Rational and Near-Rational Bubbles without Drift
Forthcoming in Economic Journal
+ abstract This paper derives a general class of intrinsic rational bubble solutions in a Lucas-type asset pricing model. I show that the rational bubble component of the price-dividend ratio can evolve as a geometric random walk without drift, such that the mean of the bubble growth rate is zero. Driftless bubbles are part of a continuum of equilibrium solutions that satisfy a period-by-period no-arbitrage condition. I also derive a near-rational solution in which the agent's forecast rule is under-parameterized. The near-rational solution generates intermittent bubbles and other behavior that is quantitatively similar to that observed in long-run U.S. stock market data.
Capital-Labor Substitution and Equilibrium Indeterminacy
Journal of Economic Dynamics and Control 33, December 2009, 1991-2000 :: With Guo
+ abstract Empirical evidence indicates that the elasticity of capital-labor substitution for the aggregate U.S. economy is below unity. In contrast, the existing indeterminacy literature has mostly restricted attention to a Cobb-Douglas production function which imposes a substitution elasticity exactly equal to unity. This paper examines the quantitative relationship between capital-labor substitution and the conditions needed for equilibrium indeterminacy (and belief-driven fluctuations) in a one-sector growth model. With variable capital utilization, the substitution elasticity has little quantitative impact on the minimum degree of increasing returns needed for indeterminacy. However, when capital utilization is constant, a below-unity substitution elasticity sharply raises the minimum degree of increasing returns. In this version of the model, lower substitution elasticities impose a higher adjustment cost on labor hours that cannot be mitigated by shifts in the capital utilization rate. Overall, our results show that empirically plausible departures from the Cobb-Douglas specification can make indeterminacy more difficult to achieve.
Speculative Bubbles and Overreaction to Technological Innovation
Journal of Financial Transformation 26, June 2009, 51-54
+ abstract "Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street,'' observed legendary speculator Jesse Livermore. History tells us that periods of major technological innovation are typically accompanied by speculative bubbles as economic agents overreact to genuine advancements in productivity. Excessive run-ups in asset prices can have important consequences for the economy as firms and investors respond to the price signals, resulting in capital misallocation. On the one hand, speculation can magnify the volatility of economic and financial variables, thus harming the welfare of those who are averse to uncertainty and fluctuations. But on the other hand, speculation can increase investment in risky ventures, thus yielding benefits to a society that suffers from an underinvestment problem.
Time Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve
Review of Economic Dynamics 12(2), April 2009, 304-326
+ abstract This paper introduces a form of boundedly-rational inflation expectations in the New Keynesian Phillips curve. The representative agent is assumed to behave as an econometrician, employing a time series model for inflation that allows for both permanent and temporary shocks. The near-unity coefficient on expected inflation in the Phillips curve causes the agent's perception of a unit root in inflation to become close to self-fulfilling. In a "consistent expectations equilibrium," the value of the Kalman gain parameter in the agent's forecast rule is pinned down using the observed autocorrelation of inflation changes. The forecast errors observed by the agent are close to white noise, making it difficult for the agent to detect a misspecification of the forecast rule. I show that this simple model of inflation expectations can generate time-varying persistence and volatility that is broadly similar to that observed in long-run U.S. data. Model-based values for expected inflation track well with movements in survey-based measures of U.S. expected inflation. In numerical simulations, the model can generate pronounced low-frequency swings in the level of inflation that are driven solely by expectational feedback, not by changes in monetary policy.
Maintenance Expenditures and Indeterminacy under Increasing Returns to Scale
International Journal of Economic Theory 3(2), June 2007, 147-158 :: With Guo
+ abstract This paper develops a one-sector real business cycle model in which competitive firms allocate resources for the production of goods, investment in new capital and maintenance of existing capital. Firms also choose the utilization rate of existing capital. A higher utilization rate leads to faster capital depreciation, and an increase in maintenance activity has the opposite effect. We show that as the equilibrium ratio of maintenance expenditures to GDP rises, the required degree of increasing returns for local indeterminacy declines over a wide range of parameter combinations. When the model is calibrated to match empirical evidence on the relative size of maintenance and repair activity, we find that local indeterminacy (and belief-driven fluctuations) can occur with a mild and empirically-plausible degree of increasing returns: approximately 1.08.
Tax Reform with Useful Public Expenditures
Journal of Public Economic Theory 8(4), October 2006, 631-676 :: With Cassou
+ abstract This paper examines the economic effects of tax reform in an endogenous
growth model that allows for two types of useful public expenditures; one type contributes to human capital formation while the other provides direct utility to households. We show that the optimal fiscal policy calls for full expensing of private investments, which shifts the tax base to private consumption. The efficient levels of public investment and public consumption relative to output are uniquely pinned down by parameters that govern both technology and preferences. In general, implementing the optimal fiscal policy requires a change in the size of government. If a tax reform holds the size of government fixed to satisfy a revenue-neutrality constraint, then the reform will be suboptimal; theory alone cannot tell us if welfare will be improved. For some calibrations of the model, we find that commonly proposed versions of revenue-neutral tax reforms can result in large welfare gains. For other quite plausible calibrations, the exact same reform can result in tiny or even negative welfare gains as the revenue-neutrality constraint
becomes more severely binding. Comparing across calibrations, we find that the welfare rankings of various reforms can change, depending on
parameter values. Overall, our results highlight the uncertainty surrounding the potential welfare benefits of fundamental U.S. tax reform.
Lock-in of Extrapolative Expectations in an Asset Pricing Model
Macroeconomic Dynamics 10(3), June 2006, 317-348
+ abstract This paper examines an agent's choice of forecast method within a standard asset
pricing model. To make a conditional forecast, a representative agent may choose one
of the following: (1) a rational (or fundamentals-based) forecast that employs knowledge
of the stochastic process governing dividends, (2) a constant forecast based on a simple
long-run average of the forecast variable, or (3) a time-varying forecast that extrapolates
from the last observation of the forecast variable. I show that a representative agent
who is concerned about minimizing forecast errors may inadvertently become "locked in"
to an extrapolative forecast. In particular, the initial use of extrapolation alters the
law of motion of the forecast variable so that the agent perceives no accuracy gain from
switching to one of the alternative forecast methods. Under extrapolative expectations,
the model can generate excess volatility of stock prices, time-varying volatility of returns,
long-horizon predictability of returns, bubbles driven by optimism about the future, and
sharp downward movements in stock prices that resemble market crashes. All of these
features appear to be present in long-run U.S. stock market data.
Inflation-Induced Valuation Errors in the Stock Market
Journal of Financial Transformation 13, April 2005, 124-126
Growth Effects of Shifting from a Graduated Rate Tax System to a Flat Tax
Economic Inquiry 42(2), April 2004, 194-213 :: With Cassou
+ abstract We compute the growth effects of adopting a revenue-neutral flat tax for
both a human capital-based endogenous growth model and a standard neoclassical growth model. Long-run growth effects are decomposed into the parts attributable to the flattening of the marginal tax schedule, the full expensing of physical-capital investment, and the elimination of double taxation of business income. The most important element of the reform is the flattening of the marginal tax schedule. Without this element, the combined effects of the other parts of the reform can actually reduce long-run growth. In the years immediately following the reform, the transition dynamics implied by the neoclassical growth model are quite similar to that of the endogenous growth model.
Forward-Looking Behavior and Optimal Discretionary Monetary Policy
Economics Letters 81(2), November 2003, 249-256 :: With Trehan
+ abstract This paper derives a closed-form solution for the optimal discretionary monetary policy in a small macroeconomic model that allows for varying degrees of forward-looking behavior. We show that a more forward-looking
aggregate demand equation serves to attenuate the response to inflation and the output gap in the optimal interest rate rule. In contrast, a more forward-looking real interest rate equation serves to magnify the response to both variables. A more forward-looking Phillips curve serves to attenuate the response to inflation but magnify the response to the output gap. The results have implications for studies that attempt to reconcile estimated versions of the central bank's policy rule with optimal discretionary monetary policy. In particular, a successful reconciliation is likely to require a different degree of forward-looking behavior in each part of the model economy.
Globally Stabilizing Fiscal Policy Rules
Studies in Nonlinear Dynamics and Econometrics 7(2), April 2003 :: With Guo
+ abstract This paper demonstrates how fiscal policy rules can be designed to eliminate all forms of endogenous fluctuations in a one-sector growth model with increasing returns-to-scale. When the policy rules are implemented, agents' optimal decisions depend only on the current state of the economy and not on any expected future states. This property shuts down the mechanism for expectations-driven fluctuations. The proposed policy rules ensure a globally unique and stable equilibrium, regardless of the degree of increasing returns.
Fiscal Policy, Increasing Returns, and Endogenous Fluctuations
Macroeconomic Dynamics 6(5), November 2002, 633-664 :: With Guo
+ abstract This paper examines the quantitative implications of government fiscal
policy in a discrete-time one-sector growth model with a productive externality that generates social increasing returns to scale. Starting from a laissez-faire economy that exhibits local indeterminacy, we show that the introduction of a constant capital tax or subsidy can lead to various forms of endogenous fluctuations, including stable 2-, 4-, 8-, and 10-cycles, quasiperiodic orbits, and chaos. In contrast, a constant labor tax or subsidy has no effect on the qualitative nature of the model's dynamics. We show that the use of local steady-state analysis to detect the presence of multiple equilibria in this class of models can be misleading. For a plausible range of capital tax rates, the log-linearized dynamical system exhibits saddle-point stability, suggesting a unique equilibrium, whereas the true nonlinear model exhibits global indeterminacy. This result implies that stabilization
policies designed to suppress sunspot fluctuations near the steady state may not prevent sunspots, cycles, or chaos in regions away from the steady state. Overall, our results highlight the importance of using a model's nonlinear equilibrium conditions to fully investigate global dynamics.
Expectations Credibility and Disinflation in a Small Macroeconomic Model
Journal of Economics and Business 51, January 2000, 51-86 :: With Huh
+ abstract We used a version of the Fuhrer-Moore model to study the effects of expectations and central bank credibility on the economy's dynamic transition path during a disinflation. Simulations were compared under four different specifications of the model which vary according to the way that expectations are formed (rational versus adaptive) and the degree of central bank credibility (full versus partial). The various specifications exhibited qualitatively similar behavior and were able to reasonably approximate the trend movements in U.S. macro variables during the Volcker disinflation of the early 1980s. However, the specification with adaptive expectations/partial credibility was the only one to capture the temporary rise in long-term nominal interest rates observed in U.S. data at the start of the disinflation. We also found that incremental reductions in the output sacrifice ratio were largest at the low end of the credibility range, suggesting that a central bank may face diminishing returns in its efforts to enhance credibility.
Optimal Redistributive Capital Taxation in a Neoclassical Growth Model
Journal of Public Economics 73, 1999, 423-453
Optimal Taxation of Capital Income with Imperfectly Competitive Product Markets
Journal of Economic Dynamics and Control 23, 1999, 967-995 :: With Guo
Fiscal Policy and Productivity Growth in the OECD
Canadian Journal of Economics 32, 1999, 1215-1226 :: With Cassou
Indeterminacy and Stabilization Policy
Journal of Economic Theory 82, 1998, 481-490 :: With Guo
Optimal Fiscal Policy, Public Capital, and the Productivity Slowdown
Journal of Economic Dynamics and Control 22, 1998, 911-935 :: With Cassou
Optimal Fiscal Policy in a Business Cycle Model with Public Capital
Canadian Journal of Economics 31, 1998, 337-364
Growth, Welfare, or Stabilization: A Comparison of Different Fiscal Objectives
In Business Cycles and Macroeconomic Stability, ed. by Hairault, Henin, and Portier :: New York: Kluwer Academic Publishers, 1997. 55-78 :: With Cassou
Computable General Equilibrium Models and Monetary Policy Advice
Journal of Money Credit and Banking 27, 1995, 1472-1493 :: With Altig and Carlstrom