nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2014‒12‒24
twenty-two papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. How Does Tax Progressivity and Household Heterogeneity Affect Laffer Curves? By Hans A. Holter; Dirk Krueger; Serhiy Stepanchuk
  2. Lending Standards, Credit Booms and Monetary Policy By Elena Afanasyeva; Jochen Güntner
  3. Financial frictions, the housing market, and unemployment By Branch, William A.; Petrosky-Nadeau, Nicolas; Rocheteau, Guillaume
  4. Great opportunities or poor alternatives: self-employment, unemployment and paid employment over the business cycle By Ludo Visschers; Ana Millan; Matthias Kredler
  5. Heterogeneity and Government Revenues: Higher Taxes at the Top? By Guner, Nezih; Lopez-Daneri, Martin; Ventura, Gustavo
  6. Public Debt and Total Factor Productivity By Leo Kaas
  7. Funding Liquidity and Market Liquidity By Yuan Yuan
  8. Assessing The Effects of Public Expenditure Shocks on the Labor Market in the Euro-Area. By Thierry Betti
  9. Monetary and macroprudential policy with multi-period loans By Paolo Gelain; Marcin Kolasa; Michał Brzoza-Brzezina
  10. Universal Basic Income versus Unemployment Insurance By Alice Fabre; Stéphane Pallage; Christian Zimmermann
  11. Macroeconomic linkages between monetary policy and the term structure of interest rates By Howard Kung
  12. A DSGE Model of China By Dai, Li; Minford, Patrick; Zhou, Peng
  13. Optimal monetary policy rules and house prices: the role of financial frictions By Alessandro Notarpietro; Stefano Siviero
  14. Assessing the macroeconomic effects of LTROS. By C. Cahn; J. Matheron; J-G. Sahuc
  15. Front-loading the Payment of Unemployment Benefits By Etienne Lalé
  16. Trends and Cycles in Small Open Economies: Making The Case For A General Equilibrium Approach By Kan Chen; Mario J. Crucini
  17. Economic theory and forecasting: lessons from the literature By Giacomini, Raffaella
  18. In search of the transmission mechanism of fiscal policy in the Euro area By Fève, Patrick; Sahuc, Jean-Guillaume
  19. Aging, social security design and capital accumulation By DEDRY, Antoine; ONDER, Arun; PESTIEAU, Pierre
  20. FISCO: Modelo Fiscal para Colombia By Hernán Rincón; Diego Rodríguez; Jorge Toro; Santiago Téllez
  21. Is Government Spending at the Zero Lower Bound Desirable? By Florin O. Bilbiie; Tommaso Monacelli; Roberto Perotti
  22. Dynamic Contracting: An Irrelevance Result By Peter Eso; Balazs Szentes

  1. By: Hans A. Holter (Department of Economics, University of Oslo); Dirk Krueger (Department of Economics, University of Pennsylvania); Serhiy Stepanchuk (Ecole Polytechnique Fédérale de Lausanne, Switzerland)
    Abstract: How much additional tax revenue can the government generate by increasing labor income taxes? In this paper we provide a quantitative answer to this question, and study the importance of the progressivity of the tax schedule for the ability of the government to generate tax revenues. We develop a rich overlapping generations model featuring an explicit family structure, extensive and intensive margins of labor supply, endogenous accumulation of labor market experience as well as standard intertemporal consumption-savings choices in the presence of uninsurable idiosyncratic labor productivity risk. We calibrate the model to US macro, micro and tax data and characterize the labor income tax Laffer curve under the current choice of the progressivity of the labor income tax code as well as when varying progressivity. We find that more progressive labor income taxes significantly reduce tax revenues. For the US, converting to a flat tax code raises the peak of the Laffer curve by 6%, whereas converting to a tax system with progressivity similar to Denmark, would lower the peak by 7%. We also show that, relative to a representative agent economy tax revenues are less sensitive to the progressivity of the tax code in our economy. This finding is due to the fact that labor supply of two earner households is less elastic (along the intensive margin) and the endogenous accumulation of labor market experience makes labor supply of females less elastic (around the extensive margin) to changes in tax progressivity.
    Keywords: Progressive Taxation, Fiscal Policy, Laffer Curve, Government Debt
    JEL: E62 H20 H60
    Date: 2014–03–01
  2. By: Elena Afanasyeva; Jochen Güntner
    Abstract: This paper investigates the risk channel of monetary policy on the asset side of banks' balance sheets. We use a factoraugmented vector autoregression (FAVAR) model to show that aggregate lending standards of U.S. banks, such as their collateral requirements for firms, are significantly loosened in response to an unexpected decrease in the Federal Funds rate. Based on this evidence, we reformulate the costly state verification (CSV) contract to allow for an active financial intermediary, embed it in a New Keynesian dynamic stochastic general equilibrium (DSGE) model, and show that - consistent with our empirical findings - an expansionary monetary policy shock implies a temporary increase in bank lending relative to borrower collateral. In the model, this is accompanied by a higher default rate of borrowers.
    Keywords: Bank lending standards, Credit supply, Monetary policy, Risk channel
    JEL: E44 E52
    Date: 2014–10
  3. By: Branch, William A. (University of California, Irvine); Petrosky-Nadeau, Nicolas (Federal Reserve Bank of San Francisco); Rocheteau, Guillaume (University of California, Irvine)
    Abstract: We develop a two-sector search-matching model of the labor market with imperfect mobility of workers, augmented to incorporate a housing market and a frictional goods market. Homeowners use home equity as collateral to finance idiosyncratic consumption opportunities. A financial innovation that raises the acceptability of homes as collateral raises house prices and reduces unemployment. It also triggers a reallocation of workers, with the direction of the change depending on firms’ market power in the goods market. A calibrated version of the model under adaptive learning can account for house prices, sectoral labor flows, and unemployment rate changes over 1996-2010.
    Keywords: credit; unemployment; limited commitment; liquidity
    JEL: D82 D83 E40 E50
    Date: 2014–11
  4. By: Ludo Visschers (Universidad Carlos III, Madrid and University of Edinburgh); Ana Millan (Universidad Carlos III de Madrid); Matthias Kredler (Universidad Carlos III Madrid)
    Abstract: In this paper, we study the flows between self-employment, unemployment and paid employment, and how these vary over the business cycle. First, we document these flows in the data, paying particular attention to previous labor market outcomes for workers entering self-employment, and subsequent labor market outcomes for those leaving self-employment, and how these are affected by cyclical conditions. Second, we construct a two-ladder equilibrium model of a frictional labor market capturing these flows: workers search both on and off the job, and receive business ideas while in any of the three states: self-, paid employment and unemployment. We study this model in an environment with aggregate shocks, which affect both the productivity of matches in the paid-employment sector, and the profitability of ideas for the self-employed. Third, we (plan to) calibrate to see how well it can quantitatively account for observed patterns over the business cycle. These allow us to have a notion of entry into self- employment by "opportunity" (highly profitable ideas), and "necessity" (lack of alternatives in paid employment), and how these vary over the business cycle, and to quantify "prosperity pull" of self-employment in good times, and "recession push" in bad times. Finally, we plan to study the impact of labor market policies on self-employment, and on unemployment, taking into account the option to enter self-employment.
    Date: 2014
  5. By: Guner, Nezih; Lopez-Daneri, Martin; Ventura, Gustavo
    Abstract: We evaluate the effectiveness of a more progressive tax scheme in raising government revenues. We develop a life-cycle economy with heterogeneity and endogenous labor supply. Households face a progressive income tax schedule, mimicking the Federal Income tax, and flat-rate taxes that capture payroll, state and local taxes and the corporate income tax. We parameterize this model to reproduce aggregate and cross-sectional observations for the U.S. economy, including the shares of labor income for top earners. We find that a tilt of the Federal income tax schedule towards high earners leads to small increases in revenues which are maximized at an effective marginal tax rate of about 36.9% for the richest 5% of households -- in contrast to a 21.7% marginal rate in the benchmark economy. Maximized revenue from Federal income taxes is only 8.4% higher than it is in the benchmark economy, while revenues from all sources increase only by about 1.6%. The room for higher revenues from more progressive taxes is even lower when average taxes are higher to start with. We conclude that these policy recommendations are misguided if the aim is to exclusively raise government revenue.
    Keywords: labor supply; progressivity; taxation
    JEL: E6 H2
    Date: 2014–07
  6. By: Leo Kaas (Department of Economics, University of Konstanz, Germany)
    Abstract: This paper explores the role of public debt and fiscal deficits on factor productivity in an economy with credit market frictions and heterogeneous firms. When credit market conditions are sufficiently weak, low interest rates permit the government to run Ponzi schemes so that permanent primary deficits can be sustained. For small enough deficit ratios, the model has two steady states of which one is an unstable bubble and the other one is stable. The stable equilibrium features higher levels of credit and capital, but also a lower interest rate, lower total factor productivity and output. The model is calibrated to the US economy to derive the maximum sustain- able deficit ratio and to examine the dynamic responses to changes in debt policy. A reduction of the primary deficit triggers an expansion of credit and capital, but it also leads to a deterioration of total factor productivity since more low-productivity firms prefer to remain active at the lower equilibrium interest rate.
    Keywords: Credit constraints; Unbacked public debt; Dynamic inefficiency; Sustainable deficits
    JEL: D92 E62 H62
    Date: 2014–12–15
  7. By: Yuan Yuan (Department of Economics, Temple University)
    Abstract: Recent empirical studies have shown an increasing co-movement between fund and market liquidity, which is driven by common factors such as monetary shocks. Modeling this co-movement becomes desirable to evaluate policies relating to liquidity and financial instability. This paper establishes a monetary model with capital to explain the dynamic interactions between funding and market liquidity in a search framework featured by Kiyotaki and Wright [1989]. Capital and money are two important elements here. As the collateral and production input, capital affects both fund and goods trading market. As medium of exchange, money is essential to trade; meanwhile the opportunity cost of carrying it affects the fund market imbalance as well. As a result, monetary policy can change traders' expectations and negotiations, and have non-trivial impact on fund markets and liquidity risks. Calibrated the model, simulated liquidity moments respond to monetary shocks, moving together across time and presenting business cycle properties.
    Keywords: Liquidity, Monetary Policy, Search and Matching
    JEL: E5 E51 E52 G12
    Date: 2014–12
  8. By: Thierry Betti
    Abstract: The core of the paper is a medium-scale DSGE model calibrated for the Euro-Area with a detailed fiscal sector including both public consumption and public investment. The financing of the spending can be tax-based or debt-based. In the case of a debt-funded expenditure expansion, I find strong negative multipliers on the unemployment rate for the public consumption shock, around -0.6% at the peak, and more ambiguous results for a public investment shock. In both cases, the effects on the unemployment rate are short-lasting. With a sensitivity analysis exercice, it is shown than the parameters included in households’ preferences do not drammatically change the results in the case of the public consumption shock but the results are very sensitive to these parameters for the public investment shock. Finally, with the introduction of some distortive taxes and assuming that they fund the half of the deficit engendered by public spending expansion, I show that the multipliers little vary little even if the cumulated unemployment fiscal multiplier can become significantly positive with a raise of public investment.
    Keywords: Fiscal multipliers, labor market, DSGE models, preferences, unemployment.
    JEL: E32
    Date: 2014
  9. By: Paolo Gelain (Norges Bank); Marcin Kolasa (National Bank of Poland); Michał Brzoza-Brzezina (National Bank of Poland)
    Abstract: We study the implications of multi-period loans for monetary and macroprudential policy, considering several realistic modifications -- variable vs. fixed loan rates, non-negativity constraint on newly granted loans, and occasionally binding collateral constraint -- to an otherwise standard DSGE model with housing and financial intermediaries. In line with the literature, we find that monetary policy is less effective when contracts are multi-period, but only under fixed rate mortgages or when borrowers cannot be forced to accelerate repayment of their loans. Moreover, the probability that the collateral constraint becomes slack depends on loan maturity only for fixed rate mortgages while the probability that the non-negativity constraint becomes binding grows with loan maturity regardless of the contract type. As a result, muti-period loans not only weaken monetary and macroprudential policy, but also introduce asymmetry into their transmission.
    Date: 2014
  10. By: Alice Fabre (Aix Marseille University (Aix Marseille School of Economics, CNRS & EHESS)); Stéphane Pallage (ESG UQAM, CIRPEE and Département des Sciences Economiques, Université du Québec `a Montréal); Christian Zimmermann (Federal Reserve Bank of St-Louis, IZA, RCEA and CESifo)
    Abstract: In this paper we compare the welfare effects of unemployment insurance (UI) with an universal basic income (UBI) system in an economy with idiosyncratic shocks to employment. Both policies provide a safety net in the face of idiosyncratic shocks. While the unemployment insurance program should do a better job at protecting the unemployed, it suffers from moral hazard and substantial monitoring costs, which may threaten its usefulness. The universal basic income, which is simpler to manage and immune to moral hazard, may represent an interesting alternative in this context. We work within a dynamic equilibrium model with savings calibrated to the United States for 1990 and 2011, and provide results that show that UI beats UBI for insurance purposes because it is better targeted towards those in need.
    Keywords: universal basic income, idiosyncratic shocks, unemployment insurance, heterogeneous agents, Moral Hazard
    JEL: E24 D7 J65
    Date: 2014–11–14
  11. By: Howard Kung (University of British Columbia)
    Abstract: This paper studies the equilibrium term structure of nominal and real interest rates and time-varying bond risk premia implied by a stochastic endogenous growth model with imperfect price adjustment. The production and price-setting decisions of firms drive low-frequency movements in growth and inflation rates that are negatively related. With recursive preferences, these growth and inflation dynamics are crucial for rationalizing key stylized facts in bond markets. When calibrated to macroeconomic data, the model quantitatively explains the means and volatilities of nominal bond yields and the failure of the expectations hypothesis.
    Date: 2014
  12. By: Dai, Li; Minford, Patrick; Zhou, Peng
    Abstract: We use available methods for testing macro models to evaluate a model of China over the period from Deng Xiaoping's reforms up until the crisis period. Bayesian ranking methods are heavily influenced by controversial priors on the degree of price/wage rigidity. When the overall models are tested by Likelihood or Indirect Inference methods, the New Keynesian model is rejected in favour of one with a fair-sized competitive product market sector. This model behaves quite a lot more 'flexibly' than the New Keynesian.
    Keywords: Bayesian Inference; China; DSGE; Indirect Inference
    JEL: C11 C15 C18 E27
    Date: 2014–06
  13. By: Alessandro Notarpietro (Bank of Italy); Stefano Siviero (Bank of Italy)
    Abstract: We probe the scope for reacting to house prices in simple and implementable monetary policy rules, using a New Keynesian model with a housing sector and financial frictions on the household side. We show that the social welfare maximizing monetary policy rule features a reaction to house price variations, when the latter are generated by housing demand or financial shocks. The sign and size of the reaction crucially depend on the degree of financial frictions in the economy. When the share of constrained agents is relatively small, the optimal reaction is negative, implying that the central bank must move the policy rate in the opposite direction with respect to house prices. However, when the economy is characterized by a sufficiently high average loan-to-value ratio, then it becomes optimal to counter house price increases by raising the policy rate.
    Keywords: Optimal simple interest rate rules; Housing; Credit frictions.
    JEL: E20 E44 E52
    Date: 2014–10
  14. By: C. Cahn; J. Matheron; J-G. Sahuc
    Abstract: In response to the 2008-2009 crisis, faced with distressed financial intermediaries, the ECB embarked in long-term refinancing operations (LTROs). Using an estimated DSGE model with a frictional banking sector, we find that such liquidity injections can have large macroeconomic effects, with multipliers up to 0.5. However, the latter depend in an important way on how standard monetary policy is adjusted in conjunction with these non-standard measures. We find that the effects are larger when the separation principle is breached, that is to say when we force monetary policy not to react to the stimulative effects of LTROs.
    Keywords: Financial frictions, unconventional monetary policy, long-term refinancing operations, DSGE model.
    JEL: E32 E58
    Date: 2014
  15. By: Etienne Lalé
    Abstract: We study the effects of front-loading the payment of unemployment benefits in general equilibrium economies with imperfect labor and insurance markets, focusing on the trade-off between improved re-employment rates and the potential welfare losses accruing from consumption-smoothing problems. The calibration to U.S. data shows that these losses are large, enough to offset most gains from front-loading the benefit system. The nature of labor market frictions – i.e. stemming from workers’ search efforts or firms’ vacancy posting – changes the underlying mechanisms, but not the overall welfare figures. We discuss robustness to changing the generosity, duration and eligibility of unemployment insurance.
    Keywords: Unemployment Insurance, Precautionary Savings, Labor-Market Frictions, Welfare Effect.
    JEL: E21 I38 J63 J65
    Date: 2014–12
  16. By: Kan Chen; Mario J. Crucini
    Abstract: Economic research into the causes of business cycles in small open economies is almost always undertaken using a partial equilibrium model. This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices. We demonstrate the failure of the second assumption by contrasting general and partial equilibrium approaches to the study of a cross-section of small open economies. In doing so, we provide a method for modelling small open economies in general equilibrium that is no more technically demanding than the small open economy approach while preserving much of the value of the general equilibrium approach.
    Date: 2014–12
  17. By: Giacomini, Raffaella
    Abstract: Does economic theory help in forecasting key macroeconomic variables? This article aims to provide some insight into the question by drawing lessons from the literature. The definition of "economic theory" includes a broad range of examples, such as accounting identities, disaggregation and spatial restrictions when forecasting aggregate variables, cointegration and forecasting with Dynamic Stochastic General Equilibrium (DSGE) models. We group the lessons into three themes. The first discusses the importance of using the correct econometric tools when answering the question. The second presents examples of theory-based forecasting that have not proven useful, such as theory-driven variable selection and some popular DSGE models. The third set of lessons discusses types of theoretical restrictions that have shown some usefulness in forecasting, such as accounting identities, disaggregation and spatial restrictions, and cointegrating relationships. We conclude by suggesting that economic theory might help in overcoming the widespread instability that affects the forecasting performance of econometric models by guiding the search for stable relationships that could be usefully exploited for forecasting.
    Keywords: Bayesian methods; DSGE models; exponential tilting
    JEL: C52 C53
    Date: 2014–10
  18. By: Fève, Patrick; Sahuc, Jean-Guillaume
    Abstract: Hand-to-mouth consumers and Edgeworth complementarity between private consumption and public expenditures are two competing mechanisms that were put forward by the literature to investigate the effects of government spending. Using Bayesian prior and posterior analysis and several econometric experiments, we find that a model with Edgeworth complementarity is a better representation for the transmission mechanism of fiscal policy in the euro area. We also show that a small change in the degree of Edgeworth complementarity has a large impact on the estimated share of hand-to-mouth consumers. These findings are robust to a number of perturbations.
    Keywords: Fiscal multipliers, DSGE Models, Hand-to-Mouth, Edgeworth Complementarity, Euro Area, Bayesian Econometrics.
    JEL: C32 E32 E62
    Date: 2014–11–07
  19. By: DEDRY, Antoine (University of Liège); ONDER, Arun (University of Liège); PESTIEAU, Pierre (University of Liège; Université catholique de Louvain, CORE, Belgium)
    Abstract: This paper analyzes the impact of aging on capital accumulation and welfare in a country with a sizable unfunded social security system. Using a two-period overlapping-generation model with endogenous retirement decisions, we show that both the type of aging and the type of unfunded social security system are important in understanding this impact. We consider two demographic changes, declining fertility and increasing longevity, and three types of pensions, defined contributions, defined benefits and defined annuities, to investigate the differences in implications of aging.
    Keywords: aging, public finance sustainability, social security
    JEL: H2 F42 H8
    Date: 2014–07–03
  20. By: Hernán Rincón; Diego Rodríguez; Jorge Toro; Santiago Téllez
    Abstract: El gobierno es un agente que influye sobre la actividad económica a lo largo del ciclo y afecta las variables reales y nominales de un país por medio de sus políticas de ingreso y de gasto. También es un determinante importante de la estabilidad macroeconómica, en cuanto que esta depende, entre otros, de la sostenibilidad de sus finanzas y de la contraciclicidad de sus políticas. El objetivo de este documento es construir un modelo fiscalmicrofundamentado de equilibrio general dinámico y estocástico DSGE-neokeynesiano para Colombia (FISCO), en donde el gobierno juega un papel preponderante en la economía. El modelo se construye, calibra, estima y evalúa teniendo en cuenta sus particularidades económicas e institucionales. El propósito es que sirva como herramienta de análisis de la política fiscal y su nexo con la economía y la política monetaria. Con el propósito de evaluar las predicciones del modelo FISCO se presentan algunas simulaciones y se estudian las dinámicas de las principales variables macroeconómicas ante choques positivos y transitorios a las tasas de tributación, al gasto de funcionamiento, al gasto de inversión, a la tasa de interés de política monetaria y a la renta petrolera del gobierno. Las cinco conclusiones principales de política económica que emergen del modelo y de sus simulaciones son las siguientes. Primera, la inflación es un asunto que compete a la política monetaria, como se sabe, pero también a la política fiscal. Segunda, los choques positivos a la política fiscal son contrarrestados en cierto grado por la política monetaria; por el contrario, choques a esta última son refrendados por la política fiscal. Tercera, el choque al gasto de funcionamiento del gobierno desplaza a la inversión privada. Lo contario sucede con el choque a la inversión. En este mismo sentido, el recorte al gasto de inversión impacta en mayor medida a la economía que el ajuste al de funcionamiento. Cuarta, el balance estructural del gobierno depende del tipo de choque de política que enfrenta la economía. Quinta, la regla fiscal cumple un rol estabilizador de las finanzas del gobierno y de la economía, como es su objetivo; sin embargo, puede convertirse a la vez en un agravante de la situación macroeconómica ante ciertos choques. Classification JEL: D58, E2, E62, E63, C11, C13
    Date: 2014–12
  21. By: Florin O. Bilbiie; Tommaso Monacelli; Roberto Perotti
    Abstract: Government spending at the zero lower bound (ZLB) is not necessarily welfare enhancing, even when its output multiplier is large. We illustrate this point in the context of a standard New Keynesian model. In that model, when government spending provides direct utility to the household, its optimal level is at most 0.5-1 percent of GDP for recessions of -4 percent; the numbers are higher for deeper recessions. When spending does not provide direct utility, it is generically welfare-detrimental: it should be kept unchanged at a long run-optimal value.
    JEL: D91 E21 E62
    Date: 2014–11
  22. By: Peter Eso (University of Oxford); Balazs Szentes (London School of Economics)
    Abstract: This paper considers a general, dynamic contracting problem with adverse selection and moral hazard, in which the agent's type stochastically evolves over time. The agent's final payoff depends on the entire history of private and public information, contractible decisions and the agent's hidden actions, and it is linear in the transfer between her and the principal. We transform the model into an equivalent one where the agent's subsequent information is independent in each period. Our main result is that for any fixed decision-action rule implemented by a mechanism, the maximal expected revenue that the principal can obtain is the same as if the principal could observe the agent's orthogonalized types after the initial period. In this sense, the dynamic nature of the relationship is irrelevant: the agent only receives information rents for her initial private information. We also show that any monotonic decision-action rule can be implemented in a Markov environment satisfying certain regularity conditions.
    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.