Economics of Fluctuations and Dynamics

‘Dynamic Models with Robust Decision Makers: Identification and Estimation,’ Christensen, T., 2019.

This paper studies identification and estimation of a class of dynamic models in which the decision maker (DM) is uncertain about the data-generating process. The DM surrounds a benchmark model that he or she fears is misspecified by a set of models. Decisions are evaluated under a worst-case model delivering the lowest utility among all models in this set. The DM’s benchmark model and preference parameters are jointly underidentified. With the benchmark model held fixed, primitive conditions are established for identification of the DM’s worst-case model and preference parameters. The key step in the identification analysis is to establish existence and uniqueness of the DM’s continuation value function allowing for unbounded state space and unbounded utilities. To do so, fixed-point results are derived for monotone, convex operators that act on a Banach space of thin-tailed functions arising naturally from the structure of the continuation value recursion. The fixed-point results are quite general; applications to models with learning and Rust-type dynamic discrete choice models are also discussed. For estimation, a perturbation result is derived which provides a necessary and sufficient condition for consistent estimation of continuation values and the worst-case model. The result also allows convergence rates of estimators to be characterized. An empirical application studies an endowment economy where the DM’s benchmark model may be interpreted as an aggregate of experts’ forecasting models. The application reveals time-variation in the way the DM pessimistically distorts benchmark probabilities. Consequences for asset pricing are explored and connections are drawn with the literature on macroeconomic uncertainty

‘Survey data and subjective beliefs in business cycle models,’ Borovicka, J. (with A. Bhandari and P. Ho), 2017.

Survey data on household forecasts for unemployment and inflation rates reveal large upward biases that are positively correlated and countercyclical. We develop a framework to analyze general equilibrium settings where agents’ subjective beliefs are endogenous and shaped by time-varying concerns for model misspecification. Applying our framework to a New-Keynesian model with frictional labor markets, we find that, consistent with the survey evidence, an increase in concerns for model uncertainty generates large belief distortions, which reduce aggregate demand and propagate through frictional goods and labor market to cause a contraction. As part of our analysis, we also develop solution techniques that preserve the effects of time-varying concerns for model misspecification in the class of linear solutions.

‘Agency Business Cycles’ Menzio, G. (with M. Golosov), 2017.

We develop a theory of endogenous and stochastic áuctuations in aggregate economic activity. Individual Örms choose to randomize over Öring or keeping workers who performed poorly in the past to give them an ex-ante incentive to perform. Di§erent Örms choose to correlate the outcome of their randomization to reduce the probability with which they Öre non-performing workers. Correlated randomization leads to aggregate áuctuations. Aggregate áuctuations are endogenousó they emerge because Örms choose to randomize and they choose to randomize in a correlated fashionó and they are stochasticó they are the manifestation of a randomization process. The hallmark of a theory of endogenous and stochastic áuctuations is that the stochastic process for aggregate ìshocksîis an equilibrium object.

‘The Anatomy of sentiment- driven fluctuations,’ Benhabib, J. (with S. Acharya and Z. Huo), 2017.

We characterize the entire set of linear equilibria of beauty contest games under general information structures. In particular, we focus on equilibria in which sentiments, that is self-fulfilling changes in beliefs that are orthogonal to fundamentals and exogenous noise, can drive aggregate fluctuations. We show that, under rational expectations, there exists a continuum of sentiment-driven equilibria that generate aggregate fluctuations. Without having to take a stance on the private information agents might possess, we provide a general characterization of necessary and sufficient conditions under which a change in sentiments can have prolonged effects on aggregate outcomes and when it can only have short-lived effects. In addition, we also provide a practical way to characterize these equilibria.

‘Reconciling Models of Diffusion and Innovation: A Theory of the Productivity Distribution and Technology Frontier,’ Benhabib, J. (with J. Perla and C. Tonetti), 2017.

We study how innovation and technology diffusion interact to endogenously determine the productivity distribution and generate aggregate growth. We model firms that choose to innovate, adopt technology, or produce with their existing technology. Costly adoption creates a spread between the best and worst technologies concurrently used to produce similar goods. The balance of adoption and innovation determines the shape of the distribution; innovation stretches the distribution, while adoption compresses it. Whether and how innovation and diffusion contribute to aggregate growth depends on the support of the productivity distribution. With finite support, the aggregate growth rate cannot exceed the maximum growth rate of innovators. Infinite support allows for “latent growth”: extra growth from initial conditions or auxiliary stochastic processes. While innovation drives long-run growth, changes in the adoption process can influence growth by affecting innovation incentives, either directly, through licensing excludable technologies, or indirectly, via the option value of adoption.

‘On the Joint Evolution of Culture and Institutions,’ Bisin, A. (with T. Verdier), 2017.

Explanations of economic growth and prosperity commonly identify a unique causal effect, e.g., institutions, culture, human capital, geography. In this paper we provide instead a theoretical modeling of the interaction between culture and institutions and their effects on economic activity. We characterize conditions on the socio-economic environment such that culture and institutions complement (resp. substitute) each other, giving rise to a multiplier effect which amplifies (resp. dampens) their combined ability to spur economic activity. We show how the joint dynamics of culture and institutions may display interesting non-ergodic behavior, hysteresis, oscillations, and comparative dynamics. Finally, in specific example societies, we study how culture and institutions interact to determine the sustainability of extractive societies as well as the formation of civic capital and of legal systems protecting property rights.

‘Reputation Cycles and Earnings Dynamics,’ Jovanovic, B.(with J. Prat), 2018.

Cyclical patterns in earnings can arise when contracts between firms and their workers are incomplete, and when workers cannot borrow or lend so as to smooth their consumption. Earnings cycles generate occasional large changes in earnings, consistent with some recent empirical findings. At the calibrated parameter values, financial constraints promote investment in reputation – an intangible capital form – in contrast to their documented inhibiting effect on investment in tangible capital.

‘Structural Breaks in an Endogenous Growth,’ Jovanovic, B. and Cogley T., 2018.

We study the effects of parameter uncertainty prompted by structural breaks. In our model, agents respond differently to uncertainty prompted by regime shifts in shock processes than they react to comparable perceived increases in shock volatility. The magnitude of the response to an increase in uncertainty associated with a structural break is greater than that of a response to a comparable perceived rise in volatility. This is because lifetime utility varies more when shocks shift beliefs and perceived wealth.

‘The Macroeconomics of Private Equity,’ Jovanovic, B. and Rousseau T., 2018.

We ask two questions about private equity. Why are returns to venture funds higher than those of buyout funds? And why does the investment of venture funds respond more strongly to the business cycle than that of buyout funds? To address them, we build a model in which venture and buyout play different roles in the private equity market. Venture brings in new capital whereas buyout largely reorganizes existing capital, and this can explain the stronger co-movement of venture investment with aggregate Tobin’s Q.
This stronger co-movement stems from a higher correlation of venture returns with aggregate consumption and therefore a higher premium than buyout, and a thicker right tail in the distribution of projects funded through venture magnifies that difference. The model embodies this logic and fits the aggregate time series of private equity investment and returns well.

‘Product Recalls and Firm Reputation,’ Jovanovic, B. and Rousseau T., 2018.

We model reputation capital as a reward for good behavior of
sellers of a product the quality of which is not contractible. The market reacts unfavorably to product recalls which are the result of product defects. A recall triggers a reduction in the firm’s value which then rises steadily until its next defect occurs. We fit the model to data on product recalls in the transportation-equipment sector, and on stock-price reductions following such recalls and find that reputation accounts for about 11.2 percent of firm value. Contract incompleteness leads to a welfare level of 49 percent of first best. A simple policy intervention attains first best, namely a recall tax and a production subsidy.

‘Growth through Learning,’ Jovanovic, B., 2016.

This paper analyzes a decision problem under parameter uncertainty; first that of a single agent, and then for a group of agents that face related problems and that can invest in information that they share. Each period the unknown parameter has a permanent and a transitory component. The distinctive aspect is that the N-player game generates endogenous growth via statistical learning alone. The equilibrium growth rate rises with agents’ risk aversion and its distribution has a thick right tail. Research entails a free riding problem, but the scale effect dominates and growth rises with the number of agents.

‘Uncertainty and Business Cycles: Exogenous Impulse or Endogenous Response?,’ Ludvigson, S.C., and S. Ma (with S. Ng), 2018.

Uncertainty about the future rises in recessions. But is uncertainty a source of business cycles or an endogenous response to them, and does the type of uncertainty matter? To address these questions, we propose a novel shock-restricted identification strategy. We find that sharply higher uncertainty about macroeconomic activity in recessions is often an endogenous response to output shocks, while uncertainty about financial markets is a likely source of output fluctuations. The findings point to the need for a better understanding of how uncertainty in financial markets is transmitted to the macroeconomy.

‘Origins of Stock Market Fluctuations,’ Ludvigson, S.C. (with D.L. Greenwald and M. Lettau), 2016.

Three mutually uncorrelated economic disturbances that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952. A model is employed to interpret these disturbances in terms of three latent primitive shocks. In the short run, shocks that affect the willingness to bear risk independently of macroeconomic fundamentals explain most of the variation in the market. In the long run, the market is profoundly affected by shocks that reallocate the rewards of a given level of production between workers and shareholders. Productivity shocks play a small role in historical stock market fluctuations at all horizons.

‘Discount Rates, Learning by Doing, and Employment Fluctuations,’ Midrigan, V. (with P. Kehoe and E. Pastorino), 2015.

We revisit the Shimer (2005) puzzle in a search and matching model with on-the-job human capital accumulation in which households exhibit preference for consumption smoothing. We parameterize the model so that it accords with the micro-evidence on returns to tenure and experience as well as individual life-cycle earning profiles. We find that employment fluctuations in response to productivity shocks are greatly amplified in this environment.

‘ Uncertainty, financial frictions, and investment dynamics,’ Gilchrist, S. (with J. Sim, E. Zakrajsek), 2014.

Micro- and macro-level evidence indicates that fluctuations in idiosyncratic uncertainty have a large effect on investment; the impact of uncertainty on investment occurs primarily through changes in credit spreads; and innovations in credit spreads have a strong effect on investment, irrespective of the level of uncertainty. These findings raise a question regarding the economic significance of the traditional “wait-and-see” effect of uncertainty shocks and point to financial distortions as the main mechanism through which fluctuations in uncertainty affect macroeconomic outcomes. The relative importance of these two mechanisms is analyzed within a quantitative general equilibrium model, featuring heterogeneous firms that face time-varying idiosyncratic uncertainty, irreversibility, nonconvex capital adjustment costs, and financial frictions. The model successfully replicates the stylized facts concerning the macroeconomic implications of uncertainty and financial shocks. By influencing the effective supply of credit, both types of shocks exert a powerful effect on investment and generate countercyclical credit spreads and procyclical leverage, dynamics consistent with the data and counter to those implied by the technology-driven real business cycle models.

‘Can heterogeneity in price stickiness account for the persistence and volatility of good-level real exchange rates?,’ Midrigan, V. (with P. Kehoe), 2007.

The classic explanation for the persistence and volatility of real exchange rates is that they are the result of nominal shocks in an economy with sticky goods prices. A key implication of this explanation is that if goods have differing degrees of price stickiness then relatively more sticky goods tend to have relatively more persistent and volatile good-level real exchange rates. Using panel data, we find only modest support for these key implications. The predictions of the theory for persistence have some modest support: in the data, the stickier is the price of a good the more persistent is its real exchange rate, but the theory predicts much more variation in persistence than is in the data. The predictions of the theory for volatility fare less well: in the data, the stickier is the price of a good the smaller is its conditional variance while in the theory the opposite holds. We show that allowing for pricing complementarities leads to a modest improvement in the theory’s predictions for persistence but little improvement in the theory’s predictions for conditional variances.

‘Inequality, Business Cycles and Fiscal-Monetary Policy,’ Sargent, T. (with A. Bhandari, D. Evans and M. Golosov), 2017.

We study fluctuations in macroeconomic aggregates and cross-section income and wealth distributions in a heterogeneous agent model with incomplete markets and sticky nominal prices. Optimal fiscal-monetary policy balances gains from ”fiscal hedging” against benefits from redistributional hedging that responds to social concerns about inequality. A Ramsey planner uses inflation to offset inequality-increasing shocks to the cross-section distribution of labor earnings. A calibration that imitates how US recessions reshape that cross section distribution in ways documented by Guvenen et al. (2014) indicates that substantial welfare benefits come from making inflation respond to aggregate shocks.

‘Domestic Price Dollarization in Emerging Economies,’ Perez, D. (with A. Drenik), 2019.

This paper provides an empirical investigation of the currency of denomination of prices in domestic markets of various emerging economies. Using data from the largest e-trade platform in Latin America, we document that a significant fraction of prices is set in dollars. Across countries, price dollarization is positively correlated with asset dollarization, and negatively correlated with the size of the economy. At the micro level, larger sellers are more likely to price in dollars, and more tradeable goods are more likely to be posted in dollars. We show that prices are sticky, and hence the currency of prices determines the short-run reaction of prices to a nominal exchange rate shock. More importantly, we document that these shocks ultimately impact the quantities sold differentially, depending on the currency of prices. Finally, our findings are relevant for the dynamics of the CPI. Keywords: prices, dollar, exchange rate, pass-through..

‘Global Banks and Systemic Debt Crises,’ Perez, D. (with P. Ottonello, J. Morelli), 2019.

We study the role of global financial intermediaries in international lending. We construct a model of the world economy, where heterogeneous borrowers issue risky securities purchased by financial intermediaries. Aggregate shocks transmit internationally through financial intermediaries’ net worth. The strength of this transmission is governed by the degree of frictions intermediaries face financing their risky investments. We provide direct empirical evidence on this mechanism showing that, around Lehman Brothers’ collapse, emerging-market bonds held by more-distressed global banks experienced larger price contractions. A quantitative analysis of the model shows that global financial intermediaries play a relevant role driving borrowing-cost and consumption fluctuations in emerging-market economies, both during debt crises and in regular business cycles. The portfolio of financial intermediaries and the distribution of bond holdings in the world economy are key to determine aggregate dynamics.

‘The Fundamental Surplus,’ Sargent, T., and L. Ljungqvist, 2017.

To generate big responses of unemployment to productivity changes, researchers have reconfigured matching models in various ways: by elevating the utility of leisure, by making wages sticky, by assuming alternating-offer wage bargaining, by introducing costly acquisition of credit, by assuming fixed matching costs, or by positing government mandated unemployment compensation and layoff costs. All of these redesigned matching models increase responses of unemployment to movements in productivity by diminishing the fundamental surplus fraction, an upper bound on the fraction of a job’s output that the invisible hand can allocate to vacancy creation. Business cycles and welfare state dynamics of an entire class of reconfigured matching models all operate through this common channel.

‘Technology Innovation and Diffusion as Sources of Output and Asset Price Fluctuations,’ Gertler, M. (with D. Comin and A.M. Santacreu), 2009.

We develop a model in which innovations in an economy’s growth potential are an important driving force of the business cycle. The framework shares the emphasis of the recent ”news shock” literature on revisions of beliefs about the future as a source of fluctuations, but differs by tieing these beliefs to fundamentals of the evolution of the technology frontier. An important feature of the model is that the process of moving to the frontier involves costly technology adoption. In this way, news of improved growth potential has a positive effect on current hours. As we show, the model also has reasonable implications for stock prices. We estimate our model for data post-1984 and show that the innovations shock accounts for nearly a third of the variation in output at business cycle frequencies. The estimated model also accounts reasonably well for the large gyration in stock prices over this period. Finally, the endogenous adoption mechanism plays a significant role in amplifying other shocks.

‘Endogenous Technology Adoption and R&D as Sources of Business Cycle Persistence,’ Gertler, M., D. Anzoategui, and J. Martinez (with D. Comin), 2017.

We examine the hypothesis that the slowdown in productivity following the Great Recession was in significant part an endogenous response to the contraction in demand that induced the downturn. To do so we augment a workhorse New Keynesian DSGE model with an endogenous TFP mechanism that allows for both costly development and adoption of new technologies. We then estimate the model and use it to assess the sources of the productivity slowdown. We find that the post-Great Recession fall in productivity was a largely endogenous phenomenon. The endogenous productivity mechanism also helps account for the slowdown in productivity prior to the Great Recession. Overall, the results are consistent with the view that demand factors have played a role in the slowdown of capacity growth. More generally, they provide insight into why recoveries from financial crises may be so slow.