nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2012‒09‒03
twenty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Uncertainty shocks are aggregate demand shocks By Sylvain Leduc; Zheng Liu
  2. Reserve Accumulation, Growth and Financial Crises By Gianluca Benigno; Luca Fornaro
  3. Testing macroeconomic models by indirect inference on unfiltered data By Meenagh, David; Minford, Patrick; Wickens, Michael
  4. Inflation dynamics: the role of public debt and policy regimes By Saroj Bhattarai; Jae Won Lee; Woong Yong Park
  5. Universal banking, competition and risk in a macro model By Tatiana Damjanovic; Vladislav Damjanovic; Charles Nolan
  6. Home Production and the Optimal Rate of Unemployment Insurance By Temel Taskin
  7. Monetary Rules and Sectoral Unemployment in Open Economies By William D. Craighead
  8. House prices, credit growth, and excess volatility: implications for monetary and macroprudential policy By Paolo Gelain; Kevin J. Lansing; Caterina Mendicino
  9. Equalizing Outcomes vs. Equalizing Opportunities: Optimal Taxation when Children's Abilities Depend on Parents' Resources By Alexander M. Gelber; Matthew C. Weinzierl
  10. Quantifying the role of alternative pension reforms on the Austrian economy By Miguel Sánchez Romero; Joze Sambt; Alexia Prskawetz
  11. On existence, efficiency and bubbles of Ramsey equilibrium with borrowing constraints By Robert Becker; Stefano Bosi; Cuong Le Van; Thomas Seegmuller
  12. Collective versus Decentralized Wage Bargaining and the Efficient Allocation of Resources By Xiaoming Cai; Pieter A. Gautier; Makoto Watanabe
  13. The Labor Market Consequences of Adverse Financial Shocks By Tito Boeri; Pietro Garibaldi; Espen R. Moen
  14. (De)Regulation and Market Thickness By Jean Guillaume Forand; Vikram Maheshri
  15. Credit Constraints and Growth in a Global Economy By Coeurdacier, Nicolas; Guibaud, Stéphane; Jin, Keyu
  16. Macro-Prudential Policy and the Conduct of Monetary Policy. By Beau, D.; Clerc, L.; Mojon, B.
  17. Useless Prevention vs. Costly Remediation By Jean Guillaume Forand
  18. Runs, Panics and Bubbles: Diamond Dybvig and Morris Shin Reconsidered By Eric Smith; Martin Shubik
  19. Do falling iceberg costs explain recent U.S. export growth? By George Alessandria; Horag Choi
  20. Consumers' Imperfect Information and Price Rigidities By Jean-Paul L'Huillier

  1. By: Sylvain Leduc; Zheng Liu
    Abstract: We study the macroeconomic effects of uncertainty shocks in a DSGE model with labor search frictions and sticky prices. In contrast to a real business cycle model, the model with search frictions implies that uncertainty shocks reduce potential output, because a job match represents a long-term employment relation and heightened uncertainty reduces the value of a match. In the sticky-price equilibrium, an uncertainty shock--regardless of its source--consistently acts like an aggregate demand shock because it raises unemployment and lowers inflation. We present empirical evidence--based on a vector autoregression model and using a few alternative measures of uncertainty--that supports the theory's prediction that uncertainty shocks are aggregate demand shocks.
    Keywords: Uncertainty ; Inflation (Finance) ; Unemployment
    Date: 2012
  2. By: Gianluca Benigno; Luca Fornaro
    Abstract: We present a model that reproduces two salient facts characterizing the international monetary system: i) Faster growing countries are associated with lower net capital inflows and ii) Countries that grow faster accumulate more international reserves and receive more net private inflows. We study a two-sector, tradable and non-tradable, small open economy. There is a growth externality in the tradable sector and agents have imperfect access to international financial markets. By accumulating foreign reserves, the government induces a real exchange rate depreciation and a reallocation of production towards the tradable sector that boosts growth. Financial frictions generate imperfect substitutability between private and public debt flows so that private agents do not perfectly offset the government policy. The possibility of using reserves to provide liquidity during crises amplifies the positive impact of reserve accumulation on growth. We use the model to compare the laissez-faire equilibrium and the optimal reserve policy in an economy that is opening to international capital flows. We find that the optimal reserve management entails a fast rate of reserve accumulation, as well as higher growth and larger current account surpluses compared to the economy with no policy intervention. We also find that the welfare gains of reserve policy are large, in the order of 1 percent of permanent consumption equivalent.
    Keywords: foreign reserve accumulation, gross capital flows, growth, financial crises
    JEL: F31 F32 F41 F43
    Date: 2012–08
  3. By: Meenagh, David (Cardiff Business School); Minford, Patrick (Cardiff Business School); Wickens, Michael (Cardiff Business School)
    Abstract: We extend the method of indirect inference testing to data that is not filtered and so may be non-stationary. We apply the method to an open economy real business cycle model on UK data. We review the method using a Monte Carlo experiment and find that it performs accurately and has good power.
    Keywords: Bootstrap; DSGE; VECM; indirect inference; Monte Carlo
    JEL: C12 C32 C52 E1
    Date: 2012–07
  4. By: Saroj Bhattarai; Jae Won Lee; Woong Yong Park
    Abstract: We investigate the roles of a time-varying inflation target and monetary and fiscal policy stances on the dynamics of inflation in a DSGE model. Under an active monetary and passive fiscal policy regime, inflation closely follows the path of the inflation target and a stronger reaction of monetary policy to inflation decreases the equilibrium response of inflation to non-policy shocks. In sharp contrast, under an active fiscal and passive monetary policy regime, inflation moves in an opposite direction from the inflation target and a stronger reaction of monetary policy to inflation increases the equilibrium response of inflation to non-policy shocks. Moreover, a weaker response of fiscal policy to debt decreases the response of inflation to non-policy shocks. These results are due to variation in the value of public debt that leads to wealth effects on households. Finally, under a passive monetary and passive fiscal policy regime, both monetary and fiscal policy stances affect inflation dynamics, but because of a role for self-fulfilling beliefs due to equilibrium indeterminacy, theory provides no clear answer on the overall behavior of inflation. We characterize these results analytically in a simple model and numerically in a richer quantitative model.
    Keywords: Price levels ; Monetary policy ; Macroeconomics
    Date: 2012
  5. By: Tatiana Damjanovic (Department of Economics, University of Exeter); Vladislav Damjanovic (Department of Economics, University of Exeter); Charles Nolan (University of Glasgow)
    Abstract: A stylized macroeconomic model is developed with an indebted, heterogeneous Investment Banking Sector funded by borrowing from a retail banking sector. The government guarantees retail deposits. Investment banks choose how risky their activities should be. We find that the financial sector can move very sharply from safe to risky investment strategies and that the degree of competitiveness is important for risk premia. We also compared the benefits of separated vs. universal banking modelled as a vertical integration of the retail and investment banks. The incidence of banking default is considered under different constellations of shocks and degrees of competitiveness. The benefits of universal banking rise in the volatility of idiosyncratic shocks to trading strategies and are positive even for very bad common shocks, even though government bailouts, which are costly, are larger compared to the case of separated banking entities. The benefits of universal banking are positive but decreasing in the value and volatility of shocks to the quality of financial capital. When shock is moderate, competition improves the welfare. However, banks with some market power have a cushion of profits against adverse shocks which is beneficial since there is an excess burden associated with government bailouts. Hence, when a worse shock hits the economy, the optimal degree of competitiveness of separate banking firms is higher than for universal firms. So, the welfare assessment of the structure of banks may depend crucially on the kinds of shock hitting the economy as well as on the efficiency of government intervention.
    Keywords: Risk in DSGE models, investment banking, financial intermediation, separating commercial and investment banking, competition and risk, moral hazard in banking, prudential regulation, systematic vs. idiosyncratic risks.
    JEL: E13 E44 G11 G24 G28
    Date: 2012
  6. By: Temel Taskin
    Abstract: In this paper, we incorporate home production into a quantitative model of unemployment and show that realistic levels of home production have a signifi- cant impact on the optimal unemployment insurance rate. Motivated by recently documented empirical facts, we augment an incomplete markets model of unem- ployment with a home production technology, which allows unemployed workers to use their extra non-market time as partial insurance against the drop in income due to unemployment. In the benchmark model, we find that the optimal replacement rate in the presence of home production is roughly 40% of wages, which is 40% lower than the no home production model’s optimal replacement rate of 65%. The 40% optimal rate is also close to the estimated rate in practice. The fact that home production makes a significant difference in the optimal unemployment insurance rate is robust to a variety of parameterizations and alternative model environments.
    Keywords: Unemployment insurance, home production, incomplete markets, self-insurance
    JEL: D13 E21 J65
    Date: 2012
  7. By: William D. Craighead (Department of Economics, Wesleyan University)
    Abstract: This paper incorporates a search-and-matching model of the labor market into a “New Open Economy Macroeconomics” framework. This allows for an examination of the behavior of tradable and nontradable sector unemployment rates under alternative monetary rules. An examination of dynamics in response to shocks to productivity, world prices and interest rates, and foreign demand suggests that monetary rules that respond to prices of domestic output rather than consumer prices may be better able to stabilize unemployment.
    Keywords: search-and-matching model, monetary rules
    JEL: F4 E5
    Date: 2012–08
  8. By: Paolo Gelain; Kevin J. Lansing; Caterina Mendicino
    Abstract: Progress on the question of whether policymakers should respond directly to financial variables requires a realistic economic model that captures the links between asset prices, credit expansion, and real economic activity. Standard DSGE models with fully-rational expectations have difficulty producing large swings in house prices and household debt that resemble the patterns observed in many developed countries over the past decade. We introduce excess volatility into an otherwise standard DSGE model by allowing a fraction of households to depart from fully-rational expectations. Specifically, we show that the introduction of simple moving-average forecast rules for a subset of households can significantly magnify the volatility and persistence of house prices and household debt relative to otherwise similar model with fully-rational expectations. We evaluate various policy actions that might be used to dampen the resulting excess volatility, including a direct response to house price growth or credit growth in the central bank’s interest rate rule, the imposition of more restrictive loan-to-value ratios, and the use of a modified collateral constraint that takes into account the borrower’s loan-to-income ratio. Of these, we find that a loan-to-income constraint is the most effective tool for dampening overall excess volatility in the model economy. We find that while an interest-rate response to house price growth or credit growth can stabilize some economic variables, it can significantly magnify the volatility of others, particularly inflation.
    Keywords: Housing - Prices ; Housing - Econometric models
    Date: 2012
  9. By: Alexander M. Gelber; Matthew C. Weinzierl
    Abstract: Empirical research suggests that parentseconomic resources affect their children's future earnings abilities. Optimal tax policy, defined as the policy that maximizes the aggregate present-value dynastic utility of existing families, therefore will treat future ability distributions as endogenous to current taxes. We model this endogeneity, calibrate the model to match estimates of the intergenerational transmission of earnings ability in the United States, and use the model to simulate such an optimal policy numerically. The optimal policy in this context is more redistributive toward low-income parents than existing U.S. tax policy. It also increases the probability that low-income children move up the economic ladder, generating a present-value welfare gain of 1.28% of consumption in our baseline case.
    JEL: H21 I30
    Date: 2012–08
  10. By: Miguel Sánchez Romero (Max Planck Institute for Demographic Research, Rostock, Germany); Joze Sambt; Alexia Prskawetz (Max Planck Institute for Demographic Research, Rostock, Germany)
    Abstract: This paper investigates the role of recent pension reforms for the development of the social security system and economic growth in Austria. We use a computable general equilibrium model that is built up of overlapping generations that differ by their household structure, longevity, educational attainment, and capital accumulation. Each household optimally decides over its consumption paths, work effort, and retirement age according to the life-cycle theory of labor, while they face survival risk. We find that the pension reforms implemented from 2000 to 2004, although in the correct direction, are not sufficient to solve the labor market distortion caused by the Austrian PAYG pension system. Using alternative policy options, our simulations indicate that a change to a notional defined contribution system and an increase in the educational distribution of the work force would increase the incentive for later retirement ages and thereby increase labor supply and economic growth.
    Keywords: Austria, ageing, retirement, social security
    JEL: J1 Z0
    Date: 2012–08
  11. By: Robert Becker (Indiana University); Stefano Bosi (EPEE, University of Evry); Cuong Le Van (CES, CNRS, VCREME and Hanoi WRU); Thomas Seegmuller (GREQAM, Aix-Marseille University)
    Abstract: We address the fundamental issues of existence and efficiency of a Ramsey equilibrium with heterogenous discounting, elastic labor supply and borrowing constraints. In the first part, we prove the equilibrium existence in a truncated bounded economy through a fixed-point argument by Gale and Mas-Colell (1975). This equilibrium is also an equilibrium of any unbounded economy with the same fundamentals. The proof of existence is eventually given for an infinite-horizon economy as a limit of a sequence of truncated economies. Our general approach is suitable for applications to other models with different market imperfections. In the second part, we show the impossibility of bubbles in a productive economy and we give sufficient conditions for equilibrium efficiency.
    Date: 2012–02
  12. By: Xiaoming Cai (VU University Amsterdam); Pieter A. Gautier (VU University Amsterdam); Makoto Watanabe (VU University Amsterdam)
    Abstract: An advantage of collective wage agreement is that search and business-stealing externalities can be internalized. A disadvantage is that it takes more time before an optimal allocation is reached because more productive firms (for a particular worker type) can no longer signal this by posting higher wages. Specifically, we consider a search model with two sided heterogeneity and on-the-job search. We compare the most favorable case of a collective wage agreement (i.e. the wage that a planner would choose under the constraint that all firms in a sector-ocupation cell must offer the same wage) with the case without collective wage agreement. We find that collective wage agreements are never desirable if firms can commit ex ante to a wage and only desirable if firms cannot commit and the relative efficiency of on the job search to off- the job search is less than 20%. This result is hardly sensitive to the bargaining power of workers. Empirically we find both for the Netherlands and the US that this value is closer to 50%.
    Keywords: Collective wage agreements; on-the-job search; efficiency
    JEL: E24 J62 J63 J64
    Date: 2012–08–28
  13. By: Tito Boeri; Pietro Garibaldi; Espen R. Moen
    Abstract: The recent financial crises, alongside a dramatic rise in unemployment on both sides of the Atlantic, suggest that financial shocks do translate into the labor markets. In this paper we first document that financial recessions amplify labor market volatility and Okun's elasticity over the business cycle. Second, we highlight a key mechanisms linking financial shocks to job destruction, presenting and solving a simple model of labor market search and endogenous finance. While finance increases job creation and net output in normal times, it also augments their aggregate response in the aftermath of a financial shock. Third, we present evidence coherent with the idea that more leveraged sectors experience larger employment volatility during financial recessions. Theoretically, the job destruction effect of finance works as follows. Leveraged firms may find them- selves in a position in which their liquidity is suddenly called back by the lender. This has direct consequences on a firm ability to run and manage e xisting jobs. As a result, firms may be obliged to shut down part of their operations and destroy existing jobs. We argue that with well developed capital markets, firms will have an incentive to rely more on liquidity, and in normal times deep capital markets lead to tight labor markets. After an adverse liquidity shock, firms that rely much on liquidity, are hit disproportionally hard. This may explain why the unemployment rate in the US during the Great Recession increased more than in European countries experiencing larger output losses. Empirically, the paper uses a variety of datasets to test the implications of the model. At first we identify crises that, just like in the model, caused a sudden reduction of liquidity to firms. Next we draw on sector-level data on employment and leverage in a number of OECD countries at quarterly frequencies to assess whether highly leveraged equilibria originate more employment adjustment under financial recessions. We find that highly leveraged sectors and periods are associated with higher employment-to-output elasticities during banking crises and this effect explains the observation of higher Okun's elasticities during financial recessions. We also argue that the effect of leverage on employment adjustment can be interpreted as a causal effect, if our identification assumptions are considered plausible. All this amounts essentially for a test of the labor demand channel of adjustment. keywords: credit squeeze,matching,leverage JEL codes: G01,J23,J63
    Date: 2012
  14. By: Jean Guillaume Forand (Department of Economics, University of Waterloo); Vikram Maheshri (Department of Economics, University of Houston)
    Abstract: In this paper, we develop a general concept of regulation as a set of constraints imposed on market transactions by a welfare-maximizing authority. We present a model of regulated exchange in a dynamic matching framework with horizontal differentiation and argue that in less developed, or ‘thin’, markets, regulation is an important tool tocorrect market failure arising from mismatch between buyers and sellers. However, if markets develop and become ‘thick’, regulations can become onerous vestiges and deregulation is welfare-enhancing. When market thickness reduces trade frictions, a regulator can rely on market participants’ equilibrium behavior instead of explicit constraints on economic activities to ensure that transactions occur efficiently.
    JEL: D04 L51 C73 C78
    Date: 2012–04
  15. By: Coeurdacier, Nicolas; Guibaud, Stéphane; Jin, Keyu
    Abstract: In a period of rapid integration and accelerated growth in emerging markets, three striking trends have been (1) a divergence in the private saving rates of emerging markets and advanced economies, (2) large net capital outflows from emerging markets, and (3) a sustained decline in the world interest rate. This paper shows that in a multi-period OLG model, the interaction between growth and household credit constraints --- more severe in emerging markets --- is able to account for all of the above facts. We provide micro-level evidence that corroborates our mechanism: saving behaviors across age groups in the U.S. and China are broadly supportive of the predictions of the model.
    Keywords: capital flows; credit constraints; Globalization; life-cycle household savings; saving and current account imbalances
    JEL: F21 F32 F41
    Date: 2012–08
  16. By: Beau, D.; Clerc, L.; Mojon, B.
    Abstract: In this paper, we analyse the interactions between monetary and macro-prudential policies and the circumstances under which such interactions call for their coordinated implementation. We start with a review of the interdependencies between monetary and macro-prudential policies. Then, we use a DSGE model incorporating financial frictions, heterogeneous agents and housing, which is estimated for the euro area over the period 1985 -2010, to identify the circumstances under which monetary and macro-prudential policies may have compounding, neutral or conflicting impacts on price stability. We compare inflation dynamics across four “policy regimes” depending on: (a) the monetary policy objectives – that is, whether the policy instrument, the short-term interest rate factors in financial stability considerations by leaning against credit growth; and (b) the existence, or not, of an authority in charge of a financial stability objective through the implementation of macro-prudential policies that can “lean against credit” without affecting the short-term interest rate.
    Keywords: Monetary Policy; Financial Stability; Macro-prudential Policy; ESRB.
    JEL: E51 E58 E37 G13 G18
    Date: 2012
  17. By: Jean Guillaume Forand (Department of Economics, University of Waterloo)
    Abstract: I model the dynamic agency relationship underlying prevention. In each period, a politician with private information about a problem affecting the economy levies taxes from a voter and either directs them to solving the problem or diverts them into rents. Problems are persistent and rectifiable: they randomly generate observable disasters until enough money has been committed to solving them. In equilibrium, the voter trades off (a) preventing disasters while squandering tax levies in informational rents to politicians facing trivial problems and (b) limiting taxes and remediating costly disasters that eliminate politicians informational advantage and prove the need for action.
    JEL: D72 H10 C73
    Date: 2012–07
  18. By: Eric Smith (Santa Fe Institute); Martin Shubik (Cowles Foundation, Yale University)
    Abstract: The basic two-noncooperative-equilibrium-point model of Diamond and Dybvig is considered along with the work of Morris and Shin utilizing the possibility of outside noise to select a unique equilibrium point. Both of these approaches are essentially nondynamic. We add an explicit replicator dynamic from evolutionary game theory to provide for a sensitivity analysis that encompasses both models and contains the results of both depending on parameter settings.
    Keywords: Multiple equilibria, Runs, Replicator dynamics, Sensitivity analysis
    JEL: C73 D84 E59
    Date: 2012–08
  19. By: George Alessandria; Horag Choi
    Abstract: We study empirically and theoretically the growth of U.S. manufacturing exports from 1987 to 2007. We identify the change in iceberg costs with plant-level data on the intensity of exporting by exporters. Given this change in iceberg costs, we find that a GE model with heterogeneous establishments and a sunk cost of starting to export is consistent with both aggregate U.S. export growth and the changes in the number and size of U.S. exporters. The model also captures the non-linear dynamics of U.S. export growth. A model without a sunk export cost generates substantially less trade growth and misses out on the timing of export growth. Contrary to the theory, employment was largely reallocated from very large establishments, those with more than 2,500 employees, toward very small manufacturing establishments, those with fewer than 100 employees. Allowing for faster productivity growth in manufacturing, changes in capital intensity, and some changes in the underlying shock process makes the theory consistent with the changes in the employment size distribution. We also find that the contribution of trade to the contraction in U.S. manufacturing employment is small.
    Keywords: Exports ; Trade
    Date: 2012
  20. By: Jean-Paul L'Huillier (EIEF)
    Abstract: This paper develops a model of price rigidities and information diffusion in decentralized markets with private information. First, I provide a strategic microfoundation for price rigidities, by showing that firms are better off delaying the adjustment of prices when they face a high number of uninformed consumers. Second, in an environment where consumers learn from firms' prices, the diffusion of information follows a Bernoulli differential equation. Therefore, learning follows nonlinear dynamics. Third, the price rigidity produces an informational externality that affects welfare. Fourth, the dynamics of output are hump-shaped due to consumer learning.
    Date: 2012

This nep-dge issue is ©2012 by Christian Zimmermann. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.