Policy change and learning in the RBC model

November 30, 2011

By Kaushik Mitra, George Evans, and Seppo Honkapohja


What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.

When we analyze policy changes, we too often assume everybody knows immediately everything about the new policy. What if this is not the case? Political and policy uncertainties, as they are prevalent in several countries right now, make this question very relevant. This paper, by the leaders on the learning literature in macroeconomics, One highlight of the paper is that under adaptive learning responses to policy changes exhibit an hump shape. Another is that the impact of announced future policy changes can be more dramatic under adaptive learning than rational expectations, and it could even generate waves.


The Lucas Orchard

November 26, 2011

By Ian Martin


This paper investigates the behavior of asset prices in an endowment economy in which a representative agent with power utility consumes the dividends of multiple assets. The assets are Lucas trees; a collection of Lucas trees is a Lucas orchard. The model generates return correlations that vary endogenously, spiking at times of disaster. Since disasters spread across assets, the model generates large risk premia even for assets with stable fundamentals. Very small assets may comove endogenously and hence earn positive risk premia even if their fundamentals are independent of the rest of the economy. I provide conditions under which the variation in a small asset’s price-dividend ratio can be attributed almost entirely to variation in its risk premium.

Besides the cute title, this paper shows how returns are correlated across assets even when fundamentals are not. In the current context, this seems particularly relevant. This week even an new issue of German Treasury bonds had difficulties selling out even though has doubted the fundamentals of Germany. This paper rationalizes this.

Rising indebtedness and temptation: a welfare analysis

November 19, 2011

By Makoto Nakajima


Is the observed large increase in consumer indebtedness since 1970 beneficial for U.S. consumers? This paper quantitatively investigates the macroeconomic and welfare implications of relaxing borrowing constraints using a model with preferences featuring temptation and self-control. The model can capture two contrasting views: the positive view, which links increased indebtedness to financial innovation and thus better consumption smoothing, and the negative view, which is associated with consumers’ over-borrowing. The author finds that the latter is sizable: the calibrated model implies a social welfare loss equivalent to a 0.4 percent decrease in per-period consumption from the relaxed borrowing constraint consistent with the observed increase in indebtedness. The welfare implication is strikingly different from the standard model without temptation, which implies a welfare gain of 0.7 percent, even though the two models are observationally similar. Naturally, the optimal level of the borrowing limit is significantly tighter according to the temptation model, as a tighter borrowing limit helps consumers by preventing over-borrowing.

As a foreigner living in the United States, I have puzzled why Americans are holding so much debt, and sometimes to buy goods that do not seem that essential. Lack of self-control may be the reason, and thus the fact that all these unsecured debt instruments are available may be welfare-decreasing, as detailed in this paper. I still wonder whether this could be generalized to other countries. Is temptation that much of a problem elsewhere?

What Do Participation Fluctuations Tell Us About Labor Supply Elasticities?

November 14, 2011

By Christian Haefke and Michael Reiter


In this paper we use information on the cyclical variation of labor market participation to learn about the aggregate labor supply elasticity. For this purpose, we extend the standard labor market matching model to allow for endogenous participation. A model that is calibrated to replicate the variability of unemployment and participation, and the negative correlation of unemployment and GDP, implies an aggregate labor supply elasticity along the extensive margin of around 0.3 for men and 0.5 for women. This is in line with recent micro-econometric estimates.

Another paper that tries to reconcile macro and micro estimates of the labor supply elasticity. The novel approach here is to exploit information about the participation rate.

Buyers, Sellers and Middlemen: Variations on Search-Theoretic Themes

November 7, 2011

By Yuet-Yee Wong and Randall Wright


We study bilateral exchange, both direct trade and indirect trade that happens through chains of intermediaries or middlemen. We develop a model of this activity and present applications. This illustrates how, and how many, intermediaries get involved, and how the terms of trade are determined. We show how bargaining with one intermediary depends on upcoming negotiations with downstream intermediaries, leading to holdup problems. We discuss the roles of buyers and sellers in bilateral exchanges, and how to interpret prices. We develop a particular bargaining solution and relate it to other solutions. In addition to contrasting our framework with other models of middlemen, we discuss the connection to different branches of search theory. We also illustrate how bubbles can emerge in intermediation.

We do not have good theories of middlemen. This is an interesting attempt at creating on that is based on search theory. Indeed, middlemen are good are overcoming (and exploiting) some frictions in markets, and search theory seems to be a natural place to start.