nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2022‒07‒18
seventeen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Exchange rate disconnect in general equilibrium By Itskhoki, Oleg; Mukhin, Dmitry
  2. Transmission of Flood Damage to the Real Economy and Financial Intermediation: Simulation Analysis using a DSGE Model By Ryuichiro Hashimoto; Nao Sudo
  3. Aging, Inadequacy and Fiscal Constraint: The Case of Thailand By Phitawat Poonpolkul; Ponpoje Porapakkarm; Nada Wasi
  4. Endogenous Liquidity and Capital Reallocation By Wei Cui; Randall Wright; Yu Zhu
  5. Has Public Debt Been Too High in Canada and The U.S.? A Quantitative Assessment By Marco Cozzi
  6. Robust Optimal Macroprudential Policy By Federico Bennett; Giselle Montamat; Francisco Roch
  7. Rational housing demand bubble By Lise Clain-Chamosset-Yvrard; Xavier Raurich; Thomas Seegmuller
  8. Near-Rational Equilibria in Heterogeneous-Agent Models: A Verification Method By Leonid Kogan; Indrajit Mitra
  9. The limited power of monetary policy in a pandemic By Antoine Lepetit; Cristina Fuentes-Albero
  10. On the Macroeconomic Effects of Shadow Banking Development By Georgios Magkonis; Eun Young Oh; Shuonan Zhang
  11. It takes two: Fiscal and monetary policy in Mexico By Ana Aguilar; Carlos Cantú; Claudia Ramírez
  12. Temporary Layoffs, Loss-of-Recall and Cyclical Unemployment Dynamics By Mark Gertler; Christopher K. Huckfeldt; Antonella Trigari
  13. Escaping Secular Stagnation with Unconventional Monetary Policy By Luba Petersen; Ryan Rholes
  14. When Could Macroprudential and Monetary Policies Be in Conflict? By Jose Garcia Revelo; Grégory Levieuge
  15. Low Passthrough from Inflation Expectations to Income Growth Expectations: Why People Dislike Inflation By Ina Hajdini; Edward S. Knotek; John Leer; Mathieu Pedemonte; Robert W. Rich; Raphael Schoenle
  16. The Effects of Energy Supply Shocks and Interest Rate Liberalization in China By Yihao Xue; Qiaoyu Liang; Bing Tong
  17. Asset Pricing with Costly and Delayed Firm Entry By Lorant Kaszab; Ales Marsal; Katrin Rabitsch

  1. By: Itskhoki, Oleg; Mukhin, Dmitry
    Abstract: We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comove-ment with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.
    JEL: F3 G3 J1
    Date: 2021–08–01
  2. By: Ryuichiro Hashimoto (Bank of Japan); Nao Sudo (Bank of Japan)
    Abstract: This paper quantitatively assesses the indirect effect of floods on the real economy and financial intermediation in Japan by estimating a dynamic stochastic general equilibrium (DSGE) model that incorporates a mechanism through which floods cause the capital stock and the public infrastructure to depreciate exogenously, using the data on flood damage recorded in the Flood Statistics released by the Japanese government. The result of the analysis is twofold. First, flood shocks dampen GDP from the supply side by reducing the capital stock inputs. The decline in GDP then impairs the balance sheets of firms and financial intermediaries, resulting in disruptions to financial intermediation and thus dampening GDP further from the demand side. Even when the direct damage due to floods is fully covered by insurance, the downward pressure on GDP endogenously deteriorates the balance sheets of these sectors, causing the same mechanism to operate. Second, the quantitative impacts of flood shocks on GDP up to now have been minor compared to the standard structural shocks that are considered important in existing macroeconomic studies, including shocks to total factor productivity (TFP) and the subjective discount factor. According to the estimates that use the relationship between the key variables in our model together with climate change scenarios published by an external organization, the impacts of these shocks could become somewhat larger in the future.
    Keywords: Climate change; Natural disasters; Physical risk; Financial System; DSGE model
    JEL: E32 E37 E44 Q54
    Date: 2022–06–03
  3. By: Phitawat Poonpolkul; Ponpoje Porapakkarm; Nada Wasi
    Abstract: Over the coming decades, many developing countries are set to face unprecedented challenges. While their population is aging extremely fast, the old-age income supports are inadequate and fiscal resources are limited. This study develops an overlapping generations model (OLG) with formal and informal sectors for a middle-income country. Besides aging population structure overtime, the model incorporates common features of developing countries—a sizable informal sector, a connectedness between the formal and informal sectors, and inadequate pension provisions. The households are heterogeneous with respect to their education, formality status, and survival probabilities. The model is calibrated to Thailand’s economy where the government budget structure is based on the country’s fiscal historical data, and the basic universal pension scheme and Social Security scheme are realistically specified. We assess the costs of these two schemes under three long-run scenarios: (i) introducing indexation to the currently non-indexed schemes; (ii) triple increasing the basic pension scheme; and (iii) specifying the basic pension to proportionally decrease with the Social Security benefits. Using a consumption tax to quantify the costs, the consumption tax must be increased by three, eleven and nine percentage points from the current level, respectively. The Social Security scheme is projected to be unsustainable, with its fund depleted in 2045. Without any reform and benefit cuts, the scheme requires a drastic increase in the contribution rate. Welfare gains and losses across household types and redistributive impacts of the reforms are discussed.
    Keywords: Overlapping generations model; Fiscal sustainability; Pension; Social Security; Thailand
    JEL: J1 H55 I38
    Date: 2022–06
  4. By: Wei Cui; Randall Wright; Yu Zhu
    Abstract: We study economies where firms acquire capital in primary markets then retrade it in secondary markets after information on idiosyncratic productivity arrives. Our secondary markets incorporate bilateral trade with search, bargaining and liquidity frictions. We distinguish between full and partial sales (one firm gets all or some of the other’s capital). Both exhibit interesting long- and short-run patterns in data that the model can match. Depending on monetary and credit conditions, more partial sales occur when liquidity is tight. Quantitatively, we find significant steady-state and business-cycle implications. We also investigate the impact of search, taxation and persistence in firm-specific shocks.
    Keywords: Business fluctuations and cycles; Monetary policy
    Date: 2022–06
  5. By: Marco Cozzi (Department of Economics, University of Victoria)
    Abstract: I quantify the welfare effects of changing the long-run value of public debt using a two-region OLG model with rich income dynamics over the life-cycle, incomplete insurance, and an integrated asset market. I consider two model calibrations, one for Canada and one for the US. In the former case, I find that changes in public debt cause small interest rate effects. To validate the model, I conduct a formal empirical analysis, which does not reject the two-region theoretical framework. The quantitative model is used to perform a welfare analysis of counterfactual debt policies. In the long-run, for both Canada and the US, I find that negative quantities of public debt involve considerable welfare gains. For the US economy, when taking into account the welfare costs of the transitional dynamics, the result is reversed. However, imposing the empirical correlation between changes in public debt and changes in public expenditure found in the OECD data restores the finding that moving to equilibria with public wealth leads to welfare gains.
    Keywords: Public debt, Incomplete markets, Welfare
    Date: 2022–05–30
  6. By: Federico Bennett (Duke University); Giselle Montamat (Uber); Francisco Roch (IMF)
    Abstract: We consider how fear of model misspecification on the part of the planner and/or the households affects welfare gains from optimal macroprudential taxes in an economy with occasionally binding collateral constraints as in Bianchi (2011). In this setup, the decentralized equilibrium may differ from the social planner’s equilibrium both because of the pecuniary externalities associated with the collateral constraint and because of the paternalistic imposition of the planner’s beliefs when designing policy. When robust agents have doubts about the model, they create endogenous worst-case beliefs by assigning a high probability to low-utility events. The ratio of worst-case beliefs of the planner over the household’s captures the degree of paternalism. We show that this novel channel could render the directions of welfare gains from a policy intervention ambiguous. However, our quantitative results suggest that doubts about the model need to be large in order to make a “laissez-faire regime” better than an intervention regime.
    Keywords: Robust Control, Model Uncertainty, Optimal Taxation, Sudden Stops, Financial Crises
    JEL: D62 E32 E44 E62 F32 F41 G01 H21
    Date: 2022–05
  7. By: Lise Clain-Chamosset-Yvrard (Univ. Lyon, Universite Lumiere Lyon 2, GATE UMR 5824, F-69130 Ecully, France.); Xavier Raurich (Departament d'Economia and CREB, Universitat de Barcelona.); Thomas Seegmuller (Aix-Marseille Univ., CNRS, AMSE, Marseille France.)
    Abstract: We provide a unified framework with demand for housing over the life cycle and financial frictions to analyze the existence and macroeconomic effects of rational housing bubbles. We distinguish a housing price bubble, defined as the difference between the housing market price and its fundamental value, from a housing demand bubble, which corresponds to a situation where a pure speculative housing demand exists. In an overlapping generation exchange economy, we show that no housing price bubble occurs. However, a housing demand bubble may occur, generating a boom in housing prices and a drop in the interest rate, when households face a binding borrowing constraint. Multiplicity of steady states and endogenous fluctuations can occur when credit market imperfections are moderate. These fluctuations involve transitions between equilibria with and without a housing demand bubble that generate large fluctuations in housing prices consistent with observed patterns. We finally extend the basic framework to a production economy and we show that a housing demand bubble increases the housing price, housing price to income ratio and economic growth.
    Keywords: Bubble; Housing; Self-ful lling uctuations
    JEL: E32 E44 R21
    Date: 2022–06
  8. By: Leonid Kogan; Indrajit Mitra
    Abstract: We propose a general simulation-based procedure for estimating quality of approximate policies in heterogeneous-agent equilibrium models, which allows to verify that such approximate solutions describe a near-rational equilibrium. Our procedure endows agents with superior knowledge of the future path of the economy, while imposing a suitable penalty for such foresight. The relaxed problem is more tractable than the original, and results in an upper bound on agents’ welfare. Our method is general, straightforward to implement, and can be used in conjunction with various solution algorithms. We illustrate our approach in two applications: the incomplete-markets model of Krusell and Smith (1998) and the heterogeneous firm model of Khan and Thomas (2008).
    JEL: C02 C18 C63 C68 E00 E37 G1
    Date: 2022–06
  9. By: Antoine Lepetit; Cristina Fuentes-Albero
    Abstract: We embed an extension of the canonical epidemiology model in a New Keynesian model and analyze the role of monetary policy as a virus spreads and triggers a sizable recession. In our framework, consumption is less sensitive to real interest changes in a pandemic than in normal times because individuals have to balance the benefits of taking advantage of intertemporal substitution opportunities with the risk of becoming sick. Accommodative monetary policies such as forward guidance result in large increases in inflation but have only limited effects on real economic activity as long as the risk of infection is large. The optimal design of monetary policy hinges on how other tools used to limit virus spread, such as lockdowns, are deployed. If the lockdown policy is conducted optimally, monetary policy should focus on keeping inflation on target. However, if the lockdown policy is not optimal, the central bank faces a trade-off between its objective of stabilizing inflation and the necessity to minimize the inefficiencies associated with virus spread.
    Keywords: COVID-19, SIR macro model, statedependent effects of monetary policy, forward guidance, monetary policy trade-offs, optimal monetary policy
    JEL: E5 E1 E11
    Date: 2022–05
  10. By: Georgios Magkonis (University of Portsmouth); Eun Young Oh (University of Portsmouth); Shuonan Zhang (University of Portsmouth)
    Abstract: We build and estimate a dynamic stochastic general equilibrium model with risky innovation and shadow credits to study the macroeconomic implications of shadow banking (SB), particularly on productivity. Our analysis is motivated by negative relationships between SB development and innovation outcome or total factor productivity (TFP) growth. In our model, information asymmetry associated with technology utilization leads to an agency problem in which shadow intermediation reduces banks’ incentives to screen project quality. An SB boom crowd-out traditional financial services, decreases inno- vation quality and technology efficiency, and thereby reduces TFP. In the light of model mechanisms, we analyse cross-country differences and deliver important implications of SB. SB development mainly driven by financial factors (e.g., the US case) leads to significant loss on TFP while that relatively prompted by real-sided factors (e.g., China and the EA cases), could be less harmful.
    Keywords: Shadow Banking; Total Factor Productivity; Endogenous Growth; Financial Development; Bayesian Methods
    JEL: C32 E32 O40
    Date: 2022–07–06
  11. By: Ana Aguilar; Carlos Cantú; Claudia Ramírez
    Abstract: We model the interaction between fiscal and monetary policy and qualify their effects in a semi-structural small open economy model calibrated for Mexico. In our model, fiscal and monetary policy follow rules tied to specific targets. We estimate how fiscal policy, through deficits and public debt accumulation, and monetary policy, through the interest rate, directly affect the economy. We study the nature of the feedback between policy decisions and examine their indirect effects through the sovereign risk channel. We find that the response of monetary policy to stabilise the economy after a shock depends on how strict is the fiscal rule. A loose fiscal stance pushes a tighter monetary policy stance. Instead, the economy recovers faster when monetary and fiscal policy complement each other.
    Keywords: monetary policy, fiscal policy, sovereign risk premium, policy rules
    JEL: E52 E58 H5 H63
    Date: 2022–05
  12. By: Mark Gertler; Christopher K. Huckfeldt; Antonella Trigari
    Abstract: We revisit the role of temporary layoffs in the business cycle, motivated by their unprecedented surge during the pandemic recession. We first measure the contribution of temporary layoffs to unemployment dynamics over the period 1979 to the present. While many have emphasized a stabilizing effect due to recall hiring, we quantify an important destabilizing effect due to “loss-of-recall”, whereby workers in temporary-layoff unemployment lose their job permanently and do so at higher rates in recessions. We then develop a quantitative model that allows for endogenous flows of workers across employment and both temporary-layoff and jobless unemployment. The model captures well pre-pandemic unemployment dynamics and shows how loss-of-recall enhances the recessionary contribution of temporary layoffs. We also show that with some modification the model can capture the pandemic recession. We then use our structural model to show that the Paycheck Protection Program generated significant employment gains. It did so in part by significantly reducing loss-of-recall.
    JEL: E0 E24
    Date: 2022–06
  13. By: Luba Petersen; Ryan Rholes
    Abstract: We design a new experimental framework to study policy interventions to combat secular stagnations and liquidity traps in an overlapping-generations environment where participants form expectations and make real economic decisions. We observe that participants can learn to coordinate on high inflation full-employment equilibria. Permanent deleveraging shocks induce pessimistic, backward-looking expectations and considerable consumption heterogeneity as the economies experience persistent deflation. We explore the ability of unconventional monetary policy to lead economies out of deflationary traps. Permanently increasing the central bank's inflation target is insufficient to generate inflationary expectations due to low central bank credibility. Negative interest rates stimulate spending and generate the necessary inflation for the economies to escape the zero lower bound. Negative interest rates are more potent than raising the inflation target at shifting consumption to the present.
    JEL: C92 E03 E52 E70
    Date: 2022–06
  14. By: Jose Garcia Revelo; Grégory Levieuge
    Abstract: This paper aims to provide a comprehensive analysis of the potential conflicts between macroprudential and monetary policies within a DGSE model with financial frictions. The identification of conflicts is conditional on different types of shocks, policy instruments, and policy objectives. We first find that conflicts are not systematic but are fairly frequent, especially in the case of supply-side and widespread shocks such as investment efficiency and bank capital shocks. Second, monetary policy and countercyclical capital requirements generate conflicts in many circumstances. By affecting interest rates, they both “get in all the cracks”, albeit with their respective targets generally moving in opposite directions. Nonetheless, monetary policy could reduce its adverse financial side effects by responding strongly to the output gap. Third, countercyclical loan-to-value caps, as sector-specific instruments, cause fewer conflicts. Thus, they can be more easily implemented without concerns about generating spillovers, whereas smooth coordination is required between state-contingent capital requirements and monetary policy.
    Keywords: Macroprudential Policy, Loan-to-Value, Countercyclical Buffer, Monetary Policy, Conflicts, DSGE Model
    JEL: E44 E58 E61
    Date: 2022
  15. By: Ina Hajdini; Edward S. Knotek; John Leer; Mathieu Pedemonte; Robert W. Rich; Raphael Schoenle
    Abstract: Using a novel experimental setup, we study the direction of causality between consumers’ inflation expectations and their income growth expectations. In a large, nationally representative survey of US consumers, we find that the rate of passthrough from expected inflation to expected income growth is incomplete, on the order of 20 percent. There is no statistically significant effect going in the other direction. Passthrough varies systematically with demographic and socioeconomic factors, with greater passthrough for higher-income individuals than lower-income individuals, although it is still incomplete. Higher inflation expectations also cause consumers to report a higher probability that they will search for a new job that pays more. Using our survey findings to calibrate a search-and-matching model, we find that dampened responses of real wages to demand and supply shocks translate into greater fluctuations in output. Taken together, the survey results and model exercises provide a labor market channel to explain why people dislike inflation.
    Keywords: inflation; wage-price spiral; expectations; randomized controlled trial
    JEL: E31 E24 E71 C83
    Date: 2022–06–23
  16. By: Yihao Xue (School of Economics at Henan University, Kaifeng, Henan); Qiaoyu Liang (School of Economics at Henan University, Kaifeng, Henan); Bing Tong (Center for Financial Development and Stability at Henan University, and School of Economics at Henan University, Kaifeng, Henan)
    Abstract: Based on a New Keynesian model with a transient interest rate peg and energy inputs in production, we examine the impact of China`s interest rate liberalization on the transmission of energy supply shocks. Theoretical analysis shows that in the face of negative supply shocks, output decreases less or even increases while inflation rises more under a fixed interest rate compared with a flexible interest rate. We construct the Divisia energy index based on Chinese data to test the model predictions. We identify energy supply shocks following the strategy of Kilian (2009) and obtain impulse responses using the local projection method proposed by Jordà (2005). The empirical results are consistent with our model predictions.
    Keywords: Interest rate liberalization, Energy supply shocks, Divisia Index, New Keynesian model
    JEL: E31 E42 E43 E52 E58 Q43
    Date: 2022–01
  17. By: Lorant Kaszab (Department of Economics, Vienna University of Economics and Business, Magyar Nemzeti Bank); Ales Marsal (Department of Economics, Vienna University of Economics and Business, National Bank of Slovakia); Katrin Rabitsch (Department of Economics, Vienna University of Economics and Business)
    Abstract: Survey evidence tells us that stock prices reflect the risks investors associate with long-run technological change. However, there is a shortage of models that can rationalise long-run risks. Unlike the previous literature assuming a fixed number of products our model allows for new product varieties that appear in the form of new firms which face entry costs and delay in the entry process. The fixed variety model has a significant limitation in translating macroeconomic volatility into asset return volatility. Our model with growing varieties induces endogenous low-frequency fluctuations in productivity driving large persistent variations in consumption growth and asset prices. It also changes the valuation of assets through the increase in the volatility of the pricing kernel (with a positive long-run component) and leads to higher excess returns. Our model is motivated with a simple recursively identifed VAR model containing quarterly US data 1992Q3-2019Q4 with the following list of variables: total factor productivity, consumption, a measure of firm entry, and the excess return on stocks.
    Keywords: ?rm entry, equity premium, Epstein-Zin, New Keynesian
    JEL: E13 E31 E43 E44 E62
    Date: 2022–05

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