Research Database

The key question asked by standard monetary models used for policy analysis is, How do changes in short-term interest rates affect the economy? All of the standard models imply that such changes in interest rates affect the economy by altering the conditional means of the macroeconomic aggregates and have no effect on the conditional variances of these aggregates. We argue that the data on exchange rates imply nearly the opposite: the observation that exchange rates are approximately random walks implies that fluctuations in interest rates are associated with nearly one-for-one changes in conditional variances and nearly no changes in conditional means. In this sense, standard monetary models capture essentially none of what is going on in the data. We thus argue that almost everything we say about monetary policy using these models is wrong.

Wage inequality between education groups in the United States has increased substantially since the early 1980s. The relative number of college-educated workers has also increased dramatically in the postwar period. This paper presents a unified framework where the dynamics of both skill accumulation and wage inequality arise as an equilibrium outcome driven by measured investment-specific technological change. Working through equipment-skill complementarity and endogenous skill accumulation, the model does well in capturing the steady growth in the relative quantity of skilled labor during the postwar period and the substantial rise in wage inequality after the early 1980s. Based on the calibrated model, we examine the quantitative effects of some hypothetical tax-policy reforms on skill accumulation, wage inequality, and welfare.

Entrepreneurship is a key determinant of investment, saving, wealth holdings, and wealth inequality. We study the aggregate and the distributional effects of several tax reforms in a model that recognizes the key role played by the entrepreneurs, and that matches very well the extreme degree of wealth inequality observed in the U.S. data. We find that the effects of tax reforms on output and capital formation can be particularly large when they affect the majority of small and medium-size businesses, which face the most severe financial constraints, rather than a small number of big businesses. We show that the consequences of changes in the estate tax depend heavily on the size of its exemption level. The current effective estate tax system seems to insulate most of the businesses from the negative effects of estate taxation thus minimizing the aggregate costs of redistribution. Abolishing the current estate tax would generate a modest increase in wealth inequality and slightly reduce aggregate output. Decreasing progressivity of the income tax can generate large increases in output, as this stimulates entrepreneurial savings and capital formation, but at the cost of large increases in wealth concentration.

The main substantive finding of the recent structural vector autoregression literature with a differenced specification of hours (DSVAR) is that technology shocks lead to a fall in hours. Researchers have used these results to argue that business cycle models in which technology shocks lead to a rise in hours should be discarded. We evaluate the DSVAR approach by asking, is the specification derived from this approach misspecified when the data are generated by the very model the literature is trying to discard? We find that it is misspecified. Moreover, this misspecification is so great that it leads to mistaken inferences that are quantitatively large. We show that the other popular specification that uses the level of hours (LSVAR) is also misspecified. We argue that alternative state space approaches, including the business cycle accounting approach, are more fruitful techniques for guiding the development of business cycle theory.

We use an extended Barro-Becker model of endogenous fertility, in which parents are heterogeneous in their labor productivity, to study the efficient degree of consumption inequality in the long run. In our environment a utilitarian planner allows for consumption inequality even when labor productivity is public information. We show that adding private information does not alter this result. We also show that the informationally constrained optimal insurance contract has a resetting property—whenever a family line experiences the highest shock, the continuation utility of each child is reset to a (high) level that is independent of history. This implies that there is a non-trivial, stationary distribution over continuation utilities and there is no mass at misery. The novelty of our approach is that the no-immiseration result is achieved without requiring that the objectives of the planner and the private agents disagree. Because there is no discrepancy between planner and private agents' objectives, the policy implications for implementation of the efficient allocation differ from previous results in the literature. Two examples of these are: 1) estate taxes are positive and 2) there are positive taxes on family size.

The classic explanation for the persistence and volatility of real exchange rates is that they are the result of nominal shocks in an economy with sticky goods prices. A key implication of this explanation is that if goods have differing degrees of price stickiness then relatively more sticky goods tend to have relatively more persistent and volatile good-level real exchange rates. Using panel data, we find only modest support for these key implications. The predictions of the theory for persistence have some modest support: in the data, the stickier is the price of a good the more persistent is its real exchange rate, but the theory predicts much more variation in persistence than is in the data. The predictions of the theory for volatility fare less well: in the data, the stickier is the price of a good the smaller is its conditional variance while in the theory the opposite holds. We show that allowing for pricing complementarities leads to a modest improvement in the theory’s predictions for persistence but little improvement in the theory’s predictions for conditional variances.

Previous literature has shown that the study and characterization of constrained efficient allocations in economies with limited enforcement is useful to understand the limited risk sharing observed in many contexts, in particular between sovereign countries. In this paper we show that these constrained efficient allocations arise as equilibria in an economy in which private agents behave competitively, taking as given a set of taxes. We then show that these taxes, which end up limiting risk sharing, arise as an equilibrium of a dynamic game between governments. Our decentralization is different from the existing ones proposed in the literature. We find it intuitively appealing and we think it goes farther than the existing literature in endogenizing the primitive forces that lead to a lack of risk sharing in equilibrium.

In this paper, we consider an environment in which agents’ productivities are private information, potentially multi-dimensional, and follow arbitrary stochastic processes. We allow for arbitrary incentive-compatible and physically feasible tax schemes. We prove that it is typically Pareto optimal to have positive capital taxes. As well, we prove that in any given period, it is Pareto optimal to tax consumption goods at a uniform rate.

How much discretion is it optimal to give the monetary authority in setting its policy? We analyze this mechanism design question in an economy with an agreed-upon social welfare function that depends on the randomly fluctuating state of the economy. The monetary authority has private information about that state. In the model, well-designed rules trade off society’s desire to give the monetary authority flexibility to react to its private information against society’s need to guard against the standard time inconsistency problem arising from the temptation to stimulate the economy with unexpected inflation. We find that the optimal degree of monetary policy discretion is decreasing in the severity of the time inconsistency problem. As this problem becomes sufficiently severe, the optimal degree of discretion is none at all. We also find that, despite the apparent complexity of this dynamic mechanism design problem, society can implement the optimal policy simply by legislating an inflation cap that specifies the highest allowable inflation rate.

The possibility of regime shifts in monetary policy can have important effects on rational agents’ expectation formation and equilibrium dynamics. In a DSGE model where the monetary policy rule switches between a dovish regime that accommodates inflation and a hawkish regime that stabilizes inflation, the expectation effect is asymmetric across regimes. Such an asymmetric effect makes it difficult, but still possible, to generate substantial reductions in the volatilities of inflation and output as the monetary policy switches from the dovish regime to the hawkish regime.

The goal of this paper is to probe the validity of the fiscal theory of the price level by modeling explicitly the market structure in which households and the governments make their decisions. I describe the economy as a game, and I am thus able to state precisely the consequences of actions that are out of the equilibrium path. I show that there exist government strategies that lead to a version of the fiscal theory, in which the price level is determined by fiscal variables alone. However, these strategies are more complex than the simple budgetary rules usually associated with the fiscal theory, and the government budget constraint cannot be merely viewed as an equilibrium condition.

This paper studies efficient allocation of resources in an economy in which agents are initially heterogeneous with regard to their wealth levels and whether they have ideas or not. An agent with an idea can start a business that generates random returns. Agents have private information about (1) their initial types, (2) how they allocate their resources, and (3) the realized returns. The unobservability of returns creates a novel motive for subsidizing agents who have ideas but lack resources to invest in them. To analyze this motive in isolation, the paper assumes that agents are risk-neutral and abstracts away from equality and insurance considerations. The unobservability of initial types and actions implies that the subsidy that poor agents with ideas receive is limited by incentive compatibility: the society should provide other agents with enough incentives so that they do not claim to be poor and have ideas. The paper then provides an implementation of the constrained-efficient allocation in an incomplete markets setup that is similar to the U.S. Small Business Administration’s Business Loan Program. Finally, the paper extends the model in several dimensions to show that the results are robust to these generalizations of the model.

People are having longer retirement periods, and population growth is slowing and has even stopped in some countries. In this paper we determined the implications of these changes for the needed amount of government debt. The needed debt is near zero if there are high tax rates and the transfer share of gross national income (GNI) is high. But, with such a system there are huge dead-weight losses as the result of the high tax rate on labor income. With a savings system, a large government debt to annual GNI ratio is needed, as large as 5 times GNI, and welfare is as much as 24 percent higher in terms of lifetime consumption equivalents than the tax-and-transfer system.

In the data, a sizable fraction of price changes are temporary price reductions referred to as sales. Existing models include no role for sales. Hence, when confronted with data in which a large fraction of price changes are sales related, the models must either exclude sales from the data or leave them in and implicitly treat sales like any other price change. When sales are included, prices change frequently and standard sticky price models with this high frequency of price changes predict small effects from money shocks. If sales are excluded, prices change much less frequently and a standard sticky price model with this low frequency of price changes predict much larger effects of money shocks. This paper adds a motive for sales in a parsimonious extension of existing sticky price models. We show that the model can account for most of the patterns of sales in the data. Using our model as the data generating process, we evaluate the existing approaches and find that neither well approximates the real effects of money in our economy in which sales are explicitly modeled.

Micro data over the life cycle shows two different patterns of consumption of housing and non-housing goods: the consumption profile of non-housing goods is hump-shaped while the consumption profile for housing first increases monotonically and then flattens out. These patterns hold true at each consumption quartile. This paper develops a quantitative, dynamic general equilibrium model of life cycle behavior, which generates consumption profiles consistent with the observed data. Borrowing constraints are essential in explaining the accumulation of housing assets early in life, while transaction costs are crucial in generating the slow downsizing of the housing assets later in life. The bequest motives play a role in determining total life time wealth, but not the housing profile.

No abstract available.

A classic question in international economics is whether it is better to use the exchange rate or the money growth rate as the instrument of monetary policy. A common argument is that the exchange rate has a natural advantage since exchange rates provide signals of policymakers’ actions that are easier to monitor than those provided by money growth rates. We formalize this argument in a simple model in which the government chooses which instrument it will use to target inflation. In it, the exchange rate is more transparent than the money growth rate in that the exchange rate is easier for the public to monitor. We find that the greater transparency of the exchange rate regime makes it easier to provide the central bank with incentives to pursue good policies and hence gives this regime a natural advantage over the money regime.

There is a large amount of intermediated borrowing and lending between households. Some of it is intergenerational, but most is between older households. The average difference in borrowing and lending rates is over 2 percent. In this paper, we develop a model economy that displays these facts and matches not only the returns on assets but also their quantities. The heterogeneity giving rise to borrowing and lending and differences in equity holdings depends on differences in the strength of the bequest motive. In equilibrium, the lenders are annuity holders and the borrowers are those who have equity holdings, who live off its income when retired, and who leave a bequest. The borrowing rate and return on equity are the same in the absence of aggregate uncertainty. The divergence between borrowing and lending rates can thus give rise to an equity premium, even in a world without aggregate uncertainty.

This paper describes a simple model of aggregate and firm growth based on the introduction of new goods. An incumbent firm can combine labor with blueprints for goods it already produces to develop new blueprints. Every worker in the economy is also a potential entrepreneur who can design a new blueprint from scratch and set up a new firm. The implied firm size distribution closely matches the fat tail observed in the data when the marginal entrepreneur is far out in the tail of the entrepreneurial skill distribution. The model produces a variance of firm growth that declines with size. But the decline is more rapid than suggested by the evidence. The model also predicts a new-firm entry rate equal to only 2.5% per annum, instead of the observed rate of 10% in U.S. data.

Previous studies quantifying the effects of increased taxation during the U.S. Great Depression find that its contribution is small, in accounting for both the downturn in the early 1930s and the slow recovery after 1934. This paper shows that this conclusion rests critically on the assumption that the only taxable capital income is business profits. Effects of capital taxation are much larger when taxes on property, capital stock, excess profits, undistributed profits, and dividends are included in the analysis. When fed into a general equilibrium model, the increased taxes imply significant declines in investment and equity values and nontrivial declines in gross domestic product (GDP) and hours of work. Of particular importance during the Great Depression was the dramatic rise in the effective tax rate on corporate dividends.

During the Second Industrial Revolution, 1860–1900, many new technologies, including electricity, were invented. These inventions launched a transition to a new economy, a period of about 70 years of ongoing, rapid technical change. After this revolution began, however, several decades passed before measured productivity growth increased. This delay is paradoxical from the point of view of the standard growth model. Historians hypothesize that this delay was due to the slow diffusion of new technologies among manufacturing plants together with the ongoing learning in plants after the new technologies had been adopted. The slow diffusion is thought to be due to manufacturers’ reluctance to abandon their accumulated expertise with old technologies, which were embodied in the design of existing plants. Motivated by these hypotheses, we build a quantitative model of technology diffusion which we use to study this transition to a new economy. We show that it implies both slow diffusion and a delay in growth similar to that in the data.

The United States is indisputably undergoing a financial crisis and is perhaps headed for a deep recession. Here we examine three claims about the way the financial crisis is affecting the economy as a whole and argue that all three claims are myths. We also present three underappreciated facts about how the financial system intermediates funds between households and corporate businesses. Conventional analyses of the financial crisis focus on interest rate spreads. We argue that such analyses may lead to mistaken inferences about the real costs of borrowing and argue that, during financial crises, variations in the levels of nominal interest rates might lead to better inferences about variations in the real costs of borrowing. Moreover, we argue that even if current increase in spreads indicate increases in the riskiness of the underlying projects, by itself, this increase does not necessarily indicate the need for massive government intervention. We call for policymakers to articulate the precise nature of the market failure they see, to present hard evidence that differentiates their view of the data from other views which would not require such intervention, and to share with the public the logic and evidence that burnishes the case that the particular intervention they are advocating will fix this market failure.

Innovative activities have public good characteristics in the sense that the cost of producing the innovation is high compared to the cost of producing subsequent units. Moreover, knowledge of how to produce subsequent units is widely known once the innovation has occurred and is, therefore, non-rivalrous. The main question of this paper is whether mechanisms can be found which exploit market information to provide appropriate incentives for innovation. The ability of the mechanism designer to exploit such information depends crucially on the ability of the innovator to manipulate market signals. We show that if the innovator cannot manipulate market signals, then the efficient levels of innovation can be implemented without deadweight losses–for example, by using appropriately designed prizes. If the innovator can use bribes, buybacks, or other ways of manipulating market signals, patents are necessary.

American consumer bankruptcy provides for a Fresh Start through the discharge of a household’s debt. Until recently, many European countries specified a No Fresh Start policy of life-long liability for debt. The trade-off between these two policies is that while Fresh Start provides insurance across states, it drives up interest rates and thereby makes life-cycle smoothing more difficult. This paper quantitatively compares these bankruptcy rules using a life-cycle model with incomplete markets calibrated to the U.S. and Germany. A key innovation is that households face idiosyncratic uncertainty about their net asset holdings (expense shocks) and labor income. We find that expense uncertainty plays a key role in evaluating consumer bankruptcy laws.

In this paper we describe how to optimally design a disability insurance system. The key friction in the model is imperfectly observable disability. We solve a dynamic mechanism design problem and provide a theoretical and numerical characterization of the social optimum. We then propose a simple tax system that implements an optimal allocation as a competitive equilibrium. The tax system that we propose includes only taxes and transfers that are similar to those already present in the U.S. tax code: a savings tax and an asset-tested transfer program. Using a numerical simulation, we compare our optimal disability system to the current disability system. Our results suggest a significant welfare gain from switching to an optimal system.

Expensed investments are expenditures financed by the owners of capital that increase future profits but, by national accounting rules, are treated as an operating expense rather than as a capital expenditure. Sweat investment is financed by worker-owners who allocate time to their business and receive compensation at less than their market rate. Such investments are made with the expectation of realizing capital gains when the business goes public or is sold. But these investments are not included in GDP. Taking into account hours spent building equity while ignoring the output introduces an error in measured productivity and distorts the picture of what is happening in the economy. In this paper, we incorporate expensed and sweat equity in an otherwise standard business cycle model. We use the model to analyze productivity in the United States during the 1990s boom. We find that expensed plus sweat investment was large during this period and critical for understanding the dramatic rise in hours and the modest growth in measured productivity.

Both Chile and Mexico experienced severe economic crises in the early 1980s, yet Chile recovered much faster than Mexico. This study analyzes four possible explanations for this difference and rules out three, explanations based on money supply expansion, real wage and real exchange rate declines, and foreign debt overhangs. The fourth explanation is based on government policy reforms in the two countries. Using growth accounting and a calibrated growth model, the study determines that the only policy reforms promising as explanations are those that primarily affect total factor productivity, or how inputs are used, not the inputs themselves. Interpreting historical evidence with economic theory, the study concludes that the crucial difference between Chile and Mexico in the 1980s and 1990s is earlier government policy reforms in Chile, particularly reforms in policies affecting the banking system and bankruptcy procedures.

Most economic activity occurs in cities. This creates a tension between local increasing returns, implied by the existence of cities, and aggregate constant returns, implied by balanced growth. To address this tension, we develop a theory of economic growth in an urban environment. We show how the urban structure is the margin that eliminates local increasing returns to yield constant returns to scale in the aggregate, thereby implying a city size distribution that is well described by a power distribution with coefficient one: Zipf’s Law. Under strong assumptions our theory produces Zipf’s Law exactly. More generally, it produces the systematic deviations from Zipf’s Law observed in the data, namely, the underrepresentation of small cities and the absence of very large ones. In these cases, the model identifies the standard deviation of industry productivity shocks as the key element determining dispersion in the city size distribution. We present evidence that the dispersion of city sizes is consistent with the dispersion of productivity shocks in the data.

Models with sticky prices predict that monetary policy changes will affect relative prices and relative quantities in the short run because some prices are more flexible than others. In U.S. micro data, the degree of price stickiness differs dramatically across consumption categories. This study exploits that diversity to ask whether popular measures of monetary shocks (for example, innovations in the federal funds rate) have the predicted effects. The study finds that they do not. Short-run responses of relative prices have the wrong sign. And monetary policy shocks seem to have persistent effects on both relative prices and relative quantities, rather than the transitory effects one would expect from differences in price flexibility across goods. The findings reject the joint hypothesis that the sticky-price models typically employed in policy analysis capture the U.S. economy and that commonly used monetary policy shocks represent exogenous shifts.

This article uses data from the 1998 Survey of Consumer Finances and from recent waves of the Panel Study of Income Dynamics to update a study of economic inequality in the United States based on 1992 and earlier data. The article reports data on the U.S. distributions of earnings, income, and wealth and on related features of inequality, such as age, employment status, educational attainment, and marital status. It also reports data on the economic inequality among U.S. households in financial trouble and on the economic mobility of U.S. households. The article finds that earnings, income, and wealth were very unequally distributed among U.S. households late in the 1990s, just as they had been at the beginning of the decade. It concludes that the basic facts about economic inequality in the United States did not change much during the 1990s.

I study a version of the Lagos-Wright (2003) model of monetary exchange in which buyers have private information about their tastes and sellers make take-it-or-leave-it-offers (i.e., have the power to set prices and quantities). The introduction of imperfect information makes the existence of monetary equilibrium a more robust feature of the environment. In general, the model has a monetary steady state in which only a proportion of the agents hold money. Agents who do not hold money cannot participate in trade in the decentralized market. The proportion of agents holding money is endogenous and depends (negatively) on the level of expected inflation. As in Lagos and Wright’s model, in equilibrium there is a positive welfare cost of expected inflation, but the origins of this cost are very different.

This article describes three long-run monetary facts derived by examining data for 110 countries over a 30-year period, using three definitions of a country's money supply and two subsamples of countries: (1) Growth rates of a country's money supply and the general price level are highly correlated for all three money definitions, for the full sample of countries, and for both subsamples. (2) The growth rates of money and real output are not correlated, except for a subsample of countries in the Organisation for Economic Co-operation and Development, where these growth rates are positively correlated. (3) The rate of inflation and the growth rate of real output are essentially uncorrelated.

Economists have offered many theories for the U.S. Great Depression, but no consensus has formed on the main forces behind it. Here we describe and demonstrate a simple methodology for determining which theories are the most promising. We show that a large class of models, including models with various frictions, are equivalent to a prototype growth model with time-varying efficiency, labor, and investment wedges that, at least on face value, look like time-varying productivity, labor taxes, and investment taxes. We use U.S. data to measure these wedges, feed them back into the prototype growth model, and assess the fraction of the fluctuations in 1929–39 that they account for. We find that the efficiency and labor wedges account for essentially all of the decline and subsequent recovery. Investment wedges play, at best, a minor role.

This article describes a debate about the validity of the quantity theory of money and offers further evidence against it. The evidence is primarily from the North American colonies of Virginia, New York, and Pennsylvania and regards the issue of measuring the money supply. Studies have shown that changes in colonial money and inflation are inconsistent with the quantity theory. Some have argued that those studies measure money wrong: specie belongs in the measure because the colonies were on a fixed exchange rate system with Britain; changes in colonial paper money were offset by specie flows. When specie is counted, the quantity theory stands. This study responds with evidence that the critics are wrong: the colonies had no such fixed exchange rate regime, and movements in the stock of colonial paper currency cannot have been offset by specie flows.

This article investigates U.S. interbank relationships before the Civil War using previously unknown data for Pennsylvania banks from 1851 to 1859 that disaggregate the amounts due from other banks by debtor bank. It finds that country banks, banks outside of Philadelphia and Pittsburgh, dealt almost exclusively with financial center banks. Most had a large, highly stable relationship with a single correspondent bank. The location of a country bank’s correspondent was consistent with trade patterns, particularly railroad and canal linkages. Philadelphia banks, in contrast, did not establish correspondent-type banking relationships. Further, Philadelphia’s correspondent banking market was not highly concentrated, and entry was easy.

This study describes and reconciles two common, seemingly contradictory views about a key monetary policy relationship: that between money and interest rates. Data since 1960 for about 40 countries support the Fisher equation view, that these variables are positively related. But studies taking expectations into account support the liquidity effect view, that they are negatively related. A simple model incorporates both views and demonstrates that which view applies at any time depends on when the change in money occurs and how long the public expects it to last. A surprise money change that is not expected to change future money growth moves interest rates in the opposite direction; one that is expected to change future money growth moves interest rates in the same direction. The study also demonstrates that stating monetary policy as a rule for interest rates rather than money does not change the relationship between these variables.

We deduce properties of optimal monetary policies based on modern theory and standard empirical findings. In light of this analysis, we examine FOMC policy procedures and conclude that they put too much emphasis on short-term economic stabilization and too little emphasis on longer-term price stability. We propose a form of inflation targeting to address this problem.

This study primarily establishes two things: (1) that monopoly has been pervasive in the U.S. water transportation industry in both the 19th and 20th centuries and has led to prices above competitive levels and the adoption of inefficient technologies and (2) that the competition of railroads has greatly weakened this monopolistic tendency, leading to lower water transport prices and fewer inefficient technologies. The study establishes these points using standard economic theory and extensive historical U.S. data on the behavior of unions and shipping companies. These gains from competition have been ignored by researchers studying the contribution of railroads to U.S. economic growth. Researchers have assumed that if railroads had not been developed, the long-distance transportation industry would have been competitive. This study shows that it would not have been. The quantitative estimates of previous studies thus are likely to have significantly understated the gains from the development of railroads.

We present a simple theory of the quality of elected officials. Quality has (at least) two dimensions: competence and honesty. Voters prefer competent and honest policymakers, so high-quality citizens have a greater chance of being elected to office. But low-quality citizens have a “comparative advantage” in pursuing elective office, because their market wages are lower than the market wages of high-quality citizens (competence), and/or because they reap higher returns from holding office (honesty). In the political equilibrium, the average quality of the elected body depends on the structure of rewards from holding public office. Under the assumption that the rewards from office are increasing in the average quality of office holders there can be multiple equilibria in quality. Under the assumption that incumbent policymakers set the rewards for future policymakers there can be path dependence in quality.

This study uses John Rawls’ behind-the-veil of ignorance device as a fairness criterion to evaluate social policies and applies it to a contracting model in which the terms equality of opportunity and equality of result are well defined. The results suggest that fairness and inequality—even extreme inequality—are compatible. In a static world, when incentives must be provided, fairness implies equality of opportunity, but inequality of result. In a dynamic world of long-lived individuals, fairness implies not only inequality of result, but also, eventually, infinite inequality of result. If each period of the dynamic model is interpreted as a generation, then eventual infinite inequality holds for opportunity as well, as long as fairness is from the perspective of the first generation. If preferences of later generations are taken into account, then inequality of opportunity still occurs, although not at extreme levels.

A sizeable literature has argued that the growth effects of changes in flat rate taxes are small. In this paper, we investigate the relatively unexplored area of the growth effect of changes in the tax structure, in particular, in the progressivity of taxes. Considering such a tax reform seems empirically more relevant than considering changes in flat tax rates. We construct a general equilibrium model of endogenous growth in which there is heterogeneity in income and in the tax rates. We limit heterogeneity to two types, skilled and unskilled, and posit that the probability of staying or becoming skilled in the subsequent period depends positively on expenses on “teacher” time. In the production sector, we consider two sources of growth. In the first, growth arises as a purely external effect on account of production activities of skilled workers. In the second, a portion of the skilled workforce is used to work in research and other productivity enhancing activities and is compensated for it. Our analysis shows that changes in the progressivity of tax rates can have positive growth effects even in situations where changes in flat rate taxes have no effect. Experiments on a calibrated model indicate that the quantitative effects of moving to a flat rate system are economically significant. The assumption made about the engine of growth has an important effect on the impact of a change in progressivity. Quantitatively, welfare is unambiguously higher in a flat rate system when comparisons are made across balanced growth equlibria; however, when the costs of transition to the higher growth equilibrium is taken into account only the currently rich slightly prefer the flat rate system.

This article analyzes Keynes’s “Economic Possibilities for our Grandchildren”—an essay presenting Keynes’s views about economic growth into the 21st century—from the perspective of modern growth theory. I find that the implicit theoretical framework used by Keynes to form his expectations about the 21st-century world economy is remarkably close to modern growth models, featuring a stable steady-state growth path driven by technological progress. On the other hand, Keynes’s forecast of employment in the 21st century is far off the mark, reflecting a mistaken view that the income elasticity of leisure is much higher than that of consumption.

In this paper we present an analytically tractable general equilibrium overlapping-generations model of human capital accumulation, and study its implications for the evolution of the U.S. wage distribution from 1970 to 2000. The key feature of the model, and the only source of heterogeneity, is that individuals differ in their ability to accumulate human capital. Therefore, wage inequality results only from differences in human capital accumulation. We examine the response of this model to skill-biased technical change (SBTC) theoretically. We show that in response to SBTC, the model generates behavior consistent with the U.S. data including (i) a rise in overall wage inequality in both the short run and long run, (ii) an initial fall in the education premium followed by a strong recovery, leading to a higher premium in the long run, (iii) the fact that most of this fall and rise takes place among younger workers, (iv) stagnation in median wage growth (and a slowdown in aggregate labor productivity), and (v) a rise in consumption inequality that is much smaller than the rise in wage inequality. These results suggest that the heterogeneity in the ability to accumulate human capital is an important feature for understanding the effects of SBTC, and interpreting the transformation that the U.S. economy has gone through since the 1970s.