Economic Fluctuations and Growth

Mikhail Golosov, Princeton University and NBER, and Guido Menzio, University of Pennsylvania and NBER

Agency Business Cycles

Golosov and Menzio propose a new theory of business cycles. Firms need to randomize over firing or keeping workers who have performed poorly in the past, in order to give them ex-ante an incentive to exert effort on the job. Firms want to coordinate on the outcome of their randomization, as coordination allows them to load the firing probability on states of the world when it is costlier for workers to become unemployed and, hence, it allows them to reduce the overall firing probability. In the unique robust equilibrium, firms use a sunspot to coordinate on the randomization outcomes and the economy experiences aggregate fluctuations that are endogenous — in the sense that they are not driven by exogenous shocks to fundamentals or by exogenous shocks to the selection of equilibrium — and stochastic — in the sense that they follow a non-deterministic path. The researchers' theory of business cycles implies a novel view of recessions which is opposite to a view of recessions as "rainy days" proposed by real business cycle theory.

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Xavier Gabaix, New York University and NBER; Jean-Michel Lasry, Université Paris Dauphine; Pierre-Louis Lions, College de France; and Benjamin Moll, Princeton University and NBER

The Dynamics of Inequality (NBER Working Paper No. 21363)

The past forty years have seen a rapid rise in top income inequality in the United States. While there is a large number of existing theories of the Pareto tails of the income and wealth distributions at a given point in time, almost none of these address the fast rise in top inequality observed in the data. Gabaix, Lasry, Lions, and Moll show that standard theories, which build on a random growth mechanism, generate transition dynamics that are an order of magnitude too slow relative to those observed in the data. The researchers then suggest parsimonious deviations from the basic model that can explain such changes, namely heterogeneity in mean growth rates or deviations from Gibrat's law. These deviations are consistent with theories in which the increase in top income inequality is driven by the rise of "superstar" entrepreneurs or managers.

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Wouter den Haan, London School of Economics; Pontus Rendahl, University of Cambridge; and Markus Riegler, University of Bonn

Unemployment (fears) and Deflationary Spirals

The interaction of incomplete markets and sticky nominal wages is shown to magnify business cycles even though these two features — in isolation — dampen them. During recessions, fears of unemployment stir up precautionary sentiments which induces agents to save more. Den Haan, Rendahl, and Riegler find that the additional savings may be used as investments in both a productive asset (equity) and an unproductive asset (money). But even a small rise in money demand has important consequences. The desire to hold money puts deflationary pressure on the economy, which, provided that nominal wages are sticky, increases wage costs and reduces firm profits. Lower profits repress the desire to save in equity, which increases (the fear of) unemployment, and so on. This is a powerful mechanism which causes the model to behave differently from both its complete markets version, and a version with incomplete markets but without aggregate uncertainty. In contrast to previous results in the literature, agents uniformly prefer non-trivial levels of unemployment insurance.

Iván Werning, MIT and NBER

Incomplete Markets and Aggregate Demand (NBER Working Paper No. 21448)

In this paper, Werning studies aggregate consumption dynamics under incomplete markets, focusing on the relationship between consumption and the path for interest rates. Werning first provides a general aggregation result under extreme illiquidity (no borrowing and no outside assets), deriving a generalized Euler relation involving the real interest rate, current and future aggregate consumption. This provides a tractable way of incorporating incomplete markets in macroeconomic models, dealing only with aggregates. Although this relation does not necessarily coincide with the standard representative-agent Euler equation, the researcher shows that it does for an important benchmark specification. When this is the case, idiosyncratic uncertainty and incomplete markets leave their imprint by affecting the discount factor in this representation, but the sensitivity of consumption to current and future interest rates is unaffected. An immediate corollary is that "forward guidance" (lower future interest rates) is as powerful as in representative agent models. Werning shows that the same representation holds with positive liquidity (borrowing and outside assets) when utility is logarithmic. He shows that away from these benchmark cases, consumption is likely to become more sensitive to interest rate, and especially future interest rates. Finally, Werning applies his approach to a real business cycle economy, providing an exact analytical aggregation result that complements existing numerical results.

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Marco Del Negro and Marc Giannoni, Federal Reserve Bank of New York, and Christina Patterson, MIT

The Forward Guidance Puzzle

With short-term interest rates at the zero lower bound, forward guidance has become a key tool for central bankers, and yet little is known about its effectiveness. This paper first empirically documents the impact of forward guidance announcements on a broad cross section of financial markets data and professional forecasts. Del Negro, Giannoni, and Patterson find that FOMC announcements containing forward guidance had heterogenous effects depending on the other content of the statement. The researchers show that once they control for these other elements, forward guidance, on average, had positive effects on output and inflation. Using this benchmark, they then show that standard medium-scale DSGE models tend to grossly overestimate the impact of forward guidance on the macroeconomy, a phenomenon they call the "forward guidance puzzle." The authors explain why this is the case and show that incorporating a perpetual youth structure into the benchmark provides a tentative resolution to the puzzle.

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Cosmin Ilut, Duke University and NBER; Rosen Valchev, Boston College; and Nicolas Vincent, HEC Montreal

Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty

The degree of rigidity of nominal variables is central to many predictions of modern macroeconomic models. Yet, standard models of price stickiness are at odds with certain robust empirical facts from micro price datasets. Ilut, Valchev, and Vincent propose a new, parsimonious theory of price rigidity, built around the idea of demand uncertainty, that is consistent with a number of salient micro facts. In the model, the monopolistic firm faces Knightian uncertainty about its competitive environment. It learns non-parametrically about the underlying, uncertain demand and makes robust pricing decisions. The nonparametric learning leads to kinks in the expected profit function at previously observed prices, which generate price stickiness and a discrete price distribution. In addition, the researchers show that when the ambiguity-averse firm worries that aggregate inflation is an ambiguous signal of the prices of its direct competitors in the short run, the authors' rigidity becomes nominal in nature.