This paper studies the government spending multiplier in the presence of the cost channel of the nominal interest rate. I find that the spending multiplier of normal times declines markedly when this channel is introduced. The rise in government spending leads to a rise in the nominal interest rate and, with the cost channel, to a rise in the marginal cost and inflation. In turn, this leads to a bigger rise in the nominal interest rate and the expected real interest rate, hence a lower multiplier, than in a model that abstracts from the cost channel. On the other hand, in a liquidity trap, the cost channel makes the spending multiplier larger. Therefore, by ignoring the cost channel, the spending multiplier is overestimated in normal times and underestimated during liquidity trap episodes. Since liquidity traps are rare, however, the spending multiplier is mostly lower than in previous estimates.

In this paper, we adopt a Ramsey optimal approach to identify the combination of income taxes, public expenditure, and inflation designed to achieve a fiscal consolidation. In contrast with empirical contributions that emphasize the benefits of expenditure-based consolidations, the optimal policy calls for increases in taxes and inflation. Strong monetary accommodation is quite beneficial relative to a situation where the Central Bank is only concerned with inflation stability and the inflation target is defined as a ceiling, as in the Eurozone.

This paper examines the dynamic effects of international commodity trade by merging two benchmark environments, namely, the static factor endowments model and the neoclassical growth model. Two main questions are asked. First, how does commodity trade affect the capital-accumulation paths of two trade partners? Second, do the welfare effects associated with these dynamics serve to reinforce or mitigate the well-known welfare effects associated with the static factor endowments model? It is demonstrated that trade will eventually, if not immediately, narrow the difference in domestic capital accumulation paths. This narrowing introduces a negative welfare effect that is large enough to worsen overall welfare for the country whose capital accumulation has declined. Thus, although the dynamic effects of trade are large enough to dominate the static effects, they do not reinforce the concept of mutually advantageous trade.

One usually assumes that the joint probability distribution is known or that agents will use Bayesian updating to estimate the true probabilities after a number of trials when the states of nature are finite in classical decision theory under uncertainty. If there are important states that have very low probabilities of occurrence, then each agent must make a subjective assessment of the probability distribution until a sufficient number of outcomes are observed in order to generate a precise estimate of the probability distribution. If one assumes that all agents know the states and their payoffs, the probability distribution is stationary, and they observe all outcomes that unfold over time, then it will take at least 10 times the mean time between occurrences of the lowest probability event in order to generate enough outcomes that all agents share the same objective knowledge of the distribution. The mean time of recurrence depends on both the probability distribution and the time unit used between recordings of the observations. If at least one state has a low probability of occurrence, then the time to convergence will exceed the period of stationarity of the process.

This paper studies the dynamic propagation of a liquidity shock through two real propagation channels: dynamic complementarities and time-varying capital utilization. The findings for an economy with intertemporal externalities are: (1) An otherwise transient liquidity shock will have real effects on output for several years; (2) time-varying capital utilization strongly augments this propagation; (3) the real effects of monetary shocks last longer when external productivity depreciates faster; and (4) nominal prices respond more sluggishly to a change in the money supply when there is a strong real propagation channel.

Jacques Drèze was born in Verviers, Belgium, in 1929 and completed his Ph.D. in Economics in 1958 at Columbia. His contribution to economics is exceptional, opening up new paths of research in various areas including general equilibrium, decision theory, game theory, econometrics (in particular, Bayesian econometrics), followed by contributions to macroeconomics and economic policy. Drèze has been president of the Econometric Society as well as associate editor and co-editor of Econometrica; founding member and first president of the European Economic Association; president of the International Economic Association and honorary member of the American Economic Association and the National Academy of Sciences. He has received 15 honorary doctorates, including one from the University of Chicago. He has engaged in the promotion and development of research and higher education in Europe, being a founding member of the Centre for Operations Research and Econometrics (CORE) and of the European Doctoral Program in Quantitative Economics (EDP). He has also actively participated in the most pressing economic problems in Europe.

The interview mainly aims at inviting Jacques Drèze to explain what have been his major contributions and what avenues he suggests for future research in macroeconomics. The interview has been conducted sequentially. It started in October 2002 at the European University Institute. The long material collected along these highly illuminating talks was polished and condensed in the following pages. They are organized in the following way. The first section refers to Jacques' initial experiences in Belgium followed by his study of economics in the United States. The second section is devoted to the unity underlying an apparent diversity in his research interests. The third section is devoted to his more recent contributions to macroeconomics, which may be stated as “incomplete markets drive multiplicity of equilibria, calling for active economic policies.” The interview concludes with his contribution to the promotion of research and, in particular, research institutions across Europe.

Both Pierre Dehez and Omar Licandro were students of Jacques Drèze. Dehez and Drèze co-authored several papers, some of which are mentioned in the interview.

The puzzling bias of equity portfolios toward domestic assets (equity home bias) remains substantial. This paper proposes a dynamic stochastic general equilibrium model and demonstrates that shocks to consumption tastes (taste shocks) are an effective explanation for the equity home bias puzzle. In the model, home assets provide insurance for home agents to hedge against domestic taste fluctuations, whereas such insurance cannot be offered by foreign assets. The empirical evidence shows that, in explaining equity home bias, hedging against consumption taste risks is more relevant than hedging against labor income risks or real exchange rate risks.

We argue that a fixed exchange rate can be an optimal choice even if a policy maker could commit to the first-best monetary policy whenever the private sector's beliefs reflect incomplete information about the policy maker's dependability. This model implies that joining a currency area may be optimal for its impact not on the behavior of the policy maker, but on the beliefs of the private sector. Monetary policies are evaluated using a new Keynesian model of a small open economy solved under imperfect policy credibility. We quantify the minimum distance between announced policy and the private sector's beliefs that is necessary for a peg to perform better than an independent monetary policy when the policy maker can commit to the first-best policy.

We study identification in a class of linear rational expectations models. For any given exactly identified model, we provide an algorithm that generates a class of equivalent models that have the same reduced form. We use our algorithm to show that a model proposed by Jess Benhabib and Roger Farmer is observationally equivalent to the standard new-Keynesian model when observed over a single policy regime. However, the two models have different implications for the design of an optimal policy rule.

This note analytically examines the interrelations between macroeconomic (in)stability and investment adjustment costs in a one-sector endogenously growing small–open economy representative-agent model. We show that under costly capital accumulation, the economy exhibits indeterminacy and sunspots if and only if the equilibrium wage–hours locus slopes upward and is steeper than the household's labor supply curve. By contrast, the economy without adjustment costs for capital investment always displays saddlepath stability and equilibrium uniqueness, regardless of the degree of increasing returns inaggregate production.

This paper compares the effects of pro- and countercyclical government spending on income inequality and welfare in a small open economy. We examine the consequences of alternative government spending rules following shocks to productivity, domestic interest rates, terms of trade, and export demand. The simulated results show that welfare and income inequality indices can move in opposite directions for government spending rules, with countercyclical spending improving welfare and procyclical spending improving income equality.

The reduction in international trade has been more than the reduction in economic activity during the 2008 financial crisis, against the one-to-one relationship between them implied by standard trade models. This so-called the Great Trade Collapse (GTC) has been investigated extensively in the literature resulting in alternative competing stories as potential explanations. By introducing and estimating a dynamic stochastic general equilibrium model using 18 quarterly series from the USA, including those that represent the competing stories, this paper evaluates the contribution of each story to GTC. The results show that retail inventories have contributed the most to the collapse and the corresponding recovery, followed by protectionist policies, intermediate-input trade, and trade finance. Productivity and demand shocks have played negligible roles.

This paper estimates univariate and multivariate trend-cycle decomposition models of GDP and considers the novel possibility of regime switches in the growth of potential output. We compute both ex post and real-time estimates of the output gap to check the stability of our estimates to GDP data revisions. We find some evidence of regime changes in the growth of potential output during the recessions experienced by the euro area. We also run a forecasting experiment to evaluate the predictive power of the output gap for inflation. The benchmark autoregressive model tends to obtain the best forecasts for one-quarter-ahead forecasts, but the output gap measures help to forecast inflation for longer horizons.

This study examines the driving forces behind the strong decline in German unemployment from 2005 onwards and the exceptionally small increase during the Great Recession. Structural vector autoregressions (VARs) with sign restrictions show that wage moderation in the aftermath of labor market reforms was the dominant factor of the unemployment decline, and that improved matching and shrinking labor supply also contributed to it. The adjustment to business cycle shocks (Great Recession), on the other hand, is to a large extent borne by the intensive margin, which can be explained by institutional aspects of the German labor market.

This paper analyzes the global dynamics of a convex overlapping generations model with land. It derives a competitive equilibrium such that for every given initial level of capital per capita, the economy has a unique perfect-foresight equilibrium. It shows that the existence and uniqueness of this perfect-foresight equilibrium is robust to the presence of multiple steady-state levels of capital per capita. Furthermore, it shows that this model can provide an interesting insight into the economics of land taxation. Specifically, it shows that changes in the rate of land taxation may cause a bifurcation in the model's dynamical system and so may allow an economy with a low initial capital stock to break out of a “poverty trap” steady-state equilibrium.

In this paper, we set up a three-period stochastic overlapping-generations model to analyze the implications of income inequality and mobility for demand for redistribution and social insurance. We model the size of two different public programs under the welfare state. We investigate bidimensional voting on the tax rates that determine the allocation of government revenues among transfer payments and old-age pensions. We show that the coalitions formed, the resulting political equilibria, and the demand for redistribution crucially depend on the level of income inequality and mobility.

This paper surveys the first stage in the development of models of endogenous growth over the two decades between 1952 and 1973, including seminal works by Arrow, Frankel, Phelps, Uzawa, and others as faculty and graduate students who interacted in the Stanford–Chicago–MIT–Yale Nexus. The paper also deals with American Economic Association (AEA) and Econometric Society (ES) conference sessions over the period 1964–1968 on growth, technical progress, and innovations and with the contributions in the 1967 Shell volume, in addition to dissertations, working papers, and book chapters by those involved in the “first wave” over the period 1965–1973. Finally, the paper considers the initial efforts at building more sophisticated models based on technical progress, human capital, increasing returns and imperfect competition, and the incompatibility between increasing returns with competitive equilibrium.

This paper investigates the degree of comovements in quarterly Italian time series of sectoral output. A recently developed multivariate technique for the empirical analysis of long-run, cyclical and seasonal comovements is used in the context of a multisectoral real-business-cycle model augmented with persistent seasonal shocks in productivity. Our empirical results emphasize the role of input–output relations in the propagation mechanism and indicate that sectoral outputs have a relatively low number of common stochastic trends, in conflict with the hypothesis of independent productivity shocks. In contrast, stochastic seasonals seem to move idiosyncratically. Furthermore, our findings suggest that the theoretical model should be extended to allow for deterministic seasonal shifts in preferences.

This paper considers an optimal endogenous growth model where the production function is assumed to exhibit increasing returns to scale and two types of resource (renewable and nonrenewable) are imperfect substitutes. Natural resources, labor, and physical capital are used in the final goods sector and in the accumulation of knowledge. Based on results in the calculus of variations, a direct proof of the existence of an optimal solution is provided. Analytical solutions for the planner case, balanced growth paths, and steady states are found for a specific CRRA utility and Cobb–Douglas production function. It is possible to have long-run growth where both energy resources are used simultaneously along the equilibrium path. As the law of motion of the technological change is not concave, reflecting the increasing returns to scale, so that the Arrow–Mangasarian sufficiency conditions do not apply, we provide a sufficient condition directly. Transitional dynamics to the steady state from the theoretical model are used to derive three convergence equations of output intensity growth rate, exhaustible resource growth rate, and renewable resource growth rate, which are tested based on OECD data on production and energy consumption.