Accounting for the Great Recession in the UK: Real Business Cycles and Financial Frictions

April 25, 2012

By Jagjit S. Chadha and James Warren

Using the business cycle accounting (BCA) framework pioneered by Chari, Kehoe and McGratten (2006) we examine the 2008-09 recession in the UK. There has been much commentary on the financial causes of this recession, which we might have expected to shock the equation governing the intertemporal rate of substitution in consumption. However, the recession appears to have been mostly driven by shocks to the efficiency wedge in total production, rather than the intertemporal consumption, labour or spending wedge. From an expenditure perspective this result is consistent with the observed large falls in both consumption and investment during the recession. To assess this result we also simulate artificial data from a DSGE model in which asset price shocks dominate and find no strong role for the intertemporal consumption wedge using the BCA method. This result does not imply that financial frictions did not matter for the recent recession but that such frictions do not necessarily impact only on the intertemporal rate of substitution in consumption.

These are intriguing results and I wonder whether they stem from a missing wedge (a misspecification in econometric terms). Were the model to capture also, say, financial frictions, those would have likely become the main source or the recession. Absent this, the existing wedges need to absorb somehow the downturn, and the efficiency wedge (TFP) is the most likely candidate as the economy was suddenly producing less with the same real resources. Now repeating the exercise with a model that does feature some financial frictions (Bernanke-Gertler (1999)), the latter still do not capture the recession, but rather the labor wedge. Either financial frictions really did not matter for the UK, or the BGG model is not the right one.


Does habit formation always increase the agents’ desire to smooth consumption?

April 22, 2012

By Emmanuelle Augeraud-Veron and Mauro Bambi

In the literature, habit formation has been often introduced to enhance the agents’ desire to smooth consumption over time. This characteristic was found particularly useful in solving the equity premium puzzle and in matching several stylized facts in growth, and business cycles theory as, for example, the high persistence in the U.S. output volatility. In this paper we propose a definition of habit formation, which is “general” relative to the assumptions on the intensity, persistence, and lag structure, and we unveil two mechanisms which point to the opposite direction: habits may reduce the desire of smoothing consumption over time and then may potentially decrease the power of a model in explaining the previously mentioned facts. More precisely, we propose a complete taxonomy of the rich dynamics which may emerge in an AK model with external addictive habits for all the feasible combinations of the intensity, persistence and lag structure characterizing their formation and we point out to the region in the parameters’ space coherent with less smoothing in consumption. An economic explanation of these mechanisms is suggested and the robustness of our results in the case of internal habits verified. Finally and crucially habit formation always reduces the desire of consumption smoothing once the model is calibrated to match the average U.S. output and utility growth rates observed in the data.

Interesting paper that highlights how we tend to abuse habit formation. There are many ways to formulate habit formation which can have important implications for model results. It can for example imply less consumption smoothing. Remember that the consumer is smoothing more that consumption. Read this paper before you use habit formation in your model.

Liquidity, Business Cycles, and Monetary Policy

April 12, 2012

By Nobuhiro Kiyotaki and John Moore

The paper presents a model of a monetary economy where there are differences in liquidity across assets. Money circulates because it is more liquid than other assets, not because it has any special function. There is a spectrum of returns on assets, reflecting their differences in liquidity. The model is used, first, to investigate how aggregate activity and asset prices fluctuate with shocks to productivity and liquidity; second, to examine what role government policy might have through open market operations that change the mix of assets held by the private sector. With its emphasis on liquidity rather than sticky prices, the model harks back to an earlier interpretation of Keynes (1936), following Tobin (1969).

The latest Kiyotaki-Moore. Once more, they get us to think about the basics in an elegant way, this time in considering money as an asset like any other with the difference that it is more liquid in the sense that other assets need time to sell or buy. Money is then useful, despite its lack of nominal return, because of a “liquidity-in-advance” property of transactions. In a world where entrepreneurs need financing, having a central bank changing the amount of liquidity in the economy through open-market operations then matters, because it alters relative prices and because the central bank swap illiquid assets for liquid ones. And the economy is then better lubricated.

Equilibrium labour turnover, firm growth and unemployment

April 7, 2012

By Melvyn Coles and Dale Mortensen

This paper identifies a data-consistent, equilibrium model of unemployment, wage dispersion, quit turnover and firm growth dynamics. In a separating equilibrium, more productive firms signal their type by paying strictly higher wages in every state of the market. Workers optimally quit to firms paying a higher wage and so move effciently from less to more productive firms. Start-up firms are initially small and grow endogenously over time. Consistent with Gibrats law, individual firm growth rates depend on firm productivity but not on firm size. Aggregate unemployment evolves endogenously. Restrictions are identified so that the model is consistent with empirical wage distributions.

A very rich, yet relatively tractable model of firma and wage heterogeneity. I predict this model will become an invaluable tool in comparing labor market and firm creation policies across countries. This should help a lot in disentangling and understanding why some economies stagnate with low unemployment or grwo fast with high wage iniequality, for example.

A Century of Human Capital and Hours

April 1, 2012

By Diego Restuccia and Guillaume Vandenbroucke

An average person born in the United States in the second half of the nineteenth century completed 7 years of schooling and spent 58 hours a week working in the market. By contrast, an average person born at the end of the twentieth century completed 14 years of schooling and spent 40 hours a week working. In the span of 100 years, completed years of schooling doubled and working hours decreased by 30 percent. What explains these trends? We consider a model of human capital and labor supply to quantitatively assess the contribution of exogenous variations in productivity (wage) and life expectancy in accounting for the secular trends in educational attainment and hours of work. We find that the observed increase in wages and life expectancy account for 80 percent of the increase in years of schooling and 88 percent of the reduction in hours of work. Rising wages alone account for 75 percent of the increase in schooling and almost all the decrease in hours in the model, whereas rising life expectancy alone accounts for 25 percent of the increase in schooling and almost none of the decrease in hours of work.

Interesting paper that shows how important the incentives from higher wages are in getting people to obtain more education. The model assumes that the path of wages is given, though. This can have important implactions when we think of development policy, which implicitely assumes that encouraging higher education will eventually lead to higher wages.