Research Database

This paper considers four models in which immortal agents face idiosyncratic shocks and trade only a single risk-free asset over time. The four models specify this single asset to be private bonds, public bonds, public money, or private money respectively. I prove that, given an equilibrium in one of these economies, it is possible to pick the exogenous elements in the other three economies so that there is an outcome-equivalent equilibrium in each of them. (The term “exogenous variables” refers to the limits on private issue of money or bonds, or the supplies of publicly issued bonds or money.)

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.

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.

The key question asked by standard monetary models used for policy analysis, 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.

I characterize time consistent equilibrium in an economy with price rigidity and an optimizing monetary authority operating under discretion. Firms have the option to increase their frequency of price change, at a cost, in response to higher inflation. Previous studies, which assume a constant degree of price rigidity across inflation regimes, find two time consistent equilibria—one with low inflation, the other with high inflation. In contrast, when price rigidity is endogenous, the high inflation equilibrium ceases to exist. Hence, time consistent equilibrium is unique. This result depends on two features of the analysis: (1) a plausible quantitative specification of the fixed cost of price change, and (2) the presence of an arbitrarily small cost of inflation that is independent of price rigidity.

In the last century, the evolution of female labor force participation has been S-shaped: It rose slowly at first, then quickly, and has leveled off recently. Central to this dramatic rise has been entry of women with young children. We argue that this S-shaped dynamic came from generations of women learning about the relative importance of nature (endowed ability) and nurture (time spent child-rearing) for children’s outcomes. Each generation updates their parents’ beliefs by observing the children of employed women. When few women participate in the labor force, most observations are uninformative and participation rises slowly. As information accumulates and the effects of labor force participation become less uncertain, more women participate, learning accelerates and labor force participation rises faster. As beliefs converge to the truth, participation flattens out. Survey data, wage data and participation data support our mechanism and distinguish it from alternative explanations.

In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfolios should be heavily biased toward foreign assets. The fact that the opposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed a portfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.

Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation.

We make three comparisons relevant for the business cycle accounting approach. We show that in theory, representing the investment wedge as a tax on investment is equivalent to representing this wedge as a tax on capital income as long as the probability distributions over this wedge in the two representations are the same. In practice, convenience dictates that the underlying probability distributions over the investment wedge are different in the two representations. Even so, the quantitative results under the two representations are essentially identical. We also compare our methodology, the CKM methodology, to an alternative one used in Christiano and Davis (2006) and by us in early incarnations of the business cycle accounting approach. We argue that the CKM methodology rests on more secure theoretical foundations. Finally, we show that the results from the VAR-style decomposition of Christiano and Davis reinforce the results of the business cycle decomposition of CKM.

The optimal choice of a monetary policy instrument depends on how tight and transparent the available instruments are and on whether policymakers can commit to future policies. Tightness is always desirable; transparency is only if policymakers cannot commit. Interest rates, which can be made endogenously tight, have a natural advantage over money growth and exchange rates, which cannot. As prices, interest and exchange rates are more transparent than money growth. All else equal, the best instrument is interest rates and the next-best, exchange rates. These findings are consistent with the observed instrument choices of developed and less-developed economies.

We investigate the consequences of demographic change for business cycle analysis. We find that changes in the age composition of the labor force account for a significant fraction of the variation in business cycle volatility observed in the U.S. and other G7 economies. During the postwar period, these countries experienced dramatic demographic change, although details regarding extent and timing differ from place to place. Using panel-data methods, we exploit this variation to show that the age composition of the workforce has a large and statistically significant effect on cyclical volatility. We conclude by relating these findings to the recent decline in U.S. business cycle volatility. Using both simple accounting exercises and a quantitative general equilibrium model, we find that demographic change accounts for a significant part of this moderation.

How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization.

We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.

The central finding of the recent structural vector autoregression (SVAR) literature with a differenced specification of hours is that technology shocks lead to a fall in hours. Researchers have used this finding to argue that real business cycle models are unpromising. We subject this SVAR specification to a natural economic test and show that when applied to data from a multiple-shock business cycle model, the procedure incorrectly concludes that the model could not have generated the data as long as demand shocks play a nontrivial role. We also test another popular specification, which uses the level of hours, and show that with nontrivial demand shocks, it cannot distinguish between real business cycle models and sticky price models. The crux of the problem for both SVAR specifications is that available data require a VAR with a small number of lags and such a VAR is a poor approximation to the model’s VAR.

This paper studies lifetime aggregate labor supply with endogenous workweek length. Such a theory is needed to evaluate various government policies. A key feature of our model is a nonlinear mapping from hours worked to labor services. This gives rise to an endogenous workweek that can differ across occupations. The theory determines what fraction of the lifetime an individual works, not when. We find that constraints on workweek length have different consequences for total hours than total labor services. Also, we find that policies designed to increase the length of the working life may not increase aggregate lifetime labor supply.

This paper is a primer on the great depressions methodology developed by Cole and Ohanian (1999, 2007) and Kehoe and Prescott (2002, 2007). We use growth accounting and simple dynamic general equilibrium models to study the depression that occurred in Finland in the early 1990s. We find that the sharp drop in real GDP over the period 1990–93 was driven by a combination of a drop in total factor productivity (TFP) during 1990–92 and of increases in taxes on labor and consumption and increases in government consumption during 1989–94, which drove down hours worked in Finland. We attempt to endogenize the drop in TFP in variants of the model with an investment sector and with terms-of-trade shocks but are unsuccessful.

A framework is developed with what we call technology capital. A country is a measure of locations. Absent policy constraints, a firm owning a unit of technology capital can produce the composite output good using the unit of technology capital at as many locations as it chooses. But it can operate only one operation at a given location, so the number of locations is what constrains the number of units it operates using this unit of technology capital. If it has two units of technology capital, it can operate twice as many operations at every location. In this paper, aggregation is carried out and the aggregate production functions for the countries are derived. Our framework interacts well with the national accounts in the same way as does the neoclassical growth model. It also interacts well with the international accounts. There are constant returns to scale, and therefore no monopoly rents. Yet there are gains to being economically integrated. In the framework, a country’s openness is measured by the effect of its policies on the productivity of foreign operations. Our analysis indicates that there are large gains to this openness.

Here we reply to Robert Solow’s comment on our work, Modern Macroeconomics in Practice: How Theory is Shaping Policy.

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.

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.

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.

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.

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.

This article is a primer on the great depressions methodology developed by Cole and Ohanian (1999, 2007) and Kehoe and Prescott (2002, 2007). We use growth accounting and simple dynamic general equilibrium models to study the depression that occurred in Finland in the early 1990s. We find that the sharp drop in real GDP over the period 1990–93 was driven by a combination of a drop in total factor productivity (TFP) during 1990–92 and of increases in taxes on labor and consumption and increases in government consumption during 1989–94, which drove down hours worked in Finland. We attempt to endogenize the drop in TFP in variants of the model with an investment sector and with terms-of-trade shocks but are unsuccessful.

People are enjoying longer retirement periods, and population growth is slowing and, in some countries, falling. In this article, we determine the implications of these demographic changes for the needed amount of government debt. If tax rates and the transfer share of gross national income (GNI) are both high, the needed debt is near zero. With such a system, however, huge deadweight losses are incurred as a result of the high tax rate on labor income. With a savings system, a large government debt to annual GNI ratio is needed. In a country with early retirement and no population growth, the needed government debt is as large as five times GNI, and welfare is as much as 24 percent higher in terms of lifetime consumption equivalents in the savings system relative to the tax-and-transfer system.