Volume 14, Issue 1

This paper provides a rationale for fixed portfolios that exhibit fund separation as an optimal general equilibrium strategy when heterogeneous investors have wealth-varying relative risk aversion in the context of the standard stochastic neoclassical growth model. Agents’ wealth heterogeneity varies endogenously through time. Preferences exhibit linear risk tolerance with respect to consumption, consumption and labor are separable and the momentary utility function for leisure is isoelastic. Production possibilities are represented by J neoclassical technologies which are subject to shocks. I show that any competitive equilibrium allocation that is Pareto optimal can be supported by means of constant portfolios with only a few assets: a mutual fund of stocks, a consol and two other securities perfectly linearly correlated with aggregate labor income and the wage rate. Remarkably, this result holds in spite of the changing degree of agents’ heterogeneity and wealth-varying relative risk aversion, both stemming from movements in the stock of capital.

We study the implications of a stockout constraint in a dynamic general equilibrium model, which can explain both standard business cycle and inventory facts. Under this constraint, inventories and demand are complements in generating sales, and hence the optimal level of inventories increases in expected demand. We show that the inventory to sales ratio is both persistent and countercyclical because the cost of carrying inventories is mainly determined by the interest rate. We use this model to disentangle output and sales, by matching the key inventory moments, and find that preference and productivity shocks are equally important in the data. Finally, we assess whether improvements in inventory management can explain the Great Moderation. We find that, although improvements in inventory management can reduce the need for inventory holdings, which decreases output volatility relative to sales volatility, lower levels of inventories actually increases sales volatility. Because these two effects offset each other, a change in inventory management does not change output volatility to any great extent.

In this paper we derive conditions under which optimal tax rates for addictive goods exceed tax rates for non-addictive consumption goods within a rational addiction framework where exogenous government spending cannot be financed with lump sum taxes. We reexamine classic results on optimal commodity taxation and find a rich set of new findings. Two dynamic effects exist. First, households anticipating higher future addictive tax rates reduce current addictive consumption, so they will be less addicted when the tax rate increases. Therefore, addictive tax revenue falls prior to the tax increase. Surprisingly, the optimal tax rate on addictive goods is generally decreasing in the strength of tolerance, since strong tolerance strengthens this tax anticipation effect. Second, high current tax rates on addictive goods make households less addicted in the future, affecting all future tax revenues in a way which depends on how elasticities are changing over time. Classic results on uniform commodity taxation emerge as special cases when elasticities are constant and the addiction function is homogeneous of degree one. Finally, we also study features of addictive goods such as complementarity to leisure that, while not directly related to the definition of addiction, are nonetheless properties many addictive goods display.

We study aggregate effects on capital accumulation of changes in the permanent rate of inflation in a model that incorporates both residential and non-residential capital. The framework is a dynamic general equilibrium life-cycle economy populated by heterogeneous individuals with respect to age, income and homeownership status. Inflation raises the non-residential capital income tax burden, affects the user cost of housing capital and raises the opportunity cost of holding money. A numerical analysis is provided based on parameter values from the US economy. We find that housing capital and inflation exhibit a positive correlation while inflation reduces savings in business capital. It is shown that this outcome arises from the interaction of inflation with individual tenure decisions and a number of characteristics and tax provisions available in the housing market.

The optimality of the long-run capital-income tax rate is revisited in a simple neoclassical growth model with credit frictions. Firms pay their factors of production in advance, which requires borrowing at the beginning of the period. Borrowing, in turn, is constrained by the value of collateral that they own at the beginning of the period, leading to inefficiently low amounts of capital and labor. In this environment, the optimal capital-income tax in the steady state is non zero. Specifically, the quantitative analyses show that the capital-income tax is negative and, therefore, the distortions stemming from the credit friction are offset by subsidizing capital. However, when the government cannot distinguish between capital-income and profits, the capital-income tax is positive as the government levies the same tax rate on both sources of income. These results stand in contrast to the celebrated result of zero capital-income taxation of Judd (Judd, K. 1985. “Redistributive Taxation in a Simple Perfect Foresight Model.” Journal of Public Economics 28: 59–83.) and Chamley (Chamley, C. 1986. “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives.” Econometrica 54: 607–622.).

I study the general equilibrium of the housing market in an economy populated by overlapping generations of households. A contribution of the present paper is to solve for the housing market equilibrium in the presence of aggregate (interest rate) uncertainty with a realistic mortgage contract. In addition, households also face idiosyncratic uncertainty resulting from stochastic changes over the lifecycle in tastes (or needs) for housing. In this environment, profit-maximizing banks offer fixed-rate mortgage (FRM) contracts to homebuyers. As seems plausible, each housing market transaction is subject to a fixed cost, which gives rise to S-s policy rules for housing transactions: existing homeowners change the size of their houses only if there is a sufficiently large change in the state of the economy (i.e., in interest rates, in their taste for housing, etc.). A plausibly calibrated version of the model is consistent with three empirically documented features of the housing market: (i) highly volatile housing prices and transaction volume, (ii) a strong positive correlation between transaction volume and housing prices, and (iii) a significant negative relationship between interest rates and housing prices, which can rationalize a large part of the recent boom in housing prices in the US and around the world.

The idea that expectations about future economic fundamentals can drive business cycles dates back to the early 20th century. However, the standard real business cycle (RBC) model fails to generate positive comovement in output, consumption, labor-hours and investment in response to news shocks. This paper proposes a simple and intuitive solution to this puzzling feature of the RBC model, based on a mechanism that has strong empirical support: learning-by-doing (LBD). First, we show that the one-sector RBC model augmented by LBD can generate aggregate comovement in response to news shock about technology. Second, we show that in the two-sector RBC model, LBD along with an intratemporal adjustment cost can generate sectoral comovement in response to news about three types of shocks: i) neutral technology shock, ii) consumption technology shock, and iii) investment technology shock. We show that these results hold for contemporaneous technology shocks and for different specifications of LBD.

It is well known that the standard real business cycle (RBC) model with energy cannot generate the large drops in value added following the energy price increases in the 1970s, although previous empirical studies have confirmed the important role of energy prices. In this paper, endogenous capacity utilization is incorporated into an otherwise standard RBC model as an amplification mechanism. The simulated results show that the endogenous capacity utilization successfully generates the large contraction in value added observed in the Japanese data. It is also shown that the introduction of capacity utilization produces more realistic dynamics of total factor productivity.

This paper uses a new method for describing dynamic comovement and persistence in economic time series which builds on the contemporaneous forecast error method developed in den Haan [den Haan, W. J. 2000. “The Comovement between Output and Prices.” Journal of Monetary Economics 46: 3–30]. This data description method is then used to address issues in New Keynesian model performance in two ways. First, well known data patterns, such as output and inflation leads and lags and inflation persistence, are decomposed into forecast horizon components to give a more complete description of the data patterns. These results show that the well-known lead and lag patterns between output and inflation arise mostly in the medium-term forecasts horizons. Second, the data summary method is used to investigate a small-scale New Keynesian model with some important modeling features to see which of these features can reproduce lead, lag and persistence patterns seen in the data. We show that a general equilibrium model with habit formation, persistent IS curve shocks and persistent supply shocks can reproduce the lead, lag and persistence patterns seen in the data.

We examine whether the robustifying nature of Taylor rule cross-checking under model uncertainty carries over to the case of parameter uncertainty. Adjusting monetary policy based on this kind of cross-checking can improve the outcome for the monetary authority. This, however, crucially depends on the relative welfare weight that is attached to the output gap and also the degree of monetary policy commitment. We find that Taylor rule cross-checking is on average able to improve losses when the monetary authority only moderately cares about output stabilization and when policy is set in a discretionary way.

Had there been no involvement in Afghanistan and Iraq, how much lower would military and health spending have been in the US and the UK? And what is the total effect of war on real output variations as compared with its counterfactual? We use a synthetic control method and find that while the UK and the US have experienced similar relative increases in health spending, especially towards the end of the 10-year window, the effect on military spending is much more pronounced in the US. We find that the combined cumulative costs amount to more than 17% of the US GDP and more than 9% of the UK GDP. Moreover, there are no robust signs of a convergence between the true and counterfactual levels of military spending while health spending shows a level shift in the last 5 years in both countries. Finally, there is no evidence of changes in the national income following the sharp increase in defense spending.

Is the failure of natural resource abundance to achieve better economic outcomes due to limited financial development or fiscal policy short-termism? I answer this question in a precautionary savings model where both resource revenues and asset returns are uncertain. Calibrating for Colombia, I find that under policy impatience, welfare costs are large, net assets are insufficient and net discretionary expenditures are too sensitive to resource revenues. If financial markets are underdeveloped, we can generate welfare costs of the same magnitude but not also explain why there are insufficient net effective assets, nor the heightened sensitivity to revenues.

Using a two-sector model with potentially different capital shares in each sector, I show that the evolution of the skill premium from 1970 to 2005 is consistent with skill-neutrality and even a mild unskill-bias of technological change. The main channel of adjustment to changes in labor supply is instead via the reallocation of capital. New investment occurs predominantly in the skilled sector, to the detriment of the unskilled sector of the economy. This result is shown both theoretically in a simple model and in a quantitative exercise using data on the US economy.

Predictions about the macroeconomic impacts of recent US natural gas trends vary widely. I re-evaluate the possible effects on US economic activity using a standard general equilibrium model. Within this framework I show that increases in natural gas supply result in small-to-moderate economic gains, even with unemployment or under-utilized capital. Subsequent rises in economy-wide productivity are the key to magnifying the economic impacts of greater natural gas supply and resources. I also find that the macroeconomic effects of greater domestic oil production differ from those of natural gas.

We study optimal fiscal and monetary policy in a Ramsey economy where firms learn from their production experience and incur a real cost in changing their prices. Two central results emerge from our study. First, optimal tax policy is counter-cyclical – tax rates fall during recession and rise during boom. This finding contrasts with pro-cyclical tax results obtained in standard sticky price Ramsey models. In presence of learning-by-doing (LBD) mechanism, the Ramsey planner finds it relatively more costly to raise taxes in response to a negative technology shock. Higher taxes would reduce hours, output, and hence future level of organizational capital which will magnify the shock further by lowering future productivity. Hence, in response to a negative productivity shock, the planner finds it optimal to lower taxes in order to raise the after tax return to work and minimize the welfare-reducing effects of the shock. Second, optimal inflation is very stable and persistent over the business cycle. We show that while a dynamic link between current production and future productivity generates the inflation persistence, the real cost of price adjustment is the key factor behind the very low volatility in optimal inflation. Both of these mechanisms work through the monopolistic firms’ optimal pricing condition – namely the New Keynesian Philips Curve.

Standard models of international asset trade lack mechanisms linking an economy’s financial openness and industrial specialization. This paper presents a simple model of global portfolio diversification in which a link between financial liberalization and production specialization emerges very naturally. Within that model, an economy that liberalizes its financial markets is able to share its consumption risks, which in turn would allow the country to take extra risks in production by specializing in the good it produces more efficiently, resulting in higher output volatility and less correlated business cycles. The model provides insights about the effects of cross-country and cross-sector productivity shock correlations on portfolio choice, industrial specialization and consumption smoothing. Output volatility will increase as countries get more financially open, whereas consumption smoothing will depend on both the actual level of financial openness and on the productivity shock correlations between sectors and between countries. Higher integration induces greater production specialization, whereas the effect of productivity correlations on production diversification is ambiguous and depends on the degree of financial frictions.

Abstract: We study optimal monetary policy in an economy where firms’ debt overhangs lead to under-investment and under-production. The magnitude of this debt-induced distortion varies over the business cycle, rising significantly during recessions. When debt is contracted in nominal terms, this distortion gives rise to a balance sheet channel for monetary policy. In the presence of real and financial shocks, the monetary authority faces a trade-off between inflation and output gap stabilization. The optimal monetary policy rule prescribes that the anticipated component of inflation should be set equal to a target level, while the unanticipated component should rise in response to adverse shocks, smoothing the debt overhang distortion and the output gap.

In this paper we consider a modified version of Diamond’s OLG model. We show, first, that dynamic inefficiency may be relevant when the presence of imperfect competition is taken into account. Second, if fiscal policy is used to avoid inefficiency and maintain an optimal capital intensity, the required debt ratio will be inversely related to the growth rate. Third, austerity policies – reductions in government consumption and entitlement programs for the old generation – raise the required debt ratio.

Temporal aggregation alters time-series properties of high-frequency data, thereby affecting the estimation of models based on time-aggregated low-frequency data. This paper examines the effect of temporal aggregation of interest rates on forward-looking Taylor-type monetary policy rules. Results show that using quarterly-averaged interest rates in standard forward-looking structures adds a spurious bias to parameters that measure the extent of interest rate smoothing and serial correlation of shocks. Consequently, empirical interpretations of persistence in policy interest rate changes are distorted.

We study the impact of foreign debt on transmission of productivity shocks and on international risk sharing in a two-country DSGE model with incomplete asset markets and deviations from the purchasing power parity. We elucidate two channels through which debt affects international shock transmission. First, changes in domestic output cause fluctuations in the debt-to-GDP ratio and thus affect the risk premium on foreign borrowing. Second, fluctuations in the real exchange rate alter the real value of existing liabilities, generating wealth effects for the consumers in the indebted economy. Together, these two channels help to address the Backus-Smith puzzle by producing a negative consumption-real exchange rate correlation in an environment driven by productivity shocks. Our findings are robust to monetary policy rule specification but depend critically on the currency of debt denomination.

We present empirical evidence on whether the introduction of the euro has changed the effect of economic fundamentals on the growth rates of euro countries’ GDPpc and GDPpc volatility. We find that there is a statistically significant structural break in the impact of increments in government debt on both economic growth and uncertainty. In particular, after adoption of the euro increments in government debt decreased growth and increased uncertainty. These results are robust to a battery of checks, including exclusion of the recent financial crisis period, comparison with non-euro European countries, and controlling for different debt/GDP ratios.

How does technical change affect real factor prices? This paper gives a comprehensive answer for the most important benchmark used in the modern debate: technical change is factor-augmenting and materializes in a neoclassical economy with competitive firms equipped with a constant elasticity of substitution (CES) production function. I establish that the effect of labor-augmenting technical change crucially hinges on whether the economy’s capital endowment exceeds or falls short of its amount of efficient labor. This distinction determines the sign of the effect for sufficiently small values of the elasticity of substitution. In the former case, labor-augmenting technical progress must increase the equilibrium wage. In the latter case the equilibrium wage is reduced. In both cases, technical progress increases the price of capital. Overall, the analysis stresses that not only the elasticity of substitution but also the degree of diminishing returns, the distribution parameters of the CES, and the level of the efficient capital intensity matter for the effect of labor-augmenting technical change on real factor prices. Mutatis mutandis, these considerations carry over to the case of capital-augmenting technical change.

In this paper we study the joint behavior of the federal funds rate and 10-year TIPS yields before the start of the financial crisis in 2007. We make three points. First, the decade before the crisis was characterized by a collapse in the yield on TIPS. Second, estimated VARs for the federal funds rate and the TIPS yield show that while monetary policy shocks had negligible effects on the TIPS yield, shocks to the latter had one-to-one effects on the federal funds rate. Third, these findings can be rationalized in a New Keynesian model.