Representative Agent Model Research Articles

Aggregate stock market behavior and investors’ low risk aversion

This paper studies whether investors’ high risk aversion can be avoided in a representative-agent model that is able to explain aggregate stock market behavior in the US financial market. We present a consumption-based asset pricing model with a representative agent who has a ‘catching up with the Joneses’ preference to show that high risk aversion can be avoided in a representative-agent model that can help explain many of the empirically observed properties of the aggregate stock market return, including the equity premium and risk-free rate puzzles, the predictability of long-horizon stock returns, and the ‘leverage effect’ in return volatility.

Optimal Taxation of Capital Income in Models with Endogenous Fertility

This paper studies the issue of the efficient taxation of capital income in intertemporal optimizing models with infinite horizons and endogenous population growth. We discover that, in the steady state, the optimal capital income tax is negative when the economy is closed. Instead, in a small open economy facing perfect capital mobility, the Chamley-Judd result of a zero tax rate is obtained if capital taxation is source-based; otherwise, income from wealth should be subsidized if taxation is residence-based. Moreover, we find that in our setup, taxing capital income with immediate expensing of capital expenditure may replicate the first-best equilibrium when labor is subsidized. Our findings, which depart substantially from those obtained in representative agent models with an endogenous labor supply, are to be ascribed to a wealth effect in the fertility choices that directly affects the pseudo-welfare function of the social planner.

Computing business-as-usual with a representative agent and a pollution externality

Computing the no-policy equilibrium (business-as-usual) in a representative-agent (RA) model is complicated by the presence of a pollution externality, since simple optimization internalizes the pollution cost. Many researchers use ad-hoc methods, but there is no way to know how reliable these are. A solution is presented in which the RA model is divided into N identical components, each identified with its own sub-agent. Sub-agents play a dynamic game, leading to a Nash equilibrium. For sufficiently large N, this approach keeps most of the pollution cost external, and in the limit it is equivalent to a myopic-firms model, in which the entire cost is external. This approach has the advantage of theoretical consistency, and empirical applications indicate that it is easily implemented.

Is the Real Yield Curve Inverted?

Lengwiler (2005) presents a model of an endowment economy in which economic actors have different degrees of patience. The model implies that the social discount rate declines as the time horizon increases and that the resulting term structure of the interest rate cannot be produced by a representative agent model. This paper examines the sensitivity of Lengwiler's results to changes in the model's assumptions. In particular, it examines what sort of changes to Lengwiler's model will yield an upward sloping or even flat real yield curve. Although this paper shows that it is possible to add production to Lengwiler's model without changing the results, it also shows that the results are sensitive to the curvature of the utility function. If it is assumed that utility from consumption is logarithmic, but utility from leisure is quadratic, this paper shows that it is possible for the yield curve to be upward-sloping, downward-sloping or horizontal. Finally the paper informally explores the effect of adding capital accumulation to the model and concludes that this would reinforce the tendency for the yield curve to have a downward slope. This reinforces the general conclusion that the shape of the utility function determines the shape of the real yield curve.

Can environmental taxation stimulate growth? The role of indeterminacy in endogenous growth models with environmental externalities

This paper examines the effects of environmental taxation on long-run growth in an infinitely lived representative agent model of endogenous growth with negative pollution externalities. The novelty of this paper lies in its investigation of how the long-run effects of environmental taxes are affected by the possible emergence of indeterminacy of equilibria in Romer's [1986. Increasing returns and long-run growth. Journal of Political Economy 94, 1002–1037] learning-by-doing model with endogenous labor supply. The analysis shows that environmental taxation generally enhances (harms) long-run growth when the balanced growth path is indeterminate (determinate).

A cobweb model with local externalities

This paper considers an extension of the standard cobweb model in a market with local externalities. In contrast with the standard cobweb model, firms must forecast both prices and local quantities; we develop new constructive stability and existence conditions for equilibria with positive outputs. We find evidence of clusters of firms whose output behavior is correlated as equilibrium is reached. We also show that an appropriately defined ‘representative agent model’ with a global externality exhibits the same mean or second-order properties of aggregate output as the more complex model with local externalities.

The rise in returns to education and the decline in household savings

Over the past 25 years, returns to higher education have increased while the household savings rate has fallen to almost zero. In this paper, we present a representative agent model where a decline in savings emerges as an outcome of an exogenously driven increase in the return to education. In particular, we find that a rise in the return to education raises the education spending ratio by less than what it reduces the aggregate savings rate, and for some parameter values, it actually reduces both ratios. The paper highlights the fact that a part of the decline in savings may reflect a relative reallocation towards human capital investments away from physical capital.

A Dynamic Analysis of a Demand Curve-Based Capacity Market Proposal: The PJM Reliability Pricing Model

Because of high generation adequacy standards in the power industry, some peaking capacity operates for a limited time during the year and may not receive sufficient energy revenues to meet its fixed costs. This is particularly true when energy prices are capped in order to mitigate market power. The northeastern U.S. independent system operators (ISOs) have responded to this issue by establishing capacity obligations for loads and markets for installed capacity, thus providing a capacity revenue stream to generators. The installed capacity (ICAP) markets in the northeastern U.S. markets are a response to this need for additional incentives to construct generation. The Federal Energy Regulatory Commission (FERC) has accepted the PJM Interconnection's (PJM) proposal to replace the present fixed ICAP requirement that is placed upon load serving entities (LSEs) with a demand curve-based system in which the ISO would be responsible for acquiring residual capacity on behalf of LSEs. The demand curve approach pays more when reserve margins are smaller and provides a reduced incentive for investment when installed reserves are above the target. Another goal is to make revenues more predictable for generators, making investment less costly and, ultimately, lowering prices for consumers. A dynamic representative agent model is presented for projecting effects upon reserve margins, generator profitability, and consumer costs and is applied to alternative demand curves proposed for the PJM market. The consumer costs resulting from a sloped demand curve are robustly lower compared to the present fixed requirement under a wide range of assumptions concerning behavior of generation owners, including risk attitudes, bidding behavior, and willingness to build capacity as a function of forecast profit. The cost savings arise from lower capital costs to generators due to reduced risk and risk premiums. Also, average installed capacity is less for the same level of reliability because of reduced fluctuations in installed reserves

Specialization in a dynamic trade model: An overlapping generations case

We explore a small open economy with overlapping generations to show that demographic structure is an important factor for the determination of a production pattern in the dynamic trade theory. In the representative agent model, Baxter (1992) shows that even if there are two commodities and two production factors, there is a Ricardian implication that opening up to trade leads to perfect specialization in a small open economy. In contrast, using the overlapping generations model, we find that the heterogeneity of the economic agents generally makes imperfect specialization occur. We also find that whether the stability condition holds or not is crucial for the determination of the long-run production pattern.

Time-varying risk aversion and asset prices

This paper uses a variant of the consumption-based representative agent model in Campbell and Cochrane [Campbell, J.Y., Cochrane, J.H., 1999. By force of habit: Consumption-based explanation of aggregate stock market behavior. Journal of Political Economy 107, 205–251] to study how investors’ time-varying risk aversion affects asset prices. First, we show that a countercyclical variation of risk aversion drives a procyclical conditional risk premium. Second, we show that with a small value for the volatility of the log surplus consumption ratio, a large value of risk aversion may not determine whether the equity premium and the risk-free rate puzzles can be resolved or not. Third, we show that countercyclical risk aversion may not help explain the predictability of long-horizon stock returns, the univariate mean-reversion of stock prices and the “leverage effect” in return volatility.

On Some Subtle Implications of the Choice of Numeraire for Monetary Policy

In this paper we show how two seemingly irrelevant accounting principles for central banks -the choice of the unit of account for its balance sheet and the method of inventory valuation of foreign currency reserves- can overstate or understate profits transferred to the treasury and how this can threaten the ability of central banks to control inflation. We show the first point through Monte Carlo experiments calibrated for the Venezuelan economy and the second point in an infinitely lived representative agent model that illustrates the problem of the joint determination of the level of foreign currency reserves and the size of profits transferred to the treasury when the objective is to eliminate the possibility of a hyperinflation.

Endogenous Time Preference, Inflation, and Capital Accumulation

In an infinitely lived, representative agent model with the Becker-Mulligan (1997) endogenous time preference, this paper reexamines the effects of monetary growth. An increase in the inflation rate reduces the resources spent on imagining the future, which increases the rate of time preference and decreases the steady-state value of capital stock. This model relates inflation and consumer patience, and shows that inflation will make people less patient. Finally, Friedman's optimal monetary growth rule is also investigated and found not to hold.

Business Cycle Dynamics of a New Keynesian Overlapping Generations Model with Progressive Income Taxation

In our dynamic optimizing sticky price model, agents are heterogeneous with regard to their age and their productivity. We find that the business cycle dynamics in the OLG model in response to both a technology shock and a monetary shock are similar, but not completely identical to those found in the corresponding representative-agent model. In particular, working hours in the OLG model decrease in response to a positive technological shock, since for young workers the income effect dominates the substitution effect. This is in line with the adverse effect of productivity shocks on employment found in structural vector autoregressions.

The Transitional Dynamics of Fiscal Policy in Small Open Economies

The paper studies the dynamic macroeconomic effects of fiscal shocks of various duration (permanent and temporary) under different financing methods (lump-sum tax and government debt). To this end, we develop an intertemporal macroeconomic model for a small open economy, featuring monopolistic competition in the intermediate goods market, endogenous (intertemporal) labor supply, and finitely lived households. Endogenous labor supply is crucial in generating cyclical adjustment paths and yields faster convergence to the new steady state compared with exogenous labor supply. The quantitative output effects and transitional dynamics of fiscal policy differ substantially from those of an infinitely lived representative agent model. In addition, government debt is key in making the timing of shocks matter, thus yielding permanent output effects of temporary fiscal shocks.

Social Dynamics of Obesity

In order to explain the substantial recent increases in obesity rates in the United States, we consider the effect of falling food prices in the context of a model involving endogenous body weight norms and an explicit, empirically grounded description of human metabolism. Unlike previous representative agent models of price-induced gains in average weight, our model, by including metabolic heterogeneity, is able to capture changes in additional features of the distribution, such as the dramatic growth in upper-quartile weights that are not readily inferred from the representative agent setting. We calibrate an analytical choice model to American women in the 30-to-60-year-old age bracket and compare the model's equilibrium weight distributions to data from NHANES surveys spanning (intermittently) the period from 1976 through 2000. The model predicts increases in average weight and obesity rates with considerable accuracy and captures a considerable portion of the relative growth in upperquantile weights. The differential response to price declines across the distribution depends on the fact that human basal metabolism (or resting calorie expenditure) is increasing and yet concave in body weight, and therefore food price effects on weight tend to be larger for individuals who are heavier initially. The lagged adjustment of weight norms helps to explain recent observations that obesity rates have continued to rise since the mid 1990s, despite an apparent leveling off of price declines. The predicted increase in body weight aspirations agrees with an observed trend in self-reported desired weights, and it defies the conventional wisdom that thinness has been a growing obsession among American women in recent decades.

Income, Wealth and Sustainable Welfare in Representative-Agent Economies

In a finite-horizon general equilibrium model national income is the value of output at supporting prices and a perturbation increases welfare if and only if it raises national income. National income therefore serves as both a welfare measure and a cost-benefit criterion. We construct a measure with these properties for an infinite horizon representative agent model (following suggestions by Fisher and by Samuelson), and relate it to a debate about how to measure welfare in a dynamic model, how to measure green national income, and how to measure sustainability. Our measure has all the right properties - it measures national income, provides an if and only if welfare increase criterion (thus integrating national income accounting and cost-benefit analysis), and acts as a good indicator of sustainability. It is observable and has been measured for a number of countries. Our index is a Fisherian wealth measure and our results represent the completion of a research agenda set out by Samuelson in 1961.

Private provision of public goods: incentives for donations

Purpose – The purpose of this paper is to examine the commonly used policy approach to subsidize the private provision of public goods by granting agents deductions with respect to their income or corporate tax burden.Design/methodology/approach – In the framework of a microeconomic representative agent model the commonly used policy approach to subsidize donations by granting agents deductions with respect to their income tax burden is examined. The paper especially considers that most income tax schemes are progressive and deductibility is limited. After pointing to the problems arising from these specific properties of tax‐refund schemes the paper turns towards the effects that such a tax‐refund scheme has with respect to donations on the one hand and welfare on the other hand.Findings – Findings shows that the effects of the commonly practiced methods of supporting donations depend crucially on the specific properties of the tax scheme and preferences of agents. While Pareto‐improvements and even Pare...

Real exchange rate and employment performance in an open economy

The usual neoclassical model of labor supply and employment determination has been based in closed economy models. This paper studies the effect of introducing open economy features on the determinants of equilibrium employment. It derives the long run employment level as a function of the real wage, real interest rate and real exchange rate from a standard open economy optimizing representative agent model. The paper tests the steady state solution of the model using US and UK data and, in order to avoid the Lucas' critique, it tests for the superexogeneity of the interest rate and exchange rate. The evidence shows a significant impact of the real exchange rate, real interest rate, and real wage only for the US, where it is also robust to the Lucas' critique.

A Stochastic Monopsony Theory of the Business Cycle

Two distinct regimes, contractions and expansions, are generated in a model in which goods markets clear and all individuals are optimizing, strict wage and price takers, have fully rational expectations, and are heterogeneous in both preferences and resource endowments. Involuntary unemployment, asymmetric monetary policy effectiveness, and a changing relationship between real wages and employment over the business cycle are the result of optimizing behavior by monopsonistic, wage-setting, and price-taking firms faced with price uncertainty, an upward-sloped supply of employees, and efficiency wage behavior. Disequilibrium and involuntary unemployment can occur at the level of the individual firm's labor market. (JEL E32, E52, J41, J42) I. INTRODUCTION For many economists, three stylized facts are central to any plausible theory of the business cycle. (1) Friedman and Schwartz (1963) and Romer and Romer (1994) concluded that monetary shocks have output, employment, and unemployment effects at least some of the time and such effects are asymmetric with respect to the state of the economy. (2) Unemployment is subject to fluctuations associated with recessions and expansions and, in some recessions, has been very high. (1) (3) The relationship between real wages and employment appears to be time period sensitive as reported by Abraham and Haltiwanger (1995). Although first proposed by Keynes, modern economists such as Benassy (2002) argue that at least some unemployment is best characterized as involuntary and indicates a state of disequilibrium. In this article, we consider a plausible alternative to disequilibrium explanations of these elements of the business cycle based on goods market imperfections, such as those by Benassy (2002) and Dixon and Rankin (1995), who considered monopoly power by firms in the goods market, and Benassy (1995), who assumed monopoly power by unions in the labor market. We assume that the goods market is characterized by competitive market clearing, but firms have some monopsony power as reflected in an upward-sloped or bounded supply of labor to the firm and the ability to set the optimal wage before knowing the price they will receive for their output, which is assumed to be stochastic, and making their employment decision. These modifications are embedded in an otherwise conventional general equilibrium model in which all agents (firms and consumers/workers/capitalists) are fully optimizing and form totally rational expectations and labor may exhibit efficiency wage behavior. (2) This is not a representative agent model and cannot be reduced to such. Individuals are heterogeneous in both their endowments and preferences. Firms may be heterogeneous with respect to their production technology and the interests of firm owners are distinct from those of their employees. The latter is essential to generate the changing regimes that produce predictions that correspond to the stylized facts. Monetary shocks affect output, prices, employment, and unemployment in an asymmetrical manner consistent with the traditional business cycle. The key to understanding these effects is the labor market. If the expected quantity of money is generated, then the competitive, market-clearing real wage will result. Lower than expected quantities of money generate a deficiency of aggregate demand, lower than expected output prices and real wages above the competitive wage. Real wages above the competitive wage are associated with excess supply of labor and involuntary unemployment (independent of that associated with efficiency wage behavior). This contractionary regime will persist as long as the low quantities of money persist, even though all agents have fully rational expectations, are optimizing, and the goods market clears. In this regime, increases in the quantity of money increase prices, employment, and output, and employment varies negatively with the real wage. Efficiency wage behavior may decrease effort as the real wage rate is decreased. …

Financial Liberalization and Consumption Volatility in Developing Countries

One of the chief benefits of financial liberalization proposed by theoretical literature is that it should allow countries to better smooth consumption through international risk sharing. Recent empirical evidence does not support this prediction. In developing countries, financial liberalization seems to be associated with an increase in consumption volatility. This paper seeks to rationalize the evidence by linking it to two important features of developing countries. First, domestic financial markets are underdeveloped. We model this by adopting the Kocherlakota (1996) framework of risk sharing subject to limited commitment. Second, access to international markets is not available to all members of society. We show that when risks are idiosyncratic, that is, insurable within the domestic economy, opening up to international markets reduces the amount of risk sharing attained at home and raises the volatility of consumption. When risk is aggregate to the economy, the underdeveloped financial system prevents the pooling of aggregate risk across agents for the purposes of insurance in the international markets. Thus, while the volatility of consumption coming from aggregate risk decreases with financial liberalization, it does so by much less than would be predicted by a representative agent model.