The Divisia monetary index weights each monetary asset by its expenditure share, evaluated at its user cost.See Barnett et al. [1997, equations (5) and (6)]. In a world of perfect certainty, the user costs can be computed directly from asset return data, and so, the index is model-free. In the presence of uncertainty, however, the true user cost of a monetary asset depends on the covariance of the asset's return with the marginal utility of wealth. Intuitively, an asset's value depends both on its expected payoff and on the asset's ability to hedge wealth fluctuations. As a result, the true user cost cannot be computed without an explicit model of preferences. It follows that the exact Divisia monetary index in a stochastic economy is not model-free, but depends on the underlying preference assumptions.

We highlight a state variable misspecification with one accepted method to implement stochastic volatility (SV) in DSGE models when transforming the nonlinear state-innovation dynamics to its linear representation. Although the technique is more efficient numerically, we show that it is not exact but only serves as an approximation when the magnitude of SV is small. Not accounting for this approximation error may induce substantial spurious volatility in macroeconomic series, which could lead to incorrect inference about the performance of the model. We also show that, by simply lagging and expanding the state vector, one can obtain the correct state-space specification. Finally, we validate our augmented implementation approach against an established alternative through numerical simulation.

We examine whether input–output interactions among industries impact the transmission of monetary policy shocks through the economy. Using vector autoregressive (VAR) methods we find evidence of heterogeneity in the output response to a monetary policy shock in both finished goods industries and intermediate goods industries. While output responses in finished goods industries can be related to heterogeneity in industry characteristics, this relationship is not so obvious for intermediate goods industries. For the intermediate goods industries in our sample, we find new evidence of demand-spillover effects that impact the transmission of monetary policy via input–output linkages.

We propose a model to study monetary policy under discretion. We focus on Markov perfect equilibria, ruling out trigger strategies. The model is simple enough that the determinants of monetary policy under discretion are clear. We also find that for all parameterizations with an equilibrium inflation rate around 2%, there is a second equilibrium with an inflation rate just above 10%. Thus the model can simultaneously account for the low- and high-inflation episodes in the U.S. experience.

A variety of international macroeconomic models predict a relationship between the real exchange rate and consumption. The empirical evidence in favor of such a relationship is limited, the so-called Backus and Smith puzzle. In this paper, we extend the analysis to allow for nonlinear dynamics and volatility changes across exchange rate regimes. Our findings suggest that long-run relationships in line with standard international business cycle models do exist for many Organization for Economic Co-operation and Development (OECD) countries. Further, Monte Carlo experiments illustrate that the nonlinear models can generate the Backus and Smith and the exchange rate disconnect puzzles. In this paper, we also contribute to the nonlinear real exchange rate literature by establishing a theoretical relationship between volatility and persistence. In accordance with the theoretical results, our empirical findings suggest that the increase in volatility in the post-Bretton Woods era is associated with relatively fast mean reversion of the real rate toward its equilibrium value.

By developing a class of dynamic stochastic general equilibrium models with nominal rigidities and assuming a two-country currency union with sovereign risk, we show that there is not necessarily a trade-off between the prevention of default risk and stabilizing inflation. Under optimal monetary and fiscal policy, comprising a de facto inflation stabilization policy, the tax rate as an optimal fiscal policy tool plays an important role in stabilizing inflation, although not completely because of the distorted steady state. Changes in the tax rate to minimize welfare costs via stabilizing inflation then improve the fiscal surplus, and because of this and the incompletely stabilized inflation, the default rate does not increase as much.

This paper seeks to provide a theoretical explanation for the weak association between measures of financial structure—as defined by the mixture of bank-based and market-based financial systems in an economy—and economic development. Lenders fund risky investment projects of firms by drawing up loan contracts in the presence of an informational asymmetry. An optimal contract entails the issue of debt, equity, or a mix of the two. The equilibrium choice of contract and the financial structure depend on the state of the economy, which in turn depends on the contracting regime. Based on this analysis, the paper provides a theory that can explain the wide diversity of financial structure among middle-income countries.

This paper introduces a new measure to capture dynamic losses for exporting firms on markets that exhibit hysteresis on the supply side. Our indicator aims to quantify dynamic losses caused by sunk adjustment costs in case of exchange rate fluctuations. While the standard procedure in welfare analysis is to compare two equilibria, we focus on welfare effects that take place during dynamics. We analyze negative dynamic effects on producers' income that are generated due to writing off sunk adjustment costs. As an example, we investigate Italian wine exports to the United States over the period 1995–2013. After testing for hysteresis on the market, we present the indicator of hysteresis losses. It captures a continuous increase of dynamic losses during the period 2003–2008. Moreover, over-proportionately large hysteresis losses are generated in comparison to the exchange rate changes if the pain threshold of the exchange rate (ca. 1.25$/€) is passed.

In the context of I(1) time series, we provide some asymptotic results for the Davidson-MacKinnon J-type test. We examine both the case where our regressor sets x1t and x2t are not cointegrated, and the case where they are. In the former case, the OLS estimator of the weighting coefficient from the artificial compound model converges at rate T to a mixed normal distribution, and the associated t-statistic has an asymptotic standard normal distribution. In the latter case, we find that the J-test also has power against violation of weak exogeneity (with respect to the short-run coefficients of the null model), which is caused by correlation between the disturbance of the null model and that of the cointegrating equation linking x1t and x2t. Moreover, unlike the previous case, the OLS estimator of the weighting coefficient from the artificial compound model converges at \sqrt{T} to an asymptotic normal distribution when the null model is specified correctly. In an empirical illustration, we use the tests to examine an industrial production data set for six countries.

In the context of a prototypical New Keynesian model, this paper examines the theoretical interrelations between two tractable formulations of progressive taxation on labor income versus (i) the equilibrium degree of nominal-wage rigidity as well as (ii) the resulting volatilities of hours worked and output in response to a monetary shock. In sharp contrast to the traditional stabilization view, we analytically show that linearly progressive taxation always operates like an automatic destabilizer which leads to higher cyclical fluctuations within the macroeconomy. We also obtain the same business cycle destabilization result under continuously progressive taxation if the initial degree of tax progressivity is sufficiently low.

We study whether monetary authorities in the G7 countries were changing their responses to inflation in a similar manner during and following the Great Inflation era. We find that the common to the G7 countries inflation pattern during the Great Inflation period could be associated with a common pattern in the monetary policy response to inflation: we find that until the early 1980s monetary authorities in the G7 countries responded mildly to inflation, systematically fought it throughout the 1980s and lessened again their response during the 2000s. The estimated Taylor rule coefficients on inflation are co-integrated, implying the existence of a long-run relationship in the responses to inflation during and after the Great Inflation period. At the same time, principal component analysis of the residuals of the estimated Taylor rules indicates that the shocks' structure cannot account enough for the monetary policies' co-movements. We interpret these findings as suggestive of common monetary policy patterns.

In this paper, we study the relationship between changes in the world interest rate and within-country inequality during the 1985–2005 period in which the world interest rate sharply declined. In line with the predictions of the seminal model of Galor and Zeira [Income distribution and macroeconomics. Review of Economic Studies 60, 35–52], the analysis suggests that the decrease in the world interest rate is associated with a decrease in inequality in poor countries and an increase in inequality in rich ones.

This study proposes the unified framework of a three-sector model with structural change where agriculture, manufacturing, and service sectors have different production technologies. All three sectors use the factors of capital, labor, and land as inputs. The constant-growth path (CGP), which is the trajectory along which the rental rate of capital remains constant, is used to reconcile the Kaldor and Kuznets facts, and plays a role in linking the wage rate and land rent in the three-factors model. Because the prices of agricultural goods and services are determined endogenously, the CGP condition is no longer the knife-edge condition. We find that the dynamic system along the CGP in the three-sector, three-factor model corresponds to the standard two-sector optimal growth model.

William A. Brock has taught in the Departments of Economics at the University of Rochester, Cornell University, and the University of Chicago, before moving to the University of Wisconsin, Madison, where he is now Vilas Research Professor of Economics. He has also been an External Professor at the Santa Fe Institute since 1989. His many awards include election as a Fellow of the Econometric Society in 1974, a Fellow of the American Academy of Arts and Sciences in 1992, and as a Member of the National Academy of Sciences in 1998. His over 100 invited lectures include presentations in Poland, Belgium, France, Mexico, Canada, Japan, Australia, England, Sweden, Norway, and Australia.

Brock has been a leading contributor to the development of methods of intertemporal equilibrium analysis in the areas of growth theory, monetary theory, and finance. More recently, he has played a crucial role in the development of new methods for the analysis of nonlinear dynamics in macroeconomics and finance, and models of expectations that relax the assumption of rational expectations.

I interviewed Buz in the faculty cafeteria near the Social Science Research Institute building, on the Madison campus of the University of Wisconsin, on October 22, 1998. Our interview was interrupted when he had to go to teach, and then was finished by phone on December 11, 1998. The transcript that follows does little justice to the liveliness of Buz's conversation, mainly because of my inability to transcribe the animated facial expressions and hand gestures that made the mathematical references more concrete. I have added several footnotes to the transcript, identifying some of the published sources that were mentioned during our conversation.

Recent empirical research has documented the clustered volatility and fat tails of return distribution in stock markets, yet returns are uncorrelated over time. Certain agent-based theoretical models attempt to explain the empirical features in terms of investors' order-splitting or dynamic switching strategies, both of which are frequently used by actual stock investors. However, little theoretical research has discriminated among the behavioral assumptions within a model and compared the impacts of the assumptions on the empirical features. Nor has the research simultaneously replicated the return features and empirical features on market microstructure, such as patterns of order choice. This study constructs an artificial limit order market in which investors split orders into small pieces or use fundamental and trend-following predictors interchangeably over time. We demonstrate that, on one hand, the market that features strategies with order splitting and dynamic predictor selection can independently replicate clustered volatility and fat tails with near-zero return autocorrelations. However, we also show that patterns of order choice do not match those found in certain previous empirical studies in both types of economies. Thus, we conclude that, in reality, the two strategies can work to generate the empirical return features but that investors may also use other strategies in actual stock markets. We also demonstrate that the impact of both strategies on the volatility persistence tends to be greater as the number of traders increases in the market; this finding implies that the order-splitting strategy and dynamic predictor selection are more crucial for the empirical phenomena pertaining to larger capital stocks.

This paper shows that the ability of the credible wage bargaining model to match the observed unemployment volatility hinges on an unrealistic assumption about disagreement payoffs to the firm. Relaxing this assumption can lead to the substantial wage flexibility. As a consequence, the model is unable to capture the observed unemployment volatility.

The events driven by the financial crisis have highlighted limits and drawbacks of current paradigms. Economists began to rethink the role and impacts of financial factors and standard policies. At the same time, a more general sentiment of revision has challenged several consolidated “dogmas.” Accordingly, this special issue of Macroeconomic Dynamics aims to refresh the debate on some important macroeconomic topics from new and fresh perspectives. A number of questions relating to the challenges faced by macroeconomic theory and policies are raised. The issue, first, discusses some topics that stemmed from the financial factors, such as overleveraging, forward guidance, bank regulation; it then explores other “waters” related to price-setting behavior, productivity, and growth.

Historically, industrialization has been associated with falling relative returns to skills. This fact is at odds with most unified theories of industrialization, which tend to imply rising skill premia as natural concomitants of economic growth. This paper develops a very simple model of historical growth to help solve this puzzle. Assuming that human capital is both a consumption good and an investment good, the model demonstrates how gradually rising investments in human capital, nonmonotonic fertility rates, and falling skill premia can all be explained within one theory.

In this paper, we examine the influence of monetary policy on the speed of convergence in a standard monetary growth model à la Sidrauski allowing for differences in the elasticity of substitution between factors of production. The respective changes in the rate of convergence and its sensitivities to the central model parameters are derived both analytically and numerically. By normalizing the constant elasticity of substitution (CES) production functions both outside the steady state and within the steady state, it is possible to distinguish between an efficiency and a distribution effect of a change in the elasticity of substitution. We show that monetary policy is the more effective, the lower is the elasticity of substitution, and that the impact of monetary policy on the speed of convergence is mainly channeled via the efficiency effect.

We build a two-country model of endogenous growth to study the welfare effects of taxes on tradable primary inputs when countries engage in asymmetric trade. We obtain explicit links between persistent gaps in productivity growth and the incentives of resource-exporting (importing) countries to subsidize (tax) domestic resource use. The exporters' incentive to subsidize hinges on slower productivity growth and is disconnected from the importers' incentive to tax resource inflows—i.e., rent extraction. Moreover, faster productivity growth exacerbates the importers' incentive to tax, beyond the rent-extraction motive. In a strategic tax game, the only equilibrium is of Stackelberg type and features, for a wide range of parameter values, positive exporters' subsidies and positive importers' taxes at the same time.