Volume 20, Issue 1

We compare aggregate wage dynamics in Japan and the US from 1970 to 2013 from the perspective of the New Keynesian wage Phillips curve (NKWPC), derived by [Galí, Jordi. 2011a. “The Return of the Wage Phillips Curve.” Journal of the European Economic Association 9 (3): 436–461.]. We consider time variations in NKWPC’s parameters and make comparisons with micro-based evidence. Our main findings are three-fold. First, although Japan’s NKWPC has flattened over time, the slope of the NKWPC is much steeper in Japan than in the US. This suggests that nominal wage changes are less frequent in the US than in Japan. Second, inflation indexation, more prevalent in Japan in earlier periods, has recently become more important in the US although its role has declined over time in both countries. Third, our macro-level empirical results on the NKWPC are generally in line with micro-based evidence in each country, which suggests that the NKWPC provides a reasonable platform for modeling aggregate wage dynamics.

We develop a model to study how risk averse banks use excess reserves to manage risk on their asset portfolios. Our model predicts that risk averse banks accumulate substantial holdings of excess reserves in response to large, low-probability shocks to the risk on loans. Our findings support the hypothesis that risk aversion led banks to build-up excess reserves within the US banking system in September of 2008 following news about the failure of Lehman Brothers and the credit downgrade of AIG. Moreover, our model also explains the magnitude of excess reserve fluctuations observed in the US over typical business cycles.

What are the consequences of asymmetry of information about the future state of the economy between a benevolent Central Bank (CB) and private agents near the zero lower bound? How is the conduct of monetary policy modified under such a scenario? We propose a game theoretical signaling model, where the CB has better information than private agents about a future shock hitting the economy. The policy rate itself is the signal that conveys information to private agents in addition to its traditional role in the monetary transmission mechanism. We find that only multiple “pooling equilibria” arise in this environment, where a CB privately forecasting a contraction will most likely follow a less expansionary policy compared to a complete information context, in order to avoid making matters worse by revealing bad times ahead. On the other hand, a CB privately forecasting no contraction is most likely to distort its complete information policy rate, the consequences of which are welfare detrimental. However, this is necessary because deviating from the pooling policy rate would be perceived by private agents as an attempt to mislead them into believing that a contraction is not expected, which would be even more harmful for society.

This paper studies risk premia in the foreign exchange market when investors entertain multiple models for consumption growth. Investors confront two sources of uncertainty: (1) individual models might be misspecified, and (2) it is not known which of these potentially misspecified models is the best approximation to the actual data-generating process. Following Hansen and Sargent (Hansen, L. P., and T. J. Sargent. 2010. “Fragile Beliefs and the Price of Uncertainty.” Quantitative Economics 1 (1): 129–162.), agents formulate “robust” portfolio policies. These policies are implemented by applying two risk-sensitivity operators. One is forward-looking, and pessimistically distorts the state dynamics of each individual model. The other is backward-looking, and pessimistically distorts the probability weights assigned to each model. A robust learner assigns higher weights to worst-case models that yield lower continuation values. The magnitude of this distortion evolves over time in response to realized consumption growth. It is shown that robust learning not only explains unconditional risk premia in the foreign exchange market, it can also explain the dynamics of risk premia. In particular, an empirically plausible concern for model misspecification and model uncertainty generates a stochastic discount factor that uniformly satisfies the spectral Hansen-Jagannathan bound of Otrok et al. (Otrok, C., B. Ravikumar, and C. H. Whiteman. 2007. “A Generalized Volatility Bound for Dynamic Economies.” Journal of Monetary Economics 54 (8): 2269–2290.).

This paper examines the effects of shocks to foreign official holdings of long-term U.S. Treasuries (FOHL) on macroeconomic aggregates using a dynamic general equilibrium model. The model treats short- and long-term bonds as imperfect substitutes through endogenous portfolio adjustment frictions. This provides a channel for changes in relative supply of assests to influence asset prices. Three key findings emerge: (1) positive shocks to FOHL impact the long-term interest rate and the term spread negatively through a stock effect channel – defined as persistent changes in interest rates as a result of movement along the Treasury demand curve. This result is consistent with findings in the empirical literature. (2) Through a feedback mechanism from an endogenous term structure in the model, the decline in the long-term interest rate induces an expansion in economic activity which leads to an increase in consumption, output and inflation. Both the stock effect and the feedback mechanism are generated by the portfolio frictions. (3) Higher degrees of persistence of FOHL shocks or imperfect asset substitution generate a prolonged negative stock effect following shocks to FOHL. This causes a longer delay of the term spread to return to its steady state after it falls; hence, inducing an extended and stronger stimulative feedback effect from the endogenous term structure into the modeled economy.  These findings help explain macroeconomic events such as the so-called ``Greenspan conundrum'' of the mid 2000s.

Because optimal plans are time-inconsistent, continuing one from a previous period is not optimal from today’s perspective, and may not outperform discretion, even ignoring surprise deviations. Hence, a once-and-for-all commitment to the optimal plan from a particular period does not always outperform discretion over time, even if superior from the perspective of the original period. Forward-looking policymakers might therefore not want to bind themselves to the optimal plan from any period. The vast literature on commitment strategies illustrates that it is a common misconception that a once-and-for-all commitment to the optimal plan is always preferable to discretion.

Once New Keynesian (NK) theory is combined with a standard model of lumpy investment, the resulting framework loses its ability to generate a realistic monetary transmission mechanism. This is the puzzle uncovered in Reiter, Sveen, and Weinke [Reiter, M., T. Sveen, and L. Weinke. 2013. “Lumpy Investment and the Monetary Transmission Mechanism.” Journal of Monetary Economics 60: 821–834.]. The simple economic reason behind it is the unrealistically large interest rate elasticity of investment, as implied by the standard theory of lumpy investment. In order to address this puzzle we develop a NK model featuring fully flexible investment combined with a financial friction. This model is used to isolate the quantitative importance of the financial friction for the monetary transmission mechanism.

This paper examines optimal monetary policy rules in a model of vertical production and trade with reference currency. As evidenced by empirical findings, we assume that final-goods prices are sticky, but intermediate-goods prices are flexible. We find that even if intermediate-goods prices are flexible, monetary authorities need to respond to the shocks at the stage of intermediate-goods production. We also find that, when a shock occurs at the stage of final-goods production, monetary responses are independent of the expenditure share of final-goods producers on intermediate goods. For the first time in the literature, our model gives a condition under which both countries are willing to participate in monetary cooperation. Thus the gains from cooperation are real. In addition, we compare the volatility of the nominal exchange rate in Nash case with that in cooperative case, and compare the volatility of the nominal exchange rate in our model with that in a model without vertical production and trade as well. We also extend the model to consider a case of dual price stickiness. We find that the change in solution methods completely alters the conclusions of the model.

This paper investigates the effects of mark-to-market accounting for risky liabilities on the business cycle. While marking assets to market results in an amplification of the business cycle, as is well-known from the financial accelerator model à la Bernanke, Gertler, and Gilchrist [Bernanke, B. S., M. Gertler, and S. Gilchrist. 1999. “The Financial Accelerator in a Quantitative Business Cycle Framework.” In Handbook of Macroeconomics , edited by J. Taylor and M. Woodford, Elsevier.], allowing for debt with a specific maturity priced at market value generates ambiguous effects. Changes in the market price of debt affects firms’ net worth since the accounting principle takes the perspective of repurchasing debt. This is called the prolongation channel of debt. Real economic activity is attenuated as long as asset and debt prices move in the same direction, whereas the response of debt prices is stronger. This happens for a monetary policy shock or a shock to total factor productivity. Amplification occurs if both prices move in opposite directions, as is the case for a demand shock. The implications for the business cycle eventually depend on the occurrence of shocks. Implementing mark-to-market accounting for liabilities in a model for the US yields a higher volatility of the business cycle.

The paper presents the welfare cost of inflation in a banking time economy that models exchange credit through a bank production approach. The estimate of welfare cost uses fundamental parameters of utility and production technologies. It is compared to a cash-only economy, and a [Lucas, Robert Jr. E. 2000. “Inflation and Welfare.” Econometrica 68 (2): 247–274.] shopping economy without leisure, as special cases. The paper estimates the welfare cost of a 10% inflation rate instead of zero, for comparison to other estimates, as well as the cost of a 2% inflation rate instead of a zero inflation rate. A zero rate is statutorily specified as the US inflation rate target in the 1978 Employment Act amendments. The paper provides a conservative welfare cost estimate of 2% inflation instead of zero at $33 billion a year. Estimates of the percent of government expenditure that can be financed through a 2% vs. zero inflation rate are also provided.

In this paper we aim to present a novel channel through which the volatility of the monetary/financial sector affects the instability of the real macroeconomic variables originated by self-fulfilling market sentiments. To this aim, we insert some elements of Prospect Theory in the preferences of agents living in an overlapping generations economy where consumers’ heterogeneity and firms’ imperfect information on the level of aggregate demand allow market sentiments to affect the equilibrium path of the economy under rational expectations. In this environment, greater heterogeneity in the household’s narrow framing parameter and in the degree of competition in goods markets favor the emergence of self-fulfilling equilibria by exacerbating the coordination problem generated by a pair-wise matching process taking place in the labor market. Furthermore, the more dispersed are agents’ deviations from standard rationality the higher is the volatility of the economy due to sentiment fluctuations. Finally, a higher volatility of the money/financial market, by increasing the effect of Prospect Theory on households’ choices under risk, increases the noise of the signal upon which firms make their hiring decisions; this, in its turn, generates greater variability in market sentiments and hence in real economic activity.

Credit markets in emerging economies can be distinguished from those in advanced economies in many respects, including the collateral required for households to borrow. This work proposes a DSGE framework to analyze one peculiarity that characterizes the credit markets of some emerging markets: payroll-deducted personal loans. We add the possibility for households to contract long-term debt and compare two different types of credit constraints with one another, one based on housing and the other based on future income. We estimate the model for Brazil using a Bayesian technique. The model is able to solve a puzzle of the Brazilian economy: responses to monetary shocks at first appear to be strong but dissipate quickly. This occurs because income – and the amount available for loans – responds more rapidly to monetary shocks than housing prices. To smooth consumption, agents (borrowers) compensate for lower income and for borrowing by working more hours to repay loans and erase debt in a shorter time. Therefore, in addition to the income and substitution effects, workers consider the effects on their credit constraints when deciding how much labor to supply, which becomes an additional channel through which financial frictions affect the economy.

While the global financial crisis revealed a need for macroprudential policy tools to mitigate the build-up of risk in the financial system, the impact of such policies on the banking sector and the macroeconomy remains largely uncertain. We contribute to the empirical literature that estimates the impact of shocks to bank capital buffers on bank lending and the macroeconomy by estimating a Bayesian VAR model identified with sign restrictions. We use bank-level data for large euro area listed banks to construct an aggregate bank capital buffer for the euro area, which is included as another variable in the model. We estimate three shocks affecting the euro area economy, namely a demand shock, a monetary policy shock and a shock to bank capital buffers. We find that banks curtail lending and reduce their relative exposure to riskier assets in response to a shock to the bank capital buffer. Historical shock decomposition analysis shows that shocks to bank capital buffers have contributed to impair bank lending growth and to widen bank lending spreads, hence depressing economic activity.

This paper explores both the long-run and short-run effects of monetary policy on input inventories in a search model with monetary propagation and two-stage production. Inventories arise endogenously due to search frictions. In the long run, we analytically show that an increase in the money growth rate has hump-shaped real effects on steady-state input inventory investment, input inventory-to-sales ratio as well as sales. These effects are driven by both the extensive and intensive margins in the finished goods market. We then calibrate the model to the US data to study the short-run effects of monetary policy. We first show that our model can reproduce the stylized facts of input inventories quite well and then find that input inventories amplify aggregate fluctuations over business cycles.

Public infrastructure is one of the foundations for the economic growth of a country. While there is a strong consensus regarding infrastructure’s effect on growth, less is known about the effect of infrastructure on welfare and the distribution of wealth. In this paper, we examine the quantitative effect of infrastructure investment on welfare and the degree of inequality present within a developing country. In so doing, we characterize the effects resulting from increased infrastructure investment by tracing out the entire transition path between steady states. Three results standout: (i) both average and individual welfare effects are sizable, regardless of how the additional investment is financed, (ii) when distortionary taxes are adjusted to finance additional investment, poorer agents benefit more when the interest income tax is used, while richer agents benefit more when either the consumption or labor income taxes are used, (iii) inequality, as measured by the wealth Gini, rises in the short-run, but the long-run effect depends on which financing method is chosen.

This paper presents a model economy with endogenous credit constraints à la Kiyotaki-Moore and endogenous growth à la Uzawa-Lucas, in which agents face a trade-off between investing resources to improve the pledgeability of collateral assets and the accumulation of human capital. The model generates both growth miracles and stagnant economies.

This paper studies the effects of financial deepening and fiscal policy on human capital formation, working hours and growth in a model with financial frictions and productivity heterogeneity. The paper first shows that in the range of capital tax rates that attains a balanced growth path, taxation exerts inverted U-shaped effects on growth. The paper then analytically derives and shows that the growth maximizing tax rate and the corresponding growth are increasing concave functions of the financial deepening level. Finally, it is shown that theoretical predictions of the model are in line with data from OECD countries.

Conventional macroeconomic theory is based on the idea that demand shocks can only have temporary effects on unemployment, however several European economies display highly persistent unemployment dynamics. The theory of hysteresis points out that, under certain conditions, demand disturbances can have permanent effects. We find strong evidence of unemployment hysteresis in advanced economies since the 1990s. Relying on an identification scheme instigated by an insider/outsider model, we exploit the heterogeneity in impulse responses to demand shocks to investigate what labor institutions soften or amplify these responses. Our results indicate that strengthening labor institutions that promote a faster adjustment of real wages, removing disincentives for firms to hire and for workers to be employed, and improving the matching between labor supply and demand can lessen the effects of adverse demand shocks and lead to a faster reversion of unemployment rates to pre-shock levels.

For money to be essential, environments have been considered in which there is imperfect monitoring of past actions and in which it is difficult to coordinate among economic agents. This paper provides an environment in which there is no monitoring of past actions while coordination is difficult. In this environment, we show that the first best allocation is achieved without money, and hence, money is not essential. The implication is that, for money to be essential, no monitoring is not enough but coordination must also be free.

I develop a model with status concerns to analyze how different economic factors affect female labor participation and welfare, as well as average household incomes and wages. Reductions in the price of domestic goods and increases in female wages have positive effects on female participation. Increases in male wages have different effects on female participation depending on whether they affect female wages or not. Events that lead to increases in female participation are usually associated with decreases in the welfare of stay-at-home wives but are not necessarily associated with increases in welfare of working wives. Allowing for part-time work can lead to an increase in overall female labor force participation, but some women that would have worked full-time end up working part-time. If female wages are endogenous, an increase in male wages leads to an increase in the female participation rate even if it is not associated with a decrease in the gender wage gap. The positive feedback of increased female participation on their wages can lead to hysteresis of dual equilibria of high and low female labor force participation and a discontinuous transition between these equilibria.

Canova et al. [Canova, F., J. D. López-Salido, and C. Michelacci. 2010. “The Effects of Technology Shocks on Hours and Output: A Robustness Analysis.” Journal of Applied Econometrics 25: 755–773; Canova, F., J. D. López-Salido, and C. Michelacci. 2012. “The Ins and Outs of Unemployment: An Analysis Conditional on Technology Shocks.” The Economic Journal 123: 515–539] estimate the dynamic response of labor market variables to technological shocks. They show that investment-specific shocks imply predominantly an adjustment along the intensive margin (i.e., hours per worker), whereas for neutral shocks the largest share of the adjustment takes place along the extensive margin (i.e., employment). In this paper we develop a New Keynesian model featuring capital accumulation, two margins of labor adjustment and a hiring cost. The model is used to analyze a novel economic mechanism to explain that evidence.

We develop a simple growth model featuring individuals’ choices between general and specific skills, endogenous technological innovation, and a government subsidy for education. The two types of skills differ by their productivity and transferability: general skills are transferable across firms, while each firm-specific skill has a productivity advantage in the firm. Firms face uncertainty in their innovation activities, and the resulting heterogeneity in their labor demand makes the transferability of general skill valuable. We theoretically show that as a country catch up to the world technology frontier, firms invest more in innovation activities. This rises firms’ technological uncertainty and, thus, their demands for general skills increases. As a result, especially in more advanced economies, education subsidies may enhance GDP by increasing the supply of general skills. Using aggregated data for 12 European OECD counties, we calibrate the model and compare the theoretical prediction with the data. In cross-country comparisons, we find that the returns on general skills and the impact of general education expenditure on GDP are higher in countries with higher total factor productivity. These findings support our theoretical argument of the positive relationship between firms’ demand for general skills and countries’ stages of development.

Workers, firms and policymakers often face a trade-off between shorter unemployment spells on the one hand, and better quality matches on the other. During recessions this manifests itself through job competition, where high skilled workers misallocate their labor to positions for which they are over-qualified in order get back to work faster. In the presence of job-specific human capital, as high skilled workers gain experience in this low skilled sector they may find themselves “locked in” to these jobs. This is because workers will not want to lose their seniority by searching for a job that better utilizes their general human capital. As a result, this misallocation can persist even in economic recoveries leading to inefficient outcomes. This paper explores such an economy and finds that a UI system that becomes more generous during a recession increases welfare and better allocates human capital over the business cycle.

We introduce fiscal policy into a sovereign debt model with endogenous default costs and examine the implications for the determination of the output costs of default. We find that the quantitative properties of the output costs of default, and their dependence on primitives such as the elasticity of labor supply, are distinctly different depending on the margin of fiscal adjustment. The consideration of fiscal policy thus has potentially important implications for the quantitative properties of models of sovereign debt and default.

This paper examines the effects of boundedly rational expectation on the business cycle in a two-country New Keynesian model. Forecast heuristics in a closed-economy, De Grauwe’s (2011) model, is extended, and the effects of heterogeneous agents are incorporated in an open economy. In particular, the expectation formation process is constrained by waves of optimists and pessimists – the so-called “animal spirits.” As a result, the model is able to explain group behavior based on forecast performance, which has significant effects on output and inflation dynamics in the two countries. The simulation results suggest that heterogeneity in group behavior and nominal rigidities, as well as a moderate degree of international trade, amplify spillover effects on international business cycles leading to high cross-correlations in output and inflation.

In this paper, the optimal taxation problem in a small open economy with international trade in capital or investment goods is investigated. The monopolistic power of a small open economy over the terms of trade causes distortions in consumption and investment. The results suggest that due to the external distortion in investment, the long-run optimal capital income tax could be positive under the baseline calibration, and it is increasing in the degree of investment openness and decreasing in the elasticity of substitution between domestic and foreign goods. The long-run optimal labor income tax exhibits the opposite relationships with the openness and elasticity parameters. During the course of business cycles, the fluctuations in the external distortions cause the optimal labor income tax to be more volatile and the optimal capital income tax to be less volatile than their closed-economy counterparts.