nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2010‒10‒16
twenty-two papers chosen by
Christian Zimmermann
University of Connecticut

  1. A DSGE model for Iceland By Martin Seneca
  2. New Keynesian DSGE Models and the IS-LM Paradigm By Ingrid Größl; Ulrich Fritsche
  3. Consumption Paths under Prospect Utility in an Optimal Growth Model By Reto Foellmi; Rina Rosenblatt-Wisch; Klaus Reiner Schenk-Hoppé
  4. Growth and Welfare under Endogenous Lifetime By Maik T. Schneider; Ralph Winkler
  5. Indeterminate credit cycles By Zheng Liu; Pengfei Wang
  6. Investment-specific technology shocks and consumption By Fransesco Furlanetto; Martin Seneca
  7. Public Expenditure Policy in Bolivia: Growth and Welfare By Carlos Gustavo Machicado; Paul Estrada; Ximena Flores
  8. Credit Constraints, Firms' Precautionary Investment, and the Business Cycle By Ander Pérez Orive
  9. Why Have Girls Gone to College? A Quantitative Examination of the Female College Enrollment Rate in the United States: 1955-1980 By Hui He
  10. Education and the welfare gains from employment protection By Charlot Olivier; Malherbet Franck
  11. Inequality and Aggregate Savings in the Neoclassical Growth Model By Reto Foellmi
  12. Investment - Specific Technology Shocks and International Business Cycles: An Empirical Assessment By Pau Rabanal; Juan F. Rubio-Ramirez; Federico S. Mandelman; Diego Vilan
  13. Inequality and Growth in a Knowledge Economy By Kunal Dasgupta
  14. Mortality, fertility and elderly care in a gendered growth model By Andreassen Leif
  15. Macroeconomic volatility after trade and capital account liberalization By Pancaro, Cosimo
  16. From transfers to capital: analyzing the spanish demand for wealth using NTA By Miguel Sánchez Romero; Concepcion Patxot; Elisenda Renteria; Guadalupe Souto
  17. Should Public Retirement Plans be Fully Funded? By Bohn, Henning
  18. Learning and Knowledge Diffusion in a Global Economy By Kunal Dasgupta
  19. Demographic Change in Models of Endogenous Economic Growth. A Survey. By Klaus Prettner; Alexia Prskawetz
  20. Optimal Fiscal Policy with Robust Control By Justin Svec
  21. A Note on a Rapid Grid Search Method for Solving Dynamic Programming Problems in Economics By Hui He; Hao Zhang
  22. "Non-Self-Averaging in Macroeconomic Models: A Criticism of Modern Micro-founded Macroeconomics" By Masanao Aoki; Hiroshi Yoshikawa

  1. By: Martin Seneca
    Abstract: This paper presents a dynamic stochastic general equilibrium (DSGE) model for a small open economy fitted to Icelandic data. The model has been developed at the Central Bank of Iceland as a tool for policy analysis and forecasting purposes in support of inflation targeting. As the existing macroeconometric model at the Central Bank, the model is a dynamic quarterly model. But it differs by being fully founded on well-defined microeconomic decision problems of agents in the economy. This allows for a structural interpretation of shocks to the economy. The model features endogenous capital accumulation subject to investment adjustment costs, variable capacity utilisation, habit formation in consumption, monopolistic competition in goods and labour markets, as well as sticky prices and wages. The home economy engages freely in international trade, while international financial intermediation is subject to endogenous costs. Monetary policy is conducted by an inflation targeting central bank. The model is fitted to Icelandic data for the sample period 1991-2005 through a combination of calibration and formal Bayesian estimation. The paper presents the estimation results, and it discusses the model's properties. Finally, first applications are shown to illustrate the model's potential in guiding monetary policy.
    Date: 2010–09
  2. By: Ingrid Größl (University of Hamburg); Ulrich Fritsche (University of Hamburg)
    Abstract: New Keynesian DSGE models propose a dynamic and expectational version of the old IS-LM paradigm. Acknowledging that the Taylor rule as a substitute for the LM-curve has its merits we show that standard DSGE models do not model how the central bank achieves its targets. In filling this gap we make evident that models neglecting a store-of-value function of money but still assuming a Taylor rule are inconsistent. Our major point concerns the-so called new Keynesian IS-curve. We prove that DSGE models which typically rest on the assumption of representative agents are unable to derive the IS-curve. This implies that these models lack the capability to analyse the role of savings as a a gap in aggregate demand. By assuming overlapping generations we make evident how this shortcoming can be avoided. We also show how OLG models add a richer dynamics to the standard DSGE approach.
    Date: 2010
  3. By: Reto Foellmi; Rina Rosenblatt-Wisch; Klaus Reiner Schenk-Hoppé
    Abstract: This paper studies the Cass-Koopmans-Ramsey model of optimal economic growth in the presence of loss aversion and habit formation. The representative agent's preferences for consumption can be gradually varied between the standard constant intertemporal elasticity of substitution (CIES) case and Kahneman and Tversky's prospect utility. We find that the transitional dynamics of optimal consumption paths differ distinctly from the standard model, in particular consumption smoothing is more pronounced. We also show that prospect utility can cause the economy to remain in a steady state with low consumption and low capital.
    Keywords: Ramsey growth model; prospect theory; loss aversion; optimal consumption
    JEL: E21 O41
    Date: 2010–08
  4. By: Maik T. Schneider; Ralph Winkler
    Abstract: We develop a perpetual youth model to investigate how longevity affects economic growth and welfare. Life expectancy is determined by individuals' investments in healthcare. We find that improvements in the healthcare technology always increase the steady state growth rate. Although the effect is small, even for large increases in longevity, welfare gains may be substantial depending on the type of the technological improvement. We identify two externalities associated with healthcare investments and provide a condition when healthcare expenditures are inefficiently low in the market equilibrium. Finally, we discuss our results with respect to alternative spillover specifications in the production sector.
    Keywords: economic growth; endogenous longevity; healthcare expenditures; healthcare technology; quality-quantity trade-off
    JEL: O40 I10 J10
    Date: 2010–09
  5. By: Zheng Liu; Pengfei Wang
    Abstract: We present a model with heterogeneous firms, in which credit constraints may give rise to self-fulfilling, sunspot-driven business cycle fluctuations. We derive optimal incentive-compatible loan contracts, under which a firm’s borrowing capacity is constrained by expected equity value. Interactions between debt and equity value made possible by credit constraints generate a credit externality, which leads to procyclical total factor productivity (TFP) and, with sufficiently high cost of financial intermediation, to equilibrium indeterminacy. At the aggregate level, the credit externality is observationally equivalent to production externality. Aggregate dynamics in our model with credit constraints and constant returns technology at the firm level are isomorphic to those in an aggregate economy with increasing returns, such as that studied by Benhabib and Farmer (1994).
    Keywords: Credit
    Date: 2010
  6. By: Fransesco Furlanetto; Martin Seneca
    Abstract: Modern business cycle models systematically underestimate the correlation between consumption and investment. One reason for this failure is that, generally, positive investment-specific technology shocks induce a negative consumption response. The objective of this paper is to investigate whether a positive consumption response to investment-specific technology shocks can be obtained in a modern business cycle model. We find that the answer to this question is yes. With a combination of nominal rigidities and non-separable preferences, the consumption response is positive for very general parameterisations of the model.
    Date: 2010–07
  7. By: Carlos Gustavo Machicado (Institute for Advanced Development Studies); Paul Estrada (Institute for Advanced Development Studies); Ximena Flores (Institute for Advanced Development Studies)
    Abstract: It has been widely documented that fiscal policy can promote economic growth, when it is based on an efficient provision of pubic capital. But little work has been done, in Bolivia, in relation to the macroeconomic and sectoral impacts of increasing public investment in infrastructure. This paper develops a Dynamic Stochastic General Equilibrium (DSGE) model for a small open economy with five sectors: Non-tradable or services, importable or manufacturing, hydrocarbons, mining and agriculture. The model is parameterized and solved for the Bolivian economy and several interesting scenarios are simulated by changing government expenditures, taxes, country risk, Total Factor Productivity, effectiveness of public capital and terms of trade. This analysis is relevant for the Bolivian economy, because the government is using fiscal policy as one of its main tool to attack poverty and aims to put public investment as the foremost instruments to promote growth and welfare.
    Keywords: Fiscal Policy, Infrastructure, Multisector Growth Model
    JEL: E62 H54 O41
    Date: 2010–05
  8. By: Ander Pérez Orive
    Abstract: This paper studies the macroeconomic implications of firms' precautionary investment behavior in response to the anticipation of future financing constraints. Firms increase their demand for liquid and safe investments in order to alleviate future borrowing constraints and decrease the probability of having to forego future profitable investment opportunities. This results in an increase in the share of short-term projects that produces a temporary increase in output, at the expense of lower long-run investment and future output. I show in a calibrated model that this behavior is at the source of a novel and powerful channel of shock transmission of productivity shocks that produces short-run dampening and long-run propagation. Furthermore, it can account for the observed business cycle patterns of the aggregate and firm-level composition of investment.
    Keywords: Investment Choice, Financial Frictions, Business Cycles, Idiosyncratic Production Risk.
    JEL: D92 E22 E32 G32
    Date: 2010–09
  9. By: Hui He (University of Hawaii at Manoa, Department of Economics)
    Abstract: This paper documents a dramatic increase in the college enrollment rate of women from 1955 to 1980 and asks a quantitative question: to what extent can such increase be accounted for by the change in the female cohort-specific college wage premium? I develop and calibrate an overlapping generations model with discrete schooling choice. I find that changes in the life-cycle earnings differential can explain the increase in the female college enrollment rate very well. Young women's changing expectations of future earnings may also play an important role in driving their college attendance decision.
    Keywords: Female College Enrollment rate, College Wage Premium, Life-cycle
    JEL: E24 J24 J31 I21
    Date: 2010–09–17
  10. By: Charlot Olivier; Malherbet Franck (Universite de Cergy-Pontoise, THEMA, F-95000 Cergy-Pontoise.; Universite de Cergy-Pontoise, THEMA, F-95000 Cergy-Pontoise, IZA and fRDB.)
    Abstract: In this paper, we generalize the study of the return to education undertaken in e.g. Laing, Palivos and Wang (1995) or Burdett and Smith (2002) to an environment where the link between education and employment stability is taken into account. This enables us to study how an European-like and Employment Protection Legislation (EPL) with heavily regulated long-term contracts and more flexible short-term contracts affects the return to schooling, equilibrium unemployment and welfare. In this context, we show that ¯ring costs and temporary employment have opposite effects on the rate of use of human capital and thus, on educational investments. We furthermore demonstrate that a laissez faire economy with no regulation is inefficient as it is characterized by insufficient educational investments leading to excess job destruction and inadequate job creation. By stabilizing employment relationships, firing costs may spur educational investments and therefore lead to welfare and productivity gains, though a first-best policy would be to subsidize education. However, there is little chance for a dual (European-like) EPL to raise the incentives to schooling and aggregate welfare.
    Keywords: human capital; job destruction; matching frictions; efficiency
    JEL: I20 J20 J60
    Date: 2010
  11. By: Reto Foellmi
    Abstract: Within the context of the neoclassical growth model I investigate the implications of (initial) endowment inequality when the rich have a higher marginal savings rate than the poor. More unequal societies grow faster in the transition process, and therefore exhibit a higher speed of convergence. Furthermore, there is divergence in consumption and lifetime wealth if the rich exhibit a higher intertemporal elasticity of substitution. Unlike the Solow-Stiglitz model, the steady state is always unique although the consumption function is concave.
    Keywords: Marginal propensity to consume; income distribution; growth; concave consumption funktion
    JEL: O40 D30 O10
    Date: 2010–08
  12. By: Pau Rabanal; Juan F. Rubio-Ramirez; Federico S. Mandelman; Diego Vilan
    Abstract: In this paper, we first introduce investment-specific technology (IST) shocks to an otherwise standard international real business cycle model and show that a thoughtful calibration of them along the lines of Raffo (2009) successfully addresses the "quantity", "international comovement", "Backus-Smith", and "price" puzzles. Second, we use OECD data for the relative price of investment to build and estimate these IST processes across the U.S and a "rest of the world" aggregate, showing that they are cointegrated and well represented by a vector error correction model (VECM). Finally, we demonstrate that when we fit such estimated IST processes in the model instead of the calibrated ones, the shocks are actually not as powerful to explain any of the four montioned puzzles.
    Keywords: Business cycles , Consumption , Cross country analysis , Demand , Economic models , External shocks , International trade , Investment , Productivity , United States ,
    Date: 2010–09–09
  13. By: Kunal Dasgupta
    Abstract: We develop a two sector growth model to understand the relation between inequality and growth. Agents, who are endowed with different levels of knowledge, select either into a retail or a manufacturing sector. Agents in the manufacturing sector match to carry out production. A by-product of production is creation of ideas that spill over to the retail sector and improve productivity, thereby causing growth. Ideas are generated according to an idea production function that takes the knowledge of all the agents in a firm as arguments. We go on to study how an increase in the inequality of the knowledge distribution affects the growth rate. A change in the distribution not only affects the occupational choice of agents, but also the way agents match within the manufacturing sector. We show that if the idea generation function is sufficiently convex, an increase in inequality raises the growth rate of the economy.
    Keywords: Inequality, growth, idea generation, matching, knowledge
    JEL: O30 O40 O41
    Date: 2010–09–30
  14. By: Andreassen Leif (University of Turin)
    Abstract: The paper studies the interaction of publicly provided care for the elderly on demographic developments. A two-sex OLG model is used to examines how exogenous changes in mortality, the cost of children and the bargaining power of women influence fertility, public and private care for the elderly, and the length of education taken by women and men. The paper focuses especially on the interaction between declining mortality and the expansion of care for the elderly. In the model declining mortality can affect fertility differently according to how developed the economy is. At an early development stage, when public care is little developed, the effect of decreasing mortality on fertility can be positive, while at a later stage with higher levels of public care, the effect can be negative. The model is consistent with observed developments over the last century including fluctuations and decline in fertility, increases in the average age of giving birth, increasing levels of education with lessening differences in the education levels of women and men, increasing incomes, and increased public care for the elderly. In a small open economy where individuals live for five periods with uncertain lifetimes, the choices made by males and females are the result of a combination of utility maximization and negotiation. First, bargaining positions are formed through utility maximization given individual budget constraints, then the Nash bargaining solution determines the number of children and voting determines the level of public care for the elderly, and finally couples maximize a joint household welfare function to determine education, private care for the elderly and consumption. The only exogenous differences between women and men concern mortality, bargaining power and required time devoted to raising young children; otherwise women and men have identical utility functions and opportunities. Functional forms are chosen so that the model has a recursive nature with simple closed form solutions.
    Date: 2010–07
  15. By: Pancaro, Cosimo
    Abstract: What are the equilibrium effects of trade and capital liberalization on consumption smoothing? This question is addressed by studying the response to productivity shocks in a baseline two country, two goods, incomplete market model, where foreign borrowing is secured by collateral. The paper shows that international financial integration, modeled by relaxing a borrowing constraint a la Kiyotaki in the domestic country, worsens consumption smoothing; international trade integration, modeled by a reduction of non linear iceberg transportation costs, improves it. As a measure of consumption smoothing, the analysis uses the ratio between the simulated standard deviation of consumption growth and the simulated standard deviation of output growth. These results are qualitatively consistent with the empirical evidence provided by Kose, Prasad and Terrones (2003).
    Keywords: Emerging Markets,Economic Theory&Research,Free Trade,Debt Markets,Trade Policy
    Date: 2010–10–01
  16. By: Miguel Sánchez Romero (Max Planck Institute for Demographic Research, Rostock, Germany); Concepcion Patxot; Elisenda Renteria; Guadalupe Souto
    Abstract: Inter- and intra-family transfers are a very important part of our daily economic activity. These transfers, whether familial or public, may influence our economic decisions to the same extent that financial markets do. In this paper, we seek to understand how the Spanish stock of capital will evolve if the set of intergenerational transfers observed in year 2000 are maintained in the future. With that aim in mind, we have implemented a general equilibrium overlapping generations model with realistic public and familial transfers drawn from the National Transfer Accounts project (NTA). Given that familial transfers go from parents to children, and public transfers go from children to parents, we show that the Spanish baby boom and baby bust will make the second demographic dividend temporary, and that welfare will be reduced from 2040 onwards.
    Keywords: Spain, demographic ageing, economic demography, economic growth
    JEL: J1 Z0
    Date: 2010–10
  17. By: Bohn, Henning
    Abstract: Most state and local retirement plans strive for full funding, at least by actuarial standards. Funding measured at market values fluctuates and often falls short. A common argument for full funding is that pensions are a form of deferred compensation that does not justify a debt. The paper examines public finance, political economy, and financial market issues that bear on optimal funding, broadly and in a series of models. In a model where most taxpayers hold debt and face intermediation costs, returns on pension assets are less than taxpayers’ cost of borrowing. Pension funding is costly and hence zero funding is optimal. The model also implies that unfunded pension promises are properly discounted at a rate strictly greater than the government’s borrowing rate. If pension funds serve as collateral, funding can be warranted despite the cost. This is shown in a model with legal ambiguity and default risk. Except in special cases, the optimal funding ratio is less than full funding.
    Keywords: Public pensions, pension funding
    Date: 2010–09–01
  18. By: Kunal Dasgupta
    Abstract: I develop a dynamic general equilibrium model to understand how multinationals affect host countries through knowledge diffusion. Workers in the model learn from their managers and knowledge diffusion takes place through worker mobility. Unlike in a model without learning, I present a novel mechanism through which an integrated equilibrium represents a Pareto improvement for the host country. I go on to explore other dynamic consequences of integration. The entry of multinationals makes the lifetime earning profiles of host country workers steeper. At the same time, if agents learn fast enough, integration creates unequal opportunities, thereby widening inequality. The ex-workers of foreign multinationals also found new firms which are, on average, larger than the largest firms under autarky.
    Keywords: Multinationals, knowledge diffusion, learning, worker mobility, Pareto improvement, spin-offs.
    JEL: F15 F23 F40
    Date: 2010–09–30
  19. By: Klaus Prettner; Alexia Prskawetz
    Abstract: The purpose of this article is to identify the role of population size, population growth and population ageing in models of endogenous economic growth. While in exogenous growth models demographic variables are linked to economic prosperity mainly via the population size, the structure of the workforce, and the capital intensity of workers, endogenous growth models and their successors also allow for interrelationships between demography and technological change. However, most of the existing literature considers only the interrelationships based on population size and its growth rate and does not explicitly account for population ageing. The aim of this paper is (a) to review the role of population size and population growth in the most commonly used economic growth models (with a focus on endogenous economic growth models), (b) discuss models that also allow for population ageing, and (c) sketch out the policy implications of the most commonly used endogenous growth models and compare them to each other.
    Keywords: Demographic change, endogenous R&D, economic growth
    Date: 2010–10
  20. By: Justin Svec (Department of Economics, College of the Holy Cross)
    Abstract: This paper compares the fiscal policies implemented by two types of government when confronted by consumer uncertainty. Consumers, lacking confidence in their knowledge of the stochastic environment, endogenously tilt their subjective probability model away from an approximating probability model. The government does not face this uncertainty. Through its choice of a labor tax and the supply of one-period public debt, the government manipulates the competitive equilibrium allocation and the consumers' probability distortion. I consider two types of altruistic government. A "benevolent" government maximizes the consumers' expected utility under the approximating probability model, whereas a "political" government maximizes the consumers' expected utility under the consumers' subjective probability model. I find that, relative to a full-confidence setup, the benevolent government relies more heavily on labor taxes to finance fluctuations in spending, while the political government depends more on public debt to absorb the fiscal shock. These policies are designed to re-align the consumers' savings decisions with their full-confidence values and to reduce the fluctuations in the consumers' welfare across states, respectively.
    Keywords: Robust control, uncertainty, taxes, debt, Ramsey problem
    JEL: E61 E62 H21
    Date: 2010–10
  21. By: Hui He (University of Hawaii at Manoa, Department of Economics); Hao Zhang (University of Hawaii at Manoa, Department of Economics)
    Abstract: We introduce a rapid grid search method in solving the dynamic programming problems in economics. Compared to mainstream grid search methods, by using local information of the Bellman equation, this method can significantly increase the efficiency in solving dynamic programming problems by reducing the grid points searched in the control space.
    Keywords: Dynamic Programming, Grid Search, Control Space
    JEL: C63 C61 C68
    Date: 2010–09–17
  22. By: Masanao Aoki (Department of Economics, University of California, Los Angeles); Hiroshi Yoshikawa (Faculty of Economics, University of Tokyo)
    Abstract: When the coefficient of variation, namely the standard deviation relative to mean approaches zero as the number of economic agents becomes large, the system is called self-averaging. Otherwise, it is non-self-averaging. Most economic models take it for granted that economic system is self-averaging. However, they are based on an extremely unrealistic assumption that all the economic agents face the same probability distribution. Once this unrealistic assumption is dropped, non-self averaging naturally emerges. Using a simple stochastic growth model, this paper demonstrates that the coefficient of variation of aggregate output or GDP does not go to zero even if the number of sectors or economic agents goes to infinity. Non-self-averaging implies that even if the number of economic agents is large, dispersion can remain significant, and, therefore, that we can not legitimately focus on the means of aggregate variables. It, in turn, means that the standard microeconomic foundations based on representative agents has little value for they are meant to provide us with accurate dynamics of the means of aggregate variables. Contrary to the main stream view, micro-founded macroeconomics such as a dynamic general equilibrium model does not provide solid micro foundations.
    Date: 2010–09

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