Journal of Macroeconomics 33 (2011) 1–3

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Journal of Macroeconomics

journal homepage: www.elsevier .com/locate / jmacro

Introduction to special issue: Macroeconomics with frictions

Ian KingDepartment of Economics, University of Melbourne, Melbourne, Victoria 3010, Australia

a r t i c l e i n f o

Article history:Received 20 October 2010Accepted 20 October 2010Available online 26 October 2010

JEL classification:E00

Keywords:MacroeconomicsFrictionsDynamic quantitative analysis

0164-0704/$ - see front matter � 2010 Elsevier Incdoi:10.1016/j.jmacro.2010.10.004

E-mail address: ipking@unimelb.edu.au

a b s t r a c t

This is an introduction and overview of the special issue on ‘‘Macroeconomics withfrictions’’.

� 2010 Elsevier Inc. All rights reserved.

Modern macroeconomic theory, from the 1980s onwards, has undergone a fundamental revolution in its methodology.Two major theoretical tools, introduced to macroeconomics in that decade, have transformed the way macroeconomiststhink about the world. Both of these tools were previously restricted to the domain of mathematical microeconomics, buthave emerged as crucial elements in current macroeconomic modelling. The first is dynamic general equilibrium (DGE)theory, whose entry into mainstream macroeconomics was pioneered by the 2004 Nobel laureates Finn Kydland and EdwardPrescott. The second is the theory of search and frictions, pioneered by the 2010 Nobel laureates Peter Diamond, DaleMortensen, and Christopher Pissarides.

Both of these developments theory have several inherent properties that make them appealing for macroeconomic anal-ysis. First, they provide standard microeconomic foundations for macroeconomic phenomena – bringing together the twobranches of economic theory (microeconomic and macroeconomic) that were previously quite (embarrassingly) indepen-dent of each other. Second, as a result, they allow for macroeconomic policy analysis, and explicit welfare analysis, thatcan draw on the wealth of results that have already been developed in the fields of public finance and welfare economics.Third, both are quite amenable to quantitative analysis – allowing researchers to ask quantitative questions, based on appro-priately calibrated models.

While early DGE macroeconomic analysis focussed on models without frictions – where the welfare theorems hold –more recent work of this type has explored the role of frictions explicitly, both qualitatively and quantitatively. Today,we see frictions being carefully modelled in all areas of macroeconomics through this lens, including unemployment,growth, inflation, taxation, financial markets, international macroeconomics, and so on. As this body of work grows, so doesour awareness of the role of government policy in environments where the welfare theorems do not typically hold. Thisawareness now pervades the globe, wherever modern macroeconomics research and teaching prevail.

In July 2009, the School of Economics at the University of Sydney and the Department of Economics at the University ofMelbourne, pooled resources to host the Sydney-Melbourne Conference on Macroeconomics. This event attracted top schol-ars from across the world to meet to discuss the latest results on macroeconomics with frictions. The papers in this volume

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2 I. King / Journal of Macroeconomics 33 (2011) 1–3

were selected from those that were presented at the conference, but have also been subjected to a vigorous refereeing pro-cess, consistent with the standards of the Journal of Macroeconomics. Broadly speaking, the eight papers in this volume studyfour essential macroeconomic frictions using dynamic quantitative analysis: imperfect capital markets, coordination prob-lems in labour markets, overlapping generations with tax distortions, and price stickiness.

Given the macroeconomic climate of the time, it is quite fitting that the first four papers study the effects of imperfectcapital markets. Daphne Chen and Dean Corbae examine the implications of informational asymmetries in financial markets– specifically around the question of how long a person’s record of bankruptcy should be available to potential creditors:after what period of time should a person be given a ‘‘fresh start’’? The question is non-trivial because a fundamentaltrade-off exists. Allowing individuals to have the bankruptcy flag removed from their credit history, thus allowing them ac-cess to the credit market again, clearly makes these individuals better off, but also raises costs for other individuals. Chen andCorbae use the default risk framework developed recently by Chatterjee et al. (2007), together with a measure of consump-tion equivalence, to answer this question quantitatively. They come up with a surprising answer: while the current policyremoves the bankruptcy flag after 10 years, the optimal policy would be to remove it after only 1 year. However, perhapsreassuringly, they also find that the welfare gains from moving to the optimal policy are really quite small. Even significantdeviations from the optimal rule do not affect welfare very much.

Bandyopadhyay and Tang’s study also has imperfect capital markets as a key ingredient, but they study quite a differentquestion. They ask: how can we account for the conflicting empirical results that have been found on the growth–inequalityrelationship? In particular, why do some studies find a positive relationship while others find a negative one? Bandyopad-hyay and Tang argue that, for any economy, this relationship depends on the structure of the economy, which can beinfluenced by government policy. To make this case, they use a model where both the growth rate and the distribution ofincome are endogenous variables, based on Benabou’s (2002) model, but extended to allow for physical capital accumula-tion. In that environment, with heterogenous individual abilities, capital market imperfections prevent efficient human cap-ital accumulation and, thereby, open the door to policies that redistribute income for efficiency reasons, raising the growthrate. However, redistributive measures can also be distortionary, and can thereby reduce aggregate savings and growth.Thus, the equilibrium relationship between growth and inequality depends on government policy parameters. The authorsuse New Zealand as a case study, calibrate the model to the New Zealand economy, and argue that changes in both immi-gration policies (which affect the underlying distribution of types) and redistribution policies have played important roles,and can explain the co-movement of that country’s growth and inequality measures over time.

Both the Li and Dressler paper and the Moaz, Peled, and Sarid paper consider the implications of international borrowingconstraints. In the first of these two papers, occasionally binding constraints are identified as a key source of business cycleasymmetries. In the second, borrowing constraints provide a rationale for self-interested foreign aid from donor countries. Liand Dressler use an open economy real business cycle model, based on Mendoza’s (1991) work, but with occasionally bind-ing international borrowing constraints where international borrowing cannot exceed a given fraction of the country’s cap-ital stock. They calibrate the model to the Canadian economy and, under certain conditions, downturns are sharp becausethey are unconstrained, but recoveries are slow due to the fact that they are hindered by the binding borrowing constraint.They identify the initial level of debt as a key variable that is responsible for this pattern. This offers, then, an explanation forwhy these asymmetries are observed for some, but not all, economies internationally.

Moaz, Peled, and Sarid use a 2-country version of Rebelo’s (1991) 2-sector endogenous growth model, to identify condi-tions under which a country may find it to be in their own interests to provide foreign aid to another country. In this setting,free trade with perfect capital markets would be the first-best solution but, in the absence of properly functioning capitalmarkets, efficiency gains can be made by transferring capital to the poorer country, which can more than offset the donationsthemselves. Interestingly, they find that, although the recipient country would always prefer free trade, conditions exist(depending on bargaining arrangements) under which the donor country would prefer the borrowing-constrained donationequilibrium.

Unemployment is, without doubt, one of the most important issues in macroeconomics. Incorporating fully micro-founded unemployment into DGE models has proved to be something of a problem for the profession. One of the centralchallenges has been to provide a theory that accounts for the co-existence of both unemployed workers and unfilled vacan-cies – something that sticky wage theories, or employment lottery theories cannot explain. The matching function approachof Diamond (1982), Mortensen (1982a), and Pissarides (1985) offers a clever solution to this, but a purely technological solu-tion – where unemployed workers and vacancies meet purely randomly, and some people are simply unlucky. The directedsearch models of Julien et al. (2000) and Burdett et al. (2001) provide a micro-foundation for this matching function, whereagents in the model choose who to approach, but face a coordination problem. The paper by Julien, Kennes, and King in thisvolume explores this avenue further by making the link with a particular pricing mechanism known as the ‘‘Mortensen rule’’.This rule, which was introduced originally by Mortensen (1982b), in the context of random search, turns out to have veryuseful applications in the context of directed search. The authors show that, contrary to the view of some that this rule can-not be implemented, the rule can be implemented through a simple auction – where workers sell their labour in this way.Moreover, this rule delivers constrained-efficient allocations even in small markets and, given unemployment rates, plausi-ble numbers for vacancies, when a dynamic model is calibrated to the US economy. The model also delivers some wage dis-persion; however, in the calibrated model, this dispersion is small relative to empirical estimates.

Two papers in this volume (Cho and Francis, and Kudrna and Woodland) explore the public finance implications of over-lapping generations, using quantitative models with multiple generations. Sang-Wook Cho and Johanna Francis use this

I. King / Journal of Macroeconomics 33 (2011) 1–3 3

framework to examine the extent to which the favourable tax treatment of home ownership in the US contributes to itswealth inequality. To answer this question, they construct an OLG model where agents live a maximum of 23 periods,and a housing sector, based on Gervais (2002). Once the model is calibrated, they consider the implications of the counter-factual policy of eliminating the preferential tax structure. They find that, while this would increase their measure of ‘‘aggre-gate welfare’’, its effect on the steady state wealth distribution would in fact be quite small. Thus, according to their study,the current tax treatment of housing in the US cannot be seen as a major contributor to ongoing wealth inequality.

George Kudrna and Alan Woodland also look at distributional issues and government programs but, in this case, attentionis focussed on public pension schemes. Specifically, they ask: what are the macroeconomic effects of means-testing of publicpensions? Australia is used as the case study in this work, where public pensions are currently means-tested. The authors usean open economy variant of Auerbach and Kotlikoff’s (1987) computable OLG model, where agents live up to 70 periods, cal-ibrate the model to the Australian economy, and examine what happens when the means-testing is eliminated (or reduced).The labour supply of older workers is a key variable in their model, and they show that means-testing of pensions cansignificantly reduce this supply – and, consequently, output and other macro variables. Although the elimination ofmeans-testing would clearly not represent a Pareto improvement (hard to find in most OLG models), there is a significantaggregate efficiency gain and, consequently, a potential Pareto improvement from this move.

The final paper in this volume tackles what it perhaps the most traditional friction in macroeconomic analysis: pricestickiness. Empirically, microeconomic estimates of price stickiness are significantly smaller than macroeconomic estimates,using the New Keynesian Phillips Curve – representing a puzzle for researchers. Adam Cagliarini, Tim Robinson, and AllenTran present a resolution of this puzzle, using a model based on micro-level heterogeneity and roundabout production(interdependence between firms, both within and across sectors). They show that, under these conditions, conventionalmacroeconomic methods of estimating price stickiness will overestimate it – providing an explanation for the puzzle. Theyalso show that the existence of roundabout production can have the further effect of leading to overestimates of the propor-tion of prices that are indexed to past inflation.

Each of the papers in this volume highlights a particular friction, or set of frictions, and examines their influences onmacroeconomic outcomes. In each case, equilibrium allocations deviate in a significant way from those in purely frictionlesssettings. Complete and perfect information in Chen and Corbae’s environment would completely obviate the need for bank-ruptcy regulation at all. Perfect capital markets would completely eliminate the efficiency role for redistribution in Bandyo-padhyay and Tang’s model, and thereby eliminate their explanation for the empirical relationship they consider. Perfectinternational capital markets would eliminate the explanations for business cycle asymmetries in Li and Dressler, and therole of foreign aid emphasised in Moaz, Peled, and Sariz. Removing the coordination problem from the Julien, Kennes, andKing’s model would eliminate both unemployment and unfilled vacancies. Allowing for altruistic dynasties in the Choand Francis and the Kudrna and Woodland environments would eliminate any role for public policy. Finally, of course, with-out price stickiness, empirical estimates of stickiness would be meaningless.

As macroeconomists, dynamic general equilibrium theory, with frictions, equips us in a very distinctive way. The researchin this volume has used this equipment on a variety of topics and, I hope you’ll agree, the fruits of this labour are very inter-esting indeed.

References

Auerbach, A., Kotlikoff, L., 1987. Dynamic Fiscal Policy. Cambridge University Press, Cambridge.Benabou, R., 2002. Tax and education policy in a heterogeneous-agent economy: what levels of redistribution maximize growth and efficiency?

Econometrica 70, 481–517.Burdett, K., Shi, S., Wright, R., 2001. Pricing and matching with frictions. Journal of Political Economy 109, 1060–1085.Chatterjee, S., Corbae, D., Nakajima, M., Rios Rull, J.-V., 2007. A quantitative theory of unsecured consumer credit with risk of default. Econometrica 75,

1525–1589.Diamond, P., 1982. Wage determination and efficiency in search equilibrium. Review of Economic Studies 49, 217–229.Gervais, M., 2002. Housing taxation and capital accumulation. Journal of Monetary Economics 49, 1461–1489.Julien, B., Kennes, J., King, I., 2000. Bidding for labor. Review of Economic Dynamics 3, 619–649.Mendoza, E., 1991. Real business cycles in a small open economy. American Economic Review 85, 797–803.Mortensen, D., 1982a. The matching process as a noncooperative/bargaining game. In: McCall, J.J. (Ed.), The Economics of Information and Uncertainty.

University of Chicago Press, Chicago, pp. 233–254.Mortensen, D., 1982b. Efficiency of mating, racing and related games. American Economic Review 72, 968–979.Pissarides, C., 1985. Short-run equilibrium dynamics of unemployment, vacancies, and real wages. American Economic Review 75, 676–690.Rebelo, S., 1991. Long-run policy analysis and long-run growth. Journal of Political Economy 99, 500–521.