Towards a micro-founded theory of aggregate labor supply

July 31, 2011

By Andrés Erosa, Luisa Fuster and Gueorgui Kambourov

We document various facts about the labor supply decisions of male workers in the US over their life cycle. We then build a neoclassical model of labor markets with non-linear wages and heterogeneous agents. The key model feature for delivering periods of non-participation is the non-linear mapping between hours of work and earnings. We show that our model can go a long way towards capturing salient features of individual labor supply over the life cycle. Moreover, the aggregate response of labor supply to a one time unanticipated wage shock is much larger than predicted by the Frisch elasticity of labor supply.

This is a very active line of work, better understand the labor supply and in particular its Frisch elasticity. Determining the size the substitution effect is crucial to study labor markets through the business cycle, and unfortunately micro and macro estimates of the elasticity do not agree, by far. This paper highlights that some non-linearities may play an important role here, both in terms of estimate discrepancies and the behavior of labor markets.


DSGE And Beyond – Computable And Constructive Challenges

July 25, 2011

By K. Vela Velupillai

The genesis and the path towards what has come to be called the DSGE model is traced, from its origins in the Arrow-Debreu General Equilibrium model (ADGE), via Scarf’s Computable General Equilibrium model (CGE) and its applied version as Applied Computable General Equilibrium model (ACGE), to its ostensible dynamization as a Recursive Competitive Equilibrium (RCE). An outline of a similar nature, albeit very briefly, of the development and structure of Agent-Based Economics (ABE) is also included. It is shown that these transformations of the ADGE model are computably and constructively untenable. Suggestions for going ‘beyond DSGE and ABE’ are, then, outlined on the basis of a framework that is underpinned -from the outset- by computability and constructivity consideration

Velupillai’s point is that while there are theorems that show that an equilibrium exists for DSGE models, it is impossible to find it, in particular computationally as computers work on a finite number of points. In his words. it follows that formulating optimal decision problems as dynamic programming problems is impossible. This comes about because DSGE rely in their proofs on various theorems, some of which make assumptions leading to non-computability or non-constructivity. The only way out it to assume that the computer is solving a model economy where agents themselves are computers.

Computing Dynamic Heterogeneous-Agent Economies: Tracking the Distribution

July 22, 2011

By Grey Gordon

Theoretical formulations of dynamic heterogeneous-agent economies typically include a distribution as an aggregate state variable. This paper introduces a method for computing equilibrium of these models by including a distribution directly as a state variable if it is finite-dimensional or a fine approximation of it if infinite-dimensional. The method accurately computes equilibrium in an extreme calibration of Huffman’s (1987) overlapping-generations economy where quasi-aggregation, the accurate forecasting of prices using a small state space, fails to obtain. The method also accurately solves for equilibrium in a version of Krusell and Smith’s (1998) economy wherein quasi-aggregation obtains but households face occasionally binding constraints. The method is demonstrated to be not only accurate but also feasible with equilibria for both economies being computed in under ten minutes in Matlab. Feasibility is achieved by using Smolyak’s (1963) sparse-grid interpolation algorithm to limit the necessary number of grid points by many orders of magnitude relative to linear interpolation. Accuracy is achieved by using Smolyak’s algorithm, which relies on smoothness, only for representing the distribution and not for other state variables such as individual asset holdings.

This is an interesting method that should extend significantly the class of heterogeneous models with aggregate shocks that can be solved with reasonable accuracy and within reasonable computing time. The relevant computer code is also available, which should boost its usage.

Precautionary Savings and Global Imbalances in World General Equilibrium

July 17, 2011

By Damiano Sandri

In this paper we assess the implications of precautionary savings for global imbalances by considering a world economy model composed by the US, the Euro Area, Japan, China, oil-exporting countries, and the rest of the world. These areas are assumed to differ only with respect to GDP volatility which is calibrated based on the 1980-2008 period. The model predicts a wide dispersion in net foreign asset positions, with the highly volatile oil-exporting countries accumulating very large asset holdings. While heterogeneity in GDP volatility may lead to large imbalances in international investment positions, its impact on current accounts is much weaker. This is because countries are expected to move towards their optimal NFA at a very slow pace.

Can the dispersion in cross-country net foreign asset positions be explained by differences in precautionary savings stemming from differences in output volatility? This paper claims it can, and because adjustments are very slow, it can also account for relatively small current accounts.