nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2015‒02‒28
48 papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. The Asymmetric Cyclical Behavior of the U.S. Labor Market By Domenico Ferraro
  2. Self-Fulfilling Credit Cycles By Yi Wen ; Leo Kaas ; Costas Azariadis
  3. Intergenerational Redistribution through Monetary Policy By Makoto Nakajima
  4. Wealth distribution and asset prices By Dan Cao ; Jinhui Bai
  5. Precautionary Saving and Aggregate Demand By Julien Matheron ; Juan Rubio-Ramirez ; Edouard Challe ; Xavier Ragot
  6. Labor Market Reform and the Cost of Business Cycles By Tom Krebs
  7. Fiscal multipliers in a two-sector search and matching model By Konstantinos Angelopoulos ; Wei Jiang ; James Malley
  8. Financial Distress and Endogenous Uncertainty By Francois Gourio
  9. Efficient Perturbation Methods for Solving Regime-Switching DSGE Models By Junior Maih
  10. What Should I Be When I Grow Up? Occupations and Unemployment over the Life Cycle By Yaniv Yedid-Levi ; Nir Jaimovich ; Henry Siu ; Martin Gervais
  11. International Interest Rates and Housing Markets By Luis Franjo
  12. Yield curve and monetary policy expectations in small open economies By Doh, Taeyoung ; Park, Woong Yong ; Bong, Kwan Soo
  13. Online Appendix to "Optimal Monetary Policy with Endogenous Export Participation" By Dudley Cooke
  14. A Tale of Two Countries: Sovereign Default, Exchange Rate, and Trade By Gu, Grace Weishi
  15. Medium-term forecasting of euro-area macroeconomic variables with DSGE and BVARX models By Lorenzo Burlon ; Simone Emiliozzi ; Alessandro Notarpietro ; Massimiliano Pisani
  16. On the Size of the Government Spending Multiplier in the Euro Area By P. Fève ; J-G. Sahuc
  17. Intertemporal equilibrium with financial asset and physical capital. By Cuong Le Van ; Ngoc-Sang Pham
  18. Debt Constraints and Unemployment By Virgiliu Midrigan ; Elena Pastorino ; Patrick Kehoe
  19. The Dynamics of Sovereign Default Risk and Political Turnover By Almuth Scholl
  20. Optimal capital requirements over the business and financial cycles By Malherbe, Frédéric
  21. Equilibrium Dynamics in a Matching Theoretic-Model of the Housing Market By Lisi, Gaetano
  22. The Race Between Technology and Human Capital By Nancy L Stokey
  23. The Cyclical Behavior of Unemployment and Vacancies with Loss of Skills during Unemployment By Victor Ortego-Marti
  24. Securitization under Asymmetric Information over the Business Cycle By Martin Kuncl
  25. Growth and Mitigation Policies with Uncertain Climate Damage By Lucas Bretschger ; Alexandra Vinogradova
  26. House prices, heterogeneous banks and unconventional monetary policy options By Smith, Andrew Lee
  27. Can a data-rich environment help identify the sources of model misspecification? By Francesca Monti
  28. Debt and government spending in ambiguous times By Anastasios Karantounias ; Axelle Ferriere
  29. Unemployment (fears), precautionary savings, and aggregate demand By Wouter den Haan ; Markus Riegler ; Pontus Rendahl
  30. Capital goods, measured TFP and growth: The case of Spain By Antonia Diaz ; Luis Franjo
  31. The Benchmark Macroeconomic Models of the Labour Market By Lisi, Gaetano
  32. Aggregate Fluctuations and the Industry Structure of the US Economy By Julieta Caunedo
  33. Near-Rational Expectations: How Far Are Surveys from Rationality? By Sergey Ivashchenko
  34. Sophisticated Intermediation and Aggregate Volatility By Luigi Iovino
  35. Serial Entrepreneurship and the Impact of Credit Constraints of Economic Development By Galina Vereshchagina
  36. The Price vs Quantity Debate: Climate policy and the role of business cycles By Anna Grodecka ; Karlygash Kuralbayeva
  37. Asymmetric firm dynamics under rational inattention By Cheremukhin, Anton A. ; Tutino, Antonella
  38. Equity Sales and Manager Efficiency Across Firms and the Business Cycle By Karen Lewis ; Fabio Ghironi
  39. Model Misspecification and Relaxing Rational Expectations By Lance Kent
  40. Is the Friedman Rule Stabilizing? Some Unpleasant Results in a Heterogeneous Expectations Framework By Mattia Guerini
  41. Information Aversion By Valentin Haddad ; Marianne Andries
  42. Equilibrium Bank Runs Revisied By Ed Nosal ; Bruno Sultanum ; David Andolfatto
  43. Differential Mortality and Progressivity of Social Security By Ali Shourideh ; Roozbeh Hosseini
  44. Macroelasticities and the U.S. sequestration budget cuts By Zarazaga, Carlos E.
  45. Optimum Growth and Carbon Policies with Lags in the Climate System By Lucas Bretschger ; Christos Karydas
  46. Poverty and Self Control By Sevin Yeltekin ; Debraj Ray ; B. Douglas Bernheim
  47. The Welfare Effects of Asset Means-Testing Income Support By Wellschmied, Felix
  48. Rating Agencies By Thomas Cooley ; Harold Cole

  1. By: Domenico Ferraro (Duke University )
    Abstract: Cyclical fluctuations in the U.S. labor market and output exhibit a significant asymmetry. In this paper, I develop a search-and-matching model with endogenous job destruction and permanently heterogeneous workers (in skill/productivity) that accounts for this asymmetry while also generating (i) realistic volatility in unemployment and job-finding rates and (ii) preserving a downward-sloping Beveridge curve. The model delivers stark predictions for the time series of skill-specific unemployment rates that hold in CPS micro data once I sort workers by age and education. A general implication of the analysis is that the responsiveness of unemployment to stimulus policies increases substantially during recessions.
    Date: 2014
  2. By: Yi Wen (Federal Reserve Bank of St. Louis ); Leo Kaas (University of Konstanz ); Costas Azariadis (Washington University in St Louis )
    Abstract: In U.S. data 1981-2012, unsecured firm credit moves procyclically and tends to lead GDP, while secured firm credit is at best acyclical. In this paper we develop a tractable dynamic general equilibrium model in which unsecured firm credit arises from self-enforcing borrowing constraints preventing an efficient capital allocation among heterogeneous firms. Capital from less productive firms is lent to more productive ones in the form of credit secured by collateral and also as unsecured credit based on reputation which is a forward-looking variable. We argue that self-fulfilling beliefs over future credit conditions naturally generate endogenously persistent business cycle dynamics. A dynamic complementarity between current and future borrowing limits permits uncorrelated sunspot shocks to trigger persistent aggregate fluctuations in debt, factor productivity and output. We show that sunspot shocks are quantitatively important, accounting for a substantial part of the volatility in firm credit and output.
    Date: 2014
  3. By: Makoto Nakajima (Federal Reserve Bank of Philadelphia )
    Abstract: How important are intergenerational heterogeneity and an aging population for the design of systematic monetary policy? We answer this question using a New-Keynesian business cycle model with overlapping generations of households. Our model features rich heterogeneity; households differ not only in their stage in the life-cycle, but also in the amount and allocation of wealth and in the size of non-financial income. Monetary policy generates redistribution of income and wealth in the model. Since retirees tend to hold larger (positive) amounts of financial assets and especially bonds, a rise in the interest rate induced by monetary policy increases their income. At the same time, working-age households tend to suffer because of falling wages and higher borrowing costs. The resulting wealth effects lead to a rise in aggregate labor supply, altering the monetary transmission channel compared to an representative agent economy. After showing that intergenerational redistribution of income and wealth can be significant when monetary policy strongly reacts to a severe recession, we study the design of implementable monetary policy in comparison to the complete market and representative agent benchmarks.
    Date: 2014
  4. By: Dan Cao (Georgetown University ); Jinhui Bai (Georgetown University )
    Abstract: We propose a model that explains the relationship between wealth distribution and asset prices over the business cycles. The model features an economy with a continuum of agents and with both idiosyncratic and aggregate shock a la Krusell and Smith (1998). However, we allow agents to trade in a long-lived asset in addition to in-contingent bonds. We develop a numerical method to calculate wealth-recursive equilibrium in the economy and apply the method to examine quantitatively the relationship between wealth distribution and asset prices in the U.S. economy.
    Date: 2014
  5. By: Julien Matheron (Banque de France ); Juan Rubio-Ramirez (Duke University ); Edouard Challe (Ecole Polytechnique ); Xavier Ragot (Paris School of Economics )
    Abstract: This paper introduces incomplete insurance against idioyncratic labour income risk into an otherwise standard New Keynesian business cycle model with involuntary unemployment. Following an adverse monetary policy shock that lowers aggregate demand, job creation is discouraged and unemployment risk persistently rises. Imperfectly insured households rationally respond to the rise in idiosyncratic income uncertainty by increasing precautionary saving, thereby cutting consumption and depleting aggregate demand even further; this in turn magnifies the initial labour market contraction and further raises unemployment risk. A Bayesian estimation of the model is used to assess the contribution of time-varying precautionary saving to movements in aggregate consumption.
    Date: 2014
  6. By: Tom Krebs (University of Mannheim )
    Abstract: This paper studies the effect of labor market reform on the welfare cost of business cycles. Motivated by the German labor market reforms of 2003-2005, the so-called Hartz reforms, the paper focuses on two labor market institutions: the unemployment insurance system determining search incentives and the system of job placement services affecting matching efficiency. The paper develops a tractable search model with idiosyncratic labor market risk and risk-averse workers, and derives a closed-form solution for the welfare cost of business cycles as a function of the various parameters of interest. An improvement in job placement services leads to a reduction in the welfare cost of business cycles, but a change in unemployment benefit generosity has in general an ambiguous effect. A quantitative analysis based on a calibrated version of the model suggests that the German labor market reforms of 2003-2005 reduced the non-cyclical unemployment rate by 3 percentage points and reduced the welfare cost of business cycles by 30 percent.
    Date: 2014
  7. By: Konstantinos Angelopoulos ; Wei Jiang ; James Malley
    Abstract: This paper evaluates the e¤ects of policy interventions on sectoral labour markets and the aggregate economy in a business cycle model with search and matching frictions. We extend the canonical model by including capital-skill complementarity in production, labour mar- kets with skilled and unskilled workers and on-the-job-learning (OJL) within and across skill types. We …rst …nd that, the model does a good job at matching the cyclical properties of sectoral employment and the wage-skill premium. We next …nd that vacancy subsidies for skilled and unskilled jobs lead to output multipliers which are greater than unity with OJL and less than unity without OJL. In contrast, the positive output e¤ects from cutting skilled and unskilled income taxes are close to zero. Finally, we …nd that the sectoral and aggre- gate e¤ects of vacancy subsidies do not depend on whether they are …nanced via public debt or distorting taxes
    Keywords: fiscal multipliers, sectoral labour markets, search and matching
    JEL: E24 E32 J63 J64 J68
    Date: 2015–01
  8. By: Francois Gourio (FRB Chicago )
    Abstract: What is the macroeconomic effect of having a substantial number of firms close to default? This paper studies financial distress costs in a model where customers, suppliers and workers suffer losses if their employer goes bankrupt. I show that this mechanism generates amplification of fundamental shocks through procyclical TFP and countercyclical labor wedge. Because the strength of this amplification depends on the share of firms that are in financial distress, it operates mostly in recessions, when equity values are low. This leads macroeconomic volatility to be endogenously countercyclical. The cross-sectional distribution of firms' equity values affects directly aggregate macroeconomic volatility. Empirical evidence consistent with the model is provided.
    Date: 2014
  9. By: Junior Maih
    Abstract: In an environment where economic structures break, variances change, distributions shift, conventional policies weaken and past events tend to reoccur, economic agents have to form expectations over different regimes. This makes the regime-switching dynamic stochastic general equilibrium (RS-DSGE) model the natural framework for analyzing the dynamics of macroeconomic variables. We present efficient solution methods for solving this class of models, allowing for the transition probabilities to be endogenous and for agents to react to anticipated events. The solution algorithms derived use a perturbation strategy which, unlike what has been proposed in the literature, does not rely on the partitioning of the switching parameters. These algorithms are all implemented in RISE, a flexible object-oriented toolbox that can easily integrate alternative solution methods. We show that our algorithms replicate various examples found in the literature. Among those is a switching RBC model for which we present a third-order perturbation solution.
    Keywords: DSGE, Markov switching, Sylvester equation, Newton algorithm, perturbation, matrix polynomial
    Date: 2014–12
  10. By: Yaniv Yedid-Levi (The University of British Columbia ); Nir Jaimovich (Duke University ); Henry Siu (University of British Columbia ); Martin Gervais (University of Iowa )
    Abstract: Why is unemployment higher for younger individuals? We address this question in a frictional model of the labor market that features learning about occupational fit. In order to learn the occupation in which they are most productive, workers sample occupations over their careers. Because young workers are more likely to be in matches that represent a poor occupational fit, they spend more time in transition between occupations. Through this mechanism, our model can replicate the observed age differences in unemployment which, as in the data, are due to differences in job separation rates.
    Date: 2014
  11. By: Luis Franjo (Chair of International Finance, Ecole Polytechnique Federale de Lausanne (EPFL), Switzerland )
    Abstract: Current account deficits and housing prices showed a strong positive correlation throughout the mid-90s to 2007. This paper studies the effect of a decrease in the international interest rate and in the downpayment requirement to buy a house during that period on the joint behavior of the current account and housing prices. To this end, I build a small open economy model with life-cycle heterogeneous agents and two goods: tradable (non-housing) and non-tradable (housing). I calibrate the model to replicate selected aggregate statistics of the U.S. economy and compute the transition after the decrease in the interest rate and in the downpayment. The model is able to match some relevant facts: the boom and the bust (after 2007) in the housing market, where the bust, as the data show, occurs without a reversal in the interest rate; the increase in the homeownership rate; the simultaneous boom - and bust - in non-housing consumption; and the coexistence of borrowing from abroad with a current account deficit throughout the transition.
    Keywords: Current account, housing prices, debt, non-housing consumption, home-ownership, collateralized borrowing constraints.
    JEL: E21 F41 G11
    Date: 2015–02
  12. By: Doh, Taeyoung (Federal Reserve Bank of Kansas City ); Park, Woong Yong ; Bong, Kwan Soo
    Abstract: This paper estimates a New Keynesian dynamic stochastic general equilibrium (DSGE) model in small open economies using the yield curve data as well as standard macro data. The DSGE model is estimated on the data of three inflation-targeting small open economies (Australia, Canada, and New Zealand) using Bayesian methods. We find that the long-end of the yield curve is highly correlated with the current and future short-term interest rates determined by domestic central banks. Yield curve data are particularly informative about the future stance of monetary policy in Australia and Canada in that the correlation between the model-implied monetary policy expectations and the ex-post realized policy interest rates increases when the yield curve data are used in estimation. Unlike the estimation results solely based on the macro data that imply the cental bank’s relatively strong focus on inflation stabilization, our results using yield curve information suggest that even inflation-targeting central banks have a significant concern for output stabilization. We also document that persistent domestic shocks, not foreign disturbances, drive the average level of the yield curve in these three countries
    Keywords: dynamic general equilibrium model; small open economy model; yield curve; monetary policy expectations
    Date: 2014–11–01
  13. By: Dudley Cooke (University of Exeter )
    Abstract: Online appendix for the Review of Economic Dynamics article
    Date: 2015
  14. By: Gu, Grace Weishi
    Abstract: This paper explores the impacts of sovereign defaults on trade and income through a real exchange rate channel, in a DSGE model of two risk-averse open economies, with production. In the model, once the borrower country defaults due to an adverse productivity shock, foreign firms reduce their imports of intermediate goods from the defaulting country, whose income consequently declines. This causes the defaulting country to adjust its consumption portfolio of domestic goods and imports according to its home bias preference, triggers a collapse in its real exchange rate, and leads to a further endogenous plummet in national income. This paper makes three main contributions. First, along business cycles, the model generates countercyclical trade balances, procyclical trade flows, and countercyclical bond spreads with a data-consistent average. Second, following a sovereign default, the model endogenously delivers sharp real exchange rate deterioration, output drops, trade balance improvements, and bilateral trade flow declines. This paper thus also studies a real exchange rate channel, through which default risks and occurrences, income, and trade interact with each other. Lastly, this model predicts lasting welfare gains for the creditor country through the real exchange rate channel, but relatively short-lived welfare losses for the borrower country and the world during and after a sovereign default.
    Keywords: sovereign default, real exchange rate, trade, DSGE
    JEL: E44 F31 F34 F41
    Date: 2015–02–23
  15. By: Lorenzo Burlon (Bank of Italy ); Simone Emiliozzi (Bank of Italy ); Alessandro Notarpietro (Bank of Italy ); Massimiliano Pisani (Bank of Italy )
    Abstract: The paper assesses the performance of medium-term forecasts of euro-area GDP and inflation obtained with a DSGE model and a BVARX model currently in use at the Bank of Italy. The performance is compared with that of simple univariate models and with the Eurosystem projections; the same real time assumptions underlying the latter are used to condition the DSGE and the BVARX forecasts. We find that the performance of both forecasts is similar to that of Eurosystem forecasts and overall more accurate than that of simple autoregressive models. The DSGE model shows a relatively better performance in forecasting inflation, while the BVARX model fares better in forecasting
    Keywords: forecasting, DSGE, BVARX, euro area
    JEL: C53 E32 E37
    Date: 2015–01
  16. By: P. Fève ; J-G. Sahuc
    Abstract: This article addresses the existence of a wide range of estimated government spending multipliers in a dynamic stochastic general equilibrium model of the euro area. Our estimation results and counterfactual exercises provide evidence that omitting the interactions of key ingredients at the estimation stage (such as Edgeworth complementarity/substitutability between private consumption and government expenditures, endogenous government spending policy and general habits in consumption) paves the way for potentially large biases. We argue that uncertainty on the quantitative assessments of fiscal programmes could partly originate from these biases.
    Keywords: Government spending multiplier, DSGE models, Estimation bias, Euro area.
    JEL: C32 E32 E62
    Date: 2015
  17. By: Cuong Le Van (Centre d'Economie de la Sorbonne - Paris School of Economics, IPAG Business School and VCREME ); Ngoc-Sang Pham (Centre d'Economie de la Sorbonne )
    Abstract: We build an infinite-horizon dynamic deterministic general equilibrium model with imperfect markets (because of borrowing constraints), in which heterogeneous agents invest in capital or/and financial asset, and consume. There is a representative firm who maximizes its profit. Firstly, the existence of intertemporal equilibrium is proved even if aggregate capital is not uniformly bounded. Secondly, we study the interaction between the financial market and the productive sector. We also explore the nature of physical capital bubble and financial asset bubble as well.
    Keywords: Infinite horizon, intertemporal equilibrium, financial friction, productivity, efficiency, fluctuation, bubbles.
    JEL: C62 D31 D91 G10 E44
    Date: 2014–08
  18. By: Virgiliu Midrigan (New York University ); Elena Pastorino (University of Minnesota ); Patrick Kehoe (Princeton University )
    Abstract: In the Great Contraction, regions of the United States that experienced the largest change in household debt to income ratios also experienced the largest drops in output and employment. Such output drops not only occurred for firms that sell primarily to a local region but also for regional establishments of nation-wide firms that sell highly traded goods to both the rest of the United States and abroad. These patterns are difficult to reconcile with standard models of financial frictions in which tightened financial constraints mainly affect firms' ability to borrow. We develop a Bewley-Huggett-Aiyagari incomplete market model with search and matching frictions of the Diamond-Mortenson-Pissarides type that generates such patterns. Critically, we allow for human capital acquisition by employed individuals, which generates realistic wage-tenure profiles. We show that with such upward sloping wage profiles, an unanticipated tightening of borrowing constraints leads consumers to value less the prospect of consumption when employed and, thus, to find employment relatively less attractive. In equilibrium, firms anticipate this behavior by consumers and consequently reduce the number of vacancies they post. The key result is that in equilibrium the tightening of borrowing constraints generates a path of increased unemployment that lingers, as consumers slowly adjust their asset positions given the tighter constraints, and seemingly `sticky' wages, despite wages being continually renegotiated.
    Date: 2014
  19. By: Almuth Scholl (Department of Economics, University of Konstanz, Germany )
    Abstract: This paper develops a stochastic dynamic politico-economic model of sovereign debt to analyze the interaction of sovereign default risk and political turnover. Two parties differ in their preferred size of public spending which is financed by taxes and external debt. Electoral outcomes are characterized by tradeoffs between the economic benefits from the incumbent's policies against idiosyncratic ideological aspects. Quantitative simulations replicate the typical empirical facts of emerging markets. Endogenous political turnovers increase the parties' discrepancies between debt and default policies. Debt crises are associated with adverse economic shocks and trigger political turnovers. Political turnovers generate defaults even without negative shocks.
    Keywords: sovereign debt, default risk, political turnover, fiscal policy
    JEL: E62 F34 F41 D72
    Date: 2015–02–25
  20. By: Malherbe, Frédéric
    Abstract: I propose a simple theory of intertwined business and financial cycles, where financial regulation both optimally responds to and influences the cycles. In this model, banks do not internalize the effect of their credit expansion on other banks’ expected bankruptcy costs, which leads to excessive aggregate lending. In response, the regulator sets a capital requirement to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy and, because of a general equilibrium effect, its stringency increases with aggregate banking capital. A regulation that fails to take this effect into account would exacerbate economic fluctuations and result in excessive aggregate lending during a boom. It would also allow for an excessive build-up of risk in the financial sector, which implies that, at the peak of a boom, even a small adverse shock could trigger a banking sector collapse, followed by an excessively severe credit crunch.
    Keywords: Basel 3; capital requirement; costly default; counter-cyclical buffers; financial cycles; financial regulation
    JEL: E44 G01 G21 G28
    Date: 2015–02
  21. By: Lisi, Gaetano
    Abstract: In light of the recent and growing literature which has extended the use of search and matching models even to the housing market, this paper introduces dynamic analysis to a simple stationary state equilibrium model. Contrary to what occurs in the labour market, the dynamic adjustment to equilibrium depends on the level of matching frictions present in the market. Precisely, if matching frictions are high, sellers bear in mind future expectations regarding total vacancies when deciding how many vacancies to post on the market; as a consequence, the market tensions respond quickly to any changes, immediately reaching the equilibrium value. Instead, with low matching frictions any dynamic adjustment path leads to equilibrium without the need for “forward looking” behaviour on behalf of sellers.
    Keywords: Housing Markets, Matching Theory, Equilibrium Dynamics
    JEL: J63 J64 R21 R3 R31
    Date: 2013–07–01
  22. By: Nancy L Stokey (Department of Economics )
    Abstract: This paper develops a model in which heterogenous firms invest in R&D to improve technology, and heterogeneous workers invest in human capital to increase their earnings. Both investment technologies have stochastic components, and the balanced growth path has stationary, nondegenerate distributions of technology and human capital. Technology and human capital are complements in production, so the labor market produces assortative matching between firms and workers: firms with higher productivity employ higher quality workers and pay higher wages. Thus, wage differentials across firms have two sources: differences in firm productivity and differences in labor quality.
    Date: 2014
  23. By: Victor Ortego-Marti (Department of Economics, University of California Riverside )
    Abstract: This paper studies the cyclical fluctuations in unemployment and vacancies in a search and matching model in which workers lose skills during periods of unemployment. Firms’ profits fluctuate more because aggregate productivity affects the economy’s average human capital. Moreover, wages for workers with lower levels of human capital are closer to the value of non-market time, leading to more rigid wages. Fluctuations in the vacancy-unemployment ratio are larger than in the baseline search and matching model and similar to those we observe in the data.
    Date: 2015–02
  24. By: Martin Kuncl
    Abstract: This paper studies the efficiency of financial intermediation through securitization in a model with heterogeneous investment projects and asymmetric information about the quality of securitized assets. I show that when retaining part of the risk, the issuer of securitized assets may credibly signal its quality. However, in the boom stage of the business cycle this practice is inefficient, information on asset quality remains private, and lower-quality assets accumulate on balance sheets of financial intermediaries. This prolongs and deepens a subsequent recession with an intensity proportional to the length of the preceding boom. In recessions, the model also produces amplification of adverse selection problems on resale markets for securitized assets. These are especially severe after a prolonged boom period and when securitized high-quality assets are no longer traded. The model also suggests that improperly designed regulation requiring higher explicit risk retention may become counterproductive due to a negative general-equilibrium effect; i.e., it may adversely affect both the quantity and the quality of investment in the economy.
    Keywords: Business fluctuations and cycles, Credit and credit aggregates, Economic models, Financial markets, Financial stability, Financial system regulation and policies
    JEL: E E3 E32 E4 E44 G G0 G01 G2 G20
    Date: 2015
  25. By: Lucas Bretschger ; Alexandra Vinogradova
    Abstract: Climate physics predicts that the intensity of natural disasters will increase in the future due to climate change.  One of the biggest challenges for economic modeling is the inherent uncertainty of climate events, which crucially affects consumption, investment, and abatement decisions.  We present a stochastic model of a growing economy where natural disasters are multiple and random, with damages driven by the economy's polluting activity.  We provide a closed-form solution and show that the optimal path is characterized by a constant growth rate of consumption and the capital stock until a shock arrives, triggering a downward jump in both variables.  Optimum mitigation policy consists of spending a constant fraction of output on emissions abatement.  This fraction is an increasing function of the arrival rate, polluting intensity of output, and the damage intensity of emissions.  A sharp response of the optimum growth rate and the abatement share to changes in the arrival rate and the damage intensity justifies more stringent climate policies as compared to the expectation-based scenario.  We subsequently extend the baseline model by adding climate-induced fluctuations around the growth trend and stock-pollution effects, demonstrating robustness of our results.  In a quantitative assessment of our model we show that the optimal abatement expenditure at the global level may represent 0.9% of output, which is equivalent to a tax of $71 per ton carbon.
    Keywords: Climate policy, uncertainty, natural disasters, endogenous growth
    JEL: O10 Q52 Q54
    Date: 2014–08–04
  26. By: Smith, Andrew Lee (Federal Reserve Bank of Kansas City )
    Abstract: This paper develops a nancial mechanism which integrates housing and the real econ- omy through housing-secured debt. In this environment, movements in home prices are ampli ed through both borrowers and banks' balance sheets, leading to a self-reinforcing credit/liquidity crunch. When placed within a traditional business cycle model, this - financial structure quantitatively captures empirical relationships the traditional nancial accelerator mechanism struggles to explain and the qualitative predictions of the model are consistent with dynamic responses from a VAR. The model provides a framework to examine the ability of QE policies and equity injections into big banks to mitigate a housing bust. Although both are e ective, the nuances of the policies are important. A prolonged asset purchase program is preferable to a short-term equity injection; however, the model suggests the equity injections may have been necessary to prevent an economic collapse at the acute stage of the 2008 Financial Crisis.
    Keywords: Financial Crises; Financial Frictions; Unconventional Monetary Policy; Housing
    JEL: E32 E44 G01 G21
    Date: 2014–10–01
  27. By: Francesca Monti (Bank of England ; Centre for Macroeconomics (CFM) )
    Abstract: This paper proposes a method for detecting the sources of misspecification in a DSGE model based on testing, in a data-rich environment, the exogeneity of the variables of the DSGE with respect to some auxiliary variables. Finding evidence of non-exogeneity implies misspecification, but finding that some specific variables help predict certain shocks can shed light on the dimensions along which the model is misspecified. Forecast error variance decomposition analysis then helps assess the relevance of the missing channels. The paper puts the proposed methodology to work both in a controlled experiment - by running a Monte Carlo simulations with a known DGP - and using a state-of-the-art model and US data up to 2011.
    Keywords: DSGE Models, Model Misspecification, Bayesian Analysis
    JEL: C32 C52
    Date: 2015–01
  28. By: Anastasios Karantounias (Federal Reserve Bank of Atlanta ); Axelle Ferriere (New York University )
    Abstract: First, we endogenize government expenditures and study their optimal provision and mix with distortionary taxes in an economy without ambiguity. Second, we show that uncertainty over the distribution of shocks generates procyclical or countercyclical allocation of distortions, whereas without ambiguity distortions would be acyclical. Third, we provide a quantitative evaluation of the fiscal plan with ambiguity and analyze its short- and long-run properties. Preliminary results suggest that optimal policy would, (1) delay distortions for the future, or, (2) accelerate distortions and converge to a balanced budget in the long-run, depending on the size of the intertemporal elasticity of substitution.
    Date: 2014
  29. By: Wouter den Haan ; Markus Riegler (LSE ); Pontus Rendahl (University of Cambridge )
    Abstract: environment, an increase in the risk of remaining unemployed for a long time increases precautionary savings and reduces aggregate demand, which in turn exacerbates the unemployment duration further. We show that this feedback mechanism can propagate relatively modest exogenous shocks many times over and cause deep and prolonged recessions. A temporary rise in unemployment insurance, however, can largely break this vicious cycle and therefore assume the role of a powerful countercyclical policy tool.
    Date: 2014
  30. By: Antonia Diaz ; Luis Franjo (Chair of International Finance, Ecole Polytechnique Federale de Lausanne (EPFL), Switzerland )
    Abstract: This paper reconciles two, apparently, contradictory facts about the Spanish economy: real GDP per working age person has grown at 2.4 percent during the period 1996-2007, on average, whereas Total Factor Productivity has been stagnant during that period. Here we argue that the Spanish economy has grown, in spite of stagnant TFP, because investment in structures has been heavily subsidized. This inefficiently high rate of investment in structures is the main reason for the increase in hours worked observed during that period. We use a three sector model economy where we distinguish between equipment and structures to quantify the sources of changes in measured TFP in Spain. We find that measured TFP is low because Investment-Specific Technical Change in Spain is very low. A calibrated version of this model is able to reproduce very well the growth experience of Spain for the period 1970-2007. We use the model economy to quantify the cost of direct and indirect subsidies to structures and the gains of eliminating them in terms of TFP and income growth. Our three sector model economy also allows us to quantify the cost in measured TFP of the housing price boom experienced during the 2000s.
    Keywords: Home Market Effect, Terms of Trade, Tariffs and Subsidies
    JEL: E01 E13 E32
    Date: 2014–10
  31. By: Lisi, Gaetano
    Abstract: This technical note aims to provide a practical overview of the labour market’s benchmark macroeconomic models. The matching models are the primary and most popular theoretical tools used by economists to evaluate various labour market policies and to study the problem of unemployment. These models explain the co-existence in equilibrium of unemployment and vacancies through frictions in matching workers and firms and generate predictions that have the right direction: unemployment goes up in recession and down in boom, while job vacancies shift in the opposite direction. The central role of these models in imperfect labour markets has recently been confirmed by the 2010 Nobel Prize for economy awarded to the founders of this approach: Peter Diamond, Dale Mortensen and Christopher Pissarides.
    Keywords: Matching and Job Search Theory; “non-walrasian” Labour Market; Search and Matching frictions; Job Creation and Job Destruction; Equilibrium Unemployment
    JEL: J63 J64
    Date: 2013–07
  32. By: Julieta Caunedo (Washington University in St. Louis )
    Abstract: Reallocation of inputs in production and substitution across them, are mechanisms through which the economy adjusts to changes in relative efficiency in production across sectors. When input productivity moves along relative prices, cost shares are constant and the input output structure of the economy does not change. I document that cost shares of intermediate inputs fluctuate on average 5% in the investment sector (equipment production) and 3% in the consumption sector. Furthermore, cost shares of intermediate inputs from the equipment (consumption) sector are countercyclical (procyclical) across the economy. These facts are used to discipline the behavior of a multisector RBC model with intermediate goods. I compare the predictions of the model against a comparable economy calibrated to the same steady state, under constant cost shares. Most of the volatility of output is explained by sector specific shocks. However, I find that neutral shocks become relatively more important in generating output volatility when cost shares are allowed to áuctuate as in the data. Additionally, the paper provides conditions for the existence of a balanced growth path in which all intermediate inputs are used in production, and the economy displays investment specific technological change.
    Date: 2014
  33. By: Sergey Ivashchenko
    Abstract: New simple forms of deviation from rational expectations (RE) are suggested: strong near-rational expectations (SNRE) and weak near-rational expectations (WNRE). The medium-scale DSGE model is estimated with the RE, the SNRE and the WNRE. It is estimated with and without observed from the surveys expectations. The quality of out-of-sample forecasts is estimated. It is shown that near-rational concept produce the same advantages as learning without its disadvantages. However, the DSGE model with the RE and the observed expectations with measurement errors can produce results that only slightly worse than with the WNRE. The influence of the observed expectations on the forecasting quality is analyzed.
    Keywords: DSGE, out of sample forecasts, survey expectations, near-rational expectations
    JEL: E32 E37 E47
    Date: 2014–12–31
  34. By: Luigi Iovino (Bocconi )
    Abstract: I consider an economy where investors delegate their investment decisions to financial institutions that choose across multiple investment opportunities featuring different levels of idiosyncratic risk and different degrees of correlation with the aggregate of the economy. Investors solve an optimal contracting problem to induce financial institutions to allocate their investment optimally. I then study how investment decisions are affected when financial securities are introduced that allow agents to trade their risks. Investors do not have the necessary information to understand these securities, but give incentives to financial institutions to hedge certain risks. I show that hedging idiosyncratic risks ameliorates the agency problem between investors and financial institutions and reduces aggregate volatility. On the contrary, when aggregate risk can be hedged the agency problem worsens and aggregate volatility increases. Finally, I study the efficiency properties of the equilibrium and the potential role for financial regulation.
    Date: 2014
  35. By: Galina Vereshchagina (Arizona State University )
    Abstract: This paper argues that the impact of credit constraints on the entrepreneurial activity and, via it, on economic development, crucially depends on the serial correlation in arrival of entrepreneurial ideas. Using an occupational choice model, it demonstrates that calibrating the serial correlation to match the amount of repeated entrepreneurship observed in the U.S., as opposed to assuming that arrivals of new entrepreneurial ideas are uncorrelated, reduces the impact of borrowing constraints on output per capita by more than fifty percent. The driving force behind this result is that people with past entrepreneurial experience tend to be richer and, thus, can implement new ideas more efficiently.
    Date: 2014
  36. By: Anna Grodecka ; Karlygash Kuralbayeva
    Abstract: What is the optimal instrument design and choice for a regular attempting to control emissions by private agents in face of uncertainty arising from business cycles?  In applying Weitzman's result [Prices vs. quantities, Review of Economic Studies, 41 (1974), 477-491] to the problem of greenhouse gas emissions, the price-quantity literature has shown that, under uncertainty about abatement costs, price instruments (carbon taxes) are preferred to quantity restrictions (caps on emission), since the damages from climate change are relatively flat.  On the other hand, another recent piece of academic literature has highlighted the importance of adjusting cabon taxes to business cycle fluctuations in a procyclical manner.  In this paper, we analyze the optimal design and the relative performance of price versus quantity instruments in the face of uncertainty stemming from business cycles.  Our theoretical framework is a general equilibrium real business cycle model with a climate change externality and distortionary fiscal policy.  First, we find that in an infinitely flexible control environment, the carbon tax fluctuates very little and is approximately constant, whilst emissions fluctuate a great deal in response to a productivity shock.  Second, we find that a fixed price instrument is advantageous over a fixed quantity instrument due to the cyclical behavior of abatement costs, which tend to increase during expansions and decline during economic downturns.  Our results suggest that the cabon tax is approximately constant over business cycles due to "flat" damages in the short-run and thus procyclical behavior as suggested by other studies cannot be justified merely on the gorunds of targeting the climate externality.
    Keywords: carbon tax, cap-and-trade, business cycles, distortionary taxes, climate change
    JEL: E32 H23 Q54 Q58
    Date: 2014–05–15
  37. By: Cheremukhin, Anton A. (Federal Reserve Bank of Dallas ); Tutino, Antonella (Federal Reserve Bank of Dallas )
    Abstract: We study the link between business failures, markups and business cycle asymmetry in the U.S. economy with a model of optimal firm exit under rational inattention. We show that the model's predictions of lagged, counter-cyclical and positively skewed markups together with counter-cyclical exit rates are consistent with the empirical evidence. Moreover, our model uncovers a new mechanism that links information processing with the business cycle. It predicts counter-cyclical attention to economic conditions consistent with survey evidence.
    Keywords: Information; markups; exit rates; rational inattention.
    JEL: C63 D21 D22 D80 E32
    Date: 2014–11–01
  38. By: Karen Lewis (University of Pennsylvania ); Fabio Ghironi (University of Washington )
    Abstract: Smaller firms sell more equity in response to expansions than do larger firms. Also, consumption is more pro-cyclical for high income groups than others. In this paper, we present a model that captures key features of both of these patterns found in recent empirical studies. Managers own firms with unique differentiated products and can sell ownership in these firms. Equity sales require paying consulting fees, but the resulting scrutiny also make firms more efficient. We find four main results: (1) Equity sales are pro-cylical since the benefits of higher profits outweigh the consulting fees during a boom. (2) Equity shares in smaller firms are more pro-cyclical because expansions induce previously solely-owned firms to seek outside equity financing. (3) Households must absorb the increased equity sales by managers, thereby affecting their consumption response relative to managers. (4) Greater underlying managerial inefficiency induces more firms to seek outside advice and ownership in equilibrium. As a result, the cyclical impact on efficiency is mitigated by outside ownership.
    Date: 2014
  39. By: Lance Kent (Department of Economics, College of William and Mary )
    Abstract: All models are misspecified to some degree, and the assumption of rational expectations could potentially be a serious source of misspecification. Many theories relax rational expectations and improve the predictive properties of benchmark macroeconomic models. Problematically, the space of possible deviations from rational expectations is very large, especially since it is difficult both to measure expectations and to know whose expectations matter. This paper provides evidence on which small reduced-form state-contingent deviations from rational expectations yield the most improvement in replicating features of macroeconomic time series, and which aspects of model misspecification are and are not ameliorated by these small deviations from rational expectations. The findings: a) The data favor deviations from rational expectations among firms, both for good pricing and wage setting. b) Relaxing rational expectations in a New Keynesian model partially substitutes for the additional structural mechanisms in the larger Smets Wouters (2007) model. Relaxing rational expectations within the Smets Wouters (2007) model improves that model’s ability to reproduce some of the spectral coherencies between output growth, investment growth, and labor supply. The mechanism is a combination of shocks to beliefs themselves and the role that deviations from rational expectations have in changing the propagation of other shocks.
    Keywords: Expectations, DSGE, misspecification, Bayesian estimation
    JEL: C52 E17 E27 E32
    Date: 2015–02–15
  40. By: Mattia Guerini (Sant'Anna School of Advanced Studies, Pisa )
    Abstract: The recent economic crisis gave proof of the fact that the Taylor rule is no more that good instrument as it was thought to be just ten years ago; this might be due to the fact that agents acting in the economy hold Heterogeneous Expectations (HE). In a recent paper Anufriev et al. (2013) suggest that a way to force stability on the economic system is to adopt a more aggressive Taylor rule. In the present paper a standard NK-DSGE is considered in order to investigate whether a Friedman k-percent monetary policy rule may be a valid instrument to counteract the instability created by the presence of HE in a framework à la Brock and Hommes (1997). The model here presented suggests that when such a money supply rule is adopted by the Central Bank, stability strongly depends on the intensity of choice, which represents the ability of the agents to switch toward the best available predictor.
    Keywords: Heterogeneous Expectations, Friedman Monetary Policy Rule, Macroeconomic Stability
    JEL: E37 E52 E58
    Date: 2013–11
  41. By: Valentin Haddad (Princeton University ); Marianne Andries (Toulouse School of Economics )
    Abstract: We propose a theory of inattention solely based on preferences, absent any cognitive limitations, or external costs of acquiring information. Under disappointment aversion, information decisions and risk attitude are intertwined, and agents are intrinsically information averse. We illustrate this link between attitude towards risk and information in a standard portfolio problem. We show agents never choose to receive information continuously in a diffusive environment: they optimally acquire information at infrequent intervals only. In contrast to existing theories, we show the optimal frequency of information acquisition can decrease when risk increases, consistent with empirical evidence. We show information aversion tends to lower significantly the benefits of diversification, leads to a joint evaluation of project gains and their information process, as well as creates scope for the creation of information providers. These results suggest our approach can explain many observed features of decision under uncertainty.
    Date: 2014
  42. By: Ed Nosal (Federal Reserve Bank of Chicago ); Bruno Sultanum (The Pennsylvania State University ); David Andolfatto (Federal Reserve Bank of St. Louis )
    Abstract: Peck and Shell (2003) show that equilibrium bank runs are possible in the Diamond and Dybvig (1983)environment. We show that their result is an artifact of their restriction to direct mechanisms. That is, their bank contract is not an optimal one. We show that an indirect mechanism eliminates the possibility of bank-run equilibria and implements the socially efficient outcome. The optimal mechanism can be interpreted as a form of deposit insurance.
    Date: 2014
  43. By: Ali Shourideh (University of Pennsylavnia ); Roozbeh Hosseini (Arizona State University )
    Abstract: Abstract This paper is motivated by two facts: 1) There is a significant difference in mortality across income groups. 2) This difference in mortality is getting larger. I study the extent in which progressively of social security is affected by differences in mortality across income groups and how changes in mortality differential affect the progressively of the social security and its budget. I use a life cycle overlapping generation model in which individuals are different in their lifetime earning profiles and higher earning individuals have lower mortality. I first calibrate the relation between earning and mortality using 1983-1997 data (reported in Cristia (Journal of Health Economics, 2009)) and compare current US system with a system in which there is a separate budget for each earning/mortality group (therefore by design there is no redistribution across earning/mortality groups). I find that these two systems have very similar replacement ratios, expect for the lowest 2% of earning distribution. To find the value of redistribution in current US social security system I calculate welfare differences between the resulting allocations. I find that the welfare gains from progressivity in current social security system are not monotone in lifetime earnings. Individuals in bottom two percent of earning distribution gain the most from it (up to 2.83% of their consumption) while those in second decile lose the most (up to 1% of their consumption). However, ex post gains and losses completely offset each other. There is no ex ante welfare gain. Using more recent earning and mortality relationship (1998-2003), I find that increase in the mortality differential will increase the cost of the social security by about 5%. Adjusting the benefit to maintain the cost will make the system even more regressive.
    Date: 2014
  44. By: Zarazaga, Carlos E. (Federal Reserve Bank of Dallas )
    Abstract: Microeconomic studies keep reporting that the intertemporal substitution in consumption and the Frisch elasticity of aggregate labor supply have significantly lower values than macroeconomic models find consistent with the dynamics of aggregate variables. The paper argues that in the U.S. such dynamics have been influenced since 2013 by the temporary spending cuts imposed by the so-called budget sequestration. The paper exploits the "policy experiment" features of that measure to gauge macroelasticity values from the evidence associated with it, adopting to that effect a macroeconomic model constructed according to the methodological principles advocated by the real business cycle literature. Readings of the preliminary evidence available at the time of this writing with such a measuring device do not particularly favor high values for either of the two macroelasticities under study. Although it's too early to be conclusive, this finding illustrates how existing disagreements about the value of key macroelasticities can eventually be narrowed down by applying the approach proposed in this paper to the evidence coming out of the budget sequestration policy, as it unfolds over time.
    JEL: E22 E24 E32 E65 J22
    Date: 2014–11–01
  45. By: Lucas Bretschger ; Christos Karydas
    Abstract: We study the effects of greenhouse gas emissions on optimum growth and climate policy by using an endogenous growth model with polluting non-renewable resources.  Climate change harms the capital stock.  Our main contribution is to introduce and extensively explore the naturally determined time lag between greenhouse gas emissions and the damages due to climate change, which proves to be crucial for the trasition of the ecnomy towards its steady state.  The social optimum and the optimal abatement policies are fully characterized.  The inclusion of a green technology delays optimal resource extraction.  The optimal tax rate on emissions is proportional to ouptut.  Poor understanding of the emissions diffusion process leads to suboptimal carbon taxes and suboptimal growth and resource extraction.
    Keywords: Non-Renewable Resource Dynamics, Pollution Diffusion Lag, Optimum Growth, Clean Energy, Climate Policy
    JEL: Q54 O11 Q52 Q32
    Date: 2014–08–01
  46. By: Sevin Yeltekin (Carnegie Mellon University ); Debraj Ray (New York University ); B. Douglas Bernheim (Stanford University )
    Abstract: The absence of self-control is often viewed as an important correlate of persistent poverty. Using a standard intertemporal allocation problem with credit constraints faced by an individual with quasi-hyperbolic preferences, we argue that poverty damages the ability to exercise self-control. Our theory invokes George Ainslie’s notion of “personal rules,†interpreted as subgame-perfect equilibria of an intrapersonal game played by a time-inconsistent decision maker. Our main result pertains to situations in which the individual is neither so patient that accumulation is possible from every asset level, nor so impatient that decumulation is unavoidable from every asset level. Such cases always possess a threshold level of assets above which personal rules support unbounded accumulation, and a second threshold level of assets below which there is a “poverty trapâ€: no personal rule permits the individual to avoid depleting all liquid wealth. In short, poverty perpetuates itself by undermining the ability to exercise self-control. Thus policies designed to help the poor accumulate assets may be highly effective, even if they are temporary. We also explore the implications for saving with easier access to credit, the demand for commitment devices, the design of accounts to promote saving, and the variation of the marginal propensity to consume across classes of resource claims.
    Date: 2014
  47. By: Wellschmied, Felix (Universidad Carlos III de Madrid )
    Abstract: This paper quantitatively determines the asset limit in income support programs which minimizes consumption volatility in a lifecycle model with incomplete markets and idiosyncratic earnings risk. An asset limit allows allocating transfers to those households with the highest utility gains from extra consumption. Moreover, it serves as substitute for history and age dependent taxation. However, a low limit provides incentives for high school dropouts to accumulate almost no wealth. Consequently, they miss self-insurance and suffer from high consumption volatility. For an unborn, these effects are optimally traded-off with an asset limit of $145000.
    Keywords: means-tested programs, public insurance, incomplete markets
    JEL: D91 I38 J26
    Date: 2015–02
  48. By: Thomas Cooley (New York University ); Harold Cole (University of Pennsylvania )
    Abstract: For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings has been compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will re ect sound assessment of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the con ict created by issuers paying for ratings is misguided.
    Date: 2014

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