nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒08‒14
23 papers chosen by
Christian Zimmermann
University of Connecticut

  1. The Great Depression in Belgium from a Neo-Classical Perspective By Luca, PENSIEROSO
  2. Search Frictions on Product and Labor markets : Money in the Matching Function By Etienne, LEHMANN; Bruno, VAN DER LINDEN
  3. Simulating the Dynamic Macroeconomic and Microeconomic Effects of the FairTax1 By Sabine Jokisch; Laurence J. Kotlikoff
  4. Island Matching By Dale T. Mortensen
  5. Ambiguity Aversion, the Equity Premium and the Welfare Costs of Business Cycles By Alonso, Irasema; Prado, Jr., Jose Mauricio
  7. Investment Options and the Business Cycle By Boyan Jovanovic
  9. Sustained Output Growth Under Uncertainty: A Simple Model With Human Capital By Dimitrios Varvarigos
  10. Liquidity, Redistribution, and the Welfare Cost of Inflation By Jonathan Chiu; Miguel Molico
  11. Stochastic labour market shocks, labour market programmes, and human capital formation: a theoretical and empirical analysis By Michael Lechner; Rosalia Vazquez-Alvarez
  12. Ambiguity Aversion and the Term Structure of Interest Rates By Patrick Gagliardini; Paolo Porchia; Fabio Trojani
  13. Explaining High Economic Growth in Small Tourism Countries with a Dynamic General Equilibrium Model. By Carmen Álvarez-Albelo; Raúl Hernández-Martín
  14. With additional default enforcements,collateral avoids Ponzi schemes,only if large enough By Thiago Revil; Juan Pablo Torres-Martinez
  15. Trade and the Diffusion of the Industrial Revolution By Robert E. Lucas, Jr.
  16. Disentangling the demographic determinants of the English take-off : 1530-1860 By Raouf, BOUCEKKINE; David, DE LA CROIX; Dominique, PEETERS
  17. Pairwise-core Monetary Trade in the Lagos-Wright Model By Tai-wei Hu; John Kennan; Neil Wallace
  18. Pension Systems and their Influence on Fertility and Growth By Johannes Holler
  19. Divorce and the Option Value of Marital Search By VALERIO FILOSO
  21. Is the U.S. Bankrupt? By Laurence J. Kotlikoff
  22. THE EXCESS BURDEN OF GOVERNMENT INDECISION By Francisco J. Gomes; Laurence J. Kotlikoff; Luis M. Viceira
  23. A theory of dynamics and inequalities under epidemics By Raouf, BOUCEKKINE

    Abstract: This paper casts the Belgian Great Depression of the 1930s within a dynamic stochastic general equilibrium (DSGE) framework. Results show that a total factor productivity shock within a standard real business cycle model is unsatisfactory. Introducing war expectations in the baseline model produces little improvement. Given the evidence on sticky wages put forward by historians, it shows that a simple DGSE model with sticky wages ˆ la Taylor improves on the result.
    Keywords: Great Depression; Belgium; sticky wages; dynamic stochastic general equilibrium
    JEL: E13 N14
    Date: 2007–08–02
  2. By: Etienne, LEHMANN; Bruno, VAN DER LINDEN (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics)
    Abstract: This paper builds a macroeconomic model of equilibrium unemployment in which firms persistently face difficulties in selling their production and this affects their decisions to create jobs. Due to search-frictins on the product market, equilibrium unemployment is a U-shaped function of the ratio of total demand to total supply on this market. When prices are at their Competitive Search Equilibrium values, the unemployment rate is minimized. Yet, the Competitive Search Equilibrium is not efficient. Inflation is detrimental to unemployment.
    Keywords: Equilibrium unemployment, Matching, Inflation, Demand Constraints
    JEL: E12 E24 E31 J63
    Date: 2007–03–28
  3. By: Sabine Jokisch (Centre for European Economic Research); Laurence J. Kotlikoff (Department of Economics, Boston University and NBER)
    Abstract: America's aging coupled with high and growing old age health and pension benefits augers for much higher payroll taxes, with damaging effects on the U.S. economy. This prognosis is supported by our analysis of a detailed dynamic life-cycle general equilibrium model. The FairTax, which proposes to replace the federal payroll, personal income, corporate income, and estate tax with a progressive consumption tax, offers a potential alternative to this dismal economic future. According to our simulation model, these policy changes would lead to major improvements in the U.S. capital stock, long-run real wages and the wellbeing of the majority of Americans.
    Date: 2007–04
  4. By: Dale T. Mortensen
    Abstract: A synthesis of the Lucas-Prescott island model and the Mortensen- Pissarides matching model of unemployment is studied. By assumption, all unmatched workers and jobs are randomly assigned to islands at the beginning of each period and the number of matches that form on a particular island is the minimum of the two realizations. When calibrated to the recently observed averages of U.S. unemployment and vacancy rates, the model fits the observed vacancy-unemployment Beveridge relationship very well and implies an implicit log linear relationship between the job finding rate and the vacancy-unemployment relationship with an elasticity near 0.5. The constrained efficient solution to the model is decentralized by a equilibrium outcome in which wages on each island are determined by a modified auction. Although the efficient solution explains only about 25% of the observed volatility in the U.S. vacancy-unemployment ratio, an equilibrium outcome in which wages are determined as the solution to a strategic bargaining game explains almost all of it.
    JEL: E24 E32 J64
    Date: 2007–08
  5. By: Alonso, Irasema (Yale University); Prado, Jr., Jose Mauricio (Institute for International Economic Studies, Stockholm University)
    Abstract: We examine the potential importance of consumer ambiguity aversion for asset prices and how consumption ‡fluctuations influence consumer welfare. First, considering a simple Mehra-Prescott-style endowment economy with a representative agent facing consumption fluctuations calibrated to match U.S. data, we study to what extent ambiguity aversion can deliver asset prices that are consistent with data: a high return on equity and a low return on riskfree bonds. For some configurations of preference parameters— a discount factor, a degree of relative risk aversion, and a measure of ambiguity aversion— we find that it can. Then, we use these parameter configurations to investigate how much consumers would be willing to pay to reduce endowment fluctuations to zero, thus delivering a Lucas-style welfare cost of fluctuations. These costs turn out to be very large: consumers are willing to pay over 10% of consumption in permanent terms.
    Keywords: Ambiguity aversion; asset prices; business cycle
    JEL: D14 E32 G12
    Date: 2007–08–06
  6. By: Francois Gourio (Boston University, Department of Economics); Anil K Kashyap
    Abstract: Using plant-level data from Chile and the U.S., we show that investment spikes are highly pro-cyclical, so much so that changes in the number of establishments undergoing investment spikes (the “extensive margin”) account for the bulk of variation in aggregate investment. The number of establishments undergoing investment spikes also has independent predictive power for aggregate investment, even controlling for past investment and sales. We re-calibrate the Thomas (2002) model (that includes fixed costs of investing) so that it assigns a prominent role to extensive adjustment. The recalibrated model has different properties than the standard RBC model for some shocks.
    Keywords: adjustment costs, investment, investment tax credit, fixed costs, extensive margin.
    JEL: E22 E23
    Date: 2007–05
  7. By: Boyan Jovanovic
    Abstract: This paper extends Lucas (1978) to a production economy with two capital goods. It is an RBC model in which each unit of investment requires a new idea, an "option". When options are scarce, new capital is harder to put in place and the value of old capital rises. Thus the stock market and Tobin's Q are negative indexes of intangibles. During a boom, Q rises gradually, as options are used up. Because investment represents an exercise of options, it has an intertemporal substitution tradeoff that is absent in the adjustment-cost model. Equilibrium may be efficient even without markets for knowledge; the stock market may suffice.
    JEL: E3 E44
    Date: 2007–08
  8. By: Francois Gourio (Boston University, Department of Economics)
    Abstract: I derive a production-based asset pricing formula to infer aggregate stock market returns from macroeconomic time series when the technology is putty-clay. Capital heterogeneity leads to variation in the aggregate stock market value through a new compositional effect. The asset pricing formula, which holds regardless of the stochastic discount factor, predicts that stock returns are high when the ratio of investment to gross job creation is low. This contrasts with the adjustment cost model which predicts that stock returns are high when the investment-capital ratio is high. Incorporating the putty-clay technology increases substantially the ability of the adjustment cost model to match the data on U.S. stock returns.
    Date: 2007–01
  9. By: Dimitrios Varvarigos (Dept of Economics, Loughborough University)
    Abstract: In a model where agents use their labour/education choice to adjust their consumption profile over time, I show that the impact of uncertainty on growth depends, critically, on agents’ attitudes towards risk, reflected by the coefficient of relative risk aversion. In this respect, the well known result from the literature on ‘saving under uncertainty’ can be extended into a broader context, whereby the intertemporal profile of consumption is determined via human capital accumulation rather than saving and physical capital investment.
    Keywords: Growth, Uncertainty
    JEL: O41
    Date: 2007–08
  10. By: Jonathan Chiu; Miguel Molico
    Abstract: This paper studies the long run welfare costs of inflation in a micro-founded model with trading frictions and costly liquidity management. Agents face uninsurable idiosyncratic uncertainty regarding trading opportunities in a decentralized goods market and must pay a fixed cost to rebalance their liquidity holdings in a centralized liquidity market. By endogenizing the participation decision in the liquidity market, this model endogenizes the responses of velocity, output, the degree of market segmentation, as well as the distribution of money. We find that, compared to the traditional estimates based on a representative agent model, the welfare costs of inflation are significantly smaller due to distributional effects of inflation. The welfare cost of increasing inflation from 0% to 10% is 0.62% of income for the U.S. economy and 0.20% of income for the Canadian economy. Furthermore, the welfare cost is generally non-linear in the rate of inflation, depending on the endogenous responses of the liquidity market participation to inflation and liquidity management costs.
    Keywords: Inflation: costs and benefits
    JEL: E40 E50
    Date: 2007
  11. By: Michael Lechner; Rosalia Vazquez-Alvarez
    Abstract: This paper develops a life-cycle model of labour supply that captures endogenous human capital formation allowing for individual’s heterogeneous responses to stochastic labour market shocks. The shocks determines conditions in the labour market and sort individuals into three labour market regimes; employment, unemployment with and unemployment without participation in labour market programmes. The structural model entails time independent stochastic shocks that have transitory effects on monetary returns while the effect on human capital formation may be permanent. The permanent effect may justify the existence of active labour market programmes if these programmes imply non-depreciating human capital and human capital depreciation is detected for the non-participant unemployed. Using several years of the Swiss Labour Force Survey (SAKE, 1991 – 2004) the empirical section compares the dynamic formation of human capital between labour market regimes. The results are consistent with the assumptions of the structural model and suggest human capital depreciation for unemployment without programme participation. They further show that labour programmes may act as a buffer to reduce human capital loss while unemployed.
    Keywords: Human capital formation, life-cycle labour supply models, active labour market policies, search activities, productivity shocks, unemployment
    JEL: D31 D91 J24 J68
    Date: 2007–07
  12. By: Patrick Gagliardini; Paolo Porchia; Fabio Trojani
    Abstract: This paper studies the term structure implications of a simple structural economy in which the representative agent displays ambiguity aversion, modeled by Multiple Priors Recursive Utility. Bond excess returns reflect a premium for ambiguity, which is observationally distinct from the risk premium of affine yield curve models. The ambiguity premium can be large even in the simplest logutility model and is non zero also for stochastic factors that have a zero risk premium. A calibrated low-dimensional two-factor economy with ambiguity is able to reproduce the deviations from the expectations hypothesis documented in the literature, without modifying in a substantial way the nonlinear mean reversion dynamics of the short interest rate. In this economy, we do not find any apparent tradeoffs between fitting the first and second moments of the yield curve and the large equity premium.
    Keywords: General Equilibrium, Term Structure of Interest Rates, Ambiguity Aversion, Expectations Hypothesis, Campbell-Shiller Regression
    JEL: C68 G12 G13
    Date: 2007–07
  13. By: Carmen Álvarez-Albelo (Grup de Recerca en Economia del Benestar (CREB), Department of Economic Analysis, University of La Laguna); Raúl Hernández-Martín (Department of Applied Economics, University of La Laguna)
    Abstract: This paper shows that tourism specialisation can help to explain the observed high growth rates of small countries. For this purpose, two models of growth and trade are constructed to represent the trade relations between two countries. One of the countries is large, rich, has an own source of sustained growth and produces a tradable capital good. The other is a small poor economy, which does not have an own engine of growth and produces tradable tourism services. The poor country exports tourism services to and imports capital goods from the rich economy. In one model tourism is a luxury good, while in the other the expenditure elasticity of tourism imports is unitary. Two main results are obtained. In the long run, the tourism country overcomes decreasing returns and permanently grows because its terms of trade continuously improve. Since the tourism sector is relatively less productive than the capital good sector, tourism services become relatively scarcer and hence more expensive than the capital good. Moreover, along the transition the growth rate of the tourism economy holds well above the one of the rich country for a long time. The growth rate differential between countries is particularly high when tourism is a luxury good. In this case, there is a faster increase in the tourism demand. As a result, investment of the small economy is boosted and its terms of trade highly improve.
    Keywords: High growth, Small tourism countries, Terms of trade, Luxury good, Dynamic general equilibrium.
    JEL: F43 O33 O41
    Date: 2007–07
  14. By: Thiago Revil; Juan Pablo Torres-Martinez (Department of Economics, PUC-Rio)
    Abstract: In infinite horizon incomplete market economies, Ponzi schemes are avoided and equilibrium exists when collateral repossession is the only mechanism enforcing borrowers not to entirely default on their promises. In these economies, we add default enforcement mechanisms that are effective, i.e. induce payments besides the value of the collateral guarantees. We prove that, independently of prices, the individual problem does not have a solution when collateral guarantees are not large enough relative to the effectiveness of the additional enforcement mechanisms. We also show that this result does not depend on specific types for these mechanisms, as long as they are effective.
    Keywords: Effective default enforcements, Collateral repossession, Individual’s optimality.
    JEL: D50 D52
    Date: 2007–07
  15. By: Robert E. Lucas, Jr.
    Abstract: A model is proposed to describe the evolution of real GDPs in the world economy that is intended to apply to all open economies. The five parameters of the model are calibrated using the Sachs-Warner definition of openness and time-series and cross-section data on incomes and other variables from the 19th and 20th centuries. The model predicts convergence of income levels and growth rates and has strong but reasonable implications for transition dynamics.
    JEL: O0 O1 O19
    Date: 2007–08
  16. By: Raouf, BOUCEKKINE (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics); David, DE LA CROIX (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics); Dominique, PEETERS
    Abstract: We propose a model with some of the main demographic, economic and institutional factors usually considered to matter in the transition to modern growth. We apply our theory to England over the period 1530-1860. We use the model to measure the impact of mortality, population density and technological progress on school foundations, literacy and growth through a set of experiments. We find that one third of the rise in literacy over the period 1530-1850 can be directly related to the rise in population density, while one sixth is linked to higher longevity and one half to exogenous total factor productivity growth. Moreover, the timing of the effect of population density in the model is consistent with the available evidence for England, where it is shown that schools were established at a high rate over the period 1540-1620.
    JEL: O41 I21 R12 J11
    Date: 2007–07–30
  17. By: Tai-wei Hu; John Kennan; Neil Wallace
    Abstract: The Lagos-Wright model has been analyzed using particular trading protocols. Here, weakly and strongly implementable allocations are studied, where weak and strong are used in the sense of (weak) Nash (immune to individual defection) and strong Nash (immune to individual and cooperative pairwise defection). It is shown that the first-best allocation is strongly implementable without intervention for all sufficiently high discount factors. And, if people are free to skip the centralized meeting, then Friedman-rule intervention that uses lump-sum taxation in the centralized meeting to raise the return on money does not enlarge even the set of weakly implementable allocations.
    JEL: E40
    Date: 2007–08
  18. By: Johannes Holler
    Abstract: This paper studies the implications of di¤erent public pension systems on fertility and economic growth. Employing a three period overlapping gener- ations endogenous growth model we compare the di¤erent impacts of pay-as- you-go-, fully funded- and informal pension systems. The novelty of our work lies in the formulation of altruism that is assumed to be one sided (descending) for economies represented by a public pension system and two sided (descend- ing and ascending) for economies with informal pension systems. Through the incorporation of a mixed procreation motive we can study the case of fully crowded out intrafamilial transfers inside a public pension system model while still capturing fertility endogenously. We show that the introduction of public pension systems to a developing economy reduce fertility and stimulate economic growth. Through a comparison of the di¤erent public pension systems we highlight that a fully funded pension system results in higher economic growth compared to a pay-as-you-go one despite higher fertility because the growth enhancing e¤ect of the higher capital stock is dominant. This suggests that observed fertility and growth di¤erences between the US and Europe can partly be explained by the di¤erent types of pension systems.
    JEL: H55 J13 O41
    Date: 2007–06
    Abstract: This works tests whether or not the introduction of divorce law changes the timing of marital search. Common sense suggests that rational agents should adjust to the divorce risk by increasing the average length of search spell, whereas the option value theory stresses the role played by irreversible investments: in this case, the new exit option available to married partners should result in shorter search spells. Using a dynamic model of marital search, a new dataset of retrospective individual Italian data, and two robust statistical specifications based upon the Before-After estimator, we find strong evidence that the legal innovation actually lowered the age at marriage, thereby worsening the level of marital matching, and possibly reinforcing self-fulfilling prophecies of divorce.
    Keywords: Marital Search, Divorce, Marriag
    JEL: J12 C41 D83
    Date: 2007–03
  20. By: Simon Gilchrist (Boston University and NBER); Jae W. Sim (Boston University)
    Abstract: Without capital market imperfections, the capital structure of a firm, including the size, the maturity and the currency composition of debts, should not matter for investment decisions. The Asian financial crises provide a good opportunity to test this hypothesis. We approach the problem in two ways: First, we apply a conventional reduced-form analysis to a panel data of Korean manufacturing firms, arguing that the devaluation that occurred during the crisis provides a natural experiment in which to assess the effect of balance sheet shocks to investment. Second, we use indirect inference to estimate a structural dynamic programming problem of a firm with foreign debts and financial constraints. Both reduced-form evidence and structural parameter estimates imply an important role for finance in investment at the firm level. Counterfactual simulations imply that balance sheet effects may account for 50% to 80% of the drop in investment during the crisis period. Although our estimates suggest that foreign denominated debt had relatively little effect on aggregate investment spending for the Korean economy during this crisis episode, counterfactual experiments imply sizeable contractions in investment through this mechanism for economies that are more heavily dependent on foreign-denominated debt.
    Date: 2007–01
  21. By: Laurence J. Kotlikoff (Department of Economics, Boston University and the National Bureau of Economic Research)
    Abstract: Is the U.S. bankrupt? Or to paraphrase the Oxford Dictionary, is the U.S. at the end of its resources, exhausted, stripped bear, destitute, bereft, wanting in property, or wrecked in consequence of failure to pay its creditors? Many would scoff at this notion. They’d point out that the country has never defaulted on its debt, that its debt-to-GDP ratio is substantially lower than that of Japan and other developed countries, that its long-term nominal interest rates are historically low, that the dollar is the world’s reserve currency, and that China, Japan, and other countries have an insatiable demand for U.S. Treasuries. Others would argue that the official debt reflects nomenclature, not fiscal fundamentals, that the sum total of official and unofficial liabilities is massive, that federal discretionary spending and medical expenditures are exploding, that the U.S. has a history of defaulting on its official debt via inflation, that the government has cut taxes well below the bone, that countries now holding U.S. government bonds can sell them in a nanosecond, that the financial markets have a long and impressive record of mispricing securities, and that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the U.S. is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of U.S. fiscal institutions is essential to secure the nation’s economic future. The paper offers three policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy. The policies would replace the current tax system with a retail sales tax, personalize Social Security, and move to a globally budgeted universal healthcare system implemented via individual-specific health insurance vouchers. The radical nature of these proposals reflects the critical nature of our time. Unless the U.S. moves quickly to fundamentally change and restrain its fiscal behavior, its bankruptcy will become a foregone conclusion.
    Date: 2007–03
  22. By: Francisco J. Gomes (London Business School and CEPR); Laurence J. Kotlikoff (Boston University and NBER); Luis M. Viceira (Harvard Business School, CEPR and NBER)
    Abstract: Governments are known for procrastinating when it comes to resolving painful policy problems. Whatever the political motives for waiting to decide, procrastination distorts economic decisions relative to what would arise with early policy resolution. In so doing, it engenders excess burden. This paper posits, calibrates, and simulates a life cycle model with earnings, lifespan, investment return, and future policy uncertainty. It then measures the excess burden from delayed resolution of policy uncertainty. The first uncertain policy we consider concerns the level of future Social Security benefits. Specifically, we examine how an agent would respond to learning in advance whether she will experience a major Social Security benefit cut starting at age 65. We show that having to wait to learn materially affects consumption, saving, and portfolio decisions. It also reduces welfare. Indeed, we show that the excess burden of government indecision can, in this instance, range as high as 0.6 percent of the agent's economic resources. This is a significant distortion in of itself. It's also significant when compared to other distortions measured in the literature. The second uncertain policy we consider concerns marginal tax rates. We obtain similar results once we adjust for the impact of tax rates on income.
    JEL: H2 H21 H55 H6
    Date: 2007–01
  23. By: Raouf, BOUCEKKINE (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics)
    Abstract: We develop a tractable general theory for the study of the economic and demographic impact of epidemics. In particular, we analytically characterise the short and medium term consequences of epidemics for population size, age pyramid, economic performance and income distribution. To this end, we develop a three-period overlapping generations where altruistic parents choose optimal health expenditures for their children and themselves. The survival probability of (junior) adults and children depend on such investments. Agents can be skilled or unskilled. The model emphasizes the role of orphans. Orphans are not only penalized in front of death, they are also penalized in the access to education. Epidemics are modeled as one period exogenous shocks to the survival rates. We identify three kinds of epidemics depending on how th epidemic shock alters the marginal efficiency of health expenditures. We first study the demographic dynamics, and prove that while a one-period epidemic shock has no permanent effect on income distribution, it can perfectly alter it in the short and medium run. We then study the impact of the three kinds of epidemics when they hit children and/or junior adults. We prove that while the three epidemics have significatly different demographic implications in the medium run, they all imply a worsening in the short and medium run of economic performance and income distribution. In particular, the distributional implications of the model mainly rely on orphans : if orphans are more penalized in the access to a high level of education than in front of death, they will necessarily lead to the medium-term increase in the proportion of the unskilled, triggering the impoverishment of the economy at that time horizon.
    Keywords: Epidemics; orphans; inome distribution; endogeneous survival; medium-term dynamics
    JEL: D9 I1 I2
    Date: 2007–07–30

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