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Series:Discussion Paper / Institute for Empirical Macroeconomics  Bank:Federal Reserve Bank of Minneapolis 

Discussion Paper
The social discount rate
In welfare theory it is standard to pick the consumption stream that maximizes the welfare of the representative agent. We argue against this position, and show that a benevolent social planner will generally place a greater weight on future consumption than does the representative agent.
AUTHORS: Caplin, Andrew; Leahy, John V.
DATE: 2001

Discussion Paper
Capital accumulation in a model of growth and creative destruction
Capital accumulation and creative destruction is modeled together with risk-averse households. The novel aspect-risk-averse households-allows to use well-known models not only for analyzing long-run growth as in the literature but also short-run fluctuations. The model remains analytically tractable due to a very convenient property of the household's investment decision in this stochastic continuous-time setup.
AUTHORS: Walde, Klaus
DATE: 2001

Discussion Paper
Bad politicians
We present a simple theory of the quality of elected officials. Quality has (at least) two dimensions: competence and honesty. Voters prefer competent and honest policymakers, so high-quality citizens have a greater chance of being elected to office. But low-quality citizens have a comparative advantage in pursuing elective office, because their market wages are lower than the market wages of high-quality citizens (competence), and/or because they reap higher returns from holding office (honesty). In the political equilibrium, the average quality of the elected body depends on the structure of rewards from holding public office. Under the assumption that the rewards from office are increasing in the average quality of office holders there can be multiple equilibria in quality. Under the assumption that incumbent policymakers set the rewards for future policymakers there can be path dependence in quality.
AUTHORS: Morelli, Massimo; Caselli, Francesco
DATE: 2000

Discussion Paper
Knowledge exchange, matching, and agglomeration
Despite wide recognition of their significant role in explaining sustained growth and economic development, uncompensated knowledge spillovers have not yet been fully modeled with a microeconomic foundation. The main purpose of this paper is to illustrate the exchange of knowledge as well as its consequences on agglomerative activity in a general-equilibrium search-theoretic framework. Agents, possessing differentiated types of knowledge, search for partners to exchange ideas and create new knowledge in order to improve production efficacy. When individuals types of knowledge are too diverse, a match is less likely to generate significant innovations. We demonstrate the extent of agglomeration has significant implications for the patterns of information flows in economies. Further, by simultaneously determining the patterns of knowledge exchange and the spatial agglomeration of an economy we identify additional channels for interaction between agglomerative activity and knowledge exchange. Finally, contrary to previous work in spatial agglomeration, our model suggests that agglomerative environments may be either under-specialized and under-populated or over-specialized and over-populated relative to the social optimum.
AUTHORS: Wang, Ping; Adams, Robert M.; Berliant, Marcus
DATE: 2000

Discussion Paper
Time inconsistent preferences and Social Security
In this paper we examine the role of social security in an economy populated by overlapping generations of individuals with time-inconsistent preferences who face mortality risk, individual income risk, and borrowing constraints. Agents in this economy are heterogeneous with respect to age, employment status, retirement status, hours worked, and asset holdings. We consider two cases of time-inconsistent preferences. First, we model agents as quasi-hyperbolic discounters. They can be sophisticated and play a symmetric Nash game against their future selves; or they can be naive and believe that their future selves will exponentially discount. Second, we consider retrospective time inconsistency. We find that (1) there are substantial welfare costs to quasi-hyperbolic discounters of their time-inconsistent behavior, (2) social security is a poor substitute for a perfect commitment technology in maintaining old-age consumption, (3) there is little scope for social security in a world of quasi-hyperbolic discounters (with a short-term discount rate up to 15%), and, (4) the ex ante annual discount rate must be at least 10% greater than seems warranted ex post in order for a majority of individuals with retrospective time inconsistency to prefer a social security tax rate of 10% to no social security. Our findings question the effectiveness of unfunded social security in correcting for the undersaving resulting from time-inconsistent preferences.
AUTHORS: Imrohoroglu, Ayse; Imrohoroglu, Selahattin; Joines, Douglas H.
DATE: 2000

Discussion Paper
Does the progressivity of taxes matter for economic growth?
A sizeable literature has argued that the growth effects of changes in flat rate taxes are small. In this paper, we investigate the relatively unexplored area of the growth effect of changes in the tax structure, in particular, in the progressivity of taxes. Considering such a tax reform seems empirically more relevant than considering changes in flat tax rates. We construct a general equilibrium model of endogenous growth in which there is heterogeneity in income and in the tax rates. We limit heterogeneity to two types, skilled and unskilled, and posit that the probability of staying or becoming skilled in the subsequent period depends positively on expenses on "teacher" time. In the production sector, we consider two sources of growth. In the first, growth arises as a purely external effect on account of production activities of skilled workers. In the second, a portion of the skilled workforce is used to work in research and other productivity enhancing activities and is compensated for it. Our analysis shows that changes in the progressivity of tax rates can have positive growth effects even in situations where changes in flat rate taxes have no effect. Experiments on a calibrated model indicate that the quantitative effects of moving to a flat rate system are economically significant. The assumption made about the engine of growth has an important effect on the impact of a change in progressivity. Quantitatively, welfare is unambiguously higher in a flat rate system when comparisons are made across balanced growth equilibria; however, when the costs of transition to the higher growth equilibrium is taken into account only the currently rich slightly prefer the flat rate system.
AUTHORS: Caucutt, Elizabeth M.; Imrohoroglu, Selahattin; Kumar, Krishna B.
DATE: 2000

Discussion Paper
Urban structure and growth
Most economic activity occurs in cities. This creates a tension between local increasing returns, implied by the existence of cities, and aggregate constant returns, implied by balanced growth. To address this tension, we develop a theory of economic growth in an urban environment. We show how the urban structure is the margin that eliminates local increasing returns to yield constant returns to scale in the aggregate, thereby implying a city size distribution that is well described by a power distribution with coefficient one: Zipf's Law. Under strong assumptions our theory produces Zipf's Law exactly. More generally, it produces the systematic deviations from Zipf's Law observed in the data, namely, the underrepresentation of small cities and the absence of very large ones. In these cases, the model identifies the standard deviation of industry productivity shocks as the key element determining dispersion in the city size distribution. We present evidence that the dispersion of city sizes is consistent with the dispersion of productivity shocks in the data.
AUTHORS: Rossi-Hansberg, Esteban; Wright, Mark L. J.
DATE: 2003

Discussion Paper
Ben-Porath meets skill-biased technical change: a theoretical analysis of rising inequality
In this paper we present an analytically tractable general equilibrium overlapping-generations model of human capital accumulation, and study its implications for the evolution of the U.S. wage distribution from 1970 to 2000. The key feature of the model, and the only source of heterogeneity, is that individuals differ in their ability to accumulate human capital. Therefore, wage inequality results only from differences in human capital accumulation. We examine the response of this model to skill-biased technical change (SBTC) theoretically. We show that in response to SBTC, the model generates behavior consistent with the U.S. data including (i) a rise in overall wage inequality in both the short run and long run, (ii) an initial fall in the education premium followed by a strong recovery, leading to a higher premium in the long run, (iii) the fact that most of this fall and rise takes place among younger workers, (iv) stagnation in median wage growth (and a slowdown in aggregate labor productivity), and (v) a rise in consumption inequality that is much smaller than the rise in wage inequality. These results suggest that the heterogeneity in the ability to accumulate human capital is an important feature for understanding the effects of SBTC, and interpreting the transformation that the U.S. economy has gone through since the 1970s.
AUTHORS: Kuruscu, Burhanettin; Guvenen, Fatih
DATE: 2006

Discussion Paper
Learning your earning: are labor income shocks really very persistent?
The current literature offers two views on the nature of the labor income process. According to the first view, which we call the restricted income profiles (RIP) model, individuals are subject to large and very persistent shocks while facing similar life-cycle income profiles (MaCurdy, 1982). According to the alternative view, which we call the heterogeneous income profiles (HIP) model, individuals are subject to income shocks with modest persistence while facing individual-specific income profiles (Lillard and Weiss, 1979). In this paper we study the restrictions imposed by the RIP and HIP models on consumption datain the context of a life-cycle modelto distinguish between these two hypotheses. In the life-cycle model with a HIP process, which has not been studied in the previous literature, we assume that individuals enter the labor market with a prior belief about their individual-specific profile and learn over time in a Bayesian fashion. We find that learning is slow, and thus initial uncertainty affects decisions throughout the life cycle. The resulting HIP model is consistent with several features of consumption data including (i) the substantial rise in within-cohort consumption inequality, (ii) the non-concave shape of the age-inequality profile, and (iii) the fact that consumption profiles are steeper for higher educated individuals. The RIP model we consider is also consistent with (i), but not with (ii) and (iii). These results bring new evidence from consumption data on the nature of labor income risk.
AUTHORS: Guvenen, Fatih
DATE: 2006

Discussion Paper
Dynamic optimal taxation with private information
We study dynamic optimal taxation in a class of economies with private information. Constrained optimal allocations in these environments are complicated and history-dependent. Yet, we show that they can be implemented as competitive equilibria in market economies supplemented with simple tax systems. The market structure in these economies is similar to that in Bewley (1986): agents supply labor and trade risk-free claims to future consumption, subject to a budget constraint and a debt limit. Optimal taxes are conditioned only on two observable characteristicsan agents accumulated stock of claims, or wealth, and her current labour incomeand they are not additively separable in these variables. The marginal wealth tax is decreasing in labour income and its expected value is generally positive. The marginal labour income tax is decreasing in wealth.
AUTHORS: Albanesi, Stefania; Sleet, Christopher
DATE: 2004

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