Money-demand specifications exhibit instability, especially for long spans of data. This paper reconsiders the welfare cost of inflation for the US economy using a flexible time-varying (TV) cointegration methodology to estimate the money-demand function. We find evidence that the TV cointegration estimation provides a better fit of the actual data than a time-invariant estimation and that the throughout unitary income elasticity only exists for the log–log form over the entire sample period. Our estimate of the welfare cost of inflation for a 10% inflation rate lies in the range of 0.025–0.75% of gross domestic product (GDP) and averages 0.27%. In sum, our findings fall well within the ranges of existing studies of the welfare cost of inflation. We find that the welfare cost averages 7.4% higher during expansions than recessions for 10% inflation rate. Finally, the interest elasticity of money demand shows substantial variability over our sample period.

Currency fluctuations are an important determinant of labor market dynamics. Vice versa, relative labor costs affect real exchange rate dynamics. The optimal choice of exchange rate regimes cannot neglect this nexus. We assess such a choice using a two-country model with frictional labor markets. The monetary authority faces a tension between the classical insulating property of floating exchange rates and the destabilizing effects of currency fluctuations on (relative) job flows. Results show that the second motive is important: optimal monetary policy prescribes (some) response to the exchange rate. We also reexamine the conditions for optimal policy in a currency area whose members experience asymmetries in labor market institutions.

Theoretically, two-country real business cycle models with time-separable preferences and complete markets predict that cross-country investment correlations will be negative. The opposite is true in the data. This phenomenon has been described by Backus et al. [in Cooley (ed.), Frontiers of Business Cycle Research, pp. 331–356 (Princeton, NJ: Princeton University Press, 1995)] as a quantity anomaly. This paper proposes to address this discrepancy by allowing the nonseparability of preferences over time. Here, we incorporate internal habit formation into consumption. Our model predicts the empirically plausible value of cross-country investment correlation without sacrificing other business cycle statistics. The results are robust to the degree of spillovers and persistence in the specification of the productivity shocks.

This research empirically establishes and interprets the hypothesis that the relationship between population aging and inventive activity is hump-shaped. We estimate a reduced form, hump-shaped relationship in a panel of 33 OECD countries over the period 1960–2012, as well as in a panel of 248 NUTS 2 regions in Europe over the period 2001–2012. The increasing part of the hump may be associated with various channels including the acknowledgement that population aging requires inventive activity to guarantee current and future standards of living, or the observation that older educated workers are more innovative than their young peers. The decreasing part may reflect the tendency of aging societies to lose dynamism and the willingness to take risks.

This paper examines the heterogeneity of exchange rate pass-through into industry-specific import, producer, and consumer prices. Results show that depending on the imported input contents, price responsiveness to the aggregate and relative exchange rate changes displays significant differences. We found that direct exchange rate impacts are more significant than indirect effects. The importance of the indirect effects is largely influenced from energy, basic metal, and chemical industries that provide intermediate inputs to others. The time horizon plays a role in the transition process: exchange rate pass-through tends to get stronger and spread to different price indices over time. The short-run impacts of aggregate exchange rate changes are not significant, while relative exchange rate changes partially transmit to producer and consumer prices in low-import content industries. In the long run direct impacts of both aggregate and relative exchange rates are significant on import prices in all industries and producer prices in high-import content industries. Another interesting finding is that the relative and aggregate exchange rate changes have opposing impacts on domestic prices: asymmetric information about industry-specific exchange rates can create pricing opportunities.

We analyze the welfare effects of asset bubbles in a model with income inequality and financial friction. We show that a bubble that emerges in the value of housing, a durable asset that is fundamentally useful for everyone, has regressive welfare effects. By raising the housing price, the bubble benefits high-income savers but negatively affects low-income borrowers. The key intuition is that, by creating a bubble in the market price, savers’ demand for the housing asset for investment purposes imposes a negative externality on borrowers, who only demand the housing asset for utility purposes. The model also implies a feedback loop: high-income inequality depresses the interest rates, facilitating the existence of housing bubbles, which in turn has regressive welfare effects.

This paper develops a stochastic growth model that reproduces the main stylized facts of Imperial China's dynastic cycle—in particular, the time path of taxation, public spending, and corruption and their attendant impacts on production and income distribution. In this model, the emperor uses part of his tax income to finance the building of public capital and administrative institutions. This “institutional capital” enhances the productivity of the economy and limits extortion by the county magistrates. The dynastic cycle is driven by random shocks to the authority of the emperor and his central administration, which change the efficiency of institutional capital.

Bullard and Mitra [Journal of Monetary Economics 49 (2002), 1105–1130] find that, in a New Keynesian economy without capital and under four variants of the Taylor rule, the Taylor principle is sufficient to guarantee both determinacy and E-stability of equilibrium in most cases. Xiao [Macroeconomic Dynamics 12 (2008), 22–49] claims that with capital and mild increasing returns the Taylor principle cannot guarantee either determinacy or E-stability with any of the four rules. In this paper we show that in the Calvo-type sticky price models a second-order condition for profit maximization must be satisfied in firms' pricing decision problem, and we point out that the examples given in Xiao's paper to support his conclusion violate this condition. After imposing this condition, we find that increasing returns have little effect on determinacy and E-stability under two of the policy rules but significant effects under the other two. These results are obtained in models both with and without capital.

This paper examines a class of interest rate rules that respond to public expectations and to lagged variables and considers varying levels of commitment that correspond to varying degrees of response to lagged output. Under commitment the policymaker adjusts the nominal rate with lagged output to impact public expectations. Within this class of rules, I provide a condition for nonexplosive and determinate solutions. Expectational stability obtains for any nonnegative response to lagged output. Simulation results show that modified commitment is best under least-squares learning. However, in the presence of parameter uncertainty and/or measurement error in the policymaker's data on public expectations, the best policy is one of partial commitment, where the response to lagged output is less than under modified commitment. The case for partial commitment is strengthened if the gain parameter in the learning mechanism is high, which can be interpreted as the use of few lags by public agents in the formation of expectations or as an indication of low credibility of the policymaker. The appointment of a conservative central banker ameliorates these concerns about modified commitment.

In this paper, we explore the consequence of learning to forecast in a very simple environment. Agents have bounded memory and incorrectly believe that there is nonlinear structure underlying the aggregate time series dynamics. Under social learning with finite memory, agents may be unable to learn the true structure of the economy and rather may chase spurious trends, destabilizing the actual aggregate dynamics. We explore the degree to which agents' forecasts are drawn toward a minimal state variable learning equilibrium as well as a weaker long-run consistency condition.

The recent global financial crisis and the subsequent recession have revitalized the discussion on causal interactions between financial and economic sectors. In this study, I apply the financial stress and the national activity indices–respectively developed by Federal Reserve Banks of Kansas City and Chicago–to investigate the impact of financial uncertainty on an overall economic performance. I examine nonlinear dynamics in a vector smooth transition autoregressive framework, and illustrate regime-dependent asymmetries in the financial and economic indices using the generalized impulse-response functions. The results reveal more amplified dynamics during the stressed conditions. I further evaluate benefits of nonlinear modeling in an out-of-sample setting. The forecasting exercise brings out the important advantages that nonlinear modeling provides in the identification of the causal effect of financial instability on overall economic performance.

We present a new simple and short proof of the existence of equilibria in the classical single-sector growth model.

In a model where banks face a capital sufficiency requirement, we demonstrate that news about a fall in the expected return on a portfolio of international long bonds held by a bank leads to an immediate and persistent fall in economic activity. Even if the news never materializes, economic activity falls below steady state for several periods, followed by a recovery. The portfolio adjustment induced by the capital sufficiency requirements leads to a rise in loan rates and tighter credit conditions, which trigger the fall in activity. We contribute to the news-shock literature by showing that imperfect signals about future financial returns can create business cycles without relying on the usual suspects—shocks to technology, preferences, or fiscal policy—and to the emerging economy business cycle literature in that disturbances in world financial markets can cause domestic business cycles without shocks to the world interest rate or to country spreads.

We develop a classical macroeconomic model to examine the growth and distributional consequences of education. Contrary to the received wisdom, we show that human capital accumulation is not necessarily growth-inducing and inequality-reducing. Expansive education policies may foster growth and reduce earning inequalities between workers, but only by transferring income from workers to capitalists. Further, the overall effect of an increase in education depends on the actual characteristics of the educational system and on the nature of labor market relations. Although the primary aim of the paper is theoretical, we argue that the model identifies some causal mechanisms that can contribute to shed light on recent stylized facts on growth, distribution, and education for the USA.

This paper presents an integrated theory of money and dynamic credit. I study financial intermediation when both the intermediary and individuals have private information. I show that money is essential to solving two-sided incentive problems under the dynamic credit arrangement. First, requiring settlement with money can induce market trades that generate information-revealing prices to discipline the intermediary. Second, it is optimal for the intermediary to issue money that can record its own history of being used in settlements, and to require that settlements be made with only money that has been returned to the intermediary every settlement period. This arrangement effectively reduces individuals' incentives to deviate and allows intermediation to achieve efficient allocations.

Japan’s so-called Lost Decade of the 1990s presents a unique case study of an economy with a recent severe and prolonged recession, with large changes in the labor market and fiscal policy as the main policy available to the government. Japanese unemployment rate surged from 2.1% in 1991 to 5.4% in 2002. Meanwhile, the Japanese economy experienced a rise in government expenditures, while taxes remained fairly stable. This paper quantitatively evaluates the impact of these changes in fiscal policies on labor market variables, in particular the unemployment rate, during the 1990s. We build, calibrate, and simulate a dynamic general equilibrium model with search frictions in the labor market, a productive government sector, heterogenous government spendings, and different categories of taxes. Our model is able to reproduce the paths of the main labor market variables, and the counterfactual experiments show that the changes that took place in the different spending components affected the unemployment rate heterogeneously, although overall they kept unemployment lower than it could have been. We also find that had the government also implemented countercyclical tax policies, unemployment would not have risen as much as it did by 2002.

In a life-cycle model with dynastic households, parents value the transfer of tangible assets to their offspring in the event of premature death. This raises the subjective reward from investing in them relative to intangible human capital and tilts investment choice away from the latter. These effects of mortality on human capital risk and relative investment can translate into divergent growth paths, delayed transition from physical to human capital accumulation, and a dampened response to mortality shock in developing countries.

We extend the dynamic Heckscher–Ohlin model in Bond et al. [Economic Theory (48, 171–204, 2011)] and show that if the labor-intensive good is inferior, then there may exist multiple steady states in autarky and poverty traps can arise. Poverty traps for the world economy, in the form of Pareto-dominated steady states, are also shown to exist. We show that the opening of trade can have the effect of pulling the initially poorer country out of a poverty trap, with both countries having steady state capital stocks exceeding the autarky level. However, trade can also pull an initially richer country into a poverty trap. These possibilities are a sharp contrast with dynamic Heckscher–Ohlin models with normality in consumption, where the country with the larger (smaller) capital stock than the other will reach a steady state where the level of welfare is higher (lower) than in the autarkic steady state.

We examine the impact of balanced-budget labor income taxes on the existence of expectation-driven business cycles in a two-sector version of the Schmitt-Grohé and Uribe (SGU) [(1997) Journal of Political Economy 105, 976–1000] model with constant government expenditures and counter-cyclical taxes. Our results show that the destabilizing impact of labor income taxes strongly depends on the capital intensity difference across sectors. Local indeterminacy is indeed more likely when the consumption good sector is capital intensive, as the minimal tax rate decreases, and less likely when the investment good sector is capital intensive, as the minimal tax rate increases. The implication of this result can be quantitatively significant. Indeed, when compared to SGU, local indeterminacy can be either completely ruled out for all OECD countries when the investment good is sufficiently capital intensive or drastically improved, delivering indeterminacy for a larger set of OECD countries, if the consumption good is sufficiently capital intensive. Focusing however on recent estimates of the sectoral capital shares corresponding to the empirically plausible case of a capital intensive consumption good, we find that there is a significant increase of the range of economically relevant labor tax rates (from a minimum tax rate of 30% to 24.7% for which local indeterminacy arises with respect to the aggregate formulation of SGU.

Now that most countries have harmonized intellectual property right (IPR) legislation as a consequence of signing the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs), the dispute about the optimal level of IPR protection has shifted toward IPR enforcement. This paper develops an endogenous growth framework with two open economies satisfying the classical North–South assumptions to study (a) the regions' incentives to enforce IPRs in a decentralized game, (b) the desired IPR enforcement of the two regions in negotiation rounds on global harmonization, and (c) the constrained efficient enforcement level. We show how the different solutions relate to each other and how the results depend on the research productivity in the North and the regions' relative market sizes. Although growth rates increase substantially when IPR enforcement is harmonized at the North's desired level, our numerical simulation suggests that the South may also benefit in terms of long-run welfare.