General Equilibrium Effects Research Articles

What We Don't Know Doesn't Hurt Us: Rational Inattention and the Permanent Income Hypothesis in General Equilibrium

This paper derives the general equilibrium effects of rational inattention (or RI; Sims 2003, 2010) in a model of incomplete income insurance (Huggett 1993, Wang 2003). We show that, under the assumption of CARA utility with Gaussian shocks, the permanent income hypothesis (PIH) arises in steady state equilibrium due to a balancing of precautionary savings and impatience. We then explore how RI affects the equilibrium joint dynamics of consumption, income and wealth, and find that elastic attention can make the model fit the data better. We finally show that the welfare costs of incomplete information are even smaller due to general equilibrium adjustments in interest rates.

Population Aging, Migration Spillovers, and the Decline in Interstate Migration

Interstate migration in the United States has declined by 50 percent since the mid-1980s. This paper studies the role of the aging population in this long-run decline. We argue that demographic changes trigger a general equilibrium effect in the labor market, which affects the migration rate of all workers. We document that an increase in the share of middle-aged workers (those ages 40 to 60) in the working-age population in one state causes a large fall in the migration rate of all workers in that state, regardless of their age. To understand this finding, we develop an equilibrium search model of many locations populated by workers whose moving costs differ. Firms prefer hiring local workers with high moving costs as they command lower wages due to their lower outside option. An increase in the share of middle-aged workers causes firms to recruit more from the local labor market instead of hiring from other locations, which increases the local job-finding rate and reduces everyone’s migration rate (“migration spillovers”). Our model reproduces remarkably well several cross-sectional facts between population flows and the age structure of the labor force. Our quantitative analysis suggests that population aging accounts for about half of the observed decline, of which 75 percent is attributable to the general equilibrium effect.

An evaluation of the revenue side as a source of fiscal consolidation in high debt economies

Purpose– Unsustainable levels of debt in some European economies are causing enormous strain in the Euro area. Successful debt consolidation in high-debt economies is the single most important objective for the European policy makers. The paper aims to discuss these issues.Design/methodology/approach– The author uses a dynamic general equilibrium closed economy model to compute the dynamic Laffer curves for Portugal, Ireland, Greece and Spain for different class of taxes. The general equilibrium effects of the interaction of labor tax, consumption tax and capital tax is demonstrated.Findings– Location of each economy on its Laffer curve suggests that there exists a scope for considerable revenue generation by raising consumption and labor tax rates but no such possibilities exist for capital tax rate. Thus revenue generation with certain tax rates as instruments, holds key to successful and sustained debt reduction.Originality/value– This to the best of knowledge is one of the first papers which looks closely at the tax revenue – tax rate panel for the major deeply indebted European economies.

On the Optimality of Bank Capital Requirement Policy in a Macroeconomic Framework

An increasingly widespread “macro-prudential” view holds that bank capital requirements should be loosened during recessions and tightened during expansions to avoid excessive credit and output swings. We present a dynamic general equilibrium framework that accounts for the effects of capital requirement policies on the saving decisions of households, and, through this channel, on bank loans and output. We evaluate optimal capital requirement policy in the presence of loan write-offs (loan supply) and productivity (loan demand) shocks. We show that capital requirements should be reduced in response to unanticipated loan write-offs. We also show that capital requirements should be tightened in anticipation of future declines in productivity, and loosened at the onset of recessions. We conclude that macro-prudential capital requirement policies can be optimal from a welfare standpoint, but they can also generate output and credit booms through general equilibrium effects.

High Marginal Tax Rates on the Top 1%? Lessons from a Life Cycle Model with Idiosyncratic Income Risk

In this paper we argue that very high marginal labor income tax rates are an effective tool for social insurance even when households have preferences with high labor supply elasticity, make dynamic savings decisions, and policies have general equilibrium effects. To make this point we construct a large scale Overlapping Generations Model with uninsurable labor productivity risk, show that it has a wealth distribution that matches the data well, and then use it to characterize fiscal policies that achieve a desired degree of redistribution in society. We find that marginal tax rates on the top 1% of the earnings distribution of close to 90% are optimal. We document that this result is robust to plausible variation in the labor supply elasticity and holds regardless of whether social welfare is measured at the steady state only or includes transitional generations.

General equilibrium effects of spatial structure: Health outcomes and health behaviours in Scotland

Socioeconomic characteristics, health behaviours, and the utilisation and quality of healthcare are prime examples of socioeconomic, cultural and demographic phenomena that are inherently spatial in nature. Understanding the spatial structure of these factors is particularly relevant in order to efficiently allocate resources. This paper explores the general equilibrium spatial structure of health outcomes and health behaviours across Scottish health boards using a variant of the spatial Durbin model which allows for an a priori unknown spatial weights matrix. The results suggest that there is substantial spatial dynamics in behaviours across health boards and that these spillovers are, as expected, asymmetric. We then demonstrate how the model can be used to estimate the behavioural and health impact of a targeted education policy within each health board taking into account both the direct effect on the particular health board itself and the indirect effect in terms of spillovers. The results illustrate how the dynamic effects should play a large role in designing place based policies that maximise the overall effectiveness of health interventions. Taking into account the spatial dynamics allows policy makers to better target resources and interventions on particular clusters where the direct and indirect spillover benefits are likely to be the greatest in terms of improving health.

High Marginal Tax Rates on the Top 1%?

In this paper we argue that very high marginal labor income tax rates are an effective tool for social insurance even when households have preferences with high labor supply elasticity, make dynamic savings decisions, and policies have general equilibrium effects. To make this point we construct a large scale Overlapping Generations Model with uninsurable labor productivity risk, show that it has a wealth distribution that matches the data well, and then use it to characterize fiscal policies that achieve a desired degree of redistribution in society. We find that marginal tax rates on the top 1% of the earnings distribution of close to 90% are optimal. We document that this result is robust to plausible variation in the labor supply elasticity and holds regardless of whether social welfare is measured at the steady state only or includes transitional generations.

The Minimum Wage and Inequality: The Effects of Education and Technology

While there has been intense debate in the empirical literature about the effects of minimum wages on inequality in the US, its general equilibrium effects have been given little attention. In order to quantify the full effects of a decreasing minimum wage on inequality, I build a dynamic general equilibrium model, based on a two-sector growth model where the supply of high-skilled workers and the direction of technical change are endogenous. I find that a permanent reduction in the minimum wage leads to an expansion of low-skilled employment, which increases the incentives to acquire skills, thus changing the composition and size of high-skilled employment. These permanent changes in the supply of labour alter the investment flow into R&D, thereby decreasing the skill-bias of technology. The reduction in the minimum wage has spill-over effects on the entire distribution, affecting uppertail inequality. Through a calibration exercise, I find that a 30 percent reduction in the real value of the minimum wage, as in the early 1980s, accounts for 15 percent of the subsequent rise in the skill premium, 18.5 percent of the increase in overall inequality, 45 percent of the increase in inequality in the bottom half, and 7 percent of the rise in inequality at the top half of the wage distribution.

Credit Status and College Investment: Implications for Student Loan Policies

The private market for student loans has become an important source of college financing in the United States. Unlike government student loans, the terms on student loans in the private market are based on credit status. We quantify the importance of the private market for student loans and of credit status for college investment in a general equilibrium heterogeneous life-cycle economy. We find that students with good credit status invest in more college education (compared to those with bad credit status) and that this effect is more pronounced for low-income students. Furthermore, results suggest that the relationship between credit status and college investment has important policy implications. Specifically, when borrowing limits in the government student loan program are relaxed (as implemented in 2008), college investment increases, but so does the riskiness of the pool of borrowers, leading to higher default rates in the private market for student loans. When general equilibrium effects are accounted for, the welfare gains experienced from a more generous government student loan program are negated. This compares to budget-neutral tuition subsidies that increase college investment and welfare.

Engines of liberation redux when home appliances prices are endogenous

We propose a model of the household where the transmission mechanism between home appliances and women’s labor supply is identical to the one in Greenwood et al. (2005b) with one important exception. We explicitly model firms’ pricing and output choices in the appliances sector and thus, the price of home appliances is determined endogenously by the laws of supply and demand rather than being taken exogenously from outside the model. We use this new framework to characterize the general equilibrium effects of rising household wages on the price of home appliances, and thus ultimately women’s labor supply. The ratio between the price of home appliances and household wages declines following a rise in the wage level, which leads to widespread adoption of home appliances and increased labor force participation of married women. A numerical example shows that rising wages account for half of the increase in participation of married women between 1960 and 1970.

Product quality, firm heterogeneity and trade liberalization

This paper develops a framework for studying the general equilibrium effects of endogenous quality upgrading, a new margin of trade, on the welfare impact of trade liberalization. The theoretical model introduces product quality differentiation amongst heterogeneous firms and focuses on supply-side determinants of international trade. Among other results, in general equilibrium, trade liberalization decreases the share of high-quality varieties in exports and the average productivity of exporters. These changes affect average export price in opposite ways. Nevertheless, trade liberalization in the quality-extended model increases consumers’ welfare by more than in the benchmark model.

Environmental Taxation, Health, and the Life-Cycle

We build a model that takes into consideration the evolution of health over the life cycle and its consequences on individual optimal choices. In this framework, the effects of environmental taxation are not limited to the traditional negative crowding-out and positive productivity effects. We show that environmental taxation generates new general equilibrium effects ignored by previous contributions. Indeed, as the environmental tax improves the health profile over the life-cycle, it influences saving, labor supply, and retirement. We also show that whether those general equilibrium effects are positive or negative for the economy crucially depends on the degree of substitutability between young and old labor. Our numerical examples suggest that ignoring those new effects may result in large overstatement of the negative effect of an increase in environmental taxation on output, and understatement of the positive effect on welfare.

Education and Crime over the Life Cycle

We compare two large-scale policy interventions aimed at reducing crime: subsidizing high school completion and increasing the length of prison sentences. To this purpose we use a life-cycle model with endogenous education and crime choices. We apply the model to property crime and calibrate it to U.S. data. We find that targeting crime reductions through increases in high school graduation rates entails large efficiency and welfare gains. These gains are absent if the same crime reduction is achieved by increasing the length of sentences. We also find that general equilibrium effects explain roughly one half of the reduction in crime from subsidizing high school.

Can Cash Transfers Promote the Local Economy? A Case Study for Cambodia

Providing the poorest with safety nets and some form of social protection is becoming part of the agenda of the majority of developing countries. And while cash transfer programs started 15 years ago with experiments and pilot projects, there is currently a scaling up of policies in many parts of the developing world. These policies involve large financial flows which are likely to impact markets, employment and prices.While previous research on cash transfer programs has primarily concentrated on micro-economic effects, this paper analyzes general equilibrium effects of social transfer policies using a computable general equilibrium model applied to Cambodia. It identifies the potential impact of these transfers on the local economy, looking particularly at prices and market responses to an increase in demand through production and trade. Our findings show that, for goods and services for which domestic supply is not elastic enough to respond to a significant rise in demand, prices will increase, affecting the value of transfers on poverty reduction. However, productivity gains from the health and education component of conditional cash transfers appear to be likely to mitigate the price effects associated with cash transfers alone. Our simulation results also show strong complementarities between social protection and rural development policies. At a given level of public spending, a combination of these two types of policies is likely to generate more poverty reduction than cash transfers alone, while also significantly benefiting the local economy. The results indicate that in the context of weak market integration and insufficient supply response, cash transfers would be more effective if embedded in development strategies that improve trade and domestic production. Social protection programs could therefore become more effective when implemented simultaneously with productivity-enhancing policies.

Local Multipliers and the Informal Sector in Mexico 2000-2010

This paper analyzes local multipliers and the relation between tradable job creation and informality in Mexico. Building upon local multipliers analysis, and taking into consideration agglomeration economies as well as general equilibrium effects, if finds that a new job in the tradable sector traduces into three new jobs in the nontradable sector. Half of these jobs occur in the informal sector, which is not a desirable outcome considering the low tax collection and vulnerability to labor market shocks associated to informality. Considering the skill composition of the tradable sector, individuals with some college or more have a much higher multiplier over nontradable jobs compared to other skill levels. There are asymmetric effects in terms of the multiplier as negative shocks job losses have higher effects.

Urban growth, transportation and the spatial dimension of the labour market: A note

AbstractRecently, Duranton and Turner estimated the impact of interstate highways on the average growth of US cities between 1983 and 2003. By estimating a structural model, one of their striking points is that increasing a city's initial stock of highways by 10 per cent leads to a 1.5 per cent positive respond of the city's employment over the sample period. This note mainly argues that their investigation leaves out potential spillovers of labour input from neighbouring growth centres/cities in the steady‐state directly implied by the open city assumption. More specifically, this contribution readily extends Duranton and Turner's work by a general equilibrium effect induced by the urban system's labour market fluctuations which is a direct consequence of the open city assumption.

Welfare and distributional impacts of price shocks in Malawi: a non-parametric approach

This analysis used measures of Compensating Variation and Net Benefit Ratio to assess the short-run effects of higher prices on different wealth groups in rural and urban areas of Malawi. Compensating Variation analysis indicated that in aggregate terms, both rural and urban households had suffered with the recent price increases, but urban areas were more severely impacted. Relatively better-off households in urban areas had much larger welfare losses than the poorest, while in rural areas there was not much difference across wealth groups. Losses in expenditure on food consumption (particularly dominated by cereals and grains) were higher in rural areas. In both areas, the poorest households carried the heaviest burden of the food price increases. The opposite result was found for non-food items, where negative effects were stronger among urban households and, in both areas, the relatively better-off carried a heavier burden. Accounting for substitution effects in consumption, with households adjusting away from more expensive items, resulted in a significant reduction in welfare losses and poverty incidence in urban, but not in rural areas. In each scenario, female-headed households experienced the most adverse impacts. Results were translated into tangible policy and programmatic recommendations, specifying alternative budget scenarios which could compensate the most adversely affected groups. Net Benefit Ratio Analysis, which brings in supply side considerations, found that, assuming “no wage effects”, doubling the price of food would reduce real income by about a third in urban areas, and by less that a fifth in rural areas, with the poorest in each area suffering the most. This is a reflection of the fact that there are relatively more households that produce and sell in rural areas than in urban areas. Assuming a wage response to price increases, we find that the adverse effects were reduced more strongly in urban areas, which is a reflection of a more active wage labor market in those areas, where wage adjustments help to minimize the negative effects of price shocks. This analysis suggested that policies should be oriented towards supporting household livelihoods by strengthening social protection interventions, including direct cash transfers and labor intensive public works programs, to effectively protect and compensate households for welfare losses that result from price shocks. In order to be able to capture general equilibrium and long-term effects of price shocks and adjustment to them, it is recommended that future research should combine partial equilibrium methods with a general equilibrium framework.

Multiple Pollutants, Uncovered Sectors, and Suboptimal Environmental Policies

In our analytical general equilibrium model where two polluting inputs can be substitutes or complements in production, we study the effects of a tax on one pollutant in two cases: one where both pollutants face taxes and the second where the other pollutant is subject to a permit policy. In each case, we solve for closed-form solutions that highlight important parameters. We demonstrate two important ways that environmental taxes and permits are not equivalent. First, the change in the pollutant facing a tax increase depends on whether the other pollutant is subject to a tax or permit policy. Second, if that other pollutant is subject to a tax, then general equilibrium effects can increase or decrease its quantity (affecting overall welfare). However, when the second pollutant is subject to a permit policy that binds, then welfare is not affected by this spillover effect. Finally, a numerical exercise helps demonstrate these two ways that taxes and permits differ. Using the example of coal-fired power plants, our numerical exercise examines the impacts of increasing a hypothetical carbon tax on the quantity of sulfur dioxide emissions.

Heterogeneous Information and Labor Market Fluctuations

Idiosyncratic productivity shocks induce larger adjustments to hiring than aggregate shocks, because general equilibrium effects on search frictions and wages partially offset the latter. When firms cannot disentangle the two shocks, they attribute aggregate disturbances partly to idiosyncratic factors and to that extent, respond more aggressively. This translates into increased aggregate volatility, an order of magnitude higher than the benchmark full information model. A calibrated model predicts moments that match closely levels observed in the US data. These results hold under both random and directed search specifications.

Credit Status and College Investment: Implications for Student Loan Policies

The private market for student loans has become an important source of college financing in the United States. Unlike government student loans, the terms on student loans in the private market are based on credit status. We quantify the importance of the private market for student loans and of credit status for college investment in a general equilibrium heterogeneous life-cycle economy. We find that students with good credit status invest in more college education (compared to those with bad credit status) and that this effect is more pronounced for low-income students. Furthermore, results suggest that the relationship between credit status and college investment has important policy implications. Specifically, when borrowing limits in the government student loan program are relaxed (as implemented in 2008), college investment increases, but so does the riskiness of the pool of borrowers, leading to higher default rates in the private market for student loans. When general equilibrium effects are accounted for, the welfare gains experienced from a more generous government student loan program are negated. This compares to budget-neutral tuition subsidies that increase college investment and welfare.