Estimating substitution elasticities in household production models

Summary Dynamic general equilibrium models that include explicit household production sectors provide a useful framework within which to analyze a variety of macroeconomic issues. However, some implications of these models depend critically on parameters, including the elasticity of substitution between market and home consumption goods, about which there is little information in the literature. Using the PSID, we estimate these parameters for single males, single females, and married couples. At least for single females and married couples, the results indicate a high enough substitution elasticity that including home production will make a significant difference in applied general equilibrium theory.We thank the National Science Foundation for financial support, and Ellen McGrattan, David Runkle, George Jakubson, Zvi Eckstein, Timothy J. Kehoe, Ed Prescott, a referee, and seminar participants at the Cleveland Fed and the Penn Macro Lunch Group for comments. The views expressed here are those of the authors and not necessarily those of any Federal Reserve Bank or the Federal Reserve System.     

An evaluation of the performance of an applied general equilibrium model of the Spanish economy

Summary In 1985–86 the authors were members of a team that constructed a static applied general equilibrium model that was used to analyze the impact on the Spanish economy of the 1986 fiscal reform, which accompanied Spain's entry into the European Community. This paper compares the results obtained to recently published data for 1985–87; we find that the model performed well in predicting the changes in relative prices and resource allocation that actually occurred, particularly if we incorporate exogenous shocks that affected the Spanish economy in 1986. We also analyze the sensitivity of the results to alternative specifications of the labor market and macroeconomic closure rules; we find that the central results are robust.We gratefully acknowledge financial support from NSF Grant SES 89-22036 (Kehoe) and CICYT Grant PB 89 + 0309 (Polo and Sancho). We thank participants in the IIASA Applied General Equilibrium Conference, Laxenburg, Austria, August 1991; the International Trade Workshop at UCLA, March 1992; the Graduate Public Finance Course at the University of Minnesota, Winter 1993; Antonio Gomez Gomez-Plana; and Betsy Caucutt for helpful suggestions. Above all, we wish to thank our colleagues who have worked with us on the MEGA (Model d'Equilibri General Aplicat) Project at the Universitat Autònoma de Barcelona: Antonio Manresa, Pedro Javier Noyola, Jaime Serra-Puche, Cristina Echevarria, Walter Garcia, Ana Laborda, and Xavier Ramirez. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.     

A model of the federal funds market

Summary This paper develops a stochastic general equilibrium model of the federal funds market that incorporates non-Fisherian effects on interest rates stemming from both supply and demand shocks to reserves. Such a model may reconcile the widespread belief in a liquidity effect of money supply shocks with the difficulty many researchers have had in finding empirical support for such an effect. The model also cautions against interpreting the observed negative correlation between the federal funds rate and innovations to nonborrowed reserves as empirical confirmation of the ability of the Federal Reserve to lower short-term real interest rates.This paper should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or its staff. We gratefully acknowledge lengthy discussions and correspondence with V. V. Chari, Marty Eichenbaum, and especially Larry Christiano, that helped to clarify many issues. We were told many institutional details by Jim Clouse and Josh Feinman, and we received many helpful comments from David Altig, Michael Dotsey, and participants at the conference on Recent Research on the Liquidity Effect of Monetary Policy, 1993, Federal Research Bank of Cleveland, the conference on Recent Macroeconomic Research: Lessons for Policymaking, 1993, Federal Reserve Bank of Atlanta and the conference on Operating Procedures and the Conduct of Monetary Policy, 1992, Federal Reserve Bank of St. Louis.     

Competitive equilibrium when preferences change over time

Summary. We show the existence of a competitive equilibrium in an economy with many consumers whose preferences may change over time. The demand correspondence of an individual consumer is determined by the set of subgame-perfect equilibrium outcomes in his intrapersonal game. For additively separable preferences with concave period utility functions that are unbounded above, this demand correspondence will satisfy the usual boundary conditions. Whenever consumers can recall their own mixed actions, this correspondence is convex-valued. This ensures the existence of a symmetric competitive equilibrium.Received: 29 July 2004, Revised: 17 November 2004, JEL Classification Numbers: D51, D91, C73. Correspondence to: Thomas MariottiWe thank Michele Piccione for useful comments and suggestions. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.     

EFFICIENCY EFFECTS OF CHANGES IN COMMONWEALTH GRANTS TO THE STATES: A CGE ANALYSIS*

This paper describes CSF, a general equilibrium model encompassing factors of relevance to economic efficiency in Federal/State funding including: interstate differences in tax bases and unit costs of State‐provided goods; factor mobility; congestion; State‐government behaviour incorporating the possibility that governments in subsidised States embark on expenditures with low benefit/cost ratios (flypaper effects); fiscal externalities; and non‐discretionary expenditures in each State associated with special national responsibilities. The model is applied to Australia where Federal/State funding is a major political and economic issue. Welfare effects of moving from the present Australian funding system based on fiscal equalisation to a system of equal‐per‐capita grants are calculated. CSF implies that the welfare gain from this move would be small. The most important source of potential welfare gain is a reduction in flypaper effects. The recognition of congestion externalities can eliminate the small welfare gain, but only under seemingly extreme assumptions. The results are not very sensitive to variations in assumptions concerning population mobility and fiscal externalities.     

Is the Fed’s news perception different from the private sector’s?

The recent literature on monetary policy has dedicated considerable attention to modelling agents’ processing of information about the future in real time. This paper contributes to this growing strand by investigating the implied differences in the so-called news shocks estimated from the standard New Keynesian dynamic stochastic general equilibrium (DSGE) model using the real-time data sets from the Survey of Professional Forecasters (SPF) and the Federal Reserve’s Greenbook (GB) forecasts. Alternative specifications with either the SPF or GB forecasts aim to delineate the differences in the private sector’s and the Fed’s expectations of future macroeconomic outcomes and identify the differences in their perception of news shocks. Our results indicate that while the demand news shocks have very similar distributions in the two datasets, the monetary and cost-push news shocks from the models estimated on the GB data tend to be larger than those from the SPF. These findings suggest that the Federal Reserve’s forecasting methods allow for more variation in future outcomes than the SPF’s. These findings mesh well with the extant literature on the superiority of the Fed’s forecasts relative to the private sector’s and provide a structural explanation for the source of this superiority.     

On characterizing equilibria of economies with externalities and taxes as solutions to optimization problems

Summary We characterize equilibria of general equilibrium models with externalities and taxes as solutions to optimization problems. This characterization is similar to Negishi's characterization of equilibria of economies without externalities or taxes as solutions to social planning problems. It is often useful for computing equilibria or deriving their properties. Frequently, however, finding the optimization problem that a particular equilibrium solves is difficult. This is especially true in economies with multiple equilibria. In a dynamic economy with externalities or taxes there may be a robust continuum of equilibria even if there is a representative consumer. This indeterminacy of equilibria is closely related to that in overlapping generations economies.An earlier version of this paper, entitled Externalities and Taxes in General Equilibrium, was presented at the North American meetings of the Econometric Society, June 1988, at the University of Minnesota. We are grateful to David Backus, Kenneth Judd, Patrick Kehoe, and Rodolfo Manuelli for helpful conversations. National Science Foundation grants SES 86-18325 and SES 87-08616 provided financial support.The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.     

Nonuniqueness of solutions in applied general equilibrium models with scale economies and imperfect competition

Summary Since the publication of Harris (1984), applied general equilibrium models with imperfect competition and economies of scale have been extensively used for analyzing international trade and development policy issues. Their attractiveness comes from their offering a natural framework for testing the empirical relevance of numerous propositions from the industrial organization and new trade theoretical literature. Their role in the recent debates on the North American Free Trade Agreement demonstrates their potential importance in policy analysis. This paper warns model builders and users that considerable caution is however needed in interpreting the results and in deriving strong policy conclusion from these models: it is shown that in this generation of applied general equilibrium models, nonuniqueness of equilibria is not a theoretical curiosum, but a potentially serious problem. Disregarding this may lead to dramatically wrong policy appraisals.I am particularly indebted to Tim Kehoe both for his comments and for pinpointing a flaw in a previous version of the paper. I also thank for comments, discussions and/or encouragements Irma Adelman, Len Dudley, Robert Gary-Bobo, Rick Harris, Ed Prescott, Jacques Robert, Herb Scarf, T. N. Srinivasan, and an anonymous referee. Financial support from the FCAR of the Government of Québec and from the SSHRC of the Government of Canada and hospitality from the Federal Reserve Bank of Minneapolis are gratefully acknowledged.     

Language after liftoff: Fed communication away from the zero lower bound

This paper examines the Federal Reserve's communication strategy to see how well it has worked and how it can be improved. It argues that Federal Reserve communication when short-term interest rates are no longer constrained by the zero lower bound should be focused on relaying a data-based reaction function which informs market participants how interest rates will adjust as new information arrives. Instead, the Federal Reserve in recent years has relied more heavily than desired on “time-based” forward guidance, focusing on when interest rates are likely to rise rather than under what circumstances. We argue that, except under unusual circumstances, this is an imprudent strategy, as it mutes the effect of macroeconomic news on interest rates and unnecessarily places restrictions on future Federal Reserve action when new information arrives. We argue that the Federal Reserve can improve communication in the current environment by moving away from time-based forward guidance, clarifying how interest rates are likely to change given new information, and providing more information in the Summary of Economic Projections.     

Optimal versus realized policy rules in a regime-switching framework

In this paper we compare a deterministic model and a Markov switching model to analyze the behavior of the US economy and the Federal Reserve. We examine both optimal and empirical monetary policies for the US Federal Reserve between 1960 and 2008. We compare the optimal monetary policy to the actual interest rates and to the empirical reaction function. We also evaluate the sensitivity of the results to the preferences assigned to each objective. We find that there is no unique optimal solution that fits the Federal Reserve behavior over the entire period. The best fit to the actual interest rates is obtained by an optimal policy with preference switches following the rule: a high-volatility regime coincides with a priority on inflation alone while in a low-volatility regime there is equal policy priority on output stabilization and inflation.     

Implementing Arrow-Debreu equilibria by trading infinitely-lived securities

Summary. We show that Arrow-Debreu equilibria with countably additive prices in infinite-time economy under uncertainty can be implemented by trading infinitely-lived securities in complete sequential markets under two different portfolio feasibility constraints: wealth constraint, and essentially bounded portfolios. Sequential equilibria with no price bubbles implement Arrow-Debreu equilibria, while those with price bubbles implement Arrow-Debreu equilibria with transfers. Transfers are equal to price bubbles on initial portfolio holdings. Price bubbles arise in sequential equilibrium under the wealth constraint if some securities are in zero supply or negative prices are permitted, but cannot arise with essentially bounded portfolios.Received: 19 November 2003, Revised: 24 February 2004, JEL Classification Numbers: D50, G12, E44.Correspondence to: Jan WernerWe acknowledge helpful discussions with Roko Aliprantis, Subir Chattopaydhyay, Steve LeRoy, Manuel Santos, and seminar participants at Brown University, University of Pennsylvania, NBER Workshop in General Equilibrium Theory, SITE 2000, the 2000 World Congress of the Econometric Society, and Federal Reserve Bank of Kansas City. The views expressed herein are those of the authors and do not necessarily reflect the views of Federal Reserve Bank of Kansas City or the Federal Reserve System.     

On the optimality of interest-bearing reserves in economies of overlapping generations

Summary Paying interest on required reserves is considered in an overlapping generations model in which the return to capital dominates the return to fiat money. As Smith (1991) showed, financing interest on reserves benefits the initial old at the expense of future generations. We show that the transfer of wealth associated with interest on reserves can be offset by an accommodating open market purchase, so that the payment of interest on reserves is a Pareto improvement. We also show that paying interest on reserves improves welfare even when financed by distorting taxes on capital.The authors thank Mike Cox, Greg Huffman, Evan Koenig, and Bruce Smith for helpful discussion. Any remaining errors are solely ours. This work originated while Freeman was a Research Associate at the Federal Reserve Bank of Dallas. The views expressed herein do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System.     

Friedman and Schwartz (1982) revisited: Assessing annual and phase-average models of money demand in the United Kingdom

Several studies have developed empirical models of U.K. mondy demand using the century of annual and phase-average data in Friedman and Schwartz (1982). The current paper evaluates key models from those studies, employing tests of constancy and encompassing. The evidence strongly favors an annual model from Ericsson, Hendry, and Prestwich (1998a), whereas models based on the phase-average data fare poorly.The first author is a staff economist in the Division of International Finace, Board of Governors of the Federal Reserve System, Washington, DC 20551 USA. The second author is Leverhulme Personal Research Professor of Economics at Nuffield College, Oxford OX1 1NF. The third author was a research assistan in the Division of International Finance at the Federal Reserve Board when this paper was initially drafted. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated with the Federal Reserve System. The first author gratefully acknowledges the generous hospitality of Norges Bank, where he revised some of the material herein. The second author gratefully acknowledges financial support from the U.K. Economic and Social Research Council under grant R000234954. We wish to thank Clifford Attfield, David Demery, and Nigel Duck for compiling the data in Attfield, Demery, and Duck (1995); and Neva Kerbeshian, Helmut Lütkepohl, Jaime Marquez, and two anonymous referees for helpful comments. All numerical results were obtained using PcGive Professional Version 9.0: see Doornik and Hendry (1996). The data may be obtained from the Internet at http://wotan.wiwi.hu-berlin.de/oeknometrie/engl/data.html     

Liquidity and Liquidation

The manager of a firm that is selling an illiquid asset has discretion as to the sale price: if he chooses a high (low) selling price, early sale is unlikely (likely). If the manager has the option to default on the debt that is collateralized by the illiquid asset, the optimal selling price depends on whether the manager acts in the interests of owners or creditors. We model the former case. In equilibrium the owner will always offer the illiquid asset for sale at a strictly higher price than he paid, and will default if he fails to sell. As a result, upon successful sales the illiquid asset changes hands at successively higher prices. We also consider a generalization of the model which permits sellers to finance sales using either debt or preferred stock, or both. This allows derivation of an optimal capital structure. We are indebted to seminar participants at the University of California, Los Angeles; University of California, Santa Barbara; Utah State University; University of Miami; Federal Reserve Bank of Atlanta; Federal Reserve Bank of San Francisco and Federal Reserve Bank of Kansas City. We have received helpful comments from Tom Cooley.     

Empirical modeling of money demand

This paper examines several central issues in the empirical modeling of money demand. These issues include economic theory, data measurement, parameter constancy, the opportunity cost of holding money, cointegration, model specification, exogeneity, and inferences for policy. Review of these issues at a general level is paralleled by discussion of specific empirical applications, including some new results on the demand for narrow money in the United Kingdom.The author is a staff economist in the Division of International Finance, Board of Governors of the Federal Reserve System, Washington, DC 20551 USA, and may be reached on the Internet at ericsson@frb.gov. The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System, the Reserve Bank of Australia, or any other person associated with the Federal Reserve System or the Reserve Bank of Australia. I am grateful for the generous hospitality of the Reserve Bank of Australia, where I was on secondment when this research was begun. I also wish to thank Tony Brennan, Gordon de Brouwer, Julia Campos, Ed Nelson, Jerome Fahrer, Jon Faust, Steve Grenville, David Hendry, John Irons, Katarina Juselius, Neva Kerbeshian, Helmut Lütkepohl, Dieter Nautz, Athanasios Orphanides, Kevin Prestwich, Robert Subbaraman, Timo Teräsvirta, Jenny Wilkinson, Jürgen Wolters, and two anonymous referees for helpful comments and discussions. All numerical results were obtained using PcGive Professional Version 9.0; see Doornik and Hendry (1996). This paper is a condensed version of Ericsson (1998), which provides additional empirical and analytical examples and more extensive references. The data may be obtained from the Internet at http://wotan.wiwi.hu-berlin.de/oekonometrie/engl/data.html.     

Hours and employment variation in business cycle theory

Summary Previous business cycle models have made the assumption that all the variation in the labor input is either due to changes in hours per worker or changes in number of workers, but not both. In this paper, both vary. We think this is a better model for estimating the contribution of Solow technology shocks to aggregate fluctuations. We find that about 70% of the variance of U.S. postwar cyclical fluctuations is induced by variations in the Solow technology parameter.This material is based on work supported by the National Science Foundation under Grant Numbers SES-8722451 and SES-8909361. The Government has certain rights to this material.Any opinions, findings, conclusions, or recommendations expressed herein are those of the authors and not necessarily those of the National Science Foundation, the University of Minnesota, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System.     

Fiat money in the Kiyotaki-Wright model

Summary We study versions of the Kiyotaki-Wright (1989) model with fiat money and show that: (1) The use of a low storage cost fiat money may be necessary for specialization and trade, (2) there can be valued fiat money steady states which are indeterminate, (3) there are no nontrivial steady-states in which all trades consist of fiat money for goods, (4) fiat money may be valued even if it is not the least costly-to-store object, and lastly, (5) two fiat monies with different storage costs may both be valued.We thank Randall Wright for comments and helpful discussions.The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.     

Contract enforcement and the size of the informal economy

This paper describes a model where the size of the informal sector decreases as the degree to which financing contracts can be enforced in the formal sector rises. Agents who choose to operate in the informal sector can evade taxes, but they have no access to official means of contract enforcement. Numerical simulations of the model suggest that lax tax enforcement alone does not suffice to generate a large informal sector. Contractual imperfections, on the other hand, can generate a large informal sector and account for several distinguishing features of the organization of production in developing economies. I would like to thank Tim Kehoe, Ed Prescott and Manuel Santos for their guidance, and seminar participants at ITAM, the Universidad Torcuato di Tella and the University of Montréal for their valuable comments. The views expressed herein are those of the authors and may not reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.     

Broad money demand and financial liberalization in Greece

This paper develops a constant, data-coherent, equilibrium correction model for broad money demand (M3) in Greece over 1976–1994. The aggregate M3 was targeteduntil recently, and current monetary policy still uses such aggregates as guidelines. In spite of financial innovation, financial liberalization, and large fluctuations in the inflation rate, the estimated model is remarkabli stable. Dynamics are important, with price and income elasticities being much smaller in the short run than in the long run. The model provides a better understanding of the portfolio consequences of financial innovation and the effects of monetary policy in Greece.The authors are staff economists in the Division of International Finance, Federal Reserve Board, Washington, DC 20551 USA, and the Research Department, International Monetary Fund, Washington, DC 20431 USA, respectively. They may be reached on the Internet at ericsson@frb.gov and ssharma@imf.org. The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reflecting those of the Board of Governors of the Federal Reserve System, the International Monetary Fund, or other members of their staffs. We wish to thank the Bank of Greece for providing the data; Sophocles Brissimis, Nicholas Paleocrassas, and George Simigiannis for offering insights into institutional aspects of the Greek financial system; and Richard Agénor, Caroline Atkinson, Adi Brender, Julia Campos, Dimitri Demekas, David Hendry, Katarina Juselius, Tim Lane, Helmut Lütkepohl, Jaime Marquez, Jürgen Wolters, and two anonymous referees for useful comments. An earlier version of this paper appeared as Ericsson and Sharma (1996). All numerical results were obtained using PcGive Professional Versions 8 and 9: see Doornik and Hendry (1994a, 1994b, 1996, 1997) and Hendry and Doornik (1996). The data may be obtained from the Internet, http://wotan.wiwi.hu-berlin.de/ oekonometrie/engl/data.html     

Indivisibilities,lotteries, and sunspot equilibria

Summary We analyze economies with indivisible commodities. There are two reasons for doing so. First, we extend and provide some new insights into sunspot equilibrium theory. Finite competitive economies with perfect markets and convex consumption sets do not allow sunspot equilibria; these same economies with nonconvex consumption sets do, and they have several properties that can never arise in convex environments. Second, we provide a reinterpretation of the employment lotteries used in contract theory and in macroeconomic models with indivisible labor. We show how socially optimal employment lotteries can be decentralized as competitive equilibria without lotteries once sunspots are introduced.We thank Kenneth Arrow, Aditya Goenka, Ed Green, Jeremy Greenwood, Walter Heller, Steve Matthews, Herve Moulin, Roger Meyerson, Jim Peck, Patrick Kehoe, Ramon Marimon, Ed Prescott, Richard Rogerson, Nancy Stokey and Raghu Sundaram for their comments. We also thank participants in seminars at Northwestern, Yale, USC, Cornell, Barcelona, Madrid, Santander, and the Canadian Economics Association annual meetings in Victoria. We are grateful to the National Science Foundation (through grants SES-8606944 and SES-8821225), the Center for Analytic Economics, the Thorne Fund, and the University of Pennsylvania Research Foundation for research support. The views expressed here are those of the authors, and not necessarily those of the Federal Reserve System or the Federal Reserve Bank of Minneapolis.