
on Dynamic General Equilibrium 
By:  Guido Menzio; Shouyong Shi 
Abstract:  In this paper, we develop a general stochastic model of directed search on the job. Like in the analogous models of random search on the job, the state of the economy in our model includes the infinitedimensional distribution of workers across different employment states (unemployment, and employment at different wages). Unlike the analogous models of random search on the job, our model admits an equilibrium in which the agents' value and policy functions do not depend on the distribution of workers. We refer to this type of equilibrium as a Block Recursive Equilibrium. Therefore, while solving the equilibrium of a random search model in a stochastic environment is a difficult task both analytically and computationally, solving the Block Recursive Equilibrium of our model is as easy as solving a representative agent model. 
JEL:  E32 J64 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:14907&r=dge 
By:  Thomas Y. Mathä (Central Bank of Luxembourg, 2 bd. Royal, L2983 Luxembourg.); Olivier Pierrard (Central Bank of Luxembourg, 2 bd. Royal, L2983 Luxembourg.) 
Abstract:  We develop a searchmatching model, where firms search for customers (e.g. in form of advertising). Firms use longterm contracts and bargain over prices, resulting in a price mark up above marginal cost, which is procyclical and depends on firms’ relative bargaining power. Product market frictions decrease the steady state equilibrium, improve the cyclical properties of the model and provide a more realistic picture of firms’ business environment. This suggests that product market frictions may well be crucial in explaining business cycle fluctuations. Finally, we also show that welfare costs of price rigidities are negligible relative to welfare costs of frictions. JEL Classification: E10, E31, E32. 
Keywords:  Business cycle, Frictions, Product market, Price bargain. 
Date:  2009–03 
URL:  http://d.repec.org/n?u=RePEc:ecb:ecbwps:200901036&r=dge 
By:  Zhigang Feng; Jianjun Miao; Adrian PeraltaAlva; Manuel S. Santos 
Abstract:  In this paper we present a recursive method for the computation of dynamic competitive equilibria in models with heterogeneous agents and market frictions. This method is based on a convergent operator over an expanded set of state variables. The fixed point of this operator defines the set of all Markovian equilibria. We study approximation properties of the operator as well as the convergence of the moments of simulated sample paths. We apply our numerical algorithm to two growth models, an overlapping generations economy with money, and an asset pricing model with financial frictions. 
Keywords:  Econometric models 
Date:  2009 
URL:  http://d.repec.org/n?u=RePEc:fip:fedlwp:200918&r=dge 
By:  Aronsson, Thomas (Department of Economics, Umeå University); JohanssonStenman, Olof (Department of Economics, School of Business, Economics and Law, Göteborg University) 
Abstract:  This paper concerns optimal income taxation under asymmetric information in a twotype overlapping generations model, where people care about their relative consumption compared to others. The appearance of positional concerns affects the policy choices via two channels: (i) the size of the average degree of positionality and (ii) positionality differences between the (mimicked) lowability type and the mimicker. Under plausible empirical estimates, the marginal labor income tax rates become substantially larger, and the absolute value of the marginal capital income tax rate implemented for the lowability type becomes substantially smaller, compared to the conventional optimal income tax model. In addition to measures of reference consumption based on the average consumption, results for the cases of withingeneration and upward comparisons are also presented.<p> 
Keywords:  Optimal income taxation; asymmetric information; relative consumption; status; positional goods 
JEL:  D62 H21 H23 H41 
Date:  2009–04–16 
URL:  http://d.repec.org/n?u=RePEc:hhs:gunwpe:0355&r=dge 
By:  Yi Wen 
Abstract:  This paper reconsiders the welfare costs of inflation and the welfare gains from financial intermediation in a heterogeneousagent economy where money is held as a store of value (as in Bewley, 1980). The dynamic stochastic general equilibrium model recaptures some essential features of the liquiditypreference theory of Keynes (1930, 1936). Because of heterogeneous liquidity demand, transitory lumpsum money injections can have persistent expansionary effects despite flexible prices, and such effects can be greatly amplified by the banking system through the credit channel. However, permanent money growth can be extremely costly: With log utility functions, consumers are willing to reduce consumption by 15% (or more) to avoid a 10% annual inflation. For the same reason, financial intermediation can significantly improve welfare: The welfare costs of a collapse of the banking system is estimated as about 1068% of aggregate output. These welfare implications differ dramatically from those of the existing literature. 
Keywords:  Liquidity (Economics) 
Date:  2009 
URL:  http://d.repec.org/n?u=RePEc:fip:fedlwp:200919&r=dge 
By:  FernándezVillaverde, Jesús; GuerronQuintana, Pablo A.; RubioRamirez, Juan Francisco; Uribe, Martín 
Abstract:  This paper shows how changes in the volatility of the real interest rate at which small open emerging economies borrow have a quantitatively important effect on real variables like output, consumption, investment, and hours worked. To motivate our investigation, we document the strong evidence of timevarying volatility in the real interest rates faced by a sample of four emerging small open economies: Argentina, Ecuador, Venezuela, and Brazil. We postulate a stochastic volatility process for real interest rates using Tbill rates and country spreads and estimate it with the help of the Particle filter and Bayesian methods. Then, we feed the estimated stochastic volatility process for real interest rates in an otherwise standard small open economy business cycle model. We calibrate eight versions of our model to match basic aggregate observations, two versions for each of the four countries in our sample. We find that an increase in real interest rate volatility triggers a fall in output, consumption, investment, and hours worked, and a notable change in the current account of the economy. 
Keywords:  DSGE Models; Small Open Economy; Stochastic Volatility 
JEL:  C32 C63 F32 F41 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:cpr:ceprdp:7264&r=dge 
By:  Roland Straub (European Central Bank, Kaiserstrasse 29, D60311 Frankfurt am Main, Germany.); Christian Thimann (European Central Bank, Kaiserstrasse 29, D60311 Frankfurt am Main, Germany.) 
Abstract:  This paper sheds new light on the external and domestic dimension of China’s exchange rate policy. It presents an open economy model to analyse both dimensions of macroeconomic adjustment in China under both flexible and fixed exchange rate regimes. The modelbased results indicate that persistent current account surpluses in China cannot be rationalized, under general circumstances, by the occurrence of permanent technology or labour supply shocks. As a result, the understanding of the macroeconomic adjustment process in China requires to mimic the effects of potential inefficiencies, which induce the subdued response of domestic absorption to permanent income shocks causing thereby the observed positive unconditional correlation of trade balance and output. The paper argues that these inefficiencies can be potentially seen as a byproduct of the fixed exchange rate regime, and can be approximated by a stochastic tax on domestic consumption or time varying transaction cost technology related to money holdings. Our results indicate that a fixed exchange regime with financial market distortions, as defined above, might induce negative effects on GDP growth in the mediumterm compared to a more flexible exchange rate regime. JEL Classification: E32, E62. 
Keywords:  DSGE modelling, China, current account. 
Date:  2009–03 
URL:  http://d.repec.org/n?u=RePEc:ecb:ecbwps:200901040&r=dge 
By:  Aleksander Berentsen; Guido Menzio; Randall Wright 
Abstract:  We study the longrun relation between money, measured by inflation or interest rates, and unemployment. We first discuss data, documenting a strong positive relation between the variables at low frequencies. We then develop a framework where both money and unemployment are modeled using explicit microfoundations, integrating and extending recent work in macro and monetary economics, and providing a unified theory to analyze labor and goods markets. We calibrate the model, to ask how monetary factors account quantitatively for lowfrequency labor market behavior. The answer depends on two key parameters: the elasticity of money demand, which translates monetary policy to real balances and profits; and the value of leisure, which affects the transmission from profits to entry and employment. For conservative parameterizations, money accounts for some but not that much of trend unemployment  by one measure, about 1/5 of the increase during the stagflation episode of the 70s can be explained by monetary policy alone. For less conservative but still reasonable parameters, money accounts for almost all lowfrequency movement in unemployment over the last half century 
JEL:  E24 E52 
Date:  2009–03 
URL:  http://d.repec.org/n?u=RePEc:kie:kieliw:1501&r=dge 
By:  Ju, Nengjiu; Miao, Jianjun 
Abstract:  We propose a novel generalized recursive smooth ambiguity model which allows a threeway separation among risk aversion, ambiguity aversion, and intertemporal substitution. We apply this utility to a consumptionbased asset pricing model in which consumption and dividends follow hidden Markov regimeswitching processes. Our calibrated model can match the mean equity premium, the mean riskfree rate, and the volatility of the equity premium observed in the data. In addition, our model can generate a variety of dynamic asset pricing phenomena, including the procyclical variation of pricedividend ratios, the countercyclical variation of equity premia and equity volatility, and the mean reversion of excess returns. The key intuition is that an ambiguity averse agent behaves pessimistically by attaching more weight to the pricing kernel in bad times when his continuation values are low. 
Keywords:  Ambiguity aversion; learning; asset pricing puzzles; model uncertainty; robustness; pessimism 
JEL:  D81 G12 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:14737&r=dge 
By:  Michael B Devereux (University of British Columbia, Canada); Alan Sutherland (University of St Andrews, UK) 
Abstract:  Since the crises of the late 1990's, most emerging market economies have built up substantial positive holdings of US dollar treasury bills, while at the same time experiencing a boom in FDI capital inflows. This paper develops a DSGE model of the interaction between an emerging market economy and an advanced economy which incorporates twoway capital flows between the economies. The novel aspect of the paper is to make use of new methods for analyzing portfolio choice in DSGE models. We compare a range of alternative financial market structures, in each case computing equilibrium portfolios. We find that an asymmetric configuration where the emerging economy holds nominal bonds and issues claims on capital (FDI) can achieve a considerable degree of international risksharing. This risksharing can be enhanced by a more stable monetary policy in the advanced economy. 
Keywords:  Country Portfolios, Emerging Markets 
JEL:  E52 E58 F41 
Date:  2009–02 
URL:  http://d.repec.org/n?u=RePEc:hkm:wpaper:082009&r=dge 
By:  Jim Malley; Ulrich Woitek 
Abstract:  This paper contributes to the ongoing empirical debate regarding the role of the RBC model and in particular of technology shocks in explaining aggregate fluctuations. To this end we estimate the model’s posterior density using MarkovChain MonteCarlo (MCMC) methods. Within this framework we extend Ireland’s (2001, 2004) hybrid estimation approach to allow for a vector autoregressive moving average (VARMA) process to describe the movements and comovements of the model’s errors not explained by the basic RBC model. The results of marginal likelihood ratio tests reveal that the more general model of the errors significantly improves the model’s fit relative to the VAR and AR alternatives. Moreover, despite setting the RBC model a more difficult task under the VARMA specification, our analysis, based on forecast error and spectral decompositions, suggests that the RBC model is still capable of explaining a significant fraction of the observed variation in macroeconomic aggregates in the postwar U.S. economy. 
Keywords:  Real Business Cycle, Bayesian estimation, VARMA errors 
JEL:  C11 C52 E32 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:gla:glaewp:2009_15&r=dge 
By:  Veronica Guerrieri; Robert Shimer; Randall Wright 
Abstract:  We extend the concept of competitive search equilibrium to environments with private information, and in particular adverse selection. Principals (e.g. employers or agents who want to buy assets) post contracts, which we model as revelation mechanisms. Agents (e.g. workers, or asset holders) have private information about the potential gains from trade. Agents observe the posted contracts and decide where to apply, trading off the contracts' terms of trade against the probability of matching, which depends in general on the principals' capacity constraints and market search frictions. We characterize equilibrium as the solution to a constrained optimization problem, and prove that principals offer separating contracts to attract different types of agents. We then present a series of applications, including models of signaling, insurance, and lemons. These illustrate the usefulness and generality of the approach, and serve to contrast our findings with standard results in both the contract and search literatures. 
JEL:  D82 E24 J6 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:14915&r=dge 
By:  JeanFranois, MERTENS (UNIVERSITE CATHOLIQUE DE LOUVAIN, Department of Economics); Anna, RUBINCHIK 
Abstract:  For two independent principles of intergenerational equity, the implied discount rate equals the growth rate of real percapital income, say 2%, thus falling right into the range suggested by the U.S. Office of Management and Budget. To prove this, we develop a simple tool to evaluate small policy changes affecting several generations, by reducing the dynamic problem to a static one. A necessary condition is timeinvariance, which is statisfied by any common solution concept in an overlapping generations model with exogenous growth. This tool is applied to derive the discount rate for costbenefit analysis under two different utilitarian welfare functions : classical and relative. It is only with relative utilitarianism that the discount rate is welldefined for a heterogeneous society, is corroborated by an independent principle equation values of human lives, and equals the growth rate of real percapital income 
Keywords:  Social welfare function; social welfare functional; overlapping generations; exogenous growth; policy reform; intergenerational equity; intergenerational fairness; costbenefit analysis; discount rate; social discount rate; utilitarianism; relative utilitarianism; welfarism 
JEL:  D31 D61 D63 E60 H43 
Date:  2008–12–02 
URL:  http://d.repec.org/n?u=RePEc:ctl:louvec:2008047&r=dge 
By:  Basak, Suleyman; Chabakauri, Georgy 
Abstract:  Meanvariance criteria remain prevalent in multiperiod problems, and yet not much is known about their dynamically optimal policies. We provide a fully analytical characterization of the optimal dynamic meanvariance portfolios within a general incompletemarket economy, and recover a simple structure that also inherits several conventional properties of static models. We also identify a probability measure that incorporates intertemporal hedging demands and facilitates much tractability in the explicit computation of portfolios. We solve the problem by explicitly recognizing the timeinconsistency of the meanvariance criterion and deriving a recursive representation for it, which makes dynamic programming applicable. We further show that our timeconsistent solution is generically different from the precommitment solutions in the extant literature, which maximize the meanvariance criterion at an initial date and which the investor commits to follow despite incentives to deviate. We illustrate the usefulness of our analysis by explicitly computing dynamic meanvariance portfolios under various stochastic investment opportunities in a straightforward way, which does not involve solving a HamiltonJacobiBellman differential equation. A calibration exercise shows that the meanvariance hedging demands may comprise a significant fraction of the investor's total risky asset demand. 
Keywords:  Dynamic Programming; Incomplete Markets; MeanVariance Analysis; MultiPeriod Portfolio Choice; Stochastic Investment Opportunities; TimeConsistency 
JEL:  C61 D81 G11 
Date:  2009–04 
URL:  http://d.repec.org/n?u=RePEc:cpr:ceprdp:7256&r=dge 
By:  Douglas Gollin (Williams College); Christian Zimmermann (University of Connecticut) 
Abstract:  The World Health Organization (WHO) reports that malaria, a parasitic disease transmitted by mosquitoes, causes over 300 million episodes of “acute illness” and more than one million deaths annually. Most of the deaths occur in poor countries of the tropics, and especially subSaharan Africa. Most of the countries with high rates of malaria prevalence are also poor, and some researchers have suggested a direct link from malaria to poverty. This paper explores the potential impact of malaria on national income levels, using a dynamic general equilibrium framework with epidemiological features. We find that if there is no feasible prevention or control, malaria can have a significant impact on income levels. However, if people have any effective way of avoiding infection, the disease impacts on income levels are likely to be small. This is true even where preventive measures are costly. 
Date:  2008–10 
URL:  http://d.repec.org/n?u=RePEc:wil:wileco:200817&r=dge 