nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒09‒25
twenty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. An Analytical Characterization of Noisy Fiscal Policy By Fève, Patrick; Kass-Hanna, Tannous; Pietrunti, Mario
  2. Effect of Quantitative Easing on the Indian Economy: A Dynamic Stochastic General Equilibrium Perspective By Parantap Basu; Shesadri Banerjee
  3. Welfare Cost of Fluctuations when Labor Market Search Interacts with Financial Frictions By Thepthida Sopraseuth; François Langot; Eleni Iliopulos
  4. Credit market heterogeneity, balance sheet (in)dependence, financial shocks By Chris Garbers; Guangling Liu
  5. Foreign Official Holdings of U.S Treasuries, Stock Effect and the Economy: A DSGE Approach By John Nana Francois
  6. Unemployment and Gross Credit Flows in a New Keynesian Framework By Florian, David; Francis, Johanna L.
  7. Debt Constraints and Employment By Kehoe, Patrick J.; Midrigan, Virgiliu; Pastorino, Elena
  8. Fiscal Rules for Resource Windfall Allocation; The Case of Trinidad and Tobago By Keyra Primus
  9. Optimal unemployment insurance and international risk sharing By Moyen, Stéphane; Stähler, Nikolai; Winkler, Fabian
  10. Foreign exchange intervention and monetary policy design: a market microstructure analysis By Montoro, Carlos; Ortiz, Marco
  11. The Inequality Accelerator By Roberto Pancrazi; Eric Mengus
  12. Agent-based Macroeconomics and Dynamic Stochastic General Equilibrium Models: Where do we go from here? By Özge Dilaver; Robert Jump; Paul Levine
  13. Forecast uncertainty in the neighborhood of the effective lower bound: How much asymmetry should we expect? By Andrew Binning; Junior Maih
  14. Reassessing price adjustment costs in DSGE models By Sienknecht, Sebastian
  15. Lack of Commitment, Retroactive Tax Chagnes, and Macroeconomic Instability By Salvador Ortigueira; Joana Pereira
  16. Applications of sudden stops of international capital to the Mexican economy By Paula Lourdes Hernández Verme; Mónica Karina Rosales Pérez
  17. Online Appendix to "With Strings Attached: Grandparent-Provided Child Care and Female Labor Market Outcomes" By Eva Garcia-Moran; Zoe Kuehn
  18. Bailouts, Moral Hazard, and Banks’ Home Bias for Sovereign Debt By Ariel Zetlin-Jones; Gaetano Gaballo
  19. Asset bubbles and efficiency in a generalized two-sector model By Stefano BOSI; Cuong LE VAN; Ngoc-Sang PHAM
  20. A DGSE Model to Assess the Post-Crisis Regulation of Universal Banks. By O. de Bandt; M. Chahad

  1. By: Fève, Patrick; Kass-Hanna, Tannous; Pietrunti, Mario
    Abstract: This paper provides an analytical characterization of the effects of noisy news shocks on fiscal policy. We consider a small-scale Dynamic Stochastic General Equilibrium (DSGE) model with capital accumulation and endogenous labor supply and show that noise dampens the propagation of anticipated fiscal policy over the business cycle, thus reducing the fiscal multiplier.
    Keywords: Government spending shocks, Expected shocks, Noisy Information, DSGE Models.
    JEL: C32 E62
    Date: 2016–09
  2. By: Parantap Basu (Durham Business School); Shesadri Banerjee (National Council of Applied Economic Research (NCAER))
    Abstract: The effect of external Quantitative Easing (QE) on a small open economy such as India is analyzed using a dynamic stochastic general equilibrium (DSGE) model. The modelling is motivated by some broad empirical regularities of the Indian economy during the pre and post QE periods. QE is modelled as a negative foreign interest rate shock with a mean reverting pattern. The mean reversion reáects the phasing out of the QE operation. In addition, we analyze the "news" effect of the tapering out phase of QE. Our model has standard frictions which include limited asset market participation of agents, home bias in consumption and nominal frictions in terms of staggered price settings. Monetary policy is modelled by the forward looking ináation targeting Taylor rule. The model explores a novel transmission channel of QE via the terms of trade measured by the ratio of import to export prices. We show that the impact and news e§ects of QE work through the terms of trade via the uncovered interest parity condition. Our model reproduces two prominent features of the Indian data: (i) initial decline of the terms of trade followed by a sharp reversal, and (ii) divergent behaviour of foreign and domestic interest rates. The model is broadly consistent with other empirical regularities including a deflationary spell in the Indian economy after 2012
    Keywords: Quantitative Easing, India.
    Date: 2015–03
  3. By: Thepthida Sopraseuth (University of Cergy); François Langot (GAINS-TEPP (Université du Maine) & PSE); Eleni Iliopulos (PSE, University of Pairs 1, CEPREMAP)
    Abstract: We show that the interaction between labor search and financial frictions can account for the high responsiveness of the job finding rate to the business cycle through counter-cyclical opportunity costs of opening a vacancy and endogenous wage sluggishness. We then provide an assessment of the welfare costs associated to the implied large fluctuations. The matching process in the labor market leads positive shocks to reduce unemployment less than negative shocks increase it. The magnitude of this non-linearity is magnified by financial frictions and lead to sizable welfare costs, beyond the size of the fluctuations. By amplifying this asymmetric effect of the business cycle, financial frictions shift the distribution of welfare costs to regions characterized by more asymmetry and greater losses.
    Date: 2016
  4. By: Chris Garbers (Department of Economics, University of Stellenbosch); Guangling Liu (Department of Economics, University of Stellenbosch)
    Abstract: This paper presents a real business cycle model with financial frictions and two credit markets to investigate the qualitative and quantitative relevance of credit market heterogeneity. To address this line of inquiry we contrast the transmission of financial shocks in an economy where loans are the only form of credit to one in which both loans and bonds exist. We estimate the model using Bayesian methods over the sample period 1985Q1 - 2015Q1 for the U.S. economy. We find that credit market heterogeneity plays an important role in attenuating the impact of financial shocks by allowing borrowers to substitute away from the affected credit market. The shock attenuation property of credit market heterogeneity works through asset prices and substitution toward alternative credit types. Bank balance sheet linkages reduce the shock attenuation effect associated with heterogeneous credit markets. The origination of financial shocks can influence both the size and the persistence of their impact.
    Keywords: Credit Market, Business Cycle, Financial Intermediation, Operational Diversification, Heterogeneity, DSGE
    JEL: E32 E43 E44 E51 E52 E20
    Date: 2016
  5. By: John Nana Francois
    Abstract: Previous studies focus on quantifying the effect of foreign official holdings of long-term U.S Treasuries (FOHL) on the long-term interest rate. The consensus is that FOHL has a large and negative effect on the long-term interest rate. The long-term interest rate matters in determining aggregate demand, (Andres et al., 2004). However, these studies discount the macroeconomic implications of FOHL on the U.S economy. This paper extends the literature and studies the macroeconomic implications of FOHL shocks through their impact on the long-term interest rate in a dynamic stochastic general equilibrium (DSGE) model. The model treats short and long-term government bonds as imperfect substitutes through endogenous portfolio adjustment frictions(costs). Three main findings emerge from the baseline model: (1) A positive shock to FOHL impacts the long-term interest rate negatively through a stock effect channel-defined as persistent changes in interest rate as a result of movement along the Treasury demand curve. This result is consistent with the empirical literature; (2) The decline in the long-term interest rate creates favorable economic conditions that feed back into the economy and increases consumption, output and inflation through an endogenous term structure implied by the model and; (3) Monetary authority responds to the increase in inflation and output by raising the short-term interest rate. The simultaneous increase in the short-term interest rate and fall in the long-term interest rate causes the term spread to fall. This last result sheds light on the decoupling of interest rates observed between 2004-2006, a phenomenon known as the ``Greenspan Conundrum". The findings from the DSGE model are supported by impulse response functions obtained from a structural near-Vector Auto-regression(near-VAR) model.
    JEL: E43 E52 E58 F21
    Date: 2016–09–21
  6. By: Florian, David (Banco Central de Reserva del Perú); Francis, Johanna L. (Fordham University)
    Abstract: The Great Recession of 2008-09 was characterized by high and prolonged unemployment and lack of bank lending. The recession was preceded by a housing crisis that quickly spread to the banking and broader financial sectors. In this paper, we attempt to account for the depth and persistence of unemployment during and after the crisis by considering the relationship between credit and firm hiring explicitly. We develop a New Keynesian model with nominal rigidities in wages and prices augmented by a banking sector characterized by search and matching frictions with endogenous credit destruction. In the model, financial shocks are propagated and amplified through significant variation over the business cycle in the endogenous component of the total factor productivity, the credit inefficiency gap, arising from the existence of search and matching frictions in the credit market. In response to a financial shock, the model economy produces large and persistent increases in credit destruction, declines in credit creation, and overall declines in excess reallocation among banks and firms. The tightening of the credit market results in a sharp rise in the average interest rate spread and the average loan rate. Due to the increase in credit inefficiency that arises from the reduction in firm-bank matches, total factor productivity declines and unemployment increases. Total factor productivity and unemployment take at least 12 quarters to return to baseline. This result is due to a combination of nominal and real frictions. Credit frictions not only amplify the effect of financial shocks by creating variation in the number of firms able to produce due to credit restrictions following a shock - an extensive margin effect - as well as in labor demand by each firm, but they also increase the persistence of the shock's effects. Nominal rigidities play an important role primarily increasing the amplitude of the responses of credit and output variables. These findings suggest that credit frictions are a plausible amplification mechanism for the impact of financial shocks and also provide a means for such shocks to impact the labor market in a number of important ways.
    Keywords: Unemployment, nancial crises, gross credit ows, productivity
    JEL: J64 E32 E44 E52
    Date: 2016–09
  7. By: Kehoe, Patrick J. (Federal Reserve Bank of Minneapolis); Midrigan, Virgiliu (New York University); Pastorino, Elena (Federal Reserve Bank of Minneapolis)
    Abstract: During the Great Recession, regions of the United States that experienced the largest declines in household debt also experienced the largest drops in consumption, employment, and wages. Employment declines were larger in the nontradable sector and for firms that were facing the worst credit conditions. Motivated by these findings, we develop a search and matching model with credit frictions that affect both consumers and firms. In the model, tighter debt constraints raise the cost of investing in new job vacancies and thus reduce worker job finding rates and employment. Two key features of our model, on-the-job human capital accumulation and consumer-side credit frictions, are critical to generating sizable drops in employment. On-the-job human capital accumulation makes the flows of benefits from posting vacancies long-lived and so greatly amplifies the sensitivity of such investments to credit frictions. Consumer-side credit frictions further magnify these effects by leading wages to fall only modestly. We show that the model reproduces well the salient cross-regional features of the U.S. data during the Great Recession.
    Keywords: Search and matching; Employment; Debt constraints; Human capital
    JEL: E21 E24 E32 J21 J64
    Date: 2016–09–19
  8. By: Keyra Primus
    Abstract: Managing resource revenues is a critical policy issue for small open resource-rich countries. This paper uses an open economy dynamic stochastic general equilibrium model to analyze the transmission of resource price shocks and a shock to resource production in the Trinidad and Tobago economy. It also applies alternative fiscal rules to determine the optimal allocation of resource windfalls between spending today and saving in a sovereign wealth fund. The results show that spending all the resource windfall on consumption and investment creates more volatility and amplifies Dutch disease effects, when compared to the case where all the excess revenues are saved. Also, neither a policy of full spending nor full saving of the surplus revenue inflows is optimal if the government is concerned about both household welfare and fiscal stability. In order to minimize deviations from both objectives, the optimal fiscal response suggests that a larger fraction of the resource windfalls should be saved.
    Date: 2016–09–16
  9. By: Moyen, Stéphane; Stähler, Nikolai; Winkler, Fabian
    Abstract: We discuss how cross-country unemployment insurance can be used to improve international risk sharing. We use a two-country business cycle model with incomplete financial markets and frictional labor markets where the unemployment insurance scheme operates across both countries. Cross-country insurance through the unemployment insurance system can be achieved without affecting unemployment outcomes. The Ramsey-optimal policy however prescribes a more countercyclical replacement rate when international risk sharing concerns enter the unemployment insurance trade-off. We calibrate our model to Eurozone data and find that optimal stabilizing transfers through the unemployment insurance system are sizable and mainly stabilize consumption in the periphery countries, while optimal replacement rates are countercylical overall. Moreover, we find that debt-financed national policies are a poor substitute for fiscal transfers.
    Keywords: Unemployment Insurance,International Business Cycles,Fiscal Union,International Risk Sharing
    JEL: E32 E62 H21 J64
    Date: 2016
  10. By: Montoro, Carlos (Banco Central de Reserva del Perú; Concejo Fiscal (CF)); Ortiz, Marco (Banco Central de Reserva del Perú)
    Abstract: In this paper we extend a new Keynesian open economy model to include risk-averse FX dealers and FX intervention by the monetary authority. These ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, in this setup portfolio decisions of the dealers add endogenously a time variant risk-premium element to the traditional UIP that depends on FX intervention by the central bank and FX orders by foreign investors. We analyse the effectiveness of different strategies of FX intervention (e.g.,unanticipated operations or via a preannounced rule) to affect the volatility of the exchange rate and the transmission mechanism of the interest rate. Our findings are as follows: (i) FX intervention has a strong interaction with monetary policy in general equilibrium; (ii) FX intervention rules can have stronger stabilisation power than discretion in response to shocks because they exploit the expectations channel; and (iii) there are some trade-offs in the use of FX intervention, since it can help to isolate the economy from external financial shocks, but it prevents some necessary adjustments on the exchange rate as a response to nominal and real external shocks.
    Keywords: Foreign exchange Microestructure, Exchange rate dynamics, Exchange Rate Intervention, Monetary policy, Information Heterogeneity
    JEL: E4 E5 F3 G15
    Date: 2016–09
  11. By: Roberto Pancrazi (University of Warwick); Eric Mengus (HEC Paris)
    Abstract: We show that the transition from an economy characterized by idiosyncratic income shocks and incomplete markets a la Aiyagari (1994) to markets where state-contingent assets are available but costly (in order to purchase a contingent asset, households have to pay a fixed participation cost) leads to a large increase of wealth inequality. Using a standard calibration our model can match a Gini of 0.93 close to the level of wealth inequality observed in the US. In addition, under this level of participation costs, wealth inequality is particularly sensitive to income inequality. We label this phenomenon as the Inequality Accelerator. We demonstrate how costly access to contingent asset-markets generates these effects. The key insight stems from the non-monotonic relationship between wealth and desired degree of insurance, in an economy with participation costs. Poor borrowing constrained households remain uninsured, middle-class households are almost perfectly insured, while rich households decide to self-insure by purchasing risk-free assets. This feature of households’ risk management has crucial effects in asset prices, wealth inequality, and social mobility.
    Date: 2016
  12. By: Özge Dilaver (University of Surrey); Robert Jump (Kingston University London); Paul Levine (University of Surrey)
    Abstract: Agent-based computational economics (ACE) has been used for tackling major research questions in macroeconomics for at least two decades. This growing field positions itself as an alternative to dynamic stochastic general equilibrium (DSGE) models. In this paper we first review the arguments raised against DSGE in the ACE literature. We then review existing ACE models, and their empirical performance. We then turn to a literature on behavioural New Keynesian models that attempts to synthesise these two approaches to macroeconomic modelling by incorporating some of the insights of ACE into DSGE modelling. We highlight the individually rational New Keynesian model following Deak et al. (2015) and discuss how this line of research can progress.
    JEL: E03 E12 E32
    Date: 2016–01
  13. By: Andrew Binning (Norges Bank (Central Bank of Norway)); Junior Maih (Norges Bank (Central Bank of Norway) and BI Norwegian Business School)
    Abstract: The lower bound on interest rates has restricted the impact of conventional monetary policies over recent years and could continue to do so in the near future, with the decline in natural real rates not predicted to reverse any time soon. A binding lower bound on interest rates has consequences not only for point forecasts but also for the entire model forecast distribution. In this paper we investigate the ramifications of the lower bound constraint on the forecast distributions from DSGE models and the implications for risk and uncertainty. To that end we start out by making the case for regime-switching as a framework for imposing the lower bound constraint on interest rates in DSGE models. We then use the framework to investigate the implications of the lower bound constraint on the forecast distributions and try to answer the question of how much asymmetry we should expect when the lower bound binds. The results suggest that: i) a lower bound constraint need not in itself imply asymmetric fan charts, ii) the degree of asymmetry of fan charts depends on various factors such as the degree of interest rate smoothing and the degree of price rigidity, and iii) different approaches to imposing the lower bound yield different results for both the width of the fan charts and their asymmetry.
    Keywords: Effective Lower Bound, Regime-Switching, DSGE, Forecast Uncertainty, Fan Charts
    Date: 2016–09–06
  14. By: Sienknecht, Sebastian
    Abstract: Indexation theories have become standard for inflation persistence in DSGE models (Smets and Wouters (2003, 2007)). However, these theories overlook an important stylized fact of U.S. business cycles: high fluctuations in the first difference of inflation. I find that this pattern can be captured by adjustment costs precisely from the first difference of inflation (Pesaran (1991) labels this difference as a "speed change"). I estimate four DSGE models differing in their rigidity assumption and find that a framework with inflation-based adjustment costs has the highest probability to fit U.S. data.
    Keywords: Phillips curve; Economic fluctuations; Estimation.
    JEL: C51 E31 E32
    Date: 2016–03–25
  15. By: Salvador Ortigueira (Department of Economics, University of Miami); Joana Pereira (Economics Department, New York University)
    Abstract: It is not uncommon that tax reform laws contain retroactive provisions. In this paper we are concerned with the fiscal and macroeconomic consequences of the constitutional ability of the government to retroactively revoke pre-announced income taxes. To this end, we study time-consistent optimal fiscal policy in a neoclassical economy where the government chooses the level of expenditure in a public good, debt issues and income taxation. When the government lacks commitment to these three fiscal variables, a complementarity between the decisions of the households and the government emerges, generating a multiplicity of expectations-driven equilibria. That is, fiscal policy is not uniquely pinned down by economic fundamentals, but it is determined by households' expectations about current and future policies. Accordingly, economies with identical fundamentals may display significantly different fiscal policies, consumption and investment.
    Keywords: Retroactive Taxation; Expectation traps; Equilibrium Multiplicity Publication Status: Under Review
    JEL: E21 H24 H31 J12
    Date: 2016–09–13
  16. By: Paula Lourdes Hernández Verme (Universidad de Guanajuato); Mónica Karina Rosales Pérez (Universidad de Guanajuato)
    Abstract: There was nothing in the fundamentals of the Mexican economy that would suggest at the moment the beginning of a crisis of such magnitude. The 1994 crisis was extremely unexpected for households and domestic and foreign firms, because there were good economic indicators so far, together with the financial stability of the previous years. The Mexico of 1994 had a de jure fixed exchange rate regime, but in practice, it was an intermediate peg, not a serious hard peg. Our goal is to try to find out whether things would have been different if there would have been instead either a floating exchange rate regime or a hard peg in Mexico at the time of the crisis of 1994. In our aim at trying to answer this question, we set up a Dynamic Stochastic General Equilibrium Model (DSGE) that shared the main stylized characteristics of the Mexican economy of that time. We considered a pure exchange, monetary, small open economy with a DSGE framework in discrete time that obtains from micro-foundations.
    Keywords: exchange rate regimes, sudden stops of international capital, bank panics, dynamic stochastic general equilibrium, monetary policy, small open economy
    JEL: E13 E52 E58 F33 G21
    Date: 2016–09
  17. By: Eva Garcia-Moran (University of Wuerzburg); Zoe Kuehn (Universidad Autonoma de Madrid)
    Abstract: Online appendix for the Review of Economic Dynamics article
    Date: 2016
  18. By: Ariel Zetlin-Jones (Carnegie Mellon University); Gaetano Gaballo (Banque de France)
    Abstract: We show that an increase in banks’ holdings of domestic sovereign debt decreases the ability of domestic Sovereigns to successfully enact bailouts. When Sovereigns finance bailouts with newly issued debt and the price of sovereign debt is sensitive to unanticipated debt issues, then bailouts dilute the value of banks’ sovereign debt holdings rendering bailouts less effective. We explore this feedback mechanism in a model of financial intermediation in which banks are subject to managerial moral hazard and ex ante optimality requires lenders to commit to ex post inefficient bank liquidations. A benevolent Sovereign may desire to enact bailouts to prevent such liquidations thereby neutralizing lenders’ commitment. In this context, home bias for sovereign debt may arise as a mechanism to deter bailouts and restore lenders’ commitment.
    Date: 2016
  19. By: Stefano BOSI (EPEE (University of Evry)); Cuong LE VAN (IPAG, CNRS, and Paris School of Economics); Ngoc-Sang PHAM (LEM (University of Lille 3) and EPEE (University of Evry))
    Abstract: We consider a multi-sector infinite-horizon general equilibrium model. Asset supply is endogenous. The issues of equilibrium existence, efficiency, and bubble emergence are addressed. We show how different assets give rise to very different rational bubbles. We also point out that efficient bubbly equilibria may exist.
    Keywords: infinite-horizon, general equilibrium, aggregate good bubble, capital good bubble, efficiency
    JEL: D31 D91 E22 G10
    Date: 2016
  20. By: O. de Bandt; M. Chahad
    Abstract: The paper assesses the overall consistency and impact on both the financial sector and the real economy, of the numerous banking regulations that have been introduced in the aftermath of the Great Financial Crisis. For this purpose, we develop, within a multi-period asset framework, a large scale DSGE model with a real and a financial sector. Universal banks grant credit but invest also in corporate and sovereign bonds. Small companies are financed through bank loans only, while large corporate can also issue bonds. The main findings of the paper are that: (i) the implementation of liquidity regulation which affects private consumption dynamics has a less persistent effect than solvency regulation that affects loan distribution as well as investment; (ii) the model assesses to what extent the Liquidity Coverage Ratio may induce banks to substitute sovereign bonds to business loans; (iii) liquidity and solvency regulations appear to be complementary; (iv) while the implementation of the LCR has qualitatively similar results as the NSFR, even if, quantitatively, the latter has a more mMarrakech_14oderate effect.
    Keywords: Basel III, Solvency ratio, Liquidity ratios, Multi-period assets, Firms' heterogeneity.
    JEL: D58 E3 E44 G21
    Date: 2016

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