nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2011‒08‒29
twenty-six papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Credit Shocks and Aggregate Fluctuations in an Economy with Production Heterogeneity By Aubhik Khan; Julia K. Thomas
  2. A model of borrower reputation as intangible collateral By Nikolov, Kalin
  3. How Institutions Shape the Distributive Impact of Macroeconomic Shocks: A DSGE Analysis By Rudiger Ahrend; Charlotte Moeser; Tommaso Monacelli
  4. Old-age Social Security vs. Forward Intergenerational Public Goods Provision By Ryo Arawatari; Tetsuo Ono
  5. Do investment-specific technological changes matter for business fluctuations? Evidence from Japan By Hirose, Yasuo; Kurozumi, Takushi
  6. Optimal Unemployment Insurance in GE: a Robust Calibration Approach By Marco Cozzi
  7. Wage Dispersion and Labour Turnover with Adverse Selection By Carlos Carrillo-Tudela; Leo Kaas
  8. Transition Dynamics in the Neoclassical Growth Model: The Case of South Korea By Yongsung Chang; Andreas Hornstein
  9. The Role of Frictions on Academic Recruitment System By Bonaventura, Luigi
  10. A Framework for Pension Policy Analysis in Ireland: PENMOD, a Dynamic Simulation Model By Callan, Tim; Van de Ven, Justin
  11. Maturity, indebtedness, and default risk By Satyajit Chatterjee; Burcu Eyigungor
  12. A Model of the Consumption Response to Fiscal Stimulus Payments By Greg Kaplan; Giovanni L. Violante
  13. The Curse of the Elders? Aid Effectiveness and Gerontocracy in Developing Countries By Marc Raffinot; Baptiste Venet
  14. Country Size, International Trade, and Aggregate Fluctuations in Granular Economies By Julian di Giovanni; Andrei A. Levchenko
  15. Fixed Exchange Rate Versus Inflation Targeting: Evidence from DSGE Modelling By Viktors Ajevskis; Kristine Vitola
  16. Dynamically optimal R&D subsidization By Grossmann, Volker; Steger, Thomas M.; Trimborn, Timo
  17. The Effect of Interventions to Reduce Fertility on Economic Growth By Quamrul H. Ashraf; David N. Weil; Joshua Wilde
  18. Optimal Fiscal Policy with Endogenous Product Variety By Sanjay K. Chugh; Fabio Ghironi
  19. Inflation Persistence and Exchange Rate Regime: Implications for dynamic adjustment to shocks in a small open economy By Karlygash Kuralbayeva
  20. Economic integration and the optimal corporate tax structure with heterogeneous firms By Christian Bauer; Ronald B Davies; Andreas Haufler
  21. Rare Macroeconomic Disasters By Robert J. Barro; José F. Ursua
  22. A Long-Run, Short-Run and Politico-Economic Analysis of the Welfare Costs of Inflation By Scott J. Dressler
  23. Asset Liquidity and International Portfolio Choice By Athanasios Geromichalos; Ina Simonovska
  24. Liquidity When It Matters Most: QE and Tobin’s q By Driffill, John; Miller, Marcus
  25. Fiscal Volatility Shocks and Economic Activity By Jesús Fernández-Villaverde; Pablo A. Guerrón-Quintana; Keith Kuester; Juan Rubio-Ramírez
  26. From Tradition to Modernity: Economic Growth in a Small World By Lindner, Ines; Strulik, Holger

  1. By: Aubhik Khan; Julia K. Thomas
    Abstract: We study the cyclical implications of credit market imperfections in a calibrated dynamic, stochastic general equilibrium model wherein firms face persistent shocks to aggregate and individual productivity. In our model economy, optimal capital reallocation is distorted by two frictions: collateralized borrowing and partial capital irreversibility yielding (S,s) firm-level investment policies. In the presence of persistent heterogeneity in capital, debt and total factor productivity, the effects of a financial shock are amplified and propagated through large and long-lived disruptions to the distribution of capital that, in turn, imply large and persistent reductions in aggregate total factor productivity. We find that an unanticipated tightening in borrowing conditions can, on its own, generate a large recession far more persistent than the financial shock itself. This recession, and the subsequent recovery, is distinguished both quantitatively and qualitatively from that driven by exogenous shocks to total factor productivity.
    JEL: E22 E32 E44
    Date: 2011–08
  2. By: Nikolov, Kalin
    Abstract: In this paper, we build a framework which can generate endogenous fluctuations in downpayment requirements. We extend the model of Kiyotaki and Moore (1997) by considering an environment, in which savers can keep their anonymity but borrowers cannot. This allows lenders to punish defaulting borrowers by excluding them from future borrowing. They cannot however stop them from saving in the anonymous financial market. We show how the possibility of such market exclusion can lead to the emergence of intangible collateral in equilibrium alongside the tangible collateral which is usually studied in the literature. Fluctuations in the value of intangible collateral are isomorphic to fluctuations in the amount of borrowing firms can secure against the value of their tangible assets. We find that, when we combine the intangible collateral mechanism in our paper with counter-cyclical variance of idiosyncratic productivity shocks, this helps to generate realistic negative co-movement of downpayment requirements and aggregate output over the business cycle. In this case, the presence of intangible collateral increases the amplification of business cycle fluctuations relative to the standard Kiyotaki-Moore (1997) model.
    Keywords: Collateral constraints; Aggregate fluctuations
    JEL: E32
    Date: 2011
  3. By: Rudiger Ahrend; Charlotte Moeser; Tommaso Monacelli
    Abstract: This paper examines how the the distributive impact of macroeconomic shocks is shaped by selected institutions. It uses a dynamic stochastic general equilibrium (DSGE) framework with heterogeneous agents and an endogenous collateral constraint. The model is based on the “credit view” of business cycles, where shocks affect the real economy also via their impact on the borrowing capacity of economic agents. In this framework a positive shock to credit spreads, as seen in the recent crisis, redistributes from capital to labour as well as from from equity to bond holders. In contrast, both productivity and inflation shocks redistribute towards capital or equity holders. Distributive impacts are shown to be shaped by institutions. More sophisticated financial markets are found to amplify the redistributive impact of shocks, whereas more flexible wages, a more elastic labour supply, and a more reactive central bank are found to dampen it.<P>Comment les institutions influencent la redistribution liée aux chocs macroéconomiques<BR>L'article analyse comment les institutions influencent la redistribution qui résulte des chocs macroéconomiques. Premièrement, l'article propose un modèle à agents hétérogènes en équilibre général à dynamique stochastique où les contraintes de crédit sont endogènes. Les chocs macroéconomiques sont transmis à l'activité économique directement et indirectement, via les contraintes de crédit des agents. Dans ce modèle, un choc positif sur les spreads de crédits, comme lors de la dernière crise, affecte moins les agents détenant du travail que ceux qui détiennent du capital, et affecte moins les agents qui détiennent des obligations que des actions. Au contraire, les agents détenant du travail et des obligations sont plus vulnérables aux chocs inflationnistes et aux chocs de productivité. Deuxièmement, l'article évalue comment les institutions influencent la redistribution liée aux chocs macroéconomiques. La sophistication des marchés financiers apparaît amplifier la redistribution liée aux chocs macroéconomiques, tandis que la flexibilité des salaires, l'élasticité de l'offre de travail et la réactivité des banques centrales, apparaissent limiter celle-ci.
    Keywords: institutions, shocks, income distribution, DSGE, heterogeneous agents, credit frictions, institutions, distribution des revenus, chocs macroéconomiques, agents hétérogènes, modèle d'équilibre général à dynamique stochastique, contraintes de crédit
    JEL: D31 D58 E21 E44
    Date: 2011–07–21
  4. By: Ryo Arawatari (yGraduate School of Economics, Nagoya University, Furo-cho, Chikusa-ku, Nagoya); Tetsuo Ono (Graduate School of Economics, Osaka University)
    Abstract: This paper introduces an overlapping-generations model with earnings hetero- geneity and borrowing constraints. The labor income tax and the allocation of tax revenue across social security and forward intergenerational public goods are determined in a bidimensional majoritarian voting game played by successive gen- erations. The political equilibrium is characterized by an ends-against-the-middle equilibrium where low- and high-income individuals form a coalition in favor of a low tax rate and less social security while middle-income individuals favor a high tax rate and greater social security. Government spending then shifts from social security to public goods provision if higher wage inequality is associated with the borrowing constraint and a low interest-rate elasticity of consumption.
    Keywords: Borrowing constraint; Old-age social security; Forward intergenera- tional public goods; Ends-against-the-middle equilibrium; Wage inequality
    JEL: H41 H55 D72
    Date: 2011–08
  5. By: Hirose, Yasuo; Kurozumi, Takushi
    Abstract: The observed decline in the relative price of investment goods to consumption goods in Japan suggests the existence of investment-specific technological (IST) changes. We examine whether IST changes are a major source of business fluctuations in Japan, by estimating a dynamic stochastic general equilibrium model with Bayesian methods. We show that IST changes are less important than neutral technological changes in explaining output fluctuations. We also demonstrate that investment fluctuations are mainly driven by shocks to investment adjustment costs. Such shocks represent variations of costs involved in changing investment spending, such as financial intermediation costs. We then find that the estimated series of the investment adjustment cost shock correlates strongly with the diffusion index of firms' financial position in the Tankan (Short-term Economic Survey of Enterprises in Japan). We thus argue that the large decline in investment growth in the early 1990s is due to an increase in investment adjustment costs stemming from firms' tight financial constraint after the collapse of Japan's asset price bubble.
    Keywords: Business fluctuation; Investment-specific technology; Investment adjustment cost shock; Financial intermediation cost; Firms' financial constraint
    JEL: E32 E31 E22
    Date: 2011–03–07
  6. By: Marco Cozzi (Queen’s University)
    Abstract: This paper implements a simple Bayesian approach to quantitatively study the Hansen and Imrohoroglu (1992) economy, a calibrated GE model with uninsurable employment risk, designed to assess the optimal replacement rate for a public Unemployment Insurance scheme. The results of this sensitivity analysis are consistent with the original findings, but with several caveats. One novel result in particular is that the distribution of the optimal UI is bimodal. Depending on the calibrated parameters, the optimal UI is in one of two regimes: a very generous scheme with high replacement ratios, where insurance is mainly provided by the UI scheme, or one with low replacement ratios, where insurance is mainly achieved through self-insurance. Even in the absence of moral hazard, it is never optimal to provide full insurance. Moreover, for many plausible parameters’ configurations, the welfare maximizing replacement rate does not decrease with the level of MH. The qualitative patterns and quantitative findings are not altered substantially when considering an enlarged labor force, which includes the marginally attached workers. Finally, the parameters representing the hours worked, the leisure share in the households’ consumption bundle, and the intertemporal elasticity of substitution have a first order impact on the average welfare. The determination of the optimal UI scheme depends heavily on them. This finding suggests that extra caution should be paid when calibrating these parameters in similar environments.
    Keywords: Calibration methods, Unemployment Risk, Optimal Unemployment Insurance, Heterogeneous Agents, Incomplete Markets, Computable General Equilibrium, Monte Carlo
    JEL: E21 D52 D58
    Date: 2011–08
  7. By: Carlos Carrillo-Tudela (Department of Economics, University of Essex, United Kingdom); Leo Kaas (Department of Economics, University of Konstanz, Germany)
    Abstract: We consider a model of on-the-job search where firms offer long-term wage contracts to workers of different ability. Firms do not observe worker ability upon hiring but learn it gradually over time. With sufficiently strong information frictions, low-wage firms offer separating contracts and hire all types of workers in equilibrium, whereas high-wage firms offer pooling contracts designed to retain high-ability workers only. Low-ability workers have higher turnover rates, they are more often employed in low-wage firms and face an earnings distribution with a higher frictional component. Furthermore, positive sorting obtains in equilibrium.
    Keywords: Adverse Selection, On-the-job Search, Wage Dispersion, Sorting
    JEL: D82 J63 J64
    Date: 2011–08–16
  8. By: Yongsung Chang (University of Rochester); Andreas Hornstein (Federal Reserve Bank of Richmond)
    Abstract: Many cases of successful economic development, such as South Korea, exhibit long periods of sustained capital accumulation rates. This empirical feature is at odds with the standard neoclassical growth model which predicts initially high and then declining capital accumulation rates. We show that minor modifications of the neoclassical model go a long way towards accounting for the transition dynamics of the South Korean economy. Our modifications recognize that (1) agriculture essentially does not use reproducible capital, and that during the transition period (2) the relative price of capital declines substantially, and (3) the nonfarm employment share increases substantially.
    Keywords: neoclassical growth model, transition dynamics, industrialization, price of capital, South Korea
    JEL: E13 E22 O11 O13 O14 O16 O4 O53
    Date: 2011–07
  9. By: Bonaventura, Luigi (University of Catania, Department of Economics and Quantitative Methods)
    Abstract: In a matching model of the academic labour market, with high-skilled (brain) and low-skilled (local) workers, this paper shows that brain workers are harmed by the local. This depends on two types of search frictions: information and cooptation frictions. Search frictions reduce the probability to get an academic job for brain workers compared to the local. A high level of cooptation discards the brain workers but, under certain conditions, the absence of cooptation does not decreases the possibility to get an academic job for the local workers. Whithin this framework, some explanations about the low probability to catch the brains and the obstacles for a e ective equal opportunity between local and outside candidates are discussed.
    Keywords: academic labour market; search frictions; cooptation; recruitment system.
    JEL: I23 J45 J71
    Date: 2011–06–01
  10. By: Callan, Tim; Van de Ven, Justin
    Abstract: This paper describes a structural dynamic microsimulation model of the household that has been developed to explore behavioural responses to pensions policy counterfactuals in Ireland. The model is based upon the life-cycle theory of behaviour, which assumes that individuals make their decisions to maximise expected lifetime utility, subject to expectations that are consistent with the prevailing decision making environment. The model is calibrated to match Irish survey data.
    Keywords: data/Dynamic Programming,Savings,Labor Supply,Pensions/Individuals/Ireland
    JEL: C51 C61 C63 H31
    Date: 2011–08
  11. By: Satyajit Chatterjee; Burcu Eyigungor
    Abstract: In this paper, the authors advance the theory and computation of Eaton-Gersovitz style models of sovereign debt by incorporating long-term debt and proving the existence of an equilibrium price function with the property that the interest rate on debt is increasing in the amount borrowed and implementing a novel method of computing the equilibrium accurately. Using Argentina as a test case, they show that incorporating long-term debt allows the model to match the average external debt-to-output ratio, average spread on external debt, the standard deviation of spreads and simultaneously improve upon the model's ability to account for Argentina's other cyclical facts.
    Keywords: Debts, Public ; Debts, External
    Date: 2011
  12. By: Greg Kaplan; Giovanni L. Violante
    Abstract: A wide body of empirical evidence, based on randomized experiments, finds that 20-40 percent of fiscal stimulus payments (e.g. tax rebates) are spent on nondurable household consumption in the quarter that they are received. We develop a structural economic model to interpret this evidence. Our model integrates the classical Baumol-Tobin model of money demand into the workhorse incomplete-markets life-cycle economy. In this framework, households can hold two assets: a low-return liquid asset (e.g., cash, checking account) and a high-return illiquid asset (e.g., housing, retirement account) that carries a transaction cost. The optimal life-cycle pattern of wealth accumulation implies that many households are "wealthy hand-to-mouth" : they hold little or no liquid wealth despite owning sizeable quantities of illiquid assets. They therefore display large propensities to consume out of additional income. We document the existence of such households in data from the Survey of Consumer Finances. A version of the model parameterized to the 2001 tax rebate episode is able to generate consumption responses to fiscal stimulus payments that are in line with the data.
    JEL: D31 D91 E21 H31
    Date: 2011–08
  13. By: Marc Raffinot (LEDa, UMR DIAL-Paris-Dauphine); Baptiste Venet (LEDa, UMR DIAL-Paris-Dauphine)
    Abstract: (english) In this paper we use a simple standard overlapping-generation model to assess the impact of foreign aid. Because of deference to the elders, donors are not able to modify the sharing out of aid between the old and the young in the recipient economy. The model shows that, if aid is considered as a device intended to help attain the spontaneous steady state of the economy, it may lead to a rise or fall in savings, and hence in the growth rate of the economy, depending on a threshold share of aid accruing to elders. Alternately, if aid is intended to help the economy to reach its golden-rule steady state, the relevant level of aid increases with the share of aid accruing to elders, up to a certain threshold. If this share is higher than the threshold, the optimal level of aid is negative. _________________________________ (français) Nous utilisons un modèle à générations imbriquées pour montre que la répartition de l’aide entre jeunes et vieux peut avoir un impact sur l’efficacité de l’aide en termes d’épargne, de croissance et de bien-être. Les sociétés en développement sont généralement marquées par une « déférence pour les anciens » profondément ancrée dans la culture traditionnelle. Nous supposons que les donateurs sont incapables de manipuler cette part, et nous montrons que la part de l’aide qui revient aux vieux a un impact sur la croissance et le bien-être positif en dessous d’un certain seuil et négatif au-delà.
    Keywords: Developing Countries, Elders, Aid effectiveness, Overlapping Generations Models.
    JEL: E61 F35 F43 O11 O19
    Date: 2011–01
  14. By: Julian di Giovanni; Andrei A. Levchenko
    Abstract: This paper proposes a new mechanism by which country size and international trade affect macroeconomic volatility. We study a multi-country, multi-sector model with heterogeneous firms that are subject to idiosyncratic firm-specific shocks. When the distribution of firm sizes follows a power law with an exponent close to -1, the idiosyncratic shocks to large firms have an impact on aggregate output volatility. We explore the quantitative properties of the model calibrated to data for the 50 largest economies in the world. Smaller countries have fewer firms, and thus higher volatility. The model performs well in matching this pattern both qualitatively and quantitatively: the rate at which macroeconomic volatility decreases in country size in the model is very close to what is found in the data. Opening to trade increases the importance of large firms to the economy, thus raising macroeconomic volatility. Our simulation exercise shows that the contribution of trade to aggregate fluctuations depends strongly on country size: in the largest economies in the world, such as the U.S. or Japan, international trade increases volatility by only 1.5-3.5%. By contrast, trade increases aggregate volatility by some 15-20% in a small open economy, such as Denmark or Romania.
    JEL: F12 F15 F41
    Date: 2011–08
  15. By: Viktors Ajevskis; Kristine Vitola
    Abstract: We evaluate implications of inflation targeting versus fixed exchange rate regime for the UK, Sweden, Poland, the Czech Republic, Estonia, Latvia and Lithuania, i.e. seven EU non-euro area countries. To this end, we estimate a small open economy DSGE model and simulate a model under estimated structural parameters and different sets of policy parameters. The results obtained are compared in terms of inflation, output gap and interest rate volatility. For inflation targeting countries, a policy switch to fixed exchange rate would entail 3–6 times higher inflation volatility. In the Baltic economies, a policy change to inflation targeting with fully flexible exchange rate would amplify inflation volatility 2–4 times, whereas the existing price stabilisation and exchange rate fluctuations within the ERM II bands would entail 3–6 times more volatile inflation. Policy simulations thus show evidence that in all the countries the existing monetary rule guarantees more stable inflation and output than under alternative regimes.
    Keywords: DSGE, small open economy, fixed exchange rate, inflation targeting, Bayesian estimation
    JEL: C11 C3 C51 D58 E58 F41
    Date: 2011–07–25
  16. By: Grossmann, Volker; Steger, Thomas M.; Trimborn, Timo
    Abstract: Previous research on optimal R&D subsidies has focussed on the long run. This paper characterizes the optimal time path of R&D subsidization in a semi-endogenous growth model, by exploiting a recently developed numerical method. Starting from the steady state under current R&D subsidization in the US, the R&D subsidy should significantly jump upwards and then slightly decrease over time. There is a negligible loss in welfare, however, from immediately setting the R&D subsidy to its optimal long run level, compared to the case where the dynamically optimal policy is implemented. --
    Keywords: R&D subsidy,transitional dynamics,semi-endogenous growth,welfare
    JEL: H20 O30 O40
    Date: 2011
  17. By: Quamrul H. Ashraf (Williams College); David N. Weil (Brown University); Joshua Wilde (University of South Florida)
    Abstract: We assess quantitatively the effect of exogenous reductions in fertility on output per capita. Our simulation model allows for effects that run through schooling, the size and age structure of the population, capital accumulation, parental time input into child-rearing, and crowding of fixed natural resources. The model is parameterized using a combination of microeconomic estimates, data on demographics and natural resource income in developing countries, and standard components of quantitative macroeconomic theory. We apply the model to examine the effect of an intervention that immediately reduces TFR by 1.0, using current Nigerian vital rates as a baseline. For a base case set of parameters, we find that an immediate decline in the TFR of 1.0 will raise output per capita by approximately 13.2 percent at a horizon of 20 years, and by 25.4 percent at a horizon of 50 years.
    Keywords: Fertility, Population size, Age structure, Child quality, Worker experience, Labor force participation, Capital accumulation, Natural resources, Income per capita
    JEL: E17 J11 J13 J18 J21 J22 J24 O11 O13 O55
    Date: 2011–08
  18. By: Sanjay K. Chugh; Fabio Ghironi
    Abstract: We study Ramsey-optimal fiscal policy in an economy in which product varieties are the result of forward-looking investment decisions by firms. There are two main results. First, depending on the particular form of variety aggregation in preferences, firms' dividend payments may be either subsidized or taxed in the long run. This policy balances monopoly incentives for product creation with consumers' welfare benefit of product variety. In the most empirically relevant form of variety aggregation, socially efficient outcomes entail a substantial tax on dividend income, removing the incentive for over-accumulation of capital, which takes the form of variety. Second, optimal policy induces dramatically smaller, but efficient, fluctuations of both capital and labor markets than in a calibrated exogenous policy. Decentralization requires zero intertemporal distortions and constant static distortions over the cycle. The results relate to Ramsey theory, which we show by developing welfare-relevant concepts of efficiency that take into account product creation.
    JEL: E32 E62 H21
    Date: 2011–08
  19. By: Karlygash Kuralbayeva
    Abstract: The paper examines implications of inflation persistence for business cycle dynamics following terms of trade shock in a small oil producing economy, under inflation targeting and exchange rate targeting regimes. It is shown that due to the 'Walters critique' effect, the country's adjustment paths are slow and cyclical if there is a significant backward-looking element in the inflation dynamics and the exchange rate is fixed. It is also shown that such cyclical adjustment paths are moderated if there is a high proportion of forward-looking price setters in theh economy, so that when the Phillips curve becomes completely forward-looking cyclicality in adjustment paths disappears and the response of the real exchange rate becomes hump-shaped. In contrast, with an independent monetary policy, irrespective of the degree of inflation persistence, flexible exchange rate allows to escape severe cycles, which results in a smooth response of the real exchange rate.
    Keywords: inflation inertia, inflation targeting, exchange rate targeting, Phillips curve, oil shocks, small open economy
    JEL: E32 F40 F41
    Date: 2011
  20. By: Christian Bauer (University of Munich); Ronald B Davies (University College Dublin); Andreas Haufler (University of Munich)
    Abstract: We study the optimal combination of corporate tax rate and tax base in a model of a small open economy with heterogeneous firms. We show that it is optimal for the small country's government to effectively subsidize capital inputs by granting a tax allowance in excess of the true costs of capital. Economic integration reduces the optimal capital subsidy and drives low-productivity firms from the small country's home market, replacing them with high-productivity exporters from abroad. This endogenous policy response creates a selection effect that increases the average productivity of home firms when trade barriers fall, in addition to the well-known direct effects.
    Keywords: corporate tax reform, trade liberalization, firm heterogeneity
    Date: 2011–08–23
  21. By: Robert J. Barro; José F. Ursua
    Abstract: The potential for rare macroeconomic disasters may explain an array of asset-pricing puzzles. Our empirical studies of these extreme events rely on long-term data now covering 28 countries for consumption and 40 for GDP. A baseline model calibrated with observed peak-to-trough disaster sizes accords with the average equity premium with a reasonable coefficient of relative risk aversion. High stock-price volatility can be explained by incorporating time-varying long-run growth rates and disaster probabilities. Business-cycle models with shocks to disaster probability have implications for the cyclical behavior of asset returns and corporate leverage, and international versions may explain the uncovered-interest-parity puzzle. Richer models of disaster dynamics allow for transitions between normalcy and disaster, bring in post-crisis recoveries, and use the full time series on consumption. Potential future research includes applications to long-term economic growth and environmental economics and the use of stock-price options and other variables to gauge time-varying disaster probabilities.
    JEL: E01 E44 G12 G15
    Date: 2011–08
  22. By: Scott J. Dressler (Department of Economics and Statistics, Villanova School of Business, Villanova University)
    Abstract: This paper assesses the long-run and short-run (i.e. along the transition path) welfare implications of permanent changes in inflation in an environment with essential money and perfectly competitive markets. The model delivers a monetary distribution that matches moments of the distribution seen in the US data. Although there is potential for wealth redistribution to deliver welfare gains from inflation, the (total) costs of 10 percent inflation relative to zero is over 7 percent of consumption. While these results suggest a dominating real-balance effect of inflation, a politico-economic analysis concludes that the prevailing (majority rule) inflation rate is above the Friedman Rule.
    Keywords: Inflation; Welfare; Transitions; Voting
    JEL: E40 E50
    Date: 2011–08
  23. By: Athanasios Geromichalos; Ina Simonovska
    Abstract: We study optimal asset portfolio choice in a two-country search-theoretic model of monetary exchange. We allow assets not only to represent claims on future consumption, but also to serve as means of payment. Assuming foreign assets trade at a cost, we characterize equilibria in which different countries' assets arise as media of exchange in different types of trades. More frequent trading opportunities at home result in agents holding proportionately more domestic over foreign assets. Consequently, agents have larger claims to domestic over foreign consumption goods. Moreover, foreign assets turn over faster than home assets because the former have desirable liquidity properties, but unfavorable returns over time. Our mechanism offers an answer to a long-standing puzzle in international finance: a positive relationship between consumption and asset home bias, coupled with higher turnover rates of foreign over domestic assets.
    JEL: E44 F15 F36 G11
    Date: 2011–08
  24. By: Driffill, John; Miller, Marcus
    Abstract: How and why do financial conditions matter for real outcomes? The ‘workhorse model of money and liquidity’ of Kiyotaki and Moore (2008) shows how--with full employment maintained by flexible prices--shifting credit constraints can affect investment and future aggregate supply. We show that, when the flex-price assumption is dropped, an adverse but temporary liquidity shock can rapidly lead to Keynesian-style demand failure. Optimistic expectations may speed recovery, but simulation results suggest that prompt liquidity infusion by the central bank--i.e. Quantitative Easing--is needed to check prolonged recession.
    Keywords: Credit Constraints; Liquidity Shocks; Temporary Equilibrium
    JEL: B22 E12 E20 E30 E44
    Date: 2011–08
  25. By: Jesús Fernández-Villaverde; Pablo A. Guerrón-Quintana; Keith Kuester; Juan Rubio-Ramírez
    Abstract: We study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. Fiscal deficits and public debt have risen sharply in the wake of the financial crisis. While these developments make fiscal consolidation inevitable, there is considerable uncertainty about the policy mix and timing of such budgetary adjustment. To evaluate the consequences of this increased uncertainty, we first estimate tax and spending processes for the U.S. that allow for time-varying volatility. We then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. We find that fiscal volatility shocks have an adverse effect on economic activity that is comparable to the effects of a 25-basis-point innovation in the federal funds rate.
    JEL: C11 E10 E30
    Date: 2011–08
  26. By: Lindner, Ines; Strulik, Holger
    Abstract: This paper introduces the Small World model (Watts and Strogatz, Nature, 1998) into the theory of economic growth and investigates how increasing economic integration affects firm size and effciency, norm enforcement, and aggregate economic performance. When economic integration is low and local connectivity is high, informal norms control entrepreneurial behavior and more integration mainly improves search for effcient investment opportunities. At a higher level of economic integration neighborhood enforcement deteriorates and formal institutions are needed to keep entrepreneurs in check. A gradual take-off to perpetual growth is explained by a feedback effect from investment to the formation of long-distance links and the diffusion of knowledge. If formal institutions are weak, however, the economy does not take off but stagnates at an intermediate income level. Structurally, the equilibrium of stagnation differs from balanced growth by the presence of relatively many small firms of low productivity.
    Keywords: modernization, economic integration, firm size, norms, networks, knowledge spillovers, growth
    JEL: O10 O40 L10 L14 Z13
    Date: 2011–08

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