Two-sector Dynamic General Equilibrium Model Research Articles

Is the output growth rate in NIPA a welfare measure?

Abstract This paper shows that, in a dynamic general equilibrium framework, the rate of output growth as measured by national income and product accounts reflects changes in welfare in the precise sense of equivalent variation. The main argument is straightforward. In a two-sector dynamic general equilibrium model of heterogeneous households, recursive preferences and quasi-concave technology, the Bellman equation provides a representation of household preferences over current consumption and investment. When applied to this representation of preferences, a Fisher–Shell true quantity index turns out to be equal to the Divisia index, closely approximated by the Fisher ideal chain index used in national income and product accounts.

Convergence of shadow economy across U.S. states

ABSTRACT Using a novel shadow economy measure constructed from a two-sector dynamic deterministic general equilibrium model, this paper provides the first piece of evidence on the convergence dynamics of the shadow economy at the U.S. state level over the period 1999–2019. The result of the panel club convergence test demonstrates the absence of absolute convergence but also identifies the presence of six club memberships without an apparent regional conglomeration. Further analysis based on the ordered logit regression uncovers that factors such as gross state product, the share of higher education, government size, the share of union participation, capital tax rate, institutional quality, and unemployment rate significantly influence the club membership of the shadow economy. Understanding these findings is imperative for developing policies to curtail the spread of shadow economies across the states in the U.S.

Inter-industry trade and business cycle dynamics

Abstract Motivated by the increased importance of trade between industrialized and less-developed countries, we build a two-sector dynamic stochastic general equilibrium model featuring inter-industry trade as well as intra-industry trade to analyze the business cycle dynamics of industrialized countries. We find that import-competing sectors are more sensitive to domestic productivity shocks than exporting sectors, due to their stronger reliance on domestic demand. This generates pressure to adjust relative prices and to reallocate factors of production. It also propagates the international spillover effects of productivity shocks leading to stronger business cycle comovement across countries, relative to a traditional business cycle model that does not feature inter-industry trade.

Optimal monetary policy responses to carbon and green bubbles:A two-sector DSGE analysis

This paper investigates the emergence of carbon and green bubbles and their impacts on macroeconomic performance and the environment, with a particular focus on identifying the optimal monetary policy responses. We construct a two-sector dynamic stochastic general equilibrium (DSGE) model that incorporates monetary policy and allows carbon and green rational bubbles to emerge. We find that while supply-side shocks drive bubble formation in both sectors, demand-side shocks have a disproportionate impact on these sectors. The paper also shows that contractionary monetary policies are effective in reducing both carbon emissions and asset bubbles. Optimal monetary policy response to the emergence of asset bubbles is calculated, emphasizing the crucial role of central banks in designing monetary policy rules that account for the emergence of bubbles. Social welfare can be optimized by reducing annual interest rates by 0.0612% and 0.0512% when green and brown bubble sizes increase by 1%, respectively. Furthermore, the most effective strategy to achieve a significant improvement in social welfare in both the short-run and the long-run is to implement policies where nominal interest rates react negatively to both types of asset bubbles simultaneously. The impacts of carbon taxation and green credit policies on asset bubbles are also studied.

Tackling the shadow economy through inflation and access to credit

How do changes in inflation and financial market development affect the size of the shadow economy? Previous studies show that lowering the tax rate, coupled with increasing the level of tax enforcement through policing and imposing high penalties for tax evasion may reduce the size of the shadow economy. While increasing the level of enforcement may be a viable strategy, most developing countries are unable to effectively enforce their tax laws. Based on empirical observations, we suggest that monetary authority could play an important role in this regard. Using a two-sector dynamic general equilibrium model of a small open economy, we demonstrate how monetary policy can be used to reduce the size of the shadow economy. The results suggest that, conditional on access to credit, a rise in inflation leads to a reduction in the size of the shadow economy. With little or no access to credit, such a policy will be ineffective. We evaluate alternative policy measures to achieve a targeted size of the informal sector.

Macroeconomic impact of the Sino–U.S. trade frictions: Based on a two-country, two-sector DSGE model

To examine the impact of the recent Sino–U.S. trade frictions on the macroeconomics of China and the United States, we constructed a two-country, two-sector dynamic stochastic general equilibrium model. This model was used to explore the tariff transmission mechanism in such trade frictions and provide a basic analytical framework for future research on bilateral trade frictions. Based on our benchmark analysis, the tariff shocks affect non-tradable sectors through the tradable sectors, which, in turn, have impacted consumption, investments, prices, and production. Specifically, the tariffs on intermediate and final goods affect the economy from the supply and demand sides, respectively, and as the trade dependence decreases, the economic volatility caused by the tariff shocks also decreases. Moreover, our simulation showed that the impact of the trade frictions on the macroeconomics of the two countries has been asymmetrical, which is consistent with the objective economic realities.

Measuring the size and dynamics of U.S. state-level shadow economies using a dynamic general equilibrium model with trends

We use a two-sector dynamic deterministic general equilibrium model that specifically accounts for trends among time-series variables to estimate the size of the shadow economy for the 50 U.S. states from 1999 to 2019, following Solis-Garcia and Xie (2018, 2022). This paper improves on existing measures of the state-level shadow economy (such as the multiple indicators, multiple causes (MIMIC) methodology by Wiseman (2013a)). In particular, this new measure is based on theoretical foundations, extends the previous measure to include the Great Recession, includes dollar value estimates of the shadow economy, and produces considerably more variation over time and across states. Furthermore, we explore determinants of this new shadow economy measure using a panel vector autoregressive model and find that, on average, states with higher levels of economic freedom, lower regulatory barriers, and larger real GDP have smaller shadow economies. States with bigger governments, on average, have larger shadow economies, and the effect of corruption on shadow economic activity is non-linear, with a positive initial and subsequent negative impact.

Skilled immigration, firms, and policy

We develop a two-sector dynamic general equilibrium model with skilled immigration that focuses on the role of firms. The model is consistent with data on firm demand for foreign labor and firm size in the United States. Monopolistically competitive firms in the skill-intensive sector differ in productivity and a subset of relatively larger firms hire foreign workers subject to skilled immigration policies that are similar to the United States: Firms face hiring costs and there is an immigration cap that binds if the aggregate demand for foreign workers exceeds a quota. A binding immigration cap reduces firms’ demand for foreign skilled workers and, quantitatively, accounts for 16.82% of the hiring distortion in the decentralized equilibrium when compared to the first-best allocation. We evaluate the effects of different immigration cap changes and quantify the welfare implications for domestic households.

The production of national defense and the macroeconomy

This study investigates the interactions between defense production and the rest of the economy. We develop a two-sector dynamic stochastic general equilibrium model with military and nonmilitary production. Inputs (capital and labor) are distributed between the two sectors. Calibration of the model to key targets of the US economy results in an elasticity of substitution between consumption of goods and services and national defense services of 0.56. The estimated complementarity between consumption goods and defense services results in positive spillovers across military and final goods production sectors, even when the nonmilitary production function is not directly related to military spending. We find that military spending is procyclical and that military spending as a percentage of output is countercyclical. Finally, investment-specific technological shocks to military equipment have a positive impact on nonmilitary output, although they reduce business investment.

Shadow Economies Around the World: Evidence from Metropolitan Areas

In this paper, I use a calibrated two-sector dynamic general equilibrium model to construct annual estimates of shadow economy size (as a percentage of GDP) for 57 metropolitan areas from 31 countries throughout the world from 2001 to 2016. In addition to fully describing and characterizing the constructed dataset, I also provide some stylized facts regarding the trends of these estimates and some of their correlates. I also use the model to evaluate the effects of two policy tools: Changing the tax burden and tax enforcement.

Inflation – Harrod-Balassa-Samuelson Effect in a DSGE Model Setting

This paper sets up a two-country two-sector dynamic stochastic general equilibrium model that introduces sector specific productivity shocks with quality improvement mechanism of goods. It provides a model-based theoretical background for the Harrod-Balassa-Samuelson phenomenon that describes the relationship between productivity and price inflation within different sectors in a particular economy. Both, the calibrated and the estimated model are able to show that the Harrod-Balassa-Samuelson effect is confirmed by inducing tradable sector productivity shocks as they drive the non-tradable sector price inflation higher than the tradable sector price inflation. By doing this, we overcome the problem that the tradable productivity increase in a typical open economy specification reduces the relative price of domestic tradable goods relative to the foreign ones. DOI: 10.15458/ebr.86

Money Growth Rules in an Emerging Small Open Economy with an informal sector

This paper is concerned with the saddle-path stability of monetary growth rules in a two-country two-sector dynamic stochastic general equilibrium model. Alongside standard features of emerging economies, such as a combination of producer and local currency pricing for exports, fiscal dominance and oil exports, this model also incorporates informal labour and production sectors and examines how these features matter in the context of monetary policy in emerging economies. We estimate the model on Iran and US data for home and foreign block respectively using Bayesian estimation techniques. Under a benchmark instruments of monetary policy, we show that a Taylor-type money growth rule rather than interest rate, even up to a four period ahead forward-looking has complete stability and determinacy properties in the economy which is also hold regardless of the level of asset market participation, therefore the inverted Taylor principles does not apply in our economy. Our findings confirm the important propagation channels which are active in the emerging economies and taking into account these features is essential for any policy-related study, such as the stabilizer effect of terms of trade between formal and informal sector, buffer behaviour of informal sector which is dampened in the model of higher informal frictions, disturbance effects of credit constrained household on the business cycle fluctuations and finally, monetary policy shock which is less effective in an environment of high share of informal sector, low informal frictions, high share of limited asset market participations and a trade autarky economy.

Endogenous time preference, consumption externalities, and trade: multiple steady states and indeterminacy

This study presents a two-sector dynamic general equilibrium model with capital accumulation and discusses the role of endogenous time preference and consumption externalities in closed and small open economies. While the economy has a unique and saddle-point stable steady state under autarky, under free trade with decreasing marginal impatience (i.e., a household’s discount rate is a decreasing function of its consumption), there might exist multiple steady states and indeterminacy of equilibrium paths. Specifically, if the degree of decreasing marginal impatience is sufficiently large and individuals’ preferences exhibit admiration, the dynamic equilibria with diversified production might become indeterminate. We also analyze the economy’s long-run trade pattern and its relationship with indeterminacy.

Measuring the size of the shadow economy using a dynamic general equilibrium model with trends

We propose a methodology for measuring the size and properties of the shadow economy. We use a two-sector dynamic deterministic general equilibrium model with four different trends: hours worked, investment-specific productivity, formal productivity, and shadow productivity. We find that the shadow productivity trend is endogenous, in the sense that it is an exact function of model parameters and the other three trends. We also document that, in order to be consistent with observed (real-world) trend growths, the shadow sector needs to exhibit increasing returns to scale, which is contrary to the standard procedure of imposing decreasing returns to this sector. We apply our methodology to a set of seven Latin American and Asian countries and document several empirical regularities that emerge from our analysis, the most important one being that the volatility of shadow sector output is considerably larger than the one in formal sector output.

Tax reform in Japan: Is it welfare-enhancing?

The ongoing tax reform in Japan, particularly a corporate income tax cut financed by an increase in consumption tax, is expected to bring positive effects on investment and output. However, the overall effects on government fiscal balance and welfare can be ambiguous, depending on the dynamic responses of macroeconomic variables to changes in tax rates. This paper aims to provide quantitative forecasts of Japanese tax reform on welfare and fiscal balance using a small open two-sector dynamic general equilibrium model calibrated to the Japanese economy. The simulation results show that under conditions of unrestricted international borrowing and no consumption habit, a corporate income tax cut of 5% financed by an increase in consumption tax improves welfare by 0.53%. However, the positive effects of corporate income tax cuts decrease when international borrowing becomes limited or consumers show habit formation. In addition, we show that a corporate income tax cut in the tradable sector generates better welfare and fiscal consequences than a tax cut in the nontradable sector.

Tax reforms and the underground economy: a simulation-based analysis

This paper studies the effects of several tax reforms in an economy where taxes are partially evaded by means of undeclared work. To this purpose, we consider a two-sector dynamic general equilibrium model calibrated to Italy which explicitly accounts for underground production. We construct various tax reform scenarios, such as ex ante budget-neutral tax shifts from direct to indirect taxes, and tax cuts on labor and business financed by decreases of government spending. Our results indicate that neglecting the existence of the underground sector may lead to severely miscalculating the macroeconomic effects of tax reforms. Further, the dimension of the underground sector is permanently and considerably reduced by changes in the tax mix that diminish the labor tax wedge. Reductions of the business tax prove to be highly expansionary in the presence of a sizable informal sector.

To tax or not to tax? When does it matter for informality?

Theoretical models generally always predict or assume that higher taxes lead to larger informal sectors. Empirically, however, there is considerable debate on the effect of taxes on informality. In this paper I show that whether a positive, negative or non-relation arises between tax rates and informality depends on the degree of tax enforcement and the level of credit market development in an economy. Higher enforcement implies a higher probability of detection and punishment while more credit implies better formal sector access to finance. Both are incentives to become formal. In a two-sector dynamic general equilibrium model with borrowing constraints, I show that informality rises with the tax rate up to a threshold level of tax enforcement beyond which it falls as tax increases. This enforcement threshold depends negatively on the level of credit in the economy.

Dynamic scoring of tax reforms in a small open economy model

We examine dynamic revenue effects of a permanent tax cut on labor and capital income using a small open two-sector dynamic general equilibrium model. We use a dynamic scoring technique to calculate long-run as well as transitional effects on fiscal revenue when a tax cut is financed by either a lump-sum tax or consumption tax. We show that the revenue loss from an income tax cut becomes substantially smaller when agents can use international financial markets compared to the case of the closed economy. Responses of tradable and nontradable sectors to the capital income tax cut display a stark contrast in both long-run equilibrium and transitional dynamics due to different factor intensities. Capital income tax cut in the tradable sector is the most efficient policy instrument in terms of minimizing fiscal revenue loss. These simulation results suggest that fiscal sustainability issue when implementing a tax cut could be overstated.

Welfare effects of tourism-driven Dutch disease: The roles of international borrowings and factor intensity

This paper develops a two-sector dynamic general equilibrium model to analyze the welfare implications of the Dutch disease induced by the demand shock arising from a tourism boom. Compared with the existing literature, we introduce two new elements, namely, international borrowings and the relative factor-intensiveness, and examine their interplay with the welfare effects of the Dutch disease. We show that (i) when the household can freely borrow from the world financial market, the Dutch disease will not affect welfare; (ii) when the economy is closed to the world financial market, the Dutch disease is beneficial (harmful) to the residents' welfare if the tourism good sector is capital-intensive (labor-intensive). Moreover, this paper provides a simulation analysis to examine the welfare effect of both the steady-state and the transitional responses arising from a tourism boom.

Tax Reforms and the Underground Economy: A Simulation-Based Analysis

This paper studies the effects of several tax reforms in an economy in which taxes are partially evaded by means of undeclared work. To this purpose, we consider a two-sector dynamic general equilibrium model calibrated to Italy which explicitly accounts for underground production. We construct various tax reform scenarios, such as deductibility of labor costs from business tax, ex-ante budget-neutral tax shifts from direct to indirect taxes, and various tax cuts financed by decreases of government spending. We find the following results. First, neglecting the existence of the underground sector may lead to severely miscalculate the macroeconomic impact effects of tax reforms, especially in the short run, where policy interventions produce direct and indirect effects on the markup. Second, partial deductibility of labor costs from the business tax base proves to be highly expansionary and highly detrimental to the size of the underground sector. Third, the dimension of the underground sector is permanently and considerably reduced by changes in the tax mix that diminish the labor tax wedge. Finally, all the considered tax reforms take the public-debt-to-output ratio toward a prolonged downward path.