Simple General Equilibrium Research Articles

The credit channel of monetary transmission in a small open economy

This paper studies the credit channel of monetary transmission in a small open economy. We develop a simple general equilibrium model by extending Bernanke and Blinder's (1988) CC-LM framework and Edwards and Végh's (1997) banking specification. Under a floating exchange rate regime and with imperfect capital mobility, we establish that bank-lending behavior may amplify, neutralize or attenuate the impact of monetary policy on output, price and the nominal exchange rate as compared to the standard interest rate channel. An important explanatory factor is the sensitivity of banks and firms to loans and market interest rates. This examination is important to consider in light of the standard AD-AS model at the policy-making level, and in light of recent empirical evidence regarding the credit channel as an important element of the monetary transmission mechanism.

On the intensity of downside risk aversion

The degree of downside risk aversion (or equivalently prudence) is so far usually measured by $\frac{-U^{\prime \prime \prime }}{U^{\prime \prime }}$ . We propose here another measure, $\frac{U^{\prime \prime \prime }}{U^{\prime }}$ , which has specific and interesting local and global properties. Some of these properties are to a wide extent similar to those of the classical measure of absolute risk aversion, which is not always the case for $\frac{ -U^{\prime \prime \prime }}{U^{\prime \prime }}$ . It also appears that the two measures are not mutually exclusive. Instead, they seem to be rather complementary as shown through an economic application dealing with a simple general equilibrium model of savings.

Social Preferences and Redistribution under Direct Democracy

There is growing evidence on the roles of fairness and social preferences as fundamental human motives, in general, as well as in voting contexts. In contrast, models of political economy are based on sel…sh-voters who derive utility solely from ‘own’payo¤. We examine the implications of introducing voters with social preferences, as in Fehr and Schmidt (1999), in a simple general equilibrium model with endogenous labour supply. We demonstrate the existence of a Condorcet winner for voters, with heterogeneous social preferences (including purely sel…sh preferences), using the single crossing property of voters’preferences. Relatively small changes in the preference of voters can have relatively large redistributive consequences. We implications for the size of the welfare state; regional integration; and issues of culture, identity and immigration.

Forecast with Judgment and Models

This paper proposes a simple and model-consistent method for combining forecasts generated by structural micro-founded models and judgmental forecasts. The method also enables the judgmental forecasts to be interpreted through the lens of the model. We illustrate the proposed methodology with a real-time forecasting exercise, using a simple neo-Keynesian dynamic stochastic general equilibrium model and prediction from the Survey of Professional Forecasters.

ECONOMIC PERFORMANCE THROUGH TIME: A GENERAL EQUILIBRIUM MODEL

This paper presents a simple general equilibrium model of economic performance through time. The model incorporates four main determinants of economic performance: technology, capital investment, the division of labor and quality of institutions. It demonstrates that growth is not automatic even with technological progress. In order to maintain economic growth, it is important to continuously implement new technologies through capital investment. It also shows that institutional improvement promotes the social division of labor, which is an independent source of economic growth.

School finance reform: Assessing general equilibrium effects

In 1994 the state of Michigan implemented one of the most comprehensive school finance reforms undertaken to date in any of the states. Understanding the effects of the reform is thus of value in informing other potential reform initiatives. In addition, the reform and associated changes in the economic environment provide an opportunity to assess whether a simple general equilibrium model can be of value in framing the study of such reform initiatives. In this paper, we present and use such a model to derive predictions about the effects of the reform on housing prices and neighborhood demographic compositions. Broadly, our analysis implies that the effects of the reform and changes in the economic environment are likely to have been reflected primarily in housing prices and only modestly on neighborhood demographics. We find that evidence for the Detroit metropolitan area from the decade encompassing the reform is largely consistent with the predictions of the model.

The Macroeconomic Effects of a Productivity Shock in the Nontraded Goods Sector

This paper analyses the macroeconomic effects of a productivity shock in the nontraded goods sector using a small open economy model. The paper develops a simple dynamic general equilibrium model offering intuitive explanations of how a productivity shock affects a small open economy. The model gives a surprisingly pessimistic view on the benefits of productivity shocks. For example, a productivity shock has, except for one special case, a negative effect on the output of nontraded goods in the short run. This result differs from the results of RBC models. The paper gives an interesting insight into the possible effects that the introduction of the EU (European Union) services directive or GATS (General Agreement on Trade in Services) agreement may have.

Who bears the burden of a tax on carbon emissions in Japan?

We develop a simple general equilibrium model in the style of Harberger to analyze the distributional effects of the proposed “environment tax” on carbon in Japan. We derive closed-form equations that show how a change in the tax rate affects the economy-wide return to capital, wage, and output prices. The two main features of the economy that determine the sources-side incidence of the tax are the factor intensities of the polluting and nonpolluting industries and the elasticity of substitution in production between polluting inputs and labor or capital. The input that is a better substitute for pollution usually bears a lower burden of the tax than the other input, although we find conditions under which this is not true. If the polluting sector is relatively capital intensive, then capital can bear a higher burden of the tax. Calibrating this model to the Japanese economy, we find a trade-off between these two effects. Polluting industries are more capital intensive, but capital is likely to be a better substitute for pollution than is labor.

Modeling Great Depressions: The Depression in Finland in the 1990s

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.

The Macroeconomic Effects of Nonzero Trend Inflation

We study the macroeconomic effects of nonzero trend inflation in a simple dynamic stochastic general equilibrium model under three common time‐dependent pricing schemes: Calvo, truncated‐Calvo, and Taylor. We show that, regardless of the pricing mechanism, trend inflation leads to a reduction in the stochastic means of output, consumption and employment, and an increase in the stochastic mean of inflation beyond its deterministic steady‐state level. The variability of most aggregates also increases. These effects are quantitatively much stronger with Calvo pricing.

EXTERNALITIES AND PARTIAL TAX REFORM: DOES IT MAKE SENSE TO TAX ROAD FREIGHT (BUT NOT PASSENGER) TRANSPORT?*

ABSTRACT Externalities such as pollution and road congestion are jointly produced by the use of intermediate inputs by firms and the consumption of final goods by households. To cope with such externalities, policy proposals often suggest partial tax reforms. This paper uses a simple general equilibrium model to explore the effects of a reform of taxes on freight transport in a second‐best setting. The theoretical model shows that the welfare effect of higher freight taxes is positive, unless passenger transport is severely under‐taxed and the tax reform attracts substantially more passenger transport. Moreover, the optimal freight tax may be below or above marginal external cost. Budgetary neutral tax reform exercises with a numerical simulation model for the U.K. suggest that, under a wide variety of parameter values, higher freight transport taxes are indeed welfare increasing. The welfare gain of freight tax reform rises with the level of the passenger tax, but the optimal freight tax declines at higher taxes on passenger transport. Substantial net benefits of tax reform are obtained only under labor tax recycling of the revenues.

Concerning Inequality, Technology Adoption, and Structural Change

Empirical evidence suggests that there has been a divergence over time in income distributions across countries and within countries. Furthermore, developing economies show a great deal of diversity in their growth patterns during the process of economic development. For example, some of these countries converge rapidly on the leaders, while others stagnate, or even experience reversals and declines in their growth processes. In this paper we study a simple dynamic general equilibrium model with household specific costs of technology adoption which is consistent with these stylized facts. In our model, growth is endogenous, and there are two-period lived overlapping generations of agents, assumed to be heterogeneous in their initial holdings of wealth and capital. We find that in a special case of our model, with costs associated with the adoption of more productive technologies fixed across households, inequalities in wealth and income may increase over time, tending to delay the convergence in international income differences. The model is also capable of explaining some of the observed diversity in the growth pattern of transitional economies. According to the model, this diversity may be the result of variability in adoption costs over time, or the relative position of a transitional economy in the world income distribution. In the more general case of the model with household specific adoption costs, negative growth rates during the transitional process are also possible.

The pricing of foreign currency options under jump‐diffusion processes

AbstractIn this article, the authors derive explicit formulas for European foreign exchange (FX) call and put option values when the exchange rate dynamics are governed by jump‐diffusion processes. The authors use a simple general equilibrium international asset pricing model with continuous trading and frictionless international capital markets. The domestic and foreign price level are introduced as state variables that contain jumps caused by monetary shocks and catastrophic events such as 9/11 or Hurricane Katrina. The domestic and foreign interest rates are stochastic and endogenously determined in the model and are shown to be critically affected by the jump risk of the foreign exchange. The model shows that the behavior of FX options is affected through the impact of state variables and parameters on the nominal interest rates. The model contrasts with those of M. Garman and S. Kohlhagen (1983) and O. Grabbe (1983), whose models have exogenously determined interest rates. © 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:669–695, 2007

Asset Pricing in a Production Economy with Chew-Dekel Preferences

In this paper we provide a thorough characterization of the asset returns impliedby a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein Zin preferences, there exist plausible parameter values such that the model generates unconditional mean risk free rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the price dividend ratio is pro cyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the risk free rate with output growth and consumption growth and (ii) the correlation pattern between risk free rate, equity return, and equity premium. The risk implied by the model is rather low. Given the work of Rabin (2000) among others, it is not surprising that our Epstein Zin agent exhibits a much higher risk aversion when faced with substantially larger risks. This shortcoming, however, does not extend to the case in which agents are disappointment averse in the sense of Gul (1991). When faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility!

International capital flows

Abstract The surge in international asset trade since the early 1990s has lead to renewed interest in models with international portfolio choice. We develop the implications of portfolio choice for both gross and net international capital flows in the context of a simple two-country dynamic stochastic general equilibrium (DSGE) model. We focus on the time-variation in portfolio allocation following shocks, and resulting capital flows. Endogenous time-variation in expected returns and risk, which are the key determinants of portfolio choice, affect capital flows in often subtle ways. The model is consistent with a broad range of empirical evidence. An additional contribution of the paper is to overcome the technical difficulty of solving DSGE models with portfolio choice by developing a broadly applicable solution method.

Introducing CGE Models to the Classroom Using Excel

This paper demonstrates how simple general equilibrium models can be solved with the help of Microsoft Excel. Two different general equilibrium models for tax incidence analysis are used as illustrative examples. The methods presented here are intended to be beneficial to both students and teachers working with general equilibrium theory in the classroom and can easily be extended to various policy analysis term projects. The techniques presented here are simple and effective tools for inclusion in any student's toolkit.

UNEMPLOYMENT POLICIES IN AN ECONOMY WITH ADVERSE SELECTION

ABSTRACTThis paper studies the effects of unemployment policies in a simple static general equilibrium model with adverse selection in the labour market. Firms offer a contract that induces the self‐selection of workers. In equilibrium, all unskilled workers are screened out and some skilled workers are rationed out. It is shown that the provision of unemployment insuranceraisesinvoluntary unemployment by encouraging adverse selection, while unemployment assistance – or subsidy to unemployment – reduces involuntary unemployment. A simple efficiency wage model is also presented to show that either of the two policies reduces employment by taxing effort and subsidizing shirking. The key is whether the social role of unemployment is a sorting device or a worker discipline device.

Asset Pricing in a General Equilibrium Production Economy With Chew-Dekel Risk Preferences

In this paper we provide a thorough characterization of the asset returns implied by a simple general equilibrium production economy with convex investment adjustment costs. When households have Epstein-Zin references, there exist plausible parameter values such that the model generates unconditional mean risk-free rate and equity return, and volatility of consumption growth, which are in line with historical averages for the US economy. Consistently with the data, the model's implied price-dividend ratio is pro-cyclical and stock returns are predictable (and increasingly so as the time horizon increases), while dividend growth is not. The model also implies realistic values for (i) the correlation of the risk-free rate with output growth and consumption growth and (ii) the correlation pattern between risk-free rate, equity return, and equity premium. The risk implied by the model is rather low. At the modal state of nature, an individual that expects to consume for 100,000 dollars a year faces a lottery over future consumption with a standard deviation of 55 dollars (per quarter). Her risk aversion is such that she's willing to pay 1 dollar (per quarter) in order to avoid that lottery. Very similar results can be obtained assuming that agents are disappointment averse in the sense of Gul. With such risk preferences, the universality requirement is not a problem to the extent that it is in the case of expected utility. In fact, faced with a lottery that has a coefficient of variation 100 times as large as that implied by our model, a disappointment averse agent displays the same relative risk aversion as an expected utility agent with logarithmic utility.

Equilibrium Correlations of Asset Price and Return

Two empirical questions concerning the equity and housing have been studied extensively: (1) Are the price and return serially correlated, and (2) What is the optimal weight of housing in the portfolio? The answer to the second question crucially depends on the cross-correlation of assets. This paper complements the literature by building a simple dynamic general equilibrium with fully rational agents, and obtain closed form solutions for the implied auto- and cross-correlations. The length of time horizon, as well as the persistence of economic shock matter. Implications and future research directions are then discussed.

Dynamic Equilibrium with Overpriced Put Options

It is a well-known anomaly that prices of put options are too high when options are out-of-the-money. This paper presents a simple general equilibrium model of the market where European put options become substantially overpriced when they are out-of-the-money. Overpricing is due to the presence of short-sale constraints on trading stocks and derivatives, as well as the heterogeneity between investors. We confirm the predicting power of the model by comparing its implications with existing empirical results.