CAEPR Working Papers

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    Endogenous Network Dynamics
    (Center for Applied Economics and Policy Research, 2009-02-24) Wooders, Myrna H.; Page, Frank H. Jr.
    Modeling club structures as bipartite directed networks, we formulate the problem of club formation as a noncooperative game of network formation and identify conditions on network formation rules and players' network payoffs sufficient to guarantee that the game has a potential function. Our sufficient conditions on network formation rules require that each player be choose freely and unilaterally those clubs he joins and also his activities within these clubs (subject to his set of feasible actions). We refer to our conditions on rules as noncooperative free mobility. We also require that players' payoffs be additively separable in player-specific payoffs and externalities (additive separability) and that payoff externalities - a function of club membership, club activities, and crowding - be identical across players (externality homogeneity). We then show that under these conditions, the noncooperative game of club network formation is a potential game over directed club networks and we discuss the implications of this result.
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    Demographic Uncertainty and Welfare in a Life-cycle Model under Alternative Public Pension Systems
    (Center for Applied Economics and Policy Research, 2008-09-19) Rahman, M Saifur
    In this paper, I analyze consumption, aggregate savings, output and welfare implications of five different social security arrangements whenever there is demographic uncertainty. Following Bohn (2002), I analyze the effect of an uncertain population growth in an extended version of a modified Life-cycle model developed by Gertler (1999). Population growth dampens savings and output under all arrangements. Pay-as-you-go-Defined Benefit system appears to fare better than all other alternatives, falling short of the private annuity market with no pension system. But social security in general increases social welfare, with Fully Funded systems faring the best. Thus there appears to be a clear trade-off between growth and social welfare. The social security system also reduces the volatility of the economy.
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    Should Dynamic Scoring be done with Heterogeneous Agent-Based Models? Challenging the Conventional Wisdom
    (Center for Applied Economics and Policy Research, 2008-09-19) Rahman, M Saifur
    Traditionally, Dynamic Scoring calculations experiments are carried out using representative agent based macroeconomic models. Existing literature does not provide any objection to this approach. In this paper, I develop a heterogeneous agent model similar to the Saver-Spenders model of Mankiw (2000). But spenders in my model are merely credit constrained and not rule-of-thumb consumers. Both groups are intertemporal optimizers because of the existence of Internal Habit Persistence. Transition path of most of the macro and fiscal variables for various tax cuts under alternative financing scheme shows pattern which are significantly different and sometimes contrasting to the representative agent model. Dynamic scoring calculations reveal a downward bias of the representative agent model. Underestimation of the dynamic response could be as large as 45%. Finally, steady state results indicate smaller impact of contractionary policies on major fiscal variables such as net tax revenue and tax base. Over all, the paper argues that the need to use heterogeneous agent based model in dynamic fiscal calculations is not only desirable, but also essential.
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    Estimation Risk Effects on Backtesting for Parametric Value-at-Risk Models
    (Center for Applied Economics and Policy Research, 2008-09-04) Escanciano, Juan Carlos; Olmo, Jose
    One of the implications of the creation of Basel Committee on Banking Supervision was the implementation of Value-at-Risk (VaR) as the standard tool for measuring market risk. Thereby the correct specification of parametric VaR models became of crucial importance in order to provide accurate and reliable risk measures. If the underlying risk model is not correctly specified, VaR estimates understate/overstate risk exposure. This can have dramatic consequences on stability and reputation of financial institutions or lead to sub-optimal capital allocation. We show that the use of the standard unconditional backtesting procedures to assess VaR models is completely misleading. These tests do not consider the impact of estimation risk and therefore use wrong critical values to assess market risk. The purpose of this paper is to quantify such estimation risk in a very general class of dynamic parametric VaR models and to correct standard backtesting procedures to provide valid inference in specification analyses. A Monte Carlo study illustrates our theoretical findings in finite-samples. Finally, an application to S&P500 Index shows the importance of this correction and its impact on capital requirements as imposed by Basel Accord, and on the choice of dynamic parametric models for risk management.
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    Specification Tests of Parametric Dynamic Conditional Quantiles
    (Center for Applied Economics and Policy Research, 2008-08-15) Escanciano, Juan Carlos; Velasco, Carlos
    This article proposes omnibus specification tests of parametric dynamic quantile regression models. Contrary to the existing procedures, we allow for a flexible and general specification framework where a possibly continuum of quantiles are simultaneously specified. This is the case for many econometric applications for both time series and cross section data which require a global diagnostic tool. We study the asymptotic distribution of the test statistics under fairly weak conditions on the serial dependence in the underlying data generating process. It turns out that the asymptotic null distribution depends on the data generating process and the hypothesized model. We propose a subsampling procedure for approximating the asymptotic critical values of the tests. An appealing property of the proposed tests is that they do not require estimation of the non-parametric (conditional) sparsity function. A Monte Carlo study compares the proposed tests and shows that the asymptotic results provide good approximations for small sample sizes. Finally, an application to some European stock indexes provides evidence that our methodology is a powerful and flexible alternative to standard backtesting procedures in evaluating market risk by using information from a range of quantiles in the lower tail of returns.
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    Strategic Disclosure of Valuable Information within Competitive Environments
    (Center for Applied Economics and Policy Research, 2008-08-25) Yoon, Young-Ro
    Can valuable information be disclosed intentionally by the informed agent even within a competitive environment? In this article, we bring our interest into the asymmetry in reward and penalty in the payoff structure and explore its effects on the strategic disclosure of valuable information. According to our results, the asymmetry in reward and penalty is a necessary condition for the disclosure of valuable information. This asymmetry also decides which quality of information is revealed for which incentive; if the penalty is larger than the reward or the reward is weakly larger than the penalty, there exists an equilibrium in which only a low quality type of information is revealed, in order to induce imitation. On the other hand, if the reward is sufficiently larger than the penalty, there exist equilibria in which either all types or only high quality type of information is revealed, in order to induce deviation. The evaluation of the equilibrium in terms of expected payoff yields that the equilibrium where valuable information is disclosed strategically dominates the equilibrium where it is concealed.
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    Initial Expectations in New Keynesian Models with Learning
    (Center for Applied Economics and Policy Research, 2008-06-13) Murray, James
    This paper examines how the estimation results for a standard New Keynesian model with constant gain least squares learning is sensitive to the stance taken on agents beliefs at the beginning of the sample. The New Keynesian model is estimated under rational expectations and under learning with three different frameworks for how expectations are set at the beginning of the sample. The results show that initial beliefs can have an impact on the predictions of an estimated model; in fact previous literature has exposed this sensitivity to explain the changing volatilities of output and inflation in the post-war United States. The results indicate statistical evidence for adaptive learning, however the rational expectations framework performs at least as well as the learning frameworks, if not better, in in-sample and out-of-sample forecast error criteria. Moreover, learning is not found to better explain time varying macroeconomic volatility any better than rational expectations. Finally, impulse response functions from the estimated models show that the dynamics following a structural shock can depend crucially on how expectations are initialized and what information agents are assumed to have.
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    Solving Endogeneity in Assessing the Efficacy of Foreign Exchange Market Interventions
    (Center for Applied Economics and Policy Research, 2008-06-12) Park, Seok Gil
    Sterilized foreign exchange market interventions have been suspected of being inefficient by many empirical studies, but they are plagued by endogeneity problems. To solve the problems, this paper identifies a system that depicts interactions between the interventions and the foreign exchange rate. The model shows that the interventions are effective when the interventions alter the market participants' conditional expectations of the rate without decreasing the conditional variances. This paper estimates Markov-switching type policy reaction functions by conditional MLE, and market demand/supply curves by IV estimation with generated regressors. The empirical results verify that the interventions of the Bank of Korea from 2001 to 2002 were indeed effective.
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    Empirical Significance of Learning in a New Keynesian Model with Firm-Specific Capital
    (Center for Applied Economics and Policy Research, 2008-06-13) Murray, James
    This paper examines the empirical significance of learning, a type of adaptive, boundedly rational expectations, in the U.S. economy within the framework of the New Keynesian model. Two popular specifications of the model are estimated: the standard three equation model that does not include capital, and an extended model that allows for endogenous capital accumulation. Estimation results for learning models can be sensitive to the choice for the initial conditions for agents expectations, so four different methods for choosing initial conditions are examined, including jointly estimating the initial conditions with the other parameters of the model. Maximum likelihood results show that learning under all methods for initial conditions lead to very similar predictions as rational expectations, and do not significantly improve the fit the model. The evolution of forecast errors show that the learning models do not out perform the rational expectations model during the run-up of inflation in the 1970s and the subsequent decline in the 1980s, a period of U.S. history which others have suggested learning may play a role. Despite the failure of learning models to better explain the data, analysis of the paths of expectations and structural shocks during the sample show that allowing for learning in the models can lead to different explanations for the data.
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    Fiscal Foresight: Analytics and Econometrics
    (Center for Applied Economics and Policy Research, 2008-05-12) Leeper, Eric M.; Walker, Todd B.; Yang, Shu-Chun Susan
    Fiscal foresight---the phenomenon that legislative and implementation lags ensure that private agents receive clear signals about the tax rates they face in the future---is intrinsic to the tax policy process. This paper develops an analytical framework to study the econometric implications of fiscal foresight. Simple theoretical examples show that foresight produces equilibrium time series with a non-invertible moving average component, which misaligns the agents' and the econometrician's information sets in estimated VARs. Economically meaningful shocks to taxes, therefore, cannot be extracted from statistical innovations in conventional ways. Econometric analyses that fail to align agents' and the econometrician's information sets can produce distorted inferences about the effects of tax policies. Because non-invertibility arises as a natural outgrowth of the fact that agents' optimal decisions discount future tax obligations, it is likely to be endemic to the study of fiscal policy. In light of the implications of the analytical framework, we evaluate two existing empirical approaches to quantifying the impacts of fiscal foresight. The paper also offers a formal interpretation of the narrative approach to identifying fiscal policy.
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    Calculating Welfare Costs of Inflation in a Search Model with Preference Heterogeneity: A Calibration Exercise
    (Center for Applied Economics and Policy Research, 2008-04-30) de Araujo, Pedro
    Using U.S. cross-sectional data, this paper calculates the welfare cost of a 10% inflation for different individuals and finds that the difference in cost between the poorest 10%, measured by their expenditure share on cash goods, and the richest 10% is in the order of 176%. That is, a poor person is on average willing to forgive 176% more of their total consumption in order to have inflation reduced from 10% to 0. In absolute terms this represents a cost of 2.687% of consumption for the poorest and 0.974% for the richest. I accomplish this by introducing preference heterogeneity in a monetary search model first developed by Lagos and Wright (2005), and calibrate the model to match the expenditure share on cash goods and total expenditures for each individual type using data from the Consumer Expenditure Survey (CEX) for the second quarter of 1996. I also show that this welfare difference increases to 210% (10.522% for the poorest 10% and 3.401% for the richest 10%) whenever frictions in the use of money are imposed (holdup problem). The ability to explicitly model these frictions is the advantage of using this model. Hence, inflation in this framework, as other studies have shown, acts as a regressive consumption tax; and this regressiveness is augmented with the holdup problem.
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    Regime Switching, Learning, and the Great Moderation
    (Center for Applied Economics and Policy Research, 2008-04-30) Murray, James
    This paper examines the "bad luck" explanation for changing volatility in U.S. inflation and output when agents do not have rational expectations, but instead form expectations through least squares learning with an endogenously changing learning gain. It has been suggested that this type of endogenously changing learning mechanism can create periods of excess volatility without the need for changes in the variance of the underlying shocks. Bad luck is modeled into a standard New Keynesian model by augmenting it with two states that evolve according to a Markov chain, where one state is characterized by large variances for structural shocks, and the other state has relatively smaller variances. To assess whether learning can explain the Great Moderation, the New Keynesian model with volatility regime switching and dynamic gain learning is estimated by maximum likelihood. The results show that learning does lead to lower variances for the shocks in the volatile regime, but changes in regime is still significant in differences in volatility from the 1970s and after the 1980s.
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    Empirical Significance of Learning in a New Keynesian Model with Firm-Specific Capital
    (Center for Applied Economics and Policy Research, 2007-11-21) Murray, James
    This paper examines the empirical significance of learning, a type of adaptive, boundedly rational expectations, in the U.S. economy within the framework of the New Keynesian model. Two popular specifications of the model are estimated: the standard three equation model that does not include capital, and an extended model that allows for endogenous capital accumulation. Estimation results for learning models can be sensitive to the choice for the initial conditions for agents expectations, so four different methods for choosing initial conditions are examined, including jointly estimating the initial conditions with the other parameters of the model. Maximum likelihood results show that learning under all methods for initial conditions lead to very similar predictions as rational expectations, and do not significantly improve the fit the model. The evolution of forecast errors show that the learning models do not out perform the rational expectations model during the run-up of inflation in the 1970s and the subsequent decline in the 1980s, a period of U.S. history which others have suggested learning may play a role. Despite the failure of learning models to better explain the data, analysis of the paths of expectations and structural shocks during the sample show that allowing for learning in the models can lead to different explanations for the data.
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    Simulating Sequential Search Models with Genetic Algorithms: Analysis of Price Ceilings, Taxes, Advertising and Welfare
    (Center for Applied Economics and Policy Research, 2008-04-30) McCarthy, Ian
    This paper studies advertising, price ceilings and taxes in a sequential search model with bilateral heterogeneities in production and search costs. We estimate equilibria using a genetic algorithm (GA) applied to over 100 market scenarios, each differing based on the number of firms, number of consumers, existence of price ceilings or taxes, costs of production, costs of advertising, consumers' susceptibility to advertising and consumers' search costs. We compare our equilibrium results to those of the standard theoretical consumer search literature and analyze the welfare effects of advertising, price ceilings and sales taxes. We find that price ceilings and uninformative advertising can improve welfare, especially if search costs are sufficiently high.
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    Performance Measurement under Rational International Overpromising Regimes
    (Center for Applied Economics and Policy Research, 2008-04-03) von Furstenberg, George
    Overpromising remains ingrained in international agreements, clouding their expected aggregate outcomes and how to assess the Parties’ performance. This paper provides a theory-based explanation and evaluation of this regime and its consequences, with an empirical application to the Kyoto Protocol. It shows (1) overpromising to be part of a sustainable strategy for electoral success, and (2) there are common determinants of the countries’ overpromising values that characterize the group regime. (3) Targets need to be adjusted for regression-predicted overpromising to yield rationally-expected outcomes. (4) Individual countries’ performance is best identified by deviations of outcomes from their adjusted, not the agreed, targets.
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    Oil Price Shocks and Exchange Rate Management: The Implications of Consumer Durables for the Small Open Economy
    (Center for Applied Economics and Policy Research, 2008-04-17) Plante, Michael
    This paper examines exchange rate management issues when a small open economy is hit by an exogenous oil price shock. In this model consumer durables play an important role in the demand for oil and oil based products as opposed to the traditional role of oil as a factor of production. When prices are sticky, oil price shocks lead to reduced output, lower inflation, and real exchange rate deprecation. These recessionary effects occur whether or not oil is in the production function because of the close relationship between consumer durables and oil. Tentative results suggest that flexible exchange rates produce smaller output losses and less volatile inflation in the non-tradables sector than fixed exchange rates but at the cost of front-loading real exchange rate movements.
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    Oil Price Shocks and Exchange Rate Management: The Implications of Consumer Durables for the Small Open Economy
    (Center for Applied Economics and Policy Research, 2008-04-10) Plante, Michael
    This paper examines exchange rate management issues when a small open economy is hit by an exogenous oil price shock. In this model consumer durables play an important role in the demand for oil and oil based products as opposed to the traditional role of oil as a factor of production. When prices are sticky, oil price shocks lead to reduced output, lower inflation, and real exchange rate deprecation. These recessionary effects occur whether or not oil is in the production function because of the close relationship between consumer durables and oil. Tentative results suggest that flexible exchange rates produce smaller output losses and less volatile inflation in the non-tradables sector than fixed exchange rates but at the cost of front-loading real exchange rate movements.
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    The Macroeconomics of Health Savings Accounts
    (Center for Applied Economics and Policy Research, 2008-04-11) Jung, Juergen; Tran, Chung
    We analyze whether a consumer driven health care plan like the newly established Health Savings Accounts (HSAs) can reduce health care expenditures in the United States and increase the fraction of the population with health insurance. We use an overlapping generations model with health uncertainty and endogenous health care spending. Agents can choose between a low deductible- and a high deductible health insurance. If agents choose to purchase the high deductible health insurance, they are allowed to contribute tax free to an HSA. We examine the steady state effects of introducing HSAs into a system with private health insurance for young agents and Medicare for old agents. Since the model is a general equilibrium model, we fully account for feedback effects from both, factor markets and insurance markets. Our results from numerical simulations indicate that HSAs can decrease total health expenditures by up to 3% of GDP but increase the number of uninsured individuals by almost 5%. Furthermore, HSAs decrease the aggregate level of health capital and therefore decrease output. We also address possible extensions of the HSA reform that include the eligibility to pay health insurance premiums with HSA funds, the full privatization of Medicaid via HSAs, and Medicare for workers.
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    Search Costs and Medicare Plan Choice
    (Center for Applied Economics and Policy Research, 2008-04-03) McCarthy, Ian; Tchernis, Rusty
    There is increasing evidence suggesting that Medicare beneficiaries do not make fully informed decisions when choosing among alternative Medicare health plans. To the extent that deciphering the intricacies of alternative plans consumes time and money, the Medicare health plan market is one in which search costs may play an important role. To account for this, we split beneficiaries into two groups--those who are informed and those who are uninformed. If uninformed, beneficiaries only use a subset of covariates to compute their maximum utilities, and if informed, they use the full set of variables considered. In a Bayesian framework with Markov Chain Monte Carlo (MCMC) methods, we estimate search cost coefficients based on the minimum and maximum statistics of the search cost distribution, incorporating both horizontal differentiation and information heterogeneities across eligibles. Our results suggest that, conditional on being uninformed, older, higher income beneficiaries with lower self-reported health status are more likely to utilize easier access to information.
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    Advertising Intensity and Welfare in an Equilibrium Search Model
    (Center for Applied Economics and Policy Research, 2008-01-24) McCarthy, Ian
    We analyze an equilibrium search model in a duopoly setting with bilateral heterogeneities in production and search costs in which firms can advertise by announcing price and location. We study existence, stability, and comparative statics in such a setting, compare the market advertising level to the socially optimal level, and find conditions in which firms advertise more or less than the social optimum.