nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2017‒11‒19
fourteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Financial Crises and the Role of Debt Maturity for Emerging Economies By Hewei Shen
  2. Labor Market Institutions and the Cost of Recessions By Tom Krebs; Martin Scheffel
  3. Dynamic scoring of tax reforms in the European Union By Barrios, Salvador; Dolls, Mathias; Maftei, Anamaria; Peichl, Andreas; Riscado, Sara; Varga, Janos; Wittneben, Christian
  4. Rebalancing in China: a taxation approach By Damien Cubizol
  5. Leverage and Risk Weighted Capital Requirements By Sudipto Karmakar; Leonardo Gambacorta
  6. Dynamic Principal–Agent Models By Philipp Renner; Karl Schmedders
  7. Financial Regulation in a Quantitative Model of the Modern Banking System By Begenau, Juliane; Landvoigt, Tim
  8. The Role of Inflation Target Adjustment in Stabilization Policy By EO, Yunjong; LIE, Denny
  9. Debunking the Myth of Southern Profligacy. A DSGE Analysis of Business Cycles in the EMU’s Big Four By Alice, Albonico; Roberta, Cardani; Patrizio, Tirelli
  10. Catch-up Cycle: A General Equilibrium Framework By Peilin, Liu; Shen, Jia; Xun, Zhang
  11. Financial Crises and Lending of Last Resort in Open Economies By Bocola, Luigi; Lorenzoni, Guido
  12. A Theory of Repurchase Agreements, Collateral Re-use, and Repo Intermediation By Piero Gottardi; Vincent Maurin; Cyril Monnet
  13. The Effects of Secondary Markets for Government Bonds on Inflation Dynamics By Dominguez, Begona; Gomis-Porqueras, Pedro
  14. Is Something Really Wrong with Macroeconomics? By Ricardo Reis

  1. By: Hewei Shen (Indiana University)
    Abstract: This paper studies the role of debt maturity for small open economies subject to endogenous financial crises. It uses an off-the-shelf two-sector DSGE model featuring collateral constraints and endogenous financial crises but allows the duration of the bond in the economy to vary. This model generates a trade-off between the borrowing cost and insurance benefit of a long-term bond. On one hand, it is more costly for small open economies to borrow through the long-term bond than the short-term bond. On the other hand, a long-term bond also provides an insurance benefit against aggregate shocks and the probability of financial crises declines monotonically in the duration of the bond. As a result, the quantitative analysis shows that the ex-ante welfare is maximized when the duration of the bond in the economy is seven quarters and this result sheds some light on why emerging market economies adopt controls on short-term capital flows.
    Keywords: Bond Duration, Credit Constraints, Financial Crises
    Date: 2016–06
  2. By: Tom Krebs; Martin Scheffel
    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
  3. By: Barrios, Salvador; Dolls, Mathias; Maftei, Anamaria; Peichl, Andreas; Riscado, Sara; Varga, Janos; Wittneben, Christian
    Abstract: In this paper, we present the first dynamic scoring exercise linking a multi†country microsimulation and DSGE models for all countries of the European Union. We illustrate our novel methodology analysing a hypothetical tax reform for Belgium. We then evaluate real tax reforms in Italy and Poland. Our approach takes into account the feedback effects resulting from adjustments in the labor market and the economy†wide reaction to the tax policy changes. Our results suggest that accounting for the behavioral reaction and macroeconomic feedback to tax policy changes enriches the tax reforms' analysis, by increasing the accuracy of the direct fiscal and distributional impact assessment provided by the microsimulation model for the tax reforms considered. Our results are in line with previous dynamic scoring exercises, showing that most tax reforms entail relatively smaller feedback effects in terms of the labor tax revenues for tax cuts benefiting workers, compared with the ones granted to firms.
    Date: 2017–10–30
  4. By: Damien Cubizol (Univ Lyon, CNRS, GATE L-SE UMR 5824, F-69130 Ecully, France)
    Abstract: The rebalancing of the Chinese economy is analyzed through a heterogeneous taxation of various types of firms. Based on a two-country dynamic general equilibrium model, the paper applies tax reforms to raise consumption, reduce some firms' overinvestment and maintain a high level of welfare. To rebalance consumption and investment, taxation may allow reallocating a part of the labor force to firms that are not overinvesting. Moreover, the correction of distortions in production factor costs (capital and labor) is necessary during certain reforms applied in the model; that is, on the one hand, higher credit costs for State-Owned Enterprises (SOEs) and, on the other hand, a catch-up of foreign firms' wages by domestic firms (public and private). In this model, firms' credit cost is a key channel because it impacts both firms' investment and household consumption (through returns on savings). These consumption and investment reforms bring welfare benefits to households, and the results are close to direct welfare maximization. In this framework, the rebalancing of the domestic demand does not require the readjustment of the external financial position because the aggregate savings rate remains high and the supply of domestic assets is reduced. Finally, another theoretical framework proposes a heterogeneous taxation of consumption across home and foreign goods to enhance consumption.
    Keywords: The Chinese economy, tax reforms, financial intermediation, consumption, investment, welfare, foreign assets
    JEL: F20 F30 H20 H30 P20 P30
    Date: 2017
  5. By: Sudipto Karmakar; Leonardo Gambacorta
    Abstract: The global financial crisis has highlighted the limitations of risk-sensitive bank capital ratios. To tackle this problem, the Basel III regulatory framework has introduced a minimum leverage ratio, defined as a banks Tier 1 capital over an exposure measure, which is independent of risk assessment. Using a medium sized DSGE model that features a banking sector, financial frictions and various economic agents with differing degrees of creditworthiness, we seek to answer three questions: 1) How does the leverage ratio behave over the cycle compared with the risk-weighted asset ratio? 2) What are the costs and the benefits of introducing a leverage ratio, in terms of the levels and volatilities of some key macro variables of interest? 3) What can we learn about the interaction of the two regulatory ratios in the long run? The main answers are the following: 1) The leverage ratio acts as a backstop to the risk-sensitive capital requirement: it is a tight constraint during a boom and a soft constraint in a bust; 2) the net benefits of introducing the leverage ratio could be substantial; 3) the steady state value of the regulatory minima for the two ratios strongly depends on the riskiness and the composition of bank lending portfolios
    Keywords: Bank Capital Buffers, Regulation, Risk-Weighted Assets, Leverage
    JEL: G21 G28 G32
    Date: 2017–10
  6. By: Philipp Renner; Karl Schmedders
    Abstract: This paper contributes to the theoretical and numerical analysis of discrete time dynamic principal-agent problems with continuous choice sets. We first provide a new and simplified proof for the recursive reformulation of the sequential dynamic principal-agent relationship. Next we prove the existence of a unique solution for the principal's value function, which solves the dynamic programming problem in the recursive formulation. By showing that the Bellman operator is a contraction mapping, we also obtain a convergence result for the value function iteration. To compute a solution for the problem, we have to solve a collection of static principal{agent problems at each iteration. Under the assumption that the agent's expected utility is a rational function of his action, we can transform the bi-level optimization problem into a standard nonlinear program. The final results of our solution method are numerical approximations of the policy and value functions for the dynamic principal-agent model. We illustrate our solution method by solving variations of two prominent social planning models from the economics literature.
    Keywords: Optimal unemployment tax, principal-agent model, repeated moral hazard
    JEL: C63 D80 D82
    Date: 2017
  7. By: Begenau, Juliane (Harvard University); Landvoigt, Tim (University of TX)
    Abstract: How does the shadow banking system respond to changes in the capital regulation of commercial banks? We propose a tractable, quantitative general equilibrium model with regulated and unregulated banks to study the unintended consequences of regulatory policy. Tightening the capital requirement from the status quo creates a safer banking system despite more shadow banking activity. A reduction in aggregate liquidity provision decreases the funding costs of all banks, raising profits and reducing risk-taking incentives. Calibrating the model to data on financial institutions in the U.S., we find the optimal capital requirement is around 15%.
    Date: 2017–04
  8. By: EO, Yunjong; LIE, Denny
    Abstract: How and under what circumstances can adjusting the inflation target serve as a stabilization-policy tool and contribute to welfare improvement? We answer these questions quantitatively with a standard New Keynesian model that includes cost-push type shocks which create a trade-o↵ between inflation and output gap stabilization. We show that this trade-o↵ leads to a non-trivial welfare cost under a standard Taylor rule, even with optimized policy coefficients. We then propose an additional policy tool of an inflation target rule and find that the optimal target needs to be adjusted in a persistent manner and in the opposite direction to the realization of a cost-push shock. The inflation target rule, combined with a Taylor rule, significantly reduces fluctuations in inflation originating from the cost-push shocks and mitigates the policy trade-o↵, resulting in a similar level of welfare to that associated with the Ramsey optimal policy. The welfare implications of the inflation target rule are more pronounced under a flatter Phillips curve.
    Keywords: Welfare analysis, Monetary policy, Cost-push shocks, Medium-run inflation, targeting, Flat Phillips curve
    JEL: E12 E32 E58 E61
    Date: 2017–10
  9. By: Alice, Albonico; Roberta, Cardani; Patrizio, Tirelli
    Abstract: We investigate the drivers of EMU big fours' business cycles in a DSGE model. Our approach allows to disentangle the role of demand and technology shocks, where the latter may generate permanent consequences on national productivity levels. For the years before the financial crisis we cannot find evidence of a demand-driven boom in Spain and Italy relative to what happened in France and Germany. The aftermath of the sovereign bond crisis was characterized by a sequence of adverse permanent technology shocks both in Spain and in Italy. These latter results are consistent with recent theoretical developments that emphasize the adverse supply-side effects of a credit crunch.
    Keywords: Asymmetric Euro crisis, two-country DSGE, Bayesian estimation
    JEL: C11 C13 C32 E21 E32 E37
    Date: 2017–11–05
  10. By: Peilin, Liu (Asian Development Bank Institute); Shen, Jia (Asian Development Bank Institute); Xun, Zhang (Asian Development Bank Institute)
    Abstract: Certain stylized facts are common among successful economic latecomers: an inverse U-shaped gross domestic product and capital per capita growth rate, high growth rates during the catch-up period, and rapid structural changes. We propose, for the first time, a general equilibrium framework to document the catch-up cycle that a successful latecomer is likely to experience. We argue that technology adoption and imitation, and diminishing marginal returns to capital are the two driving forces of the catch-up cycle. The technological gap and speed/efficiency of technological catching-up are two fundamental factors for successful catching-up. This paper concludes with a case study for the People’s Republic of China and sheds light on the different policy choices at various stages of the catch-up cycle.
    Keywords: Catch-up cycle; Latecomers; General Equilibrium; Total Factor Productivity (TFP); China
    JEL: E13 E60 O11
    Date: 2017–02–03
  11. By: Bocola, Luigi (Federal Reserve Bank of Minneapolis); Lorenzoni, Guido (Northwestern University)
    Abstract: We study financial panics in a small open economy with floating exchange rates. In our model, bank runs trigger a decline in domestic wealth and a currency depreciation. Runs are more likely when banks have dollar debt. Dollar debt emerges endogenously in response to the precautionary motive of domestic savers: dollar savings provide insurance against crises; so when crises are possible it becomes relatively more expensive for banks to borrow in local currency, which gives them an incentive to issue dollar debt. This feedback between aggregate risk and savers’ behavior can generate multiple equilibria, with the bad equilibrium characterized by financial dollarization and the possibility of bank runs. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holding foreign currency reserves hedges the fiscal position of the government and enhances its credibility, thus improving financial stability.
    Keywords: Financial crises; Dollarization; Lending of last resort; Foreign reserves
    JEL: E44 F34 G11 G15
    Date: 2017–10–24
  12. By: Piero Gottardi; Vincent Maurin; Cyril Monnet
    Abstract: We show that repurchase agreements (repos) arise as the instrument of choice to borrow in a competitive model with limited commitment. The repo contract traded in equilibrium provides insurance against fluctuations in the asset price in states where collateral value is high and maximizes borrowing capacity when it is low. Haircuts increase both with counterparty risk and asset risk. In equilibrium, lenders choose to re-use collateral. This increases the circulation of the asset and generates a "collateral multiplier" effect. Finally, we show that intermediation by dealers may endogenously arise in equilibrium, with chains of repos among traders.
    Keywords: repos, collateral multiplier, limited commitment, intermediation
    JEL: G19
    Date: 2017
  13. By: Dominguez, Begona; Gomis-Porqueras, Pedro
    Abstract: We analyze how trading in secondary markets for public debt change the inherent links between monetary and fiscal policy, by studying both inflation and debt dynamics. When agents do not trade in these markets, there exists a unique steady state and traditional passive/active policy prescriptions are useful in delivering determinate equilibria. In contrast, when agents trade in secondary markets and bonds are scarce, there exist a liquidity premium on public debt and bonds affect inflation dynamics and vice versa. Then, in a monetary equilibrium, the government budget constraint can be satisfied for different combinations of inflation and debt. Thus, self-fulfilling beliefs that deliver multiple steady states are possible. Moreover, traditional passive/active policy prescriptions are not always useful in delivering determinate equilibria. However, monetary and fiscal policies can be used as an equilibrium selection device. We find that, with a low inflation target, active monetary policies are more likely to deliver real and nominal determinacy and further amplify the effectiveness of these policies in reducing steady state inflation.
    Keywords: taxes; inflation; secondary markets, liquidity premium.
    JEL: E4 E61 E62 H21
    Date: 2016–11
  14. By: Ricardo Reis
    Abstract: While there is much that is wrong with macroeconomics today, most critiques of the state of macroeconomics are off target. Current macroeconomic research is not mindless DSGE modelling filled with ridiculous assumptions and oblivious of data. Rather, young macroeconomists are doing vibrant, varied, and exciting work, getting jobs, and being published. Macroeconomics informs economic policy only moderately and not more nor all that differently than other fields in economics. Monetary policy has benefitted significantly from this advice in keeping inflation under control and preventing a new Great Depression. Macroeconomic forecasts perform poorly in absolute terms and given the size of the challenge probably always will. But relative to the level of aggregation, the time horizon, and the amount of funding, they are not so obviously worse than those in other fields. What is most wrong with macroeconomics today is perhaps that there is too little discussion of which models to teach and too little investment in graduate-level textbooks.
    JEL: E00
    Date: 2017

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