nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒03‒03
seventeen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Can heterogeneous preferences stabilize endogenous fluctuations ? By Stéphano Bosi; Thomas Seegmuller
  2. Asset Pricing with Limited Risk Sharing and Heterogeneous Agents By Gomes, Francisco J; Michaelides, Alexander
  3. Vector autoregressions and reduced form representations of DSGE models By Federico Ravenna
  4. Money, Tobin Effect, and Increasing Returns By Basci, Erdem; Erdogan, Ayse M.; Saglam, Ismail
  5. The welfare effects of government's preferences over spending and its financing By Alper, C. Emre; Ardic, Oya Pinar; Mumcu, Ayşe; Saglam, Ismail
  6. The Role of Debt and Equity Finance over the Business Cycle By Covas, Francisco; Den Haan, Wouter
  7. Search in asset markets: market structure, liquidity, and welfare By Ricardo Lagos; Guillaume Rocheteau
  8. Welfare Gains from Optimal Policy in a Partially Dollarized Economy By Carlos Gustavo Machicado
  9. Schooling, Inequality and Government Policy By Oleksiy Kryvtsov; Alexander Ueberfeldt
  10. The Valuation Channel of External Adjustment By Fabio Ghironi; Jaewoo Lee; Alessandro Rebucci
  11. Home bias, exchange rate disconnect, and optimal exchange rate policy By Jian Wang
  12. Capital taxation and Laffer effects in endogenous growth models By Fredriksson, Anders
  13. Real Origins of the Great Depression: Monopolistic Competition, Union Power, and the American Business Cycle in the 1920s By Ebell, Monique; Ritschl, Albrecht
  14. Political Institutions and Economic Growth By Marsiliani, Laura; Renström, Thomas I
  15. Financial Integration, Financial Deepness and Global Imbalances By Mendoza, Enrique G; Quadrini, Vincenzo; Ríos-Rull, José-Víctor
  16. Macroeconomic Implications of Size-Dependent Policies By Guner, Nezih; Ventura, Gustavo; Xu, Yi
  17. Endogenous State Prices, Liquidity, Default, and the Yield Curve By Raphael A. Espinoza; Charles A. E. Goodhart; Dimitrios P. Tsomocos

  1. By: Stéphano Bosi (EQUIPPE - Département d'Economie - [Université des Sciences et Technologie de Lille - Lille I], EPEE - [Université d'Evry-Val d'Essonne]); Thomas Seegmuller (CES - Centre d'économie de la Sorbonne - [CNRS : UMR8174] - [Université Panthéon-Sorbonne - Paris I])
    Abstract: While most of the literature concerned with indeterminacy and endogenous cycles is based on the questionable assumption of a representative consumer, some recent works have investigated the role of heterogeneous agents on dynamics. This paper adds a contribution to the debate, highlighting the effects of heterogeneity in consumers' preferences within an overlapping generations economy with capital accumulation, endogenous labor supply and consumption in both periods. Using a mean-preserving approach to heterogeneity, we show that increasing the dispersion of propensities to save turns out to stabilize the macroeconomic volatility, by reducing the range of parameters compatible with indeterminacy and ruling out expectations-driven fluctuations under a sufficiently large heterogeneity.
    Keywords: Endogenous fluctuations, heterogeneous preferences, mean-preserving dispersion, overlapping generations.
    Date: 2007–02–09
  2. By: Gomes, Francisco J; Michaelides, Alexander
    Abstract: We solve a model with incomplete markets and heterogeneous agents that generates a large equity premium, while simultaneously matching stock market participation and individual asset holdings. The high risk premium is driven by incomplete risk sharing among stockholders, which results from the combination of aggregate uncertainty, borrowing constraints and a (realistically) calibrated life-cycle earnings profile subject to idiosyncratic shocks. We show that it is challenging to simultaneously match asset pricing moments and individual portfolio decisions, while limited participation has a negligible impact on the risk premium, contrary to the results of models where it is imposed exogenously.
    Keywords: equity premium; incomplete risk sharing; life-cycle models; limited stock market participation; preference heterogeneity
    JEL: G11 G12
    Date: 2007–02
  3. By: Federico Ravenna (University of California)
    Abstract: Dynamic Stochastic General Equilibrium models are often tested against empirical VARs or estimated by minimizing the distance between the model's and the VAR impulse response functions. These methodologies require that the data-generating process consistent with the DSGE theoretical model has a VAR representation. This paper discusses the assumptions needed for a finite-order VAR(p) representation of any subset of a DSGE model variables to exist. When a VAR(p) is only an approximation to the true VAR, the paper shows that the truncated VAR(p) may return largely incorrect estimates of the impulse response function. The results do not hinge on an incorrect identification strategy or on small sample bias. But the bias introduced by truncation can lead to bias in the identification of the structural shocks. Identification strategies that are equivalent in the true VAR representation perform differently in the approximating VAR.
    Keywords: vector autoregression, dynamic stochastic general equilibrium model, business cycle shocks
    JEL: C13 C22 E32
    Date: 2006–08
  4. By: Basci, Erdem; Erdogan, Ayse M.; Saglam, Ismail
    Abstract: This paper shows that unregulated decentralized equilibrium is viable under increasing returns technologies in an overlapping generations model of production with cash-in-advance constraints. We also demonstrate that the model exhibits both the Tobin effect and the reverse Tobin effect.
    Keywords: Increasing returns; cash-in-advance constraints; overlapping generations; Phillips curve.
    JEL: E52 D51 D91 D52
    Date: 2006–09
  5. By: Alper, C. Emre; Ardic, Oya Pinar; Mumcu, Ayşe; Saglam, Ismail
    Abstract: In this paper we examine the welfare effects of government's preferences over consumption and investment spending under different methods of financing in a two-period OLG model. The government has a utility function defined over the decomposition of her spending over two periods and raises funds by issuing bonds and by printing money. She allocates her funds into consumption expenditure that benefits the current population and investment expenditure which benefits the future population. The model is calibrated using data on the U.S. economy for the period 1981-2004. The findings reveal that the government's choice of financing as well as composition of spending into consumption-investment have differing impacts on the welfare of the young and old generations.
    Keywords: Seigniorage; Bond financing; Composition of government spending; Overlapping generations
    JEL: O42 E62
    Date: 2006–05
  6. By: Covas, Francisco; Den Haan, Wouter
    Abstract: This paper documents that debt and equity issuance are procyclical for most size-sorted firm categories of listed U.S. firms. The procyclicality of equity issuance decreases monotonically with firm size. At the aggregate level, however, the results are not conclusive. The reason is that issuance is countercyclical for very large firms which, although few in number, have a large effect on the aggregate because of their enormous size. We show that the shadow price of external funds is procyclical if firms use the standard one-period contract. This model property generates procyclical equity and - as in the data - the procyclicality decreases with firm size. Another factor that causes equity to be procyclical in the model is a countercyclical cost of equity issuance. The calibrated model (i) generates a countercyclical default rate, (ii) generates a stronger cyclical response for small firms, and (iii) magnifies shocks, whereas the model without equity as an external financing source does the exact opposite.
    Keywords: agency problems; firm heterogeneity; magnification
    JEL: E32 E44
    Date: 2007–02
  7. By: Ricardo Lagos; Guillaume Rocheteau
    Abstract: This paper investigates how market structure affects efficiency and several dimensions of liquidity in an asset market. To this end, we generalize the search-theoretic model of financial intermediation of Darrell Duffie et al. (2005) to allow for entry of dealers and unrestricted asset holdings.
    Keywords: Portfolio management
    Date: 2007
  8. By: Carlos Gustavo Machicado (Institute for Advanced Development Studies)
    Abstract: This paper evaluates welfare under optimal monetary and fiscal policy in a dynamic stochastic model of currency substitution and capital. It shows that in a partially dollarized economy, the main optimal policy results, i.e. the Friedman Rule and the zero capital tax, hold. Welfare implications of these optimal policies are computed for the Bolivian economy using a second-order approximation technique. The primary conclusions are that the welfare gains under optimal monetary policy are negligible. The welfare gains when optimal fiscal policy is considered alone or in conjunction with optimal monetary policy are sizable and come from the increase in real variables and also by the increase in real balances in local currency. Thus, welfare gains are negatively related to dollarization.
    Keywords: Dollarization, Optimal Fiscal and Monetary Policy, Second-order approximation technique.
    JEL: F31 E61 E63
    Date: 2006–09
  9. By: Oleksiy Kryvtsov; Alexander Ueberfeldt
    Abstract: This paper asks: What is the effect of government policy on output and inequality in an environment with education and labor-supply decisions? The answer is given in a general equilibrium model, consistent with the post 1960s facts on male wage inequality and labor supply in the U.S. In the model, education and labor-supply decisions depend on progressive income taxation, the education system, the social security system, and technology-driven wage differentials. Government policies affect output and inequality through two channels. First, a policy change leads to an asymmetric adjustment of working hours and savings of schooled and unschooled individuals. Second, there is a redistribution of the workforce between schooled and unschooled workers. Using a battery of proposed government policies, we demonstrate that skill redistribution dampens the response of wage inequality to a policy change and amplifies the response of output by an additional 1 to 2 percent.
    Keywords: Labour markets; Potential output; Productivity
    JEL: H52 J31 J38
    Date: 2007
  10. By: Fabio Ghironi; Jaewoo Lee; Alessandro Rebucci
    Abstract: Ongoing international financial integration has greatly increased foreign asset holdings across countries, enhancing the scope for a "valuation channel" of external adjustment (i.e., the changes in a country's net foreign asset position due to exchange rate and asset price changes). We examine this channel of adjustment in a dynamic stochastic general equilibrium model with international equity trading in incomplete asset markets. We show that the risk-sharing properties of international equity trading are tied to the distribution of income between labor income and profits when equities are defined as claims to firm profits in a production economy. For a given level of international financial integration (measured by the size of gross foreign asset positions), the quantitative importance of the valuation channel of external adjustment depends on features of the international transmission mechanism such as the size of financial frictions, substitutability across goods, and the persistence of shocks. Finally, moving from less to more international financial integration, risk sharing through asset markets increases, and valuation changes are larger, but their relative importance in net foreign asset dynamics is smaller.
    JEL: F32 F41 G11 G15
    Date: 2007–02
  11. By: Jian Wang
    Abstract: This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that the home bias in consumption is important to duplicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest-rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is strongly supported by the data. Then a second-order accurate solution method is employed to solve the model and compare the conditional welfare under different policy regimes. The results suggest that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model also suggests no welfare gain from the international monetary cooperation, which extends Obstfeld and Rogoff s (2002) findings to a DSGE model.
    Date: 2007
  12. By: Fredriksson, Anders (Institute for international economic studies)
    Abstract: This paper adds to a literature asking whether tax cuts rather than tax increases can improve the government budget. We use an endogenous growth model with physical and human capital to study possibilities for such self-financing tax cuts. Apart from the standard dynamic effect from taxation in endogenous growth models a second margin is introduced when physical and human capital are taxed differently. Endogenizing leisure with a raw-time specification introduces both a consumption/leisure trade-off and a dynamic effect through leisure´s impact on the growth rate. By providing analytical expressions for when Laffer effects occur the influence of each of these margins is shown. The addition of these margins adds scope for Laffer effects that are not present in the AK-models previously studied.
    Keywords: Human capital; compositional effects from taxation; dynamic effects from taxation; Laffer effect; dynamic scoring
    JEL: E62 H30 O41
    Date: 2007–02–23
  13. By: Ebell, Monique; Ritschl, Albrecht
    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 labour 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 favour 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: collective bargaining; Great Depression; trade unions
    JEL: E24 J51 J64 N12 N22
    Date: 2007–02
  14. By: Marsiliani, Laura; Renström, Thomas I
    Abstract: We analyze the impact of micro-founded political institutions on economic growth in an overlapping-generations economy, where individuals differ in preferences over a public good (as well as in age). Labour and capital taxes finance the public good and a public input. The benchmark institution is a parliament, where all decisions are taken. Party entry, parliamentary composition, coalition formation, and bargaining are endogenous. We compare this constitution to delegation of decision-making, where a spending minister (elected in parliament or appointed by the largest party). Delegation of decision-making tends to yield lower growth, mainly due to the occurrence of production inefficiency.
    Keywords: bargaining; endogenous growth; overlapping generations; taxation; voting
    JEL: D72 D90 H20 H41 O41
    Date: 2007–02
  15. By: Mendoza, Enrique G; Quadrini, Vincenzo; Ríos-Rull, José-Víctor
    Abstract: Large and persistent global financial imbalances need not be the harbinger of a world financial crash. Instead, we show that these imbalances can be the outcome of financial integration when countries differ in financial markets deepness. In particular, countries with more advanced financial markets accumulate foreign liabilities in a gradual, long-lasting process. Differences in financial deepness also affect the composition of foreign portfolios: countries with negative net foreign asset positions maintain positive net holdings of non-diversifiable equity and FDI. Abstracting from the potential impact of globalization on financial development, liberalization leads to sizable welfare gains for the more financially-developed countries and losses for the others. Three empirical observations motivate our analysis: (1) financial deepness varies widely even amongst industrial countries, with the United States ranking at the top; (2) the secular decline in the U.S. net foreign asset position started in the early 1980s, together with a gradual process of international capital markets liberalization; (3) net exports and current account balances are negatively correlated with indicators of financial development.
    Keywords: international imbalances; portfolio composition; precautionary savings
    JEL: F36 F4
    Date: 2007–02
  16. By: Guner, Nezih; Ventura, Gustavo; Xu, Yi
    Abstract: Government policies that impose restrictions on the size of large establishments or firms, or promote small ones, are widespread across countries. In this paper, we develop a framework to systematically study policies of this class. We study a simple growth model with an endogenous size distribution of production units. We parameterize this model to account for the size distribution of establishments and for the (observed) large share of employment in large establishments. Then, we ask: quantitatively, how costly are policies that distort the size of production units? What is the impact of these policies on productivity measures, the equilibrium number of establishments and their size distribution? We find that these effects are potentially large: policies that reduce the average size of establishments by 20% lead to reductions in output and output per establishment up to 8.1% and 25.6% respectively, as well as large increases in the number of establishments (23.5%).
    Keywords: establishment size; productivity differences; size distortions
    JEL: E23 O40
    Date: 2007–02
  17. By: Raphael A. Espinoza; Charles A. E. Goodhart; Dimitrios P. Tsomocos
    Abstract: We show, in an exchange economy with default, liquidity constraints and no aggregate uncertainty, that state prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank. Our model is derived along the lines of Dubey and Geanakoplos (1992). Two agents trade goods and nominal assets (Arrow-Debreu (AD) securities) to smooth consumption across periods and future states, in the presence of cashin-advance financing costs. We show that, with Von Neumann-Morgenstern logarithmic utility functions, the price of AD securities, are inversely related to liquidity. The upshot of our argument is that agents’ expectations computed using risk-neutral probabilities give more weight in the states with higher interest rates. This result cannot be found in a Lucas-type representative agent general equilibrium model where there is neither trade or money nor default. Hence, an upward yield curve can be supported in equilibrium, even though short-term interest rates are fairly stable. The risk-premium in the term structure is therefore a pure default risk premium.
    Keywords: cash-in-advance constraints; risk-neutral probabilities; state prices; term structure of interest rate
    JEL: E43 G12
    Date: 2007

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