nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒02‒10
seventeen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Taxing Capital? Not a Bad Idea After All! By Juan Carlos Conesa; Sagiri Kitao; Dirk Krueger
  2. Capital Market Frictions and the Business Cycle By Giulio, NICOLETTI; Olivier, PIERRARD
  3. Technology-policy interaction in frictional labor markets By Andreas Hornstein; Per Krusell; Giovanni L. Violante
  4. Optimal fiscal and monetary policy when money is essential By S. Boragan Aruoba; Sanjay K. Chugh
  5. Inflation and interest rates with endogenous market segmentation By Aubhik Khan; Julia Thomas
  6. Comparing alternative representations and alternative methodologies in business cycle accounting By V. V. Chari; Patrick J. Kehoe; Ellen R. McGrattan
  7. Risk Sharing and Growth in the Gifts Economy By Atsue Mizushima; Keiichi Koda
  8. Risky human capital and deferred capital income taxation By Borys Grochulski; Tomasz Piskorski
  9. Implementing Technology By Diego Comin; Bart Hobijn
  10. Computing business cycles in emerging economy models By Juan Carlos Hatchondo; Leonardo Martinez; Horacio Sapriza
  11. Dynamics and monetary policy in a fair wage model of the business cylce By David, DE LA CROIX; Gregory, DE WALQUE; Rafael, WOUTERS
  12. Overconfidence in financial markets and consumption over the life cycle By Frank Caliendo; Kevin X. D. Huang
  13. Reassessing the Shimer facts By Shigeru Fujita; Garey Ramey
  14. Real Origins of the Great Depression: Monopolistic Competition, Union Power, and the American Business Cycle in the 1920s By Monique Ebell; Albrecht Ritschl
  15. Open economy DSGE-VAR forecasting and policy analysis - head to head with the RBNZ published forecasts By Kirdan Lees; Troy Matheson; Christie Smith
  16. Growth Effects of Spatial Redistribution Policies By Calin Arcalean; Gerhard Glomm; Ioana Schiopu
  17. The Ins and Outs of Cyclical Unemployment By Michael W. Elsby; Ryan Michaels; Gary Solon

  1. By: Juan Carlos Conesa; Sagiri Kitao; Dirk Krueger
    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 in our model the optimal capital income tax rate 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.
    JEL: E62 H21 H24
    Date: 2007–01
  2. By: Giulio, NICOLETTI; Olivier, PIERRARD
    Abstract: We augment a RBC model with capital and labor market frictions. We follow the approach of Wasmer and Weil (2004) which model market imperfections as search processes : firms must sequentially find a match with a bank first and then with a worker in order to start production. We show that the interactions between labor and capital market frictions may generate a financial accelerator or decelerator, depending on a parameter condition. We compare our model with US National Accounts data and with the empirical findings of DellÕAriccia and Garibaldi (2005) : we find that the financial accelerator as well as real wage rigidities help in improving the statistical propqerties of the model
    Date: 2006–11–15
  3. By: Andreas Hornstein; Per Krusell; Giovanni L. Violante
    Abstract: Does capital-embodied technological change play an important role in shaping labor market outcomes? To address this question, we develop a model with vintage capital and search-matching frictions where irreversible investment in new vintages of capital creates heterogeneity in productivity among firms, matched as well as vacant. We demonstrate that capital-embodied technological change reduces labor demand and raises equilibrium unemployment and unemployment durations. In addition, the presence of labor market regulation?we analyze unemployment benefits, payroll and income taxes, and firing costs?exacerbates these effects. Thus, the model is qualitatively consistent with some key features of the European labor market experience, relative to that of the United States: it features a sharper rise in unemployment and a sharper fall in the vacancy rate and the labor share. A calibrated version of our model suggests that this technology-policy interaction could explain a sizeable fraction of the observed differences between the United States and Europe.
    Keywords: Technology
    Date: 2006
  4. By: S. Boragan Aruoba; Sanjay K. Chugh
    Abstract: We study optimal fiscal and monetary policy in an environment where explicit frictions give rise to valued money, making money essential in the sense that it expands the set of feasible trades. Our main results are in stark contrast to the prescriptions of earlier flexible-price Ramsey models. Two especially important findings emerge from our work: the Friedman Rule is typically not optimal and inflation is stable over time. Inflation is not a substitute instrument for a missing tax, as is sometimes the case in standard Ramsey models. Rather, the inflation tax is exactly the right tax to use because the use of money has a rent associated with it. Regarding the optimal dynamic policy, realized (ex-post) inflation is quite stable over time, in contrast to the very volatile ex-post inflation rates that arise in standard flexible-price Ramsey models. We also find that because capital is underaccumulated, optimal policy includes a subsidy on capital income. Taken together, these findings turn conventional wisdom from traditional Ramsey monetary models on its head.
    Date: 2006
  5. By: Aubhik Khan; Julia Thomas
    Abstract: The authors examine a monetary economy where households incur fixed transactions costs when exchanging bonds and money and, as a result, carry money balances in excess of current spending to limit the frequency of such trades. As only a fraction of households choose to actively trade bonds and money at any given time, the market is endogenously segmented. Moreover, because households in this model economy have the ability to alter the timing of their trading activities, the extent of market segmentation varies over time in response to real and nominal shocks. The authors find that this added flexibility can substantially reinforce both sluggishness in aggregate price adjustment and the persistence of liquidity effects in real and nominal interest rates relative to that seen in models with exogenously segmented markets.
    Date: 2007
  6. By: V. V. Chari; Patrick J. Kehoe; Ellen R. McGrattan
    Abstract: We make two comparisons relevant for the business cycle accounting approach. We show that in theory representing the investment wedge as a tax on investment is equivalent to representing this wedge as a tax on capital income as long as the probability distributions over this wedge in the two representations are the same. In practice, convenience dictates differing probability distributions over this wedge in the two representations. Even so, the quantitative results under the two representations are essentially identical. We also compare our methodology, the CKM methodology, to an alternative one used in Christiano and Davis (2006) as well as by us in early incarnations of the business cycle accounting approach. We argue that the CKM methodology rests on more secure theoretical foundations.
    Date: 2007
  7. By: Atsue Mizushima (Graduate School of Economics, Osaka University); Keiichi Koda (International Graduate School of Social Science Graduate School of Economics, Yokohama National University)
    Abstract: We consider a two-period overlapping generations model where agents face the uncertainty of intergenerational transfers from their children. To avoid this kind of risk, agents have an incentive to share the risk within the same generation. However, there exists an information asymmetry about the realization of the old periodfs income between the insurance company and old agents. By analyzing economies with and without risk sharing, we find that risk sharing decreases the rate of economic growth and accelerates social welfare when the rate of social time preference is sufficiently large.
    Keywords: gifts economy, risk sharing, information asymmetry, economic growth, overlapping generations
    JEL: D81 D82 G22 O40
    Date: 2007–02
  8. By: Borys Grochulski; Tomasz Piskorski
    Abstract: We study the structure of optimal wedges and capital taxes in a Mirrlees economy with endogenous skills. Human capital is a private state variable that drives the skill process of each individual. Building on the findings of the labor literature, we assume that human capital investment is a) risky, b) made early in the life-cycle, and c) hard to distinguish from consumption. These assumptions lead to the optimality of a) a human capital premium, i.e., an excess return on human capital relative to physical capital, b) a large intertemporal wedge early in the life-cycle stemming from the lack of Rogerson's [Econometrica, 1985] "inverse Euler" characterization of the optimal consumption process, and c) an intra-temporal distortion of the effort/consumption margin even at the top of the skill distribution at all dates except the terminal date. The main implication for the structure of linear capital taxes is the necessity of deferred taxation of physical capital. In particular, deferred taxation of capital prevents the agents from making a joint deviation of under-investing in human capital ex ante and shirking from labor effort at some future date in the life-cycle, as the marginal deferred tax rate on physical capital held early in the life-cycle is history-dependent. The average marginal tax rate on physical capital held in every period is zero in present value. Thus, as in Kocherlakota [Econometrica, 2005], the government revenue from capital taxation is zero. However, since a portion of the capital tax must be deferred, expected capital tax payments cannot be zero in every period. Necessarily, agents face negative expected capital tax payments due early in the life-cycle and positive expected capital tax payments late in the life-cycle. Also, relative to economies with exogenous skills, the optimal marginal wealth tax rate is more volatile
    Keywords: Taxation
    Date: 2007
  9. By: Diego Comin; Bart Hobijn
    Abstract: We introduce a tractable model of endogenous growth in which the returns to innovation are determined by the technology adoption decisions of the users of new technologies. Technology adoption involves an implementation investment that determines the initial productivity of a new technology. After implementation, learning increases the productivity of a technology to its full potential. In this framework, implementation enhances growth, while growth increases obsolescence and reduces implementation. In a calibrated version of our model, the optimal policy involves a subsidy to capital and to implementation and a R&D tax. This policy would lead to a welfare improvement of 7.6 percent. Out of steady-state analysis yields that the transitional dynamics of the detrended variables after a shock to capital are very similar to the dynamics of the neoclassical growth model, but transitory shocks have permanent effects on the level of productivity.
    JEL: O0 O3
    Date: 2007–02
  10. By: Juan Carlos Hatchondo; Leonardo Martinez; Horacio Sapriza
    Abstract: We show that computing business cycles in emerging economy models using the discrete state space technique may be misleading. We solve the models of sovereign default presented by Aguiar and Gopinath (2006) using interpolation. We find that the simulated behavior of the spread is quite different from the behavior obtained using discrete state space. In fact, some of the results obtained by Aguiar and Gopinath (2006) using discrete state space are reversed when using interpolation. Our analysis thus provides a new set of benchmark results for quantitative models of sovereign default.
    Keywords: Business cycles
    Date: 2006
  11. By: David, DE LA CROIX (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics); Gregory, DE WALQUE; Rafael, WOUTERS
    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 firmÕs 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 affect nominal interest rates and inflation outcomes
    Keywords: Efficiency wage, effort, inflation persistence, monetary policy
    JEL: E4 E5
    Date: 2006–11–13
  12. By: Frank Caliendo; Kevin X. D. Huang
    Abstract: Overconfidence is a widely documented phenomenon. Empirical evidence reveal two types of overconfidence in financial markets: investors both overestimate the average rate of return to their assets and underestimate uncertainty associated with the return. This paper explores implications of overconfidence in financial markets for consumption over the life cycle. The authors obtain a closed-form solution to the time-inconsistent problem facing an overconfident investor/consumer who has a CRRA utility function. They use this solution to show that overestimation of the mean return gives rise to a hump in consumption during the work life if and only if the elasticity of intertemporal substitution in consumption is less than unit. They find that underestimation of uncertainty has little effect on the long-run average behavior of consumption over the work life. Their calibrated model produces a hump-shaped work-life consumption profile with both the age and the amplitude of peak consumption consistent with empirical observations.
    Date: 2007
  13. By: Shigeru Fujita; Garey Ramey
    Abstract: In a recent influential paper, Shimer uses CPS duration and gross flow data to draw two conclusions: (1) separation rates are nearly acyclic; and (2) separation rates contribute little to the variability of unemployment. In this paper the authors assert that Shimer's analysis is problematic, for two reasons: (1) cyclicality is not evaluated systematically; and (2) the measured contributions to unemployment variability do not actually decompose total unemployment variability. The authors address these problems by applying a standard statistical measure of business cycle comovement, and constructing a precise decomposition of unemployment variability. Their results disconfirm Shimer's conclusions. More specifically, separation rates are highly countercyclical under various business cycle measures and filtering methods. The authors also find that fluctuations in separation rates make a substantial contribution to overall unemployment variability.
    Date: 2007
  14. By: Monique Ebell; Albrecht Ritschl
    Abstract: Most treatments of the Great Depression have focused on its onset and its aftermath. In contrast, we take a unified view of the interwar period. We look at the slide into and the emergence from the 1920-21 recession and the roaring 1920s boom, as well as the slide into the Great Depression after 1929, and attempt to explain these phenomena in a unified framework. The model framework combines monopolistic product market competition with search frictions and bargaining in the labor market, allowing for both individual and collective (unionized) wage bargaining. We attribute the extraordinary macroeconomic and financial volatility of this period to two factors: Shifts in the wage bargaining regime and in the degree of monopoly power in the economy. The pro-union provisions of the Clayton Act of 1914 contributed to the slide in asset prices and the depression of 1920-21, while a series of tough anti-union Supreme Court decisions in late 1921 and 1922 coupled with the lax anti-trust enforcement of the Coolidge and Hoover administrations enabled a major rise in corporate profits and stock market valuations throughout the 1920s. Landmark court decisions in favor of trade unions in the late 1920s, as well as political pressure on firms to adopt the welfare capitalism model of high wages, made the economy increasingly susceptible to collapsing profit expectations. We model the onset of the great depression as an equilibrium switch from individual wage bargaining to (actual or mimicked) collective wage bargaining. The general equilibrium effects of this regime change are consistent with large decreases in output, employment, and stock prices.
    Keywords: Trade unions, collective bargaining, Great Depression
    JEL: E24 E27 J51 J64 N12 N22
    Date: 2007–02
  15. By: Kirdan Lees; Troy Matheson; Christie Smith (Reserve Bank of New Zealand)
    Abstract: We evaluate the performance of an open economy DSGE-VAR model for New Zealand along both forecasting and policy dimensions. We show that forecasts from a DSGE-VAR and a 'vanilla' DSGE model are competitive with, and in some dimensions superior to, the Reserve Bank of New Zealand's official forecasts. We also use the estimated DSGE-VAR structure to identify optimal policy rules that are consistent with the Reserve Bank's Policy Targets Agreement. Optimal policy rules under parameter uncertainty prove to be relatively similar to the certainty case. The optimal policies react aggressively to inflation and contain a large degree of interest rate smoothing, but place a low weight on responding to output or the change in the nominal exchange rate.
    JEL: C51 E52 F41
    Date: 2007–01
  16. By: Calin Arcalean (Indiana University); Gerhard Glomm (Indiana University); Ioana Schiopu (Indiana University)
    Abstract: We develop a two-region, two sector model with migration and public investment in infrastructure and education. In a numerical example calibrated to Portugal, we find that the structural funds can improve the growth rate of the lagging region and slightly reduce the regional inequality, without necessarily producing convergence. When the mix of national public investment departs from optimum, the allocation of supra-national funds across infrastructure and public education can partially offset this national sub-optimality. We also find that the short-run growth-maximizing mix is different from the long-run mix. Moreover, the rich region has an incentive to bias the allocation of structural funds towards human capital formation.
    Keywords: endogenous growth, spatial redistribution, regional policy, European Union
    JEL: H7 R12 R58
    Date: 2007–01
  17. By: Michael W. Elsby; Ryan Michaels; Gary Solon
    Abstract: One of the strongest trends in recent macroeconomic modeling of labor market fluctuations is to treat unemployment inflows as acyclical. This trend stems in large part from an influential paper by Shimer on "Reassessing the Ins and Outs of Unemployment," i.e., the extent to which increased unemployment during a recession arises from an increase in the number of unemployment spells versus an increase in their duration. After broadly reviewing the previous literature, we replicate and extend Shimer's main analysis. Like Shimer, we find an important role for increased duration. But contrary to Shimer's conclusions, we find that even his own methods and data, when viewed in an appropriate metric, reveal an important role for increased inflows to unemployment as well. This finding is further strengthened by our refinements of Shimer's methods of correcting for data problems and by our detailed examination of particular components of the inflow to unemployment. We conclude that a complete understanding of cyclical unemployment requires an explanation of countercyclical inflow rates as well as procyclical outflow rates.
    JEL: E24 E32 J63 J64
    Date: 2007–01

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