nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2006‒10‒21
fifteen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Shooting the Auctioneer By Roger E. A. Farmer; Andrew Hollenhorst
  2. Nominal wage rigidities in a new Keynesian model with frictional unemployment By Vincent Bodart; Gregory de Walque; Olivier Pierrard; Henri R. Sneessens; Raf Wouters
  3. Equilibrium Dynamics in an Overlapping Generations Economy with Endogenous Labor Supply By Atsue Mizushima
  4. Solving Heterogeneous-Agent Models by Projection and Perturbation By Michael Reiter
  5. Social Security and Risk Sharing By Piero Gottardi; Felix Kubler
  6. Fiscal Policy and Macroeconomic Uncertainty in Developing Countries: The Tale of the Tormented Insurer By Enrique G. Mendoza; P. Marcelo Oviedo
  7. Macroeconomic fluctuations and firm entry : theory and evidence By Vivien Lewis
  8. The effects of aging population on the sustainability of fiscal policy By Puhakka , Mikko
  9. Measuring the Cost of Economic Fluctuations with Preferences that Rationalize the Equity Premium By Angelo Melino
  10. The optimal tax treatment of housing capital in the neoclassical growth model By Eerola , Essi; Määttänen , Niku
  11. Monetary Equilibria in a Baumol-Tobin Economy By Ingolf Schwarz
  12. Dynamics and monetary policy in a fair wage model of the business cycle By David de la Croix; Gregory de Walque; Rafael Wouters
  13. The Effects of the Size of the Public Sector on Fertility By Mikko Puhakka; Matti Viren
  14. Labour and product market competition in a small open economy, Simulation results using a DGE model of the Finnish economy By Kilponen, Juha; Ripatti , Antti
  15. Forecasting with a forward-looking DGE model: combining long-run views of financial markets with macro forecasting By Männistö , Hanna-Leena

  1. By: Roger E. A. Farmer; Andrew Hollenhorst
    Abstract: Most dynamic stochastic general equilibrium models of the macroeconomy assume that labor is traded in a spot market. Two exceptions by David Andolfatto and Monika Merz combine a two-sided search model with a one-sector real business cycle model. These hybrid models are successful, in some dimensions, but they cannot account for observed volatility in unemployment and vacancies. Following suggestions by Robert Hall and Robert Shimer, this paper shows that a relatively standard DSGE model with sticky wages can account for these facts. Using a second-order approximation to the policy function we simulate moments of an artificial economy with and without sticky wages and we document the dependence of unemployment and vacancy volatility on two key parameters; the disutility of effort and the degree of wage stickiness. We compute the welfare costs of the sticky wage equilibrium and find them to be small.
    JEL: E32 J6
    Date: 2006–10
  2. By: Vincent Bodart (Department of Economics, Université catholique de Louvain); Gregory de Walque (National Bank of Belgium, Research department; Department of Economics, University of Namur); Olivier Pierrard (Department of Economics, Université catholique de Louvain; Banque centrale du Luxembourg); Henri R. Sneessens (Department of Economics, Université catholique de Louvain); Raf Wouters (National Bank of Belgium, Research department)
    Abstract: In this paper, we propose a search and matching model with nominal stickiness à la Calvo in the wage bargaining. We analyze the properties of the model, first, in the context of a typical real business cycle model driven by stochastic productivity shocks and second, in a fully specified monetary DSGE model with various real and nominal rigidities and multiple shocks. The model generates realistic statistics for the important labor market variables
    Keywords: DSGE, Search and Matching, Nominal Wage Rigidity, Monetary Policy
    JEL: E31 E32 E52 J64
    Date: 2006–10
  3. By: Atsue Mizushima (Graduate School of Economics, Osaka University)
    Abstract: This note develops a one-sector, two-period, overlapping generations model that incorporates endogenous labor-care choice. Care choice is modeled by allowing young agents to participate in the production of household health status. Using this model, we derive the steady-state equilibrium dynamics.
    Keywords: care supply, equilibrium dynamics, household production
    JEL: D13 J22
    Date: 2006–10
  4. By: Michael Reiter
    Abstract: The paper proposes a numerical solution method for general equilibrium models with a continuum of heterogeneous agents, which combines elements of projection and of perturbation methods. The basic idea is to solve first for the stationary solution of the model, without aggregate shocks but with fully specified idiosyncratic shocks. Afterwards one computes a first-order perturbation of the solution in the aggregate shocks. This approach allows to include a high-dimensional representation of the cross-sectional distribution in the state vector. The method is applied to a model of household saving with uninsurable income risk and liquidity constraints. The model includes not only productivity shocks, but also shocks to redistributive taxation, which cause substantial short-run variation in the cross-sectional distribution of wealth. If those shocks are operative, it is shown that a solution method based on very few statistics of the distribution is not suitable, while the proposed method can solve the model with high accuracy, at least for the case of small aggregate shocks. Techniques are discussed to reduce the dimension of the state space such that higher order perturbations are feasible. Matlab programs to solve the model can be downloaded.
    Keywords: Heterogeneous agents; projection methods; perturbation methods
    JEL: C63 C68 E21
    Date: 2006–09
  5. By: Piero Gottardi (Department of Economics, University Of Venice Cà Foscari); Felix Kubler (University of Pennsylvania and Universitat Mannheim)
    Abstract: In this paper we identify conditions under which the introduction of a pay-as-you-go social security system is ex-ante Pareto-improving in a stochastic overlapping generations economy with capital accumulation and land. We argue that these conditions are consistent with many calibrations of the model used in the literature. In our model financial markets are complete and competitive equilibria are interim Pareto efficient. Therefore, a welfare improvement can only be obtained if agents' welfare is evaluated ex ante, and arises from the possibility of inducing, through social security, an improved level of intergenerational risk sharing. We will also examine the optimal size of a given social security system as well as its optimal reform. The analysis will be carried out in a relatively simple set-up, where the various effects of social security, on the prices of long-lived assets and the stock of capital, and hence on output, wages and risky rates of returns, can be clearly identified.
    Keywords: Intergenerational Risk Sharing, Social Security, Ex Ante Welfare Improvements, Interim Optimality, Price Effects.
    Date: 2006
  6. By: Enrique G. Mendoza; P. Marcelo Oviedo
    Abstract: Governments in emerging markets often behave like a "tormented insurer," trying to use non-state-contingent debt instruments to avoid cuts in payments to private agents despite large fluctuations in public revenues. In the data, average public debt-GDP ratios decline as the variability of revenues increases, primary balances and current expenditures follow cyclical patterns sharply at odds with the countercyclical patterns of industrial countries, and the cyclical variability of public expenditures exceeds that of private expenditures by a wide margin. This paper proposes a model of a small open economy with incomplete markets that can rationalize this behavior. In the model a fiscal authority makes optimal expenditure and debt plans given shocks to output and revenues, and private agents make optimal consumption and asset accumulation plans. Quantitative analysis of the model calibrated to Mexico yields a negative relationship between average public debt and revenue variability similar to the one observed in the data. The model mimics Mexico's GDP correlations of government purchases and the primary balance. The ratio of public-to-private expenditures fluctuates widely and the implied welfare costs dwarf conventional estimates of negligible benefits of risk sharing and consumption smoothing.
    JEL: E62 F34 H63
    Date: 2006–10
  7. By: Vivien Lewis (Center for Economic Studies, Catholic University Leuven)
    Abstract: This paper studies the behaviour of firm entry and exit in response to macroeconomic shocks. We formulate a dynamic stochastic general equilibrium model with an endogenous number of producers. From the calibrated model, we derive a minimum set of robust sign restrictions to identify four kinds of macroeconomic shocks in a vector autoregression, namely supply, demand, monetary and entry cost shocks. The variables entering the VAR are output, inflation, the nominal interest rate, profits and firm entry. The response of firm entry to the various shocks is freely estimated. Our main finding is that entry responds significantly to all types of shocks. The results also show a crowding-in of firm entry following an exogenous rise in demand, consistent with the effect of a consumption preference shock predicted by the model
    Keywords: firm entry, VAR, business cycles
    JEL: E30 E32
    Date: 2006–10
  8. By: Puhakka , Mikko (Department of Economics, University of Oulu)
    Abstract: We study the effects of aging population on the sustainability of fiscal policy in overlapping generations models with government debt and a pay-as-you-go pension system. The smaller the population growth rate, the lower the maximum sustainable level of deficits. When the utility function is of a specific form, an increase in the payroll tax rate and the replacement rate decreases the level of maximum sustainable deficits; except in the case when pension depends on the wage level prevailing during the working period. The ratio of the deficits in two economies with different population growth rates is characterized with numerical examples.
    Keywords: aging; pensions; overlapping generations; fiscal policy
    JEL: E21 E32
    Date: 2005–10–11
  9. By: Angelo Melino
    Abstract: Lucas (2003) argues that the potential welfare gains from stabilizing the business cycle are small. In fact, he shows that the benefits of eliminating all economic fluctuations are small, both in an absolute sense and when compared to the potential gains from other reforms. His estimates are obtained using standard preferences. In this paper, I show that a model consistent with observed data on asset returns leads to very different conclusions. Calibrating preferences to observed asset market data raises the estimated welfare gains from completely eliminating aggregate fluctuations by approximately two orders of magnitude. Most of the gains, however, come from the elimination of low frequency contributions.
    Keywords: welfare cost, fluctuations, stabilization
    JEL: E32 E61
    Date: 2006–10–08
  10. By: Eerola , Essi (RUESG, University of Helsinki); Määttänen , Niku (The Research Institute of the Finnish Economy and CEBR)
    Abstract: In a dynamic setting, housing is both an asset and a consumption good. But should it be taxed like other forms of consumption or like other forms of saving? We consider the optimal taxation of the imputed rent from owner housing within a version of the neoclassical growth model. We find that the optimal tax rate on the imputed rent is quite sensitive to the constraints imposed on the other available tax rates. In general, it is not optimal to tax the imputed rent at the same rate as the business capital income.
    Keywords: housing; capital taxation; optimal taxation
    JEL: E21 H21
    Date: 2005–07–11
  11. By: Ingolf Schwarz (Max Planck Institute for Research on Collective Goods, Bonn)
    Abstract: This paper provides a non-steady state general equilibrium foundation for the transactions demand for money going back to Baumol (1952) and Tobin (1956). In our economy, money competes against real capital as a store of value. We prove existence of a monetary general equilibrium in which both real capital and fiat money are voluntarily held over time. The demand for money is generated by fixed transactions costs. More precisely, we assume that house-holds have two physically separated accounts. On the first account they finance consumption and might want to hold money over time. On the second account households receive their wages, hold claims on capital and earn interest income from renting capital to firms. Every transfer of wealth between the two accounts requires fixed resources. In equilibrium, households space apart the transaction dates in time. Between these transaction dates, money is held as a store of value on the first account for transactions purposes. The number of periods over which money is held is endogenous and the nonconvexity of the problem is explicitly taken into account.
    Keywords: Baumol-Tobin, Monetary Theory, General Equilibrium Theory
    JEL: D50 E40 E41
    Date: 2006–06
  12. By: David de la Croix (Department of economics, Université catholique de Louvain; CORE); Gregory de Walque (National Bank of Belgium, Research department; Department of Economics, University of Namur); Rafael Wouters (National Bank of Belgium, Research department)
    Abstract: We first build a fair wage model in which effort varies over the business cycle. This mechanism decreases the need for other sources of sluggishness to explain the observed high inflation persistence. Second, we confront empirically our fair wage model with a New Keynesian model based on the standard assumption of monopolistic competition in the labor market. We show that, in terms of overall fit, the fair wage model outperforms the New Keynesian one. The extension of the fair wage model with lagged wage is judged insignificant by the data, but the extension based on a rent sharing argument including firm’s productivity gains in the fair wage is not. Looking at the implications for monetary policy, we conclude that the additional trade-off problem created by the inefficient real wage behavior significantly affects nominal interest rates and inflation outcomes
    Keywords: Efficiency wage, effort, inflation persistence, monetary policy
    JEL: E4 E5
    Date: 2006–10
  13. By: Mikko Puhakka (Department of Economics, University of Oulu); Matti Viren (Department of Economics, University of Turku)
    Abstract: We construct a simple exchange economy overlapping generations model in which there are along with a public social security various private insurance schemes to explore fertility and the effects of various variables on it. In the private system parents can invest in children and benefit from their support (care and income support) in the old age. An introduction of the public system will lower the incentive to have children, i.e. the fertility will be lower. This is an important negative externality of public pension system. We test some of the model's basic implications using long historical panel data from 11 countries for the period 1750-1995. In addition, two other data sets, the WDI (World Bank) and MZES (Manheim University) are used to reinforce the empirical results that are obtained with historical data. These analyses show that, opposite to common beliefs, there is a positive relationship between ageing and fertility if we control for the key determinants of fertility (size of the public sector, level of income, education and infant mortality). By contrast there is a strong negative relationship between the size of the public sector and fertility. The same is true in terms of income and education while the fertility effect of infant mortality is clearly positive.
    Keywords: fertility, pensions, overlapping generations
    JEL: E21 E32
    Date: 2006–10
  14. By: Kilponen, Juha (Bank of Finland Research); Ripatti , Antti (Bank of Finland Research)
    Abstract: Using the DGE model of the Finnish Economy (the ‘Aino’ model), we study the response of the economy to reforms in both labour and product markets. The reforms are two-fold. We assume that the wage mark-up, ie the monopoly power of wage-setters is gradually reduced by 5 percentage points. At the same time, the degree of competition is increased, ie price margins are exogenously reduced by 2 percentage points. These reforms imply a very favourable outcome of the economy. Both consumption and employment in-creases permanently and the reforms are welfare enhancing. Public balances improve giving room for 1.5 percentage point cut in income taxes. Our simulation exercises clearly demonstrate that such reforms may help in financing the future fiscal burden of an ageing population.
    Keywords: competition; dynamic general equilibrium; public finance
    JEL: C68 E60
    Date: 2006–04–19
  15. By: Männistö , Hanna-Leena (Bank of Finland Research)
    Abstract: To develop forecasting procedures with a forward-looking dynamic general equilibrium model, we built a small New-Keynesian model and calibrated it to euro area data. It was essential in this context that we allowed for long-run growth in GDP. We brought additional asset price equations based on the expecta-tions hypothesis and the Gordon growth model, into the standard open economy model, in order to extract information on private sector long-run expectations on fundamentals, and to combine that information into the macro economic forecast. We propose a method of transforming the model in forecasting use in such a way, as to match, in an economically meaningful way, the short-term forecast levels, especially of the model's jump-variables, to the parameters affecting the long-run trends of the key macroeconomic variables. More specifically, in the model we have used for illustrative purposes, we pinned down the long-run inflation expectations and domestic and foreign potential growth-rates using the model's steady state solution in combination with, by assumption, forward looking information in up-to-date financial market data. Consequently, our proposed solution preserves consistency with market expectations and results, as a favourable by-product, in forecast paths with no initial, first forecast period jumps. Further-more, no ad hoc re-calibration is called for in the proposed forecasting procedures, which clearly is an advantage from point of view of transparency in communication.
    Keywords: forecasting; New Keynesian model; DSGE model; rational expectations; open economy
    JEL: E17 E30 E31 F41
    Date: 2005–10–11

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