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Working papers

IGIER fellows and affiliates publish books and articles in academic journals. Their current research projects are featured in the Working Paper series. 

2011 - n° 405
We examine a model of limited communication in which the seller is selling a single good to two potential buyers. Limited communication is modeled as follows: in each of the finite number of periods the seller asks one of the two buyers a binary question. After the final answer, the allocation and the transfers are executed. The model sheds light on the communication protocols that arise in welfare maximizing mechanisms. Among other things, we show that when the total number of questions is bounded the welfare optimal mechanism requires the seller to start with questioning one of the buyers and conclude with a single last question to the other buyer.


Nenad Kos
2011 - n° 404
We study the distributional effects of globalization within a model of heterogeneous agents where both managerial talent and knowledge of the local economic environment are required in order to become a successful entrepreneur. Agents willing to set up a firm abroad incur a learning cost that depends on how different the foreign and domestic entrepreneurial environments are. In this context, we show that globalization fosters FDI and raises wages, output and productivity. However, not everybody wins. The steady state relationship between globalization and income is U-shaped: high- and low-income agents are better off in a globalized world, while middle-income agents (domestic entrepreneurs) are worse off. Thus, consistently with recent empirical evidence, the model predicts globalization to increase inequality at the top of the income distribution while decreasing it at the bottom.

Giovanni Pica and José V. Rodriguez Mora
Keywords: Distributional Effects of Globalization, Heterogeneous Agents, Income Inequality,Endogenous TFP, Multinational Firms
2011 - n° 403
We provide evidence that incumbent and entrant rms' access to business group deep pockets affects entry patterns in product markets. Relying on a unique French data set on business groups, our paper shows that entry in manufacturing industries is negatively related to the cash hoarded by incumbent-affiliated groups, and positively related to entrant groups' cash. In line with theoretical predictions, we nd that the impact on entry of group cash holdings is more important in environments where financial constraints are pronounced and in more financially dependent sectors. The cash holdings of incumbent and entrant groups also affect the survival rate of entrants in the 3 to 5 year post-entry window. Overall, our findings suggest that internal capital markets operate within corporate groups and affect the product market behavior of affiliated firms by mitigating financial constraints.

Xavier Boutin, Giacinta Cestone, Chiara Fumagalli, Giovanni Pica and Nicolas Serrano-Velarde
Keywords: Business Groups, Cash Holdings, Internal Capital Markets, Entry
2011 - n° 402
Part of a long-run project to put together a systematic database of prices and wages for the American continents, this paper takes a first look at standards of living in a series of North American and Latin American cities. From secondary sources we collected price data that –with diverse degrees of quality– covers various years between colonization and independence and, following the methodology now familiar in the literature, we built estimations of price indexes for Boston, Philadelphia, and the Chesapeake Bay region in North America and Bogot, Mexico, and Potos in Latin America exploring alternative assumptions on the characteristics of the reference basket. We use these indexes to deflate the (relatively more scarce) figures on wages, and compare the results with each other, and with the now widely known series for various European and Asian cities. We find that real wages were higher in North America than in Latin America from the very early colonial period: four times the World Bank Poverty Line (WBPL) in North America while only two times the WBPL in Latin America. These wages place the North American colonies among the most advanced countries in the world alongside Northwestern European countries and the Latin American colonies among the least developed countries at a similar level to Southern European and Asian countries. These wage differences existed from the early colonial period because wages in the American colonies were determined by wages in the respective metropoles and by the Malthusian population dynamics of indigenous peoples. Settlers would not migrate unless they could maintain their standard of living, so wages in the colonies were set in the metropole. Political institutions, forced labour regimes, economic geography, disease environments and culture shaped the size of the economy of each colony but did not affect income levels.

Robert C. Allen, Tommy E. Murphy and Eric B. Schneider
Keywords: economic history, real wages, standard of living, labour market, population,
2011 - n° 401
This paper examines the incomes of individuals who have joined self-help groups in poor neighborhoods of Nairobi. Self-help groups are often advocated as a way of facilitating income pooling. We ...nd that incomes are indeed more correlated among individuals in the same group than among individuals who belong to dierent groups. Using an original methodology, we test whether this correlation is due to self-selection of similar individuals into the same groups. We ...nd that this correlation is not driven by positive assortative matching. If anything, selection works in the opposite direction: incomes from group activities would be more correlated if individuals were matched at random. These ...ndings are consistent with the idea that self-help groups play a mutual assistance role.

Marcel Fafchamps and Eliana La Ferrara
Keywords: mutual insurance; social capital; associations; self-selection
2011 - n° 400
We consider decision makers that know that payo relevant observations are generated by a process that belongs to a given class M, as postulated in Wald [33]. We incorporate this Waldean piece of objective information within an otherwise subjective setting a la Savage [30] and show that this leads to a two-stages subjective expected utility model that accounts for both state and model uncertainty.


Simone Cerreia-Vioglio, Fabio Maccheroni, Massimo Marinacci andLuigi Montrucchio
2011 - n° 399
Do childhood events shape adult political views and behavior? This paper investigates the impact of Fourth of July celebrations in the US during childhood on partisanship and participation later in life. Using daily precipitation data to proxy for exogenous variation in participation on Fourth of July as a child, we examine the role of the celebrations for people born in 1920-1990. We find that days without rain on Fourth of July in childhood have lifelong effects. In particular, they shift adult views and behavior in favor of the Republicans and increase later-life political participation. Our estimates are significant: one Fourth of July without rain before age 18 raises the likelihood of identifying as a Republican by 2 percent and voting for the Republican candidate by 4 percent. It also increases voter turnout by 0.9 percent and boosts political campaign contributions by 3 percent. Taken together, the evidence suggests that important childhood events can have persistent effects on political beliefs and participation and that Fourth of July celebrations in the US affect the nation's political landscape.


Andreas Madestam and David Yanagizawa-Drott
2011 - n° 398
The existing empirical evidence does not yet provide a clear understanding of how leverage and expected equity returns are related. While some studies show a positive relationship between financial leverage and returns, others conclude that returns are either insensitive or decrease with leverage, after controlling for size and book-to-market. We re-examine this evidence by explicitly accounting for the dynamic nature of a firm's optimal leverage policy in the presence of frictions. Specifically, consistent with recent dynamic models of capital structure, we allow firms to temporarily deviate from their optimal capital structure due to adjustment costs. For each firm we estimate target leverage, and compute relative leverage as the difference between observed and target leverage. We find that relative leverage is positively and significantly related to expected equity returns, and has a dominant effect over size and book-to-market. The relative leverage premium shows a remarkable symmetry for over- and under-leveraged firms. Finally, the relative leverage premium is not captured by Fama and French's three-factor model, and it appears to be consistent with rational asset pricing. We conjecture that risk-averse investors require a higher expected return for over-leveraged stocks than for under-leveraged ones because the former are counter-cyclical, while the latter are cyclical.

Filippo Ippolito, Roberto Steri and Claudio Tebaldi
Keywords: leverage, cross section of returns, target leverage, dynamic capital
2011 - n° 397
We evaluate the effect of relaxing fiscal rules on policy outcomes applying a quasiexperimental research design. In 1999 the Italian central government introduced fiscal rules aimed at imposing fiscal discipline on municipal governments, and in 2001 relaxed the rules for municipalities below 5,000 inhabitants. This shift allows us to implement a "difference-in-discontinuities" design by combining the before/after with the discontinuous policy variation. Our estimates show that relaxing fiscal rules triggers a substantial deficit bias, captured by a shift from a balanced budget to a deficit that amounts to 2 percent of the total budget. The deficit comes primarily from reduced revenues as unconstrained municipalities show lower real estate and income tax rates. Finally, we investigate the heterogeneity in policy responses across municipalities to provide new evidence on the costs and benefits of restricting fiscal policy. The impact is larger if the mayor can run for reelection, the number of political parties in the city council is higher, voters are older, and the performance of the mayor in providing public goods is lower, consistent with models of the political economy of fiscal adjustment.

Veronica Grembi, Tommaso Nannicini and Ugo Troiano
Keywords: fiscal rules, local government finance, difference-in-discontinuities
2011 - n° 396
We derive envelope theorems for optimization problems in which the value function takes values in a general Banach lattice, and not necessarily in the real line. We impose no restriction whatsoever on the choice set. Our result extend therefore the ones of Milgrom and Segal (2002). We apply our results to discuss the existence of a well-defined notion of marginal utility of wealth in optimal consumption-portfolio problems in which the utility from consumption is additive but possibly state-dependent and, most importantly, the information structure is not required to be Markovian. In this general setting, the value function is itself a random variable and, if integrable, takes values in a Banach lattice so that our general results can be applied.


Anna Battauz, Marzia De Donno and Fulvio Ortu
2011 - n° 395
The goal of an individual searching for a marriage partner is typically to form a long-term relationship. Marital search is a complicated and costly activity, where opportunities typically arrive over time at uncertain intervals, each party has to evaluate each other's characteristics, and expectations play an important role. Given these features of marital search, a seminal paper by Mortensen (1988) has shown that the matching framework can be suited for the analysis of marriage markets and also raised the possibility of a thick market externality in these markets. We contribute to this literature by empirically investigating whether marriage markets are characterized by increasing, constant, or decreasing returns to scale. We focus on three societies-late medieval and early Renaissance Tuscany, China in the 1980s, and the United States in 2000-which are different in terms of population size, economic structure, sex ratios, marriage transfers, and the social norms governing marriage markets. Our main finding is that in all three societies, there is no evidence of increasing returns to scale in marriage markets, whereas the hypothesis of constant returns to scale cannot be rejected. The remarkably similar and precise estimates suggest that the number of eligibles (and potential contacts) in a marriage market is less important than economic factors, such as wealth levels and income dispersion, in affecting the marriage rate across different societies. The key message is that where individuals live, in large cities or small towns, have a minimal effect on their marriage rates.

Maristella Botticini and Aloysius Siow
Keywords: marriage markets, matching, thick market externality, returns to scale,
2011 - n° 394
This paper studies the asset pricing implications of a general equilibrium model in which real investment is reversible at a cost. Firms face higher costs in contracting than in expanding their capital stock and decide to invest when their productive capital is scarce relative to the overall capital of the economy. Positive shocks to the production process of the firm increase the size of the firm and reduce the value of growth options. As a result, the firm is burdened with more unproductive capital and its value lowers with respect to the accumulated capital. The optimal consumption policy alters the optimal allocation of resources and affects firm's value, generating mean-reverting dynamics for the M/B ratios. The model (1) captures convergence of price-to-book ratios - negative for growth stocks and positive for value stocks - (firm migration), (2) generates deviations from the classic CAPM in line with the cross-sectional variation in expected stock returns and (3) generates a non-monotone relationship between Tobin's q and conditional volatility consistent with the empirical evidence.

Giovanni W. Puopolo
Keywords: Investment; General equilibrium; Firm migration; Cross-section of returns; Book-to-market
2011 - n° 393
This paper studies a model where exclusive dealing (ED) can both promote investment and foreclose a more effcient supplier. While investment promotion is usually regarded as a pro-competitive effect of ED, our paper shows that it may be the very reason why a contract that forecloses a more effcient supplier is signed. Absent the effect on investment, the contract would not be signed and foreclosure would not be a concern. For this reason, considering potential foreclosure and investment promotion in isolation and then summing them up may not be a suitable approach to assess the net effect of ED. The paper therefore invites a more cautious attitude towards accepting possible investment promotion arguments as a defense for ED.
Chiara Fumagalli, Massimo Motta and Thomas Rönde
2011 - n° 392
The family is a primal institution, whose internal organization can be transferred to collective institutions, which come to substitute the family in one of its economic roles. We study how the family structure affected the initial design of pension systems. Our theoretical framework predicts that, when pensions systems are introduced in society with weak family ties, they act as a safety net, while in societies with strong ties pensions they replicate the tight link between generations and tend to provide generous benefits. Using Todd (1983) historical classification of family ties, we show that in societies dominated by absolute nuclear families, i.e. weak family ties (f.i. Anglo-Saxon countries), pension systems emerged as a safety net; and viceversa in societies dominated by strong families. Yet, historical family types are not correlated with the size of the pension systems, which have largely changed over time. These results are robust to controlling for alternative explanations, such as legal origin, religion, urbanization and democratization, electoral rules and forms of government. Moreover, evidence on individual data confirm the cross-country results: individuals whose ancestors came to the US from countries featuring communitarian or egalitarian nuclear families prefer to rely on the government as a provider of old age security through generous retirement benefits.

Vincenzo Galasso and Paola Profeta
Keywords: culture; institutions; family ties, pension design
2011 - n° 391
We study orders of risk and model uncertainty aversion in the smooth ambiguity model proposed by Klibano, Marinacci, and Mukerji [4]. We consider a quadratic approximation of their model and we show that both risk and model uncertainty attitudes have at most a second order effect. Specifically, the order depends on the properties of the support of the decision maker's limit prior, which we fully characterize. We find that model uncertainty attitudes have a second order effect unless the support is a singleton, that is, unless model uncertainty fades away in the limit. Special attention is given to the binomial state spaces often used in mathematical finance.


Fabio Maccheroni, Massimo Marinacci, Doriana Ruffino
2011 - n° 390
We use a new dataset on eight Italian cities and a novel identification strategy to analyze the relationship between the employment status of migrants and the percentage of migrants living nearby. Our data contain information at the very local level (i.e. the residential block) and are representative of the population of both legal and illegal migrants. Identification is based on an instrumental variable strategy that exploits the physical characteristics of the local buildings as a source of exogenous variation in the incidence of migrants in each location. We find evidence that migrants who reside in areas with a high concentration of non-Italians are less likely to be employed compared to similar migrants who reside in more mixed areas. This penalty is higher if the migrants leaving nearby are illegal and it is not mitigated by living close to migrants who are from own's ethnic group nor who are more proficient in the Italian language. The employment prospects of natives do not appear to be affected by the vicinity of migrants.

Tito Boeri, Marta De Philippis, Eleonora Patacchini, Michele Pellizzari
Keywords: Immigrant residential density, housing discrimination, ethnic networks
2011 - n° 389
Recent evidence on electronic limit order markets shows a growing use of undisclosed orders. This paper offers a theory for the optimal submission strategy in a limit order book where traders simultaneously select price, quantity and exposure, and choose among limit, market, reserve (partially undisclosed) and hidden (totally invisible) orders. Our findings show that to compete for the provision of liquidity in shallow markets relatively patient traders use reserve orders, whilst aggressive traders use hidden pegged orders to undercut depth at the top of liquid books. Undisclosed orders are effective defensive strategies against front running by parasitic traders, whereas they protect against picking-off by scalpers only in slow markets where Fill&Kill orders are not used. Finally, our results show that undisclosed orders increase market depth on the top of the book, but widen the inside spread; as a result they can benefit institutional investors but harm retail traders.


Sabrina Buti and Barbara Rindi
2011 - n° 388
In this paper we relate the very persistent component of interest rates to a specific demographic variable, MYt, the proportion of middle-aged to young population. We first reconsider the results in Fama (2006) to document how MYt captures the long run component identified by Fama in his analysis of the one-year spot rate. Using MYt to model this low frequency component of interest rates is particularly useful for forecasting the term structure as the demographic variable is exogenous and highly predictable, even at very long horizons. We then study the forecasting performance of a no-arbitrage affine term structure model that allows for the presence of a persistent component driven by demographics. This performance is superior to that of a traditional affine term structure model with macroeconomic factors (e.g. Ang, Dong and Piazzesi, 2005).

Carlo A. Favero, Arie E. Gozluklu, Haoxi Yang
Keywords: demographics, affine term-strucutre models, forecasting
2011 - n° 387
This paper proposes a test of racial bias in capital sentencing based upon patterns of judicial errors in lower courts. We model the behavior of the trial court as minimizing a weighted sum of the probability of sentencing an innocent and that of letting a guilty defendant free. We define racial bias as a situation where the relative weight on the two types of errors is a function of defendant and/or victim race. The key prediction of the model is that if the court is unbiased, ex post the error rate should be independent of the combination of defendant and victim race. We test this prediction using an original dataset that contains the the race of the defendant and of the victim(s) for all capital appeals that became final between 1973 and 1995. We find robust evidence of bias against minority defendants who killed white victims: in Direct Appeal and Habeas Corpus the probability of error in these cases is 3 and 9 percentage points higher, respectively, than for minority defendants who killed minority victims.


Alberto Alesina and Eliana La Ferrara
2011 - n° 386
We introduce and study finitely well-positioned sets, a class of asymptotically "narrow" sets that generalize the well-positioned sets recently investigated by Adly, Ernst and Thera in [1] and [3], as well as the plastering property of Krasnoselskii.


Massimo Marinacci and Luigi Montrucchio
2011 - n° 385
There is a large literature on social interactions and still little is known about the economic mechanisms leading to the high level of clustering in behavior that is so commonly observed in the data. In this paper we present a model in which agents are allowed to interact according to three distinct mechanisms, and we derive testable implications on the mean and the variance of the outcomes within and across groups. The empirical tests allow us to distinguish which mechanism(s) generates the observed patterns in the data. In our application we study the performance of undergraduate students and we find that social interactions take the form of mutual insurance. Such a result bears crucial policy implications for all those situations in which social interactions are important, from teamwork to class formation in education and co-authorship in academic research.

Giacomo De Giorgi and Michele Pellizzari
Keywords: Social interactions, peer effects, teamwork
2011 - n° 384
This paper contrasts measures of teacher effectiveness with the students' evaluations for the same teachers using administrative data from Bocconi University (Italy). The effectiveness measures are estimated by comparing the subsequent performance in follow-on coursework of students who are randomly assigned to teachers in each of their compulsory courses. We find that, even in a setting where the syllabuses are fixed, teachers still matter substantially. The average difference in subsequent performance between students who were assigned to the best and worst teachers (on the effectiveness scale) is approximately 43% of a standard deviation in the distribution of exam grades, corresponding to about 5.6% of the average grade. Additionally, we find that our measure of teacher effectiveness is negatively correlated with the students' evaluations of professors: in other words, teachers who are associated with better subsequent performance receive worst evaluations from their students. We rationalize these results with a simple model where teachers can either engage in real teaching or in teaching-to-the-test, the former requiring higher students' effort than the latter. Teaching-to-the-test guarantees high grades in the current course but does not improve future outcomes. Hence, if students are myopic and evaluate better teachers from which they derive higher utility in a static framework, the model is capable of predicting our empirical finding that good teachers receive bad evaluations, especially when teaching-to-the-test is very effective. Consistently with the predictions of the model, we also find that classes in which high skill students are over-represented produce evaluations that are less at odds with estimated teacher effectiveness.

Michela Braga, Marco Paccagnella and Michele Pellizzari
Keywords: Teacher quality, Postsecondary Education
2011 - n° 383
This paper uses a structural, large dimensional factor model to evaluate the role of 'news' shocks (shocks with a delayed effect on productivity) in generating the business cycle. We find that (i) existing small-scale VECM models are affected by 'non-fundamentalness' and therefore fail to recover the correct shock and impulse response functions; (ii) news shocks have a limited role in explaining the business cycle; (iii) their effects are in line with what predicted by standard neoclassical theory; (iv) the bulk of business cycle fluctuations are explained by shocks unrelated to technology.

Mario Forni, Luca Gambetti and Luca Sala
Keywords: structural factor model, news shocks, invertibility, fundamentalness
2011 - n° 382
Starting with the seminal paper of Gilboa and Schmeidler (1989) an analogy between the maxmin approach of Decision Theory under Ambiguity and the minimax approach of Robust Statistics -- e.g. Huber and Strassen (1973) -- has been hinted at. The present paper formally clarifies this relation by showing the conditions under which the two approaches are actually equivalent.


Simone Cerreia-Vioglio, Fabio Maccheroni, Massimo Marinacci and Luigi Montrucchio
2011 - n° 381
Many separable dynamic incentive problems have primal recursive formulations in which utility promises serve as state variables. We associate families of dual recursive problems with these by selectively dualizing constraints. We make transparent the connections between recursive primal and dual approaches, relate value iteration under each and give conditions for it to be convergent to the true value function.


Matthias Messner, Nicola Pavoni andChristopher Sleet
2011 - n° 380
In real-life elections, vote-counting is often imperfect. We analyze the consequences of such imperfections in plurality and runoff rule voting games. We call a strategy profile a robust equilibrium if it is an equilibrium if the probability of a miscount is positive but small.

All robust equilibria of plurality voting games satisfy Duverger's Law: In any robust equilibrium, exactly two candidates receive a positive number of votes. Moreover, robust- ness (only) rules out a victory of the Condorcet loser.

All robust equilibria under runoff rule satisfy Duverger's Hypothesis: First round votes vare (almost always) dispersed over more than two alternatives. Robustness has strong implications for equilibrium outcomes under runoff rule: For large parts of the parameter space, the robust equilibrium outcome is unique.

Matthias Messner and Mattias K. Polborn
Keywords: strategic voting, plurality rule, runoff rule, Duverger's Law and Hypothesis
2011 - n° 379
This is a survey of some of the recent decision-theoretic literature involving beliefs that cannot be quantified by a Bayesian prior. We discuss historical, philosophical, and axiomatic foundations of the Bayesian model, as well as of several alternative models recently proposed. The definition and comparison of ambiguity aversion and the updating of non-Bayesian beliefs are briefly discussed. Finally, several applications are mentioned to illustrate the way that ambiguity (or "Knightian uncertainty") can change the way we think about economic problems.


Itzhak Gilboa and Massimo Marinacci
2011 - n° 378
The available empirical evidence suggests that the distribution of income and its composition play an important role in explaining tax noncompliance. We address the issue from a macroeconomic point of view, building a dynamic general equilibrium Bewley- Huggett-Aiyagari model that jointly endogenizes tax evasion and income heterogeneity. Our results showthat the model can successfully replicate the salient qualitative and quantitative features of U.S. data. In particular, the model replicates fairly well the shape of the cross-sectional distribution of misreporting rates over true income levels. Furthermore, we show that a switch from progressive to proportional taxation has important quantitative effects on noncompliance rates and tax revenues.

Marco Maffezzoli
Keywords: Tax Evasion, Income Heterogeneity, Incomplete markets
2011 - n° 377
This article compares the impact of plague across Europe during the seventeenth century. It shows that, contrary to received wisdom, seventeenth century plague cannot be considered a "great equalizer": the disease affected southern Europe much more severely than the north. In particular, Italy was by far the area worst struck. Using both archival sources and previously published data, the article introduces a novel epidemiological variable that has not been considered in the literature: territorial pervasiveness of the contagion. This variable is much more relevant than local mortality rates in accounting for the different regional impact of plague. The article shows that pandemics, and not economic hardship, generated a severe demographic crisis in Italy during the seventeenth century --- at a time when northern European populations were growing quickly. Plague caused a "system shock" to the economy of the Italian peninsula that might be key in understanding the start of its relative decline compared to the emerging northern European countries.


Guido Alfani
2011 - n° 376
We analyze forward-induction reasoning in games with asymmetric information assuming some commonly understood restrictions on beliefs. Specifically, we assume that some given restrictions Δ on players' initial or conditional first-order beliefs are transparent, that is, not only the restrictions Δ hold, but there is common belief in Δ at every node. Most applied models of asymmetric information are covered as special cases whereby Δ pins down the probabilities initially assigned to states of nature. But the abstract analysis also allows for transparent restrictions on beliefs about behavior, e.g. independence restrictions or restrictions induced by the context behind the game. Our contribution is twofold. First, we use dynamic interactive epistemology to formalize assumptions that capture foward-induction reasoning given the transparency of Δ, and show that the behavioral implications of these assumptions are characterized by the Δ-rationalizability solution procedure of Battigalli (1999, 2003). Second, we study the differences and similarities between this solution concept and a simpler solution procedure put forward by Battigalli and Siniscalchi (2003). We show that the two procedures are equivalent if Δ is 'closed under compositions', a property that holds in all the applications considered by Battigalli and Siniscalchi (2003). We also show that when Δ is not closed under compositions the simpler solution procedure may fail to characterize the behavioral implications of forward induction reasoning.

Pierpaolo Battigalli and Andrea Prestipino
Keywords: Epistemic game theory, Rationalizability, Forward induction, Transparent restrictions on beliefs
2011 - n° 375
Interactive epistemology in dynamic games studies forms of strategic reasoning like backward induction and forward induction by formally representing the players' beliefs about each other, conditional on each history. Work on this topic typically relies on epistemic models where states of the world specify both strategies and beliefs. In this literature, strategies are interpreted as objective descriptions of what the players would choose at each history. But the intuitive interpretation of strategy is that of (subjective) contingent plan of action. As players do not delegate their moves to devices that mechanically execute a strategy, plans cannot be anything but beliefs of players about their own behavior. In this paper we analyze strategic reasoning in dynamic games with perfect information by means of epistemic models where behavior is described only by the play path, and players' beliefs include their contingent plans. We define rational planning, a property of beliefs only, and material consistency, which connects plans with choices on the play path. Material rationality is the conjunction of rational planning and material consistency. In perfect information games of depth two, the simplest dynamic games, correct belief in material rationality only implies a Nash outcome, not the backward-induction one. We have to consider stronger assumptions of persistence of belief in material rationality in order to obtain backward induction and forward induction. We relate our work to the existing literature, and we discuss the extension of our analysis to games with imperfect information.


Pierpaolo Battigalli, Alfredo Di Tillio and Dov Samet
2010 - n° 374
Trafficking of persons is a serious and very complex issue, although too often neglected, in many developing countries, including the Philippines. We make a first attempt to produce empirical research from the angle of development economists to assess the risk factors for entering into trafficking and evaluate the prospects of reintegration of trafficked victims. We have interviewed young women resident in shelters in the Cebu area and the sample consists of girls 14 years and above living in 12 shelters in the Cebu area. We find that trafficked victims have on average lower levels of education than the non-trafficked girls. Trafficking victims are also more likely to come from larger families. 20 percent of the girls came from households where the mother was absent during the last year she lived with her family. Therefore, as expected, income appears as a main factor of vulnerability. Any policy oriented to create safety nets for families at risk, empowering women, and create better labor opportunities for girls is likely to reduce to probabilities of entering into trafficking. In terms of family dynamics, trafficking victims come from families with relatively more inter-personal conflicts. There is also more prevalence of physical violence in houses where trafficked victims lived. The violent home environment of these vulnerable girls needs to be kept in mind when designing reintegration programs. Using techniques that elicit the expectations that the girls had when leaving their household and then comparing them with what actually happened, we observe that trafficked girls underestimate the cost of leaving the household (in terms of likelihood to get pregnant, ill, use drugs) and overestimate the benefits (in terms of likelihood to marry a foreign man and being able to send back money to the family). Moreover, we also find that friends are the most prevalent mode of recruitment of trafficking while the role of formal recruiters is less important. In our sample, only 27 percent of the girls obtained their job via a recruiter. Information campaigns to explain the danger of the jobs offered could contribute to stopping the trafficking phenomenon. Finally, important insights emerged by looking at inter-temporal preferences and risk preferences of our respondents, where these preferences were elicited using the tools of experimental economics. Former victims of trafficking exhibited a relatively high degree of impatience compared to other girls. On the other hand, both groups were extremely risk averse. These results suggests that an important role should be given, when designing reintegration programs for vulnerable girls – and especially former victims of trafficking – in working on the formation of their expectation, inter-temporal preferences and risk preferences.
Elsa Artadi, Martina Bjorkman, and Eliana La Ferrara
2010 - n° 373
We derive the analogue of the classic Arrow-Pratt approximation of the certainty equivalent under model uncertainty as defined by the smooth model of decision making under ambiguity of Klibanoff, Marinacci and Mukerji (2005). We study its scope via a portfolio allocation exercise that delivers a tractable mean-variance model adjusted for model uncertainty. In a problem with a risk-free asset, a risky asset, and an ambiguous asset, we find that portfolio rebalancing in response to higher model uncertainty only depends on the ambiguous asset's alpha, setting the performance of the risky asset as benchmark. In addition, the portfolios recommended by our model are not systematically conservative on the share held in the ambiguous asset: indeed, in general, it is not true that greater ambiguity reduces the optimal demand for the ambiguous asset. The analytical tractability of the enhanced Arrow-Pratt approximation renders our model especially well suited for calibration exercises aimed at exploring the consequences of ambiguity aversion on equilibrium asset prices.

'Crises feed uncertainty. And uncertainty affects behaviour, which feeds the crisis.'
Olivier Blanchard, The Economist, January 29, 2009


Fabio Maccheroni, Massimo Marinacci and Doriana Ruffino
2010 - n° 372
This paper presents a new model of occupational licensing, where producers are heterogeneous both in their ability or productivity and in the level of the barriers to entry in the profession that they face. The model bears important implications on the effects of liberalization policies that differ dramatically from those implied by the standard model, where heterogeneity is unidimensional in productivity. Specifically, we find that liberalization policies induce higher quality of services if barriers to entry are high for the most able agents. The opposite if such a correlation is low. We test these implications using detailed microdata on Italian lawyers and find a strong effect of the 2006 Italian liberalizing reform on the composition of the outflows from the legal profession. While higher ability lawyers are more likely to leave the profession before the reform, the opposite happens in its aftermaths, consistently with the idea that monopoly power selects high-productivity lawyers out of the profession.

Michele Pellizzari and Giovanni Pica
2010 - n° 371
We model a dynamic financial market where traders submit orders either to a limit order book (LOB) or to a Dark Pool (DP). We show that there is a positive liquidity externality in the DP, that orders migrate from the LOB to the DP, but that overall trading volume increases when a DP is introduced. We also demonstrate that DP market share is higher when LOB depth is high, when LOB spread is narrow, when the tick size is large and when traders seek protection from price impact. Further, while inside quoted depth in the LOB always decreases when a DP is introduced, quoted spreads can narrow for liquid stocks and widen for illiquid ones. We also show that traders' interaction with both LOB and DP generates interesting systematic patterns in order ‡ow: dierently from Parlour (1998), the probability of a continuation is greater than that of a reversal only for liquid stocks. In addition, when depth decreases on one side of LOB, liquidity is drained from DP. When a DP is added to a LOB, total welfare as well as institutional traders' welfare increase but only for liquid stocks; retail traders' welfare instead always decreases. Finally, when flash orders provide select traders with information about the state of the DP, we show that more orders migrate from the LOB to the DP, and DP welfare effects are enhanced.

Sabrina Buti, Barbara Rindi,and Ingrid M. Werner
2010 - n° 370
A characteristic function-based method is proposed to estimate the time-changed Levy models, which take into account both stochastic volatility and infinite-activity jumps. The method facilitates computation and overcomes problems related to the discretization error and to the non-tractable probability density. Estimation results and option pricing performance indicate that the infiniteactivity model performs better than the finite-activity one. By introducing a jump component in the volatility process, a double-jump model is also investigated.

Junye Lia, Carlo Favero and Fulvio Ortu
Keywords: Empirical characteristic function; Stochastic volatility; Infinite-activity jumps; Option pricing; Continuous GMM
2010 - n° 369
Why do people have kids in developed societies? We propose an empirical test of two economic theories of fertility - children as "consumption" or "investment" good. We use as a natural experiment the Italian pension reforms of the 90s, which by decreasing expected pension benefits generated a large negative income effect, with a sharp discontinuity across workers. This policy experiment is particularly well suited, since lower future pensions are expected to have differential effects on fertility under the "consumption" and 'investment' theories. Empirical analyses identify a causal, robust positive effect of less generous future pensions on postreform fertility. These findings are consistent with an "old-age security" motive also for contemporary fertility in advanced societies or with the original Becker- Lewis (1973) version of the "consumption" theory, based on the interaction between quantity and quality of children.

Francesco Billari and Vincenzo Galasso
Keywords: old-age security, quantity-quality trade-off, public pension systems,
2010 - n° 368
Is electoral competition good for political selection? To address this issue, we introduce a theoretical model where ideological parties select and allocate high-valence (experts) and lowvalence (party loyalists) candidates into electoral districts. Voters care about a national policy (e.g., party ideology) and the valence of their district's candidates. High-valence candidates are more costly for the parties to recruit. We show that parties compete by selecting and allocating good politicians to the most contestable districts. Empirical evidence on Italian members of parliament confirms this prediction: politicians with higher ex-ante quality, measured by years of schooling, previous market income, and local government experience, are more likely to run in contestable districts. Indeed, despite being different on average, politicians belonging to opposite political coalitions converge to high-quality levels in close electoral races. Furthermore, politicians elected in contestable districts make fewer absences in parliament, due to a selection effect more than to reelection incentives.

Vincenzo Galasso and Tommaso Nannicini
Keywords: political competition, political selection, probabilistic voting•
2010 - n° 367
The term structure of the stock market risk, defined as the per period conditional variance of cumulative returns, is measured in the strategic asset allocation literature (e.g. Campbell and Viceira (2002), (2005)) via multi-step ahead predictions from a VAR model of the joint process for one-period returns and their predictor, the dividend-price ratio. In this paper we modify the dynamic dividend growth model to allow for a time varying linearization point driven by the age structure of population. This specification leads to a decomposition of the dividend-price prices into an high volatility little persistence noise component, and a low volatility high persistence information component. The dividend-price ratio is mean reverting toward the time-varying mean and its deviations from it have a predicting power for returns that increases with the horizon. As a result of these two effects, the forward solution of the model delivers a negative sloping term structure of stock market risk. Direct regressions of returns at different horizons on the relevant predictors are much better suited to capture this feature than VAR based multi-period iterated forecasts. This evidence is very little affected by parameters' uncertainty and is robust to the existence of "imperfect predictiors", as a parsimoniuos parameterization is very precisely estimated and no-projections for future variables are needed in the direct regression approach.

Carlo A. Favero and Andrea Tamoni
Keywords: multiperiod iterated forecasts, direct regressions, stock marketrisk, demographics•
2010 - n° 366
We establish integral representation results for suitably pointwise continuous and comonotonic additive functionals of bounded variation defined on Stone lattices.

2000 Mathematics Subject Classification: Primary 28A12, 28A25, 46G12; Secondary 91B06


Simone Cerreia-Vioglio, Fabio Maccheroni, Massimo Marinacci and Luigi Montrucchio
2010 - n° 365
We use a standard quantitative business cycle model with nominal price and wage rigidities to estimate two measures of economic inefficiency in recent U.S. data: the output gap - the gap between the actual and effcient levels of output - and the labor wedge|the wedge between households' marginal rate of substitution and firms' marginal product of labor. We establish three results. (i ) The output gap and the labor wedge are closely related, suggesting that most inefficiencies in output are due to the inecient allocation of labor. (ii ) The estimates are sensitive to the structural interpretation of shocks to the labor market, which is ambiguous in the model. (iii ) Movements in hours worked are essentially exogenous, directly driven by labor market shocks, whereas wage rigidities generate a markup of the real wage over the marginal rate of substitution that is acyclical. We conclude that the model fails in two important respects: it does not give clear guidance concerning the effciency of business cycle fluctuations, and it provides an unsatisfactory explanation of labor market and business cycle dynamics.

Luca Sala, Ulf Soderstrom and Antonella Trigari
Keywords: Business cycles, Efficiency, Labor markets, Monetary Policy
2010 - n° 364
Recent developments in endogenous growth theory suggest fertility decline in the context of the demographic transition was crucial for achieving long-term growth, and that it was triggered by forces eminently economic in nature. It is then somewhat puzzling that France, which was not as industrialised as other parts of Europe, lead that decline. Taking advantage of the considerable internal heterogeneity, this paper looks within France for some answers. Using dpartement level data for the last quarter of the nineteenth century, it studies the correlates of fertility estimating a 2SLS fixed-effects model. Results confirm the importance of some of the forces suggested by standard fertility choice models. Nevertheless, certain non-economic factors (such as secularisation) -for which I provide new measurements- also explain part of the variation. Spatial dependence turns out as well to be significant in all specifications of the model, suggesting some sort of diffusion was indeed taking place.

Tommy E. Murphy
Keywords: Economic history, France, demographic transition, nineteenth century,fertility decline
2010 - n° 363
This paper brings the French case into the current debate on Malthusian dynamics in early modern times. In particular, it studies the long-term evolution of aggregate variables, showing that nineteenth century France was hardly a Malthusian world in a strict sense. Homeostasis was maintained throughout the century and there were signs of a strong positive check, but if there was some sort of preventive check, this was not 'written in stone'. The results of both cointegrated VAR and short-run analysis grant a reading where departure from the Malthusian world (if there ever was one) is due to a secular change in the relationship between income, marriages, and births. If this interpretation is correct, the fertility decline was instrumental in the sustained decline in mortalit1y during the century.

Tommy E. Murphy
Keywords: economic history, demographic history (Europe pre-1913), France, demographic economics, fertility, cointegrated VAR, short-run analysis
2010 - n° 362
Differences in college enrollment rates between poor and rich students are a prevalent phenomenon, but particularly striking in Latin America. The literature suggests explanations such as differences in "college preparedness" on the one hand, in that poor students lack skills that enable them to benefit from college, and "credit constraints" on the other hand. One explanation that has been neglected in this analysis consists of differences in information sets between the poor and the rich - for example about career opportunities-translating into different perceptions of individual returns to college. Data on people's subjective expectations of returns allow to take this factor into account and to directly address the following identification problem: conditional on their information sets poor people might expect low returns and thus decide not to attend. Or they might face high (unobserved) costs that prevent them from attending de-spite high expected returns. Conventional approaches rely on strong assumptions about people's information sets and about how they form expectations to address this identification problem.

Data on people's subjective expectations of returns as well as on their schooling decisions allow me to directly estimate and compare cost distributions of poor and rich individuals. I find that poor individuals require significantly higher expected returns to be induced to attend college, implying that they face higher costs than individuals with wealthy parents. I then test predictions of a model of college attendance choice in the presence of credit constraints, using parental income and wealth as a proxy for the household's (unobserved) interest rate. I find that poor individuals with high expected returns are particularly responsive to changes in direct costs, which is consistent with credit constraints playing an important role. Evaluating potential welfare implications by applying the Local Instrumental Variables approach of Heckman and Vytlacil (2005) to my model, I find that a sizeable fraction of poor individuals would change their decision in response to a reduction in direct costs. Individuals at the margin have expected returns that are as high or higher than the individuals already attending college, suggesting that government policies such as fellowship programs could lead to large welfare gains.

Katja Maria Kaufmann
Keywords: Schooling Choice, Credit Constraints, Subjective Expectations, Marginal Returns to Schooling, Local Instrumental Variables Approach, Mexico
2010 - n° 361
The currently available empirical evidence shows remarkable differences between various estimates of the effects on U.S output of an exogenous shift in Federal tax liabilities. Shocks identified via the narrative method, imply a multiplier of about three over . an horizon of three years. Tax shocks identified in fiscal VAR models deliver a much smaller multipier of about one. Is this heterogeneity real, or is it simply the result of different approaches to the identification of exogenous shifts in taxes? Or of different specifications of the empirical model used to estimate the tax multiplier? In this paper we reconcile this apparently contradictory evidence by showing that the large multiplier obtained via the narrative identification methods are generated by the choice of a limited information approach in their estimation and not by the different nature of the shocks. Using the shocks identified by a Narrative methods in a multivariate dynamic model delivers estimates of the tax multiplier very much in line with those obtained in the traditional fiscal VAR approach.

Carlo A. Favero and Francesco Giavazzi
Keywords: fiscal policy, public debt, government budget constraint, VARmodels
2010 - n° 360
This paper documents the existence of a slowly evolving trend in the dividendprice ratio, dpt , determined by a demographic variable, MY : the middle-aged to young ratio. Deviations of dpt from this long-run component explain transitory but persistent fluctuations in stock market returns. The relation between MY and dpt is a prediction of an overlapping generation model. The joint significance of MY and dpt in longhorizon forecasting regressions for market returns explain the mixed evidence on the ability of dpt to predict stock returns and provide a model-based interpretation of statistical corrections for breaks in the mean of this financial ratio.

Carlo A. Favero, Arie E. Gozlukluand Andrea Tamoni
Keywords: dynamic dividend growth model, long run returns predictability, demographics
2010 - n° 359
We characterize the boundaries of the set of transfers implementing a given allocation rule without imposing any assumptions on the agent's type space or utility function besides quasi-linearity. In particular, we characterize the pointwise largest and the pointwise smallest transfer that implement a given allocation rule and are equal to zero at some prespecied type (extremal transfers). Exploiting the concept of extremal transfers allows us to obtain an exact characterization of the set of all implementable allocation rules (the set of transfers is non-empty) and the set of allocation rules satisfying Revenue Equivalence (the extremal transfers coincide).

Furthermore, we show how the extremal transfers can be put to use in mechanism design problems where Revenue Equivalence does not hold. To this end we rst explore the role of extremal transfers when the agents with type dependent outside options are free to participate in the mechanism. Finally, we consider the question of budget balanced implementation. We show that an allocation rule can be implemented in an incentive compatible, individually rational and ex post budget balanced mechanism if and only if there exists an individually rational extremal transfer scheme that delivers an ex ante budget surplus.

Nenad Kos and Matthias Messner
Keywords: Incentive Compatibility, Revenue Equivalence, Budget Balance, Mechanism Design
2010 - n° 358
This paper uses a quasi-experimental strategy to disclose utterly political reasons behind the allocation of intergovernmental transfers in a federal state. We apply a regression discontinuity design in close elections to identify the effect of political alignment on federal transfers to municipal governments in Brazil. We find that municipalities where the mayor is affiliated with the coalition of the Brazilian President receive larger (discretionary) infrastructure transfers by about 40% in preelection years. This effect is mainly driven by the fact that the federal government penalizes municipalities run by mayors from the opposition coalition who won by a narrow margin, thereby tying their hands for the next election.

Fernanda Brollo and Tommaso Nannicini
Keywords: federal transfers, political alignment, regression discontinuity
2009 - n° 357
How to sustain cooperation is a key challenge for any society. Different social organizations have evolved in the course of history to cope with this challenge by relying on different combinations of external (formal and informal) enforcement institutions and intrinsic motivation. Some societies rely more on informal enforcement and moral obligations within their constituting groups. Others rely more on formal enforcement and general moral obligations towards society at large. How do culture and institutions interact in generating different evolutionary trajectories of societal organizations? Do contemporary attitudes, institutions and behavior reflect distinct pre-modern trajectories?

Avner Greif and Guido Tabellini
Keywords: Value, Culture, China, City, Cooperation
2009 - n° 356
The paper studies the effect of additional government revenues on political corruption and on the quality of politicians, both with theory and data. The theory is based on a version of the career concerns model of political agency with endogenous entry of political candidates. The evidence refers to municipalities in Brazil, where federal transfers to municipal governments change exogenously according to given population thresholds. We exploit a regression discontinuity design to test the implications of the theory and identify the causal effect of larger federal transfers on political corruption and the observed features of political candidates at the municipal level. In accordance with the predictions of the theory, we find that larger transfers increase political corruption and reduce the quality of candidates for mayor.

Fernanda Brollo, Tommaso Nannicini, Roberto Perotti and Guido Tabellini
Keywords: government spending, corruption, political selection
2009 - n° 355
This paper uses German micro data and a quasi-natural experiment to provide new evidence on the empirical importance of precautionary savings. Our quasi-natural experiment draws on a sharp increase in uncertainty (as reported in a survey of German citizens) observed in the run-up to the 1998 general election. Our estimates are obtained from a diff-in-diff estimator and thus overcome the identification problem that often aects measures of precautionary savings. We find that household saving increases significantly following the increase in uncertainty about the future path of income, suggesting a significant precautionary savings motive. We also analyze households'response in terms of labor market choices: we find evidence of a labor supply response by workers who can use the margin offered by part-time employment. While independent of the reasons why uncertainty increased in the run-up to the election, our results are suggestive of the economic effects of "wars of attrition", i.e. situations in which reforms are delayed because political parties are unable to agree on how the burden of a reform should be shared between various groups in society. Delays in adopting a reform, or the possibilty that a reform, after it has been adopted by one government might be revoked by another, raise uncertainty and induce households to save more: consumption may fall and the economy might slow down for no other reason than political uncertainty.

Francesco Giavazzi and Michael McMahon
Keywords: Precautionary savings; uncertainty and labor supply; wars of attrition
2009 - n° 354
University tuition typically remains constant throughout years of enrollment while delayed degree completion is an increasing problem for many academic institutions around the world. Theory suggests that if continuation tuition were raised the probability of late graduation would be reduced. Using a Regression Discontinuity Design on data from Bocconi University in Italy, we show that an increase of 1,000 euro in continuation tuition reduces the probability of late graduation by 9.9 percentage points with respect to a benchmark average probability of 80%. We conclude suggesting that an upward sloping tuition profile would be desirable when effort is sub-optimally supplied, for instance in the presence of public subsidies to education, congestion externalities and/or peer effects.

Pietro Garibaldi. Francesco Giavazzi, Andrea Ichino andEnrico Rettore
Keywords: Tuition, Students Performance, Regression Discontinuity
2009 - n° 353
We study whether cultural attitudes towards gender, the young, and leisure are significant determinants of the evolution over time of the employment rates of women and of the young, and of hours worked in OECD countries. Beyond controlling for a larger menu of policies, institutions and structural characteristics of the economy than has been done so far, our analysis improves upon existing studies of the role of "culture" for labor market outcomes by dealing explicitly with the endogeneity of attitudes, policies and institutions, and by allowing for the persistent nature of labor market outcomes. When we do all this we find that culture still matters for women employment rates and for hours worked. However, policies and other institutional or structural characteristics are also important. Attitudes towards youth independence, however, do not appear to be important in explaining the employment rate of the young. In the case of women employment rates, the policy variable that is significant along with attitudes, is the OECD index of employment protection legislation. For hours worked the policy variables that play a role, along with attitudes, are the tax wedge and unemployment benefits. The quantitative impact of these policy variables is such that changes in policies have at least the potential to undo the eect of variations in cultural traits on labor market outcomes.

Francesco Giavazzi, Fabio Schiantarelli and Michel Serafinelli
Keywords: Culture, Policies, Institutions, Employment, Hours
2009 - n° 352
We use a transparent statistical methodology for data-driven case studies-synthetic control methods-to investigate the impact of economic liberalization episodes on the pattern of real per capita GDP in a worldwide sample of countries. Economic liberalizations are measured by a widely used indicator that captures the scope of the market in the economy, mainly in terms of openness to international trade. The applied methodology compares the post- liberalization growth of treated (open) economies with the growth of a convex combination of similar but untreated (closed) economies, controlling for time-varying unobservables. We find that opening up the economy had a positive effect in most regions that we can analyze in our framework, but we note that more recent liberalizations (after 1990), mainly in Africa, had no significant impact on growth, indicating an early bird gain from globalization.

Andreas Billmeier and Tommaso Nannicini
Keywords: conomic liberalization, trade openness, growth, synthetic control methods
2009 - n° 351
This paper studies the case where a game is played in a particular context. The context influences what beliefs players hold. As such, it may affect forward induction reasoning: If players rule out specific beliefs, they may not be able to rationalize observed behavior. The effects are not obvious. Context-laden forward induction may allow outcomes precluded by context-free forward induction. At the formal level, forward induction and contextual reasoning are defined within an epistemic structure. In particular, we represent contextual forward induction reasoning as rationality and common strong belief of rationality"(RCSBR) within an arbitrary type structure. (The concept is due to Battigalli-Siniscalchi [6, 2002].) We ask: What strategies are consistent with RCSBR (across all type structures)? We show that the RCSBR is characterized by a solution concept we call Extensive Form Best Response Sets (EFBRS's). We go on to study the EFBRS concept in games of interest.


Pierpaolo Battigalli and Amand Friedenberg
2009 - n° 350
We use the time series of shifts in U.S. taxes constructed by Romer and Romer to estimate tax multipliers. Differently from the single-equation approach adopted by Romer and Romer, our estimation strategy (a Var that includes output, government spending and revenues, inflation and the nominal interest rate) does not rely upon the assumption that tax shocks are orthogonal to each other as well as to lagged values of other macro variables. Our estimated multiplier is much smaller: one, rather than three at a three-year horizon. When we split the sample in two sub-samples (before and after 1980) we find, before 1980, a multiplier whose size is never greater than one, after 1980 a multiplier not significantly different from zero. Following the findings in Bohn (1998), we also experiment with a model that includes debt and the non-linear government budget constraint. We find that, while in general not very important, the non-linearity that arises from the budget constraint makes a difference after 1980, when the response offiscal variables to the level of the debt becomes stronger.

Carlo Favero and Francesco Giavazzi
Keywords: fiscal policy, public debt, government budget constraint, VAR models
2009 - n° 349
We analyze optimal policy design when firms' research activity may lead to socially harmful innovations. Public intervention, affecting the expected profitability of innovation, may both thwart the incentives to undertake research (average deterrence) and guide the use to which innovation is put (marginal deterrence). We show that public intervention should become increasingly stringent as the probability of social harm increases, switching First from laissez-faire to a penalty regime, then to a lenient authorization regime, and finally to a strict one. In contrast, absent innovative activity, regulation should rely only on authorizations, and laissez-faire is never optimal. Therefore, in innovative industries regulation should be softer.

Giovanni Immordino, Marco Pagano and Michele Polo
Keywords: innovation, liability for harm, safety regulation, authorization
2009 - n° 348
We compare single round vs runoff elections under plurality rule, allowing for partly endogenous party formation. Under runoff elections, the number of political candidates is larger, but the influence of extremist voters on equilibrium policy and hence policy volatility are smaller, because the bargaining power of the political extremes is reduced compared to single round elections. The predictions on the number of candidates and on policy volatility are confirmed by evidence from a regression discontinuity design in Italy, where cities above 15,000 inhabitants elect the mayor with a runoff system, while those below hold single round elections.

Massimo Bordignon, Tommaso Nannicini and Guido Tabellini
2008 - n° 347
I study the coexistence of formal and informal finance in underdeveloped credit markets. Formal banks have access to unlimited funds but are unable to control the use of credit. Informal lenders can prevent non-diligent behavior but often lack the needed capital. The model implies that formal and informal credit can be either complements or substitutes. The model also explains why weak legal institutions raise the prevalence of informal finance in some markets and reduce it in others, why financial market segmentation persists, and why informal interest rates can be highly variable within the same sub economy.

Andreas Madestam
Keywords: Credit markets; Financial development; Institutions; Market structure
2008 - n° 346
The wage paid to elected officials affects both the choice of citizens to run for office and the performance of those who are appointed. On the one hand, if skilled individuals shy away from politics because of higher opportunities in the private sector, an increase in politicians' pay may change their mind. On the other hand, if the reelection prospects of incumbents depend on their in-office deeds, a higher wage may foster performance. We use data on all Italian municipalities from 1993 to 2007 to test these hypotheses in a quasi-experimental framework. In Italy, the wage of the mayor depends on population size and sharply increases at nine thresholds. We apply a regression discontinuity design to two thresholds that uniquely identify a wage increase (1,000 and 5,000 inhabitants) to control for unobservable town characteristics. Exploiting the existence of a two-term limit, we further disentangle the composition from the incentive component of the impact of the wage on performance. The empirical results show that a higher wage attracts more educated and high-skilled candidates, and that better paid politicians lessen the government machinery by reducing per-capita taxes, tariffs, and current expenditure, while leaving investments unchanged. Importantly, most of the performance effect is driven by the selection of better candidates, rather than the incentive to be reelected.

Stefano Gagliarducci and Tommaso Nannicini
Keywords: political selection, efficiency wage, term limit, local finance, regression discontinuity design
2008 - n° 345
The dynamic dividend growth model (Campbell&Shiller, 1988) linking the log dividend yield to future expected dividend growth and stock market returns has been extensively used in the literature for forecasting stock returns. The empirical evidence on the performance of the model is mixed as its strength varies with the sample choice. This model is derived on the assumption of stationary dpt, dividend-yield. The empirical validity of such hypothesis has been challenged in recent literature (Lettau&Van Nieuwerburgh, 2007) with strong evidence on a time varying mean, due to breaks, in this financial ratio. In this paper, we show that the slowly evolving mean toward which the dividend price ratio is reverting is determined by demographic factors. We also show that a forecasting model based on demographics and a demand factor as captured by excess consumption in the sense of Lettau and Ludvigson(2004) overperforms virtually all alternative models proposed in the empirical literature in the framework of the dynamic dividend growth model. Finally, we exploit the predictability of demographic factors to project the equity risk premium up to 2050.

Andrea Tamoni, Arie E.Gozluklu and Carlo A.Favero
Keywords: dynamic dividend growth model, demographics, cointegration, forecasting stock market returns
2008 - n° 344
This paper investigates whether or not the adoption of the Euro has
facilitated the introduction of structural reforms, defined as deregulation
in the product markets and liberalization and deregulation in the labor
markets. After reviewing the theoretical arguments that may link the
adoption of the Euro and structural reforms, we investigate the empirical
evidence. We find that the adoption of the Euro has been associated with
an acceleration of the pace of structural reforms in the product market.
The adoption of the Euro does not seem to have accelerated labor market
reforms in the "primary labor market;" however, the run up to the Euro
adoption seems to have been accompanied by wage moderation. We also
investigate issues concerning the sequencing of goods and labor market

Alberto Alesina, Silvia Ardagna and Vincenzo Galasso
Keywords: Euro, structural reforms, deregulation, European labor markets
2008 - n° 343
Why do people have kids in developed societies? We propose an empirical test of
two alternative theories - children as consumption vs. investment good. We use
as a natural experiment the Italian pension reforms of the 90s that introduced a clear
discontinuity in the treatment across workers. This policy experiment is particularly
well suited, since the consumption motive predicts lower future pensions to reduce
fertility, while the old-age security to increase it. Our empirical analysis identifies
a clear and robust positive effect of less generous future pensions on post-reform
fertility. These findings are consistent with old-age security even for contemporary

Francesco C. Billari and Vincenzo Galasso
Keywords: old-age security, public pension systems, fertility, altruism
2008 - n° 342
In a stochastic two-period OLG model, featuring an aggregate shock to the economy,
ex-ante optimality requires intergenerational risk sharing. We compare the level
of time-consistent intergenerational risk sharing chosen by a social planner and by office
seeking politicians. In the political setting, the transfer of resources across generations
- a PAYG pension system - is determined as a Markov equilibrium of a probabilistic
voting game. Negative shocks represented by low realized returns on the risky asset
induce politicians to compensate the old through a PAYG system. Unless the young are
crucial to win the election, this political system generates more intergenerational risk
sharing than the (time consistent) social optimum. In particular, these transfers are
more persistent and less responsive to the realization of the shock than optimal. This is
because politicians anticipate their current transfers to the elderly to be compensated
through offsetting transfers by future politicians, and thus have an incentive to overspend.
Perhaps surprisingly, aging increases the socially optimal transfer but makes
politicians less likely to overspend, by making it more costly for future politicians to
compensate the current young.

Marcello DAmato and Vincenzo Galasso
Keywords: Pension Systems, Markov equilibria, social optimum
2008 - n° 341

We develop and estimate a medium scale macroeconomic model that allows for unemployment
and staggered nominal wage contracting. In contrast to most existing quantitative models,
employment adjustment is on the extensive margain and the employment of existing workers is
efficient. Wage rigidity, however, affects the hiring of new workers. The former is introduced
via the staggered Nash bargaing setup of Gertler and Trigari (2006). A robust finding is that
the model with wage rigidity provides a better description of the data than does a flexible wage
version. Overall, the model fits the data roughly as well as existing quantitative macroeconomic
models, such as Smets and Wouters (2007) or Christiano, Eichenbaum and Evans (2005). More
work is necessary, however, to ensure a robust identification of the key labor market parameters.

Mark Gertler, Luca Sala and Antonella Trigari
2008 - n° 340
We use an interactive epistemology framework to provide a systematic analysis of some solu- tion concepts for games with asymmetric information. We characterize solution concepts using expressible epistemic assumptions, represented as events in the canonical space generated by primitive uncertainty about the payoff relevant state, payoff irrelevant information, and actions. In most of the paper we adopt an interim perspective, which is appropriate to analyze genuine incomplete information. We relate Delta-rationalizability (Battigalli and Siniscalchi, 2003) to interim correlated rationalizability (Dekel, Fudenberg, and Morris, 2007) and to rationalizability in the interim strategic form. We also consider the ex ante perspective, which is appropriate to ana- lyze asymmetric information about an initial chance move. We prove the equivalence between interim correlated rationalizability and an ex ante notion of correlated rationalizability.

Pierpaolo Battigalli, Alfredo Di Tillio, Edoardo Grillo and Antonio Penta
Keywords: asymmetric information, type spaces, Bayesian games, rationalizability
2008 - n° 339
We study the relation between the off-shoring of intermediates and services
and productivity growth in the Italian manufacturing industries in 1995-2003.
Our results indicate that the off-shoring of intermediates within the same
industry (narrow off-shoring) is beneficial for productivity growth, while
the off-shoring of services is not. We also find that the way in which off-
shoring is measured may matter considerably. The positive relation between off-
shoring of intermediates and productivity growth is there with our direct
measures based on input-output data but disappears when either a broad measure
or the Feenstra-Hanson off-shoring measure employed in other studies are used

Francesco Daveri and Cecilia Jona-Lasinio
Keywords: Off-shoring; productivity growth; Italy's decline; Manufacturing
2008 - n° 338
We consider a model in which voters over time receive more information about
their preferences concerning an irreversible social decision. Voters can either implement
the project in the first period, or they can postpone the decision to the
second period. We analyze the effects of different majority rules. Individual first
period voting behavior may become "less conservative" under supermajority rules,
and it is even possible that a project is implemented in the first period under a
supermajority rule that would not be implemented under simple majority rule.
We characterize the optimal majority rule, which is a supermajority rule. In
contrast to individual investment problems, society may be better off if the option
to postpone the decision did not exist. These results are qualitatively robust to
natural generalizations of our model.

Matthias Messner and Mattias K. Polborn
Keywords: supermajority rules, information, investment, option value
2008 - n° 337
We analyze the effect of judicial errors on the innovative activity of firms.
If successful, the innovative effort allows to take new actions that may be ex-post wel-
fare enhancing (legal) or decreasing (illegal). Deterrence in this setting works by affecting
the incentives to invest in innovation (average deterrence). Type-I errors, through over-
enforcement, discourage innovative effort while type-II errors (under-enforcement) spur it.
The ex-ante expected welfare effect of innovations shapes the optimal policy design. When
innovations are ex-ante welfare improving, laissez-faire is chosen. When innovations are
instead welfare decreasing, law enforcement should limit them through average deterrence.
We consider several policy environments differing in the instruments available. Enforcement
effort is always positive and fines are (weakly) increasing in the social loss of innovations. In
some cases accuracy is not implemented, contrary to the traditional model where it always
enhances (marginal) deterrence, while in others it is improved selectively only on type-II
errors (asymmetric protocols of investigation).

Giovanni Immordino and Michele Polo
Keywords: norm design, innovative activity, enforcement, errors
2008 - n° 336
In 2003 the Brazilian central government (CG) launched an anti-corruption program. Since then municipalities have been randomly selected to be audited on a monthly basis. Evidence in the literature suggests that the probability of re-election of an incumbent mayor decreases as the number of reported corruption violations rises before the municipal elections. By exploiting the exogenous variation in the timing of the release of the audit reports and the Brazilian institutional scheme, this paper sheds light on the mechanisms through which the Brazilian anti-corruption program functions. After the release of the audit reports, municipalities where more than two corruption violations were reported receive 26% fewer transfers from the CG. Total expenditure on infrastructure is also reduced. While the CG increases the amount of transfers to municipalities where the mayor is both affiliated with the partys president and found to be honest, it helps politically aligned municipalities with high levels of released corruption to move through the punishment process more quickly. The effects of the dissemination of corruption information on the probability of re-election of incumbent mayors seem to gradually disappear with time. Yet, when these effects have completely faded and voters have time to feel the consequences of receiving fewer transfers, the probability of re-election of corrupt politicians decreases.

Fernanda Brollo
Keywords: Intergovernmental transfers, corruption, accountability, decentralization
2008 - n° 335
This paper brings together several important strands of the econometrics literature: errorcorrection,
cointegration and dynamic factor models. It introduces the Factor-augmented Error
Correction Model (FECM), where the factors estimated from a large set of variables in levels
are jointly modelled with a few key economic variables of interest. With respect to the standard
ECM, the FECM protects, at least in part, from omitted variable bias and the dependence of
cointegration analysis on the specific limited set of variables under analysis. It may also be in
some cases a refinement of the standard Dynamic Factor Model (DFM), since it allows us to
include the error correction terms into the equations, and by allowing for cointegration prevent
the errors from being non-invertible moving average processes. In addition, the FECM is a
natural generalization of factor augmented VARs (FAVAR) considered by Bernanke, Boivin and
Eliasz (2005) inter alia, which are specified in first differences and are therefore misspecified in
the presence of cointegration. The FECM has a vast range of applicability. A set of Monte Carlo
experiments and two detailed empirical examples highlight its merits in finite samples relative to
standard ECM and FAVAR models. The analysis is conducted primarily within an in-sample
framework, although the out-of-sample implications are also explored.

Anindya Banerjee and Massimiliano Marcellino
Keywords: Dynamic FactorModels, Error CorrectionModels, Cointegration, Factor-augmented Error Correction Models, VAR, FAVAR
2008 - n° 334
We conduct a detailed simulation study of the forecasting performance of
diffusion index-based methods in short samples with structural change. We
consider several data generation processes, to mimic different types of
structural change, and compare the relative forecasting performance of factor
models and more traditional time series methods. We find that changes in the
loading structure of the factors into the variables of interest are extremely
important in determining the performance of factor models. We complement
the analysis with an empirical evaluation of forecasts for the key
macroeconomic variables of the Euro area and Slovenia, for which relatively
short samples are officially available and structural changes are likely. The
results are coherent with the findings of the simulation exercise, and confirm
the relatively good performance of factor-based forecasts also in short samples
with structural change.

Anindya Banerjee, Massimiliano Marcellino and Igor Masten
Keywords: Factor models, forecasts, time series models, structural change, shortsamples, parameter uncertainty
2008 - n° 333
This paper compares different ways to estimate the current state of the economy using factor
models that can handle unbalanced datasets. Due to the different release lags of business cycle
indicators, data unbalancedness often emerges at the end of multivariate samples, which is some-
times referred to as the 'ragged edge' of the data. Using a large monthly dataset of the German
economy, we compare the performance of different factor models in the presence of the ragged edge:
static and dynamic principal components based on realigned data, the Expectation-Maximisation
(EM) algorithm and the Kalman smoother in a state-space model context. The monthly factors
are used to estimate current quarter GDP, called the 'nowcast', using different versions of what
we call factor-based mixed-data sampling (Factor-MIDAS) approaches. We compare all possible
combinations of factor estimation methods and Factor-MIDAS projections with respect to now-
cast performance. Additionally, we compare the performance of the nowcast factor models with
the performance of quarterly factor models based on time-aggregated and thus balanced data,
which neglect the most timely observations of business cycle indicators at the end of the sample.
Our empirical findings show that the factor estimation methods don't differ much with respect
to nowcasting accuracy. Concerning the projections, the most parsimonious MIDAS projection
performs best overall. Finally, quarterly models are in general outperformed by the nowcast factor
models that can exploit ragged-edge data.

Massimiliano Marcellino and Christian Schumacher
Keywords: nowcasting, business cycle, large factor models, mixed-frequency data, missing values, MIDAS
2008 - n° 332
A reduction in income tax rates generates substantial dynamic responses within the frame-
work of the standard neoclassical growth model. The short-run revenue loss after an in-
come tax cut is partly -- or, depending on parameter values, even completely -- offset
by growth in the long-run, due to the resulting incentives to further accumulate capital.
We study how the dynamic response of government revenue to a tax cut changes if we
allow a Ramsey economy to engage in international trade: the open economy's ability to
reallocate resources between labor-intensive and capital-intensive industries reduces the
negative effect of factor accumulation on factor returns, thus encouraging the economy to
accumulate more than it would do under autarky. We explore the quantitative implica-
tions of this intuition for the US in terms of two issues recently treated in the literature:
dynamic scoring and the Laffer curve. Our results demonstrate that international trade
enhances the response of government revenue to tax cuts by a relevant amount. In our
benchmark calibration, a reduction in the capital-income tax rate has virtually no effect
on government revenue in steady state.

Alejandro Cuat, Szabolcs Dek and Marco Maffezzoli
Keywords: international trade, Heckscher-Ohlin, dynamic macroeconomics, taxation, revenue estimation, Laffer Curve
2008 - n° 331
This paper studies monetary policy in the Euro area looking at the
variable most directly related to current and expected monetary policy,
the yield on long term government bonds. We find that the level of longterm
rates in Europe is almost entirely explained by U.S. shocks and by
the systematic response of U.S. and European variables (inflation, short
term rates and the output gap) to these shocks. Our results suggest in
particular that U.S. variables are more important than local variables
in the policy rule followed by European monetary authorities: this was
true for the Bundesbank before EMU and has remained true for the
ECB, at least so far. Using closed economy models to analyze monetary
policy in the Euro is thus inconsistent with the empirical evidence on the
determinants of Euro area long-term rates. It is also inconsistent with
the way the Governing Council of the ECB appears to make actual policy

Carlo Favero and Francesco Giavazzi
Keywords: Euro area, long-term rates, monetary policy
2007 - n° 330
How and why does distant political and economic history shape
the functioning of current institutions? This paper argues that individual
values and convictions about the scope of application of norms
of good conduct provide the "missing link". Evidence from a variety
of sources points to two main findings. First, individual values consistent
with generalized (as opposed to limited) morality are widespread
in societies that were ruled by non-despotic political institutions in
the distant past. Second, well functioning institutions are often observed
in countries or regions where individual values are consistent
with generalized morality, and under different identifying assumptions
this suggests a causal effect from values to institutional outcomes. The
paper ends with a discussion of the implications for future research.

Guido Tabellini
Keywords: culture, institutions, growth, political economy
2007 - n° 329
This chapter concentrates on the Econometrics of Monetary Policy. We describe
the evolution of models estimated to evaluate the macroeconomic impact of the
effect of monetary policy . We argue that the main challenge for the
econometrics of monetary policy is the combination of theoretical models and
information from the data to construct empirical models. The failure of the
large econometrics models at the beginning of the 1970s might be explained by
their incapability of taking proper account of both these aspects. The great
critiques by Lucas and Sims have generated an alternative approach which, at
least initially, has been almost entirely dominated by theory. The LSE
approach has instead concentrated on the properties of the statistical models
and on the best way of incorporating information from the data into the
empirical models, paying little attention to the economic foundation of the
adopted specification. The realization that the solution of a DSGE model can
be approximated by a restricted VAR, which is also a statistical model, has
generated a potential link between the two approaches. The open question is
which type of VARs are most appropriate for the econometric analysis of
monetary policy.

Carlo A. Favero
Keywords: Econometrics, Monetary Policy, identification, DSGE, VAR, FAVAR
2007 - n° 328
What explains the range of situations in which individuals cooperate?
This paper studies a theoretical model where individuals respond
to incentives but are also influenced by norms of good conduct inherited
from earlier generations. Parents rationally choose what values to
transmit to their offspring, and this choice is influenced by the quality
of external enforcement and the pattern of likely future transactions.
The equilibrium displays strategic complementarities between values
and current behavior, which reinforce the effects of changes in the
external environment. Values evolve gradually over time, and if the
quality of external enforcement is chosen under majority rule, there is
histeresis: adverse initial conditions may lead to a unique equilibrium
path where external enforcement remains weak and individual values
discourage cooperation.

Guido Tabellini
Keywords: culture, cooperation, institutions, cultural transmission
2007 - n° 327

This paper reconsiders the developments of model evaluation in macroeconometrics over the last forty years. Our analysis starts from the failure of early empirical macroeconomic models caused by stagflation in the seventies. The different diagnosis of this failure are then analyzed to classify them in two groups: explanations related to problems in the theoretical models that lead to problems in the identification of the relevant econometric model and explanations related to problems in the underlying statistical model that lead to misspecification of the relevant econometric model. Developments in macroeconometric model evaluation after the failure of the Cowles foundation models are then discussed to illustrate how the different critiques have initiated different approaches in macroeconometrics. The evolution of what has been considered the consensus approach to macroeconometric model evaluation over the last thirty years is then followed. The criticism moved to Cowles foundation models in the early seventies might apply almost exactly to DSGE-VAR model evaluation in the first decade of
the new millenium. However, the combination of general statistical model, such as a Factor Augmented VAR, with a DSGE model seems to produce forecasts that perform better than those based exclusively on the theoretical and on the statistical model.

Carlo A. Favero
Keywords: Macroeconometrics, Model Evaluation
2007 - n° 326
In response to extensive corruption in the education sector, the Government
of Uganda began to publish newspaper ads on the timing and amount of funds
disbursed to the districts. The intent of the campaign was to boost schools' and
parents' ability to monitor the local officials in charge of disbursing funds to the
schools. The mass information campaign was successful. But since newspaper
penetration varies greatly across districts, the exposure to information about the
program, and thus funding, dier across districts. I use this variation in program
exposure between districts to evaluate whether public funds have an effect on
student performance. The results show that money matters: On average, stu-
dents in districts highly exposed to the information campaign, and hence to the
grant program, scored 0.40 standard deviations better in the Primary Leaving
Exam (PLE) than students in districts less exposed to information. The results
are robust to controlling for a broad range of confounding factors.

Martina Bjrkman
Keywords: Primary education; Capitation grant; Test scores; Uganda
2007 - n° 325
We examine the effect of trust on financial investment and contracting decisions in a micro-economic environment where trust is exogenous. Using hand-collected data on European venture capital, we show that the Eurobarometer measure of trust among nations significantly affects investment decisions. This holds even after controlling for investor and company fixed effects, geographic distance, information and transaction costs. The national identity of venture capital firms' individual partners further contributes to the effect of trust. Education and work experience reduce the effect of trust but do not eliminate it. We also examine the relationship between trust and sophisticated contracts involving contingent control rights and find that, even after controlling for endogeneity, they are complements, not substitutes.

Laura Bottazzi, Marco Da Rin and Thomas Hellmann
Keywords: Venture Capital, Social Capital, Trust, Financial Contracts, Corporate Governance
2007 - n° 324
Dynamic Stochastic General Equilibrium (DSGE) models are now con-
sidered attractive by the profession not only from the theoretical perspec-
tive but also from an empirical standpoint. As a consequence of this
development, methods for diagnosing the fit of these models are being
proposed and implemented. In this article we illustrate how the concept
of statistical identification, that was introduced and used by Spanos(1990)
to criticize traditional evaluation methods of Cowles Commission models,
could be relevant for DSGE models. We conclude that the recently pro-
posed model evaluation method, based on the DSGE - VAR(λ), might not satisfy
the condition for statistical identification. However, our appli-
cation also shows that the adoption of a FAVAR as a statistically identified
benchmark leaves unaltered the support of the data for the DSGE model
and that a DSGE-FAVAR can be an optimal forecasting model.

Agostino Consolo, Carlo A. Favero andAlessia Paccagnini
Keywords: Bayesian analysis; Dynamic stochastic general equilibrium model; Model evaluation, Statistical Identification, Vector autoregression, Factor-Augmented Vector Autoregression
2007 - n° 323
The paper explores the determinants of yield differentials between sovereign
bonds in the Euro area. There is a common trend in yield differentials, which
is correlated with a measure of aggregate risk. In contrast, liquidity differentials
display sizeable heterogeneity and no common factor. We propose a simple model
with endogenous liquidity demand, where a bond's liquidity premium depends both
on its transaction cost and on investment opportunities. The model predicts that
yield differentials should increase in both liquidity and risk, with an interaction
term of the opposite sign. Testing these predictions on daily data, we find that
the aggregate risk factor is consistently priced, liquidity differentials are priced for
a subset of countries, and their interaction with the risk factor is in line with the
model's prediction and crucial to detect their effect.

Carlo Favero, Marco Pagano and Ernst-Ludwig von Thadden
2007 - n° 322

We estimate the effect of political regime transitions on growth with semi-parametric methods, combining difference in differences with
matching, that have not been used in macroeconomic settings. Our semi-parametric estimates suggest that previous parametric estimates
may have seriously underestimated the growth effects of democracy. In particular, we find an average negative effect on growth of leav-
ing democracy on the order of -2 percentage points implying effects on income per capita as large as 45 percent over the 1960-2000 panel.
Heterogenous characteristics of reforming and non-reforming countries appear to play an important role in driving these results.

Torsten Persson and Guido Tabellini
2007 - n° 321
Development accounting exercises based on an aggregate production function find tech-
nology is biased in favor of a country's abundant production factors. We provide an expla-
nation to this finding based on the Heckscher-Ohlin model. Countries trade and specialize
in the industries that use intensively the production factors they are abundantly endowed
with. For given factor endowment ratios, this implies smaller international differences in
factor price ratios than under autarky. Thus, when measuring the factor bias of technol-
ogy with the same aggregate production function for all countries, they appear to have
an abundant-factor bias in their technologies.

Alejandro Cuat and Marco Maffezzoli
Keywords: International Trade, Heckscher-Ohlin, Simulation, Development Account-ing
2007 - n° 320
In this paper we analyze a novel dataset of Business and Consumer Surveys, using dynamic
factor techniques, to produce composite coincident indices (CCIs) at the sectoral
level for the European countries and for Europe as a whole. Few CCIs are available
for Europe compared to the US, and most of them use macroeconomic variables and
focus on aggregate activity. However, there are often delays in the release of macroeconomic
data, later revisions, and differences in the definition of the variables across
countries, while the surveys are timely available, not subject to revision, and fully comparable
across countries. Moreover, there are substantial discrepancies in activity at
the sectoral level, which justifies the interest in a sectoral disaggregation. Compared
to the Confidence Indicators produced by the European Commission, which are based
on a simple average of the aggregate survey answers, we show that factor based CCIs,
using survey answers at a more disaggregate level, produce higher correlation with the
reference series for the majority of sectors and countries.

Andrea Carriero and Massimiliano Marcellino
Keywords: Coincident Indicators, Business and Consumer Surveys, Sectors, DynamicFactor Models
2007 - n° 319
Monitoring the current status of the economy is quite relevant for policy making
but also for the decisions of private agents, consumers and firms. Since it is difficult
to identify a single variable that provides a good measure of current economic
conditions, it can be preferable to consider a combination of several coincident indicators,
i.e., a composite coincident index (CCI). In this paper, we review the main
statistical techniques for the construction of CCIs, propose a new pooling-based
method, and apply the alternative techniques for constructing CCIs for the largest
European countries in the euro area and for the euro area as a whole. We find that
different statistical techniques yield comparable CCIs, so that it is possible to reach
a consensus on the status of the economy.

Andrea Carriero and Massimiliano Marcellino
Keywords: Business Cycles, Leading Indicators, Coincident Indicators, TurningPoints, Forecasting
2007 - n° 318
This paper addresses the issue of forecasting the term structure.
We provide a unified state-space modelling framework that encom-
passes different existing discrete-time yield curve models. within such
framework we analyze the impact on forecasting performance of two
crucial modelling choices, i.e. the imposition of no-arbitrage restric-
tions and the size of the information set used to extract factors. Using
US yield curve data, we find that: a. macro factors are very useful in
forecasting at medium/long forecasting horizon; b. financial factors
are useful in short run forecasting; c. no-arbitrage models are effec-
tive in shrinking the dimensionality of the parameter space and, when
supplemented with additional macro information, are very effective in
forecasting; d. within no-arbitrage models, assuming time-varying risk
price is more favorable than assuming constant risk price for medium
horizon-maturity forecast when yield factors dominate the informa-
tion set, and for short horizon and long maturity forecast when macro
factors dominate the information set; e. however, given the complex-
ity and the highly non-linear parameterization of no-arbitrage models,
it is very difficult to exploit within this type of models the additional
information offered by large macroeconomic datasets.

Carlo Favero , Linlin Niu and Luca Sala
Keywords: Yield curve, term structure of interest rates, forecast-ing, large data set, factor models
2007 - n° 317
Empirical investigations of the effects of fiscal policy shocks share
a common weakness: taxes, government spending and interest rates
are assumed to respond to various macroeconomic variables but not
to the level of the public debt; moreover the impact of fiscal shocks
on the dynamics of the debt-to-GDP ratio are not tracked. We ana-
lyze the effects of fiscal shocks allowing for a direct response of taxes,
government spending and the cost of debt service to the level of the
public debt. We show that omitting such a feedback can result in
incorrect estimates of the dynamic effects of fiscal shocks. In par-
ticular the absence of an effect of fiscal shocks on long-term interest
rates-a frequent finding in research based on VAR's that omit a debt
feedback-can be explained by their mis-specification, especially over
samples in which the debt dynamics appears to be unstable. Using
data for the U.S. economy and the identification assumption proposed
by Blanchard and Perotti (2002) we reconsider the effects of fiscal
policy shocks correcting for these shortcomings.

Carlo Favero and Francesco Giavazzi
Keywords: fiscal policy, public debt, government budget con- straint, VAR models
2006 - n° 316
monetary policy in an estimated, semi-structural, small-open-economy model of the
U.K. Compared to the closed economy, the presence of an exchange rate channel for
monetary policy not only produces new trade-offs for monetary policy, but it also
introduces an additional source of specification errors. We find that exchange rate
shocks are an important contributor to volatility in the model, and that the exchange
rate equation is particularly vulnerable to model misspecification, along with the
equation for domestic inflation. However, when policy is set with discretion, the
cost of insuring against model misspecification appears reasonably small.

Richard Dennis, Kai Leitemo and Ulf Soderstrom
Keywords: political equilibria, aging, postponing retirement
2006 - n° 315
Conventional economic wisdom suggests because of the aging process, social security
systems will have to be retrenched. In particular, retirement age will have to be largely
increased. Yet, is this policy measure feasible in OECD countries? Since the answer
belongs mainly to the realm of politics, I evaluate the political feasibility of postponing
retirement under aging in France, Italy, the UK, and the US. Simulations for the year
2050 steady state demographic, economic and political scenario suggest that retirement
age will be postponed in all countries, while the social security contribution rate will
rise in all countries, but Italy. The political support for increasing the retirement age
stems mainly from the negative income effect induced by aging, which reduces the
profitability of the existing social security system, and thus the individuals net social
security wealth.

Vincenzo Galasso
Keywords: political equilibria, aging, postponing retirement
2006 - n° 314
We model an enforcement problem where firms can take a known and lawful
action or seek a profitable innovation that may enhance or reduce welfare. The legislator
sets fines calibrated to the harmfulness of unlawful actions. The range of fines defines norm
flexibility. Expected sanctions guide firms' choices among unlawful actions (marginal deter-
rence) and/or stunt their initiative altogether (average deterrence). With loyal enforcers,
maximum norm flexibility is optimal, so as to exploit both marginal and average deterrence.
With corrupt enforcers, instead, the legislator should prefer more rigid norms that prevent
bribery and misreporting, at the cost of reducing marginal deterrence and stunting private
initiative. The greater is potential corruption, the more rigid the optimal norms.

Giovanni Immordino, Marco Pagano andMichele Polo
Keywords: norm design, initiative, enforcement, corruption
2006 - n° 313
The goal of this paper is to characterize a measure of diversity among individu-
als, which we call generalized fractionalization index, that uses information on similarities
among individuals. We show that the generalized index is a natural extension of the
widely used ethno-linguistic fractionalization index and is alsosimple tocompute. The
paper offers some empirical illustrations on how the new index can be operationalized and
what difference it makes as compared to standard indices. These applications pertain to
the pattern of diversity in the United States across states. Journal of Economic Literature

Walter Bossert,Conchita DAmbrosio andEliana La Ferrara
Keywords: Diversity, Similarity, Ethno-Linguistic Fractionalization
2006 - n° 312
We study the relationship between the term structure of interest rates and
fiscal policy by considering the Italian case. Empirical analysis has been so
far rather inconclusive on this important topic. We abscribe such evidence
to three problems: identification, regime-switching and maturity effects. All
these aspects are particularly relevant to the Italian case.
We propose a parsimonious model with three factors to
represent the whole yield curve, and we consider yield
differentials between Italian and German Government bonds.
To take into account the possibility of regime-switching, we explicitly include
a hidden two-state Markov chain that represents market expectations. The
model is estimated using Bayesian econometric techniques. We find that government
debt and its evolution significantly influence the yield of government
bonds, that such effects are maturity dependent and regime-dependent. Hence
when investigating the effect of fiscal policy on the term-structure it is of crucial
importance to allow for multiple regimes in the estimation.

Kewords: Fiscal Policy, Term Structure, regime switching, Bayesian estimation

Carlo Favero and Stefano W. Giglio
2006 - n° 311
This paper extends Savage's subjective approach to probability and
utility from decision problems under exogenous uncertainty to choice in strategic
environments. Interactive uncertainty is modeled both explicitly - using
hierarchies of preference relations, the analogue of beliefs hierarchies
implicitly - using preference structures, the analogue of type spaces la
Harsanyi - and it is shown that the two approaches are equivalent.
Preference structures can be seen as those sets of hierarchies arising when certain
restrictions on preferences, along with the players' common certainty of
the restrictions, are imposed. Preferences are a priori assumed to satisfy only
very mild properties (reflexivity, transitivity, and monotone continuity).
Thus, the results provide a framework for the analysis of behavior in games
under essentially any axiomatic structure. An explicit characterization is
given for Savage's axioms, and it is shown that a hierarchy of relatively
simple preference relations uniquely identifies the decision maker's
utilities and beliefs of all orders. Connections with the literature on beliefs
hierarchies and correlated equilibria are discussed.

Kewords: Subjective probability, Preference hierarchies, Type spaces, Beliefs
hierarchies, Common belief, Expected utility, Incomplete information,
Correlated equilibria

Alfredo Di Tillio
2006 - n° 310
This paper analyses the sources of buyer power and its effect
on sellers' investment. We show that a retailer extracts a larger
surplus from the negotiation with an upstream manufacturer the
more it is essential to the creation of total surplus. In turn, this
depends on the rivalry between retailers in the bargaining process.
Rivalry increases when the retail market is more fragmented, when
the retailers are less differentiated and when decreasing returns to
scale in production are larger. The allocation of total surplus affects
also the incentives of producers to invest in product quality, an instance
of the hold up problem. This not only makes both the supplier and
consumers worse off, but it may harm also the retailers.

Kewords: Retailers' power, Hold-up, Supplier's under-investment

Pierpaolo Battigalli, Chiara Fumagalli and Michele Polo
2006 - n° 309
Is the process of workforce aging a burden or a blessing for the firm?

Our paper seeks to answer this question by providing evidence on the

age-productivity and age-earnings profiles for a sample of plants in three

manufacturing industries (forest, industrial machinery and electronics) in

Finland. Our main result is that exposure to rapid technological and managerial

changes does make a difference for plant productivity, less so for wages. In

electronics, the Finnish industry undergoing a major technological and

managerial shock in the 1990s, the response of productivity to age-related

variables is first sizably positive and then becomes sizably negative as one

looks at plants with higher average seniority and experience. This declining

part of the curve is not there either for the forest industry or for industrial

machinery. It is not there either for wages in electronics. These conclusions

survive when a host of other plausible productivity determinants (notably,

education and plant vintage) are included in the analysis. We conclude that

workforce aging may be a burden for firms in high-tech industries and less so in

other industries.

Francesco Daveri and Mika Maliranta
Keywords: Aging, technology, TFP, wage determination, Finland, new economy, growth
2006 - n° 308

We study the joint dynamics of economic and political change. Predictions of the simple model that we formulate in the paper get
considerable support in a panel of data on political regimes and GDP per capita for about 150 countries over 150 years. Democratic cap-
ital - measured by a nation's historical experience with democracy and by the incidence of democracy in its neighborhood - reduces the
exit rate from democracy and raises the exit rate from autocracy. In democracies, a higher stock of democratic capital stimulates growth
in an indirect way by decreasing the probability of a sucessful coup. Our results suggest a virtuous circle, where the accumulation of phys-
ical and democratic capital reinforce each other, promoting economic development jointly with the consolidation of democracy.

Torsten Persson and Guido Tabellini
2006 - n° 307
Robust control allows policymakers to formulate policies that guard against
model misspecification. The principal tools used to solve robust control problems
are state-space methods (see Hansen and Sargent, 2006, and Giordani and
Soderlind, 2004). In this paper we show that the structural-form methods
developed by Dennis (2006) to solve control problems with rational expectations
can also be applied to robust control problems, with the advantage that they
bypass the task, often onerous, of having to express the reference model in
statespace form. Interestingly, because state-space forms and structural forms
are not unique the two approaches do not necessarily return the same equilibria
for robust control problems. We apply both state-space and structural solution
methods to an empirical New Keynesian business cycle model and find that the
differences between the methods are both qualitatively and quantitatively important.
In particular, with the structural-form solution methods the specification errors generally
involve changes to the conditional variances in addition to theconditional means of the
shock processes.

Richard Dennis, Kai Leitemo, and Ulf Soderstrom
Keywords: Robust control, Misspecification, Optimal policy
2006 - n° 306
The estimation of structural dynamic factor models (DFMs) for large sets of variables
is attracting considerable attention. In this paper we briefly review the underlying
theory and then compare the impulse response functions resulting from two alternative
estimation methods for the DFM. Finally, as an example, we reconsider the issue of
the identification of the driving forces of the US economy, using data for about 150
macroeconomic variables.

George Kapetanios and Massimiliano Marcellino
Keywords: Factor models, Principal components, Subspace algorithms, StructuralIdentification, Structural VAR