nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2014‒03‒22
seventeen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Inequality and Debt in a Model with Heterogeneous Agents By Federico Ravenna; Nicolas Vincent
  2. Liquidity policies and systemic risk By Adrian, Tobias; Boyarchenko, Nina
  3. Uncertainty Traps By Pablo Fajgelbaum; Edouard Schaal; Mathieu Taschereau-Dumouchel
  4. Search Frictions, Job Flows and Optimal Monetary Policy By Shoujian Zhang
  5. Implications of Labor Market Frictions for Risk Aversion and Risk Premia By Eric Swanson
  6. REALLY UNCERTAIN BUSINESS CYCLES By Nicholas Bloom; Max Floetotto; Nir Jaimovich; Itay Saporta-Eksten; Stephen J. Terry
  7. A Model of Monetary Policy Shocks for Financial Crises and Normal Conditions By John Keating; Logan Kelly; Andrew Lee Smith; Victor J. Valcarcel
  8. Spatiotemporal Search By Navid Mojir; Ahmed Khwaja; K. Sudhir
  9. Capital Accumulation through Studying Abroad and Return Migration By Takumi Naito; Laixun Zhao
  10. Asset prices in general equilibrium with recursive utility and illiquidity induced by transactions costs By Buss, Adrian; Uppal, Raman; Vilkov, Grigory
  11. Does Human Capital Risk Explain The Value Premium Puzzle? By Sylvain, Serginio
  12. Consumption-investment problems with stochastic mortality risk By Schendel, Lorenz S.
  13. Technology, Wage Dispersion and Inflation By Shoujian Zhang
  14. Life insurance demand under health shock risk By Kraft, Holger; Schendel, Lorenz S.; Steffensen, Mogens
  15. Firm Dynamics and Residual Inequality in Open Economies By Gabriel Felbermayr; Giammario Impullitti; Julien Prat
  16. Fiscal devaluation scenarios: a quantitative assessment for the Italian economy By Barbara Annicchiarico; Fabio Di Dio; Francesco Felici
  17. Openness and Optimal Monetary Policy By Giovanni Lombardo; Federico Ravenna

  1. By: Federico Ravenna; Nicolas Vincent
    Abstract: We propose a DSGE model with income heterogeneity to help discriminate across competing explanations of the cross-sectional divergence in debt-to-income ratios in US data. We show that for a DSGE model to be consistent with the data, the divergence in income growth should not be anticipated and should happen in an economy with low cost of access to financial intermediation. Differential productivity growth across the top and bottom-income quantile of the population has a much smaller impact on debt accumulation by the bottom income-quantile relative to a cross-sectional tax reallocation.
    Keywords: Inequality, Debt, DSGE model
    JEL: E21 E32 E44
    Date: 2014
  2. By: Adrian, Tobias (Federal Reserve Bank of New York); Boyarchenko, Nina (Federal Reserve Bank of New York)
    Abstract: The growth of wholesale-funded credit intermediation has motivated liquidity regulations. We analyze a dynamic stochastic general equilibrium model in which liquidity and capital regulations interact with the supply of risk-free assets. In the model, the endogenously time-varying tightness of liquidity and capital constraints generates intermediaries’ leverage cycle, influencing the pricing of risk and the level of risk in the economy. Our analysis focuses on liquidity policies’ implications for household welfare. Within the context of our model, liquidity requirements are preferable to capital requirements, as tightening liquidity requirements lowers the likelihood of systemic distress without impairing consumption growth. In addition, we find that intermediate ranges of risk-free asset supply achieve higher welfare.
    Keywords: liquidity regulation; systemic risk; DSGE; financial intermediation
    JEL: E02 E32 G00 G28
    Date: 2014–12–01
  3. By: Pablo Fajgelbaum; Edouard Schaal; Mathieu Taschereau-Dumouchel
    Abstract: We develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The unique equilibrium of this economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have nearly permanent effects on the level of activity. The economy is subject to an information externality but uncertainty traps remain even in the efficient allocation. We extend our framework to include additional features of standard business cycle models and show, in that context, that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions.
    JEL: E32
    Date: 2014–03
  4. By: Shoujian Zhang (University of St Andrews)
    Abstract: Job creation and job destruction are investigated in an economy featured by search frictions in both labour and goods markets. We show that both the unemployment rate and the endogenous job destruction rate increase when the inflation rate rises, because the demand declines due to the increase in the cost of holding money. Our numerical exercises suggest that the destruction of lower productivity jobs and the creation of higher productivity jobs may be inefficiently low under the zero nominal interest rate, which in turn causes the deviation of optimal long run monetary policy from the Friedman rule.
    Keywords: inflation, search frictions, money, welfare
    JEL: E24 E52
    Date: 2014–03–12
  5. By: Eric Swanson (Federal Reserve Bank of San Francisco)
    Abstract: A flexible labor margin allows households to absorb shocks to asset values with changes in hours worked as well as changes in consumption. This ability to absorb shocks along both margins can greatly alter the household's attitudes toward risk, as shown by Swanson (2012a). The present paper analyzes how those results are affected by labor market frictions and shows that: 1) risk aversion is higher in recessions, 2) risk aversion is higher in more frictional labor markets, and 3) risk aversion is higher for households that are less employable. Quantitatively, labor market flow rates in the U.S. and other OECD countries are large relative to the discount rate, implying that the cost of labor market frictions is small because frictions only delay adjustment. Thus, the frictionless formulas in Swanson (2012a,b) appear to be very good approximations in frictional labor markets as well.
    Date: 2013
  6. By: Nicholas Bloom; Max Floetotto; Nir Jaimovich; Itay Saporta-Eksten; Stephen J. Terry
    Abstract: We propose uncertainty shocks as a new shock that drives business cycles. First, we demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of 2007-2009. Second, we quantify the impact of time-varying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. We find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, we show that increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.
    Keywords: uncertainty, adjustment costs, and business cycles.
    JEL: D92 E22 D8 C23
    Date: 2014–03
  7. By: John Keating (University of Kansas, Department of Economics, Lawrence, KS 66045); Logan Kelly (University of Wisconsin, Department of Economics, River Falls, WI 54022); Andrew Lee Smith (University of Kansas, Department of Economics, Lawrence, KS 66045); Victor J. Valcarcel (University of Wisconsin, Center for Economic Research, River Falls, WI 54022)
    Abstract: In their classic 1999 paper, "Monetary policy shocks: What have we learned and to what end?," Christiano, Eichenbaum, and Evans (CEE) investigate one of the most widely used methods for identifying monetary policy shocks of its time. Unfortunately, their approach is no longer viable, at least not in its original form. A major problem stems from the recent behavior of two key variables in their model, the Fed Funds rate and non-borrowed reserves. We develop a new identification scheme that remedies these difficulties but maintains the basic CEE framework. Our empirical specification is motivated by a standard New Keynesian DSGE model augmented by a simple financial structure. The model provides theoretical support for variables we use in place of certain variables that were used in the classic VAR approach outlined in CEE. One significant innovation is our use of Divisia M4, the broadest monetary aggregate currently available for the United States, as the policy indicator variable. We obtain four major empirical results that support the use of a properly measured broad monetary aggregate as the policy variable. First, policy shocks have significant effects on output and on the price level, even when an interest rate is included in our model -- contradicting the New-Keynesian argument that monetary aggregates are redundant. Second, we develop a model that is not subject to the output, price or liquidity puzzles common to this literature -- contradicting the view that using the interest rate as the policy indicator generally yields more reasonable responses than a monetary aggregate. Third, during normal conditions policy shocks from our Divisia-based model have similar effects on variables to those found in the Fed Funds model of monetary policy, and where there are differences our model with Divisia M4 obtains results that are more consistent with standard economic theory. Fourth, our preferred specification produces plausible responses to a monetary policy shock in samples that include or exclude the recent financial crisis.
    Keywords: Monetary Policy Rules, Output Puzzle, Price Puzzle, Liquidy Puzzle, Financial Crisis, Divisia Index Number, Dynamic Stochastic General Equilibrium (DSGE) Model
    JEL: E3 E4 E5
    Date: 2014–03
  8. By: Navid Mojir (Yale School of Management); Ahmed Khwaja (Yale School of Management and Cowles Foundation); K. Sudhir (Yale School of Management and Cowles Foundation)
    Abstract: Despite evidence that consumers search across both stores (spatial) and time (temporal), the search literature models search in only one dimension. We develop a model of spatiotemporal search that nests a finite horizon model of spatial search within an infinite horizon model of inter-temporal search. The model is estimated using an iterative procedure that formulates it as a mathematical program with equilibrium constraints (MPEC) embedded within an E-M algorithm to allow for latent class heterogeneity. The empirical analysis is based on data on household store visits and purchases in the milk category. In contrast to extant research, we find that omitting the temporal dimension underestimates price elasticity. We attribute this difference to the importance of stockouts relative to stockpiling in the milk category. Further, contrary to the conventional wisdom that promotions reduce loyalty, we find that in the presence of search frictions, price promotions can be a store loyalty-enhancing tool.
    Keywords: Structural models, Sales promotions, Dynamic Programming, Retailing
    JEL: L81 M31 D12
    Date: 2014–03
  9. By: Takumi Naito (Waseda University); Laixun Zhao (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan)
    Abstract: This paper characterizes the interactions among studying abroad, return migration, and capital accumulation, in a two-country overlapping generations model with households of heterogeneous ability. The model exhibits positive selection of migration status (i.e., permanent, return, and non-migrants) based on ability, and over time, return migration increases as capital accumulates. Further, a decrease in the fixed cost of studying abroad and a simultaneous offsetting increase in the fixed cost of working abroad raise the relative supply of capital in the source country without decreasing anyone’s utility. Nevertheless, any single change in either fixed cost cannot achieve it.
    Keywords: Capital accumulation; Studying abroad; Return migration; Heterogeneous ability; Positive selection; Brain gain
    JEL: F22 I25 O15
    Date: 2014–03
  10. By: Buss, Adrian; Uppal, Raman; Vilkov, Grigory
    Abstract: In this paper, we study the effect of proportional transaction costs on consumption-portfolio decisions and asset prices in a dynamic general equilibrium economy with a financial market that has a single-period bond and two risky stocks, one of which incurs the transaction cost. Our model has multiple investors with stochastic labor income, heterogeneous beliefs, and heterogeneous Epstein-Zin-Weil utility functions. The transaction cost gives rise to endogenous variations in liquidity. We show how equilibrium in this incomplete-markets economy can be characterized and solved for in a recursive fashion. We have three main findings. One, costs for trading a stock lead to a substantial reduction in the trading volume of that stock, but have only a small effect on the trading volume of the other stock and the bond. Two, even in the presence of stochastic labor income and heterogeneous beliefs, transaction costs have only a small effect on the consumption decisions of investors, and hence, on equity risk premia and the liquidity premium. Three, the effects of transaction costs on quantities such as the liquidity premium are overestimated in partial equilibrium relative to general equilibrium. --
    Keywords: liquidity premium,incomplete markets,portfolio choice,heterogeneous agents
    JEL: G11 G12
    Date: 2014
  11. By: Sylvain, Serginio
    Abstract: Using a general equilibrium model with endogenous growth, I show that risk to human capital leads to a “Value” premium in equity returns. In particular, firms with relatively more firm-specific human capital or more positive covariance between asset growth and returns on human capital are less valuable (and hence have greater Book-to-Market Equity) and yield greater expected equity returns since human capital is more tied to the fate of said firms. Thus, I reproduce some of the results of Fama and French (1996) and show that in the model their HmL factor is a proxy for human capital risk as measured by macroeconomic and financial variables such as the covariance between human capital growth, or labor income growth, with the growth rate of firm assets. The model implies relatively lower investment-to-asset ratio and lower average asset growth for Value firms as observed in data and as argued in Zhang (2005). Furthermore, the model yields counter-cyclical Value premium and relative Book-to-Market Equity, greater long-run risk exposure for Value firms, and failure of the CAPM. Hence, it replicates several results from the related literature.
    Keywords: Adjustment cost, Book-to-Market Equity, Endogenous growth, General equilibrium, Human capital, Value Premium
    JEL: E20 G10 G12
    Date: 2014–03–14
  12. By: Schendel, Lorenz S.
    Abstract: I numerically solve realistically calibrated life cycle consumption-investment problems in continuous time featuring stochastic mortality risk driven by jumps, unspanned labor income as well as short-sale and liquidity constraints and a simple insurance. I compare models with deterministic and stochastic hazard rate of death to a model without mortality risk. Mortality risk has only minor effects on the optimal controls early in the life cycle but it becomes crucial in later years. A diffusive component in the hazard rate of death has no significant impact, whereas a jump component is desired by the agent and influences optimal controls and wealth evolution. The insurance is used to ensure optimal bequest such that there is no accidental bequest. In the absence of the insurance, the biggest part of bequest is accidental. --
    Keywords: Stochastic mortality risk,Health jumps,Labor income risk,Portfolio choice,Insurance
    JEL: D91 G11
    Date: 2014
  13. By: Shoujian Zhang (University of St Andrews)
    Abstract: We study the effect of inflation on the wage dispersions due to firm heterogeneity and on-the-job search, in the context of a labour market á la Postel-Vinay and Robin (International Economic Review 43, 2002) and micro-founded money demand. The productivity distribution of firms is firstly assumed to be exogenously given and we find that a rise of inflation diminishes the wage dispersion. We then allow the firms to adjust their productivity level by investment. We then find that a rise in inflation can makes firms' productivity less dispersed by driving the least productive firms not profitable and thus out of business, because the demand declines due to the increase in the cost of holding money. This decrease in productivity dispersion furthermore also diminishes the wage dispersion.
    Keywords: inflation, search frictions, wage dispersion
    JEL: E24 E52
    Date: 2014–03–12
  14. By: Kraft, Holger; Schendel, Lorenz S.; Steffensen, Mogens
    Abstract: This paper studies the life cycle consumption-investment-insurance problem of a family. The wage earner faces the risk of a health shock that significantly increases his probability of dying. The family can buy term life insurance with realistic features. In particular, the available contracts are long term so that decisions are sticky and can only be revised at significant costs. Furthermore, a revision is only possible as long as the insured person is healthy. A second important and realistic feature of our model is that the labor income of the wage earner is unspanned. We document that the combination of unspanned labor income and the stickiness of insurance decisions reduces the insurance demand significantly. This is because an income shock induces the need to reduce the insurance coverage, since premia become less affordable. Since such a reduction is costly and families anticipate these potential costs, they buy less protection at all ages. In particular, young families stay away from life insurance markets altogether. --
    Keywords: Health shocks,Portfolio choice,Term life insurance,Mortality risk,Labor income risk
    JEL: D14 D91 G11 G22
    Date: 2014
  15. By: Gabriel Felbermayr; Giammario Impullitti; Julien Prat
    Abstract: Increasing wage inequality between similar workers plays an important role for overall inequality trends in industrialized societies. To analyse this pattern, we incorporate directed labour market search into a dynamic model of international trade with heterogeneous firms and homogeneous workers. Wage inequality across and within firms results from their different hiring needs along their life cycles and the convexity of their adjustment costs. The interaction between wage posting and firms' growth process allows us to explain some recent empirical regularities on firm and labour market dynamics. Fitting the model to capture key features obtained from German linked employer-employee data, we investigate how falling trade costs and institutional reforms interact in shaping firm dynamics and aggregate labor market outcomes. Focusing on the period 1996-2007, we find that neither trade nor key features of the Hartz labour market reforms account for the sharp increase in residual inequality observed in the data. By contrast, inequality is highly responsive to the increase in product market competition triggered by domestic deregulation reforms
    Keywords: Wage Inequality, International Trade, Directed Search, Firm Dynamics, Product and Labour Market Regulation.
    Date: 2014
  16. By: Barbara Annicchiarico; Fabio Di Dio; Francesco Felici
    Abstract: We study the potential impact of fiscal devaluation policies on the Italian economy using IGEM, a dynamic general equilibrium model for the Italian economy developed at the Department of Treasury of the Italian Ministry of the Economy and Finance. The simulations show that fiscal devaluation policies are likely to produce slight improvements on the external position of the economy only in the short run, while the output gains seem to persist in the long run. Non-negligible distributional effects across households are also observed, since taxation on consumption tends to be regressive.
    Keywords: Fiscal devaluation, DGE, structural reforms, Italy
    JEL: E10 C50 E60
    Date: 2014–02
  17. By: Giovanni Lombardo; Federico Ravenna
    Abstract: We show that the composition of international trade has important implications for the optimal volatility of the exchange rate, above and beyond the size of trade flows. Using an analytically tractable small open economy model, we characterize the impact of the trade composition on the policy trade-off and on the role played by the exchange rate in correcting for price misalignments. Contrary to models where openness can be summarized by the degree of home bias, we find that openness can be a poor proxy of the welfare impact of alternative monetary policies. Using input-output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. The estimates are used in a richer small-open-economy DSGE model to quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports. We find that the main determinant of the losses is the share of non-traded goods in final demand.
    Keywords: International Trade, Exchange Rate Regimes, Non-tradable Goods, Optimal Policy
    JEL: E3 E42 E52 F41
    Date: 2014

This nep-dge issue is ©2014 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.