nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2021‒04‒26
twenty papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Stock prices and monetary policy in Japan: An analysis of a Bayesian DSGE model By Hoshino, Satoshi; Ida, Daisuke
  2. Optimal monetary policy with the risk-taking channel By Angela Abbate; Dominik Thaler
  3. Economic depression in Brazil: the 2014-2016 fall By Brinca, Pedro; Costa-Filho, João
  4. Budget deficit for full-employment under growth and inflation by excessive deficit in an OLG model with bequest motive By Tanaka, Yasuhito
  5. The “Matthew Effect” and Market Concentration:Search Complementarities and Monopsony Power By Jesús Fernández-Villaverde; Federico Mandelman; Yang Yu; Francesco Zanetti
  6. Monetary-Fiscal Interactions and Redistribution in Small Open Economies By Gergo Motyovszki
  7. Population aging, relative prices and capital flows across the globe By Andrea Papetti
  8. (In)efficient Separations, Firing Costs and Temporary Contracts By Andrea Gerali; Elisa Guglielminetti; Danilo Liberati
  9. Output falls and the international transmission of crises By Brinca, Pedro; João, Costa-Filho
  10. Budget Deficit to Achieve and Maintain Full-employment Under Growth by Technological Progress By Tanaka, Yasuhito
  11. Optimal Constrained Interest-Rate Rules under Heterogeneous Expectations By Gasteiger, Emanuel
  12. The Environmental Unsustainability of Public Debt: Non-Renewable Resources, Public Finances Stabilization and Growth By Nicolas Clootens; Francesco Magris
  13. Risky Business Cycles By Susanto Basu; Giacomo Candian; Ryan Chahrour; Rosen Valchev
  14. On robustness of average inflation targeting By Honkapohja, Seppo; McClung, Nigel
  15. Optimal Taxes and Transfers with Household Heterogeneity By Boris Chafwehé; François Courtoy
  16. The Supply of Hours Worked and Fluctuations between Growth Regimes By Ka-Kit Iong; Andreas Irmen
  17. Deep Reinforcement Learning in a Monetary Model By Mingli Chen; Andreas Joseph; Michael Kumhof; Xinlei Pan; Rui Shi; Xuan Zhou
  18. Barriers to Global Capital Allocation By Bruno Pellegrino; Enrico Spolaore; Romain Wacziarg
  19. The Insurance Value of Financial Aid By Kristy Fan; Tyler J. Fisher; Andrew A. Samwick
  20. Deadly Debt Crises: COVID-19 in Emerging Markets By Cristina Arellano; Yan Bai; Gabriel Mihalache

  1. By: Hoshino, Satoshi; Ida, Daisuke
    Abstract: This paper reevaluates the role of asset price stabilization in Japan during the 1980s through a Bayesian estimation of the dynamic stochastic general equilibrium model. Our results show the presence of the wealth channel from increased stock prices in Japan. In addition, we argue the possibility that the Bank of Japan (BOJ) may have conducted its monetary policy by targeting the stock price stability in addition to inflation and the output gap. The BOJ's response to stock price movements as a matter of policy, however, is subject to considerable uncertainty. Our results indicate that while the BOJ may have reacted to stock prices deviated from their fundamental values, it could not prevent a stock price bubble simply by implementing a contractionary monetary policy shock. Therefore, we conclude that the BOJ's monetary policy stance aimed at stabilizing stock price fluctuations and minimizing macroeconomic volatility, whereas endogenous volatility was caused by bad shocks.
    Keywords: Monetary policy; Bayesian estimation; DSGE model; Stock prices; Wealth effect;
    JEL: E52 E58
    Date: 2021–04–21
  2. By: Angela Abbate; Dominik Thaler
    Abstract: Empirical research suggests that lower interest rates induce banks to take higher risks. We assess analytically what this risk-taking channel implies for optimal monetary policy in a tractable New Keynesian model. We show that this channel creates a motive for the planner to stabilize the real rate. This objective conflicts with the standard inflation stabilization objective. Optimal policy thus tolerates more inflation volatility. An inertial Taylor-type reaction function becomes optimal. We then quantify the significance of the risk-taking channel for monetary policy in an estimated medium-scale extension of the model. Ignoring the channel when designing policy entails non-negligible welfare costs (0.7% lifetime consumption equivalent).
    Keywords: Risk-taking channel, optimal monetary policy
    JEL: E44 E52
    Date: 2021
  3. By: Brinca, Pedro; Costa-Filho, João
    Abstract: What is behind the economic depression Brazil experienced within 2014-2016? Using a synthetic control estimations we find that its roots are domestic. With that in mind, we apply the business cycle accounting method and find that the episode was driven by the efficiency wedge. The econometric evidence reveals that the public development bank outlays have a positive (negative) impact in the short (long) run in the efficiency wedge. A dynamic general equilibrium model with financial frictions and a public development bank is able to reproduce the dynamics of output during the crisis.
    Keywords: Business Cycle Accounting, Brazil, DSGE, Financial Frictions
    JEL: E32 E44 E50
    Date: 2021–04–20
  4. By: Tanaka, Yasuhito
    Abstract: We will show, using a simple two-periods overlapping generations (OLG) model with bequest motive in which goods are produced solely by labor in a monopolistically competitive industry, that a continuous budget deficit is necessary to maintain full-employment under economic growth driven by technological progress. Since the budget deficit to maintain full-employment must be continuous, it should be financed by seigniorage not by public debt. Budget deficit is necessary under growth because of deficiency of the consumptions of the older generation. This budget deficit is not debt and does not need to be redeemed. If the budget deficit is excessive, inflation will be triggered. About this excessive budget deficit that has caused inflation, only the excess portion should be reduced, and there is no need to make up for past excesses by creating surpluses or reducing deficits. We also show that insufficient government expenditure causes involuntary unemployment.
    Keywords: overlapping generations model, budget deficit, full-employment, growth, inflation
    JEL: E12 E24
    Date: 2021–04–18
  5. By: Jesús Fernández-Villaverde; Federico Mandelman; Yang Yu; Francesco Zanetti
    Abstract: This paper develops a dynamic general equilibrium model with heterogeneous firms that face search complementarities in the formation of vendor contracts. Search complementarities amplify small differences in productivity among firms. Market concentration fosters monopsony power in the labor market, magnifying profits and further enhancing high-productivity firms’ output share. Firms want to get bigger and hire more workers, in stark contrast with the classic monopsony model, where a firm aims to reduce the amount of labor it hires. The combination of search complementarities and monopsony power induces a strong “Matthew effect” that endogenously generates superstar firms out of uniform idiosyncratic productivity distributions. Reductions in search costs increase market concentration, lower the labor income share, and increase wage inequality.
    Keywords: Market concentration, superstar firms, search complementarities, monopsony power in the labor market
    Date: 2021–02–08
  6. By: Gergo Motyovszki
    Abstract: Ballooning public debts in the wake of the covid-19 pandemic can present monetary-fiscal policies with a dilemma if and when neutral real interest rates rise, which might arrive sooner in emerging markets: policymakers can stabilize debts either by relying on fiscal adjustments (AM-PF) or by tolerating higher inflation (PM-AF). The choice between these policy mixes affects the efficacy of the fiscal expansion already today and can interact with the distributive properties of the stimulus across heterogeneous households. To study this, I build a two agent New Keynesian (TANK) small open economy model with monetary-fiscal interactions. Targeting fiscal transfers more towards high-MPC agents increases the output multiplier of a fiscal stimulus, while raising the degree of deficit-financing for these transfers also helps. However, precise targeting is much more important under the AM-PF regime than the question of financing, while the opposite is the case with a PM-AF policy mix: then deficit-spending is crucial for the size of the multiplier, and targeting matters less. Under the PM-AF regime fiscal stimulus entails a real exchange rate depreciation which might offset "import leakage" by stimulating net exports, if the share of hand-to-mouth households is low and trade is price elastic enough. Therefore, a PM-AF policy mix might break the Mundell-Fleming prediction that open economies have smaller fiscal multipliers relative to closed economies.
    Keywords: monetary-fiscal interactions, small open economy, hand-to-mouth agents, redistribution, public debt, Ricardian equivalence
    Date: 2021
  7. By: Andrea Papetti (Bank of Italy)
    Abstract: This paper develops a multi-country two-sector overlapping-generations model to study the impact of demographic change on the relative price of nontradables and current account balances. An aging population expands the relative demand for nontradables, exerting upward pressure on their relative price (structural transformation), and entails a willingness to save more, as households discount higher survival probabilities, and invest less, as firms face increasing labor scarcity. The general equilibrium reduction of the real interest rate (secular stagnation) dampens the increase in the relative price as savings become less profitable, thus lowering consumption at older ages. The model robustly predicts that faster-aging countries will face greater increases in the relative price of nontradables and unprecedented accumulations of net foreign asset positions (global imbalances) over the twenty-first century.
    Keywords: population aging, relative prices, capital flows, overlapping generations, tradable nontradable, secular stagnation, structural transformation, global imbalances
    JEL: E21 F21 J11 O11 O14
    Date: 2021–04
  8. By: Andrea Gerali (Bank of Italy); Elisa Guglielminetti (Bank of Italy); Danilo Liberati (Bank of Italy)
    Abstract: In this paper we study the allocative (in)efficiency of employment protection in relation to firing costs, in a general equilibrium model with labor market frictions. The optimal firing costs depend on the level of unemployment benefits and the degree of centralized wage bargaining, two features of the labor market that induce downward wage rigidity and trigger inefficient employment separations. When restrictions on firing employees with permanent contracts are inefficiently high, the introduction of temporary contracts improves welfare but does not fully restore efficiency. A quantitative analysis for the Italian economy shows that the firing costs before the recent labor market reforms were 30% higher than the optimal level, implying a consumption loss of almost 2% in the steady state. The introduction of fixed-term jobs in the early 2000’s closed one fourth of the gap between inefficient and efficient allocation, although it led to higher unemployment rates and turnover.
    Keywords: employment protection, temporary contracts, labor market institutions, structural reforms, general equilibrium model, search and matching
    JEL: E32 J41 J65
    Date: 2021–04
  9. By: Brinca, Pedro; João, Costa-Filho
    Abstract: Economic crises are usually transmitted across countries via either price or quantity shocks on the balance of payments. This paper complements the literature on international trade and business cycles by analyzing the role of imported intermediates goods inputs during the Great Financial Crisis in small open economies. We find that in an increasingly integrated world, intra-industry international trade is an important channel of propagation of shocks. A depreciation of the real exchange rate rises to costs of intermediate output, which decreases production. Our quantitative model is able to reproduce both the intensity and the velocity of the crisis in Mexico.
    Keywords: Great Recession, Intermediate goods, Business Cycle Accounting
    JEL: E27 E30 E32 E37
    Date: 2021–04–20
  10. By: Tanaka, Yasuhito
    Abstract: The purpose of this paper is to show, using a simple two-periods overlapping generations (OLG) model in which goods are produced solely by labor in a monopolistically competitive industry, that a continuous budget deficit is necessary to maintain full-employment under economic growth driven by autonomous technological progress. Since the budget deficit must be continuous, it should be financed by seigniorage not by public debt. Also we will show that to achieve full employment in the presence of involuntary unemployment we need extra budget deficit. Budget deficit is necessary under growth because of deficiency of the savings of the older generation. These budget deficits are not debt and do not need to be redeemed. The money supply equals the savings. An increase in the money supply equals an increase in the savings. It equals the budget deficit. The rate of an increase in the savings equals the growth rate and therefore budget deficit does not cause inflation.
    Keywords: overlapping generations model, budget deficit, full-employment, growth
    JEL: E12 E24
    Date: 2021–04–18
  11. By: Gasteiger, Emanuel
    Abstract: This paper examines optimal monetary policy under heterogeneous expectations. To this end, we develop a stochastic New Keynesian model with a cost-push shock and coexistence of one-step-ahead rational and adaptive expectations in decentralized markets. On the one side, heterogeneous expectations imply an amplification mechanism that has many adverse consequences missing under the rational expectations paradigm. On the other side, even discretionary optimal monetary policy can manipulate expectations via a novel channel. We argue that the incorporation of heterogeneous expectations in both the design and implemen tation of discretionary optimal monetary policy to exploit this channel lowers macroeconomic volatility. We find that: (1.) surprisingly, a more hawkish policy can reduce losses due to volatility, but an overly hawkish policy does not; (2.) overestimating the share of rational expectations in the design and implementation of policy creates additional losses, while the underestimation does not; (3.) credible commitment eliminates or mitigates many of the ramifications of heterogeneous expectations.
    Keywords: heterogeneous expectations,optimal monetary policy,policy design,policy implementation
    JEL: D84 E52
    Date: 2021
  12. By: Nicolas Clootens (AMSE, Ecole Centrale Marseille); Francesco Magris (DEAMS, University of Trieste)
    Abstract: This paper introduces a public debt stabilization constraint in an overlapping generation model in which non-renewable resources constitute a necessary input in the production function and belong to agents. It shows that stabilization of public debt at high level (as share of capital) may prevent the existence of a sustainable development path. Public debt thus appears as a threat to sustainable development. It also shows that higher public debt-to-capital ratios (and public expenditures-to-capital ones) are associated with lower growth. Two transmission channels are identified. As usual, public debt crowds out capital accumulation. In addition, public debt tends to increase resource use which reduces the rate of growth. We also analyze the dynamics and we show that the economy is characterized by saddle path stability. Finally, we show that the public debt-to-capital ratio may be calibrated to implement the social planner optimal allocation.
    Keywords: Non-renewable Resources, Growth, Public Finances, Overlapping Generations,
    JEL: Q32 Q38 H63
    Date: 2021–06
  13. By: Susanto Basu; Giacomo Candian; Ryan Chahrour; Rosen Valchev
    Abstract: We identify a shock that explains the bulk of fluctuations in equity risk premia, and show that the shock also explains a large fraction of the business-cycle comovements of output, consumption, employment, and investment. Recessions induced by the shock are associated with reallocation away from full-time permanent positions, towards part-time and flexible contract workers. A real model with labor market frictions and fluctuations in risk appetite can explain all of these facts, both qualitatively and quantitatively. The size of risk-driven fluctuations depends on the relationship between the riskiness and productivity of different stores of value: if safe savings vehicles have relatively low marginal products, then a flight to safety will drive a larger aggregate contraction.
    JEL: E24 E32 G12
    Date: 2021–04
  14. By: Honkapohja, Seppo; McClung, Nigel
    Abstract: This paper considers the performance of average inflation targeting (AIT) policy in a New Keynesian model with adaptive learning agents. Our analysis raises concerns regarding robustness of AIT when agents have imperfect knowledge. In particular, the target steady state can be locally unstable under learning if details about the policy are not publicly available. Near the low steady state with interest rates at the zero lower bound, AIT does not necessarily outperform a standard inflation targeting policy. Policymakers can improve outcomes under AIT by (i) targeting a discounted average of inflation, or (ii) communicating the data window for the target.
    JEL: E31 E52 E58
    Date: 2021–04–21
  15. By: Boris Chafwehé (European Commission (Joint Research Center)); François Courtoy (IRES/LIDAM, UCLouvain)
    Abstract: We investigate the properties of optimal fiscal policy in a framework where householdheterogeneity is accounted for. The Ramsey planner chooses (distortionary) labor taxes andtransfers to maximize aggregate welfare in a two-agent economy. We contrast the propertiesof optimal labor taxes in our model to the ones obtained in the representative agent counter-part. We first show that the presence of household heterogeneity introduces an additionalsource of fluctuations in the optimal tax rate, as varying taxes allows the planner to use trans-fers for redistributive purposes. We then show that, depending on the assumptions that aremade on how transfer receipts are distributed among households, and the type of shockshitting the economy, the structure of government bond markets becomes more or less im-portant in shaping the dynamics of the Ramsey allocation. In some cases, the presence oftransfers brings the incomplete markets allocation close to the one in which the planner hasaccess to state-contingent claims. We finally show that the presence of heterogeneity andoptimal transfers helps bring the behaviour of fiscal variables in the Ramsey model closer totheir counterpart in US data.
    Keywords: Fiscal policy, Household heterogeneity, Optimal taxation, Transfers
    JEL: E32 E62 H21 H23 H31
    Date: 2021–04–16
  16. By: Ka-Kit Iong; Andreas Irmen
    Abstract: Declining hours of work per worker in conjunction with a growing work force may give rise to fluctuations between growth regimes. This is shown in an overlapping generations model with two-period lived individuals endowed with Boppart-Krusell preferences (Boppart and Krusell (2020)). On the supply side, economic growth is due to the expansion of consumption-good varieties through endogenous research. A sufficiently negative equilibrium elasticity of the individual supply of hours worked to an expansion in the set of consumption-good varieties destabilizes the steady state so that equilibrium trajectories may fluctuate between two growth regimes, one with and the other without an active research sector. Fluctuations affect intergenerational welfare, the evolution of GDP, and the functional income distribution. A stabilization policy can shift the economy onto its steady-state path. Fluctuations arise for empirically reasonable parameter constellations. The economics of fluctuations between growth regimes is linked to the intergenerational trade of shares and their pricing in the asset market.
    Keywords: endogenous fluctuations, growth regimes, endogenous technological change, endogenous labor supply, OLG-model
    JEL: J22 O33 O41
    Date: 2021
  17. By: Mingli Chen; Andreas Joseph; Michael Kumhof; Xinlei Pan; Rui Shi; Xuan Zhou
    Abstract: We propose using deep reinforcement learning to solve dynamic stochastic general equilibrium models. Agents are represented by deep artificial neural networks and learn to solve their dynamic optimisation problem by interacting with the model environment, of which they have no a priori knowledge. Deep reinforcement learning offers a flexible yet principled way to model bounded rationality within this general class of models. We apply our proposed approach to a classical model from the adaptive learning literature in macroeconomics which looks at the interaction of monetary and fiscal policy. We find that, contrary to adaptive learning, the artificially intelligent household can solve the model in all policy regimes.
    Date: 2021–04
  18. By: Bruno Pellegrino; Enrico Spolaore; Romain Wacziarg
    Abstract: We quantify the impact of barriers to international investment, using a novel multi-country dynamic general equilibrium model with heterogeneous investors and imperfect capital mobility. Our model yields a gravity equation for bilateral foreign asset positions. We estimate this gravity equation using recently-developed foreign investment data that have been restated to account for offshore investment and financing vehicles. We show that a parsimonious implementation of the model with four barriers (geographic distance, cultural distance, foreign investment taxation, and political risk) accounts for a large share of the observed variation in bilateral foreign investment positions. Our model predicts (out of sample) a significant home bias, higher rates of return on capital in emerging markets, as well as “upstream” capital flows. In our benchmark calibration, we estimate that the capital misallocation induced by these barriers reduces World GDP by 7%, compared to a situation without barriers. We also find that barriers to global capital allocation contribute significantly to cross-country inequality: the standard deviation of log capital per employee is 80% higher than it would be in a world without barriers to international investment, while the dispersion in output per employee is 42% higher.
    JEL: E22 E44 F2 F3 F4 G15 O4
    Date: 2021–04
  19. By: Kristy Fan; Tyler J. Fisher; Andrew A. Samwick
    Abstract: Financial aid programs enable students from families with fewer financial resources to pay less to attend college than other students from families with greater financial resources. When income is uncertain, a means-tested financial aid formula that requires more of an Expected Family Contribution (EFC) when income and assets are high and less of an EFC when income and assets are low provides insurance against that uncertainty. Using a stochastic, life-cycle model of consumption and labor supply, we show that the insurance value of financial aid is substantial. Across a range of parameterizations, we calculate that financial aid would have to increase by enough to reduce the net cost of attendance by 30 to 80 percent to compensate families for the loss of the income- and asset-contingent elements of the current formula. This compensating variation is net of the negative welfare consequences of the disincentives to work and save inherent in the means-testing of financial aid. Replacing just the "financial aid tax" on assets with a lump sum would also reduce welfare.
    JEL: D15 G52 I22
    Date: 2021–04
  20. By: Cristina Arellano; Yan Bai; Gabriel Mihalache
    Abstract: The coronavirus pandemic has severely impacted emerging markets by generating a large death toll, deep recessions, and a wave of sovereign defaults. We study this compound health, economic, and debt crisis and its mitigation by integrating epidemiological dynamics into a sovereign default model. The epidemic leads to an urgent need for social distancing measures, a large drop in economic activity, and a protracted debt crisis. The presence of default risk restricts fiscal space and presents emerging markets with a trade-off between mitigation of the pandemic and fiscal distress. A quantitative analysis of our model accounts well for the dynamics of deaths, social distance measures, and sovereign spreads in Latin America. In the model, the welfare cost of the pandemic is higher because of financial market frictions: about a third of the cost comes from default risk, compared with a version of the model with perfect financial markets. We study debt relief programs through counterfactuals and find a compelling case for their implementation, as they deliver large social gains.
    Date: 2021

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