Working papers results

2005 - n° 294 11/07/2005

We study how constrained fiscal policy can affect regional inflation and output in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government expenditure and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under constant taxes and constant regional inflations. With cooperation debt and deficit constraints reduce regional inflation variability, but the path of output is suboptimal. Under non-cooperation the opposite occurs due to a trade-off between taxation and inflation variability. Decentralized rules, rather than constraints, stabilize regional inflation and output. They imply more fiscal action for smaller union members.

Evi Pappa(LSE, CEP and IGIER)
Keywords: Inflation Differentials, Monetary Union, Budgetary Restrictions, Fiscal rules
2005 - n° 293 11/07/2005

We study the mechanics of transmission of fiscal shocks to labor markets. We
characterize a set of robust implications following government consumption, investment
and employment shocks in a RBC and a New-Keynesian model and use part of them to
identify shocks in the data. In line with the New-Keynesian story, shocks to government
consumption and investment increase real wages and employment contemporaneously
both in US aggregate and in US state data. The dynamics in response to employment
shocks are mixed, but in many cases are inconsistent with the predictions of the RBC
model.

Evi Pappa
2005 - n° 292 10/06/2005

Does culture have a causal effect on economic development? The data on European
regions suggest that it does. Culture is measured by indicators of individual values
and beliefs, such as trust and respect for others, and confidence in individual selfdetermination.
To isolate the exogenous variation in culture, I rely on two historical
variables used as instruments: the literacy rate at the end of the XIXth century, and
the political institutions in place over the past several centuries. The political and
social history of Europe provides a rich source of variation in these two variables at a
regional level. The exogenous component of culture due to history is strongly
correlated with current regional economic development, after controlling for
contemporaneous education, urbanization rates around 1850 and national effects.
Moreover, the data do not reject the over-identifying assumption that the two
historical variables used as instruments only influence regional development through
culture. The indicators of culture used in this paper are also strongly correlated with
economic development and with available measures of institutions in a cross-country
setting.

Guido Tabellini (IGIER, Università Bocconi and CEPR)
Keywords: culture, economic development, trust, literacy, institutions
2005 - n° 291 07/06/2005

Consumption is striking back. Some recent evidence indicates that
the well-known asset pricing puzzles generated by the difficulties of
matching fluctuations in asset prices with high frequency fluctuations
in consumption might be solved found by considering consumption in
the long-run. A first strand of the literature concentrates on multiperiod
differences in log consumption, a second concentrates on the
cointegrating relation for consumption. Interestingly, only the (multiperiod)
Euler Equation for the consumer optimization problem is
considered by the first strand of the literature, while the cointegrationbased
literature concentrates exclusively on the (linearized) intertemporal
budget constraint. In this paper, we show that using the first
order condition in the linearized budget constraint to derive an explicit
long-run consumption function delivers an even more striking
strike back.

Carlo A. Favero (IGIER, Università Bocconi and CEPR)
Keywords: Cointegrating Consumption function, lon-run stock marketreturns, elasticity of intertemporal substitution
2005 - n° 290 29/04/2005

This paper studies how a central bank's preference for robustness against
model misspecification affects the design of monetary policy in a New-Keynesian
model of a small open economy. Due to the simple model structure,
we are able to solve analytically for the optimal robust policy rule, and we
separately analyze the effects of robustness against misspecification concerning
the determination of inflation, output and the exchange rate. We show that
an increased central bank preference for robustness makes monetary policy
respond more aggressively or more cautiously to shocks, depending on the
type of shock and the source of misspecification.

Kai Leitemo (Norwegian School of Management)and Ulf Soderstrom (IGIER and Bocconi University)
Keywords: Knightian uncertainty, model uncertainty, robust control, minmaxpolicies
2005 - n° 289 29/04/2005

This paper introduces underground activities and tax evasion into a one sector dynamic general equilibrium model with external effects. The model presents a novel mechanism driving the self-fulfilling prophecies, which is triggered by the reallocation of resources to the underground sector to avoid the excess tax burden. This mechanism differs from the customary one, and it is complementary to it. In addition, the explicit introduction of an (even tiny) underground sector allows to reduce aggregate degree of increasing returns required for indeterminacy, and for having well behaved input demand schedules (in the sense they slope down).

Journal of Economic Literature Classification Numbers: O40, E260

Francesco Busato (University of Aarhus), Bruno Chiarini (University of Naples, Parthenope)and Enrico Marchetti (La Sapienza, Rome)
Keywords: Indeterminacy and Sunspots, Tax Evasion and Underground Activities
2005 - n° 288 22/04/2005

A central problem for the game theoretic analysis of voting is that voting games
have very many Nash equilibria. In this paper, we consider a new refinement
concept for voting games that combines two ideas that appear reasonable for voting
games: First, trembling hand perfection (voters sometimes make mistakes when
casting their vote) and second, coordination of voters with similar interests. We
apply this refinement to an analysis of multicandidate elections under plurality rule
and runoff rule.
For plurality rule, we show that our refinement implies Duverger's law: In all
equilibria, (at most) two candidates receive a positive number of votes. For the case
of 3 candidates, we can completely characterize the set of equilibria. Often, there
exists a unique equilibrium satisfying our refinement; surprisingly, this is even true,
if there is no Condorcet winner. We also consider the equilibria under a runoff rule
and analyze when plurality rule and runoff rule yield different outcomes.

Matthias Messner and Mattias Polborn
Keywords: strategic voting, runoff rule, plurality rule, equilibrium refinement, trembling hand perfection, coalition-proofness
2005 - n° 287 15/04/2005

Building on recent work on dynamic interactive epistemology, we
extend the analysis of extensive-form psychological games (Geneakoplos,
Pearce & Stacchetti, Games and Economic Behavior, 1989) to
include conditional higher-order beliefs and enlarged domains of pay-off
functions. The approach allows modeling dynamic psychological
effects (such as sequential reciprocity, psychological forward induction,
and regret) that are ruled out when epistemic types are identified with
hierarchies of initial beliefs. We define a notion of psycholigical sequential
equilibrium, which generalizes the sequential equilibrium notion for
traditional games, for which we prove existence under mild assumptions.
Our framework also allows us to directly formulate assumptions about
"dynamic" rationality and interactive beliefs in order to explore strategic
interaction without assuming that players' beliefs are coordinated on an
equilibrium. In particular, we provide an exploration of (extensive-form)
rationalizability in psychological games.

Pierpaolo Battigalli (University Bocconi)and Martin Dufwenberg (University of Arizona)
Keywords: psychological games, belief-dependent motivation, extensive-form solution concepts,dynamic interactive epistemology
2005 - n° 286 14/03/2005

We provide a summary updated guide for the construction, use and evaluation of
leading indicators, and an assessment of the most relevant recent developments in this
field of economic forecasting. To begin with, we analyze the problem of selecting a
target coincident variable for the leading indicators, which requires coincident indicator
selection, construction of composite coincident indexes, choice of filtering methods,
and business cycle dating procedures to transform the continous target into a binary
expansion/recession indicator. Next, we deal with criteria for choosing good leading
indicators, and simple non-model based methods to combine them into composite indexes.
Then, we examine models and methods to transform the leading indicators into
forecasts of the target variable. Finally, we consider the evaluation of the resulting
leading indicator based forecasts, and review the recent literature on the forecasting
performance of leading indicators.

Massimilano Marcellino (Università Bocconi and IGIER)
Keywords: Business Cycles, Leading Indicators, Coincident Indicators, Turning Points,Forecasting
2005 - n° 285 14/03/2005
Mark Watson (Princeton University and NBER)

Abstract

Iterated multiperiod ahead time series forecasts are made using a one-period ahead model, iterated forward for the desired number of periods, whereas direct forecasts are made using a horizon-specific estimated model, where the dependent variable is the multi-period ahead value being forecasted. Which approach is better is an empirical matter: in theory, iterated forecasts are more efficient if correctly specified, but direct forecasts are more robust to model misspecification. This paper compares empirical iterated and direct forecasts from linear univariate and bivariate models by applying simulated out-of-sample methods to 171 U.S. monthly macroeconomic time series spanning 1959 - 2002. The iterated forecasts typically outperform the direct forecasts, particularly if the models can select long lag specifications. The relative performance of the iterated forecasts improves with the forecast horizon.

Massimiliano Marcellino (Università Bocconi and IGIER), James Stock (Harvard University and NBER) and Mark Watson (Princeton University and NBER)
Keywords: multistep forecasts, VAR forecasts, forecast comparisons