Demand, Markups and the Business Cycle. Bayesian Estimation and Quantitative Analysis in Closed and Open Economies

Abstract

We generalize the demand side of a Real Business Cycle model introducing non-homothetic preferences over differentiated final goods. Under monopolistic competition this generates variable markups that depend on the level of consumption. We estimate a flexible preference specification through Bayesian methods and obtain countercyclical markups. The associated closed-economy model magnifies the propagation of shocks (compared to perfect competition or fixed markups) through additional substitution effects on labor supply and consumption. In an open-economy framework, it also generates positive comovements of output, labor and investment and reduces consumption correlation between countries: in particular, a positive shock in the Home country reduces its markups and improves its terms of trade, which promotes consumption in the Home country but also production in the Foreign country to exploit the increased profitability of exports.

Macroeconomics with Endogenous Markups and Optimal Taxation

“…One could introduce price frictions (in the intermediate good sector) for the analysis of monetary shocks in a New‐Keynesian style. Finally, one could study shocks and policies in an open economy framework (see Ghironi and Melitz with CES preferences): an attempt in this direction is in Cavallari and Etro (). A flourishing literature in international trade has been recently departing from CES preferences to investigate the main classes of preferences emphasized here with heterogeneous firms.…”

“…My ultimate objective would be to provide a general microfoundation of DSGE models to expand their ability to replicate empirical findings on international business cycles (for some related insights see Cavallari and Etro or Anderson et al ), incorporate realistic imperfections in the labor and credit markets (see La Croce and Rossi and Etro ), and be used for the analysis of fiscal and monetary policy (see Ghironi ). I believe that many of the limits of the standard macroeconomic framework are deeply linked with the ubiquity of CES preferences and exogenous market structures, which prevent one from modeling realistic imperfections in the goods market and fully understanding interactions between demand and supply at the aggregate level.…”

“…These preferences generate countercyclical markups because is decreasing in consumption, but the authors show that monopolistic competition delivers a moderate magnification of business cycle compared to perfect competition. Cavallari and Etro () adopt a different formulation that nests CES preferences, with bi‐power subutility and γ > 0, which again generates countercyclical markups due to the elasticity . Estimating the preference parameters, the authors obtain a substantial magnification of business cycle propagation compared to perfect competition, suggesting that endogenous markups can contribute to improve the quantitative performance of RBC models.…”

“…I also propose a new type of general additive preferences that nests direct additivity, indirect additivity, generalized additivity (Pollak ; Gorman ), homothetic additivity (Kimball ), and implicit additivity (Hanoch ), including the unexplored class of implicit CES preferences, which can be useful for future quantitative exercises. While the scope of this work is only methodological, Cavallari and Etro () provide a first quantitative assessment of models based on directly additive preferences in both closed and open economies subject to productivity shocks and show that endogenous countercyclical markups can contribute in a substantial way to improve the performance of RBC models.…”

Macroeconomics with Endogenous Markups and Optimal Taxation

“…My ultimate objective would be to provide a general microfoundation of DSGE models to expand their ability to replicate empirical findings on international business cycles (for some related insights see Cavallari andEtro 2017 or Anderson et al 2018), incorporate realistic imperfections in the labor and credit markets (see La Croce and Rossi 2014 and Etro 2016b), and be used for the analysis of fiscal and monetary policy (see Ghironi 2018). I believe that many of the limits of the standard macroeconomic framework are deeply linked with the ubiquity of CES preferences and exogenous market structures, which prevent me from modeling realistic imperfections in the goods market and fully understanding interactions between demand and supply at the aggregate level.…”