The unemployment volatility puzzle: the role of the underground economy

May 26, 2010

By Gaetano Lisi

Relying on the non-negligible role played by the underground economy in the labour market fluctuations, this paper extends the standard matching model à la Mortensen-Pissarides by introducing an underground sector along with an endogenous sector choice for both entrepreneurs and workers. These modifications improve the quantitative properties of the standard matching model, thus providing a possible explanation for the unemployment volatility puzzle.

It is too often forgotten that a substantial part of economic activity is not recorded. While home production has been considered in business cycle models, the underground economy has not. This paper shows that it matters, even when you limit yourself to observing outcomes in the visible economy.


Involuntary Unemployment and the Business Cycle

May 16, 2010

By Lawrence Christiano, Mathias Trabandt and Karl Walentin

We propose a monetary model in which the unemployed satisfy the official US definition of unemployment: they are people without jobs who are (i) currently making concrete efforts to find work and (ii) willing and able to work. In addition, our model has the property that people searching for jobs are better off if they find a job than if they do not (i.e., unemployment is ‘involuntary’). We integrate our model of involuntary unemployment into the simple New Keynesian framework with no capital and use the resulting model to discuss the concept of the ‘non-accelerating inflation rate of unemployment’. We then integrate the model into a medium sized DSGE model with capital and show that the resulting model does as well as existing models at accounting for the response of standard macroeconomic variables to monetary policy shocks and two technology shocks. In addition, the model does well at accounting for the response of the labor force and unemployment rate to the three shocks.

Can a DSGE model properly account for involuntary unemployment? The ‘standard’ way is to embed a Mortensen-Pissarides matching function into a RBC model, à la Andolfatto (1996). But this gives no role for money. Here, various other frictions are added to find a Phillips curve, and thus give a role to monetary policy. Is this the way to go?

Theory, General Equilibrium and Political Economy in Development Economics

May 13, 2010

By Daron Acemoglu

I discuss the role of economic theory in empirical work in development economics with special emphasis on general equilibrium and political economy considerations. I argue that economic theory plays (should play) a central role in formulating models, estimates of which can be used for counterfactual and policy analysis. I discuss why counterfactual analysis based on microdata that ignores general equilibrium and political economy issues may lead to misleading conclusions. I illustrate the main arguments using examples from recent work in development economics and political economy.

Having, modestly, tried myself to push the use of theory in development economics, especially where the quality of the data does not allow to draw good and/or generalizable empirical conclusions, I am happy to see this paper. There is only so much one can do with data without theory. Ultimately, policy prescriptions need to be based on some theory, and good theory is available.

Trading Off Generations: Infinitely-Lived Agent Versus OLG

May 4, 2010

By Maik Schneider, Christian Traeger and Ralph Winkler

The prevailing literature discusses intergenerational trade-offs predominantly in infinitely-lived agent models despite the finite lifetime of individuals. We discuss these trade-offs in a continuous time OLG framework and relate the results to the infinitely-lived agent setting. We identify three shortcomings of the latter: First, underlying normative assumptions about social preferences cannot be deduced unambiguously. Second, the distribution among generations living at the same time cannot be captured. Third, the optimal solution may not be implementable in overlapping generations market economies. Regarding the recent debate on climate change, we conclude that it is indispensable to explicitly consider the generations’ life cycles.

It is clear the world is composed of overlapping generations, but modelers often use infinitively-lived agents, for covenience, or under the belief that is does not make a difference for aggregates, or because there is intergenerational altruism. This paper, taking a continuous-time approach, shows when the two modeling assumptions are observationally equivalent. But the authors highlight that the two assumptions may have dramatic implications for policy advice.