Incomplete information and self-fulfilling prophecies

This paper shows that incomplete information can be a rich source of sunspots equilibria. This is demonstrated in a standard dynamic general equilibrium model of monopolistic competition … la Dixit-Stiglitz. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium, but there are also multiple stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. In other words, sunspots can exist in infinite-horizon dynamic models with a unique saddle path steady state. In contrast to the recent sunspots literature (e.g., Benhabib and Farmer 1994), sunspots arising under incomplete information can be serially correlated and are robust to parameters associated with production technologies and preferences. Markup is always countercyclical in sunspots equilibria (which is consistent with empirical evidence) and fluctuations driven by sunspots look very similar to fluctuations driven by technology shocks.Business cycles ; Prices

Inventory accelerator in general equilibrium

We develop a general-equilibrium model of inventories with explicit micro-foundations by embedding the production-cost-smoothing motive (e.g., Eichenbaum, AER 1989) into an otherwise standard DSGE model. We show that firms facing idiosyncratic cost shocks have incentives to bunch production and smooth sales by carrying inventories. The optimal inventory target of a firm is derived explicitly. The model is broadly consistent with many of the observed stylized facts of aggregate inventory fluctuations, such as the procyclical inventory investment and the countercyclical inventory-sales ratio. In addition, the model yields novel predictions for the role of inventories in macroeconomic stability: Inventories may not only greatly amplify but also propagate the business cycle. That is, the incentive to accumulate inventories under the cost-smoothing motive can give rise to hump-shaped output dynamics and significantly higher volatility of GDP. Such predictions are in sharp contrast to the implications of the recent general-equilibrium inventory literature (e.g., Khan and Thomas, 2007; and Wen, 2008), which shows that inventory investment induced by traditional mechanisms (e.g., the stockout-avoidance motive and the (S,s) rule) does not increase the variance of aggregate output.Equilibrium (Economics) ; Business cycles ; Inventories

Can rising housing prices explain China’s high household saving rate?

China’s average household saving rate is one of the highest in the world. One popular view attributes the high saving rate to fast rising housing prices and other costs of living in China. This article uses simple economic logic to show that rising housing prices and living costs per se cannot explain China’s high household saving rate. Although borrowing constraints and demographic changes can help translate housing prices to the aggregate saving rate, quantitative simulations using Chinese data on household income, housing prices, and demographics indicate that rising mortgage costs contribute at most 5 percentage points to the Chinese aggregate household saving rate, given the down-payment structure of China’s mortgage markets.Economic conditions - China ; Housing - Prices ; Consumer behavior ; China

Imperfect competition and sunspots

This paper shows that imperfect competition can be a rich source of sunspots equilibria and coordination failures. This is demonstrated in a dynamic general equilibrium model that has no major distortions except imperfect competition. In the absence of fundamental shocks, the model has a unique certainty (fundamental) equilibrium. But there is also a continuum of stochastic (sunspots) equilibria that are not mere randomizations over fundamental equilibria. Markup is always counter-cyclical in sunspots equilibria, which is consistent with empirical evidence. The paper provides a justification for exogenous variations over time in desired markups, which play an important role as a source of cost-push shocks in the monetary policy literature. We show that fluctuations driven by self-fulfilling expectations (or sunspots) look very similar to fluctuations driven by technology shocks, and we prove that such fluctuations are welfare reducing.Equilibrium (Economics) ; Business cycles

Imperfect competition and indeterminacy of aggregate output

This paper shows imperfect competition can lead to indeterminacy in aggregate output in a standard DSGE model with imperfect competition. Indeterminacy arises in the model from the composition of aggregate output. In sharp contrast to the indeterminacy literature pioneered by Benhabib and Farmer [3] and Gali [19], indeterminacy in our model is global; hence it is more robust to structural parameters. In addition, sunspots in our model can be autocorrelated. The paper provides a justification for exogenous variations in desired markups, which play an important role as a source of cost-push shocks in the monetary policy literature. Our model outperforms a standard RBC model driven by technology shocks in several dimensions, including the volatility of labor market and the hump-shaped output dynamics.Prices ; Business cycles

Endogenous volatility, endogenous growth, and large welfare gains from stabilization policies

This paper shows that (i) fluctuations driven by self-fulfilling expectations can negatively affect long-run growth and (ii) the welfare gain from further stabilizing the U.S. economy can be several orders larger than that calculated by Lucas (1987) because policies designed to reduce fluctuations can generate permanently higher rates of growth. Self fulfilling expectations arise from incomplete information for price setting firms. ; Previously titled: Volatility, growth, and large welfare gains from stabilization policies

Speculative bubbles and financial crisis

Why are asset prices so much more volatile and so often detached from their fundamentals? Why does the burst of financial bubbles depress the real economy? This paper addresses these questions by constructing an infinite-horizon heterogeneous-agent general-equilibrium model with speculative bubbles. We show that agents are willing to invest in asset bubbles even though they have positive probability to burst. We prove that any storable goods, regardless of their intrinsic values, may give birth to bubbles with market prices far exceeding their fundamental values. We also show that perceived changes in the bubbles probability to bust can generate boom-bust cycles and produce asset price movements that are many times more volatile than the economy's fundamentals, as in the data.Financial crises ; Speculation ; Asset pricing

Financial development and economic volatility: a unified explanation

Empirical studies showed that firm-level volatility has been increasing but the aggregate volatility has been decreasing in the US for the post-war period. This paper proposes a unified explanation for these diverging trends. Our explanation is based on a story of financial development - measured by the reduction of borrowing constraints because of greater access to external financing and options for risk sharing. By constructing a dynamic stochastic general-equilibrium model of heterogenous firms facing borrowing constraints and investment irreversibility, it is shown that financial liberalization increases the lumpiness of firm-level investment but decreases the variance of aggregate output. Hence, the model predicts that financial development leads to a larger firm-level volatility but a lower aggregate volatility. In addition, our model is also consistent with the observed decline in volatility of private held firms which do not have (or have only limited) access to external funds.Financial institutions ; Business cycles

Another look at sticky prices and output persistence

Price rigidity is the key mechanism for propagating business cycles in traditional Keynesian theory. Yet the New Keynesian literature has failed to show that sticky prices by themselves can effectively propagate business cycles in general equilibrium. We show that price rigidity in fact can (by itself) give rise to a strong propagation mechanism of the business cycle in standard New Keynesian models, provided that investment is also subject to a cash-in-advance constraint. In particular, we show that reasonable price stickiness can generate highly persistent, hump-shaped movements in output, investment and employment in response to either monetary or non-monetary shocks, even if investment is only partially cash-in-advance constrained. Hence, whether or not price rigidity is responsible for output persistence (and the business cycle in general) may not be a theoretical question, but an empirical one.Prices ; Business cycles