Ben S. Bernanke

Julio J. Rotemberg

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: NBER Macroeconomics Annual 1996, Volume 11
Volume Author/Editor: Ben S. Bernanke and Julio J. Rotemberg, Editors
Volume Publisher: MIT Press
Volume ISBN: 0-262-02414-4
Volume URL: http://www.nber.org/books/bern96-1
Conference Date: March 8-9, 1996
Publication Date: January 1996
Chapter Title: Editorial in "NBER Macroeconomics Annual 1996, Volume
11"
Chapter Author: Ben S. Bernanke, Julio J. Rotemberg
Chapter URL: http://www.nber.org/chapters/c11025
Chapter pages in book: (p. 1 - 6)Editorial,  NBER  Macroeconomics 
Annual  1996 
The 1996 edition  of the NBER Macroeconomics  Annual contains  six papers 
on current issues  of macroeconomic  theory and policy. 
The first paper of the volume,  by Roland Benabou, is an overview  of an 
expanding  literature that seeks  to understand  the connections  between 
income  (or wealth)  inequality and economic  growth.  An important moti- 
vation for this literature is the striking empirical finding, documented  and 
discussed  by the author, of a strong negative relationship across countries 
between  the  degree  of  inequality  and  the  rate of  long-term  economic 
growth.  Another,  more  technical  motivation  for the recent work is the 
increased interest by macroeconomists  in formal models in which hetero- 
geneity  among  agents  precludes  the  use  of the  "representative  agent" 
construct.  In this paper Benabou  looks  at models  in which  utility func- 
tions are of the Gorman form, so that, if political-economy  considerations 
were absent and markets were complete,  the representative-agent  model 
would  be applicable.  However,  absent these  ideal preconditions,  evolv- 
ing  heterogeneity  among  agents  plays  a key  role  in  determining  the 
growth  rate of the economy. 
As  Benabou  shows,  political-economy  considerations  can  lead  to  a 
connection  between  inequality  and  growth  under  two  sets  of  circum- 
stances.  The first arises when  increased  inequality  of incomes  leads  the 
pivotal  voter  to desire  more redistribution,  and the political system  ac- 
commodates  this  desire  through  increased  taxation  of  capital income. 
Under  these  circumstances,  increased  inequality  can discourage  capital 
accumulation  and  reduce  growth.  The  second  possibility  is  that  in- 
creased  inequality  creates stronger incentives  for the poor to attempt to 
expropriate  the  rich directly  (e.g.,  through  "social conflict"), which  in- 
duces  the rich to hold  fewer assets  in forms that are expropriable by the 
poor.  Again,  capital  accumulation  and  growth  suffer  as  a result.  The 2 *  BERNANKE  & ROTEMBERG 
latter,  conflict-based  theory  seems  more  consistent  with  the  facts,  as 
there  is little  evidence  for the  prediction  of the  capital-taxation  theory 
that  high  rates  of  redistribution  will  be  associated  with  low  rates  of 
growth.  Much of the discussion  at the meeting  related to the question  of 
why  the  political-economy  model  in  which  voters  choose  the  level  of 
capital taxation does  not perform better empirically. 
Another  reason that inequality might be related to growth is that mar- 
kets  may  be  incomplete;  in  particular,  because  of  informational  and 
agency problems in credit markets, people with low levels of wealth may 
find it difficult to borrow. From a social (as well as private) point of view 
these  credit constraints  will be costly, particularly if those  denied  credit 
have low levels of physical or human capital and thus high marginal rates 
of return to investment.  In this scenario, redistribution from the rich to the 
poor, by allowing  more productive investments  to be made, may raise the 
social  rate of return  on  capital and  the  rate of economic  growth.  This 
conclusion  is consistent  with  the observed  positive  correlation between 
redistribution and growth,  although this positive correlation could also be 
due  to "reverse causation"  (fast-growing  countries  find it easier to help 
the poor).  Much of the discussion  of this paper focused  on how  future 
research should  go about developing  sharper empirical tests of the vari- 
ous competing  hypotheses. 
The  second  paper  in  the  volume,  by  Matthew  Shapiro  and  David 
Wilcox, addresses  the issue  of whether  the Consumer  Price Index accu- 
rately measures  the cost of living.  As the authors stress,  this seemingly 
technical  issue  is of great practical importance,  for example  because  of 
the widespread  indexation  of tax and transfer payments  and because  of 
the  close  attention  paid  to  inflation  statistics  by  makers  of  monetary 
policy. Shapiro and Wilcox begin  with  a primer on how  the CPI is con- 
structed,  emphasizing  the daunting  technical and logistical complexities 
and  the great care taken by the Bureau of Labor Statistics.  Despite  the 
efforts by the BLS, however,  there remain significant  sources  of bias in 
the CPI inflation measure,  including  substitution  effects, imperfect treat- 
ment  of  new  items  and  new  outlets,  and  incomplete  adjustment  for 
quality change.  The authors illustrate the practical problems involved  by 
constructing  a new  price index  for cataract surgery, showing  that stan- 
dard methods  (which focus on the costs of inputs) significantly underesti- 
mate the improved  quality of service received by cataract patients. 
To emphasize  the inherent uncertainties in measuring  the biases in the 
CPI, the authors present  their estimates  for each type of bias in terms of 
a probability distribution rather than a single number; they also allow for 
the  possibility  of correlated  errors in estimating  biases.  They conclude 
that, with 80% probability, the bias in the CPI-based measure of inflation Editorial 3 
lies  between  0.6 and  1.5 percentage  points  per year. They also  discuss 
the  possibility  that the bias in the  CPI inflation  measure  varies  signifi- 
cantly over time. 
Much  of  the  discussion  of  Shapiro  and  Wilcox's  paper  emphasized 
the  point  that  the  appropriate  method  for constructing  any  index  de- 
pends  vitally  on  the  purpose  for  which  it  is  intended.  For example, 
social  security  recipients  presumably  consume  different  baskets  of 
goods  than  working  people,  which  has  implications  for the  choice  of 
index  for social  security  benefits.  More generally,  depending  on  one's 
views  about  social  risk sharing,  one  might  consider  novel  approaches 
to indexing  retirement  benefits,  e.g.,  tying benefits  to average nominal 
wages  or consumption. 
The  third  paper,  by  John Campbell  and  Robert Shiller,  also  takes  a 
current policy issue  as its subject; namely, whether  the U.S. government 
should  issue  debt  indexed  to  the  price  level.  Like  many  economists 
before  them,  Campbell  and  Shiller favor the issuance  of indexed  debt, 
primarily  on  the  grounds  that  it would  provide  long-term  protection 
from inflation to savers and enhance  opportunities  for risk sharing. They 
argue  that  savers  do  not  now  have,  and would  greatly benefit  from,  a 
practical  means  of  locking  in  long-run  real returns.  In particular, the 
authors  provide  evidence  that  the  strategy  of  rolling  over  short-term 
nominal  bills  is not  a good  substitute  for holding  indexed  bonds.  The 
usefulness  of indexed  bonds  as a long-term  inflation  hedge  would  de- 
pend,  however,  on the way in which  these bonds are taxed; if the princi- 
pal adjustment  of the bond  due to inflation is taxed as ordinary income, 
then  the ability of savers  to protect themselves  from inflation would  be 
much diminished. 
Campbell and Shiller also consider the likely effects of issuing  indexed 
bonds  on Treasury borrowing  costs,  although  they  emphasize  that (for 
Ricardian reasons)  these  should  not be a primary consideration.  Using 
several methods,  including  a CAPM-type approach, the authors estimate 
that the inflation  premium  paid by the Treasury on a five-year nominal 
bond  is  in  the  vicinity  of  50  to  100 basis  points,  a nontrivial  amount 
considering  the volume  of Treasury debt outstanding.  They also consider 
and dismiss  the argument  that the issuance  of indexed  debt would  "bal- 
kanize"  the  market  for  government  securities,  pointing  out  that  the 
government  already  sells  a wide  variety  of  debt  instruments.  Finally, 
Campbell and Shiller suggest  that indexed  debt would  have other social 
benefits,  including  the revelation  of information about inflation expecta- 
tions  that  might  aid  the  Federal  Reserve  in its  policymaking,  and  the 
provision  of a "demonstration  effect" that would  encourage  the use  of 
indexed  instruments  by private-sector  borrowers and lenders  as well. 4 *  BERNANKE  & ROTEMBERG 
The  formal  commentators  and  the  other  conference  participants 
seemed  in general to agree with the recommendation  that indexed debt be 
introduced,  but some concerns were also raised: These included the possi- 
bility that the  demand  for indexed  debt would  be low,  leading  to poor 
liquidity in the market; that the tax treatment would most likely be such as 
to reduce the risk-sharing and informational benefits of indexed debt; and 
that the "demonstration  effect" to the private sector would  be weak.  We 
may soon  learn which  if any of these conjectures are correct, as the Trea- 
sury has recently announced  plans to begin issuing  indexed  debt. 
The fourth  paper, by Andreas  Hornstein  and Per Krusell, focuses  on 
reasons  for the post-1973 productivity  slowdown.  Hornstein and Krusell 
raise the intriguing  possibility  that the productivity  slowdown  is due in 
part to improvements  in the quality of capital goods.  There are two chan- 
nels  through  which  higher-quality  capital  might  lead  to  a  temporary 
reduction  in  the  (measured)  rate  of  growth  of  productivity:  First, in- 
creases  in the sophistication  or flexibility of capital may lead to a short- 
run decline  in final output  per unit of input as people  must  spend  time 
and  effort  learning  how  to  use  the  new  capital.  Discussant  Valerie 
Ramey  gave  the  example  of the  short-run productivity  costs  associated 
with  learning  a new  word-processing  program.  Second,  the availability 
of better capital may be associated  with  difficult-to-measure  quality im- 
provements  in  final  goods  (e.g.,  a greater variety  of  fonts  in Ramey's 
word-processed  document).  One  hopeful,  if  momentarily  untestable, 
implication  of  this  analysis  is that productivity  growth  will  eventually 
recover to its pre-1973 level or higher. 
Hornstein  and  Krusell present  a variety of data consistent  with  their 
hypothesis.  They note,  for example,  that long-term  declines  in the rela- 
tive  price  of  capital goods  fit nicely  with  their view  that capital-goods 
quality is increasing;  and they  point  out that sectors in which  quality is 
hard to measure  have assumed  increasing importance over time in virtu- 
ally  every  industrialized  economy.  The  authors  also  use  calibrated 
growth  models-one  model in which  new  capital is less productive  dur- 
ing a learning  period,  and one in which  unmeasured  quality is a compo- 
nent  of output-to  assess  the plausibility  of their argument.  According 
to the simulations,  the unmeasured-quality  channel  seems  to fare some- 
what better as an explanation  of the productivity  slowdown,  as learning 
effects  seem  to be too transitory to account for the prolonged  weakness 
in productivity  growth.  Unfortunately,  uncertainty  about the appropri- 
ate values  of some  parameters  in the model  prevents  clear conclusions. 
The  discussion  raised  a number  of  questions:  For example,  Ramey 
focused  on whether  implications  of the theory were  borne out for vari- 
ables  not  considered  in  the  paper,  such  as  the  value  of  equities.  Dis- Editorial 5 
cussant  Robert Gordon expressed  doubts that these effects could explain 
the  productivity  slowdown  in the nonmanufacturing  sector, where  the 
ratio of capital to hours of work may have actually fallen. 
The next paper, by Nobu  Kiyotaki and Kenneth  West, is an empirical 
examination  of business  fixed investment  in Japan in recent years. Their 
study  is  motivated  by  the  leading  role  played  by  investment  in  the 
Japanese boom  and bust of the last decade.  They first attempt to explain 
the  behavior  of  Japanese  investment  by  Tobin's  Q-theory,  using  ob- 
served  stock  prices  to  measure  the  market  value  of  capital.  This  ap- 
proach  is unsuccessful,  perhaps  because  of problems  in measuring  Q. 
Next,  they  turn  to  a  sophisticated  version  of  the  flexible  accelerator 
model  of  investment,  in  which  capital  is  assumed  to  adjust  partially 
toward  its desired  level  in each period,  and the desired  level  of capital 
depends  on the marginal product of capital (proportional to output) and 
the cost of capital. 
The flexible  accelerator model  seems  to work well  for Japan. The be- 
havior  of  investment  over  the  boom  period  (1986-1991)  and  the  bust 
period  (1991-1994)  appears to be well explained  and consistent  with the 
estimates  for  the  entire  1961-1994  sample.  In particular, the  authors 
show  that a substantial  portion  of the recent fluctuation  in investment 
can be tied to innovations  in output  and the cost of capital. The discus- 
sion praised the careful empirical analysis but also noted two limitations: 
first, that output  and the cost of capital are treated as exogenous,  so that 
the explanation  of investment  behavior is of a partial equilibrium nature; 
and  second,  that the empirical analysis  does  not explicitly  discriminate 
between  the flexible accelerator model  and some  potential  alternatives, 
such as "collateral-based" models. 
The sixth and final paper, by Paul Krugman, is an investigation  of the 
causes  of currency  crises.  The issue  that concerns  Krugman is whether 
exchange-rate  crises  are  due  only  to  economic  fundamentals  (e.g., 
flawed  macroeconomic  policies  that  make  a particular fixed  exchange 
rate unsustainable),  or whether  they  may  also  be  the  product  of  self- 
fulfilling expectations  of exchange-rate  collapse,  as has been argued by a 
recent  literature  due  to  Maurice  Obstfeld  and  others.  In  particular, 
Krugman  makes  two  main  points.  First, he  shows  that the  theoretical 
assumptions  common  to the recent literature, (1) that the government  is 
optimizing  and  (2) that its decision  to abandon  the fixed exchange  rate 
may  depend  on  both  the  level  and  expected  rate of change  of the  ex- 
change  rate,  are  not  sufficient  in  and  of  themselves  to  generate  self- 
fulfilling runs on the currency. Instead, if (for example) fundamentals  are 
expected  to deteriorate  over  time,  then  it still may be the case that the 
timing of the run is determinate  (occurring at the first moment  that it can 6 ?  BERNANKE  & ROTEMBERG 
succeed,  as determined  by a backward induction)  and related solely  to 
fundamentals.  Second,  as  an  empirical  matter,  Krugman  argues  that 
fundamental  factors are probably adequate to explain the recent specula- 
tive  attacks  on  the  ERM and  the  Mexican  peso,  notwithstanding  the 
conclusions  by  some  economists  that self-fulfilling  expectations  played 
an important role in these  episodes. 
The discussants  agreed with Krugman's point that deteriorating funda- 
mentals  can  sometimes  be  enough  to  rule out  multiple  equilibria,  but 
argued  that this result is not generic.  In particular, although  the condi- 
tions under which  self-fulfilling  crises can occur are typically determined 
by fundamentals,  "sunspot" equilibria do arise for some plausible model 
specifications  and for some range of parameter values.  The more difficult 
issues  were empirical: While it is possible  to tell stories about the ERM or 
Mexico  that  appear  consistent  with  either  the  unique-equilibrium  or 
multiple-equilibrium  views,  tests to sharply distinguish  the two types  of 
model  do not appear to exist. 
Discussion  also focused  on the facts that exchange-rate crises are often 
not  tied  to  contemporaneous  adverse  news,  nor are they  typically  re- 
flected in rising interest-rate differentials ex ante. These facts are anoma- 
lous  for the  single-equilibrium  models  favored by Krugman,  assuming 
that expectations  are rational. The two  observations  may be compatible 
with multiple-equilibrium  models with rational expectations if the ex ante 
probability of a self-fulfilling  attack is sufficiently  low. However,  neither 
Krugman nor the discussants  seemed  particularly satisfied with this reso- 
lution,  suggesting  that additional  theoretical  analyses  of exchange-rate 
crises remain to be done. 
We close  with  some  acknowledgments.  First, all participants  at the 
meeting  owe  special thanks to the NBER's conference  department for its 
flawless  management  of the conference's  logistics,  despite  the interven- 
tion of a blizzard  that disrupted  everyone's  best-laid plans.  Ilian Mihov 
did an excellent  job as assistant  editor for the volume.  Finally, we  thank 
Martin Feldstein  and  the  National  Bureau for its continued  support  of 
the Macro Annual  conference  and publication,  now  in its eleventh  year. 
Ben S. Bernanke and Julio J. Rotemberg 

NBER Macroeconomics Annual 1996, Volume 11

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