nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2017‒02‒26
twenty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Labor Market Institutions and the Cost of Recessions By Krebs, Tom; Scheffel, Martin
  2. Optimal Policy Analysis in a New Keynesian Economy with Credit Market Search By Junichi Fujimoto; Ko Munakata; Koji Nakamura; Yuki Teranishi
  3. Tight Money-Tight Credit: Coordination Failure in the Conduct of Monetary and Financial Policies By Julio A. Carrillo; Enrique G. Mendoza; Victoria Nuguer; Jessica Roldán-Peña
  4. Monetary Policy and Financial Frictions in a Small Open-Economy Model for Uganda By Francis Leni Anguyo; Rangan Gupta; Kevin Kotze
  5. Financial Intermediation, Resource Allocation, and Macroeconomic Interdependence By G. Kemal Ozhan
  6. Wage Risk, Employment Risk and the Rise in Wage Inequality By Mecikovsky, Ariel; Wellschmied, Felix
  7. Reforming the Social Security Earnings Cap: The Role of Endogenous Human Capital By Adam Blandin
  8. Can a Marginally Distorted Labor Market Improve Capital Accumulation, Output and Welfare? By Sjögren, Tomas
  9. Secular Stagnation? Growth, Asset Returns and Welfare in the Next Decades By Ludwig, Alexander; Geppert, Christian; Abiry, Raphael
  10. Learning by Doing and Ben-Porath: Life-cycle Predictions and Policy Implications By Adam Blandin
  11. Austerity in the Aftermath of the Great Recession By Christopher L. House; Christian Proebsting; Linda L. Tesar
  12. Monetary Policy, Bounded Rationality, and Incomplete Markets By Emmanuel Farhi; Ivan Werning
  13. Aiyagari Meets Ramsey: Optimal Capital Taxation with Incomplete Markets By Chen, Yunmin; Chien, YiLi; Yang, C.C.
  14. Optimal Monetary and Macroprudential Policy in a Currency Union By Schwanebeck, Benjamin; Palek, Jakob
  15. Wage Posting as a Positive Selection Device: Theory and Empirical Evidence By Gartner, Hermann; Holzner, Christian
  16. Das House-Kapital: A Theory of Wealth-to-Income Ratios By Steger, Thomas Michael; Grossmann, Volker
  17. Redistributive Innovation Policy, Inequality and Efficiency By Parantap Basu; Yoseph Getachew
  18. 'Unemployment, Growth and Welfare Effects of Labor Market Reforms' By Pierre-Richard Agénor; King Yoong Lim
  19. Commodity Spot, Forward, and Futures Prices with a Firm's Optimal Strategy By NAKAJIMA Katsushi
  20. The Hartz Reforms, the German Miracle, and the Reallocation Puzzle By Bauer, Anja; King, Ian Paul

  1. By: Krebs, Tom (University of Mannheim); Scheffel, Martin (University of Cologne)
    Abstract: This paper studies the effect of two labor market institutions, unemployment insurance (UI) and job search assistance (JSA), on the output cost and welfare cost of recessions. The paper develops a tractable incomplete-market model with search unemployment, skill depreciation during unemployment, and idiosyncratic as well as aggregate labor market risk. The theoretical analysis shows that an increase in JSA and a reduction in UI reduce the output cost of recessions by making the labor market more fluid along the job finding margin and thus making the economy more resilient to macroeconomic shocks. In contrast, the effect of JSA and UI on the welfare cost of recessions is in general ambiguous. The paper also provides a quantitative application to the German labor market reforms of 2003- 2005, the so-called Hartz reforms, which improved JSA (Hartz III reform) and reduced UI (Hartz IV reform). According to the baseline calibration, the two labor market reforms led to a substantial reduction in the output cost of recessions and a more moderate reduction in the welfare cost of recessions in Germany.
    Keywords: labor market institutions, cost of recessions, german labor market reform
    JEL: E21 E24 D52 J24
    Date: 2016–12
  2. By: Junichi Fujimoto (National Graduate Institute for Policy Studies); Ko Munakata (Bank of Japan); Koji Nakamura (Bank of Japan); Yuki Teranishi (Keio University)
    Abstract: To reveal a policy mandate for financial stability, we introduce a frictional credit market with a search and matching process into a standard New Keynesian model with nominal rigidities in the goods market, and then investigate optimal policy under financial frictions. We show that a second-order approximation of social wel- fare includes terms for credit, in addition to terms for inflation and consumption, so that any optimal policy must hold responsibility for financial and price stabilities. We highlight this issue by considering several tools for monetary and macropru- dential policy. We find that optimal monetary policy requires keeping the credit market countercyclical against the real economy. Also, optimal macroprudential policy, which poses constraints on supply and demand sides of credit, reduces ex- cessive variations in lending and contributes to both financial and price stabilities.
    Date: 2017–02
  3. By: Julio A. Carrillo; Enrique G. Mendoza; Victoria Nuguer; Jessica Roldán-Peña
    Abstract: Quantitative analysis of a New Keynesian model with the Bernanke-Gertler accelerator and risk shocks shows that violations of Tinbergen’s Rule and strategic interaction between policymaking authorities undermine significantly the effectiveness of monetary and financial policies. Separate monetary and financial policy rules, with the latter subsidizing lenders to encourage lending when credit spreads rise, produce higher welfare and smoother business cycles than a monetary rule augmented with credit spreads. The latter yields a tight money-tight credit regime in which the interest rate responds too much to inflation and not enough to adverse credit conditions. Reaction curves for the choice of policy-rule elasticity that minimizes each authority’s loss function given the other authority’s elasticity are nonlinear, reflecting shifts from strategic substitutes to complements in setting policy-rule parameters. The Nash equilibrium is significantly inferior to the Cooperative equilibrium, both are inferior to a first-best outcome that maximizes welfare, and both produce tight money-tight credit regimes.
    JEL: E3 E44 E52 G18
    Date: 2017–02
  4. By: Francis Leni Anguyo (School of Economics, University of Cape Town); Rangan Gupta (Department of Economics, University of Pretoria); Kevin Kotze (School of Economics, University of Cape Town)
    Abstract: This paper considers the role of financial frictions and the conduct of monetary policy in Uganda. It makes use of a dynamic stochastic general equilibrium model, which incorporates small open-economy features and financial frictions that are introduced though the activities of heterogeneous agents in the household. Most of the parameters in the model are estimated with the aid of Bayesian techniques and quarterly macroeconomic data from 2000q1 to 2015q4. The results suggest that the central bank currently responds to changes in the interest rate spread, despite the fact that capital and financial markets are relatively inefficient in this low income country. In addition, the analysis also suggests that to reduce macroeconomic volatility the central bank should continue to respond to these financial sector frictions and that it may be possible to derive a more favourable sacrifice ratio by making use of a slightly more aggressive response to macroeconomic developments.
    Date: 2017
  5. By: G. Kemal Ozhan (University of St Andrews)
    Abstract: This paper studies the role of the financial sector in affecting domestic resource allocation and cross-border capital flows. I develop a quantitative, two-country, macroeconomic model in which banks face endogenous and occasionally binding leverage constraints. Banks lend funds to be invested in tradable or non-tradable sector capital and there is international financial integration in the market for bank liabilities. I focus on news about economic fundamentals as the key source of fluctuations. Specifically, in the case of positive news on the valuation of non-traded sector capital that turn out to be incorrect at a later date, the model generates an asymmetric, belief-driven boom-bust cycle that reproduces key features of the recent Eurozone crisis. Bank balance sheets amplify and propagate fluctuations through three channels when leverage constraints bind: First, amplified wealth effects induce jumps in import-demand (demand channel). Second, changes in the value of non-tradable sector assets alter bank lending to tradable sector firms (intra-national spillover channel). Third, domestic and foreign households re-adjust their savings in domestic banks, and capital flows further amplify fluctuations (international spillover channel). A common central bank’s unconventional policies of private asset purchases and liquidity facilities in response to unfulfilled expectations are successful at ameliorating the economic downturn.
    Keywords: Bank Lending, Belief-Driven Dynamics, Current Account, Macroeconomic Interdependence
    JEL: E44 F32 F41 G15 G21
    Date: 2017–02–17
  6. By: Mecikovsky, Ariel (University of Bonn); Wellschmied, Felix (Universidad Carlos III de Madrid)
    Abstract: We estimate the changes in US male labor market risk over the last three decades in a model of endogenous labor supply and job mobility. Across education groups permanent shocks to productivity have become more dispersed. Moreover, heterogeneity in pay across offered jobs has increased for workers with at least some college education. Simulating these changes in a life-cycle model with search frictions, we show that the estimated changes in risk can account for 85 percent of the increase in within group wage inequality. The welfare costs of rising risk are small.
    Keywords: wage risk, secular trends, insurance
    JEL: D91 J11 J22 J31 J64
    Date: 2016–12
  7. By: Adam Blandin (Department of Economics, Virginia Commonwealth University)
    Abstract: Old age Social Security benefits in the US are funded by a 10.6% payroll tax up to a cap, currently set at $118,500. Despite calls from policy circles to eliminate the cap on taxable earnings, there has been little work examining the likely outcomes of such a policy change. I use a life-cycle human capital model with heterogeneous individuals to investigate the aggregate and distributional steady state impacts of several policy changes to the earnings cap. I find: (1) Eliminating the earnings cap generates large reductions in aggregate output and consumption, between 2.1- 3.1%. (2) The role of endogenous human capital is first order: when I do not allow the life-cycle human capital profiles of workers to adjust across policy regimes, the change in economic aggregates is roughly cut in half. (3) While eliminating the earnings cap increases revenues from the payroll tax by 12%, the decline in output lowers tax revenues from other sources, so that total federal tax revenues never increase by more than 1.2%. (4) Eliminating the earnings cap produces modest welfare gains for about 2/3 of workers, while about 1/3 of workers experience welfare losses, which are typically large. (5) Lowering the earnings cap to a level near the mean of earnings increases aggregate output by 1.3%, and also increases welfare for the vast majority of workers.
  8. By: Sjögren, Tomas (Department of Economics, Umeå University)
    Abstract: This paper sets up an intertemporal two-sector general equilibrium model where capital and labor are complements in production and where the labor market initially functions as a competitive spot market in both sectors of the economy. The purpose is to analyze how the introduction of a marginal distortion on the labor market in one sector of the economy (here represented by the formation of a trade with a bargaining power marginally above zero) affects factor prices, the allocation of per-worker capital between the unionized and non-unionized sectors of the economy, aggregate saving, capital accumulation, output and welfare. It is shown that if the output elasticity w.r.t. capital is larger (smaller) in the unionized sector than in the non-unionized sector of the economy, then the formation of a weak trade union leads to a reallocation of capital and labor in such proportions that the per-worker capital stock increases (decreases) in the non-unionized part of the economy. This leads to a higher (lower) non-union wage, a reduced (increased) interest rate and an increase (decrease) in aggregate saving. The savings effect implies that the steady-state capital stock and the steady-state aggregate output both increase (decrease). It is also shown that if the output elasticity w.r.t. capital is larger (smaller) in the unionized sector than in the non-unionized sector of the economy, and if the steady-state capital stock initially exceeds the Golden Rule capital stock, then the formation of a weak trade union has a negative (positive) effect on the steady-state welfare.
    Keywords: Capital accumulation; trade unions; wage determination; employment
    JEL: E22 E24 J51
    Date: 2017–02–16
  9. By: Ludwig, Alexander; Geppert, Christian; Abiry, Raphael
    Abstract: Ongoing demographic change will lead to a relative scarcity of raw labor to the effect that output growth will be decreasing in the next decades, a secular stagnation. As physical capital will be relatively abundant, this decrease of output will be accompanied by reductions of asset returns. We quantify these effects for the US economy by developing an overlapping generations model in which we explicitly model risky and risk-free asset returns. This enables us to predict how the natural interest rate is affected by the demography induced secular stagnation. Without adjustments of human capital, risky returns decrease until 2035 by about 0.7 percentage point, and the risk-free rate by about one percentage point, leading to severe welfare losses for asset rich households. Endogenous human capital adjustments strongly mitigate these effects. We conclude that human capital policies will be crucial in the context of labor shortages.
    JEL: E17 C68 G12
    Date: 2016
  10. By: Adam Blandin (Department of Economics, Virginia Commonwealth University)
    Abstract: Many government policies affect incentives to acquire human cap- ital. Two workhorse models dominate the literature analyzing these policies: Learning by Doing (LBD) and Ben-Porath (BP). This paper makes two novel findings related to these models. First, LBD and BP generate different life-cycle predictions. Second, the model features that generate different life-cycle predictions between models also generate different policy implications. Specifically, increasing marginal labor tax rates for top earners depresses human capital accumulation more under BP. As a result, the Laffer curve for top marginal income tax rates is flatter, and peaks 10 percentage points lower, with BP versus LBD.
    Keywords: Life-cycle, Human capital, Progressive taxes
    JEL: E2 D91 H2 J24
    Date: 2016–10
  11. By: Christopher L. House; Christian Proebsting; Linda L. Tesar
    Abstract: We examine austerity in advanced economies since the Great Recession. Austerity shocks are reductions in government purchases that exceed reduced-form forecasts. Austerity shocks are statistically associated with lower real GDP, lower inflation and higher net exports. We estimate a cross-sectional multiplier of roughly 2. A multi-country DSGE model calibrated to 29 advanced economies generates a multiplier consistent with the data. Counterfactuals suggest that eliminating austerity would have substantially reduced output losses in Europe. Austerity shocks were sufficiently contractionary that debt-to-GDP ratios in some European countries increased as a consequence of endogenous reductions in GDP and tax revenue.
    JEL: E00 E62 F41 F44 F45
    Date: 2017–02
  12. By: Emmanuel Farhi; Ivan Werning
    Abstract: This paper extends the benchmark New-Keynesian model with a representative agent and rational expectations by introducing two key frictions: (1) incomplete markets with uninsurable idiosyncratic risk and occasionally-binding borrowing constraints; and (2) bounded rationality in the form of level- k thinking. Compared to the benchmark model, we show that the interaction of these two frictions leads to a powerful mitigation of the effects of monetary policy, which is much more pronounced at long horizons. This offers a potential rationalization of the ?forward guidance puzzle?. Each of these frictions, in isolation, would lead to no or much smaller departures from the benchmark model. We conclude that the interaction of bounded rationality and is important.
    Date: 2017–01
  13. By: Chen, Yunmin (Institute of Economics, Academia Sinica); Chien, YiLi (Federal Reserve Bank of St. Louis); Yang, C.C. (Institute of Economics, Academia Sinica)
    Abstract: What is the prescription of Ramsey capital taxes for Aiyagari’s (1994) incomplete-markets economy in steady state? Departing from the endogenous setting in Aiyagari (1995), this paper answers the question by assuming an exogenous stream of government purchases as in the canonical Ramsey problem. The departure makes the planner’s Euler equation involve the whole distribution of agents’ consumption, which is absent in Aiyagari (1995). Imposing the “measurability condition” to account for the incompleteness of markets, we are able to apply the primal approach to analytically solving for the Ramsey problem of the Aiyagari (1994) economy. It is shown that capital should be taxed in steady state to implement the modified golden rule; though this result may not hold for economies with other frictions. We also address transitional dynamics, showing that capital should be taxed all the time during transition if the elasticity of intertemporal substitution is not elastic.
    Keywords: Capital taxation; Ramsey problem; Heterogeneous Agents; Incomplete markets
    JEL: C61 E22 E62 H21 H30
    Date: 2017–02–13
  14. By: Schwanebeck, Benjamin; Palek, Jakob
    Abstract: The financial crisis proved strikingly that stabilizing the price level is a necessary but not a sufficient condition to ensure macroeconomic stability. The obvious candidate for addressing systemic risk is macroprudential policy. In this paper we study the optimal (Ramsey) monetary and macroprudential policy mix in a currency union in the case of different kinds of aggregate and idiosyncratic shocks. The monetary and macroprudential instruments are modelled as independent tools. With a union-wide macroprudential tool, full absorption on the aggregate level is possible, but welfare losses due to fluctuations in relative variables prevail. With country-specific macroprudential tools, full absorption of shocks is always possible. But it is only optimal as long as there is no difference in the financing of production factors. Evaluating the performance of different policy regimes shows that the additional welfare gain from having country-specific macroprudential tools vanishes as the ability of the central bank to commit decreases.
    JEL: E58 E32 E44
    Date: 2016
  15. By: Gartner, Hermann; Holzner, Christian
    Abstract: We use the German Job Vacancy Survey to investigate whether firms are able to attract more suitable applicants by offering bargain wages rather than posting fixed wages. Contrary to the theoretical predictions provided by the literature, we find that the offer to bargain over pay decreases the share of suitable applicants. To explain these findings we develop a directed search model with asymmetric information about workers' types and incomplete contracts, which allows firms to condition their hiring decision on the match quality revealed at the job interview. We show that wage-posting and wage-bargaining firms coexist if pooling workers with different expected match quality is too costly for wage-posting firms and if the bargaining power is not too far away from satisfying the Hosios condition. In such an equilibrium wage-posting firms hire only workers with a high match quality and wage-bargaining firms hire workers with a high and a medium match quality.
    JEL: J63 M51 J64
    Date: 2016
  16. By: Steger, Thomas Michael; Grossmann, Volker
    Abstract: This paper presents a novel dynamic general equilibrium model to examine the evolution of two major wealth-to-income ratios - housing wealth and non-residential wealth - in advanced countries since WWII. Our theory rests on three premises: (1) the overall land endowment is fixed; (2) the production of new houses requires land as an essential input; (3) land employed for real estate development must be permanently withdrawn from alternative uses. The model distinguishes, for the first time, between the extensive and the intensive margin of housing production. The calibrated model replicates the post WWII increase in the two major wealth-to-income ratios. It also suggests a moderate further increase in wealth-to-income ratios that is associated with a considerable future surge in land prices and house prices. Higher population density and technological progress do, however, not affect long run wealth-to-income ratios. The model also accounts for the close connection of house prices to land prices in the data.
    JEL: E10 E20 O40
    Date: 2016
  17. By: Parantap Basu (Durham University, Durham University Business School); Yoseph Getachew (Department of Economics, University of Pretoria, 0028, Pretoria, South Africa)
    Abstract: Using a heterogenous-agent growth model with in-house R&D and incomplete capital markets, we examine the efficiency and distributional e¤ects of alternative public R&D policies that target high-tech and low-tech sectors. We nd that such policies have important implication for efficiency, inequality and social mobility. A regressive public R&D investment nanced by income tax could boost growth and welfare via a positive e¤ect on individual savings and e¤ort. However, it could also discourage them via its effect on the efficiency inequality trade off. The relationship between public R&D spending and welfare is therefore hump shaped admitting an optimal degree of regressivity in public R&D spending. A case for optimal progressive public R&D investment, however, can be made with a properly designed R&D policy that combines consumption tax and investment subsidy policies.
    Date: 2017–02
  18. By: Pierre-Richard Agénor; King Yoong Lim
    Abstract: The effects of labor market reforms are studied in an innovation-driven model of endogenous growth with a heterogeneous labor force, labor market rigidities, and structural unemployment. The model is calibrated for "typical" high- and middle-income economies and used to perform a range of experiments, including both individual labor market reforms (cuts in the minimum wage and unemployment benefit rates) and composite reform programs involving additional measures. The results show that individual reforms may generate conflicting effects on growth and welfare in the long run, even in the presence of positive policy externalities. A reduction in training costs may also create an oversupply of qualified labor and higher unemployment in the long run. The effectiveness of labor market reforms, in terms of promoting growth and employment, is enhanced when they are accompanied by productivity-enhancing policies. Public investment in infrastructure, partly through its effects on innovation, can help to mitigate the trade-offs between growth and welfare associated with these reforms.
    Date: 2016
  19. By: NAKAJIMA Katsushi
    Abstract: This paper studies commodity spot, forward, and futures prices under a continuous-time setting. The model is an enhanced version of Nakajima (2015) which was modeled through discrete time. Our model considers a firm, which uses an input commodity to produce an output commodity, stores the commodity, and trades forwards or futures commodities to hedge. Through the Hamilton-Jacobi-Bellman equation and Feynman-Kac formula, we derive relations between spot, forward, and futures prices. The convenience yield can be interpreted as shadow price of storage, short selling constraints, and limits of risk. We compare our result with the existing models and conduct a numerical analysis. The optimal production plan and trading strategy for spot commodities and forwards are also derived. The model can be easily modified to consider cash settlement or hedging using output commodity forward contracts.
    Date: 2017–02
  20. By: Bauer, Anja; King, Ian Paul
    Abstract: We examine the proposition that the German Hartz reforms offset the GFC's effect on unemployment (leading to the "German miracle") and the GFC offset the Hartz reform's effects on reallocation, in Germany (leading to the "reallocation puzzle") over the period 2005-2010. To do so, we use a labor reallocation model based on Lucas and Prescott (1974), but with the additional features of unemployment benefits and rest unemployment. The model generates two simple conditions that must hold for two events to offset each other in this way. We estimate the key parameters of the model to assess the extent to whether these conditions were satisfied in Germany over that period. We find that the observed drop in productivity due to the GFC (6.3%) was very close to the drop required to explain the reallocation puzzle (6.8%). Conditional on this offset taking place, the observed percentage drop in unemployment benefits (16.7%) was approximately twice that required (6.3%) for the German miracle, and consistent with the significant drop in unemployment over the period.
    JEL: E24 J24 E65
    Date: 2016

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