Research Database

Most economic activity occurs in cities. This creates a tension between local increasing returns, implied by the existence of cities, and aggregate constant returns, implied by balanced growth. To address this tension, we develop a general equilibrium theory of economic growth in an urban environment. In our theory, variation in the urban structure through the growth, birth, and death of cities is the margin that eliminates local increasing returns to yield constant returns to scale in the aggregate. We show that, consistent with the data, the theory produces a city size distribution that is well approximated by Zipf’s Law, but that also displays the observed systematic under-representation of both very small and very large cities. Using our model, we show that the dispersion of city sizes is consistent with the dispersion of productivity shocks found in the data.

We show that a simple model of COVID-19 that incorporates feedback from disease prevalence to disease transmission through an endogenous response of human behavior does a remarkable job fitting the main features of the data on the growth rates of daily deaths observed across a large number countries and states of the United States from March to November of 2020. This finding, however, suggests a new empirical puzzle. Using an accounting procedure akin to that used for Business Cycle Accounting as in Chari et al. (2007), we show that when the parameters of the behavioral response of transmission to disease prevalence are estimated from the early phase of the epidemic, very large wedges that shift disease transmission rates holding disease prevalence fixed are required both across regions and within a region over time for the model to match the data on deaths from COVID-19 as an equilibrium outcome exactly. We show that these wedges correspond to large shifts in model forecasts for the long-run attack rate of COVID-19 both across locations and over time. Future research should focus on understanding the sources in these wedges in the relationship between disease prevalence and disease transmission.

Following its opening to trade and foreign investment in the mid-1980s, Mexico’s economic growth has been modest at best, particularly in comparison with that of China. Comparing these countries and reviewing the literature, we conclude that the relation between openness and growth is not a simple one. Using standard trade theory, we find that Mexico has gained from trade, and by some measures, more so than China. We sketch out a theory in which developing countries can grow faster than the United States by reforming. As a country becomes richer, this sort of catch-up becomes more difficult. Absent continuing reforms, Chinese growth is likely to slow down sharply, perhaps leaving China at a level less than Mexico’s real GDP per working-age person.

We show that much of the recent reported decrease in interstate migration is a statistical artifact. Before 2006, the Census Bureau’s imputation procedure for dealing with missing data in the Current Population Survey inflated the estimated interstate migration rate. An undocumented change in the procedure corrected the problem starting in 2006, thus reducing the estimated migration rate. The change in imputation procedures explains 90 percent of the reported decrease in interstate migration between 2005 and 2006, and 42 percent of the decrease between 2000 (the recent high-water mark) and 2010. After we remove the effect of the change in procedures, we find that the annual interstate migration rate follows a smooth downward trend from 1996 to 2010. Contrary to popular belief, the 2007–2009 recession is not associated with any additional decrease in interstate migration relative to trend.

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.

This paper presents a model of cumulative innovation where firms are heterogeneous in their research ability. We study the optimal reward policy when the quality of the ideas and their subsequent development effort are private information. The optimal assignment of property rights must counterbalance the incentives of current and future innovators. The resulting mechanism resembles a menu of patents that have infinite duration and fixed scope, where the latter increases in the value of the idea. Finally, we provide a way to implement this patent menu by using a simple buyout scheme: The innovator commits at the outset to a price ceiling at which he will sell his rights to a future inventor. By paying a larger fee initially, a higher price ceiling is obtained. Any subsequent innovator must pay this price and purchase its own buyout fee contract.

Great Lakes iron ore producers had faced no competition from foreign iron ore in the Great Lakes steel market for nearly a century as the 1970s closed. In the early 1980s, as a result of unprecedented developments in the world steel market, Brazilian producers were offering to deliver iron ore to Chicago (the heart of the Great Lakes market) at prices substantially below local iron ore prices. The U.S. and Canadian iron ore industries faced a major crisis that cast doubt on their future. In response to the crisis, these industries dramatically increased productivity. Labor productivity doubled in a few years (whereas it had changed little in the preceding decade). Materials productivity increased by more than half. Capital productivity increased as well. I show that most of the productivity gains were due to changes in work practices. Work practice changes reduced overstaffing and hence increased labor productivity. Changes in work practices, by increasing the fraction of time equipment was in operating mode, also significantly increased materials and capital productivity.

The Cincinnati Post published its last edition on New Year's Eve 2007, leaving the Cincinnati Enquirer as the only daily newspaper in the market. The next year, fewer candidates ran for municipal office in the Kentucky suburbs most reliant on the Post, incumbents became more likely to win re-election, and voter turnout and campaign spending fell. These changes happened even though the Enquirer at least temporarily increased its coverage of the Post's former strongholds. Voter turnout remained depressed through 2010, nearly three years after the Post closed, but the other effects diminished with time. We exploit a difference-in-differences strategy and the fact that the Post's closing date was fixed 30 years in advance to rule out some noncausal explanations for our results. Although our findings are statistically imprecise, they suggest that newspapers - even underdogs such as the Post, which had a circulation of just 27,000 when it closed - can have a substantial and measurable impact on public life.

In this paper, we construct a parsimonious overlapping-generations model of human capital accumulation and study its quantitative implications for the evolution of the U.S. wage distribution from 1970 to 2000. A key feature of the model is that individuals differ in their ability to accumulate human capital, which is the main source of wage inequality in this model. We examine the response of this model to skill-biased technical change (SBTC), which is modeled as an increase in the trend growth rate of the price of human capital starting in the early 1970s. The model displays behavior that is consistent with several important trends observed in the US data, including the rise in overall wage inequality; the fall and subsequent rise in the college premium, as well as the fact that this behavior was most pronounced for younger workers; the rise in within-group inequality; the stagnation in median wage growth; and the small rise in consumption inequality despite the large rise in wage inequality. We consider different scenarios regarding how individuals’ expectations evolve during SBTC. Specifically, we study the case where individuals immediately realize the advent of SBTC (perfect foresight), and the case where they initially underestimate the future growth of the price of human capital (pessimistic priors), but learn the truth in a Bayesian fashion over time. Lack of perfect foresight appears to have little effect on the main results of the paper. Overall, the model shows promise for explaining a diverse set of wage distribution trends observed since the 1970s in a unifying human capital framework.

This online appendix accompanies Staff Report 560: Sweat Equity in U.S. Private Business.

We study the possible specialness of circulating as opposed to noncirculating private securities using models whose equilibria imply the existence of both. The models are pure exchange setups with spatial separation and with the potential for a variety of intertemporal trades. We find a sense in which unregulated circulating private securities are troublesome. It can happen that in order for an equilibrium to exist, the amounts of circulating debts issued at the same time in spatially and informationally separated markets have to satisfy restrictions not implied by individual maximization and market clearing in each market separately.

In this paper I describe a “monetary” system in which backing is provided for the government’s liabilities by way of contingent resort to taxes. The system has some of the features of a commodity money system with a large seignorage spread between bid and ask prices. It is studied within the context of a one-good, pure exchange model of two-period-lived overlapping generations in which, aside from various uniform boundedness assumptions, considerable diversity is allowed both within and across generations. Two results are established: (i) the existence of at least one perfect foresight competitive equilibrium, and (ii) the Pareto optimality of any such equilibrium.

Following are the technical appendixes for “Banking in Computable Equilibrium Economies” by Javier Díaz-Giménez, Edward C. Prescott, Terry Fitzgerald, and Fernando Alvarez, in Journal of Economic Dynamics and Control 16 (1992), 533–59. Technical Appendix I, by Fernando Alvarez, describes the procedures used to construct the balance sheets reported in Tables 1 and 2 in page 536 and 537 of the paper. Technical Appendix II, by Terry Fitzgerald, describes the computational procedures used in this paper.

In this appendix, we provide details on the data sources and construction of variables for our analysis in "What Do Survey Data Tell Us about U.S. Businesses?" We also include the auxiliary tables and figures omitted from the main text.

The inefficiency of fixed rate consumer price subsidies, relative to cash transfers, is one of the best-known propositions in welfare economics. It has also been used to show that matching grants are a more inefficient intergovernmental aid than are lump sum grants. Furthermore, the cost of fixed rate subsidies cannot be controlled without providing a “cap” beyond which amount no subsidy is received. This paper reports, both qualitatively and quantitatively, that a broad class of variable rate price subsidies also dominates fixed rate subsidies on both counts. The relative inefficiency of matching grants compared to the variable rate Federal General Revenue Sharing program is estimated.

There have been tremendous advances in macroeconomics, following the introduction of labor supply into the field. Today it is widely acknowledged that labor supply matters for many key economic issues, particularly for business cycles and tax policy analysis. However, the extent to which labor supply matters for such questions depends on the aggregate labor supply elasticity—that is, the sensitivity of the time allocation between market and non-market activities to changes in the effective wage. The magnitude of the aggregate labor supply elasticity has been the subject of much debate for several decades. In this paper we review this debate and conclude that the elasticity of labor supply of the aggregate household is much higher than the elasticity of the identical households being aggregated. The aggregate household utility function differs from individuals’ utility functions for the same reason the aggregate production function differs from individual firms’ production functions being aggregated. The differences in individual and aggregate supply elasticities are what aggregation theory predicts.

I characterize time consistent equilibrium in an economy with price rigidity and an optimizing monetary authority operating under discretion. Firms have the option to increase their frequency of price change, at a cost, in response to higher inflation. Previous studies, which assume a constant degree of price rigidity across inflation regimes, find two time consistent equilibria—one with low inflation, the other with high inflation. In contrast, when price rigidity is endogenous, the high inflation equilibrium ceases to exist. Hence, time consistent equilibrium is unique. This result depends on two features of the analysis: (1) a plausible quantitative specification of the fixed cost of price change, and (2) the presence of an arbitrarily small cost of inflation that is independent of price rigidity.

We develop a model in which, in order to provide managerial incentives, it is optimal to have costly bankruptcy. If benevolent governments can commit to their policies, it is optimal not to interfere with private contracts. Such policies are time inconsistent in the sense that, without commitment, governments have incentives to bail out firms by buying up the debt of distressed firms and renegotiating their contracts with managers. From an ex ante perspective, however, such bailouts are costly because they worsen incentives and thereby reduce welfare. We show that regulation in the form of limits on the debt-to-value ratio of firms mitigates the time-inconsistency problem by eliminating the incentives of governments to undertake bailouts. In terms of the cyclical properties of regulation, we show that regulation should be tightest in aggregate states in which resources lost to bankruptcy in the equilibrium without a government are largest.

No abstract available.

The welfare-maximizing income tax structure, rate of money creation, and amounts of intergenerational transfers are jointly determined for given rates of government consumption. When government consumption is zero, it is found for the parameter values examined that the income tax structure is progressive, the rate of money change is negative, and positive transfers are made to the old. As government consumption increases, the tax structure’s progressivity declines and turns increasingly regressive, the rate of money change rises, and transfers decrease. It is found that the bulk of the increase in government consumption is optimally financed by a cut in transfers.

We document and attempt to explain the observation that automobile insurance premiums vary dramatically across local markets. We argue high premiums can be attributed to the large numbers of uninsured motorists in some cities, while at the same time, the uninsured motorists can be attributed to high premiums. We construct a simple noncooperative equilibrium model, where limited liability can generate inefficient equilibria with uninsured drivers and high, yet actuarially fair, premiums. For certain parameterizations, an optimal full insurance equilibrium and inefficient high price equilibria with uninsured drivers exist simultaneously, consistent with the observed price variability across seemingly similar cities.

Monetary policy instruments differ in tightness—how closely they are linked to inflation—and transparency—how easily they can be monitored. Tightness is always desirable in a monetary policy instrument; when is transparency? When a government cannot commit to follow a given policy. We apply this argument to a classic question: Is the exchange rate or the money growth rate the better monetary policy instrument? We show that if the instruments are equally tight and a government cannot commit to a policy, then the exchange rate’s greater transparency gives it an advantage as a monetary policy instrument.

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.

We study decentralized learning in organizations. Decentralization is captured through a symmetry constraint on agents’ strategies. Among such attainable strategies, we solve for optimal and equilibrium strategies. We model the organization as a repeated game with imperfectly observable actions. A fixed but unknown subset of action profiles are successes and all other action profiles are failures. The game is played until either there is a success or the time horizon is reached. For any time horizon, including infinity, we demonstrate existence of optimal attainable strategies and show that they are Nash equilibria. For some time horizons, we can solve explicitly for the optimal attainable strategies and show uniqueness. The solution connects the learning behavior of agents to the fundamentals that characterize the organization: Agents in the organization respond more slowly to failure as the future becomes more important, the size of the organization increases and the probability of success decreases.

This paper provides a quantitative assessment of the effects of inflation through changes in the value of nominal assets. We document nominal positions in the U.S. across sectors as well as different groups of households, and estimate the redistribution brought about by a moderate inflation episode. Redistribution takes the form of “ends-against-the-middle:” the middle class gains at the cost of the rich and poor. In addition, inflation favors the young over the old, and hurts foreigners. A calibrated OLG model is used to assess the macroeconomic implications of this redistribution under alternative fiscal policy rules. We show that inflation-induced redistribution has a persistent negative effect on output, but improves the weighted welfare of domestic households.

We study the effects of large transportation costs on economic development. We argue that the Midwest and the Northeast of the U.S. is a natural case because starting from 1840 decent data is available showing that the two regions shared key characteristics with today’s developing countries and that transportation costs were large and then came way down. To disentangle the effects of the large reduction in transportation costs from those of other changes that happened during 1840–1860, we build a model that speaks to the distribution of people across regions and across the sectors of production. We find that the large reduction in transportation costs was a quantitatively important force behind the settlement of the Midwest and the regional specialization that concentrated agriculture in the Midwest and industry in the Northeast. Moreover, we find that it led to the convergence of the regional per capita incomes measured in current regional prices and that it increased real GDP per capita. However, the increase in real GDP per capita is considerably smaller than that resulting from the productivity growth in the nontransportation sectors.

We show how to use panel data on household consumption to directly estimate households’ risk preferences. Specifically, we measure heterogeneity in risk aversion among households in Thai villages using a full risk-sharing model, which we then test allowing for this heterogeneity. There is substantial, statistically significant heterogeneity in estimated risk preferences. Full insurance cannot be rejected. As the risk sharing, as-if-complete-markets theory might predict, estimated risk preferences are unrelated to wealth or other characteristics. The heterogeneity matters for policy: Although the average household would benefit from eliminating village-level risk, less-risk-averse households who are paid to absorb that risk would be worse off by several percent of household consumption.

No abstract available.

This paper catalogues formulas that are useful for estimating dynamic linear economic models. We describe algorithms for computing equilibria of an economic model and for recursively computing a Gaussian likelihood function and its gradient with respect to parameters. We apply these methods to several example economies.

This paper presents a simple general equilibrium model of optimal taxation in which both private agents and the government can default on their debt. As a benchmark we consider Ramsey equilibria in which the government can precommit to its policies at the beginning of time, but in which private agents can default. We then consider sustainable equilibria in which both government and private agent decision rules are required to be sequentially rational. We completely characterize the set of sustainable equilibria. In particular, we show that when there is sufficiently little discounting and government consumption fluctuates enough, the Ramsey allocations and policies (in which the government never defaults) can be supported by a sustainable equilibrium.

According to previous studies, the demand-liability feature of national bank notes did not present a problem for note-issuing banks because the nonbank public treated notes and other currency as perfect substitutes. However, that view, when combined with nonbindingness of the collateral restriction against note issue, itself an implication of the fact that some eligible collateral was not used for that purpose, implies that the safe short-term interest rate is pegged at the tax rate on note circulation. Since evidence on short-term interest rates is inconsistent with such a peg, that view must be rejected.

This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government's inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.

In the last century, the evolution of female labor force participation has been S-shaped: It rose slowly at first, then quickly, and has leveled off recently. Central to this dramatic rise has been entry of women with young children. We argue that this S-shaped dynamic came from generations of women learning about the relative importance of nature (endowed ability) and nurture (time spent child-rearing) for children’s outcomes. Each generation updates their parents’ beliefs by observing the children of employed women. When few women participate in the labor force, most observations are uninformative and participation rises slowly. As information accumulates and the effects of labor force participation become less uncertain, more women participate, learning accelerates and labor force participation rises faster. As beliefs converge to the truth, participation flattens out. Survey data, wage data and participation data support our mechanism and distinguish it from alternative explanations.

We develop and calibrate an overlapping generations general equilibrium model of the U.S. economy with heterogeneous consumers who face idiosyncratic earnings and health risk to study the implications of exogenous trends in increasing college attainment, decreasing fertility, and increasing longevity between 2005 and 2100. While all three trends contribute to a higher old age dependency ratio, increasing college attainment has different macroeconomic implications because it increases labor productivity. Decreasing fertility and increasing longevity require the government to increase the average labor tax rate from 32.0 to 44.4 percent. Increasing college attainment lowers the required tax increase by 10.1 percentage points. The required tax increase is higher under general equilibrium than in a small open economy with a constant interest rate because the reduction in the interest rate lowers capital income tax revenues.

In this appendix I present details of the model and the empirical analysis, and results of counterfactual experiments omitted from the paper. In Section 1 I describe a simple example that illustrates how, even in the absence of human capital acquisition, productivity shocks, or separation shocks, the learning component of the model can naturally generate mobility between jobs within a firm and turnover between firms. I also include the proofs of Propositions 1 and 2 in the paper. In Section 2 I discuss model identification in detail, where, in particular, I prove that information in my data on the performance ratings of managers allows me to identify the learning process separately from the human capital process. In Section 3 I describe the original U.S. firm dataset of Baker, Gibbs, and Holmström (1994a,b), on which my work is based. In Section 4 I provide details about the estimation of the model, including the derivation of the likelihood function, a description of the numerical solution of the model, and a discussion of the results from a Monte Carlo exercise showing the identifiability of the model’s parameters in practice. There I also derive bounds on the informativeness of the jobs of the competitors of the firm in my data, based on the estimates of the parameters reported in the paper. Finally, in Section 5 I present estimation results based on a larger sample that includes entrants into the firm at levels higher than Level 1. Results of counterfactual experiments omitted from the paper are contained in Tables A.12–A.14.

We provide new time-varying estimates of the housing wealth effect back to the 1980s. We use three identification strategies: OLS with a rich set of controls, the Saiz housing supply elasticity instrument, and a new instrument that exploits systematic differences in city-level exposure to regional house price cycles. All three identification strategies indicate that housing wealth elasticities were if anything slightly smaller in the 2000s than in earlier time periods. This implies that the important role housing played in the boom and bust of the 2000s was due to larger price movements rather than an increase in the sensitivity of consumption to house prices. Full-sample estimates based on our new instrument are smaller than recent estimates, though they remain economically important. We find no significant evidence of a boom-bust asymmetry in the housing wealth elasticity. We show that these empirical results are consistent with the behavior of the housing wealth elasticity in a standard life-cycle model with borrowing constraints, uninsurable income risk, illiquid housing, and long-term mortgages. In our model, the housing wealth elasticity is relatively insensitive to changes in the distribution of LTV for two reasons: First, low-leverage homeowners account for a substantial and stable part of the aggregate housing wealth elasticity; Second, a rightward shift in the LTV distribution increases not only the number of highly sensitive constrained agents but also the number of underwater agents whose consumption is insensitive to house prices.

Using optimal control theory and a vector autoregressive representation of the relationship between money and interest rates, one can derive a feedback control procedure which defines the best possible tradeoff between money supply fluctuations and interest rate volatility and which could be used to reduce both from their current levels.

Central to ongoing debates over the desirability of monetary unions is a supposed trade-off, outlined by Mundell [1961]: a monetary union reduces transactions costs but renders stabilization policy less effective. If shocks across countries are sufficiently correlated, then, according to this argument, delegating monetary policy to a single central bank is not very costly and a monetary union is desirable.

This paper explores this argument in a setting with both monetary and fiscal policies. In an economy with monetary policy alone, we confirm the presence of the trade-off and find that indeed a monetary union will not be welfare improving if the correlation of national shocks is too low. However, fiscal interventions by national governments, combined with a central bank that has the ability to commit to monetary policy, overturn these results. In equilibrium, such a monetary union will be welfare improving for any correlation of shocks.

Contemporaries, and economic historians, have noted several features of medieval and early modern European monetary systems that are hard to analyze using models of centralized exchange. For example, contemporaries complained of recurrent shortages of small change and argued that an abundance/dearth of money had real effects on exchange. To confront these facts, we build a random matching monetary model with two indivisible coins with different intrinsic values. The model shows that small change shortages can exist in the sense that adding small coins to an economy with only large coins is welfare improving. This effect is amplified by increases in trading opportunities. Further, changes in the quantity of monetary metals affect the real economy and the amount of exchange as well as the optimal denomination size. Finally, the model shows that replacing full-bodied small coins with tokens is not necessarily welfare improving.

Why do growth and net exit rates of establishments decline with size? What determines the size distribution of establishments? This paper presents a theory of establishment dynamics that simultaneously rationalizes the basic facts on economy-wide establishment growth, net exit, and size distributions. The theory emphasizes the accumulation of industry-specific human capital in response to industry-specific productivity shocks. It predicts that establishment growth and net exit rates should decline faster with size and that the establishment size distribution should have thinner tails in sectors that use human capital less intensively or physical capital more intensively. In line with the theory, the data show substantial sectoral heterogeneity in U.S. establishment size dynamics and distributions, which is well explained by variation in physical capital intensity.

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.

We describe several methods for approximating the solution to a model in which inequality constraints occasionally bind, and we compare their performance. We apply the methods to a particular model economy which satisfies two criteria: It is similar to the type of model used in actual research applications, and it is sufficiently simple that we can compute what we presume is virtually the exact solution. We have two results. First, all the algorithms are reasonably accurate. Second, on the basis of speed, accuracy and convenience of implementation, one algorithm dominates the rest. We show how to implement this algorithm in a general multidimensional setting, and discuss the likelihood that the results based on our example economy generalize.

We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).

We develop an equilibrium business cycle model where producers of final goods pursue generalized (S,s) inventory policies with respect to intermediate goods due to nonconvex factor adjustment costs. When calibrated to reproduce the average inventory-to-sales ratio in postwar U.S. data, our model explains over half of the cyclical variability of inventory investment. Moreover, inventory accumulation is strongly procyclical, and production is more volatile than sales, as in the data.

The comovement between inventory investment and final sales is often interpreted as evidence that inventories amplify aggregate fluctuations. In contrast, our model economy exhibits a business cycle similar to that of a comparable benchmark without inventories, though we do observe somewhat higher variability in employment, and lower variability in consumption and investment. Thus, our equilibrium analysis reveals that the presence of inventories does not substantially raise the cyclical variability of production, because it dampens movements in final sales.

The formation and maintenance of the institutions of money and a futures market are analyzed in an overlapping generations model with a first period. With money and a futures market the economy converges to the allocation where costly transactions are foregone and marginal products and marginal utilities equated. However, neither institution may be formed, or money may be formed without a futures market. Moreover, stochastic output technologies raise the possibility of persistent recession and depression and of valuable government insurance of the futures market.

Different conclusions about the effects of open market operations are reached even among economists using full employment and rational expectations models. I show that these differences can be attributed to different assumptions regarding the concept of the deficit that is held fixed for an open market operation, the diversity among agents, and the features generating money demand. With regard to those features, I argue that plausible ways of explaining the holding of low-return money preclude the kind of perfect credit markets needed to obtain Ricardian equivalence.

Monetary policy is analyzed within a model that ignores transaction costs and appeals solely to legal restrictions on private intermediation to explain the coexistence of currency and interest-bearing default-free bonds. The interaction between such legal restrictions and monetary policy is illustrated in versions of overlapping generations models that contain three assets: government-issued currency and bonds and real capital. It is shown that legal restrictions and the use of both currency and bonds permit the government to levy a discriminatory inflation tax and that such a tax may be better in terms of the Pareto criterion than a uniform inflation tax.

The analyses of fiscal and monetary policies that the Congressional Budget Office (CBO) provides Congress tend to be biased, encouraging the use of activist stabilization policies. The CBO’s virtual neglect of economic uncertainties and its emphasis on very short time horizons make active policies appear much more attractive than its own model implies. Moreover, the CBO’s adoption of the macroeconometric approach fundamentally biases its analyses. Macroeconometric models do not remain invariant to changes in policy rules and are mute on the implications of alternative policies for efficiency and income distribution. The rational expectations equilibrium approach overcomes these difficulties and implies that less activist and less inflationary policies are desirable.