nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒09‒16
seventeen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Wage Rigidity and Job Creation By Christian Haefke; Marcus Sonntag; Thijs van Rens
  2. Capital Taxation and Ownership when Markets are Incomplete By Emmanuel Farhi
  3. Incomplete information and self-fulfilling prophecies By Pengfei Wang; Yi Wen
  4. Optimal fiscal policy in the design of Social Security reforms By Juan Carlos Conesa; Carlos Garriga
  5. Bargaining, fairness, and price rigidity in a DSGE environment By David M. Arseneau; Sanjay K. Chugh
  6. Assessing the Impact of a Change in the Composition of Public Spending: A DSGE Approach By Ivan Tchakarov; Roland Straub
  7. The optimal inflation target in an economy with limited enforcement By Gaetano Antinolfi; Costas Azariadis; James B. Bullard
  8. Money Shocks in a Small Open Economy with Dollarization, Factor Price Rigidities, and Nontradeables By Sarajevs, Vadims
  9. A Note on Public Debt, Tax-Exempt Bonds, and Ponzi Games By Berthold U. Wigger
  10. The Role of Nonseparable Utility and Nontradeables in International Business Cycle and Portfolio Choice By Akito Matsumoto
  11. From simple growth to numerical simulations: a primer in dynamic programming By Gianluca Femminis
  12. A Simple DGE Model for Inflation Targeting By Jaromir Benes; David Vávra; Marta de Castello Branco
  13. Accounting for changes in the homeownership rate By Matthew Chambers; Carlos Garriga; Don Schlagenhauf
  14. An Empirical Analysis of Labor Income Processes By Fatih Guvenen
  15. Factor Analysis in a Model with Rational Expectations By Andreas Beyer; Roger E. A. Farmer; Jérôme Henry; Massimiliano Marcellino
  16. Essential Interest-Bearing Money By Andolfatto, David
  17. Optimal taxation with imperfect competition and aggregate returns to specialization By Javier Coto-Martínez; Carlos Garriga; Fernando Sánchez-Losada

  1. By: Christian Haefke; Marcus Sonntag; Thijs van Rens
    Abstract: Shimer (2005) and Hall (2005) have documented the failure of standard labor market search models to match business cycle fluctuations in employment and unemployment. They argue that it is likely that wages are not adjusted as regularly as suggested by the model, which would explain why employment is more volatile than the model predicts. We explore whether this explanation is consistent with the data. The main insight is that the relevant wage data for the search model are not aggregate wages, but wages of newly hired workers. Our results show that wages for those workers are much more volatile than aggregate wages and respond one-for-one to changes in labor productivity. Thus, we find no evidence for wage rigidity.
    Keywords: Wage Rigidity, Search and Matching Model, Business Cycle
    JEL: E24 E32 J31 J41 J64
    Date: 2007–04
  2. By: Emmanuel Farhi
    Abstract: This paper analyzes the theoretical and quantitative implications of optimal capital taxation in the neoclassical growth model with aggregate shocks and incomplete markets. The model features a representative-agent economy with proportional taxes on labor and capital. I first consider the case that the only asset the government can trade is a real risk-free bond. Taxes on capital are set one period in advance, reflecting inertia in tax codes and ruling out replication of the complete markets allocation. Because capital income varies with the state of the economy, capital taxation provides a state contingent source of revenues. I thus identify a novel potential role for capital taxation as a risk sharing instrument between the government and private agents. However, this benefit must be weighted again the distortionary cost of capital taxation. For a baseline case, the optimal policy features a zero tax on capital. Moreover, numerical simulations show that the baseline case provides an excellent benchmark. I next allow the government to hold a non trivial position in capital. Capital ownership provides the same benefit or risk sharing but without the cost of tax distortions. In a variety of quantitative exercises, I show that capital ownership allows the government to realize about 90% of the welfare gains from moving to complete markets. Large positions are typically required for optimality. But smaller positions achieve substantial benefits. In a business-cycle simulation, I show that a 15% short equity position achieves over 40% of the welfare gains from completing markets.
    JEL: A1 E21 E22 E23 E6 E60 E62 E66 H21 H3 H31 H32 H6 H60 H61 H62
    Date: 2007–09
  3. By: Pengfei Wang; Yi Wen
    Abstract: This paper shows that incomplete information can be a rich source of sunspots equilibria. This is demonstrated in a standard dynamic general equilibrium model of monopolistic competition … la Dixit-Stiglitz. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium, but there are also multiple stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. In other words, sunspots can exist in infinite-horizon dynamic models with a unique saddle path steady state. In contrast to the recent sunspots literature (e.g., Benhabib and Farmer 1994), sunspots arising under incomplete information can be serially correlated and are robust to parameters associated with production technologies and preferences. Markup is always countercyclical in sunspots equilibria (which is consistent with empirical evidence) and fluctuations driven by sunspots look very similar to fluctuations driven by technology shocks.
    Keywords: Business cycles ; Prices
    Date: 2007
  4. By: Juan Carlos Conesa; Carlos Garriga
    Abstract: The quantitative macroeconomics literature has documented that in the basic Overlapping Generations model a privatization of the social security system, going from a Pay-As-You-Go to a Fully Funded system, generates large long run welfare gains at the cost of substantial welfare losses for initial generations. We propose an alternative to previous literature. In this paper we maximize over the entire policy space, following the optimal fiscal policy approach, rather than comparing alternative policy paths one to one. That is, policies are chosen as part of the optimal design of a social security privatization in a Pareto improving way. The government decides endogenously how to finance the implicit social security liabilities and compensate the initial generations alive during the transition. In contrast with previous analysis the resulting allocation, by construction, lies on the constrained Pareto frontier. We find that the optimal design of reforms exhibits sizeable welfare gains, arising because of the reduction in labor supply distortions. In contrast, the welfare gains coming from the reduction of savings distortions are relatively small.
    Keywords: Fiscal policy ; Social security
    Date: 2007
  5. By: David M. Arseneau; Sanjay K. Chugh
    Abstract: A growing body of evidence suggests that an important reason why firms do not change prices nearly as much as standard theory predicts is out of concern for disrupting ongoing customer relationships because price changes may be viewed as "unfair". Existing models that try to capture this concern regarding price-setting are all based on goods markets that are fundamentally Walrasian. In Walrasian goods markets, transactions are spot, making the idea of ongoing customer relationships somewhat difficult to understand. We develop a simple dynamic general equilibrium model of a search-based goods market to make precise the notion of a customer as a repeat buyer at a particular location. In this environment, the transactions price plays a distributive role as well as an allocative role. We exploit this distributive role of prices to explore how concerns for fairness influence price dynamics. Using pricing schemes with bargaining-theoretic foundations, we show that the particular way in which a "fair" outcome is determined matters for price dynamics. The most stark result we find is that complete price stability can arise endogenously. There are issues about which models based on standard Walrasian goods markets are silent.
    Date: 2007
  6. By: Ivan Tchakarov; Roland Straub
    Abstract: Despite intense calls for safeguarding public investment in Europe, public investment expenditure, when measured in relation to GDP, has steadily fallen in the last three decades, evoking fears that economic activity may be correspondingly negatively affected. At the same time, however, public consumption in the EU-12 countries has trended up. In this paper, we provide a macroeconomic assessment of the observed change in the composition of public spending in the euro area in a medium-scale two-country dynamic stochastic general equilibrium (DSGE) model. First, we identify the channels through which both temporary and permanent public investment shocks generate larger fiscal multipliers than exogenous increases in public consumption. Second, we quantify the negative impact of a change in fiscal stance, characterized by a permanent rise in public consumption and a permanent fall in public investment, keeping the overall level of public spending constant. The key message of the paper is that calls for reversing the observed trend in the composition of public spending are well justified.
    Date: 2007–07–17
  7. By: Gaetano Antinolfi; Costas Azariadis; James B. Bullard
    Abstract: We formulate the central bank?s problem of selecting an optimal long-run inflation rate as the choice of a distorting tax by a planner who wishes to maximize discounted utility for a heterogeneous population of infinitely-lived households in an economy with constant aggregate income. Households are divided into cash agents, who store value in currency alone, and credit agents who have access to both currency and loans. The planner?s problem is equivalent to choosing inflation and nominal rates consistent with a resource constraint along with an incentive constraint that ensures credit agents prefer the superior consumption-smoothing power of loans to that of currency. We show that the optimum rate of inflation is positive, and the optimum nominal interest rate is higher than the inflation rate, if the social welfare function weighs credit agents no more than their population fraction.
    Keywords: Inflation (Finance) ; Deflation (Finance) ; Monetary policy - United States
    Date: 2007
  8. By: Sarajevs, Vadims (BOFIT)
    Abstract: The impact of an unanticipated monetary shock in a small open economy with dollarization, factor price rigidities, and nontradeables is re-examined in an optimizing intertemporal general equilibrium model. The framework of an earlier study is extended to incorporate foreign real money balances into the repre-sentative agent's utility function and to account for the phenomenon of dollarization so characteristic of transition economies. The major finding is that in the event of small monetary shocks, the presence of dollarization does not alter the outcome that relates the sign of response of consumption, current account balance, and other macroeconomic variables to the difference between intertemporal and intratemporal elasticities of substitutions of the total consumption index. The solution also shows that the elasticity of intertemporal substitution of money services and the share of traded goods in total consumption - a proxy for openness of the economy - are the crucial parameters in determining the response and the possibility of overshooting of the model variables, with economic openness playing a stabilizing role for the econ-omy in the event of monetary shocks.
    Keywords: new open-economy macroeconomics; monetary shocks; dollarization; factor price rigidities; nontradeables; current account
    JEL: F31 F32 F41 F47
    Date: 2007–09–13
  9. By: Berthold U. Wigger
    Abstract: By issuing tax-exempt bonds, the government can incur debt and never pay back any principal or interest, even if the economy without public debt evolves on a dynamically efficient growth path. The welfare effects of such a Ponzi type borrowing scheme are mixed. The current young will unambiguously benefit.Depending on preferences and the aggregate technology, also a finite number of subsequent generations may benefit. The welfare of all generations thereafter, however, will be lower than in the economy without public debt.
    Date: 2007–07–17
  10. By: Akito Matsumoto
    Abstract: This paper analyzes the role of nonseparable utility and nontradables in business cycles and portfolio choice. I find that nonseparability in utility can change the portfolio choice significantly. Unlike previous results in literature, the optimal portfolio of the traded-good sector equities is no longer a well diversified portfolio and becomes sensitive to parameter values. As a result, the model often generates extreme home bias or anti-home bias portfolios implying that some frictions in asset markets, which prevent agents from holding these extreme portfolios, can explain the lack of international risk sharing.
    Date: 2007–07–17
  11. By: Gianluca Femminis (DISCE, Università Cattolica)
    Abstract: These notes provide an intuitive introduction to dynamic programming. The first two Sections present the standard deterministic Ramsey model using the Lagrangian approach. These can be skipped by whom is already acquainted with this framework. Section 3 shows how to solve the well understood Ramsey model by means of a Bellman equation, while Section 4 shows how to "guess" the solution (when this is possible). Section 5 is devoted to applications of the envelope theorem. Section 6 provides a "paper and pencil" introduction to the numerical techniques used in dynamic programming, and can be skipped by the uninterested reader. Sections 7 to 9 are devoted to stochastic modelling, and to stochastic Bellman equations. Section 10 extends the discussion of numerical techniques. An Appendix provides details about the Matlab routines used to solve the examples.
    Keywords: Dynamic programming, Bellman equation, Optimal growth, Numerical techniques.
    JEL: C61 O41 C63
    Date: 2007–07
  12. By: Jaromir Benes; David Vávra; Marta de Castello Branco
    Abstract: The paper presents a DGE model designed as a core projection tool to support monetary policy in inflation-targeting (IT) emerging market economies. The paper uses a particularly simple and flexible general equilibrium model structure that can be amended to account for various phenomena that often complicate policy analysis in emerging markets, such as persistent trends in relative prices. The model's calibration is intuitive and can draw on the vast experience many countries have with calibrating small 'gap' models of monetary policy transmission. Moreover, the definition of the model's steady state in terms of nominal expenditure ratios, rather than levels of real variables, allows for the easy use of the model in a regular forecast production cycle in an IT central bank. The paper tests the model's properties on recent Turkish data, demonstrating that the main stylized features relevant for monetary policy making are well captured by the model.
    Date: 2007–08–03
  13. By: Matthew Chambers; Carlos Garriga; Don Schlagenhauf
    Abstract: After three decades of being relatively constant, the homeownership rate increased over the period 1994 to 2005 to attain record highs. The objective of this paper is to account for the observed boom in ownership by examining the role played changes in demographic factors and innovations in the mortgage market which lessened downpayment requirements. To measure the aggregate and distributional impact of these factors, we construct a quantitative general equilibrium overlapping generation model with housing. We find that the long-run importance of the introduction of new mortgage products for the aggregate homeownership rate ranges from 56 and 70 percent. Demographic factors account for between 16 and 31 percent of the change. Transitional analysis suggests that demographic factors play a more important, but not dominant, role the further away from the long-run equilibrium. From a distributional perspective, mortgage market innovations have a larger impact explaining participation rate changes of younger households, while demographic factors seem to be the key to understanding the participation rate changes of older households. Our analysis suggests that the key to understand the increase in the homeownership rate is the expansion of the set of mortgage contracts. We test the robustness of this result by considering changes in mortgage financing after World War II. We find that the introduction of the conventional fixed rate mortgage, which replaced balloon contacts, accounts for at least fifty percent of the observed increase in homeownership during that period.
    Keywords: Home ownership ; Mortgage loans
    Date: 2007
  14. By: Fatih Guvenen
    Abstract: In this paper we reassess the evidence on labor income risk. There are two leading views on the nature of the income process in the current literature. The first view, which we call the "Restricted Income Profiles" (RIP) process, holds that individuals are subject to large and very persistent shocks, while facing similar life-cycle income profiles. The alternative view, which we call the "Heterogeneous Income Profiles" (HIP) process, holds that individuals are subject to income shocks with modest persistence, while facing individual-specific income profiles.We first show that ignoring profile heterogeneity, when in fact it is present, introduces an upward bias into the estimates of persistence. Second, we estimate a parsimonious parameterization of the HIP process that is suitable for calibrating economic models. The estimated persistence is about 0.8 in the HIP process compared to about 0.99 in the RIP process. Moreover, the heterogeneity in income profiles is estimated to be substantial, explaining between 56 to 75 percent of income inequality at age 55. We also find that profile heterogeneity is substantially larger among higher educated individuals. Third, we discuss the source of identification -- in other words, the aspects of labor income data that allow one to distinguish between the HIP and RIP processes. Finally, we show that the main evidence against profile heterogeneity in the existing literature -- that the autocorrelations of income changes are small and negative -- is also replicated by the HIP process, suggesting that this evidence may have been misinterpreted.
    JEL: E24 J31
    Date: 2007–09
  15. By: Andreas Beyer; Roger E. A. Farmer; Jérôme Henry; Massimiliano Marcellino
    Abstract: DSGE models are characterized by the presence of expectations as explanatory variables. To use these models for policy evaluation, the econometrician must estimate the parameters of expectation terms. Standard estimation methods have several drawbacks, including possible lack or weakness of identification of the parameters, misspecification of the model due to omitted variables or parameter instability, and the common use of inefficient estimation methods. Several authors have raised concerns over the implications of using inappropriate instruments to achieve identification. In this paper we analyze the practical relevance of these problems and we propose to combine factor analysis for information extraction from large data sets and GMM to estimate the parameters of systems of forward looking equations. Using these techniques, we evaluate the robustness of recent findings on the importance of forward looking components in the equations of a standard New-Keynesian model.
    JEL: E5 E52 E58
    Date: 2007–09
  16. By: Andolfatto, David
    Abstract: In this paper, I provide a rationale for why money should earn interest; or, what amounts to the same thing, why risk-free claims to non-interest-bearing money should trade at discount. I argue that interest-bearing money is essential when individual money balances are private information. The analysis also suggests one reason for why it is sufficient (as well as necessary) for interest to be paid only on large money balances; or equivalently, why bonds need only be issued in large denominations.
    Keywords: Money; Bonds; Monetary Policy; Friedman Rule
    JEL: E4
    Date: 2007–09–07
  17. By: Javier Coto-Martínez; Carlos Garriga; Fernando Sánchez-Losada
    Abstract: In this paper we explore the proposition that in economies with imperfect competitive markets the optimal capital income tax is negative and the optimal tax on rms prots is conscatory. We show that if the total factor productivity as well as the measure of rms or varieties are endogenous instead of xed, then the optimal scal policy can lead to di_erent results. The government faces a trade-o_ between the xed costs that society pays for the introduction of a new rm and the productivity gains associated to the introduction of a new variety. We nd that the optimal scal policy depends on the relationship between the index of market power, the returns to specialization, and the governments ability to control entry.
    Keywords: Taxation ; Fiscal policy
    Date: 2007

This nep-dge issue is ©2007 by Christian Zimmermann. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.