nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒09‒11
twenty-one papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Dealing with Financial Instability under a DSGE modeling approach with Banking Intermediation: a predictability analysis versus TVP-VARs By Stelios D. Bekiros; Roberta Cardani; Alessia Paccagnini; Stefania Villa
  2. The Fiscal Multiplier in Small Open Economy; The Role of Liquidity Frictions By Jasmin Sin
  3. Default, Mortgage Standards, and Housing Liquidity By Hongfei Sun; Chenggang Zhou; Allen Head
  4. Explaining Income Inequality and Intergenerational Mobility: The Role of Fertility and Family Transfers By Julian Kozlowski; Diego Daruich
  5. The Pruned State-Space System for Non-Linear DSGE Models: Theory and Empirical Applications By Martin M. Andreasen; Jesús Fernández-Villaverde; Juan F. Rubio-Ramírez
  6. Domestic and External Debt and Default By Dirk Niepelt
  7. Credit Defaults, Bank Lending and the Real Economy By Sebastiaan Pool
  8. Optimal Monetary Policy at the Zero Lower Bound on Nominal Interest Rates in a Cost Channel Economy By Lasitha R. C. Pathberiyay
  9. Learning, Confidence and Business Cycle By Hikaru Saijo; Cosmin Ilut
  10. Sorting and Wage Inequality By Kory Kantenga
  11. Endogenous Growth, Firm Heterogeneity and the Long-run Impact of Financial Crises By Tom Schmitz
  12. Monetary Policy, Heterogeneity and the Housing Channel By Serdar Ozkan; Kurt Mitman; Fatih Karahan; Aaron Hedlund
  13. Numerical solution of a semilinear parabolic degenerate Hamilton-Jacobi-Bellman equation with singularity By Mourad Lazgham
  14. A General Endogenous Grid Method for Multi-Dimensional Models with Non-Convexities and Constraints By Jeppe Druedahl; Thomas Høgholm Jørgensen
  15. Sovereign Risk and Bank Risk-Taking By Anil Ari
  16. Finance and Synchronization By Cesa-Bianchi, Ambrogio; Imbs, Jean; Saleheen, Jumana
  17. Money, Asset Prices and the Liquidity Premium By Lee, Seungduck
  18. Welfare effects of TTIP in a DSGE model By Engler, Philipp; Tervala, Juha
  19. Government Spending Multipliers under the Zero Lower Bound: Evidence from Japan By Thuy Lan Nguyen; Dmitriy Sergeyev; Wataru Miyamoto
  20. (S,s) insights into the role of inventories in business cycles and high frequency fluctuations By Julia Thomas; Aubhik Khan
  21. Private Money and Equilibrium Liquidity By Roberto Robatto; Pierpaolo Benigno

  1. By: Stelios D. Bekiros; Roberta Cardani; Alessia Paccagnini; Stefania Villa
    Abstract: In the dynamic stochastic general equilibrium (DSGE) literature there has been an increasing awareness on the role that the banking sector can play in macroeconomic activity. We present a DSGE model with financial intermediation as in Gertler and Karadi (2011). The estimation of shocks and of the structural parameters shows that time-variation should be crucial in any attempted empirical analysis. Since DSGE modelling usually fails to take into account inherent nonlinearities of the economy, we propose a novel time-varying parameter (TVP) state-space estimation method for VAR processes both for homoskedastic and heteroskedastic error structures. We conduct an exhaustive empirical exercise to compare the out-of-sample predictive performance of the estimated DSGE model with that of standard ARs, VARs, Bayesian VARs and TVP-VARs. We find that the TVP-VAR provides the best forecasting performance for the series of GDP and net worth of financial intermediaries for all steps-ahead, while the DSGE model outperforms the other specifications in forecasting inflation and the federal funds rate at shorter horizons.
    Keywords: Financial frictions; DSGE; Time-varying coefficients; Extended Kalman filter; Banking sector
    JEL: C11 C13 C32 E37
    Date: 2016–08
  2. By: Jasmin Sin
    Abstract: This paper studies the fiscal multiplier using a small-open-economy DSGE model enriched with financial frictions. It shows that the multiplier is large when frictions are present in domestic and international financial markets. The reason is that in the model government bonds are more liquid than private financial assets and that entrepreneurs face liquidity constraints. A bond-financed fiscal expansion eases these constraints and stimulates investment and hence growth. This mechanism, however, breaks down under the assumption of perfect international capital mobility, suggesting that conventional models which ignore the presence of frictions in international capital markets tend to underestimate the fiscal multiplier.
    Keywords: Fiscal stimulus and multipliers;Fiscal policy;Liquidity;Government expenditures;Small open economies;General equilibrium models;Sensitivity analysis;DSGE model, fiscal multiplier, small open economy, liquidity frictions
    Date: 2016–07–12
  3. By: Hongfei Sun (Queen's University); Chenggang Zhou (Queen's University); Allen Head (Queen's University)
    Abstract: The influence of households' indebtedness on their house-selling decisions is studied in a tractable dynamic general equilibrium model with housing market search and defaultable long-term mortgages. In equilibrium, sellers' behavior varies significantly with their indebtedness. Specifically, both asking prices and time-to-sell increase with the relative size of sellers' outstanding mortgages. In turn, the liquidity of the housing market associated with equilibrium time-to-sell determines the mortgage standards offered by competitive banks. When calibrated to the U.S. economy the model generates, as observed, negative correlations over time between both house prices and time-to-sell with down-payment ratios.
    Date: 2016
  4. By: Julian Kozlowski (New York University); Diego Daruich (New York University)
    Abstract: How much of income inequality is due to initial opportunities relative to adult income risk? What factors determine intergenerational mobility? We study these questions with a particular interest in the impact of family choices: fertility and transfers. Fertility rates, which are higher for low-income than high-income families, are associated with differences in the level of resources available for children's education. To evaluate the quantitative importance of fertility and family transfers we extend the standard heterogeneous agent life-cycle model with idiosyncratic income shocks and incomplete markets to allow for endogenous fertility, family transfers and education. Initial conditions are defined as the agents' initial state variables, which are endogenously related to parental background. We find that initial conditions account for 50\% of the variation in lifetime-earnings. Moreover, fertility and parents-to-children transfers generate 20 and 39\% of the intergenerational mobility respectively.
    Date: 2016
  5. By: Martin M. Andreasen; Jesús Fernández-Villaverde; Juan F. Rubio-Ramírez
    Abstract: This paper studies the pruned state-space system for higher-order perturbation approximations to DSGE models. We show the stability of the pruned approximation up to third order and provide closed-form expressions for first and second unconditional moments and impulse response functions. Our results introduce GMM estimation and impulse-response matching for DSGE models approximated up to third order and provide a foundation for indirect inference and SMM. As an application, we consider a New Keynesian model with Epstein-Zin-Weil preferences and two novel feedback effects from long-term bonds to the real economy, allowing us to match the level and variability of the 10-year term premium in the U.S. with a low relative risk aversion of 5.
    Date: 2016–09
  6. By: Dirk Niepelt (Study Center Gerzensee; U Bern)
    Abstract: We develop a general equilibrium model with defaultable domestic and external debt. Overlapping generations work, consume, accumulate capital and public debt. Successive, democratically elected governments choose taxes, public goods spending, domestic and external debt issuance and repayment. In Markov perfect equilibrium, political distortions inherent in democratic societies strengthen debt capacity; macroeconomic shocks affect the cost of public funds and debt returns; and debt serves intergenerational risk sharing. Default decisions may or may not be correlated across debt tranches. Minimum debt returns raise the cost of public funds ex post and render default on other tranches more likely; ex ante, they increase the revenue from debt sales but crowd out capital. Political and general equilibrium "wedges" undermine the inter-temporal smoothing of the shadow cost of public funds. Under standard functional form assumptions the model is solved in closed form.
    Date: 2016
  7. By: Sebastiaan Pool
    Abstract: This paper examines how the materialization of credit defaults affects the real economy. I estimate a DSGE model including banks, firms and financial frictions using euro area data. The estimation results show that a positive credit default shock, which is identified as an unanticipated increase in credit default losses, complicates monetary policy because output falls while inflation goes up. The monetary authority must choose between stabilizing output and inflation and is therefore less effective. Inflation increases slightly because firms experience besides a demand contraction also a cost-push effect when banks increase the lending rate. Countercyclical capital buffers can in this case complement conventional monetary policy but there is a trade-off: they effectively attenuate macroeconomic fluctuations, but increase the persistence of the slump as banks rebuild their capital more slowly. A bank recapitalization overcomes this trade-off and significantly reduces macroeconomic fluctuations.
    Keywords: Banking; Credit risk; Credit defaults; Countercyclical Capital Buffer; Bayesian Estimation
    JEL: E44 E51 E52
    Date: 2016–08
  8. By: Lasitha R. C. Pathberiyay (School of Economics, The University of Queensland, St Lucia, Brisbane, Australia)
    Abstract: The nominal interest rates were at zero level in the recent past in many countries across the globe. It has been widely debated recently what a central bank should do to stimulate the economy when the nominal interest rate is at the zero lower bound (ZLB). The optimal monetary policy literature suggests that monetary policy inertia, i.e. committing to continue zero interest regime even after the ZLB is not binding, is a way to get the economy out of recession. In this paper, I examine whether this result holds when monetary policy has not only the conventional demand-side effect but also a supply-side effect on the economy. To accomplish this objective, I incorporate the cost channel of monetary policy into an otherwise standard new Keynesian model and evaluate the optimal monetary policy at the ZLB. The study revealed some important insights in the conduct of the optimal monetary policy in a cost channel economy at the ZLB. First, the discretionary policy requires central banks to keep interest rates at the zero lower bound for longer in a cost channel economy compared to no-cost channel economies. This is because, in cost channel economies, the deflation is high and persistent due to a larger negative demand shock than that found in no-cost channel economies. Further, cost channel economies introduce a policy trade-o between inflation and output gap. Under commitment policy, the simulation exercise shows that the central bank is able to terminate the zero interest rate regime earlier in a cost channel economy than otherwise. The reason for that is, in a cost channel economy, the private sector has inflated inflationary expectations when the central bank is planning to conduct a tight monetary policy. This result is in contrast to the results found under discretionary policy. It was also revealed that the cost channel generates substantially high welfare losses, under both discretionary and commitment policies. Accordingly, abstracting the cost channel in these types of models can lead to under estimation of welfare losses.
    Keywords: optimal monetary policy, zero rates on nominal interest rates, cost channel of monetary policy, new Keynesian model, liquidity trap
    JEL: E31 E52 E58 E61
    Date: 2016–09–01
  9. By: Hikaru Saijo (University of California Santa Cruz); Cosmin Ilut (Duke University)
    Abstract: We construct and estimate a heterogeneous-firm business cycle model where firms face Knightian uncertainty about their profitability and learn it through production. The cross-sectional mean of firm-level uncertainty is high in recessions because firms invest and hire less. The higher uncertainty reduces agents' confidence and further discourages economic activity. This feedback mechanism endogenously generates properties traditionally explained through additional shocks or rigidities: countercyclical labor and financial wedges, co-movement driven by demand shocks, and amplified and hump-shaped dynamics. We find that endogenous idiosyncratic confidence reduces the empirical role of standard rigidities and changes inference about sources of fluctuations and policy experiments.
    Date: 2016
  10. By: Kory Kantenga (University of Pennsylvania)
    Abstract: We measure the roles of the permanent component of worker and firm produc- tivities, complementarities between them, search frictions, and equilibrium sorting in driving German wage dispersion. We do this using a standard assortative matching model with on-the-job search. The model is identified and estimated using matched employer-employee data on wages and labor market transitions without imposing para- metric restrictions on the production technology. The model’s fit to the wage data is comparable to prominent wage regressions with additive worker and firm fixed effects that use many more degrees of freedom. Moreover, we propose a direct test that rejects the restrictions underlying the additive specification. We use the model to decompose the rise in German wage dispersion between the 1990s and the 2000s. We find that changes in the production function and the induced changes in equilibrium sorting pat- terns account for virtually all the rise in the observed wage dispersion. Search frictions are an important determinant of the level of wage dispersion but have had little impact on its rise over time.
    Date: 2016
  11. By: Tom Schmitz (Università Bocconi)
    Abstract: I propose a new endogenous growth model with heterogeneous firms and aggregate shocks. The model shows that firm heterogeneity generates several new amplification and persistence mechanisms for a transitory shock to financing conditions. This shock imposes financing constraints, which force small and young innovating firms (with low retained earnings) to reduce their R&D, and therefore leads to R&D misallocation. Furthermore, it lowers entry and persistently reduces the mass of innovating firms. Thus, even as financing constraints disappear, aggregate R&D and innovation remain persistently depressed, as the remaining large firms can only imperfectly substitute for the R&D of the missing generation of young and small ones. Finally, lower R&D during and after the shock also limits the scope for incremental follow-up innovations. My model's main features are in line with developments in the Spanish manufacturing sector during the 2008-2013 economic and financial crisis.
    Date: 2016
  12. By: Serdar Ozkan (University of Toronto); Kurt Mitman (Stockholm University); Fatih Karahan (Federal Reserve Bank of New York); Aaron Hedlund (University of Missouri)
    Abstract: We investigate the role of housing and mortgage debt in the transmission of monetary policy to household consumption and the aggregate economy. In order to do so, we develop a heterogenous agents model with a frictional housing market, nominal long-term borrowing, default, and price rigidities. The model is able to capture rich heterogeneity in home ownership and leverage. Endogenous cyclical movements in house prices as well as counter-cyclical dynamics in the liquidity of housing allows us to explore the various indirect mechanisms through which monetary policy affects consumption. Nominal long-term mortgage debt implies that changes in monetary policy will result in redistribution between lenders and borrowers. Further, a contractionary monetary policy shock raises the cost of borrowing which reduces liquidity in the housing market, depresses house prices and feeds back into increasing the cost of borrowing. We find that this amplification channel disproportionally affects households with high leverage and high marginal propensities to consume. Finally, we investigate how booms and busts in the housing market asymmetrically affect the efficacy of monetary policy.
    Date: 2016
  13. By: Mourad Lazgham
    Abstract: We consider a semilinear parabolic degenerated Hamilton-Jacobi-Bellman (HJB) equation with singularity which is related to a stochastic control problem with fuel constraint. The fuel constraint translates into a singular initial condition for the HJB equation. We first propose a transformation based on a change of variables that gives rise to an equivalent HJB equation with nonsingular initial condition but irregular coefficients. We then construct explicit and implicit numerical schemes for solving the transformed HJB equation and prove their convergences by establishing an extension to the result of Barles and Souganidis (1991).
    Date: 2016–09
  14. By: Jeppe Druedahl (Department of Economics, University of Copenhagen); Thomas Høgholm Jørgensen (Department of Economics, University of Copenhagen)
    Abstract: The endogenous grid method (EGM) significantly speeds up the solution of stochastic dynamic programming problems by simplifying or completely eliminating rootfinding. We propose a general and parsimonious EGM extended to handle 1) multiple continuous states and choices, 2) multiple occasionally binding constraints, and 3) non-convexities such as discrete choices. Our method enjoys the speed gains of the original one-dimensional EGM, while avoiding expensive interpolation on multi-dimensional irregular endogenous grids. We explicitly define a broad class of models for which our solution method is applicable, and illustrate its speed and accuracy using a consumption-saving model with both liquid assets and illiquid pension assets and a discrete retirement choice.
    Keywords: Endogenous grid method, post-decision states, stochastic dynamic programming, continuous and discrete choices, occasionally binding constraints
    JEL: C13 C63 D91
    Date: 2016–09–05
  15. By: Anil Ari (University of Cambridge)
    Abstract: In European countries recently hit by a sovereign debt crisis, the share of domestic sovereign debt held by the national banking system has sharply increased, raising issues in their economic and financial resilience, as well as in policy design. This paper examines these issues by analyzing the banking equilibrium in a model with optimizing banks and depositors. To the extent that sovereign default causes bank losses also independently of their holding of domestic government bonds, undercapitalized banks have an incentive to gamble on these bonds. The optimal reaction by depositors to insolvency risk imposes discipline, but also leaves the economy susceptible to self-fulfilling shifts in sentiments, where sovereign default also causes a banking crisis. Policy interventions face a trade-off between alleviating funding constraints and strengthening incentives to gamble. Subsidized loans to banks, similar to the ECB's non-targeted longer-term refinancing operations (LTRO), may eliminate the good equilibrium when the banking sector is undercapitalized. Targeted interventions have the capacity to eliminate adverse equilibria.
    Date: 2016
  16. By: Cesa-Bianchi, Ambrogio (Bank of England); Imbs, Jean (Paris School of Economics); Saleheen, Jumana (Bank of England)
    Abstract: In the workhorse model of international real business cycles, financial integration exacerbates the cycle asymmetry created by country-specific supply shocks. The prediction is identical in response to purely common shocks in the same model augmented with simple country heterogeneity (eg, where depreciation rates or factor shares are different across countries). This happens because common shocks have heterogeneous consequences on the marginal products of capital across countries, which triggers international investment. In the data, filtering out common shocks requires therefore allowing for country-specific loadings. We show that finance and synchronization correlate negatively in response to such common shocks, consistent with previous findings. But finance and synchronization correlate non-negatively, almost always positively, in response to purely country-specific shocks.
    Keywords: Financial linkages; business cycles synchronization; contagion; common shocks; idiosyncratic shocks
    JEL: E32 F15 F36 G21 G28
    Date: 2016–08–25
  17. By: Lee, Seungduck
    Abstract: This paper examines the effect of monetary policy on the liquidity premium, i.e., the market value of the liquidity services that financial assets provide. To guide the empirical analysis, I set up a monetary search model in which bonds provide liquidity services in addition to money. The theory predicts that money supply and the nominal interest rate are positively correlated with the liquidity premium, but the latter is negatively correlated with the bond supply. The empirical analysis over the period from 1946 and 2008 confirms the theoretical findings. This indicates that liquid bonds are substantive substitutes for money and the opportunity cost of holding money plays a key role in asset price determination. The model can rationalize the existence of negative nominal yields, when the nominal interest rate is low and liquid bond supply decreases.
    Keywords: asset price, money search model, liquidity, liquidity premium, money supply
    JEL: E31 E41 E51 E52 G12
    Date: 2016–08
  18. By: Engler, Philipp; Tervala, Juha
    Abstract: Several studies have analyzed the trade and output effects of the Transatlantic Trade and Investment Partnership (TTIP) between the United States and the European Union, but our paper is the first attempt to study its welfare effects. We measure the welfare effect of TTIP as the percentage of initial consumption that households would be willing to pay for TTIP in order to remain as well off with TTIP as without it. The discounted present value of the welfare gain of TTIP, which leads to the elimination of tariffs and cuts in non-tariff measures by 25%, is in the range of 1% to 4% of initial consumption, depending on the parameterization. The welfare gain increases in the elasticity of substitution between domestic and foreign goods. The bulk of the welfare gain is caused by cuts in non-tariff measures.
    Keywords: tariffs,TTIP,trade agreement,trade liberalization
    JEL: F13 F41 E60
    Date: 2016
  19. By: Thuy Lan Nguyen (Santa Clara University); Dmitriy Sergeyev (Bocconi University); Wataru Miyamoto (Bank of Canada)
    Abstract: Using a rich data set on government spending forecasts, we estimate the effects of unexpected government spending both when the nominal interest rate is near zero lower bound (ZLB) and outside of the ZLB period in Japan. The output multiplier is 1.5 on impact in the ZLB period, while it is 0.7 outside of the ZLB period. We estimate that the government spending shocks increase both private consumption and investment during the ZLB period but crowd them out in the normal period. The unemployment rate decreases in the ZLB period, while it does not respond significantly during the normal period. We argue that these results are not driven by the amount of slack in the economy. We estimate a positive but mild inflation response in both periods. A calibrated standard New Keynesian model with a fundamental-driven ZLB period can match our empirical findings.
    Date: 2016
  20. By: Julia Thomas (Ohio State University); Aubhik Khan (Ohio State University)
    Abstract: We develop an equilibrium model to explain salient business cycle patterns involving aggregate production, sales and inventory investment alongside a distinct set of patterns at high frequencies. Our firms face idiosyncratic productivity shocks and fixed costs of ordering inputs, leading them to order infrequently and accumulate inventories. Thus, the model’s aggregate state vector includes a time-varying distribution of firms over productivities and inventories. Disciplined by data on aggregate inventories and firm-level sales and output, our model reproduces key patterns in the data at business cycle frequencies: Inventory investment is procyclical and positively correlated with final sales, GDP varies more than sales, and the inventory-to-sales ratio is countercyclical. These successes are robust to a wide range of micro-level parameters governing firms’ order costs and relative productivities, while those parameters are key to the model’s high-frequency performance. When order costs are more predictable and shifts in relative productivities are transitory, the model also performs well in key high frequency respects: The relative volatility of inventory investment rises sharply, and sales and inventory investment are negatively correlated, while both series maintain positive correlations with GDP. Despite these distinctions, our model predicts that aggregate fluctuations are surprisingly unaffected by inventories even at high frequencies.
    Date: 2016
  21. By: Roberto Robatto (University Wisconsin Madison); Pierpaolo Benigno (LUISS Guido Carli)
    Abstract: Can creation of private money by financial intermediaries fulfill the liquidity needs of the economy? The answer is no if the market is run only by forces of free competition. Multiple equilibria are possible: equilibria with complete satiation of liquidity and absence of default coexists with ones characterized by shortages and partial default. In this framework, capital requirements, distortions to demand or supply of private money, and the role of public liquidity are investigated.
    Date: 2016

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