
on Dynamic General Equilibrium 
By:  Büyükkarabacak, Berrak; Mykhaylova, Olena 
Abstract:  We augment a closedeconomy DSGE model with collateral constraints tied to real estate values by incorporating the timetobuild phenomenon in the housing construction sector. Adding construction sector delays significantly improves business cycle properties of the model relative to the versions with no timetobuild delays or with permanently fixed housing stock. We also find that in the presence of construction lags adding housing prices to the central bank policy function increases aggregate welfare in the economy by up to 0.3 percent of consumption. This result is robust to several specifications of the Taylor rule and to changes in key parameter values. 
Keywords:  Housing prices; housing construction; timetobuild; welfare. 
JEL:  E32 E58 E52 E44 
Date:  2010–06–15 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:23322&r=dge 
By:  Paul Levine (University of Surrey); Joseph Pearlman (London Metropolitan University); George Perendia (London Metropolitan University); Bo Yang (University of Surrey) 
Abstract:  We provide a tool for estimating DSGE models by BayesianMaximumlikelihood methods under very general information assumptions. This framework is applied to a New Keynesian model where we compare the standard approach, that assumes an informational asymmetry between private agents and the econometrician, with an assumption of informational symmetry. For the former, private agents observe all state variables including shocks, whereas the econometrician uses only data for output, inflation and interest rates. For the latter both agents have the same imperfect information set and this corresponds to what we term the 'informational consistency principle'. We first assume rational expectations and then generalize the model to allow some households and firms to form expectations adaptively. We find that in terms of model posterior probabilities, impulse responses, second moments and autocorrelations, the assumption of informational symmetry by rational agents significantly improves the model fit. We also find qualified empirical support for the heterogenous expectations model. JEL Classification: C11, C52, E12, E32. 
Keywords:  Imperfect Information, DSGE Model, Rational versus Adaptive Expectations, Bayesian Estimation 
JEL:  E52 E37 E58 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:sur:surrec:0310&r=dge 
By:  Paul Levine (University of Surrey) 
Abstract:  The past forty years or so has seen a remarkable transformation in macromodels used by central banks, policymakers and forecasting bodies. This papers describes this transformation from reducedform behavioural equations estimated separately, through to contemporarymicrofounded dynamic stochastic general equilibrium (DSGE) models estimated by systems methods. In particular by treating DSGE models estimated by BayesianMaximumLikelihood methods I argue that they can be considered as probability models in the sense described by Sims (2007) and be used for riskassessment and policy design. This is true for any one model, but with a range of models on offer it is possible also to design interest rate rules that are simple and robust across the rival models and across the distribution of parameter estimates for each of these rivals as in Levine et al. (2008). After making models better in a number of important dimensions, a possible road ahead is to consider rival models as being distinguished by the model of expectations. This would avoid becoming 'a prisoner of a single system' at least with respect to expectations formation where, as I argue, there is relatively less consensus on the appropriate modelling strategy. 
Keywords:  structured uncertainty, DSGE models, robustness, Bayesian estimation, interestrate rules 
JEL:  E52 E37 E58 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:sur:surrec:0210&r=dge 
By:  Nicoletta Batini (University of Surrey and IMF); Vasco Gabriel (University of Surrey); Paul Levine (University of Surrey); Joseph Pearlman (London Metropolitan University) 
Abstract:  We first develop a twobloc model of an emerging open economy interacting with the rest of the world calibrated using Indian and US data. The model features a financial accelerator and is suitable for examining the effects of financial stress on the real economy. Three variants of the model are highlighted with increasing degrees of financial frictions. The model is used to compare two monetary interest rate regimes: domestic Inflation targeting with a floating exchange rate (FLEX(D)) and a managed exchange rate (MEX). Both rules are characterized as a Taylortype interest rate rules. MEX involves a nominal exchange rate target in the rule and a constraint on its volatility. We find that the imposition of a low exchange rate volatility is only achieved at a significant welfare loss if the policymaker is restricted to a simple domestic in flation plus exchange rate targeting rule. If on the other hand the policymaker can implement a complex optimal rule then an almost fixed exchange rate can be achieved at a relatively small welfare cost. This finding suggests that future research should examine alternative simple rules that mimic the fully optimal rule more closely. JEL Classification: E52, E37, E58 
Keywords:  DSGE model, Indian economy, monetary interest rate rules, floating versus managed exchange rate, financial frictions. 
JEL:  E52 E37 E58 
Date:  2010–04 
URL:  http://d.repec.org/n?u=RePEc:sur:surrec:0410&r=dge 
By:  JeanOlivier Hairault (EEPPSE  Ecole d'Économie de Paris  Paris School of Economics  Ecole d'Économie de Paris, CES  Centre d'économie de la Sorbonne  CNRS : UMR8174  Université PanthéonSorbonne  Paris I, IZA  Institute for the Study of Labor); François Langot (IZA  Institute for the Study of Labor, GAINSTEPP  Université du Mans, CEPREMAP  Centre pour la recherche économique et ses applications) 
Abstract:  Gali et al. (2007) have recently shown in a quantitative way that inefficient fluctuations in the allocation of resources do not generate sizable welfare costs. In this note, we show that their evaluation underestimates the welfare costs of inefficient fluctuations and propose a biased estimate of the impact of structural distortions on business cycle costs. As monopolistic suppliers, both firms and households aim at preserving their expected markups ; the interaction between aggregate fluctuations in the efficiency gap and pricesetting behaviors results in making average consumption and employment lower than their counterparts in the flexible price economy. This level increases the welfare cost of business cycles. It is all the more sizable in that the degree of inefficiency is structurally high at the steady state. 
Keywords:  Business cycle costs, inefficiency gap, newKeynesian macroeconomics. 
Date:  2010–03 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:halshs00492204_v1&r=dge 
By:  Yi Wen 
Abstract:  Heterogeneity matters. This point is illustrated in a heterogeneousagent, cashinadvance economy where money serves both as a medium of exchange and as a store of value (as in Lucas, 1980). It is shown that heterogeneity can lead to dramatically different implications of monetary policies from those under the representativeagent assumption, including (i) the velocity of money is not constant but highly volatile, as in the data; (ii) lumpsum transitory money injections have expansionary effects on aggregate output despite flexible prices; and (iii) the welfare cost of anticipated inflation is potentially a couple of orders larger than the estimates of Cooley and Hansen (1989) based on a representativeagent, cashinadvance economy. 
Keywords:  Demand for money ; Monetary theory 
Date:  2010 
URL:  http://d.repec.org/n?u=RePEc:fip:fedlwp:2010014&r=dge 
By:  Olivier Coibion; Yuriy Gorodnichenko; Johannes F. Wieland 
Abstract:  We study the effects of positive steadystate inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utilitybased welfare loss function taking into account the effects of positive steadystate inflation and show that steadystate inflation affects welfare through three distinct channels: steadystate effects, the magnitude of the coefficients in the utilityfunction approximation, and the dynamics of the model. We solve for the optimal level of inflation in the model and find that, for plausible calibrations, the optimal inflation rate is low, less than two percent, even after considering a variety of extensions, including price indexation, endogenous price stickiness, capital formation, modeluncertainty, and downward nominal wage rigidities. In our models, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability. 
JEL:  E3 E4 E5 
Date:  2010–06 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:16093&r=dge 
By:  Patrick Bolton; Christopher Harris 
Abstract:  We study a dynamiccontracting problem involving risk sharing between two parties — the Proposer and the Responder — who invest in a risky asset until an exogenous but random termination time. In any time period they must invest all their wealth in the risky asset, but they can share the underlying investment and termination risk. When the project ends they consume their final accumulated wealth. The Proposer and the Responder have constant relative risk aversion R and r respectively, with R>r>0. We show that the optimal contract has three components: a noncontingent flow payment, a share in investment risk and a termination payment. We derive approximations for the optimal share in investment risk and the optimal termination payment, and we use numerical simulations to show that these approximations offer a close fit to the exact rules. The approximations take the form of a myopic benchmark plus a dynamic correction. In the case of the approximation for the optimal share in investment risk, the myopic benchmark is simply the classical formula for optimal risk sharing. This benchmark is endogenous because it depends on the wealths of the two parties. The dynamic correction is driven by counterparty risk. If both parties are fairly risk tolerant, in the sense that 2>R>r, then the Proposer takes on more risk than she would under the myopic benchmark. If both parties are fairly risk averse, in the sense that R>r>2, then the Proposer takes on less risk than she would under the myopic benchmark. In the mixed case, in which R>2>r, the Proposer takes on more risk when the Responder's share in total wealth is low and less risk when the Responder's share in total wealth is high. In the case of the approximation for the optimal termination payment, the myopic benchmark is zero. The dynamic correction tells us, among other things, that: (i) if the asset has a high return then, following termination, the Responder compensates the Proposer for the loss of a valuable investment opportunity; and (ii) if the asset has a low return then, prior to termination, the Responder compensates the Proposer for the low returns obtained. Finally, we exploit our representation of the optimal contract to derive simple and easily interpretable sufficient conditions for the existence of an optimal contract. 
JEL:  D86 G22 
Date:  2010–06 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:16094&r=dge 
By:  Francesca Rondina 
Abstract:  This paper studies optimal monetary policy in a framework that explicitly accounts for policymakers' uncertainty about the channels of transmission of oil prices into the economy. More specfically, I examine the robust response to the real price of oil that US monetary authorities would have been recommended to implement in the period 1970 2009; had they used the approach proposed by Cogley and Sargent (2005b) to incorporate model uncertainty and learning into policy decisions. In this context, I investigate the extent to which regulator' changing beliefs over different models of the economy play a role in the policy selection process. The main conclusion of this work is that, in the specific environment under analysis, one of the underlying models dominates the optimal interest rate response to oil prices. This result persists even when alternative assumptions on the model's priors change the pattern of the relative posterior probabilities, and can thus be attributed to the presence of model uncertainty itself. 
Keywords:  model uncertainty, learning, robust policy, Bayesian model averaging, oil prices 
JEL:  C52 E43 E58 E65 
Date:  2010–06–11 
URL:  http://d.repec.org/n?u=RePEc:aub:autbar:834.10&r=dge 
By:  Fernando Martin (Simon Fraser University); David Andolfatto (Simon Fraser University) 
Abstract:  Conventional theory suggests that fiat money will have value in capitalpoor economies. We demonstrate that fiat money may also have value in capitalrich economies, if the price of capital is excessively volatile. Excess assetprice volatility is generated by news; information that has no social value, but is privately useful in forming forecasts over the shortrun return to capital. One advantage of fiat money is that its expected return is not linked directly to news concerning the prospects of an underlying asset. When money and capital compete as media of exchange, excess volatility in the shortterm returns of liquid asset portfolios is mitigated and welfare is improved. A legal restriction that prohibits the use of capital as a payment instrument renders the expected return to money perfectly stable and, as a consequence, may generate an additional welfare benefit. 
Keywords:  fiat money, capital, news shocks 
JEL:  E41 E42 E52 
Date:  2009–09 
URL:  http://d.repec.org/n?u=RePEc:sfu:sfudps:dp0902&r=dge 
By:  Bichaka Fayissa; Paulos Gutema 
Abstract:  Conventional growth theories in the literature explain the poor economic performance of African economies by stressing the inadequacy of savings, human capital, and poor institutional quality. However, the key question is how to enhance savings for the accumulation of both physical and human capital in order to spur growth. A common thread that runs through the existing models is that the dependency ratio, not only remains constant over time, but has no longrun negative impact on economic growth. By relaxing this rigid assumption, this paper constructs a growth estimating equation which accommodates this demographic factor. The analytic results from the modified model suggest that economies with high dependency ratio face their stable equilibrium at lower levels of their income per capita. Moreover, econometric results from analysis of panel data drawn from SubSaharan Africa economies suggest that the growth puzzle can be well explained in terms of the demographic factors, especially the level and dynamics of dependency ratio of the region. 
Keywords:  SubSaharan Africa, growth model, dependency ratio, steady state, panel data, fixedeffects model, randomeffects model 
JEL:  R11 N3 F43 
Date:  2010–06 
URL:  http://d.repec.org/n?u=RePEc:mts:wpaper:201010&r=dge 
By:  Hubert Kempf (EEPPSE  Ecole d'Économie de Paris  Paris School of Economics  Ecole d'Économie de Paris, CES  Centre d'économie de la Sorbonne  CNRS : UMR8174  Université PanthéonSorbonne  Paris I, Banque de France  Direction de la Recherche); Grégoire RotaGraziosi (CERDI  Centre d'études et de recherches sur le developpement international  CNRS : UMR6587  Université d'Auvergne  ClermontFerrand I) 
Abstract:  This note investigates the endogenous choice of leadership in commodity tax competition. We apply an endogenous timing game, where jurisdictions commit themselves to lead or to follow, to the Kanbur and Keen (1993) model. We show that the Subgame Pefect Nash Equilibria (SPNE) correspond to the two Stackelberg situations, yielding to a coordination issue. Selecting an equilibrium by means of the riskdominance criterion, we prove that the smaller country has to lead. If asymmetry among countries is sufficient Paretodominance reinforces riskdominance in selecting the same SPE. We deduce two important results for the literature of tax competition : when countries differ sufficiently by their size, the "bigcountryhighertax" rule does not hold anymore ; when countries are close in size, tax harmonization through a unique tax rate among countries occurs without any international agreement. 
Keywords:  Commitment, commodity tax competition, strategic complements, Stackelberg equilibrium, Pareto dominance, risk dominance. 
Date:  2010–05 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:halshs00492104_v1&r=dge 