Research Database

We analyze financial collapses, such as the one that occurred during the U.S. Great Depression, from the perspective of a monetary model with multiple equilibria. The multiplicity arises from the presence of a strategic complementarity due to increasing returns to scale in the intermediation process. Intermediaries provide the link between savers and firms who require working capital for production. Fluctuations in the intermediation process are driven by variations in the confidence agents place in the financial system. From a positive perspective, our model matches closely the qualitative changes in important financial and real variables (the currency/deposit ratio, ex-post real interest rates, the level of intermediated activity, deflation, employment and production) over the Great Depression period, an experience often attributed to financial collapse. Further, we show how adding liquidity to the banking system through increases in the money supply is sufficient to overcome strategic uncertainty and thus avoid financial collapse.

This paper presents a government debt game with the property that if the timing of debt auctions within a period is sufficiently unfettered, the set of equilibrium outcome paths of real economic variables given the government has access to a rich debt structure is identical to the set of equilibrium outcome paths given the government can issue only one-period debt.

This paper presents a simple model of government reputation which captures two characteristics of policy outcomes in less developed countries: governments which betray public trust do so erratically, and, after a betrayal, public trust is regained only gradually.

The skill premium fell substantially in the first part of the 20th century, and then rose at the end of the century. I argue that these changes are connected to the organization of production. When production is organized into large plants, jobs become routinized, favoring less skilled workers. Building on the notion that numerically controlled machines made capital more “flexible” at the end of the century, the model allows for changes in the ability of capital to do a wide variety of tasks. When calibrated to data on the distribution of plant sizes, the model can account for between half and two-thirds of the movement in the skill premium over the century. It is also in accord with a variety of industry level evidence.

Total factor productivity (TFP) differs greatly across countries. In this paper, I provide a novel rationalization for these differences. I consider two environments, one in which enforcement is full and the other in which enforcement is limited. In both settings, manufactured goods can be produced using a high-TFP technology or a low-TFP technology; there is a fixed cost associated with adoption of the former. I suppose that the fixed cost is sufficiently small that adoption takes place in a symmetric Pareto optimum in the limited-enforcement setting. Under this condition, I prove two results. First, adoption takes place in all Pareto optima in the full-enforcement setting. Second, adoption may not take place in a Pareto optimum in the limited-enforcement setting, if the division of social surplus is sufficiently unequal. I conclude that limited enforcement and high inequality interact to create particularly strong barriers to riches (in the language of Parente and Prescott (1999, 2000).

Between 1929 and 1933, real output per adult fell over 30 percent and total factor productivity fell 18 percent. This productivity decrease is much larger than expected from just extrapolating the productivity decrease that typically occurs during recessions. This paper evaluates what factors may have caused this large decrease, including unmeasured factor utilization, changes in the composition of production, and increasing returns. I find that these factors combined explain less than one-third of the 18 percent decrease, and I conclude that the productivity decrease during the Great Depression remains a puzzle.

This paper quantitatively tests the “new trade theory” based on product differentiation, increasing returns, and imperfect competition. We employ a standard model, which allows both changes in the distribution of income among industrialized countries, emphasized by Helpman and Krugman (1985), and nonhomothetic preferences, emphasized by Markusen (1986), to effect trade directions and volumes. In addition, we generalize the model to allow changes in relative prices to have large effects. We test the model by calibrating it to 1990 data and then “backcasting” to 1961 to see what changes in crucial variables between 1961 and 1990 are predicted by the theory. The results show that, although the model is capable of explaining much of the increased concentration of trade among industrialized countries, it is not capable of explaining the enormous increase in the ratio of trade to income. Our analysis suggests that it is policy changes, rather than the elements emphasized in the new trade theory, that have been the most significant determinants of the increase in trade volume.

In this paper, we consider an environment in which agents’ skills are private information, are 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.

Chile and Mexico experienced severe economic crises in the early 1980s. This paper analyzes four possible explanations for why Chile recovered much faster than did Mexico. Comparing data from the two countries allows us to rule out a monetarist explanation, an explanation based on falls in real wages and real exchange rates, and a debt overhang explanation. Using growth accounting, a calibrated growth model, and economic theory, we conclude that the crucial difference between the two countries was the earlier policy reforms in Chile that generated faster productivity growth. The most crucial of these reforms were in banking and bankruptcy procedures.

Between 1913 and 1929, real GDP per person in the UK fell 1 percent, while this same measure of economic activity rose about 25 percent in the rest of the world. Why was Britain so depressed in a decade of strong economic activity around the world? This paper argues that the standard explanations of contractionary monetary shocks and an overvalued nominal exchange rate are not the prime suspects for killing the British economy. Rather, we argue that large, negative sectoral shocks, coupled with generous unemployment benefits and housing subsidies, are the primary causes of this long and deep depression.

Unable to reproduce abstract due to symbols in text. See title page for complete abstract text.

U.S. stock prices have increased much faster than gross domestic product GDP) in the postwar period. Between 1962 and 2000, corporate equity value relative to GDP nearly doubled. In this paper, we determine what standard growth theory says the equity value should be in 1962 and 2000, the two years for which our steady-state assumption is a reasonable one. We find that the actual valuations were close to the theoretical predictions in both years. The reason for the large run-up in equity value relative to GDP is that the average tax rate on dividends fell dramatically between 1962 and 2000. We also find that, given legal constraints that effectively prohibited the holding of stocks as reserves for pension plans, there is no equity premium puzzle in the postwar period. The average returns on debt and equity are as theory predicts.

Banks have historically provided mutual insurance against asset risk, where the insurance arrangement itself was characterized by limited enforcement. This paper shows that a non-trivial interaction between asset and liquidity risk plays a crucial role in shaping optimal banking arrangements in the presence of limited enforcement. We find that liquidity shocks are essential for the provision of insurance against asset shocks, as they mitigate interbank enforcement problems. These enforcement problems generate endogenous aggregate uncertainty as investment allocations depend upon the joint distribution of shocks. Paradoxically, a negative correlation between liquidity and asset shocks ameliorates enforcement limitations and facilitates interbank cooperation.

There are two striking aspects of the recovery from the Great Depression in the United States: the recovery was very weak and real wages in several sectors rose significantly above trend. These data contrast sharply with neoclassical theory, which predicts a strong recovery with low real wages. We evaluate the contribution of New Deal cartelization policies designed to limit competition and increase labor bargaining power to the persistence of the Depression. We develop a model of the bargaining process between labor and firms that occurred with these policies, and embed that model within a multi-sector dynamic general equilibrium model. We find that New Deal cartelization policies are an important factor in accounting for the post-1933 Depression. We also find that the key depressing element of New Deal policies was not collusion per se, but rather the link between paying high wages and collusion.

We analyze the optimal design of monetary rules. We suppose there is an agreed upon social welfare function that depends on the randomly fluctuating state of the economy and that the monetary authority has private information about that state. We suppose the government can constrain the policies of the monetary authority by legislating a rule. In general, well-designed rules trade-off the need to constrain policymakers from the standard time consistency problem arising from the temptation for unexpected inflation with the desire to give them flexibility to react to their private information. Surprisingly, we show that for a wide variety of circumstances the optimal rule gives the monetary authority no flexibility. This rule can be interpreted as a strict inflation targeting rule where the target is a prespecified function of publicly observed data. In this sense, optimal monetary policy is transparent.

This study argues that the delegation of monetary policy control by one country to another can reduce inflation in the delegating country. Hyperinflation is common in a divided society, one in which special interest groups can pressure a weak central government to issue money to finance their own demands while neglecting the country’s overall welfare. A commitment device like dollarization or a currency board, which gives control of the divided country’s money supply to another country, can eliminate this inflation bias. This is illustrated by Argentina’s experience with inflation and a currency board which, in effect, gave control of Argentina’s money supply to the United States. This argument is made precise using a two-country overlapping generations model to study the effects of delegation. The study also finds that a dollarization treaty between the two countries can be welfare-improving for both.

This study argues that strong evidence contradicting the traditional assumption of time-consistent preferences is not available. The study builds and analyzes the implications of a deterministic general equilibrium model and compares them to data from the U.S. asset market. The model implies that (1) because of dynamic arbitrage, the prices of retradable assets cannot reveal whether preferences are time-inconsistent; but (2) the prices of commitment assets, investments which must be held for their lifetime, can. These prices will be higher than the present values of their future payoffs only when preferences are time-inconsistent. And (3) when preferences are time-inconsistent, people will not hold both retradable and commitment assets. Empirical observations on two examples of commitment assets—education and individual retirement accounts—are not consistent with these model implications.

Evidence of the statistical significance of profits in Q regressions remains one of the principal findings in the empirical investment literature. This result is frequently taken to support the view that capital market imperfections are an important element for understanding investment. This paper challenges that conclusion. We argue that allowing the profit function at the firm level to be strictly concave, reflecting, for example, market power, is sufficient to replicate the Q theory based regression results in which profits are a significant factor determining investment. To be clear, our ability to replicate the existing results does not require the specification of any capital market imperfections. Thus the friction that explains the statistical significance of profits could be market power by sellers rather than capital market imperfections.

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.

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.

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.

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.

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.

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.

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.

In welfare theory it is standard to pick the consumption stream that maximizes the welfare of the representative agent. We argue against this position, and show that a benevolent social planner will generally place a greater weight on future consumption than does the representative agent.

Capital accumulation and creative destruction is modeled together with risk-averse households. The novel aspect—risk-averse households—allows to use well-known models not only for analyzing long-run growth as in the literature but also short-run fluctuations. The model remains analytically tractable due to a very convenient property of the household’s investment decision in this stochastic continuous-time setup.

This study evaluates the conventional wisdom that modern Phillips curve-based models are useful tools for forecasting inflation. These models are based on the non-accelerating inflation rate of unemployment (the NAIRU). The study compares the accuracy, over the last 15 years, of three sets of inflation forecasts from NAIRU models to the naive forecast that at any date inflation will be the same over the next year as it has been over the last year. The conventional wisdom is wrong; none of the NAIRU forecasts is more accurate than the naive forecast. The likelihood of accurately predicting a change in the inflation rate from these three forecasts is no better than the likelihood of accurately predicting a change based on a coin flip. The forecasts include those from a textbook NAIRU model, those from two models similar to Stock and Watson’s, and those produced by the Federal Reserve Board.

This essay concerns how the Federal Reserve’s role as a payment services provider can best be aligned with its broad mission to foster the integrity, efficiency, and accessibility of the U.S. payments system. A recommended strategy involves specialization in providing services where the central bank has a comparative advantage—notably, services directly related to providing a comprehensive, secure system of accounts for interbank settlement and potentially some additional services justified by economies of scope. If markets for other payment services evolve as expected, the recommended strategy would have the Fed generally rely on means other than direct service provision to help ensure that services are provided effectively and equitably. Several specific implications of this strategy are suggested.