nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2013‒08‒16
thirteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Solving second and third-order approximations to DSGE models: A recursive Sylvester equation solution By Andrew Binning
  2. On the Provision of Insurance Against Search-Induced Wage Fluctuations By Jean-Baptiste Michau
  3. Learning Leverage Shocks and the Great Recession. By Pintus, P. A.; Suda, J.
  4. DSGE Models and the Lucas critique By Samuel Hurtado
  5. Stochastic Optimal Growth with Risky Labor Supply By Yiyong CAI; Takashi Kamihigashi; John Stachurski
  6. Strict Fiscal Rules and Macroeconomic Stability: The Case of Social VAT. By Fève, P.; Matheron, J.; Sahuc,J-G.
  7. Efficiency, Distortions and Factor Utilization during the Interwar Period By Klein, Alexander School of Economics, University of Kent; Otsuy, Keisuke
  8. Investment in a Growth Model of Non-Excludable Aggregate Capital By Eric Fesselmeyer; Leonard J. Mirman; Marc Santugini
  9. Bank size and macroeconomic shock transmission: Are there economic volatility gains from shrinking large, too big to fail banks? By Uluc Aysun
  10. The Laffer Curve in an Incomplete-Market Economy. By Fève, P.; Matheron, J.; Sahuc,J-G.
  11. Collateral constraints and macroeconomic asymmetries By Luca Guerrieri; Matteo Iacoviello
  12. The determinants of the deviations from the interest rate parity condition By Uluc Aysun; Sanglim Lee
  13. Sudden stops, time inconsistency, and the duration of sovereign debt By Juan Carlos Hatchondo; Leonardo Martinez

  1. By: Andrew Binning (Norges Bank (Central Bank of Norway))
    Abstract: In this paper I derive the matrix chain rules for solving a second and a third-order approximation to a DSGE model that allow the use of a recursive Sylvester equation solution method. In particular I use the solution algorithms of Kamenik (2005) and Martin & Van Loan (2006) to solve the generalised Sylvester equations. Because I use matrix algebra instead of tensor notation to find the system of equations, I am able to provide standalone Matlab routines that make it feasible to solve a medium scale DSGE model in a competitive time. I also provide Fortran code and Matlab/Fortran mex files for my method.
    Keywords: Solving dynamic models, Second-order approximation, Third-order appeoximation, Second-order matrix chain rule, Third-order matrix chain rule, Generalised Sylvester equations
    Date: 2013–08–05
  2. By: Jean-Baptiste Michau (Department of Economics, Ecole Polytechnique - CNRS : UMR7176 - Polytechnique - X)
    Abstract: This paper investigates the provision of insurance to workers against search-induced wage uctuations. I rely on numerical simulations of a model of on-the-job search and precautionary savings. The model is calibrated to low skilled workers in the U.S.. The extent of insurance is determined by the degree of progressivity of a non-linear transfer schedule. The fundamental trade-off is that a more generous provision of insurance reduces incentives to search for better paying jobs, which is detrimental to the production efficiency of the economy. I show that progressivity raises the search intensity of unemployed worker, which reduces the equilibrium rate of unemployment, but lowers the search intensity of employed job seekers, which results in a lower output level. I also solve numerically for the optimal non-linear transfer schedule. The optimal policy is to provide almost no insurance up to a monthly income level of $1450, such as to preserve incentives to move up the wage ladder, and full insurance above $1650. This policy halves the standard deviation of labor incomes, increases output by 2.4% and generates a consumption-equivalent welfare gain of 1.3%. Forbidding private savings does not fundamentally change the shape of the optimal transfer function, but tilts the optimal policy towards more insurance at the expense of production efficiency.
    Keywords: Moral hazard on the job, Optimal social insurance, Progressivity, Search frictions
    Date: 2013–08–07
  3. By: Pintus, P. A.; Suda, J.
    Abstract: This paper develops a simple business-cycle model in which financial shocks have large macroeconomic effects when private agents are gradually learning their economic environment. When agents update their beliefs about the unobserved process driving financial shocks to the leverage ratio, the responses of output and other aggregates under adaptive learning are significantly larger than under rational expectations. In our benchmark case calibrated using US data on leverage, debt-to-GDP and land value-to-GDP ratios for 1996Q1-2008Q4, learning amplifies leverage shocks by a factor of about three, relative to rational expectations. When fed with the actual leverage innovations, the learning model predicts the correct magnitude for the Great Recession, while its rational expectations counterpart predicts a counter-factual expansion. In addition, we show that procyclical leverage reinforces the impact of learning and, accordingly, that macro-prudential policies enforcing countercyclical leverage dampen the effects of leverage shocks. Finally, we illustrate how learning with a misspecified model that ignores real/financial linkages also contributes to magnify financial shocks.
    Keywords: Borrowing Constraints, Collateral, Leverage, Learning, Financial Shocks, Recession
    JEL: E32 E44 G18
    Date: 2013
  4. By: Samuel Hurtado (Banco de España)
    Abstract: Modern DSGE models are microfounded and have deep parameters that should be invariant to changes in economic policy, so in principle they are not subject to the Lucas critique. But the literature has already established that misspecification issues also cause parameter instability after policy changes in DSGE models. This paper will look at the implications of parameter shifts for econometric policy evaluation, to see whether policy advice derived from DSGE models would have differed fundamentally from that which the policymakers of the 1970s derived from their reduced-form Phillips curves. The results show drift in most parameters, including those that are supposedly structural (such as the share of capital in production, habits or the elasticity of labor supply to the real wage), and major shifts in the impulse response functions derived from the real-time estimation of the model. After the expansionary monetary shocks of the early 1970s, a standard DSGE model would have behaved very similarly to an old-style Phillips curve, with marked shifts in parameter values and impulse response functions.
    Keywords: keyword, keyword, Macroeconomics, DSGE, Lucas Critique
    JEL: C11 C32 E32 E60
    Date: 2013–08
  5. By: Yiyong CAI (CSIRO Centre for Complex Systems Science, Commonwealth Scientific and Industrial Research Organisation, Australia and Centre for Applied Macroeconomic Analysis, Australian National University); Takashi Kamihigashi (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan); John Stachurski (Research School of Economics, Australian National University, Australia)
    Abstract: Production takes time, and labor supply and profit maximization decisions that relate to current production are typically made before all shocks affecting that production have been realized. In this paper we re-examine the problem of stochastic optimal growth with aggregate risk where the timing of the model conforms to this information structure. We provide a set of conditions under which the economy has a unique, nontrivial and stable stationary distribution. In addition, we verify key optimality properties in the presence of unbounded shocks and rewards, and provide the sample path laws necessary for consistent estimation and simulation.
    Keywords: stochastic stability, elastic labor, optimal growth
    JEL: C62 C63
    Date: 2013–08
  6. By: Fève, P.; Matheron, J.; Sahuc,J-G.
    Abstract: This paper studies the local dynamic properties of a simple general equilibrium model with Social VAT. Strict balanced budget rules often lead to real indeterminacy of aggregate equilibrium, leaving room for «sunspots» fluctuations. In a closed-economy setup, social VAT escapes this property and only reduces the aggregate labor supply elasticity. However, the quantitative effects are weak.
    Keywords: Macroeconomic stability, Social VAT, Labor supply elasticity, Aggregate fluctuations.
    JEL: E32 E62
    Date: 2013
  7. By: Klein, Alexander School of Economics, University of Kent (University of Kent); Otsuy, Keisuke (University of Kent)
    Abstract: In this paper, we analyze the International Great Depression in the US and Western Europe using the business cycle accounting method a la Chari, Kehoe and McGrattan (CKM 2007). We extend the business cycle accounting model by incorporating endogenous factor utilization which turns out to be an important transmission mechanism of the disturbances in the economy. Our main …ndings are that in the U.S. labor wedges account for roughly half of the drop in output while efficiency and investment wedges each account for a quarter of it during the 1929-1933 period while in Western Europe labor wedges account for more than one-third of the output drop and efficiency, government and investment wedges are responsible for the remaining during the 1929-1932 period. Our …ndings are consistent with several strands of existing descriptive and empirical literature on the International Great Depression.
    Keywords: International Great Depression; Business Cycle Accounting; Efficiency, Market Distortions
    Date: 2013
  8. By: Eric Fesselmeyer; Leonard J. Mirman; Marc Santugini (IEA, HEC Montréal)
    Abstract: We study the effect of investment on the dynamics of aggregate capital when different sectors of the economy compete strategically for the utilization of non-excludable capital to produce both consumption and investment goods. We consider two types of investment goods: complements and substitutes. For each case, we derive the equilibrium and provide the corresponding stationary distribution. We then compare the equilibrium with the social planner's optimal solution.
    Keywords: Capital accumulation, Dynamic game, Growth, Investment, Non-excludable capital
    JEL: C72 C73 D81 D92 O40
    Date: 2013–07
  9. By: Uluc Aysun (University of Central Florida, Orlando, FL)
    Abstract: This paper investigates the transmission of macroeconomic shocks to production in a model that includes a large and a small bank. The two banks are differentiated by parameters that govern their sensitivities to their own and their borrowers’ balance sheets and simulations show that the large (small) bank responds more to demand/financial (supply) shocks. Bank-level evidence generally supports the model’s assumptions but indicates that the large banks’ sensitivities and the sensitivity to borrower balance sheets are more important. Incorporating U.S. macroeconomic shocks into the empirical model illustrates a stronger transmission through large bank lending. Shrinking banks can, therefore, decrease volatility.
    Keywords: bank size, economic fluctuations, call report data, too big to fail, DSGE model
    JEL: E44 E32 G21 E02
    Date: 2013–08
  10. By: Fève, P.; Matheron, J.; Sahuc,J-G.
    Abstract: This paper investigates the characteristics of the Laffer curve in a neoclassical growth model of the US economy with incomplete markets and heterogeneous agents. The shape of the Laffer curve changes depending on which of transfers or government debt are varied to balance the government budget constraint. While the Laffer curve has the traditional shape when transfers vary, it looks like a horizontal S when debt varies. In this case, fiscal revenues can be associated with up to three different levels of taxation. This finding occurs because the tax rates change non-monotonically with public debt when markets are incomplete.
    Keywords: Laffer Curve, Incomplete Markets, Labor Supply, Precautionary Savings, Public Debt.
    JEL: E0 E60
    Date: 2013
  11. By: Luca Guerrieri; Matteo Iacoviello
    Abstract: A model with collateral constraints displays asymmetric responses to house price changes. When housing wealth is high, collateral constraints become slack, and the response of consumption and hours to shocks that move house prices is positive yet small. When housing wealth is low, collateral constraints become tight, and the response of consumption and hours to house price changes is negative and large. This finding is corroborated using evidence from national, state-level, and MSA-level data. Wealth effects computed in normal times may underestimate the response to large house price declines. Debt-relief policies may be far more effective during protracted housing slumps.
    Date: 2013
  12. By: Uluc Aysun (University of Central Florida, Orlando, FL); Sanglim Lee (Korea Energy Economics Institute, 132 Naesonsunhwan-ro, Uiwang-si, Gyeonggi-do, Korea)
    Abstract: This paper shows that the deviation from the uncovered interest parity (UIP) condition is equally large in advanced and emergingmarket economies. Using monthly data, and a GARCH-M model we find that a large share of these deviations in both country groups are explained by time varying risk premium. To more clearly identify risk premium shocks, we then estimate a two country, New Keynesian, DSGE model using a Bayesian methodology and quarterly data. The results suggest that at the quarterly frequency, the large deviations from the UIP condition and the high explanatory power of risk premium is only observed for emerging market economies.
    Keywords: Uncovered Interest Rate Parity, Forward Premium Puzzle, Time Varying Risk Premium
    JEL: E32 E44 F31 F33 F44
    Date: 2013–08
  13. By: Juan Carlos Hatchondo; Leonardo Martinez
    Abstract: We study the sovereign debt duration chosen by the government in the context of a standard model of sovereign default. The government balances increasing the duration of its debt to mitigate rollover risk and lowering duration to mitigate the debt dilution problem. We present two main results. First, when the government decides the debt duration on a sequential basis, sudden stop risk increases the average duration by 1 year. Second, we illustrate the time inconsistency problem in the choice of sovereign debt duration: Governments would like to commit to a duration that is 1.7 years shorter than the one they choose when decisions are made sequentially.
    Keywords: Debt
    Date: 2013

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