We evaluate whether the spirit of capitalism improves the ability of the real business cycle model to explain the main features of both asset return and the business cycle. In our model, the spirit of capitalism is embodied in the assumption that individuals have preferences for financial wealth. Our simulation results suggest that this assumption may improve the model's ability to explain the risk-free rate puzzle but not the equity premium puzzle. This assumption also markedly deteriorates the model's ability to account for the main features of the business cycle.

This paper develops a two-sector small open economy model to analyze the effects of the currency denomination of debt on default risk and interest rates in emerging market economies. Default risk is determined endogenously and depends on the incentives for repayment. The economy can borrow using tradable-denominated nonindexed bonds or bonds whose return is indexed to the domestic price index, which are used as proxies for foreign currency and domestic currency debt, respectively. The model predicts that foreign currency debt leads to lower default risk for high output levels and domestic currency debt reduces the default risk for low output levels. Although the effect of debt denomination on default risk changes with the output level, the default rate of the economy and average interest rates decline as domestic currency borrowing increases. In addition, domestic currency borrowing is found to reduce the countercyclicality of interest rates and the trade balance.

This study evaluates the accuracy of a set of techniques that approximate the solution of continuous-time Dynamic Stochastic General Equilibrium models. Using the neoclassical growth model, I compare linear-quadratic, perturbation, and projection methods. All techniques are applied to the Hamilton–Jacobi–Bellman equation and the optimality conditions that define the general equilibrium of the economy. Two cases are studied depending on whether a closed-form solution is available. I also analyze how different degrees of non-linearities affect the approximated solution. The results encourage the use of perturbations for reasonable values of the structural parameters of the model and suggest the use of projection methods when a high degree of accuracy is required.

We model agents' endogenous updating of information sets over time under changing macroeconomic conditions. Building on sticky information models, the degree of inattentiveness is endogenized by allowing agents to choose between a costly full-information predictor and a costless sticky-information predictor. This is modeled as a choice between discrete alternatives under rational inattention. Recursive simulation shows that the dynamic equilibrium paths of aggregate variables are highly persistent and match the moments of U.S. data better than a model with fixed sticky information or with sticky prices, especially with regard to higher moments and the degree of persistence. Predictors are chosen in line with the predictions from rational inattention models, as the aggregate degree of attentiveness increases with rising variance of the forecast variable. Moreover, the model can generate hump-shaped impulse responses of inflation to a monetary policy shock if the degree of inattentiveness is sufficiently high.

Trade in intermediate goods is an important feature of trade in developed small open economies. We show that a model that assumes trade in intermediate goods brings the dynamics of an otherwise standard small open economy closer to what is observed in the data. With trade in intermediate goods, movements of international relative prices affect the economy through an additional channel, denoted the “cost channel.” A model embedding this channel comes closer to business cycle data in several dimensions compared to models with trade in final goods only. It increases the share of output variance explained by foreign shocks, lowers the exchange rate pass-through, and delivers a positive international correlation of outputs. In addition, the matching of other business cycle moments is at least as good as in a model with trade in final goods only.

It has been shown that the Ramsey growth model with agents that differ in their initial wealth endowments is compatible with a wide range of distributional outcomes, yet it is difficult to characterize under which circumstances the distribution of wealth becomes more or less unequal. In this note, we characterize the steady state distribution of wealth and compare it to the initial distribution, obtaining analytical conditions for one to be more skewed than the other. We show that whether wealth inequality increases or decreases during the transition to the steady state depends on simple and intuitive conditions on parameter values. Standard values for these parameters indicate that it is more likely that wealth inequality decreases as the economy accumulates capital.

In this paper, we study the equilibrium dynamics of an overlapping generations model with capital, money, and cash-in-advance constraints. At each period, the economy can experience two different regimes: Either the cash-in-advance constraint is binding and money is a dominated asset, or the constraint is strictly satisfied and money has the same return as capital. When the second regime occurs, we say that the economy experiences a temporary bubble. We show the existence of temporary bubbles, and we prove that cyclical equilibria may exist. In these equilibria, the economy experiences some periods without bubbles and some periods with bubbles. We also show that monetary creation can be used to eliminate temporary bubbles.

Rocheteau, Rupert, and Wright [Scandinavian Journal of Economics 109 (2007), 837–855] show that the relationship between inflation and unemployment can be positive or negative, depending on the primitives of the model. The key features are indivisible labor, nonseparable preferences, and bargaining. Their results are derived only for a special case of bargaining, take-it-or-leave-it offer by buyers. Instead of bargaining, this paper considers competitive search. I show that the results of Rocheteau et al. can be generalized to an environment where both buyers and sellers have nonseparable preferences. In addition, the relationship between inflation and unemployment is robust to allowing free entry by sellers, which cannot be studied in Rocheteau et al. (2007).

Yes, indeed; at least for macroeconomic policy interaction. We examine a Neo-Classical economy and provide the conditions for policy arrangements to successfully stabilize the economy when agents have either rational or adaptive expectations. For a contemporaneous-data monetary policy rule, the monetarist solution is unique and stationary under a passive fiscal/active monetary policy regime if monetary policy appropriately incorporates expectational heterogeneity. In contrast, the active fiscal/passive monetary policy regime's fiscalist solution is prone to explosiveness due to empirically plausible expectational heterogeneity. Nevertheless, this can be a well-defined, rather orthodox equilibrium. For operational monetary policy rules, only the results for the fiscalist solution prevail. Moreover, our results are plausible from an adaptive learning viewpoint.

We compare two stylized frameworks for the implementation of monetary policy. The first framework relies only on standing facilities, whereas the second framework relies only on open-market operations. We show that the Friedman rule cannot be implemented when the central bank uses standing facilities only. For a given rate of inflation, we show that standing facilities unambiguously achieve higher welfare than just conducting open-market operations. We conclude that elements of both frameworks should be combined. Also, our results suggest that any monetary policy implementation framework should remunerate both required and excess reserves.

This paper focuses on the possibility that financial markets require risk premia on holding sovereign debt of countries that appear vulnerable from a fiscal sustainability perspective. Both the level of debt as well as the rate of change of debt are assumed to impact on the risk premium. We analyze the impact of such an endogenous risk premium in a simple debt game between a monetary and a fiscal player, as introduced by [Tabellini (1986) Journal of Economic Dynamics and Control 10, 427–442]. The risk premium term adds a nonlinearity to the linear model in case risk premia are absent. We analyze outcomes in case of noncooperative open-loop Nash strategies and in case of cooperative strategies and consider the workings of the risk premium as a market-based disciplining device (in case of high debt) and adjustment rewarding device (in case of a declining debt trajectory).

This paper proposes the use of wavelet methods to estimate U.S. core inflation. It explains wavelet methods and suggests that they are ideally suited to this task. Comparisons are made with traditional Consumer Price Index–based and regression-based measures for their performance in following trend inflation and predicting future inflation. Results suggest that wavelet-based measures perform better, and sometimes much better, than the traditional approaches. These results suggest that wavelet methods are a promising avenue for future research on core inflation.

Daily financial returns (and daily stock returns, in particular) are commonly modeled as GARCH(1, 1) processes. Here we test this specification using new model evaluation technology developed by Ashley and Patterson that examines the ability of the estimated model to reproduce features of particular interest: various aspects of nonlinear serial dependence, in the present instance. Using daily returns to the CRSP equally weighted stock index, we find that the GARCH(1, 1) specification cannot be rejected; thus, this model appears to be reasonably adequate in terms of reproducing the kinds of nonlinear serial dependence addressed by the battery of nonlinearity tests used here.

We study a dynamic equilibrium model in which agents have adaptive expectations and monetary authorities pursue an inflation target. We show how alternative monetary stabilization policies become more effective when fiscal constraints on deficits are implemented, although they are not binding at the equilibrium target. In particular, we show that the inflation target equilibrium can be locally, or even globally, stable for a large class of adaptive learning schemes. We also compare alternative stabilization policies in terms of their stability properties. Commonly postulated conditional Taylor-type rules tend to be dominated by other rules, such as an unconditional Friedman type.

We introduce increasing returns to scale into an otherwise standard New Keynesian model with capital, and study the determinacy and E-stability of equilibrium under Taylor-type interest rate rules. With very mild increasing returns supported by empirical research, the conventional wisdom regarding the design of interest rate rules can be overturned. In particular, the “Taylor principle” no longer guarantees either determinacy or E-stability of the rational expectations equilibrium.

The DICE (for Dynamic Integrated model of Climate and the Economy) introduced two important policy aspects to the economic discussion of global warming. First, it argues for a “climate-policy ramp” that deems back-loading of mitigation optimal. Second, it demonstrates that an intergenerational tradeoff is at the heart of the mitigation problem. In this paper we argue that both of these findings rest on contestable assumptions. To demonstrate this a recast DICE is presented. Its outcomes show that DICE's predictions are not robust with higher migitations earlier on and slower temperature increases along the optimal path. The adoption of a baseline scenario in which pollution is a negative externality makes mitigating climate change a Pareto improvement. The alleged sacrifice of present generations vanishes. This strengthens the case for immediate policy action.

This paper examines the dynamic and desirable properties of monetary regimes in a remittances recipient economy, with emphasis on the effect on sectoral output and nontradable inflation dynamics. The findings indicate that under a fixed exchange rate regime, an increase in remittances creates increased demand for nontradable goods, and hence a rise in nontradable inflation, as well as expansion in output of nontradables. Under a nontradable inflation targeting regime, however, a decrease in nontradable inflation and an expansion in tradable goods production are observed following an increase in remittances. A near-zero nontradable inflation rate and managed variability in the nominal exchange rate typify the optimal monetary policy, suggesting that an inflation targeting regime is preferable to a fixed exchange regime under such a scenario. A VAR analysis shows that the dynamics of inflation in El Salvador and the Philippines is in consonance with those observed in the model under the fixed exchange rate and nontradable inflation targeting regimes, respectively.

This paper attempts to determine the factors generating the persistence of unemployment over the business cycle. The observations show that the total unemployment rate is highly persistent, and that the persistence of the unemployment rate of unskilled workers is higher than that of skilled workers. To account for these observations, the paper develops a framework that features search frictions. Individuals are either high educated or low educated, and firms post two types of vacancies: the complex, which can be matched with the high educated, and the simple, which can be matched with the high and the low educated. On-the-job search for a complex occupation is undertaken by the high educated in simple occupations. A negative aggregate technological shock induces the high educated unemployed to compete with the low educated by increasing their search intensity for simple vacancies. As the high educated occupy simple vacancies, they crowd out the low educated into unemployment. This downgrading of jobs in a cyclical downturn, or the increase in the labor input of the high educated in simple occupations, and the subsequent crowding out of the low educated into unemployment, provide a possible explanation for unemployment persistence.

The traditional economic approach to index number theory is based on a ratio of cost functions. Diewert defined superlative price and quantity indices as observable indices that were exact for a ratio of unit cost functions or for a ratio of linearly homogeneous utility functions. The present paper looks for counterparts to his results in the difference context, for both flexible homothetic and flexible nonhomothetic preferences. The Bennet indicators of price and quantity change turn out to be superlative for the nonhomothetic case. The underlying preferences are of the translation-homothetic form discussed by Balk, Chambers, Dickenson, Färe, and Grosskopf.

We construct a multiple-shock, discrete-time version of the Mortensen–Pissarides labor market search model to investigate the basic model's well-known tendency to underpredict the volatility of key labor market variables. In addition to the standard labor productivity shock, we introduce shocks to matching efficiency and job separation. We estimate the multiple-shock model and then simulate its properties. Although it generates significantly more volatility while preserving the Beveridge curve relationship, the multiple-shock model generates counterfactual implications for the cyclicality of job separations. Using a business cycle accounting approach, next we show that the model requires significantly procyclical and volatile matching efficiency and counterfactually procyclical job separations to render the observed data without error. We conjecture that the basic Mortensen–Pissarides model lacks mechanisms to generate sufficiently strong labor market reallocation over the business cycle, and suggest nontrivial labor force participation and job-to-job transitions as promising avenues of research.