nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒08‒28
sixteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Optimal Fiscal Policy in a Model of Firm Entry and Financial Frictions By Dudley Cooke; Tatiana Damjanovic
  2. The Role of Capital Requirements and Credit Composition in the Transmission of Macroeconomic and Financial Shocks By Oscar Valencia; Daniel Osorio; Pablo Garay
  3. Endogenous Separations, Wage Rigidities and Employment Volatility By Carlsson, Mikael; Westermark, Andreas
  4. Buffer stock savings in a New-Keynesian business cycle model By Katrin Rabitsch; Christian Schoder
  6. Fast Bellman Iteration: An Application of Legendre-Fenchel Duality to Deterministic Dynamic Programming in Discrete Time By Ronaldo Carpio; Takashi Kamihigashi
  7. Marketmaking Middlemen By Gautier, Pieter A.; Hu, Bo; Watanabe, Makoto
  8. Trends & Cycles in Small Open Economies:Making the Case for a General Equilibrium Approach By Kan Chen; Mario Crucini
  9. The I Theory of Money By Markus K. Brunnermeier; Yuliy Sannikov
  10. Network Search: Climbing the Job Ladder Faster By Marcelo Arbex; Dennis O'Dea; David Wiczer
  11. Monetary Policy and Indeterminacy after the 2001 Slump By Firmin Doko Tchatoka; Nicolas Groshenny; Qazi Haque; Mark Weder
  12. VAT multipliers and pass-through dynamics By Simon Voigts; ;
  13. Expectations, stagnation and fiscal policy By Evans, George W.; Honkapohja, Seppo; Mitra, Kaushik
  14. Nominal Rigidities in Debt and Product Markets By Carlos Garriga; Finn E. Kydland; Roman Šustek
  15. Fiscal Space under Demographic Shift By Christine Ma; Chung Tran
  16. News and noise in the housing market By Gazzani, Andrea

  1. By: Dudley Cooke (Department of Economics, University of Exeter); Tatiana Damjanovic (Department of Economics, Durham University)
    Abstract: This paper develops a general equilibrium model of firm entry and financial frictions. Movements in the volatility of firm-level shocks and aggregate productivity generate procyclical entry and a countercyclical firm default rate. We derive analytical results for optimal fiscal policy and show that the government faces two trade-offs. The first arises from a profit destruction and a consumer surplus effect when firm entry is endogenous. The second arises because financial frictions reduce firm entry and default is costly. We also study the optimal mix of taxes on labor-income and firm profits in a quantitative version of the model. We find that a countercyclical labor-income tax is always part of the optimal fiscal policy, whereas the cyclicality of the profit tax is sensitive to the source of aggregate fl uctuations.
    Keywords: Firm Entry, Financial Frictions, Optimal Fiscal Policy.
    JEL: E31 E52 F41
    Date: 2016
  2. By: Oscar Valencia (Banco de la República de Colombia); Daniel Osorio (Banco de la República de Colombia); Pablo Garay
    Abstract: This paper builds a general equilibrium model that incorporates banks, financial frictions, default and a capital requirements. Ex-ante heterogeneous households decide how much to save or borrow for the sake of consumption (consumer credit) or the provision of housing services(mortgages). These choices are subject to borrowing limits, which depend on the value of real estate assets (for mortgages) or labour income (for consumer loans). The model includes final goods producers who must borrow in order to finance working capital/labour requirements (business credit borrowing) and intermediate good producers subject to nominal rigidities. Saving and borrowing are intermediated by a bank facing different capital requirements for each credit category. Any shock that has an impact on bank capital (for instance, a default shock) directly affects the bank’s income, the cost of external finance and, eventually, interest rates on loans. Changes in interest rates have second-round effects on labour and consumption through the borrowing limits. Simulations of the model suggest that the business cycle properties of credit and credit quality for each credit category are consistent with what is observed in the data. Classification JEL: E5, G21, G28
    Keywords: DSGE Models; Financial Frictions; Macroprudential Policy
    Date: 2016–08
  3. By: Carlsson, Mikael (Uppsala University); Westermark, Andreas (Research Department, Central Bank of Sweden)
    Abstract: We show that in micro data, as well as in a search and matching model with endogenous separations and rigid wages, separations and hence employment volatility are non-neutral to wage rigidities of incumbent workers. In contrast to when all wages are flexible, the standard deviation of unemployment in a model with rigid wages for incumbent workers (only) matches the standard deviation in the data. Thus, the degree of wage rigidity for newly hired workers is not a sufficient statistic for determining the effect of wage rigidities on macroeconomic outcomes in this class of models.
    Keywords: Search and matching; Unemployment volatility puzzle; Wage rigidities; Job Destruction
    JEL: E30 J63 J64
    Date: 2016–07–01
  4. By: Katrin Rabitsch (Department of Economics, Vienna University of Economics and Business); Christian Schoder (The New School for Social Research)
    Abstract: We introduce the tractable buffer stock savings setup of Carroll (2009 NBER Working Paper) into an otherwise conventional New-Keynesian dynamic stochastic general equilibrium model with financial frictions. The introduction of a precautionary saving motive arising from an uninsurable risk of permanent income loss, affects the model's properties in a number of interesting ways: it produces a more hump-shaped reaction of consumption in response to both supply (technology) and demand (monetary) shocks, and more pronounced reactions in response to demand shocks. Adoption of the buffer stock savings setup thus offers a more microfounded way, compared to, e.g., habit preferences in consumption, to introduce Keynesian features into the model, serving as a device to curbing excessive consumption smoothing, and to attributing a higher role to demand driven fluctuations. We also discuss steady state effects, determinacy properties as well as other practical issues.
    Keywords: precautionary saving, buffer stock saving, dynamic stochastic general equilibrium model
    JEL: D91 E21
    Date: 2016–08
  5. By: Freddy Heylen; Pieter Van Rymenant; Brecht Boone; Tim Buyse (-)
    Abstract: This paper investigates the possibility of today’s OECD economies entering into a very long period of poor per capita economic growth and very low real interest rates. We construct a general equilibrium model with overlapping generations of heterogeneous individuals, differing in ability and human capital, and with genetic and financial transfers from parents to children. Our model allows to study within one coherent framework the effects of those factors that are most often mentioned in the literature as possible drivers of secular stagnation: demographic change, a slowdown in the rate of technical progress, rising inequality, borrowing constraints, and downward rigidity in the real interest rate. We calibrate our model to Belgium and find that its predictions match key facts in Belgium in 1950-2009 very well. We then simulate projected future changes in technical progress and demography. In alternative scenarios we additionally impose rising inequality, borrowing constraints and/or a lower bound to the real interest rate. When we assume unchanged public policies and a modest future rate of technical progress, our conclusions about future per capita output and growth are rather pessimistic. Demographic change is by far the most influential cause of low growth. If a lower bound to the real interest rate is binding, it could considerably aggravate the problem of stagnation.
    Keywords: secular stagnation, overlapping generations, economic growth, ageing, demography, inequality
    JEL: C68 D91 E17 J11 O40
    Date: 2016–08
  6. By: Ronaldo Carpio (School of Business and Finance, University of International Business and Economics); Takashi Kamihigashi (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan)
    Abstract: We propose an algorithm, which we call " Fast Bellman Iteration " (FBI), to compute the value function of a deterministic infinite-horizon dynamic programming problem in discrete time. FBI is an efficient algorithm applicable to a class of multidimensional dynamic programming problems with concave return (or convex cost) functions and linear constraints. In this algorithm, a sequence of functions is generated starting from the zero function by repeatedly applying a simple algebraic rule involving the Legendre-Fenchel transform of the return function. The resulting sequence is guaranteed to converge, and the Legendre-Fenchel transform of the limiting function coincides with the value function.
    Keywords: Dynamic programming, Legendre-Fenchel transform, Bellman operator, Convex analysis
    Date: 2016–07
  7. By: Gautier, Pieter A. (Vrije Universiteit Amsterdam); Hu, Bo (Vrije Universiteit Amsterdam); Watanabe, Makoto (Vrije Universiteit Amsterdam)
    Abstract: This paper develops a model in which market structure is determined endogenously by the choice of intermediation mode. We consider two representative business modes of intermediation that are widely used in real-life markets: one is a middleman mode where an intermediary holds inventories which he stocks from sellers for the purpose of reselling to buyers; the other is a market-making mode where an intermediary offers a platform for buyers and sellers to trade with each other. In our model, buyers and sellers can simultaneously search in an outside market and use the intermediation service. We show that a marketmaking middleman, who adopts the mixture of these two intermediation modes, can emerge in a directed search equilibrium.
    Keywords: middlemen, marketmakers, platform, directed search
    JEL: D4 G2 L1 L8 R1
    Date: 2016–08
  8. By: Kan Chen; Mario Crucini
    Abstract: This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices
    Keywords: Economic Analysis , Global , USA , Working Paper
    JEL: C55 C68 F41 F44
    Date: 2016–08
  9. By: Markus K. Brunnermeier; Yuliy Sannikov
    Abstract: A theory of money needs a proper place for financial intermediaries. Intermediaries diversify risks and create inside money. In downturns, micro-prudent intermediaries shrink their lending activity, fire-sell assets and supply less inside money, exactly when money demand rises. The resulting Fisher disinflation hurts intermediaries and other borrowers. Shocks are amplified, volatility spikes and risk premia rise. Monetary policy is redistributive. Accommodative monetary policy that boosts assets held by balance sheet-impaired sectors, recapitalizes them and mitigates the adverse liquidity and disinflationary spirals. Since monetary policy cannot provide insurance and control risk-taking separately, adding macroprudential policy that limits leverage attains higher welfare.
    JEL: E32 E41 E44 E51 E52 E58 G01 G11 G21
    Date: 2016–08
  10. By: Marcelo Arbex (Department of Economics, University of Windsor); Dennis O'Dea (Department of Economics, University of Washington); David Wiczer (Research Division, Federal Reserve Bank of St. Louis)
    Abstract: We introduce a complex network into a search model in which workers find jobs through their network or directly from firms. This framework links heterogeneity in network position to heterogeneity in wage-employment dynamics: better-connected workers climb the job ladder faster, drawing more frequently from the network offer distribution which stochastically dominates the direct-search distribution. The mean- field approach allows a tractable, recursive formulation and our calibrated version is consistent with several empirical findings. Further, we present new evidence consistent with our model: Job-to-job switches use networks more frequently at higher rungs of the ladder.
    Keywords: Labor Markets; Social networks; Job search; Unemployment; Wages dispersion.
    JEL: D83 D85 E24 J31 J64
    Date: 2016–08
  11. By: Firmin Doko Tchatoka (School of Economics, University of Adelaide); Nicolas Groshenny (School of Economics, University of Adelaide); Qazi Haque (School of Economics, University of Adelaide); Mark Weder (School of Economics, University of Adelaide)
    Abstract: This paper estimates a New Keynesian model of the U.S. economy over the period following the 2001 slump, a period for which the adequacy of monetary policy is intensely debated. To relate to this debate, we consider alternative inflation series in the estimation. We find that only when measuring inflation with core PCE monetary policy appears to have been reasonable and sufficiently active to rule out indeterminacy. We then relax the assumption that inflation in the model is measured by a single indicator and re-formulate the artificial economy as a factor model where the theoryÂ’s concept of inflation is the common factor to the empirical inflation series. We find that CPT and PCE provide better indicators of the latent concept while core PCE is less informative. Finally, we allow for positive trend inflation and the emerging results complement our previous findings. Again, even with these extensions, the only instance in which we can confidently rule out indeterminacy is when we measure inflation with core PCE.
    Keywords: Indeterminacy, Taylor Rules, Trend Infl?ation, Great Deviation.
    JEL: E32 E52 E58
    Date: 2016–07
  12. By: Simon Voigts; ;
    Abstract: To quantify fiscal multipliers in Eurozone countries, ECB, European Commission and IMF draw heavily on large-scale DSGE models. In these models, the value added tax (VAT) is implemented as consumption tax, implying essentially full contemporaneous pass-through of changes in the tax liability to consumers. However, empirical evidence suggests that VAT pass-through in Europe occurs only gradually. To investigate how realistic pass-through dynamics affect VAT multipliers, a DSGE model is augmented by a retail sector, which allows to replicate empirical pass- through estimates. The resulting short-run multipliers are dramatically smaller than those from a consumption tax, suggesting systematic over- estimation in institutional research.
    Keywords: Fiscal multipliers, value added tax, tax pass-through, DSGE models.
    JEL: E62
    Date: 2016–08
  13. By: Evans, George W.; Honkapohja, Seppo; Mitra, Kaushik
    Abstract: Stagnation as the new norm and fiscal policy are examined in a New Keynesian model with adaptive learning determining expectations. We impose inflation and consumption lower bounds, which can be relevant when agents are pessimistic. The inflation target is locally stable under learning. Pessimistic initial expectations may sink the economy into steady-state stagnation with deflation. The deflation rate can be near zero for discount factors near one or if credit frictions are present. Following a severe pessimistic expectations shock a large temporary fiscal stimulus is needed to avoid or emerge from stagnation. A modest stimulus is sufficient if implemented early.
    Keywords: stagnation, deflation, expectations, output multiplier, New Keynesian model, adaptive learning, fiscal policy
    JEL: E62 D84 E21 E43
    Date: 2016–08–11
  14. By: Carlos Garriga (Federal Reserve Bank of St. Louis); Finn E. Kydland (University of California-Santa Barbara and NBER); Roman Šustek (Queen Mary University of London, Centre for Macroeconomics, and CERGE-EI)
    Abstract: Standard models used for monetary policy analysis rely on sticky prices. Recently, the literature started to explore also nominal debt contracts. Focusing on mortgages, this paper compares the two channels of transmission within a common framework. The sticky price channel is dominant when shocks to the policy interest rate are temporary, the mortgage channel is important when the shocks are persistent. The first channel has significant aggregate effects but small redistributive effects. The opposite holds for the second channel. Using yield curve data decomposed into temporary and persistent components, the redistributive and aggregate consequences are found to be quantitatively comparable.
    Keywords: Mortgage contracts, Sticky prices, Monetary policy, Yield curve, Redistributive vs. aggregate effects.
    JEL: E32 E52 G21 R21
    Date: 2016–08
  15. By: Christine Ma; Chung Tran
    Abstract: In this paper we quantitatively explore implications of ageing demographic structure for government revenue raising capacity through lens of fiscal space. We base our analysis on dynamic general equilibrium, overlapping generations model calibrated to data from Japan and USA.We first map out fundamental-based fiscal limit using the Laffer curve approach, and then compute fiscal space in terms of budgetary room between the current revenue and the maximum revenue defined by the peak of Laffer curves. We demonstrate that the evolution of underlying demographic structures plays an important role in shaping a country’s fiscal limit and fiscal space. There will be significant contractions in fiscal space in Japan and USA when the two countries enter their late stage of demographic transition in 2040. In particular, the results from the model calibrated to Japan indicates that an increase in old-age dependency ratio to over 70 percent can reduce Japan’s fiscal space by 36 percent. When factoring in the increased fiscal cost of existing commitments to the age pension program, the net fiscal space for Japan turns negative.
    Keywords: Population Ageing, Laffer Curve, Fiscal Limit, Sustainability, Heterogeneity, Dynamic General Equilibrium.
    JEL: E62 H20 H60 J11
    Date: 2016–08
  16. By: Gazzani, Andrea
    Abstract: Housing prices are subject to boom and bust episodes with long-lasting deviation from fundamentals. By considering a present value housing price model under noisy information, I study the macroeconomic implications of movements in housing prices related (news) and not related (noise) to future fundamentals. I provide empirical evidence of the sizable macroeconomic effects of news and noise shocks. Following Forni et al. (2014, 2016), I identify news and noise shocks through a non-standard VAR technique which exploits future information. In the US, news shocks are the main driver of the housing market at low frequencies, but in the short-medium horizon noise shocks explain a large share of the variability in housing prices, residential investment and GDP. Historically, many housing cycles are driven by noise. The empirical findings are consistent with a model à la Iacoviello which features a rental market. In this model, the usual optimal policy exercise concerns an augmented Taylor rule and a pro-cyclical loan-to-value ratio. I propose pro-cyclical property taxes as the most effective policy tool to deal with fluctuations originating from the housing market. JEL Classification: E30, E40, E50
    Keywords: housing market, macro-prudential, noise, non-fundamental VAR, property tax
    Date: 2016–07

This nep-dge issue is ©2016 by Christian Zimmermann. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.