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.
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.
December 28, 2013
By Roland Meeks, Benjamin Nelson and Piergiorgio Alessandri
We develop a macroeconomic model in which commercial banks can offload risky loans onto a “shadow” banking sector and financial intermediaries trade in securitized assets. We analyze the responses of aggregate activity, credit supply and credit spreads to business cycle and financial shocks. We find that interactions and spillover effects between financial institutions affect credit dynamics, that high leverage in the shadow banking system heightens the economy’s vulnerability to aggregate disturbances, and that following a financial shock, a stabilization policy aimed solely at the securitization markets is relatively ineffective.
Not only does this paper include a financial sector, nowadays a must for any macro model looking at the recent sector, this model also includes securitization and shadow banking. The latter arises as a better way to leverage illiquid loans. Banks try to transfer risk to their shadow operations, but not explicitly because of regulation. In fact, there is no regulatory motive to shadow banking in this paper, something that would be much beyond its current complexity. This paper is an interesting modeling strategy trying to push the envelope further in integrating the financial sector in macro models.
December 23, 2013
By Yongsung Chang, Jay Hong and Marios Karabarbounis
The standard theory of household portfolio choice is hard to reconcile with the following facts. (i) Despite a high rate of returns the average household holds a low share of risky assets (equity premium puzzle). (ii) The share of risky assets increases in age. (iii) The share of risky assets is disproportionately larger for richer households. We show that a simple life-cycle model with learning about earnings ability can successfully address all three puzzles. Young workers, on average asset poor, face larger uncertainty in their life-time labor income because they do have perfect knowledge of their ability in the market. They hedge this risk in human capital by investing in relatively safe financial assets. As earnings ability is gradually revealed over time, they take more risk in financial investment. When the labor income risks are calibrated to those observed in the Panel Study of Income Dynamics, our model with learning reproduces the investment profile we see in the Survey of Consumer Finances.
Often neglected in portfolio theory, labor income risk appears to be critical to understand portfolio choices over the life cycle. It not only the fact that younger people do not have the means to invest in financial assets, the paper here shows that the uncertainly about the path of future labor income is overwhelming at first and then vanishes as they learn it over time. It is only then that they can afford financial asset return risk.
December 22, 2013
By Marina Azzimonti and Matthew Talbert
We are motivated by four stylized facts computed for emerging and developed economies: (i) business cycle movements are wider in emerging countries; (ii) economies in emerging countries experience greater economic policy uncertainty; (iii) emerging economies are more polarized and less politically stable; and (iv) economic policy uncertainty is positively related to political polarization. We show that a standard real business cycle (RBC) model augmented to incorporate political polarization, a ‘polarized business cycle’ (PBC) model, is consistent with these facts. Our main hypothesis is that fluctuations in economic variables are not only caused by innovations to productivity, as traditionally assumed in macroeconomic models, but also by shifts in political ideology. Switches between left-wing and right-wing governments generate uncertainty about the returns to private investment, and this affects real economic outcomes. Since emerging economies are more polarized than developed ones, the effects of political turnover are more pronounced. This translates into higher economic policy uncertainty and amplifies business cycles. We derive our results analytically by fully characterizing the long-run distribution of economic and fiscal variables. We then analyze the effect of a permanent increase in polarization on PBCs.
In a well-functioning government, public policies are close to optimal and fluctuate little over time. In a highly polarized government with power shifts, policy swings around wildly and has the potential to have more of an impact. The paper here looks at the effect on the business cycle and finds one way to rationalize the higher business cycle volatility found in emergent and developing economies. The point here is that it is the policy uncertainty that influences business decisions, in particular investment. This should resonate with those complaining about polarization in Washington.
December 10, 2013
By Johannes Brumm, Michael Grill, Felix Kubler and Karl Schmedders
Many assets derive their value not only from future cash flows but also from their ability to serve as collateral. In this paper, we investigate this collateral value and its impact on asset returns in an infinite-horizon general equilibrium model with heterogeneous agents facing collateral constraints for borrowing. We document that borrowing against collateral substantially increases the return volatility of long-lived assets. Moreover, otherwise identical assets with different degrees of collateralizability exhibit substantially different return dynamics because their prices contain a sizable collateral premium that varies over time. This premium can be positive even for assets that never pay dividends.
Assets with collateral properties are in fashion these days, for understandable reasons. Yet, the pricing of these assets has not been much studied. This paper fills this void starting, of course, from a Lucas tree with interesting results for the moments of excess returns.
December 3, 2013
By Juan Carlos Parra-Alvarez
This paper evaluates the accuracy of a set of techniques that approximate the solution of continuous-time DSGE models. Using the neoclassical growth model I compare linear-quadratic, perturbation and projection methods. All techniques are applied to the HJB equation and the optimality conditions that define the general equilibrium of the economy. Two cases are studied depending on whether a closed form solution is available. I also analyze how different degrees of non-linearities affect the approximated solution. The results encourage the use of perturbations for reasonable values of the structural parameters of the model and suggest the use of projection methods when a high degree of accuracy is required.
Continuous-time DSGE models are not very popular but do have some interest applications. While there is an extensive literature looking at solution methods for discrete-time models that is looking a computing performance and precisions, that literature is much scarcer for the continuous-time kind. That paper is a good start.