Research Database

Many would say that children are society’s most precious resource. So, how should it invest in them? To gain insight into this question, a dynamic general equilibrium model is developed where children differ by ability. Parents invest time and money in their offspring, depending on their altruism. This allows their children to grow up as more productive adults. First, the efficient allocation for the framework is characterized. Next, this is compared with the case of incomplete financial markets. Then, the situation where childcare markets are also lacking is examined. Additionally, the effects of impure altruism are analyzed.

We seem to observe different patterns of exchange at different times and in different places. The first goal of this paper is to develop a model of money as a medium of exchange which allows multiple transaction patterns. A dynamic version of Shubik’s trading post economy is used, and it is shown that this economy allows a role for fiat money, and that fiat money can coexist with barter in exchange. There are multiple decentralized equilibria, and one of these resembles the equilibrium of a cash-in-advance economy—indeed, the model can be viewed as a generalization of the cash-in-advance framework. The second goal of the paper is to show that the present model can help explain why inflation seems far more disruptive and costly than what is implied by empirical studies on the cash-in-advance model. The argument for this is based on misestimations due to the unobservability of the patterns of exchange, which are variable in this model.

This paper provides intertemporal general-equilibrium investigation of the welfare and employment consequences of Europe’s move to a unified market, using a multicountry, multisector applied model with imperfect competition, increasing returns-to-scale, and product differentiation at the firm level. The oligopolistic game between firms is assumed to be Nash in output. In the short-term, market imperfections (such as oligopolistic profits and wage rigidities) may exist. These imperfections vanish in the long run, characterized by stock-flow equilibrium consistent with steady-state growth. “Europe 1992” is interpreted as the elimination of the possibility for oligopolistic firms to price-discriminate between client countries within the European Community. Investigations are performed under alternative wage determination mechanisms (flexible wages v.s. wage indexation). We show, among other things, that the gains remain modest when dynamic effects are taken into account, and that all member countries are not sure to gain from European integration in the long run.

This article is a progress report on research that attempts to include one type of market incompleteness and frictions in macroeconomic models. The focus of the research is the absence of insurance markets in which individual-specific risks may be insured against. The article describes some areas where this type of research has been and promises to be particularly useful, including consumption and saving, wealth distribution, asset markets, business cycles, and fiscal policies. The article also describes work in each of these areas that was presented at a conference sponsored by the Federal Reserve Bank of Minneapolis in the fall of 1993.

This paper analyzes the U.S. congressional proposal to instruct the Federal Reserve to, in the next five years, lower inflation to zero from its current rate of around 5 percent. The paper concludes that, when other policy options are considered, the zero inflation policy is not advisable. Its benefits would be very small—possibly negative—while its costs would probably be significant. Other, more direct policy options could produce most of the same benefits with fewer costs. Among these alternative policies are deregulating interest rates on demand deposits, paying interest on financial institution reserves, lowering the federal tax rate on capital income, and indexing the federal tax code to inflation.

This paper studies the outcome of fully insured random selections among multiple competitive equilibria. This defines an iterative procedure of reallocation which is Pareto improving at each step. The process converges to a unique Pareto optimal allocation in finitely many steps. The key requirement is that random selections be continuous, which is a generic condition for smooth exchange economies with strictly concave utility functions.

The current tool of choice for analyzing the impact of a potential North American Free Trade Agreement on the economies of Canada, Mexico, and the United States is the static applied general equilibrium model. Although this type of model can do a good job in analyzing, and even in predicting, the impact of trade liberalization or tax reform on relative prices and resource allocation over a short time horizon, it does not attempt to capture the impact of government policy on growth rates. For this we need a dynamic model. This paper outlines some of the issues that confront a researcher interested in building a dynamic general equilibrium model to assess the potential economic impact of a NAFTA, including the impact on growth rates. Simple calculations based on preliminary empirical work indicate that the dynamic benefits of increased openness could dwarf the static benefits found by more conventional applied general equilibrium models.

This paper shows that there can be equilibria in which exchange rates display randomness unrelated to fundamentals. This is demonstrated in the context of a two currency, one good model, with three agent types and cash-in-advance constraints. A crucial feature is that the type i agents, for i=l, 2, must satisfy a cash-in-advance constraint by holding currency i, while type 3 agents can satisfy it by holding either currency. It is shown that real allocations vary across the multiple equilibria if markets for hedging exchange risk do not exist and that the randomness is innocuous if complete markets exist.

In this paper, I characterize equilibria for a sticky-price model in which Federal Reserve policy is an interest-rate rule similar to that described in Taylor (1993). For standard preferences and technologies used in the literature, the model predicts that the nominal interest rate is negatively serially correlated, and that shocks to interest rates imply a potentially large but short-lived response in output. Shocks to government spending and technology lead to persistent changes in output but the percentage change in output is predicted to be smaller than the percentage changes in spending or technology. I compare the model’s predictions to data using innovations backed out from estimated processes for interest rates, government spending, and technology shocks. These comparisons confirm the theoretical findings. In response to observed changes in government spending and technology, the model predicts a path for output that is much smoother than the data and much smoother than that predicted by non-sticky price models.

This paper uses a simple general equilibrium model in which agents use money holdings to self insure to address the classic question: What is the optimal rate of change of the money supply? The standard answer to this question, provided by Friedman, Bewley, Townsend, and others, is that this rate is negative. Because any revenues from seigniorage in our model are redistributed in lump-sum form to agents and this redistribution improves insurance possibilities, we find that the optimal rate is sometimes positive. We also discuss the measurement of welfare gains or losses from inflation and their quantitative significance.

The effects on ex ante optima of a lag in seeing monetary realizations are studied using a matching model of money. The main new ingredient in the model is meetings in which producers have more information than consumers. A consequence is that increases in the amount of money that occur with small enough probability can have negative impact effects on output, because it is optimal to shut down trade in such low probability meetings rather than have lower output when high probability realizations occur. The information lag also produces prices that do not respond much to current monetary realizations.

We ask whether a two-country real business cycle model can account simultaneously for domestic and international aspects of business cycles. With this question in mind, we document a number of discrepancies between theory and data. The most striking discrepancy concerns the correlations of consumption and output across countries. In the data, outputs are generally more highly correlated across countries than consumptions. In the model we see the opposite.

Two policies toward payments-system risk are common, but superficially appear to be contradictory. One policy is to restrict the exposure to risk generated by one participant to other participants who are, by one measure or another, directly concerned with the risky participant. The other policy is to provide a “safety net,” typically provided by government and funded by taxes collected from all participants and even from non-participants, to share losses due to “systemic risk.” In this paper, we provide a model in which both of these policies can be constituents of an economically efficient regime of payments-risk management.

We consider the nature of optimal cyclical monetary policy in three different stochastic models with various shocks. The first is a pure liquidity effect model, the second is a cost of changing prices model, and the third is an optimal seinorage model. In each case we solve for the optimal monetary policy and describe how money growth and interest rates respond to shocks under the optimal policy. The shocks we consider are money demand shocks, productivity shocks, and government consumption shocks. All of the models have the feature that the Friedman rule of setting the nominal interest rate to zero is not optimal. Optimal policies are always time inconsistent even though lump sum taxation is allowed. At least in some instances we find that optimal policy dictates responses of money growth and interest rates which run counter to conventional wisdom.

In aggregate unadjusted data, measured Solow residuals exhibit large seasonal variations. Total Factor Productivity grows rapidly in the fourth quarter at an annual rate of 16 percent and regresses sharply in the first quarter at an annual rate of –24 percent. This paper considers two potential explanations for the measured seasonal variation in the Solow residual: labor hoarding and increasing returns to scale. Using a specification that allows for no exogenous seasonal variation in technology and a single seasonal demand shift in the fourth quarter, we ask the following question: How much of the total seasonal variation in the measured Solow residual can be explained by Christmas? The answer to this question is surprising. With increasing returns and time varying labor effort, Christmas is sufficient to explain the seasonal variation in the Solow residual, consumption, average productivity, and output in all four quarters. Our analysis of seasonally unadjusted data uncovers important roles for labor hoarding and increasing returns which are difficult to identify in adjusted data.

We develop a model which accounts for the observed equity premium and average risk-free rate, without implying counterfactually high risk aversion. The model also does well in accounting for business-cycle phenomena. With respect to the conventional measures of business-cycle volatility and comovement with output, the model does roughly as well as the standard business-cycle model. On two other dimensions, the model’s business-cycle implications are actually improved. Its enhanced internal propagation allows it to account for the fact that there is positive persistence in output growth, and the model also provides a resolution to the “excess sensitivity puzzle” for consumption and income. Two key features of the model are habit persistence preferences and a multisector technology with limited intersectoral mobility of factors of production.

Bimetallism has been the subject of considerable debate: Was it a viable monetary system? Was it a desirable system? In our model, the (exogenous and stochastic) amount of each metal can be split between monetary uses to satisfy a cash-in-advance constraint, and nonmonetary uses in which the stock of uncoined metal yields utility. The ratio of the monies in the cash-in-advance constraint is endogenous. Bimetallism is feasible: we find a continuum of steady states (in the certainty case) indexed by the constant exchange rate of the monies; we also prove existence for a range of fixed exchange rates in the stochastic version. Bimetallism does not appear desirable on a welfare basis: among steady states, we prove that welfare under monometallism is higher than under any bimetallic equilibrium. We compute welfare and the variance of the price level under a variety of regimes (bimetallism, monometallism with and without trade money) and find that bimetallism can significantly stabilize the price level, depending on the covariance between the shocks to the supplies of metals.

The paper considers a model in which private foreign investors make direct long-lived capital investments in a small developing country that is subject to stochastic shocks to production. Depending upon the preferences of the host country, we find that expropriation can occur because of either desperation or opportunism. We show that under reasonable assumptions, increased investment makes expropriation less likely to occur and that the level of investment chosen by atomistic foreign investors may be nonoptimal.

This paper develops a two-country model in which trade is central to the process by which technology diffuses from the innovating country (North) to the backward country (South). Innovation in North leads to the introduction of higher-quality equipment goods that South can import only after some resources have been spent to adapt those equipment goods to the local conditions of South. Barriers to trade and policies that increase the cost of adapting equipment goods to the local environment decrease the rate of technology adoption, leading to a lower steady state relative income level in South. The model is calibrated to quantify this negative impact of barriers to trade and technology adoption on relative income levels and explore some additional implications of the model.

The implications of adding household production to an otherwise standard real business cycle model are explored in this article. The model developed treats the business and household sectors symmetrically. In particular, both sectors use capital and labor to produce output. The article finds that the household production model can outperform the standard model in accounting for several aspects of U.S. business cycle fluctuations.

In this paper we estimate and test a conditional version of the international CAPM. By using a parsimonious parameterization recently proposed by Ding and Engle (1994), we allow risk premia, betas, and correlations to vary through time and test the cross-section restrictions of the model using a relatively large number of assets. One advantage of our test is is that it does not require the market weights to be observed in each period. In support of the international CAPM, we find that world-wide risk is priced whereas country-specific risk is not. Further, we find that the price of world risk is time-varying and has a strong January seasonal. When the price of risk is allowed to vary, a January dummy and the world dividend yield are driven out as independently priced factors. However, contrary to the prediction of the model, differences in risk premia across countries are explained not only by world-wide risk, but also by a constant country-specific factor. The estimated correlations reveal three main facts, cross-country correlations vary through time; they have been affected only to a limited extent by the process of liberalization of the last decade; they tend to increase during severe bear markets in the U.S. However, international correlations are smaller than correlations among U.S. assets. Therefore, investors gain from global diversification, even with contagious bear markets.

We study a random-matching, absence-of-double-coincidence environment in which people cannot precommit and in which there are two imperfect ways of keeping track of what other people have done in the past: money and a public record of all past actions that is updated with an average lag. We study how the magnitude of that lag affects the allocations that are optimal from among allocations that are stationary and feasible and that satisfy incentive constraints which arise from the absence of commitment and the imperfect ways of keeping track of what others have done in the past.

It is often argued that with a positively skewed income distribution (median less than mean) a majority voting over proportional tax rates would result in higher tax rates than those that maximize average welfare, and will accordingly reduce aggregate savings. We reexamine this view in a capital accumulation model, in which distorting redistributive taxes provide insurance against idiosyncratic shocks, and income distributions evolve endogenously. We find small differences of either sign between the tax rates set by a majority voting and a utilitarian government, for reasonable parametric specifications. We show how these differences reflect a greater responsiveness of a utilitarian government to the average need for the insurance provided by the tax-redistribution scheme. These conclusions remain true despite the fact that the model simulations produce positively skewed distributions of total income across agents.

Economic development is typically accompanied by a very pronounced migration of labor from rural to urban employment. This migration, in turn, is often associated with large scale urban underemployment. Both factors appear to play a very prominent role in the process of development. We consider a model in which rural-urban migration and urban underemployment are integrated into an otherwise conventional neoclassical growth model. Unemployment arises not from any exogenous rigidities, but from an adverse selection problem in labor markets. We demonstrate that, in the most natural case, rural-urban migration—and its associated underemployment—can be a source of multiple, asymptotically stable steady state equilibria, and hence of development traps. They also easily give rise to an indeterminacy of perfect foresight equilibrium, as well as to the existence of a large set of periodic equilibria displaying undamped oscillation. Many such equilibria display long periods of uninterrupted growth and rural-urban migration, punctuated by brief but severe recessions associated with net migration from urban to rural employment. Such equilibria are argued to be broadly consistent with historical U.S. experience.

In empirical studies of the CAPM, it is commonly assumed that (a) the return to the value weighted portfolio of all stocks is a reasonable proxy for the return on the market portfolio of all assets in the economy, and (b) betas of assets remain constant over time. Under these assumptions, Fama and French (1992) find that the relation between average return and beta is flat. We argue that these two auxiliary assumptions are not reasonable. We demonstrate that when these assumptions are relaxed, the empirical support for the CAPM is surprisingly strong. When human capital is also included in measuring wealth, the CAPM is able to explain 28 percent of the cross sectional variation in average returns in the 100 portfolios studied by Fama and French. When, in addition, betas are allowed to vary over the business cycle, the CAPM is able to explain 57 percent. More important, relative size does not explain what is left unexplained after taking sampling errors into account.

We study the general equilibrium effects of social insurance on the transition in a model in which the process of moving workers from matches in the state sector to new matches in the private sector takes time and involves uncertainty. As to be expected, adding social insurance to an economy without any improves welfare. Contrary to standard intuition, however, adding social insurance may slow transition. We show that this result depends crucially on general equilibrium interactions of interest rates and savings under alternative market structures.

This paper examines the seasonal pattern of accruals for loan-loss provisions and chargeoffs chosen by bank managers. Using the existing literature on intra-year discretionary accruals, knowledge of the incentive systems used to evaluate bank managers' performance, and various regulatory characteristics, we predict that accruals for provisions and chargeoffs will cluster in the fourth quarter of each year. We examine quarterly data for 105 large bank holding companies from the first quarter of 1980 through the fourth quarter of 1990. Our results indicate that: (1) provisions and chargeoffs are clustered in the fourth quarter, (2) this clustering is not related to the level of business activity of the banks, (3) the proximity of a bank's actual capital to its regulatory capital requirement does not affect this clustering, and (4) current provisions are affected both by current chargeoffs and by expectations about future chargeoffs. To examine whether the systematic characteristics of these loan-loss provision and chargeoff decisions are understood by users, we also estimate a quarterly equity valuation model in which quarterly provisions should be differentially weighted to reflect their seasonal characteristics. We find strong evidence to indicate that equity prices behave as if the market participants take these seasonal properties into account.

A random matching model with money is used to study the nominal yield on small denomination, bearer, safe, discount securities issued by the government. There is always one steady state with matured securities circulating at par and, for some parameters, another with them circulating at a discount. In the former, a necessary and sufficient condition for a positive nominal yield on not-yet-matured securities is exogenous discriminatory treatment of them by the government. In the latter, the post-maturity discount on securities induces a deeper pre-maturity discount even without such discriminatory treatment.

Economic equilibria are usually solutions to fixed point problems rather than solutions to convex optimization problems. This leads to two difficulties that are closely related: First, equilibria may be difficult to compute. Second, a model economy may have more than one equilibrium. This paper explores these issues for a number of stylized economies, including static economies that involve both pure exchange and production, economies that have infinite numbers of goods because of time and uncertainty, and economies with distortionary taxes and externalities. There are numerous numerical examples that illustrate the theory and could serve as test problems for algorithms.

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.

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.

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.

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.

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.

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).

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 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.

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.

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.

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.

We describe a model for calculating the optimal quantity of debt and then apply it to the U.S. economy. The model consists of a large number of infinitely-lived households whose saving behavior is influenced by precautionary saving motives and borrowing constraints. This model incorporates a different role for government debt than the standard representative agent growth model and captures different trade-offs between the benefits and costs of varying its level. Government debt enhances the liquidity of households by providing additional assets for smoothing consumption (in addition to claims to capital) and effectively loosening borrowing constraints. By raising the interest rate, government debt makes assets less costly to hold and more effective in smoothing consumption. However, the implied taxes have wealth distribution, incentive, and insurance effects. Further, government debt crowds out capital (via higher interest rates) and lowers per capita consumption. Our quantitative analysis suggests that the crowding out effect is decisive for welfare. We also describe variations of the model which permit endogenous growth. It turns out that even with lump sum taxes and inelastic labor, government debt as well as government consumption have growth rate effects, thereby implying large welfare gains from reducing the level of debt.

We examine an otherwise standard model of capital accumulation to which spatial separation and limited communication create a role for money and shocks to portfolio needs create a role for banks. In this context we examine the existence, multiplicity, and dynamical properties of monetary equilibria with positive nominal interest rates. Moderate levels of risk aversion can lead to the existence of multiple monetary steady states, all of which can be approached from a given set of initial conditions. In addition, even if there is a unique monetary steady state, monetary equilibria can be indeterminate, and oscillatory equilibrium paths can be observed. Thus financial market frictions are a potential source of both indeterminacies and endogenously arising economic volatility.

We also consider the consequences of monetary policy actions that rearrange the composition of government liabilities. Contractionary monetary policy activities can have complicated consequences, depending especially on the nature of the steady state equilibrium that obtains when there are multiple steady states. Under plausible conditions, however, a permanent contractionary change in monetary policy raises both the nominal rate of interest and the rate of inflation, and reduces long-run output levels. Thus liquidity provision by a central bank—just as by the banking system as a whole—can be growth promoting. Loose monetary policy also is conducive to avoiding development trap phenomena.

This article asks whether or not the overall welfare of U.S. residents would be greater if U.S. federal law prohibited state governments from offering tax breaks to particular businesses. The answer of a formal model is yes, making such tax breaks illegal could increase a summary measure of total welfare in the economy. According to the model, the policy could increase welfare because it would increase the tax revenue collected from capital agents, and that revenue could finance an increase in spending on public goods. The policy would also spread the tax burden more evenly in the economy and so reduce the deadweight loss of taxation per dollar collected. In addition, the policy would lead to a more efficient pattern of industry locations in the economy.

We show how to use security market data to restrict the admissible region for means and standard deviations of intertemporal marginal rates of substitution (IMRS’s) of consumers. Our approach is (i) nonparametric and applies to a rich class of models of dynamic economies; (ii) characterizes the duality between the mean-standard deviation frontier for IMRS’s and the familiar mean-standard deviation frontier for asset returns; and (iii) exploits the restriction that IMRS’s are positive random variables. The region provides a convenient summary of the sense in which asset market data are anomalous from the vantage point of intertemporal asset pricing theory.

The welfare effects of alternative monetary arrangements are computed for an economy calibrated to U.S. data. In the model world, people vary their holdings of liquid assets in order to smooth their consumption. In such worlds, we find that the feature of an arrangement that matters is the equilibrium after-tax real return on savings. We also find that relative to a tax on labor income, seigniorage is a poor source of revenue.

We study transition in a model in which the process of moving workers from matches in the state sector to new matches in the private sector takes time and involves uncertainty. When there are incentive problems in this rematching process, the optimal scheme may involve forced layoffs, involuntary unemployment, and a recession.

This paper surveys recently developed methods for Bayesian inference and their use in economic time series models. It begins by reviewing aspects of Bayesian inference essential to understanding the implications of the Bayesian paradigm for time series analysis. It next describes the use of posterior simulators to solve otherwise intractable analytical problems. The theory and the computational advances are brought together in setting forth a practical framework for decision-making and forecasting. These developments are illustrated in the context of the vector autoregressions, stochastic volatility models, and models of changing regimes.

We consider the problem of an insurer who enters into a repeated relationship with a set of risk averse agents in the presence of ex post verification costs. The insurer wishes to minimize the expected cost of providing these agents a certain expected utility level. We characterize the optimal contract between the insurer and the insured agents. We then apply the analysis to the provision of deposit insurance. Our results suggest—in a deposit insurance context—that it may be optimal to utilize the discount window early on, and to make deposit insurance payments only later, or not at all.

We don’t really know why the U.S. banking industry is consolidating rapidly, as it has been doing for the last decade or so. After a large number of studies on the topic including this one, what seems clear is that consolidation is not producing significant efficiencies — at least not on average. Other dimensions of the consolidation trend — such as its heavy concentration in large banks — are just as poorly understood. Given this ignorance as to the “why” of consolidation, it is extremely risky to predict its future effects. Based on past experience and data, at least, we can conclude the following.

Earlier researchers have found either no relation or a positive relation between the conditional expected return and the conditional variance of the monthly excess return on stocks when they used the standard GARCH-M model. This is in contrast to the negative relation found when other approaches were used to model conditional variance. We show that the difference in the estimated relation arises because the standard GARCH-M model is misspecified. When the standard model is modified allow for (i) the presence for seasonal patterns in volatility, (ii) positive and negative innovations to returns to having different impacts on conditional volatility, and (iii) nominal interest rates to affect conditional variance, we once again find support for a negative relation. Using the modified GARCH-M model, we also show that there is little evidence to support the traditional view that conditional volatility is highly persistent. Also, positive unanticipated returns result in a downward revision of the conditional volatility whereas negative unanticipated returns result in an upward revision of conditional volatility of a similar magnitude. Hence the time series properties of the monthly excess return on stocks appear to be substantially different from that of the daily excess return on stocks.

I consider two theories of the determination of political institutions. One of these theories stresses effects of changes in the balance of military power between the ruler and subjects on the distribution of property rights which the political system enforces. The other theory emphasizes the effect of changing informational constraints which require institutional changes to be made in order to maintain efficiency. I examine how each of these theories would apply to explaining the development of parliamentary government in thirteenth-century England. My general conclusion is that both theories are required to understand fully the process by which liberal political institutions emerge.

The reduced rank regression model arises repeatedly in theoretical and applied econometrics. To date the only general treatment of this model have been frequentist. This paper develops general methods for Bayesian inference with noninformative reference priors in this model, based on a Markov chain sampling algorithm, and procedures for obtaining predictive odds ratios for regression models with different ranks. These methods are used to obtain evidence on the number of factors in a capital asset pricing model.

This paper provides a general and efficient method for computing density ratio class bounds on posterior moments, given the output of a posterior simulator. It shows how density ratio class bounds for posterior odds ratios may be formed in many situations, also on the basis of posterior simulator output. The computational method is used to provide density ratio class bounds in two econometric models. It is found that the exact bounds are approximated poorly by their asymptotic approximation, when the posterior distribution of the function of interest is skewed. It is also found that posterior odds ratios display substantial variation within the density ratio class, in ways that cannot be anticipated by the asymptotic approximation.

The money demand literature presents much conflicting evidence on this question. For example, Lucas (1988) reports unrestricted money demand regressions which seem to imply that long-run money demand elasticities are highly unstable across subsamples. At the same time, he also presents evidence from money demand regressions with the income elasticity restricted to unity which seem to suggest stability. We conduct a formal analysis which weighs these apparently conflicting facts to determine which hypothesis is more plausible; the hypothesis that money demand is stable, or the hypothesis that money demand is unstable. We find that the stability hypothesis is the more plausible one. Thus, according to our data set, the answer to the question in the title is "yes".

We consider a two country growth model with international capital markets. These markets fund capital investment in both countries, and operate subject to a costly state verification (CSV) problem. Investors in each country require some external finance, but also provide internal finance, which mitigates the CSV problem. When two identical (except for their initial capital stocks) economies are closed, they necessarily converge monotonically to the same steady state output level. Unrestricted international financial trade precludes otherwise identical economies from converging, and poor countries are necessarily net lenders to rich countries. Oscillation in real activity and international capital flows can occur.

The best-known example of a privately created and well-functioning interbank payments system is the Suffolk Banking System. Operating in New England between 1825 and 1858, it was the first regionwide net-clearing system for bank notes in the United States. Some historians portray the System as being owned and managed by a coalition of large Boston banks in order to achieve a public purpose. They argue that while the System was not particularly profitable, it maintained par circulation of bank notes throughout the region. We reconsider this history and find the public-purpose view of the Suffolk Banking System to be specious. The System was owned and operated solely by the Suffolk Bank. It was operated not to promote a common currency or any other public purpose, but to serve the private interests of the Suffolk Bank’s shareholders, which it did quite successfully.

This paper develops a model of vintage human capital in which each technology requires vintage specific skills. We examine the properties of a stationary equilibrium for our economy. The stationary equilibrium is characterized by an endogenous distribution of skilled workers across vintages. The distribution is shown to be single peaked and, under general conditions, there is a lag between the time when a technology appears and the peak of it's usage, a phenomenon known as diffusion. An increase in the rate of exogenous technological change shifts the distribution of human capital to more recent vintages thereby increasing the diffusion rate.

This paper reexamines the conventional wisdom that commercial banking is an industry in severe decline. We find that a careful reading of the evidence does not justify this conclusion. It is true that on-balance sheet assets held by commercial banks have declined as a share of total intermediary assets. But this measure overstates any drop in banking, for three reasons. First, it ignores the rapid growth in commercial banks' off-balance sheet activities. Second, it fails to take account of the substantial growth in off-shore C&I lending by foreign banks. Third, it ignores the fact that over the last several decades financial intermediation has grown rapidly relative to the rest of the economy. We find that after adjusting the measure of bank assets to account for these considerations there is no clear evidence of secular decline. To corroborate these findings, we also construct an alternative measure of the importance of banking, using data from the National Income Accounts. Again, we find no clear evidence of a sustained declined. At most the industry may have suffered a slight loss of market share over the last decade. But as we discuss, this loss may reflect a transitory response to a series of adverse shocks and the phasing in of new regulatory requirements, rather than the beginning of a permanent decline.

This paper integrates and extends some recent computational advances in Bayesian inference with the objective of more fully realizing the Bayesian promise of coherent inference and model comparison in economics. It combines Markov chain Monte Carlo and independence Monte Carlo with importance sampling to provide an efficient and generic method for updating posterior distributions. It exploits the multiplicative decomposition of marginalized likelihood into predictive factors, to compute posterior odds ratios efficiently and with minimal further investment in software. It argues for the use of predictive odds ratios in model comparison in economics. Finally, it suggests procedures for public reporting that will enable remote clients to conveniently modify priors, form posterior expectations of their own functions of interest, and update the posterior distribution with new observations. A series of examples explores the practicality and efficiency of these methods.

Before the establishment of federal deposit insurance, the U.S. experienced periodic banking panics, during which banks suspended specie payments and reduced lending. There was often a corresponding economic slowdown. The Panic of 1837 is considered one of the worst banking panics, and it coincided with a slowdown that lasted for almost five years. The economic disruption was not uniform across the country, however. The slowdown in New England was substantially less severe than elsewhere. Here we suggest that the Suffolk Bank, a private bank, was one reason for New England’s relative success. We argue that the Suffolk Bank’s provision of note-clearing and lender of last resort services (via the Suffolk Banking System) lessened the effects of the Panic of 1837 in New England relative to the rest of the country, where no bank provided such services.

The classical and early neoclassical economists knew that the essential function of money was its role as a medium of exchange. Recently, this idea has been formalized using search-theoretic noncooperative equilibrium models of the exchange process. The goal of this paper is to use a simple model of this class to analyze four substantive issues in monetary economics: the interaction between specialization and exchange, dual fiat currency regimes, the welfare improving role of money, and the susceptibility of monetary economies to extrinsic uncertainty.

The distinguishing feature of natural-catastrophe risk is claimed to be aggregate risk. Because such risk is encompassed in the general competitive model, it seems to pose no new theoretical challenge. However, that model has markets contingent on exogenous events, while the actual economy seems to be developing mainly markets contingent on the level of total damage. In the context of a model with aggregate risk and endogenous total damage, a notion of competitive markets contingent on total damage is formulated. That notion implies that such markets achieve the same (efficient) risk sharing as markets contingent on exogenous events.

A paradigm is presented where both the extent of financial intermediation and the rate of economic growth are endogenously determined. Financial intermediation promotes growth because it allows a higher rate of return to be earned on capital, and growth in turn provides the means to implement costly financial structures. Thus, financial intermediation and economic growth are inextricably linked in accord with the Goldsmith-McKinnon-Shaw view on economic development. The model also generates a development cycle reminiscent of the Kuznets hypothesis. In particular, in the transition from a primitive slow-growing economy to a developed fast-growing one, a nation passes through a stage where the distribution of wealth across the rich and poor widens.

This paper establishes the stylized fact that medieval debasements were accompanied by unusually large minting volumes and revenues. This fact is a puzzle under the commonly held view that metallic coins are commodity money and exchange by weight. An existing explanation is that debased coins were used to reduce the real burden of nominally denominated debts. This explanation is logically flawed: nothing prevents agents from renegotiating contracts and avoid incurring minting costs. The paper also establishes other facts about monetary mutations, which altogether pose a challenge to monetary economics.

Constant returns to scale is a central construct of neoclassical theory. Previous studies argued that one must adopt a specification of the production function with substantial unobserved service variation to reconcile constant returns with the data. Some economists have argued that this finding has not resolved the size of returns to scale, since factor service variation is unobserved, and there is no generally accepted theory to guide specification of this alternative framework. In this paper we show that the stochastic version of the neoclassical growth model delivers an orthogonality condition which can be used to estimate returns to scale. Rather than the standard finding of increasing returns, we show that standard theory and conventional measures of output and inputs yield estimates of constant returns to scale at the aggregate level. Our estimates also suggest that factor service variation is not an important determinant of output fluctuations.

We investigate ex-ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults, even in states in which the borrower is fully able to repay. We then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if the implementation costs are actually nontrivial (as seems likely), standard debt contracts will be (very close to) optimal.

We find that precautionary saving accounts for only a modest (less than 3 percentage point) increase in the aggregate saving rate, at least for moderate and empirically plausible parameter values. This finding is based on a quantitative analysis of a reasonably parameterized version of the standard growth model modified to include a large number of agents who receive uninsured idiosyncratic labor endowment shocks. In contrast to representative agent models, asset trading is quite important to individuals. The model can also account qualitatively for the positive skewness of wealth and income distributions, and significantly greater wealth inequality compared to income inequality.

This paper provides structural estimates of a dynamic model of schooling, work, and occupational choice decisions based on 11 years of observations on a sample of young men from the 1979 youth cohort of the National Longitudinal Surveys of Labor Market Experience (NLSY). The structural estimation framework that we adopt fully imposes the restrictions of the theory and permits an investigation of whether such a theoretically restricted model can succeed in quantitatively fitting the observed data patterns. We find that a suitably extended human capital investment model can in fact do an excellent job of fitting observed data on school attendance, work, occupational choices, and wages in the NLSY data on young men and also produces reasonable forecasts of future work decisions and wage patterns.

In U.S. elections, voters often vote for candidates from different parties for president and Congress. Voters also express dissatisfaction with the performance of Congress as a whole and satisfaction with their own representative. We develop a model of split-ticket voting in which government spending is financed by uniform taxes but the benefits from this spending are concentrated. While the model generates split-ticket voting, overall spending is too high only if the president’s powers are limited. Overall spending is too high in a parliamentary system, and our model can be used as the basis of an argument for term limits.

This paper is motivated by observations concerning the size of the banking sector and the growth rate of the economy before and after successful stabilizations of high inflations. The facts suggest that the relative size of the banking sector increases during a period of accelerating inflation and decreases immediately following a successful monetary stabilization. Furthermore, the GDP growth rate is lower during the high inflation period than after stabilization. The goal of this paper is to develop a monetary growth model which is qualitatively consistent with these observations. The model we use is a variant of the Lucas and Stokey (1987) model of cash and credit goods. The main innovation in our model is that while cash goods and credit goods are perfect substitutes in consumption we posit different technologies for their production. We show that the model’s predictions on the impact of a permanent stabilization are consistent with the main real and monetary observations on high inflation countries.