Biased Bayesian learning with an application to the risk-free rate puzzle

Based on the axiomatic framework of Choquet decision theory, we develop a closed-form model of Bayesian learning with ambiguous beliefs about the mean of a normal distribution. In contrast to rational models of Bayesian learning the resulting Choquet Bayesian estimator results in a long-run bias that reflects the agent's ambiguity attitudes. By calibrating the standard equilibrium conditions of the consumption based asset pricing model we illustrate that our approach contributes towards a resolution of the risk-free rate puzzle. For a plausible parameterization we obtain a risk-free rate in the range of 3.5–5%. This is 1–2.5% closer to the empirical risk-free rate than according calibrations of the rational expectations model.     

Volatility, growth, and welfare

This paper constructs an endogenous growth model driven by self-fulfilling expectation shocks to explain the stylized fact that the average growth rate of GDP is related negatively to volatility and positively to capacity utilization. The implied welfare gain from further stabilizing the U.S. economy is about a quarter of annual consumption, which is consistent in order of magnitude with estimates based on the empirical studies of Ramey and Ramey (1995) and Alvarez and Jermann (2004). Hence, policies designed to reduce fluctuations can generate large welfare gains because smaller fluctuations are associated with permanently higher rates of growth.     

Risk aversion in a model of endogenous growth

Despite the evidence on incomplete financial markets and substantial risk being borne by innovators, current models of growth through creative destruction predominantly model innovators’ as risk neutral. Risk aversion is expected to reduce the incentive to innovate and we might fear that without insurance innovation completely disappears in the long run. The present paper introduces risk averse agents into an occupational choice model of endogenous growth in which insurance against failure to innovate is not available. We derive a clear negative relationship between the level of risk aversion and long run growth. Surprisingly, we show that in an equilibrium there exists a cut-off value of risk aversion below which the growth rate of the mass of innovators tends to a strictly positive constant. In this case, innovation persists on the long run and consumption per capita grows at a strictly positive rate. On the other hand, for levels of risk aversion above the cut-off value, the economy eventually stagnates.     

A portfolio approach to endogenous growth: equilibrium and optimal policy

This paper develops a portfolio approach to modeling endogenous growth in continuous time that is especially suitable for addressing fiscal and financial issues in policy design. The analysis focuses on the equilibrium relationship between fiscal and financial policy, rates of return and wealth allocation. We analyze two models. The first is based on the Arrow-Romer model with increasing returns and an external effect of capital on labor productivity. The second draws on Barro's analysis of government spending and endogenous growth. In both models, we study the equilibrium allocation and discuss the optimal fiscal and financial policy.     

Feasibility and optimality of sustainable growth under materials balance

Pollution from consumption and production is an inevitable part of economic processes. We employ a materials balance approach and develop an endogenous growth theory, with recycling activity, to examine the evolution of the economic and environment systems. This paper provides feasibility and optimality conditions for sustainable economic growth with rising environmental quality. The fundamental condition of feasibility is that the flow of natural resources, which eventually returns to the environment as waste and pollution, has a negative growth rate in the long run.     

Spatial agglomeration and endogenous growth

This paper constructs a dynamic general equilibrium model with spatial interactions in which a human capital externality is the centripetal force towards agglomeration. The resource cost of transportation is, on the other hand, the main centrifugal force, preventing a city from growing unboundedly. A central feature of our analysis is the dynamic interaction between (perpetual) economic growth and (bounded) city growth. We examine the socially optimal and the decentralized growth rates as well as city sizes. In the decentralized environment, individuals under-invest, whereas cities are under-populated. We show how public policies may enable a decentralized city to attain the socially optimal allocation.     

Socio-political instability and growth dynamics

We develop an overlapping generations (OLG) monetary endogenous growth model characterized by socio-political instability, with the latter being specified as a fraction of output lost due to strikes, riots and protests. We show that growth dynamics arise in this model when socio-political instability is a function of inflation. In particular, two distinct growth dynamics emerge, one convergent and the other divergent contingent on the strength of the response of socio-political instability to inflation. Since our theoretical results hinge on socio-political instability being a function of inflation, we test the prediction that inflation affects socio-political instability positively by using a panel of 156 countries for the 1980–2012 period, and allowing for country and time fixed effects. The results indicate that inflation relates positively with socio-political instability. Policy makers should be cognisant that it is crucial to maintain long-run price stability, as failure to do so may result in high inflation emanating from excessive money supply growth, leading to high (er) socio-political instability, and ultimately, the economy being on a divergent balanced growth path.     

THE DECADES‐LONG DISPUTE OVER SCALE EFFECTS IN THE THEORY OF ECONOMIC GROWTH

The so‐called “new growth theory” is characterized by the now Nobel Prize winning insight that ideas are a nonrival input to and output from endogenous investment in innovation. Nonrivalry implies increasing returns to scale, but this also unintentionally creates an empirically disputed scale effect that a growing population implies an ever‐increasing growth rate. Empirical evidence supports fully‐endogenous growth without scale effects, but theoretical issues sustain the decades‐long dispute over exactly how to negate the scale effect. This article surveys theoretical approaches to resolving the scale effect and shows how four generations of endogenous growth theory are defined by the maturing of modeling techniques for constraining increasing returns. The synthesis suggests that the dispute over scale effects is really a narrative about how the powerful application of increasing returns has followed a standard theoretical development pattern. This implies that a fourth generation is now emerging that negates the scale effect while retaining fully‐endogenous growth without relying on assumptions of linearity. Instead, the market response to excessive increasing returns to innovation constrains explosive growth by expanding the market, rather than by a linear assumption. This latest class of endogenous growth models may be the final chapter to resolving the long‐running dispute.     

The Solow–Swan model with a bounded population growth rate

The paper analyzes the dynamic of the Solow–Swan growth model when the labor growth rate is non-constant but variable and bounded over time. Per capita capital is seen to stabilize to the non-trivial steady state of the Solow–Swan model with a particular constant labor growth rate. The solution of the model is proved to be asymptotically stable. In case of a Cobb-Douglas production function and a generalized logistic population growth law, the solution is shown to have a closed-form expression via Hypergeometric functions.     

Information technologies, embodiment and growth

This paper studies the conditions under which an IT revolution may occur and have permanent effects on long-term growth. To this end, we construct a multi-sectoral growth model with endogenous embodied technical progress. The R&D sector expands the range of softwares. The capital sector produces efficient capital combining hardware with available softwares. Technological progress is therefore embodied: New softwares can only be run on the most recent generations of hardware. The new softwares are copyrighted during a fixed period of time. First, we analytically characterize the balanced growth paths of the model. Then we focus on the dynamic response of the economy to technological shocks. Substitution effects favorable to the IT sectors are shown to arise when positive supply shocks affect the production of efficient capital and/or the creation of new softwares. Positive shocks specific to the capital sector are unable to produce effects on long-term growth, in contrast to the shocks specific to the R&D sector.     

An objective function for simulation based inference on exchange rate data

The assessment of models of financial market behaviour requires evaluation tools. When complexity hinders a direct estimation approach, e.g., for agent based microsimulation models, simulation based estimators might provide an alternative. In order to apply such techniques, an objective function is required, which should be based on robust statistics of the time series under consideration. Based on the identification of robust statistics of foreign exchange rate time series in previous research, an objective function is derived. This function takes into account stylized facts about the unconditional distribution of exchange rate returns and properties of the conditional distribution, in particular, autoregressive conditional heteroscedasticity and long memory. A bootstrap procedure is used to obtain an estimate of the variance-covariance matrix of the different moments included in the objective function, which is used as a base for the weighting matrix. Finally, the properties of the objective function are analyzed for two different agent based models of the foreign exchange market, a simple GARCH-model and a stochastic volatility model using the DM/US-$ exchange rate as a benchmark. It is also discussed how the results might be used for inference purposes. Research has been supported by the DFG grant WI 20024/2-1/2. We are indebted to two anonymous referees of this journal, Leigh Tesfatsion, Patrick Burns and other participants of the CEF’06 conference in Limassol for helpful comments on preliminary versions of this paper.     

Variable markups in the long-run: A generalization of preferences in growth models

This paper introduces variable markups in a horizontal-differentiation growth model by considering a larger class of preferences that nests the classic “CES” specification usually present in the workhorse love-for-variety models. Our first result is to obtain a generalized characterization of the Euler condition for this broader class of utility functions: in our model, the Euler rule features a supplementary term aiming at compensating the consumer for variations in the preference for variety along the consumption level. We are then also able to demonstrate that in our generalized framework, the economy’s balanced growth path displays both endogenous markups and a strictly positive growth rate of the number of available varieties (being the engine of growth). Finally, we show that under endogenous markups, the economy’s growth rate and firms’ market power can display a negative correlation, as opposed to the standard result obtained in the CES framework.     

Financial market globalization and growth with interdependent countries

This paper examines the effect of externalities on the consequences of financial market globalization in a two-country growth model augmented with domestic credit market imperfections. Following the endogenous growth literature, externalities are byproducts of capital production. Unlike previous studies, I find that their formation matters. Specifically, when transnational externalities consist solely of a rich country’s capital stock, financial market globalization brings about world-wide gains in growth. However, when these externalities are a product of both the rich and the poor countries’ capital stock, this globalization process only fosters growth in the rich country. Furthermore, if such externalities are sufficiently weak, both the rich and the poor countries may become locked in a stage with no meaningful growth.     

Abatement R&D,market imperfections,and environmental policy in an endogenous growth model

We develop an endogenous growth model featuring environmental externalities, abatement R&D, and market imperfections. We compare the economic performances under three distinct regimes that encompass public abatement, private abatement without tax recycling, and private abatement with tax recycling. It is found that the benefit arising from private abatement will be larger if the degree of the firms’ monopoly power is greater. With a reasonably high degree of monopoly power, a mixed abatement policy by which the government recycles environmental tax revenues to subsidize the private abatement R&D is a plausible way of reaching the highest growth rate and welfare.     

On the closed-form solution of an endogenous growth model with anticipated consumption

This paper derives a closed-form solution of the AK endogenous growth model with logarithmic preferences and anticipated future consumption which enters additively into effective consumption. We get an explicit representation of the time paths of the economic variables in level by resorting to Gaussian Hypergeometric functions. We compare the model with anticipated future consumption to the model with habit formation. The maximum utility attainable in the model with anticipation is shown to be higher than the one attainable in the model with habits. Using the derived explicit expressions, we perform some comparative-dynamics and -statics analyses with respect to relevant parameters. Numerical simulations complement the theoretical results. Thus, this work provides further support to the usefulness of especial functions in the study of economic dynamics.     

The growth effects of anticipated versus unanticipated population aging

We analyze the effects of anticipated population aging within a general equilibrium R&D-based endogenous growth model with overlapping generations. In doing so we model aging as a rise of longevity and a simultaneous drop in fertility. In contrast to an unanticipated rise of longevity, consumers increase their savings and reduce their consumption long before the rise of longevity actually happens. This implies that individuals save more in anticipation of aging, which puts downward pressure on the interest rate and raises economic growth through an increase in R&D incentives. Irrespective of the anticipation effect, the economic change at impact is not smooth but still features a kink in consumption.     

Equilibrium dynamics in a class of one-sector endogenous growth models with external habits: An application of special functions

This paper analyzes the equilibrium dynamics in a class of one-sector endogenous growth models with external habits. Using an explicit solution expressed in terms of the Gauss hypergeometric function, we show that the levels of consumption, habits and capital may exhibit non-monotonic transition dynamics, even though their ratios converge monotonically. A numerical simulation illustrates this result.     

Abatement,R&D and growth with a pollution ceiling

The consequences of the 2 °C climate target and the implicitly imposed ceiling on CO₂ have been analyzed in several studies. We use an endogenous growth model with a ceiling and an abatement option to study the effect of the ceiling on the allocation of limited funds for R&D, abatement and capital accumulation. It is found that the advantagenousness of abatement rises with the cost advantage of fossil fuel versus backstop. If the cost advantage is sufficiently large at some point in time it outweighs the costs of abatement and the gains of R&D and capital accumulation. The reallocation of production towards abatement may cause an increase or decrease in long-run consumption. In the latter case, abatement allows an intertemporal consumption trade-off which may even justify the disregard of everlasting growth. In case of stock dependent fossil fuel costs, an abatement induced speed-up of technology development may cause an increase in fossil fuel stock left in situ.     

Innovation dynamics and fiscal policy: Implications for growth,asset prices,and welfare

We study the equilibrium implications of different fiscal policies on macroeconomic quantities and welfare by utilizing an endogenous growth model that matches asset pricing data well. The fiscal instruments of interest are (i) subsidies to R&D expenditure, consumption and capital investment, and (ii) cuts in labor and corporate tax rates. Our equilibrium analysis provides new insights on the interplay of innovation dynamics and fiscal policy. Importantly, we find growth and welfare to be inversely related when changing R&D subsidies. However, this depends on how well the model reproduces asset pricing dynamics. Moreover, only subsidies to capital investments and cuts in the corporate tax rate have the potential to increase both growth and welfare.     

Implied volatility term structure and exchange rate predictability

This paper provides empirical evidence of the predictive power of the currency implied volatility term structure (IVTS) for the behavior of the exchange rate from both cross-sectional and time series perspectives. Intriguingly, the direction of the prediction is not the same for developed and emerging markets. For developed markets, a high slope means low future returns, while for emerging markets it means high future returns. We analyze predictability from a cross-sectional perspective by building portfolios based on the slope of the term structure, and thus present a new currency trading strategy. For developed (emerging) currencies, we buy (sell) the two currencies with the lowest slopes and sell (buy) the two with the highest slopes. The proposed strategy performs better than common currency strategies – carry trade, risk reversal, and volatility risk premium (VRP) – based on the Sharpe ratio, considering only currency returns, which supports the exchange rate predictability of the IVTS from a cross-sectional perspective.