Economic Fluctuations and Growth

July 16, 2016
Fernando Alvarez of University of Chicago and Emi Nakamura of Columbia Business School, Organizers

Anmol Bhandari, University of Minnesota; David Evans, University of Oregon; Mikhail Golosov, Princeton University and NBER; and Thomas Sargent, New York University and NBER

Fiscal Policy and Debt Management with Incomplete Markets

A Ramsey planner chooses a distorting tax on labor and manages a portfolio of securities in an economy with incomplete markets. Bhandari, Evans, Golosov, and Sargent develop a method that uses second order approximations of Ramsey policies to obtain formulas for conditional and unconditional moments of government debt and taxes that include means and variances of the invariant distribution as well as speeds of mean reversion. The researchers establish that asymptotically the planner's portfolio minimizes a measure of fiscal risk. Analytic expressions that approximate moments of the invariant distribution apply to data on a primary government deficit, aggregate consumption, and returns on traded securities. For U.S. data, the researchers find that an optimal target debt level is negative but close to zero, that the invariant distribution of debt is very dispersed, and that mean reversion is slow.

Gabriel Chodorow-Reich, Harvard University and NBER, and Loukas Karabarbounis, Federal Reserve Bank of Minneapolis and NBER

The Limited Macroeconomic Effects of Unemployment Benefit Extensions

By how much does an extension of unemployment benefits affect macroeconomic outcomes such as unemployment? Answering this question is challenging because U.S. law extends benefits for states experiencing high unemployment. Chodorow-Reich and Karabarbounis use data revisions to decompose the variation in the duration of benefits into the part coming from actual differences in economic conditions and the part coming from measurement error in the real-time data used to determine benefit extensions. Using only the variation coming from measurement error, the researchers find that benefit extensions have a limited influence on state-level macroeconomic outcomes. The researchers use estimates to quantify the effects of the increase in the duration of benefits during the Great Recession and find that they increased the unemployment rate by at most 0.3 percentage point.

Lorenz Kueng, Northwestern University and NBER

Explaining Consumption Excess Sensitivity with Near-Rationality: Evidence from Large Predetermined Payments (NBER Working Paper No. 21772)

Using new transaction data, Kueng shows that consumption is excessively sensitive to salient, predetermined, large and regular payments from the Alaska Permanent Fund, with an average marginal propensity to consume (MPC) of 30%. This deviation from the standard consumption model is concentrated among households for whom the loss from failing to smooth consumption is small. Indeed, the MPC is increasing in household income but decreasing in the size of the loss. Hence, statistically significant excess sensitivity is consistent with near-rational consumption plans. For many macroeconomic policies, these near-rational alternatives might be the more relevant behavior than the standard consumption model.

Greg Kaplan, Princeton University and NBER; Kurt Mitman, Institute for International Economic Studies; and Giovanni Violante, New York University and NBER

Consumption and House Prices in the Great Recession

Kaplan, Mitman, and Violante build a heterogeneous-agent life-cycle incomplete-markets model of the U.S. economy with multiple aggregate shocks (income, financial deregulation, and beliefs) leading to fluctuations in equilibrium house prices. Through a series of counterfactual numerical experiments, the researchers address three questions. First, what was the main source of the boom and bust in house prices? They find that the belief shock plays a chief role in the behavior of prices and rents. Financial deregulation alone was unimportant, but its interaction with the other shocks explains the dynamics of home-ownership, leverage, and cash-out refinancing. The model's cross-sectional implications are in line with the 'new narrative' of the crisis that emphasizes the role of middle- and high-income households. Second, how much of the dynamics of U.S. nondurable consumption around the Great Recession was caused by the boom-bust of house prices? The researchers' model suggests that changes in house prices alone can explain at least 1/2 of the corresponding boom-bust in expenditures, mostly occurring through a wealth effect rather than tightening access to credit. Third, would a massive debt forgiveness policy have cushioned the macroeconomic bust and accelerated the recovery? The researchers' simulations imply that such government intervention would have dramatically reduced foreclosure rates, but would have had a trivial impact on the collapse of house prices and consumption expenditures. Finally, the model illustrates how the size of the elasticity of consumption to house prices depends crucially on the underlying shock that moves house prices. This finding has consequences for the use of sufficient-statistic approaches in this context.

Xavier Gabaix, New York University and NBER

Behavioral Macroeconomics via Sparse Dynamic Programming (NBER Working Paper No. 21848)

In this paper, Gabaix proposes a tractable way to model boundedly rational dynamic programming. The agent uses an endogenously simplified, or "sparse," model of the world and the consequences of his actions and acts according to a behavioral Bellman equation. The framework yields a behavioral version of some of the canonical models in macroeconomics and finance. In the life-cycle model, the agent initially does not pay much attention to retirement and undersaves; late in life, he progressively saves more, generating realistic dynamics. In the consumption-savings model, the consumer decides to pay little or no attention to the interest rate and more attention to his income. Ricardian equivalence and the Lucas critique partially fail because the consumer may not pay full attention to taxes and policy changes. In a Merton-style dynamic portfolio choice problem, the agent endogenously pays limited or no attention to the varying equity premium and hedging demand terms. Finally, in the neoclassical growth model, agents act on a simplified model of the macroeconomy; in equilibrium, fluctuations are larger and more persistent.

Sydney Ludvigson, New York University and NBER; Sai Ma, New York University; and Serena Ng, Columbia University and NBER

Uncertainty and Business Cycles: Exogenous Impulse or Endogenous Response (NBER Working Paper No. 21803)

Uncertainty about the future rises in recessions. But is uncertainty a source of business cycle fluctuations or an endogenous response to them, and does the type of uncertainty matter? Ludvigson, Ma, and Ng find that sharply higher uncertainty about real economic activity in recessions is fully an endogenous response to other shocks that cause business cycle fluctuations, while uncertainty about financial markets is a likely source of the fluctuations. Financial market uncertainty has quantitatively large negative consequences for several measures of real activity including employment, production, and orders. Such are the main conclusions drawn from estimation of three-variable structural vector autoregressions. To establish causal effects, the researchers propose an iterative projection IV ( IPIV) approach to construct external instruments that are valid under credible interpretations of the structural shocks.

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