Public Expenditure Policy in Bolivia: Growth and Welfare

October 23, 2010

By: Carlos Gustavo Machicado, Paul Estrada and Ximena Flores

It has been widely documented that fiscal policy can promote economic growth, when it is based on an efficient provision of pubic capital. But little work has been done, in Bolivia, in relation to the macroeconomic and sectoral impacts of increasing public investment in infrastructure. This paper develops a Dynamic Stochastic General Equilibrium (DSGE) model for a small open economy with five sectors: Non-tradable or services, importable or manufacturing, hydrocarbons, mining and agriculture. The model is parameterized and solved for the Bolivian economy and several interesting scenarios are simulated by changing government expenditures, taxes, country risk, Total Factor Productivity, effectiveness of public capital and terms of trade. This analysis is relevant for the Bolivian economy, because the government is using fiscal policy as one of its main tool to attack poverty and aims to put public investment as the foremost instruments to promote growth and welfare.

We see many general equilibrium models that study industrialized economies, and this one is an exception. Looking at Bolivia, it studies the impact of various public investment strategies. Does it make sense to use such models for developing economies?


A Dynamic Politico-Economic Model of Intergenerational Contracts

October 13, 2010

By Francesca Lancia and Alessia Russo

This paper investigates the conditions for the emergence of implicit intergenerational contracts without assuming reputation mechanisms, commitment technology and altruism. We present a tractable dynamic politico-economic model in OLG environment where politicians play Markovian strategies in a probabilistic voting environment, setting multidimensional political agenda. Both backward and forward intergenerational transfers, respectively in the form of pension benefits and higher education investments, are simultaneously considered in an endogenous human capital setting with labor income taxation. On one hand, social security sustains investment in public education; on the other hand investment in education creates a dynamic linkage across periods through both human and physical capital driving the economy toward different Welfare State Regimes. Embedding a repeated-voting setup of electoral competition, we find that in a dynamic efficient economy both forward and backward intergenerational transfers simultaneously arise. The equilibrium allocation is education efficient, but, due to political overrepresentation of elderly agents, the electoral competition process induces overtaxation compared with a Benevolent Government solution with balanced welfare weights.

This paper takes a careful look why dynamically inefficient schemes like a pay-as-you-go social security system or investment in education can survive politically. The interesting result is that it can happen even when there is only self-interest among members of different generations. The mechanism is that young households subsidize education of the children to obtain higher future productivity, which they can partially capture by getting social security payments when old. There is always a majority of people in favor of such a scheme as long as it is viewed as a whole package.

Labor-Market Heterogeneity, Aggregation, and the Lucas Critique

October 8, 2010

By Yongsung Chang, Sun-Bin Kim and Frank Schorfheide

This paper assesses biases in policy predictions due to the lack of invariance of “structural” parameters in representative-agent models. We simulate data under various fiscal policy regimes from a heterogeneous-agents economy with incomplete asset markets and indivisible labor supply. Imperfect aggregation manifests itself through preference shocks in the estimated representative-agent model. Preference and technology parameter estimates are not invariant with respect to policy changes. As a result, the bias in the representative-agent model’s policy predictions is large compared to the length of predictive intervals that reflect parameter uncertainty.

When structural models are estimated, it is assumed that those structural parameters are policy invariant, or the Lucas Critique would be applicable. That is going to be a problem especially if aggregate data is used to estimate the model, as composition effects may bias estimates. This paper simulates data under various policies and finds a measurable bias is present. Should we thus stop using aggregate data to estimate these models?

Matching frictions, unemployment dynamics and the cost of business cycles

October 4, 2010

By Jean-Olivier Hairault, François Langot and Sophie Osotimehin

We investigate the welfare cost of business cycles implied by matching frictions. First, using the reduced-form of the matching model, we show that job finding rate fluctuations generate intrinsically a non-linear effect on unemployment: positive shocks reduce unemployment less than negative shocks increase it. For the observed process of the job finding rate in the US economy, this intrinsic asymmetry increases average unemployment, which leads to substantial business cycles costs. Moreover, the structural matching model embeds other non-linearities, which alter the average job finding rate and consequently the welfare cost of business cycles. Our theory suggests to subsidizing employment in order to dampen the impact of the job finding rate fluctuations on welfare.

There has been some talk, but not much, about subsidizing new hires in the US, but the focus seems to be more on Keynesian measures. Is this paper a good way of understanding why unemployment is currently so high, and what could be done about it? There is certainly mounting evidence that sectoral and geographical frictions on the labor market are important, but this has not always been so, especially compared to Europe.