Creator: Chari, V. V., Kehoe, Patrick J., and McGrattan, Ellen R. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 664 Abstract:
In the 1970s macroeconomists often disagreed bitterly. Macroeconomists have now largely converged on method, model design, and macroeconomic policy advice. The disagreements that remain all stem from the practical implementation of the methodology. Some macroeconomists think that New Keynesian models are on the verge of being useful for quarter-to-quarter quantitative policy advice. We do not. We argue that the shocks in these models are dubiously structural and show that many of the features of the model as well as the implications due to these features are inconsistent with microeconomic evidence. These arguments lead us to conclude that New Keynesian models are not yet useful for policy analysis.
Subject (JEL): E32 - Business Fluctuations; Cycles and E58 - Central Banks and Their Policies
Creator: Ales, Laurence and Maziero, Pricila Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 663 Abstract:
We study the quantitative properties of constrained efficient allocations in an environment where risk sharing is limited by the presence of private information. We consider a life cycle version of a standard Mirrlees economy where shocks to labor productivity have a component that is public information and one that is private information. The presence of private shocks has important implications for the age profiles of consumption and income. First, they introduce an endogenous dispersion of continuation utilities. As a result, consumption inequality rises with age even if the variance of the shocks does not. Second, they introduce an endogenous rise of the distortion on the marginal rate of substitution between consumption and leisure over the life cycle. This is because, as agents age, the ability to properly provide incentives for work must become less and less tied to promises of benefits (through either increased leisure or consumption) in future periods. Both of these features are also present in the data. We look at the data through the lens of our model and estimate the fraction of labor productivity that is private information. We find that for the model and data to be consistent, a large fraction of shocks to labor productivities must be private information.
Keyword: Risk sharing, Private information, and Consumption inequality Subject (JEL): D91 - Micro-Based Behavioral Economics: Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making, H21 - Taxation and Subsidies: Efficiency; Optimal Taxation, D11 - Consumer Economics: Theory, D58 - Computable and Other Applied General Equilibrium Models, D86 - Economics of Contract: Theory, and D82 - Asymmetric and Private Information; Mechanism Design
Creator: Kehoe, Patrick J. and Midrigan, Virgiliu Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 661 Abstract:
In the data, a large fraction of price changes are temporary. We provide a simple menu cost model which explicitly includes a motive for temporary price changes. We show that this simple model can account for the main regularities concerning temporary and permanent price changes. We use the model as a benchmark to evaluate existing shortcuts that do not explicitly model temporary price changes. One shortcut is to take the temporary changes out of the data and fit a simple Calvo model to it. If we do so prices change only every 50 weeks and the Calvo model overestimates the real effects of monetary shocks by almost 70%. A second shortcut is to leave the temporary changes in the data. If we do so prices change every 3 weeks and the Calvo model produces only 1/9 of the real effects of money as in our benchmark. We show that a simple Calvo model can generate the same real effects as our benchmark model if we set parameters so that prices change every 17 weeks.
Subject (JEL): E12 - General Aggregative Models: Keynes; Keynesian; Post-Keynesian, E50 - Monetary Policy, Central Banking, and the Supply of Money and Credit: General, and E58 - Central Banks and Their Policies
Creator: Guner, Nezih, Kaygusuz, Remzi, and Ventura, Gustavo Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 660 Abstract:
We evaluate reforms to the U.S. tax system in a dynamic setup with heterogeneous married and single households, and with an operative extensive margin in labor supply. We restrict our model with observations on gender and skill premia, labor force participation of married females across skill groups, and the structure of marital sorting. We study four revenue-neutral tax reforms: a proportional consumption tax, a proportional income tax, a progressive consumption tax, and a reform in which married individuals file taxes separately. Our findings indicate that tax reforms are accompanied by large and differential effects on labor supply: while hours per-worker display small increases, total hours and female labor force participation increase substantially. Married females account for more than 50% of the changes in hours associated to reforms, and their importance increases sharply for values of the intertemporal labor supply elasticity on the low side of empirical estimates. Tax reforms in a standard version of the model result in output gains that are up to 15% lower than in our benchmark economy.
Keyword: Taxation, Two-earner households, and Labor force participation Subject (JEL): E62 - Fiscal Policy, H31 - Fiscal Policies and Behavior of Economic Agents: Household, J22 - Time Allocation and Labor Supply, and J12 - Marriage; Marital Dissolution; Family Structure; Domestic Abuse
Creator: Atkeson, Andrew, Chari, V. V., and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 659 Abstract:
The Ramsey approach to policy analysis finds the best competitive equilibrium given a set of available instruments. This approach is silent about unique implementation, namely designing policies so that the associated competitive equilibrium is unique. This silence is particularly problematic in monetary policy environments where many ways of specifying policy lead to indeterminacy. We show that sophisticated policies which depend on the history of private actions and which can differ on and off the equilibrium path can uniquely implement any desired competitive equilibrium. A large literature has argued that monetary policy should adhere to the Taylor principle to eliminate indeterminacy. Our findings say that adherence to the Taylor principle on these grounds is unnecessary. Finally, we show that sophisticated policies are robust to imperfect information.
Subject (JEL): E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General, E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination, E50 - Monetary Policy, Central Banking, and the Supply of Money and Credit: General, E58 - Central Banks and Their Policies, and E52 - Monetary Policy
Creator: Luttmer, Erzo G. J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 657 Abstract:
Given a common technology for replicating blueprints, high-quality blueprints will be replicated more quickly than low-quality blueprints. If quality begets quality, and firms are identified with collections of blueprints derived from the same initial blueprint, then, along a balanced growth path, Gibrat’s Law holds for every type of firm. A firm size distribution with the thick right tail observed in the data can then arise only when the number of blueprints in the economy grows over time, or else firms cannot grow at a positive rate on average. But when calibrated to match the observed firm entry rate and the right tail of the size distribution, this model implies that the median age among firms with more than 10,000 employees is about 750 years. The problem is Gibrat’s Law. If the relative quality of a firm’s blueprints depreciates as the firm ages, then the firm’s growth rate slows down over time. By allowing for rapid and noisy initial growth, this version of the model can explain high observed entry rates, a thick-tailed size distribution, and the relatively young age of large U.S. corporations.
Keyword: Gibrat's Law, Firm age and size distribution, and Capital accumulation Subject (JEL): L11 - Production, Pricing, and Market Structure; Size Distribution of Firms and O40 - Economic Growth and Aggregate Productivity: General
Creator: Kehoe, Patrick J. and Midrigan, Virgiliu Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 656 Abstract:
The classic explanation for the persistence and volatility of real exchange rates is that they are the result of nominal shocks in an economy with sticky goods prices. A key implication of this explanation is that if goods have differing degrees of price stickiness then relatively more sticky goods tend to have relatively more persistent and volatile good-level real exchange rates. Using panel data, we find only modest support for these key implications. The predictions of the theory for persistence have some modest support: in the data, the stickier is the price of a good the more persistent is its real exchange rate, but the theory predicts much more variation in persistence than is in the data. The predictions of the theory for volatility fare less well: in the data, the stickier is the price of a good the smaller is its conditional variance while in the theory the opposite holds. We show that allowing for pricing complementarities leads to a modest improvement in the theory’s predictions for persistence but little improvement in the theory’s predictions for conditional variances.
Subject (JEL): F00 - International Economics: General and F40 - Macroeconomic Aspects of International Trade and Finance: General
Creator: Chari, V. V. and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 654 Abstract:
Here we reply to Robert Solow’s comment on our work, Modern Macroeconomics in Practice: How Theory is Shaping Policy.
Creator: Liu, Zheng, Waggoner, Daniel F., and Zha, Tao Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 653 Abstract:
The possibility of regime shifts in monetary policy can have important effects on rational agents’ expectation formation and equilibrium dynamics. In a DSGE model where the monetary policy rule switches between a dovish regime that accommodates inflation and a hawkish regime that stabilizes inflation, the expectation effect is asymmetric across regimes. Such an asymmetric effect makes it difficult, but still possible, to generate substantial reductions in the volatilities of inflation and output as the monetary policy switches from the dovish regime to the hawkish regime.
Keyword: Structural breaks, Monetary policy regime, Expectations formation, Lucas critique, and Macroeconomic volatility Subject (JEL): E32 - Business Fluctuations; Cycles, E42 - Monetary Systems; Standards; Regimes; Government and the Monetary System; Payment Systems, and E52 - Monetary Policy
Creator: Kehoe, Patrick J. and Midrigan, Virgiliu Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 652 Abstract:
In the data, a sizable fraction of price changes are temporary price reductions referred to as sales. Existing models include no role for sales. Hence, when confronted with data in which a large fraction of price changes are sales related, the models must either exclude sales from the data or leave them in and implicitly treat sales like any other price change. When sales are included, prices change frequently and standard sticky price models with this high frequency of price changes predict small effects from money shocks. If sales are excluded, prices change much less frequently and a standard sticky price model with this low frequency of price changes predict much larger effects of money shocks. This paper adds a motive for sales in a parsimonious extension of existing sticky price models. We show that the model can account for most of the patterns of sales in the data. Using our model as the data generating process, we evaluate the existing approaches and find that neither well approximates the real effects of money in our economy in which sales are explicitly modeled.
Creator: McGrattan, Ellen R. and Prescott, Edward C. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 651 Abstract:
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.
Keyword: Foreign direct investment and Openness Subject (JEL): F23 - Multinational Firms; International Business, F43 - Economic Growth of Open Economies, and O11 - Macroeconomic Analyses of Economic Development
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: Birkeland, Kathryn and Prescott, Edward C. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 648 Abstract:
People are having longer retirement periods, and population growth is slowing and has even stopped in some countries. In this paper we determined the implications of these changes for the needed amount of government debt. The needed debt is near zero if there are high tax rates and the transfer share of gross national income (GNI) is high. But, with such a system there are huge dead-weight losses as the result of the high tax rate on labor income. With a savings system, a large government debt to annual GNI ratio is needed, as large as 5 times GNI, and welfare is as much as 24 percent higher in terms of lifetime consumption equivalents than the tax-and-transfer system.
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: Chari, V. V., Kehoe, Patrick J., and McGrattan, Ellen R. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 647 Abstract:
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.
Creator: McGrattan, Ellen R. and Prescott, Edward C. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 646 Abstract:
Over the period 1982–2006, the U.S. Bureau of Economic Analysis (BEA) estimates the return on investments of foreign subsidiaries of U.S. multinational companies averaged 9.4 percent per year after taxes while U.S. subsidiaries of foreign multinationals earned on average only 3.2 percent. We estimate the importance of two factors that distort BEA returns: technology capital and plant-specific intangible capital. Technology capital is accumulated know-how from intangible investments in R&D, brands, and organizations that can be used in foreign and domestic locations. Technology capital used abroad generates profits for foreign subsidiaries with no foreign direct investment. Plant-specific intangible capital in foreign subsidiaries is expensed abroad, lowering current profits on foreign direct investment (FDI) and increasing future profits. We develop a multicountry general equilibrium model with an essential role for FDI and apply the same methodology as the BEA to construct economic statistics for the model economy. We estimate that mismeasurement of intangible investments accounts for over 60 percent of the difference in BEA returns.
Subject (JEL): F32 - Current Account Adjustment; Short-term Capital Movements and F23 - Multinational Firms; International Business
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: Zhang, Yuzhe Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 640 Abstract:
In this paper I develop continuous-time methods for solving dynamic principal-agent problems in which the agent’s privately observed productivity shocks are persistent over time. I characterize the optimal contract as the solution to a system of ordinary differential equations, and show that, under this contract, the agent’s utility converges to its lower bound—immiseration occurs. I also show that, unlike in environments with i.i.d. shocks, the principal would like to renegotiate with the agent when the agent’s productivity is low—it is not renegotiation-proof. I apply the theoretical methods I have developed and numerically solve this (Mirrleesian) dynamic taxation model. I find that it is optimal to allow a wedge between the marginal rate of transformation and individuals’ marginal rate of substitution between consumption and leisure. This wedge is significantly higher than what is found in the i.i.d. case. Thus, using the i.i.d. assumption is not a good approximation quantitatively when there is persistence in productivity shocks.
Keyword: Principal-agent problem, Persistence, Efficiency lines, and Stochastic control problem Subject (JEL): E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination, D80 - Information, Knowledge, and Uncertainty: General, and D82 - Asymmetric and Private Information; Mechanism Design
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