nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2008‒10‒21
sixteen papers chosen by
Christian Zimmermann
University of Connecticut

  1. Price Level Targeting in a Small Open Economy with Financial Frictions: Welfare Analysis By Ali Dib; Caterina Mendicino; Yahong Zhang
  2. Optimal Monetary Policy in an Operational Medium-Sized DSGE Model By Adolfson, Malin; Laseén, Stefan; Lindé, Jesper; Svensson, Lars E.O.
  3. Revisiting the Comovement Puzzle: the Input-Output Structure as an Additional Solution By Federico di Pace
  4. Macroeconometric equivalence, microeconomic dissonance, and the design of monetary policy By Andrew T. Levin; J. David López-Salido; Edward Nelson; Tack Yun
  5. Do Tax Cuts Generate Twin Deficits? A Multi-Country Analysis By Martin Boileau; Michel Normandin
  6. Fixed Costs and Long-Lived Investments By Christopher L. House
  7. Vertical specialization and international business cycle synchronization By Costas Arkolakis; Ananth Ramanarayanan
  8. Bankruptcy Costs, Liability Dollarization, and Vulnerability to Sudden Stops By Uluc Aysun; Adam Honig
  9. A Model of Quality Ladders with Horizontal Entry By Pedro Rui Mazeda Gil; Paulo Brito; Óscar Afonso
  10. On the Role of Pension Systems in Economic Development and Demographic Transition By Johannes Holler
  11. Expected returns and liquidity risk: Does entrepreneurial income matter? By Saffi, Pedro
  12. Asset Pricing Under Information with Stochastic Volatility By Bertram Düring
  13. Timeless perspective policymaking: When is discretion superior? By Richard Dennis
  14. The J2 Status of Chaos in Period Macroeconomic Models By Peter Flaschel; Christian Proano
  15. Asymmetric expectation effects of regime shifts in monetary policy By Zheng Liu; Daniel F. Waggoner; Tao Zha
  16. Temporary price changes and the real effects of monetary policy By Patrick J. Kehoe; Virgiliu Midrigan

  1. By: Ali Dib; Caterina Mendicino; Yahong Zhang
    Abstract: How important are the benefits of low price-level uncertainty? This paper explores the desirability of price-level path targeting in an estimated DSGE model fit to Canadian data. The policy implications are based on social welfare evaluations. Compared to the historical inflation targeting rule, an optimal price level targeting regime substantially reduces the welfare cost of business cycle fluctuations in terms of steady state consumption. The optimal price-level targeting rule performs also better than the optimal inflation targeting rule in minimizing the distortion generated by the presence of nominal debt contracts. The occurrence of financial shocks, which are among the main sources of business cycle fluctuations in the model, significantly contributes to quantify the welfare gains of price level targeting.
    Keywords: Financial stability; Inflation and prices; Monetary policy framework
    JEL: E31 E32 E52
    Date: 2008
  2. By: Adolfson, Malin (Monetary Policy Department, Central Bank of Sweden); Laseén, Stefan (Monetary Policy Department, Central Bank of Sweden); Lindé, Jesper (Monetary Policy Department, Central Bank of Sweden, Sveriges Riksbank, SE-103 37 Stockholm, Sweden and CEPR); Svensson, Lars E.O. (Central Bank of Sweden, Sveriges Riksbank, SE-103 37 Stockholm, Sweden, Princeton University, CEPR and NBER)
    Abstract: We show how to construct optimal policy projections in Ramses, the Riksbank’s openeconomy medium-sized DSGE model for forecasting and policy analysis. Bayesian estimation of the parameters of the model indicates that they are relatively invariant to alternative policy assumptions and supports that the model may be regarded as structural in a stable low inflation environment. Past policy of the Riksbank until 2007:3 (the end of the sample used) is better explained as following a simple instrument rule than as optimal policy under commitment. We show and discuss the differences between policy projections for the estimated instrument rule and for optimal policy under commitment, under alternative definitions of the output gap, different initial values of the Lagrange multipliers representing policy in a timeless perspective, and different weights in the central-bank loss function.
    Keywords: Optimal monetary policy; instrument rules; optimal policy projections; openeconomy DSGE models
    JEL: E52 E58
    Date: 2008–08–01
  3. By: Federico di Pace (School of Economics, Mathematics & Statistics, Birkbeck)
    Abstract: We propose an additional solution to the comovement puzzle by developing a two-sector monetary model with housing production and an input-output structure. The model generates comovement between consumption and residential investment for large range of shocks hitting the economy. Consistent with previous work, we find that our model produces highly persistence responses in aggregate consumption, aggregate output and residential investment. We show that the results are highly robust to different policy rule specifications. We find that the lower the labour shares, the higher the relative volatility of residential investment. The model with an IO structure is works under different specifications of the period utility function. We extend the model to allow for wage rigidities and show that our proposed solution can perfectly work alongside previous ones.
    Date: 2008–09
  4. By: Andrew T. Levin; J. David López-Salido; Edward Nelson; Tack Yun
    Abstract: Many recent studies in macroeconomics have focused on the estimation of DSGE models using a system of loglinear approximations to the models' nonlinear equilibrium conditions. The term macroeconometric equivalence encapsulates the idea that estimates using aggregate data based on first-order approximations to the equilibrium conditions of a DSGE model will not be able to distinguish between alternative underlying preferences and technologies. The concept of microeconomic dissonance refers to the fact that the underlying microeconomic differences become important when optimal monetary policy is analyzed in a nonlinear setting. The relevance of these concepts is established by analysis of optimal steady-state inflation and optimal policy in the stochastic economy using a small-scale New Keynesian model. Microeconomic and financial datasets are promising tools with which to overcome the equivalence problem.
    Keywords: Monetary policy ; Macroeconomics ; Microeconomics
    Date: 2008
  5. By: Martin Boileau; Michel Normandin
    Abstract: We study the effects of tax shocks on the budget and external deficits for 16 industrialized countries over the post-1975 period. Our structural approach is based on a tractable small open-economy model where a tax cut innovation generates a budget deficit. In turn, the budget deficit affects the external deficit by two distinct channels. The demographic channel works through the overlapping-generation structure of the model. The forecasting channel works through the dynamic structure of the model. Our empirical analysis documents that tax shocks generate significant positive comovements between the budget and external deficits. We also find that both the demographic and forecasting channels are important to explain the comovements.
    Keywords: Budget Deficit, External Deficit, Fiscal Policy, Overlapping Generations
    JEL: E62 F32 F41
    Date: 2008
  6. By: Christopher L. House
    Abstract: Neoclassical investment models predict that firms should make frequent, small adjustments to their capital stocks. Microeconomic evidence, however, shows just the opposite -- firms make infrequent, large adjustments to their capital stocks. In response, researchers have developed models with fixed costs of adjustment to explain the data. While these models generate the observed firm-level investment behavior, it is not clear that the aggregate behavior of these models differs importantly from the aggregate behavior of neoclassical models. This is important since most of our existing understanding of investment is based on models without fixed costs. Moreover, models with fixed costs have non-degenerate, time-varying distributions of capital holdings across firms, making the models extremely difficult to analyze. This paper shows that, for sufficiently long-lived capital, (1) the cross-sectional distribution of capital holdings has virtually no bearing on the equilibrium and (2) the aggregate behavior of the fixed-cost model is virtually identical to that of the neoclassical model. The findings are due to a near infinite elasticity of investment timing for long-lived capital goods -- a feature that fixed-cost models and neoclassical models share. The analysis shows that the so-called "irrelevance results" obtained in recent numerical studies of fixed-cost models are not parametric special cases but instead reflect fundamental properties of long-lived investments.
    JEL: E22 E32
    Date: 2008–10
  7. By: Costas Arkolakis; Ananth Ramanarayanan
    Abstract: We explore the impact of vertical specialization--trade in goods across multiple stages of production--on the relationship between trade and international business cycle synchronization. We develop a model in which the degree of vertical specialization is endogenously determined by comparative advantage across heterogeneous goods and varies with trade barriers between countries. We show analytically that fluctuations in measured productivity in our model are not linked across countries through trade, despite the greater transmission of technology shocks implied by higher degrees of vertical specialization. In numerical simulations, we find this transmission is insufficient in generating substantial dependence of business cycle synchronization on trade intensity.
    Keywords: Business cycles ; International trade
    Date: 2008
  8. By: Uluc Aysun (University of Connecticut); Adam Honig (Amherst College)
    Abstract: Emerging market countries that have improved institutions and attained intermediate levels of institutional quality have experienced severe financial crises following capital flow reversals. However, there is also evidence that countries with strong institutions and deep capital markets are less affected by external shocks. We reconcile these two observations using a calibrated DSGE model that extends the financial accelerator framework developed in Bernanke, Gertler, and Gilchrist (1999). The model captures financial market institutional quality with creditors. ability to recover assets from bankrupt firms. Bankruptcy costs affect vulnerability to sudden stops directly but also indirectly by affecting the degree of liability dollarization. Simulations reveal an inverted U-shaped relationship between bankruptcy recovery rates and the output loss following sudden stops. We provide empirical evidence that this non-linear relationship exists.
    Keywords: sudden stops, bankruptcy costs, financial accelerator, liability dollarization.
    JEL: E44 F31 F41
    Date: 2008–10
  9. By: Pedro Rui Mazeda Gil (CEMPRE and Faculdade de Economia, Universidade do Porto); Paulo Brito (Instituto Superior de Economia e Gestão and UECE, Universidade Técnica de Lisboa); Óscar Afonso (CEMPRE and Faculdade de Economia, Universidade do Porto)
    Abstract: We develop a multi-sector model of R&D-driven endogenous growth that merges the expanding-variety with the quality-ladders mechanism. The mechanism of expanding variety provides the flow of new firms (new product lines), whilst the mechanism of quality ladders provides the accumulation of non-physical capital (technological knowledge). The aim is to explore the view that, from the perspective of the households, wealth can be accumulated either by creating new firms or by accumulating capital, in a setting with no population growth. Differently from the standard expanding-variety literature, we allow for entry as well as exit of product lines from the market, view the creation of new product lines as a product development activity without positive spillovers, and postulate an horizontal entry mechanism that takes explicitly into account dynamic second-order effects. We perform a detailed comparative steady-state analysis and characterise qualitatively the local dynamics properties in a neighbourhood of the interior balanced-growth equilibrium. The model produces specific results with respect to the impact of changes in the entry-cost parameters and the fiscal-policy variables both in the aggregate growth rate and in the market structure and industry dynamics in steady state. We also conclude that the transitional dynamics is characterised by a catching-up effect, with an empirically reasonable speed of convergence under standard calibration.
    Keywords: endogenous growth, firm dynamics, transitional dynamics
    JEL: O41 D92 C62
    Date: 2008–10
  10. By: Johannes Holler
    Abstract: In this paper we examine whether di¤erent pension systems a¤ect the set of initial human capital conditions capturing an economy in a low steady state equilibrium income. To analyze this problem, we employ a three period over- lapping generations model where fertility and investments into the children?s education are chosen endogenously. We show that education investments are higher and start at lower income levels for a pay-as-you-go pension system econ- omy compared to an informal, fertility related one. The income threshold needed to escape the ?poverty trap? is therefore lower if a pay-as-you-go pension sys- tem is employed. Moreover, unless the economy is caught in the low income steady state, a pay-as-you-go pension system supports higher equilibrium in- come. We further highlight that pension systems in?uence the timing of de- mographic transition through their di¤erent valuation of fertility, contributing to the explanation for observed di¤erences between developed and developing countries.
    JEL: H55 J13 O23
    Date: 2008–06
  11. By: Saffi, Pedro (IESE Business School)
    Abstract: This paper studies the effects of jointly incorporating liquidity risk and non-tradeable wealth in a single asset pricing equation. First, I propose an overlapping-generations model with random endowment shocks and liquidity risk, evaluating their joint impact on expected returns. The model presents a single-factor asset pricing equation, with a new term capturing the covariance between assets' liquidities and non-tradeable wealth. In this economy, assets with higher liquidity or returns when non-tradeable wealth is low command lower expected returns. Second, I investigate whether risks associated with liquidity are priced after including non-tradeable wealth due to entrepreneurial income. I test the model on equally weighted and value-weighted portfolios, sorted by illiquidity levels, illiquidity variation and size, using US stock data from January 1962 to December 2004. The extra terms due to entrepreneurial income reduce liquidity risk premium by almost 40%, with an impact of -0.45% per year on expected returns of value-weighted illiquidity-sorted portfolios. Overall, liquidity risk as a whole has a yearly premium equal to 1.06%. However, liquidity levels are much more important and have a premium of 6.14% per year, contributing to most of the explanatory gains of the model.
    Keywords: Asset Pricing; Liquidity Risk; Human Capital; Labor Income;
    Date: 2008–04–29
  12. By: Bertram Düring (TU Vienna)
    Abstract: Based on a general specification of the asset specific pricing kernel, we develop a pricing model using an information process with stochastic volatility. We derive analytical asset and option pricing formulas. The asset prices in this rational expectations model exhibit crash-like, strong downward movements. The resulting option pricing formula is consistent with the strong negative skewness and high levels of kurtosis observed in empirical studies. Furthermore, we determine credit spreads in a simple structural model.
    Date: 2008–08–01
  13. By: Richard Dennis
    Abstract: In this paper I show that discretionary policymaking can be superior to timeless perspective policymaking and identify model features that make this outcome more likely. Developing a measure of conditional loss that treats the auxiliary state variables that characterize the timeless perspective equilibrium appropriately, I use a New Keynesian DSGE model to show that discretion can dominate timeless perspective policymaking when the Phillips curve is relatively flat, due, perhaps, to firm-specific capital (or labor) and/or Kimball (1995) aggregation in combination with nominal price rigidity. These results suggest that studies applying the timeless perspective might also usefully compare its performance to discretion, paying careful attention to how policy performance is evaluated.
    Keywords: Monetary policy
    Date: 2008
  14. By: Peter Flaschel (Bielefeld University, Germany); Christian Proano (IMK at the Hans Boeckler Foundation)
    Abstract: We reconsider the issue of the (non-)equivalence of period and continuous time analysis in macroeconomic theory and its implications for the existence of chaotic dynamics in empirical macro. We start from the methodological precept that period and continuous time representations of the same macrostructure should give rise to the same qualitative outcome, i.e. in particular, that the results of period analysis should not depend on the length of the period. A simple example where this is fulfilled is given by the Solow growth model, while all chaotic dynamics in period models of dimension less than 3 are in conflict with this precept. We discuss a recent and typical example from the literature, where chaos results from an asymptotically stable continuous-time macroeconomic model when this is reformulated as a discrete-time model with a long period length.
    Keywords: Period models, continuous time, (non-)equivalence, chaotic dynamics.
    JEL: E24 E31 E32
    Date: 2008
  15. By: Zheng Liu; Daniel F. Waggoner; Tao Zha
    Abstract: This paper addresses two substantive issues: (1) Does the magnitude of the expectation effect of regime switching in monetary policy depend on a particular policy regime? (2) Under which regime is the expectation effect quantitatively important? Using two canonical DSGE models, we show that there exists asymmetry in the expectation effect across regimes. The expectation effect under the dovish policy regime is quantitatively more important than that under the hawkish regime. These results suggest that the possibility of regime shifts in monetary policy can have important effects on rational agents' expectation formation and on equilibrium dynamics. They offer a theoretical explanation for the empirical possibility that a policy shift from the dovish regime to the hawkish regime may not be the main source of substantial reductions in the volatilities of inflation and output.
    Keywords: Monetary policy
    Date: 2008
  16. By: Patrick J. Kehoe; Virgiliu Midrigan
    Abstract: In the data, prices change both temporarily and permanently. Standard Calvo models focus on permanent price changes and take one of two shortcuts when confronted with the data: drop temporary changes from the data or leave them in and treat them as permanent. We provide a menu cost model that includes motives for both types of price changes. Since this model accounts for the main regularities of price changes, its predictions for the real effects of monetary policy shocks are useful benchmarks against which to judge existing shortcuts. We find that neither shortcut comes close to these benchmarks. For monetary policy analysis, researchers should use a menu cost model like ours or at least a third, theory-based shortcut: set the Calvo model's parameters so that it generates the same real effects from monetary shocks as does the bench-mark menu cost model. Following either suggestion will improve monetary policy analysis.
    Keywords: Keynesian economics ; Prices
    Date: 2008

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