Creator: Mehra, Rajnish, Piguillem, Facundo, and Prescott, Edward C. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 655 Abstract:
There is a large amount of intermediated borrowing and lending between households. Some of it is intergenerational, but most is between older households. The average difference in borrowing and lending rates is over 2 percent. In this paper, we develop a model economy that displays these facts and matches not only the returns on assets but also their quantities. The heterogeneity giving rise to borrowing and lending and differences in equity holdings depends on differences in the strength of the bequest motive. In equilibrium, the lenders are annuity holders and the borrowers are those who have equity holdings, who live off its income when retired, and who leave a bequest. The borrowing rate and return on equity are the same in the absence of aggregate uncertainty. The divergence between borrowing and lending rates can thus give rise to an equity premium, even in a world without aggregate uncertainty.
Keyword: Government debt, Equity premium, Retirement, Aggregate intermediation, Life cycle savings, Borrowing, and Lending Subject (JEL): E44 - Financial Markets and the Macroeconomy, G23 - Pension Funds; Non-bank Financial Institutions; Financial Instruments; Institutional Investors, H62 - National Deficit; Surplus, G10 - General Financial Markets: General (includes Measurement and Data), E20 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy: General (includes Measurement and Data), G11 - Portfolio Choice; Investment Decisions, D31 - Personal Income, Wealth, and Their Distributions, H00 - Public Economics: General, G12 - Asset Pricing; Trading Volume; Bond Interest Rates, and E21 - Macroeconomics: Consumption; Saving; Wealth
Creator: Alvarez, Fernando, 1964-, Atkeson, Andrew, and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 650 Abstract:
The key question asked by standard monetary models used for policy analysis is, How do changes in short-term interest rates affect the economy? All of the standard models imply that such changes in interest rates affect the economy by altering the conditional means of the macroeconomic aggregates and have no effect on the conditional variances of these aggregates. We argue that the data on exchange rates imply nearly the opposite: the observation that exchange rates are approximately random walks implies that fluctuations in interest rates are associated with nearly one-for-one changes in conditional variances and nearly no changes in conditional means. In this sense, standard monetary models capture essentially none of what is going on in the data. We thus argue that almost everything we say about monetary policy using these models is wrong.
Creator: Luttmer, Erzo G. J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 649 Abstract:
This paper describes a simple model of aggregate and firm growth based on the introduction of new goods. An incumbent firm can combine labor with blueprints for goods it already produces to develop new blueprints. Every worker in the economy is also a potential entrepreneur who can design a new blueprint from scratch and set up a new firm. The implied firm size distribution closely matches the fat tail observed in the data when the marginal entrepreneur is far out in the tail of the entrepreneurial skill distribution. The model produces a variance of firm growth that declines with size. But the decline is more rapid than suggested by the evidence. The model also predicts a new-firm entry rate equal to only 2.5% per annum, instead of the observed rate of 10% in U.S. data.
Creator: Luttmer, Erzo G. J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 645 Abstract:
This paper presents a simple model of search and matching between consumers and firms. The firm size distribution has a Pareto-like right tail if the population of consumers grows at a positive rate and the mean rate at which incumbent firms gain customers is also positive. This happens in equilibrium when entry is sufficiently costly. As entry costs grow without bound, the size distribution approaches Zipf’s law. The slow rate at which the right tail of the size distribution decays and the 10% annual gross entry rate of new firms observed in the data suggest that more than a third of all consumers must switch from one firm to another during a given year. A substantially lower consumer switching rate can be inferred only if part of the observed firm entry rate is attributed to factors outside the model. The realized growth rates of large firms in the model are too smooth.
Subject (JEL): D11 - Consumer Economics: Theory, L10 - Market Structure, Firm Strategy, and Market Performance: General, and O40 - Economic Growth and Aggregate Productivity: General
Creator: Weber, Warren E. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 642 Abstract:
Prior to the Civil War there were three major differences among states in how U.S. banks were regulated: (1) Whether they were established by charter or under free-banking laws. (2) Whether they were permitted to branch. (3) Whether the state established a state-owned bank. I use a census of the state banks that existed in the United States prior to the Civil War that I recently constructed to determine how these differences in state regulation affected the banking outcomes in these states. Specifically, I determine differences in banks per capita by state over time; bank longevities (survival rates) by state, size, and type of organization; and bank failure probabilities also by state, size, and type of organization. In addition, I estimate the losses experienced by note holders and determine whether there were systematic differences in these depending on whether or not a bank was organized under a free banking law.
Subject (JEL): N22 - Economic History: Financial Markets and Institutions: U.S.; Canada: 1913-
Creator: Yang, Fang Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 638 Abstract:
This paper studies a quantitative dynamic general equilibrium life-cycle model where parents and their children are linked by bequests, both voluntary and accidental, and by the transmission of earnings ability. This model is able to match very well the empirical observation that households with similar lifetime incomes hold very different amounts of wealth at retirement. Income heterogeneity and borrowing constraints are essential in generating the variation in retirement wealth among low lifetime income households, while the existence of intergenerational links is crucial in explaining the heterogeneity in retirement wealth among high lifetime income households.
Subject (JEL): E21 - Macroeconomics: Consumption; Saving; Wealth
Creator: Ai, Hengjie Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 637 Abstract:
We propose a notion of smoothness of nonexpected utility functions, which extends the variational analysis of nonexpected utility functions to more general settings. In particular, our theory applies to state dependent utilities, as well as the multiple prior expected utility model, both of which are not possible in previous literatures. Other nonexpected utility models are shown to satisfy smoothness under more general conditions than the Fréchet and Gateaux differentiability used in the literature. We give more general characterizations of monotonicity and risk aversion without assuming state independence of utility function.
Creator: Yang, Fang Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 635 Abstract:
Micro data over the life cycle shows two different patterns of consumption of housing and non-housing goods: the consumption profile of non-housing goods is hump-shaped while the consumption profile for housing first increases monotonically and then flattens out. These patterns hold true at each consumption quartile. This paper develops a quantitative, dynamic general equilibrium model of life cycle behavior, which generates consumption profiles consistent with the observed data. Borrowing constraints are essential in explaining the accumulation of housing assets early in life, while transaction costs are crucial in generating the slow downsizing of the housing assets later in life. The bequest motives play a role in determining total life time wealth, but not the housing profile.
Keyword: Life cycle, Consumption, Housing, and Distribution Subject (JEL): J14 - Economics of the Elderly; Economics of the Handicapped; Non-labor Market Discrimination, R21 - Urban, Rural, Regional, Real Estate, and Transportation Economics: Housing Demand, and E21 - Macroeconomics: Consumption; Saving; Wealth
Creator: Weber, Warren E. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 634 Abstract:
This paper describes a newly constructed data set of all U.S. state banks from 1782 to 1861. It contains the names and locations of all banks and branches that went into business and an estimate of when each operated. The compilation is based on reported balance sheets, listings in banknote reporters, and secondary sources. Based on these data, the paper presents a count of the number of banks and branches in business by state. I argue that my series are superior to previously existing ones for reasons of consistency, accuracy, and timing. The paper contains examples to support this argument.
Subject (JEL): N21 - Economic History: Financial Markets and Institutions: U.S.; Canada: Pre-1913
Creator: Chari, V. V., Kehoe, Patrick J., and McGrattan, Ellen R. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 631 Abstract:
The main substantive finding of the recent structural vector autoregression literature with a differenced specification of hours (DSVAR) is that technology shocks lead to a fall in hours. Researchers have used these results to argue that business cycle models in which technology shocks lead to a rise in hours should be discarded. We evaluate the DSVAR approach by asking, is the specification derived from this approach misspecified when the data are generated by the very model the literature is trying to discard? We find that it is misspecified. Moreover, this misspecification is so great that it leads to mistaken inferences that are quantitatively large. We show that the other popular specification that uses the level of hours (LSVAR) is also misspecified. We argue that alternative state space approaches, including the business cycle accounting approach, are more fruitful techniques for guiding the development of business cycle theory.
Creator: Weber, Warren E. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 629 Abstract:
This paper examines the pricing of statebank notes prior to 1860 using data on the discounts on these notes as quoted in New York, Philadelphia, Cincinnati, and Cleveland. The study is organized around determining whether these banknotes were priced consistent with their expected net redemption value. It finds a bank’s notes had higher prices when it was redeeming it notes for specie than when is was suspended. However, although prices generally varied inversely with redemption costs, the relationship was not tight and persistent arbitrage opportunities existed.
Subject (JEL): N21 - Economic History: Financial Markets and Institutions: U.S.; Canada: Pre-1913
Creator: Alvarez, Fernando, 1964-, Atkeson, Andrew, and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 627 Abstract:
Time-varying risk is the primary force driving nominal interest rate differentials on currency-denominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation—can produce key features of actual interest rates and exchange rates. The endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, the benefit of asset market participation varies, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. Our model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.
Keyword: Time-varying conditional variances, Pricing kernel, Fama puzzle, Segmented markets, Forward premium anomaly, and Asset pricing-puzzle Subject (JEL): F31 - Foreign Exchange, F41 - Open Economy Macroeconomics, G15 - International Financial Markets, G12 - Asset Pricing; Trading Volume; Bond Interest Rates, F30 - International Finance: General, and E43 - Interest Rates: Determination, Term Structure, and Effects
Creator: Bassetto, Marco Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 624 Abstract:
How should a government use the power to commit to ensure a desirable equilibrium outcome? In this paper, I show a misleading aspect of what has become a standard approach to this question, and I propose an alternative. I show that the complete description of an optimal (indeed, of any) policy scheme requires outlining the consequences of paths that are often neglected. The specification of policy along those paths is crucial in determining which schemes implement a unique equilibrium and which ones leave room for multiple equilibria that depend on the expectations of the private sector.
Keyword: Government strategy, Implementation, Commitment, and Competitive equilibrium Subject (JEL): E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination, F34 - International Lending and Debt Problems, and C73 - Stochastic and Dynamic Games; Evolutionary Games; Repeated Games
Creator: Chari, V. V. and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 622 Abstract:
Herd behavior is argued by many to be present in many markets. Existing models of such behavior have been subjected to two apparently devastating critiques. The continuous investment critique is that in the basic model herds disappear if simple zero-one investment decisions are replaced by the more appealing assumption that investment decisions are continuous. The price critique is that herds disappear if, as seems natural, other investors can observe asset market prices. We argue that neither critique is devastating. We show that once we replace the unappealing exogenous timing assumption of the early models that investors move in a pre-specified order by a more appealing endogenous timing assumption that investors can move whenever they choose then herds reappear.
Creator: Chari, V. V., Kehoe, Patrick J., and McGrattan, Ellen R. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 619_1 Description:
Technical appendix for Working Paper 619, https://doi.org/10.21034/wp.619
Creator: Livshits, Igor, MacGee, James C., and Tertilt, Michèle Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 617 Abstract:
American consumer bankruptcy provides for a Fresh Start through the discharge of a household’s debt. Until recently, many European countries specified a No Fresh Start policy of life-long liability for debt. The trade-off between these two policies is that while Fresh Start provides insurance across states, it drives up interest rates and thereby makes life-cycle smoothing more difficult. This paper quantitatively compares these bankruptcy rules using a life-cycle model with incomplete markets calibrated to the U.S. and Germany. A key innovation is that households face idiosyncratic uncertainty about their net asset holdings (expense shocks) and labor income. We find that expense uncertainty plays a key role in evaluating consumer bankruptcy laws.
Subject (JEL): D14 - Household Saving; Personal Finance, K35 - Personal Bankruptcy Law, and D91 - Micro-Based Behavioral Economics: Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
Creator: Atkeson, Andrew and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 614 Abstract:
A classic question in international economics is whether it is better to use the exchange rate or the money growth rate as the instrument of monetary policy. A common argument is that the exchange rate has a natural advantage since exchange rates provide signals of policymakers’ actions that are easier to monitor than those provided by money growth rates. We formalize this argument in a simple model in which the government chooses which instrument it will use to target inflation. In it, the exchange rate is more transparent than the money growth rate in that the exchange rate is easier for the public to monitor. We find that the greater transparency of the exchange rate regime makes it easier to provide the central bank with incentives to pursue good policies and hence gives this regime a natural advantage over the money regime.
Subject (JEL): E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination, E50 - Monetary Policy, Central Banking, and the Supply of Money and Credit: General, F33 - International Monetary Arrangements and Institutions, E52 - Monetary Policy, and F41 - Open Economy Macroeconomics
Creator: Bassetto, Marco Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 612 Abstract:
The goal of this paper is to probe the validity of the fiscal theory of the price level by modeling explicitly the market structure in which households and the governments make their decisions. I describe the economy as a game, and I am thus able to state precisely the consequences of actions that are out of the equilibrium path. I show that there exist government strategies that lead to a version of the fiscal theory, in which the price level is determined by fiscal variables alone. However, these strategies are more complex than the simple budgetary rules usually associated with the fiscal theory, and the government budget constraint cannot be merely viewed as an equilibrium condition.
Keyword: Government strategy, Fiscal theory of the price level, Intertemporal budget constraint, Equilibrium determinacy, Commitment, and Policy rule
Creator: Cooper, Russell and Ejarque, Joao Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 611 Abstract:
Evidence of the statistical significance of profits in Q regressions remains one of the principal findings in the empirical investment literature. This result is frequently taken to support the view that capital market imperfections are an important element for understanding investment. This paper challenges that conclusion. We argue that allowing the profit function at the firm level to be strictly concave, reflecting, for example, market power, is sufficient to replicate the Q theory based regression results in which profits are a significant factor determining investment. To be clear, our ability to replicate the existing results does not require the specification of any capital market imperfections. Thus the friction that explains the statistical significance of profits could be market power by sellers rather than capital market imperfections.