Volume 5, Issue 2, April 2004
The Research Agenda: Craig Burnside on the Causes and
Consequences of Twin Banking-Currency Crises
Since 1990 economists have watched the collapse of fixed or managed
exchange rate regimes in a diverse set of countries that includes, among
others, Sweden, Mexico, Thailand, Korea and Turkey. There is disagreement
about the causes of these crises, but there is widespread agreement that
these currency crises were somehow linked to banking crises that occurred
at roughly the same time in each country. This "twin crises" phenomenon
was identified by Kaminsky and Reinhart (1999). They argued that in the
1970s, worldwide, there were 26 balance-of-payments crises and 3 banking
crises, but only one instance of these crises being coincident. On the
other hand, among the 50 balance-of-payments crises and 23 banking crises
that occurred after 1980, 18 were coincident. My recent research, most of
which has been joint with Martin Eichenbaum and Sergio Rebelo,
investigates the causes and consequences of these crises.
Craig Burnside is Professor of Economics at the University of Virginia.
He is interested in macroeconomics and international macroeconomics, in
particular asset pricing, business cycles, and currency and fiscal crises.
The Asian Crisis of 1997-98
At the end of June 1997 the Asian crisis began with the collapse of
Thailand's fixed exchange rate regime after weeks of market speculation.
At the time, we were intrigued. The standard explanation for speculative
attacks--that they reflect profligate fiscal policy--had an obvious
shortcoming when applied to Thailand: its government was running a budget
surplus and had done so for several years. As events unfolded, more
exchange rate regimes in Asia collapsed, and in each case, the governments
in question had been running surpluses, or at worst small budget deficits.
In standard "first generation" currency crisis models, such as those of
Krugman (1979), Flood and Garber (1984), Obstfeld (1986), Calvo (1987),
Wijnbergen (1991), and Calvo and Végh (1998). Ongoing fiscal
to sustained reserve losses and to the eventual abandonment of a fixed
exchange rate. In these models ongoing deficits and rising debt levels
precede the collapse of a fixed exchange rate. Since neither deficits nor
rising debt levels were observed prior to the crisis in Asia, this led
many observers to argue that standard models were inadequate, and that the
crises arose from self-fulfilling expectations on the part of speculators.
We were not so sure. Each of the Asian economies that suffered through a
currency crisis also experienced a banking crisis. A consequence of these
financial crises was that the governments in Asia bore the cost of bailing
out failing banks, either by recapitalizing them, or by closing them and
honoring their debts. Thus, in Burnside, Eichenbaum and Rebelo (2001a) we
argue that the Asian currency crises were caused by fundamentals, in
particular, the large prospective deficits associated with government
bailout guarantees to failing banks. The expectation that seigniorage
revenues would finance these future deficits led to the collapse of the
fixed exchange rate regimes.
Our model has a distinctly first generation flavor in that fiscal deficits
ultimately financed by seigniorage revenues play a key role in triggering
the crisis. A key insight of our work, however, is that the deficits need
not precede the currency crisis. The currency crisis can occur in
anticipation of later deficits. Thus, a crisis can appear to be
unlikely--in the sense that fiscal policy looks healthy prior to the
Could agents in the Asian economies anticipate the coming deficits? We
argued that they could on the following basis: in most of the Asian
economies that experienced currency crises the banking sector was in
trouble prior to the crisis. In Korea and Thailand, especially, the stock
market capitalization of the financial sector had been in sharp decline
for over a year. Given the scale of the problem, agents could readily
anticipate that governments would step in and bear the cost of cleaning up
General equilibrium dynamics play an important role in the solution of our
model. First, like most currency crisis models, ours is explicitly
dynamic: equilibrium prices are determined by solving a system of first
order conditions that includes a dynamic Euler equation for money
balances. Second, unlike many currency crisis models, ours explicitly
requires that the government budget constraint be satisfied: this
endogenizes at least some aspects of the money supply path, and ensures
that the anticipation of future deficits plays a key role in driving the
The Post-Crisis Government Budget Constraint
Our prospective deficits model suffers from two important shortcomings:
Both of these predictions are at odds with what we have observed after
many twin crises. In recent episodes (e.g. Mexico 1994, Korea, Thailand
and the Philippines in 1997, Brazil 1999 and Turkey 2001) involving
substantial depreciation of the local currency, the increase in seignorage
revenues after the crisis was, at best, modest. Furthermore, in many of
these episodes the increase in inflation was also modest, or substantially
lagged behind the depreciation of the currency.
- It predicts that there should be a significant rise in seignorage
revenue after a currency crisis.
- It predicts that currency crises will be followed by substantial
inflation to the same extent that they lead to rapid depreciation of the
This evidence led us to ask the following questions: If not using
seigniorage, how do governments pay for the fiscal costs associated with
twin banking-currency crises? What are the implications of different
financing methods for post-crises rates of inflation and depreciation?
Can first generation models be reconciled with the facts?
In Burnside, Eichenbaum and Rebelo (2003a and 2003b) we address these
questions. Our answer to the first question is that after currency crises
governments finance themselves with a menu of different types of revenue.
The problem with the standard theories is that they assume, for
convenience, that governments face a simple choice between making explicit
fiscal reforms (such as raising tax rates or making social programs less
generous) to defend a fixed exchange rate, or printing money and
abandoning a fixed exchange rate. We show that, apart from seigniorage
governments have access to other types of revenue that are
depreciation-related. First, as in the fiscal theory of the price
level--exposited by Sims (1994), Woodford (1995), Dupor (2000), Cochrane
(2001), Daniel (2001a, b) and Corsetti and Mackowiak (2002)--they can
deflate the dollar value of outstanding nonindexed debt. Second,
governments can benefit from what we call "implicit fiscal reforms."
These reforms arise from changes in relative prices that are outside the
government's direct control. For example, if the government purchases
mainly nontraded goods, its expenditure, measured in dollars, will decline
if the dollar price of nontraded goods declines as the result of a crisis.
While this will also be true for revenue, the government may be a net
beneficiary of the crisis depending on the exact structure of its budget.
Also, government transfers that are indexed to the CPI decline in dollar
value if inflation lags behind depreciation. Our empirical
evidence--gleaned from case studies of Mexico, Korea and Turkey--suggests
that these additional forms of depreciation related revenue are more
important than seigniorage in some crisis episodes.
To answer the second and third questions we use variants of our
prospective deficits model in which the government budget constraint is
more realistically specified. In Burnside, Eichenbaum and Rebelo (2003a)
we use a simple reduced form model featuring a Cagan money demand
function, and a government budget constraint that allows for nominal debt
and nonindexed government transfers. In Burnside, Eichenbaum and Rebelo
(2003b) we develop a general equilibrium model with two goods, and a
government budget constraint that allows for (i) nominal debt, (ii)
transfers that are indexed to the CPI (not the exchange rate), (iii)
government purchases of goods and services, the dollar value of which is
affected by changes in relative prices, and (iv) taxes that are
proportional to economic activity. Using these models we show that the
ways in which governments finance themselves after crises have important
consequences for inflation and depreciation outcomes. Furthermore, we
show that our extended first generation models can be reconciled with the
facts as long as PPP only holds for traded goods at the producer level,
and as long as we allow for sticky nontradable goods prices.
Our results can be understood as follows. Suppose the banking crisis
imposes a fiscal cost, x dollars, on the government. One way the
government could pay for this new burden would be through explicit fiscal
reforms. If these explicit fiscal reforms raise x dollars of
model predicts that a currency crisis will be prevented. On the other
hand, if the government raises less than x dollars of revenue
explicit fiscal reform, it must abandon the fixed exchange rate regime.
Suppose that all government debt is denominated in dollars, that all goods
in the economy are tradable, and that PPP holds. In this case, the only
source of additional revenue to the government is the printing press. To
the extent that the government prints money the currency will depreciate
and, given PPP, there will be a similar amount of inflation.
On the other hand, suppose that the government has a substantial amount of
outstanding debt that is denominated in units of local currency. Then, as
the currency depreciates, the dollar value of this debt declines. In this
way, the government raises revenue implicitly,
and does not need to print as much money. This makes the model more
consistent with the facts in two ways: seigniorage becomes less important
and post-crisis inflation is also lower. Unfortunately, the model becomes
less consistent with the facts in that the model also predicts less
Now suppose the government spends more on nontraded goods than it raises
in revenue by taxing nontraded goods production (or consumption). In this
case, the government's budget balance--measured in dollars--will improve,
the greater is the decline in the dollar price of nontraded goods after a
crisis. As long as PPP only holds for traded goods and nontraded goods
prices are sticky in response to the currency crisis, the government
raises even more implicit revenue. For this reason, less money is
printed, and there is even less inflation. However, the model is fully
consistent with the facts because there will be substantial depreciation.
Why? Money demand must rise, in equilibrium, to match the money supply.
When money demand is proportional to the nominal transactions volume--say
as in a cash-in-advance model--and some prices are sticky, the prices that
are flexible adjust more in equilibrium. In our model, when nontraded
goods prices are sticky, the producer price of tradables, which, by PPP,
is equivalent to the exchange rate, rises more than it would if nontraded
goods prices were flexible.
For simplicity we assume that nontraded goods prices remain fixed for some
period of time after the crisis, and then rise in proportion to traded
goods prices. In a general equilibrium model with explicit price-setting
behavior these dynamics might be different, but we think they would be
similar, as long as the path for nontraded goods prices implied by the
model was realistic.
All of this suggests that first generation models can be rendered
consistent with the observed paths of inflation and depreciation after
recent currency crises, but only if we model the government budget
Government Guarantees to Banking Systems and Self-Fulfilling
While much of the research I have just described focuses on models in
which crises arise out of bad fundamentals in the banking sector, some of
my other recent work has considered the possibility of self-fulfilling
speculative attacks on fixed exchange rate regimes. In the models of
prospective deficits that I have just described, a currency crisis occurs
because the government bails out failing banks, and because the government
finances part of the bailout with depreciation-related revenue. These
models take the banking crisis as given, and work out the implications of
the government's financing choices for equilibrium prices.
In Korea and Thailand, the banks were in trouble prior to the crisis. It
is arguable, however, that these banks were exposed to exchange rate risk,
and that the crisis caused their balance sheets to deteriorate even
further. In other crisis episodes we see otherwise healthy banks which
are exposed to exchange rate risk, mainly because they have dollar
liabilities but do their lending in local currency. When a currency crisis
occurs these banks fail. This leads us to ask two questions:
In Burnside, Eichenbaum and Rebelo (2001b) we look at the first question
using a model of bank behavior in which banks borrow dollars from abroad
in order to finance domestic loans denominated in local currency. In the
model, the government fixes the exchange rate, but there is an exogenous
probability of the fixed exchange rate regime being abandoned in favor of
a floating rate regime with a devalued currency. The government also must
decide whether or not to issue guarantees to bank creditors. Suppose the
government issues no guarantees. Not surprisingly, the model predicts
that banks will hedge their exchange rate exposure, say in the forward
market. On the other hand, suppose that the government promises to bail
out banks that fail in the state of the world in which the exchange rate
regime is abandoned. [Mishkin (1996) and Obstfeld (1998) go as far as to
argue that a government's promise to maintain a fixed exchange rate is
often seen as an implicit guarantee to banks' creditors against the
effects of a possible devaluation.] In this case, the banks will not only
not hedge, but they will attempt to transfer as many profits as possible
from the bad state of the world to the good state of the world by selling
dollars forward. So government guarantees play a key role in determining
- Why do banks expose themselves to exchange rate risk?
- Does the fact that otherwise healthy banks are exposed to exchange
risk open the door to the possibility of currency crises driven by agents'
Again, the dynamic aspect of a bank's problem plays a key role. Bankers
maximize expected payments to their shareholders but face uncertainty
about the exchange rate. When there are no government guarantees, banks
hedge because they face higher borrowing costs if they are exposed to
exchange rate risk. These higher borrowing costs reflect the costs
associated with bankruptcy. On the other hand, under government
guarantees, a bank's creditors do not care if it is exposed to risk.
Furthermore, banks actually have an incentive to take on risk: they want
to leave nothing on the table in the bad state of the world.
In Burnside, Eichenbaum and Rebelo (2003c), we treat the probability of a
currency crisis as endogenous. Using a model similar to the one I have
just described we show that if the government does not issue guarantees,
banks hedge, and self-fulfilling speculative attacks are impossible in
equilibrium. On the other hand, if the government does issue guarantees,
banks are exposed to exchange rate risk. Suppose, in this situation,
agents come to believe that the fixed exchange rate regime will be
abandoned. They will speculate against the currency, causing the central
bank to float the currency. This will lead to the failure of the banks
exposed to exchange rate risk. The government, in turn, will have to bail
out the banks. If the government uses depreciation-related revenue to
finance the bailout, the speculative attack on the currency is rational.
Finally, in Burnside (2004), I describe how the issuance of government
guarantees combined with the methods by which these guarantees are
financed affects the probability of a crisis taking place. I show that
the greater the amount of revenue that can be raised through implicit
fiscal reforms, the lower the probability of a crisis of a given
magnitude. The reason is simple: the larger the potential implicit fiscal
reforms, the less seignorage is required to finance the budget. Other
things equal, the less money is printed the lower are the post-crisis
rates of depreciation and inflation.
In sum, this research points to the importance of government policy and
the government budget in currency and financial crises. Government
guarantees can be seen as an important determinant of a country's exposure
to self-fulfilling twin crises. Whether or not financial crises are
self-fulfilling, guarantees impose significant fiscal costs on
governments. Absent explicit fiscal reforms, paying for these costs
requires that the government abandon a fixed exchange rate regime. The
structure of the government's debt and budget act as important
determinants of the outcomes for inflation and depreciation. In our
models, these outcomes are determined by solving equilibrium models with
forward looking pricing equations.
Burnside, Craig (2004): Currency Crises and Contingent Liabilities,
Journal of International Economics
, vol. 62, pages 25-52.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2001a):
Deficits and the Asian Currency Crisis
, Journal of Political
109, pages 1155-1197.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2001b): Hedging and
Financial Fragility in Fixed Exchange Rate Regimes, European Economic
, vol. 45, pages 1151-1193.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003a): On the
Fiscal Implications of Twin Crises, in Michael P. Dooley and Jeffrey A.
Frankel, eds. Managing Currency Crises in Emerging Markets
University of Chicago Press.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003b): Government
Finance in the Wake of Currency Crises
, NBER Working Paper No. 9786.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo (2003c): Government
Guarantees and Self-Fulfilling Speculative Attacks. Forthcoming,
of Economic Theory
Calvo, Guillermo (1987): Balance
of Payments Crises in a Cash-in-Advance
, Journal of Money Credit and Banking
, vol. 19, pages
Calvo, Guillermo A. and Carlos A. Végh (1998): Inflation
BOP Crises in Developing Countries, in John B. Taylor and Michael
Woodford, eds., Handbook of Macroeconomics
, Vol. 1C. Amsterdam:
Cochrane, John (2001): Long-term
Debt and Optimal Policy in the Fiscal
Theory of the Price Level
, vol. 69, pages 69-116.
Corsetti, Giancarlo and Bartosz Mackowiak (2002): Nominal Debt and the
Dynamics of Currency Crises
. Manuscript, Yale University.
Daniel, Betty C. (2001a): The Fiscal Theory of the Price Level in an Open
Economy, Journal of Monetary Economics
, vol. 48, pages 293-308.
Daniel, Betty C. (2001b): A
Fiscal Theory of Currency Crises
International Economic Review
, vol. 42, pages 969-988.
Dupor, William (2000): Exchange Rates and the Fiscal Theory of the Price
Level, Journal of Monetary Economics
, vol. 45, pages 613-630.
Flood, Robert and Peter Garber (1984): Collapsing Exchange Rate Regimes:
Some Linear Examples, Journal of International Economics
, vol. 17,
Kaminsky, Graciela and Carmen Reinhart (1999): The Twin
Crises: the Causes
of Banking and Balance-of-Payments Problems
, American Economic
89, pages 473-500.
Krugman, Paul (1979): A
Model of Balance of Payments Crises
Money, Credit and Banking
, vol. 11, pages 311-325.
Mishkin, Frederic (1996): Understanding Financial Crises: A Developing
Country Perspective, in Michael Bruno and Boris Pleskovic, eds. Annual
World Bank Conference on Development Economics
. Washington, DC: World
Obstfeld, Maurice (1998): The
Global Capital Market: Benefactor or
Menace? Journal of Economic Perspectives
, vol. 12, pages 9-30.
Obstfeld, Maurice (1986): Speculative
Attack and the External Constraint
in a Maximizing Model of the Balance of Payments
, Canadian Journal
, vol. 29, pages 1-20.
Sims, Christopher (1994): A
Simple Model for the Determination of the
Price Level and the Interaction of Monetary and Fiscal Policy
, vol. 4, pages 381-399.
Wijnbergen, Sweder van (1991): Fiscal
Deficits, Exchange Rate Crises and
, Review of Economic Studies
, vol. 58, pages 81-92.
Woodford, Michael (1995): Price Level Determinacy Without Control of a
Monetary Aggregate, Carnegie-Rochester Conference Series on Public
, vol. 43, pages 1-46.
EconomicDynamics Interviews Vincenzo Quadrini on Firm Dynamics
Vincenzo Quadrini is Associate Professor of Economics at the Marshall
School of Business, University of Southern California. His field of
is Entrepreneurship, Financial Economics and Macroeconomics.
EconomicDynamics: In recent work with Claudio
Michelacci, you started exploring the relationship between firm
size and wages. What new insight have you obtained?
Vincenzo Quadrini: A well-known stylized fact in labor economics is that
pay higher wages than small firms. There are several studies in
the theoretical literature that try to explain this fact. However,
none of the existing studies investigate the role of financial
constraints. In the joint work with Claudio Michelacci we ask
whether financial factors can contribute to explaining the
dependence of wages on the size of the employer.
Our interest in understanding the importance of financial factors
for the firm size-wage relation is motivated by a set of
regularities about the link between the financial characteristics
of firms and their size. The view that results from the financial
literature is that smaller firms face tighter constraints. It is
natural then to ask whether the dependence of wages from the size
of the firm could derive from the tighter financial constraints
faced by small firms.
We study a model in which firms sign optimal long-term contracts
with workers. Due to limited enforceability, external investors
are willing to finance the firm only against collateralized
capital. If the investment financed with external investors is
limited--that is, the firm is financially constrained--the
optimal wage contracts offered by the firm to the workers is
characterized by an increasing wage profile. By paying lower wages
today, the firm is able to generate higher cash-flows in the
current period, which relax the tightness of the financial
constraints. Because firms with tighter constraints operate at a
sub-optimal scale--which then they gradually expand until they
become unconstrained--small firms pay on average lower wages than
large firms. At the same time, because constrained firms are the
ones that grow in size, the model also captures the empirical
regularity that fast growing firms pay lower wages. Through a
calibration exercise we show that the model can generate a firm
size-wage relation which is comparable in magnitude to the
estimates obtained in the empirical literature.
The increasing wage profile raises the question of whether the
firm may have the incentive to renegotiate the wage contract in
later periods. The key modeling feature that prevents the firm
from renegotiating the contract is the loss of sunk investment if
the worker quits. This investment could derive from recruiting
costs or training expenses that enhance the job specific human
capital of the worker. The firm's loss of valuable investment
endows the worker with a punishment tool which is not available to
external investors. This allows the firm to implicitly
borrow from workers beyond what it can borrow from external
ED: You show that the liquidation of a
firm in a long-term contract may occur even when the contract is
renegotiated, and sometimes only when the contract is
renegotiated. What does this imply for the design of corporate
law, and in particular bankruptcy law?
VQ: A well established result in models with
agency problems, is that more stringent punishments can support
superior allocations. However, punishments may be
time-inconsistent in the sense of being ex-post inefficient. For
instance, in a financial relation between an investor and an
entrepreneur characterized by information asymmetries, the threat
of liquidation may be ex-ante optimal because it induces the
desired action from the entrepreneur. However, after the
entrepreneur's action has been taken and the firm's outcome
observed, it may be inefficient to liquidate the firm. This
implies that the liquidation threat is not credible and it will be
renegotiated. This raises the question of whether an optimal
financial contract would ever lead to the liquidation of a viable
firm. In "Investment and Liquidation in Renegotiation-Proof
Contracts with Moral Hazard" I show that the firm can still be
liquidated in an optimal contract even if we impose the
renegotiation refinement. In general, allowing for the
renegotiation of contracts reduces the allocation efficiency
because it makes more difficult to create incentives.
What does this imply for the design of corporate and bankruptcy
law? In principle, there are some important policy
The time-consistency problem outlined above would be avoided if
the contractual parties could commit to not renegotiate the
contract in future dates. If the policy maker could legally
prevent the renegotiation of private contracts, the problem would
also be avoided. This requires that when a contract prescribes the
liquidation of the firm, the firm should be legally forced to exit
and liquidate its assets. While this may seem paradoxical, this is
what the theory suggests.
Of course, the time-consistency problem can also arise for the
policy maker. When a firm would otherwise be inefficiently
liquidated and the parties would have been willing to renegotiate,
the policy maker would also prefer that the parties renegotiate.
However, changing the current rules may undermine the credibility
of all existing contracts. In other words, reputation
considerations may limit the regulator's incentive to make
These policy considerations seem at odds with standard bankruptcy
laws. One of the main goals of bankruptcy law is to facilitate the
renegotiation of contracts in order to prevent default or
liquidation. However, although renegotiation may be ex-post
desirable in the event of financial distress, it is never optimal
This conclusion also holds in the international context, that is,
for borrowing and lending countries. The creation of an
effective enforcement system, however, is extremely
difficult in the international context.
In your work with Charles Himmelberg,
you show that entrepreneurs in young firms should be compensated
with options, but that options should be less and less used as
firms mature and grow. CEO compensation is the subject of intense
criticism these days in the US, partly due to large option
packages. Does this mean that current CEO compensations are
VQ: Of course, if we believe that the recent
corporate scandals were caused by the compensation structure of
managers, then there must be something wrong with this structure.
It is true that recent managerial compensations have been
dominated by generous stock options and/or stock grants. However,
this does not mean that options are not useful to create the
right managerial incentives. The recent corporate scandals
only show that the options offered to managers were not well
designed. And probably this was caused by a misunderstanding about
the fundamental agency problems between managers and investors.
In the type of models I have been working with, the agency
problems derive from the non-observability of the manager's use of
the firm's resources. In these models, the incentive for the
manager is to under-report the firm's performance because this
allows him or her to divert some of the firm's resources.
Consequently, to prevent the manager from under-reporting, his or
her compensation must rise when the performance of the firm is
good. One way to achieve this outcome is with the use of stock
options. But if the rewards for good outcomes are excessive, then
the manager starts to have the opposite incentive, that is, to
inflate the firm's performance. In this sense, the problem with
recent managerial compensation does not derive from the use of
options per se, but from their "excessive" use.
Himmelberg, Charles, and Vincenzo Quadrini (2002): Optimal Financial
Contracts and the Dynamics of Insider Ownership. Manuscript, New York
Michelacci, Claudio, and Vincenzo Quadrini (2004): Financial
Markets and Wages, Manuscript, CEMFI.
Quadrini, Vincenzo (2004):
Investment and Liquidation in Renegotiation-Proof Contracts with Moral
Hazard. Journal of Monetary Economics, vol. 51, pages 713-751.
Patrick Kehoe on Whether Price Rigidities Matter for Business Cycle
Let me take this question in several parts. First, are there any price
rigidities? Well, in the data, the prices of many individual goods stay
fixed for weeks or even months even though there are high frequency
fluctuations in demand and supply. So it looks like there are definitely
some sort of rigidities.
Patrick Kehoe is Monetary Adviser at the Research Department of the
Federal Reserve Bank of Minneapolis and the Frenzel Professor of
International Economics at the University of Minnesota. His interests span
the study of international business cycles as well as monetary and fiscal
Kehoe's RePEc/IDEAS entry
Second, do these rigidities play an important role in determining the
magnitude and persistence of deviations from trends of the major
aggregates? I think that a fair answer has to be that the verdict is still
out. There are several uphill battles, both empirical and theoretical that
need to be won before anyone can claim to have demonstrated the price
rigidities are important. Let me turn to these challenges.
Challenges for sticky price enthusiasts
A. Empirical: Observed price stickiness is short
On the empirical side Bils and Klenow (2003) and Klenow and Krystov (2003)
have dug up some interesting BLS data on individual goods price that shows
that a key feature of the data is
- The average time between price changes is relatively short, about
B. Theoretical: Existing sticky price and sticky wage models don't
generate enough persistence
On the theoretical side there is one key challenge:
The increasingly popular New Keynesian paradigm takes a
Dixit-Stiglitz-Spence monopolistic competition framework and embeds some
type of sticky prices. Chari, Kehoe, and McGrattan (2000, 2002) take that
paradigm and add to it a Taylor-type overlapping price contracts. We show
that with the parameters chosen so that when the average time between
price changes matches that in the Bils and Klenow data, then the model can
deliver much less persistence in output that is observed in the data. This
lack of persistence holds up even when we incorporate several features in
the model that are designed to increase persistence--so-called real
rigidities--such as convex demand, intermediate goods, specific factors
and adjustment costs of various kinds.
- Despite any claims to the contrary, existing models of sticky
prices cannot generate anywhere near the level of persistence in output
seen in the data.
The new work by Golosov and Lucas (2003) raise an even greater challenge
for sticky price models. Their work is motivated by some of the empirical
work of Klenow and Krystov who find the following at the level of an
individual retailer, like a store.
Likewise, the average size of price decreases is a little over 8%. To
interpret this feature of the data, recall that the average time of a
price change is about 4 months and that over this time the average
inflation rate is less than 1%. The price changes seem enormous relative
to what one would expect if prices were changed mainly because of money
shocks. Hence, it seems fair to say that the bulk of the large price
changes in the data are driven by some idiosyncratic factors at the
individual level that seem to have little to do with monetary policy.
- The average size of price increases in the data is about 9%.
This type of reasoning motivates Golosov and Lucas to construct a model
with fixed costs of changing prices with large idiosyncratic shocks at the
level of the individual retailer along with aggregate monetary shocks.
They then compare the persistence of output in their state-dependent
pricing models to that of a Calvo-type model with an exogenously specified
timing of price changes that is so popular in the literature. They find
that they get about 1/5th of the amount of persistence that a Calvo model
does with the same average time of price changes.
The intuition for this result is that in their state dependent model, when
a money shock hits the retailers that endogenously choose to change their
prices are the ones whose prices are the most out of whack. Thus, the
retailers that don't change their prices are the ones for whom not
changing is not a big deal "in terms of output loss" anyway. Hence,
the model generates very little persistence. The obvious conjecture is
that even if we try to load up the model with all kinds of bells and
whistles that go under the rubric of real rigidities the 1/5th rule will
approximately hold up. That is, once the sticky price literature squarely
confronts the micro data on price changes replacing the Calvo pricing with
a fixed cost model, it will find that the persistence of output is cut by
a factor of 5. I would also conjecture that if researchers forthrightly
confront this problem they will give up on the current strand of sticky
C. Doubtful Claims of Success
There is some recent work that claims that existing sticky price
and sticky wage models can generate as much persistence as there is in the
data. I take issue with these claims. My issues can all be summarized as
follows: The literature that claims success, lowers the bar from 10 feet
to 2 feet, jumps over it and then declares victory. Here is how the bar is
The retreat to VARs
The reason macroeconomists are interested in nominal rigidities in the
first place is that many think they play a key role over the business
cycle in determining how the economy reacts to nominal shocks. (Here by
nominal shocks I mean something a little broader than what people
typically mean. I mean both the epsilons on the end of estimated policy
rules and policy mistakes, defined as the difference between the observed
systematic component of policy and the what would be the optimal
systematic component of policy given a model.) Many of the sticky price
enthusiasts have retreated from even claiming that their models can
account for the overall business cycle patterns and instead retreat to the
rather tiny component of the business cycle identified by a VAR to be
attributable to the epsilon shocks on an estimated policy rule. (A notable
exception to this pattern is the work by Bordo, Erceg and Evans 2000.)
Thus, these macroeconomists replace the very interesting question of how
much of the business cycle can monetary shocks in the presence of price
rigidities account for, to the fairly much less interesting question of
can our model reproduce the impulse response to a blip to the epsilon on
the end of an estimated monetary policy rule.
To drive this point home, note that if you plot the last hundred years of
detrended GDP for the United States one event outshines all others: the
Great Depression. All postwar business cycles look like little blips
compared to the Great Depression. Almost all economists who have studied
the Great Depression argue that broadly defined monetary shocks played a
critical role in generating the depth and the length of the Depression.
Indeed, one of the main forces spurring the Keynesian revolution is the
perceived inadequacy of the simplest classical models without frictions to
generate such a depression. The sticky price enthusiasts seem to shy away
from building serious quantitative models that can generate the Great
Depression. From the point of view of business cycle theorists, retreating
to VARs and ignoring the Great Depression is amounts to saying that the
game you want me to play is too hard so I am going to take my marbles and
Making prices and wages stickier than they are in the data
Part of this work simply makes prices much more sticky than they are in
the data--3 quarters instead of 1 quarter--and shows that these models
generate about 3 times as much persistence as the existing models with one
quarter. Somehow this work misses the point. Another part of this work
claims that sticky wage models can generate much more persistence than
sticky price models. That is not really true. Chari, Kehoe and McGrattan
(2003) showed that if for the same degree of exogenous stickiness, sticky
wage models and sticky price models generate similar degrees of
persistence. What the literature on sticky wages actually does is simply
increase the degree of exogenous stickiness for wages to be 3 times as
much as it is for prices and argues that sticky wages generate more
persistence. (See, for example, Bordo, Erceg and Evans (2000) and
Christiano, Eichenbaum and Evans (2003).) The logic for having long
exogenous stickiness for wages with labor contracts determined in a spot
market is that many people receive only yearly changes in their nominal
Punting on measuring stickiness in long-term relationships
The deeper problem with this literature is the idea that actual wage
contracts in the U.S. economy are well approximated by a sequence of spot
market transactions. For example, in our profession most assistant
professors have fairly stable wages for about 7 years and at that time
their wages jump up by varying degrees at tenure time. All assistants
understand that if they work harder during those 7 years the probability
distribution over their post-tenure wages increases. To an outside
observer who naively models the situation as a sequence of spot-market
trades it will look like wages are sticky. As was pointed out over 20
years ago, in a long term relationship the fact the changes to payment
streams occurs in lumps in no way restricts the ability of the contract to
achieve real outcomes. Before this literature can make any progress the
issue of how best to use data to shed light on whether wages in long-term
relationships are indeed sticky needs to be addressed.
In sum I think the following. The serious work on incorporating
interesting price rigidities into serious dynamic stochastic equilibrium
models capable of confronting the data is still in its infancy. Price
rigidities may turn out to be important, but the current models we have
for addressing them seem not very promising quantitatively. Currently, I
see a large number of economists writing papers that takes the existing
sticky price models as they stand and tries to use them to address a
number of issues, especially policy issues. I think that this is not a
productive use of time. A better use of time for the sticky price
enthusiasts is to go back to the drawing board and dream up another
version of the model that has a chance at generating the patterns observed
in the Great Depression. Doing so may be difficult, but the payoff is
Bils, Mark and Peter J. Klenow (2002): Some Evidence on the
Importance of Sticky Prices
, NBER Working Paper 9069.
Bordo, Michael D., Christopher J. Erceg and Charles L. Evans (2000):
Wages and the Great Depression
, American Economic Review
Chari, V.V., Patrick J. Kehoe and Ellen McGrattan (2000): Sticky
Price Models of
the Business Cycle: Can the Contract Multiplier Solve the Persistence
, vol. 68, pages 1151-1180.
Chari, V.V., Patrick J. Kehoe and Ellen McGrattan (2002): Can Sticky
Price Models Generate Volatile and Persistent
Exchange Rates? Review of Economic Studies
, vol. 69, pages
Christiano, Lawrence, Martin Eichenbaum and Charles Evans (2003):
and the Dynamic Effects of a Shock to Monetary Policy
Journal of Political Economy
Golosov, Mikhail and Robert E. Lucas Jr. (2003): Menu Costs and
, NBER Working Paper 10187.
Klenow, Peter J. and Oleksiy Kryvtsov (2003): State Dependent
Time-Dependent Pricing: Does it Matter for Recent U.S. Inflation?
Manuscript, Federal Reserve Bank of Minneapolis.
Review of Economic
Dynamics: Letter from the Coordinating Editor
This is just a brief note to let you know that the process for submitting
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RED Coordinating Editor
Review: Mortensen's Wage Dispersion
Wage Dispersion: Why Are Similar Workers Paid Differently?
by Dale Mortensen
In in latest book, Dale Mortensen reviews the evidence and the latest
theoretical findings on a long standing puzzle: why would different firms
pay differently for the same workers? Observable worker characteristics
explain at most 30% of wage differentials across individuals. This raises
doubts about the wage equation that yields such results, the efficacy of
the standard competitive model or the functioning of labor markets.
There is now mounting evidence that firm size and industry matter. This
may mean that imperfect competition is in order which would allow
different firms to offer different pay policies. Also, explicitly
modeling the frictions on the labor market may be needed. Mortensen
addresses this by laying out a simple matching model with wage posting and
demonstrates that this can leads to wage dispersion even when all firms
and workers are identical. It is then shown how this model can be extended
to various environments where firms differ along some dimension.
The model is then extended to an intertemporal setup, the
Burdett-Mortensen model. Dale Mortensen then discusses empirical work done
with co-authors on a Danish data set and shows that including productivity
differences across employers allows the model to better match observed
distributions. What these results imply in terms of workers flows and job
tenure is the discussed in two further chapters.
This book in essential for anyone interested in some serious modeling
of the labor market. It assembles the research frontier on labor search,
both on the theoretical and empirical fronts.
"Wage Dispersion" was published in January 2004 by MIT Press.
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