nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2018‒04‒09
twenty-two papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Innovation and Trade Policy in a Globalizing World By Ufuk Akcigit
  2. Financial Disruption and State Dependant Credit Policy By Thibaud Cargoet; Jean-Christophe Poutineau
  3. Demographic Uncertainty and Generational Consumption Risk with Endogenous Human Capital By Emerson, Patrick M.; Knabb, Shawn D.
  4. Feldstein Meets George: Land Rent Taxation and Socially Optimal Allocation in Economies with Environmental Externality By Nguyen Thang Dao; Ottmar Edenhofer
  5. Fiscal Consolidation Programs and Income Inequality By Pedro Brinca; Miguel H. Ferreira; Francesco Franco; Hans A. Holter; Laurence Malafry
  6. Inequality and Real Interest Rates By Lancastre, Manuel
  7. Global Banking, Trade, and the International Transmission of the Great Recession By Alexandra Born; Zeno Enders
  8. Monetary Policy, Heterogeneity, and the Housing Channel By Serdar Ozkan; Kurt Mitman; Fatih Karahan; Aaron Hedlund
  9. Housing boom-bust cycles and asymmetric macroprudential policy By William Gatt
  10. The Household Fallacy By Roger Farmer; Pawel Zabczyk
  11. Interbank Market Turmoils and the Macroeconomy By Kopiec, Pawel
  12. Labour tax reforms, cross-country coordination and the monetary policy stance in the euro area: A structural model-based approach By Jacquinot, Pascal; Lozej, Matija; Pisani, Massimiliano
  13. The Optimal Inflation Target and the Natural Rate of Interest By P. Andrade; J. Galí; H. Le Bihan; J. Matheron
  14. Trade Liberalization Versus Protectionism: Are the Dynamic Welfare Implications Symmetric? By Michael Sposi; Ana Maria Santacreu
  15. A Real-Business-Cycle model with pollution and environmental taxation: the case of Bulgaria By Aleksandar Vasilev
  16. Business cycles and the balance sheets of the financial and non-financial sectors By Villacorta, Alonso
  17. Common Banking across Heterogenous Regions By Enzo Dia; Lunan Jiang; Lorenzo Menna; Lin Zhang
  18. Capital Misallocation: Frictions or Distortions? By Venky Venkateswaran; Joel David
  19. Labor Responses, Regulation and Business Churn in a Small Open Economy By Marta Aloi; Huw Dixon; Anthony Savagar
  20. Asset Prices in a Small Production Network By Francisco RUGE-MURCIA
  21. Growth Maximizing Government Size and Social Capital. By Carmeci, Gaetano; Mauro, Luciano; Privileggi, Fabio

  1. By: Ufuk Akcigit (University of Chicago)
    Abstract: We assess the role of import tariffs and R&D subsidies as policy responses to foreign technological competition. To this end, we build a general equilibrium growth model embedding a Ricardian framework of trade where firm innovation shapes endogenously the dynamics of technology and market leadership in a world with countries at differ- ent stages of development. Knowledge spillovers and decreasing returns to knowledge accumulation drive cross-country technological convergence. Firms’ R&D decisions are driven by the size of the market, the effort to escape competitive pressures, domestic and international business stealing, and technology spillovers. A calibrated version of the model reproduces the foreign technological catch-up the U.S. experienced by the 1970s and early 1980s. Accounting for transitional dynamics, we show that foreign technolog- ical acceleration hurts the U.S. welfare in the short and medium run through business stealing, but generates long-run benefits via higher quality of imported goods and higher domestic innovation in the U.S. induced by escape-competition effect. The model suggests that the introduction of Research and Experimentation Tax Credit in 1981 proves to be an effective policy response to foreign competition, generating substantial welfare gains. A counterfactual exercise shows that increasing trade barriers as an alternative policy re- sponse produces gains only in the very short run, leading to large losses in the medium and long run. Protectionist measures generate large dynamic losses from trade, distort- ing the impact of openness on innovation incentives and productivity growth.
    Date: 2017
  2. By: Thibaud Cargoet (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - CNRS - Centre National de la Recherche Scientifique); Jean-Christophe Poutineau (CREM - Centre de recherche en économie et management - UNICAEN - Université de Caen Normandie - NU - Normandie Université - UR1 - Université de Rennes 1 - CNRS - Centre National de la Recherche Scientifique)
    Abstract: This paper analyses how long credit policy measures should last to restore a normal function-ning of the loan market. We build a DSGE model where financial intermediaries and non financial agents face balance sheet constraints. Our results are two. First, we find that a credit policy has an intertemporal effect as it smoothes the negative shock along a greater number of periods. It dampens the inital negative consequences of financial shocks at the expense of a higherlength of the uncoventional period. Second, accounting for the joint effect of shocks on the length of the starurated period and on the fluctuation of activity in the transitory period back to the steady state situation, we find that the positive effect of this policy requires some qualification. For the benchmark calibration, conducting such a policy affects activity positively. However, for a high value of firm's leverage we find that unconventional monetary policy can be counterproductive. Ignoring credit policy will generate higher short run losses in activity but the transition to the steady state would be quicker, implying lower short run activity losses than those encountered with a credit policy where the transition to the steady state would last longer.
    Keywords: Financial Frictions,Financial Accelerator,DSGE model
    Date: 2018–01
  3. By: Emerson, Patrick M. (Oregon State University); Knabb, Shawn D. (Western Washington University)
    Abstract: This paper uses a model with overlapping generations to demonstrate that human capital accumulation can potentially attenuate factor price movements in response to birth rate shocks. Specifically, we show that if education spending per child is inversely related to the size of the generation, then there will be less movement in factor prices in response to the relative size of each generation. The degree of this attenuation effect will depend on the effectiveness of education spending in producing human capital. We also demonstrate that this attenuation effect tends to concentrate generational consumption risk around the generation subject to the birth rate shock. In a limiting case, we show that an i.i.d birth rate shock translates into an i.i.d. generational consumption shock. In other words, each generation bears all of the risk associated with their own demographic uncertainty. As a final exercise, we demonstrate that if the tax rate funding education spending varies with the size of the generation rather than education spending per child, then human capital does not influence the dynamic behavior of the economy in response to a birth rate shock.
    Keywords: human capital, consumption risk, factor price movements, fertility shocks
    JEL: J12 E21 I31 J11
    Date: 2018–02
  4. By: Nguyen Thang Dao; Ottmar Edenhofer
    Abstract: We consider an overlapping generations (OLG) economy with land as a fixed factor of production and an environmental externality on production in which tax revenue from land rent and/or from other schemes such as labor income, capital income, and production taxation can be used for environmental protection through investment in emission mitigation. We show that, for any given target of stationary stock of pollution, the land rent taxation scheme leads to a higher steady state capital accumulation than the other schemes, and hence the steady state consumption of agents when young under this scheme is also higher than under the others. In addition, under an ambitious mitigation target when the efficiency of the mitigation technology is relatively high compared to the dirtiness of production, the land rent taxation also provides a higher steady state consumption when old, resulting in higher social welfare, than the others. In the second part of the paper, we propose a period-by-period balanced budget policy, which includes land rent and capital income taxes with intergenerational transfers, to decentralize the socially optimal allocation during the transitional phase to the social planner's steady state.
    Keywords: overlapping generations economy, land rent, taxation, socially optimal allocation
    JEL: H23 I31 Q50
    Date: 2018
  5. By: Pedro Brinca (Center for Economics and Finance at Universidade of Porto, Nova School of Business and Economics, Universidade Nova de Lisboa); Miguel H. Ferreira (Nova School of Business and Economics, Universidade Nova de Lisboa); Francesco Franco (Nova School of Business and Economics, Universidade Nova de Lisboa); Hans A. Holter (Department of Economics, University of Oslo); Laurence Malafry (Department of Economics, Stockholm University)
    Abstract: Following the Great Recession, many European countries implemented fiscal consolidation policies aimed at reducing government debt. Using three independent data sources and three different empirical approaches, we document a strong positive relationship between higher income inequality and stronger recessive impacts of fiscal consolidation programs across time and place. To explain this finding, we develop a life-cycle, overlapping generations economy with uninsurable labor market risk. We calibrate our model to match key characteristics of a number of European economies, including the distribution of wages and wealth, social security, taxes and debt, and study the effects of fiscal consolidation programs. We find that higher income risk induces precautionary savings behavior, which decreases the proportion of credit-constrained agents in the economy. Credit-constrained agents have less elastic labor supply responses to fiscal consolidation achieved through either tax hikes or public spending cuts, and this explains the relationship between income inequality and the impact of fiscal consolidation programs. Our model produces a cross-country correlation between inequality and the fiscal consolidation multipliers, which is quite similar to that in the data.
    Keywords: Fiscal Consolidation, Income Inequality, Fiscal Multipliers, Public Debt, Income Risk
    JEL: E21 E62 H31 H50
    Date: 2017–11
  6. By: Lancastre, Manuel
    Abstract: We use an overlapping generations New Keynesian model with borrowing constraints and a bequest motive, to show how an increase of income inequality may trigger a permanent reduction of the real interest rate, %, based on the heterogeneity of marginal borrowing and saving rates among household income types. (i) via a contraction of aggregate borrowing, when the marginal borrowing rate of the wealthier is lower than the one of the poorer with respect to income. (ii) We then show how an increase of inequality may trigger an expansion of savings through the channel of a bequest motive where generosity towards the next generation increases endogenously with lifetime income, so that the marginal savings rate of the wealthier is higher than the poorer.
    Keywords: Income Inequality, low interest rates
    JEL: E21 E43
    Date: 2016–10–16
  7. By: Alexandra Born; Zeno Enders
    Abstract: The global financial crisis of 2007-2009 spread through different channels from its origin in the United States to large parts of the world. In this paper we explore the financial and the trade channel in a unified framework and quantify their relative importance for this transmission. Specifically, we employ a DSGE model of an open economy with an internationally operating banking sector. We investigate the transmission of the crisis via the collapse of export demand and through losses in the value of cross-border asset holdings. Calibrated to German data, the model predicts the trade channel to be twice as important for the transmission of the crisis than the financial channel. In the UK, the latter dominates due to higher foreign-asset holdings, which, at the same time, serve as an automatic stabilizer in case of plummeting foreign demand. The transmission via the financial channel triggers a much longer-lasting recession relative to the trade channel, resulting in larger cumulated output losses and a prolonged crisis particularly in the UK. Stricter enforcement of bank capital requirements would have deepened the initial slump while simultaneously speeding up the recovery. The effects of higher capital requirements depend on the way banks’ balance sheets adjust to this intervention.
    Keywords: financial crisis, international transmission, international business cycles, global banks
    JEL: F44 F41 E32
    Date: 2018
  8. 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 and effectiveness of monetary policy. First, monetary policy induced-movements in house prices translate into consumption changes because of wealth effects. Second, a contractionary monetary shock raises the cost of borrowing which reduces the demand and as a result the liquidity of the housing market, further depressing house prices and further increases the cost of borrowing. Furthermore, nominal long-term mortgage debt implies that changes in monetary policy result in redistribution between lenders and borrowers and generate cash-flow effects that are larger for borrowing constrained households. We build a heterogenous agent New Keynesian model with a frictional housing market to quantify the various mechanisms. The model is able to match the rich empirical heterogeneity in home ownership, leverage and MPC across households. In particular, our model is consistent with the significant difference in MPC between low- and high-LTV households that we document in the data. Our quantitative findings are as follows: First, we find that about 20% of the drop in aggregate consumption against a contractionary monetary shock is due to declining house prices. Second, we find asymmetric responses of the economy to shocks, with contractionary shocks yielding a larger response of all variables. Finally, we investigate how the transmission of monetary policy depends on the distribution of mortgage debt and find that monetary policy is more effective in stimulating the economy in an high-LTV environment.
    Date: 2017
  9. By: William Gatt (Central Bank of Malta)
    Abstract: Macroprudential policy is pre-emptive, aimed at preventing crises. Empirical evidence hints at the existence of asymmetric policy in booms and recessions. This paper uses a New Keynesian model with a financial friction on mortgage borrowing and collateral to show what implications this asymmetry might have on the economy. The main source of fluctuations is a bubble in the housing market, which causes house prices and credit to deviate from their fundamental values, leading to a boom and bust cycle. The main macroprudential tool is the regulatory loan to value (LTV) ratio. The author finds that while the asymmetric policy dampens the boom phase, it introduces more volatility in the economy by exacerbating the correction that follows. The higher the asymmetry in the policy response, the more volatile the economy is relative to one in which policy reacts symmetrically.
    JEL: C61 E32 E44 E61 R21
    Date: 2018
  10. By: Roger Farmer; Pawel Zabczyk
    Abstract: We refer to the idea that government must 'tighten its belt' as a necessary policy response to higher indebtedness as the household fallacy. We provide a reason to be skeptical of this claim that holds even if the economy always operates at full employment and all markets clear. Our argument rests on the fact that, in an overlapping-generations (OLG) model, changes in government debt cause changes in the real interest rate that redistribute the burden of repayment across generations. We do not rely on the assumption that the equilibrium is dynamically inefficient, and our argument holds in a version of the OLG model where the real interest rate is always positive.
    JEL: E0 H62
    Date: 2018–03
  11. By: Kopiec, Pawel
    Abstract: This paper studies the macroeconomic consequences of interbank market disruptions caused by higher counterparty risk. I propose a novel, dynamic model of banking sector where banks trade liquidity in the frictional OTC market à la Afonso and Lagos (2015) that features counterparty risk. The model is then embedded into an otherwise standard New Keynesian framework to analyze the macroeconomic impact of interbank market turmoils: economy suffers from a prolonged slump and deflationary pressure during such episodes. I use the model to analyze the effectiveness of two policy measures: rise in the supply of central bank reserves and interbank market guarantees in mitigating the adverse effects of those disruptions.
    Keywords: Financial crisis, Interbank market, Policy intervention, OTC market
    JEL: E44 E58 G21
    Date: 2018–03–07
  12. By: Jacquinot, Pascal (European Central Bank); Lozej, Matija (Central Bank of Ireland); Pisani, Massimiliano (Bank of Italy)
    Abstract: We evaluate the effects of permanently reducing labour tax rates in the euro area (EA) by simulating a large-scale open economy dynamic general equilibrium model. The model features the EA as a monetary union, split in two regions (Home and the rest of the EA - REA), the US, and the rest of the world, region-specific labour markets with search and matching frictions, and public employment. Our results are as follows. First, a permanent reduction in labour tax rates in the Home region would have stimulating effects on domestic economic activity and employment. Second, reducing labour tax rates simultaneously in both Home and REA would have additional expansionary effects on the Home region. Third, in the short run the expansionary effects on the EA economy of a EA-wide tax reduction are enhanced if the EA monetary policy is accommodative.
    Keywords: DSGE models, labour taxes, unemployment, monetary union, open-economy macroeconomics
    JEL: E24 E32 E52 E62
    Date: 2018–02
  13. By: P. Andrade; J. Galí; H. Le Bihan; J. Matheron
    Abstract: We study how changes in the value of the steady-state real interest rate affect the optimal inflation target, both in the U.S. and the euro area, using an estimated New Keynesian DSGE model that incorporates the zero (or effective) lower bound on the nominal interest rate. We find that this relation is downward sloping, but its slope is not necessarily one-forone: increases in the optimal inflation rate are generally lower than declines in the steadystate real interest rate. Our approach allows us not only to assess the uncertainty surrounding the optimal inflation target, but also to determine the latter while taking into account the parameter uncertainty facing the policy maker, including uncertainty with regard to the determinants of the steady-state real interest rate. We find that in the currently empirically relevant region for the US as well as the euro area, the slope of the curve is close to -0.9. That finding is robust to allowing for parameter uncertainty.
    Keywords: inflation target, effective lower bound.
    JEL: E31 E52 E58
    Date: 2018
  14. By: Michael Sposi (Federal Reserve Bank of Dallas); Ana Maria Santacreu (St. Louis Fed)
    Abstract: We quantify changes in welfare that result from alternative trade reforms in an economy with endogenous capital accumulation. The dynamic welfare gains associated with a particular reduction in trade frictions are larger than the dynamic welfare losses associated with returning to the initial level of the frictions. This ``asymmetry'' occurs in the short-run, yet, permanently affects welfare. Three channels contribute to the size of the asymmetry: (i) the rate of capital depreciation, (ii) the responses of measured TFP and the marginal efficiency of investment to the trade shock, and (iii) the optimal response of the investment rate. Absent transitional dynamics, the gains from a trade liberalization are equal to the losses from returning to the initial trade frictions. The short-run asymmetries imply that the sequencing of trade reforms matters for welfare.
    Date: 2017
  15. By: Aleksandar Vasilev (Independent researcher)
    Abstract: We introduce an environmental dimension into a real-business-cycle model augmented with a detailed government sector. We calibrate the model to Bulgarian data for the period following the introduction of the currency board arrangement (1999-2016). We investigate the quantitative importance of utility-enhancing environmental quality, and the mechanics of environmental ("carbon") tax on polluting production, as well as the effect of government spending on pollution abatement over the cycle. In particular, a positive shock to pollution emission in the model works like a positive technological shock, but its effect is quantitatively very small. Allowing for pollution as a by-product of production improves the model performance against data, and in addition this ex- tended setup dominates the standard RBC model framework, e.g., Vasilev (2009).
    Keywords: Business cycles, pollution, environmental quality, environmental tax, abatement spending
    JEL: E32 C68 Q2 Q4 Q54 Q58
    Date: 2018–03
  16. By: Villacorta, Alonso
    Abstract: I propose and estimate a dynamic model of financial intermediation to study the different roles of the condition of banks’ and firms’ balance sheets in real activity. The net worth of firms determines their borrowing capacity both from households and banks. Banks provide risky loans to multiple firms and use their diversified portfolio as collateral to borrow from households. This intermediation process allows additional funds to flow from households to firms. Banks require net worth for intermediation as they are exposed to aggregate risk. The net worth of banks and firms are both state variables. In normal recessions, firm and bank net worth play the same role, so their sum determines the allocation of capital. During financial crises, shocks to bank net worth have an additional effect beyond that in standard financial frictions’ models. This mechanism works through intermediation and affects activity, even if shocks redistribute net worth from banks to firms. I estimate my model and find that the new mechanism accounts for 40% of the fall in output and 80% of the fall in bank net worth during the Great Recession. Finally, the model is consistent with the different dynamics of the share of bank loans in total firm debt and credit spreads during the recessions of 1990, 2001, and 2008. JEL Classification: E44, E32, G01
    Keywords: balance sheet channel, financial crises, financial frictions, financial markets and the macroeconomy
    Date: 2018–02
  17. By: Enzo Dia; Lunan Jiang; Lorenzo Menna; Lin Zhang (Universita degli Studi di Milano Bicocca ; Center for Financial Development and Stability at Henan University, Kaifeng, Henan; Banco de Mexico)
    Abstract: We document the existence of a substantial dispersion of interest margins charged by commercial banks among Chinese provinces, and we build a parsimonious dynamic stochastic general equilibrium model featuring both banking and production sectors that we calibrate at both the national and provincial level. Our model can explain a considerable share of the interest margin charged in different provinces, and we find support for the hypothesis that Chinese banks adopt a similar technology across different provinces. Since in the case of Chinese provinces differences in wages are substantial, the adoption of a national technology implies an inefficient industrial structure for the banking industry. The adoption of a common nationwide technology generates also a stronger response of the rate on loans to productivity shocks than would be the case if banks adopted different technologies in different provinces, and the capability of banks to smooth regional idiosyncratic productivity shock hitting firms declines substantially.
    Keywords: Interest margins, market segmentation, Chinese economy
    JEL: E1
  18. By: Venky Venkateswaran (New York University); Joel David (USC)
    Abstract: We study a model of investment in which both technological and informational frictions as well as institutional/policy distortions lead to capital misallocation, i.e., static marginal products are not equalized. We devise an empirical strategy to disentangle these forces using readily observable moments in firm-level data. Applying this methodology to manufacturing firms in China reveals that adjustment costs and uncertainty have significant aggregate consequences but account for only a modest share of the observed dispersion in the marginal product of capital. A substantial fraction of misallocation stems from firmspecific distortions, both productivity/size-dependent as well as permanent. For large US firms, adjustment costs are relatively more salient, though permanent firm-level factors remain important. These results are robust to the presence of liquidity/financial constraints.
    Date: 2017
  19. By: Marta Aloi; Huw Dixon; Anthony Savagar
    Abstract: We analyze labor responses to technology shocks when firm entry is sluggish due to endogenous sunk costs. We provide closed-form solutions for transition dynamics that show, when firm entry is slow to respond, labor will increase (decrease) relative to its long-run response if returns to labor input at the firm level are increasing (decreasing). Under stricter regulation (slower business churn), such short-run deviations of labor persist for longer. There is also potential for short-run productivity effects to differ from the long run.
    Date: 2018–02
  20. By: Francisco RUGE-MURCIA
    Abstract: This paper constructs an asset pricing model where heterogeneous sectors interact with each other in a production network as producers and consumers of materials and investment goods. Idiosyncratic sectoral shocks are transmitted through the network with the dynamics being affected by the heterogeneity in production functions and capital adjustment costs. The model is estimated using sectoral and aggregate U.S. data. Results show that 1) shocks to the primary sector account for a substantial part of the equity premium in all sectors because their volatility is much higher than that of shocks to the other sectors, and 2) the model endogenously generates conditional heteroskedasticity despite the fact that shocks are conditional homoskedatic. These results depend crucially on the presence of network effects.
    Keywords: network, input-output, production economy, stock returns, sectoral shocks
    JEL: E44 G12
    Date: 2018
  21. By: Carmeci, Gaetano; Mauro, Luciano; Privileggi, Fabio (University of Turin)
    Abstract: Our paper intersects two topics in growth theory: the growth maximizing government size and the role of social capital in development. We modify a simple OLG framework by introducing two key features: endogenous growth and a role for public officials in monitoring the public expenditures for intermediate goods and services supplied to private firms. Public officials have the opportunity to steal a fraction of public resources under their own control, subject to a probability of being caught and pay a fine. Hence, not all tax revenues raised by the Government reach private firms, as a fraction of them is being diverted by public officials, thus hampering growth. Under certain conditions on parameters, our main result establishes that, if the probability of detection or the fine charged on public officials who are caught stealing, or both, increase, then an increase of the tax rate is required in order to maintain an optimal growth rate, provided that also the number of public officials is increased as well. As both the probability of detection and the fine positively depend on the Social Capital level, we conclude that maximum growth rates are compatible with Big Government size, measured both in terms of expenditures and public officials, only when associated with high levels of Social Capital.
    Date: 2018–03
  22. By: Brecht Boone; Ewoud Quaghebeur (-)
    Abstract: We explore the transitional dynamics in an Overlapping Generations framework with and without heuristic switching. Agents use simple heuristics to forecast the interest rate and the real wage. The fraction of agents using a specific heuristic depends on its relative forecasting performance. In the absence of heuristic switching, the results indicate that there is a lot of variation in the transitional dynamics over different parameter values and heuristics. They might even oscillate or diverge. Including heuristic switching has two advantages. First, it decreases the variation in the transitional dynamics significantly. Second, it has a stabilising effect on oscillating or diverging transitional dynamics.
    Keywords: Heuristic Switching, Heterogeneous Agents, Fiscal Policy, Transitional Dynamics, Overlapping Generations
    JEL: D83 D84 E60
    Date: 2018–01

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