Research Database

In this paper, I revisit some recent work on the theory of the money supply, using a theoretical framework that closely follows Karl Brunner's work. I argue that had his research proposals been followed by the profession, some of the misunderstandings related to the instability of the money demand relationship could have been avoided.

How well do people share risk? Standard risk-sharing regressions assume that any variation in households’ risk preferences is uncorrelated with variation in the cyclicality of income. I combine administrative and survey data to show that this assumption is questionable: Risk-tolerant workers hold jobs where earnings carry more aggregate risk. The correlation makes risk-sharing regressions in the previous literature too pessimistic. I derive techniques that eliminate the bias, apply them to U.S. data, and find that the effect of idiosyncratic income shocks on consumption is practically small and statistically difficult to distinguish from zero.

A problem that faces many countries including the United States is how to finance retirement consumption as the population ages. Proposals for switching to a saving-for-retirement system that do not rely on high payroll taxes have been challenged on the grounds that welfare would fall for some groups such as retirees or the working poor. We show how to devise a transition path from the current U.S. system to a saving-for-retirement system that increases the welfare of all current and future generations, with estimates of future gains higher than those found in typically used macroeconomic models. The gains are large because there is more productive capital than commonly assumed. Our quantitative results depend importantly on accounting for differences between actual government tax revenues and what revenues would be if all income were taxed at the income-weighted average marginal tax rates used in our analysis.

We develop a new methodology to compute differences in the expected longevity of individuals who are in different socioeconomic groups at age 50. We deal with two main problems associated with the standard use of life expectancy: that people’s socioeconomic characteristics evolve over time and that there is a time trend that reduces mortality over time. Using HRS data for individuals from different cohorts, we estimate a hazard model for survival with time-varying stochastic endogenous covariates that yields the desired expected durations. We uncover an enormous amount of heterogeneity in expected longevities between individuals in different socioeconomic groups, albeit less than implied by a naive (static) use of socioeconomic characteristics. Our analysis allows us to decompose the longevity differentials into differences in health at age 50, differences in mortality conditional on health, and differences in the evolution of health with age. Remarkably, it is the latter that is the most important for most socioeconomic characteristics. For instance, education and wealth are health protecting but have little impact on two-year mortality rates conditional on health. Finally, we document an increasing time trend of all these differentials in the period 1992–2008, and a likely increase in the socioeconomic gradient in mortality rates in the near future. The mortality differences that we find have huge welfare implications that dwarf the differences in consumption accruing to people in different socioeconomic groups.

The length of time from the implementation of an occupational licensing statute (i.e., licensing duration) may matter in influencing labor market outcomes. Adding to or raising the entry barriers are likely easier once an occupation is established and has gained influence in a political jurisdiction. States often enact grandfather clauses and ratchet up requirements that protect existing workers and increase entry costs to new entrants. We analyze the labor market influence of the duration of occupational licensing statutes for 13 major universally licensed occupations over a 75-year period. These occupations comprise the vast majority of workers in these regulated occupations in the United States. We provide among the first estimates of potential economic rents to grandfathering. We find that duration years of occupational licensure are positively associated with wages for continuing and grandfathered workers. The estimates show a positive relationship of duration with hours worked, but we find moderately negative results for participation in the labor market. The universally licensed occupations, however, exhibit heterogeneity in outcomes. Consequently, unlike some other labor market public policies, such as minimum wages or direct unemployment insurance benefits, occupational licensing would likely influence labor market outcomes when measured over a longer period of time.

This paper uses the information contained in the joint dynamics of individuals’ labor earnings and consumption-choice decisions to quantify both the amount of income risk that individuals face and the extent to which they have access to informal insurance against this risk. We accomplish this task by using indirect inference to estimate a structural consumption-savings model, in which individuals both learn about the nature of their income process and partly insure shocks via informal mechanisms. In this framework, we estimate (i) the degree of partial insurance, (ii) the extent of systematic differences in income growth rates, (iii) the precision with which individuals know their own income growth rates when they begin their working lives, (iv) the persistence of typical labor income shocks, (v) the tightness of borrowing constraints, and (vi) the amount of measurement error in the data. In implementing indirect inference, we find that an auxiliary model that approximates the true structural equations of the model (which are not estimable) works very well, with negligible small sample bias. The main substantive findings are that income shocks are not very persistent, systematic differences in income growth rates are large, individuals have substantial amounts of information about their income growth rates, and about one-half of income shocks are effectively smoothed via partial insurance. Putting these findings together, we argue that the amount of uninsurable lifetime income risk that individuals perceive is substantially smaller than what is typically assumed in calibrated macroeconomic models with incomplete markets.

This paper develops and structurally estimates a labor market model that integrates job assignment, learning, and human capital acquisition to account for the main patterns of careers in firms. A key innovation is that the model incorporates workers’ job mobility within and between firms, and the possibility that, through job assignment, firms affect the rate at which they acquire information about workers. The model is estimated using longitudinal administrative data on managers from one U.S. firm in a service industry (the data of Baker, Gibbs, and Holmström (1994a,b)) and fits the data remarkably well. The estimated model is used to assess both the direct effect of learning on wages and its indirect effect through its impact on the dynamics of job assignment. Consistent with the evidence in the literature on comparative advantage and learning, the estimated direct effect of learning on wages is found to be small. Unlike in previous work, by jointly estimating the dynamics of beliefs, jobs, and wages imposing all of the model restrictions, the impact of learning on job assignment can be uncovered and the indirect effect of learning on wages explicitly assessed. The key finding of the paper is that the indirect effect of learning on wages is substantial: overall learning accounts for one quarter of the cumulative wage growth on the job during the first seven years of tenure. Nearly all of the remaining growth is from human capital acquisition. A related novel finding is that the experimentation component of learning is a primary determinant of the timing of promotions and wage increases. Along with persistent uncertainty about ability, experimentation is responsible for substantially compressing wage growth at low tenures.

This essay reviews the development of neoclassical growth theory, a unified theory of aggregate economic phenomena that was first used to study business cycles and aggregate labor supply. Subsequently, the theory has been used to understand asset pricing, growth miracles and disasters, monetary economics, capital accounts, aggregate public finance, economic development, and foreign direct investment.

The focus of this essay is on real business cycle (RBC) methodology. Those who employ the discipline behind the methodology to address various quantitative questions come up with essentially the same answer—evidence that the theory has a life of its own, directing researchers to essentially the same conclusions when they apply its discipline. Deviations from the theory sometimes arise and remain open for a considerable period before they are resolved by better measurement and extensions of the theory. Elements of the discipline include selecting a model economy or sometimes a set of model economies. The model used to address a specific question or issue must have a consistent set of national accounts with all the accounting identities holding. In addition, the model assumptions must be consistent across applications and be consistent with micro as well as aggregate observations. Reality is complex, and any model economy used is necessarily an abstraction and therefore false. This does not mean, however, that model economies are not useful in drawing scientific inference.

The vast number of contributions made by many researchers who have used this methodology precludes reviewing them all in this essay. Instead, the contributions reviewed here are ones that illustrate methodological points or extend the applicability of neoclassical growth theory. Of particular interest will be important developments subsequent to the Cooley (1995) volume, Frontiers of Business Cycle Research. The interaction between theory and measurement is emphasized because this is the way in which hard quantitative sciences progress.

This paper develops a model with partial insurance against idiosyncratic wage shocks to quantify risk sharing, and to decompose inequality into life-cycle shocks versus initial heterogeneity in preferences and productivity. Closed-form solutions are obtained for equilibrium allocations and for moments of the joint distribution of consumption, hours, and wages. We prove identification and estimate the model with data from the CEX and the PSID over the period 1967–2006. We find that (i) 40% of permanent wage shocks pass through to consumption; (ii) the share of wage risk insured privately increased until the early 1980s and remained stable thereafter; (iii) life-cycle productivity shocks account for half of the cross-sectional variance of wages and earnings, but for much less of dispersion in consumption or hours worked.

Before the advent of sophisticated international financial markets, a widely accepted belief was that within a monetary union, a union-wide authority orchestrating fiscal transfers between countries is necessary to provide adequate insurance against country-specific economic fluctuations. A natural question is then: Do sophisticated international financial markets obviate the need for such an active union-wide authority? We argue that they do. Specifically, we show that in a benchmark economy with no international financial markets, an activist union-wide authority is necessary to achieve desirable outcomes. With sophisticated financial markets, however, such an authority is unnecessary if its only goal is to provide cross-country insurance. Since restricting the set of policy instruments available to member countries does not create a fiscal externality across them, this result holds in a wide variety of settings. Finally, we establish that an activist union-wide authority concerned just with providing insurance across member countries is optimal only when individual countries are either unable or unwilling to pursue desirable policies

This paper uses the information contained in the joint dynamics of households’ labor earnings and consumption-choice decisions to quantify the nature and amount of income risk that households face. We accomplish this task by estimating a structural consumption-savings model using data from the Panel Study of Income Dynamics and the Consumer Expenditure Survey. Specifically, we estimate the persistence of labor income shocks, the extent of systematic differences in income growth rates, the fraction of these systematic differences that households know when they begin their working lives, and the amount of measurement error in the data. Although data on labor earnings alone can shed light on some of these dimensions, to assess what households know about their income processes requires using the information contained in their economic choices (here, consumption-savings decisions). To estimate the consumption-savings model, we use indirect inference, a simulation method that puts virtually no restrictions on the structural model and allows the estimation of income processes from economic decisions with general specifications of utility, frequently binding borrowing constraints, and missing observations. The main substantive findings are that income shocks are not very persistent, systematic differences in income growth rates are large, and individuals have substantial amounts of information about their future income prospects. Consequently, the amount of uninsurable lifetime income risk that households perceive is substantially smaller than what is typically assumed in calibrated macroeconomic models with incomplete markets.

We revisit the question of how capital should be taxed. We allow for a rich set of tax instruments that consists of taxes widely used in practice, including consumption, dividend, capital, and labor income taxes. We restrict policies to respect promises that the government has made in the previous period regarding the current value of wealth. We show that capital should not be taxed if households have preferences that are standard in the macroeconomics literature. We show that Ramsey outcomes that must respect such promises are time consistent. We show that the presumption in the literature that capital should be taxed for some length of time arises because the tax system is restricted.

We study financial panics in a small open economy with floating exchange rates. In our model, bank runs trigger a decline in domestic wealth and a currency depreciation. Runs are more likely when banks have dollar debt. Dollar debt emerges endogenously in response to the precautionary motive of domestic savers: dollar savings provide insurance against crises; so when crises are possible it becomes relatively more expensive for banks to borrow in local currency, which gives them an incentive to issue dollar debt. This feedback between aggregate risk and savers’ behavior can generate multiple equilibria, with the bad equilibrium characterized by financial dollarization and the possibility of bank runs. A domestic lender of last resort can eliminate the bad equilibrium, but interventions need to be fiscally credible. Holding foreign currency reserves hedges the fiscal position of the government and enhances its credibility, thus improving financial stability.

Fifty-eight years ago, Harberger (1954) estimated that the costs of monopoly, which resulted from misallocation of resources across industries, were trivial. Others showed the same was true for tariffs. This research soon led to the consensus that monopoly costs are of little significance—a consensus that persists to this day.

This paper reports on a new literature that takes a different approach to the costs of monopoly. It examines the costs of monopoly and tariffs within industries. In particular, it examines the histories of industries in which a monopoly is destroyed (or tariffs greatly reduced) and the industry transitions quickly from monopoly to competition. If there are costs to monopoly and high tariffs within industries, we should be able to see these costs whittled away as the monopoly is destroyed.

In contrast to the prevailing consensus, this new research has identified significant costs of monopoly. Monopoly (and high tariffs) is shown to significantly lower productivity within establishments. It also leads to misallocation within industry: resources are transferred from high to low productivity establishments.

From these histories a common theme (or theory) emerges as to why monopoly is costly. When a monopoly is created, “rents” are created. Conflict emerges among shareholders, managers, and employees of the monopoly as they negotiate how to divide these rents. Mechanisms are set up to split the rents. These mechanisms are often means to reduce competition among members of the monopoly. Although the mechanisms divide rents, they also destroy them (by leading to low productivity and misallocation).

We construct a stochastic overlapping-generations general equilibrium model in which households are subject to aggregate shocks that affect both wages and asset prices. We use a calibrated version of the model to quantify how the welfare costs of big recessions are distributed across different household age groups. The model predicts that younger cohorts fare better than older cohorts when the equilibrium decline in asset prices is large relative to the decline in wages. Asset price declines hurt the old, who rely on asset sales to finance consumption, but benefit the young, who purchase assets at depressed prices. In our preferred calibration, asset prices decline 2.4 times as much as wages, consistent with the experience of the US economy in the Great Recession. A model recession is close to welfare neutral for households in the 20-29 age group, but translates into a large welfare loss of more than 8% of lifetime consumption for households aged 70 and over.

Many countries are facing challenging fiscal financing issues as their populations age and the number of workers per retiree falls. Policymakers need transparent and robust analyses of alternative policies to deal with demographic changes. In this paper, we propose a simple framework that can easily be matched to aggregate data from the national accounts. We demonstrate the usefulness of our framework by comparing quantitative results for our aggregate model with those of a related model that includes within-age-cohort heterogeneity through productivity differences. When we assess proposals to switch from the current tax and transfer system in the United States to a mandatory saving-for-retirement system with no payroll taxation, we find that the aggregate predictions for the two models are close.

By the 1970s, quid pro quo policy, which requires multinational firms to transfer technology in return for market access, had become a common practice in many developing countries. While many countries have subsequently liberalized quid pro quo requirements, China continues to follow the policy. In this paper, we incorporate quid pro quo policy into a multicountry dynamic general equilibrium model, using microevidence from Chinese patents to motivate key assumptions about the terms of the technology transfer deals and macroevidence on China’s inward foreign direct investment (FDI) to estimate key model parameters. We then use the model to quantify the impact of China’s quid pro quo policy and show that it has had a significant impact on global innovation and welfare.

This chapter is an introductory essay to the volume Climate Change Economics: The Role of Uncertainty and Risk, edited by V. V. Chari and Robert Litterman. This volume consists of a collection of papers that were presented at "The Next Generation of Economic Models of Climate Change," a conference hosted by the Heller-Hurwicz Economics Institute at the University of Minnesota.

There is wide variation in the sizes of manufacturing plants, even within the most narrowly defined industry classifications used by statistical agencies. Standard theories attribute all such size differences to productivity differences. This paper develops an alternative theory in which industries are made up of large plants producing standardized goods and small plants making custom or specialty goods. It uses confidential Census data to estimate the parameters of the model, including estimates of plant counts in the standardized and specialty segments by industry. The estimated model fits the data relatively well compared with estimates based on standard approaches. In particular, the predictions of the model for the impacts of a surge in imports from China are consistent with what happened to U.S. manufacturing industries that experienced such a surge over the period 1997--2007. Large-scale standardized plants were decimated, while small-scale specialty plants were relatively less impacted.