nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2012‒01‒18
nineteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Employment Protection and Business Cycles in Emerging Economies By Ruy Lama; Carlos Urrutia
  2. An Estimated DSGE Model of the Indian Economy. By Gabriel, Vasco; Levine, Paul; Pearlman, Joseph; Yang, Bo
  3. Productivity shocks and aggregate fluctuations in an estimated endogenous growth model with human capital By Jim Malley; Ulrich Woitek
  4. Directed Search over the Life Cycle By Guido Menzio; Irina A. Telyukova; Ludo Visschers
  5. "Tropical" Real Business Cycles? A Bayesian Exploration By Andrés Fernández
  6. Monetary and Fiscal Policy in a DSGE Model of India. By Levine, Paul; Pearlman, Joseph
  7. Fiscal policy and economic stability: Does PIGS stand for procyclicality in government spending? By Claeys Peter; Maravalle Alessandro
  8. Monetary and Fiscal Policy in the Presence of Informal Labour Markets By Batini, Nicoletta; Levine, Paul; Lotti, Emanuela; Yang, Bo
  9. A Tale of Tax Policies in Open Economies By Stéphane Auray; Aurélien Eyquem; Paul Gomme
  10. Debt stabilization in a Non-Ricardian economy By Campbell Leith; Ioana Moldovan; Simon Wren-Lewis
  11. Time-consistent fiscal policy under heterogeneity: Conflicting or common interests? By Konstantinos Angelopoulos; James Malley; Apostolis Philippopoulos
  12. Informal Labour and Credit Markets: A Survey. By Batini, Nicoletta; Kim, Young-Bae; Levine, Paul; Lotti, Emanuela
  13. Towards a quantitative theory of automatic stabilizers: the role of demographics By Alexandre Janiak; Paulo Santos Monteiro
  14. Labor, Output and Consumption in Business Cycle Models of Emerging Economies: A Comment By Andrés Fernández; Felipe Meza
  15. Government Spending, Monetary Policy, and the Real Exchange Rate By Hafedh Bouakez; Aurélien Eyquem
  16. Unanticipated vs. Anticipated Tax Reforms in a Two-Sector Open Economy. By Olivier Cardi; Romain Restout
  17. A Dynamic Model of Trade with Heterogeneous Firms By Peter Arendorf Bache
  18. The distributional consequences of tax reforms under market distortions By Konstantinos Angelopoulos; James R. Malley; Wei Jiang
  19. Optimal fertility during World War I By Vandenbroucke, Guillaume

  1. By: Ruy Lama; Carlos Urrutia
    Abstract: We build a small open economy, real business cycle model with labor market frictions to evaluate the role of employment protection in shaping business cycles in emerging economies. The model features matching frictions and an endogenous selection effect by which inefficient jobs are destroyed in recessions. In a quantitative version of the model calibrated to the Mexican economy we find that reducing separation costs to a level consistent with developed economies would reduce output volatility by 15 percent. We also use the model to analyze the Mexican crisis episode of 2008 and conclude that an economy with lower separation costs would have experienced a smaller drop in output and in measured total factor productivity with no significant change in aggregate employment.
    Keywords: Business cycles , Economic models , Economic recession , Emerging markets , Employment , External shocks , Labor markets ,
    Date: 2011–12–15
  2. By: Gabriel, Vasco (University of Surrey); Levine, Paul (University of Surrey); Pearlman, Joseph (London Metropolitan University); Yang, Bo (University of Surrey and London Metropolitan University)
    Abstract: We develop a closed-economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods using Dynare. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, and an informal sector. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward and backward-looking components. We find that, in terms of model posterior probabilities and standard moments criteria, inclusion of the above financial frictions and an infor- mal sector significantly improves the model fit.
    Keywords: Indian economy ; DSGE model ; Bayesian estimation ; Monetary interest rate rules ; Financial frictions
    JEL: E52 E37 E58
    Date: 2011–11
  3. By: Jim Malley; Ulrich Woitek
    Abstract: Employing an endogenous growth model with human capital, this paper explores how productivity shocks in the goods and human capital producing sectors contribute to explaining aggregate fluctuations in output, consumption, investment and hours. Given the importance of accounting for both the dynamics and the trends in the data not captured by the theoretical growth model, we introduce a vector error correction model (VECM) of the measurement errors and estimate the model’s posterior density function using Bayesian methods. To contextualize our findings with those in the literature, we also assess whether the endogenous growth model or the standard real business cycle model better explains the observed variation in these aggregates. In addressing these issues we contribute to both the methods of analysis and the ongoing debate regarding the effects of innovations to productivity on macroeconomic activity.
    Keywords: Endogenous growth, human capital, real business cycles, VEC Mmeasurement errors, Bayesian estimation
    JEL: C11 C52 E32
    Date: 2011–08
  4. By: Guido Menzio (Department of Economics, University of Pennsylvania); Irina A. Telyukova (Department of Economics, University of California, San Diego); Ludo Visschers (Universidad Carlos III de Madrid)
    Abstract: We develop a life-cycle model of the labor market in which different worker-firm matches have different quality and the assignment of the right workers to the right firms is time consuming because of search and learning frictions. The rate at which workers move between unemployment, employment and across different firms is endogenous because search is directed and, hence, workers can choose whether to seek low-wage jobs that are easy to find or high-wage jobs that are hard to find. We calibrate our theory using data on labor market transitions aggregated across workers of different ages. We validate our theory by showing that it correctly predicts the pattern of labor market transitions for workers of different ages. Finally, we use our theory to decompose the age profiles of transition rates, wages and productivity into the effects of age variation in work-life expectancy, human capital and match quality.
    Keywords: Directed Search; Labor Reallocation; Lifecycle
    JEL: E24 J63 J64
    Date: 2012–01–04
  5. By: Andrés Fernández
    Abstract: Can frictionless small open economy models driven solely by technology shocks account for business cycles in developing countries? We don't find evidence of it. We build a DSGE model that jointly includes a variety of real perturbations in addition to technology shocks, such as procyclical fiscal policies; terms of trade fluctuations; and perturbations to the foreign interest rate coupled with financial frictions and estimate it using Bayesian methods on high and low frequency data from a developing -and "tropical"- country, Colombia. We find interest rate shocks to be crucial andthat financial frictions play a central role as propagating mechanisms of transitory technology shocks. These two driving forces alone can account well for the observed properties of the Colombian business cycle. Other structural shocks such as terms of trade fluctuations and level shifts in the technology process do not appear to be relevant in the past decade and a half, but their importance increases when a longer span of data is considered.
    Date: 2011–09–06
  6. By: Levine, Paul (University of Surrey); Pearlman, Joseph (London Metropolitan University)
    Abstract: We develop a optimal rules-based interpretation of the 'three pillars macroeconomic policy framework': a combination of a freely floating exchange rate, an explict target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies.The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions. It is calibrated using India and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules. A comparison with a fixed exchange rate regime is ade. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy. These policy prescriptions contrast with the monetary-fiscal policy stance of the Indian authorities.
    Keywords: Monetary policy ; Emerging economies ; Fiscal and monetary rules ; Financial accelerator ; Liability dollarization
    JEL: E52 E37 E58
    Date: 2011–11
  7. By: Claeys Peter; Maravalle Alessandro
    Abstract: The Financial Crisis has hit particularly hard countries like Ireland or Spain. Procyclical fiscal policy has contributed to a boom-bust cycle that undermined fiscal positions and deepened current account deficits during the boom. We set up an RBC model of a small open economy, following Mendoza (1991), and introduce the effect of fiscal policy decisions that change over the cycle. We calibrate the model on data for Ireland, and simulate the effect of different spending policies in response to supply shocks. Procyclical fiscal policy distorts intertemporal allocation decisions. Temporary spending boosts in booms spur investment, and hence the need for external finance, and so generates very volatile cycles in investment and the current account. This economic instability is also harmful for the steady state level of output. Our model is able to replicate the relation between the degree of cyclicality of fiscal policy, and the volatility of consumption, investment and the current account observed in OECD countries.
    Keywords: RBC, current account, small open economy, fiscal rule, spending
    JEL: E32 E62 F41 H62
    Date: 2011–12
  8. By: Batini, Nicoletta (IMF and University of Surrey); Levine, Paul (University of Surrey); Lotti, Emanuela (University of Surrey); Yang, Bo (University of Surrey)
    Abstract: How does informality in emerging economies affect the conduct of monetary and fiscal policy? To answer this question we construct a two-sector, formal-informal new Keynesian closed-economy. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. We compare outcomes under welfare- optimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules alongside a balanced-budget fiscal regime. We compare the model, first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. Our main conclusions are first, labour and financial market frictions, the latter assumed to be stronger in the informal sector, cause the time-inconsistency problem to worsen. The importance of commitment therefore increases in economies characterized by a large informal sector with the features we have highlighted. Simple implementable optimized rules that respond only to observed aggregate inflation and formal-sector output can be significantly worse in welfare terms than their optimal counterpart, but are still far better than discretion. Simple rules that respond, if possible, to the risk premium in the formal sector result in a significant welfare improvement.
    Keywords: Informal economy ; Emerging economies ; Labour market ; Credit market ; Tax policy ; Interest rate rules
    JEL: J65 E24 E26 E32
    Date: 2011–11
  9. By: Stéphane Auray (CREST (Ensai), Université du Littoral Côte d’Opale (EQUIPPE), Université de Shebrooke (GREDI) and CIRPEE); Aurélien Eyquem (Université de Lyon, Lyon, F-69007, France ; Ecole Normale Supérieure de Lyon, Lyon, F-69007, France ; CNRS, GATE Lyon St Etienne, Ecully, F-69130, France ; and GREDI, Canada); Paul Gomme (Concordia University and CIREQ)
    Abstract: Recent financial crises in Europe as well as the periodic battles in the U.S. over the debt ceiling point to the importance of fiscal discipline among developed countries. This paper develops an open economy model, calibrated to the U.S. and a subset of the EMU, to evaluate the impact of various permanent tax changes. The first set of experiments considers a targeted one percentage point reduction in the government deficit-to-GDP ratio through raising one of : the consumption tax, the labor income tax, or the capital income tax. In terms of welfare, the consumption tax is found to be the least costly of the tax increases. A second set of experiments looks at deficit-neutral tax changes : partially replacing the capital income tax with either a higher labor income tax or higher consumption tax ; and partially replacing the labor income tax with an increased consumption tax. Reducing reliance on capital income taxation is welfare-enhancing, although it leads to short term losses. Reducing labor income taxation improves international competitiveness and is welfare-improving.
    Keywords: Fiscal policies, open economies, public deficits, tax reforms
    JEL: E31 E62 F41
    Date: 2011
  10. By: Campbell Leith; Ioana Moldovan; Simon Wren-Lewis
    Abstract: In models with a representative infinitely lived household, modern versions of tax smoothing imply that the steady-state of government debt should follow a random walk. This is unlikely to be the case in OLG economies, where, the equilibrium interest rate may differ from the policy-maker’s rate of time preference such that it may be optimal to reduce debt today to reduce distortionary taxation in the future. Moreover, the level of the capital stock (and therefore output and, possibly, consumption) in these economies is likely to be sub-optimally low, and reducing government debt will ‘crowd in’ additional capital. Using an elaborate version of the model of perpetual youth developed by Blanchard (1985) and Yaari (1965), we derive the optimal steady state level of government assets. We show how and why this level of government assets falls short of the level of debt that achieves the optimal capital stock and the level that eliminates income taxes.
    Keywords: Non-Ricardian consumers, macroeconomic stability, distortionary taxes
    JEL: E21 E32 E63
    Date: 2011–10
  11. By: Konstantinos Angelopoulos; James Malley; Apostolis Philippopoulos
    Abstract: This paper studies the aggregate and distributional implications of Markov-perfect tax-spending policy in a neoclassical growth model with capitalists and workers. Focusing on the long run, our main …ndings are: (i) it is optimal for a benevolent government, which cares equally about its citizens, to tax capital heavily and to subsidise labour; (ii) a Pareto improving means to reduce inefficiently high cap- ital taxation under discretion is for the government to place greater weight on the welfare of capitalists; (iii) capitalists and workers inter- ests, regarding the optimal amount of "capitalist bias", are not aligned implying a trade-off between efficiency and equity.
    Keywords: Optimal fiscal policy, Markov-perfect equilibrium, heterogenous agents
    JEL: E62 H21
    Date: 2011–04
  12. By: Batini, Nicoletta (IMF and University of Surrey); Kim, Young-Bae (University of Surrey); Levine, Paul (University of Surrey); Lotti, Emanuela (University of Surrey)
    Abstract: This paper reviews the literature on the informal economy, focusing first on empirical findings and then on existing approaches to modelling informality within both partial and general equilibrium environments. We concentrate on labour and credit markets, since these tend to be most affected by informality. The phenomenon is particularly important in emerging and other developing economies, given their high degrees of informal labour and financial services and the implications these have for the effectiveness of macroeconomic policy. We emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality. The survey shows that the literature on informality is quite patchy, and that there are several unexplored areas left for research.
    Keywords: Informal economy ; Labour market ; Search-matching models
    JEL: J65 E24 E26 E32
    Date: 2011–11
  13. By: Alexandre Janiak; Paulo Santos Monteiro
    Abstract: Employment volatility is larger for young workers than for prime aged. At the same time, in economies with high tax rates the share of total market hours supplied by the young workers is smaller. These two observations imply a negative correlation between government size (measured by the share of taxes in total output) and aggregate hours volatility. This paper assesses in a calibrated model the quantitative importance of these empirical facts to account for the relationship between government size and macroeconomic stability.
    Date: 2011
  14. By: Andrés Fernández; Felipe Meza
    Abstract: Motivated by the fact that, over the business cycle, labor dynamics in emerging economies differ in nontrivial ways from those observed in developed economies, we assess the relative importance of trend shocks in emerging economies in the business cycle model of Aguiar and Gopinath (2007) when labor data is explicitly taken into account. We study Mexico and Canada as representatives of emerging and developed economies, respectively. We find for Mexico that, in the benchmark case with Cobb-Douglas preferences, the income effect on consumption of trend shocks is too strong, delivering countercyclical and counterfactual fluctuations in employment. The model faces a trade-off between, on the one hand, having sizeable growth shocks, thereby having a good match in terms of relatively high consumption volatility, and, on the other, having procyclical employment dynamics. This is remedied when both quasilinear preferences are assumed and the identification strategy explicitly takes into consideration labor dynamics. In this case trend shocks continue to be relatively stronger in emerging economies. Additionally, we find that differences in labor dynamics across emerging and developing economies are associated with the relatively large informal labor sector in emerging economies. It is in this dimension, when trying to match the dynamics of formal employment, that we find less evidence supporting an important role of trend shocks as being the main driving force of business cycles in emerging economies.
    Date: 2011–09–13
  15. By: Hafedh Bouakez (HEC Montréal and CIRPÉE, 3000 chemin de la Côte-Sainte-Catherine, Montréal, Québec, Canada H3T 2A7.); Aurélien Eyquem (Université de Lyon, Lyon, F-69007, France ; Ecole Normale Supérieure de Lyon, Lyon, F-69007, France ; CNRS, GATE Lyon St Etienne, Ecully, F-69130, France ; and GREDI, Canada)
    Abstract: A robust prediction across a wide range of open-economy macroeconomic models is that an unanticipated increase in public spending in a given country appreciates it currency in real terms. This result, however, contradicts the findings of a number of recent empirical studies, which instead document a significant and persistent depreciation of the real exchange rate following an expansionary government spending shock. In this paper, we rationalize the findings of the empirical literature by proposing a small-open-economy model that features three key ingredients : incomplete and imperfect international financial markets, sticky prices, and a not-too-aggressive monetary policy. The model predicts that in response to an unexpected increase in public expenditures, the risk-adjusted long-term real interest rate falls, causing the real exchange rate to depreciate. We establish this result both analytically, within a special version of the model, and numerically for the more general case.
    Keywords: Real exchange rate, public spending shocks, small open economy, sticky prices, monetary policy.
    JEL: F31 F41
    Date: 2011
  16. By: Olivier Cardi; Romain Restout
    Abstract: We use a two-sector neoclassical open economy model with traded and non-traded goods to investigate the effects of unanticipated and anticipated tax reforms. First, an unanticipated tax reform produces an expansion of GDP, labor, and investment, while an anticipated tax reform has opposite effects before the implementation of the labor tax cut. Quantitatively, if the traded sector is more capital intensive, GDP increases by 1.6 percentage points or declines by 2.8 percentage points after three years, depending on whether the tax cut is unanticipated or anticipated. Second, we find that GDP change masks a wide dispersion in sectoral output responses. Importantly, in all scenarios, a tax reform substantially raises the relative size of the non-traded sector while traded output always drops. Allowing for the markup to depend on the number of competitors, we find that a significant share of GDP change can be attributed to the competition channel while the dispersion of sectoral output responses is amplified. Finally, the workers only benefit from the labor tax cut if the tax change is unanticipated and the traded sector is more capital intensive.
    Keywords: Non Traded Goods; Investment; Tax Reform; Anticipation effects.
    JEL: F41 E62 E22 F32
    Date: 2012
  17. By: Peter Arendorf Bache (Department of Economics and Business, Aarhus University, Denmark)
    Abstract: This paper builds a dynamic general equilibrium trade model, in which heterogeneous intermediate goods are produced and traded in a Melitz (2003) type sector. These intermediate goods are used in the production of a final good, which can be used for consumption, capital accumulation, or investment in market entry. Therefore capital accumulation is the direct alternative to investing in firm entry. This has a number of implications. First, in the short run following trade liberalizations a higher interest rate will prevail, which will tend to shelter incumbent firms from increased competition by discouraging investment in entry of new firms. Second, different forms of trade liberalizations with the same impact on the share of expenditure on domestic variety will have different effects on consumption, and thus welfare, both during transitions and in steady-state, due to different effects on aggregate investment. Third, the accumulation of capital will add a time dimension to the anti-variety effects of trade liberalizations. In effect, capital accumulation generates rich adjustment dynamics both in the aggregate and at the firm level. Further, the study of transitions in this framework provides important insights regarding the effects of different forms of trade liberalizations in general and on welfare and individual firms in particular.
    JEL: F12 F14 F41
    Date: 2012–01–04
  18. By: Konstantinos Angelopoulos; James R. Malley; Wei Jiang
    Abstract: In this paper we examine the importance of imperfect competition in product and labour markets in determining the long-run welfare e¤ects of tax reforms assuming agent heterogeneneity in capital hold- ings. Each of these market failures, independently, results in welfare losses for at least a segment of the population, after a capital tax cut and a concurrent labour tax increase. However, when combined in a realistic calibration to the UK economy, they imply that a capital tax cut will be Pareto improving in the long run. Consistent with the the- ory of second-best, the two distortions in this context work to correct the negative distributional e¤ects of a capital tax cut that each one, on its own, creates.
    Keywords: market imperfections, heterogeneous agents, unemployment, tax reform.
    JEL: E24 E62
    Date: 2011–09
  19. By: Vandenbroucke, Guillaume
    Abstract: During World War I (1914–1918) the birth rates of countries such as France, Germany, the U.K., Belgium and Italy declined by almost 50 percent. The age structure of these countries’ populations were significantly affected for the duration of the 20th century. In France, where the population was 40 millions in 1914, the deficit of births is estimated to 1.36 millions over 4 years while military losses are estimated at 1.4 millions. In short, the fertility decline doubled the demographic impact of the War. Why did fertility decline so much? The conventional wisdom is that fertility fell below its optimal level because of the absence of men gone to war. I challenge this view using the case of France. I construct and calibrate a model of optimal fertility choice where households reaching their childbearing years on the eve of WWI face a loss of husband’s income during the War as well as an increase in the probability that the wife remains alone after the War. I calibrate this probability using the casualties sustained by the French army. The model accounts for 97% of the fertility decline even though it does not feature any physical separations of couples. It also accounts for no less than half of the increase in fertility after the War, and generates a temporary increase in the age at birth as observed in the French data. This effect of the War on the optimal level of fertility is robust to alternative calibrations.
    Keywords: Fertility ; war ; growth ; uncertainty
    JEL: J1 E1 N4
    Date: 2011–12

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