Timothy J. Kehoe

Debt Constrained Asset Markets

We develop a theory of general equilibrium with endogenous debt limits in the form of individual rationality constraints similar to those in the dynamic consistency literature. If an agent defaults on a contract, he can be excluded from future contingent claims markets trading and can have his assets seized. He cannot be excluded from spot markets trading, however, and he has some private endowments that cannot be seized. All information is publicly held and common knowledge, and there is a complete set of contingent claims markets. Since there is complete information, an agent cannot enter into a contract in which he would have an incentive to default in some state. In general there is only partial insurance: variations in consumption may be imperfectly correlated across agents; interest rates may be lower than they would be without constraints; and equilibria may be Pareto ranked.

Self-Fulfilling Debt Crises

We characterize the values of government debt and the debts maturity structure under which financial crises brought on by a loss of confidence in the government can arise within a dynamic, stochastic general equilibrium model. We also characterize the optimal policy response of the government to the threat of such a crisis. We show that when the countrys fundamentals place it inside the crisis zone, the government may be motivated to reduce its debt and exit the crisis zone because this leads to an economic boom and a reduction in the interest rate on the governments debt. We show that this reduction can be gradual if debt is high or the probability of a crisis is low. We also show that, while lengthening the maturity of the debt can shrink the crisis zone, credibility-inducing policies can have perverse effects.

In search of scale effects in trade and growth

We look for the scale effects predicted by some theories of trade and growth based on the dynamic returns to scale that arise from learning by doing, investment in human capital, or development of new products. We find little empirical evidence of a relation between the growth rate of GDP per capita and the measures of scale implied by the theory. Restricting attention to the manufacturing sector, however, we find a significant relation between the growth rate of output per worker and the relevant scale variables. We also find that growth rates are significantly related to measures of intra-industry trade.

A self-fulfilling model of Mexico's 1994-1995 debt crisis

This paper explores the extent to which the Mexican governments inability to roll over its debt during December 1994 and January 1995 can be modeled as a self-fulfilling debt crisis. In the model there is a crucial interval of debt for which the government, although it finds it optimal to repay old debt if it can sell new debt, finds it optimal to default if it cannot sell new debt. If government debt is in this interval, which we call the crisis zone, then we can construct equilibria in which a crisis can occur stochastically, depending on the realization of a sunspot variable. The size of this zone depends on the average length of maturity of government debt. Our analysis suggests that for a country, like Mexico, with a very short maturity structure of debt, the crisis zone is large and includes levels of debt as low as that in Mexico before the crisis.

Liquidity Constrained Markets versus Debt Constrained Markets

This paper compares two different models in a common environment. The first model has liquidity constraints in that consumers save a single asset that they cannot sell short. The second model has debt constraints in that consumers cannot borrow so much that they would want to default, but is otherwise a standard complete markets model. Both models share the features that individuals are unable to completely insure against idiosyncratic shocks and that interest rates are lower than subjective discount rates. In a stochastic environment, the two models have quite different dynamic properties, with the debt constrained model exhibiting simple stochastic steady states, while the liquidity constrained model has greater persistence of shocks.

An evaluation of the performance of applied general equilibrium models of the impact of NAFTA

This paper evaluates the performances of three of the most prominent multisectoral static applied general equilibrium models used to predict the impact of the North American Free Trade Agreement. These models drastically underestimated the impact of NAFTA on North American trade. Furthermore, the models failed to capture much of the relative impacts on different sectors. Ex-post performance evaluations of applied GE models are essential if policymakers are to have confidence in the results produced by these models. Such valuations also help make applied GE analysis a scientific discipline in which there are well-defined puzzles with clear successes and failures for competing theories. Analyzing sectoral trade data indicates the need for a new theoretical mechanism that generates large increases in trade in product categories with little or no previous trade. To capture changes in macroeconomic aggregates, the models need to be able to capture changes in productivity.

An evaluation of the performance of an applied general equilibrium model of the Spanish economy

SummaryIn 1985–86 the authors were members of a team that constructed a static applied general equilibrium model that was used to analyze the impact on the Spanish economy of the 1986 fiscal reform, which accompanied Spains entry into the European Community. This paper compares the results obtained to recently published data for 1985–87; we find that the model performed well in predicting the changes in relative prices and resource allocation that actually occurred, particularly if we incorporate exogenous shocks that affected the Spanish economy in 1986. We also analyze the sensitivity of the results to alternative specifications of the labor market and macroeconomic closure rules; we find that the central results are robust.

Computation and multiplicity of equilibria

Economic equilibria are usually solutions to fixed point problems rather than solutions to convex optimization problems. This leads to two difficulties that are closely related: First, equilibria may be difficult to compute. Second, a model economy may have more than one equilibrium. This paper explores these issues for a number of stylized economies, including static economies that involve both pure exchange and production, economies that have infinite numbers of goods because of time and uncertainty, and economies with distortionary taxes and externalities. There are numerous numerical examples that illustrate the theory and could serve as test problems for algorithms.

Capital flows and real exchange rate fluctuations following Spain's entry into the European Community

Abstract Spains 1986 entry into the European Community was followed by a dismantling of restrictions on international capital flows. Initial trade deficits and real exchange rate appreciation were followed by trade surpluses and real exchange rate depreciation. This paper analyzes Spains financial liberalization using a dynamic general equilibrium model with a traded and nontraded good where a capital poor country opens itself to its capital rich neighbors. A carefully calibrated model has trouble accounting for the large changes in relative prices observed given the small changes in quantities. Variants of the model with frictions in factor mobility between sectors fare better.

The optimum quantity of money revisited

This paper uses a simple general equilibrium model in which agents use money holdings to self insure to address the classic question: What is the optimal rate of change of the money supply? The standard answer to this question, provided by Friedman, Bewley, Townsend, and others, is that this rate is negative. Because any revenues from seignorage in our model are redistributed in lump-sum form to agents and this redistribution improves insurance possibilities, we find that the optimal rate is sometimes positive. We also discuss the measurement of welfare gains or losses from inflation and their quantitative significance.