http://d.repec.org/n?u=RePEc:nbr:nberwo:17742&r=dge

Search frictions in the labor market help explain the equity premium in the financial market. We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences. The model produces a sizeable equity premium of 4.54% per annum with a low interest rate volatility of 1.34%. The equity premium is strongly countercyclical, and forecastable with labor market tightness, a pattern we confirm in the data. Intriguingly, search frictions, combined with a small labor surplus and large job destruction flows, give rise endogenously to rare disaster risks à la Rietz (1988) and Barro (2006).

What else can the labor search model explain? Here it solves the equity premium puzzle and rare disaster risk. These are exciting results. But skimming through the paper (I do not want to delay mailing the NEP-DGE report further) I could not find good intuition for this except for the following: with the search frictions, wages are less volatile than the marginal productivitry of labor, because of the outside option of unemployment in the Nash bargaining of the wage. That makes profits more volatile than output, and you have an equity premium. But it seems to me that it is the Nash bargaining that drives the result, not the search mechanism. Have a different wage determination, and the result may not hold. Correct me if I am wrong.

http://d.repec.org/n?u=RePEc:pen:papers:12-002&r=dge

We develop a life-cycle model of the labor market in which different worker-firm matches have different quality and the assignment of the right workers to the right firms is time consuming because of search and learning frictions. The rate at which workers move between unemployment, employment and across different firms is endogenous because search is directed and, hence, workers can choose whether to seek low-wage jobs that are easy to find or high-wage jobs that are hard to find. We calibrate our theory using data on labor market transitions aggregated across workers of different ages. We validate our theory by showing that it correctly predicts the pattern of labor market transitions for workers of different ages. Finally, we use our theory to decompose the age profiles of transition rates, wages and productivity into the effects of age variation in work-life expectancy, human capital and match quality.

This paper is a good example of the progress labor search theory is making in capturing the complex realities of the job market. The life cycle element here is a major addition, and models like this will be useful to understand the impact of labor market policies on different age cohorts.

http://d.repec.org/n?u=RePEc:zur:econwp:051&r=dge

In this paper, we quantitatively analyze to what extent a benevolent government should issue debt in a model where households are subject to idiosyncratic productivity shocks, insurance markets are missing and borrowing is restricted. In this environment, issuing government bonds facilitates saving for self-insurance. Despite this, we find that in a calibrated version of the model that is consistent with the skewed wealth and earnings distribution observable in the U.S., the government should buy private bonds, and not issue public debt in the long run. The reason is that in the U.S., a large fraction of the population has almost no wealth or is even in debt. The wealth-poor, however, do not profit from an increase in the interest rate following an increase in public debt. Instead, they gain from higher wages that result from a reduction in debt. We show that even when the short run costs of higher capital taxation are taken into account, it still pays off to reduce government debt on overall. Moreover, we find that endogenizing household’s borrowing constraints by assuming limited commitment leads to even higher asset levels being optimal in the long run.

One standard justification for government debt is that it allows to complete markets. The best case is in two-period overlapping generation models, but the same case can be made in models without other assets or money. This paper shows that this result could be reversed as government debt increases the interest rate and reduces wages, and the poor rely almost exclusively on wages for income.

http://d.repec.org/n?u=RePEc:fip:fedpwp:11-48&r=dge

The authors examine the optimal labor market-policy mix over the business cycle. In a search and matching model with risk-averse workers, endogenous hiring and separation, and unobservable search effort they first show how to decentralize the constrained-efficient allocation. This can be achieved by a combination of a production tax and three labor-market policy instruments, namely, a vacancy subsidy, a layoff tax and unemployment benefits. The authors derive analytical expressions for the optimal setting of each of these for the steady state and for the business cycle. Their propositions suggest that hiring subsidies, layoff taxes and the replacement rate of unemployment insurance should all rise in recessions. The authors find this confirmed in a calibration targeted to the U.S. economy.

Interesting piece that goes a long way to improve on the simplistic proposals out there. Interestingly, the government budget constraint is balanced every period, so one could even improve on this with some well-timed public borrowing.

http://d.repec.org/n?u=RePEc:nbr:nberwo:17622&r=dge

This article reviews macroeconomic models with heterogeneous households. A key question for the relevance of these models concerns the degree to which markets are complete. This is because the existence of complete markets imposes restrictions on (i) how much heterogeneity matters for aggregate phenomena and (ii) the types of cross-sectional distributions that can be obtained. The degree of market incompleteness, in turn, depends on two factors: (i) the richness of insurance opportunities provided by the economic environment and (ii) the nature and magnitude of idiosyncratic risks to be insured. First, I review a broad collection of empirical evidence—from econometric tests of “full insurance,” to quantitative and empirical analyses of the permanent income (“self insurance”) model that examine how it fits the facts about life cycle allocations, to studies that try to directly measure where economies place between these two benchmarks (“partial insurance”). The empirical evidence I survey reveals significant uncertainty in the profession regarding the magnitudes of idiosyncratic risks as well as whether or not these risks have increased since the 1970s. An important difficulty stems from the fact that inequality often arises from a mixture of idiosyncratic risk and fixed (or predictable) heterogeneity, making the two challenging to disentangle. I also discuss applications of incomplete markets models to trends in wealth, consumption, and earnings inequality both over the life cycle and over time, where this challenge is evident. Third, I discuss “approximate” aggregation—the finding that some incomplete markets models generate aggregate implications very similar to representative-agent models. What approximate aggregation does and does not imply is illustrated through several examples. Finally, I discuss some computational issues relevant for solving and calibrating such models and I provide a simple yet fully parallelizable global optimization algorithm that can be used to calibrate heterogeneous agent models.

This is an excellent survey that should be mandatory reading for anyone interested in modern macroeconomics. It nicely lays out what the agenda is at the frontier of research and what some of the stumbling blocks are. And it also highlights when the additional complexity of the heterogeneous approach is not really necessary and representative agents can do.

http://d.repec.org/n?u=RePEc:mrr:papers:wp252&r=dge

In this project we extend an augmented lifecycle model, incorporating a Grossman-style model of health capital, to enhance understanding of factors influencing consumption, wealth and health. We develop three primary results when using the model to explore the effects of stylized versions of Medicare and Social Security on wealth and longevity. First, our model calibration implies consumption and health are complements. As health depreciates with age, households will get less utility from consumption than would be in the case of a lifecycle model that does not endogenize health. Second, it appears that forward-looking households, when confronted by a substantially reduced safety net, will respond by reducing consumption and by reducing their health investment and therefore longevity. Third, there is a potentially important difference between short- and long-run responses to policy.

I selected this paper this week because of this very interesting result that in the absence of a safety net, people invest less in health. This seems like a vicious cycle: with more fragile health they would need even more a safety net, but its absence worsens the situation even more. This result also runs counter to the intuition we have about idiosyncratic income shocks: the less one is insured, the more one does something about it.

http://d.repec.org/n?u=RePEc:hhs:bofrdp:2011_022&r=dge

What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.

When we analyze policy changes, we too often assume everybody knows immediately everything about the new policy. What if this is not the case? Political and policy uncertainties, as they are prevalent in several countries right now, make this question very relevant. This paper, by the leaders on the learning literature in macroeconomics, One highlight of the paper is that under adaptive learning responses to policy changes exhibit an hump shape. Another is that the impact of announced future policy changes can be more dramatic under adaptive learning than rational expectations, and it could even generate waves.

http://d.repec.org/n?u=RePEc:nbr:nberwo:17563&r=dge

This paper investigates the behavior of asset prices in an endowment economy in which a representative agent with power utility consumes the dividends of multiple assets. The assets are Lucas trees; a collection of Lucas trees is a Lucas orchard. The model generates return correlations that vary endogenously, spiking at times of disaster. Since disasters spread across assets, the model generates large risk premia even for assets with stable fundamentals. Very small assets may comove endogenously and hence earn positive risk premia even if their fundamentals are independent of the rest of the economy. I provide conditions under which the variation in a small asset’s price-dividend ratio can be attributed almost entirely to variation in its risk premium.

Besides the cute title, this paper shows how returns are correlated across assets even when fundamentals are not. In the current context, this seems particularly relevant. This week even an new issue of German Treasury bonds had difficulties selling out even though has doubted the fundamentals of Germany. This paper rationalizes this.

http://d.repec.org/n?u=RePEc:fip:fedpwp:11-39&r=dge

Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers’ over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.

As a foreigner living in the United States, I have puzzled why Americans are holding so much debt, and sometimes to buy goods that do not seem that essential. Lack of self-control may be the reason, and thus the fact that all these unsecured debt instruments are available may be welfare-decreasing, as detailed in this paper. I still wonder whether this could be generalized to other countries. Is temptation that much of a problem elsewhere?

http://d.repec.org/n?u=RePEc:iza:izadps:dp6039&r=dge

In this paper we use information on the cyclical variation of labor market participation to learn about the aggregate labor supply elasticity. For this purpose, we extend the standard labor market matching model to allow for endogenous participation. A model that is calibrated to replicate the variability of unemployment and participation, and the negative correlation of unemployment and GDP, implies an aggregate labor supply elasticity along the extensive margin of around 0.3 for men and 0.5 for women. This is in line with recent micro-econometric estimates.

Another paper that tries to reconcile macro and micro estimates of the labor supply elasticity. The novel approach here is to exploit information about the participation rate.