MARKUPS AND THE REAL EFFECTS OF VOLATILITY SHOCKS

• DOI: http://doi.org/10.1111/iere.12236
• Date: 01 August 2017
• Published date: 01 August 2017

INTERNATIONAL ECONOMIC REVIEW

Vol. 58, No. 3, August 2017

MARKUPS AND THE REAL EFFECTS OF VOLATILITY SHOCKS∗

BYHERN ´

AN D. SEOANE1

Universidad Carlos III de Madrid, Spain

This article studies the role of endogenous markups in the transmission of volatility shocks in real models.

I design a variant of a small open economy model with volatility shocks and firm dynamics that gives rise to

endogenous markups. I calibrate this model to match the business cycle facts in emerging economies and show

that the impact of volatility shocks is substantially amplified if markups are endogenously time varying. Volatility

shocks increase savings, due to precautionary motives, and markups, which act as a wedge that endogenously

decreases real wages and labor supply with further negative aggregate dynamics that are absent in the models

with constant markups.

1. INTRODUCTION

This article studies the channels behind the transmission of volatility shocks in real business

cycle models. Specifically, I develop a real general equilibrium model for a small open econ-

omy with stochastic volatility and monopolistic competition, and use it to study the role of

endogenously time-varying markups in the amplification and persistence of volatility shocks.

A “volatility shock” is a shock to the standard deviation of exogenous random variables.

Even though the attention to volatility shocks as driving forces of the business cycle has recently

increased because of the Great Moderation, the understanding of these shocks is still evolving.2

The main reason for the limited understanding of volatility shocks is that these disturbances are

of a very different nature compared to any other shock commonly used in the macroeconomics

literature; volatility shocks do not affect the level of real or nominal innovations, but only the

risk associated to future realizations.

The objective of this article is to contribute to the understanding of volatility shocks. I

study the way time-varying markups, Frisch elasticity, and other model features affect the sign,

magnitude, and persistence of the response of endogenous variables to volatility shocks in pure

real models, that is, models without nominal frictions. The baseline model is a version of real

business cycle small open economy model along the lines of Mendoza (1991) and Schmitt-

Groh´

e and Uribe (2003), with GHH preferences, as in Greenwood et al. (1988), and stochastic

volatility shocks. The baseline specification of the model assumes monopolistic competition

in a setup that I borrow from Jaimovich (2007) and allows for entry and exit of firms, which

∗Manuscript received May 2014; revised February 2016.

1This article was previously circulated as “Understanding Volatility Shocks in Real Models.” I thank Andr´

es Erosa,

Jes´

us Fern´

andez-Villaverde, and two anonymous referees for comments and suggestions. Remaining errors are my

own. Support from Fundaci´

on Ram´

on Areces and the Ministerio Econom´

ıa y Competitividad (Spain), grants 2014-

ECO2014-56676-C2-1-P, MDM 2014-0431, and Comunidad de Madrid, MadEco-CM (S2015/HUM-3444) are gratefully

acknowledged.

Please address correspondence to: Hern´

an D. Seoane, Department of Economics, Universidad Carlos III de Madrid,

Calle Madrid 126, 28903 Getafe, Madrid, Spain. Phone: +34 91 624 5744. E-mail: hseoane@eco.uc3m.es.

2The Great Moderation refers to the period 1984–2007 during which the volatility of macroeconomic variables in the

United States experienced a statistically significant drop compared to the pre-1984 sample. See McConnell and Perez-

Quiros (2000) and Stock and Watson (2002). The “good luck” versus “good policy” debate was the one that intended to

find the roots of the “Great Moderation.” Specifically, this debate inquires whether the decrease in aggregate volatility

occurred due to an exogenous drop in the volatility of shocks, that is, the “good luck” scenario, or because policymakers

had designed appropriate policy instruments to deal with exogenous disturbances, the “good policy” scenario.

807

C

(2017) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social

and Economic Research Association

808 SEOANE

gives rise to countercyclical markups as firm dynamics affect the degree of competition. Besides

the firm dynamics, the model is an otherwise simple real business cycle small open economy

model. This model, hence, allows us to study the role of endogenously time-varying markups

without assuming price frictions or nominal disturbances and, consequently, allows us to isolate

the effects of markups from those of nominal frictions, something that is impossible in New-

Keynesian sticky prices models.

I find that endogenously time-varying markups induce a substantial amplification in the re-

sponses of endogenous variables to spread volatility shock because they exacerbate the response

of real wages. Specifically, an increase in volatility triggers a consumption drop because of pre-

cautionary savings motives. Additionally, it negatively affects investment because agents reduce

their exposure to financing through the more risky foreign debt. These two effects decrease the

demand side of the economy. In the open economy, the trade balance improves, imports drop,

and the domestic economy increases savings in foreign debt. Given the assumptions of monop-

olistic competitive firms, the drop in demand forces the exit of firms, which lowers the degree

of competition and drives markups up. The increase in markups operates as inducing a drop in

the measured total factor productivity (TFP) and decreases the real wage, inducing a drop in

labor supply. The joint drop in labor and technology through the increase in markups induces

an extra negative impact on output, which subsequently reinforces the drop in demand. This

channel is absent without time-varying markups. This analysis is followed by a battery of ro-

bustness exercises and sensitivity analysis to provide further insights on the mechanisms behind

the dynamics of the model. In a nutshell, I find that endogenously time-varying markups are

critical to the transmission of volatility shocks in real models.

Fern´

andez-Villaverde et al. (2011) study spread shocks and spread volatility shocks and show

they have quantitatively important effects in the dynamics of emerging economies. The findings

in this article reinforces theirs. I find that the impact of spread volatility shocks to output is

twice as large when the markup dynamics are considered than in the model with fixed markups.

When firms are subject to working capital constraints, the differences between the model with

and without endogenous markups are even larger.

For a validation of the model, I study the dynamics of markups observed in the data for small

open emerging economies. I show that markups exhibit a substantial variability, tend to be

countercyclical, and have a positive correlation with volatility measures. In the real economy,

a microfoundation for time-varying markups is likely to rely on firm dynamics. For this reason,

I provide some stylized evidence on dynamics of firms in different countries using the database

constructed by Bartelsman et al. (2009) that includes annual variables for entry and exit of firms

at industry level for several open economies. I find evidence suggesting that the dynamic of firms

is roughly in line with the implications of the model. To highlight even more the importance

of endogenously time-varying markups, in the online appendix, I study a variant of the small

open economy model with stochastic volatility in which markups change due to the existence

of deep habits, as in Ravn et al. (2006). This setup assumes that there are no firm dynamics,

and, as can be seen, the main results are robust to this alternative specification. In other words,

even though there is stylized evidence validating the mechanisms in the model, the story of firm

dynamics is not key for the quantitative results shown here.

This article is related to the literature that studies the role and importance of volatility shocks

over the business cycle such as Bloom et al. (2007), Fern´

andez-Villaverde and Rubio-Ramirez

(2007), and Fern´

andez-Villaverde et al. (2011). This literature has grown substantially during

the last years and recently expanded to the study of the effect of changes in the volatility of

technology, the volatility of fiscal and monetary policies, such as Fern´

andez-Villaverde and

Guerr ´

on-Quintana (2015) and Fern´

andez-Villaverde et al. (2010), as well as changes in the

volatility of foreign interest rates in open economy models, as in Fern´

andez-Villaverde et al.

(2011), among several additional specifications. A recent review of this literature is in Fern´

andez-

Villaverde and Rubio-Ram´

ırez (2013). However, all real models in this literature assume fixed

markups, whereas endogenous markups have only been studied together with sticky prices in

New Keynesian models.