Trade Liberalization and Firm Dynamics

April 26, 2011

By Ariel Burstein and Marc Melitz

In this paper, we analyze the transition dynamics associated with an economy’s response to trade liberalization. We start by reviewing the recent literature that incorporates firm dynamics into models of international trade. We then build upon that literature to characterize the role of firm dynamics, export-market selection, firm-level innovation, and firms’ expectations regarding the time path of liberalization in generating those transition dynamics following trade liberalization. These modeling ingredients generate substantial aggregate transition dynamics as they shift and shape the endogenous distribution of firms over time. Our results show how the responses of trade volumes, innovation, and aggregate output can vary greatly over time depending on those modeling ingredients. This has important consequences for many issues in international economics that rely on predictions for the effects of globalization over time on those key aggregate outcomes.

CGE models have been pretty bad at predicting the consequences of NAFTA. Can more modern models perform better, especially dynamic ones? This is quite important, as the costs to trade liberalization are believed to be mostly in the transition dynamics. This paper shows it is very difficult to do, as small changes in the assumptions can lead to quite different trajectories. This calls more more and better empirical studies to better ground the specification of these models.


Intergenerational Redistribution in the Great Recession

April 17, 2011

By Andrew Glover, Jonathan Heathcote, Dirk Krueger and José-Víctor Ríos-Rull

In this paper we construct a stochastic overlapping-generations general equilibrium model in which households are subject to aggregate shocks that affect both wages and asset prices. We use a calibrated version of the model to quantify how the welfare costs of severe recessions are distributed across different household age groups. The model predicts that younger cohorts fare better than older cohorts when the equilibrium decline in asset prices is large relative to the decline in wages, as observed in the data. Asset price declines hurt the old, who rely on asset sales to finance consumption, but benefit the young, who purchase assets at depressed prices. In our preferred calibration, asset prices decline more than twice as much as wages, consistent with the experience of the US economy in the Great Recession. A model recession is approximately welfare-neutral for households in the 20-29 age group, but translates into a large welfare loss of around 10% of lifetime consumption for households aged 70 and over.

This is sad to say, but this has been an interesting recession. While usually the young suffer the most in a recession due to the lack of job prospects when they enter the labor market, and it was certainly even worse this time, the old were hit by a substantial asset loss. It is then not clear who lost the most, or even whether the young lost, as they find cheap assets at the age when real estate is usually unavailable to them. This papers sorts this carefully out, and the older generation is right to be unhappy about its situation.

Real Business Cycles with a Human Capital Investment Sector and Endogenous Growth: Persistence, Volatility and Labor Puzzles

April 14, 2011

By Jing Dang, Max Gillman and Michal Kejak

A positive joint two-sector productivity shock causes Rybczynski (1955) and Stolper and Samuelson (1941) effects that release leisure time and initially raises the relative price of human capital investment so as to favor it over goods production. This enables a basic RBC model, modified by having the household sector produce human capital investment sector, to succeed along related major dimensions of output, consumption, investment and labor, similar to the international approach of Maffezzoli (2000). By modifying the dynamics relative to the important work of Jones et al. (2005), two key US facts stressed by Cogley and Nason (1995) are captured: persistent movements in the growth rates of output and hump-shaped impulse responses of output. Further, physical capital investment has data consistent persistence within a hump-shaped impulse response. And Gali’s (1999) challenging empirical finding that labour supply decreases upon impact of a positive productivity shock is reproduced, while volatility in working hours is also data-consistent because of the substitution between market and nonmarket sectors.

About ten years ago, many papers were trying to provide an internal propagation mechanism to the canonical RBC model in order to answer to Cogley and Nason (1995). Then Galí (1999) posed the next challenge before the first one was, to my mind, resolved. It looks like this paper actually makes progress on both fronts.

A Monetary Theory with Non-Degenerate Distributions

April 11, 2011

By Guido Menzio, Shouyong Shi and Hongfei Sun

Dispersion of money balances among individuals is the basis for a range of policies but it has been abstracted from in monetary theory for tractability reasons. In this paper, we fill in this gap by constructing a tractable search model of money with a non-degenerate distribution of money holdings. We assume search to be directed in the sense that buyers know the terms of trade before visiting particular sellers. Directed search makes the monetary steady state block recursive in the sense that individuals’ policy functions, value functions and the market tightness function are all independent of the distribution of individuals over money balances, although the distribution affects the aggregate activity by itself. Block recursivity enables us to characterize the equilibrium analytically. By adapting lattice-theoretic techniques, we characterize individuals’ policy and value functions, and show that these functions satisfy the standard conditions of optimization. We prove that a unique monetary steady state exists. Moreover, we provide conditions under which the steady-state distribution of buyers over money balances is non-degenerate and analyze the properties of this distribution.

There have been several papers in money search that I have featured here recently. This is because this field is evolving fast lately, and this paper is a fine example of that. All models so far do not allow any non-trivial dispersion in money holdings, except for a short period. This paper overcomes this elegantly, and this promises to be very useful for future models.

Money, Financial Stability and Efficiency

April 2, 2011

By Franklin Allen, Elena Carletti and Douglas Gale

Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed.

This is a nice and intuitive paper based on the Diamond-Dybvig model that highlights how monetary policy cannot do everything when banks are in trouble, in some cases real resources are needed.