The Increased Importance of Asset Price Misalignments for Business Cycle Dynamics

June 26, 2011

By Mikael Bask and João Madeira

http://d.repec.org/n?u=RePEc:hhs:uunewp:2011_012&r=dge

We outline a dynamic stochastic general equilibrium (DSGE) model with trend extrapolation in asset pricing that we fit to quarterly U.S. macroeconomic time series with Bayesian techniques. To be more precise, we modify the DSGE model in Smets and Wouters (2007) by incorporating asset traders who use a mix of fundamental analysis and trend extrapolation in asset pricing. We conclude that trend extrapolation in asset pricing is quantitatively relevant, statistically significant and results in a substantial improvement of the model’s fit to the data. We also find that the strength in trend extrapolation is much stronger during the Great Moderation than it was prior to this period. Moreover, allowing for asset mispricing leads to more pronounced hump-shaped dynamics of the asset price and investment. Thus, asset price misalignments should be an important ingredient in DSGE models that aim to understand business cycles dynamics in general and the interaction between the real and financial sectors in particular.

DSGE models tend to assume away mispricing, at least beyond Lucas-type real/nominal confusion. This paper shows it actually matters and can help understand current economies.


Labor wedges and open economy puzzles

June 19, 2011

By Loukas Karabarbounis

http://d.repec.org/n?u=RePEc:pra:mprapa:31370&r=dge

A parsimonious model with home production, estimated to match moments of the “labor wedge,” explains prominent puzzles of the international business cycle. If market and home activity are substitutes, then the measured labor wedge increases whenever market consumption and employment decrease. Home production breaks the tight negative link between market consumption and its marginal utility and therefore helps explain the international risk sharing puzzle. In an estimated two-country dynamic general equilibrium model in which the labor wedge is endogenously generated to match its empirical moments, market output and market employment are more correlated than market consumption and investment across countries, relative market consumption is negatively related to the real exchange rate and real net exports are countercyclical. Further, the international risk sharing puzzle becomes easier to explain as the degree of financial completeness increases.

Interesting paper that manages to resolve several papers in the international business cycle literature in one go by introducing home production into the standard model, along with estimated labor wedges. The latter does not quite follow the traditional procedure, and it would be interesting to see how the model would have done without the wedges, or at least with a fully calibrated model.


The Tragedy of Annuitization

June 13, 2011

By Ben Heijdra, Jochen Mierau and Laurie Rijnders

http://d.repec.org/n?u=RePEc:ihs:ihsesp:268&r=dge

We construct a tractable discrete-time overlapping generations model of a closed economy and use it to study government redistribution of accidental bequests and private annuities in general equilibrium. Individuals face longevity risk as there is a positive probability of passing away before the retirement period. We find non-pathological cases where it is better for long-run welfare to waste accidental bequests than to give them to the elderly. Next we study the introduction of a perfectly competitive life insurance market offering actuarially fair annuities. There exists a tragedy of annuitization: although full annuitization of assets is privately optimal it is not socially beneficial due to adverse general equilibrium repercussions.

My intuition was that annuities are privately beneficial but underused because of lack of knowledge about them and some innate fears people have about wasting savings if they die early, that is, annuities should be encouraged. This paper shows that we should discourage them. The reason is that the presence of annuities discourages savings, and the government is then better off throwing away accidental bequests.


Exploring the Causes of Frictional Wage Dispersion

June 6, 2011

By Volker Tjaden and Felix Wellschmied

http://d.repec.org/n?u=RePEc:bon:bonedp:bgse04_2011&r=dge

Standard search models are inconsistent with the amount of frictional wage dispersion found in U.S. data. We resolve this apparent puzzle by modeling skill development (learning by doing on the job, skill loss during unemployment) and duration dependence in unemployment benefits in a random on the job search model featuring two-sided heterogeneity. The model’s key parameters are calibrated using micro data on employment mobility and wages from the Survey of Income and Program Participation (SIPP). Our model is consistent with the amount of frictional wage dispersion found in the data. Skill development on the job is the most important driver behind this result. Meanwhile, firm heterogeneity never accounts for more than 20% of overall wage inequality within an age cohort.

Generating wage dispersion that compares to data is not obvious. This paper takes a labor search model and throws at it many factors that can generate dispersion (except education, which is controlled in the data I presume), calibrates it carefully and then looks what model feature sticks. It turns out unemployment spells or firm heterogeneity are relatively unimportant in this regard.


Ambiguity and the historical equity premium

June 1, 2011

By Fabrice Collard, Sujoy Mukerji, Kevin Sheppard and Jean-Marc Tallon

http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00594096&r=dge

This paper assesses the quantitative impact of ambiguity on the historically observed equity premium. We consider a Lucas-tree pure-exchange economy with a single agent where we introduce two key non-standard assumptions. First, the agent’s beliefs about the dividend/consumption process is ambiguous. Second, the agent’s preferences are sensitive to this ambiguity. We further extend the model to allow for uncertainty about the magnitude of the persistence of the latent state. The agent’s beliefs are ambiguous due to the uncertainty about the conditional mean of the probability distribution on consumption and dividends in the next period. This results in an endogenously volatile and (counter-) cyclical equity premium. We calibrate the level of ambiguity aversion to match only the first moment of the risk-free rate in data, and ambiguity to match the uncertainty conditional on the historical growth path, and evaluate the model using moderate levels of risk aversion. We find that this simple modification of Lucas-tree model accounts for a large part of the historical equity premium, both in terms of its level and variation over time.

Ambiguity is largely neglected in the macro and finance literature, but it can obviously have an impact on risk premia (broadly defined). This paper show that ambiguity can in fact be a very important contributor to the equity premium puzzle.


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