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Working Paper
Introducing financial frictions and unemployment into a small open economy model
The current financial crisis has made it abundantly clear that business cycle modeling can no longer abstract from financial factors. It is also clear that the current standard approach of modeling labor markets without explicit unemployment has its limitations. We extend what is becoming the standard new Keynesian model in three dimensions. First, we incorporate financial frictions in the accumulation and management of capital. Second, we model the labor market using a search and matching framework. Third, we extend the model into a small open economy setting. Finally, we estimate the model ...
Working Paper
Engineering a paradox of thrift recession
We build a variation of the neoclassical growth model in which financial shocks to households or wealth shocks (in the sense of wealth destruction) generate recessions. Two standard ingredients that are necessary are (1) the existence of adjustment costs that make the expansion of the tradable goods sector difficult and (2) the existence of some frictions in the labor market that prevent enormous reductions in real wages (Nash bargaining in Mortensen-Pissarides labor markets is enough). We pose a new ingredient that greatly magnifies the recession: a reduction in consumption expenditures ...
Working Paper
DSGE models for monetary policy analysis
Monetary DSGE models are widely used because they fit the data well and can be used to address important monetary policy questions. We provide a selective review of these developments. Policy analysis with DSGE models requires using data to assign numerical values to model parameters. The paper describes and implements Bayesian moment matching and impulse response matching procedures for this purpose.
Working Paper
Causes and consequences of the oil shock of 2007–08
This paper explores similarities and differences between the run-up of oil prices in 2007??08 and earlier oil price shocks, looking at what caused the price increase and what effects it had on the economy. Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007??08 was caused by strong demand confronting stagnating world production. Although the causes were different, the consequences for the economy appear to have been very similar to those observed in earlier episodes, with significant effects on overall consumption spending and ...
Working Paper
Non-linear effects of taxation on growth
We study a model in which the effects of taxation on growth are highly non-linear. Marginal increases in tax rates have a small growth impact when tax rates are low or moderate. When tax rates are high, further tax hikes have a large, negative impact on growth performance. We argue that this non-linearity is consistent with the empirical evidence on the effect of taxation and other disincentives to investment and innovation on economic growth.
Working Paper
Understanding booms and busts in housing markets
Some booms in housing prices are followed by busts. Others are not. In either case it is difficult to find observable fundamentals that are correlated with price movements. We develop a model consistent with these observations. Real estate agents have heterogeneous expectations about long-run fundamentals but change their views because of "social dynamics." Agents meet randomly with one another. Those with tighter priors are more likely to convert others to their beliefs. The model generates a "fad": The fraction of the population with a particular view rises and then falls. Depending on ...
Working Paper
Optimal unemployment insurance and cyclical fluctuations
The authors study the design of optimal unemployment insurance in an environment with moral hazard and cyclical fluctuations. The optimal unemployment insurance contract balances the insurance motive to provide consumption for the unemployed with the provision of incentives to search for a job. This balance is affected by aggregate conditions, as recessions are characterized by reductions in job finding rates. We show how benefits should vary with aggregate conditions in an optimal contract. In a special case of the model, the optimal contract can be solved in closed form. We show how this ...
Working Paper
Trading down and the business cycle
The authors document two facts: First, during recessions consumers trade down in the quality of the goods and services they consume. Second, the production of low-quality goods is less labor intensive than that of high-quality goods. Therefore, when households trade down, labor demand falls, increasing the severity of recessions. The authors find that the trading-down phenomenon accounts for a substantial fraction of the fall in U.S. employment in the recent recession. They study two business cycle models that embed quality choice and find that the presence of quality choice magnifies the ...
Working Paper
Taxes, transfers, and employment in an incomplete markets model
Tax and transfer programs are analyzed in the context of a model with idiosyncratic productivity shocks and incomplete markets. The effects are contrasted with those obtained in a stand-in household model featuring no idiosyncratic shocks and complete markets. The main finding is that the impact on hours remains very large, but the welfare consequences are very different. The analysis also suggests that tax and transfer policies have large effects on average labor productivity via selection effects on employment.
Working Paper
A model of the Twin Ds: optimal default and devaluation
This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have ...