Public Investment, Time to Build, and the Zero Lower Bound

February 10, 2014

By Hafedh Bouakez, Michel Guillard and Jordan Roulleau-Pasdeloup

Public investment represents a non-negligible fraction of total public expenditures. Yet, theoretical studies of the effects of public spending when the economy is stuck in a liquidity trap invariably assume that government expenditures are entirely wasteful. In this paper, we consider a new-Keynesian economy in which a fraction of government spending increases the stock of public capital-which is an external input in the production technology-subject to a time-to-build constraint. In this environment, an increase in public spending has two conflicting effects on current and expected inflation: a positive effect due to higher aggregate demand and a negative effect reflecting future declines in real marginal cost. We solve the model analytically both in normal times and when the zero lower bound (ZLB) on nominal interest rates binds. We show that under relatively short time-to-build delays, the spending multiplier at the ZLB decreases with the fraction of public investment in a stimulus plan. Conversely, when several quarters are required to build new public capital, this relationship is reversed. In the limiting case where a fiscal stimulus is entirely allocated to investment in public infrastructure, the spending multiplier at the ZLB is 4 to 5 times larger than in normal times when the time to build is 12 quarters.

It surprises Europeans that the US has not taken advantage of a deep recession and very low interest rates to renew its crumbling infrastructure. After all, this seems like a greate opportunity for some intertemporl substitution of government expenses. The key is likely in the American distate for public deficits. Yet, given that the stimulus money was decided anyway, why not focus on public infrastrucutre? This paper shows that the returns could have been very large. Unfortunately, I am not quite convinced of the results. Indeed, using a log-linearization in the context of a highly non-linear situation like the ZLB can yield misleading results. In addition, the log-linearization is taken around the deterministic steady-state, which is quite far from the ZLB under stochastics and the approximation error could be large even if there were no linearity issue.

News shocks and business cycles: bridging the gap from different methodologies

February 2, 2014

By Christoph Görtz and John Tsoukalas

An important disconnect in the news driven view of the business cycle formalized by Beaudry and Portier (2004), is the lack of agreement between different—VAR and DSGE—methodologies over the empirical plausibility of this view. We argue that this disconnect can be largely resolved once we augment a standard DSGE model with a financial channel that provides amplification to news shocks. Both methodologies suggest news shocks to the future growth prospects of the economy to be significant drivers of U.S. business cycles in the post-Greenspan era (1990-2011), explaining as much as 50% of the forecast error variance in hours worked in cyclical frequencies.

News shocks are interesting because they are forward-looking, compared to the other shocks in the literature that focus on current conditions. In retrospect, it is thus natural that forward-looking features of the economy, like the financial sector, need to be included in a model to properly account for news shocks. This is what this paper does.


January 29, 2014

There is now a new NEP report dedicated to economic growth. I encourage those interested in this topic to subscribe to it here. Note that while I have in the past featured growth models on NEP-DGE even when they were not DGE, I will stop doing so now.

And here are the calls for papers for the month:

Southern Workshop in Macroeconomics, Auckland, New Zealand, 7-8 March 2014

Tsinghua Workshop in Macroeconomics, Beijing, 30 May-1 June 2014.

Carnegie-Rochester-NYU Conference on Public Policy on “Monetary Policy: An Unprecedented Predicament”, Pittsburgh, 14-15 November, 2014

Paris Conference on Goods Markets, The Macroeconomy and Policy, Paris 15-16 May 2014.

First African Search and Matching Workshop, Marrakesh (Morocco) 21-23 May 2014.

Conference on Recent Developments in Macroeconomics, Mannheim (Germany), 23-24 June 2014.

Doctoral Workshop on Dynamic Macroeconomics, Strasbourg (France), 2-3 June 2014.

And let us not forget that the deadline is coming up for the Society for Economic Dynamics Annual Meeting, Toronto, 26-28 June 2014.

Two monetary models with alternating markets

January 23, 2014

By Gabriele Camera and YiLi Chien

We present a thought-provoking study of two monetary models: the cash-in-advance and the Lagos and Wright (2005) models. We report that the different approach to modeling money – reduced-form vs. explicit role – neither induces theoretical nor quantitative differences in results. Given conformity of preferences, technologies and shocks, both models reduce to one difference equation. The equations do not coincide only if price distortions are differentially imposed across models. To illustrate, when cash prices are equally distorted in both models equally large welfare costs of inflation are obtained in each model. Our insight is that if results differ, then this is due to differential assumptions about the pricing mechanism that governs cash transactions, not the explicit microfoundation of money.

I hate promoting here twice in a row a paper by a colleague, but I think this paper makes a very powerful point: CIA and Lagos-Wright are equivalent in many respects, and thus one does not need to go through the heavier machinery of the latter for many research questions. This means also that maybe some of the concerns that one has about the appropriateness of CIA can be alleviated if one is more convinced of the Lagos-Wright setup.

Mortgages and monetary policy

January 20, 2014

By Carlos Garriga, Finn Kydland and Roman Šustek

Mortgage loans are a striking example of a persistent nominal rigidity. As a result, under incomplete markets, monetary policy affects decisions through the cost of new mortgage borrowing and the value of payments on outstanding debt. Observed debt levels and payment to income ratios suggest the role of such loans in monetary transmission may be important. A general equilibrium model is developed to address this question. The transmission is found to be stronger under adjustable- than fixed-rate contracts. The source of impulse also matters: persistent inflation shocks have larger effects than cyclical fluctuations in inflation and nominal interest rates.

If monetary policy has an impact on inflation, it has real consequences on those with real liabilities. The literature focuses on nominal bonds and neglects mortgages, which this paper shows to be important. To my surprise, monetary policy has a stronger impact with adjustable mortgage rates compared to fixed ones. This comes from a combination of a price effect for new mortgages that redistributes the burden of the mortgage over its lifetime and a traditional wealth effect for ongoing mortgages where the inflation rate matters, as well as, for adjustable rate mortgages, the short-term interest rate. This is difficult to summarize in a few sentences, read the paper.

Technological Learning and Labor Market Dynamics

January 12, 2014

By Martin Gervais, Nir Jaimovich, Henry Siu and Yaniv Yedid-Levi

The search-and-matching model of the labor market fails to match two important business cycle facts: (i) a high volatility of unemployment relative to labor productivity, and (ii) a mild correlation between these two variables. We address these shortcomings by focusing on technological learning-by-doing: the notion that it takes workers time using a technology before reaching their full productive potential with it. We consider a novel source of business cycles, namely, fluctuations in the speed of technological learning and show that a search-and-matching model featuring such shocks can account for both facts. Moreover, our model provides a new interpretation of recently discussed “news shocks.”

Given the unusually large number of papers in the last NEP-DGE report, I am selecting a second paper for the blog. It is also a paper that mixes to good effect two literatures: news shocks and search-and-matching. In some sense, this argument has been made before at the aggregate level. Major technological advances require new investment to become usable, and this also adds a delay between the news of the new technology and the time it becomes effective. This could explain some asset price dynamics, for example. In the case of this paper, the burden is on the individual worker, and this helps explain labor market dynamics.

A Theory of Targeted Search

January 12, 2014

By Paulina Restrepo-Echavarria, Antonella Tutino and Anton Cheremukhin

We develop a model of matching where participants have finite information processing capacity. The equilibrium of our model covers the middle ground between the equilibria of random matching and the directed search literatures and reproduces them as limiting cases. Our theory of targeted search generates a unique equilibrium which is generally inefficient.

This is an interesting paper that embeds rational inattention, or limited information processing, into the bilateral search literature. To my surprise, this yields a unique equilibrium, which is important as it makes it possible to use this kind of modelling in many applications. The paper also highlights an inefficiency stemming from the lack of information. which also helps in getting the uniqueness. In optimal assignment models there is multiplicity because of the infinitely strong complementarity between two players: the targeted player has every incentive to reciprocate. Here the complementarity is not that strong due to the information constraint, which makes that only one pairing can happen.


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