nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2023‒02‒27
nineteen papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Fiscal Stimulus and Skill Accumulation over the Life Cycle By Laure Simon
  2. Should we increase or decrease public debt? Optimal fiscal policy with heterogeneous agents By François Le Grand; Xavier Ragot
  3. Age-Dependent Risk Aversion: Re-evaluating Fiscal Policy Impacts of Population Aging By Phitawat Poonpolkul
  4. Optimal monetary policy with the risk-taking channel By Abbate, Angela; Thaler, Dominik
  5. Geographic Mobility over the Life-Cycle By Diaz, Antonia; Jáñez, Álvaro; Wellschmied, Felix
  6. Capital income taxation and trade unions in an endogenous fertility model By Minoru Watanabe
  7. The shine beneath: foreign exchange intervention in resource-rich economies By Ortiz, Marco; Herrera, Gerardo; Perez, Fernando
  8. Make-up strategies with incomplete markets and bounded rationality By Dobrew, Michael; Gerke, Rafael; Giesen, Sebastian; Röttger, Joost
  9. Geographic Mobility Over the Life-cycle By Antonia Díaz; Álvaro Jáñez; Felix Wellschmied
  10. Lumpy Investment, Fluctuations in Volatility and Monetary Policy By Min Fang
  11. Unemployment and Labor Productivity Co-movement: the Role of Firm Exit By Miroslav Gabrovski; Mario Rafael Silva
  12. Optimal Policies with Heterogeneous Agents: Truncation and Transitions By Xavier Ragot; François Le Grand
  13. Make-up strategies and exchange rate pass-through in a low-interest-rate environment By Alessandro Cantelmo; Pietro Cova; Alessandro Notarpietro; Massimiliano Pisani
  14. The Fear Economy: A Theory of Output, Interest, and Safe Assets By Ruchir Agarwal
  15. Temporary Layoffs, Loss-of-Recall, and Cyclical Unemployment Dynamics By Mark Gertler; Christopher Huckfeldt; Antonella Trigari
  16. The real effects of financial disruptions in a monetary economy By Miroslav Gabrovski; Athanasios Geromichalos; Lucas Herrenbrueck; Ioannis Kospentaris; Sukjoon Lee
  17. The geography of structural transformation: effects on inequality and mobility By Takeda, Kohei
  18. Capital Deaccumulation and the Large Persistent Effects of Financial Crises By Matthew Knowles
  19. Minimum Wage Spillover Effects and Social Welfare in a Model of Stochastic Job Matching By Panagiotis Nanos

  1. By: Laure Simon
    Abstract: Using micro data from the U.S. Consumer Expenditure Survey and Current Population Survey, I document that government spending shocks affect individuals differently over the life cycle. Young households increase their consumption after an expansionary shock while prime-age households reduce it, regardless of their level of income or debt. Productivity and wages increase significantly for young workers. To rationalize these findings, I develop a parsimonious New Keynesian life-cycle model where young agents accumulate skills on the job through a learning-by-doing process. An increase in government spending raises hours worked, which enhances skill accumulation, particularly among young workers who face a steep learning curve. The ensuing increase in the relative labor demand for young workers boosts their wages, thus stimulating their consumption.
    Keywords: Business fluctuations and cycles; Fiscal policy; Productivity
    JEL: D12 D15 E21 E62 J11 J24
    Date: 2023–01
  2. By: François Le Grand; Xavier Ragot (ECON - Département d'économie (Sciences Po) - Sciences Po - Sciences Po - CNRS - Centre National de la Recherche Scientifique, OFCE - Observatoire français des conjonctures économiques (Sciences Po) - Sciences Po - Sciences Po)
    Abstract: We analyze optimal fiscal policy in a heterogeneous-agent model with capital accumulation and aggregate shocks, where the government uses public debt, capital tax and progressive labor tax to finance public spending. First, he existence of a steady-state equilibrium is proven to depend on three conditions, which have different economic interpretations: a Laffer condition, a Blanchard-Kahn condition and a Straub-Werning condition. First, the equilibrium can feature both a positive level of public debt and capital tax at the steady state, to correct for non-optimal private saving. Second, the optimal public debt increases after a positive public spending shock when its persistence is low, whereas it decreases when its persistence is high, due to a tradeoff between consumption smoothing and the reduction of distortions. We show that our results hold in a quantitative heterogeneous-agent model, where the optimal dynamics of the whole set of fiscal tools is analyzed. The general model also provides new results on optimal tax progressivity and the dynamics of labor tax.
    Keywords: Heterogeneous agents optimal fiscal policy public debt JEL codes: E21 E44 D91 D31, Heterogeneous agents, optimal fiscal policy, public debt, E44, D91, D31, E21
    Date: 2023–01–04
  3. By: Phitawat Poonpolkul
    Abstract: The integration of age-dependent increasing risk aversion (IRA) into an overlapping generations model (OLG) with risk-sensitive preferences provides a more comprehensive understanding of risk aversion, life-cycle behavior, and welfare under uncertainties. A quantitative analysis shows that IRA individuals accumulate more precautionary savings and adjust working hours to mitigate income shocks. However, this mitigation of uncertainty entails a cost of reduced resources, which could have otherwise been used to increase overall consumption of goods and leisures. Three alternative policies to address the challenges posed by aging are evaluated: increasing a payroll tax rate, reducing pension benefits, and extending the retirement age. The results show that individuals who expect to become more risk averse in old age may prefer the payroll tax rate increase, as the other two options results in relatively higher income uncertainty, which contradicts the results of previous studies that assumed constant risk aversion (CRA).
    Keywords: Overlapping generations model; Fiscal sustainability; Demographic changes; Increasing risk aversion; Non-expected utility
    JEL: D15 D81 E62 J11
    Date: 2023–02
  4. By: Abbate, Angela; Thaler, Dominik
    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). JEL Classification: E44, E52
    Keywords: inertial policy rate, optimal monetary policy, risk-taking channel
    Date: 2023–02
  5. By: Diaz, Antonia; Jáñez, Álvaro (Universidad Carlos III de Madrid); Wellschmied, Felix (Universidad Carlos III de Madrid)
    Abstract: When mobility between locations is frictional, a person's economic well-being is partially determined by her place of birth. Using a life cycle model of mobility, we find that search frictions are the main impairment to the mobility of young people in Spain, and these frictions are particularly strong in economically distressed locations. As a result, being born in a high-unemployment urban area carries with it a large welfare penalty. Less stable jobs, slower skill accumulation, lower average wages, and fewer possibilities for geographic mobility all contribute to these welfare losses. Paying transfers to people in distressed economic locations decreases these welfare losses without large adverse effects on mobility. In contrast, several policies that encourage people to move to low-unemployment urban areas increase these welfare losses and fail to meaningfully increase mobility towards these more successful locations.
    Keywords: mobility, local labor markets, search frictions, life cycle, dynamic spatial models
    JEL: E20 E24 E60 J21 J61 J63 J64 J68 R23 R31
    Date: 2023–01
  6. By: Minoru Watanabe (Hokusei Gakuen University)
    Abstract: The current study aimed to develop a standard overlapping generations model incorporating involuntary unemployment caused by the union wage setting and fertility choice within an endogenous growth framework. Our study assumes that capital income tax finances in work benefits, which is the income transfer conditioned on work. The results indicate that increasing capital income tax promotes employment and hence promotes economic growth. Further, we demonstrate that a rise in capital income tax improves fertility.
    Keywords: Capital income tax, Involuntary unemployment, Fertility
    JEL: H55 J13 J51
    Date: 2023–02
  7. By: Ortiz, Marco; Herrera, Gerardo; Perez, Fernando
    Abstract: We propose a dynamic general equilibrium model to study the optimal reaction to terms of trade shocks when international financial markets are imperfect and the composition of capital flows affects the exchange rate determination. These elements allow us to showcase the interactions between commodity prices and international financial market inefficiencies. Positive commodity price shocks will generate a real over-appreciation of the currency and an inefficiently large shift of factors between the tradable and non-tradable sectors. We study the welfare implications of foreign exchange intervention through optimal simple rules and find support for leaning-against-the-wind foreign exchange intervention. Our setup, allows us to rationalize the reserve accumulation episodes commonly observed during periods of high commodity prices in resource-rich economies.
    Keywords: Open economy macroeconomics; Foreign exchange intervention; Terms of trade
    JEL: D58 E32 F31 F41 G15 O24
    Date: 2022–10–28
  8. By: Dobrew, Michael; Gerke, Rafael; Giesen, Sebastian; Röttger, Joost
    Abstract: We study the impact of market incompleteness and bounded rationality on the effectiveness of make-up strategies. To do so, we simulate a heterogeneous-agent New Keynesian (HANK) model with reflective expectations and an occasionally-binding effective lower bound (ELB) on the policy rate. Our simulations show that make-up strategies can mitigate the negative consequences of the ELB for inflation and real economic activity. This result holds both for our HANK model as well as a corresponding representative-agent (RANK) model with complete markets, suggesting that market (in)completeness is not important for the effectiveness of make-up strategies. However, the stabilisation benefits of make-up strategies are small when agents' cognitive ability is consistent with micro-evidence. This result is independent of market (in)completeness, emphasising the importance of rational expectations for make-up strategies. Furthermore, while market incompleteness and bounded rationality complement each other in attenuating the effects of forward guidance in our model, we do not observe such a complementarity with respect to the benefits of make-up strategies.
    Keywords: Make-Up Strategies, Incomplete Markets, Bounded Rationality, HANK, Effective Lower Bound, Average Inflation Targeting
    JEL: C63 D31 E21 E31 E52 E58 E70
    Date: 2023
  9. By: Antonia Díaz (Instituto Complutense de Análisis Económico (ICAE), Universidad Complutense de Madrid (Spain).); Álvaro Jáñez (Universidad Carlos III de Madrid (Spain).); Felix Wellschmied (Universidad Carlos III de Madrid (Spain).)
    Abstract: When mobility between locations is frictional, a person’s economic well-being is partially determined by her place of birth. Using a life cycle model of mobility, we find that search frictions are the main impairment to the mobility of young people in Spain, and these frictions are particularly strong in economically distressed locations. As a result, being born in a highunemployment urban area carries with it a large welfare penalty. Less stable jobs, slower skill accumulation, lower average wages, and fewer possibilities for geographic mobility all contribute to these welfare losses. Paying transfers to people in distressed economic locations decreases these welfare losses without large adverse effects on mobility. In contrast, several policies that encourage people to move to low-unemployment urban areas increase these welfare losses and fail to meaningfully increase mobility towards these more successful locations.
    Keywords: Mobility; Local labor markets; Search frictions; Life cycle; Dynamic spatial models.
    JEL: E20 E24 E60 J21 J61 J63 J64 J68 R23 R31
    Date: 2023
  10. By: Min Fang (Department of Economics, University of Florida)
    Abstract: I argue that monetary policy is less effective at stimulating investment during periods of elevated volatility in firm-level productivity. Empirically, I document that high volatility weakens investment responses to monetary stimulus. I then develop a heterogeneous firm New Keynesian model with lumpy investment to interpret these findings. In the model, non-convex capital adjustment costs create a sizable extensive margin of investment which is more sensitive to changes in both the interest rate and volatility than the intensive margin. When volatility is high, firms tend to stay inactive at the extensive margin, so monetary stimulus motivates less investment at the extensive margin. I find that the quantitative implications of the model are primarily shaped by the specifications of the capital adjustment costs. Unlike much of the prior literature, I use the dynamic moments of investment to identify this key model element. Based on this parameterization, high volatility reduces the effectiveness of monetary stimulus for investment by 30%. This reduction is about half of what I find in the data. Therefore, the effect of monetary policy depends on both the lumpy nature of firm-level investment and fluctuations in volatility.
    JEL: E52 E32 E22
    Date: 2021–06
  11. By: Miroslav Gabrovski (University of Hawaii); Mario Rafael Silva (Hong Kong Baptist University)
    Abstract: The Diamond-Mortensen-Pissarides model implies a nearly perfect correlation between labor productivity and unemployment/vacancies, yet the relationship in the data is mild. We show that incorporating sunk entry costs and vacancy creation in an otherwise standard setup can reconcile the discrepancy. Sunk costs cause vacancies to be a positively valued, predetermined variable. If the destruction shock is infrequent, then most vacancies were created in the past, and hence the number of vacancies in the market correlate more closely with past than current labor productivity. Provided the destruction shock is calibrated to match either micro-level evidence on product destruction and firm exit rates or commonly used values in the growth literature, the model reproduces the empirically observed mild correlation between productivity and unemployment without breaking the strong negative co-movement between unemployment and vacancies.
    Keywords: job destruction, entry costs, unemployment, aggregate fluctuations
    JEL: E24 E32 J63 J64
    Date: 2023–01
  12. By: Xavier Ragot (ECON - Département d'économie (Sciences Po) - Sciences Po - Sciences Po - CNRS - Centre National de la Recherche Scientifique, OFCE - Observatoire français des conjonctures économiques (Sciences Po) - Sciences Po - Sciences Po); François Le Grand
    Abstract: We study the optimal provision of a public good in an heterogeneous-agent economy, with and without aggregate shocks. We rely on a method combining a Lagrangian approach and a truncation procedure that takes advantage of the restrictions imposed by the first-order conditions of the Ramsey problem. We compare these outcomes with those of other solution techniques considering transitions, as usually done in the literature. We have two main results. First, we find that the optimal Ramsey policy faces a time-inconsistency problem specific to incomplete-market economies, which is due to the non-optimality of private savings. This issue affects the solution based on the computation of transitions. Second, we find that the truncation approach provides quantitatively accurate estimates of the value of planner's instruments, both at the steady-state and during the dynamics. We also report a number of quantitative checks.
    Keywords: Heterogeneous agents optimal Ramsey program truncation method aggregate shocks D31 D52 E21, Heterogeneous agents, optimal Ramsey program, truncation method, aggregate shocks D31, D52, E21
    Date: 2023–01–04
  13. By: Alessandro Cantelmo (Bank of Italy); Pietro Cova (Bank of Italy); Alessandro Notarpietro (Bank of Italy); Massimiliano Pisani (Bank of Italy)
    Abstract: We evaluate the macroeconomic stabilization properties, with particular reference to the exchange rate pass-through, of price level targeting (PLT), average inflation targeting (AIT) and inflation targeting (IT) strategies when the effective lower bound on the monetary policy rate can be binding. The results of simulating the canonical open-economy New Keynesian model -- in which the assumption of local currency pricing holds and which is calibrated without loss of generality to the euro area -- are as follows. First, make-up strategies (PLT and AIT) stabilize inflation better than IT, by favoring a smaller appreciation (larger depreciation) of the nominal exchange rate in the event of disinflationary demand (supply) shocks. Second, and in connection with this, the exchange rate pass-through to import prices is more limited under make-up strategies than under IT, as the former stabilize the inflation rate of imports to a greater extent. Third, the results are robust to alternative values of import price stickiness and elasticity of substitution between domestic and imported goods. Fourth, the stabilization properties of make-up strategies are qualitatively preserved under partially backward-looking inflation expectations, although the relative gains of make-up strategies with respect to IT are smaller than under model-consistent inflation expectations.
    Keywords: effective lower bound, exchange rate pass-through, local currency pricing, make-up strategies, monetary policy
    JEL: E31 E52 F31 F41
    Date: 2023–02
  14. By: Ruchir Agarwal
    Abstract: This paper presents a fear theory of the economy, based on the interplay between fear of rare disasters and the interest rate on safe assets. To do this, I study the macroeconomic consequences of government-administered interest rates in the neoclassical real business cycle model. When the government has the power to fix the safe real interest rate, the gap between the `sticky real safe rate' and the `neutral rate' can generate far-reaching aggregate distortions. When fear exogenously rises, the demand for safe assets rise and the neutral rate falls. If the central bank does not lower the safe rate by the same amount, savings rise leading to a decline in consumption and aggregate demand. The same mechanism works in reverse, when fear falls. Quantitatively, I show that a single fear factor can simultaneously (i) generate cross-correlations in output, labor, consumption, and investment consistent with the postwar US economy; and (ii) generates variation in equity prices, bond prices, and a large risk premium in line with the asset pricing data. Six novel insights emerge from the model: (1) actively regulating the safe interest rate (in both directions) can mitigate the fluctuations generated by fear cycles; (2) recessions will be deeper and longer when central banks accept the zero lower bound and are unwilling to use negative rates; (3) a commitment to use negative rates in recessions—even if never implemented—raises both the short- and long-run real neutral rates, and moderates the business cycle; (4) counter-cyclical fiscal policy can act as disaster insurance and be expansionary by reducing fear; (5) quantitative easing can be narrowly effective only when fear is high at the lower bound; and (6) when fear is high, especially at the lower bound, policies that boost productivity also help fight recessions.
    Keywords: fear; business cycles; interest; safe assets; fear economy; government-administered interest rates; fear theory; business cycle model; fear factor; Output gap; Consumption; Zero lower bound; Interest rate floor; Yield curve; Global
    Date: 2022–09–09
  15. By: Mark Gertler; Christopher 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.
    Date: 2022
  16. By: Miroslav Gabrovski (University of Hawaii); Athanasios Geromichalos (University of California, Davis); Lucas Herrenbrueck (Simon Fraser University); Ioannis Kospentaris (Virginia Commonwealth University); Sukjoon Lee (New York University Shanghai)
    Abstract: A large literature in macroeconomics reaches the conclusion that disruptions in financial markets have large negative effects on output and (un)employment. Although seemingly diverse, papers in this literature share a common characteristic: they employ frameworks where money is not explicitly modeled. This paper argues that the omission of money may hinder a modelÕs ability to evaluate the real effects of financial shocks, since it deprives agents of a payment instrument that they could have used to cope with the resulting liquidity disruption. In a carefully calibrated New-Monetarist model with frictional labor, product, and financial markets we show that output and unemployment respond very modestly to shocks in the ability of agents to trade in the financial market. Explicitly modeling money enables us to show that the size of the transmission mechanism between the financial market shock and the real economy is disciplined by the inflation level.
    Keywords: search frictions, unemployment, corporate bonds, money, liquidity, inflation
    JEL: E24 E31 E41 E44
    Date: 2023–01
  17. By: Takeda, Kohei
    Abstract: The interplay between structural transformation in the aggregate and local economies is key to understanding spatial inequality and worker mobility. This paper develops a dynamic overlapping generations model of economic geography where historical exposure to different industries creates persistence in occupational structure, and non-homothetic preferences and differential productivity growth lead to different rates of structural transformation. Despite the heterogeneity across locations, sectors, and time, the model remains tractable and is calibrated with the U.S. economy from 1980 to 2010. The calibration allows us to back out measures of upward mobility and inequality, thereby providing theoretical underpinnings to the Gatsby Curve. The counterfactual analysis shows that structural transformation has substantial effects on mobility: if there were no productivity growth in the manufacturing sector, income mobility would be about 6 percent higher, and if amenities were equalized across locations, it would rise by around 10 percent. In these effects, we find that different degrees of historical exposure to industries in local economies play an important role.
    Keywords: structural transformation; upward mobility; labor mobility; economic geography
    JEL: O14 J62 R11 R13
    Date: 2022–12–12
  18. By: Matthew Knowles (University of Cologne)
    Abstract: In a panel of OECD and emerging economies, I find that recessions are associated with larger initial drops in investment and more persistent drops in output if they occur simultaneously with banking crises. Furthermore, the banking crises that are followed by more persistent output slumps are associated with particularly large initial drops in investment. I show that these patterns can arise in a model where a financial shock temporarily increases the costs of external finance for investing entrepreneurs. This leads to a drop in investment and a very persistent slump in output and employment, provided wages are sufficiently rigid. Critical to the model is the distinction between different types of capital with different depreciation rates. Intangible capital and equipment have high depreciation rates, leading these stocks to drop substantially when investment falls after a financial shock. I find that this mechanism can account for almost a third of the persistent drop in output and employment in the US Great Recession (2007-2014).
    Keywords: Financial Shocks, Great Recession, Persistent Slumps, Intangible Capital.
    JEL: E22 E32 E44
    Date: 2023–02
  19. By: Panagiotis Nanos (Department of Economics, University of Sheffield, UK)
    Abstract: In this paper, I carry out a welfare analysis of the minimum wage in the framework of a Diamond-Mortensen-Pissarides model with stochastic job matching. I explore the role of the minimum wage in a labour market with trading externalities and present the necessary and sufficient condition for a minimum wage hike to be efficiency-enhancing. In this context, I characterise minimum wage spillover effects and demonstrate that there is a direct link between the welfare effects and spillover effects of a minimum wage. This theoretical finding suggests that the welfare impact of minimum wage changes can be inferred from the empirical observation of spillover effects on the wage distribution.
    Keywords: minimum wage, wage distribution, social welfare, policy evaluation
    JEL: J08 J64 H21 H23
    Date: 2023–01

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