nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒10‒13
seventeen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Computing Stochastic Dynamic Economic Models with a Large Number of State Variables: A Description and Application of a Smolyak-Collocation Method By Benjamin Malin; Dirk Krueger; Felix Kubler
  2. Self-Employment and Labor Market Policies By Alok Kumar; Herbert J. Schuetze
  3. Intergenerational Allocation of Government Expenditures: Externalities and Optimal Taxation By Kazi Iqbal; Stephen Turnovsky
  4. Trade Shocks and Labor Adjustment: Theory By Stephen Cameron; Shubham Chaudhuri; John McLaren
  5. Public debt and aggregate risk By Audrey Desbonnet; Sumudu Kankanamge
  6. Sticky Information vs. Sticky Prices: A Horse Race in a DSGE Framework By Trabandt, Mathias
  7. A closed-form solution to the continuous-time consumption model with endogenous labor income By Aihua Zhang
  8. The International Diversification Puzzle Is Not as Bad as You Think By Fabrizio Perri; Jonathan Heathcote
  9. Precautionary Demand for Labor in Search Equilibrium By Noritaka Kudoh; Masaru Sasaki
  10. Competitive Growth in a Life-cycle Model: Existence and Dynamics By D'ALBIS Hippolyte; AUGERAUD-VERON Emmannuelle
  11. Non-constant discounting in finite horizon: The free terminal time case By Jesus Marin Solano; Jorge Navas Rodenes
  12. Unmeasured investment and the puzzling U.S. boom in the 1990s (technical appendix) By Ellen R. McGrattan; Edward C. Prescott
  13. Employment and Hours of Work By Noritaka Kudoh; Masaru Sasaki
  14. Intermediated quantities and returns By Rajnish Mehra; Facundo Piguillem; Edward C. Prescott
  15. Crashes and recoveries in illiquid markets By Ricardo Lagos; Guillaume Rocheteau; Pierre-Olivier Weill
  16. A Search Theory of Rigid Prices By Guido Menzio
  17. Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Merchantilism By Ceyhun Bora Durdu; Marco Terrones; Enrique G. Mendoza

  1. By: Benjamin Malin; Dirk Krueger; Felix Kubler
    Abstract: We describe a sparse grid collocation algorithm to compute recursive solutions of dynamic economies with a sizable number of state variables. We show how powerful this method may be in applications by computing the nonlinear recursive solution of an international real business cycle model with a substantial number of countries, complete insurance markets and frictions that impede frictionless international capital flows. In this economy the aggregate state vector includes the distribution of world capital across different countries as well as the exogenous country-specific technology shocks. We use the algorithm to efficiently solve models with 2, 4, and 6 countries (i.e., up to 12 continuous state variables).
    JEL: C68 C88 F41
    Date: 2007–10
  2. By: Alok Kumar (Department of Economics, University of Victoria); Herbert J. Schuetze (Department of Economics, University of Victoria)
    Abstract: We develop a model of self-employment in the search and matching frame-work of Mortensen and Pissarides. We integrate two strands of theoretical literature: models of self-employment and models of unemployment. Our model explains many empirical findings which are not explained by the existing models of self-employment. In our model, higher minimum wage and unemployment benefits have negative effect on self-employment. These results are supported by empirical evidence. In addition, in our model self-employed earn less, on average, than wage employed workers in equilibrium due to frictions in the labor market. Thus our model provides a novel explanation to one of the key puzzles identified in the empirical literature. We also find that a higher business tax and a lower wage tax reduce self-employment.
    Keywords: Self-employment, occupational choice, unemployment, search and matching, wage tax, business tax, minimum wage, unemployment benefits, job-creation
    JEL: J23 J58 J64
    Date: 2007–10–05
  3. By: Kazi Iqbal (World Bank); Stephen Turnovsky (University of Washington)
    Abstract: This paper studies optimal taxation in the context of provision of public goods when benefits are age-dependent. We develop a two period overlapping generations model with endogenous labor supply in both periods. We examine how the optimal Ramsey capital and labor income taxes change when the government fails to choose the optimal public provision for each cohort. The deviations of public expenditure from the optimal level create distortions at the intra and inter temporal margins and taxes are required to correct these distortions. We show that regardless of preferences, the government may choose to tax capital in the long run if spending on each cohort is not optimal. We also show that when sufficient tax instruments are available the Ramsey equilibrium can attain the first-best optimum.
    Date: 2007–10
  4. By: Stephen Cameron; Shubham Chaudhuri; John McLaren
    Abstract: We construct a dynamic, stochastic rational expectations model of labor reallocation within a trade model that is designed so that its key parameters can be estimated for trade policy analysis. A key feature is the presence of time-varying idiosyncratic moving costs faced by workers. As a consequence of these shocks: (i) Gross flows exceed net flows (an important feature of empirical labor movements); (ii) the economy features gradual and anticipatory adjustment to aggregate shocks; (iii) wage differentials across locations or industries can persist in the steady state; and (iv) the normative implications of policy can be very different from a model without idiosyncratic shocks, even when the aggregate behaviour of both models is similar. It is shown that the equilibrium solves a particular planner's problem, thus facilitating analytical results, econometric estimation, and simulation of the model for policy analysis.
    JEL: F16 F42 J60 K11
    Date: 2007–10
  5. By: Audrey Desbonnet (CES - Centre d'économie de la Sorbonne - [CNRS : UMR8174] - [Université Panthéon-Sorbonne - Paris I]); Sumudu Kankanamge (CES - Centre d'économie de la Sorbonne - [CNRS : UMR8174] - [Université Panthéon-Sorbonne - Paris I])
    Abstract: This paper assesses the optimal level of public debt in a new framework where aggregate fluctuations are taken into account. Agents are subject to both aggregate and idiosyncratic shocks and the market structure prevents them from perfectly insuring against the risk. We find that the optimal level of debt is very different when aggregate risk is taken into account : a simple idiosyncratic model generates a quarterly optimal level of debt of 60 % of GDP, our benchmark model embedding aggregate risk finds the quarterly optimal level of debt to be 180 % of GDP, our benchmark model embedding aggregate risk finds the quarterly optimal level of debt to be 180 % of GDP. Thus aggregate fluctuations have a strong positive impact on the level of public debt in the economy. Aggregate fluctuations exacerbate the overall risk level in the economy and households are forced to increase their precautionary saving in response. Public debt and the implied higher interest rate generate a strong effect that helps precautionary saving behavior.
    Keywords: Debt, aggregate risk, precautionary saving.
    Date: 2007–09
  6. By: Trabandt, Mathias (Research Department, Central Bank of Sweden)
    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: E00 E30
    Date: 2007–06–01
  7. By: Aihua Zhang
    Abstract: In this paper, we study an intertemporal maximization problem of an infinitely-lived individual who faces both labor income and asset return uncertainty. Given the growth rate of wage, the uncertainty of labor income is caused by the stochastic labor supply which is to be determined upon the available market information. Closed forms of consumption, labor supply and portfolio are obtained analytically by means of the martingale method. The Euler equation under uncertainty is established.
    Keywords: Consumption, Labor Supply, Portfolio, Euler equation, Martingale
    JEL: C61 C73 G1 J22
    Date: 2007–09
  8. By: Fabrizio Perri (Department of Economics, University of Minnesota); Jonathan Heathcote
    Abstract: In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, twogood version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.
    Keywords: Home bias, international diversification
    JEL: F36 F41
    Date: 2007–10–08
  9. By: Noritaka Kudoh (Department of Economics, Hokkaido University); Masaru Sasaki (Department of Economics, Osaka University)
    Abstract: This paper studies firmsf job creation decisions in a labor market with search frictions. A simple labor market search model is developed in which a firm can search for a second employee while producing with a first worker. A firm expands employment even if the instantaneous payoff to a large firm is less than that of staying small--a firm has a precautionary motive to expand its size. In addition, this motive is enhanced by a greater market tightness. Because of this effect, firmsf decisions become interdependent--a firm creates a vacancy if it expects other firms to do the same, creating strategic complementarity among firms and thereby self-fulfilling multiple equilibria.
    Keywords: labor demand, firm size distribution.
    JEL: E24 J23
    Date: 2007–10
  10. By: D'ALBIS Hippolyte (LERNA, TSE); AUGERAUD-VERON Emmannuelle
    Date: 2007–10
  11. By: Jesus Marin Solano; Jorge Navas Rodenes (Universitat de Barcelona)
    Abstract: This paper derives the HJB (Hamilton-Jacobi-Bellman) equation for sophisticated agents in a finite horizon dynamic optimization problem with non-constant discounting in a continuous setting, by using a dynamic programming approach. A simple example is used in order to illustrate the applicability of this HJB equation, by suggesting a method for constructing the subgame perfect equilibrium solution to the problem. Conditions for the observational equivalence with an associated problem with constant discounting are analyzed. Special attention is paid to the case of free terminal time. Strotzs model (an eating cake problem of a nonrenewable resource with non-constant discounting) is revisited.
    Keywords: naive and sophisticated agents, observational equivalence, non-constant discounting, free terminal time
    JEL: C73 D83 C61
    Date: 2007
  12. By: Ellen R. McGrattan; Edward C. Prescott
    Date: 2007
  13. By: Noritaka Kudoh (Department of Economics, Hokkaido University); Masaru Sasaki (Department of Economics, Osaka University)
    Abstract: This paper develops a dynamic model of the labor market in which the degree of substitution between employment and hours of work is determined as part of a search equilibrium. Each firm chooses the demand for working hours and the number of vacancies, and the hourly wage rate is determined by Nash bargaining. A firm increases the demand for hours as recruitment becomes more costly. Labor market tightness influences the composition of labor demand through its impact on the wage rate. Restricting working hours can expand employment, but doing so is not necessarily efficient. When there are two industries that differ in their equipment costs, workers employed by firms with higher equipment costs work longer and earn more.
    Keywords: employment, hours of work, search frictions.
    JEL: J21 J23 J31 J64
    Date: 2007–10
  14. By: Rajnish Mehra; Facundo Piguillem; Edward C. Prescott
    Abstract: There is a large amount of intermediated borrowing and lending between households. Some of it is intergenerational, but most is between older households. The average difference in borrowing and lending rates is over 2 percent. In this paper, we develop a model economy that displays these facts and matches not only the returns on assets but also their quantities. The heterogeneity giving rise to borrowing and lending and differences in equity holdings depends on differences in the strength of the bequest motive. In equilibrium, the lenders are annuity holders and the borrowers are those who have equity holdings, who live off its income when retired, and who leave a bequest. The borrowing rate and return on equity are the same in the absence of aggregate uncertainty. The divergence between borrowing and lending rates can thus give rise to an equity premium, even in a world without aggregate uncertainty.
    Date: 2007
  15. By: Ricardo Lagos; Guillaume Rocheteau; Pierre-Olivier Weill
    Abstract: We study the dynamics of liquidity provision by dealers during an asset market crash, described as a temporary negative shock to investors’ aggregate asset demand. We consider a class of dynamic market settings where dealers can trade continuously with each other, while trading between dealers and investors is subject to delays and involves bargaining. We derive conditions on fundamentals, such as preferences, market structure and the characteristics of the market crash (e.g., severity, persistence) under which dealers provide liquidity to investors following the crash. We also characterize the conditions under which dealers’ incentives to provide liquidity are consistent with market efficiency.
    Keywords: Assets (Accounting) - Prices ; Portfolio management ; Financial crises ; Liquidity (Economics)
    Date: 2007
  16. By: Guido Menzio (Department of Economics, University of Pennsylvania)
    Abstract: In this paper, I build a model marketplace populated by a finite number of sellers – each producing its own variety of the good – and a continuum of buyers–each searching for a variety he likes. Using the model, I study the response of a seller’s price to privately observed fluctuations in its idiosyncratic production cost. I find that the qualitative properties of this response critically depend on the persistence of the production cost. In particular, if the cost is i.i.d., the seller’s price does not respond at all. If the cost is somewhat persistent, the seller’s price responds slowly and incompletely. If the cost is very persistent, the seller’s price adjusts instantaneously and efficiently to all fluctuations in productivity. I argue that these findings can explain why the monthly frequency of a price change is so much lower for processed than for raw goods.
    Keywords: Search Frictions, Asymmetric Information, Rigid Prices, Sticky Prices
    JEL: L11 D83
    Date: 2007–03–01
  17. By: Ceyhun Bora Durdu; Marco Terrones; Enrique G. Mendoza
    Abstract: Financial globalization was off to a rocky start in emerging economies hit by Sudden Stops in the 1990s. The surge in foreign reserves since then is viewed as a New Merchantilism in which reserves are a war-chest for defense against Sudden Stops. We conduct a quantitative assessment of this argument using a framework in which precautionary savings affect foreign assets via business cycle volatility, financial globalization, and endogenous Sudden Stops. Our results show that financial globalization and Sudden Stop risk are plausible explanations of the surge in reserves but cyclical volatility, which has declined in the globalization period, is not.
    Keywords: Working Paper , Reserves accumulation , Crisis prevention , Financial crisis , Deflation , Deflation , Dollarization , Globalization , Business cycles , Credit , Economic models ,
    Date: 2007–06–28

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