nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2006‒12‒09
thirteen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Taxing Capital? Not a Bad Idea After All! By Conesa, Juan Carlos; Kitao, Sagiri; Krüger, Dirk
  2. Frictional Wage Dispersion in Search Models: A Quantitative Approach By Hornstein, Andreas; Krusell, Per; Violante, Giovanni L
  3. Optimal Welfare-to-Work Programs By Pavoni, Nicola; Violante, Giovanni L
  4. Pension Systems and the Allocation of Macroeconomic Risk By Bovenberg, A Lans; Uhlig, Harald
  5. Solving for Country Portfolios in Open Economy Macro Models By Devereux, Michael B; Sutherland, Alan
  6. Inflation as a Redistribution Shock: Effects on Aggregates and Welfare By Doepke, Matthias; Schneider, Martin
  7. How Well Does the US Social Insurance System Provide Social Insurance? By Mark Huggett; Juan Carlos Parra
  8. The Aggregate Labour Market Effects of the Swedish Knowledge Lift Program By Albrecht, James; van den Berg, Gerard J; Vroman, Susan
  9. The Irrelevance of Market Incompleteness for the Price of Aggregate Risk By Krüger, Dirk; Lustig, Hanno
  10. A General Equilibrium Analysis of Annuity Rates in the Presence of Aggregate Mortality Risk By Martin Weale; Justin van de Ven
  11. Origins and Consequences of Child Labour Restrictions: A Macroeconomic Perspective By Doepke, Matthias; Krüger, Dirk
  12. The Dynamic Implications of Foreign Aid and Its Variability By Cristina Arellano; Aleš Bulir; Timothy D. Lane; Leslie Lipschitz
  13. The Phillips Curve Under State-Dependent Pricing By Bakhshi, Hasan; Khan, Hashmat; Rudolf, Barbara

  1. By: Conesa, Juan Carlos; Kitao, Sagiri; Krüger, Dirk
    Abstract: In this paper we quantitatively characterize the optimal capital and labor income tax in an overlapping generations model with idiosyncratic, uninsurable income shocks, where households also differ permanently with respect to their ability to generate income. The welfare criterion we employ is ex-ante (before ability is realized) expected (with respect to uninsurable productivity shocks) utility of a newborn in a stationary equilibrium. Embedded in this welfare criterion is a concern of the policy maker for insurance against idiosyncratic shocks and redistribution among agents of different abilities. Such insurance and redistribution can be achieved by progressive labor income taxes or taxation of capital income, or both. The policy maker has then to trade off these concerns against the standard distortions these taxes generate for the labor supply and capital accumulation decision. We find that the optimal capital income tax rate is not only positive, but is significantly positive. The optimal (marginal and average) tax rate on capital is 36%, in conjunction with a progressive labor income tax code that is, to a first approximation, a flat tax of 23% with a deduction that corresponds to about $6,000 (relative to an average income of households in the model of $35,000). We argue that the high optimal capital income tax is mainly driven by the life cycle structure of the model whereas the optimal progressivity of the labor income tax is due to the insurance and redistribution role of the income tax system.
    Keywords: capital taxation; optimal taxation; progressive taxation
    JEL: E62 H21 H24
    Date: 2006–11
  2. By: Hornstein, Andreas; Krusell, Per; Violante, Giovanni L
    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 differentials among ex-ante 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 'mean-min ratio') can be obtained in closed form as a function of observable variables (i.e., interest rate, value of leisure, and statistics of labour 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 on-the-job 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.
    Keywords: mean-min ratio; search; wage dispersion
    JEL: E24 J31 J64
    Date: 2006–11
  3. By: Pavoni, Nicola; Violante, Giovanni L
    Abstract: A Welfare-to-Work (WTW) program is a mix of government expenditures on various labor market policies targeted to the unemployed (e.g., unemployment insurance, job search monitoring, social assistance, wage subsidies). This paper provides a dynamic principal-agent framework suitable for analyzing chief features of an optimal WTW program such as the sequence and duration of the different policies, the dynamic pattern of payments along the unemployment spell, and the emergence of taxes/subsidies upon re-employment. The optimal program endogenously generates an absorbing policy of last resort ('social assistance') characterized by a constant lifetime payment and no active participation by the agent. Human capital depreciation is a necessary condition for policy transitions to be part of an optimal WTW program. The typical sequence of policies is quite simple: the program starts with standard unemployment insurance, then switches into monitored search and, finally, into social assistance. The optimal benefits are decreasing during unemployment insurance and constant during both job search monitoring and social assistance. Whereas taxes (subsidies) can be either increasing or decreasing with duration during unemployment insurance, they must decrease (increase) during a phase of job search monitoring. In a calibration exercise, we use our model to analyze quantitatively the features of the optimal program for the U.S. economy. With respect to the existing U.S. system, the optimal WTW scheme delivers sizeable welfare gains to unskilled workers because the incentives to search for a job can be retained even while delivering more insurance, and using costly monitoring less intensively.
    Keywords: human capital; job search monitoring; recursive contracts; unemployment insurance; welfare-to-work
    JEL: D82 H21 J24 J64 J65
    Date: 2006–11
  4. By: Bovenberg, A Lans; Uhlig, Harald
    Abstract: This paper explores the optimal risk sharing arrangement between generations in an overlapping generations model with endogenous growth. We allow for nonseparable preferences, paying particular attention to the risk aversion of the old as well as overall 'life-cycle' risk aversion. We provide a fairly tractable model, which can serve as a starting point to explore these issues in models with a larger number of periods of life, and show how it can be solved. We provide a general risk sharing condition, and discuss its implications. We explore the properties of the model quantitatively. Among the key findings are the following. First and for reasonable parameters, the old typically bear a larger burden of the risk in productivity surprises, if old-age risk-aversion is smaller than life risk aversion, and vice versa. Thus, it is not necessarily the case that the young ensure smooth consumption of the old. Second, consumption of the young and the old always move in the same direction, even for population growth shocks. This result is in contrast to the result of a fully-funded decentralized system without risk-sharing between generations. Third, persistent increases in longevity will lead to lower total consumption of the old (and thus certainly lower per-period consumption of the old) as well as the young as well as higher work effort of the young. The additional resources are instead used to increase growth and future output, resulting in higher consumption of future generations.
    Keywords: overlapping generations; pension systems; risk sharing; social optimum
    JEL: E21 E61 E62 H21 H55 O40
    Date: 2006–11
  5. By: Devereux, Michael B; Sutherland, Alan
    Abstract: Open economy macroeconomics typically abstracts from portfolio structure. But the recent experience of financial globalization makes it important to understand the determinants and composition of gross country portfolios. This paper presents a simple approximation method for computing equilibrium financial portfolios in stochastic open economy macro models. The method is widely applicable, easy to implement, and delivers analytical solutions for optimal gross portfolio positions in any combination of types of assets. It can be used in models with any number of assets, whether markets are complete or incomplete, and can be applied to stochastic dynamic general equilibrium models of any dimension, so long as the model is amenable to a solution using standard approximation methods.
    Keywords: country profiles; solution methods
    JEL: E52 E58 F41
    Date: 2006–11
  6. By: Doepke, Matthias; Schneider, Martin
    Abstract: Episodes of unanticipated inflation reduce the real value of nominal claims and thus redistribute wealth from lenders to borrowers. In this study, we consider redistribution as a channel for aggregate and welfare effects of inflation. We model an inflation episode as an unanticipated shock to the wealth distribution in a quantitative overlapping-generations model of the U.S. economy. While the redistribution shock is zero sum, households react asymmetrically, mostly because borrowers are younger on average than lenders. As a result, inflation generates a decrease in labour supply as well as an increase in savings. Even though inflation-induced redistribution has a persistent negative effect on output, it improves the weighted welfare of domestic households.
    Keywords: aggregate effects; inflation; redistribution; welfare
    JEL: D31 D58 E31 E50
    Date: 2006–11
  7. By: Mark Huggett; Juan Carlos Parra (Department of Economics, Georgetown University)
    Abstract: This paper answers the question posed in the title within a model where agents receive idiosyncratic, wage-rate shocks that are privately observed. When the model social insurance system is comprised by the US social security and income tax system, then the maximum ex-ante welfare gain to improved insurance is equivalent to a 12.3 percent increase in consumption. We determine the reasons behind this large welfare gain. We also analyze two parametric reforms of the model social insurance system. One reform increases welfare very little, whereas the other achieves nearly all of the maximum possible welfare gain. Classification-JEL Codes: D80, D90, E21
    Keywords: Social Insurance, Social Security, Idiosyncratic Shocks, Private Information
  8. By: Albrecht, James; van den Berg, Gerard J; Vroman, Susan
    Abstract: The Swedish adult education program known as the Knowledge Lift (1997--2002) was unprecedented in its size and scope, aiming to raise the skill level of large numbers of low-skill workers. This paper evaluates the potential effects of this program on aggregate labour market outcomes. This is done by calibrating an equilibrium search model with heterogeneous worker skills using pre-program data and then forecasting the program impacts. We compare the forecasts to observed aggregate labour market outcomes after termination of the program.
    Keywords: calibration; job search; program evaluation; returns to education; Swedish labour market; unemployment; wages
    JEL: C31 D83 J21 J24 J31 J64
    Date: 2006–11
  9. By: Krüger, Dirk; Lustig, Hanno
    Abstract: In models with a large number of agents who have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labour income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks. In spite of the missing markets, a representative agent who consumes aggregate income prices the excess returns on stocks correctly. This result holds regardless of the persistence of idiosyncratic shocks, as long as they are not permanent, even when households face binding, and potentially very tight borrowing constraints. Consequently, in this class of models there is no link between the extent of self-insurance against idiosyncratic income risk and aggregate risk premia.
    Keywords: idiosyncratic income risk; incomplete markets; risk premium
    JEL: G12
    Date: 2006–11
  10. By: Martin Weale; Justin van de Ven
    Abstract: This paper explores the pricing of annuities in a structural overlapping generations model in which the mortality rate of people when old is uncertain. A market clearing price for annuities is established below the fair price. At this price the willingness of old people to pay the young to carry old people’s aggregate mortality risk is balanced by the willingness of the young to bear the risk. The model suggests that aggregate mortality risk is unlikely to be a major influence on annuity pricing.
    Date: 2006–10
  11. By: Doepke, Matthias; Krüger, Dirk
    Abstract: In this paper we investigate the positive and normative consequences of child-labour restrictions for economic aggregates and welfare. We argue that even though the laissez-faire equilibrium may be inefficient, there are usually better policies to cure these inefficiencies than the imposition of a child-labour ban. Given this finding, we investigate the potential political-economic reasons behind the emergence and persistence of child-labour legislation. Our investigation is based on a structural dynamic general equilibrium model that provides a coherent and uniform framework for our analysis.
    Keywords: child labour; inequality; political economy; welfare
    JEL: J40 J82 O11 O40
    Date: 2006–11
  12. By: Cristina Arellano; Aleš Bulir; Timothy D. Lane; Leslie Lipschitz
    Abstract: The paper examines the effects of aid and its volatility on consumption, investment, and the structure of production in the context of an intertemporal two-sector general equilibrium model. A permanent flow of aid finances mainly consumption, a result consistent with the historical failure of aid inflows to translate into sustained growth. Shocks to aid are reflected mainly in investment fluctuations, as a result of consumption smoothing. Aid shocks result in substantial welfare losses, suggesting that aid variability should be taken into account in designing aid architecture. These results are consistent with the evidence from cross-country regressions of manufactured exports.
    Date: 2005–06–27
  13. By: Bakhshi, Hasan; Khan, Hashmat; Rudolf, Barbara
    Abstract: This article is related to the large recent literature on Phillips curves in sticky- price equilibrium models. It differs in allowing for the degree of price stickiness to be determined endogenously. A closed-form solution for short-term inflation is derived from the dynamic stochastic general equilibrium (DSGE) model with state-dependent pricing developed by Dotsey, King and Wolman. This generalized Phillips curve encompasses the New Keynesian Phillips curve (NKPC) based on Calvo-type price-setting as a special case. It describes current inflation as a function of lagged inflation, expected future inflation, current and expected future real marginal costs, and current and past variations in the distribution of price vintages. We find that current inflation depends positively on its own lagged values giving rise to intrinsic persistence as a source of inflation persistence. Also, we find that the state-dependent terms (that is, the variations in the distribution of price vintages) tend to counteract the contribution of lagged inflation to inflation persistence.
    Keywords: inflation dynamics; Phillips curve; state-dependent pricing
    JEL: E31 E32
    Date: 2006–11

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