nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2012‒10‒06
nineteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. News and Financial Intermediation in Aggregate and Sectoral Fluctuations By Görtz, Christoph; Tsoukalas, John D.
  2. The banking and distribution sectors in a small open economy DSGE Model By Szabolcs Deák; Lionel Fontagné; Marco Maffezzoli; Massimiliano Marcellino
  3. Unemployment Insurance and Optimal Taxation in Search Models of the Labor Market By Athanasios Geromichalos
  4. Uncertainty Shocks in a Model of Effective Demand By Susanto Basu; Brent Bundick
  5. Sentiments and aggregate demand fluctuations By Jess Benhabib; Pengfei Wang; Yi Wen
  6. A DSGE model for a SOE with Systematic Interest and Foreign Exchange policies in which policymakers exploit the risk premium for stabilization purposes By Escudé, Guillermo J.
  7. Separations, Sorting and Cyclical Unemployment By Mueller, Andreas I.
  8. Wages and Informality in Developing Countries By Costas Meghir; Renata Narita; Jean-Marc Robin
  9. Monetary Policy, Asset Prices, and Liquidity in Over-the-Counter Markets By Athanasios Geromichalos; Lucas Herrenbrueck
  10. Monetary policy in a DSGE model with “Chinese Characteristics” By Chun Chang; Zheng Liu; Mark M. Spiegel
  11. Liquidity and welfare By Yi Wen
  12. The Optimal Carbon Tax and Economic Growth: Additive versus multiplicative damages By Armon Rezai; Frederick van der Ploeg; Cees Withagen
  13. Existence and Uniqueness of Perturbation Solutions in DSGE Models By Lan, Hong; Meyer-Gohde, Alexander
  14. Bargaining, Aggregate Demand and Employment By Charpe, Matthieu; Kühn, Stefan
  15. Optimal life-cycle portfolios for heterogeneous workers By Fabio C. Bagliano; Carolina Fugazza; Giovanna Nicodano
  16. Technical appendix: on financing retirement with an aging population By Ellen R. McGrattan; Edward C. Prescott
  17. Qualitative Easing: How it Works and Why it Matters By Roger E.A. Farmer
  18. Optimal life-cycle portfolios for heterogeneous workers By Fabio C. Bagliano; Carolina Fugazza; Giovanna Nicodano
  19. Middle-income growth traps By Agenor, Pierre-Richard; Canuto, Otaviano

  1. By: Görtz, Christoph; Tsoukalas, John D.
    Abstract: We estimate a two-sector DSGE model with financial intermediaries—a-la Gertler and Karadi (2011) and Gertler and Kiyotaki (2010)—and quantify the importance of news shocks in accounting for aggregate and sectoral fluctuations. Our results indicate a significant role of financial market news as a predictive force behind fluctuations. Specifically, news about the value of assets held by financial intermediaries, reflected one to two years in advance in corporate bond markets, generate countercyclical corporate bond spreads, affect the supply of credit, and are estimated to be a significant source of aggregate fluctuations, accounting for approximately 31% of output, 22% of investment and 31% of hours worked variation in cyclical frequencies. Importantly, asset value news shocks generate both aggregate and sectoral co-movement with a standard preference specification. Financial intermediation is key for the importance and propagation of asset value news shocks.
    Keywords: news; financial intermediation; business cycles; DSGE; Bayesian estimation
    JEL: E2 E3
    Date: 2012–09
  2. By: Szabolcs Deák; Lionel Fontagné; Marco Maffezzoli; Massimiliano Marcellino
    Abstract: The recent crisis has emphasized the role of financial - macroeconomic interactions, and international trade in goods and services, in the transmission of the shocks. Both phenomena, closely related to the higher degree of globalization, are very relevant for small open economies, and particularly so when a large share of the economy relies on financial and distribution services. Hence, in this paper we propose to incorporate the banking and distribution sectors into a medium scale DSGE model of a small open economy. As an illustration, the resulting model is then calibrated to match the specific characteristics of the Luxembourg economy, where the financial sector plays a key role. We believe that the results are also of more general interest for studying the reaction of small open economies to real and financial shocks. JEL Codes: E13; E32; Keywords: DSGE model, Small open economy, Banking, International trade, Luxembourg, Segmented labor market; Trade union
    Date: 2012
  3. By: Athanasios Geromichalos (Department of Economics, University of California Davis)
    Abstract: In many search models of the labor market, unemployment insurance (UI) is conveniently interpreted as the value of leisure or home production and is, therefore, treated as a parameter. However, in reality, UI has to be funded through taxation that might be distortionary. In this paper, I analyze the welfare implications of different taxation systems within two equilibrium models of unemployment: random search and directed search. In a random search model without taxes, efficiency is typically not achieved, unless the so-called Hosios condition is satisfied. If the bargaining power of firms is large, a lump-sum tax can discourage firms from entering and improve welfare. In a directed search model without taxes, constrained efficiency is always achieved. Since firms “direct” workers to apply to them by posting wages, raising UI funds in a lump-sum manner always distorts the efficient allocation, as it gives firms an incentive to be excessively aggressive in their attempt to maximize the probability of filing up their vacancies. I discuss two ways through which this externality can be internalized and efficiency can be re-established.
    Keywords: Directed Search, Random Search, Unemployment Insurance, Optimal Taxation
    JEL: C78 E24 J65
    Date: 2012–09–24
  4. By: Susanto Basu; Brent Bundick
    Abstract: Can increased uncertainty about the future cause a contraction in output and its components? This paper examines the role of uncertainty shocks in a one-sector, representative-agent, dynamic, stochastic general-equilibrium model. When prices are flexible, uncertainty shocks are not capable of producing business-cycle comovements among key macroeconomic variables. With countercyclical markups through sticky prices, however, uncertainty shocks can generate fluctuations that are consistent with business cycles. Monetary policy usually plays a key role in offsetting the negative impact of uncertainty shocks. If the central bank is constrained by the zero lower bound, then monetary policy can no longer perform its usual stabilizing function and higher uncertainty has even more negative effects on the economy. We calibrate the size of uncertainty shocks using fluctuations in the VIX and find that increased uncertainty about the future may indeed have played a significant role in worsening the Great Recession, which is consistent with statements by policymakers, economists, and the financial press.
    JEL: E32 E52
    Date: 2012–09
  5. By: Jess Benhabib; Pengfei Wang; Yi Wen
    Abstract: We formalize the Keynesian insight that aggregate demand driven by sentiments can generate output fluctuations under rational expectations. When production decisions must be made un- der imperfect information about aggregate demand, optimal decisions based on sentiments can generate stochastic self-fulfilling rational expectations equilibria in standard economies without aggregate shocks, externalities, persistent informational frictions, or even any strategic comple- mentarity. Our general equilibrium model is deliberately simple, but could serve as a benchmark for more complicated equilibrium models with additional features.
    Keywords: Keynesian economics ; Equilibrium (Economics)
    Date: 2012
  6. By: Escudé, Guillermo J.
    Abstract: This paper builds a DSGE model for a SOE in which the central bank systematically intervenes both the domestic currency bond and the FX markets using two policy rules: a Taylor-type rule and a second rule in which the operational target is the rate of nominal currency depreciation. For this, the instruments used by the central bank (bonds and international reserves) must be included in the model, as well as the institutional arrangements that determine the total amount of resources the central bank can use. The ‘corner’ regimes in which only one of the policy rules is used are particular cases of the model. The model is calibrated and implemented in Dynare for 1) simple policy rules, 2) optimal simple policy rules, and 3) optimal policy under commitment. Numerical losses are obtained for ad-hoc loss functions for di¤erent sets of central bank preferences (styles). The results show that the losses are systematically lower when both policy rules are used simultaneously, and much lower for the usual preferences (in which only inflation and/or output stabilization matter). It is shown that this result is basically due to the central bank’ enhanced ability, when it uses the two policy rules, to influence capital flows through the effects of its actions on the endogenous risk premium in the (risk-adjusted) interest parity equation.
    Keywords: DSGE models; small open economy; exchange rate policy; optimal policy
    JEL: E58 F41 O24
    Date: 2012–09
  7. By: Mueller, Andreas I. (Columbia University)
    Abstract: This paper establishes a new fact about the compositional changes in the pool of unemployed over the U.S. business cycle and evaluates a number of theories that can potentially explain it. Using micro-data from the Current Population Survey for the years 1962-2011, it documents that in recessions the pool of unemployed shifts towards workers with high wages in their previous job. Moreover, it shows that these changes in the composition of the unemployed are mainly due to the higher cyclicality of separations for high-wage workers, and not driven by differences in the cyclicality of job-finding rates. A search-matching model with endogenous separations and worker heterogeneity in terms of ability has difficulty in explaining these patterns, but an extension of the model with credit-constraint shocks does much better in accounting for the new facts.
    Keywords: sorting, unemployment, business cycles, search-matching, vacancies
    JEL: E24 E32 J63
    Date: 2012–09
  8. By: Costas Meghir (Economics Department, Yale University); Renata Narita (World Bank); Jean-Marc Robin (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: entrepreneurship; credit constraints; business training; consulting; managerial capital
    JEL: J24 J3 J42 J6 O17
    Date: 2012–09
  9. By: Athanasios Geromichalos; Lucas Herrenbrueck (Department of Economics, University of California Davis)
    Abstract: We revisit a traditional topic in monetary economics: the relationship between asset prices and monetary policy. We study a model in which money helps facilitate trade in decentralized markets, as in Lagos andWright (2005), and real assets are traded in an over-the-counter (OTC) market, as in Duffie, Gˆarleanu, and Pedersen (2005). Agents wish to hold liquid portfolios, but liquidity comes at a cost: inflation. The OTC market serves as a secondary asset market, in which agents can rebalance their positions depending on their liquidity needs. Hence, a contribution of our paper is to provide a micro-founded explanation of the assumption that different investors have different valuations for the same asset, which is the key for generating gains from trade in the Duffie et al framework. In equilibrium, assets can be priced higher than their fundamental value because they help agents avoid the inflation tax.
    Keywords: monetary-search models, liquidity, asset prices, over-the-counter markets
    JEL: E31 E50 E52 G12
    Date: 2012–09–25
  10. By: Chun Chang; Zheng Liu; Mark M. Spiegel
    Abstract: We examine optimal monetary policy under prevailing Chinese policy – including capital controls and nominal exchange rate targets – in a DSGE model calibrated to Chinese and global data. Under the closed capital account, domestic citizens are prohibited from holding foreign assets. Foreign currency revenues are sold to the central bank, which then sterilizes these purchases by issuing domestic debt. Uncovered interest parity conditions do not hold, so sterilization results in transfers between the private sector and the government. Given a negative shock to relative foreign interest rates, similar to that which occurred during the global financial crisis, sterilization costs increase and optimal policy calls for a reduction in sterilization activity, resulting in an easing of monetary policy and an increase in Chinese inflation. We then compare these dynamics to three alternative liberalizations: A partial opening of the capital account, removing the exchange rate peg, or doing both simultaneously. The regime with liberalized capital accounts and floating exchange rate yields the lowest losses to the central bank under the foreign interest rate shock. However, intermediate reforms do less well. In particular, letting the exchange rate float without opening the capital account results in higher losses following the interest rate shock than the benchmark case of no liberalization.
    Keywords: Monetary policy ; Foreign exchange ; China
    Date: 2012
  11. By: Yi Wen
    Abstract: This paper develops an analytically tractable Bewley model of money featuring capital and financial intermediation. It is shown that when money is a vital form of liquidity to meet uncertain consumption needs, the welfare costs of inflation can be extremely large. With log utility and parameter values that best match both the aggregate money demand curve suggested by Lucas (2000) and the variance of household consumption, agents in our model are willing to reduce consumption by 7% ~ 10% (or more) to avoid 10% annual inflation. In other words, raising the U.S. inflation target from 2% to 3% amounts to roughly a 0:5 percentage reduction in aggregate consumption. The astonishingly large welfare costs of inflation arise because inflation tightens liquidity constraints by destroying the buffer-stock value of money, thus raising the volatility of consumption at the household level. Such an inflation-induced increase in the idiosyncratic consumption-volatility at the micro level cannot be captured by representative- agent models or the Bailey triangle. Although the development of a credit and banking system can reduce the welfare costs of inflation by alleviating liquidity constraints, with realistic credit limits the cost of moderate inflation still remains several times larger than estimations based on the Bailey triangle. Our finding not only provides a justification for adopting a low inflation target by central banks, but also offers a plausible explanation for the robust positive relationship between inflation and social unrest in developing countries where money is the major form of household financial wealth.
    Keywords: Liquidity (Economics) ; Welfare
    Date: 2012
  12. By: Armon Rezai; Frederick van der Ploeg; Cees Withagen
    Abstract: In a calibrated integrated assessment model we investigate the differentia impact of additive and multiplicative damages from climate change for both a socially optimal and a business-as-usual scenario in the market economy within the context of a Ramsey model of economic growth. The sources ofenergy are fossil fuel which is available at a cost which rises as reserves diminish and a carbon-free backstop supplied at a decreasing cost. if damages are not proportional to aggregate production output, and the economy is along a development path, the social cost of carbon and the optimal carbon tax are smaller as damages can more easily be compensated for by higher output. As a result, the economy switches later from fossil fuel to the carbon-free backstop and leaves less fossil fuel in situ. This is in contrast to a partial equilibrium analysis with dmages in utility rather than in production which finds that the willingness to forsake current consumption to avoid future global warming is higher (lower) under additive damages in a growing economy if the elasticity of intertemporal substitution is smaller (bigger) than one.
    Keywords: climate change, multiplicative damages, additive damages, integrated assessment models, Ramsey growth model, fossil fuel, carbon-free backstop
    JEL: H21 Q51 Q54
    Date: 2012
  13. By: Lan, Hong; Meyer-Gohde, Alexander
    Abstract: We prove the existence of unique solutions for all undetermined coefficients of nonlinear perturbations of arbitrary order in a wide class of discrete time DSGE models under standard regularity and saddle stability assumptions for linear approximations. Our result follows from the straightforward application of matrix analysis to our perturbation derived with Kronecker tensor calculus. Additionally, we relax the assumptions needed for the local existence theorem of perturbation solutions and prove that the local solution is independent of terms first order in the perturbation parameter.
    Keywords: perturbation; DSGE; nonlinear; Sylvester equations; matrix calculus; Bézout theorem
    JEL: C61 C63 E17
    Date: 2012–09
  14. By: Charpe, Matthieu; Kühn, Stefan
    Abstract: This paper depicts the negative impact of a falling real wage caused by reduced bargaining power of workers on aggregate demand and employment. Contrary to standard New Keynesian models, the presence of consumers not participating in financial markets (rule of thumb consumers) causes an immediate negative response of output and employment, which is amplified when the economy faces a lower bound on the nominal interest rate. Additionally, the paper shows that by supporting consumption demand, minimum wages might enhance output and employment.
    Keywords: real wage; search and matching; aggregate demand; household heterogeneity
    JEL: E21 E24 E32
    Date: 2012–09
  15. By: Fabio C. Bagliano (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy); Carolina Fugazza (Department of Economics, University of Milan-Bicocca); Giovanna Nicodano (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy)
    Abstract: Household portfolios include risky bonds, beyond stocks, and respond to permanent labour income shocks. This paper brings these features into a life-cycle setting, and shows that optimal stock investment is constant or increasing in age before retirement for realistic parameter combinations. The driver of such inversion in the life-cycle profile is the resolution of uncertainty regarding social security pension, which increases the investor's risk appetite. This occurs if a small positive contemporaneous correlation between permanent labour income shocks and stock returns is matched by a realistically high variance of such shocks and/or risk aversion. Absent this combination, the typical downward sloping profile obtains. Overlooking differences in optimal investment profiles across heterogeneous workers results in large welfare losses, in the order of 17-26% of lifetime consumption.
    Keywords: Life-cycle portfolio choice, background risk, age rule, investor heterogeneity, stock market participation
    JEL: G11 D91
    Date: 2012–09
  16. By: Ellen R. McGrattan; Edward C. Prescott
    Keywords: Debt - United States ; Taxation
    Date: 2012
  17. By: Roger E.A. Farmer
    Abstract: This paper is about the effectiveness of qualitative easing; a government policy that is designed to mitigate risk through central bank purchases of privately held risky assets and their replacement by government debt, with a return that is guaranteed by the taxpayer. Policies of this kind have recently been carried out by national central banks, backed by implicit guarantees from national treasuries. I construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where agents are unable to participate in financial markets that open before they are born. I show that a change in the asset composition of the central bank’s balance sheet will change equilibrium asset prices. Further, I prove that a policy in which the central bank stabilizes fluctuations in the stock market is Pareto improving and is costless to implement.
    JEL: E0 E5 E52 E62
    Date: 2012–09
  18. By: Fabio C. Bagliano; Carolina Fugazza; Giovanna Nicodano
    Abstract: Household portfolios include risky bonds, beyond stocks, and respond to permanent labour income shocks. This paper brings these features into a life-cycle setting, and shows that optimal stock investment is constant or increasing in age before retirement for realistic parameter combinations. The driver of such inversion in the life-cycle pro?le is the resolution of un- certainty regarding social security pension, which increases the investor?s risk appetite. This occurs if a small positive contemporaneous correlation between permanent labour income shocks and stock returns is matched by a realistically high variance of such shocks and/or risk aversion. Absent this combination, the typical downward sloping pro?le obtains. Overlooking dif- ferences in optimal investment pro?les across heterogeneous workers results in large welfare losses, in the order of 17-26% of lifetime consumption.
    Keywords: Life-cycle portfolio choice, background risk, age rule, investor heterogeneity, stock market participation
    JEL: G11 D91
    Date: 2012
  19. By: Agenor, Pierre-Richard; Canuto, Otaviano
    Abstract: This paper studies the existence of middle-income growth traps in a two-period overlapping generations model of economic growth with two types of labor and endogenous occupational choices. It also distinguishes between"basic"and"advanced"infrastructure, with the latter promoting design activities, and accounts for a knowledge network externality associated with product diversification. Multiple steady-state equilibria may emerge, one of them taking the form of a low-growth trap characterized by low productivity growth and a misallocation of talent -- defined as a relatively low share of high-ability workers in design activities. Improved access to advanced infrastructure may help escape from that trap. The implications of other public policies, including the protection of property rights and labor market reforms, are also discussed.
    Keywords: Economic Theory&Research,Political Economy,Labor Policies,Economic Growth,Debt Markets
    Date: 2012–09–01

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