nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2021‒02‒22
twenty-one papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Intertemporal elasticity of substitution and the transitional dynamics and steady state of wealth distribution By Masakazu Emoto; Tamotsu Nakamura
  2. Demographic Structure, Knowledge Diffusion, and Endogenous Productivity Growth By Ken-ichi Hashimoto; Ryonghun Im; Takuma Kunieda; Akihisa Shibata
  3. Optimal Bailouts in Banking and Sovereign Crises By Sewon Hur; César Sosa-Padilla; Zeynep Yom
  4. Why Might Lump-sum Transfers Not Be a Good Idea? By Yunmin Chen; YiLi Chien; Yi Wen; C. C. Yang
  5. Diagnostic Expectations and Macroeconomic Volatility By Jean-Paul L'Huillier; Sanjay R. Singh; Donghoon Yoo
  6. Violation of the Hamilton-Jacobi-Bellman Equation in Economic Dynamics By Yuhki Hosoya
  7. State dependent government spending multipliers: Downward nominal wage rigidity and sources of business cycle fluctuations By Yoon J. Jo; Sarah Zubairy
  8. Financial Destabilization By Ken-ichi Hashimoto; Ryonghun Im; Takuma Kunieda; Akihisa Shibata
  9. Consumption and Income Inequality across Generations By Giovanni Gallipoli; Hamish Low; Aruni Mitra
  10. "Mom, Dad: I’m staying”. Initial labor market conditions, housing markets, and welfare By Rodrigo Martínez-Mazza
  11. Implications of the Slowdown in Trend Growth for Fiscal Policy in a Small Open Economy By Beames, Alexander; Kulish, Mariano; Yamout, Nadine
  12. Eliciting Time Preferences When Income and Consumption Vary: Theory, Validation & Application to Job Search By Belot, Michèle; Kircher, Philipp; Muller, Paul
  13. Homeownership and portfolio choice over the generations By Paz-Pardo, Gonzalo
  14. Differential Fertility, Intergenerational Mobility and the Process of Economic Development By Aso, Hiroki
  15. Endogenous life expectancy and R&D-based economic growth By Tscheuschner, Paul
  16. Quality Job Programs, Unemployment and the Job Quality Mix By Benoit Julien; Ian King
  17. Entrepreneurship, growth and productivity with bubbles By Lise Clain-Chamosset-Yvrard; Xavier Raurich; Thomas Seegmuller
  18. The Effects of Land Markets on Resource Allocation and Agricultural Productivity By Chaoran Chen; Diego Restuccia; Raul Santaeulalia-Llopis
  19. A Certainty Equivalent Merton Problem By Nicholas Moehle; Stephen Boyd
  20. The Riddle of the Natural Rate of Interest By Weshah Razzak
  21. Liquidity risk and the dynamics of arbitrage capital By Kondor, Peter; Vayanos, Dimitri

  1. By: Masakazu Emoto (Graduate School of Economics, Kobe University); Tamotsu Nakamura (Graduate School of Economics, Kobe University)
    Abstract: Although the steady state equilibrium is represented by a single point in the capital-consumption plane in the standard Ramsey model, it is by a straight line in a Ramsey model with heterogeneous individuals. Taking advantage of this fact, this paper applies the backward induction method to analyze the transitional dynamics of the Ramsey model with heterogeneous individuals, and examines the role of heterogeneity in intertemporal elasticity of substitution (IES). When no heterogeneity exists in IES across individuals, then the wealth Gini declines as capital accumulates, while the wealth gap expands. In contrast, with heterogeneity, various dynamics of wealth distribution can emerge, including a U-shaped relationship between income and inequality. It is also shown that an inverted U-shaped relationship, i.e., the Kuznets curve can be explained by Stone-Geary preferences, which allow IES to change with wealth.
    Date: 2021–01
  2. By: Ken-ichi Hashimoto; Ryonghun Im; Takuma Kunieda; Akihisa Shibata
    Abstract: This paper uses a dynamic general equilibrium model to examine whether financial innovations destabilize an economy. Applying a neoclassical production function, we demonstrate that as financial frictions are mitigated, the economy loses stability and a flip bifurcation occurs at a certain level of financial frictions under an empirically plausible elasticity of substitution between capital and labor. Furthermore, the amplitude of fluctuations increases as financial frictions are mitigated and is maximized when the financial market approaches perfection. These outcomes imply that financial innovations are likely to destabilize an economy.
    Date: 2021–02
  3. By: Sewon Hur (Federal Reserve Bank of Dallas); César Sosa-Padilla (University of Notre Dame and NBER); Zeynep Yom (Department of Economics, Villanova School of Business, Villanova University)
    Abstract: We study optimal bailout policies in the presence of banking and sovereign crises. First, we use European data to document that asset guarantees are the most prevalent way in which sovereigns intervene during banking crises. Then, we build a model of sovereign borrowing with limited commitment, where domestic banks hold government debt and also provide credit to the private sector. Shocks to bank capital can trigger banking crises, with government sometimes finding it optimal to extend guarantees over bank assets. This leads to a trade-off: Larger bailouts relax domestic financial frictions and increase output, but also imply increasing government fiscal needs and possible heightened default risk (i.e., they create a 'diabolic loop'). We find that the optimal bailouts exhibit clear properties. Other things equal, the fraction of banking losses that the bailouts would cover is: (i) decreasing in the level of government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of the banking crisis. Even though bailouts mitigate the adverse effects of banking crises, we find that the economy is ex ante better off without bailouts: the 'diabolic loop' they create is too costly.
    Keywords: Bailouts; Sovereign Defaults; Banking Crises; Conditional Transfers; Sovereign-bank diabolic loop
    JEL: E32 E62 F34 F41 G01 G15 H63
    Date: 2021–01
  4. By: Yunmin Chen; YiLi Chien; Yi Wen; C. C. Yang
    Abstract: We adopt an analytically tractable Aiyagari-type model to study the distinctive roles of unconditional lump-sum transfers and public debt in reducing consumption inequality due to uninsurable income risk. We show that in the absence of wealth inequality, using lump-sum transfers is not an optimal policy for reducing consumption inequality---because the Ramsey planner opts to rely solely on public debt to mitigate income risk without the need for lump-sum transfers. This result is surprising in light of the popularity of universal basic income advocated by many politicians and scholars.
    Keywords: Lump-sum Transfers; Universal Basic Income; Ramsey Problem; Public Liquidity; Incomplete Markets; Heterogeneous-Agents
    JEL: C61 E22 E62 H21 H30
    Date: 2021–02–09
  5. By: Jean-Paul L'Huillier; Sanjay R. Singh; Donghoon Yoo (Department of Economics, University of California Davis)
    Abstract: Diagnostic expectations have emerged as an important departure from rational expectations in macroeconomics and finance. We present a first treatment of diagnostic expectations in linear macroeconomic models. To this end, we establish a strong additivity property for diagnostic expectations. The solution method and stability properties are discussed in full generality. Under some conditions, diagnostic expectations generate higher volatility than rational expectations. We show that this is true in standard New Keynesian models, as in medium-scale DSGE models; in real business cycle models output and investment are characterized by dampening, instead. Finally, we discuss how the combination of diagnosticity with imperfect information can rationalize under- and over-reaction in macroeconomics.
    Keywords: diagnostic expectations, macroeconomics, volatility, linear rational expectations, overshooting
    JEL: E12 E32 E71
    Date: 2021–02–09
  6. By: Yuhki Hosoya
    Abstract: We consider an extension of the classical capital accumulation model, and present an example in which the Hamilton-Jacobi-Bellman (HJB) equation is neither necessary nor sufficient for a function to be the value function. Next, we present assumptions under which the HJB equation becomes a necessary and sufficient condition for a function to be the value function, and using this result, we propose a new method for solving the original problem using the solution of the HJB equation. Our assumptions are so mild that many macroeconomic growth models satisfy them. Therefore, our results ensure that the solution of the HJB equation is rigorously the value function in many macroeconomic models, and present a new solving method for these models.
    Date: 2021–02
  7. By: Yoon J. Jo (Texas A&M University, Department of Economics); Sarah Zubairy (Texas A&M University, Department of Economics)
    Abstract: This paper shows that the source of business cycle fluctuations matters for determining the size of government spending multipliers. We present a New Keynesian model with downward nominal wage rigidity (DNWR) and show that government spending is much more effective in stimulating output in a demand shock driven recession compared to a supply shock driven recession. Government spending multiplier is large when DNWR binds in a recession, but the nature of recession matters due to the opposing responses of inflation depending on the type of recession. In a demand-driven recession, inflation falls, preventing real wages from falling, leading to consequences for employment, while inflation rises in a supply-driven recession limiting the consequences of DNWR on employment. We document supporting empirical evidence, using both historical time series data and cross-sectional data from U.S. states, that the government spending multiplier for output is larger in a demand-driven recession compared to a supply-driven recession.
    Keywords: Government Spending Multipliers, Source of Fluctuation, Downward Nominal Wage Rigidity.
    JEL: E24 E32 E62
    Date: 2021–01–27
  8. By: Ken-ichi Hashimoto (Graduate School of Economics, Kobe University); Ryonghun Im (Kyoto University); Takuma Kunieda (Kwansei Gakuin University); Akihisa Shibata (Kyoto University)
    Abstract: This paper uses a dynamic general equilibrium model to examine whether financial innovations destabilize an economy. Applying a neoclassical production function, we demonstrate that as financial frictions are mitigated, the economy loses stability and a flip bifurcation occurs at a certain level of financial frictions under an empirically plausible elasticity of substitution between capital and labor. Furthermore, the amplitude of fluctuations increases as financial frictions are mitigated and is maximized when the financial market approaches perfection. These outcomes imply that financial innovations are likely to destabilize an economy.
    Date: 2021–02
  9. By: Giovanni Gallipoli (UBC; CEPR; HCEO; Rimini Centre for Economic Analysis); Hamish Low (University of Oxford, UK; IFS); Aruni Mitra (European University Institute, Italy)
    Abstract: We characterize the joint evolution of cross-sectional inequality in earnings, other sources of income and consumption across generations in the U.S. To account for cross-sectional dispersion, we estimate a model of intergenerational persistence and separately identify the influences of parental factors and of idiosyncratic life-cycle components. We find evidence of family persistence in earnings, consumption and saving behaviours, and marital sorting patterns. However, the quantitative contribution of idiosyncratic heterogeneity to cross-sectional inequality is significantly larger than parental effects. Our estimates imply that intergenerational persistence is not high enough to induce further large increases in inequality over time and across generations.
    Keywords: income, consumption, intergenerational persistence, inequality
    JEL: D15 D64 E21
    Date: 2021–02
  10. By: Rodrigo Martínez-Mazza (Universitat de Barcelona & IEB)
    Abstract: Young individuals are currently living with their parents more than at any other point in time, while also spending more on housing. In this paper, I first show how labor market entry conditions affect housing tenure and affordability in the long term, by using the unemployment rate at the time of graduation as an exogenous shock to income. I perform this analysis across Europe for the last 25 years. Results indicate that a 1 pp increase in the unemployment rate at the time of graduation leads, one year after, to (1) a 1.50 pp increase in the probability of living with parents, (2) a 1.02 pp decrease in the probability of home-ownership and 0.45 pp decrease in renting, and (3) worse affordability. Second, I develop an OLG model to link income shocks for young agents with changes in housing tenure at the aggregate level. I allow for an outside option for landlords which can introduce rigidity into the rental market. Results show that if rental markets are rigid, an income shock to young agents will translate into a larger share of them living with their parents, worse affordability, and larger welfare losses. Finally, I perform a policy exercise based on the French housing aid system. I show that housing aid policies can help to recover welfare losses for young agents, by enabling them to afford to rent. Recognizing the right scenario for the implementation of these policies is key to ensure welfare gains concentrate on the targeted population.
    Keywords: Housing, labor markets, long-term effects
    JEL: R20 R21 J24
    Date: 2020
  11. By: Beames, Alexander; Kulish, Mariano; Yamout, Nadine
    Abstract: We set up and estimate a small open economy model with fi scal policy in which trend growth can permanently change. The magnitude and timing of the change in trend growth are estimated alongside the structural and fiscal policy rule parameters. Around 2003:Q3, trend growth in per capita output is estimated to have fallen from just over 2 per cent to 0.6 per cent annually. The slowdown brings about a lasting transition which in the short-run decreases consumption tax revenues but increases them in the long-run changing permanently the composition of tax revenues and temporarily increasing the government debt-to-output ratio..
    Keywords: Open economy, trend growth, scal policy, real business cycles, estimation, structural breaks
    Date: 2020–05
  12. By: Belot, Michèle (Cornell University); Kircher, Philipp (Cornell University); Muller, Paul (Vrije Universiteit Amsterdam)
    Abstract: We propose a simple method for eliciting individual time preferences without estimating utility functions even in settings where background consumption changes over time. It relies on lottery tickets with high rewards. In a standard intertemporal choice model high rewards decouple lottery choices from variation in background consumption. We validate our elicitation method experimentally on two student samples: one asked in December when their current budget is reduced by extraordinary expenditures for Christmas gifts; the other asked in February when no such extra constraints exist. We illustrate an application of our method with unemployed job seekers which naturally have income/consumption variation.
    Keywords: time preferences, experimental elicitation, job search, hyperbolic discounting
    JEL: D90 J64
    Date: 2021–02
  13. By: Paz-Pardo, Gonzalo
    Abstract: Earnings are riskier and more unequal for households born in the 1960s and 1980s than for those born in the 1940s. Despite the improvements in financial conditions, younger generations are less likely to be living in their own homes than older generations at the same age. By using a life-cycle model with housing and portfolio choice that includes flexible earnings risk and aggregate asset price risk, I show that changes in earnings dynamics account for a large part of the reduction in homeownership across generations. Lower-income households find it harder to buy housing, and as a result accumulate less wealth. JEL Classification: D31, E21, E24, G11, J31
    Keywords: earnings risk, housing demand, intergenerational inequality, wealth accumulation
    Date: 2021–02
  14. By: Aso, Hiroki
    Abstract: This paper analyzes the interactions among population dynamics with differential fertility, intergenerational mobility, income inequality and economic development in an overlapping generations framework. Population dynamics with differential fertility between the educated and the uneducated has two effects on the economy: the direct effect on the educated share through changing in population size of the economy as whole, and the indirect effect on the educated share through decreasing/increasing transfer per child. When population growth increases sufficiently, the mobility and income inequality exhibit cyclical behavior due to rapidly decreasing transfer per child and increasing population size. In contrast, when population growth decreases sufficiently, the mobility and income inequality monotonically approach steady state, and the economy has two steady states: low steady state with high population growth and income inequality, and high steady state with low population growth and income inequality. As a result, this paper shows that population dynamics plays crucial role in the transitional dynamics of mobility and economic development.
    Keywords: Differential Fertility, Intergenerational Mobility and the Process of Economic Development
    JEL: I24 I25 J13 J62
    Date: 2020–03–23
  15. By: Tscheuschner, Paul
    Abstract: We propose an overlapping generations framework in which life expectancyis determined endogenously by governmental health investments. As a novelty, we are able to examine the feedback effects between life expectancy and R&D-driven economic growth for the transitional dynamics. We find that i) higher survival induces economic growth through higher savings and higherlabor force participation; ii) longevity-induced reductions in fertility hampereconomic development; iii) the positive life expectancy effects of larger savingsand higher labor force participation outweigh the negative effect of a reductionin fertility, and iv) there exists a growth-maximizing size of the health caresector that might lie beyond what is observed in most countries. Altogether, the results support a rather optimistic view on the relationship between lifeexpectancy and economic growth and contribute to the debate surroundingrising health shares and economic development.
    Keywords: long-run growth,horizontal innovation,increasing life expectancy,welfare effects of changing longevity,size of health-care sectors
    JEL: I15 J11 J13 J17 O41
    Date: 2021
  16. By: Benoit Julien; Ian King (MRG - School of Economics, The University of Queensland)
    Abstract: TWe examine the impact of Quality Jobs Programs (QJPs) on job creation, unemployment, and average job quality, in a directed search model of the labor market where firms bid for labor and can choose to create different qualities of jobs. The government has access to differential tax and subsidy structures, and unemployment benefits. QJPs are defined as job subsidy structures where higher quality jobs are subsidized more generously than lower quality ones. We find that QJPs increase the number of higher quality jobs but decrease the number of lower quality jobs commensurately — raising the average quality of jobs but leaving the unemployment rate unchanged and inducing an inefficient job quality mix. Uniform subsidies, on the other hand, increase the number of lower quality jobs while not affecting the number of higher quality jobs — thereby reducing both the average quality of jobs and the unemployment rate. If uniform subsidies are set equal to unemployment benefit levels then the job quality mix is also efficient.
  17. By: Lise Clain-Chamosset-Yvrard (GATE Lyon Saint-Étienne - Groupe d'analyse et de théorie économique - CNRS - Centre National de la Recherche Scientifique - Université de Lyon - UJM - Université Jean Monnet [Saint-Étienne] - UCBL - Université Claude Bernard Lyon 1 - Université de Lyon - UL2 - Université Lumière - Lyon 2 - ENS Lyon - École normale supérieure - Lyon); Xavier Raurich (UB - Universitat de Barcelona); Thomas Seegmuller (AMSE - Aix-Marseille Sciences Economiques - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - École Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique)
    Abstract: Entrepreneurship, growth and total factor productivity are larger when there is a financial bubble. We explain these facts using a growth model with financial bubbles in which individuals face heterogeneous wages and returns on productive investment. The heterogeneity in the return of in- vestment separates individuals between savers and entrepreneurs. Savers buy financial assets, which are deposits or a financial bubble. Entrepreneurs incur in a start-up cost and borrow to invest in productive capital. The bubble provides liquidities to credit-constrained entrepreneurs. These liquidities increase investment and entrepreneurship when the start- up cost is large enough, which explains that growth and entrepreneurship can be larger with bubbles. Finally, productivity can be larger when the bubble further increases the investment of more productive entrepreneurs. This can occur when the return of investment is correlated with wages.
    Keywords: bubble,entrepreneurship,growth,productivity
    Date: 2021–02–05
  18. By: Chaoran Chen; Diego Restuccia; Raul Santaeulalia-Llopis
    Abstract: We assess the effects of land markets on misallocation and productivity both empirically and quantitatively. Exploiting variation from a land certification reform across time and space in Ethiopia, we find that certification facilitates rentals and improves agricultural productivity. We calibrate a quantitative macroeconomic model with heterogeneous household farms facing institutional costs to land markets using the micro panel data. The effect of a counterfactual reallocation from no rentals to efficient rentals increases zone-level agricultural productivity by 43 percent on average. While our estimated institutional costs are strongly associated with land certification across zones, there are nontrivial residual frictions to rental market activity, implying that land certification only partially captures the overall effects of rentals. A full certification reform accounts for just one-fourth of the overall productivity gains from land rentals. This result highlights the importance of comprehensive reforms alleviating frictions to land transactions beyond the granting of certificates.
    Keywords: Land, Markets, Rentals, Misallocation, Productivity, Inequality, Panel Data.
    JEL: E02 O10 O11 O13 O43 O55 Q15 Q18 Q24
    Date: 2021–02–06
  19. By: Nicholas Moehle; Stephen Boyd
    Abstract: The Merton problem is the well-known stochastic control problem of choosing consumption over time, as well as an investment mix, to maximize expected constant relative risk aversion (CRRA) utility of consumption. Merton formulated the problem and provided an analytical solution in 1970; since then a number of extensions of the original formulation have been solved. In this note we identify a certainty equivalent problem, i.e., a deterministic optimal control problem with the same optimal value function and optimal policy, for the base Merton problem, as well as a number of extensions. When time is discretized, the certainty equivalent problem becomes a second-order cone program (SOCP), readily formulated and solved using domain specific languages for convex optimization. This makes it a good starting point for model predictive control, a policy that can handle extensions that are either too cumbersome or impossible to handle exactly using standard dynamic programming methods.
    Date: 2021–01
  20. By: Weshah Razzak
    Abstract: We provide a general equilibrium model with optimizing agents to compute the natural rate of interest for the G7 countries over the period 2000 to 2017. The model is solved for the equilibrium natural rate of interest, which is determined by a parsimonious equation that is easily computed from raw observable data. The model predicts that the natural rate depends positively on the consumption – leisure growth rates gap, and negatively on the capital – labor growth rates gap. Given our computed natural rate, the short-term nominal interest rates in the G7 have been higher than the natural rate since 2000, except for Germany and the U.S. during the period 2009-2017. In addition, the data do not support the prediction of the Wicksellian theory that prices tend to increase when the short-term nominal rate is lower than the natural rate. Projections of the natural rate over the period 2018 to 2024 are positive in Germany, Italy, Japan, and the U.K. and negative in Canada, France, and the U.S. The model predicts that fiscal expansion is an expensive policy to achieve a 2 percent inflation target when the Zero Lower Bound (ZLB) constraint is binding.
    Keywords: Natural rate of interest, Monetary policy
    JEL: C68 E43 E52
    Date: 2020–08–08
  21. By: Kondor, Peter; Vayanos, Dimitri
    Abstract: We develop a continuous-time model of liquidity provision in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have constant relative risk-aversion (CRRA) utility, while hedgers' asset demand is independent of wealth. An increase in hedgers' risk aversion can make arbitrageurs endogenously more risk-averse. Because arbitrageurs generate endogenous risk, an increase in their wealth or a reduction in their CRRA coefficient can raise risk premia despite Sharpe ratios declining. Arbitrageur wealth is a priced risk factor because assets held by arbitrageurs offer high expected returns but suffer the most when wealth drops. Aggregate illiquidity, which declines in wealth, captures that factor.
    Keywords: liquidity risk; wealth effects; heterogeneous agents; intermediary asset pricing; endogenous risk; 336585
    JEL: F3 G3
    Date: 2019–06–01

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