This blog is an experiment to explore the feasibility of scientific discussion on an Economics blog. NEP-DGE disseminates every week new working papers in the field of Dynamics General Equilibrium. Among them, the NEP-DGE editor selects one to be discussed. Everyone is invited to comment. Try to stay civil, or your comments will be removed. And encourage others to read or join in the discussion.
By Venky Venkateswaran and Randall Wright
When limited commitment hinders unsecured credit, assets help by serving as collateral. We study models where assets differ in pledgability – the extent to which they can be used to secure loans – and hence liquidity. Although many previous analyses of imperfect credit focus on producers, we emphasize consumers. Household debt limits are determined by the cost households incur when assets are seized in the event of default. The framework, which nests standard growth and asset-pricing theory, is calibrated to analyze the effects of monetary policy and financial innovation. We show that inflation can raise output, employment and investment, plus improve housing and stock markets. For the baseline calibration, optimal inflation is positive. Increases in pledgability can generate booms and busts in economic activity, but may still be good for welfare.
When you want to trade today but can only offer a counterpart tomorrow, you either pledge an asset or use some asset as collateral. But this is fraught with frictions, the quality of the asset may be uncertain, for example.Traders should thus endogenously determine how much asset should be used as a medium of exchange or collateral, depending on circumstances. In such a context, inflation in fiat money, which is used for transactions as well , has a positive impact: as the opportunity cost of money increases, agents substitute into other assets and thus increase working capital. Higher steady-state inflation can thus mean higher output. That result is quite difficult to obtain in micro-founded models where the Friedman Rule tends to prevail.
By Francisco Blasques
This paper proposes a functional specification approach for dynamic stochastic general equilibrium (DSGE) models that explores the properties of the solution method used to approximate policy functions. In particular, the solution-driven specification takes the properties of the solution method directly into account when designing the structural model in order to deliver enhanced flexibility and facilitate parameter identification within the structure imposed by the underlying economic theory. A prototypical application reveals the importance of this method in improving the specification of functional nonlinearities that are consistent with economic theory. The solution-driven specification is also shown to have the potential to greatly improve model fit and provide alternative policy recommendations when compared to standard DSGE model designs.
Traditionally, we specify a model, calibrate it and then apply a solution method. The latter has an impact on the result, though. For example, if a solution uses polynomial functions and it only preserve the properties of functions locally around the steady state, there is no need to use functional forms that have required properties beyond locally, especially if global properties impose additional unwelcome constraints. This means that functional-form choice depends on the solution method. And as the example in the paper shows, it can matter.
By Sophie Osotimehin and Francesco Pappadà
Recessions are conventionally considered as times when the least productive firms are driven out of the market. Do credit frictions hamper this cleansing effect of recessions? We build and calibrate a model of firm dynamics with endogenous exit and credit frictions to investigate this question. We find that, despite their distortionary effect on the selection of exiting firms, credit frictions do not reverse the cleansing effect of recession. Average idiosyncratic productivity rises following an adverse aggregate shock. Our results also suggest that recessions have a modest impact on average productivity whatever the level of credit frictions
Bernanke-Gertler meets Schumpeter, and neither seems to matter much. I was expecting the cleansing during recessions to be more important. As for frictions, it was not clear which way it would go, as more productive firms may face fewer frictions but frictions become more important in recessions, or something like that. In any case, it turns out that the popular claim that an occasional recession is good for the economy is not that true.
Here is the list of relevant CFPs for the month:
Canadian Macro Study Group, Toronto, 8-9 November 2013.
Recent Developments in Macroeconomics, Mannheim (Germany), 18-19 July 2013.
Boston University/Boston Fed Conference on Macro-Finance Linkages, Boston, 4-5 October 2013.
Bonn International School in Macroeconomics, Bonn, 3-11 July 2013.
By Jonathan Heathcote and Fabrizio Perri
This paper is structured in three parts. The first part outlines the methodological steps, involving both theoretical and empirical work, for assessing whether an observed allocation of resources across countries is efficient. The second part applies the methodology to the long-run allocation of capital and consumption in a large cross section of countries. We find that countries that grow faster in the long run also tend to save more both domestically and internationally. These facts suggest that either the long-run allocation of resources across countries is inefficient, or that there is a systematic relation between fast growth and preference for delayed consumption. The third part applies the methodology to the allocation of resources across developed countries at the business cycle frequency. Here we discuss how evidence on international quantity comovement, exchange rates, asset prices, and international portfolio holdings can be used to assess efficiency. Overall, quantities and portfolios appear consistent with efficiency, while evidence from prices is difficult to interpret using standard models. The welfare costs associated with an inefficient allocation of resources over the business cycle can be significant if shocks to relative country permanent income are large. In those cases partial financial liberalization can lower welfare.
While the allocation (or misallocation) of resources within a country, a sector or a firm are much studies, the international allocation is rarely looked at. This monumental paper, a forthcoming chapter in the Handbook for International Economics surveys the relevant literature, lays out the methodological foundations and takes a quantitative example with business cycle fluctuations among developed economies. The last statement of the abstract is intriguing. Indeed, financial autarky may be preferable in some circumstances, namely when shocks generate large differences in permanent income (very persistent, large innovations). The reasons is that if you only have bonds, they provide poor insurance as they are non-contingent. In addition, introducing bonds changes interest rate responses in a way that amplifies the impact of shocks. The interest rate in the country benefiting from a positive shock declines less than under autarky, leading to a additional wealth effect as it lending. The same would apply if the other country had a negative shock. Now think about it in the context of Germany and the European financial crisis.
By Jeremy Greenwood, Philipp Kircher, Cezar Santos and Michele Tertilt
Eleven percent of the Malawian population is HIV infected. Eighteen percent of sexual encounters are casual. A condom is used one quarter of the time. A choice-theoretic general equilibrium search model is constructed to analyze the Malawian epidemic. In the developed framework, people select between different sexual practices while knowing the inherent risk. The analysis suggests that the efficacy of public policy depends upon the induced behavioral changes and general equilibrium effects that are typically absent in epidemiological studies and small-scale field experiments. For some interventions (some forms of promoting condoms or marriage), the quantitative exercise suggests that these effects may increase HIV prevalence, while for others (such as male circumcision or increased incomes) they strengthen the effectiveness of the intervention. The underlying channels giving rise to these effects are discussed in detail.
This paper confirms some of the results of my research with Douglas Gollin: general equilibrium effects are important, behavioral responses are very important, and protection methods may be useless, or in this case counter-productive, once behavioral responses are taken into account. I also think that this is another example where the lack of reliable data can be efficiently supplemented with good use of theory.
By Sewon Hur and Illenin Kondo
Emerging economies, unlike advanced economies, have accumulated large foreign reserve holdings. We argue that this policy is an optimal response to an increase in foreign debt rollover risk. In our model, reserves play a key role in reducing debt rollover crises (“sudden stops”), akin to the role of bank reserves in preventing bank runs. We find that a small, unexpected, and permanent increase in rollover risk accounts for the outburst of sudden stops in the late 1990s, the subsequent increase in foreign reserves holdings, and the salient resilience of emerging economies to sudden stops ever since. Finally, we show that a policy of pooling reserves can substantially reduce the reserves needed by emerging economies.
Interesting paper that shows that rather small events can trigger larger ones. While this is applied to emerging economies, one can wonder whether this can carry over to Europe today. Of course, the handling of foreign reserves is completely different, but precisely the fact that they are bundled across member countries to address imbalances looks like what the authors are calling for. Maybe this is a real-life test of their proposed policy.