Resurrecting the Weak Credibility Hypothesis in Models of Exchange-Rate-Based Stabilization (with Ed Buffie)
European Economic Review (Forthcoming)

We analyze how weak credibility affects the volatility of consumption spending in a model of exchange-rate-based stabilization that allows for both durable and nondurable goods. The inclusion of durables greatly improves the explanatory power of the weak credibility hypothesis. The hypothesis can account for the main qualitative properties of the boom-bust cycle provided the elasticity of durables expenditure with respect to Tobin’s q is greater than the intertemporal elasticity of substitution. Moreover, the quantitative effects are very large. In numerical simulations based on conservative assumptions about the expenditure share of durables (20%) and wealth effects (none), aggregate consumption increases 12-28% during the low-crawl phase and the real exchange rate appreciates 24-26%. In variants of the model that incorporate supply effects, the consumption boom is equally strong but appreciation of the real exchange rate rises to 30-40%.

Trade, Growth, and Poverty in Zambia: Insights from a Dynamic General Equilibrium Model (with Ed Buffie)
Journal of Policy Modeling (Forthcoming: Published online: 24 September 2011)

Many LDCs suffer from low levels of private investment, from acute shortages of social and physical infrastructure, and from widespread poverty and underemployment. How can trade policy help combat these problems? Neoclassical trade theory objects that the premise of the question is incorrect. According to the Principle of Targeting, it is better to use other policy instruments to counteract market imperfections and to target social objectives. Instead of interfering with free trade, the government should increase domestic taxes to pay for employment subsidies, investment subsidies, transfers to the poor, and additional public investment in infrastructure. Policy makers reject this advice as impractical. Our objective in this paper is to restart the policy dialogue. We build a dynamic general equilibrium trade model that is rich in structural detail and policy instruments but not a black box. We use the model to investigate how trade policy affects poverty, underemployment, aggregate capital accumulation, and real output in Zambia. The results consistently recommend policy packages that combine an escalated structure of protection with an escalated structure of export promotion. There is no support for the view that free trade or a low uniform tariff is approximately optimal.

Growth and Inequality: Dependence on the Time Path of Productivity Increases (and Other Structural Changes) (with Santanu Chatterjee and Stephen J. Turnovsky)
Journal of Economic Dynamics and Control, Volume 36, Issue 3 (Mar, 2012), pp. 331-348.

This paper examines the significance of the time path of a given productivity increase on growth and inequality. We show that whereas the time path impacts only the transitional path of aggregate quantities and has no effect on their ultimate steady-state levels, it has both transitional and permanent consequences for wealth and income distribution. As a result, the growth-inequality tradeoff generated by a given discrete increase in productivity contrasts sharply with that obtained when the same ultimate productivity increase is acquired gradually. This is true both in transition and across steady states. We show that a gradual productivity change can generate a Kuznets-type inverted U-shaped relationship between inequality and per-capita income. The distance from the technology frontier is also shown to have important implications for both the magnitude and persistence of inequality. Finally, our results suggest that economies with similar aggregate structural characteristics may have very different outcomes for income and wealth inequality, depending on the intrinsic nature of the productivity growth path.

Solving the Unit Root Problem in Models with an Exogenous World Market Interest Rate (with Ed Buffie)
Macroeconomic Dynamics, Volume 15, Issue 5 (Nov, 2011), pp. 681-712.

The standard model of the small open economy is saddled with a unit root that greatly complicates numerical computation of the global saddle path. In this paper we solve the unit root problem by developing a set of innovative forward-shooting algorithms. Exploiting the fact that the algorithms are mechanical and model-free, we have placed canned, fully automated programs in the public domain. The programs do not require any substantive human input. The user’s only responsibility is to type in the equations of the model correctly.

Exchange-Rate-Based Stabilization, Durables Consumption, and the Stylized Facts (with Ed Buffie)
Economic Journal, Volume 121, Issue 555 (Sep, 2011), pp. 1130-1160.

In this paper we show that a model featuring durable consumer goods, imperfect substitution between domestic and foreign assets, and weak credibility can explain the qualitative and quantitative aspects of the stylized facts associated with exchange-rate-based stabilization, including the tremendous increase in real interest rates. Following a temporary reduction in the crawl, total consumption spending rises 14-26%, the real exchange rate appreciates 20-37%, and the current account deficit swells to 10-15% of GDP. Despite large capital inflows, the real interest rate increases from 10% to 20-100%.

Linearization and Higher-Order Approximations: How Good are They? (with Bassam Awad and Milton H. Marquis)  
Computational Economics, Volume 38, Issue 1 (Jun, 2011), pp. 1-31.

The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. Recently quadratic approximations have been explored. This paper examines the accuracy of these and higher-order approximations in an endogenous growth model with public capital, thereby extending the work done in the current literature on the neoclassical growth model. We find that significant errors may persist in computed transition paths and welfare even after resorting to approximations as high as fourth order. Moreover, the accuracy of approximations may not increase monotonically with the increase in the order of approximation. Also, as in the previous literature, we find that achieving acceptable levels of accuracy when computing the welfare consequences of a policy change typically requires a higher order approximation than attaining similar levels of accuracy in the computation of the transition path: typically an increase in order of approximation by one is sufficient.

Relative Wealth Concerns and Entrepreneurship (with Kislaya Prasad)
Economica, Volume 78, Issue 310 (Apr, 2011), pp. 294-316.

We develop a model of occupational choice and entrepreneurship in which market frictions limit the possibilities for diversifying entrepreneurial risk. A concern for relative standing arises in this model even though individuals care only about the consumption of standard commodities. In contrast to the complete markets outcome, an increase in sector-specific aggregate risk increases entrepreneurship due to relative wealth concerns. A change in the profile of the economy to include more risk-averse people results in an even greater increase in entrepreneurship. Thus, relative wealth concerns mitigate the reduction in entrepreneurship arising from the non-diversifiability of entrepreneurial risk. We examine the effects of uncertainty about economic policies such as market-based reforms on entrepreneurship.

Understanding Liquidity Shortages During Severe Economic Downturns (with Tor Einarsson and Milton H. Marquis)
Journal of Economic Dynamics and Control, Volume 35, Issue 3 (Mar, 2011), pp. 330-343.

One feature of economic recessions is the appearance of aggregate liquidity shortages that can exacerbate the economic downturn. We develop a model in which the demand for liquidity arises suddenly in response to continued funding needs of partially completed investment projects whose outcomes are subject to idiosyncratic shocks and moral hazard. When the economy experiences an adverse aggregate productivity shock, incentive constraints that underlie equity contracts may bind, provided the shock is severe enough. In this case, credit-rationing appears, and the heightened demand for liquidity coincides with a greater reluctance to take on equity positions or deepen investments in on-going investment projects. The consequence is a reduction in new investment and termination of on-going projects due to a lack of liquidity, thereby worsening the economic slowdown.

How Misleading is Linearization? Evaluating the Dynamics of the Neoclassical Growth Model (with Santanu Chatterjee and Stephen J. Turnovsky)  
Journal of Economic Dynamics and Control, Volume 34, Issue 9 (Sep, 2010), pp. 1550-1571.

The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. This paper investigates the reliability of this procedure in evaluating the dynamic adjustments to policy changes or structural shocks. We analyze this issue using the example of a Ramsey growth model, with two alternative specifications of productive government spending. If government expenditure is introduced as a flow and the dynamic adjustment is fast, linearization may be a reasonably good approximation of the true dynamics even for fairly large policy shocks. If government expenditure assumes the form of a stock, leading to more sluggish adjustment, linearization is more problematic. It may yield misleading predictions, both qualitatively and quantitatively. These errors occur at the beginning of the transition and weigh heavily in welfare calculations. The implications for these errors for temporary shocks and the speed of convergence are also considered.

Public Investment, Tax Evasion, and the Welfare Effects of a Tariff Reform
Contemporary Economic Policy, Volume 28, Issue 2 (Apr, 2010), pp. 219-239.

Contrary to the case considered in literature, experience of developing countries indicates that trade reforms have not been revenue neutral due to the heavy dependence of developing countries on trade taxes and pervasive tax evasion. In contrast to the plausibility of a welfare loss shown by the current literature, when the adverse effect of loss of tariff revenue on public investment is factored in the welfare outcomes of tariff reforms of past few decades turn out to be much more pessimistic. The success of future attempts at tariff reforms would require preceding such reforms with empowerment of governments with ability to fight tax evasion and strengthen domestic tax system. For countries of sub-Saharan Africa where such reforms are likely to be concentrated, this would need planning and capacity building over a longer time horizon.

Reverse Shooting Made Easy: Automating the Search for the Global Nonlinear Saddle Path (with Ed Buffie)
Computational Economics, Volume 34, Issue 3 (Oct, 2009), pp. 273-308.

We present the blueprints for a set of innovative reverse shooting algorithms that trap the global saddle path in systems with 2-4 state variables. The solution procedure is built around a new distance mapping and refined simplex algorithms. Since the algorithms are completely reliable and always work in the same way, we have been able to develop canned problems that solve for the global nonlinear saddle path in any model with 2-4 state variables. The programs are written in the spirit of plug and play: the user types in the equations of the model and then waits for the solution. (Link to the longer version of the paper)

Smart Forward Shooting (with Ed Buffie)
Computational Economics, Volume 33, Issue 1 (Feb, 2009), pp. 1-30.

In this paper we develop a set of innovative forward-shooting algorithms that solve for the global nonlinear saddle path in models with 1-3 jump variables. Exploiting the fact that the algorithms are mechanical and model-free, we have placed canned, fully-automated programs in the public domain. The programs do not require any substantive human input. The user’s only responsibility is to type in the equations of the model correctly.