What we don’t know doesn’t hurt us: rational inattention and the permanent income hypothesis in general equilibrium

March 26, 2015

By Jun Nie, Yulei Luo, Gaowang Wang and Eric Young


This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003,2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that,under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

What I take away from this paper is that general equilibrium effects are impressive. Here we have an environment where economic agents suffer from incomplete information, which should make that the permanent income hypothesis should fail, yet interest rates put them right back on track. One could say that it is not new that prices reveal information that markets participants do not know individually. However, the added difficulty here is that for the hypothesis to hold under complete information, said interest rate needs to align with time preferences. So it is not obvious that things still fall into place once you remove information.

Debt Constraints and Unemployment

March 23, 2015

By Patrick Kehoe, Virgiliu Midrigan and Elena Pastorino


In the Great Contraction, regions of the United States that experienced the largest change in household debt to income ratios also experienced the largest drops in output and employment. Such output drops not only occurred for firms that sell primarily to a local region but also for regional establishments of nation-wide firms that sell highly traded goods to both the rest of the United States and abroad. These patterns are difficult to reconcile with standard models of financial frictions in which tightened financial constraints mainly affect firms’ ability to borrow. We develop a Bewley-Huggett-Aiyagari incomplete market model with search and matching frictions of the Diamond-Mortenson-Pissarides type that generates such patterns. Critically, we allow for human capital acquisition by employed individuals, which generates realistic wage-tenure profiles. We show that with such upward sloping wage profiles, an unanticipated tightening of borrowing constraints leads consumers to value less the prospect of consumption when employed and, thus, to find employment relatively less attractive. In equilibrium, firms anticipate this behavior by consumers and consequently reduce the number of vacancies they post. The key result is that in equilibrium the tightening of borrowing constraints generates a path of increased unemployment that lingers, as consumers slowly adjust their asset positions given the tighter constraints, and seemingly `sticky’ wages, despite wages being continually renegotiated.

Interesting paper that offers an explanation why the drop in the labor force participation rate accelerated during the recession. The question is then whether those who are more responsive to these debt constraint effects are going to return to the labor market once the economy is back to normal. This is not obvious as the persistence of the effects likely very high if this channel is indeed as important as the authors argue.

Optimal Income Taxation with Asset Accumulation

March 5, 2015

By Árpád Ábrahám, Sebastian Koehne and Nicola Pavoni


Several frictions restrict the government’s ability to tax assets. First of all, it is very costly to monitor trades on international asset markets. Moreover, agents can resort to non-observable low-return assets such as cash, gold or foreign currencies if taxes on observable assets become too high. This paper shows that limitations in asset observability have important consequences for the taxation of labor income. Using a dynamic moral hazard model of social insurance, we find that optimal labor income taxes typically become less progressive when assets are imperfectly observed. We evaluate the effect quantitatively in a model calibrated to U.S. data.

This is timely research given the recent crackdown on tax havens around the world. But tax havens are always going to exist, from some distant island to the shoe box dug in the garden. The paper shows that the ability to hide asset from the view of the tax authority has a dramatic impact on the tax schedule and even on labor income tax. And this is before considering issues of tax competition which may amplify these pressures.

Labor Market Reform and the Cost of Business Cycles

February 28, 2015

By Tom Krebs and Martin Scheffel


This paper studies the effect of labor market reform on the welfare cost of business cycles. Motivated by the German labor market reforms of 2003-2005, the so-called Hartz reforms, the paper focuses on two labor market institutions: the unemployment insurance system determining search incentives and the system of job placement services affecting matching efficiency. The paper develops a tractable search model with idiosyncratic labor market risk and risk-averse workers, and derives a closed-form solution for the welfare cost of business cycles as a function of the various parameters of interest. An improvement in job placement services leads to a reduction in the welfare cost of business cycles, but a change in unemployment benefit generosity has in general an ambiguous effect. A quantitative analysis based on a calibrated version of the model suggests that the German labor market reforms of 2003-2005 reduced the non-cyclical unemployment rate by 3 percentage points and reduced the welfare cost of business cycles by 30 percent.

Labor market reform exercise are rarely assessed on how they impact welfare. It is OK to see what they do to, say, the unemployment rate, but economic well-being is more than that, the average level of things. This paper is a step in the right direction. It takes as a starting point that business cycles are costly in terms of welfare. Then it shows that some policies from the Hartz reforms where efficient in reducing that cost, but for others it is not that clear at all.

Modeling Labor Markets in Macroeconomics: Search and Matching

February 25, 2015

By Michael Krause and Thomas Lubik


We present and discuss the simple search and matching model of the labor market against the background of developments in modern macroeconomics. We derive a simple representation of the model in a general equilibrium context and how the model can be used to analyze various policy issues in labor markets and monetary policy.

A very nice introduction to the topic, good for anyone who wants to learn about the topic, read up one some of its major developments, or assign it to students.

Technology and Intergenerational Persistence: Theory and Some Evidence

February 10, 2015

By Brant Abbott and Giovanni Gallipoli


We develop and estimate an equilibrium model of intergenerational earnings persistence based on skill complementarity in production. We show that when a worker’s productivity is relatively independent of co-workers’ skills (i.e., skills are substitutable) parental investments in a child’s human capital have a stronger impact on the child’s future earnings. This leads to higher earnings’ persistence across generations. Observed patterns of geographic variation in intergenerational income persistence, both across countries and within the US, appear to be consistent with this hypothesis. We show that differences in skill substitutability may account for up to 1/5 of cross-country variation in intergenerational earnings persistence. We also find that public policies which equalize skills are more desirable in places where skills are more complementary in production. Thus cross-country differences in production arrangements provide a rationale for the observed concurrence of proactive government policies and increased economic mobility. When accounting for this indirect effect, the model explains an even larger share of cross-country differences in mobility, up to 1/3 of the total. As a by-product of this analysis we provide the first set of estimates of skill substitutability in different industries.

While the emphasis of the paper is on the international differences in intergenerational persistence, I wonder what it implies for its change through time. I believe, for example, that there is more persistence in the United States than before, and I think that jobs are more complementary that substitutable than before. Wouldn’t that contradict the results of the paper? Maybe there is another mechanism in the time dimension for the US: how borrowing or liquidity constraints are blocking access to education for some.

The Statistical Implications of Common Identifying Restrictions for DSGE Models

February 5, 2015

By Stephen Morris


I reveal identification failures in a well-known dynamic stochastic general equilibrium (DSGE) model, and study the statistical implications of common identifying restrictions. First, I provide a fully analytical methodology for determining all observationally equivalent values of the structural parameters in any parameter space. I show that either parameter admissibility or sign restrictions may yield global identification for some parameter realizations, but not for others. Second, I derive a “plug-in” maximum likelihood estimator, which requires no numerical search. I use this tool to demonstrate that the idiosyncratic identifying restriction directly impinges on both the location and distribution of the small-sample MLE, and compute correctly sized confidence intervals.

While this paper looks at the identification for a specific paper, An and Schorfheide (2007), it highlights an issue of much broader reach. Specifically, when estimating a typical DSGE model, the identification of parameter values may only be local and not necessarily global. But this can be fixed with identifying restrictions, which have an impact on the estimator.


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