**The Global Business Cycle: Measurement and Transmission**

**with Andrei A. Levchenko and Nitya Pandalai-Nayar**

**Paper, VOX coverage**

Abstract: This paper uses sector-level data for 30 countries and up to 28 years to provide a forensic account of the sources of international GDP comovement. We propose an accounting framework to decompose comovement into the component due to correlated shocks, and the component due to transmission of shocks across countries through linkages. We apply this decomposition to a multi-country multi-sector DSGE model, calibrated to international input-output and final goods trade. We derive an analytical open economy influence matrix that characterizes every country's general equilibrium GDP elasticities with respect to various shocks anywhere in the world. We then provide novel estimates of country-sector-level technology and non-technology shocks to assess their correlation and quantify the sources of comovement. We find that TFP shocks are virtually uncorrelated across countries, whereas non-technology shocks are positively correlated. The quantitative assessment shows that most of the observed comovement is due to correlated shocks. The role of transmission in synchronizing GDP across countries is positive but modest, accounting for about 15% of the observed GDP correlations. Finally, we show that while transmission of shocks across countries contributes positively to comovement, GDP correlations would not necessarily be lower if countries were in autarky. This is because the contribution of trade openness to comovement depends on whether sectors with more or less correlated shocks grow in influence as countries increase input linkages.

**Myopia and Anchoring**

**with George-Marios Angeletos**

paper, R&R at American Economic Review

paper, R&R at American Economic Review

Abstract: We offer a simple toolbox for understanding and quantifying the equilibrium effects of incomplete information. We first develop an observational equivalence between incomplete information and two behavioral distortions: myopia, or extra discounting of the future; and anchoring of the current outcome to the past outcome, as if there were habit. The distortions are larger when GE considerations are more important, reflecting the role of higher-order uncertainty. We show how to quantify the distortions with the help of evidence on the underreaction of average forecasts (Coibion and Gorodnichenko, 2015). We further explain why the documented theoretical and quantitative effects are invariant to seemingly conflicting evidence on the overreaction of individual forecasts (Bordalo, Gennaioli, Ma, and Shleifer, 2018). We finally use the combination of such evidence to select incomplete information over level-k thinking and cognitive discounting.

**A Single-Judge Solution to Beauty Contests**

**with Marcelo Zouain Pedroni**

paper, appendix, accepted at American Economic Review

paper, appendix, accepted at American Economic Review

**Previously titled: Infinite Higher Order Beliefs and First Order Beliefs: An Equivalence Result**

Abstract: We show that the equilibrium policy rule in beauty-contest models is equivalent to that of a single agent’s forecast of the economic fundamental. This forecast is conditional on a modified information process, which simply discounts the precision of idiosyncratic shocks by the degree

of strategic complementarity. The result holds for any linear Gaussian signal process (static or persistent, stationary or non-stationary, exogenous or endogenous), and also extends to network games. Theoretically, this result provides a sharp characterization of the equilibrium and its properties under dynamic information. Practically, it provides a straightforward method to solve models with complicated information structures.

**The Anatomy of Sentiment-Driven Fluctuations**

**with Sushant Acharya and Jess Benhabib**

paper

**, R&R at Journal of Economic Theory**

Abstract: We show that sentiments-self-fulfilling changes in beliefs that are orthogonal to fundamentals - can drive persistent aggregate fluctuations under rational expectations. Such fluctuations can occur even in the absence of any exogenous aggregate fundamental shocks. In addition, sentiments also alter the volatility and persistence of aggregate outcomes in response to fundamental changes. We characterize conditions under which sentiments drive persistent fluctuations and when they only affect aggregate outcomes contemporaneously. We also discuss how these sentiments are related to noise shocks-driven fluctuations studied in the literature on information frictions.

****

Abstract: This paper proposes a new equilibrium concept-organizational equilibrium-for models with state variables that have a time-inconsistency problem. The key elements of this equilibrium concept are: (1) agents are allowed to ignore the history and restart the equilibrium; (2) agents can wait for future agents to start the equilibrium. We apply this equilibrium concept to a quasi-geometric discounting growth model and to a problem of optimal dynamic fiscal policy. We find that the allocation gradually transits from that implied by its Markov perfect equilibrium towards that implied by the solution under commitment, but stopping short of the Ramsey outcome. The feature that the time inconsistency problem is resolved slowly over time rationalizes the notion that good will is valuable but has to be built gradually.

**Organizational Equilibrium with Capital****with Marco Bassetto****and José-Víctor Ríos-Rull****Paper**Abstract: This paper proposes a new equilibrium concept-organizational equilibrium-for models with state variables that have a time-inconsistency problem. The key elements of this equilibrium concept are: (1) agents are allowed to ignore the history and restart the equilibrium; (2) agents can wait for future agents to start the equilibrium. We apply this equilibrium concept to a quasi-geometric discounting growth model and to a problem of optimal dynamic fiscal policy. We find that the allocation gradually transits from that implied by its Markov perfect equilibrium towards that implied by the solution under commitment, but stopping short of the Ramsey outcome. The feature that the time inconsistency problem is resolved slowly over time rationalizes the notion that good will is valuable but has to be built gradually.

****

paper

Abstract: This paper presents a model of business cycles driven by shocks to agents' beliefs about economic fundamentals. Agents are hit both by common and idiosyncratic shocks. Common shocks act as confidence shocks, which cause economy-wide optimism or pessimism and consequently, aggregate fluctuations in real variables. Idiosyncratic shocks generate dispersed information, which prevents agents from perfectly inferring the state of the economy. Crucially, asymmetric information induces the infinite regress problem, that is, agents need to forecast the forecasts of others. We develop a method that can solve the infinite regress problem without approximation. Even though agents face a complicated learning problem, the equilibrium policy can be represented by a small number of state variables. Theoretically, we prove that the persistence of aggregate output is increasing in the degree of information frictions and strategic complementarity, and there is a hump-shaped relationship between the variance of output and the variance of the confidence shock. Quantitatively, our model with confidence shocks can match a number of the key business cycle moments.

**Higher Order Beliefs, Confidence, and Business Cycles****with Naoki Takayama, Job Market Paper**paper

Abstract: This paper presents a model of business cycles driven by shocks to agents' beliefs about economic fundamentals. Agents are hit both by common and idiosyncratic shocks. Common shocks act as confidence shocks, which cause economy-wide optimism or pessimism and consequently, aggregate fluctuations in real variables. Idiosyncratic shocks generate dispersed information, which prevents agents from perfectly inferring the state of the economy. Crucially, asymmetric information induces the infinite regress problem, that is, agents need to forecast the forecasts of others. We develop a method that can solve the infinite regress problem without approximation. Even though agents face a complicated learning problem, the equilibrium policy can be represented by a small number of state variables. Theoretically, we prove that the persistence of aggregate output is increasing in the degree of information frictions and strategic complementarity, and there is a hump-shaped relationship between the variance of output and the variance of the confidence shock. Quantitatively, our model with confidence shocks can match a number of the key business cycle moments.

paper

Abstract: This paper develops a general method of solving rational expectations models with higher order beliefs. Higher order beliefs are crucial in an environment with dispersed information and strategic complementarity, and the equilibrium policy depends on infinite higher order beliefs. It is generally believed that solving this type of equilibrium policy requires an infinite number of state variables (Townsend, 1983). This paper proves that the equilibrium policy rule can always be represented by a finite number of state variables if the signals observed by agents follow an ARMA process, in which case we obtain a general solution formula. We also prove that when the signals contain endogenous variables, a finite-state-variable representation of the equilibrium may not exist. For this case, we develop a tractable algorithm that can approximate the solution arbitrarily well. The key innovation in our method is to use the factorization identity and Wiener filter to solve signal extraction problems conditional on infinite observables. This method can be used in a wide range of applications. We demonstrate its strong practicability by solving several classical models featuring higher order beliefs, and also a full-blown business cycle model that is driven by confidence shocks.

**Rational Expectations Models with Higher Order Beliefs****with Naoki Takayama, Job Market Paper**paper

Abstract: This paper develops a general method of solving rational expectations models with higher order beliefs. Higher order beliefs are crucial in an environment with dispersed information and strategic complementarity, and the equilibrium policy depends on infinite higher order beliefs. It is generally believed that solving this type of equilibrium policy requires an infinite number of state variables (Townsend, 1983). This paper proves that the equilibrium policy rule can always be represented by a finite number of state variables if the signals observed by agents follow an ARMA process, in which case we obtain a general solution formula. We also prove that when the signals contain endogenous variables, a finite-state-variable representation of the equilibrium may not exist. For this case, we develop a tractable algorithm that can approximate the solution arbitrarily well. The key innovation in our method is to use the factorization identity and Wiener filter to solve signal extraction problems conditional on infinite observables. This method can be used in a wide range of applications. We demonstrate its strong practicability by solving several classical models featuring higher order beliefs, and also a full-blown business cycle model that is driven by confidence shocks.

**Tightening Financial Frictions on Households, Recessions, and Price Reallocations**

**with José-Víctor Ríos-Rull**

paper, code,

**Review of Economic Dynamics**

Abstract: We explore the effects of financial shocks in heterogeneous agent economies with aggregate savings and with frictions in some consumption markets, where demand contributes to productivity. Households of various wealth and earnings levels search for goods at different intensities and pay different prices in differently crowded markets. Increases in savings arising from a financial shock that tightens the borrowing limit trigger a recession via two channels: 1) the reduction in the consumption of goods that are subject to search frictions reduces productivity and output; 2) because the poorest households are more affected by the shock, consumption tilts toward the richest households, causing an additional reduction in output and productivity. We model fixed prices in a competitive search environment and show how price rigidities dramatically exacerbate the recession.

**Paradox of Thrift Recessions**

**with José-Víctor Ríos-Rull**

paper

Abstract: We build a variation of the neoclassical growth model in which both wealth shocks (in the sense of wealth destruction) and financial shocks to households generate recessions. The model features three mild departures from the standard model: (1) adjustment costs make it difficult to expand the tradable goods sector by reallocating factors of production from nontradables to tradables; (2) there is a mild form of labor market frictions (Nash bargaining wage setting with Mortensen-Pissarides labor markets); (3) goods markets for nontradables require active search from households wherein increases in consumption expenditures increase measured productivity. These departures provide a novel quantitative theory to explain recessions like those in southern Europe without relying on

technology shocks.

**Sticky Wage Models and Labor Supply Constraint**

**with José-Víctor Ríos-Rull**

paper,

**Forthcoming at American Economic Journal: Macroeconomics**

Abstract: In New Keynesian models with sticky wages, the quantity of labor is solely determined by the demand side. Unions with monopsony power set the wage above what it takes to make agents work. If wages are sticky, however, a change of circumstances may make the demand for labor higher than agents’ willingness to work. Because of the simplicity of log-linearization, the literature implicitly assumes that the markup of wages over the willingness to work is large enough to ensure that workers always comply with the quantity of labor demanded. In this paper, we explore the extent to which this is the case and find that workers are required to work against their will about 10% of the time. Moreover, when we use, as proposed by traditional theory (Drèze (1975)), the minimum of the demand and supply of labor instead of the demand-determined quantity, we find that the typical parametrization yields a variance of hours around 25% lower (depending on the particular model). The Dreze equilibrium is hard to compute, yet we find that a boundedly rational use of log-linearization methods gives a good approximation. We estimate the Dreze equilibrium for a version of the Christiano, Eichenbaum, and Evans (2005) environment and find that it yields answers that are sharply different from the demanddetermined allocation: neutral productivity shocks go from accounting for 13% of the variance of employment to accounting for 70% of the variance of employment, to the detriment of the role played by investment specific technology shocks and monetary shocks. We conclude that when working with sticky wage economies, the appropriate procedure is to estimate the model using the approximated Dreze equilibrium.

**Financial Frictions, Asset Prices, and the Great Recession**

**with José-Víctor Ríos-Rull**

paper

Abstract: We explore the effects of financial shocks in heterogeneous agent economies (a la Aiyagari) with frictions in both labor markets and goods markets. Houses serve as collaterals for borrowing, and are subject to capital loss. In this economy, households of different wealth and earnings buy different amount of varieties and different quantities of each variety, and their consumption demand contributes to productivity. Unlike in standard neoclassical models, a financial shock to the collateral constraint that increases the desire to save triggers a recession with sizeable asset market depreciation, a large decline of employment, and severer output loss which are comparable with the recent Great Recession.

**Institutional Constraints and Labor Market Outcomes**

**with Lia Pacelli, Elena Pastorino, and**

**Melissa Tartari**

slide, in progress

Abstract: In many European countries labor market regulations are pervasive. They take the form of wage floors (dependent, for instance, on a worker's job history), hiring and firing restrictions, automatic promotions, and constraints to pay growth. What are the implications of these regulations for individual employment and wage dynamics and for the aggregate wage distribution? We answer this question by developing and estimating an equilibrium model of the Italian labor market using matched employer-employee data from the Work Histories Italian Panel (WHIP) merged with unique information on the constraints implied by national collective labor agreements (Contratto Collettivo Nazionale del Lavoro or CCNL). In the model ex-ante skill-heterogeneous workers and homogeneous firms match frictionlessly and are subject to the most salient regulations implied by CCNLs. The model can replicate, qualitatively and quantitatively, the main features of the dynamics of employment and wages: unemployment to employment and job-to-job transitions, wage growth (with tenure and experience), and downward wage rigidities. It can also largely explain the cross-sectional distribution of wages. Absent the labor market regulations we consider, the model would generate counterfactual predictions about the dynamics of wages and unemployment. Based on these results, we conclude that policy frictions offer an explanation for the dynamics of wages and employment observed in European labor markets that is naturally complementary to that provided by search frictions.

**Learning Your Earning over Business Cycles:**

**Excess Consumption Volatility in Emerging Countries**

**with Shihui Ma**

in progress

Abstract: In emerging markets, business cycles are characterized by higher consumption volatility relative to output and strongly counter-cyclical current accounts. Meanwhile, agents in emerging countries face higher uncertainty in forecasting economic fundamentals. We build a general equilibrium business cycle model with heterogeneous income profiles and imperfect information. Agents observe their income to learn the growth rate of their individual human capital and the growth rate of the aggregate economy. Due to information frictions, a shock to the growth rate of the aggregate economy will be partly attributed to the growth rate of agents' own human capital, the latter of which has more persistent effects on agents' life-time income. As a result, the economy features higher consumption volatility than the output. Quantitatively, we find that the model can successfully explain the excessive volatility of consumption and generate a strongly negative correlation between the trade balance and output for a wide range of TFP and income processes.

**A Realistic Neoclassical Multiplier**

**with José-Víctor Ríos-Rull**

Economic Policy Paper, Federal Reserve Bank of Minneapolis, 2013

**Publications before graduate school**

**Disaster Risk and Wealth Distribution of Chinese Urban Residents**

**with Yanbin Chen and Jun Chen, in Chinese**

paper, Economic Research Journal, 2009

**An Empirical Study of Wealth Distribution of Urban and Rural Households in China**

**with Yunwen Liang and Kai Liu, in Chinese**

paper, Economic Research Journal, 2010

**A Conjecture of Chinese Monetary Policy Rule: Evidence from Survey Data, Markov Regime Switching and Drifting Coefficients**

**with Yanbin Chen**

paper, Annals of Economics and Finance, 2009