In the economics literature, there are two dominant approaches for solving models with optimal experimentation (also called active learning). The first approach is based on the value function and the second on an approximation method. In principle the value function approach is the preferred method. However, it suffers from the curse of dimensionality and is only applicable to small problems with a limited number of policy variables. The approximation method allows for a computationally larger class of models, but may produce results that deviate from the optimal solution. Our simulations indicate that when the effects of learning are limited, the differences may be small. However, when there is sufficient scope for learning, the value function solution seems more aggressive in the use of the policy variable.

This paper revisits two classic results in standard overlapping generations models with a pay-as-you-go (PAYG) pension system. Firstly, a PAYG system crowds out private savings and reduces the overall capital stock. Secondly, in dynamically efficient economies, a PAYG system will reduce steady-state welfare. These classic results have been derived and exposed in models with no retirement decision. However, by allowing for endogenous retirement, and without taking recourse to any frictions, uncertainty, or myopia, it is shown that a PAYG system may be neutral and may even increase the capital–labor ratio. In particular, it is shown that the effect of the pension contribution rate on capital intensity depends on the elasticity of substitution between consumption and leisure. If the elasticity of substitution is between 0 and 1, an increase in the contribution rate will increase capital intensity. Moreover, it is shown that the result regarding welfare may also be overturned. An increase in the PAYG contribution rate may increase steady-state welfare.

Carbon pricing aims to shift the risk-adjusted returns on investment in favor of green technologies vis-‘a-vis fossil investment, relying on efficient capital markets to redirect investment accordingly. Capital markets with financial frictions can distort this transmission of climate policy. This study analyses the impact of emission taxes on mitigation and low-carbon investment in the presence of financial frictions. We develop a two-sector environmental dynamic stochastic general equilibrium model calibrated to the Euro Area, to simulate an economic transition in line with the EU climate targets. Financial frictions dampen the response of the economy to the carbon tax such that the emissions target will be missed by 11 percentage points. Moreover, the adverse effects of financial frictions increase when climate policy is delayed. We further identify a volume and a risk effect that drive the impact of a financial wealth shock and an uncertainty shock on emission intensity.

This paper proposes the volatility of sovereign credit default swaps (CDS) as a measurement of economic uncertainty. Sovereign CDS provide protection against losses from sovereign defaults and are traded for almost all countries by the world’s largest financial institutions. The premium for protection, the so-called CDS spread, depends on a country’s economic conditions and provides an outside view from global financial institutions. Our empirical results show that the volatility of sovereign CDS spreads contains information about economic uncertainty. For a broad panel of 16 countries, we find that sovereign CDS volatility shares directional information with popular news-based economic policy uncertainty (EPU) indices. Using Bayesian panel vector autoregressions, we find similar responses of output and unemployment to shocks in CDS volatility, equity volatility, and EPU. Our results further suggest that sovereign CDS volatility primarily reflects economic and financial uncertainty rather than political uncertainty.

Following a contractionary monetary policy shock, the aggregate output decreases over time for six to eight quarters, while the real interest rate increases immediately and remains high for three quarters, which can hardly be replicated by models characterized by a standard consumption Euler equation. This paper adopts a segmented markets framework where some households are permanently excluded from financial markets. The aggregate output and the nominal interest rate are modeled as exogenous autoregressive processes, while the real interest rate is determined endogenously. For intermediate levels of market segmentation, the model is able to account for both the persistent decreasing path of the aggregate output and the persistent increase in the real interest rate which follow an unanticipated increase in the nominal interest rate. The sign, the size and the persistence of the responses of the real interest rate and the money growth rate are close to those in the data.

This paper examines China's optimal fiscal policy in a general equilibrium model, in which the government finances its budget through both a special instrument, an implicit tax on the residential land, and a typical conventional instrument, the value-added tax (VAT). By solving a Ramsey problem, we find that (i) the optimal policy suggests a much lower land tax rate than the existing rate in China, and (ii) a substantial part of debt stabilization should come through an adjustment in the VAT rate, instead of relying on land financing. Switching from the existing policy to the Ramsey policy generates significant welfare gains.

How much can government-driven mortgage modification programs reduce the mortgage default rate? I compare an economy without a modification option to one with easy modifications, and evaluate the impact of these loan modifications on the foreclosure rate. Through loan modification, mortgage servicers can mitigate their losses and households can improve their financial positions without having to walk away from their homes. When modifying loan contracts is prohibitively costly, the default rate increases 1.5 percentage points in response to a 2007-style unexpected drop in housing prices of 30%. I calibrate the cost of modification after the financial crisis to match the Home Affordable Modification Program (HAMP) modification rate of 0.68%. My quantitative exercises show that current government efforts to promote mortgage modifications reduce the mortgage default rate by 0.63 percentage points.

This paper studies the effects of employment protection legislation when job separation requires a mandatory advance notice or a firm's costly closure. In a tight labor market, firms use mandatory notice since job-to-job transitions reduce the expected firing costs. In a world without the lengthy procedure imposed by advance notice, job turnover is mainly accommodated by unemployment inflows. As notice length increases, the fraction of job turnover accounted for by job-to-job movements increases. These results are consistent with the fact that the North American and European markets, despite their difference in employment protection legislation, have different unemployment flows but similar job flows.

This paper investigates how a combination of monetary and macroprudential policies might affect the dynamics of a small open economy (SOE) with financial frictions under alternative discretionary shocks. Discretionary shocks in productivity and domestic and foreign monetary policies identify the roles of alternative interest rate and reserve requirement rules to stabilize the economy. The model is calibrated for the Brazilian economy. The exchange rate channel of transmission is relevant for foreign but not for domestic shocks. The interest rate rule should target domestic inflation and should not react to the exchange rate. The countercyclical reserve requirements rule, in its turn, should aggressively react to the credit-gap and not include a fixed component. Under both domestic and foreign shocks, the countercyclical effectiveness of the macroprudential policy improves when the degree of openness increases. There is a complementarity between monetary and macroprudential policy rules to stabilize the SOE.

This paper analyzes the dependence of average consumption on the saving rate in a one-sector neoclassical Solow growth model with production shocks and stochastic rates of population growth and depreciation where arbitrary ergodic processes are considered. We show that the long-run behavior of the stochastic capital intensity, and hence average consumption along any sample path, is uniquely determined by a random fixed point that depends continuously on the saving rate. This result enables us to prove the existence of a golden-rule saving rate that maximizes average consumption per capita. We also show that the golden-rule path is dynamically efficient. The results are illustrated numerically for Cobb–Douglas and CES production functions.

This paper explores the shape of the Japanese money demand function in relation to the historical path of the Bank of Japan's policy rate by employing Saikkonen and Choi's [Econometric Theory 20, 301–340 (2004)] cointegrating smooth transition model. The nonlinear model provides a unified econometric framework, not only for pursuing the time profile of interest elasticity, but also to test the linearity of the Japanese money demand function. The test results for the linearity of the Japanese money demand function provide evidence of nonlinearity with a semilog model and linearity with a double-log model. Using a nonlinear semilog model, the analysis also finds that Japanese money demand comprises three regimes and that the interest semielasticity began to increase in the early 1990s when the Bank of Japan set the policy rate below 3%.

This paper evaluates the welfare gains arising from deeper trade integration in the European Monetary Union. To do this, the European Monetary Union is represented in a realistic way by an intertemporal general equilibrium model with incomplete financial markets, sticky prices, and home bias in production. The model is estimated and not rejected by the data. Two main results emerge: (i) an increase in vertical trade (occuring at the early stage of the production process) implies welfare gains whereas (ii) an increase in horizontal trade (occuring at the late stage of the production process) implies welfare losses.

Most papers studying the impacts of technology adoption on income trajectories assume that firms adopt frontier technologies when available. If these technologies are skill intensive, less-developed economies may fail in successfully implementing them and may become trapped in a low-growth equilibrium. Within a Schumpeterian growth model, we show that differences in adoption barriers and incentives to the accumulation of skills produce differences in the technology level that is optimal to adopt. If the economy is not overly distorted, copying nonfrontier technologies helps compensating for the scarcity of skills and increases the likelihood of copying frontier technologies in the long run. If distortions are significant, it may be optimal to copy less-advanced technologies even in the long run. If adoption is not a skill-intensive activity, then copying frontier technologies is always optimal; all economies achieve a high-growth equilibrium and only income differences persist in the long run.

Progress in stochastic macroeconomic modeling justifies revisiting Milton Friedman's program on the relation between macroeconomic stability and active stabilization policies. In the lecture, we use a standard new Keynesian model but depart from rational expectations by assuming that agents behave in line with adaptive learning, which increase the potential for instability in the economy.

Optimal policy under adaptive learning displays some similarity with optimal policy under commitment in the rational expectations setting. Specifically, we find that optimal policy responds in a persistent manner when expectations threaten to become unhinged. Finally, we illustrate the dynamics associated with the change from a simple regime that ignores the expectation formation, to the optimal policy that does. The results are not unlike the behavior of the U.S. economy around the Volcker transition (October 1979).

This paper presents an overlapping generations model with technology choice and imperfect financial markets, and examines the evolution of the income distribution in economic development. The model shows that improvements in financial infrastructure facilitate economic development both by raising the aggregate capital–labor ratio and by causing a technological shift to more capital-intensive technologies. Although a higher capital–labor ratio under a given technology reduces inequality, a technological shift can lead to a concentration of economic rents among a smaller number of agents. We derive the condition under which an improvement in financial infrastructure actually decreases the average utility of agents.

In his monograph The Conquest of American Inflation (Princeton, NJ: Princeton University Press, 1999), Sargent suggests that the sharp reduction in U.S. inflation that took place under Volker may vindicate the type of econometric policy evaluation famously criticized by Lucas (Carnegie–Rochester Conference Series on Public Policy, 19–46, 1976). At the core of this vindication story is the escape dynamics, recurrent sliding away from the path leading to the time-consistent suboptimal equilibrium level of inflation and toward the low-inflation, optimal, time-inconsistent Ramsey outcome: by recurrently estimating a reduced-form model, in fact, the policy maker could periodically learn an approximate version of the natural rate hypothesis and therefore be induced to disinflate the economy. Two elements seem important in this story: the type of model used by the policy maker to represent the economy, whether structural or reduced-form, and the policy specification, whether derived taking the private sector's expectations as given or as endogenous to the policy design. Although Sargent (1999) stresses the first element, we find that it is instead the second aspect that is crucial to generate recurrent periods of low inflation: the policy maker has to recognize the endogeneity of the private sector's expectations and refrain from exploiting ephemeral short-run trade-offs between inflation and unemployment.

Viability theory is the study of dynamical systems that asks what set of initial conditions will generate evolutions that obey the laws of motion of a system and some state constraints, for the length of the evolution. We apply viability theory to Judd's dynamic tax model [The welfare cost of factor taxation in a perfect-foresight model, Journal of Political Economy 95(4), 675–709 (1987)] to identify which economic states today are sustainable under only slightly constrained tax-rate adjustments in the future, when the dynamic budget constraint and the consumers' transversality condition at infinity are satisfied. We call the set of such states the economic viability kernel. In broad terms, knowledge of the viability kernel can tell the planner what economic objectives are achievable and assist in the choice of suitable controls to realize them. We observe that high consumption levels can only be sustained when capital is abundant and, unsurprisingly, that a very high consumption economy lies outside such kernels, at least for annual tax-adjustment levels limited by 20 percentage points. Furthermore, we notice that by and large the sizes of the kernel slices do not diminish as the tax rate rises; hence high-taxation economies are not necessarily more prone to explode, or implode, than their low-taxation counterparts. In fact, higher tax rates are necessary to keep many consumption choices viable, especially when capital approaches the constraint-set boundaries.

We suggest that voters' lack of recognition of complex economic links may give rise to economic policies that eventually lead to a crisis. We consider a two-sector economy in which a majoritarian political process determines governmental regulation in one sector: a minimum nominal wage. If voters recognize general equilibrium feedbacks, workers favoring market-clearing wages will form a majority across sectors. If voters take into account only direct effects in the regulated sector, not only workers that enjoy minimum wages but also workers in the other sector are willing to vote for wage rises in each period. The reason is that they expect higher real wages for themselves, too. The political process leads to constantly rising unemployment and tax rates. The resulting crisis may trigger new insights into economic relationships on the part of the voters and may reverse bad times.

Roger Guesnerie is a prominent economic theorist. Among his many honors and distinctions, he is a Foreign Member of the American Academy of Arts and Science and an Honorary Foreign Member of the American Economic Association; he has been a President of the European Economic Association and of the Econometric Society. Currently a Professor at the College de France, he has made fundamental contributions to second-best theory and public economics, information economics, and rational expectation theory.

Guesnerie was one of the founding fathers of second-best theory. His contributions to public economics, addressing issues such as nonconvex economies and especially taxation in a second-best context, remain absolute references on these topics; more recently, he has provided an in-depth analysis of issues related to climate change and global warming from a public economics perspective. Regarding contract theory, his work with Jean Jacques Laffont has considerably extended our understanding of the properties of the basic models, as well as the set of tools that economists can use to address these problems. Finally, Guesnerie's work has been influential in the critical reassessment of rational expectation theory that took place over the last decades. On one hand, he has been a prominent figure in the development of so-called “sunspot” models, which reconcile the Keynesian notion of “animal spirits” with the formal requirements of rational expectations. On the other hand, he has provided path-breaking discussions of the theoretical relevance of rational expectation theory, based on a detailed assessment of the coordination between individual expectations that is implicit in the concept. In some classes of models, Guesnerie argues, rational expectation equilibria constitute a natural outcome, because coordination can be achieved either through “eductive” reasoning (for which common knowledge of individual rationality is sufficient) or as the product of simple evolutionary or learning dynamics (and in general in both ways). In other cases, however, such arguments do not appear to support the rational expectations solution, and its relevance is therefore much less obvious. On a more institutional side, Guesnerie has created the doctoral program “Analyse et Politique Economique” at the Ecole des Hautes Etudes en Sciences Sociales; besides this program, in 1989, several related research centers in Paris merged into Delta, which Guesnerie chaired between 1992 and 2000, and then into the Paris School of Economics (PSE), at which Guesnerie is Chairman of the Board.

This interview with Roger Guesnerie gives an opportunity to discuss further the current situation of economic theory and economics in general, as well as to compare the European and American traditions in economics.

This paper proposes a tractable sudden stop model to explain the main patterns in firm-level data from a sample of Southeast Asian firms during the Asian crisis. The model incorporates trend shocks and financial frictions, features that have so far been used separately in the literature on emerging markets. A negative shock to trend productivity growth can account, in our model, for the drop in output and its swift recovery together with the sizable and persistent downward adjustment in firms' Tobin's Q and debt levels. These patterns are broadly shared by most sudden stop episodes as documented in the literature. Trend shocks can also generate, in our model, strong leverage effects in line with the firm-level data and other observations from the literature.