nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2012‒09‒16
twenty-two papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Credit Frictions, Collateral and the Cyclical Behaviour of the Finance Premium By P-R. Agénor; G.J. Bratsiotis; D. Pfajfar
  2. Flight-to-Liquidity and the Great Recession By Sören Radde
  3. What (Really) Accounts for the Fall in Hours After a Technology Shock? By Nooman Rebei
  4. The Chicago Fed DSGE model By Scott Brave; Jeffrey R. Campbell; Jonas D. M. Fisher; Alejandro Justiniano
  5. Sovereign Defaults and Banking Crises By Sosa-Padilla, Cesar
  6. Loan regulation and child labor in rural India By Basab Dasgupta; Christian Zimmermann
  7. Macroeconomic implications of time-varying risk premia By François Gourio
  8. The Asymmetric Effects of Financial Frictions By Guillermo Ordoñez
  9. Home Production, Labor Wedges, and International Real Business Cycles By Loukas Karabarbounis
  10. Wages and Informality in Developing Countries By Costas Meghir; Renata Narita; Jean-Marc Robin
  11. A Theory of Political and Economic Cycles By Laurence Ales; Pricila Maziero; Pierre Yared
  12. Large shocks in menu cost models By Peter Karadi; Adam Reiff
  13. Deriving the Taylor Principle when the Central Bank Supplies Money By Ceri Davies; Max Gillman; Michal Kejak
  14. Eventually, noise and imitation implies balanced growth By Erzo G.J. Luttmer
  15. Capital Mobility and International Sharing of Cyclical Risk By Julien Bengui; Enrique G. Mendoza; Vincenzo Quadrini
  16. Household leverage By Stefano Corradin
  17. Asset pricing and housing supply in a production economy By Ivan Jaccard
  18. An adjustment cost model of distributional dynamics By Yoseph Yilma Getachew; Parantap Basu
  19. Deconstructing Growth - A Business Cycle Accounting Approach with application to BRICs By Chakraborty, Suparna; Otsu, Keisuke
  20. Dissecting Saving Dynamics: Measuring Wealth, Precautionary, and Credit Effects By Martin Sommer; Christopher Carroll; Jiri Slacalek
  21. Patents versus R&D subsidies in a Schumpeterian growth model with endogenous market structure By Chu, Angus C.; Furukawa, Yuichi
  22. Private versus public old-age security By Barnett, Richard C.; Bhattacharya, Joydeep; Puhakka, Mikko

  1. By: P-R. Agénor; G.J. Bratsiotis; D. Pfajfar
    Abstract: This paper examines the behaviour of the finance premium following technology and monetary shocks in a Dynamic Stochastic General Equilibrium (DSGE) model where borrowers use a fraction of their production (output) as collateral. We show that this simple framework is capable of producing a countercyclical finance premium, while matching the macro dynamics of well-documented stylized facts. A key feature is the endogenous derivation of the default probability from break even conditions, that results in the loan rate being set as a countercyclical finance premium over the cost of borrowing from the central bank. The latter is shown to provide an accelerator effect through which shocks can amplify the loan spread and the dynamic response of macro variables.
    Date: 2012
  2. By: Sören Radde
    Abstract: This paper argues that counter-cyclical liquidity hoarding by financial intermediaries may strongly amplify business cycles. It develops a dynamic stochastic general equilibrium model in which banks operate subject to financial frictions and idiosyncratic funding liquidity risk in their intermediation activity. Importantly, the amount of liquidity reserves held in the financial sector is determined endogenously: Balance sheet constraints force banks to trade off insurance against funding outflows with loan scale. The model shows that an aggregate shock to the collateral value of bank assets triggers a flight to liquidity, which amplifies the initial shock and induces credit crunch dynamics sharing key features with the Great Recession. The paper thus develops a new balance sheet channel of shock transmission that works through the composition of banks' asset portfolios rather than fluctuations in borrower net worth as in the financial accelerator literature.
    Keywords: real business cycles, financial frictions, liquidity hoarding, bank capital channel, credit crunch
    JEL: E22 E32 E44
    Date: 2012
  3. By: Nooman Rebei
    Abstract: The paper asks how state of the art DSGE models that account for the conditional response of hours following a positive neutral technology shock compare in a marginal likelihood race. To that end we construct and estimate several competing small-scale DSGE models that extend the standard real business cycle model. In particular, we identify from the literature six different hypotheses that generate the empirically observed decline in worked hours after a positive technology shock. These models alternatively exhibit (i) sticky prices; (ii) firm entry and exit with time to build; (iii) habit in consumption and costly adjustment of investment; (iv) persistence in the permanent technology shocks; (v) labor market friction with procyclical hiring costs; and (vi) Leontief production function with labor-saving technology shocks. In terms of model posterior probabilities, impulse responses, and autocorrelations, the model favored is the one that exhibits habit formation in consumption and investment adjustment costs. A robustness test shows that the sticky price model becomes as competitive as the habit formation and costly adjustment of investment model when sticky wages are included.
    Keywords: Economic models , Labor markets , Prices ,
    Date: 2012–08–28
  4. By: Scott Brave; Jeffrey R. Campbell; Jonas D. M. Fisher; Alejandro Justiniano
    Abstract: The Chicago Fed dynamic stochastic general equilibrium (DSGE) model is used for policy analysis and forecasting at the Federal Reserve Bank of Chicago. This article describes its specification and estimation, its dynamic characteristics and how it is used to forecast the US economy. In many respects the model resembles other medium scale New Keynesian frameworks, but there are several features which distinguish it: the monetary policy rule includes forward guidance, productivity is driven by neutral and investment specific technical change, multiple price indices identify inflation and there is a financial accelerator mechanism.
    Keywords: Keynesian economics ; Forecasting ; Stochastic analysis
    Date: 2012
  5. By: Sosa-Padilla, Cesar
    Abstract: Episodes of sovereign default feature three key empirical regularities in connection with the banking systems of the countries where they occur: (i) sovereign defaults and banking crises tend to happen together, (ii) commercial banks have substantial holdings of government debt, and (iii) sovereign defaults result in major contractions in bank credit and production. This paper provides a rationale for these phenomena by extending the traditional sovereign default framework to incorporate bankers that lend to both the government and the corporate sector. When these bankers are highly exposed to government debt a default triggers a banking crisis which leads to a corporate credit collapse and subsequently to an output decline. When calibrated to Argentina's 2001 default episode the model produces default on equilibrium with a frequency in line with actual default frequencies, and when it happens credit experiences a sharp contraction which generates an output drop similar in magnitude to the one observed in the data. Moreover, the model also matches several moments of the cyclical dynamics of macroeconomic aggregates.
    Keywords: Sovereign Default; Banking Crisis; Credit Crunch; Optimal Fiscal Policy; Markov Perfect Equilibrium; Endogenous Cost of Default; Domestic Debt
    JEL: E62 F34
    Date: 2012
  6. By: Basab Dasgupta; Christian Zimmermann
    Abstract: We study the impact of loan regulation in rural India on child labor with an overlapping-generations model of formal and informal lending, human capital accumulation, adverse selection, and differentiated risk types. Specifically, we build a model economy that replicates the current outcome with a loan rate cap and no lender discrimination by risk using a survey of rural lenders. Households borrow primarily from informal moneylenders and use child labor. Removing the rate cap and allowing lender discrimination markedly increases capital use, eliminates child labor, and improves welfare of all household types.
    Keywords: Loans ; Child labor ; India
    Date: 2012
  7. By: François Gourio (Boston University, Department of Economics, 270 Bay State Road, Boston MA 02215, USA and NBER)
    Abstract: A large empirical literature suggests that risk premia on stocks or corporate bonds are large and countercyclical. This paper studies a simple real business cycle model with a small, exogenously time-varying risk of disaster, and shows that it can replicate several important facts documented in the literature. In the model, an increase in disaster risk leads to a decline of output, investment, stock prices, and interest rates, and an increase in the expected return on risky assets. The model matches well business cycle data and asset price data, and the countercyclicality of risk premia. I present an extension of the model with endogenous choice of leverage and endogenous default, and show that the model accounts well for the level and cyclicality of credit spreads, and in particular the relation between investment and credit spreads. JEL Classification: E32, E44, G12
    Keywords: Business cycles, investment, credit spreads, risk premia, rare events
    Date: 2012–08
  8. By: Guillermo Ordoñez
    Abstract: Economic variables are known to move asymmetrically over the business cycle: quickly and sharply during crises, but slowly and gradually during recoveries. Not known is the fact that this asymmetry is stronger in countries with less-developed financial systems. This new fact is documented using cross-country data on loan interest rates, investment, and output. The fact is then explained using a learning model with endogenous flows of information about economic conditions. Asymmetry is shown to be stronger in less-developed countries because these countries have greater financial frictions, which are captured in the model by higher monitoring and bankruptcy costs. These greater frictions magnify the crisis reactions of lending rates and economic activity to shocks and then delay their recovery by restricting the generation of information after the crisis. Empirical evidence and a quantitative exploration of the model show that this explanation is consistent with the data.
    JEL: D53 D82 E32 E44 G33
    Date: 2012–09
  9. By: Loukas Karabarbounis
    Abstract: This paper explores implications of non-separable preferences with home production for international business cycles. Home production induces substitution effects that break the link between market consumption and its marginal utility and help explain several stylized facts of the open economy. In an estimated two-country model with complete asset markets in which home production generates a labor wedge that mimics its empirical counterpart, output is more correlated than consumption across countries, labor inputs and labor wedges are positively correlated across countries, and relative market consumption is negatively related to the real exchange rate. International time use surveys corroborate predictions of the model, showing a significant relationship between time spent on home production, labor wedges, and real exchange rates, both at business cycle frequencies and in the cross section of countries. By contrast, non-separabilities based on leisure do not help explain variations in labor wedges or real exchange rates.
    JEL: E32 F41 F44 J22
    Date: 2012–09
  10. By: Costas Meghir (Cowles Foundation, Yale University); Renata Narita (World Bank); Jean-Marc Robin (Dept. of Economics, Sciences Po)
    Abstract: It is often argued that informal labor markets in developing countries promote growth by reducing the impact of regulation. On the other hand informality may reduce the amount of social protection offered to workers. We extend the wage-posting framework of Burdett and Mortensen (1998) to allow heterogeneous firms to decide whether to locate in the formal or the informal sector, as well as set wages. Workers engage in both off the job and on the job search. We estimate the model using Brazilian micro data and evaluate the labor market and welfare effects of policies towards informality.
    Keywords: Informality, Unemployment, Job search, Wage posting, Equilibrium wage distributions, On the job search, Method of moments
    JEL: J24 J3 J42 J6 O17
    Date: 2012–09
  11. By: Laurence Ales; Pricila Maziero; Pierre Yared
    Abstract: We develop a theoretical framework in which political and economic cycles are jointly determined. These cycles are driven by three political economy frictions: policymakers are non-benevolent, they cannot commit to policies, and they have private information about the tightness of the government budget and rents. Our first main result is that, in the best sustainable equilibrium, distortions to production emerge and never disappear even in the long run. This result is driven by the interaction of limited commitment and private information on the side of the policymaker, since in the absence of either friction, there are no long run distortions to production. Our second result is that, if the variance of private information is sufficiently large, there is equilibrium turnover in the long run so that political cycles never disappear. Finally, our model produces a long run distribution of taxes, distortions, and turnover, where these all respond persistently to temporary economic shocks. We show that the model's predictions are consistent with the empirical evidence on the interaction of political and economic cycles in developing countries.
    JEL: D82 E62 H21 P16
    Date: 2012–09
  12. By: Peter Karadi (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany); Adam Reiff (Magyar Nemzeti Bank, 1054 Budapest, Szabadság tér 8-9, Hungary)
    Abstract: How do prices react to large aggregate shocks? Our new micro-data evidence on value-added tax changes shows that prices react (i) flexibly and (ii) asymmetrically to large positive and negative shocks. We use it to quantitatively evaluate the performance of prominent pricing models. We show that standard time-dependent models are unable to reproduce either of these facts. A realistically calibrated state-dependent menu cost model, in contrast, is successful in matching the observed price responses. Its success lies in its ability to capture the exploding fraction of price changes for large shocks. The evidence facilitates comparison of different menu cost models and raises doubts on alternative pricing models with information or search frictions as sole reasons for price rigidity. JEL Classification: E31, E52
    Keywords: Inflation asymmetry, state-dependent pricing, time-dependent pricing, value-added tax shock
    Date: 2012–07
  13. By: Ceri Davies; Max Gillman; Michal Kejak
    Abstract: The paper presents a human-capital-based endogenous growth, cash-in-advance economy with endogenous velocity where exchange credit is produced in a decentralized banking sector, and money is supplied stochastically by the central bank. From this it derives an exact functional form for a general equilibrium `Taylor rule'. The inflation coefficient is always greater than one when the velocity of money exceeds one; velocity growth enters the equilibrium condition as a separate variable. The paper then successfully estimates the magnitude of the coefficient on inflation from 1000 samples of Monte Carlo simulated data. This shows that it would be spurious to conclude that the central bank has a reaction function with a strong response to inflation in a `Taylor principle' sense, since it is only meeting fiscal needs through the inflation tax. The paper also estimates several deliberately misspecified models to show how an inflation coefficient of less than one can result from model misspecification. An inflation coefficient greater than one holds theoretically along the balanced growth path equilibrium, making it a sharply robust principle based on the economy's underlying structural parameters.
    Date: 2012–07–23
  14. By: Erzo G.J. Luttmer
    Abstract: This paper adds imitation by incumbent firms, and not just by new entrants, to the model of selection and growth developed in Luttmer [2007]. Noisy firm-level innovation and imitation give rise to a long-run growth rate that exceeds the average rate at which individual firms innovate. It can be shown, in simple examples, that the economy converges to a long-run balanced growth path from compactly supported initial productivity distributions. The right tail of the stationary distribution of de-trended productivity is approximately Pareto. The tail index of this distribution depends on the rate at which incumbents are able to imitate only indirectly, through general equilibrium effects of this parameter on the equilibrium growth rate.
    Date: 2012
  15. By: Julien Bengui; Enrique G. Mendoza; Vincenzo Quadrini
    Abstract: This paper investigates whether the international globalization of financial markets allows for significant cross-country risk-sharing at the business cycle frequency. We find that cross-country risk-sharing is still limited and this is unlikely to be the result of financial frictions that limit state-contingent contracts. Part of the limited international risk sharing could be the consequence of frictions that de-facto reduce the short-term mobility of financial capital. But even with these frictions we find significant divergence between model predictions and the data.
    JEL: F36 F44 G15
    Date: 2012–09
  16. By: Stefano Corradin (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany)
    Abstract: I propose a life-cycle model where a finitely lived risk averse agent finances her housing investment choosing to provide a down payment. After signing the mortgage contract, the agent may strategically default and move into the rental market. Risk neutral lenders efficiently price mortgages charging a default premium to compensate themselves for expected losses due to default on a mortgage. As a result, mortgage value and amount of leverage are closely linked. An alternative is for the agent to rent the same house, paying a rent fully adjustable to house prices. The rent risk premium is set such that the agent is indifferent ex ante between owning with a mortgage and renting. Three main results arise. First, the optimal down payment and the house price volatility are positively related. The higher the house price volatility, the higher the down payment the agent provides to decrease the volatility of the equity share in the house. Second, in the presence of borrowing constraints, a higher risk of unemployment persistence and/or a substantial drop in labor income decreases the leveraged position the agent takes. Third, ruling out the effect of taking costly leverage on owning a house significantly biases the results in favor of owning over renting. JEL Classification: G21, E21
    Keywords: Default premium, rent risk premium, loan to value ratio, loan to income ratio and negative home equity
    Date: 2012–07
  17. By: Ivan Jaccard (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt, Germany)
    Abstract: We develop a representative agent model of a production economy in order to explain the joint dynamics of house prices and equity returns. In a model generating costly business cycle fluctuations, we find that restrictions on housing supply have important implications for asset pricing. Together with habit formation in the composite of consumption and leisure, building restrictions provide an explanation for the high volatility of house prices and contribute to the resolution of asset pricing puzzles. JEL Classification: E2, E3, G1
    Keywords: House prices, cost of business cycle, adjustment costs, housing returns
    Date: 2012–07
  18. By: Yoseph Yilma Getachew (Durham Business School); Parantap Basu (Durham Business School)
    Abstract: We analyze the distributional e¤ects of adjustment cost in an environment with incomplete capital market. We find that a higher adjustment cost for human capital acquisition slows down the intergenerational mobility and results in a persistent inequality across generations. A low depreciation cost of human capital contributes to longer life of the capital which could elevate this adjustment cost and hence contribute to this inequality persistence. A lower total factor productivity could hurt poor with a higher marginal product when human capital has low depreciation. This could add to the slowing of intergenerational mobility when adjustment cost is present. The quantitative analysis of our model suggests that the human capital adjustment cost is nontrivial to reproduce the observed persistence of inequality.
    Keywords: Intergenerational mobility, inequality persistence, adjustment cost of capital
    Date: 2012–09–07
  19. By: Chakraborty, Suparna; Otsu, Keisuke
    Abstract: What are the economic mechanisms that account for sudden growth spurts? Are these mechanisms similar across episodes? Focusing on the economic resurgence of the BRICs over the last decade, we employ the Business Cycle Ac- counting methodology developed by Chari, Kehoe and McGrattan (2007) to address these questions. Our results highlight that while efficiency wedges do contribute in a large part to growth, especially in Brazil and Russia, there is an increasing importance of investment wedge especially in the late 2000s, noted in China and India. The results are typically related to the stages of development with Brazil and Russia coming off a crisis to grow in the 2000s, while India and China were already on a stable growth path. Our conclusions are robust to alternative methodological extensions where we allow shocks to the trend component of efficiency as opposed to traditional shocks to the cyclical component, as well as to standard modifications where we allow for investment adjustment costs. Relating improvements in wedges to institutional and …financial reforms, we …find that …financial development and improvements in effective governance in BRICs are consistent with improvements in investment and efficiency wedges that led to growth
    Keywords: business cycle accounting; efficiency; market frictions; trend shocks; investment adjustment costs
    JEL: E32 O57 O4
    Date: 2012–08–30
  20. By: Martin Sommer; Christopher Carroll; Jiri Slacalek
    Abstract: We argue that the U.S. personal saving rate’s long stability (from the 1960s through the early 1980s), subsequent steady decline (1980s - 2007), and recent substantial increase (2008 - 2011) can all be interpreted using a parsimonious ‘buffer stock’ model of optimal consumption in the presence of labor income uncertainty and credit constraints. Saving in the model is affected by the gap between ‘target’ and actual wealth, with the target wealth determined by credit conditions and uncertainty. An estimated structural version of the model suggests that increased credit availability accounts for most of the saving rate’s long-term decline, while fluctuations in net wealth and uncertainty capture the bulk of the business-cycle variation.
    Date: 2012–09–04
  21. By: Chu, Angus C.; Furukawa, Yuichi
    Abstract: In this note, we explore the different implications of patent breadth and R&D subsidies on economic growth and endogenous market structure in a Schumpeterian growth model. We find that these two policy instruments have the same positive effect on economic growth when the model exhibits counterfactual scale effects under an exogenous number of firms. However, when the model becomes scale-invariant under an endogenous number of …firms, R&D subsidies increase economic growth but decrease the number of firms, whereas patent breadth expands the number of firms but reduces economic growth. Therefore, R&D subsidy is perhaps a more suitable policy instrument than patent breadth for the purpose of stimulating economic growth.
    Keywords: economic growth; endogenous market structure; patents; R&D subsidies
    JEL: O30 O40
    Date: 2012–08
  22. By: Barnett, Richard C.; Bhattacharya, Joydeep; Puhakka, Mikko
    Abstract: We compare two institutions head on, a family compact – a parent makes a transfer to her parent in anticipation of a possible future gift from her children – with a pay-as-you-go, social security system in a lifecycle model with endogenous fertility wherein children are valued both as consumption and investment goods. Our focus is strictly on the pension dimension of these competing institutions. We show that an optimally-chosen family compact and a social security system cannot co-exist; indeed, the former may be preferred. A strong-enough negative shock to middle-age incomes destroys family compacts. While such a setting might appear ideal for the introduction of a social security system – as the experience of Europe, circa 1880s, would suggest – this turns out not to be the case: if incomes are too depressed to allow family compacts to flourish, they are also too low to permit introduction of an optimal social security system.
    Keywords: Fertility; social security; pensions; family compacts; intergenerational cooperation; self-enforcing constitutions
    JEL: E21 E32
    Date: 2012–09–04

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.