Research Database

We consider the existence of deterministically cycling steady state equilibria in a class of stationary overlapping generations models with sufficiently long (but, finite) lived agents. Preferences are of the discounted sum of utilities type with a fixed discount rate. Utility functions with large coefficients of relative risk aversion which generate strong income effects (relative to substitution effects) and backward bending offer curves are permitted. Lifetime endowment patterns are quite arbitrary. We show that if agents have a positive discount rate, then as agents1 lifespans get large, short period non-monetary cycles will disappear. Further, constant monetary steady states do not exist and therefore, neither do stationary monetary cycles of any period. We then consider the case where agents have a negative discount rate and show that there are robust examples in which constant monetary steady states as well as stationary monetary cycles (with undiminished amplitude) can occur no matter how long agents live.

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.

Are optimal monetary and fiscal policies time consistent in a monetary economy? Yes, but if and only if under commitment the Friedman rule of setting nominal interest rates to zero is optimal. This result is of applied interest because the Friedman rule is optimal for the standard preferences used in applied work, those consistent with the growth facts.

Methods are presented for solving a certain class of rational expectations models, principally those that arise from dynamic games. The methods allow for numerical solution using spectral factorization algorithms, and estimation of these models using maximum likelihood techniques.

A two country overlapping generations model is constructed, in which financial intermediation arises endogenously as an incentive compatible means of economizing on monitoring costs. Because of international credit markets. The model is used to generate the existence of transaction costs, money markets in the two countries are segmented and investors have differential access to predictions concerning the role of international intermediation in economic development, and to examine the nature of business cycle phenomena across alternative exchange rate regimes. Disturbances are propagated by a credit allocation mechanism, which also lends a novel flavor to the model's long run properties.

A new approach to market behavior is suggested. This approach has a coherent game theoretic foundaton, addresses such anomalous economic behaviors as strikes, rigid wages and unemployment, regulation of financial markets, depresssion, and nonmarket allocation, and, more generally, provides insights for Finance, Oligopoly Theory, Industrial Organization, and Macroeconomics. The central theme of the approach is that exchange technologies are a basic building block in a model, as are tastes, endowments, and production technologies. Moreover, the key feature of an institution of exchange is that it allows the making of a binding final offer.

We consider a simple environment in which individuals receive income shocks that are unobservable to others and can privately store resources. We show that this ability to privately store can undercut the ability to shift resources across individuals to the extent that the efficient allocation only involves consumption smoothing over time, as opposed to insurance (consumption smoothing over states) if the rate of return on savings is not too far below the rate of time preference, or, alternatively, if the worst possible outcome is sufficiently dire. We also show that unlike environments without unobservable storage, the symmetric efficient allocation is decentralizable through a competitive asset market in which individuals trade risk-free bonds among themselves.

We provide empirical evidence of a novel liquidity-based transmission mechanism through which monetary policy influences asset markets, develop a model of this mechanism, and assess the ability of the quantitative theory to match the evidence.

Many applications of search theory in monetary economics use the Shi-Trejos-Wright model, hereafter STW, while applications in finance use Duffie-Gârleanu-Pederson, hereafter DGP. These approaches have much in common, and both claim to be about liquidity, but the models also differ in a fundamental way: in STW agents use assets as payment instruments when trading goods; in DGP there are no gains from exchanging goods, but agents trade because they value assets differently with goods serving as payment instruments. We develop a framework nesting the two. This clarifies the connection between the literatures, and generates new insights and applications. Even in the special cases of the baseline STW and DGP models, we provide propositions generalizing and strengthening what is currently known, and rederiving some existing results using more tractable arguments.

A framework is developed with what we call technology capital. A country is a measure of locations. Absent policy constraints, a firm owning a unit of technology capital can produce the composite output good using the unit of technology capital at as many locations as it chooses. But it can operate only one operation at a given location, so the number of locations is what constrains the number of units it operates using this unit of technology capital. If it has two units of technology capital, it can operate twice as many operations at every location. In this paper, aggregation is carried out and the aggregate production functions for the countries are derived. Our framework interacts well with the national accounts in the same way as does the neoclassical growth model. It also interacts well with the international accounts. There are constant returns to scale, and therefore no monopoly rents. Yet there are gains to being economically integrated. In the framework, a country’s openness is measured by the effect of its policies on the productivity of foreign operations. Our analysis indicates that there are large gains to this openness.

We use minute-by-minute daily transaction-level payments data to document the cross-sectional and time-series behavior of the estimated prices and quantities negotiated by commercial banks in the fed funds market. We study the frequency and volume of trade, the size distribution of loans, the distribution of bilateral fed funds rates, and the intraday dynamics of the reserve balances held by commercial banks. We find evidence of the importance of the liquidity provision achieved by commercial banks that act as de facto intermediaries of fed funds.

This paper examines the macroeconomic implications of sovereign credit risk in a business cycle model where banks are exposed to domestic government debt. The news of a future sovereign default hampers financial intermediation. First, it tightens the funding constraints of banks, reducing their available resources to finance firms (liquidity channel). Second, it generates a precautionary motive for banks to deleverage (risk channel). I estimate the model using Italian data, finding that i) sovereign credit risk was recessionary and that ii) the risk channel was sizable. I then use the model to evaluate the effects of subsidized long term loans to banks, calibrated to the ECB’s longer-term refinancing operations. The presence of strong precautionary motives at the time of policy enactment implies that bank lending to firms is not very sensitive to these credit market interventions.

An interpretation of government policy regarding what it accepts in transactions is embedded in a version of the Kiyotaki-Wright model of media of exchange. In an example with two goods and one fiat money, the policies consistent with fiat money being the unique medium of exchange are identified. These uniqueness policies have the government favoring fiat money in its transactions. Benefits and costs accompany any such policy. The benefit is that a worse nonmonetary equilibrium is eliminated; the cost is that a better monetary equilibrium is also eliminated.

A model is presented in which demand deposits backed by fractional currency reserves and public insurance can be beneficial. The model uses Samuelson's pure consumption-loans model. The case for demand deposits, reserves, and deposit insurance rests on costs of illiquidity and incomplete information. The effect of deposit insurance depends upon how, and at what cost, the government meets its insurer's obligation--something which is not specified in practice. It remains possible that demand deposits and deposit insurance are a distortion, and reserve requirements serve only to limit the size of this distortion.

This paper investigates the macroeconomic and welfare effects of a particular public finance decision. That decision was to use debt rather than current taxation to finance deposit insurance payments related to the savings and loan debacle. We find that this decision could have significantly raised real interest rates and affected welfare. The analysis is conducted in a dynamic, open-economy, monetary general equilibrium model in which parameters are set based on empirical observations.

The fiscal year and the calendar year coincide for a large fraction of firms traded in the New York and American Stock Exchanges. It is therefore possible that part of the large positive abnormal return earned by stocks as a group during the first week of trading in January may be due to temporal resolution of uncertainty accompanying the end of the fiscal year. We study this hypothesis by examining whether stocks of firms with fiscal years ending in months other than December also realize positive abnormal returns, following the end of their fiscal years. We find that there are no excess returns for such firms in the first five trading days following the end of the fiscal year.

These notes are intended as a do-it-yourself course in economic growth along lines suggested by Lucas ("On the Mechanics of Economic Development"). We examine in turn the neoclassical growth model; theories of endogenous growth, including learning-by-doing, increasing returns to scale, and externalities; and dynamic comparative advantage in trade. Salient features of growing economies and microeconomic evidence on production processes are used to evaluate alternatives. Exercises supplement the text.

We examine deviations from trend of net exports and other components of GNP for the United States and attempt to build models consistent with their behavior. The most striking fact is that net exports have consistently been countercyclical. We show, first, that dynamic pure-exchange models can only produce a negative correlation between net exports and GNP if the variance of consumption exceeds that of output. In the United Slates it does not, so this class of models cannot explain observed comovements between output and trade. We then examine government spending and nontraded goods as potential remedies, but show that their behavior is either inconsistent with the data or can be made consistent with any pattern of comovements. The most promising model introduces production and capital formation. Fluctuations are driven by country-specific productivity shocks, in which high productivity domestically leads to high domestic investment and a deficit in the balance of trade. This theory also receives support from the large negative covariance between net exports and investment in American data.

This paper develops a forecasting procedure based on a Bayesian method for estimating vector autoregressions. The procedure is applied to ten macroeconomic variables and is shown to improve out-of-sample forecasts relative to univariate equations. Although cross-variables responses are damped by the prior, considerable interaction among the variables is shown to be captured by the estimates. We provide unconditional forecasts as of 1982:12 and 1963:3* We also describe how a model such as this can be used to make conditional projections and to analyse policy alternatives. As an example, we analyze a Congressional Budget Office forecast made in 1982:12. While no automatic causal interpretations arise from models like ours, they provide a detailed characterization of the dynamic statistical interdependence of a set of economic variables, which may help in evaluating causal hypotheses, without containing any such hypotheses themselves.

Here we reply to Robert Solow’s comment on our work, Modern Macroeconomics in Practice: How Theory is Shaping Policy.

This paper investigates two methods of approximating the optimal decision rules of a stochastic, representative agent model which exhibits growth in steady state and cannot be expressed in linear–quadratic form. Both methods are modifications on the linear quadratic approximation technique proposed by Kydland and Prescott. It is shown that one of the solution methods leads to bizarre dynamic behavior, even with shocks of empirically reasonable magnitude. The other solution technique does not exhibit such bizarre behavior.

Following the sovereign debt crisis of 2012, some southern European countries have debated proposals to leave the Euro. We evaluate this policy change in a standard monetary model with seigniorage financing of the deficit. The main novel feature is that we depart from rational expectations while maintaining full rationality of agents in a sense made very precise. Our first contribution is to show that small departures from rational expectations imply that inflation upon exit can be orders of magnitude higher than under rational expectations. Our second contribution is to provide a framework for policy analysis in models without rational expectations.

Sovereign governments owe debt to many foreign creditors and can choose which creditors to favor when making payments. This paper documents the de facto seniority structure of sovereign debt using new data on defaults (missed payments or arrears) and creditor losses in debt restructuring (haircuts). We overturn conventional wisdom by showing that official bilateral (government-to-government) debt is junior, or at least not senior, to private sovereign debt such as bank loans and bonds. Private creditors are typically paid first and lose less than bilateral official creditors. We confirm that multilateral institutions like the IMF and World Bank are senior creditors.

An intuitively natural consistency condition for contingent plans is necessary and sufficient for a contingent plan to be rationalized by maximization of conditional expected utility. One alternative theory of choice under uncertainty, the weighted-utility theory developed by Chew Soo Hong (1983) does not entail that contingent plans will generally satisfy this condition. Another alternative theory, the minimax theory as formulated by Savage (1972), does entail the consistency condition (at least for singleton-valued plans).

This paper presents a simple formula that relates the tail index of the firm size distribution to the aggregate speed with which an economy converges to its balanced growth path. The fact that there are so many firms in the right tail implies that aggregate shocks that permanently destroy employment among incumbent firms, rather than cause these firms to scale back temporarily, are followed by slow recoveries. This is true despite the presence of many rapidly growing firms. Aggregate convergence rates are non-linear: they can be very high for economies far below the balanced growth path and very low for advanced economies.

This paper puts forward a method for simulating an existing macroeconometric model while maintaining the additional assumption that individuals form their expectations rationally. This simulation technique is a first response to Lucas' criticism that standard econometric policy evaluation allows policy rules to change but doesn't allow expectations rules to change as economic theory predicts they will. The technique is applied to a version of the St. Louis Federal Reserve Model with interesting results. The rational expectations version of the St. Louis Model exhibits the same neutrality with respect to certain policy rules as small, analytic rational expectations models considered by Lucas, Sargent, and Wallace.

In this paper, we characterize those situations in which after the introduction of futures markets there is either an unambiguous change in the volatility of spot prices or an unambiguous change in welfare. We provide examples of the usefulness of this approach by giving two alternative sets of sufficient conditions for price volatility to decline following the introduction of futures trading. We also provide a set of sufficient conditions for the introduction of futures trading to increase the welfare of all agents.

Until the mid-19th century, shortages of currency were sometimes serious problems. One common response was to prohibit the export of coins. We use a random matching model with indivisible money to explain a shortage and to judge the desirability of a prohibition on the export of coins. The model, although extreme in many regards, represents better than earlier models a demand for outside money and the problems that arise when that money is indivisible. It can also rationalize a prohibition on the export of coins.

This appendix contains eight sections. Section 1 gives technical details of how we calculate standard errors in the CPS data. Section 2 discusses changes in the ACS procedures before 2005. Section 3 examines demographic and economic patterns in migration over the past two decades, in more detail than in the main paper. Section 4 examines the cross-sectional variance of location-occupation interactions in earnings when we define locations by MSAs instead of states. Section 5 describes alternative methods to estimate the variance of location-occupation interactions in income. Section 6 measures the segregation of industries across states and of occupations and industries across MSAs. Section 7 gives technical details on the use of SIPP and census data to calculate repeat and return migration rates. Section 8 discusses transition dynamics in the model.

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.

This study systematically examines the distribution of the wealth of nations and how it has evolved over time. A nation's wealth is measured by its real per-capita gross domestic product. The study documents the following key economic development facts that a theory of economic development must be consistent with: There is a great disparity in wealth between the richest and poorest countries. This disparity has changed little in the postwar period. There was an upward shift in the distribution of the wealth of nations. There has been considerable relative wealth mobility, with some spectacular changes for individual countries in the distribution.

Economic activity in the United States has been growing more slowly than average for the past three years, and it is not likely to speed up soon. The slow growth has been due primarily to pessimism among consumers about their long-run personal income. That pessimism—and its extension to the U.S. economy as a whole—is confirmed by data on real estate prices and labor force participation and by the 1992–93 forecast of a Bayesian vector autoregression model.

Much economic activity takes place within the home. Unfortunately, it is difficult to assess the cyclical properties of home production because the available data are too sporadic. Under the assumption that each observation of historical U.S. data on consumption, investment, and hours worked is consistent with optimal behavior on the part of a representative agent, we construct quarterly data on three variables that would otherwise be unobservable at a quarterly frequency: hours worked in the home sector, hours spent in leisure, and the consumption of goods produced in the home sector. Three results emerge: leisure is highly countercyclical while nonmarket hours are acyclical; there has been a large decrease in hours spent in home production since the 1970s; fluctuations in market output are a good measure of fluctuations in individual utility as long as home consumption and market consumption are either extreme complements or extreme substitutes in the production of utility. The sensitivity of results to the parametric assumptions is examined.

The way many dictators have been deposed in the 20th century resembles the way a parliamentary form of government emerged in 13th-century England. This medieval example is worth examining because the features that led to its political reform are particularly clear. Despite what many think, that reform cannot be understood simply as a shift in military power from ruler to subjects. Rather, understanding the reform requires understanding that the English king had recently acquired private information crucial to his subjects. Such private information became important after England lost Normandy to France, just before the king issued the Magna Carta (and publicly agreed to consult his subjects before taxing them). Under circumstances like these—when a threat to a society arises and significant private information about the threat develops—the society may need an arrangement for communication like parliament in order to attain economic efficiency.

This study establishes several facts about medieval monetary debasements: they were followed by unusually large minting volumes and by increased seigniorage; old and new coins circulated concurrently; and, at least some of the time, coins were valued by weight. These facts constitute a puzzle because debasements provide no additional inducements to bring coins to the mint. On theoretical and empirical grounds, the authors reject explanations based on by-tale circulation, nominal contracts, and sluggish price adjustment. They conclude that debasements pose a challenge to monetary economics.

This paper studies the time series and cross-sectional behavior of tariffs during the prewar period in a manner that recognizes their dual role: as an instrument of commercial policy and as an important source of government revenue. The fact that these objectives may be reinforcing or conflicting has made a critical difference in the choice of tariff rates across commodities and over time. Another interesting feature of prewar tariffs is that most import duties were specific, charging a nominal amount of domestic currency per physical unit imported. Existing historical accounts focus on dates of legislative change and miss the cyclical variation in tariff rates that results from the impact of changing prices on the real value of specific duties. These price effects are quantitatively important during the 1900 to 1940 period. For example, the Fordney-McCumber Act of 1922 which has been interpreted as very protectionist simply corrected the erosion of real tariff rates occurring during the inflation of World War I. The opposite is true of the infamous Smoot-Hawley Tariff Act; the deflation of the 1930s added considerably to the legislated increases. The implications of these findings for modelling the role of Smoot-Hawley in the Great Depression is also discussed.

This study argues that the delegation of monetary policy control by one country to another can reduce inflation in the delegating country. Hyperinflation is common in a divided society, one in which special interest groups can pressure a weak central government to issue money to finance their own demands while neglecting the country’s overall welfare. A commitment device like dollarization or a currency board, which gives control of the divided country’s money supply to another country, can eliminate this inflation bias. This is illustrated by Argentina’s experience with inflation and a currency board which, in effect, gave control of Argentina’s money supply to the United States. This argument is made precise using a two-country overlapping generations model to study the effects of delegation. The study also finds that a dollarization treaty between the two countries can be welfare-improving for both.

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.

To illustrate the use of social accounting matrices (SAMs) in applied general equilibrium (GE) modeling, we use an aggregated SAM for the Spanish economy to calibrate a simple applied GE model. The idea is to construct artificial people—households, government, and a foreign sector—who make the same transactions in the equilibrium of the model economy as do their counterparts in the data. This calibration procedure can be augmented, or partially substituted for, by statistical estimation of key parameters. We show the usefulness of such a model by presenting the results of a comparative exercise that mimics the policy changes that took place in Spain during its 1986 integration into the European Community. Sub-sequent data shows the model results to be remarkably accurate, especially if we account for other major shocks affected the Spanish economy in 1986.

Why do some sellers set nominal prices that apparently do not respond to changes in the aggregate price level? In many models, prices are sticky by assumption; here it is a result. We use search theory, with two consequences: prices are set in dollars, since money is the medium of exchange; and equilibrium implies a nondegenerate price distribution. When the money supply increases, some sellers may keep prices constant, earning less per unit but making it up on volume, so profit stays constant. The calibrated model matches price-change data well. But, in contrast with other sticky-price models, money is neutral.

This paper puts forward a method for improving the forecasting accuracy of an existing macroeconometric model without changing its policy response characteristics. The procedure is an extension and formalization of the practice of additive adjustments currently used by most forecasters. The method should be of special interest to forecasters who use models built by other investigators because it does not involve reestimation of the original model and uses only information routinely included in the documentation available to model users. The paper ends with a demonstration of the prediction improvement realized by application of this method to a version of the MIT-Penn-SSRC (MPS) model.

Current approaches to monetary theory and policy owe much to the "quantity theory of money." However, recent theoretical developments suggest that the manner in which money is introduced is more important, even for price level movements, than the quantity of money. Colonial American experience provides a laboratory for discriminating between these views. It is shown here that the nature of backing, rather than the quantity of money, determined its value. Large secular inflations were ended by changing the nature of backing despite the continuance of large note issues (and despite the absence of a metallic standard). Extremely large note issues and note withdrawals are shown not to have produced inflation (currency depreciation) or deflation (currency appreciation).

Three economic environments are reviewed, and in each organizations play an essential role. For an adverse selection insurance economy, we find that when mutual insurance arrangements are permitted an equilibrium necessarily exists and is optimal. This example, and the two others, illustrate the problems that may result from imposing organizational structure on an environment rather than permitting the structure to be determined endogenously.

Doan, Litterman, and Sims have described a method for estimating Bayesian vector autoregressive (BVAR) forecasting models. The method has been successfully applied to the U.S. macroeconomic dataset, which is relatively long and stable. Despite the brevity and volatility of the post-1976 Chilean macroeconomic dataset, this paper shows that a straightforward application of the DLS method to this dataset, with simple modifications to allow for delays in the release of data, also appears to satisfy at least one criterion of relative forecasting accuracy suggested by Doan, Litterman, and Sims. However, the forecast errors of the Chilean BVARs are still large in absolute terms.Also, the model's coefficients change sharply in periods marked by policy shifts, such as the floating of the peso in 1982.

A model of a labor market is developed in which agents possess private information about their marginal products. As a result, involuntary unemployment may arise as a consequence of attempts by firms to create appropriate self-selection incentives. Moreover, employment lotteries may arise for the same reason despite the fact that, in equilibrium, there is no uncertainty in the model. When employment is random, this is both privately and socially desirable. Finally, it is shown that the unemployment that arises is consistent with (a) pro-cyclical aggregate real wages and productivity, (b) employment that fluctuates (at individual and aggregate levels) much more than real wages.

This paper characterizes the behavior of investment expenditures, optimal capital stocks, and real interest rates in the time-to-build model of investment. These results are used to show that the delivery lag model of investment fails to account for time lags in investment when constructing the cost of capital variable and hence, misspecifies the effects of interest rates on investment expenditures. Second, this paper derives equilibrium pricing relationships involving the prices of existing capital and uses these relationships to obtain simple tests of the underlying investment technology. Despite the widespread use of 'q' in the empirical investment literature, it is shown that the relationship between current investment and an appropriately defined measure of Tobin's 'q' contains no such testable implications. Finally, it is shown that the practice of using stock market data to measure the price of existing capital is invalid when time lags exist in the investment process.

The Diamond-Dybvig model of banking (Journal of Political Economy, 1983) is amended by introducing communication barriers - these being implicit in their model and in most explanations of why people hold so-called liquid assets. These barriers imply the sequential-service constraint that Diamond and Dybvig imposed on private intermediation and have other implications: infeasibility of the policy that Diamond and Dybvig identify with deposit insurance and desirability of dependence of the realized return on deposits on the random order of withdrawals.

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.

Empirical studies quantifying the benefits of increased foreign direct investment (FDI) have been unable to provide conclusive evidence of a positive impact on the host country’s economic performance. I show that the lack of robust evidence is not inconsistent with theory, even if the gains to FDI openness are large. Anticipated welfare gains to increased inward FDI should lead to immediate declines in domestic investment and employment and eventual increases. Furthermore, since part of FDI is intangible investment that is expensed from company profits, gross domestic product (GDP) and gross national product (GNP) should decline during periods of abnormally high FDI investment. Using the model of McGrattan and Prescott (2009) and data from the IMF Balance of Payments to parameterize the time paths of FDI openness for each country in the sample, I do not find an economically significant relationship between the amount of inward FDI a country did over the period 1980—2005 and the growth in real GDP predicted by the model. This finding rests crucially on the fact that most of these countries are still in transition to FDI openness.

The consequences of costly divisibility of assets are studied using a model with the following features. The demand for assets is generated from an overlapping generations model with a continuum of agents in each generation and with intra-generation trade (intermediation) ruled out. There is a once-for-all supply of a stock of nonnegative-dividend assets in a large size, and there is a costly technology for dividing them into smaller sizes. Stationary equilibria are shown to exist. In contrast with similar models with costless divisibility of assets, competitive equilibria are not necessarily desirable; there can be Pareto-ordered equilibria.

A popular method of investigating the market effects of multibank holding company (MBHC) affiliation involves regression of banks' local market share on a dummy variable for MBHC affiliation. The usefulness of this procedure is called into question by means of a theoretical counterexample.

We make three comparisons relevant for the business cycle accounting approach. We show that in theory representing the investment wedge as a tax on investment is equivalent to representing this wedge as a tax on capital income as long as the probability distributions over this wedge in the two representations are the same. In practice, convenience dictates that the underlying probability distributions over the investment wedge are different in the two representations. Even so, the quantitative results under the two representations are essentially identical. We also compare our methodology, the CKM methodology, to an alternative one used in Christiano and Davis (2006) as well as by us in early incarnations of the business cycle accounting approach. We argue that the CKM methodology rests on more secure theoretical foundations. Finally, we show that the results from the VAR-style decomposition of Christiano and Davis reinforce the results of the business cycle decomposition of CKM.

The behavior of interest rates under the U.S. National Banking System is puzzling because of the apparent presence of persistent and large unexploited arbitrage opportunities for note issuing banks. Previous attempts to explain interest rate behavior have relied on the cost or the inelasticity of note issue. These attempts are not entirely satisfactory. Here we propose a new rationale to solve the puzzle. Inelastic note issuance arises endogenously because the marginal cost of issuing notes is an increasing function of circulation. We build a spatial separation model where some fraction of agents must move each period. Banknotes can be carried between locations; deposits cannot. Taking the model to the data on national banks, we find it matches the movements in long-term interest rates well. It also predicts movements in deposit rates during panics. However, the model displays more inelasticity of notes issuance than is in the data.

In this paper we analyze the constraints imposed by dynamic consistency in a model of optimal taxation. We assume that only distorting taxes are available to finance government consumption. Optimal fiscal policy requires the use of debt to smooth distortions over time. Dynamic consistency requires that governments at each point in time not have an incentive to default on the inherited debt. We consider policy functions which map the history of the economy including the actions of past governments into current decisions. A sustainable plan is a sequence of history-contingent policies which are optimal at each date given that future policies will be selected according to the plan. We show that if agents discount the future sufficiently little and if government consumption fluctuates then optimal sustainable plans yield policies and allocations which are identical to those under full commitment. We contrast our notion of dynamic consistency with other definitions.

In the postwar period velocity has risen so sharply in the U.S. that the ratio of money to nominal output has fallen by a factor of three. We analyze the implications of shrinking money for the real effects of a monetary shock in two classes of equilibrium monetary business cycle models: limited participation (liquidity) models and predetermined (sticky) price models. We show that the liquidity model predicts that a rise in velocity leads to a substantial reduction in the real effects of a monetary shock. In sharp contrast, we show that the real effects of a monetary shock in the sticky price model are largely invariant to changes in velocity. We provide evidence that suggests that the real effects of monetary shocks have fallen over the postwar period.