nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2011‒11‒28
twenty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Macroeconomic implications of downward wage rigidities By Fahr Stephen
  2. Default Risk Premium and Aggregate Fluctuations in a Small Open Economy By S. Meral Cakici
  3. Existence of competitive equilibrium in an optimal growth model with heterogeneous agents and endogenous leisure By Aditya Goenka; Cuong Le Van; Manh-Hung Nguyen
  4. Household debt and labour market fluctuations By Javier Andrés; José E. Boscá; Javier Ferri
  5. Concave consumption function and precautionary wealth accumulation By Suen, Richard M. H.
  6. Firms entry, monetary policy and the international business cycle By Cavallari Lilia
  7. Social security and the rise in health spending: a macroeconomic analysis By Zhao, Kai
  8. Relationships and Growth By Shingo Ishiguro
  9. How Big are the Gains from International Financial Integration? By Hoxha, Indrit; Kalemli-Ozcan, Sebnem; Vollrath, Dietrich
  10. Effects of Legal and Unauthorized Immigration on the U.S. Social Security System By Hugo Benítez-Silva; Eva Cárceles-Poveda; Selçuk Eren
  11. The Influence of Public Policy on Health, Wealth and Mortality By John Karl Scholz; Ananth Seshadri
  12. Skill-Biased Technical Change and the Cost of Higher Education: An Exploratory Model By John Bailey Jones; Fang (Annie) Yang
  13. The Environment and Directed Technical Change By Acemoglu, Daron; Aghion, Philippe; Bursztyn, Leonardo; Hemous, David
  14. Persistent Liquidity Effects and Long Run Money Demand By Alvarez, Fernando E; Lippi, Francesco
  15. Precautionary Savings in a Small Open Economy Revisited By Agustin Roitman
  16. A Dynamic General Equilibrium Analysis of Monetary Policy Rules, Adverse Selection and Long-Run Financial Risk By Blommestein, Hans J.; Eijffinger, Sylvester C W; Qian, Zongxin
  17. Local approximation of DSGE models around the risky steady state By Juillard Michel
  18. When Bonds Matter: Home Bias in Goods and Assets By Coeurdacier, Nicolas; Gourinchas, Pierre-Olivier
  19. Labor Supply and Government Programs: A Cross-Country Analysis By Andres Erosa; Luisa Fuster; Gueorgui Kambourov
  20. Applying perturbation analysis to dynamic optimal tax problems By Charles Brendon

  1. By: Fahr Stephen
    Abstract: Growth of wages, unemployment, employment and vacancies exhibit strong asymmetries between expansionary and contractionary phases. In this paper we analyze to what degree downward wage rigidities in the bargaining process aect other variables of the economy. We introduce asymmetric wage adjustment costs in a New-Keynesian DSGE model with search and matching frictions in the labor market. We nd that the presence of downward wage rigidities strongly improves the t of the model to the skewness of variables and the relative length of expansionary and contractionary phases even when detrending the data. Due to the asymmetry, wages increase more easily in expansions, which limits vacancy posting and employment creation, similar to the exible wage case. During contractions nominal wages decrease slowly, shifting the main burden of adjustment to employment and hours worked. The asymmetry also explains the diering transmission of positive and negative demand shocks from wages to ination. Downward wage rigidities help explaining the asymmetric business cycle of many OECD countries where long and smooth expansions with low growth rates are followed by sharp but short recessions with large negative growth rates.
    Keywords: labor market, unemployment, downward wage rigidity, asymmetric adjustment costs, non—linear dynamics
    JEL: E31 E52 C61
    Date: 2011–11
  2. By: S. Meral Cakici (Institute for International Economics, University of Bonn)
    Abstract: This study investigates the implications of risk premium shocks for aggregate fluctuations in a small open economy with financial and informational frictions. A dynamic, stochastic, general equilibrium framework is developed, where the informational asymmetries among the agents in the model and the uncertainty in the production process necessitate financial intermediation in the economy. The Holmstrom-Tirole type of uncertainty in the production process also leads to collateralized borrowing by firms, with the physical capital stock of firms serving as the collateral as well as the factor of production. There is also a government sector in the economy that borrows domestically with a partial default risk. In order to compensate the lenders for the default risk included in the government bonds, the government has to offer them some risk premium in addition to the exogenously given world interest rate offered by the foreign bond issuers. It is shown that, under certain circumstances, it is possible for the government to reduce its debt and increase its spending in response to a positive, temporary risk premium shock.
    Keywords: default risk premium, dynamic stochastic general equilibrium, aggregate fluctuations
    JEL: F41 G15 G21 H39
    Date: 2011–11
  3. By: Aditya Goenka (National University of Singapore - National University of Singapore (NUS)); Cuong Le Van (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, University of Exeter Business School - University of Exeter Business School, VCREME - VanXuan Center of Research in Economics, Management and Environment - VanXuan Center of Research in Economics, Management and Environment, Hanoi WRU - Department of Economics); Manh-Hung Nguyen (VCREME - VanXuan Center of Research in Economics, Management and Environment - VanXuan Center of Research in Economics, Management and Environment, LERNA-INRA - Toulouse School of Economics, Toulouse School of Economics - ToulouseSchool of Economic)
    Abstract: This paper proves the existence of competitive equilibrium in a single-sector dynamic economy with heterogeneous agents, elastic labor supply and complete assets markets. The method of proof relies on some recent results concerning the existence of Lagrange multipliers in in nite dimensional spaces and their representation as a summable sequence and a direct application of the inward boundary fixed point theorem.
    Keywords: Optimal growth model, Lagrange multipliers, Competitive equilib- rium, Individually Rational Pareto Optimum, Elastic labor supply.
    Date: 2011–11
  4. By: Javier Andrés (Universidad de Valencia); José E. Boscá (Universidad de Valencia); Javier Ferri (Universidad de Valencia)
    Abstract: The co-movements of labor productivity with output, total hours, vacancies and unemployment have changed since the mid 1980s. This paper offers an explanation for the sharp break in the fl uctuations of labor market variables based on endogenous labor supply decisions following the mortgage market deregulation. Our exercise shows that the dynamic pattern of the labor market variables might have been substantially affected by the increase in household leverage in the US in the last twenty years. We set up a search model with effi cient bargaining and fi nancial frictions, in which impatient borrowers can take an amount of credit that cannot exceed a proportion of the expected value of their real estate holdings. When borrowers’ equity requirements are low, the impact of a positive technology shock on the marginal utility of consumption is strengthened, which in turn results in lower hours per worker and higher wages in the bargaining process. This shift in labor supply discourages fi rms from opening vacancies, reducing the impact of the shock on employment.
    Keywords: business cycle, labor market, borrowing restrictions
    JEL: E24 E32 E44
    Date: 2011–11
  5. By: Suen, Richard M. H.
    Abstract: This paper examines the theoretical foundations of precautionary wealth accumulation in a multi-period model where consumers face uninsurable earnings risk and borrowing constraints. We begin by characterizing the consumption function of individual consumers. We show that consumption function is concave when the utility function has strictly positive third derivative and the inverse of absolute prudence is a concave function. These conditions encompass all HARA utility functions with strictly positive third derivative as special cases. We then show that when consumption function is concave, a mean-preserving spread in earnings risk would encourage wealth accumulation at both the individual and aggregate levels.
    Keywords: Consumption function; borrowing constraints; precautionary saving
    JEL: D81 D91 E21
    Date: 2011–11
  6. By: Cavallari Lilia
    Abstract: This paper provides a novel theory of the international business cycle grounded on firms entry and sticky prices. It shows that under simple monetary rules pro-cyclical entry can generate fluctuations in consumption, output and investment as large as those observed in the data while at the same time providing positive international comovements and highly volatile terms of trade. The capacity to capture these stylized facts of the international business cycle overcomes the well-known difficulties of the standard open economy real business cycle model in this regard. Numerical simulations show that floating regimes exacerbate counter-cyclical markup movements. Fixed regimes, on the other hand, lead to an increase in the volatility of?firm entry.
    Keywords: product variety, firm entry, international business cycle, monetary policy, interest rate rules, exchange rate regimes
    JEL: E31 E32 E52
    Date: 2011–11
  7. By: Zhao, Kai
    Abstract: In this paper, I develop a quantitative macroeconomic model with endogenous health and endogenous longevity and use it to study the impact of Social Security on aggregate health spending. I find that Social Security increases the aggregate health spending of the economy via two channels. First, Social Security transfers resources from the young with low marginal propensity to spend on health care to the elderly (age 65+) with high marginal propensity to spend on health care. Second, Social Security raises people's expected future utility and thus increases the marginal benefit from investing in health to live longer. In the calibrated version of the model, I show that the positive impact of Social Security on aggregate health spending is quantitatively important. The expansion of US Social Security since 1950 can account for approximately 43% of the dramatic rise in US health spending as a share of GDP over the same period (i.e. from 4% of GDP in 1950 to 13% of GDP in 2000). I also find that this positive impact of Social Security has two interesting policy implications. First, the negative effect of Social Security on capital accumulation in this model is significantly smaller than what previous studies have found, because Social Security induces extra years of life via health spending and thus encourages private savings for retirement. Second, Social Security has a significant spill-over effect on public health insurance programs (e.g. Medicare). As Social Security increases health spending and longevity, it also increases the insurance payments from these programs, thus raising their financial burden.
    Keywords: Social Security; Health Spending; Savings; Longevity
    JEL: H30 I00 E20 E60
    Date: 2011–06
  8. By: Shingo Ishiguro (Graduate School of Economics, Osaka University)
    Abstract: In this paper we present a dynamic general equilibrium model to investigate how different contracting modes based on formal and relational enforcements endogenously emerge and are dynamically linked with the process of economic development. Formal contracts are enforced by third party institutions (courts), while relational contracts are self-enforcing agreements without any third party involvement. The novel feature of our model is to demonstrate the co-evolution of these different enforcement modes and market equilibrium conditions, all of which are jointly determined. We then characterize the equilibrium paths of such dynamic processes and show the time structure of relational contracting (self-enforcing agreement) in the endogenous process of economic development. In particular we show that relational contracting fosters the emergence of the market-based economy in low development stages but its role declines as the economy grows and enters high development stages.
    Keywords: dynamic general equilibrium, economic development, armfs length contract, relational contract
    JEL: D86 E10 O11
    Date: 2011–11
  9. By: Hoxha, Indrit; Kalemli-Ozcan, Sebnem; Vollrath, Dietrich
    Abstract: The literature has shown that the implied welfare gains from international financial integration are very small. We revisit the existing findings and document that welfare gains can be substantial if capital goods are not perfect substitutes. We use a model of optimal savings that includes a production function where the elasticity of substitution between capital varieties is less then infinity, but more than the value that would generate endogenous growth. This production structure is consistent with empirical estimates of the actual elasticity of substitution between capital types, as well as with the relatively slow speed of convergence documented in the growth literature. Calibrating the model, our results are that welfare gains from financial integration are equivalent to a 9% increase in consumption for the median developing country, and up to 14% for the most capital-scarce. These gains rise substantially if capital’s share in output increases even modestly above the baseline value of 0.3, and remain large even if inflows of foreign capital after integration are limited to a fraction of the existing capital stock.
    Keywords: FDI; financial integration; neoclassical growth model; productivity; welfare
    JEL: F36 F41 F43 O4
    Date: 2011–11
  10. By: Hugo Benítez-Silva (SUNY-Stony Brook); Eva Cárceles-Poveda (SUNY-Stony Brook); Selçuk Eren (Levy Economics Institute of Bard College)
    Abstract: Immigration is having an increasingly important effect on the social insurance system in the United States. On the one hand, eligible legal immigrants have the right to eventually receive pension benefits, but also rely on other aspects of the social insurance system such as health care, disability, unemployment insurance, and welfare programs, while most of their savings have direct positive effects on the domestic economy. On the other hand, most undocumented immigrants contribute to the system through taxed wages, but they are not eligible for these programs unless they attain legal status, and a large proportion of their savings translates into remittances, which have no direct effects on the domestic economy. Moreover, a significant percentage of immigrants migrate back to their countries of origin after a relatively short period of time, and their savings while in the US are predominantly in the form of remittances. Therefore, any analysis that tries to understand the impact of immigrant workers on the overall system has to take into account the decisions and events these individuals face throughout their lives, as well as the use of the government programs they are entitled to. We propose a life-cycle OLG model in a General Equilibrium framework of legal and undocumented immigrants’ decisions regarding consumption, savings, labor supply and program participation to analyze their role in the financial sustainability of the system. Our analysis of the effects of potential policy changes, such as giving some undocumented immigrants legal status, shows increases in capital stock, output, consumption, labor productivity, and overall welfare. The effects are relatively small in percentage terms, but considerable given the size of our economy.
    Date: 2011–09
  11. By: John Karl Scholz (University of Wisconsin); Ananth Seshadri (University of Wisconsin)
    Abstract: In this project we extend an augmented lifecycle model, incorporating a Grossman-style model of health capital, to enhance understanding of factors influencing consumption, wealth and health. We develop three primary results when using the model to explore the effects of stylized versions of Medicare and Social Security on wealth and longevity. First, our model calibration implies consumption and health are complements. As health depreciates with age, households will get less utility from consumption than would be in the case of a lifecycle model that does not endogenize health. Second, it appears that forward-looking households, when confronted by a substantially reduced safety net, will respond by reducing consumption and by reducing their health investment and therefore longevity. Third, there is a potentially important difference between short- and long- run responses to policy.
    Date: 2011–09
  12. By: John Bailey Jones; Fang (Annie) Yang
    Abstract: We document trends in higher education costs and tuition over the past 50 years. To explain these trends, we develop and simulate a general equilibrium model with skill- and sector-biased technical change. We assume that higher education suffers from Baumol's (1967) service sector disease, in that the quantity of labor and capital needed to educate a student is constant over time. Calibrating the model, we show that it can explain the rise in college costs between 1959 and 2000. We then use the model to perform a number of numerical experiments. We find, consistent with a number of studies, that changes in the tuition discount rate have little long-run effect on college attainment.
    Date: 2011
  13. By: Acemoglu, Daron; Aghion, Philippe; Bursztyn, Leonardo; Hemous, David
    Abstract: This paper introduces endogenous and directed technical change in a growth model with environmental constraints. A unique final good is produced by combining inputs from two sectors. One of these sectors uses "dirty" machines and thus creates environmental degradation. Research can be directed to improving the technology of machines in either sector. We characterize dynamic tax policies that achieve sustainable growth or maximize intertemporal welfare. We show that: (i) in the case where the inputs are sufficiently substitutable, sustainable long-run growth can be achieved with temporary taxation of dirty innovation and production; (ii) optimal policy involves both .carbon taxes. and research subsidies, so that excessive use of carbon taxes is avoided; (iii) delay in intervention is costly: the sooner and the stronger is the policy response, the shorter is the slow growth transition phase; (iv) the use of an exhaustible resource in dirty input production helps the switch to clean innovation under laissez-faire when the two inputs are substitutes. Under reasonable parameter values and with sufficient substitutability between inputs, it is optimal to redirect technical change towards clean technologies immediately and optimal environmental regulation need not reduce long-run growth.
    Keywords: directed technological change; environment; exhaustible resources; innovation
    JEL: C65 O30 O31 O33
    Date: 2011–11
  14. By: Alvarez, Fernando E; Lippi, Francesco
    Abstract: We present a monetary model in the presence of segmented asset markets that im- plies a persistent fall in interest rates after a once and for all increase in liquidity. The gradual propagation mechanism produced by our model is novel in the literature. We provide an analytical characterization of this mechanism, showing that the magnitude of the liquidity effect on impact, and its persistence, depend on the ratio of two parameters: the long-run interest rate elasticity of money demand and the intertemporal substitution elasticity. At the same time, the model has completely classical long-run predictions, featuring quantity theoretic and Fisherian properties. The model simultaneously explains the short-run "instability" of money demand estimates as-well-as the stability of long-run interest-elastic money demand.
    Keywords: money demand
    JEL: E5
    Date: 2011–11
  15. By: Agustin Roitman
    Abstract: A common assumption in standard economic models is that agents are risk-averse and prudent, and it is often argued that prudence is necessary to generate precautionary savings. This paper shows that prudence is not necessary to generate precautionary savings in small open economy models with more than two periods. A new class of preferences, which enables the isolation of the effect of risk aversion on precautionary savings, is introduced. The effects of changes in risk aversion, interest rates, and persistence and volatility of shocks on average asset holdings are qualitatively identical to the ones observed for standard constant-elasticity-of-substitution preferences. These results show that the almost universal assertion in the literature - that only prudent consumers can generate positive levels of precautionary savings - is simply incorrect.
    Keywords: Borrowing , Forecasting models , Interest rates , Savings ,
    Date: 2011–11–01
  16. By: Blommestein, Hans J.; Eijffinger, Sylvester C W; Qian, Zongxin
    Abstract: This paper builds a dynamic general equilibrium macro-finance model with two types of borrowers: entrepreneurs who want to produce and gamblers who want to play a lottery. It links central bank's interest rate policy to expected cash flows of both types. This link enables us to study how the interactions between various shocks and different monetary policy rules affect the borrower pool faced by financial intermediaries. We find that when the economy is hit by an expansionary monetary policy shock, the proportion of entrepreneurs in the borrower pool will be persistently lower than the steady state level after a short period. It is lowest when the central bank does not react to output fluctuations. Quite differently, not reacting to output fluctuations avoids a persistent worsening of the borrower pool in the long run if the shock is a bad productivity shock.
    Keywords: Adverse Selection; Financial Crisis; Monetary Policy
    JEL: E44 E52
    Date: 2011–11
  17. By: Juillard Michel
    Abstract: A DSGE model takes the mathematical form of a system of nonlinear stochastic equations. Except in a very few cases, there is no analytical solution and economists are left using numerical methods in order to obtain approximated solutions. Global approximation methods are available when the state space is not too large, while the most usual approach is local approximation around the deterministic steady state. The perturbation approach introduced in economics by Judd (1996) derives a Taylor expansion of the solution from a Taylor expansion of the original problem, but ?rst order approximation is nothing but linearization that has been used in the RBC literature since its inception. Second order approximations are discussed in several papers: Sims (2000); Collard and Juillard (2001); Kim et al. (2003); Schmitt-Grohe and Uribe (2004). Second order approximations have two merits. In most cases, but not in all, they provide a more accurate approximation of the solution, but, more importantly, they break away from certainty equivalence, that is an inescapable characteristic of linear model. This is crucial to address issues related to attitudes toward risk. There is of course no reason, except size of model, to consider only ?rst or second order approximations. Higher order approximation as also sometimes used: Jin and Judd (2002); Juillard and Kamenik (2004).
    Date: 2011–11
  18. By: Coeurdacier, Nicolas; Gourinchas, Pierre-Olivier
    Abstract: This paper presents a model of international portfolios with real exchange rate and non financial risks that accounts for observed levels of equity home bias. A key feature is that investors can trade equities as well as domestic and foreign real bonds. Bonds matter: in equilibrium, investors structure their bond portfolio to hedge real exchange rate risk since relative bond returns are strongly correlated with real exchange rate movements. Equity home bias does not arise from the co-movements between relative stock returns and real exchange rates, but from the hedging properties of stock returns against other sources of risk, conditionally on bond returns. We estimate the optimal equity and bond portfolios implied by the model for G-7 countries and find strong empirical support for the theory. We are able to account for a significant share of the equity home bias and obtain a currency exposure of bond portfolios comparable to the data.
    Keywords: Equity home bias; International portfolios; International risk sharing
    JEL: F30 F41 G11
    Date: 2011–11
  19. By: Andres Erosa; Luisa Fuster; Gueorgui Kambourov
    Abstract: There are substantial cross-country differences in labor supply late in the life cycle (age 50+). A theory of labor supply and retirement decisions is developed to quantitatively assess the role of social security, disability insurance, and taxation for understanding differences in labor supply late in the life cycle across European countries and the United States. The findings support the view that government policies can go a long way towards accounting for the low labor supply late in the life cycle in the European countries relative to the United States, with social security rules accounting for the bulk of these effects.
    Keywords: Social security, disability insurance, labor supply, heterogeneity, life cycle
    JEL: D9 E2 E6 H2 H55 J2
    Date: 2011–11–15
  20. By: Charles Brendon
    Abstract: This paper shows how to derive a complete set of optimality conditions characterising the solution to a dynamic optimal income tax problem in the spirit of Mirrlees (1971), under the assumption that a ‘first-order’ approach to incentive compatibility is valid. The method relies on constructing perturbations to the consumption-output allocations of agents in a manner that preserves incentive compatibility for movements in both directions along the specified dimension. We are able to use it to generalise the ‘inverse Euler condition’ to cases in which preferences are non-separable between consumption and labour supply, and to prove a number of novel results about optimal income and savings tax wedges.
    Keywords: New Dynamic Public Finance, First-order approach, Non-separable preferences, Inverse Euler condition
    JEL: D82 E61 H21 H24
    Date: 2011

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