nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2021‒11‒22
fourteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Ascendant altruism and asset price bubbles By Bosi, Stefano; Ha-Huy, Thai; Pham, Cao-Tung; Pham, Ngoc-Sang
  2. Optimal Monetary Policy with the Risk-Taking Channel By Angela Abbate; Dominik Thaler
  3. Endogenous Growth, Downward Wage Rigidities and Optimal Inflation By Mr. Sebastian Weber; Mirko Abbritti; Agostino Consolo
  4. Budget-neutral capital tax cuts By Frédéric Dufourt; Lisa Kerdelhué; Océane Piétri
  5. Identifying the external and internal drivers of exchange rate volatility in small open economies: Evidence from Jamaica By Uluc Aysun
  6. Nonlinearities and Workers’ Heterogeneity in Unemployment Dynamics By Adjemian, Stéphane; Karamé, Frédéric; Langot, François
  7. Optimal State Contingent Sovereign Debt Instruments By Mr. Alejandro D Guerson
  8. Are Bank Bailouts Welfare Improving? By Shukayev, Malik; Ueberfeldt, Alexander
  9. The Debt Capacity of a Government By Bernard Dumas; Paul Ehling; Chunyu Yang
  10. "Welfare Costs of Exchange Rate Fluctuations: Evidence from the 1972 Okinawa Reversion" By Kazuko Kano; Takashi Kano
  11. Financial and Total Wealth Inequality with Declining Interest Rates By Greenwald, Daniel L.; Leombroni, Matteo; Lustig, Hanno; Van Nieuwerburgh, Stijn
  12. "Are you in the right job?" Human Capital Mismatch in the UK By Galanakis, Yannis
  13. Do Banks Price Environmental Transition Risks? Evidence from a Quasi-Natural Experiment in a Chinese Province By Maria Teresa Punzi; Bihong Huang; Yu Wu
  14. Unintended Consequences of U. S. Monetary Policy Shocks: Dutch Disease and Capital Flow Measures in Emerging Markets and Developing Economies By Juan Yepez

  1. By: Bosi, Stefano; Ha-Huy, Thai; Pham, Cao-Tung; Pham, Ngoc-Sang
    Abstract: We consider an overlapping generations economy with altruism towards parents and a long-lived asset that delivers no dividends (pure bubble asset). We explore the role of ascendant altruism on the dynamics properties of equilibrium and rational bubbles in the cases of exogenous and endogenous growths.
    Keywords: Overlapping generations, ascendant altruism, capital accumulation, growth, rational bubbles
    JEL: D64 E44 G10
    Date: 2021–11–01
  2. By: Angela Abbate (Swiss National Bank); Dominik Thaler (Banco de España)
    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, inertial policy rate
    JEL: E44 E52
    Date: 2021–10
  3. By: Mr. Sebastian Weber; Mirko Abbritti; Agostino Consolo
    Abstract: Standard New Keynesian (NK) models feature an optimal inflation target well below two percent, limited welfare losses from business cycle fluctuations and long-term monetary neutrality. We develop a NK framework with labour market frictions, endogenous productivity and downward wage rigidity (DWR) which challenges these results. The model features a non-vertical long-run Phillips curve between inflation and unemployment and a trade-off between price distortions and output hysteresis that change the welfare-maximizing inflation level. For a plausible set of parameters, the optimal inflation target is in excess of two percent, a target value commonly used across central banks. Deviations from the optimal target carry welfare costs multiple times higher than in traditional NK models. The main reason is that endogenous growth and DWR generate asymmetric and hysteresis effects on unemployment and output. Price level targeting or a Taylor-rule responding to the unemployment rate can handle better the asymmetric and hysteresis effects in our model and deliver significant welfare gains. Our results are robust to the inclusion of the effective lower bound on the monetary policy interest rate.
    Keywords: NK model; inflation level; invariance hypothesis; target value; target carry welfare cost; Inflation targeting; Inflation; Wage rigidity; Wages; Wage adjustments; Global
    Date: 2021–08–06
  4. By: Frédéric Dufourt (Aix-Marseille Univ, CNRS, AMSE, Marseille, France.); Lisa Kerdelhué; Océane Piétri
    Abstract: We revisit the canonical policy of eliminating capital taxation by increasing labor taxation in a endogenous-labor, heterogeneous-agent model with income and wealth heterogeneity, when the government is subject to a strict (per-period) balancedbudget constraint. By contrast with its non-budget neutral equivalent-associated with a constant tax rate over time and a permanent increase in the level of public debt-we show that the obtained endogenous path for the labor tax rate is sharply increasing in the initial period and decreasing over time. The policy then generates a deeper recession in the short-run and a greater expansion in the long-run, as well as a smaller decline in wealth inequality associated with a reduced incentive to save for precautionary motives. Overall, the policy still generates significant losses in average welfare.
    Keywords: fiscal policy, capital tax cut, tax composition, heterogeneous agents, wealth redistribution
    JEL: E21 E6 D31 H23
    Date: 2021–11
  5. By: Uluc Aysun (University of Central Florida, Orlando, FL)
    Abstract: This paper estimates a 3-country DSGE model to identify the drivers of exchange rate volatility in small open economies (SOE). In addition to the usual cross-country linkages through trade and asset holdings, the model features common shocks that a¤ect economies symmetrically. Using data from Jamaica, the US and the G-7 region (excluding the US), the paper finds that external financial shocks are the primary drivers of exchange rate fluctuations in the SOE. While domestic financial shocks are bigger contributors than US and G-7 specific shocks, shocks that are common across the US and the G-7 generally play the main role. Nonfinancial shocks, domestic and external, are inconsequential for exchange rate volatility. Inferences from a vector autoregressive model with exogenous variables are consistent with these results.
    Keywords: Jamaica, exchange rates, DSGE, small open economy, G-7, Bayesian estimation.
    JEL: E32 E44 F33 F44
    Date: 2021–11
  6. By: Adjemian, Stéphane; Karamé, Frédéric; Langot, François
    Abstract: This study demonstrates that nonlinearities, coupled with worker heterogeneity, make it possible to reconcile the Diamond–Mortensen–Pissarides model with the labor market dynamics observed in the United States. Nonlinearities, induced by firings and downward real wage rigidities, magnify adjustments in quantities, whereas heterogeneity concentrates them on the low-paid workers’ submarkets. The model fits the job finding, job separation, and unemployment rates well. It also explains the Beveridge curve’s dynamics and the cyclicality of the involuntary component of separations. The estimated dynamics of the aggregate shock that allows generating the US labor market fluctuations has a correlation with unemployment that changes of sign during the 80s. We also show that the differences in adjustment between submarkets predicted by the model are consistent with the data of job flows by educational attainment.
    Keywords: search and matching; unemployment dynamics; nonlinearities; particle filter; maximum likelihood estimation
    JEL: C51 E24 E32
    Date: 2021–10
  7. By: Mr. Alejandro D Guerson
    Abstract: This paper shows that the optimal sovereign lending contract is state-contingent when a government can default. It provides a theoretical basis for the specification of optimal state-contingent debt instruments (SCDIs) in countries subject to large shocks that can be observed and verified by all parties involved, such as natural disasters or global pandemics. The result is obtained as the endogenous solution to a contracting problem under time-inconsistency when a government cannot credibly commit to honor debt service obligations in all possible states of nature. It is shown that rational investors optimally offer SCDIs that include additional financing when the default constraint is binding, keeping the debtor engaged in the contractual relationship and avoiding asset loss. The debtor benefits because the contract implies net-positive financing when facing a large shock, increasing concurrent welfare, while maintaining access to financing in the future for consumption smoothing at the same terms as with precommitment. SCDIs require maintaining debt at a low level compared to the precommitment case, and also a fiscal consolidation when triggered to contain the increase in debt. Extension of the time inconsistency problem to add the taxation of capital returns shows that the optimal physical capital investment is also state-contingent.
    Keywords: sovereign default; natural disasters; state-contingent debt
    Date: 2021–09–10
  8. By: Shukayev, Malik (University of Alberta, Department of Economics); Ueberfeldt, Alexander (Bank of Canada)
    Abstract: The financial sector bailouts seen during the Great Recession generated substantial opposition and controversy. We assess the welfare benefits of government-funded emergency support to the financial sector, taking into account its effects on risk-taking incentives. In our quantitative general equilibrium model, the financial crisis probability depends on financial intermediaries' balance sheet choices, influenced by capital adequacy constraints and ex ante known emergency support provisions. These policy tools interact to make financial sector bailouts welfare improving when capital adequacy constraints are consistent with the current Basel III regulation, but potentially welfare decreasing with looser capital adequacy regulation existing before the Great Recession.
    Keywords: fire sales externality; short-term bank funding; endogenous financial crises; bank regulation; bailouts; government guarantees
    JEL: D62 E32 E44 G01
    Date: 2021–11–16
  9. By: Bernard Dumas; Paul Ehling; Chunyu Yang
    Abstract: In a deterministic overlapping-generations economy with production and physical capital, the price of debt can be positive without any budget surpluses being in the offing, because debt incorporates a rational bubble. Yet the dynamics of debt remain a function of the dynamics of the primary budget deficit. As a way to study their joint behavior, we endogenize a structural deficit in the form of an underfunded social-security scheme. We define debt capacity as the level of debt that can be just sustained without a change of policy all the way to an unstable steady state. When it starts below the capacity, the debt converges to a stable steady state, in which the bubble is sustained. Above capacity the bubble unravels and the deficit cannot be financed. In several realistic scenarios occurring in economies, we calculate the needed policy response, which is the true "fiscal cost" of exceeding debt capacity.
    JEL: E13 E43 E44 E50 E62 E63 H30 H62 H63 H68
    Date: 2021–10
  10. By: Kazuko Kano (School of Commerce, Waseda University); Takashi Kano (Graduate School of Economics, Hitotsubashi University and CIRJE, Faculty of Economics, The University of Tokyo)
    Abstract: The main tenet of the New Keynesian (NK) paradigm is that price dispersion caused by nominal price stickiness is the primary source of allocative inefficiency. This study empirically evaluates the welfare implications of NK models by observing how internal and external price dispersion responds to two types of large aggregate shocks: high inflation and sharp currency depreciation. For this purpose, we consider the history of US military deployment on a small southern island in Japan called Okinawa following the Pacific War. We investigate unique data variations in micro-level retail prices surveyed in Okinawa and mainland Japan before and after the Okinawan reversion to Japanese sovereignty in May of 1972. By considering the Okinawan experience of three currency regimes during the high inflation period of the early 1970s as valid quasi-natural experiments, we identify statistically significant deteriorations of currency misalignment associated with the sudden exogenous large USD depreciation versus the JPY following the Nixon Shock. Furthermore, we observe that these massive aggregate shocks left the average absolute size of price changes mostly unchanged, but significantly increased the average frequency of price changes in Okinawa. Because a calibrated small open-economy menu cost model fits these empirical findings better than the Calvo model, the welfare costs of exchange rate fluctuations may be more elusive than suggested by the open-economy NK literature.
    Date: 2021–11
  11. By: Greenwald, Daniel L. (MIT Sloan); Leombroni, Matteo (Stanford); Lustig, Hanno (Stanford GSB and NBER); Van Nieuwerburgh, Stijn (Columbia GSB and NBER)
    Abstract: Financial wealth inequality and long-term real interest rates track each other closely over the post-war period. Faced with lower returns on financial wealth, households with high levels of financial wealth must increase savings to afford the consumption that they planned before the decline in rates. Lower rates beget higher financial wealth inequality. Inequality in total wealth, the sum of financial and human wealth and the relevant concept for household welfare, rises much less than financial wealth inequality and even declines at the top of the wealth distribution. A standard Bewley model produces the observed increase in financial wealth inequality in response to a decline in real interest rates, when high financial-wealth households have a financial portfolio with high duration.
    Date: 2021–03
  12. By: Galanakis, Yannis
    Abstract: This paper examines a problem of worker misallocation into jobs. A theoretical model, allowing for heterogeneous workers and firms, shows that job search frictions generate mismatch between employees and employers. In the empirical analysis, the British Household Panel Survey (BHPS), the UK household Longitudinal Study (UKHLS) and British Cohort Study 1970 (BCS70) data are used to measure the incidence of mismatch, how it changes over time and whether it can be explained by unobserved ability. Results show that (i) the incidence of mismatch increases after the Great Recession. (ii) Individual transitions to/from matching take place due to workers' occupational mobility and over-time skills development. (iii) Employees can find better jobs or their mobility occurs earlier than the aggregate change of skills. (iv) Controlling for individual heterogeneity, measured by cognitive and non-cognitive skill test scores throughout childhood, does not decrease the incidence of mismatch. This suggests that unobserved productivity does not generate mismatch in the labour market.
    Keywords: Human Capital Mismatch,frictions,individual heterogeneity
    JEL: I26 J24 J31 J64
    Date: 2021
  13. By: Maria Teresa Punzi; Bihong Huang; Yu Wu
    Abstract: This paper assesses the financial risks arising from transition toward a low-emission economy. The environmental DSGE model shows tightening environmental regulation impairs firms’ balance sheets, and consequently threatens financial stability in the short term. The empirical analysis indicates that following the implmentation of Clean Air Action Plan, the default rates of high-polluting firms in a Chinese province rose by around 80 percent. Joint equity commercial banks with higher level of independence were able to appropriately price in their exposure to transition risks, while the Big Five commercial banks failed to factor in such risks.
    Keywords: E-DSGE Model, Financial stability, Clean Air Action Plan
    Date: 2021–09–03
  14. By: Juan Yepez
    Abstract: Dutch disease is often referred as a situation in which large and sustained foreign currency inflows lead to a contraction of the tradable sector by giving rise to a real appreciation of the home currency. This paper documents that this syndrome has been witnessed by many emerging markets and developing economies (EMDEs) as a result of surges in capital inflows driven by accommodative U. S. monetary policy. In a sample of 25 EMDEs from 2000-17, U. S. monetary policy shocks coincided with episodes of currency appreciation and a contraction in tradable output in these economies. The paper also shows empirically that the use of capital flow measures (CFMs) has been a common policy response in several EMDEs to U.S. monetary policy shocks. Against this background, the paper presents a two sector small open economy augmented with a learning-by-doing (LBD) mechanism in the tradable sector to rationalize these empirical findings. A welfare analysis provides a rationale for the use of CFMs as a second-best policy when agents do not internalize the LBD externality of costly resource misallocation as a result of greater capital inflows. However, the adequate calibration of CFMs and the quantification of the LBD externality represent important implementation challenges.
    Keywords: monetary policy shock; LBD externality; Dutch disease effect; emerging markets and developing economies; EMDEs monetary policy framework; Dutch disease; Capital inflows; Exchange rates; Exchange rate arrangements; Global
    Date: 2021–08–06

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