Economic Fluctuations and Growth

February 7, 2014
Robert Shimer, University of Chicago, and Michael Woodford, Columbia University, Organizers

Gabriel Chodorow-Reich, Harvard University, and Loukas Karabarbounis, University of Chicago and NBER

The Cyclicality of the Opportunity Cost of Employment (NBER Working Paper 19678)

The flow opportunity cost of moving from unemployment to employment consists of foregone public benefits and the foregone value of non-working time in units of consumption. Using detailed microdata, administrative data, and the structure of the search and matching model with concave and non-separable preferences, Chodorow-Reich and Karabarbounis document that the opportunity cost of employment is as procyclical as, and more volatile than, the marginal product of employment. The empirically observed cyclicality of the opportunity cost implies that unemployment volatility in search and matching models of the labor market is far smaller than that observed in the data. This result holds irrespective of the level of the opportunity cost or whether wages are set by Nash bargaining or by an alternating-offer bargaining process. The authors conclude that appealing to aspects of labor supply does not help search and matching models explain aggregate employment fluctuations.

Roger Farmer, University of California at Los Angeles and NBER, and Carine Nourry and Alain Venditti, University of the Mediterranean

The Inefficient Markets Hypothesis, Why Financial Markets Do Not Work Well in the Real World (NBER Working Paper 18647)

Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Farmer, Nourry, and Venditti provide such an explanation. They do not rely on frictions, market incompleteness, or transactions costs of any kind. Instead, they modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. The authors show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. The authors demonstrate that financial markets, by their very nature, cannot be Pareto-efficient except by chance. While individuals in the model are rational, markets are not.

Fernando Alvarez, University of Chicago and NBER; Herve Le Bihan, Banque de France; and Francesco Lippi, EIEF

Small and Large Price Changes and the Propagation of Monetary Shocks

Alvarez, Le Bihan, and Lippi document the presence of both small and large price changes in individual price records from the consumer price index (CPI) in France and the United States. After correcting for measurement error and cross-section heterogeneity the authors find that the size distribution of price changes has a positive excess kurtosis, with a shape that lies between a Normal and a Laplace distribution. They propose a model featuring random menu costs and multi-product firms that is capable of reproducing the observed empirical patterns. The authors characterize analytically the response of the aggregate economy to a monetary shock. Different propagation mechanisms, spanning the models of Taylor (1980), Calvo (1983), and Golosov and Lucas (2007), are nested under diff erent combinations of four fundamental parameters. The authors discuss the identification of these parameters using data on the size distribution of price changes and the actual cost of price adjustments borne by firms. The output effect is proportional to the ratio of kurtosis to the frequency of price changes.

Charles Carlstrom, Federal Reserve Bank of Cleveland; Timothy Fuerst, University of Notre Dame; and Matthias Paustian, Federal Reserve Board

Targeting Long Rates in a Model with Segmented Markets

Carlstrom, Fuerst, and Paustian develop a model of segmented financial markets in which the net worth of financial institutions limits the degree of arbitrage across the term structure. The model is embedded into the canonical Dynamic New Keynesian (DNK) framework. The authors' principal results include the following: First, there are welfare gains to having the central bank respond to the term premium, for example, including the term premium in the Taylor Rule. However, the sign of the preferred response depends upon the type of shocks driving the business cycle. Second, a policy that directly targets the term premium sterilizes the real economy from shocks originating in the financial sector.

Anna Orlik, Federal Reserve Board , and Laura Veldkamp, New York University and NBER

Understanding Uncertainty Shocks and the Role of Black Swans

A recent literature explores many ways in which uncertainty shocks can have important economic effects, but how large are uncertainty shocks and where do they come from? Researchers typically estimate a model with stochastic volatility, using all available data, then condition on the estimated model to infer volatility. This volatility is the uncertainty of an agent who knows the true probability of outcomes and whose only uncertainty is about what the draw from that distribution will be. Orlik and Veldkamp model a Bayesian forecaster who uses new data released each quarter to re-estimate the parameters that govern the shape of the probability distribution of GDP growth. Although the forecaster's parameter revisions are small, the probability of black swans (extreme events) is very sensitive to these revisions. The authors' real-time measure of GDP forecast uncertainty reveals that changes in the risk of a black swan explain most of the shocks to uncertainty.

Bill Dupor, Federal Reserve Bank of St. Louis, and Rong Li, The Ohio State University

The 2009 Recovery Act and the Expected Inflation Channel of Government Spending

There are sticky price models in which the output response to a government spending change can be large if the central bank is unresponsive to inflation. According to this "expected inflation channel," government spending drives up expected inflation which in turn reduces the real interest rate and leads to an increase in private consumption. Dupor and Li examine whether the channel was important in the post-World War II United States, with particular attention to the 2009 Recovery Act period. First, the authors show that a model calibrated to have a large output multiplier requires a large response of expected inflation to a government spending shock. Next, they show that this large response is inconsistent with structural vector autoregression evidence from the Federal Reserve's passive policy period (1959–1979). Then, they study expected inflation measures during the Recovery Act period in conjunction with a panel of professional forecaster surveys, a cross-country comparison of bond yields, and fiscal policy news announcements. The authors show that the expected inflation response was too small to engender a large output multiplier.