nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2016‒11‒13
thirteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Would DSGE Models have predicted the Great Recession in Austria? By Fritz Breuss
  2. LOLA 3.0: Luxembourg OverLapping generation model for policy Analysis By Luca Marchiori; Olivier Pierrard
  3. Deflation probability and the scope for monetary loosening in the United Kingdom By Haberis, Alex; Masolo, Riccardo; Reinold, Kate
  4. International Reserves and Rollover Risk By Bianchi, Javier; Hatchondo, Juan Carlos; Martinez, Leonardo
  5. Confidence Cycles and Liquidity Hoarding By Volha Audzei
  6. Training and Search on the Job By Lentz, Rasmus; Roys, Nicolas
  7. The Power of Unconventional Monetary Policy in a Liquidity Trap By Masayuki Inui; Sohei Kaihatsu
  8. Public Debt as Private Liquidity: Optimal Policy By George-Marios Angeletos; Fabrice Collard; Harris Dellas
  9. Innovation and Growth with Frictions By Wright, Randall
  10. Online Appendix to "Consumption Risk Sharing with Private Information and Limited Enforcement" By Tobias Broer; Marek Kapicka; Paul Klein
  11. Myopic misery: Maternal depression, child investments, and the neurobiological poverty trap By Strulik, Holger
  12. Optimal Inflation to Reduce Inequality By Lorenzo, Menna; Patrizio, Tirelli;
  13. Non-standard monetary policy, asset prices and macroprudential policy in a monetary union By Lorenzo Burlon; Andrea Gerali; Alessandro Notarpietro; Massimiliano Pisani

  1. By: Fritz Breuss (WIFO)
    Abstract: DSGE (Dynamic stochastic general equilibrium) models are the common workhorse of modern macroeconomic theory. Whereas story-telling and policy analysis were in the forefront of applications since its inception, the forecasting perspective of DSGE models is only recently topical. In this study, we perform a post-mortem analysis of the predictive power of DSGE models in the case of Austria's recession in 2009. For this purpose, 8 DSGE models with different characteristics (small and large models, closed and open economy models, one and two-country models) were used. The initial hypothesis was that DSGE models are inferior in ex-ante forecasting a crisis. Surprisingly however, it turned out that not all but those models which implemented features of the causes of the global financial crisis (like financial frictions or interbank credit flows) could not only detect the turning point of the Austrian business cycle early in 2008 but they also succeeded in forecasting the following severe recession in 2009. In comparison, non-DSGE methods like the ex-ante forecast with the Global Economic (Macro) Model of Oxford Economics and WIFO's expert forecasts performed not better than DSGE models in the crisis.
    Keywords: DSGE models, business cycles, forecasting, open-economy macroeconomics
    Date: 2016–11–08
  2. By: Luca Marchiori; Olivier Pierrard
    Abstract: LOLA 2.0 is a dynamic general equilibrium model for the Luxembourg economy, which features overlapping generation dynamics, labormarket frictions à la Diamond-Mortensen-Pissarides and a New Open Economy Macroeconomics structure. This paper presents the model LOLA 3.0, which essentially integrates a financial sector to LOLA 2.0. In contrast to the existing dynamic stochastic general equilibrium (DSGE) literature, the financial sector does not intermediate between resident households and resident firms, but exports wealth management services. We calibrate the model to match the size of the financial sector in terms of employment, value added, net exports and taxes. The 2008 financial crisis has affected Luxembourg's financial sector and slowed inflows of cross-border workers. Because there is a lot of uncertainty surrounding future growth of the Luxembourg financial sector and cross-border worker inflows, we use LOLA 3.0 to study the evolution of the Luxembourg economy between 2015 and 2060 under alternative scenarios (high - medium - low).
    Keywords: Overlapping generations, Long-run projections, Financial sector, Luxembourg.
    JEL: D91 E24 E62 F41 J11
    Date: 2015–11
  3. By: Haberis, Alex (Bank of England); Masolo, Riccardo (Bank of England); Reinold, Kate (Bank of England)
    Abstract: In this paper, we use an estimated DSGE model of the UK economy to investigate perceptions of the effectiveness of monetary policy since the onset of the 2007–08 financial crisis in a number of measures of deflation probability — the Survey of Economic Forecasts, financial-market option prices, and the Bank of England's Monetary Policy Committee’s (MPC) forecasts. To do so, we use stochastic simulations of the model to generate measures of deflation probability in which the effectiveness of monetary policy to offset deflationary shocks is affected by different assumptions about the existence and level of a lower bound on policy rates. We find that measures of deflation probability are consistent with the perception that the MPC was not particularly constrained in its ability to offset deflation shocks in the post-crisis period.
    Keywords: Deflation; forecasting and simulation; models and applications; interest rates; monetary policy
    JEL: E31 E37 E43 E47 E52
    Date: 2016–11–04
  4. By: Bianchi, Javier (Federal Reserve Bank of Minneapolis); Hatchondo, Juan Carlos (Indiana University); Martinez, Leonardo (International Monetary Fund)
    Abstract: We study the optimal accumulation of international reserves in a quantitative model of sovereign default with long-term debt and a risk-free asset. Keeping higher levels of reserves provides a hedge against rollover risk, but this is costly because using reserves to pay down debt allows the government to reduce sovereign spreads. Our model, parameterized to mimic salient features of a typical emerging economy, can account for a significant fraction of the holdings of international reserves, and the larger accumulation of both debt and reserves in periods of low spreads and high income. We also show that income windfalls, improved policy frameworks, larger contingent liabilities, and an increase in the importance of rollover risk imply increases in the optimal holdings of reserves that are consistent with the upward trend in reserves in emerging economies. It is essential for our results that debt maturity exceeds one period.
    Keywords: Sovereign default; international reserves; rollover risk; safe assets
    JEL: F32 F34 F41
    Date: 2016–11–03
  5. By: Volha Audzei
    Abstract: Market confidence has proved to be an important factor during past crises. However, many existing general equilibrium models do not account for agents' expectations, market volatility, or overly pessimistic investor forecasts. In this paper, we incorporate a model of the interbank market into a DSGE model, with the interbank market rate and the volume of lending depending on market confidence and the perception of counterparty risk. In our model, a credit crunch occurs if the perception of counterparty risk increases. Our results suggest that changes in market confidence can generate credit crunches and contribute to the depth of recessions. We then conduct an exercise to mimic some central bank policies: targeted and untargeted liquidity provision, and reduction of the policy rate. Our results indicate that policy actions have a limited effect on the supply of credit if they fail to influence agents' expectations. Interestingly, a policy of a low policy rate worsens recessions due to its negative impact on banks' revenues. Liquidity provision stimulates credit slightly, but its efficiency is undermined by liquidity hoarding.
    Keywords: DSGE, expectations, financial intermediation, liquidity provision
    JEL: E22 E32 G01 G18
    Date: 2016–10
  6. By: Lentz, Rasmus (University of Wisconsin-Madison; NBER; LMDG; CAP); Roys, Nicolas (Federal Reserve Bank of St. Louis)
    Abstract: The paper studies human capital accumulation over workers’ careers in an on the job search setting with heterogenous firms. In renegotiation proof employment con- tracts, more productive firms provide more training. Both general and specific training induce higher wages within jobs, and with future employers, even conditional on the future employer type. Because matches do not internalize the specific capital loss from employer changes, specific human capital can be over-accumulated, more so in low type firms. While validating the Acemoglu and Pischke (1999) mechanisms, the analysis nevertheless arrives at the opposite conclusion: That increased labor market friction reduces training in equilibrium.
    Keywords: Wage contracts; human capital; training; wage dispersion; frictional labor markets; optimal contract design; firm heterogeneity; sorting
    JEL: D21 D43 D83 E24 J24 J31 J33 J41 J62 J63 J64
    Date: 2015–10–30
  7. By: Masayuki Inui (Bank of Japan); Sohei Kaihatsu (Bank of Japan)
    Abstract: In this study, we examine what unconventional monetary policy measures are effective in escaping from a liquidity trap. We develop a heterogeneous agent New Keynesian model with uninsurable income uncertainty and a borrowing constraint. We show that adverse effects of income uncertainty deteriorate in the liquidity trap, which crucially undermines the transmission mechanism of unconventional monetary policy through an increase in precautionary savings. We then draw the following implications: (1) decreasing risk premiums by quantitative easing (QE) is more effective than forward guidance (FG) in the liquidity trap; (2) when the liquidity trap becomes deeper, central banks should conduct QE with sufficiently rapid pace of asset purchases; and (3) the combination of QE and FG yields synergy effects that strengthen the power to escape from the liquidity trap through mitigating precautionary saving motives.
    Keywords: unconventional monetary policy; liquidity trap; uninsurable income uncertainty; incomplete market; quantitative easing; forward guidance
    JEL: E21 E31 E52 E58
    Date: 2016–11–11
  8. By: George-Marios Angeletos; Fabrice Collard; Harris Dellas
    Abstract: We study the Ramsey policy problem in an economy in which public debt contributes to the supply of assets that private agents can use as buffer stock and collateral, or as a vehicle of liquidity. Issuing more debt eases the underlying financial friction. This raises welfare by improving the allocation of resources; but it also tightens the government budget by raising the interest rate on public debt. In contrast to the literature on the Friedman rule, the government’s supply of liquidity becomes intertwined with its debt policy. In contrast to the standard Ramsey paradigm, a departure from tax smoothing becomes desirable. Novel insights emerge about the optimal long-run quantity of public debt; the optimal policy response to shocks; and the sense in which a financial crisis presents the government with an opportunity for cheap borrowing.
    JEL: D52 D53 E13 E32 E51 E60 H21 H63
    Date: 2016–11
  9. By: Wright, Randall (Federal Reserve Bank of Minneapolis)
    Abstract: The generation and implementation of new ideas are major factors in economic performance and growth. If some people are better at research and others at development, there emerges a role for an “idea market,” where technology transfers reallocate knowledge to those best able to develop and apply it. Financial institutions can facilitate this reallocation by providing credit for these transfers. {{p}} However, the idea market is rife with frictions. These include so-called search-and-bargaining problems. Another obstacle is credit friction: If a debtor reneges, it is not always easy to repossess information or otherwise prevent its use. {{p}} These obstacles lead to several monetary policy implications. First, policymakers should strive for low inflation, since that encourages investment in liquidity, which is crucial for exchanging ideas when credit is imperfect. Second, policymakers should encourage financial intermediation, since that facilitates efficient reallocation of liquidity. Fiscal policy has a role, too, but in terms of lessons for central bank policy, sound money and sound banking are engines of economic growth.
    Date: 2016–11–01
  10. By: Tobias Broer (Stockholm University); Marek Kapicka (CERGE-EI); Paul Klein (Simon Fraser University)
    Abstract: Online appendix for the Review of Economic Dynamics article
    Date: 2016
  11. By: Strulik, Holger
    Abstract: In this paper, I explore in an overlapping generations framework, a mechanism motivating a neurobiological poverty trap. Poverty causes stress and depression in individuals susceptible to depression. Poor and depressed individuals discount the future at a higher rate and invest less in the human capital of their children than mentally healthy or rich individuals. This gene-environment interaction generates a vicious cycle in which poor individuals inherit not only susceptibility to depression but also stress and poverty. I show that a successful one-time intervention has the power to permanently eliminate the neurobiological poverty trap.
    Keywords: child investment,development,depression,discounting,intergenerational transmission,gene-environment interaction
    JEL: O12 O15 D10 D91 I15 I25 I30
    Date: 2016
  12. By: Lorenzo, Menna; Patrizio, Tirelli;
    Abstract: A popular argument in favour of price stability is that the inflation-tax burden would disproportionately fall on the poor because wealth is unevenly distributed and portfolio composition of poorer households is skewed towards a larger share of money holdings. We reconsider the issue in a DSGE model characterized by limited participation to the market for interest bearing assets (LAMP). We show that a combination of higher in ation and lower income taxes reduces inequality. When we calibrate the share of constrained agents to fit the wealth Gini index for the US, the optimal inflation rate is above 4%. This result is robust to alternative foundations of money demand equations.
    Keywords: in ation, monetary and fiscal policy, Ramsey plan, inequality
    JEL: E52 E58 J51 E24
    Date: 2016–11–01
  13. By: Lorenzo Burlon (Bank of Italy); Andrea Gerali (Bank of Italy); Alessandro Notarpietro (Bank of Italy); Massimiliano Pisani (Bank of Italy)
    Abstract: This paper evaluates the macroeconomic and financial effects of the Eurosystem’s Asset Purchase Programme (APP) and its interaction with a member country’s macroprudential policy. We assume that some households in a euro-area (EA) country are subject to a borrowing constraint, and that their local real estate acts as the collateral. In order to highlight the interaction between the APP and region-specific macroprudential policies, we simulate a situation in which, as the APP is carried out, households in one EA region develop overly optimistic expectations about local real estate prices. We report four main findings. First, a relatively large loan-to-value (LTV) ratio in one region can greatly amplify the expansionary effect of the union-wide non-standard monetary policy measures on domestic households’ borrowing. Second, while the APP is being implemented, an increase in households’ borrowing in one region can be further magnified by the combination of a high LTV ratio and overly optimistic expectations. Third, region-specific macroprudential measures can stabilize private sector borrowing with limited negative effects on economic activity. Fourth, our results hold also in the case of area-wide overly optimistic expectations.
    Keywords: DSGE models, open-economy macroeconomics, non-standard monetary policy, zero lower bound, macroprudential policy
    JEL: E43 E52 E58
    Date: 2016–10

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