The NEP-DGE Blog

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.

A multi-sectoral approach to the U.S. Great Depression

By Pedro S. Amaral and James C. MacGee

http://d.repec.org/n?u=RePEc:fip:fedcwp:0911&r=dge

We document sectoral differences in changes in output, hours worked, prices, and nominal wages in the United States during the Great Depression. We explore whether contractionary monetary shocks combined with different degrees of nominal wage frictions across sectors are consistent with both sectoral as well as aggregate facts. To do so, we construct a two-sector model where goods from each sector are used as intermediates to produce the sectoral goods that in turn produce final output. One sector is assumed to have flexible nominal wages, while nominal wages in the other sector are set using Taylor contracts. We calibrate the model to the U.S. economy in 1929, and then feed in monetary shocks estimated from the data. We find that while the model can qualitatively replicate the key sectoral facts, it can account for less than a third of the decline in aggregate output. This decline in output is roughly half as large as the one implied by a one-sector model. Alternatively, if wages are set using Calvo-type contracts, the decline in output is even smaller.

In recent years, aggregate models have brought interesting answers to light regarding the origin and continuation of the Great Depression, starting with the work of Cole and Ohanian (1999). Cole and Ohanian (2001) extend it to a two sector model with wage rigidities in one sector and show that this contributed little to the Great Depression. Bordo, Erceg and Evans (2000) use a one-sector model with Taylor contracts and find that it can explain a significant part of the Great Depression. Amaral and MacGee combine the two and find only a third of the decline can be explained by these wage rigidities. Is this the end of this debate?

Capital controls and welfare

By: Shigeto Kitano

http://d.repec.org/n?u=RePEc:kob:dpaper:dp2010-01&r=dge

This paper computes welfare levels under different degree of capital controls and compares them with the welfare level under perfect capital mobility by using the methodology of Schmitt-Grohe and Uribe (2007). We show that perfect capital mobility is not always optimal and that capital controls may enhance an economy’s welfare level. There exists an optimal degree of capital-account restriction that achieves a higher level of welfare than that under perfect capital mobility, if the economy has a distortion due to financial intermediaries such as inefficient banks. The results of our analysis imply that as the domestic financial intermediaries are less efficient, the government should impose stricter capital controls in the form of a tax on foreign borrowing.

Would it be beneficial to make markets more incomplete? This would be an example.

Sunspots and Credit Frictions

By Sharon Harrison and Mark Weder

http://d.repec.org/n?u=RePEc:san:cdmawp:1001&r=dge

We examine a general equilibrium model with collateral constraints and increasing returns to scale in production. The utility function is nonseparable, with no income effect on the consumer’s choice of leisure. Unlike this model without a collateral constraint, we find that indeterminacy of equilibria is possible. Hence, business cycles can be driven by self-fulfilling expectations. This is the case for more realistic parametrizations than in previous, similar models without these features.

Models with increasing returns to scale have a nasty tendency for indeterminacy, as Roger Famer has shown. It was thought that introducing nonseparable utility was sufficient to prevent this (Jaimovich 2008, Meng and Yip 2008), but it appears that collateral constraints à la Kiyotaki and Moore (1997) make it reappear. This raises again the specter of self-fulfilling expectations and sunspots as possible sources of business cycles. In particular, would the last recession fit this description?

Search Frictions and Asset Price Volatility

By B. Ravikumar and Enchuan Shao

http://d.repec.org/n?u=RePEc:bca:bocawp:10-1&r=dge

We examine the quantitative effect of search frictions in product markets on asset price volatility. We combine several features from Shi (1997) and Lagos and Wright (2005) in a model without money. Households prefer special goods and general goods. Special goods can be obtained only via a search in decentralized markets. General goods can be obtained via trade in centralized competitive markets and via ownership of an asset. There is only one asset in our model that yields general goods. The asset is also used as a medium of exchange in the decentralized market to obtain the special goods. The value of the asset in facilitating transactions in the decentralized market is determined endogenously. This transaction role makes the asset pricing implications of our model different from those in the standard asset pricing model. Our model not only delivers the observed average rate of return on equity and the volatility of the equity price, but also accounts for most of the spectral characteristics of the equity price.

The Shi (1997) and the Lagos and Wright (2005) models have become very important tools in understanding money. In this model, money is replaced by a dividend yielding asset, that thus takes the role of medium of exchange and store of value. Is this a good representation of an asset whose pricing behavior Ravikumar and Shao try to replicate? An economy without money may have very different asset dynamics than with money.

Do Credit Constraints Amplify Macroeconomic Fluctuations?

By Zheng Liu, Pengfei Wang and Tao Zha

http://d.repec.org/n?u=RePEc:emo:wp2003:0910&r=dge

Previous studies on financial frictions have been unable to establish the empirical significance of credit constraints in macroeconomic fluctuations. This paper argues that the muted impact of credit constraints stems from the absence of a mechanism to explain the observed persistent comovements between housing prices and business investment. We develop such a mechanism by incorporating two key features into a DSGE model: we identify shocks that shift the demand for collateral assets and we allow productive agents to be credit-constrained. A combination of these two features enables our model to successfully generate an empirically important mechanism that amplifies and propagates macroeconomic fluctuations through credit constraints.

Intuitively, it seems natural that credit constraint would make business cycles worse. Yet, it has proven to be really difficult to get anything quantitatively important. Maybe it is because it really does not matter that much, at least in aggregate terms. Or maybe it is that we simply have not yet identified the relevant economic mechanism. This paper suggests one that seems to do the trick.

DSGE models and forecasting

Putting the New Keynesian DSGE model to the real-time forecasting test

by Marcin Kolasa, Michał Rubaszek and Paweł Skrzypczyński

http://d.repec.org/n?u=RePEc:ecb:ecbwps:20091110&r=dge

Dynamic stochastic general equilibrium models have recently become standard tools for policy-oriented analyses. Nevertheless, their forecasting properties are still barely explored. We fill this gap by comparing the quality of real-time forecasts from a richly-specified DSGE model to those from the Survey of Professional Forecasters, Bayesian VARs and VARs using priors from a DSGE model. We show that the analyzed DSGE model is relatively successful in forecasting the US economy in the period of 1994-2008. Except for short-term forecasts of inflation and interest rates, it is as good as or clearly outperforms BVARs and DSGE-VARs. Compared to the SPF, the DSGE model generates better output forecasts at longer horizons, but less accurate short-term forecasts for interest rates. Conditional on experts’ now casts, however, the forecasting power of the DSGE turns out to be similar or better than that of the SPF for all the variables and horizons.

Combining VAR and DSGE forecast densities

by Ida Wolden Bache, Anne Sofie Jore, James Mitchell and Shaun Vahey

http://d.repec.org/n?u=RePEc:bno:worpap:2009_23&r=dge

A popular macroeconomic forecasting strategy takes combinations across many models to hedge against instabilities of unknown timing; see (among others) Stock and Watson (2004), Clark and McCracken (2010), and Jore et al. (2010). Existing studies of this forecasting strategy exclude Dynamic Stochastic General Equilibrium (DSGE) models, despite the widespread use of these models by monetary policymakers. In this paper, we combine inflation forecast densities utilizing an ensemble system comprising many Vector Autoregressions (VARs), and a policymaking DSGE model. The DSGE receives substantial weight (for short horizons) provided the VAR components exclude structural breaks. In this case, the inflation forecast densities exhibit calibration failure. Allowing for structural breaks in the VARs reduces the weight on the DSGE considerably, and produces well-calibrated forecast densities for inflation.

Forecasting the US Real House Price Index: Structural and Non-Structural Models with and without Fundamentals

by Rangan Gupta, Alain Kabundi and Stephen Miller

http://d.repec.org/n?u=RePEc:pre:wpaper:200927&r=dge

We employ a 10-variable dynamic structural general equilibrium model to forecast the US real house price index as well as its turning point in 2006:Q2. We also examine various Bayesian and classical time-series models in our forecasting exercise to compare to the dynamic stochastic general equilibrium model, estimated using Bayesian methods. In addition to standard vector-autoregressive and Bayesian vector autoregressive models, we also include the information content of either 10 or 120 quarterly series in some models to capture the influence of fundamentals. We consider two approaches for including information from large data sets – extracting common factors (principle components) in a Factor-Augmented Vector Autoregressive or Factor-Augmented Bayesian Vector Autoregressive models or Bayesian shrinkage in a large-scale Bayesian Vector Autoregressive models. We compare the out-of-sample forecast performance of the alternative models, using the average root mean squared error for the forecasts. We find that the small-scale Bayesian-shrinkage model (10 variables) outperforms the other models, including the large-scale Bayesian-shrinkage model (120 variables). Finally, we use each model to forecast the turning point in 2006:Q2, using the estimated model through 2005:Q2. Only the dynamic stochastic general equilibrium model actually forecasts a turning point with any accuracy, suggesting that attention to developing forward-looking microfounded dynamic stochastic general equilibrium models of the housing market, over and above fundamentals, proves crucial in forecasting turning points.

Perhaps by coincidence, three new papers in this week’s issue of the NEP-DGE report deal with forecasting. Kolasa, Rubaszek and Skrzypczyński says that DSGE models perform remarkably well. Bache, Jore, Mitchell and Vahey claim that VAR models with structural breaks do better, but of course structural breaks cannot be predicted with a VAR. Gupta, Kabundi and Miller show that DSGE models of real estate markets are better with turning points, which are the most difficult statistic to forecast.

Labor Supply Heterogeneity and Macroeconomic Co-movement

by Stefano Eusepi and Bruce Preston

http://d.repec.org/n?u=RePEc:nbr:nberwo:15561&r=dge

Standard real-business-cycle models must rely on total factor productivity (TFP) shocks to explain the observed co-movement between consumption, investment and hours worked. This paper shows that a neoclassical model consistent with observed heterogeneity in labor supply and consumption, can generate co-movement in absence of TFP shocks. Intertemporal substitution of goods and leisure induces co-movement over the business cycle through heterogeneity in consumption behavior of employed and unemployed workers. The result is due to two model features that are introduced to capture important characteristics of US labor market data. First, individual consumption is affected by the number of hours worked with employed consuming more on average than unemployed. Second, changes in the employment rate, a central explanator of total hours variation, then affects aggregate consumption. Demand shocks — such as shifts in the marginal efficiency of investment, government spending shocks and news shocks — are shown to generate economic fluctuations consistent with observed business cycles.

A critical aspect of any business cycle model is the (intertemporal) substitution between consumption and leisure. In particular, this drives to a large extend the correlations between labor, consumption and investment. Traditional TFP based models have been critized for getting some of these correlations wrong, unless wealth effects are assumed away. This model is an attempt to replicate these correlations without TFP shocks and adopted a household whose members are unemployed in proportions varying through the business cycle.

Lending Relationships and Monetary Policy

by Yunus Aksoy, Henrique S. Basso and Javier Coto-Martinez

http://d.repec.org/n?u=RePEc:bbk:bbkefp:0912&r=dge

Financial intermediation and bank spreads are important elements in the analysis of business cycle transmission and monetary policy. We present a simple framework that introduces lending relationships, a relevant feature of financial intermediation that has been so far neglected in the monetary economics literature, into a dynamic stochastic general equilibrium model with staggered prices and cost channels. Our main findings are: (i) banking spreads move countercyclically generating amplified output responses, (ii) spread movements are important for monetary policy making even when a standard Taylor rule is employed (iii) modifying the policy rule to include a banking spread adjustment improves stabilization of shocks and increases welfare when compared to rules that only respond to output gap and inflation, and finally (iv) the presence of strong lending relationships in the banking sector can lead to indeterminacy of equilibrium forcing the central bank to react to spread movements.

There has been relatively little work on lending relationships, primarily because it is a very hard problem to model and solve. Here is a fresh attempt that seems rather successful.

Inflation and Welfare in Long-Run Equilibrium with Firm Dynamics

By Alexandre Janiak and Paulo Santos Monteiro

http://d.repec.org/n?u=RePEc:iza:izadps:dp4559&r=dge

We analyze the welfare cost of inflation in a model with cash-in-advance constraints and an endogenous distribution of establishments’ productivities. Inflation distorts aggregate productivity through firm entry dynamics. The model is calibrated to the United States economy and the long-run equilibrium properties are compared at low and high inflation. We find that, when the period over which the cash-in-advance constraint is binding is one quarter, an annual inflation rate of 10 percent leads to a decrease in the steady-state average productivity of roughly 0.5 percent compared to the optimum’s steady-state. This decrease in productivity is not innocuous: it leads to a doubling of the welfare cost of inflation.

It has been very difficult to find substantial costs for inflation, in a large part because it is difficult to make money matter in significant ways in a microfounded model. This attempt is different in that the welfare cost comes from productivity losses through the firm entry and distribution. The resulting impact of money and inflation is indirect yet important.

Portfolio inertia and the equity premium

By Christopher Gust and David López-Salido

http://d.repec.org/n?u=RePEc:fip:fedgif:984&r=dge

We develop a DSGE model in which aggregate shocks induce endogenous movements in risk. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. We show that the model can account for the mean returns on equity and the risk-free rate, and generates countercyclical movements in the equity premium that help explain the response of stock prices to monetary shocks. The model is consistent with empirical evidence documenting that unanticipated changes in monetary policy have important effects on equity prices through changes in risk.

Yet another attempt to solve the equity premium puzzle while obtaining a reasonable risk free rate. So many explanation have been thrown at the wall, finally a explanation that will stick?