nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2008‒02‒02
sixteen papers chosen by
Christian Zimmermann
University of Connecticut

  1. The cyclical behavior of equilibrium unemployment and vacancies revisited By Marcus Hagedorn; Iourii Manovskii
  2. On-the-Job Search and Business Cycles By Guido Menzio; Shouyong Shi
  3. Exchange rate dynamics, asset market structure and the role of the trade elasticity By Christoph Thoenissen
  4. The Aggregate Effects of Anticipated and Unanticipated U.S. Tax Policy Shocks: Theory and Empirical Evidence By Karel Mertens; Morten O. Ravn
  5. Intertemporal Distortions in the Second Best By Stefania Albanesi; Roc Armenter
  6. Minimally Altruistic Wages and Unemployment in a Matching Model By Julio J. Rotemberg
  7. Indexed Sovereign Debt: a Survey and a Framework of Analysis By Filippo Taddei
  8. Do Reservation Wages Really Decline? Some International Evidence on the Determinants of Reservation Wages By Addison, John T.; Centeno, Mário; Portugal, Pedro
  9. The Transfer Paradox in a One-Sector Overlapping Generations Model By Partha Sen; Emily T. Cremers
  10. Optimal taxation of entrepreneurial capital with private information By Stefania Albanesi
  11. Advertising Intensity and Welfare in an Equilibrium Search Model By Ian McCarthy
  12. Liquidity and the Allocation of Credit: Business Cycle, Government Debt and Financial Arrangements By Filippo Taddei
  13. Collateral, Financial Arrangements and Pareto Optimality By Filippo Taddei
  14. Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth? By Filippo Taddei
  15. A Second Chance at Success: A Political Economy Perspective? By Ryo Arawatari; Tetsuo Ono
  16. Elastic Money, Inflation, and Interest Rate Policy By Allen Head; Junfeng Qiu

  1. By: Marcus Hagedorn (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Iourii Manovskii (Department of Economics, University of Pennsylvania, 160 McNeil Building, 3718 Locust Walk, Philadelphia, PA, 19104-6297, USA.)
    Abstract: Recently, a number of authors have argued that the standard search model cannot generate the observed business-cycle-frequency fluctuations in unemployment and job vacancies, given shocks of a plausible magnitude. We use data on the cost of vacancy creation and cyclicality of wages to identify the two key parameters of the model - the value of non-market activity and the bargaining weights. Our calibration implies that the model is, in fact, consistent with the data. JEL Classification: E24, E32, J41, J63, J64.
    Keywords: Search, matching, business cycles, labor markets.
    Date: 2008–01
  2. By: Guido Menzio; Shouyong Shi
    Abstract: In this paper, we develop a tractable model of the labor market where workers search for jobs both while unemployed and while on the job. Search is directed in the sense that each worker chooses to search for the offer that provides the optimal tradeoff between the probability of obtaining the offer and the increase in the value relative to the worker's current employment. There are both aggregate and match-specific shocks, on which the wage path in an offer can be contingent. We characterize the equilibrium analytically and show that the equilibrium is unique and socially efficient. On the quantitative side, we calibrate the model to the US data to measure the effect of aggregate productivity fluctuations on the labor market. We find that productivity fluctuations account for approximately 64% of the cyclical volatility in US unemployment. Moreover, productivity fluctuations generate the same matrix of correlations between unemployment and other labor market variables as in the US. In particular, the Beveridge curve is negatively sloped over business cycles, and the magnitude of the slope is the same as in the data. In light of these findings, we conclude that productivity shocks are one of the main forces driving labor market fluctuations over business cycles. Furthermore, we find that recessions have a cleansing effect on the economy.
    Keywords: Directed Search; On the Job Search; Unemployment Fluctuations
    JEL: E24 E32 J64
    Date: 2008–01–21
  3. By: Christoph Thoenissen
    Abstract: This paper shows that a canonical flexible price international real business cycle model with incomplete financial markets can address the exchange rate volatility puzzle, the exchange rate persistence puzzle, the consumption real exchange rate anomaly, as well as the quantity anomaly. Crucial for the success of the model is the choice of the elasticity of substitution between home and foreign produced goods. The paper shows that the range of this parameter which allows the model to address these international macroeconomics anomalies is very narrow. Furthermore, the paper highlights an anomalous relationship between real exchange rate persistence and the elasticity of substitution between home and foreign-produced goods.
    Keywords: real exchange rate dynamics, incomplete ?nancial markets, Backus-Smith puzzle, exchange rate persistence, trade elasticity.
    JEL: F31 F41
    Date: 2008–01
  4. By: Karel Mertens; Morten O. Ravn
    Abstract: We provide empirical evidence on the effects of tax liability changes in the United States. We make a distinction between “surprise” and “anticipated” tax shocks. Surprise tax cuts give rise to a large boom in the economy. Anticipated tax liability tax cuts are instead associated with a contraction in output, investment and hours worked prior to their implementation. After their implementation, anticipated tax liability cuts lead to an economic expansion. We build a DSGE model with changes in tax rates that may be anticipated or not, estimate key parameters using a simulation estimator and show that it can account for the main features of the data. We argue that tax shocks are empirically important for U.S. business cycles and that the Reagan tax cut, which was largely anticipated, was a main factor behind the early 1980’s recession.
    Keywords: Fiscal policy, tax liabilities, anticipation effects, structural estimation
    JEL: E20 E32 E62 H30
    Date: 2008
  5. By: Stefania Albanesi (Department of Economics, Columbia University); Roc Armenter (Federal Reserve Bank of New York)
    Abstract: We consider a very general class of public finance problems that encompasses Ramsey models of optimal taxation as well as economies with limited commitment, private information, and political economy frictions. 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.
    Date: 2007
  6. By: Julio J. Rotemberg
    Abstract: This paper presents a model in which firms recruit both unemployed and employed workers by posting vacancies. Firms act monopsonistically and set wages to retain their existing workers as well as to attract new ones. The model differs from Burdett and Mortensen (1998) in that its assumptions ensure that there is an equilibrium where all firms pay the same wage. The paper analyzes the response of this wage to exogenous changes in the marginal revenue product of labor. The paper finds parameters for which the response of wages is modest relative to the response of employment, as appears to be the case in U.S. data and shows that the insistence by workers that firms act with a minimal level of altruism can be a source of dampened wage responses. The paper also considers a setting where this minimal level of altruism is subject to fluctuations and shows that, for certain parameters, the model can explain both the standard deviations of employment and wages and the correlation between these two series over time.
    JEL: D64 E24 J30 J64
    Date: 2008–01
  7. By: Filippo Taddei
    Abstract: A small number of countries have issued real indexed sovereign debt in recent year. This type of contracts could improve risk sharing between debtor countries and international creditors and diminish the probability of occurrence of debt crises. However, it is not clear the magnitude of these effects in terms of welfare. Furthermore, it has not been analyzed whether the design of the existing contracts was optimal. This paper addresses these issues. We characterize the optimal features of indexed debt contracts in a dynamic stochastic equilibrium framework with incomplete markets and compare them to existing ones. Finally, we obtain a quantitative approximation of the welfare effects of indexation. We find that the optimal contract improves welfare and features payments increasing in the state of the economy. Existing real indexed contracts usually entail payments increasing in the state of the economy. However, they also feature threshold levels of the chosen real variable that trigger payments. We argue that the latter are usually suboptimal. Calibrating our model to Argentina’s economy we find that the welfare gains from introducing indexed debt are equivalent to an increase of between 0.6% and 2%.
    Keywords: GDP-indexed Debt, Country Portfolio, Contingent Debt.
    JEL: F34 F37
    Date: 2007
  8. By: Addison, John T. (University of South Carolina); Centeno, Mário (Banco de Portugal); Portugal, Pedro (Universidade Nova de Lisboa)
    Abstract: Using cross-country data, we investigate the determinants of reservation wages and their course over the jobless spell. Higher unemployment benefits lead to higher reservation wages. Further, again consistent with the basic search model, repeated observations on the same individual provide scant evidence of declining reservation wages.
    Keywords: reservation wages, probability of reemployment, arrival rate of job offers, unemployment benefits
    JEL: J64 J65
    Date: 2008–01
  9. By: Partha Sen (Department of Economics, Delhi School of Economics, Delhi, India); Emily T. Cremers (National University of Singapore)
    Abstract: This paper examines the effects of international income transfers on welfare and capital accumulation in a one-sector overlapping generations model. It is shown that a strong form of the transfer paradox-- in which the donor country experiences a welfare gain while the recipient country experiences a welfare loss—may occur both in and out of steady state. In addition, it is shown that a weak form of the transfer paradox—where either the donor or recipient (but not both) experience paradoxical welfare effects—may characterize all segments of the transition path not already characterized by the strong transfer paradox. The results are explained by the effects of transfers on world capital accumulation and the world interest rate, which imply secondary intertemporal welfare effects large enough to dominate the initial effects of the income transfer.
    Keywords: Transfer problem, transfer paradox, dynamics, one-sector overlapping generations model
    JEL: F11 F35 F43 O19 O41
    Date: 2007–08
  10. By: Stefania Albanesi (Department of Economics, Columbia University)
    Abstract: This paper studies optimal taxation of entrepreneurial capital with private information and multiple assets. Entrepreneurial activity is subject to a dynamic moral hazard problem and entrepreneurs face idiosyncratic capital risk. We first characterize the optimal allocation subject to the incentive compatibility constraints resulting from the private information. The optimal tax system implements such an allocation as a competitive equilibrium for a given market structure. We consider several market structures that differ in the assets or contracts traded and obtain three novel results. First, differential asset taxation is optimal. Marginal taxes on bonds depend on the correlation of their returns with idiosyncratic capital risk, which determines their hedging value. Entrepreneurial capital always receives a subsidy relative to other assets in the bad states. Second, if entrepreneurs are allowed to sell equity, the optimal tax system embeds a prescription for double taxation of capital income at the firm level and at the investor level. Finally, we show that taxation of assets is essential even with competitive insurance contracts, when entrepreneurial portfolios are also unobserved.
    JEL: D82 E22 E62 G18 H2 H21 H25 H3
    Date: 2007
  11. By: Ian McCarthy (Indiana University Bloomington)
    Abstract: We analyze an equilibrium search model in a duopoly setting with bilateral heterogeneities in production and search costs in which firms can advertise by announcing price and location. We study existence, stability, and comparative statics in such a setting, compare the market advertising level to the socially optimal level, and find conditions in which firms advertise more or less than the social optimum.
    Keywords: Search, Advertising, Welfare
    JEL: D21 D43 D83 M37
    Date: 2008–01
  12. By: Filippo Taddei
    Abstract: I analyze the equilibrium level of liquidity and its relevance for the allocation of credit, when the notion of liquidity is related to private information. The general equilibrium analysis yields the following main implications: firstly, it provides an explanation of procyclical liquidity even in the presence of security endogeneity; secondly, it illustrates how government debt, by providing liquidity to an otherwise illiquid private market, encourages rather than “crowds out” private investment; thirdly, it offers a well defined notion of securities’ value, the liquidity of which is endogenously enhanced by the arrangements within financial markets. The approach jointly analyzes the three factors crucial to liquidity: (1) its level is endogenously determined through equilibrium pricing while entrepreneurs choose which security to issue; (2) the introduction of government debt has the two-fold effect of directly providing liquidity to entrepreneurs and indirectly influencing the type of securities they issue in equilibrium; (3) financial markets develop arrangements to allow the beneficial employment of securities, not only physical assets, as collateral (financial pyramiding).
    Keywords: Liquidity, Collateral, Business Cycle, Government Debt, Financial Arrangements, Tranching, Financial Pyramiding.
    JEL: E22 E44
    Date: 2007
  13. By: Filippo Taddei
    Abstract: The existence of collateral requirements to guarantee repayment on issued securities reduces in general the efficiency of competitive equilibria. The general equilibrium analysis is presented in a world where reputation plays no role, and the lender always expects a future payment equal to the future market value of provided collateral. In this context I show that collateral requirements result in two distinct problems for efficiency. I argue that two financial arrangements, tranching and financial pyramiding, arise in developed capital markets in response to the challenges posed by collateral requirements. If these arrangements are sufficiently developed, then the pareto efficiency of competitive equilibria is restored, even in the presence of collateral requirements.
    Keywords: Collateral, Pareto Optimality, Financial Arrangements, Tranching, Financial Pyramiding.
    JEL: D5 E44
    Date: 2007
  14. By: Filippo Taddei
    Abstract: Introducing heterogeneity of beliefs across different agents builds a link between wealth distribution and the equity premium. We demonstrate that an economy populated only by risk neutral agents may nonetheless display a strictly positive equity premium. We then place our notion of belief heterogeneity within the popular representative agent construct. We show that any level of belief heterogeneity in the multi agent economy can be mapped into some specific degree of risk aversion of the representative agent economy that keeps equilibrium prices constant. A fully dynamic model follows. Finally, we suggest an explanation for the recent behavior of the equity premium: a story of "heterogeneous optimism" versus "homogeneous pessimism" is presented.
    Keywords: Belief Heterogeneity, Equity Premium Puzzle, Representative Agent, Risk Aversion, Wealth Distribution.
    JEL: D31 D51 D84 G12
    Date: 2007
  15. By: Ryo Arawatari (Department of Economics, Otaru University of Commerce); Tetsuo Ono (Graduate School of Economics, Osaka University)
    Abstract: This paper characterizes a stationary Markov perfect political equilibrium where agents vote over income taxation that distorts their educational investment. Agents become rich or poor through educational investment, and the poor have a second chance at success. The results show the following concerning the costs of a second chance. First, when the cost is low, the economy is characterized by high levels of upward mobility and inequality, and a low tax burden supported by the poor with prospects for upward mobility. Second, when the cost is high, there are multiple equilibria: one is characterized by high levels of upward mobility and inequality and a low tax burden supported by the rich, the other is characterized by low levels of upward mobility and inequality and a high tax burden supported by the poor. Numerical examples show that the low-cost economy is inferior to the high-cost economy in terms of social welfare.
    Keywords: Second chance; Political economy; Inequality; Upward mobility; Intragenerational mobility.
    JEL: D30 D72 H55
    Date: 2008–01
  16. By: Allen Head (Queen's University); Junfeng Qiu (Central University of Finance and Economics, Beijing)
    Abstract: Optimal monetary policy is studied in an environment in which money plays an essential role in facilitating exchange and aggregate shocks affect individual agents asymmetrically. Exchange may be conducted using either bank deposits (inside money) or fiat currency (outside money). A central monetary authority both controls the stock of outside money and pursues an interest rate policy that affects the rate at which private banks create inside money. We find that the optimal monetary policy requires management of both interest rates and the quantity of outside money. By controlling interest rates the monetary authority can affect the price level in the short-run and adjust households' consumption, thus providing insurance against unfavorable aggregate shocks. The feasibility of the interest rate policy requires a minimum rate of trend inflation that may be positive and in principle quite large. The paper thus links two principal components of monetary policy: the optimal interest rate policy and the optimal long-run inflation rate.
    Keywords: banking, inside money, elastic money, monetary policy, inflation, zero bound
    JEL: E43 E51 E52
    Date: 2007–12

This nep-dge issue is ©2008 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.