Creator: Arellano, Cristina, Bai, Yan, and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 466 Abstract:
The U.S. Great Recession featured a large decline in output and labor, tighter financial conditions, and a large increase in firm growth dispersion. We build a model in which increased volatility at the firm level generates a downturn and worsened credit conditions. The key idea is that hiring inputs is risky because financial frictions limit firms' ability to insure against shocks. An increase in volatility induces firms to reduce their inputs to reduce such risk. Out model can generate most of the decline in output and labor in the Great Recession and the observed increase in firms' interest rate spreads.
Keyword: Credit crunch, Credit constraints, Uncertainty shocks, Firm heterogeneity, Firm credit spreads, Labor wedge, and Great Recession Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, E23 - Macroeconomics: Production, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, D53 - General Equilibrium and Disequilibrium: Financial Markets, and D52 - Incomplete Markets
Creator: Atkeson, Andrew, Eisfeldt, Andrea L., and Weill, Pierre-Olivier Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 484 Abstract:
Building on the Merton (1974) and Leland (1994) structural models of credit risk, we develop a simple, transparent, and robust method for measuring the financial soundness of individual firms using data on their equity volatility. We use this method to retrace quantitatively the history of firms’ financial soundness during U.S. business cycles over most of the last century. We highlight three main findings. First, the three worst recessions between 1926 and 2012 coincided with insolvency crises, but other recessions did not. Second, fluctuations in asset volatility appear to drive variation in firms’ financial soundness. Finally, the financial soundness of financial firms largely resembles that of nonfinancial firms.
Keyword: Distance to Default, Volatility, Financial Frictions and Business Cycles, and Credit Risk Modeling Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, G32 - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill, and G01 - Financial Crises
Creator: Chodorow-Reich, Gabriel and Karabarbounis, Loukas Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 514 Abstract:
The flow opportunity cost of moving from unemployment to employment consists of foregone public benefits and the foregone value of non-working time in units of consumption. We construct a time series of the opportunity cost of employment using detailed microdata and administrative or national accounts data to estimate benefit levels, eligibility and take-up of benefits, consumption by labor force status, hours per worker, taxes, and preference parameters. Our estimated opportunity cost is procyclical and volatile over the business cycle. The estimated cyclicality implies far less unemployment volatility in many leading models of the labor market than that observed in the data, irrespective of the level of the opportunity cost.
Keyword: Opportunity cost of employment and Unemployment fluctuations Subject (JEL): E32 - Business Fluctuations; Cycles, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, and J64 - Unemployment: Models, Duration, Incidence, and Job Search
Creator: Kehoe, Patrick J., Midrigan, Virgiliu, and Pastorino, Elena Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 536 Abstract:
During the Great Recession, regions of the United States that experienced the largest declines in household debt also experienced the largest drops in consumption, employment, and wages. Employment declines were larger in the nontradable sector and for firms that were facing the worst credit conditions. Motivated by these findings, we develop a search and matching model with credit frictions that affect both consumers and firms. In the model, tighter debt constraints raise the cost of investing in new job vacancies and thus reduce worker job finding rates and employment. Two key features of our model, on-the-job human capital accumulation and consumer-side credit frictions, are critical to generating sizable drops in employment. On-the-job human capital accumulation makes the flows of benefits from posting vacancies long-lived and so greatly amplifies the sensitivity of such investments to credit frictions. Consumer-side credit frictions further magnify these effects by leading wages to fall only modestly. We show that the model reproduces well the salient cross-regional features of the U.S. data during the Great Recession.
Keyword: Search and matching, Human capital, Employment, and Debt constraints Subject (JEL): E21 - Macroeconomics: Consumption; Saving; Wealth, E32 - Business Fluctuations; Cycles, E24 - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity, J21 - Labor Force and Employment, Size, and Structure, and J64 - Unemployment: Models, Duration, Incidence, and Job Search
Creator: Thomas, Julia Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 302 Abstract:
Previous research has suggested that discrete and occasional plant-level capital adjustments have significant aggregate implications. In particular, it has been argued that changes in plants’ willingness to invest in response to aggregate shocks can at times generate large movements in total investment demand. In this study, I re-assess these predictions in a general equilibrium environment. Specifically, assuming nonconvex costs of capital adjustment, I derive generalized (S,s) adjustment rules yielding lumpy plant-level investment within an otherwise standard equilibrium business cycle model. In contrast to previous partial equilibrium analyses, model results reveal that the aggregate effects of lumpy investment are negligible. In general equilibrium, households’ preference for relatively smooth consumption profiles offsets changes in aggregate investment demand implied by the introduction of lumpy plant-level investment. As a result, adjustments in wages and interest rates yield quantity dynamics that are virtually indistinguishable from the standard model.
Keyword: Business Cycles, Lumpy Investment, and (S,s) Adjustment Subject (JEL): E32 - Business Fluctuations; Cycles and E22 - Investment; Capital; Intangible Capital; Capacity
Creator: Luttmer, Erzo G. J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 585 Abstract:
Most firms begin very small, and large firms are the result of typically decades of persistent growth. This growth can be understood as the result of some form of organization capital accumulation. In the US, the distribution of firm size k has a right tail only slightly thinner than 1/k. This is shown to imply that incumbent firms account for most aggregate organization capital accumulation. And it implies potentially extremely slow aggregate convergence rates. A benchmark model is proposed in which managers can use incumbent organization capital to create new organization capital. Workers are a specific factor for producing consumption, and they require managerial supervision. Through the lens of the model, the aftermath of the Great Recession of 2008 is unsurprising if the events of late 2008 and early 2009 are interpreted as a destruction of organization capital, or as a belief shock that made consumers want to reduce consumption and accumulate more wealth instead.
Keyword: Slow recoveries, Zipf's law, Firm size distribution, and Business cycles Subject (JEL): E32 - Business Fluctuations; Cycles and L11 - Production, Pricing, and Market Structure; Size Distribution of Firms
Creator: Boldrin, Michele, Christiano, Lawrence J., and Fisher, Jonas D. M. (Jonas Daniel Maurice), 1965- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 280 Abstract:
We introduce two modifications into the standard real business cycle model: habit persistence preferences and limitations on intersectoral factor mobility. The resulting model is consistent with the observed mean equity premium, mean risk free rate and Sharpe ratio on equity. The model does roughly as well as the standard real business cycle model with respect to standard measures. On four other dimensions its business cycle implications represent a substantial improvement. It accounts for (i) persistence in output, (ii) the observation that employment across different sectors moves together over the business cycle, (iii) the evidence of ‘excess sensitivity’ of consumption growth to output growth, and (iv) the ‘inverted leading indicator property of interest rates,’ that high interest rates are negatively correlated with future output.
Keyword: Capital gains, Risk aversion, Asset pricing , and Habit persistence Subject (JEL): E44 - Financial Markets and the Macroeconomy, E32 - Business Fluctuations; Cycles, and O41 - One, Two, and Multisector Growth Models
Creator: Backus, David and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 145 Abstract:
We document properties of business cycles in ten countries over the last hundred years, contrasting the behavior of real quantities with that of the price level and the stock of money. Although the magnitude of output fluctuations has varied across countries and periods, relations among variables have been remarkably uniform. Consumption has generally been about as variable as output, and investment substantially more variable, and both have been strongly procyclical. The trade balance has generally been countercyclical. The exception to this regularity is government purchases, which exhibit no systematic cyclical tendency. With respect to the size of output fluctuations, standard deviations are largest between the two world wars. In some countries (notably Australia and Canada) they are substantially larger prior to World War I than after World War II, but in others (notably Japan and the United Kingdom) there is little difference between these periods. Properties of price levels, in contrast, exhibit striking differences between periods. Inflation rates are more persistent after World War II than before, and price level fluctuations are typically procyclical before World War II, countercyclical afterward. We find no general tendency toward increased persistence in money growth rates, but find that fluctuations in money are less highly correlated with output in the postwar period.
Subject (JEL): E31 - Price Level; Inflation; Deflation and E32 - Business Fluctuations; Cycles
Creator: Braun, R. Anton and Evans, Charles, 1958- Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 168 Abstract:
We consider a dynamic, stochastic equilibrium business cycle model which is augmented to reflect seasonal shifts in preferences, technology, and government purchases. Our estimated parameterization implies implausibly large seasonal variation in the state of technology: rising at an annual rate of 24% in the fourth quarter and falling at an annual rate of 28% in the first quarter. Furthermore, our findings indicate that variation in the state of technology of this magnitude is required if the model is to explain the main features of the seasonal cycle.
Keyword: Solow residuals, Real business cycle, and Seasonality Subject (JEL): E20 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy: General (includes Measurement and Data) and E32 - Business Fluctuations; Cycles
Creator: Kydland, Finn E. and Prescott, Edward C. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 178 Abstract:
An economic experiment consists of the act of placing people in an environment desired by the experimenter, who then records the time paths of their economic behavior. Performing experiments that use actual people at the level of national economies is obviously not practical, but constructing a model economy and computing the economic behavior of the model’s people is. We refer to such experiments as computational experiments because the economic behavior of the model’s people is computed. In this essay, we specify the steps in designing a computational experiment to address some well posed quantitative question. We emphasize that the computational experiment is an econometric tool used in the task of deriving the quantitative implications of theory.
Subject (JEL): E32 - Business Fluctuations; Cycles and C50 - Econometric Modeling: General
Creator: Aiyagari, S. Rao Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 196 Abstract:
I argue that Farmer and Guo's one-sector real business cycle model with indeterminacy and sunspots fails empirically and that its failure is inherent in the logic of the model taken together with some simple labor market facts.
Keyword: Indeterminacy, Labor Market, Business cycles, and Sunspots Subject (JEL): E32 - Business Fluctuations; Cycles and C32 - Multiple or Simultaneous Equation Models: Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
Creator: Christiano, Lawrence J. and Harrison, Sharon G. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 214 Abstract:
We study a one-sector growth model which is standard except for the presence of an externality in the production function. The set of competitive equilibria is large. It includes constant equilibria, sunspot equilibria, cyclical and chaotic equilibria, and equilibria with deterministic or stochastic regime switching. The efficient allocation is characterized by constant employment and a constant growth rate. We identify an income tax-subsidy schedule that supports the efficient allocation as the unique equilibrium outcome. That schedule has two properties: (i) it specifies the tax rate to be an increasing function of aggregate employment, and (ii) earnings are subsidized when aggregate employment is at its efficient level. The first feature eliminates inefficient, fluctuating equilibria, while the second induces agents to internalize the externality.
Keyword: Business cycle, Regime switching, Stabilization, Fiscal policy, and Multiple equilibria Subject (JEL): E62 - Fiscal Policy, E32 - Business Fluctuations; Cycles, and E13 - General Aggregative Models: Neoclassical
Creator: Kilian, Lutz and Ohanian, Lee E. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 244 Abstract:
Unit root tests against trend break alternatives are based on the premise that the dating of the trend breaks coincides with major economic events with permanent effects on economic activity, such as wars and depressions. Standard economic theory, however, suggests that these events have large transitory, rather than permanent, effects on economic activity. Conventional unit root tests against trend break alternatives based on linear ARIMA models do not capture these transitory effects and can result in severely distorted inference. We quantify the size distortions for a simple model in which the effects of wars and depressions can reasonably be interpreted as transitory. Monte Carlo simulations show that in moderate samples, the widely used Zivot-Andrews (1992) test mistakes transitory dynamics for trend breaks with high probability. We conclude that these tests should be used only if there are no plausible economic explanations for apparent trend breaks in the data.
Keyword: Transitory Shocks, Unit Roots, and Trend-Breaks Subject (JEL): C15 - Statistical Simulation Methods: General, E32 - Business Fluctuations; Cycles, and C22 - Single Equation Models; Single Variables: Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
Creator: Cole, Harold Linh, 1957- and Ohanian, Lee E. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 246 Abstract:
Many economists have worried about changes in the demand for money, since money demand shocks can affect output variability and have implications for monetary policy. This paper studies the theoretical implications of changes in money demand for the nonneutrality of money in the limited participation (liquidity) model and the predetermined (sticky) price model. In the liquidity model, we find that an important connection exists between the nonneutrality of money and the relative money demands of households and firms. This model predicts that the real effect of a money shock rose by 100 percent between 1952 and 1980, and subsequently declined 65 percent. In contrast, we find that the nonneutrality of money in the sticky price model is invariant to changes in money demands or other monetary factors. Several researchers have concluded from VAR analyses that the effects of money shock over time are roughly stable. This view is consistent with the predictions of the sticky price model, but is harder to reconcile with the specific pattern of time variation predicted by the liquidity model.
Keyword: Money shocks, Liquidity, Sticky prices, and Velocity Subject (JEL): E52 - Monetary Policy, E32 - Business Fluctuations; Cycles, and E41 - Demand for Money
Creator: Jones, Larry E., Manuelli, Rodolfo E., and Siu, Henry E. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 271 Abstract:
We present a class of convex endogenous growth models and analyze their performance in terms of both growth and business cycle criteria. The models we study have close analogs in the real business cycle literature. We interpret the exogenous growth rate of productivity as an endogenous growth rate of human capital. This perspective allows us to compare the strengths of the two classes of models.
To highlight the mechanism that gives endogenous growth models the ability to improve upon their exogenous growth relatives, we study models that are symmetric in terms of human and physical capital formation—our two engines of growth. More precisely, we analyze models in which the technology used to produce human capital is identical to the technologies used to produce consumption and investment goods and in which the technology shocks in the two sectors are perfectly correlated.
Subject (JEL): D90 - Micro-Based Behavioral Economics: General and E32 - Business Fluctuations; Cycles
Creator: Ohanian, Lee E. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 285 Abstract:
Between 1929 and 1933, real output per adult fell over 30 percent and total factor productivity fell 18 percent. This productivity decrease is much larger than expected from just extrapolating the productivity decrease that typically occurs during recessions. This paper evaluates what factors may have caused this large decrease, including unmeasured factor utilization, changes in the composition of production, and increasing returns. I find that these factors combined explain less than one-third of the 18 percent decrease, and I conclude that the productivity decrease during the Great Depression remains a puzzle.
Subject (JEL): O47 - Empirical Studies of Economic Growth; Aggregate Productivity; Cross-Country Output Convergence, N12 - Economic History: Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations: U.S.; Canada: 1913-, and E32 - Business Fluctuations; Cycles
Creator: Bergoeing, Raphael, Kehoe, Patrick J., Kehoe, Timothy Jerome, 1953-, and Soto, Raimundo Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 292 Abstract:
Chile and Mexico experienced severe economic crises in the early 1980s. This paper analyzes four possible explanations for why Chile recovered much faster than did Mexico. Comparing data from the two countries allows us to rule out a monetarist explanation, an explanation based on falls in real wages and real exchange rates, and a debt overhang explanation. Using growth accounting, a calibrated growth model, and economic theory, we conclude that the crucial difference between the two countries was the earlier policy reforms in Chile that generated faster productivity growth. The most crucial of these reforms were in banking and bankruptcy procedures.
Keyword: Depression, Growth accounting, Chile, Total factor productivity, and Mexico Subject (JEL): N16 - Economic History: Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations: Latin America; Caribbean, E32 - Business Fluctuations; Cycles, and O40 - Economic Growth and Aggregate Productivity: General
Creator: Khan, Aubhik and Thomas, Julia Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 306 Abstract:
Recent empirical analysis has found nonlinearities to be important in understanding aggregated investment. Using an equilibrium business cycle model, we search for aggregate nonlinearities arising from the introduction of nonconvex capital adjustment costs. We find that, while such costs lead to nontrivial nonlinearities in aggregate investment demand, equilibrium investment is effectively unchanged. Our finding, based on a model in which aggregate fluctuations arise through exogenous changes in total factor productivity, is robust to the introduction of shocks to the relative price of investment goods.
Keyword: Adjustment costs, Lumpy investment, Nonlinearities, and Business cycles Subject (JEL): E32 - Business Fluctuations; Cycles and E22 - Investment; Capital; Intangible Capital; Capacity
Creator: Kehoe, Patrick J. and Perri, Fabrizio Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 307 Abstract:
We show how to decentralize constrained efficient allocations that arise from enforcement constraints between sovereign nations. In a pure exchange economy, these allocations can be decentralized with private agents acting competitively and taking as given government default decisions on foreign debt. In an economy with capital, these allocations can be decentralized if the government can tax capital income as well as default on foreign debt. The tax on capital income is needed to make private agents internalize a subtle externality. The decisions of the government can arise as an equilibrium of a dynamic game between governments.
Keyword: Sovereign debt, Risk-sharing, Default, Incomplete markets, Enforcement constraints, Sustainable equilibrium, and Decentralization Subject (JEL): E21 - Macroeconomics: Consumption; Saving; Wealth, F30 - International Finance: General, F34 - International Lending and Debt Problems, E32 - Business Fluctuations; Cycles, D50 - General Equilibrium and Disequilibrium: General, and E44 - Financial Markets and the Macroeconomy