It was always considered to be a major achievement of modern business cycle economics that it was solidly grounded in neoclassical growth theory. Preserving this joint foundation, however, imposes a discipline on the specification of models with variable capital utilization. In this note we show that conventional specifications of the depreciation cost of capital utilization and the labor supply elasticity, introduced into business cycle theory to generate a satisfactory amplification of shocks, entail counterfactual growth dynamics: the positive association between capital stock and GDP along the growth path turns negative. Across economies with access to the same technology, the economy with the lowest capital stock per capita is predicted to produce the highest output per capita. We compute lower and upper bounds for the involved elasticities between which these counterfactual dynamics are avoided.

This paper evaluates the optimality of a temporary worker permit policy from the point of view of the host country by using a two-country dynamic general equilibrium model, calibrated with data from the United States and Mexico. In the model, the decision to migrate and the corresponding decision to return are endogenous and take place within families that are heterogeneous in terms of human capital. After finding a migrant's optimal migration duration and the resulting shrinkage in the wage gap and change in interest rates, the paper derives the restriction on migrants' stay that maximizes natives' utility. It also derives the migrant length of stay that would pass a majority vote. When migration duration is restricted, the fraction of the native population made better off is maximized with a permit length of four years.

We investigate the importance of trend inflation and the real-activity gap in explaining inflation in G7 countries since 1960. Our analysis is based on a bivariate unobserved components model of inflation and unemployment in which inflation is decomposed into a stochastic trend and a transitory component. As in recent implementations of the New Keynesian Phillips Curve, it is the transitory component of inflation, or “inflation gap,” that is driven by the real-activity gap, which we measure as the deviation of unemployment from its natural rate. We find that both trend inflation and the inflation gap have been consistent and substantial determinants of inflation at business cycle horizons for all G7 countries since 1960. Also, the real-activity gap explains a large fraction of the variation in the inflation gap for each country. These results provide empirical support for the New Keynesian Phillips Curve augmented with trend inflation.

This paper directly shows the equivalence between the existence of stationary monetary equilibrium and the conditional Pareto suboptimality of the initial endowment in a stochastic overlapping generations model. Especially, it gives short and constructive proofs for existence and uniqueness.

Early research on the Taylor rule typically divided the data exogenously into pre-Volcker and Volcker–Greenspan subsamples. We contribute to the recent trend of endogenizing changes in monetary policy by estimating a real-time forward-looking Taylor rule with endogenous Markov switching coefficients and variance. The response of the interest rate to inflation is regime-dependent, with the pre- and post-Volcker samples containing monetary regimes where the Fed did and did not follow the Taylor principle. Although the Fed consistently adhered to the Taylor principle before 1973 and after 1984, it followed the Taylor principle from 1975 to 1979 and did not follow the Taylor principle from 1980 to 1984. We also find that the Fed only responded to real economic activity during the states in which the Taylor principle held. Our results are consistent with the idea that exogenously dividing postwar monetary policy into pre- and post-Volcker samples is misleading. The greatest qualitative difference between our results and recent research employing time-varying parameters is that we find that the Fed did not adhere to the Taylor principle during most of Paul Volcker's tenure, a finding that accords with the historical record of monetary policy.

We build a stochastic discount factor—SDF—using U.S. domestic financial data only, and provide evidence that it accounts for stylized facts about foreign markets that escape SDFs generated by consumption-based models. When our SDF is interpreted as the projection of the pricing kernel from a fully specified model in the space of returns, our results indicate that a model that accounts for the behavior of domestic assets goes a long way toward accounting for the behavior of foreign asset prices. In our tests, we address predictability, a defining feature of the forward premium puzzle—FPP—by using instruments that are known to forecast excess returns in the moment restrictions associated with Euler equations both in the equity and in the foreign markets.

We examine the determinants of income mobility and inequality in a Ramsey model with elastic labor supply and heterogeneous wealth and ability. Both agents with lower wealth and those with greater ability tend to supply more labor, implying that labor supply decisions may have an equalizing or unequalizing effect depending on the relative importance of the two sources of heterogeneity. Moreover, these decisions are central to the extent of mobility observed in an economy. The relationship between mobility and inequality is complex. For example, a reduction in the interest rate and an increase in the wage rate reduce capital income inequality and allow upward mobility of the ability-rich. However, the increase in the labor supply of high-ability agents in response to higher wages raises earnings dispersion and thus has an offsetting effect. As a result, high mobility can be associated with an increase or a decrease in overall income inequality.

Shimer (Mismatch, American Economic Review 97, 1074–1101 [2007]) introduced a model of mismatch in which limited mobility of vacant jobs and unemployed workers provides a microfoundation for their coexistence in equilibrium. He assumed that the short side of a local labor market receives all the gains from trade. In this note I show that modifying this assumption on wage-setting can deliver more reasonable predictions for wages at the level of the local market and in the aggregate.

This paper reconsiders the monetary policy implications of a model from which a distinction between CPI inflation and PPI inflation arises. More specifically, this paper addresses the policy conclusion by K. Huang and Z. Liu [2005, Inflation targeting: What inflation rate to target, Journal of Monetary Economics 52, 1435–1462], which states that central banks should use an optimal inflation index that gives substantial weight to stabilizing both CPI and PPI. This paper argues that these authors' findings rely on the assumption that producer prices are as sticky as consumer prices and shows that once empirically relevant frequencies of price adjustment are used to calibrate the model, CPI inflation receives substantial weight in the optimal inflation index. Moreover, this rule is remarkably robust to uncertainty regarding the model parameters.

Building on the time-varying-coefficient (TVC) model, we propose a generalization of the concept of cointegration, allowing for the possibility that a set of variables measured with error entails a nonlinear relationship with unknown functional form. Both the dependent and explanatory variables of this relationship may be nonstationary (not necessarily of unit-root type), but there exists a nonlinear combination of all these explanatory variables that completely explains all the variation in the dependent variable. The TVC model allows us to test for the presence of this generalized cointegration in the absence of knowledge of the true nonlinear functional form and the full set of explanatory variables. We present the basic stages of the technique and discuss in detail how the issues of nonstationarity and cointegration affect each stage of the TVC estimation procedure.

This paper develops a new methodology for estimating both the automatic and discretionary components of fiscal policy in one reaction function using the differences between real-time and ex post data. Discretionary policy should respond to information available to the policy maker at the time (real-time data), whereas automatic fiscal policy should respond to the true state of the economy at the time (proxied by the final data). We find that the intended discretionary response of fiscal policy to the cycle is counter-cyclical. Our estimates suggest that the automatic stabilizers are at the lower end of the range found in the related literature. This new methodology reduces the risk present in the conventional CAB approach that part of the discretionary actions may be wrongly attributed to automatic stabilizers. In that sense, automatic stabilizers are typically not as strong as usually claimed. This could be of particular use in countries where insufficient data exist to estimate structural budget sensitivities directly.

Based on a dynamic open-economy macroeconomic model, this paper analyzes the motive for foreign reserve accumulation in fast-growing emerging economies. The demand for foreign reserves stems from the interaction between productivity growth and underdevelopment of the domestic financial market. As domestic firms are credit-constrained, domestic saving instruments are necessary to increase their retained earnings in order to invest in capital. The central bank plays the role of a financial intermediary and provides liquid public bonds while investing the bond proceeds abroad in the form of foreign reserves. Foreign reserve accumulation is thus part of a catching-up strategy in an economy facing financial frictions. During economic transition, foreign reserve accumulation is proved to be welfare-improving as long as private capital flows are controlled. This joint strategy enables the central bank to channel sufficient external funding to the domestic economy while keeping domestic interest rates under control to cope with positive productivity shocks.

In structural VARs, unexpected monetary tightening often leads to the price puzzle, a counterintuitive increase in inflation in the impulse response function. The identification of impulse responses requires at least a minimal set of structural assumptions, and models exhibiting the price puzzle typically use standard assumptions focusing mainly on relationships among contemporaneous disturbances. This note uses a well-established stylized fact, the long lags of monetary policy, to motivate a simple additional identifying assumption. The assumption eliminates a single term in one equation of the reduced form, and with it the price puzzle.

Recent empirical findings suggest that macroeconomic variables are seldom normally distributed. For example, the distributions of aggregate output growth-rate time series of many OECD countries are well approximated by symmetric exponential-power (EP) densities with Laplace fat tails. In this work, we assess whether real business cycle (RBC) and standard medium-scale New Keynesian (NK) models are able to replicate this statistical regularity. We simulate both models, drawing Gaussian- vs Laplace-distributed shocks, and we explore the statistical properties of simulated time series. Our results cast doubts on whether RBC and NK models are able to provide a satisfactory representation of the transmission mechanisms linking exogenous shocks to macroeconomic dynamics.