nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒07‒13
thirteen papers chosen by
Christian Zimmermann
University of Connecticut

  1. The Welfare Costs of Inflation in a Micro-Founded Macroeconometric Model By Pablo A. Guerron
  2. Financial Friction, Capital Reallocation and Expectation-Driven Business Cycles By Chen, Kaiji; Song, Zheng
  3. Monetary policy and natural disasters in a DSGE model: how should the Fed have responded to Hurricane Katrina? By Benjamin D. Keen; Michael R. Pakko
  4. The labor market effects of technology shocks By Fabio Canova; David López-Salido; Claudio Michelacci
  5. Welfare Implications of Capital Account Liberalization By Ester Faia
  6. Learning and the Great Moderation By James B. Bullard; Aarti Singh
  7. Comparative Advantage in Cyclical Unemployment By Mark Bils; Yongsung Chang; Sun-Bin Kim
  8. Volatile public spending in a model of money and sustainable growth By Dimitrios Varvarigos
  9. Higher order approximations of stochastic rational expectations models By Kowal, Pawel
  10. U.S. tax policy and health insurance demand: can a regressive policy improve welfare? By Karsten Jeske; Sagiri Kitao
  11. Microentrepreneurship and the business cycle: is self-employment a desired outcome? By Federico S. Mandelman; Gabriel V. Montes Rojas
  12. What You Match Does Matter: The Effects of Data on DSGE Estimation By Pablo A. Guerron
  13. Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models By Michael F. Gallmeyer; Burton Hollifield; Francisco Palomino; Stanley E. Zin

  1. By: Pablo A. Guerron (Department of Economics, North Carolina State University)
    Abstract: This paper computes the welfare costs of inflation in an estimated dynamic stochastic general equilibrium model of the U.S. economy. Both steady state and transitional welfare results are reported. I find that a 10 percent inflation entails a steady state welfare cost of 1.9 % of annual consumption. Taking into account trasitional effects, the cost drops to 1.2%. Under some circumstances, the transitional effects can erase most of the steady state welfare losses. The role of nominal frictions such as price/wage sluggishness as well as that of uncertainty are also addressed.
    Keywords: Bayesian Estimation, DSGE, Inflation, Welfare, Transtional Dynamics
    JEL: E31 E32 E37
    Date: 2007–07
  2. By: Chen, Kaiji; Song, Zheng
    Abstract: In this paper, we show that news on future technological improvement can trigger an immediate economic expansion in a model with financial friction on capital allocation. The arrivial of good news on future technology reduces such frictions and generates significant increase in current Total Factor Productivity via capital reallocation. This triggers an immediate boom in output, consumption, investment and hours worked. Our empirical evidence using firm-level data supports strongly the above mechanisms for news to affect current aggregate productivity.
    Keywords: Financial Friction; Capital Reallocation; Business Cycle
    JEL: G34 E32
    Date: 2007–07–05
  3. By: Benjamin D. Keen; Michael R. Pakko
    Abstract: In the immediate aftermath of Hurricane Katrina, speculation arose that the Federal Reserve might respond by easing monetary policy. This paper uses a dynamic stochastic general equilibrium (DSGE) model to investigate the appropriate monetary policy response to a natural disaster. We show that the standard Taylor (1993) rule response in models with and without nominal rigidities is to increase the nominal interest rate. That finding is unchanged when we consider the optimal policy response to a disaster. A nominal interest rate increase following a disaster mitigates both temporary inflation effects and output distortions that are attributable to nominal rigidities.
    Date: 2007
  4. By: Fabio Canova (Universitat Pompeu Fabra); David López-Salido (Banco de España; Centre for Economic Policy Research (CEPR)); Claudio Michelacci (Centro de Estudios Monetarios y Financieros (CEMFI))
    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: search frictions, technological progress, creative destruction
    JEL: E00 J60 O33
    Date: 2007–07
  5. By: Ester Faia (Universitat Pompeu Fabra)
    Abstract: In recent decades, capital account liberalization in emerging economies has often been followed by a surge in capital inflows, despite the presence of severe informational asymmetries for foreign lenders. Empirical studies have shown that in emerging economies financial liberalization has led to an increase in consumption volatility (also relative to output). I use a small open economy model where foreign lending to households is constrained by an endogenous borrowing limit. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. This economy is able to replicate the aforementioned stylized fact in response to various shocks (productivity, foreign demand and government expenditure). I find that financial liberalization reduces welfare since it increases the volatility of consumption and employment.
    Keywords: endogenous borrowing limit, financial liberalization, consumption volatility.
    JEL: E52 F1
    Date: 2007–02–20
  6. By: James B. Bullard; Aarti Singh
    Abstract: We study a stylized theory of the volatility reduction in the U.S. after 1984—the Great Moderation—which attributes part of the stabilization to less volatile shocks and another part to more difficult inference on the part of Bayesian households attempting to learn the latent state of the economy. We use a standard equilibrium business cycle model with technology following an unobserved regime-switching process. After 1984, according to Kim and Nelson (1999a), the variance of U.S. macroeconomic aggregates declined because boom and recession regimes moved closer together, keeping conditional variance unchanged. In our model this makes the signal extraction problem more difficult for Bayesian households, and in response they moderate their behavior, reinforcing the effect of the less volatile stochastic technology and contributing an extra measure of moderation to the economy. We construct example economies in which this learning effect accounts for about 30 percent of a volatility reduction of the magnitude observed in the postwar U.S. data.
    Date: 2007
  7. By: Mark Bils; Yongsung Chang; Sun-Bin Kim
    Abstract: We introduce worker differences in labor supply, reflecting differences in skills and assets, into a model of separations, matching, and unemployment over the business cycle. Separating from employment when unemployment duration is long is particularly costly for workers with high labor supply. This provides a rich set of testable predictions across workers: those with higher labor supply, say due to lower assets, should display more procyclical wages and less countercyclical separations. Consequently, the model predicts that the pool of unemployed will sort toward workers with lower labor supply in a downturn. Because these workers generate lower rents to employers, this discourages vacancy creation and exacerbates the cyclicality of unemployment and unemployment durations. We examine wage cyclicality and employment separations over the past twenty years for workers in the Survey of Income and Program Participation (SIPP). Wages are much more procyclical for workers who work more. This pattern is mirrored in separations; separations from employment are much less cyclical for those who work more. We do see for recessions a strong compositional shift among those unemployed toward workers who typically work less.
    JEL: E2 E24 E32 J6 J63
    Date: 2007–07
  8. By: Dimitrios Varvarigos (Dept of Economics, Loughborough University)
    Abstract: In a model where seignorage provides the financing instrument for the government’s budget, public spending volatility has an adverse effect on long-run growth. This negative relationship arises because the incidence of volatility in this type of public policy is responsible for higher average money growth, thus induces individuals to devote less time/effort towards capital accumulation. Another implication of the model is that policy variability provides a possible argument behind the positive correlation between inflation and inflation variability.
    Keywords: Growth, Inflation, Seignorage, Volatility
    JEL: E13 E31 O42
    Date: 2007–07
  9. By: Kowal, Pawel
    Abstract: We describe algorithm to find higher order approximations of stochastic rational expectations models near the deterministic steady state. Using matrix representation of function derivatives instead of tensor representation we obtain simple expressions of matrix equations determining higher order terms.
    Keywords: perturbation method; DSGE models
    JEL: C63 C61 E17
    Date: 2007–07
  10. By: Karsten Jeske; Sagiri Kitao
    Abstract: The U.S. tax policy on health insurance is regressive because it favors only those offered group insurance through their employers, who tend to have a relatively high income. Moreover, the subsidy takes the form of deductions from the progressive income tax system, giving high-income earners a larger subsidy. To understand the effects of the policy, we construct a dynamic general equilibrium model with heterogenous agents and an endogenous demand for health insurance. We use the Medical Expenditure Panel Survey to calibrate the process for income, health expenditures, and health insurance offer status through employers and succeed in matching the pattern of insurance demand as observed in the data. We find that despite the regressiveness of the current policy, a complete removal of the subsidy would result in a partial collapse of the group insurance market, a significant reduction in the insurance coverage, and a reduction in welfare coverage. There is, however, room for raising the coverage and significantly improving welfare by extending a refundable credit to the individual insurance market.
    Date: 2007
  11. By: Federico S. Mandelman; Gabriel V. Montes Rojas
    Abstract: Should a central bank accommodate energy price shocks? Should the central bank use core inflation or headline inflation with the volatile energy component in its Taylor rule? To answer these questions, we build a dynamic stochastic general equilibrium model with energy use, durable goods, and nominal rigidities to study the effects of an energy price shock and its impact on the macroeconomy when the central bank follows a Taylor rule. We then study how the economy performs under alternative parameterizations of the rule with different weights on headline and core inflation after an increase in the energy price. Our simulation results indicate that a central bank using core inflation in its Taylor rule does better than one using headline inflation because the output drop is less severe. In general, we show that the lower the weight on energy price inflation in the Taylor rule, the impact of an energy price increase on gross domestic product and inflation is also lower.
    Date: 2007
  12. By: Pablo A. Guerron (Department of Economics, North Carolina State University)
    Abstract: This paper explores the effects of using alternative data sets for the estimation of DSGE models. I find that the estimated structural parameters and the model's outcomes are sensitive to the variables used for estimation. Depending on the set of variables the point estimate for habit formation ranges from 0.70 to 0.97. Similarly, the interest-smoothing coefficient in the Taylor rule fluctuates between 0.06 and 0.76. In terms of the model's predictions, if interest rates are excluded during estimation, the estimated structural coefficients are such that the model forecasts a strong deflation following an expansionary monetary expansion. More importanlty, three ways to assess different observable sets are proposed. Based on these measures, I find that that including the price of investment in the data set delivers the best results.
    Keywords: Bayesian Estimation, DSGE, Variable Selection, Impulse Response, Entropy
    JEL: C32 E32 E37
    Date: 2007–07
  13. By: Michael F. Gallmeyer; Burton Hollifield; Francisco Palomino; Stanley E. Zin
    Abstract: We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation - a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data.
    JEL: E4 G0 G1
    Date: 2007–07

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