nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒07‒16
twenty-one papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. South Africa's real business cycles: The cycle is the trend By Hilary Patroba; Leroi Raputsoane
  2. RBC Models and the Hours-Wages Puzzle: Puzzle Solved! By Vasilev, Aleksandar
  3. EAGLE-FLI. A macroeconomic model of banking and financial interdependence in the euro area By Bokan, Nikola; Gerali, Andrea; Gomes, Sandra; Jacquinot, Pascal; Pisani, Massimiliano
  4. Aggregate Consequences of Dynamic Credit Relationships By Stephane Verani
  5. Bank capital structure and the credit channel of central bank asset purchases By Darracq Pariès, Matthieu; Hałaj, Grzegorz; Kok, Christoffer
  6. Insurance in Human Capital Models with Limited Enforcement By Krebs, Tom; Kuhn, Moritz; Wright, Mark L. J.
  7. Liquidity and Prices in Decentralized Markets with Almost Public Information By Anton Tsoy
  8. Reviving the limit cycle view of macroeconomic fluctuations By Franck Portier; Dana Galizia; Paul Beaudry
  9. Nominal GDP targeting and the tax burden By Hatcher, Michael
  10. The Financial Stability Dark Side of Monetary Policy By Frank Smets; Stefania Villa
  11. Approximating time varying structural models with time invariant structures By Filippo Ferroni; Christian Matthes; Fabio Canova
  12. The Cyclical Behavior of the Markups in the New Keynesian Models By Nlemfu Mukoko, Jean Blaise
  13. Health Care Reform or More Affordable Health Care? By Ferreira, Pedro Cavalcanti; Gomes, Diego B. P.
  14. Macroeconomic effects of mortgage interest deduction By Cenkhan Sahin
  15. Redeem or Revalue? Some Public-Debt Calculus. By Bar-Ilan, Avner; Gliksberg, Baruch
  16. Work Incentives of Medicaid Beneficiaries and The Role of Asset Testing By Pashchenko, Svetlana; Porapakkarm, Ponpoje
  17. Money and Capital in a Persistent Liquidity Trap By Philippe Bacchetta; Kenza Benhima; Yannick Kalantzis
  18. Aggregation with a mix of indivisible and continuous labor supply decisions: the case of home production By Vasilev, Aleksandar
  19. Aggregation with two-member households and home production By Vasilev, Aleksandar
  20. The Market Resources Method for Solving Dynamic Optimization Problems By Ayse Kabukcuoglu; Enrique Martínez-García
  21. Accounting for Business Cycles By Brinca, Pedro; Chari, V. V.; Kehoe, Patrick J.; McGrattan, Ellen R.

  1. By: Hilary Patroba (Department of Economics, University of Stellenbosch); Leroi Raputsoane (Department of Economics, Tshwane University of Technology)
    Abstract: This paper tests the `cycle is the trend' hypothesis. We investigate how far permanent and transitory productivity shocks can account for the dynamics observed in the South African business cycle over the period 1946--2014. By estimating a standard small open economy real business cycle model and its financial frictions augmented counterpart, we show that permanent productivity shocks are more important than transitory ones in explaining this country's business cycle fluctuations. This finding supports the `cycle is the trend' hypothesis in the South African business cycle. The model with financial frictions successfully mimics the downward-sloping high autocorrelation of trade balance to output ratio observed in the data, whereas the benchmark model produces a flat autocorrelation function. Financial frictions such as country risk premium shocks help to explain the fluctuations in investment and in the trade balance to output ratio.
    Keywords: Small open economy, real business cycle, permanent shock, transitory shock, financial frictions, Bayesian
    JEL: E13 E32 F41 F44
    Date: 2016
  2. By: Vasilev, Aleksandar
    Abstract: This paper shows that a modified real business cycle (RBC) model, one that includes home production and fiscal spending shocks, can solve one of the RBC puzzles and generates zero correlation between wages and hours. In addition, the micro-founded model presented here provides a sound theoretical model to analyze fiscal policy in a neoclassical framework and is able to capture many aspects of the data that the benchmark RBC model was missing.
    Keywords: fiscal policy,home production,government spending shock,indivisible labor
    JEL: C63 E62 E32
    Date: 2015
  3. By: Bokan, Nikola; Gerali, Andrea; Gomes, Sandra; Jacquinot, Pascal; Pisani, Massimiliano
    Abstract: We incorporate financial linkages in EAGLE, a New Keynesian multi-country dynamic general equilibrium model of the euro area (EA) by including financial frictions and country-specific banking sectors. In this new version of the model, termed EAGLE-FLI (Euro Area and GLobal Economy with Financial LInkages), banks collect deposits from domestic households and cross- country interbank market and raise capital to finance loans issued to domestic households and firms. In order to borrow from local (regional) banks, households use domestic real estate as collateral whereas firms use both domestic real estate and physical capital. These features – together with the full characterization of trade balance and real exchange rate dynamics and with a rich array of financial shocks – allow to properly assess domestic and cross-country macroeconomic effects of financial shocks. Our results support the views that (1) the business cycles in the EA can be driven not only by real shocks, but also by financial shocks, (2) the financial sector can amplify the transmission of (real) shocks, and (3) the financial/banking shocks and the banking sectors can be sources of business cycle asymmetries and spillovers across countries in a monetary union. JEL Classification: E51, E32, E44, F45, F47
    Keywords: banks, DSGE models, econometric models, financial frictions, open-economy macroeconomics, policy analysis
    Date: 2016–06
  4. By: Stephane Verani (Federal Reserve Board)
    Abstract: Which financial frictions matter in the aggregate? This paper presents a general equilibrium model in which entrepreneurs finance a firm with a long-term contract. The contract is constrained efficient because firm revenue is costly to monitor and entrepreneurs may default. The cost of monitoring firms and the entrepreneurs' outside options determine the significance of moral hazard relative to limited enforcement for financial contracting. Calibrating the model to the U.S. economy, I find that the relative welfare loss from financial frictions is about 5 percent in terms of aggregate consumption with moral hazard, while it is 1 percent with limited enforcement. Reforms designed to strengthen contract enforcement increase aggregate consumption in the short-run, but their long-run effects are modest when monitoring costs are high. Weak contract enforcement contribute to aggregate fluctuations by amplifying the effect of aggregate technological shocks, but moral hazard does not.
    Date: 2016
  5. By: Darracq Pariès, Matthieu; Hałaj, Grzegorz; Kok, Christoffer
    Abstract: With the aim of reigniting inflation in the euro area, in early 2015 the ECB embarked on a large-scale asset purchase programme. We analyse the macroeconomic effects of the Asset Purchase Programme via the banking system, exploiting the cross-section of individual bank portfolio decisions. For this purpose, an augmented version of the DSGE model of Gertler and Karadi (2013), featuring a segmented banking sector, is estimated for the euro area and combined with a bank portfolio optimisation approach using granular bank level data. An important feature of our modelling approach is that it captures the heterogeneity of banks’ responses to yield curve shocks, due to individual banks’ balance sheet structure, different capital and liquidity constraints as well as different credit and market risk characteristics. The deep parameters of the DSGE model which control the transmission channel of central bank asset purchases are then adjusted to reproduce the easing of lending conditions consistent with the bank-level portfolio optimisation. Our macroeconomic simulations suggest that such unconventional policies have the potential to strongly support the growth momentum in the euro area and significantly lift inflation prospects. The paper also illustrates that the benefits of the measure crucially hinge on banks’ ability and incentives to ease their lending conditions, which can vary significantly across jurisdictions and segments of the banking system. JEL Classification: C61, E52, G11
    Keywords: banking, DSGE, portfolio optimisation, quantitative easing
    Date: 2016–06
  6. By: Krebs, Tom (University of Mannheim - IZA); Kuhn, Moritz (University of Bonn - IZA); Wright, Mark L. J. (Federal Reserve Bank of Chicago)
    Abstract: This paper develops a tractable human capital model with limited enforceability of contracts. The model economy is populated by a large number of long-lived, risk-averse households with homothetic preferences who can invest in risk-free physical capital and risky human capital. Households have access to a complete set of credit and insurance contracts, but their ability to use the available financial instruments is limited by the possibility of default (limited contract enforcement). We provide a convenient equilibrium characterization that facilitates the computation of recursive equilibria substantially. We use a calibrated version of the model with stochastically aging households divided into 9 age groups. Younger households have higher expected human capital returns than older households. According to the baseline calibration, for young households less than half of human capital risk is insured and the welfare losses due to the lack of insurance range from 3 percent of lifetime consumption (age 40) to 7 percent of lifetime consumption (age 23). Realistic variations in the model parameters have non-negligible effects on equilibrium insurance and welfare, but the result that young households are severely underinsured is robust to such variations.
    Keywords: Human capital; Household; Insurance; Risk; Limited Enforcement
    JEL: D52 E21 E24 J24
    Date: 2016–03–26
  7. By: Anton Tsoy (EIEF)
    Abstract: This paper develops a dynamic equilibrium model of decentralized asset markets with both search delays and endogenous bargaining delays arising in the limit of almost public information about the asset quality. The model has several implications for liquidity and prices. First, conditional on the public information, the liquidity is U-shaped in the quality and assets in the middle of the quality range may not be traded at all. Second, search and bargaining frictions have opposite effects on the market liquidity showing that transparency, while welfare improving, may also hurt the market liquidity. Third, the substitutability of different asset classes leads to flights-to-liquidity during periods of market uncertainty and reveals adverse effects of gradual transparency policies. Finally, the paper derives the effect of asset liquidity, market liquidity and market tightness on asset prices.
    Date: 2016
  8. By: Franck Portier (Toulouse School of Economics); Dana Galizia (University of British Columbia); Paul Beaudry (University of British Columbia)
    Abstract: There is a long tradition in macroeconomics suggesting that market imperfections may explain why economies repeatedly go through periods of booms and busts. This idea can be captured mathematically as a limit cycle. In this paper we present both a general structure and a particular model with the aim of giving new life to this mostly dismissed view of fluctuations. We begin by showing why and when models with strategic complementarities can give rise to unique-equilibrium dynamics characterized by a limit cycle. We then develop a fully-specified dynamic general equilibrium model that embeds a demand complementarity that allows for a limit cycle. Booms and busts arise endogenously in our setting because agents want to concentrate their purchases of goods at times when purchases by others are high, since in such situations unemployment is low and therefore taking on debt is perceived as being less risky. A key feature of our approach is that we allow limit-cycle forces to compete with exogenous disturbances in explaining the data. Our estimation results indicate that US business cycle fluctuations in employment and output can be well explained by endogenous demand-driven cycles buffeted by technological disturbances that render those fluctuations irregular.
    Date: 2016
  9. By: Hatcher, Michael
    Abstract: An overlapping generations model is set out in which monetary policy matters for distortionary taxes because unanticipated inflation has real wealth effects on households with nominal government debt. The model is used to study the tax burden under inflation and nominal GDP targeting. Nominal GDP targeting makes taxes less volatile than inflation targeting but raises average taxes. With a quadratic loss function, the expected tax burden is minimized with only indexed debt under inflation targeting, but with both indexed and nominal debt under nominal GDP targeting. Nominal GDP targeting lowers the tax burden relative to inflation targeting (except at very high indexation shares), but this conclusion hinges on risk aversion, productivity persistence and the loss function for the tax burden.
    Date: 2016–07–04
  10. By: Frank Smets (European Central Bank); Stefania Villa (KU Leuven; University of Foggia)
    Abstract: This paper examines whether financial conditions of the non-financial corporate sector can explain why the recovery from recessions in the United States is slower since the mid-1980s. Leverage by the corporate sector has increased significantly since the financial deregulation of the mid-1980s. Empirical evidence shows that slow recoveries are associated with a significant drop in the growth rates of investment and bank loans, and with a surge in the growth rates of corporate bonds. In an estimated dynamic stochastic general equilibrium model with a financial accelerator, counterfactual experiments based on estimates of two samples - 1965-1983 and 1984-2007 - show that the non-financial corporate indebtedness affects only marginally the speed of the recovery in the two samples.
    Keywords: speed of recoveries, indebtedness, financial frictions, estimated DSGE model.
    JEL: E32 E44
    Date: 2016–06
  11. By: Filippo Ferroni (Banque de France); Christian Matthes (Federal Reserve Bank of Richmond); Fabio Canova (EUI)
    Abstract: The paper studies how parameter variation affects the decision rules of a DSGE model and structural inference. We provide diagnostics to detect parameter variations and to ascertain whether they are exogenous or endogenous. Identification and inferential distortions when a constant parameter model is incorrectly assumed are examined. Likelihood and VAR-based estimates of the structural dynamics when parameter variations are neglected are compared. Time variations in the financial frictions of Gertler and Karadi's (2010) model are studied.
    Date: 2016
  12. By: Nlemfu Mukoko, Jean Blaise
    Abstract: Different methods have been used in the literature to mesure and analyze price markup cyclical behavior. We use a medium-scale DSGE Model with positive trend in ation, in which aggregate fluctuations are driven by neutral technology, marginal efficiency of investment (MEI) and monetary policy shocks and, where both price and wage markups vary. We find that when raising trend inflation from 0 to 4 percent, wage markup is more important than price markup in explaining the dynamics effects of shocks. Thus, the interactions between positive trend inflation and MEI shocks have greater cyclical effects on wage markup than on price markup. These results put into question the focus on the price markup cyclicality in the literature which ignore the implications of trend inflation.
    Keywords: Markups, cyclicality, New Keynesian Models
    JEL: E31 E32
    Date: 2015–06
  13. By: Ferreira, Pedro Cavalcanti; Gomes, Diego B. P.
    Abstract: This article investigates the impact on the U.S. economy of making health care more affordable. We compare health care cost reductions with the Patient Protection and Affordable Care Act (PPACA) using a rich life cycle general equilibrium model with heterogeneous agents. We found that all policies were able to reduce uninsured population, but the PPACA was the most effective: in the long run, less than 5% of Americans would remain uninsured. Cost reductions alleviated the government budget, while tax hikes were needed to finance the reform. Feasible cost reductions are less welfare improving than the PPACA.
    Date: 2016–06–17
  14. By: Cenkhan Sahin
    Abstract: This paper develops a general equilibrium model featuring tax deductible mortgage interest. There are two main results: (i) a higher mortgage interest deduction leads to higher house prices, more levered households, and a higher rate of mortgage default; (ii) when mortgage risk is high the presence of mortgage interest deduction leads to more volatile responses of the main macro-variables to exogenous shocks (i.e. preference, productivity, and mortgage riskiness shocks). The empirical and theoretical evidence presented support the idea that mortgage interest deductibility may be a relevant factor in the occurrence of homeowner foreclosures.
    Keywords: Mortgage interest deduction; house prices; mortgage default; DSGE
    JEL: E32 E44
    Date: 2016–07
  15. By: Bar-Ilan, Avner (Department of Economics, University of Haifa); Gliksberg, Baruch (Department of Economics, University of Haifa)
    Abstract: This paper studies the scal-monetary response to a sharp increase in the level of the public debt. To that end, we employ a general equilibrium model with distortionary income tax, distortionary nancing, and endogenous capital accumulation. The model is calibrated to the US and EU economies. A main result is that in both economies the QE is superior, welfare-wise, to other policy prescriptions to the problem of explosive debt. A major di¤erence between the EU and the US is that a Taylor rule of tight monetary and scal policy could reduce the US public debt, but given the fundamental properties of the EU economy, this policy cannot achieve this goal in Europe.
    Keywords: Distorting Taxes; Fiscal Solvency; La¤er curve in a monetary economy; Liquidity ; Rate of self nancing of tax cuts; Quantitative Easing
    JEL: E44 E47 E58 E63 H30 H63
  16. By: Pashchenko, Svetlana; Porapakkarm, Ponpoje
    Abstract: Should asset testing be used in means-tested programs? These programs target low-income people, but low income can result not only from low productivity but also from low labor supply. We aim to show that in the asymmetric information environment, there is a positive role for asset testing. We focus on Medicaid, one of the largest means-tested programs in the US, and we ask two questions: 1) Does Medicaid distort work incentives? 2) Can asset testing improve the insurance-incentives trade-off of Medicaid? Our tool is a general equilibrium model with heterogeneous agents that matches many important features of the data. We find that 23% of Medicaid enrollees do not work in order to be eligible. These distortions are costly: if individuals' productivity was observable and could be used to determine Medicaid eligibility, this results in substantial ex-ante welfare gains. When productivity is unobservable, asset testing is effective in eliminating labor supply distortions, but to minimize saving distortions, asset limits should be different for workers and non-workers. This work-dependent asset testing can produce welfare gains close to the case of observable productivity.
    Keywords: health insurance, Medicaid, labor supply, asset testing, general equilibrium, life-cycle models
    JEL: D52 D91 E21 H53 I13 I18
    Date: 2016–07–07
  17. By: Philippe Bacchetta; Kenza Benhima; Yannick Kalantzis
    Abstract: In this paper we analyze the implications of a persistent liquidity trap in a monetary model with asset scarcity and price exibility. We show that a liquidity trap leads to an increase in cash holdings and may be associated with a long-term output decline. This long-term impact is a supply-side effect that may arise when agents are heterogeneous. It occurs in particular with a persistent deleveraging shock, leading investors to hold cash yielding a low return. Policy implications differ from shorter-run analyses. Quantitative easing leads to a deeper liquidity trap. Exiting the trap by increasing expected inflation or applying negative interest rates does not solve the asset scarcity problem.
    Keywords: Zero lower bound; liquidity trap; asset scarcity; deleveraging
    JEL: E40 E22 E58
    Date: 2016–06
  18. By: Vasilev, Aleksandar
    Abstract: This note explores the problem of non-convex labor supply decision in an economy with both discrete and continuous labor decisions. In contrast to the setup in Mc- Grattan, Rogerson and Wright (1997), here each household faces an indivisible labor supply choice in the market sector, while it can choose to work any number of hours in the non-market sector. We show how lotteries as in Rogerson (1988) can again be used to convexify consumption sets, and aggregation over individual preferences. With a mix of discrete and continuous labor supply decisions, disutility of non-market work becomes separable from market work, and the elasticity of the latter increases from unity to infinity.
    Keywords: indivisible labor,non-convexities,home production,lotteries,aggregation,discrete-continuous mix
    JEL: E1 J22
    Date: 2016
  19. By: Vasilev, Aleksandar
    Abstract: This note explores the problem of family labor supply decision in an economy with two-member households, joint home production, and fixed cost of joint labor supply. Even though the labor supply decisions are not indivisible per se, the presence of such fixed cost and partners with unequal labor productivity create non-convexities. The note shows how lotteries as in Rogerson (1988) can again be used to convexify consumption sets, and we perform aggregation over individual preferences. The main result demonstrated in the paper is that aggregate preferences of males do not differ from individual level ones. However, for females, the disutility of non-market work at the aggregate becomes separable from market work, but keeps its original (logarithmic) form, while the female labor elasticity of the market hours supply increases from unity to infinity.
    Keywords: family labor supply,home production,aggregation
    JEL: E1 J22
    Date: 2016
  20. By: Ayse Kabukcuoglu (Koc University); Enrique Martínez-García (Federal Reserve Bank of Dallas, Southern Methodist University)
    Abstract: We introduce the market resources method (MRM) for solving dynamic optimization problems. MRM extends Carroll’s (2006) endogenous grid point method (EGM) for problems with more than one control variable using policy function iteration. The MRM algorithm is simple to implement and provides advantages in terms of speed and accuracy over Howard’s policy improvement algorithm. Codes are available.
    Keywords: DSGE models; Computational methods; Policy function iteration; Endogenous grid.
    JEL: C6 C61 C63 C68
    Date: 2016–07
  21. By: Brinca, Pedro (Nova School of Business and Economics); Chari, V. V. (Federal Reserve Bank of Minneapolis); Kehoe, Patrick J. (Federal Reserve Bank of Minneapolis); McGrattan, Ellen R. (Federal Reserve Bank of Minneapolis)
    Abstract: We elaborate on the business cycle accounting method proposed by Chari, Kehoe, and McGrattan (2007), clear up some misconceptions about the method, and then apply it to compare the Great Recession across OECD countries as well as to the recessions of the 1980s in these countries. We have four main findings. First, with the notable exception of the United States, Spain, and Ireland, the Great Recession was driven primarily by the efficiency wedge. Second, in the Great Recession, the labor wedge plays a dominant role only in the United States, and the investment wedge plays a dominant role in Ireland and Spain. Third, in the recessions of the 1980s the labor wedge played a dominant role only in Denmark and the United Kingdom. Finally, overall in the Great Recession the efficiency wedge played a much more important role and the investment wedge played a much less important role than they did in the recessions of the 1980s.
    Keywords: Business cycle accounting; Great Recession; 1982 recession
    JEL: E60 E61 G28 G33
    Date: 2016–06–28

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