nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2007‒12‒01
23 papers chosen by
Christian Zimmermann
University of Connecticut

  1. Private risk premium and aggregate uncertainty in the model of uninsurable investment risk By Francisco Covas; Shigeru Fujita
  2. The Business Cycle Implications of Reciprocity in Labour Relations By Danthine, Jean-Pierre; Kurmann, Andre
  3. Modeling great depressions: the depression in Finland in the 1990s By Juan Carlos Conesa; Timothy J. Kehoe; Kim J. Ruhl
  4. The Boom-Bust Cycle in Japanese Asset Prices By Alpanda, Sami
  5. Wealth and the Capitalist Spirit By Francis, Johanna L.
  6. Endogenous Entry, Product Variety, and Business Cycles By Florin Bilbiie; Fabio Ghironi; Marc J. Melitz
  7. Estimating DSGE Models under Partial Information By Paul Levine; Joseph Pearlman; George Perendia
  8. Executive Compensation: The View from General Equilibrium By Jean-Pierre Danthine; John B. Donaldson
  9. East German Unemployment from a Macroeconomic Perspective By Jens Rubart; Willi Semmler
  10. Population Ageing, Government Budgets, and Productivity Growth in Politico-Economic Equilibrium By Martín Gonzales-Eiras; Dirk Niepelt
  11. Inefficient Credit Booms By Guido Lorenzoni
  12. International trade in durable goods: understanding volatility, cyclicality, and elastics By Charles Engel; Jian Wang
  13. Dynamic Optimal Insurance and Lack of Commitment By Alexander K. Karaivanov; Fernando M. Martin
  14. Limited Commitment Models of the Labour Market By Jonathan Thomas; TIm Worrall
  15. The Heterogeneous State of Modern Macroeconomics: A Reply to Solow By V. V. Chari; Patrick J. Kehoe
  16. Long swings and chaos in the exchange rate in a DSGE model with a Taylor rule By Bask, Mikael
  17. Optimal Capital Income Taxation, Investment Subsidies and Redistribution in a Neoclassical Growth Model By Günther Rehme
  18. The Transmission of Domestic Shocks in the Open Economy By Christopher J. Erceg; Christopher Gust; David López-Salido
  19. Intertemporal Distortions in the Second best By Stefania Albanesi; Roc Armenter
  20. Endogenous Growth Models: Jones Vs Romer the Path to a Fully-Fledged Dynamic Analysis By Jalles, João Tovar
  21. On the Impact of Income and Policy Shocks on Consumption By Tamim Bayoumi; Silvia Sgherri
  22. Optimal monetary policy under heterogeneity in currency trade By Bask, Mikael
  23. The Transmission of Domestic Shocks in Open Economies By Erceg, Christopher; Gust, Christopher; López-Salido, J David

  1. By: Francisco Covas; Shigeru Fujita
    Abstract: This paper studies cyclical properties of the private risk premium in a model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks, both of which are assumed to be highly persistent. The calibrated model matches highly skewed wealth and income distributions of entrepreneurs found in the Survey of Consumer Finances. The authors provide an accurate numerical solution to the model even though the model is shown to exhibit serious nonlinearities that are absent in incomplete market models with idiosyncratic labor income risk. The model is able to generate the aggregate private risk premium of 2-3 percent and the low risk-free rate. However, it generates very little variation in these variables over the business cycle, suggesting that the model lacks the ability to amplify aggregate shocks.
    Date: 2007
  2. By: Danthine, Jean-Pierre; Kurmann, Andre
    Abstract: We develop a reciprocity-based model of wage determination and incorporate it into a modern dynamic general equilibrium framework. We estimate the model and find that, among potential determinants of wage policy, rent-sharing (between workers and firms) and a measure of wage entitlement are critical to fit the dynamic responses of hours, wages and inflation to various exogenous shocks. Aggregate employment conditions (measuring workers' outside option), on the other hand, are found to play only a negligible role in wage setting. These results are broadly consistent with micro-studies on reciprocity in labour relations but contrast with traditional efficiency wage models which emphasize aggregate labour market variables as the main determinant of wage setting. Overall, the empirical fit of the estimated model is at least as good as the fit of models postulating nominal wage contracts. In particular, the reciprocity model is more successful in generating the sharp and significant fall of inflation and nominal wage growth in response to a neutral technology shock.
    Keywords: Efficiency wages; Estimated DSGE models; Reciprocity
    JEL: E24 E31 E32 E52 J50
    Date: 2007–11
  3. By: Juan Carlos Conesa; Timothy J. Kehoe; Kim J. Ruhl
    Abstract: This paper is a primer on the great depressions methodology developed by Cole and Ohanian (1999, 2007) and Kehoe and Prescott (2002, 2007). We use growth accounting and simple dynamic general equilibrium models to study the depression that occurred in Finland in the early 1990s. We find that the sharp drop in real GDP over the period 1990–93 was driven by a combination of a drop in total factor productivity (TFP) during 1990–92 and of increases in taxes on labor and consumption and increases in government consumption during 1989–94, which drove down hours worked in Finland. We attempt to endogenize the drop in TFP in variants of the model with an investment sector and with terms-of-trade shocks but are unsuccessful.
    Date: 2007
  4. By: Alpanda, Sami
    Abstract: The Japanese economy experienced a substantial increase and a subsequent crash in land and stock prices in the 1980s and 90s. I use a neoclassical growth model to determine how much of these asset price movements can be accounted for by the observed changes in fundamentals of the Japanese economy; in particular changes in productivity growth and government policy regarding land taxation. In the model, corporations issue land-collateralized debt to reduce their tax liabilities and the government follows a land-taxation policy that is countercyclical to land prices. These features substantially magnify the effect of small shocks by reducing the required return on land. With the model calibrated to Japanese data, I find that the observed changes in fundamentals cannot simultaneously account for the movements in asset prices and macroeconomic variables. In particular, with persistent changes in fundamentals, the observed asset prices can be justified, but at the cost of counter-predicting macroeconomic variables.
    Keywords: Japan; land prices; asset pricing; land taxation; general equilibrium.
    JEL: E62 G12 C68 O40
    Date: 2007–11
  5. By: Francis, Johanna L.
    Abstract: The wealth distribution in the U.S. is more unequal, or skewed to the right, than either the income or earnings distribution, a fact current models of saving behavior have difficulty explaining. Using Max Weber's (1905) idea that individuals may have a `capitalist spirit', I construct and simulate a model where some individuals accumulate wealth for its own sake rather than as deferred consumption. Including capitalist-spirit preferences in the standard life cycle model, with no other modifications, generates a skewness of wealth consistent with that observed in the U.S. economy. Furthermore, capitalist-spirit preferences provide a way to generate decreasing risk aversion with increases in wealth without resorting to idiosyncratic rates of time preference.
    Keywords: capitalist spirit; life cycle; wealth
    JEL: D31 E21
    Date: 2007–08–15
  6. By: Florin Bilbiie; Fabio Ghironi; Marc J. Melitz
    Abstract: This paper builds a framework for the analysis of macroeconomic fluctuations that incorporates the endogenous determination of the number of producers over the business cycle. Economic expansions induce higher entry rates by prospective entrants subject to irreversible investment costs. The sluggish response of the number of producers (due to the sunk entry costs) generates a new and potentially important endogenous propagation mechanism for real business cycle models. The stock-market price of investment (corresponding to the creation of new productive units) determines household saving decisions, producer entry, and the allocation of labor across sectors. The model performs at least as well as the benchmark real business cycle model with respect to the implied second-moment properties of key macroeconomic aggregates. In addition, our framework jointly predicts a procyclical number of producers and procyclical profits even for preference specifications that imply countercyclical markups. When we include physical capital, the model can reproduce the variance and autocorrelation of GDP found in the data.
    JEL: E20 E32
    Date: 2007–11
  7. By: Paul Levine (University of Surrey); Joseph Pearlman (London Metropolitan University); George Perendia (London Metropolitan University)
    Abstract: Most DSGE models and methods make inappropriate asymmetric information assumptions. They assume that all economic agents have full access to measurement of all variables and past shocks, whereas the econometricians have no access to this. An alternative assumption is that there is symmetry, in that the information set available to both agents and econometricians is incomplete. The reality lies somewhere between the two, because agents are likely to be subject to idiosyncratic shocks which they can observe, but are unable to observe other agents’ idiosyncratic shocks, as well as being unable to observe certain economy-wide shocks; however such assumptions generally lead to models that have no closed-form solution. This research aims to compare the two alternatives - the asymmetric case, as commonly used in the literature, and the symmetric case, which uses the partial information solution of Pearlman et al. (1986) using standard EU datasets. We use Bayesian MCMC methods, with log-likelihoods accounting for partial information. The work then extends the data to allow for a greater variety of measurements, and evaluates the effect on estimates, along the lines of work by Boivin and Giannoni (2005).
    Keywords: partial information, DSGE models, Bayesian maximum likelihood
    JEL: C11 C13 D58 D82
    Date: 2007–11
  8. By: Jean-Pierre Danthine (University of Lausanne, CEPR and Swiss Finance Institute); John B. Donaldson (Columbia University)
    Abstract: We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the ¯rm to risk averse managers. The optimal contract has two main components: an incentive component corresponding to a non-tradable equity position and a variable 'salary' component indexed to the aggregate wage bill and to aggregate dividends. Tying a manager's compensation to the performance of her own ¯rm ensures that her interests are aligned with the goals of ¯rm owners and that maximizing the discounted sum of future dividends will be her objective. Linking managers' compensation to overall economic performance is also required to make sure that managers use the appropriate stochastic discount factor to value those future dividends.
    Keywords: incentives, optimal contracting, stochastic discount factor
    JEL: E32 E44
    Date: 2007–09
  9. By: Jens Rubart (Institut für Volkswirtschaftslehre (Department of Economics), Technische Universität Darmstadt (Darmstadt University of Technology)); Willi Semmler (Institut für Volkswirtschaftslehre (Department of Economics), Universität Bielefeld (University of Bielefeld); Graduate Faculty, New School for Social Research, New York)
    Abstract: When reviewing the literature concerning the development of the Eastern German economy, a too rigid labor market and its respective institutions are considered as the main source of the persistent high unemployment rates and the slow economic performance. However, when important macroeconomic variables are considered a significant decline in investment in new technologies is observed. In addition, we find evidences that the decline in investment might be affected by the steady migration of young and skilled workers to West Germany. The decline in the proportion of skilled workers induces firms not to invest in Eastern Germany which leads to a general decline in job creating activities irrespective rigid labor markets and generous social benefits. In the recent paper we employ a rather standard Dynamic General Equilibrium model in order to study the effects of a decline in the proportion of skilled workers as well as the impacts of increasing benefit payments. Furthermore, we assume equilibrium unemployment due to search and matching frictions on the labor market. This approach enables us further to consider job creating activities of the firms. We show that an emigration shock of skilled- workers is capable to reproduce the findings for the decline in economic activity. This effect is strengthened by assuming generous social benefit payments.
    Keywords: DSGE Model, Heterogenous Labor, Skill Biased Technological Change, Search Unemployment, Employment Protection, Minimum Wages
    JEL: E20 J21 J24 J64
    Date: 2007–09
  10. By: Martín Gonzales-Eiras (Universidad de San Andrés); Dirk Niepelt
    Abstract: We analyze the effect of changes in fertility and longevity on taxes, the composition of government spending, and productivity. To that purpose, we introduce politics in an OLG economy with endogenous growth due to human and physical capital accumulation. Population ageing shifts political power from students and workers to retirees, leading to a reallocation of resources from education spending to retirement benefits and a slowdown of productivity growth. Calibrated to U.S. data, the closed-form solutions of the model predict retirement benefits as a share of GDP to strongly increase over the next decades and the education share to fall. This effect depresses the annual productivity growth rate by 10 basis points. In spite of higher labor-income taxes, per-capita labor supply is predicted to rise, as a consequence of increased life expectancy. The equilibrium allocation is consumption and production efficient, but the political process allocates a much smaller share of resources to eduction than a Ramsey planner with balanced welfare weights.
    Date: 2007–11
  11. By: Guido Lorenzoni
    Abstract: This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.
    JEL: E32 E44 E61 G10 G18
    Date: 2007–11
  12. By: Charles Engel; Jian Wang
    Abstract: Data for OECD countries document: 1. imports and exports are about three times as volatile as GDP; 2. imports and exports are pro-cyclical, and positively correlated with each other; 3. net exports are counter-cyclical. Standard models fail to replicate the behavior of imports and exports, though they can match net exports relatively well. Inspired by the fact that a large fraction of international trade is in durable goods, we propose a two-country two-sector model, in which durable goods are traded across countries. Our model can match the business cycle statistics on the volatility and comovement of the imports and exports relatively well. In addition, the model with trade in durables helps to understand the empirical regularity noted in the trade literature: home and foreign goods are highly substitutable in the long run, but the short-run elasticity of substitution is low. We note that durable consumption also has implications for the appropriate measures of consumption and prices to assess risk-sharing opportunities, as in the empirical work on the Backus-Smith puzzle. The fact that our model can match data better in multiple dimensions suggests that trade in durable goods may be an important element in open-economy macro models.
    Keywords: Durable goods, Consumer ; International trade
    Date: 2007
  13. By: Alexander K. Karaivanov (Simon Fraser University); Fernando M. Martin (Simon Fraser University)
    Abstract: We analyze the role of commitment in a dynamic principal-agent model of optimal insurance with hidden effort and observable but non-contractible savings. We argue that the optimal contract under full commitment is time-inconsistent. Consequently, we analyze the optimal time-consistent Markov-perfect insurance contract when both the agent and the principal cannot commit for longer than one period and contrast our results with the full commitment case from the existing literature. We find that the optimal contract under lack of commitment provides additional insurance relative to the autarky allocation and features non-degenerate long-run asset and consumption distributions. Furthermore, the no-commitment contract differs significantly from the commitment contract in the time profiles of consumption, savings, and welfare. We solve for the optimal insurance contracts in several environments featuring different degrees of market incompleteness and find that the welfare loss due to lack of commitment can be very high relative to the welfare costs of moral hazard or savings non-contractibility.
    Keywords: optimal insurance, time consistency, moral hazard
    JEL: D11 E21
    Date: 2007–10
  14. By: Jonathan Thomas; TIm Worrall
    Abstract: We present an overview of models of long-term self-enforcing labour contracts in which risk sharing is the dominant motive for contractual solutions. A base model is developed which is sufficiently general to encompass the two-agent problem central to most of the literature, including variable hours. We consider two-sided limited commitment and look at its implications for aggregate labour market variables. We consider the implications for empirical testing and the available empirical evidence. We also consider the one-sided limited commitment problem for which there exists a considerable amount of empirical support.
    Keywords: Labour contracts, self-enforcing contracts, unemployment, business cycle.
    JEL: E32 J41
    Date: 2007–11–26
  15. By: V. V. Chari; Patrick J. Kehoe
    Abstract: Robert Solow has criticized our 2006 Journal of Economic Perspectives essay describing "Modern Macroeconomics in Practice." Solow eloquently voices the commonly heard complaint that too much macroeconomic work today starts with a model with a single type of agent. We argue that modern macroeconomics may not end too far from where Solow prefers. He is also critical of how modern macroeconomists use data to construct models. Specifically, he seems to think that calibration is the only way that our models encounter data. To the contrary, we argue that modern macroeconomics uses a wide variety of empirical methods and that this big-tent approach has served macroeconomics well. Solow also questions our claim that modern macroeconomics is firmly grounded in economic theory. We disagree and explain why.
    JEL: E12 E13 E2 E20 E21 E22 E32 E4 E5 E52 E58 E6 E62
    Date: 2007–11
  16. By: Bask, Mikael (Bank of Finland Research)
    Abstract: A DSGE model with a Taylor rule is augmented with an evolutionary switching between technical and fundamental analyses in currency trade, where the fractions of these trading tools are determined within the model. Then, a shock hits the economy. As a result, chaotic dynamics and long swings may occur in the exchange rate, which are appealing features of the model given existing empirical evidence on chaos and long swings in exchange rate fluctuations.
    Keywords: chaotic dynamics; foreign exchange; fundamental analysis; monetary policy; technical analysis
    JEL: C65 E32 E44 E52 F31
    Date: 2007–11–12
  17. By: Günther Rehme (Institut für Volkswirtschaftslehre (Department of Economics), Technische Universität Darmstadt (Darmstadt University of Technology))
    Abstract: In this paper I readdress the result that capital income taxes are bad instruments for pure redistribution and should be zero in the long run. In a neoclassical growth model a capital income cum investment subsidy tax, which is not distorting accumulation, is considered to investigate if net capital income taxes used for pure redistribution are zero in a long-run optimum. I find that capital income taxes may be nonzero, depending on the political power of those who receive redistributive transfers, the distribution of pre-tax factor incomes, and the intertemporal elasticity of substitution.
    Keywords: Growth, Redistribution, Investment Subsidies, Capital Income Taxes
    JEL: O41 H21 D33
    Date: 2007–09
  18. By: Christopher J. Erceg; Christopher Gust; David López-Salido
    Abstract: This paper uses an open economy DSGE model to explore how trade openness affects the transmission of domestic shocks. For some calibrations, closed and open economies appear dramatically different, reminiscent of the implications of Mundell-Fleming style models. However, we argue such stark differences hinge on calibrations that impose an implausibly high trade price elasticity and Frisch elasticity of labor supply. Overall, our results suggest that the main effects of openness are on the composition of expenditure, and on the wedge between consumer and domestic prices, rather than on the response of aggregate output and domestic prices.
    JEL: E52 F41 F47
    Date: 2007–11
  19. By: Stefania Albanesi; Roc Armenter
    Abstract: We consider a very general class of public finance problems that encompasses the Ramsey model of optimal taxation as well as economies with limited commitment, private information, and political economy frictions, and allows for incomplete markets. We identify a sufficient condition to rule out permanent intertemporal distortions at the optimum. If there exists an admissible allocation that converges to the first best steady state, then all intertemporal distortions are temporary in the second best. We analyze a series of applications to illustrate the significance of this result.
    JEL: E6 H21
    Date: 2007–11
  20. By: Jalles, João Tovar
    Abstract: The last two decades were marked by a high increase in economic growth research, namely related to three important issues as stated in Klenow et al. [1997]: world growth, country growth and dispersion in income levels. The Charles Jones’ [2002] technique to solve endogenous growth models relies on the two-step approach, which is in fact a clever way to study the dynamic behaviour of the usual two production factors of this type of models, technology and capital. However, he does that sequentially, therefore reducing the general scope of the model, as it is a special case of a broader version developed by David Romer [2001]. Romer’s general case analyse the dynamic behaviour more closely and, more importantly, allowing for a simultaneous analysis of the dynamics of the endogenous factors, which provide additional insights. The aim of this paper is to tackle the differences between the two endogenous models as an exercise to see expost exogenous shocks’ implications to the variables of interest. More specifically, in addition to the strictly theoretical analysis of some dynamic properties of the model, by programming difference equations in discrete time, one is also able to simulate and examine how the model will respond to shocks that one administer to it, on an ad-hoc basis – deterministic simulation.
    Date: 2007
  21. By: Tamim Bayoumi; Silvia Sgherri
    Abstract: An increasing body of evidence suggests that the behavior of the economy has changed in many fundamental ways over the last decades. In particular, greater financial deregulation, larger wealth accumulation, and better policies might have helped lower uncertainty about future income and lengthen private sectors' planning horizon. In an overlapping-generations model, in which individuals discount the future more rapidly than implied by the market rate of interest, we find indeed evidence of a falling degree of impatience, providing empirical support for this hypothesis. The degree of persistence of 'windfall' shocks to disposable income also appears to have varied over time. Shifts of this kind are shown to have a key impact on the average marginal propensity to consume and on the size of policy multipliers.
    Keywords: Fiscal Policy; Discount Rate; Overlapping Generations Model
    Date: 2007–11
  22. By: Bask, Mikael (Bank of Finland Research)
    Abstract: We embed an expectations-based optimal policy rule into a DSGE model for a small open economy that is augmented with trend extrapolation or chartism, which is a form of technical trading, in currency trade to examine the prerequisites for monetary policy. We find that a unique REE that is least-squares learnable is often the outcome when there is a limited amount of trend extrapolation, but that a less flexible inflation rate targeting may cause a multiplicity of REE. We also compute impulse-response functions for key macroeconomic variables to study how the economy returns to steady state after being hit by a shock.
    Keywords: determinacy; DSGE model; least-squares learning; targeting rule; technical trading; monetary policy
    JEL: C62 E52 F31 F41
    Date: 2007–11–14
  23. By: Erceg, Christopher; Gust, Christopher; López-Salido, J David
    Abstract: This paper uses an open economy DSGE model to explore how trade openness affects the transmission of domestic shocks. For some calibrations, closed and open economies appear dramatically different, reminiscent of the implications of Mundell-Fleming style models. However, we argue such stark differences hinge on calibrations that impose an implausibly high trade price elasticity and Frisch elasticity of labour supply. Overall, our results suggest that the main effects of openness are on the composition of expenditure, and on the wedge between consumer and domestic prices, rather than on the response of aggregate output and domestic prices.
    Keywords: imported intermediate inputs; open economy Phillips Curve; variable markups
    JEL: E52 F41 F47
    Date: 2007–11

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