nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2008‒12‒07
twenty-one papers chosen by
Christian Zimmermann
University of Connecticut

  1. Monetary policy and housing prices in an estimated DSGE model for the US and the euro area. By Matthieu Darracq Pariès; Alessandro Notarpietro
  2. Do nominal rigidities matter for the transmission of technology shocks? By Zheng Liu; Louis Phaneuf
  3. Estimating the parameters of a small open economy DSGE model: identifiability and inferential validity By Daniel O. Beltran; David Draper
  4. Population, Pensions, and Endogenous Economic Growth By Burkhard Heer; Andreas Irmen
  5. Measuring the Welfare Costs of Inflation in a Life-cycle Model By Paul Gomme
  6. The Return to Capital and the Business Cycle By Paul Gomme; B. Ravikumar; Peter Rupert
  7. Monetary Policy in a Small Open Economy Model: A DSGE-VAR Approach for Switzerland By Gregor Bäuerle; Tobias Menz
  8. Priors from DSGE Models for Dynamic Factor Analysis By Gregor Bäurle
  9. Sluggish responses of prices and inflation to monetary shocks in an inventory model of money demand By Fernando Alvarez; Andrew Atkeson; Chris Edmond
  10. How Misleading is Linearization? Evaluating the Dynamics of the Neoclassical Growth Model By Manoj Atolia; Santanu Chatterjee; Stephen J. Turnovsky
  11. On the threat of counterfeiting By Yiting Li; Guillaume Rocheteau
  12. Trade Policy, Poverty, and Development in a Dynamic General Equilibrium Model for Zambia By Edward F. Buffie; Manoj Atolia
  13. When bonds matter: home bias in goods and assets By Nicolas Coeurdacier; Pierre-Olivier Gourinchas
  14. Bubbles and multiplicity of equilibria under portfolio constraints By Julien Hugonnier
  15. Interactions between private and public sector wages. By António Afonso; Pedro Gomes
  16. Reconnecting Money to Inflation: The Role of the External Finance Premium By Jagjit S. Chadha; Luisa Corrado; Sean Holly
  17. Bayesian inference based only on simulated likelihood: particle filter analysis of dynamic economic models By Thomas Flury; Neil Shephard
  18. Measuring Unemployment Insurance Generosity By Stephane Pallage; Lyle Scruggs; Christian Zimmermann
  19. Unemployment Insurance Generosity: A Trans-Atlantic Comparison By Stephane Pallage; Lyle Scruggs; Christian Zimmermann
  20. Age-Dependent Employment Protection By Chéron, Arnaud; Hairault, Jean-Olivier; Langot, François
  21. Inventories, lumpy trade, and large devaluations By George Alessandria; Joseph Kaboski; Virgiliu Midrigan

  1. By: Matthieu Darracq Pariès (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Alessandro Notarpietro (Università Bocconi, Via Sarfatti 25, I-20136 Milano, Italy.)
    Abstract: We estimate a two-country Dynamic Stochastic General Equilibrium model for the US and the euro area including relevant housing market features and examine the monetary policy implications of housing-related disturbances. In particular, we derive the optimal monetary policy cooperation consistent with the structural specification of the model. Our estimation results reinforce the existing evidence on the role of housing and mortgage markets for the US and provide new evidence on the importance of the collateral channel in the euro area. Moreover, we document the various implications of credit frictions for the propagation of macroeconomic disturbances and the conduct of monetary policy. We find that allowing for some degree of monetary policy response to fluctuations in the price of residential goods improves the empirical fit of the model and is consistent with the main features of optimal monetary policy response to housing-related shocks. JEL Classification: E4, E5, F4.
    Keywords: Housing, credit frictions, optimal monetary policy, new open economy macroeconomics, Bayesian estimation.
    Date: 2008–11
  2. By: Zheng Liu; Louis Phaneuf
    Abstract: A commonly held view is that nominal rigidities are important for the transmission of monetary policy shocks. We argue that they are also important for understanding the dynamic effects of technology shocks, especially on labor hours, wages, and prices. Based on a dynamic general equilibrium framework, our closed-form solutions reveal that a pure sticky-price model predicts correctly that hours decline following a positive technology shock, but fails to generate the observed gradual rise in the real wage and the near-constance of the nominal wage; a pure sticky-wage model does well in generating slow adjustments in the nominal wage, but it does not generate plausible dynamics of hours and the real wage. A model with both types of nominal rigidities is more successful in replicating the empirical evidence about hours, wages and prices. This finding is robust for a wide range of parameter values, including a relatively small Frisch elasticity of hours and a relatively high frequency of price reoptimization that are consistent with microeconomic evidence.
    Date: 2008
  3. By: Daniel O. Beltran; David Draper
    Abstract: This paper estimates the parameters of a stylized dynamic stochastic general equilibrium model using maximum likelihood and Bayesian methods, paying special attention to the issue of weak parameter identification. Given the model and the available data, the posterior estimates of the weakly identified parameters are very sensitive to the choice of priors. We provide a set of tools to diagnose weak identification, which include surface plots of the log-likelihood as a function of two parameters, heat plots of the log-likelihood as a function of three parameters, Monte Carlo simulations using artificial data, and Bayesian estimation using three sets of priors. We find that the policy coefficients and the parameter governing the elasticity of labor supply are weakly identified by the data, and posterior predictive distributions remind us that DSGE models may make poor forecasts even when they fit the data well. Although parameter identification is model- and data-specific, the lack of identification of some key structural parameters in a small-scale DSGE model such as the one we examine should raise a red flag to researchers trying to estimate--and draw valid inferences from--large-scale models featuring many more parameters.
    Date: 2008
  4. By: Burkhard Heer (Free University of Bolzano-Bozen, School of Economics and Management,); Andreas Irmen (University of Heidelberg, Department of Economics)
    Abstract: We study the effect of a declining labor force on the incentives to engage in labor-saving technical change and ask how this effect is influenced by institutional characteristics of the pension scheme. When labor is scarcer it becomes more expensive and innovation investments that increase labor productivity are more profitable. We incorporate this channel in a new dynamic general equilibrium model with endogenous economic growth and heterogeneous overlapping generations. We calibrate the model for the US economy. First, we establish that the net effect of a decline in population growth on the growth rate of per-capita magnitudes is positive and quantitatively significant. Second, we find that the pension system matters both for the growth performance and for individual welfare. Third, we show that the assessment of pension reform proposals may be different in an endogenous growth framework as opposed to the standard framework with exogenous growth.
    Keywords: Growth, Demographic Transition, Capital Accumulation, Pension Reform
    JEL: O41 C68 O11 D91 D31
    Date: 2008–11
  5. By: Paul Gomme (Department of Economics, Concordia University)
    Abstract: In macroeconomics, life-cycle models are typically used to address exclusively life-cycle issues. This paper shows that modeling the life-cycle may be important when addressing public policy issues, in this case the welfare costs of inflation. In the representative agent model, the optimal inflation rate is characterized by the Friedman rule: deflate at the real interest rate. In the corresponding life-cycle model, the optimal inflation rate is quite high: for the benchmark calibration, it is around 95% per annum. Much of the paper is concerned with understanding this result. Briefly, in the life-cycle model there are distributional consequences of injecting money via lump-sum transfers. The net effect is to transfer income from old, rich agents to young, poor ones. These transfers twist the age-utility profile in a way that agents find desirable from a lifetime utility point of view. A second issue concerns how to assess the costs of inflation in a life-cycle model. Metrics that are equivalent in the representative agent model can give very different answers in a life-cycle model.
    Keywords: monetary policy, inflation, welfare costs, life-cycle model
    JEL: E52 E31 E32 D58 D91
    Date: 2008–08
  6. By: Paul Gomme (Department of Economics, Concordia University); B. Ravikumar (Department of Economics, University of Iowa); Peter Rupert (Department of Economics, University of California, Santa Barbara)
    Abstract: We measure the return to capital directly from the NIPA and BEA data and examine the return implications of the real business cycle model. Specifically, we construct a quarterly time series of the after-tax return to business capital. The business cycle properties of this return differs considerably from those of the S&P 500 returns. First, its volatility is considerably smaller than that of S\&P 500 returns. Second, our measured return is procyclical and leads output by one quarter; S&P 500 returns are countercyclical and lead the cycle by four quarters. The standard business cycle model captures almost 50% of the volatility in the return to capital (relative to the volatility of output), and does well in capturing the lead-lag pattern. We consider several departures from the benchmark model; the model with stochastic taxes captures nearly 85% of the relative volatility in the return to capital and the model with high risk aversion captures 80% of the relative volatility. We then include capital gains in our measurement and use a model with investment specific technological change to address the higher volatility in the return to capital. This model accounts for more than 80% of the return volatility, and essentially all of the relative volatility.
    Keywords: return to capital, business cycles, asset returns
    JEL: E01 E32 E13
    Date: 2008–04
  7. By: Gregor Bäuerle (University of Bern); Tobias Menz (University of Bern and Study Center Gerzensee)
    Abstract: We study the transmission of monetary shocks and monetary policy with a behavioral model, corrected for potential misspecification using the DSGE-VAR framework elaborated by DelNegro and Schorfheide (2004). In particular, we investigate if the central bank should react to movements in the nominal exchange rate. We contribute to the empirical literature as we use Swiss data, which is very rarely used in that context.
    Date: 2008–11
  8. By: Gregor Bäurle
    Abstract: We propose a method to incorporate information from Dynamic Stochastic General Equilibrium (DSGE) models into Dynamic Factor Analysis. The method combines a procedure previously applied for Bayesian Vector Autoregressions and a Gibbs Sampling approach for Dynamic Factor Models. The factors in the model are rotated such that they can be interpreted as variables from a DSGE model. In contrast to standard Dynamic Factor Analysis, a direct economic interpretation of the factors is given. We evaluate the forecast performance of the model with respect to the amount of information from the DSGE model included in the estimation. We conclude that using prior information from a standard New Keynesian DSGE model improves the forecast performance. We also analyze the impact of identified monetary shocks on both the factors and selected series. The interpretation of the factors as variables from the DSGE model allows us to use an identification scheme which is directly linked to the DSGE model. The responses of the factors in our application resemble responses found using VARs. However, there are deviations from standard results when looking at the responses of specific series to common shocks.
    Keywords: Dynamic Factor Model; DSGE Model; Bayesian Analysis; Forecasting; Transmission of Shocks
    JEL: C11 C32 E0
    Date: 2008–08
  9. By: Fernando Alvarez; Andrew Atkeson; Chris Edmond
    Abstract: We examine the responses of prices and inflation to monetary shocks in an inventory-theoretic model of money demand. We show that the price level responds sluggishly to an exogenous increase in the money stock because the dynamics of households' money inventories leads to a partially offsetting endogenous reduction in velocity. We also show that inflation responds sluggishly to an exogenous increase in the nominal interest rate because changes in monetary policy affect the real interest rate. In a quantitative example, we show that this nominal sluggishness is substantial and persistent if inventories in the model are calibrated to match U.S. households' holdings of M2.
    Keywords: Demand for money ; Inflation (Finance) ; Prices
    Date: 2008
  10. By: Manoj Atolia (Department of Economics, Florida State University); Santanu Chatterjee (Terry College of Business, University of Georgia); Stephen J. Turnovsky (Department of Economics, University of Washington)
    Abstract: The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. This raises the central question of this paper: How reliable is this procedure in evaluating the dynamic adjustments to policy changes or structural shocks? This question is significant since one of the basic objectives of contemporary micro-based macroeconomic models is the analysis of intertemporal welfare. We analyze this issue in the context of a neoclassical Ramsey growth model, with two alternative specifications of productive government spending, by employing both linearization and non-linear solution techniques. We find that if government expenditure is introduced as a flow and the dynamic adjustment is fast, linearization may be a reasonably good approximation of the true dynamics even for fairly large policy shocks. In contrast, if government expenditure assumes the form of a stock, leading to more sluggish adjustment, linearization is more problematic. The linearization procedure may yield misleading predictions, both qualitatively and quantitatively. These occur at the beginning of the transition and therefore weigh heavily in intertemporal welfare calculations. These patterns are verified for temporary shocks as well.
    Keywords: Public expenditure, growth, nonlinearities, welfare analysis
    JEL: E62 O41
    Date: 2008–01
  11. By: Yiting Li; Guillaume Rocheteau
    Abstract: We study counterfeiting of currency in a search–theoretic model of monetary exchange. In contrast to Nosal and Wallace (2007), we establish that counterfeiting does not pose a threat to the existence of a monetary equilibrium; i.e., a monetary equilibrium exists irrespective of the cost of producing counterfeits, or the ease with which genuine money can be authenticated. However, the possibility to counterfeit ?at money can affect its value, velocity, output and welfare, even if no counterfeiting occurs in equilibrium. We provide two extensions of the model under which the threat of counterfeiting can materialize: counterfeits can circulate across periods, and sellers set terms of trades in some matches. Policies that make the currency more costly to counterfeit or easier to recognize raise the value of money and society’s welfare, but the latter policy does not always decrease counterfeiting.
    Keywords: Counterfeits and counterfeiting
    Date: 2008
  12. By: Edward F. Buffie (Department of Economics, Indiana University); Manoj Atolia (Department of Economics, Florida State University)
    Abstract: Many LDCs suffer from low levels of private investment, from acute shortages of social and physical infrastructure, and from widespread poverty and underemployment. How can trade policy help combat these problems? Neoclassical trade theory objects that the premise of the question is incorrect. According to the Principle of Targeting, it is better to use other policy instruments to counteract market imperfections and to target social objectives. Instead of interfering with free trade, the government should increase domestic taxes to pay for employment subsidies, investment subsidies, transfers to the poor, and additional public investment in infrastructure. Policy makers reject this advice as impractical. Our objective in this paper is to restart the policy dialogue. We build a dynamic general equilibrium trade model that is rich in structural detail and policy instruments but not a black box. We use the model to investigate how trade policy affects poverty, underemployment, aggregate capital accumulation, and real output in Zambia. The results consistently recommend policy packages that combine an escalated structure of protection with an escalated structure of export promotion. There is no support for the view that free trade or a low uniform tariff is approximately optimal.
    Date: 2008–01
  13. By: Nicolas Coeurdacier; Pierre-Olivier Gourinchas
    Abstract: Recent models of international equity portfolios exhibit two potential weaknesses: 1) the structure of equilibrium equity portfolios is determined by the correlation of equity returns with real exchange rates; yet empirically equities don't appear to be a good hedge against real exchange rate risk; 2) Equity portfolios are highly sensitive to preference parameters. This paper solves both problems. It first shows that in more general and realistic environments, the hedging of real exchange rate risks occurs through international bond holdings since relative bond returns are strongly correlated with real exchange rate fluctuations. Equilibrium equity positions are then optimally determined by the correlation of equity returns with the return on non-financial wealth, conditional on the bond returns. The model delivers equilibrium portfolios that are well-behaved as a function of the underlying preference parameters. We find reasonable empirical support for the theory for G-7 countries. We are able to explain short positions in domestic currency bonds for all G-7 countries, as well as significant levels of home equity bias for the US, Japan and Canada.
    Date: 2008
  14. By: Julien Hugonnier (University of Lausanne and Swiss Finance Institute)
    Abstract: This article shows that, as long as agents are required to maintain positive wealth, the presence of portfolio constraints may give rise to asset pricing bubbles in equilibrium even if there are unconstrained agents in the economy who can benefit from the induced arbitrage opportunity. Furthermore, it is shown that the presence of bubbles in the aggregate price system can lead to both multiplicity and real indeterminacy of equilibrium. The general results are illustrated by two explicitly solved examples where seemingly innocuous portfolio constraints make bubbles a necessary condition for the existence of an equilibrium.
    Keywords: Predictability, asset pricing bubbles, general equilibrium, portfolio constraints
    JEL: D51 D52 D53 G11 G12
    Date: 2008–09
  15. By: António Afonso (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Pedro Gomes (London School of Economics & Political Science; STICERD – Suntory and Toyota InternationalCentres for Economics and Related Disciplines, Houghton Street, London WC2A 2AE, U.K..)
    Abstract: We analyse the interactions between public and private sector wages per employee in OECD countries. We motivate the analysis with a dynamic labour market equilibrium model with search and matching frictions to study the effects of public sector employment and wages on the labour market, particularly on private sector wages. Our empirical evidence shows that the growth of public sector wages and of public sector employment positively affects the growth of private sector wages. Moreover, total factor productivity, the unemployment rate, hours per worker, and inflation, are also important determinants of private sector wage growth. With respect to public sector wage growth, we find that, in addition to some market related variables, it is also influenced by fiscal conditions. JEL Classification: E24, E62, H50.
    Keywords: public wages, private wages, employment.
    Date: 2008–11
  16. By: Jagjit S. Chadha; Luisa Corrado; Sean Holly
    Abstract: We re-connect money to inflation using Goodfriend and McCallum’s (2007) model where banks supply loans to cash-in-advance constrained consumers on the basis of the value of collateral provided and the monitoring skills of banks. We show that when shocks to monitoring and collateral dominate those to goods productivity and the velocity of money demand, money and the external finance premium become closely linked. This is because increases in asset prices allow banks to raise the supply of loans leading to an expansion in aggregate demand, via a compression of financial interest rates spreads, which in turn tends to be inflationary. Thus money and financial spreads are negatively correlated when banking sector shocks dominate. We suggest a simple augmented stabilising monetary policy rule that exploits the joint information from money and the external finance premium.
    Keywords: money, DSGE, policy rules, external finance premium
    JEL: E31 E40 E51
    Date: 2008–11
  17. By: Thomas Flury; Neil Shephard
    Abstract: Suppose we wish to carry out likelihood based inference but we solely have an unbiased simulation based estimator of the likelihood. We note that unbiasedness is enough when the estimated likelihood is used inside a Metropolis-Hastings algorithm. This result has recently been intro- duced in statistics literature by Andrieu, Doucet, and Holenstein (2007) and is perhaps surprising given the celebrated results on maximum simulated likelihood estimation. Bayesian inference based on simulated likelihood can be widely applied in microeconomics, macroeconomics and financial econometrics. One way of generating unbiased estimates of the likelihood is by the use of a particle filter. We illustrate these methods on four problems in econometrics, producing rather generic methods. Taken together, these methods imply that if we can simulate from an economic model we can carry out likelihood based inference using its simulations.
    Keywords: Dynamic stochastic general equilibrium models, inference, likelihood, MCMC, Metropolis-Hastings, particle filter, state space models, stochastic volatility
    JEL: C11 C13 C15 C32 E32
    Date: 2008
  18. By: Stephane Pallage (Universite du Quebec a Montreal); Lyle Scruggs (University of Connecticut); Christian Zimmermann (University of Connecticut)
    Abstract: In this paper, we develop a methodology to summarize the various policy parameters of an unemployment insurance scheme into a single generosity parameter. Unemployment insurance policies are multdimensional objects. They are typically defined by waiting periods, eligibility duration, benefit levels and asset tests when eligible, which makes intertemporal or international comparisons difficult. To make things worse, labor market conditions, such as the likelihood and duration of unemployment matter when assessing the generosity of different policies. We build a first model with such complex characteristics. Our model features heterogeneous agents that are liquidity constrained but can self-insure. We then build a second model that is similar, except that the unemployment insurance is simpler: it is deprived of waiting periods and agents are eligible forever with constant benefits. We then determine which level of benefits in this second model makes agents indifferent between both unemployment insurance policies. We apply this strategy to the unemployment insurance program of the United Kingdom and study how its generosity evolved over time.
    Keywords: unemployment insurance, labor market policy, measurement
    JEL: J65 E24
    Date: 2008–11
  19. By: Stephane Pallage (Universite du Quebec a Montreal); Lyle Scruggs (University of Connecticut); Christian Zimmermann (University of Connecticut)
    Abstract: The goal of this paper is to establish if unemployment insurance policies are more generous in Europe than in the United States, and by how much. We take the examples of France and one particular American state, Ohio, and use the methodology of Pallage, Scruggs and Zimmermann (2008) to find a unique parameter value for each region that fully characterizes the generosity of the system. These two values can then be used in structural models that compare the regions, for example to explain the differences in unemployment rates.
    Keywords: unemployment insurance, labor market policy, measurement, France
    JEL: J65 E24
    Date: 2008–11
  20. By: Chéron, Arnaud (University of Le Mans); Hairault, Jean-Olivier (University of Paris 1); Langot, François (University of Le Mans)
    Abstract: This paper examines the age-related design of firing taxes by extending the theory of job creation and job destruction to account for a finite working life-time. We first argue that the potential employment gains related to employment protection are high for older workers, but higher firing taxes for these workers increase job destruction rates for the younger generations. On the other hand, age-decreasing firing taxes can lead to lower job destruction rates at all ages. Furthermore, from a normative standpoint, because firings of older (younger) workers exert a negative (positive) externality on the matching process, we find that the first best age-dynamic of firing taxes and hiring subsidies is typically hump-shaped. Taking into account distortions related to unemployment benefits and bargaining power shows the robustness of this result, in contradiction with the existing policies in most OECD countries.
    Keywords: foo
    JEL: J22 J26 H55
    Date: 2008–11
  21. By: George Alessandria; Joseph Kaboski; Virgiliu Midrigan
    Abstract: Fixed transaction costs and delivery lags are important costs of international trade. These costs lead firms to import infrequently and hold substantially larger inventories of imported goods than domestic goods. Using multiple sources of data, we document these facts. We then show that a parsimoniously parameterized model economy with importers facing an (S, s)-type inventory management problem successfully accounts for these features of the data. Moreover, the model can account for import and import price dynamics in the aftermath of large devaluations. In particular, desired inventory adjustment in response to a sudden, large increase in the relative price of imported goods creates a short-term trade implosion, an immediate, temporary drop in the value and number of distinct varieties imported, as well as a slow increase in the retail price of imported goods. Our study of six current account reversals following large devaluation episodes in the last decade provide strong support for the model's predictions.
    Date: 2008

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