Vasco M. Carvalho

The Great Diversification and its Undoing

We investigate the hypothesis that macroeconomic fluctuations are primitively the results of many microeconomic shocks, and show that it has significant explanatory power for the evolution of macroeconomic volatility. We define “fundamental” volatility as the volatility that would arise from an economy made entirely of idiosyncratic microeconomic shocks, occurring primitively at the level of sectors or firms. In its empirical construction, motivated by a simple model, the sales share of different sectors vary over time (in a way we directly measure), while the volatility of those sectors remains constant. We find that fundamental volatility accounts for the swings in macroeconomic volatility in the US and the other major world economies in the past half century. It accounts for the “great moderation” and its undoing. Controlling for our measure of fundamental volatility, there is no break in output volatility. The initial great moderation is due to a decreasing share of manufacturing between 1975 and 1985. The recent rise of macroeconomic volatility is due to the increase of the size of the financial sector. We provide a model to think quantitatively about the large comovement generated by idiosyncratic shocks. As the origin of aggregate shocks can be traced to identifiable microeconomic shocks, we may better understand the origins of aggregate fluctuations.

A Note on Common Cycles, Common Trends, and Convergence

This article compares and contrasts structural time series models and the common features methodology. The way in which trends are handled is highlighted by describing a recent structural time series model that allows convergence to a common growth path. Postsample data are used to test its forecasting performance for income per head in U.S. regions. A test for common cycles is proposed, its asymptotic distribution is given, and small-sample properties are studied by Monte Carlo experiments. Applications are presented, with special attention given to the implications of using higher-order cycles.

Models for Converging Economies

The aim of this article is the development of models for converging economies. After discussing models of balanced growth, univariate models of the gap between per capital income in two economies are examined. The preferred models combine unobserved components with an error correction mechanism and allow a decomposition into trend, cycle and convergence components. A new type of second-order error correction mechanism is shown to be particularly useful in this respect. The levels of per capita income in two economies may be modelled jointly by bivariate convergence models. These models generalise balanced growth models and can be based on autoregressive or unobserved components formulations. Both approaches provide coherent forecasts but the unobserved components models also yield a description of trends, cycles and convergence components. The methods are applied to data on the US and Japan. The generalisation to multivariate series is then set out.

Robust-Optimal Fiscal Policy

This paper introduces a concern for model misspecification in a Lucas-Stokey optimal fiscal policy setting. The representative household in this economy is endowed with the knowledge of a reference model for the government spending process but acknowledges that this model is potentially misspecified. The paper shows how this concern for misspecification affects the competitive equilibrium pricing of state contingent bonds and how this in turn affects the calculation of present value budget constraints. The paper shows how the Ramsey problem and optimal solutions are affected by the size of potential misspecifications entertained. The implications for optimal maturity structure for non-contingent debt are analysed, paying particular attention to how the pricing of these assets is affected by robustness considerations. A linear quadratic specification serves to implement numerically the economy under study.