nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2014‒08‒28
thirty-two papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Endogenous Economic Disasters and Asset Prices By Lu Zhang; Lars-Alexander Kuehn; Nicolas Petrosky-Nadeau
  2. The Domestic and International Effects of Interstate U.S. Banking By Cacciatore, Matteo; Ghironi, Fabio; Stebunovs, Viktors
  3. In‡flation Dynamics and Marginal Costs: the Crucial Role of Hiring and Investment Frictions By Eran Yashiv; Renato Faccini
  4. Capital Taxes, Labor Taxes and the Household By Rigas Oikonomou; Christian Siegel
  5. International Trade and Intertemporal Substitution By Fernando Leibovici; Michael E. Waugh
  6. Export Dynamics in Large Devaluations By George Alessandria; Sangeeta Pratap; Vivian Yue
  7. Private Pensions, Retirement Wealth and Lifetime Earnings By Jie Zhou; James MacGee
  8. Financial crises, debt volatility and optimal taxes By Julian A. Parra-Polania; Carmiña O. Vargas
  9. Constrained Inefficiency and Optimal Taxation with Uninsurable Risks By Piero Gottardi; Atsushi Kajii; Tomoyuki Nakajima
  10. Capital Taxation under Political Constraints By Alexander Wolitzky; Florian Scheuer
  11. Relationship Skills in the Labor and Marriage Markets By Laura Turner; Aloysius Siow; Gueorgui Kambourov
  12. Housework and Fiscal Expansions By Stefano Gnocchi; Daniela Hauser; Evi Pappa
  13. Liquidity Premia, Price-Rent Dynamics, and Business Cycles By Jianjun Miao; Pengfei Wang; Tao Zha
  14. Reducing Government Debt in the Presence of Inequality By Christoph Winter; Sigrid Roehrs
  15. Firm Entry and Employment Dynamics in the Great Recession By Siemer, Michael
  16. The Redistributional Consequences of Tax Reform Under Financial Integration By Ayse Kabukcuoglu
  17. Sovereign Debt Booms in Monetary Unions By Aguiar, Mark; Amador, Manuel; Farhi, Emmanuel; Gopinath, Gita
  18. Asset Price Bubbles and Monetary Policy in a Small Open Economy By Martha López
  19. Occasionally binding emission caps and real business cycles By Valentina Bosetti; Marco Maffezzoli
  20. Optimal progressive taxation in a model with endogenous skill supply By Konstantinos Angelopoulos; Stylianos Asimakopoulos; James Malley
  21. Banking, Liquidity and Bank Runs in an Infinite Horizon Economy By Mark Gertler; Nobuhiro Kiyotaki
  22. Capital Accumulation and Structural Change in a Small-Open Economy By Yunfang Hu; Kazuo Mino
  23. A macroeconomic model of liquidity crises By Keiichiro Kobayashi; Tomoyuki Nakajima
  24. Commitment versus Discretion in a Political Economy Model of Fiscal and Monetary Policy Interaction By David Miller
  25. Staggered Price Setting, Bertrand Competition and Optimal Monetary Policy By Federico Etro; Lorenza Rossi
  26. Inflation Dynamics During the Financial Crisis By Jae Sim; Raphael Schoenle; Egon Zakrajsek; Simon Gilchrist
  27. A Model of the Twin DS: Optimal Default and Devaluation By Seunghoon Na; Stephanie Schmitt-Grohe; Martin Uribe; Vivian Z. Yue
  28. Distortions in the Investment Goods Sector and Productivity Decline By Cavalcanti Ferreira, Pedro; Pessôa de Abreu, Samuel; Veloso A., Fernando
  29. Central Bank Purchases of Private Assets By Stephen Williamson
  30. The Wealthy Hand-to-Mouth By Gianluca Violante; Greg Kaplan; Justin Weidner
  31. Dynamic Selection: An Idea Flows Theory of Entry, Trade and Growth By Thomas Sampson
  32. Will China Escape the Middle-income Trap? A Politico-economic Theory of Growth and State Capitalism By Yikai Wang

  1. By: Lu Zhang (The Ohio State University); Lars-Alexander Kuehn (Carnegie Mellon University); Nicolas Petrosky-Nadeau (Carnegie Mellon University)
    Abstract: Frictions in the labor market are important for understanding the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces realistic equity premium and stock market volatility, as well as a low and stable interest rate. The equity premium is countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, three key ingredients (small profits, large job flows, and matching frictions) in the model combine to give rise endogenously to rare disasters a la Rietz (1988) and Barro (2006).
    Date: 2014
  2. By: Cacciatore, Matteo (Institute of Applied Economics); Ghironi, Fabio (University of Washington); Stebunovs, Viktors (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: This paper studies the domestic and international effects of national bank market integration in a two-country, dynamic, stochastic, general equilibrium model with endogenous producer entry. Integration of banking across localities reduces the degree of local monopoly power of financial intermediaries. The economy that implements this form of deregulation experiences increased producer entry, real exchange rate appreciation, and a current account deficit. The foreign economy experiences a long-run increase in GDP and consumption. Less monopoly power in financial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks. Bank market integration thus contributes to moderation of firm-level and aggregate output volatility. In turn, trade and financial ties allow also the foreign economy to enjoy lower GDP volatility in most scenarios we consider. These results are consistent with features of U.S. and international fluctuations after the United States began its transition to interstate banking in the late 1970s.
    Keywords: Business cycle volatility; current account; deregulation; interstate banking; producer entry; real exchange rate
    JEL: E32 F32 F41 G21
    Date: 2014–08–01
  3. By: Eran Yashiv (Tel Aviv University); Renato Faccini (Queen Mary, University of London)
    Abstract: We embed convex hiring and investment costs and their interaction in a New Keynesian DSGE model with Nash wage bargaining. We explore the implications with respect to infl‡ation dynamics. We estimate hiring frictions to explain about 60% of the variation in marginal costs, the labor share to explain around 30%, while the remaining 10% is accounted for by intrafi…rm bargaining. These results have been obtained with moderate total and marginal adjustment costs. Labor market frictions are thus far more important than the labor share in driving marginal costs at business cycle frequencies, in sharp contrast to results in the literature.
    Date: 2014
  4. By: Rigas Oikonomou (HEC Montreal and Institut d'Analisi Economica); Christian Siegel (Department of Economics, University of Exeter)
    Abstract: We study the impact of capital and labor taxation in an economy where couples bargain over the intrahousehold allocation. We present a life cycle model with heterogeneous individuals and incomplete nancial markets. Drawing from the literature of the collective framework of household behavior, we model decision making within the couple as a contract under limited commitment. In this framework more wealth improves commitment and gives rise to insurance gains within the household. Our theory motivates these gains by the empirical observation that wealth, in contrast to labor income, is a commonly held resource within households. Based on this observation we study whether eliminating capital taxes from the economy, and raising labor taxes to balance the government's budget, may generate welfare gains to married households. We illustrate that the quantitative eects from this reform are rather small. We attribute the small effects to the life cycle pattern of wealth accumulation and to the impact of labor income taxes on household risk sharing: In particular, we show that higher labor taxes may deteriorate the limited commitment problem, even though they may make the distribution of labor income more equitable within the household.
    Keywords: Life cycle models, incomplete financial markets, tax reform, intrahousehold allocations.
    JEL: D13 D52 E21 E62 H31
    Date: 2014
  5. By: Fernando Leibovici (Department of Economics, York University, Toronto, Canada); Michael E. Waugh (New York University and NBER)
    Abstract: This paper studies the dynamics of international trade flows at business cycle frequencies. We show that introducing dynamic considerations into an otherwise standard model of trade can account for several puzzling features of trade flows at business cycle frequencies. Our insight is that because international trade is time-intensive, variation in the rate at which agents are willing to substitute across time affects how trade volumes respond to changes in output and prices. We formalize this idea and calibrate our model to match key features of U.S. data. We find that, in contrast to standard staticmodels of international trade, ourmodel is quantitatively consistent with salient features of U.S. cyclical import fluctuations. We also find that our model accounts for two-thirds of the peak-to-trough decline in imports during the 2008-2009 recession.
    Date: 2014–08–11
  6. By: George Alessandria; Sangeeta Pratap; Vivian Yue
    Abstract: We study the source and consequences of sluggish export dynamics in emerging markets following large devaluations. We document two main features of exports that are puzzling for standard trade models. First, given the change in relative prices, exports tend to grow gradually following a devaluation. Second, countries with higher interest rates tend to have slower export growth. To address these features of export dynamics, we embed a model of endogenous export participation due to sunk and per period export costs into an otherwise standard small open economy. In response to shocks to productivity, the interest rate, and the discount factor, we find the model can capture the salient features of the documented export dynamics. At the aggregate level, the features giving rise to sluggish exports lead to more gradual net export reversals, sharper contractions and recoveries in output, and endogenous stagnation in labor productivity.
    Date: 2014–08
  7. By: Jie Zhou (Bank of Canada); James MacGee (UWO)
    Abstract: This paper investigates the effect of private pensions on the retirement wealth distribution. We incorporate stochastic private pension coverage into a calibrated life-cycle model with stochastic earnings. Private pensions lead to higher net worth inequality at retirement, which is closer to the inequality observed in the PSID than a model without private pensions. However, the offset effect of private pension wealth on net worth is much larger in the model than in the data. We find that taxation and inflation can largely account for the difference.
    Date: 2014
  8. By: Julian A. Parra-Polania; Carmiña O. Vargas
    Abstract: We study ?financial crises in a model of a small open production economy subject to a credit constraint and to uncertainty on the real value of debt repayments. We find that, unlike most of the previous literature, the decentralized equilibrium exhibits underborrowing. The future possibility of reducing the severity of crises gives the incentives to the central planner (CP) to increase both current debt and the crisis probability. We also ?find that the CP equilibrium can be implemented by means of a tax on debt (a macro-prudential policy) and, only during crises, subsidies on consumption and a tax on non-tradable labor. The welfare gain of moving to the CP equilibrium is small for the baseline scenario but very sensitive to changes in debt volatility and the degree of openness of the economy.
    Keywords: Financial crisis, capital controls, debt shocks, optimal tax.
    JEL: F34 F41 H21
    Date: 2014–08–13
  9. By: Piero Gottardi; Atsushi Kajii (Kyoto University); Tomoyuki Nakajima (Kyoto University and CIGS)
    Abstract: When individuals' labor and capital income are subject to uninsurable idiosyncratic risks, should capital and labor be taxed, and if so how? In a two period general equilibrium model with production, we derive a decomposition formula of the welfare effects of these taxes into insurance and distribution effects. This allows us to determine how the sign of the optimal taxes on capital and labor depend on the nature of the shocks, the degree of heterogeneity among consumers' income as well as on the way in which the tax revenue is used to provide lump sum transfers to consumers. When shocks affect primarily labor income and heterogeneity is small, the optimal tax on capital is positive. However in other cases a negative tax on capital is welfare improving.
    Keywords: optimal linear taxes, incomplete markets,constrained effciency
    JEL: D52 H21
    Date: 2014–03
  10. By: Alexander Wolitzky (Stanford University); Florian Scheuer (Stanford University)
    Abstract: This paper studies optimal dynamic tax policy under the threat of political reform. A policy will be reformed ex post if a large enough political coalition supports reform; thus, credible policies are those that will continue to attract enough political support in the future. If the reform threat is to fully equalize consumption, we find that optimal marginal capital taxes are U-shaped, so that savings are subsidized for the middle class but are taxed for the poor and rich. If ex post the government may strategically propose a reform other than full equalization in order to secure additional political support, then optimal capital taxes are instead progressive throughout.
    Date: 2014
  11. By: Laura Turner (University of Toronto); Aloysius Siow (University of Toronto); Gueorgui Kambourov (University of Toronto)
    Abstract: This paper examines the role of relationship skills in determining life cycle outcomes in education, labor and marriage markets. We posit a two-factor model with human capital and "relationship" or "partnering" skill. Relationship skill is understood in our framework as the ability to maintain long-term relationships, both in the formal job market and the home sector. Using a Mincer-Jovanovic (1981) framework and evidence on job and marital separations in the PSID, we argue that relationship skills are naturally modeled as an individual fixed factor that increases the durability of relationships in multiple sectors. Next, we use data from the Occupational Information Network to extract and develop a common factor from measures of non-cognitive skills that reduce divorce and job loss likelihood conditional on partners' wages and education. In both empirical and numerical analysis, we show that this factor operates differently in the market and home sectors. It is highly complementary in the market sector but fairly substitutable in the home sector: that is, stability of marriage depends most strongly on at least one partner being endowed with strong partnering skills. It therefore stands in contrast to measures of more general human capital, such as educational attainment that are highly complementary inputs into marriage. To explore the quantitative implications of relationship skill, we use the PSID to develop and estimate a two-factor life cycle model of schooling, job search and marriage that allows us to test the importance of partnering skills, including their implications for optimal schooling and occupational decisions, and the joint distribution of relationship skills and human capital in the population.
    Date: 2014
  12. By: Stefano Gnocchi; Daniela Hauser; Evi Pappa
    Abstract: We build an otherwise-standard business cycle model with housework, calibrated consistently with data on time use, in order to discipline consumption-hours complementarity and relate its strength to the size of fiscal multipliers. We show that if substitutability between home and market goods is calibrated on the empirically relevant range, consumption-hours complementarity is large and the model generates fiscal multipliers that agree with the evidence. Hence, our analysis supports the relevance of consumption-hours complementarity for fiscal multipliers. However, we also find that explicitly modeling the home sector is more appealing than restricting to the consumption-leisure margin and/or to the preferences proposed by Greenwood, Hercowitz and Huffman (1988). A housework model can imply substantial complementarity, without low wealth effects contradicting the microeconomic evidence.
    Keywords: Fiscal policy; Business fluctuations and cycles
    JEL: E24 E32 E52 E62
    Date: 2014
  13. By: Jianjun Miao; Pengfei Wang; Tao Zha
    Abstract: In the U.S. economy over the past twenty five years, house prices exhibit fluctuations considerably larger than house rents and these large fluctuations tend to move together with business cycles. We build a simple theoretical model to characterize these observations by showing the tight connection between price-rent fluctuation and the liquidity constraint faced by productive firms. After developing economic intuition for this result, we estimate a medium-scale dynamic general equilibrium model to assess the empirical importance of the role the price-rent fluctuation plays in the business cycle. According to our estimation, a shock that drives most of the price-rent fluctuation explains $30% of output fluctuation over a six-year horizon.
    JEL: E22 E32 E44
    Date: 2014–08
  14. By: Christoph Winter (University of Zurich); Sigrid Roehrs (Goethe University Frankfurt)
    Abstract: What are the welfare consequences of debt reduction policies? In this paper, we answer this question with the help of an incomplete markets economy with production in which households are subject to uninsurable income shocks. We focus on policies that raise revenues from taxing income. We make three contributions. First, we show that quantitatively sizable welfare gains can be reaped by reducing debt, at least in the long-run. Second, we find that, for some policies, the short-run losses that occur during the transition more than outweigh the long-run gains. And third, we show that both short-run and long-run welfare effects of government debt depend on the income composition of the consumption-poor. In our calibration, we thus target the skewed wealth and the earnings distribution of the US economy. Our results have important implications for the design of debt reduction strategies. Policies that imply more redistribution will find more political support, as they compensate the consumption-poor, who suffer the most during the transition.
    Date: 2014
  15. By: Siemer, Michael (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: The 2007-2009 recession is characterized by: a large drop in employment, an unprecedented decline in firm entry, and a slow recovery. Using confidential firm-level data, I show that financial constraints reduced employment growth in small relative to large firms by 4.8 to 10.5 percentage points. The effect of financial constraints is robust to controlling for aggregate demand and is particularly strong in small young firms. I show in a heterogeneous firms model with endogenous firm entry and financial constraints that a large financial shock results in a long-lasting recession caused by a "missing generation" of entrants.
    Keywords: Employment; firm entry; financial crisis; small business; financial friction; slow recovery; start-ups
    JEL: E24 E32 E44 G01 J20 L25
    Date: 2014–07–30
  16. By: Ayse Kabukcuoglu (Department of Economics, Koc University)
    Abstract: I quantify the welfare effects of replacing the US capital income tax with higher labor income taxes under international financial integration using a two-country, heterogeneous-agent incomplete markets model calibrated to represent the US and the rest of the world. Short-run and long-run factor price dynamics are key: after the tax reform, interest rates rise less under financial openness than in autarky. Therefore, wealthy households gain less. Post-tax wages also fall less as a result of the faster capital accumulation, so the poor are hurt less. Hence, the distributional impacts of the reform are significantly dampened relative to autarky although a majority of households prefer the status quo. Aggregate welfare effect to the US is a permanent 0.2% consumption equivalent loss under financial openness which is roughly 15% of the welfare loss under autarky.
    Keywords: Heterogeneous agents and incomplete markets, taxation, financial integration.
    JEL: E62 F41 D52
    Date: 2014–08
  17. By: Aguiar, Mark; Amador, Manuel; Farhi, Emmanuel; Gopinath, Gita
    Abstract: We propose a continuous time model to investigate the impact of inflation credibility on sovereign debt dynamics. At every point in time, an impatient government decides fiscal surplus and inflation, without commitment. Inflation is costly, but reduces the real value of outstanding nominal debt. In equilibrium, debt dynamics is the result of two opposing forces: (i) impatience and (ii) the desire to conquer low inflation. A large increase in inflation credibility can trigger a process of debt accumulation. This rationalizes the sovereign debt booms that are often experienced by low inflation credibility countries upon joining a currency union.
    Date: 2014
  18. By: Martha López
    Abstract: In this paper we expanded the closed economy model by Bernanke and Gertler (1999) in order to account for the macroeconomic effects of an asset price bubble in the context of a small open economy model. During the nineties emerging market economies opened their financial accounts to foreign investment but it generated growing macroeconomic imbalances in these economies. Our goal in this paper is twofold: first we want to analyze if the conclusions of Bernanke and Gertler (1999) remain in the case of a small open economy. And second, we want to compare the results in terms of macroeconomic volatility of the model for a closed economy versus the model for a small open economy. Our results show that the conclusion about the fact that the Central Bank should not react to asset prices remains as in the case of a closed economy model, and that small open economies are more vulnerable to asset prices bubbles due to capital inflows and the exchange rate mechanism of the monetary policy. Therefore in small open economies the business cycle is deeper. Finally, in the face of a boom followed by a bust in an asset price bubble, macroeconomic volatility would be dampened if the monetary authority focus only on inflation. Classification JEL: E32, R40, E47, E52.
    Date: 2014–08
  19. By: Valentina Bosetti; Marco Maffezzoli
    Abstract: Recent applications to the modeling of emission permit markets by means of stochastic dynamic general equilibrium models look into the relative merits of different policy mechanisms under uncertainty. The approach taken in these studies is to assume the existence of an emission constraints that is always binding (i.e. the emission cap is always smaller than what actual emissions would be in the absence of climate policy). Although this might seem a reasonable assumption in the longer term, as policies will be increasingly stringent, in the short run there might be instances where this assumption is in sharp contrast with reality. A notable example would be the current status of the European Emission Trading Scheme. This paper explores the implications of adopting a technique that allows occasionally, rather than strictly, binding constraints. With this new setup the paper sets out to investigate the relative merits of different climate policy instruments under different macro-economic shocks. Keywords: Dynamic Stochastic General Equilibrium model, emission trading, carbon tax, occasionally binding constraints. JEL codes: Q58, Q54, E2.
    Date: 2014
  20. By: Konstantinos Angelopoulos; Stylianos Asimakopoulos; James Malley
    Abstract: This paper examines whether efficiency considerations require that optimal labour income taxation is progressive or regressive in a model with skill heterogeneity, endogenous skill acquisition and a production sector with capital-skill complementarity. We find that wage inequality driven by the resource requirements of skill-creation implies progressive labour income taxation in the steady-state as well as along the transition path from the exogenous to optimal policy steady-state. We find that these results are explained by a lower labour supply elasticity for skilled versus unskilled labour which results from the introduction of the skill acquisition technology.
    Keywords: optimal progressive taxation, skill premium, allocative efficiency
    JEL: E24 E32 E62
    Date: 2014–07
  21. By: Mark Gertler (New York University (E-mail:; Nobuhiro Kiyotaki (Princeton University (E-mail:
    Abstract: We develop a variation of the macroeconomic model of banking in Gertler and Kiyotaki (2011) that allows for liquidity mismatch and bank runs as in Diamond and Dybvig (1983). As in Gertler and Kiyotaki, because bank net worth fluctuates with aggregate production, the spread between the expected rates of return on bank assets and deposits fluctuates countercyclically. However, because bank assets are less liquid than deposits, bank runs are possible as in Diamond and Dybvig. Whether a bank run equilibrium exists depends on bank balance sheets and an endogenous liquidation price for bank assets. While in normal times a bank run equilibrium may not exist, the possibility can arise in a recession. We also analyze the effects of anticipated bank runs. Overall, the goal is to present a framework that synthesizes the macroeconomic and microeconomic approaches to banking and banking instability.
    Keywords: Financial Intermediation, Liquidity Mismatch, Financial Accelerator, Rollover Risk
    JEL: E44 G21
    Date: 2014–08
  22. By: Yunfang Hu (Kobe University); Kazuo Mino (Kyoto University)
    Abstract: This paper explores the relation between capital accumulation and transformation of industrial structure in a small open-economy. Using a three-sector, neoclassical growth model with non-homothetic preferences, we examine dynamic behavior of the small country in the alternative trade regimes. We show that capital accumulation plays a leading role in the process of structural transformation. It is also revealed that the trade pattern significantly affects structural change. We demonstrate that our model can mimic a typical pattern of change in industrial structure that has been observed in many developed economies.
    Keywords: Structural change, Small-open economy, Trade Pattern, Three-sector model, Non-homothetic preferences
    JEL: E21 O10 O41
    Date: 2014–08
  23. By: Keiichiro Kobayashi; Tomoyuki Nakajima (Institute of Economic Research,Kyoto University and CIGS)
    Abstract: We develop a macroeconomic model in which liquidity plays an essential role in the production process, because _rms have a commitment problem regarding factor payments. A liquidity crisis occurs when _rms fail to obtain su_cient liquidity, and may be caused either by self-ful_lling beliefs or by fundamental shocks. Our model is consistent with the observation that the decline in output during the Great Recession is mostly attributable to the deterioration in the labor wedge, rather than in productivity. The government's commitment to guarantee bank deposits reduces the possibility of a self-fulfilling crisis, but it increases that of a fundamental crisis.
    Keywords: Liquidity crises; Systemic crises; Corporate liquidity demand; Limited commitment; Debt overhang.
    JEL: E30 G01 G21
    Date: 2014–03
  24. By: David Miller (Federal Reserve Board)
    Abstract: Price commitment results in lower welfare. I explore the consequences of price commitment by pairing an independent monetary authority issuing nominal bonds with a fiscal authority whose endogenous spending decisions are determined by a political economy model. Without price commitment, nominal bonds are backed by a new form of endogenous commitment that overcomes time inconsistency to make tax smoothing possible. With price commitment, nominal bonds will be used for both tax smoothing and wasteful spending. Price commitment eliminates monetary control over fiscal decisions. I show that the combination observed in advanced economies of a politically distorted fiscal authority and an independent monetary authority with nominal bonds and without price commitment is the solution to a constrained mechanism design problem that overcomes time inconsistency and results in the highest welfare.
    Date: 2014
  25. By: Federico Etro (Department of Economics, University Of Venice Cà Foscari); Lorenza Rossi (Department of Economics, University Of Pavia)
    Abstract: We reconsider the New Keynesian model with staggered price setting when each market is characterized by a small number of firms competing in prices à la Bertrand rather than a continuum of isolated monopolists. Price adjusters change their prices less when there are more firms that do not adjust, creating a natural and strong form of real rigidity. In a DSGE model with Calvo pricing this reduces the level of nominal rigidities needed to generate high reactions of output to monetary shocks. As a consequence, the determinacy region enlarges and the optimal monetary rule under cost push shocks, derived with the linear quadratic approach, becomes less aggressive, and the welfare gains from commitment to the optimal monetary policy decrease.
    Keywords: New Keynesian Phillips Curve, Real rigidities, Sticky prices, Optimal monetary policy, Inflation, Endogenous entry
    JEL: E3 E4 E5
    Date: 2014
  26. By: Jae Sim (Federal Reeserve Board); Raphael Schoenle (Brandeis University); Egon Zakrajsek (Federal Reserve Board); Simon Gilchrist (Boston University)
    Abstract: Using confidential product-level price data underlying the U.S. Producer Price Index (PPI), this paper analyzes the effect of changes in firms' financial conditions on their price-setting behavior during the "Great Recession" that surrounds the financial crisis. The evidence indicates that during the height of the crisis in late 2008, firms with "weak" balance sheets increased prices significantly relative to industry averages, whereas firms with "strong" balance sheets lowered prices, a response consistent with an adverse demand shock. These stark differences in price-setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks. We explore the implications of these empirical findings within a general equilibrium framework that allows for customer markets and departures from the frictionless financial markets. In the model, firms have an incentive to set a low price to invest in market share, though when financial distortions are severe, firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance-sheet capacity. Consistent with our empirical findings, the model with financial distortions—relative to the baseline model without such distortions—implies a substantial attenuation of price dynamics in response to contractionary demand shocks.
    Date: 2014
  27. By: Seunghoon Na; Stephanie Schmitt-Grohe; Martin Uribe; Vivian Z. Yue
    Abstract: This paper characterizes jointly optimal default and exchange-rate policy. The theoretical environment is a small open economy with downward nominal wage rigidity as in Schmitt-Grohe and Uribe (2013) and limited enforcement of international debt contracts as in Eaton and Gersovitz (1981). It is shown that under optimal policy default is accompanied by large devaluations. At the same time, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are found to be able to support less external debt than economies with optimally floating rates. In addition, the following three analytical results are presented: 1) Real economies with limited enforcement of international debt contracts in the tradition of Eaton and Gersovitz (1981) can be decentralized using capital controls; 2) Real economies in the tradition of Eaton and Gersovitz can be interpreted as the centralized version of models with downward nominal wage rigidity, optimal capital controls, and a full-employment exchange-rate policy; and 3) Full-employment is optimal in an economy with downward nominal wage rigidity, limited enforcement of debt contracts, and optimal capital controls.
    Date: 2014–08
  28. By: Cavalcanti Ferreira, Pedro; Pessôa de Abreu, Samuel; Veloso A., Fernando
    Abstract: We study the impact of distortions in the investment goods sector onaggregate total factor productivity (TFP). We develop a two-sector neo-classical growth model in which TFP in the capital goods sector relative toTFP in the consumption sector is inversely related to the price of invest-ment relative to consumption, so that we use relative prices to measureTFP in the investment goods sector. The model is calibrated to Braziland we nd that distortions in the investment goods sector may explainmost of the decline in Brazilian TFP relative to the United States sincethe mid-1970s.
    Date: 2014–08–14
  29. By: Stephen Williamson (Washington University in St. Louis)
    Abstract: A model is constructed in which consumers and banks have incentives to fake the quality of collateral. Conventional central banking policy can exacerbate these problems, in that lower nominal interest rates make asset prices higher, which makes faking collateral more profitable, thus increasing haircuts and interest rate differentials. Central bank purchases of private mortgages can increase welfare by bypassing incentive problems associated with private banks, increasing asset prices, and relaxing collateral constraints. However, this may exacerbate incentive problems in the mortgage market.
    Date: 2014
  30. By: Gianluca Violante (NYU); Greg Kaplan (Princeton University); Justin Weidner
    Abstract: The wealthy hand-to-mouth are households who hold little or no liquid wealth (e.g. cash, checking, and saving accounts), despite owning sizable amounts of illiquid assets (i.e., assets that carry a transaction cost, such as housing, large durables, or retirement accounts). This portfolio configuration implies that these households have large marginal propensities to consume out of small income changes –a key determinant of the macroeconomic effects of fiscal policy. The wealthy hand-to-mouth, therefore, behave in many respects like households with little or no net worth, yet they escape standard definitions (and empirical measurements) of hand-to-mouth agents based on net worth. We use survey data on household portfolios for the U.S., Canada, Australia, the U.K., Germany, France, Italy, and Spain to document the share of such households across countries, their demographic characteristics, the composition of their balance sheet, and the persistence of hand-to-mouth status over the life cycle. Finally, we discuss the implications of this group of consumers for macroeconomic modelling and policy analysis.
    Date: 2014
  31. By: Thomas Sampson
    Abstract: This paper develops an idea flows theory of trade and growth with heterogeneous firms. New firms learn from incumbent firms, but the diffusion technology ensures entrants learn not only from frontier technologies, but from the entire technology distribution. By shifting the productivity distribution upwards, selection on productivity causes technology diffusion and this complementarity generates endogenous growth without scale effects. On the balanced growth path, the productivity distribution is a traveling wave with an increasing lower bound. Growth of the lower bound causes dynamic selection. Free entry mandates that trade liberalization increases the rates of technology diffusion and dynamic selection to offset the profits from new export opportunities. Consequently, trade integration raises long-run growth. The dynamic selection effect is a new source of gains from trade not found when firms are homogeneous. Calibrating the model implies that dynamic selection approximately triples the gains from trade relative to heterogeneous firm economies with static steady states.
    Keywords: International trade, firm heterogeneity, technology diffusion, endogenous growth
    JEL: F12 O41
    Date: 2014–08
  32. By: Yikai Wang
    Abstract: Is China's rapid growth sustainable if the labor and capital market distortions persist? Will democratization occur given that Chinese middle-class are supportive of the regime? To answer the above questions, this paper proposes a politico-economic theory, as follows. In oligarchy, a political elite extracts surplus from the state sector and taxes the private sector, but it also needs political support from sufficiently many citizens to maintain its power. “Divide-and-rule†strategy is implemented to guarantee such support: state workers receive high wages and become supporters of the elite, while wages of private workers are reduced due to the policy distortion. In the short-run, the low wages in the private sector lead to rapid growth of the private firms and total output. However, long-run growth is harmed by capital market distortions favoring the state firms. The theory suggests that the economy develops along a three-stage transition: “rapid growthâ€, “state capitalismâ€, and two cases in the third stage: “middle-income trap†or “sustained growthâ€, depending on whether democratization occurs endogenously. The theory is consistent with salient aspects of China's recent development and gives predictions on China's future development path.
    Date: 2014

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