoing most of the price impact of additional local supply regulations. Finally, the calibration with increasing wage dispersion suggests that the welfare effects of housing supply regulation are large. 
JEL:  E24 R12 R13 
Date:  2006–09 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12538&r=dge 
By:  Marco Cagetti; Mariacristina De Nardi 
Abstract:  In the United States wealth is highly concentrated and very unequally distributed: the richest 1% hold one third of the total wealth in the economy. Understanding the determinants of wealth inequality is a challenge for many economic models. We summarize some key facts about the wealth distribution and what economic models have been able to explain so far. 
JEL:  D3 D58 D64 E2 E20 E23 H0 H31 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12550&r=dge 
By:  Roland Meeks (Nuffield College, University of Oxford) 
Abstract:  This paper asks how well a general equilibrium agency cost model describes the dynamic relationship between credit variables and the business cycle. A Bayesian VAR is used to obtain probability intervals for empirical correlations. The agency cost model is found to predict the leading, countercyclical correlation of spreads with output when shocks arising from the credit market contribute to output fluctuations. The contribution of technology shocks is held at conventional RBC levels. Sensitivity analysis shows that moderate prior calibration uncertainty leads to significant dispersion in predictedcorrelations. Most predictive uncertainty arises from a single parameter. 
Keywords:  agency costs, credit cycles, calibration, shocks. 
JEL:  C11 C32 E32 E37 E44 
Date:  2006–08–25 
URL:  http://d.repec.org/n?u=RePEc:nuf:econwp:0611&r=dge 
By:  Dirk Krueger (University of Frankfurt, CEPR, CFS and NBER); Hanno Lustig (University of California Los Angeles and NBER); Fabrizio Perri (University of Minnesota, Federal Reserve Bank of Minneapolis, CEPR and NBER) 
Abstract:  We evaluate the asset pricing implications of a class of models in which risk sharing is imperfect because of the limited enforcement of intertemporal contracts. Lustig (2004) has shown that in such a model the asset pricing kernel can be written as a simple function of the aggregate consumption growth rate and the growth rate of consumption of the set of households that do not face binding enforcement constraints in that state of the world. These unconstrained households have lower consumption growth rates than constrained households, i.e. they are located in the lower tail of the crosssectional consumption growth distribution. We use household consumption data from the U.S. Consumer Expenditure Survey to estimate the pricing kernel implied by the model and to evaluate its performance in pricing aggregate risk. We employ the same data to construct aggregate consumption and to derive the standard complete markets pricing kernel. We find that the limited enforcement pricing kernel generates a market price of risk that is substantially larger than the standard complete markets asset pricing kernel. 
Keywords:  Limited Commitment, Equity Premium, Stochastic Discount Factor, Household Consumption Data 
JEL:  G12 D52 E44 
Date:  2006–10–06 
URL:  http://d.repec.org/n?u=RePEc:cfs:cfswop:wp2000622&r=dge 
By:  Nir Jaimovich; Sergio Rebelo 
Abstract:  We propose a model that generates an economic expansion in response to good news about future total factor productivity (TFP) or investmentspecific technical change. The model has three key elements: variable capital utilization, adjustment costs to investment, and preferences that exhibit a weak shortrun wealth effect on the labor supply. These preferences nest the two classes of utility functions most widely used in the business cycle literature as special cases. Our model can generate recessions that resemble those of the postwar U.S. economy without relying on negative productivity shocks. The recessions are caused not by contemporaneous negative shocks but rather by lackluster news about future TFP or investmentspecific technical change. 
JEL:  E24 E32 
Date:  2006–09 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12537&r=dge 
By:  Dmitry Livdan; Horacio Sapriza; Lu Zhang 
Abstract:  More financially constrained firms are riskier and earn higher expected returns than less financially constrained firms, although this effect can be subsumed by size and booktomarket. Further, because the stochastic discount factor makes capital investment more procyclical, financial constraints are more binding in economic booms. These insights arise from two dynamic models. In Model 1, firms face dividend nonnegativity constraints without any access to external funds. In Model 2, firms can retain earnings, raise debt and equity, but face collateral constraints on debt capacity. Despite their diverse structures, the two models share largely similar predictions. 
JEL:  G12 G31 G32 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12555&r=dge 
By:  Linnea Polgreen; Pedro Silos 
Abstract:  Higher oil price shocks benefit unskilled workers relative to skilled workers: Over the business cycle, energy prices and the skill premium display a strong negative correlation. This correlation is robust to different detrending procedures. We construct and estimate a model economy with energy use and heterogeneous skills and study its business cycle implications, in particular the cyclical behavior of oil prices and the skill premium. In our model economy, the skill premium and the ratio of hours worked by skilled workers to hours worked by unskilled workers are both negatively correlated with oil prices over the business cycle. For the skill premium and energy prices to move in opposite directions, the key ingredient is the larger substitutability of capital for unskilled labor than for skilled labor. The negative correlation arises even when energy and capital are fairly good substitutes. 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedawp:200614&r=dge 
By:  Nir Jaimovich; Sergio Rebelo 
Abstract:  We explore the business cycle implications of expectation shocks and of two wellknown psychological biases, optimism and overconfidence. The expectations of optimistic agents are biased toward good outcomes, while overconfident agents overestimate the precision of the signals that they receive. Both expectation shocks and overconfidence can increase businesscycle volatility, while preserving the model's properties in terms of comovement, and relative volatilities. In contrast, optimism is not a useful source of volatility in our model. 
JEL:  E32 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12570&r=dge 
By:  Marco Cagetti; Mariacristina De Nardi 
Abstract:  Entrepreneurship is a key determinant of investment, saving, and wealth inequality. We study the aggregate and distributional effects of several tax reforms in a model that recognizes this key role and that matches the large wealth inequality observed in the U.S. data. The aggregate effects of tax reforms can be particularly large when they affect small and mediumsized businesses, which face the most severe financial constraints, rather than big businesses. The consequences of changes in the estate tax depend heavily on the size of its exemption level. The current effective estate tax system insulates smaller businesses from the negative effects of estate taxation, minimizing the aggregate costs of redistribution. Abolishing the current estate tax would generate a modest increase in wealth inequality and slightly reduce aggregate output. Decreasing the progressivity of the income tax generates large increases in output, at the cost of large increases in wealth concentration. 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedhwp:wp0607&r=dge 
By:  Marina AzzimontiRenzo; Eva de Francisco; Per Krusell 
Abstract:  We explore a political economy model of labor subsidies, extending Meltzer and Richard's median voter model to a dynamic setting. We explore only one source of heterogeneity: initial wealth. As a consequence, given an operative wealth effect, poorer agents work harder, and if the agent with median wealth is poorer than average, a politicoeconomic equilibrium will feature a subsidy to labor. The dynamic model does not have capital, but it has perfect markets for borrowing and lending. Because tax rates influence interest rates, another channel for redistribution appears, since a decrease in current interest rates favors agents with a negative (belowaverage) asset position. ; By the same token  and as is typically the case in dynamic politicoeconomic models with rational agents  the setting features timeinconsistency: the median voter would like to commit to not manipulating interest rates in the future. Under commitment, and under the assumption that preferences admit aggregation, we show that labor subsidies subsist only for one period; after that, subsidies are zero. That is, under commitment, the median voter takes advantage of the voting power once and for all. His wealth moves closer to that of the mean (which is zero), but afterwards he refrains voluntarily from further subsidization. Under lack of commitment, which we analyze formally by looking at the Markovperfect (timeconsistent) equilibrium in a game between successive median voters in the same environment. Instead, subsidies persist  they are constant over time  and are more distortionary than under commitment. Moreover, in the situation without commitment, the median voter does not manage to reduce asset inequality, unlike in the commitment case. 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedrwp:0609&r=dge 
By:  Roc Armenter; Amartya Lahiri 
Abstract:  Crosscountry data reveal that the per capita incomes of the richest countries exceed those of the poorest countries by a factor of thirtyfive. We formalize a model with embodied technical change in which newer, more productive vintages of capital coexist with older, less productive vintages. A reduction in the cost of investment raises both the quantity and productivity of capital simultaneously. The model induces a simple relationship between the relative price of investment goods and per capita income. Using crosscountry data on the prices of investment goods, we find that the model does fairly well in quantitatively accounting for the observed dispersion in world income. For our baseline parameterization, the model generates thirtyfivefold income gaps and sixfold productivity differences between the richest and poorest countries in our sample. 
Keywords:  Productivity ; Wealth ; Income ; Capital 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fednsr:258&r=dge 
By:  Thomas A. Lubik; Paolo Surico 
Abstract:  This paper reconsiders the empirical relevance of the Lucas critique using a DSGE sticky price model in which a weak central bank response to inflation generates equilibrium indeterminacy. The model is calibrated on the magnitude of the historical shift in the Federal Reserve’s policy rule and is capable of generating the decline in the volatility of inflation and real activity observed in U.S. data. Using Monte Carlo simulations and a backwardlooking model of aggregate supply and demand, we show that shifts in the policy rule induce breaks in both the reducedform coefficients and the reducedform error variances. The statistics of popular parameter stability tests are shown to have low power if such heteroskedasticity is neglected. In contrast, when the instability of the reducedform error variances is accounted for, the Lucas critique is found to be empirically relevant for both artificial and actual data. 
Keywords:  Monetary policy ; Econometric models 
Date:  2006 
URL:  http://d.repec.org/n?u=RePEc:fip:fedrwp:0605&r=dge 
By:  Andy Snell; Jonathan Thomas 
Abstract:  This paper analyses a model in which firms cannot pay discriminate based on year of entry to a firm, and develops an equilibrium model of wage dynamics and unemployment. The model is developed under the assumption of worker mobility, so that workers can costlessly quit jobs at any time. Firms on the other hand are committed to contracts. Thus the model is related to Beaudry and DiNardo (1991). We solve for the dynamics of wages and unemployment, and show that real wages do not necessarily clear the labor market. Using sectoral productivity data from the postwar US economy, we assess the ability of the model to match actual unemployment and wage series. We also show that equal treatment follows in our model from the assumption of atwill employment contracting. 
JEL:  E32 J41 
Date:  2006–09 
URL:  http://d.repec.org/n?u=RePEc:san:cdmacp:0603&r=dge 
By:  Mariacristina De Nardi; Eric French; John Bailey Jones 
Abstract:  People have heterogenous life expectancies: women live longer than men, rich people live longer than poor people, and healthy people live longer than sick people. People are also subject to heterogenous outofpocket medical expense risk. We construct a rich structural model of saving behavior for retired single households that accounts for this heterogeneity, and we estimate the model using AHEAD data and the method of simulated moments. We find that the risk of living long and facing high medical expenses goes a long way toward explaining the elderly's savings decisions. Specifically, medical expenses that rise quickly with both age and permanent income can explain why the elderly singles, and especially the richest ones, run down their assets so slowly. We also find that social insurance has a big impact on the elderly's savings. 
JEL:  D1 D31 E2 H31 H51 I1 
Date:  2006–10 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12554&r=dge 