nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒03‒06
thirty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Layoff taxes, unemployment insurance, and business cycle fluctuations By Ahrens, Steffen; Nejati, Nooshin; Pfeiffer, Philipp L.
  2. Risky Mortgages, Bank Leverage and Credit Policy By Ferrante, Francesco
  3. Domestic Debt and Sovereign Defaults By Mallucci, Enrico
  4. Financial Frictions, Asset Prices, and the Great Recession By Rios-Rull, Jose-Victor; Huo, Zhen
  5. Self-oriented monetary policy, global financial markets and excess volatility of international capital flows By Ryan Niladri Banerjee; Michael B Devereux; Giovanni Lombardo
  6. The Great Recession and Financial Shocks By Rios-Rull, Jose-Victor; Huo, Zhen
  7. Differential Mortality and the Progressivity of Social Security? By Shantanu Bagchi
  8. Infinite-Horizon Deterministic Dynamic Programming in Discrete Time: A Monotone Convergence Principle and a Penalty Method By Takashi Kamihigashi; Masayuki Yao
  9. Estimation of DSGE Models under Diffuse Priors and Data-Driven Identification Constraints By Markku Lanne; Jani Luoto
  10. Dynamic stochastic general equilibrium (dsge) modelling: Theory and practice By Dilip M. Nachane
  11. Post Reunification Economic Fluctuations in Germany: A Real Business Cycle Interpretation By Michael Flor
  12. Top Incomes, Rising Inequality, and Welfare By Kevin J. Lansing; Agnieszka Markiewicz
  13. Demonstration Effect and Dynamic Efficiency By Thibault, Emmanuel
  14. Capital structure, investment, and fire sales By Douglas Gale; Piero Gottardi
  15. Optimal Monetary and Macroprudential Policies: Gains and Pitfalls in a Model of Financial Intermediation By Kiley, Michael T.; Sim, Jae W.
  16. Neighborhood Dynamics and the Distribution of Opportunity By Aliprantis, Dionissi; Carroll, Daniel
  17. An incomplete markets explanation of the UIP puzzle By Rabitsch, Katrin
  18. Endogenous firm competition and the cyclicality of markups By Afrouzi, Hassan
  19. Why may large economies suffer more at the zero lower bound? By Michał Brzoza-Brzezina
  20. Tax Reforms and the Underground Economy: A Simulation-Based Analysis By Barbara Annicchiarico; Claudio Cesaroni
  21. Monetary policy and the asset risk-taking channel By Abbate, Angela; Thaler, Dominik
  22. Consumption Taxes and Divisibility of Labor under Incomplete Markets By Tomoyuki Nakajima; Shuhei Takahashi
  23. Collateralized Borrowing and Risk Taking at Low Interest Rates By Cociuba, Simona; Shukayev, Malik; Ueberfeldt, Alexander
  24. The Risky Steady State and the Interest Rate Lower Bound By Hills, Timothy S.; Nakata, Taisuke; Schmidt, Sebastian
  25. Are all the fiscal policy shocks identical? Analysing the effects on private consumption of civilian and military spending shocks By Luca, Pieroni; Lorusso, Marco
  26. Over-the-Counter Markets, Intermediation, and Monetary Policy By Han, Han
  27. Equity Premium and Monetary Policy in a Model with Limited Asset Market Participation By Roman Horvath; Lorant Kaszab
  28. Stochastic Target Games and Dynamic Programming via Regularized Viscosity Solutions By Bruno Bouchard; Marcel Nutz
  29. Plausibility of big shocks within a linear state space setting with skewness By Koloch, Grzegorz
  30. Sunspot Fluctuations in Two-Sector Models with Variable Income Effects By Frédéric Dufourt; Kazuo Nishimura; Carine Nourry; Alain Venditti

  1. By: Ahrens, Steffen; Nejati, Nooshin; Pfeiffer, Philipp L.
    Abstract: This paper studies the role of labor market institutions in business cycle fluctuations. We develop a DSGE model with search and matching frictions and incorporate a US unemployment insurance experience rating system. Layoff taxes based on experience rating finance the cost of unemployment benefits and create considerable employment adjustment costs. Our framework helps realign the search and matching model with the empirical properties of its most salient variables. The model reproduces the negative correlation between vacancies and unemployment, i.e., the Beveridge curve. Simulations show that the model generates more cyclical volatility in its key variable - the ratio of job vacancies to unemployment (labor market tightness). Moreover, layoff taxes reduce the excess sensitivity of job destruction found in Krause and Lubik (2007) and strengthen the negative correlation of job creation and job destruction. Thus, the model matches key labor market data while incorporating an important feature of the US labor market.
    Keywords: search and matching,experience rating,unemployment insurance,Beveridge curve
    JEL: E24 J64 J65
    Date: 2015
  2. By: Ferrante, Francesco (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: Two key channels that allowed the 2007-2009 mortgage crisis to severely impact the real economy were: a housing net worth channel, as defined by Mian and Sufi (2014), which affected the wealth of leveraged households; and a bank net worth channel, which reduced the ability of financial intermediaries to provide credit. To capture these features of the Great Recession, I develop a DSGE model with balance-sheet constrained banks financing both risky mortgages and productive capital. Mortgages are provided to agents facing idiosyncratic housing depreciation risk, implying an endogenous default decision and a link between their borrowing capacity and house prices. The interaction among the housing net worth channel, the bank net worth channel and endogenous foreclosures generates novel amplification mechanisms. I analyze the quantitative implications of these new channels by considering two different shocks linked to the supply of mortgage credit: an increase in the variance of housing risk and a deterioration in the collateral value of mortgages for bank funding. Both shocks are able to produce co-movements in house prices, business investment, consumption and output. Finally, I study two types of policy interventions that are able to reduce the severity of a mortgage crisis: debt relief for borrowing households and central bank credit intermediation.
    Keywords: Bank runs; deposit insurance; large depositors
    JEL: E32 E44 E58 G21
    Date: 2015–12–18
  3. By: Mallucci, Enrico (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: This paper examines how domestic holdings of government debt affect sovereign default risk and government debt management. I develop a dynamic stochastic general equilibrium model with both external and domestic debt that endogenously generates output contraction upon default. Domestic holdings of government debt weaken investors' balance sheets and induce a contraction of credit and output upon default. I calibrate the model to the Argentinean economy and show that the model reproduces key empirical moments. Introducing domestic debt also yields relevant normative implications. While domestic debt is crucial to determining the risk of default, the efficient internal-external composition of debt cannot be achieved without government intervention. Pigouvian subsidies can restore efficiency.
    Keywords: Sovereign Defaults; Domestic Debt; Debt Crises; Credit Market
    JEL: F34 F41 H63
    Date: 2015–12–18
  4. By: Rios-Rull, Jose-Victor (Federal Reserve Bank of Minneapolis); Huo, Zhen (New York University)
    Abstract: We study financial shocks to households’ ability to borrow in an economy that quantitatively replicates U.S. earnings, financial, and housing wealth distributions and the main macro aggregates. Such shocks generate large recessions via the negative wealth effect associated with the large drop in house prices triggered by the reduced access to credit of a large number of households. The model incorporates additional margins that are crucial for a large recession to occur: that it is difficult to reallocate production from consumption to investment or net exports, and that the reductions in consumption contribute to reductions in measured TFP.
    Keywords: Balance sheet recession; Asset price; Goods market frictions; Labor market frictions
    JEL: E20 E32 E44
    Date: 2016–02–05
  5. By: Ryan Niladri Banerjee; Michael B Devereux; Giovanni Lombardo
    Abstract: This paper explores the nature of macroeconomic spillovers from advanced economies to emerging market economies (EMEs) and the consequences for independent use of monetary policy in EMEs. We first empirically document the effects of US monetary policy shocks on a sample group of EMEs. A contractionary monetary shock leads a retrenchment in EME capital flows, a fall in EME GDP, and an exchange rate depreciation. We construct a theoretical model which can help to account for these findings. In the model, macroeconomic spillovers are exacerbated by financial frictions. We assess the extent to which domestic monetary policy can mitigate the negative spillovers from foreign shocks. Absent financial frictions, international spillovers are minor, and an inflation targeting rule represents an effective policy for the EME. With frictions in financial intermediation, however, spillovers are substantially magnified, and an inflation targeting rule has little advantage over an exchange rate peg. However, an optimal monetary policy markedly improves on the performance of naive inflation targeting or an exchange rate peg. Furthermore, optimal policies don't need to be coordinated across countries. Under the specific set of assumptions maintained in our model, a non-cooperative, self-oriented optimal policy gives results very similar to those of a global cooperative optimal policy.
    Keywords: International spillovers, Local Projections, Capital flows, Financial intermediaries, Monetary policy
    Date: 2016–01
  6. By: Rios-Rull, Jose-Victor (Federal Reserve Bank of Minneapolis); Huo, Zhen (New York University)
    Abstract: A case can be made for the Great Recession being the result of a large financial shock that makes household borrowing difficult. The channel involves large reductions in house prices, which trigger sharp reductions in consumption. {{p}} We discuss the ingredients necessary for a quantitative macroeconomic model to successfully implement such a theory. They include: wealth heterogeneity, where the majority of the population needs to acquire financing to purchase houses despite the large amount of wealth in the economy; sizable real frictions that hinder the transformation of consumption into exports and investment and that constrain the increase of household working hours; and a role for expenditures in contributing to productivity.
    Date: 2016–02–09
  7. By: Shantanu Bagchi (Department of Economics, Towson University)
    Abstract: I examine how strongly Social Security benefits should be linked to past work-life income, while accounting for the fact that the wealthy live longer than the poor. Using a general equilibrium macroeconomic model calibrated to the U.S. economy, I find that the optimal Social Security arrangement warrants benefits that are flat and completely unrelated to past work-life income. While this arrangement leads to higher implicit tax rates for high-income households, their welfare losses are relatively small, because Social Security's current tax structure is regressive: the marginal tax rate is zero above the taxable maximum. On the other hand, full insurance from unfavorable labor income shocks generates large welfare gains to the low- and medium-income households. Under this flat-benefit arrangement, Social Security benefits increase by as much as a factor of 17 for low-income households, and decline by as much as 40% for high-income households, but the overall size of Social Security remains unchanged.
    Keywords: Differential mortality, Social Security, taxable maximum, mortality risk, labor income risk, incomplete markets, general equilibrium.
    JEL: E21 E62 H55
    Date: 2016–02
  8. By: Takashi Kamihigashi (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan); Masayuki Yao (Graduate School of Economics, Keio University)
    Abstract: We consider infinite-horizon deterministic dynamic programming problems in discrete time. We show that the value function of such a problem is always a fixed point of a modi ed version of the Bellman operator. We also show that value iteration converges increasingly to the value function if the initial function is dominated by the value function, is mapped upward by the modified Bellman operator, and satisfies a transversality-like condition. These results require no assumption except for the general framework of infinite-horizon d-terministic dynamic programming. As an application, we show that the value function can be approximated by computing the value function of an unconstrained version of the problem with the constraint replaced by a penalty function.
    Keywords: Dynamic programming, Bellman operator, Fixed point, Value iteration
    Date: 2016–02
  9. By: Markku Lanne (University of Helsinki and CREATES); Jani Luoto (University of Helsinki)
    Abstract: We propose a sequential Monte Carlo (SMC) method augmented with an importance sampling step for estimation of DSGE models. In addition to being theoretically well motivated, the new method facilitates the assessment of estimation accuracy. Furthermore, in order to alleviate the problem of multimodal posterior distributions due to poor identification of DSGE models when uninformative prior distributions are assumed, we recommend imposing data-driven identification constraints and devise a procedure for finding them. An empirical application to the Smets-Wouters (2007) model demonstrates the properties of the estimation method, and shows how the problem of multimodal posterior distributions caused by parameter redundancy is eliminated by identification constraints. Out-of-sample forecast comparisons as well as Bayes factors lend support to the constrained model.
    Keywords: Particle filter, importance sampling, Bayesian identification
    JEL: D58 C11 C32 C52
    Date: 2015–08–18
  10. By: Dilip M. Nachane (Indira Gandhi Institute of Development Research)
    Abstract: In recent years DSGE (dynamic stochastic general equilibrium) models have come to play an increasing role in central banks, as an aid in the formulation of monetary policy (and increasingly after the global crisis, for maintaining financial stability). DSGE models, compared to other widely prevalent econometric models (such as VAR, or large-scale econometric models) are less a theoretic and with secure micro-foundations based on the optimizing behavior of rational economic agents. Apart from being "structural", the models bring out the key role of expectations and (being of a general equilibrium nature) can help the policy maker by explicitly projecting the macro - economic scenarios in response to various contemplated policy outcomes. Additionally the models in spite of being strongly tied to theory, can be "taken to the data" in a meaningful way. A major feature of these models is that their theoretical underpinnings lie in what has now come to be called as the New Consensus Macro -economics (NCM). Using the prototype real business cycle model as an illustration, this paper brings out the econometric structure underpinning such models. Estimation and inferential issues are discussed at length with a special emphasis on the role of Bayesian maximum likelihood methods. A detailed analytical critique is also presented together with some promising leads for future research.
    Keywords: real business cycle, log-linearization, stochastic singularity, Bayesian maximum likelihood, complexity theory, agent-based modeling, robustness
    JEL: C52 E32
    Date: 2016–01
  11. By: Michael Flor
    Abstract: We consider the cyclical properties of the German economy prior and after reunication in 1990 from the perspective of a real business cycle model. The model provides the framework for the selection and consistent measurement of the variables whose time series properties characterize the cycle. Simulations of the calibrated model reveal the model's potential to interpret the data. Major findings are that: i) the volatility of most aggregate time series has not changed significantly between the two time periods, ii) despite many conceptual differences between the European and the U.S. System of Accounts, the calibrated parameter values for the German economy are within the range of values usually employed in the real business cycle literature, iii) the model is closer to the data for the time period prior to reunication.
    Keywords: Macroeconomic Data, Measurement and Data on National Income and Product Accounts, Economic Fluctuations, Real Business Cycles
    JEL: C82 E01 E32
    Date: 2014–04
  12. By: Kevin J. Lansing (Federal Reserve Bank of San Francisco, and Norges Bank); Agnieszka Markiewicz (Erasmus University Rotterdam)
    Abstract: This paper develops a general-equilibrium model of skill-biased technological change that approximates the observed shifts in the shares of wage and non-wage income going to the top decile of U.S. households since 1980. Under realistic assumptions, we find that all agents can benefit from the technology change, provided that the observed rise in redistributive transfers over this period is taken into account. We show that the increase in capital’s share of total income and the presence of capital-entrepreneurial skill complementarity are two key features that help support the wages of ordinary workers as the new technology diffuses.
    Keywords: Income Inequality, Skill-biased Technological Change, Capital-skill
    JEL: E32 E44 H23 O33
    Date: 2012–10–26
  13. By: Thibault, Emmanuel
    Abstract: We show that contrary to conventional wisdom intergenerational family transfers dominate fiscal policies as a remedy to the dynamic inefficiency arising in a Diamond (1965, American Economic Review) economy with logarithmic utility and Cobb-Douglas technology. Using the demonstration-effect approach popularized by Cox and Stark (2005, Journal of Public Economics), we prove that, differently from public debt, family transfers can serve the role of automatic stabilizers. Indeed, they are nil under dynamic efficiency, implying that both capital accumulation and welfare are not worsened. They are positive under dynamic inefficiency, and instrumental to depress capital accumulation so to approach the Golden Rule capital stock.
    Keywords: OLG model, Dynamic efficiency, Intergenerational family transfers.
    JEL: C62 D91 O41
    Date: 2016–01
  14. By: Douglas Gale; Piero Gottardi
    Abstract: We study a dynamic general equilibrium model in which firms choose their investment level and their capital structure, trading off the tax advantages of debt against the risk of costly default. The costs of bankruptcy are endogenously determined, as bankrupt firms are forced to liquidate their assets, resulting in a fire sale if the market is illiquid. When the corporate income tax rate is positive, firms have a unique optimal capital structure. In equilibrium firms default with positive probability and their assets are liquidated at fire-sale prices. The equilibrium not only features underinvestment but is also constrained inefficient. In particular there is too little debt and too little default.
    Keywords: Debt; equity; capital structure; default; market liquidity; constrained inefficiency; incomplete markets
    JEL: D5 D6 G32 G33
    Date: 2014–11–04
  15. By: Kiley, Michael T. (Board of Governors of the Federal Reserve System (U.S.)); Sim, Jae W. (Board of Governors of the Federal Reserve System (U.S.))
    Abstract: We estimate a quantitative general equilibrium model with nominal rigidities and financial intermediation to examine the interaction of monetary and macroprudential stabilization policies. The estimation procedure uses credit spreads to help identify the role of financial shocks amenable to stabilization via monetary or macroprudential instruments. The estimated model implies that monetary policy should not respond strongly to the credit cycle and can only partially insulate the economy from the distortionary effects of financial frictions/shocks. A counter-cyclical macroprudential instrument can enhance welfare, but faces important implementation challenges. In particular, a Ramsey planner who adjusts a leverage tax in an optimal way can largely insulate the economy from shocks to intermediation, but a simple-rule approach must be cautious not to limit credit expansions associated with efficient investment opportunities. These results demonstrate the importance of considering both optimal Ramsey policies and simpler, but more practical, approaches in an empirically grounded model.
    Keywords: Bayesian estimation; DSGE models; Macroprudential policy; Monetary policy
    JEL: E58 E61 G18
    Date: 2015–09–04
  16. By: Aliprantis, Dionissi (Federal Reserve Bank of Cleveland); Carroll, Daniel (Federal Reserve Bank of Cleveland)
    Abstract: Wilson (1987) argued that policies ending racial discrimination would not equalize opportunity without addressing residential sorting and neighborhood externalities. This paper studies related counterfactual policies using an overlapping-generations dynamic general equilibrium model of residential sorting and intergenerational human capital accumulation. In the model, households choose where to live and how much to invest toward the production of their child’s human capital. The return on parents’ investment is determined in part by the child’s ability and in part by an externality determined by the human capital in their neighborhood. We calibrate the model with two neighborhoods and neighborhood-specific production technologies to data from Chicago when mobility was restricted by race. We then conduct three numerical experiments by eliminating the restriction on neighborhood choice, equalizing production technologies, or both. We find that allowing residential mobility generates persistent income inequality, even when technologies are equalized across neighborhoods. Equalizing technologies only equalizes opportunity for residents in the originally segregated neighborhood when high-income households reside there. Our findings suggest that policies aimed at improving outcomes in impoverished areas should feature incentives for high-income households to stay or migrate into the neighborhood.
    Keywords: Neighborhood externality; Segregation; Human Capital
    JEL: D31 D58 E24 J24 R23
    Date: 2015–10–22
  17. By: Rabitsch, Katrin
    Abstract: A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a timevarying risk premium. This paper presents a mechanism in a simple two-country two-good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents' strong resulting precautionary motives successfully generates a time-varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.
    Keywords: Uncovered Interest Rate Parity,Incomplete Markets Precautionary Savings,Time-Varying Risk Premium
    JEL: F31 F41 G12 G15
    Date: 2016
  18. By: Afrouzi, Hassan (The University of Texas at Austin)
    Abstract: The cyclicality of markups is crucial to understanding the propagation of shocks and the size of multipliers. I show that the degree of inertia in the response of output to shocks can reverse the cyclicality of markups within implicit collusion and customer-base models. In both classes of models, markups follow a forward looking law of motion in which they depend on firms' conditional expectations over stochastic discount rates and changes in output, implying that auxiliary assumptions that affect the inertia of output can potentially reverse cyclicality of markups in each of these models. I test this common law of motion with data for firms' expectations from New Zealand and find that firms' markup setting behavior is more consistent with implicit collusion models than customer base models. Calibrating an implicit collusion model to the U.S. data, I find that markups are procyclical if there is inertia in the response of output to shocks, as commonly found in the data.
    JEL: D21 D92 E3
    Date: 2016–02–01
  19. By: Michał Brzoza-Brzezina
    Abstract: This paper compares the consequences of hitting the zero lower bound in small open and large closed economies. I costruct a two-economy New Kenynesian model and calibrate it so that one economy is small and open and the second large and closed. Then I conduct a number of experiments assuming that the zero lower bound binds for one or the other economy. At the ZLB bad shocks are amplified and good shocks dampened. I show that this modifications are much stronger in the large than in the small economy. As a result the large economy may suffer more at the ZLB.
    Keywords: zero lower bound, small open economy, amplification of shocks
    JEL: E43 E52
    Date: 2016
  20. By: Barbara Annicchiarico (University of Rome "Tor Vergata"); Claudio Cesaroni (DEF, Università di Roma "Tor Vergata")
    Abstract: This paper studies the effects of several tax reforms in an economy in which taxes are partially evaded by means of undeclared work. To this purpose, we consider a two-sector dynamic general equilibrium model calibrated to Italy which explicitly accounts for underground production. We construct various tax reform scenarios, such as deductibility of labor costs from business tax, ex-ante budget-neutral tax shifts from direct to indirect taxes, and various tax cuts financed by decreases of government spending. We find the following results. First, neglecting the existence of the underground sector may lead to severely miscalculate the macroeconomic impact effects of tax reforms, especially in the short run, where policy interventions produce direct and indirect effects on the markup. Second, partial deductibility of labor costs from the business tax base proves to be highly expansionary and highly detrimental to the size of the underground sector. Third, the dimension of the underground sector is permanently and considerably reduced by changes in the tax mix that diminish the labor tax wedge. Finally, all the considered tax reforms take the public-debt-to-output ratio toward a prolonged downward path.
    Keywords: Dynamic General Equilibrium Model, Underground Economy, Tax Reforms, Italy
    JEL: E62 O41 O52
    Date: 2016–02–10
  21. By: Abbate, Angela; Thaler, Dominik
    Abstract: Motivated by VAR evidence, we develop a monetary DSGE model where an agency problem between bank financiers, stemming from limited liability and unobservable risk taking, distorts banks' incentives leading them to choose excessively risky investments. A monetary policy expansion magnifies these distortions, increasing excessive risk taking and lowering the expected return on investment. We estimate the model on US data using Bayesian techniques and assess how this novel channel affects optimal monetary policy. Our results suggest that the monetary authority should stabilize the real interest rate, trading off more inflation volatility in exchange for less volatility in risk taking and output.
    Keywords: Bank Risk,Monetary policy,DSGE Models
    JEL: E12 E44 E58
    Date: 2015
  22. By: Tomoyuki Nakajima (Institute of Economic Research, Kyoto University); Shuhei Takahashi (Institute of Economic Research, Kyoto University)
    Abstract: We analyze lump-sum transfers nanced through consumption taxes in a heterogeneous-agent model with uninsured idiosyncratic wage risk and endogenous labor supply. The model is calibrated to the U.S. econ- omy. We nd that consumption inequality and uncertainty decrease with transfers much more substantially under divisible than indivisible labor. Increasing transfers by raising the consumption tax rate from 5% to 35% decreases the consumption Gini by 0.04 under divisible labor, whereas it has almost no e¤ect on the consumption Gini under indivis- ible labor. The divisibility of labor also a¤ects the relationship among consumption-tax nanced transfers, aggregate saving, and the wealth distribution.
    Keywords: Transfers, consumption taxes, consumption inequality and uncertainty, the divisibility of labor, incomplete markets
    JEL: E62 H63
    Date: 2016–02
  23. By: Cociuba, Simona (University of Western Ontario); Shukayev, Malik (University of Alberta, Department of Economics); Ueberfeldt, Alexander (Bank of Canada)
    Abstract: Empirical evidence suggests financial intermediaries increase risky investments when interest rates are low. We develop a model consistent with this observation and ask whether the risks undertaken exceed the social optimum. Interest rate policy affects risk taking in the model through two opposing channels. First, low policy rates make riskier assets more attractive than safe bonds. Second, low policy rates reduce the amount of safe bonds available for collateralized borrowing in interbank markets. The calibrated model features excessive risk taking at the optimal policy. However, at low policy rates, collateral constraints tighten and risk taking doesn't exceed the social optimum.
    Keywords: Financial intermediation; risk taking; optimal interest rate policy
    JEL: E44 E52 G11 G18
    Date: 2016–02–09
  24. By: Hills, Timothy S. (New York University); Nakata, Taisuke (Board of Governors of the Federal Reserve System (U.S.)); Schmidt, Sebastian (European Central Bank)
    Abstract: Even when the policy rate is currently not constrained by its effective lower bound (ELB), the possibility that the policy rate will become constrained in the future lowers today's inflation by creating tail risk in future inflation and thus reducing expected inflation. In an empirically rich model calibrated to match key features of the U.S. economy, we find that the tail risk induced by the ELB causes inflation to undershoot the target rate of 2 percent by as much as 45 basis points at the economy's risky steady state. Our model suggests that achieving the inflation target may be more difficult now than before the Great Recession, if the recent ELB experience has led households and firms to revise up their estimate of the ELB frequency.
    Keywords: Deflationary Bias; Disinflation; Inflation Targeting; Risky Steady State; Tail Risk; Zero Lower Bound
    JEL: E32 E52
    Date: 2016–02–12
  25. By: Luca, Pieroni; Lorusso, Marco
    Abstract: In this paper, we show that civilian and military government spending have specific characteristics that can affect differently private consumption. Our VAR estimates for the US economy show that civilian expenditure induces a positive and significant response on private consumption whereas military spending has a negative impact. We adopt a new Keynesian approach and develop a DSGE model in order to simulate the empirical evidence. Both the larger persistence of shocks in military spending and the different financing mechanisms, which accounts for the propensity of policy-makers to use budget deficits to finance wars, mimic the differences in the empirical responses of private consumption. Simulated impulse response functions of alternative specification models prove the robustness of our analysis.
    Keywords: Military and Civilian Spending, SVAR, DSGE Model.
    JEL: E32 E62
    Date: 2015–12
  26. By: Han, Han
    Abstract: During the Great Recession, the Federal Reserve implemented two monetary policies: cutting interest rates and quantitative easing (QE). I develop a model to examine these two policies in a frictional financial environment. In this model, agents sell assets to acquire money when a consumption opportunity arises, which can only be done through over-the-counter (OTC) markets. In equilibrium, when the interest rate is low (not necessarily zero), households who trade in OTC markets achieve their optimal consumption. When the interest rate is high, QE will raise asset prices and lower households’ consumption. The asset price increase indicates a higher liquidity premium, which reflects inefficiency in money reallocation.
    Keywords: OTC markets, Middlemen, Monetary Policy, QE, Asset Pricing
    JEL: E44 E52 E58 G12
    Date: 2015–12–18
  27. By: Roman Horvath (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic); Lorant Kaszab (Central Bank of Hungary)
    Abstract: This short paper shows that a New Keynesian model with limited asset market participation can generate a high risk-premium on unlevered equity relative to short-term risk-free bonds and high variability of equity returns driven by monetary policy shocks with zero persistence.
    Keywords: Limited Participation, Monetary Policy, DSGE, Equity Premium
    JEL: E32 E44 G12
    Date: 2016–02
  28. By: Bruno Bouchard (CREST - Centre de Recherche en Économie et Statistique - INSEE - École Nationale de la Statistique et de l'Administration Économique, CEREMADE - CEntre de REcherches en MAthématiques de la DEcision - Université Paris IX - Paris Dauphine - CNRS - Centre National de la Recherche Scientifique); Marcel Nutz (Dept. of Mathematics - Columbia University [New York])
    Abstract: We study a class of stochastic target games where one player tries to find a strategy such that the state process almost-surely reaches a given target, no matter which action is chosen by the opponent. Our main result is a geometric dynamic programming principle which allows us to characterize the value function as the viscosity solution of a non-linear partial differential equation. Because abstract mea-surable selection arguments cannot be used in this context, the main obstacle is the construction of measurable almost-optimal strategies. We propose a novel approach where smooth supersolutions are used to define almost-optimal strategies of Markovian type, similarly as in ver-ification arguments for classical solutions of Hamilton–Jacobi–Bellman equations. The smooth supersolutions are constructed by an exten-sion of Krylov's method of shaken coefficients. We apply our results to a problem of option pricing under model uncertainty with different interest rates for borrowing and lending.
    Keywords: 49L20,Viscosity solution AMS 2000 Subject Classification 93E20,Shaking of coefficients,91B28,Knightian uncertainty,Stochastic differential game,Stochastic target
    Date: 2015–07–10
  29. By: Koloch, Grzegorz
    Abstract: In this paper we provide formulae for likelihood function, filtration densities and prediction densities of a linear state space model in which shocks are allowed to be skewed. In particular we work with the closed skew normal distribution, see González-Farías et al. (2004), which nests a normal distribution as a special case. Closure of the csn distribution with respect to all necessary transformations in the state space setting is guaranteed by a simple state dimension reduction procedure which does not influence the value of the likelihood function. Presented formulae allow for estimation, filtration and prediction of vector autoregressions and first order perturbations of DSGE models with skewed shocks. This allows to assess asymmetries in shocks, observed data, impulse responses and forecasts confidence intervals. Some of the advantages of using the outlined approach may involve capturing asymmetric inflation risks in central banks forecasts or producing more plausible probabilities of deep but rare recessionary episodes with DSGE/VAR filtration. Exemplary estimation results are provided which show that within a linear setting with skewness frequency of big shocks can be rather plausibly identifed.
    Keywords: Maximum likelihood estimation, state space models, closed skew-normal distribution, DSGE, VAR
    JEL: C13 C51 E32
    Date: 2016–01–25
  30. By: Frédéric Dufourt (AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université); Kazuo Nishimura (KIER, Kyoto University - Kyoto University [Kyoto], RIEB, Kobe University - Kobe University); Carine Nourry (AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université); Alain Venditti (Edhec Business School - Edhec - Edhec, AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université)
    Abstract: We analyze a version of the Benhabib and Farmer [3] two-sector model with sector-specific externalities in which we consider a class of utility functions inspired from the one considered in Jaimovich and Rebelo [14] which is flexible enough to encompass varying degrees of income effect. First, we show that local indeterminacy and sunspot fluctuations occur in 2-sector models under plausible configurations regarding all structural parameters – in particular regarding the intensity of income effects. Second, we prove that there even exist some configurations for which local indeterminacy arises under any degree of income effect. More precisely, for any given size of income effect, we show that there is a non-empty range of values for the Frisch elasticity of labor and the elasticity of intertemporal substitution in consumption such that indeterminacy occurs. This contrasts with the results obtained in one-sector models in both Nishimura et al. [19], in which it is shown that indeterminacy cannot occur under either GHH and KPR preferences, and in Jaimovich [13] in which local indeterminacy only arises for intermediary income effects.
    Keywords: indeterminacy,sunspots,income and substitution effects,sector-specific externalities,infinite-horizon two-sector model
    Date: 2015–12

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