Nick Bloom, Macro Topics, Fall 2008 Nick Bloom Micro-heterogeneity & Macro, general equilibrium

Nick Bloom, Macro Topics, Fall 2008 Do micro distributions matter for macro outcomes Probably the greatest unanswered question in macro is how to get a tractable micro-to-macro model. Currently the battleground is in general equilibrium models First overview the basics, and then discuss a couple of key papers

Nick Bloom, Macro Topics, Fall 2008 The easy life under partial equilibrium In partial equilibrium models each firms solves its own problem, for example solving for capital and labor: V(K,L,A)=max K’,L’ {F(A,K’,L’) – wL - C(K’-K,L’-L) + (1/(1+r))*E(V(K’,L’,A’))} The key assumption is wages (w) and interest rates (r) are fixed. This allows you to ignore the interaction between firms Bertola, Caballero, Engel etc.. all do this in their earlier work for numerical simplicity, but is this valid?

Nick Bloom, Macro Topics, Fall 2008 The problem is the curse of dimensionallity In general equilibrium each firm is still assumed to be solving its own profit maximisation problem. But now wages and prices are functions of the cross-sectional distribution (m) so that w=f(m), r=g(m): V(K,L,A,m)=max K’,L’ {F(A,K’,L’) – w(m)L - C(K’-K,L’-L) + (1/(1+r(m)))*E(V(K’,L’,A’,m))} This problem is now a lot tougher – every firm has to keep track of its own state variables and every other firms state variables. So if you have 3 states (K,L,A) and N firms, that’s 3N states!

Nick Bloom, Macro Topics, Fall 2008 Solving models under General Equilibrium This is called the “Curse” because its exponential in N If it takes a XGB to solve for 1 firm, it will take X N GB to solve for N firms. Hence lots of computing power alone is never going to solve this So the trick is to somehow approximate this cross-sectional distribution in a way that: Reduces it down to something finite and managable Does not dramatically change the GE flavor of the solution Anything that does this is also easily defensible under bounded rationality – most individuals/firms also approximate life….

Nick Bloom, Macro Topics, Fall 2008 Per Krusell and Anthony Smith (1998) “Income and wealth heterogeneity in the macroeconomy” Journal of Political Economy

Nick Bloom, Macro Topics, Fall 2008 Overview Undertakes a GE estimation of the effects of wealth distribution on the economy The fundamental idea was to: Approximate the cross-sectional distribution using moments Use this to operationalize a Recursive Competitive Equilibrium (to be explained more in a minute) Also combined different parameters to fit actual data better An important paper: (i) First paper to undertake this GE approximation (ii) Shares the code for this and provides sufficiently good instructions for others to follow – always do this!

Nick Bloom, Macro Topics, Fall 2008 Hugely cited – this paper has had a major impact…

Nick Bloom, Macro Topics, Fall 2008 A Recursive Competitive Equilibrium - Theory In short this makes sure three sets of conditions are met: 1) Firms and households are optimising given: Market prices (typically wages and interest rates) Expectations over evolution of aggregate and cross-section 2) Market prices clear the goods and labor markets 3) Expectations are consistent with outcomes

Nick Bloom, Macro Topics, Fall 2008 A Recursive Competitive Equilibrium - Practice Numerical solutions assume you can approximate the expectation of distributions. They reformulate using this approximation This assumes bounded rationality due to computational costs Important to test this by confirming that the value maximisation for firms and agents is only reduced marginally by the approximation With this approach you then numerically solve recursively: Solve for (1, value functions) and (2, market clearing) jointly given an assumption on (3, distributions). Then simulates data for (3, distributions). Then use this simulation to re-solve (1, value functions) and (2, market clearing). Then simulate (3, expectations) again, and continue to loop until you converge

Nick Bloom, Macro Topics, Fall 2008 Solving Recursive Competitive Equilibrium models Unfortunately there are no results showing that approximate numerical solutions to RCEs with fixed-costs are well behaved: A solution exists This is unique The RCE solution mechanism outlined earlier will converge In practice, however, it seems to work. But anyone that can make progress on showing any of the above will have a winning paper…

Nick Bloom, Macro Topics, Fall 2008 The Krusell Smith moments approach to RCEs They use moments to approximate the distribution – appealing as a statistically standard way to describe any distribution There are other approaches, for example: Cabellero and Engel played around with various Characteristic functions (Taylor, Fourier, Chebyshev etc..) Khan and Thomas (2004,2007) used uniform histograms The choice depends really on the support of the distribution to be approximated

Nick Bloom, Macro Topics, Fall 2008 The Krusell Smith results from using moments In the paper they report finding that only the 1 st moment is required for the solution of the model, with higher moments providing no additional fit. This is also a result that Thomas (2002) and Bachman, Caballero and Engel (2006) report One question is whether this is generally robust – for example with time varying uncertainty distributions compress and expand Another great paper would be to properly evaluate this across many models

Nick Bloom, Macro Topics, Fall 2008 They find no impact of cross-sectional distribution The main result from KS is that cross-sectional distribution of wealth has no real effect on – approximate aggregation This is because their utility function is pretty linear for medium and high levels of wealth, so consumption behaviour is roughly linear. Since consumption (which is individual weighted by wealth) is mostly in the hands of the rich the average agent is linear If agents are linear higher order moments don’t matter (next slide) This had a big impact on macro – suggests that “RAs (Representative Agents rather than Research Assistants) rule OK”

Nick Bloom, Macro Topics, Fall 2008 Remember our old friend from last time… Aggregate investment Adjustment hazard Distribution of plants Mandated (desired) investment Year If the response function (the adjustment hazard for investment and the MPC for consumption) is constant (linear in the gap/wealth) then distributions does not matter

Nick Bloom, Macro Topics, Fall 2008 Message is – at least for consumption - micro- distribution appears not to matter Good paper – how could you build on this: Topic – Look at something more non-linear (labor or investment) Technique – Use higher moments, these might matter Technical – Provide some more formal proofs for RCEs

Nick Bloom, Macro Topics, Fall 2008 Ruediger Bachmann, Ricardo Caballero and Eduardo Engel (2007) “Lumpy Investment in Dynamic General Equilibrium” Yale WP

Nick Bloom, Macro Topics, Fall 2008 Overview Paper estimates micro-to-macro investment in GE setting. In particular revisits the results from Khan and Thomas, finding lumpiness matters Contribution is: Demonstrates the impact of micro-macro GE is sensitive to parameter choices Provides alternative methodologies for estimating these parameters Quantifies separate impact of PE and GE smoothing Good paper, shows that key results on GE smoothing are very sensitive to a few parameters, plus new techniques

Nick Bloom, Macro Topics, Fall 2008 They follow basic Khan and Thomas (2005) approach Generally follow the approach of Khan and Thomas (2004) - note this is the prior paper to the KT (2007) paper we read in class Main points of departure are over parameter choices, particularly: Bigger adjustment costs – more lumps (so micro matters more) More curvature of the production function – curvature means higher option values, so actions now influence the future Higher intertemporal elasticity of substitution – higher values mean output moves more over time to save adjustment costs Inclusion of maintenance investment – reduces drift rate so raises the “memory” of the process

Nick Bloom, Macro Topics, Fall 2008 With these alternative parameters they find a major role for micro smoothing

Nick Bloom, Macro Topics, Fall 2008 While Khan and Thomas (2005) do not

Nick Bloom, Macro Topics, Fall 2008 Key identifying assumption in there is PE at industry level – which allows you to compare PE to GE Good idea to try and use additional data to identify paramters They (like me) believe plant level is already partially aggregated So use industry level data assuming it is fully aggregated, but PE Volatility of investment rates

Nick Bloom, Macro Topics, Fall 2008 Our old friend – time varying responsiveness index If you accept the RI is time varying (note this is a simulation result above) then this requires additional assumptions: - Time varying cross-section matters (very possible) - Time varying adjustment costs (less likely) - Other time varying factors in the model (need to introduce these) - Other time varying shocks – uncertainty….

Nick Bloom, Macro Topics, Fall 2008 Message is parameter choices matter a lot in determining micro-macro aggregation effects Good paper – how could you build on this – similar to earlier, plus: Modeling – Include other adjustment costs (quadratic and linear), allow for labor adjustment costs or even technology vintages Technique – evaluate impact of using higher moments (is there any way to get them to matter?) Identification – robust ways to estimate the underlying parameters So what – push beyond time varying RI to look at major shocks (tax credits etc), when this would be really valuable