nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2018‒04‒16
seventeen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. What is the Major Source of Business Cycles : Spillovers from Land Prices, Investment Shocks, or Anything Else? By Shirota, Toyoichiro
  2. DSGE forecasts of the lost recovery By Cai, Michael; Del Negro, Marco; Giannoni, Marc; Gupta, Abhi; Li, Pearl; Moszkowski, Erica
  3. 'Optimal Fiscal Policy with Consumption Taxation' By Giorgio Motta; Raffaele Rossi
  4. Annuity Markets and Capital Accumulation By Shantanu Bagchi; James Feigenbaum
  5. Competitiveness and Wage Bargaining Reform in Italy By Alvar Kangur
  6. Euro area real-time density forecasting with financial or labor market frictions By McAdam, Peter; Warne, Anders
  7. Aging, Secular Stagnation and the Business Cycle By Callum Jones
  8. Sovereign risk and asset market dynamics in the euro area By Erica Perego
  9. Monetary policy with non-homothetic preferences By Cavallari, Lilia
  10. DSGE Reno: Adding a Housing Block to a Small Open Economy Model By Christopher G Gibbs; Jonathan Hambur; Gabriela Nodari
  11. The importance of hiring frictions in business cycles By Faccini, Renato; Yashiv, Eran
  12. Social capital, human capital and fertility By Coppier, Raffaella; Sabatini, Fabio; Sodini, Mauro
  13. DSGE Models with Observation-Driven Time-Varying parameters By Giovanni Angelini; Paolo Gorgi
  14. Unequal vulnerability to climate change and the transmission of adverse effects through international trade By Karine Constant; Marion Davin
  15. Loan supply and bank capital: A micro-macro linkage By Kick, Thomas; Kreiser, Swetlana; Merkl, Christian
  16. Monetary policy and cross-border interbank market fragmentation: lessons from the crisis By Blattner, Tobias Sebastian; Swarbrick, Jonathan M.
  17. Exchange rate misalignment, capital flows, and optimal monetary policy trade-offs By Corsetti, Giancarlo; Dedola, Luca; Leduc, Sylvain

  1. By: Shirota, Toyoichiro
    Abstract: Some recent studies argue that spillovers from land prices into the aggregate economy are the crucial drivers of business cycles. Other studies stress the importance of investment shocks at business cycle frequencies. This study evaluates these two strands of the literature in a single unified framework by estimating a New Keynesian dynamic stochastic general equilibrium model with a collateral constraint on investment financing. The results are twofold: (i) when these features are combined, neither shocks that drives most of land-price fluctuations nor investment shocks are the primary source of U.S. business cycles; and (ii) technology shocks play an important role in business cycles.
    Keywords: Source of business cycles, Land price dynamics, Investment shock, Collateral constraint, Bayesian estimation,
    Date: 2018–03
  2. By: Cai, Michael (Federal Reserve Bank of New York); Del Negro, Marco (Federal Reserve Bank of New York); Giannoni, Marc (Federal Reserve Bank of Dallas); Gupta, Abhi (Federal Reserve Bank of New York); Li, Pearl (Federal Reserve Bank of New York); Moszkowski, Erica (Harvard Business School)
    Abstract: The years following the Great Recession were challenging for forecasters. Unlike other deep downturns, this recession was not followed by a swift recovery, but generated a sizable and persistent output gap that was not accompanied by deflation as a traditional Phillips curve relationship would have predicted. Moreover, the zero lower bound and unconventional monetary policy generated a policy environment without precedents. We document the real real-time forecasting performance of the New York Fed dynamic stochastic general equilibrium (DSGE) model during this period and explain the results using the pseudo real-time forecasting performance results from a battery of DSGE models. We find the New York Fed DSGE model’s forecasting accuracy to be comparable to that of private forecasters—and notably better, for output growth, than the median forecasts from the FOMC’s Summary of Economic Projections. The model’s financial frictions were key in obtaining these results, as they implied a slow recovery following the financial crisis.
    Keywords: DSGE models; real-time forecasts; Great Recession; financial frictions
    JEL: C11 C32 C54 E43 E44
    Date: 2018–03–01
  3. By: Giorgio Motta; Raffaele Rossi
    Abstract: We characterise optimal fiscal policies in a tractable Dynamic General Equilibrium model with monopolistic competition and endogenous public spending. The government has access to consumption taxation, as alternative to labour income taxes. Consumption taxation acts as indirect taxation of profits (intratemporal gains of taxing consumption) and enables the policy-maker to manage the burden of public debt more efficiently (intertemporal gains of taxing consumption). We show analytically that these two gains imply that the optimal share of government spending is higher under consumption taxation than with labour income taxation. Then, we quantify numerically each of these gains on households’ welfare by calibrating the model on the US economy.
    Date: 2018
  4. By: Shantanu Bagchi (Department of Economics, Towson University); James Feigenbaum (Department of Economics, Utah State University)
    Abstract: We examine how the absence of annuities in financial markets affects capital accumulation in a two-period overlapping generations model. Our findings indicate that the effect on capital is ambiguous in general equilibrium, because there are two competing mechanisms at work. On the one hand, the absence of annuities increases the price of old-age consumption relative to the price of early-life consumption. This induces a substitution effect that reduces saving and capital, and an income effect that has the opposite effect as households want to consume less when young, causing them to save more. On the other hand, accidental bequests originate from the assets of the deceased under missing annuity markets. The bequest received in early life always has a positive income effect on saving, but the bequest received in old age, conditional on survival, is effectively a partial annuity with both substitution and income effects. We find that when the desire to smooth consumption is high, the income effects dominate, so the capital stock always increases when annuity markets are missing. However, when the desire to smooth consumption is low, the substitution effects dominate, and the capital stock decreases with missing annuity markets.
    Keywords: Mortality risk, frictionless annuities, accidental bequests, savings, capital stock.
    JEL: D52 E21
    Date: 2018–04
  5. By: Alvar Kangur
    Abstract: The growth of Italian exports has lagged that of euro area peers. Against the backdrop of unit labor costs that have risen faster than those in euro area peers, this paper examines whether there is a competitiveness challenge in Italy and evaluates the framework of wage bargaining. Wages are set at the sectoral level and extended nationally. However, they do not respond well to firm-specific productivity, regional disparities, or skill mismatches. Nominally rigid wages have also implied adjustment through lower profits and employment. Wage developments explain about 45 percent of the manufacturing unit labor cost gap with Germany. In a search-and-match DSGE model of the Italian labor market, this paper finds substantial gains from moving from sectoral- to firm-level wage setting of at least 3.5 percentage points lower unemployment (or higher employment) rate and a notable improvement in Italy’s competitiveness over the medium term.
    Date: 2018–03–16
  6. By: McAdam, Peter; Warne, Anders
    Abstract: We compare real-time density forecasts for the euro area using three DSGE models. The benchmark is the Smets-Wouters model and its forecasts of real GDP growth and inflation are compared with those from two extensions. The first adds financial frictions and expands the observables to include a measure of the external finance premium. The second allows for the extensive labor-market margin and adds the unemployment rate to the observables. The main question we address is if these extensions improve the density forecasts of real GDP and inflation and their joint forecasts up to an eight-quarter horizon. We find that adding financial frictions leads to a deterioration in the forecasts, with the exception of longer-term inflation forecasts and the period around the Great Recession. The labor market extension improves the medium to longer-term real GDP growth and shorter to medium-term inflation forecasts weakly compared with the benchmark model. JEL Classification: C11, C32, C52, C53, E37
    Keywords: Bayesian inference, DSGE models, forecast comparison, inflation, output, predictive likelihood
    Date: 2018–04
  7. By: Callum Jones
    Abstract: As of 2015, U.S. log output per capita was 12 percent below what its pre-2008 linear trend would predict. To understand why, I develop and estimate a model of the US with demographics, real and monetary shocks, and the occasionally binding ZLB on nominal rates. Demographic changes generate slow-moving trends in the real interest rate, employment, and productivity. I find that demographics alone can explain one-third of the gap between log output per capita and its linear trend in 2015. Demographics also lowered real rates, causing the ZLB to bind between 2009 and 2015, contributing to the slow recovery after the Great Recession.
    Date: 2018–03–23
  8. By: Erica Perego (University of Evry-Val d’Essonne)
    Abstract: This paper studies the behaviour of euro area asset market comovements during the period 2010- 2014, through the lens of a DSGE model. The economy is a two-country world consisting of a core and a periphery and featuring an international banking sector, home bias in bond holdings, and default. The periphery is buffeted by a sovereign risk shock, whose process is estimated from the data. The model successfully accounts for the divergence in core-periphery correlations between stock and bond returns. Simulation results indicate that the sovereign risk shock explains 50% of the increase in sovereign and loan-deposit spreads and 7% of the decrease in global output during the sovereign debt crisis.
    Keywords: Currency union, international financial markets, sovereign risk, general equilibrium
    JEL: F41 F44 G15
    Date: 2018
  9. By: Cavallari, Lilia
    Abstract: This paper studies the role of non-homothetic preferences for monetary policy from both a positive and a normative perspective. It draws on a dynamic stochastic general equilibrium model characterized by preferences with a variable elasticity of substitution among goods and with price adjustment costs à la Rotemberg. These preferences have remarkable implications for monetary policy. Three main results stand out from a comparison of models with an increasing and a constant elasticity. First, an increasing elasticity induces novel intertemporal substitution effects that amplify the propagation of monetary and technology shocks. Second, it weakens the ability of a simple Taylor rule to attain a given level of macroeconomic stabilization. Third, the smallest welfare losses can be attained by stabilizing both inflation and output, in contrast to the prevailing view - based on models with a constant elasticity - that the best thing the monetary authority can do is to control inflation only.
    Keywords: non-homothetic preferences; monetary policy; output stabilization; inflation stabilization; Taylor rule; new-Keynesian model; time-varying elasticity.
    JEL: E12 E32 E52 E61
    Date: 2018–02
  10. By: Christopher G Gibbs (UNSW Sydney); Jonathan Hambur (Reserve Bank of Australia); Gabriela Nodari (Reserve Bank of Australia)
    Abstract: We propose a straightforward approach to adding a housing sector to a large-scale open economy dynamic stochastic general equilibrium model. The model has four intermediate sectors: non-traded, housing, traded, and resources. Households are assumed to consume housing services as part of their consumption bundle and gain utility from holding housing stock. The utility specification increases households' willingness to hold housing stock and implies a relatively high sensitivity of housing investment to monetary policy. We estimate the model on Australian data and find that our model is better able to match a number of empirical regularities compared to a model without housing. These regularities include the sensitivity of housing investment to interest rates and the persistence of aggregate output's response to monetary policy shocks. We then use the model to explore the role of the housing sector in the rebalancing of the Australian economy following the end of the mining boom. First, we find that most of the recent increase in housing investment has been an endogenous response to the large fall in commodity prices and associated declines in interest rates. Second, the pick-up in housing investment has significantly supported the economy over the past five years, ading a ½ percentage point to GDP growth and a ¼ percentage point to inflation, in year-ended terms.
    Keywords: housing; DSGE; open economy; monetary policy; residential investment
    JEL: E23 E32 R31
    Date: 2018–04
  11. By: Faccini, Renato; Yashiv, Eran
    Abstract: The paper shows that there is an important direct role for hiring frictions in business cycles. This runs counter to key models in several strands of the macroeconomic literature, which imply that hiring frictions are not important per-se. In our model, conventional shocks yield non-standard and non-obvious macroeconomic outcomes in the presence of hiring frictions. Specifically, hiring frictions operate to offset, and possibly reverse, the effects of price frictions. This confluence of frictions has substantial effects. For a sub-set of the parameter space, model outcomes appear “frictionless,” though both hiring frictions and price frictions are at play. For a different sub-space, these interactions between the two frictions generate amplification in the responses of employment and unemployment to technology shocks, rather than friction-induced mitigation of responses. Despite the presence of price rigidity, positive technology shocks may still be expansionary in employment, and the effects of monetary policy shocks may still be negligible. We explain the underlying economic mechanisms and show their empirical implementation. In doing so, we argue in favor of the importance of explicitly using hiring frictions in business cycle modelling.
    Keywords: hiring frictions; business cycles; interactions with price frictions; endogenous wage rigidity
    JEL: E22 E24 E32 E52
    Date: 2017–11
  12. By: Coppier, Raffaella; Sabatini, Fabio; Sodini, Mauro
    Abstract: Abstract We develop an overlapping generations model to study how the interplay between social and human capital affects fertility. In a framework where families face a trade-off between the quantity and quality of children, we incorporate the assumption that social capital plays a key role in the accumulation of human capital. We show how the erosion of social capital can trigger a chain of reactions leading households to base their childbearing decisions on quantity, instead of quality, resulting in higher fertility.
    Keywords: fertility, quantity-quality trade-off, human capital, education, social capital, trust
    JEL: I25 J13 Z0 Z13
    Date: 2018–03–11
  13. By: Giovanni Angelini (University of Bologna, Italy); Paolo Gorgi (VU Amsterdam, The Netherlands)
    Abstract: This paper proposes a novel approach to introduce time-variation in structural parameters of DSGE models. Structural parameters are allowed to evolve over time via an observation-driven updating equation. The estimation of the resulting DSGE model can be easily performed by maximum likelihood without the need of time-consuming simulation-based methods. An application to a DSGE model with time varying volatility for structural shocks is presented. The results indicate a significant improvement in forecasting performance.
    Keywords: DSGE models; score-driven models; time-varying parameters
    JEL: C32 C5
    Date: 2018–03–30
  14. By: Karine Constant; Marion Davin
    Abstract: In this paper, we consider the unequal distribution of climate change damages in the world and we examine how the underlying costs can spread from a vulnerable to a non-vulnerable country through international trade. To focus on such indirect effects, we treat this topic in a North-South trade overlapping generations model in which the South is vulnerable to the damages entailed by global pollution while the North is not. We show that the impact of climate change in the South can be a source of welfare loss for northern consumers, in both the short and the long run. In the long run, an increase in the South’s vulnerability can reduce the welfare in the North economy even in the case in which it improves its terms of trade. In the short run, the South’s vulnerability can also represent a source of intergenerational inequity in the North. Therefore, we emphasize the strong economic incentives for non-vulnerable - and a fortiori less-vulnerable - economies to reduce the climate change damages on - more - vulnerable countries.
    Date: 2018–02
  15. By: Kick, Thomas; Kreiser, Swetlana; Merkl, Christian
    Abstract: In the presence of financial frictions, banks' capital position may constrain their ability to provide loans. The banking sector may thus have important feedback effects on the macroeconomy. To shed new light on this issue, we combine two approaches. First, we use microeconomic balance sheet data from Germany and estimate banks' loan supply response to capital changes. Second, we modify the model of Gertler and Karadi (2011) such that it can be calibrated to the estimated partial equilibrium elasticity of bank loan supply with respect to bank capital. Although the targeted elasticity is remarkably different from the one in the baseline model, banks continue to be an important originator and amplifier of macroeconomic shocks.Thus, combining microeconometric results with macroeconomic modeling provides evidence on the effects of the banking sector on the macroeconomy.
    Keywords: DSGE,bank capital,loan supply,financial frictions
    Date: 2018
  16. By: Blattner, Tobias Sebastian; Swarbrick, Jonathan M.
    Abstract: We present a two-country model with an enhanced banking sector featuring risky lending and cross-border interbank market frictions. We find that (i) the strength of the financial accelerator, when applied to banks operating under uncertainty in an interbank market, will critically depend on the economic and financial structure of the economy; (ii) adverse shocks to the real economy can be the source of banking crisis, causing an increase in interbank funding costs, aggravating the initial shock; and (iii) central bank asset purchases and long-term refinancing operations can be effective substitutes for, or supplements to, conventional monetary policy. JEL Classification: E44, E52, F32, F36
    Keywords: cross-border capital flows, financial frictions, interbank market, monetary union, unconventional monetary policy
    Date: 2018–04
  17. By: Corsetti, Giancarlo; Dedola, Luca; Leduc, Sylvain
    Abstract: What determines the optimal monetary trade-o§ between internal objectives (inflation, and output gap) and external objectives (competitiveness and trade imbalances) when inefficient capital flows cause exchange rate misalignment and distort current account positions? We characterize this trade-o§ analytically, using the workhorse model of modern monetary theory in open economies under incomplete markets–where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive a quadratic approximation of the utility-based global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under cooperation. We show that, in economies with a low degree of exchange rate pass-through, the optimal response to inefficient capital inflows associated with real appreciation is contractionary, above and beyond the natural rate: the optimal policy curbs excessive demand at the cost of exacerbating currency overvaluation. In contrast, a high degree of pass-through, and/or low trade elasticities, warrants expansionary policies that lean against exchange rate appreciation and competitive losses, at the cost of inefficient inflation.
    Keywords: currency misalignments; trade imbalances; asset markets and risk sharing; optimal targeting rules; international policy cooperation; exchange rate pass-through
    JEL: E44 E52 E61 F41 F42
    Date: 2018–03

This nep-dge issue is ©2018 by Christian Zimmermann. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.