Research Database

Robert Solow has criticized our 2006 Journal of Economic Perspectives essay describing “Modern Macroeconomics in Practice.” Solow eloquently voices the commonly heard complaint that too much macroeconomic work today starts with a model with a single type of agent. We argue that modern macroeconomics may not end too far from where Solow prefers. He is also critical of how modern macroeconomists use data to construct models. Specifically, he seems to think that calibration is the only way that our models encounter data. To the contrary, we argue that modern macroeconomics uses a wide variety of empirical methods and that this big-tent approach has served macroeconomics well. Solow also questions our claim that modern macroeconomics is firmly grounded in economic theory. We disagree and explain why.

This essay develops a theory of the evolution of international income levels. In particular, it augments the Hansen-Prescott theory of economic development with the Parente-Prescott theory of relative efficiencies and shows that the unified theory accounts for the evolution of international income levels over the last millennium. The essence of this unified theory is that a country starts to experience sustained increases in its living standard when production efficiency reaches a critical point. Countries reach this critical level of efficiency at different dates not because they have access to different stocks of knowledge, but rather because they differ in the amount of society-imposed constraints on the technology choices of their citizenry.

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.

We derive the quantitative implications of growth theory for U.S. corporate equity plus net debt over the period 1960–2001. There were large secular movements in corporate equity values relative to GDP, with dramatic declines in the 1970s and dramatic increases starting in the 1980s and continuing throughout the 1990s. During the same period, there was little change in the capital-output ratio or earnings share of output. We ask specifically whether the theory accounts for these observations. We find that it does, with the critical factor being changes in the U.S. tax and regulatory system. We find that the theory also accounts for the even larger movements in U.K. equity values relative to GDP in this period.

We develop an ECON-EPI network model to evaluate policies designed to improve health and economic outcomes during a pandemic. Relative to the standard epidemiological SIR set-up, we explicitly model social contacts among individuals and allow for heterogeneity in their number and stability. In addition, we embed the network in a structural economic model describing how contacts generate economic activity. We calibrate it to the New York metro area during the 2020 COVID-19 crisis and show three main results. First, the ECON-EPI network implies patterns of infections that better match the data compared to the standard SIR. The switching during the early phase of the pandemic from unstable to stable contacts is crucial for this result. Second, the model suggests the design of smart policies that reduce infections and at the same time boost economic activity. Third, the model shows that reopening sectors characterized by numerous and unstable contacts (such as large events or schools) too early leads to fast growth of infections.

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.

No abstract available.

Recent literature suggests that historical accidents can trap economies in inefficient equilibria. In a prototype model in the literature, there are two locations, the productive South and the unproductive North. By accident of history, the industry starts in the North. Because of agglomeration economies, the industry may reside in the North forever—an inefficient outcome. This paper modifies the standard model by assuming there is a continuum of locations between the North and the South. Productivity gradually increases as one moves South. There is a unique long-run equilibrium in this economy where all agents locate at the most productive locations.

We study the impact of regulation on productivity and welfare in the U.S. sugar manufacturing industry. While this U.S. industry has been protected from foreign competition for nearly 150 years, it was regulated only during the Sugar Act period, 1934–74. We show that regulation significantly reduced productivity, with these productivity losses leading to large welfare losses. Our initial results indicate that the welfare losses are many times larger than those typically studied—those arising from higher prices. We also argue that the channels through which regulation led to large productivity and welfare declines in this industry were also present in many other regulated industries, like banking and trucking.

Unit root tests against trend break alternatives are based on the premise that the dating of the trend breaks coincides with major economic events with permanent effects on economic activity, such as wars and depressions. Standard economic theory, however, suggests that these events have large transitory, rather than permanent, effects on economic activity. Conventional unit root tests against trend break alternatives based on linear ARIMA models do not capture these transitory effects and can result in severely distorted inference. We quantify the size distortions for a simple model in which the effects of wars and depressions can reasonably be interpreted as transitory. Monte Carlo simulations show that in moderate samples, the widely used Zivot-Andrews (1992) test mistakes transitory dynamics for trend breaks with high probability. We conclude that these tests should be used only if there are no plausible economic explanations for apparent trend breaks in the data.

I study asset prices in a two-agent macroeconomic model with two key features: limited stock market participation and heterogeneity in the elasticity of intertemporal substitution in consumption (EIS). The model is consistent with some prominent features of asset prices, such as a high equity premium; relatively smooth interest rates; procyclical stock prices; and countercyclical variation in the equity premium, its volatility, and in the Sharpe ratio. In this model, the risk-free asset market plays a central role by allowing non-stockholders (with low EIS) to smooth the fluctuations in their labor income. This process concentrates non-stockholders’ labor income risk among a small group of stockholders, who then demand a high premium for bearing the aggregate equity risk. Furthermore, this mechanism is consistent with the very small share of aggregate wealth held by non-stockholders in the US data, which has proved problematic for previous models with limited participation. I show that this large wealth inequality is also important for the model’s ability to generate a countercyclical equity premium. When it comes to business cycle performance the model’s progress has been more limited: consumption is still too volatile compared to the data, whereas investment is still too smooth. These are important areas for potential improvement in this framework.

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.

Using a simple model, we show why previous empirical studies of budget policy effects are flawed. Due to an identification problem, those studies’ findings can be shown to be consistent with either policies mattering or not.

This study examines the pricing of U.S. state banknotes before 1860 using discount data from New York, Philadelphia, Cincinnati, and Cleveland. The study determines whether these banknotes were priced consistent with their expected net redemption value as securities are. The evidence is mixed. Prices for a bank’s notes were higher when the bank was redeeming its notes for specie than when it was not, and banknote prices generally reflected the costs of note redemption. However, the relationship between prices and redemption costs was not tight, and there were cases in which the notes of distant banks went at par.

International trade is frequently thought of as a production technology in which the inputs are exports and the outputs are imports. Exports are transformed into imports at the rate of the price of exports relative to the price of imports: the reciprocal of the terms of trade. Cast this way, a change in the terms of trade acts as a productivity shock. Or does it? In this paper, we show that this line of reasoning cannot work in standard models. Starting with a simple model and then generalizing, we show that changes in the terms of trade have no first-order effect on productivity when output is measured as chain-weighted real GDP. The terms of trade do affect real income and consumption in a country, and we show how measures of real income change with the terms of trade at business cycle frequencies and during financial crises.

Measured aggregate U.S. consumption does not behave like a martingale. This paper develops and tests two variants of the permanent income model that are consistent with this fact. In both variants, we assume agents make decisions on a continuous time basis. According to the first variant, the martingale hypothesis holds in continuous time and serial persistence in measured consumption reflects only the effects of time aggregation. We investigate this variant using both structural and atheoretical econometric models. The evidence against these models is far from overwhelming. This suggests that the martingale hypothesis may yet be a useful way to conceptualize the relationship between aggregate quarterly U.S. consumption and income. According to the second variant of the permanent income model, serial persistence in measured consumption reflects the effects of exogenous technology shocks and time aggression. In this model, continuous time consumption does not behave like a martingale. We find little evidence against this variance of the permanent income model. It is difficult, on the basis of aggregate quarterly U.S. data, to convincingly distinguish between the different continuous time models considered in the paper.

A major motivation for the wave of privatizations of state-owned enterprises (SOEs) in the last twenty years was a belief that privatization would increase economic efficiency. There are now many studies showing most privatizations achieved this goal. Our theme is that the productivity gains from privatization are much more general and widespread than has typically been recognized in this literature. In assessing the productivity gains from privatization, the literature has only examined the productivity gains accruing at the privatized SOEs. But privatization may have significant impact on the private producers that often exist side-by-side with SOEs. In this paper we show that this was indeed the case when Brazil privatized its SOEs in the iron ore industry. That is, after their privatization, the iron ore SOEs dramatically increased their labor productivity, but so did the private iron ore companies in the industry.