nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒07‒07
25 papers chosen by
Christian Zimmermann
University of Connecticut

  1. Labor Search and Matching in Macroeconomics By Eran Yashiv
  2. Sequential optimization, front-loaded information, and U.S. consumption By Alpo Willman
  3. Linear-quadratic approximation, external habit and targeting rules By Paul Levine; Joseph Pearlman; Richard Pierse
  4. Stock Market Valuation and Monopolistic Competition: a Dynamic Stochastic General Equilibrium Approach By Gabriel Talmain
  5. Liquidity and Trading Dynamics By Veronica Guerrieri; Guido Lorenzoni
  6. Hyperbolic Discounting and the Phillips Curve By Liam Graham; Dennis J. Snower
  7. Euro Area Inflation Persistence in an Estimated Nonlinear DSGE Model By Amisano, Giovanni; Tristani, Oreste
  8. Concerning Inequality, Technology Adoption, and Structural Change By Radhika Lahiri; Shyama Ratnasiri
  9. The Labour Market Effects of Technology Shocks By Canova, Fabio; Lopez-Salido, Jose David; Michelacci, Claudio
  10. Inflation and Unemployment: Lagos-Wright meets Mortensen-Pissarides By Aleksander Berentsen; Guido Menzio; Randall Wright
  11. Sources of Lifetime Inequality By Mark Huggett; Gustavo Ventura; Amir Yaron
  12. Macroeconomic modelling in EMU: how relevant is the change in regime? By Javier Andrés; Fernando Restoy
  13. Long-Run Risks and Financial Markets By Ravi Bansal
  14. Optimal Reserve Management and Sovereign Debt By Laura Alfaro; Fabio Kanczuk
  15. Monetary Policy and Business Cycles with Endogenous Entry and Product Variety By Florin O. Bilbiie; Fabio Ghironi; Marc J. Melitz
  16. Unemployment Insurance Design: Inducing Moving and Retraining By Hassler, John; Rodríguez Mora, José Vicente
  17. Endogenous Aggregate Elasticity of Substitution By Kaz Miyagiwa; Chris Papageorgiou
  18. Sticky Information vs. Sticky Prices: A Horse Race in a DSGE Framework By Mathias Trabandt
  19. The Environmental Kuznets Curve in a World of Irreversibility By Fabien Prieur
  20. Back to square one: identification issues in DSGE models By Fabio Canova; Luca Sala
  21. Expectation Effects of Regimes Shifts in Monetary Policy By Zheng Liu; Daniel F. Waggoner; Tao Zha
  22. Why Are Capital Income Taxes So High? By Flodén, Martin
  23. Can adjustment costs explain the variability and counter-cyclicality of the labour share at the firm and aggregate level? By Philip Vermeulen
  24. The Credit Channel of Tax Policy By Strulik, Holger
  25. Entrepreneurship, Wealth, Liquidity Constraints and Start-up Costs By Raquel Fonseca; Pierre-Carl Michaud; Thepthida Sopraseuth

  1. By: Eran Yashiv
    Abstract: The labor search and matching model plays a growing role in macroeconomic analysis. Thispaper provides a critical, selective survey of the literature. Four fundamental questions areexplored: how are unemployment, job vacancies, and employment determined as equilibriumphenomena? What determines worker flows and transition rates from one labor market stateto another? How are wages determined? What role do labor market dynamics play inexplaining business cycles and growth? The survey describes the basic model, reviews itstheoretical extensions, and discusses its empirical applications in macroeconomics. Themodel has developed against the background of difficulties with the use of the neoclassical,frictionless model of the labor market in macroeconomics. Its success includes the modellingof labor market outcomes as equilibrium phenomena, the reasonable fit of the data, and —when inserted into business cycle models — improved performance of more generalmacroeconomic models. At the same time, there is evidence against the Nash solution usedfor wage setting and an active debate as to the ability of the model to account for some of thecyclical facts.
    Keywords: search, matching, macroeconomics, business cycles, worker flows, growth, policy
    JEL: E24 E32 E52 J23 J31 J41 J63 J64 J65
    Date: 2007–06
  2. By: Alpo Willman (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: In an overlapping generations maximization framework with consumers, whose information on uncertain future income realizations is front-loaded, a closed form aggregate consumption function with CRRA preferences is derived. To have a closed form solution we assume that consumers solve their intertemporal optimization problem sequentially. First they assess riskadjusted life-time wealth and then the optimal consumption path. The derived model captures precautionary saving, which is dependent on the human to non-human wealth ratio. On aggregate level, after accounting for habit formation, the model is able to explain both the short-run (e.g. the excess sensitivity and the excess smoothness puzzle) and long-run stylized facts of the U.S. consumption data. JEL Classification: D11, D12, D82, E21.
    Keywords: Consumption, Information, Habit Persistence, Precautionary Saving.
    Date: 2007–06
  3. By: Paul Levine (Department of Economics, University of Surrey, Guildford, Surrey, GU2 7XH, United Kingdom.); Joseph Pearlman (London Metropolitan University, 31 Jewry Street, London, EC3N 2EY, United Kingdom.); Richard Pierse (Department of Economics, University of Surrey, Guildford, Surrey, GU2 7XH, United Kingdom.)
    Abstract: We examine the linear-quadratic (LQ) approximation of non-linear stochastic dynamic optimization problems in macroeconomics, in particular for monetary policy. We make four main contributions: first, we draw attention to a general Hamiltonian framework for LQ approximation due toMagill (1977). We show that the procedure for the ‘large distortions’ case of Benigno and Woodford (2003, 2005) is equivalent to the Hamiltonian approach, but the latter is far easier to implement. Second, we apply the Hamiltonian approach to a Dynamic Stochastic General Equilibrium model with external habit in consumption. Third, we introduce the concept of target-implementability which fits in with the general notion of targeting rules proposed by Svensson (2003, 2005). We derive sufficient conditions for the LQ approximation to have this property in the vicinity of a zero-inflation steady state. Finally, we extend the Hamiltonian approach to a non-cooperative equilibrium in a two-country model. JEL Classification: E52, E37, E58.
    Keywords: Linear-quadratic approximation, dynamic stochastic general equilibrium models, utility-based loss function.
    Date: 2007–06
  4. By: Gabriel Talmain
    Abstract: This paper extends a Real Business Cycle model to an economy in which monopolistic competitive firms’ technology is subject to idiosyncratic and common shocks. The value of future technology rents drive stock market valuation. We study how the arrival of new information about future technological developments affect each firm’s stream of future profit, the rate on return on physical capital, and the value of equity. We show that good news about future technology of a specific firm or industry will lift the price of shares of the specific firms, but that good news about future aggregate productivity will raise the discount rate, leaving the price of shares unchanged. On the other hand, good news about future aggregate profit margins will lift the price of shares.
    Keywords: Equity, Heterogeneous (non-representative) firms, Monopolistic Competition, Real Business Cycle (RBC), Stock Market
    JEL: E25 E32 G12
    Date: 2007–06
  5. By: Veronica Guerrieri; Guido Lorenzoni
    Abstract: How do financial frictions affect the response of an economy to aggregate shocks? In this paper, we address this question, focusing on liquidity constraints and uninsurable idiosyncratic risk. We consider a search model where agents use liquid assets to smooth individual income shocks. We show that the response of this economy to aggregate shocks depends on the rate of return on liquid assets. In economies where liquid assets pay a low return, agents hold smaller liquid reserves and the response of the economy tends to be larger. In this case, agents expect to be liquidity constrained and, due to a self-insurance motive, their consumption decisions are more sensitive to changes in expected income. On the other hand, in economies where liquid assets pay a large return, agents hold larger reserves and their consumption decisions are more insulated from income uncertainty. Therefore, aggregate shocks tend to have larger effects if liquid assets pay a lower rate of return.
    JEL: D83 E41 E44
    Date: 2007–06
  6. By: Liam Graham; Dennis J. Snower
    Abstract: Using a standard dynamic general equilibrium model, we show that the interaction of staggered nominal contracts with hyperbolic discounting leads to inflation having significant long-run effects on real variables.
    Keywords: inflation, unemployment, Phillips curve, nominal inertia, monetary policy, dynamic general equilibrium
    JEL: E20 E40 E50
    Date: 2007–06
  7. By: Amisano, Giovanni; Tristani, Oreste
    Abstract: We estimate the approximate nonlinear solution of a small DSGE model on euro area data, using the conditional particle filter to compute the model likelihood. Our results are consistent with previous findings, based on simulated data, suggesting that this approach delivers sharper inference compared to the estimation of the linearised model. We also show that the nonlinear model can account for richer economic dynamics: the impulse responses to structural shocks vary depending on initial conditions selected within our estimation sample.
    Keywords: Bayesian estimation; DSGE models; inflation persistence; second order approximations; sequential Monte Carlo
    JEL: C11 C15 E31 E32 E52
    Date: 2007–06
  8. By: Radhika Lahiri; Shyama Ratnasiri
    Abstract: Empirical evidence suggests that there has been a divergence over time in income distributions across countries and within countries. In this paper we study a simple dynamic general equilibrium model of technology adoption which is consistent with these stylized facts. In our model, growth is endogenous, and agents are assumed to be heterogeneous in their initial holdings of wealth and capital. We find that in the presence of barriers or costs associated with the adoption of more productive technologies, inequalities in wealth and income may increase over time tending to delay the convergence in international income differences. The model is also capable of explaining the observed diversity in the growth pattern of transitional economies. According to the model, this diversity may be the result of variability in adoption costs, or the relative position of a transitional economy in the world income distribution.
    Date: 2006–11–01
  9. By: Canova, Fabio; Lopez-Salido, Jose David; Michelacci, Claudio
    Abstract: We analyze the effects of neutral and investment-specific technology shocks on hours worked and unemployment. We characterize the response of unemployment in terms of job separation and job finding rates. We find that job separation rates mainly account for the impact response of unemployment while job finding rates for movements along its adjustment path. Neutral shocks increase unemployment and explain a substantial portion of unemployment and output volatility; investment-specific shocks expand employment and hours worked and mostly contribute to hours worked volatility. We show that this evidence is consistent with the view that neutral technological progress prompts Schumpeterian creative destruction, while investment specific technological progress has standard neoclassical features.
    Keywords: creative destruction; Search frictions; technological progress
    JEL: E00 J60 O33
    Date: 2007–06
  10. By: Aleksander Berentsen; Guido Menzio; Randall Wright
    Abstract: Inflation and unemployment are central issues in macroeconomics. While progress has been made on these issues recently using models that explicitly incorporate search-type frictions, existing models analyze either unemployment or inflation in isolation. We develop a framework to analyze unemployment and inflation together. This makes contributions to disparate literatures, and provides a unified model for theory, policy, and quantitative analysis. We discuss optimal fiscal and monetary policy. We calibrate the model, and discuss the extent to which it can account for salient aspects of a half century’s experience with inflation, unemployment, interest rates, and velocity. Depending on some details concerning how one calibrations certain parameters, the model can do a good job matching the data.
    Date: 2007–06
  11. By: Mark Huggett; Gustavo Ventura; Amir Yaron
    Abstract: Is lifetime inequality mainly due to differences across people established early in life or to differences in luck experienced over the working lifetime? We answer this question within a model that features idiosyncratic shocks to human capital, estimated directly from data, as well as heterogeneity in ability to learn, initial human capital, and initial wealth -- features which are chosen to match observed properties of earnings dynamics by cohorts. We find that as of age 20, differences in initial conditions account for more of the variation in lifetime utility, lifetime earnings and lifetime wealth than do differences in shocks received over the lifetime. Among initial conditions, variation in initial human capital is substantially more important than variation in learning ability or initial wealth for determining how an agent fares in life. An increase in an agent's human capital affects expected lifetime utility by raising an agent's expected earnings profile, whereas an increase in learning ability affects expected utility by producing a steeper expected earnings profile.
    JEL: D31 D91 E21
    Date: 2007–07
  12. By: Javier Andrés (Universidad de Valencia); Fernando Restoy (Banco de España)
    Abstract: We analyse the likely effects of changes in the monetary and financial regimes of EMU countries on the dynamics of output and inflation. In particular, we evaluate the impact of the regime shift on the forecasting performance of reduced-form models. Data for both the pre-EMU and the EMU regimes are generated by a relatively standard open-economy-DSGE model with sticky prices and wages and restricted access to financial markets for some individuals. We find that the effects of the shift in the monetary regime on the processes followed by macroeconomic variables depend on the nature of the shocks hitting the economy. For plausible shocks distributions the reduction in the accuracy of VAR-based inflation forecasts is relatively large and significant. The effect of the regime shift on output forecasts seem rather more modest and statistically insignificant. The impact on ouput forecasting accuracy would be comparatively much larger if the new monetary union regime is accompanied by a moderate relaxation of constraints affecting financial market access.
    Keywords: forecasting, general equilibrium models, monetary union, inflation and output dynamics
    JEL: E17 E32 E37
    Date: 2007–06
  13. By: Ravi Bansal
    Abstract: The recently developed long-run risks asset pricing model shows that concerns about long-run expected growth and time-varying uncertainty (i.e., volatility) about future economic prospects drive asset prices. These two channels of economic risks can account for the risk premia and asset price fluctuations. In addition, the model can empirically account for the cross-sectional differences in asset returns. Hence, the long-run risks model provides a coherent and systematic framework for analyzing financial markets.
    JEL: E0 E44 G0 G1 G12
    Date: 2007–06
  14. By: Laura Alfaro; Fabio Kanczuk
    Abstract: Most models currently used to determine optimal foreign reserve holdings take the level of international debt as given. However, given the sovereign's willingness-to-pay incentive problems, reserve accumulation may reduce sustainable debt levels. In addition, assuming constant debt levels does not allow addressing one of the puzzles behind using reserves as a means to avoid the negative effects of crisis: why do not sovereign countries reduce their sovereign debt instead? To study the joint decision of holding sovereign debt and reserves, we construct a stochastic dynamic equilibrium model calibrated to a sample of emerging markets. We obtain that the reserve accumulation does not play a quantitative important role in this model. In fact, we find the optimal policy is not to hold reserves at all. This finding is robust to considering interest rate shocks, sudden stops, contingent reserves and reserve dependent output costs.
    JEL: F32 F33 F34 F4
    Date: 2007–07
  15. By: Florin O. Bilbiie; Fabio Ghironi; Marc J. Melitz
    Abstract: This paper studies the role of endogenous producer entry and product creation for monetary policy analysis and business cycle dynamics in a general equilibrium model with imperfect price adjustment. Optimal monetary policy stabilizes product prices, but lets the consumer price index vary to accommodate changes in the number of available products. The free entry condition links the price of equity (the value of products) with marginal cost and markups, and hence with inflation dynamics. No-arbitrage between bonds and equity links the expected return on shares, and thus the financing of product creation, with the return on bonds, affected by monetary policy via interest rate setting. This new channel of monetary policy transmission through asset prices restores the Taylor Principle in the presence of capital accumulation (in the form of new production lines) and forward-looking interest rate setting, unlike in models with traditional physical capital. We also study the implications of endogenous variety for the New Keynesian Phillips curve and business cycle dynamics more generally, and we document the effects of technology, deregulation, and monetary policy shocks, as well as the second moment properties of our model, by means of numerical examples.
    JEL: E31 E32 E52
    Date: 2007–06
  16. By: Hassler, John; Rodríguez Mora, José Vicente
    Abstract: Evidence suggests that unemployed individuals can sometimes affect their job prospects by undertaking a costly action like deciding to move or retrain. Realistically, such an opportunity only arises for some individuals and the identity of those may be unobservable ex-ante. The problem of characterizing constrained optimal unemployment insurance in this case has been neglected in previous literature. We construct a model of optimal unemployment insurance where multiple incentive constraints are easily handled. The model is used to analyze the case when an incentive constraint involving moving costs must be respected in addition to the standard constraint involving costly unobservable job-search. In particular, we derive closed-form solutions showing that when the moving/retraining incentive constraint binds, unemployment benefits should increase over the unemployment spell, with an initial period with low benefits and an increase after this period has expired.
    Keywords: adverse selection; moral hazard; search; Unemployment benefits
    JEL: E24 J64 J65
    Date: 2007–06
  17. By: Kaz Miyagiwa; Chris Papageorgiou
    Abstract: In the literature studying aggregate economies the aggregate elasticity of substitution (AES) between capital and labor is often treated as a constant or “deep” parameter. This view contrasts with the conjecture put forward by Arrow et al. (1961) that AES evolves over time and changes with the process of economic development. This paper evaluates this conjecture in a simple dynamic multi-sector growth model, in which AES is endogenously determined. Our findings support the conjecture, and in particular demonstrate that AES tends to be positively related to the state of economic development, a result consistent with recent empirical findings.
    Date: 2007–03
  18. By: Mathias Trabandt
    Abstract: How can we explain the observed behavior of aggregate inflation in response to e.g. monetary policy changes? Mankiw and Reis (2002) have proposed sticky information as an alternative to Calvo sticky prices in order to model the conventional view that i) inflation reacts with delay and gradually to a monetary policy shock, ii) announced and credible disinflations are contractionary and iii) inflation accelerates with vigorous economic activity. I use a fully-fledged DSGE model with sticky information and compare it to Calvo sticky prices, allowing also for dynamic inflation indexation as in Christiano, Eichenbaum, and Evans (2005). I find that sticky information and sticky prices with dynamic inflation indexation do equally well in my DSGE model in delivering the conventional view.
    Keywords: sticky information, sticky prices, inflation indexation, DSGE
    JEL: E0 E3
    Date: 2007–06
  19. By: Fabien Prieur (GREQAM and INRA-LAMETA)
    Abstract: We develop an overlapping generations model where consumption is the source of polluting emissions. Pollution stock accumulates with emissions but is partially assimilated by nature at each period. The assimilation capacity of nature is limited and vanishes beyond a critical level of pollution. We first show that multiple equilibria exist. More importantly, some exhibit irreversible pollution levels although an abatement activity is operative. Thus, the simple engagement of maintenance does not necessarily suffice to protect an economy against convergence toward a steady state having the properties of an ecological and economic poverty trap. In contrast with earlier related studies, the emergence of the environmental Kuznets curve is no longer the rule. Instead, we detect a sort of degenerated Environmental Kuznets Curve that corresponds to the equilibrium trajectory leading to the irreversible solution.
    Keywords: Overlapping Generations, Irreversible Pollution, Poverty Trap, Environmental Kuznets Curve
    JEL: Q56 D62 D91
    Date: 2007–05
  20. By: Fabio Canova (Universitat Pompeu Fabra); Luca Sala (Innocenzo Gasparini Institute for Economic Research (IGIER) - Università Commerciale Luigi Bocconi)
    Abstract: We investigate identifiability issues in DSGE models and their consequences for parameter estimation and model evaluation when the objective function measures the distance between estimated and model impulse responses. Observational equivalence, partial and weak identification problems are widespread and they lead to biased estimates, unreliable t-statistics and may induce investigators to select false models. We examine whether different objective functions affect identification and study how small samples interact with parameters and shock identification. We provide diagnostics and tests to detect identification failures and apply them to a state-of-the-art model.
    Keywords: identification, impulse responses, DSGE models, small samples
    JEL: C10 C52 E32 E50
    Date: 2007–06
  21. By: Zheng Liu; Daniel F. Waggoner; Tao Zha
    Abstract: We assess the quantitative importance of expectation effects of regime shifts in monetary policy in a DSGE model that allows the monetary policy rule to switch between a “bad” regime and a ”good” regime. When agents take into account such regime shifts in forming expectations, the expectation effect is asymmetric. In the good regime, the expectation effect is small despite agents’ disbelief that the regime will last forever. In the bad regime, however, the expectation effect on equilibrium dynamics of inflation and output is quantitatively important, even if agents put a small probability that monetary policy will switch to the good regime. Although the expectation effect dampens aggregate fluctuations in the bad regime, a switch from the bad regime to the good regime can still substantially reduce the volatility of both inflation and output, provided that we allow some “reduced-form” parameters in the private sector to change with monetary policy regime.
    Date: 2007–06
  22. By: Flodén, Martin
    Abstract: The Ramsey optimal taxation theory implies that the tax rate on capital income should be zero in the long run. This result holds even if the social planner only cares about workers that do not hold assets, or if the planner only cares about any other group in the economy. This paper demonstrates that although all households agree that capital income taxation should be eliminated in the long run, they do not agree on how to eliminate these taxes. Wealthy households would prefer a reform that is funded by higher taxes on labour income while households with little wealth would prefer a reform that is funded mostly by high taxes on initial wealth. Pareto improving reforms typically exist, but the welfare gains of such reforms are modest.
    Keywords: inequality; optimal taxation; redistribution
    JEL: E60 H21
    Date: 2007–06
  23. By: Philip Vermeulen (DG-Resarch, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany;.)
    Abstract: This paper shows that adjustment costs modelled as firing costs of moderate size go a long way in explaining the variability and counter- cyclicality of the labour share at the firm and aggregate level. Firing costs cause firms to fire less in recessions and hire less in booms causing wage costs to fluctuate less cyclically than output, thus inducing variability and countercyclicality in the labour share. The paper develops a dynamic labour demand model with firing costs. The model is then calibrated using moments derived from 1634 French manufacturing firms and aggregate French manufacturing data. The calibrated model is able to closely match the variability and counter-cyclicality of the labour share at the firm level while it also generates a countercyclical aggregate labour share with a variability 60 % of that in French aggregate manufacturing. JEL Classification: D21, E25.
    Keywords: Labour share, labor adjustment costs, firing costs, real business cycles.
    Date: 2007–06
  24. By: Strulik, Holger
    Abstract: A neoclassical growth model is augmented by a corporate sector, financial intermediation, and a set of tax rates. In this setting, capital structure is determined by the interplay between an advantage of debt finance resulting from the tax system and a disadvantage resulting from asymmetric information and the entailed agency costs. Effects of capital tax reforms are investigated with a special focus on the credit channel that operates through the finance decision of firms. The theoretical part of the article derives which financial and real effects of private and corporate income tax policies can be expected. Using a calibration with U.S.\ data, the applied part demonstrates that tax cuts cause significant adjustments of capital structure. Nevertheless, the credit channel creates relatively small effects of tax reforms on consumption, investment, and growth.
    Keywords: Tax Reform, Corporate Finance, Agency Costs, Ecinomic Growth
    JEL: H30 E44 E62 O16
    Date: 2007–06
  25. By: Raquel Fonseca (RAND); Pierre-Carl Michaud (RAND and IZA); Thepthida Sopraseuth (EPEE, University of Evry)
    Abstract: We study the effects of liquidity constraints and start-up costs on the relationship between wealth and the fraction of entrepreneurs in an economy. We develop a dynamic occupational choice model with endogenous wealth and entry into entrepreneurship. The model predicts that, with liquidity constraints, the probability of entering entrepreneurship is an increasing function of individual wealth while the introduction of start-up costs tends to flatten this relationship. The theoretical predictions can be tested on cross-sectional data with exogenous variation in liquidity constraints (e.g. access to credit) and business start-up costs. We use three highly comparable micro datasets (SHARE, ELSA and HRS) providing harmonized data on wealth and work status in 9 countries that characterized by very different levels of start-up costs and liquidity constraints. Our results support our theoretical predictions. While higher liquidity constraints yield a positive relationship with wealth profile for the fraction of workers in entrepreneurship, start-up costs weaken this relationship by depressing the marginal value of being an entrepreneur as a function of wealth. Countries with high start-up costs such as Italy, Spain and France have flatter wealth gradients.
    Keywords: entrepreneurship, wealth, liquidity constraints, start-up costs
    JEL: E20 D31 J62
    Date: 2007–06

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