Working paper (Federal Reserve Bank of Minneapolis. Research Dept.)
This paper is about a useful way of taking account of frictions in asset pricing and macroeconomics. I start by noting that complete frictionless markets models have a number of empirical deficiencies. Then I suggest an alternative class of models with incomplete markets and heterogenous agents which can also accommodate a variety of other frictions. These models are quantitatively attractive and computationally feasible and have the potential to overcome many or all of the empirical deficiencies of complete frictionless markets models. The incomplete markets model can also differ significantly from the complete frictionless markets model on some important policy questions.
We formulate a representative consumer model of intertemporal resource reallocation in which fluctuations in equity prices contribute to the smoothing of consumption flows. Features of the model include (a) an incompletely observable stochastic process of productivity shocks leading to fluctuating confidence of beliefs and (b) technologies involving commitments of a resource good. These features are exploited to show that (1) equities are not a representative form of total wealth and (2) the valuation of currently active firms is not representative of the valuation of all firms. We examine the implications of (1) and (2) to argue that empirical findings for the volatility and 'value shortfall' of equity prices may be consistent with a frictionless representative consumer model having a low degree of risk-aversion. Simulation of a calibrated version of the model for a risk-neutral consumer shows that when the 'data' is analyzed according to current econometric procedures, it is found to exhibit volatility of the same order of magnitude as that found in the actual data, although the model contains no excess volatility.
A necessary feature for equilibrium is that beliefs about the behavior of other agents are rational. We argue that in stationary OLG environments this implies that any future generation in the same situation as the initial generation must do as well as the initial generation did in that situation. We conclude that the existing equilibrium concepts in the literature do not satisfy this condition. We then propose an alternative equilibrium concept, organizational equilibrium, that satisfies this condition. We show that equilibrium exists, it is unique, and it improves over autarky without achieving optimality. Moreover, the equilibrium can be readily found by solving a maximization program.
The new classical view that macroeconomic fluctuations can be modeled as an equilibrium system perturbed by transitory monetary disturbances has been challenged in recent years by another equilibrium view of fluctuations, the so-called real business cycle theory. In this latter framework, shocks to the production function induce both intertemporal substitution of labor supply and permanent shifts in the stochastic trend of output. Monetary shocks, on the other hand, play only a minor role in this view of the cycle. Much of the empirical support for the real business cycle view of fluctuations is based on a re-examination of traditional methods for detrending economic time series. The issues raised by the real business cycle theorists are not new; indeed, they go back at least to the NBER's first business cycle studies. However, the real business cycle theorists attach a radical economic interpretation to what, on the surface, appears to be a purely technical note on the proper method for detrending economic data. This paper reviews the debate over stochastic trends, discusses the economic implications of the real business cycle interpretation of stochastic trend models, and weighs the time series evidence for some of the stronger claims made by real business cycle theorists. We conclude that, while this literature raises real and useful questions about the interpretation of observed fluctuations, the new classical view of the cycle is not ruled out by the data.