nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2014‒11‒22
24 papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Overlending and Macroprudential Tools By Natalie Tiernan; Pedro Gete
  2. Credit, bankruptcy, and aggregate fluctuations By Nakajima, Makoto; Rios-Rull, Jose-Victor
  3. Home Production and Small Open Economy Business Cycles By Chen, Kuan-Jen; Chu, Angus C.; Lai, Ching-Chong
  4. Total Factor Productivity and the Propagation of Shocks; Empirical Evidence and Implications for the Business Cycle By Eric Mayer; Sebastian Rüth; Johann Scharler
  5. Time-consistent consumption taxation By Sarolta Laczo; Raffaele Rossi
  6. Separations, Sorting and Cyclical Unemployment By Andreas Mueller
  7. What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium By Luo, Yulei; Nie, Jun; Wang, Gaowang; Young, Eric
  8. Accuracy Verification for Numerical Solutions of Equilibrium Models By Indrajit Mitra; Leonid Kogan
  9. Enhancing Growth and Welfare through debt-financed Education By Stauvermann, Peter Josef; Kumar, Ronald
  10. Online Appendix to "The dynamics of public investment under persistent electoral advantage" By Marina Azzimonti
  11. Euro- US Real Exchange Rate Dynamics: How Far Can We Push Equilibrium Models? By Aydan Dogan
  12. Working Less and Bargain Hunting More: Macro Implications of Sales during Japan's Lost Decades By Sudo, Nao; Ueda, Kozo; Watanabe, Kota; Watanabe, Tsutomu
  13. Intermediation and Voluntary Exposure to Counterparty Risk By Maryam Farboodi
  14. Uncertainty shocks: it's a matter of habit By Bonciani, Dario
  15. Inflation Dynamics During the Financial Crisis By Simon Gilchrist; Raphael Schoenle; Jae W. Sim; Egon Zakrajsek
  16. A Life-Cycel Model with Ambiguous Survival Beliefs By Max Groneck; Alexander Ludwig
  17. Portfolio Choice with Information-Processing Limits By Batchuluun, Altantsetseg; Luo, Yulei; Young, Eric
  18. On the Causal Effects of Selective Admission Policies on Students’ Performances. Evidence from a Quasi-experiment in a Large Italian University By Vincenzo Carrieri; Marcello D'Amato; Roberto Zotti
  19. Solving forward-looking models of cross-country adjustment within the euro area By Torój, Andrzej
  20. The dilemma of international capital tax competition in the presence of public capital and endogenous growth By Stauvermann, Peter J.; Kumar, Ronald R.
  21. Optimal Monetary Policy in a Currency Union: Implications of a Country-specific Cost Channel By Jochen Michaelis; Jakob Palek
  22. Efficiency Wage and Endogenous Job Destruction in the DMP Model----- an Extension By Bandopadhyay, Titas Kumar
  23. Labour Policies In The DMP Model—A Theoretical Analysis By Bandopadhyay, Titas Kumar
  24. Evaluating a Structural Model Forecast: Decomposition Approach By Frantisek Brazdik; Zuzana Humplova; Frantisek Kopriva

  1. By: Natalie Tiernan (Office of the Comptroller of the Currency); Pedro Gete (Georgetown University)
    Abstract: This paper is a quantitative study of two frictions that generate banks' underinvestment in screening borrowers and, thus, overlending: 1) Limited liability, and 2) Banks failing to internalize that their credit decisions alter the pool of borrowers faced by other banks. The resulting lax lending standards overexpose banks to negative economic shocks and amplify the effects of economic fluctuations. They generate excessive volatility in credit, banks' capital and output. We study a calibrated model whose predictions concerning the quantity and quality of credit are in line with recent U.S. business cycles. Quantitatively, limited liability is the friction that generates laxer lending standards. It induces 27% excess volatility in output relative to 8% from the other friction. Then we study three policy tools: capital requirements and taxes on banks' lending and borrowings. The three tools encourage banks to screen more and should be state-contingent because the frictions vary with macroeconomic conditions. In quantitative terms, we find that taxes are better tools than capital requirements because they do not reduce credit going to the more productive agents.
    Date: 2014
  2. By: Nakajima, Makoto (Federal Reserve Bank of Philadelphia); Rios-Rull, Jose-Victor (Federal Reserve Bank of Philadelphia)
    Abstract: We ask two questions related to how access to credit affects the nature of business cycles. First, does the standard theory of unsecured credit account for the high volatility and procyclicality of credit and the high volatility and countercyclicality of bankruptcy filings found in U.S. data? Yes, it does, but only if we explicitly model recessions as displaying countercyclical earnings risk (i.e., rather than having all households fare slightly worse than normal during recessions, we ensure that more households than normal fare very poorly). Second, does access to credit smooth aggregate consumption or aggregate hours worked, and if so, does it matter with respect to the nature of business cycles? No, it does not; in fact, consumption is 20 percent more volatile when credit is available. The interest rate premia increase in recessions because of higher bankruptcy risk discouraging households from using credit. This finding contradicts the intuition that access to credit helps households to smooth their consumption.
    Keywords: Consumer credit; Default; Bankruptcy; Debt; Business cycle; Heterogeneous agents; Incomplete markets
    JEL: D91 E21 E32 E44 K35
    Date: 2014–10–20
  3. By: Chen, Kuan-Jen; Chu, Angus C.; Lai, Ching-Chong
    Abstract: This paper incorporates home production into a real business cycle (RBC) model of a small open economy to provide a parsimonious explanation of the empirical pattern of international business cycles in developed economies and emerging markets. It is well known in the literature that in order for the RBC model to replicate quantitatively plausible empirical moments of small open economies, the model needs to feature counterfactually a small income effect on labor supply. This paper provides a plausible solution to this puzzle by considering home production that introduces substitutability between market consumption and home consumption, which in turn generates a high volatility in market consumption in accordance with the data, even in the presence of a sizable income effect on labor supply. Furthermore, the model with estimated parameter values based on the simulated method of moments is able to match other empirical moments, such as the standard deviations of output, investment and the trade balance and the correlations between output and other standard macroeconomic variables. Given that home production is more prevalent in emerging markets than in developed economies, the model is also able to replicate empirical differences between emerging markets and developed economies in the volatility of market consumption and the volatility/countercyclicality of the trade balance.
    Keywords: small open economy; home production; emerging markets; business cycles
    JEL: D13 E32 F41 O16
    Date: 2014–09
  4. By: Eric Mayer; Sebastian Rüth; Johann Scharler
    Abstract: Using a sign restrictions approach, we document that total factor productivity (TFP) moves counter-cyclically in the aftermath of supply and demand side shocks. To interpret our empirical results, we conduct counter-factual simulations, based on a New Keynesian DSGE model in which TFP fluctuates endogenously due to time-varying labor effort. The simulations show that the decline in the output gap, following an adverse shock, is dampened by the endogenously improving TFP as long as the nominal interest rate remains strictly positive during the downturn. If the economy hits the zero lower bound, the decline in the output gap is amplified when TFP improves endogenously.
    Keywords: TFP, labor effort, zero lower bound
    JEL: E24 E30 E32 E40
    Date: 2014–10
  5. By: Sarolta Laczo; Raffaele Rossi
    Abstract: We characterise optimal fiscal policies when the government has access to consumption taxation but cannot credibly commit to future policies, in a calibrated Real Business Cycle model of the United States economy. Contrary to the case where only labour and capital income are taxed, the optimal time-consistent policies are remarkably similar to their Ramsey counterparts, as long as the capital income tax causes some distortion within the period. The welfare gains from commitment are negligible, while they are substantial without consumption taxation. Further, the welfare gains from taxing consumption are much higher without commitment. These results suggest that the policy-maker's ability to commit is of secondary importance if consumption is taxed optimally.
    Keywords: fiscal policy, Markov-perfect policies, consumption taxation, variable capital utilisation, endogenous government spending
    JEL: E62 H21
    Date: 2014
  6. By: Andreas Mueller (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.
    Date: 2014
  7. By: Luo, Yulei; Nie, Jun; Wang, Gaowang; Young, Eric
    Abstract: This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the Permanent Income Hypothesis (PIH) arises in equilibrium, as in models with full information-rational expectations, due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.
    Keywords: Rational Inattention; Permanent Income Hypothesis; General Equilibrium; Consumption and Income Volatility.
    JEL: C61 D83 E21
    Date: 2014
  8. By: Indrajit Mitra (MIT); Leonid Kogan (MIT)
    Abstract: We propose a simulation-based procedure for evaluating approximation accuracy of numerical solutions of general equilibrium models with heterogeneous agents. We measure the approximation accuracy by the magnitude of the loss suered by the agents as a result of following suboptimal policies. Our procedure allows agents to have knowledge of the future paths of the economy under suitably imposed costs of such foresight. This method is very general, straightforward to implement, and can be used in conjunction with various solution algorithms. We illustrate our method in the context of the incomplete-markets model of Krusell and Smith (1998), where we apply it to two widely used approximation techniques: cross-sectional moment truncation and history truncation.
    Date: 2014
  9. By: Stauvermann, Peter Josef; Kumar, Ronald
    Abstract: Using an over-lapping generations (OLG) model, we show how small open economies can enhance their growth through educational subsidies financed via public debt and reduce their fertility rate. We show that subsidizing education through public debt leads to a Pareto improvement of all generations. Even if a country is a net borrower in the international capital market, we show that this subsidy-policy can help, under certain conditions, to improve its net borrowing position. Especially, our analysis can be applied to less-developed countries.
    Keywords: fertility; human capital; education subsidy; government debt.
    JEL: H24 O1 O15 O41
    Date: 2014–06
  10. By: Marina Azzimonti (SUNY Stony Brook)
    Abstract: Online appendix for the Review of Economic Dynamics article
    Date: 2014
  11. By: Aydan Dogan
    Abstract: This paper re-assesses the problem of general equilibrium models in matching the behaviour of real exchange rate. We do so by developing a two country general equilibrium model with non-traded goods, home bias, incomplete markets and partial degrees of pass through as well as nominal rigidities both in the goods and labour markets. We combine this comprehensive framework with a data consistent shock structure. Our key finding is that presenting an encompassing model structure improves the performance of the model in addressing the behaviour of the real exchange rate but this improvement is at the expense of failing to replicate some other characteristics of the data, such as high consumption volatility and negative cross-country consumption correlation. We argue that the ability of a general equilibrium model to account for the features of the data is closely related to the predominant driving source of the fluctuations.
    Keywords: Real Exchange Rates; Non-traded goods; Incomplete Asset Markets; Imperfect Exchange Rate Pass Through; Nominal Rigidities
    JEL: F31 F32 F41
    Date: 2014–10
  12. By: Sudo, Nao (Bank of Japan); Ueda, Kozo (Waseda University); Watanabe, Kota (Meiji University); Watanabe, Tsutomu (University of Tokyo)
    Abstract: Standard New Keynesian models have often neglected temporary sales. In this paper, we ask whether this treatment is appropriate. In the empirical part of the paper, we provide evidence using Japanese scanner data covering the last two decades that the frequency of sales was closely related with macroeconomic developments. Specifically, we find that the frequency of sales and hours worked move in opposite directions in response to technology shocks, producing a negative correlation between the two. We then construct a dynamic stochastic general equilibrium model that takes households' decisions regarding their allocation of time for work, leisure, and bargain hunting into account. Using this model, we show that the rise in the frequency of sales, which is observed in the data, can be accounted for by the decline in hours worked during Japan's lost decades. We also find that the real effect of monetary policy shocks weakens by around 40% due to the presence of temporary sales, but monetary policy still matters.
    JEL: E3 E5
    Date: 2014–09–01
  13. By: Maryam Farboodi (University of Chicago)
    Abstract: I develop a model of the financial sector in which endogenous intermediation among debt financed banks generates excessive systemic risk. Financial institutions have incentives to capture intermediation spreads through strategic borrowing and lending decisions. By doing so, they tilt the division of surplus along an intermediation chain in their favor, while at the same time reducing aggregate surplus. I show that a core-periphery network -- few highly interconnected and many sparsely connected banks -- endogenously emerges in my model. The network is inefficient relative to a constrained efficient benchmark since banks who make risky investments "overconnect", exposing themselves to excessive counterparty risk, while banks who mainly provide funding end up with too few connections. The predictions of the model are consistent with empirical evidence in the literature.
    Date: 2014
  14. By: Bonciani, Dario
    Abstract: This paper provides empirical and theoretical evidence that uncertainty shocks have strong asymmetric effects on economic activity. Specifically, in the empirical analysis I find that uncertainty shocks dampen investment and consumption twice as much during recessions than in "normal" times. In the theoretical analysis I employ a sticky-prices general equilibrium model featuring external habit formation to show that the asymmetric effects of uncertainty shocks can be explained by countercyclical fluctuations in precautionary savings.
    Keywords: Uncertainty Shocks, STVAR, External habits, Precautionary savings.
    JEL: E21 E32
    Date: 2014–10–19
  15. By: Simon Gilchrist (Boston University and NBER); Raphael Schoenle (Brandeis University); Jae W. Sim (Federal Reserve Board); Egon Zakrajsek (Federal Reserve Board)
    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.” The evidence indicates that during the height of the crisis in late 2008, firms with “weak” balance sheets increased prices significantly, 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 macroeco- nomic shocks. We explore the implications of these empirical findings within the New Keynesian general equilibrium framework that allows for customer markets and departures from the fric- tionless 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 oppor- tunities 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.
    Keywords: Producer Price Inflation; Customer Markets; Financial Frictions
    JEL: E31 E32 E44
    Date: 2013–09
  16. By: Max Groneck (CMR, University of Cologne; Netspar; Albertus-Magnus-Platz; 50923 Köln; Germany); Alexander Ludwig (SAFE, Goethe University Frankfurt; MEA; Netspar; House of Finance; Grüneburgplatz 1; 60323 Frankfurt am Main; Germany; Department of Economics; University of Pretoria; Private Bag X20; Hatfield 0028; South Africa)
    Abstract: On average, ``young" people underestimate whereas ``old" people overestimate their chances to survive into the future. We adopt a Bayesian learning model of ambiguous survival beliefs which replicates these patterns. The model is em- bedded within a non-expected utility model of life-cycle consumption and saving. Our analysis shows that agents with ambiguous survival beliefs (i) save less than originally planned, (ii) exhibit undersaving at younger ages, and (iii) hold larger amounts of assets in old age than their rational expectations counterparts who correctly assess their survival probabilities. Our ambiguity-driven model therefore simultaneously accounts for three important empirical findings on household saving behavior.
    Keywords: Cumulative prospect theory; Choquet expected utility; Dynamic inconsistency; Life-cycle hypothesis; Saving puzzles
    JEL: D91 D83 E21
    Date: 2014–10
  17. By: Batchuluun, Altantsetseg; Luo, Yulei; Young, Eric
    Abstract: In this paper, we examine the joint consumption-portfolio decision of an agent with limited information-processing capacity (rational inattention or RI) in the sense of Sims (2003) within a non-linear-quadratic (non-LQ) setting. Our model predicts that, as processing capacity falls, agents choose to hold less of their savings in the form of risky assets on average; however, they still choose to hold substantial risky assets with some positive probability. Low capacity causes households to act as if they are more risk averse and more willing to substitute consumption intertemporally.
    Keywords: Rational Inattention, Optimal Consumption-Saving, Portfolio Choice.
    JEL: C6 C61 E21 G11
    Date: 2014
  18. By: Vincenzo Carrieri (Università di Salerno, CELPE and HEDG.); Marcello D'Amato (Università di Salerno, CELPE and CSEF); Roberto Zotti (Università di Salerno)
    Abstract: We present a dynamic OLG model of educational signaling, inequality and mobility with missing credit markets. Agents are characterized by two sources of unobserved heterogeneity: ability and parental income, consistent with empirical evidence on returns to schooling. Both quantity and quality of human capital evolve endogenously. The model generates a Kuznets inverted-U pattern in skill premia similar to historical US and UK experience. In the first (resp. later) phase the skill premium rises (falls), social returns to education exceed (falls below) private returns: under-investment owing to financial imperfections dominate (are dominated by) over-investment owing to signaling distortions. There always exist Pareto-improving policy interventions reallocating education between poor and rich children. JEL Classification: Tertiary education, Selective test based admission policies; students’ performances; peer effects; quasiexperiment
    Keywords: I21; I28; C21
    Date: 2014–11–06
  19. By: Torój, Andrzej (Ministry of Finance in Poland)
    Abstract: This paper generalizes the standard methods of solving rational expectations models to the case of time-varying nonstochastic parameters, recurring in a finite cycle. Such a specification occurs in a simple stylized New Keynesian model of the euro area when we combine the rotation in the ECB Governing Council (as constituted by the Treaty of Nice) and home bias in the interest rate decisions taken by its members. In small and mid-size economies, this combination slightly increases output and inflation volatility, as compared to a monetary policy setup without rotation. The method of Christiano (2002) has also been applied to solve the model when we assume a lagged perception of foreign macroeconomic shocks by domestic agents. When the cross-country synchronization of shocks is low or moderate and when these shocks are relatively persistent, the exclusion of contemporaneous foreign shocks from domestic agents' information sets may raise the volatility of output. There is also some tentative evidence that this effect could particularly affect mid-size economies.
    Keywords: EMU; monetary policy; solving rational expectations models; generalized Schur decomposition; heterogeneity
    JEL: C32 C61 E52 F15
    Date: 2009–09–04
  20. By: Stauvermann, Peter J.; Kumar, Ronald R.
    Abstract: Using an OLG-model with endogenous growth and public capital we show, that an international capital tax competition leads to inefficiently low tax rates, and as a consequence to lower welfare levels and growth rates. Each national government has an incentive to reduce the capital income tax rates in its effort to ensure that this policy measure increases the domestic private capital stock, domestic income and domestic economic growth. This effort is justified as long as only one country applies this policy. However, if all countries follow this path then all countries will be made worse off in the long run.
    Keywords: capital tax competition, OLG model, endogenous growth, public capital
    JEL: H21 H54 O41
    Date: 2014–09
  21. By: Jochen Michaelis (University of Kassel); Jakob Palek (University of Kassel)
    Abstract: There is growing empirical evidence that the strength of the cost channel of monetary policy differs across countries. Using a New Keynesian model of a two-country monetary union, we show how the introduction of a cost channel (differential) alters the optimal monetary responses to union-wide and national shocks. The cost channel makes monetary policy less effective in combating inflation, but it is shown that the optimal response to the decline in effectiveness is a stronger use of the instrument. On the other hand, the larger the cost channel differential, the less aggressive will the optimal monetary policy be. For almost all parameter constellations, our welfare analysis suggests a clear-cut ranking of policy regimes: commitment outperforms the Taylor rule, the Taylor rule outperforms strict inflation targeting, and strict inflation targeting outperforms discretion.
    Keywords: cost channel; optimal monetary policy; monetary union; open economy macroeconomics
    JEL: E31 E52 F41
    Date: 2014
  22. By: Bandopadhyay, Titas Kumar
    Abstract: This paper introduces efficiency wage relation and assumes endogenous job destruction in the benchmark DMP model. A comparative static analysis has also been made which shows that most of the results obtained in the DMP model get altered in the extended model
    Keywords: Efficiency wage, job destruction
    JEL: J2 J20 J24
    Date: 2014–10–29
  23. By: Bandopadhyay, Titas Kumar
    Abstract: In this paper we examine different types of labour policies in the benchmark model of DMP in both cases where job-destruction rate is exogenous and endogenous. Our theoretical results show that the labour market tightness and the unemployment rate would be more volatile if job-destruction is endogenous.
    Keywords: Labour policies, job-destruction, labour market tightness, unemployment rate.
    JEL: J2 J6
    Date: 2014–11–02
  24. By: Frantisek Brazdik; Zuzana Humplova; Frantisek Kopriva
    Abstract: Macroeconomic forecasters are often criticized for a lack of transparency when presenting their forecasts. To deter such criticism, the transparency of the forecasting process should be enhanced by tracing and explaining the effects of data revisions and expert judgment updates on variations in the forecasts. This paper presents a forecast decomposition analysis framework designed to examine the differences between two forecasts generated by a linear structural model. The differences between the forecasts considered can be decomposed into the contributions of various forecast elements, such as the effect of new data or expert judgment. The framework allows us to evaluate the contributions of forecast assumptions in the presence of expert judgment applied in the expected way. The simplest application of this framework examines alternative forecast scenarios with different forecast assumptions. Next, a one-period difference between the forecasts’ initial periods is added to the examination. Finally, a replication of the Inflation Forecast Evaluation presented in Inflation Report III/2013 is created to illustrate the full capabilities of the decomposition framework.
    Keywords: Data revisions, DSGE models, forecasting, forecast revisions
    JEL: C53 E01 E47
    Date: 2014–08

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