FEDS 1996-50
Smart Systems and Simple Agents: Industry Pricing by Parallel Rules

Raymond Board and P.A. Tinsley


A standard macroeconomic specification is that the aggregate economy is directed by a single, smart representative agent using optimal decision rules. This paper explores an alternative conjecture--that the dynamic behavior of markets is often better interpreted as the interactions of many heterogeneous, rule-of-thumb agents who are loosely coupled in smart systems--much like the contrast of a single serial processor with global information versus parallel processors with limited communications. The illustration used in this paper is the contrast between a conventional macro model of sluggish adjustments in an aggregate producer price index and a model of delayed industry price adjustments in a distributed production system under costly inter-firm communications.

Full paper (183 KB Postscript)

Keywords: Costly communications, parallel Jacobi solutions, producer pricing

FEDS 1996-49
Off-Farm Labor Supply and Fertilizer Use

Russell L. Lamb


I develop a two-period stochastic dynamic programming model to explain the interaction between fertilizer use and off-farm labor supply. Using a well-known sample of Indian farmers, I find that fertilizer use responds strongly to the village wage and that irrigation raises fertilizer use, while larger farmers use less fertilizer (per acre) than smaller ones. Response to one-sided production shocks, is stronger for female labor, indicating that it is more important for smoothing consumption than male labor.

FEDS 1996-48
The Endogeneity of Employment Adjustment Costs: The Tradeoff between Efficiency and Flexibility


This paper models a firm's choice of employment adjustment costs as one component of its choice of production process. In making a one-time choice of production process, firms tradeoff increased flexibility--the reduced cost of changing levels of production--against the diminished efficiency of producing a given level of output. The model predicts that firms facing greater volatility in expected employment choose production processes that entail relatively low costs of adjusting employment. Using estimates of adjustment costs and employment volatility for four-digit manufacturing industries, the paper finds empirical support for the model: Among four-digit industries facing similar choices of production process, those with more volatile employment tend to have lower costs of adjusting employment. Moreover, the paper finds that interindustry heterogeneity in the amplitude of deterministic seasonal fluctuations in employment is more important than the variance of stochastic employment fluctuations in explaining the choice of adjustment costs.

Full paper (1126 KB Postscript)

Keywords: Employment adjustment cost, manufacturing, industry, heterogeneity, endogeneity

FEDS 1996-47
Moving Endpoints and the Internal Consistency of Agents' Ex Ante Forecasts

Sharon Kozicki and P.A. Tinsley


Forecasts by rational agents contain embedded initial and terminal boundary conditions. Standard time series models generate two types of long-run "endpoints"---fixed endpoints and moving average endpoints. Neither can explain the shifting endpoints implied by postwar movements in the cross-section of forward rate forecasts in the term structure or by post-1979 changes in survey estimates of expected inflation. Multiperiod forecasts by a broader class of "moving endpoint" time series models provide substantially improved tracking of the historical term structure and generally support the internal consistency of the ex ante long-run expectations of bond traders and survey respondents.

Full paper (517 KB Postscript)

Keywords: Boundary values, expected inflation, term structure

FEDS 1996-46
Evidence on the Link between Firm-Level and Aggregate Inventory Behavior

Scott Schuh


This paper describes the finished goods inventory behavior of more than 700 U.S. manufacturing firms between 1985-93 using a new Census Bureau longitudinal data base. Three key results emerge. First, there is a broad mix of production-smoothing and production-bunching firms, with about two-fifths smoothing production. Second, firm-level inventory adjustment speeds are about an order of magnitude larger than aggregate adjustment speeds due to econometric aggregation bias. Finally, accounting for time variation in the inventory adjustment speed due to fluctuations in firm size improves the fit of a traditional aggregate inventory model by one-fifth.

Full paper (687 KB Postscript)

Keywords: Inventory investment, production smoothing, adjustment speeds, aggregation bias

FEDS 1996-45
Recent Developments in Bootstrapping Time Series

Jeremy Berkowitz and Lutz Kilian


In recent years, several new parametric and nonparametric bootstrap methods have been proposed for time series data. Which of these methods should applied researchers use? We provide evidence that for many applications in time series econometrics parametric methods are more accurate, and we identify directions for future research on improving nonparametric methods. We explicitly address the important, but often neglected issue of model selection in bootstrapping. In particular, we emphasize the advantages of the AIC over other lag order selection criteria and the need to account for lag order uncertainty in resampling. We also show that the block size plays an important role in determining the success of the block bootstrap, and we propose a data-based block size selection procedure.

Keywords: Bootstrap, ARMA, frequency domain, blocks

FEDS 1996-44
The Effect of Deficit-Reduction Laws on Real Interest Rates

Douglas W. Elmendorf


This paper uses news reports about two deficit-reduction laws of the past decade to identify days when expected fiscal policy clearly became more or less expansionary. The paper also proposes a technique for identifying whether the real interest rate increased or decreased on those days, based on changes in the nominal interest rate, the exchange rate, commodity prices, and stock prices. As economic theory predicts, higher expected government spending and budget deficits raised real interest rates and the value of the dollar, while lower expected spending and deficits reduced real rates and the value of the dollar.

Full paper (320 KB Postscript)

Keywords: Interest rates, budget deficit, government spending

FEDS 1996-43
Investment and Union Certification

Bruce C. Fallick and Kevin A. Hassett


A growing body of work--both theoretical and empirical--has emphasized that unionization may be better understood as a tax on capital rather than a tax on labor. Under this "new" view, unionization unambiguously lowers investment. Using data on union certification elections, we estimate the impact of unionization on firms' investment behavior. Employing both a standard q-model and an "investment surprises" technique, we find that union certification significantly reduces investment. We find that a winning certification election has, on average, about the same effect on investment as would a 30 percentage point increase in the corporate tax.

Full paper (283 KB Postscript)

Keywords: Investment, union

FEDS 1996-42
A Guide to FRB/US: A Macroeconomic Model of the United States

F. Brayton and P. Tinsley (eds.)


FRB/US is a large-scale quarterly econometric model of the U.S. economy, developed to replace the MPS model. Most behavioral equations are based on specifications of optimizing behavior containing explicit expectations of firms, households, and financial markets. Although expectations are explicit, the empirical fits of the structural descriptions of macroeconomic behavior are comparable to those of reduced-form time series models. In most instances, tests do not reject overidentifying restrictions of rational expectations or the hypothesis of serially independent residuals. As modeled, private sector expectations of policy constitute a major transmission channel of monetary policy.

Full paper (503 KB Postscript)

Keywords: Macroeconomic models, private sector learning, rational expectations, vector autoregressions

FEDS 1996-41
"Forecasting the Forecasts of Others:" Expectational Heterogeneity and Aggregate Dynamics

Antulio N. Bomfim


I construct a dynamic general equilibrium model where agents differ in the way they form expectations. Sophisticated agents form model-consistent expectations. Rule-of-thumb agents' expectations are based on an intuitive forecasting rule. All agents solve standard dynamic optimization problems and face strategic complementarity in production. Extending the work of Haltiwanger and Waldman (1989), I show that even a minority of rule-of-thumb forecasters can have a significant effect on the aggregate properties of the economy. For instance, as agents try to forecast each others' behavior they effectively strengthen the internal propagation mechanism of the economy. I solve the model by assuming a hierarchical information structure similar to the one in Townsend's (1983) model of informationally dispersed markets. The quantitative results are obtained by calibrating the model and running a battery of sensitivity tests on key parameters. The analysis highlights the role of strategic complementarity in the heterogeneous expectations literature and precisely quantify many qualitative claims about the aggregate implications of expectational heterogeneity.

Full paper (367 KB Postscript)

Keywords: Business cycles, expectatations, strategic complementarity, bounded rationality

FEDS 1996-40
Motor Vehicle Stocks, Scrappage, and Sales

Alan Greenspan and Darrel Cohen


This paper offers a new framework for analyzing aggregate sales of new motor vehicles that incorporates separate models for the change in the vehicle stock and for the rate of vehicle scrappage. Because this approach requires only a minimal set of assumptions about demographic trends, the state of the economy, consumer "preferences," new vehicle prices and repair costs, and vehicle retirements, it is shown to be especially useful as a macroeconomic forecasting tool. In addition, a new historical annual time series estimate of motor vehicle stocks in the United States is presented.

Full paper (264 KB Postscript)

Keywords: Motor vehicles, scrappage

FEDS 1996-39
Long-Horizon Exchange Rate Predictability?

Jeremy Berkowitz and Lorenzo Giorgianni


Several authors have recently investigated the predictability of exchange rates by fitting a sequence of long-horizon error-correction regressions. We show that such a procedure gives rise to spurious evidence of predictive power. A simulation study demonstrates that even when using this technique on two independent series, estimates and diagnostic statistics suggest a high degree of predictability of the dependent variable. We apply a simple modification of the long-horizon regression due to Jegadeesh (1991), which may provide more accurate inferences for researchers interested in comparing short and long-run predictability of U.S. dollar exchange rates.

Full paper (892 KB Postscript)

Keywords: Spurious, inference, long-run

FEDS 1996-38
What's Good for GM...? Using Auto Industry Stock Returns to Forecast Business Cycles and Test the Q-Theory of Investment

Gregory R. Duffee and Stephen D. Prowse


We examine the ability of auto industry stock returns to forecast quarterly changes in the growth rates of real GDP, consumption, and investment. We find that auto stock returns are superior to aggregate stock market returns in predicting growth rates of GDP and various forms of consumption. The superior predictive power of auto returns holds for both in-sample and out-of-sample forecasts and has not declined over time. We then apply a finding in this paper---that market returns have no explanatory power for future output or consumption growth when auto returns are included in the regression---to analyze the causal relation between the stock market and investment. We use auto returns to proxy for forecasts of future fundamentals, allowing market returns to capture the effect of the stock market on investment. We find that aggregate returns forecast equipment investment in the presence of auto returns, providing empirical support for q-theory. Results for structures investment are less convincing.

Full paper (399 KB Postscript)

Keywords: Aggregate consumption, aggregate investment, auto industry, stock returns

FEDS 1996-37
Generalized Spectral Estimation

Jeremy Berkowitz


This paper provides a famework for estimating parameters in a wide class of dynamic rational expectations models. The framework recognizes that RE models are often meant to match the data only in limited ways. In particular, interest may focus on a subset of frequencies. This paper designs a frequency domain version of GMM. The estimator has several advantages over traditional GMM. Aside from allowing band-restricted estimation, it does not require making arbitrary instrument or weighting matrix choices. The framework also includes least squares, maximum likelihood, and band restricted maximum likelihood as special cases.

Full paper (221 KB Postscript)

Keywords: Estimation, frequency domain, misspecification

FEDS 1996-36
Debt Maturity and the Use of Interest Rate Derivatives by Nonfinancial Firms

George W. Fenn, Mitch Post, and Steven A. Sharpe


We develop and test a simple model of a firm's optimal debt maturity and its demand for interest rate swaps using 1994 data of over 4000 nonfinancial corporations. As in other models of derivative use, ours predicts a systematic relationship between a firm's swap position and the interest-sensitivity of its cash flow. We test this by estimating the cross-sectional relationship between a firm's swap position and: (1) the amount of short-term and floating-rate debt in its capital structure; and (2) the interest-sensitivity of its EBITD. We find strong evidence that firms use swaps to hedge interest rate risk arising from debt obligations but little evidence that they hedge interest rate risks from operating income. Consistent with theories of swap use (Arak et al., 1988, Wall, 1989, and Titman, 1992), our model also predicts that firms that avoid using swaps because of "transactions costs" issue less short-term debt than swap users, since the former are unable to hedge the resulting interest rate risk. We find this to be the case.

Full paper (481 KB Postscript)

Keywords: Derivatives, debt maturity, swaps, hedging

FEDS 1996-35
Vehicle Ownership, Vehicle Acquisitions, and the Growth of Auto Leasing: Evidence from Consumer Surveys

Ana Aizcorbe and Martha Starr-McCluer


This paper documents the basic features of data on motor vehicles from the Federal Reserve Board's Survey of Consumer Finances and the Bureau of Labor Statistics' Consumer Expenditure Survey. Despite some methodological differences between the two surveys, we find that they yield strikingly similar pictures of households' vehicle holdings. The survey data are also quite consistent with population estimates of vehicle stocks obtained from other sources. Finally, we document the growth of auto leasing by consumers, and find little evidence for the commonly-held view that liquidity constraints are an important motivation for leasing.

Full paper (97 KB Postscript)

Keywords: Vehicles, consumers, auto leasing

FEDS 1996-34
Initial Public Offerings in Hot and Cold Markets

Jean Helwege and Nellie Liang


Asymmetric information models characterize hot IPO markets as periods when better quality firms have an incentive to issue equity, and cold markets when the lemons premium associated with equity is too high to draw in many issuers. Recent empirical evidence, however, suggests that firms that issue in hot markets are a major source of stock price underperformance of equity issuers. We investigate these opposing views with data on IPO firms that issued in 1983, a hot market, and 1988, a cold market. We find that the two sets of firms have similar operating performance, but stock returns are worse for firms that went public in the hot market. Our results are largely consistent with investor overoptimism in hot markets, but not with the asymmetric information models.

Keywords: Initial public offerings, stock price underperformance, asymmetric information

FEDS 1996-33
The Lead of Output over Inflation in Sticky Price Models


Output growth is negatively correlated with inflation, and detrended output is positively correlated with inflation, in the major North American and European economies. In addition, output growth and detrended output lead inflation. I explore the consistency of these correlations with three models of price adjustment: the partial adjustment model, a staggered price setting model, and the P-bar model. The ratio of the variance of supply to demand shocks necessary to match the pattern of output- inflation correlations can be ranked across the three models; the P-Bar model requires the lowest ratio, and the partial adjustment model requires the highest ratio. These results reveal that the recent burst of researchers using the partial adjustment model will find a larger role for supply shocks than alternative models of price rigidity.

Full paper (328 KB Postscript)

Keywords: Output, inflation, sticky prices

FEDS 1996-32
Taxation of Labor Income and the Demand for Risky Assets

Douglas W. Elmendorf and Miles S. Kimball


We analyze the effect of labor income risk on the joint saving/portfolio-composition problem. It is well known that when private insurance markets are incomplete, the insurance afforded by labor income taxes can reduce overall saving through the precautionary saving motive. This insurance may change the composition of saving as well, because the reduction in labor income risk may affect the amount of financial risk that an individual chooses to bear. We find that, given plausible restrictions on preferences, any change in taxes that reduces an individual's labor income risk and does not make her worse off will lead her to invest more in risky assets. This result holds even when labor income is statistically independent of the return to risky assets. We also find that the effect of labor income risk on financial risk-taking can be quantitatively important for realistic changes in tax rates.

Keywords: Taxation, saving, uncertainty

FEDS 1996-31
Tax Exhaustion, Firm Investment, and Leasing: A Test of the Q Model of Investment

Michael P. O'Malley


Standard models of investment usually incorporate various tax factors but often overlook "tax exhaustion," the case when a firm has negative taxable income and cannot claim immediately its tax deductions or credits. However, tax exhausted firms face a higher cost of capital, and evidence shows that tax exhaustion is not uncommon. This paper incorporates tax exhaustion into a "Q" model of investment to see whether its performance is improved. In addition, leased investment is fully incorporated into the model, in part because tax exhaustion creates incentives to lease investment products and because investment models explain decisions to use equipment, not the decision about how to finance them. The results show that accounting for leasing improves significantly the performance of the Q model, whereas accounting for tax exhaustion does not affect the results meaningfully.

Full paper (368 KB Postscript)

Keywords: Investment, corporate taxation, leasing

FEDS 1996-30
Is "Learning-by-Exporting" Important? Micro-dynamic Evidence from Colombia, Mexico, and Morocco

Sofronis Clerides, Saul Lach, and James Tybout


Is there any empirical evidence that firms become more efficient after becoming exporters? Do firms that become exporters generate positive spillovers for domestically-oriented producers in their industry or region? In this paper we analyze the causal links between exporting and productivity using firm-level panel data from three semi-industrialized economies. Representing export market participation and production costs as jointly dependent autoregressive processes, we look for evidence that firms' stochastic cost process shifts when they break into foreign markets. We find that relatively more efficient firms become exporters, and that their costs are not affected by previous export market participation. This implies that self-selection of the more efficient firms into the export market, and not learning-by-exporting, explains the efficiency gap between exporter and non-exporters previously documented in the literature. Further, we find some evidence that exporters reduce the costs of breaking into foreign markets for domestically oriented producers, but do not appear to help these producers become more efficient.

Keywords: Export participation, productivity, learning

FEDS 1996-29
Estimating the Price of Default Risk

Gregory R. Duffee


A firm's instantaneous probability of default is modeled as a square-root diffusion process. The parameters of these processes are estimated for 188 firms, using both the time series and cross-sectional (term structure) properties of the individual firms' bond prices. Although the estimated models are moderately successful at bond pricing, there is strong evidence of misspecification. The results indicate that single factor models of instantaneous default risk face a significant challenge in matching certain key features of actual corporate bond yield spreads. In particular, such models have difficulty generating both relatively flat yield spreads when firms have low credit risk and steeper yield spreads when firms have higher credit risk.

Full paper (1053 KB Postscript)

Keywords: Term structure, credit risk, credit ratings, corporate bonds, credit derivatives

FEDS 1996-28
Minimum Wage Effects of Employment and School Enrollment: Reply to Evans and Turner

David Neumark and William Wascher


In earlier work, we presented results suggesting that minimum wage increases have important consequences for both the employment opportunities of youths and their decision to enroll in school. In this paper, we show that the recent claim made by William Evans and Mark Turner that our results are sensitive to changes in the definition of the enrollment rate is based upon an analysis that uses a mismeasured minimum wage index. When the data are constructed properly, our original conclusions are not affected by changes in the enrollment definition.

FEDS 1996-27
The Effect of Interest-Rate Changes on Household Saving and Consumption: A Survey

Douglas W. Elmendorf


Direct estimates of the interest elasticity of saving suffer from several serious problems. As an alternative, this survey uses an indirect approach that combines models of individual behavior with estimates of certain features of individuals' preferences. The paper examines the effect of interest-rate changes on the consumption and saving of people who follow the lifecycle model, who plan to leave bequests, who save to reach a fixed target, and who have short planning horizons.

It is not possible to provide a precise estimate of the interest elasticity of saving with any confidence. Nevertheless, the models that likely describe the behavior of the people who account for most of aggregate saving imply positive elasticities, so the aggregate interest elasticity of saving is probably positive.

Full paper (884 KB Postscript)

Keywords: Consumption, saving, interest elasticity

FEDS 1996-26
A Comparison of the Household Sector from the Flow of Funds Accounts and the Survey of Consumer Finances

Rochelle L. Antoniewicz


This paper compares figures on selected assets and liabilities from the FFA household sector with survey-based estimates from the 1989 and 1992 Survey of Consumer Finances (SCF). Comparisons of the FFA asset and liability categories to those constructed from the SCF have proved difficult in the past, and many previous studies have not fully adjusted for definitional differences between the SCF and FFA. This analysis addresses some common misperceptions about the definitions of the various components of the FFA household sector’s assets and liabilities, describes more fully the reconciliations between the SCF and FFA measures, provides a more detailed classification of assets and liabilities, and offers alternative explanations for the discrepancies between the SCF and FFA household wealth components. The results show that for some asset and liability categories the SCF and FFA estimates are quite close in 1989 and 1992. The measures of total liabilities match up better than those for total assets.

Full paper (114 KB Postscript)

FEDS 1996-25
Does Corporate Lending by Banks and Finance Companies Differ? Evidence on Specialization in Private Debt Contracting

Mark Carey, Mitch Post, and Stephen A. Sharpe


This paper establishes empirically that specialization in private-market corporate lending exists, adding a new dimension to the public vs. private debt distinctions now common in the literature on debt contracting and financial intermediation. Using a large database of individual loans, we compare lending by finance companies to that by banks. The evidence implies that it is intermediaries in general that are special in solving information problems, not banks in particular. But lending by the two types of institutions is not identical. Finance companies tend to serve observably riskier borrowers, especially highly leveraged borrowers, although banks and finance companies do compete across the spectrum of borrower risk. The evidence supports both regulatory and reputational explanations for this specialization and perhaps an explanation based on institutional differences in borrower monitoring and control. In passing, we shed light on various theories of debt contracting and intermediation and also present facts about finance companies, which have received little attention.

Keywords: Private debt, bank loan, finance company

FEDS 1996-24
The Opportunistic Approach to Disinflation

Athanasios Orphanides and David W. Wilcox


This paper explores the theoretical foundations of a new approach to monetary policy. Proponents of this approach hold that when inflation is moderate but still above the long-run objective, the Fed should not take deliberate anti-inflation action, but rather should wait for external circumstances-such as favorable supply shocks and unforeseen recessions-to deliver the desired reduction in inflation. While waiting for such circumstances to arise, the Fed should aggressively resist incipient increases in inflation. This strategy has come to be known as "the opportunistic approach to disinflation." We deduce policymaker preferences that rationalize the opportunistic approach as the optimal strategy for disinflation in the context of a model that is standard in other respects. The policymaker who is endowed with these preferences tends to focus on stabilizing output when inflation is low, but on fighting inflation when inflation is high. We contrast the opportunistic approach to amore conventional strategy derived from strictly quadratic preferences.

Keywords: Inflation, monetary policy, interest rates, policy rules

FEDS 1996-23
Endogenous Price Stickiness and Business Cycle Persistence


Both imperfect information and sticky prices allow nominal shocks to act as business cycle impulses, but only sticky prices propagate the real effects of nominal shocks. A simple model of imperfect information and sticky prices developed herein indicates that high rates of inflation lead to less price stickiness, and hence less persistent output fluctuations. Estimation of the model, as well as simple autocorrelations of real output, indicate that indeed output fluctuations are less persistent in high inflation economies. These results lend little support to models in which output persistence is explained through persistent real shocks, capital accumulation, or adjustment costs.

Full paper (435 KB Postscript)

Keywords: Output persistence, sticky prices, menu costs

FEDS 1996-22
Changes in REIT Liquidity 1990-94: Evidence from Intra-day Transactions

Vijay Bhasin, Rebel Cole, and Joseph K. Kiely


In this study, we use data on intra-day transactions to analyze whether REIT liquidity as measured by the bid-ask spread changed from 1990 to 1994, a period during which the industry s market capitalization increased from $9 billion to $45 billion. We find that REIT spreads narrowed significantly. We then use a variation of the empirical model proposed by Stoll (1978) to analyze the determinants of percentage spreads including whether spreads are determined by return variability, share price, exchange listing, and asset type. We find strong support for Stoll s model, in that return variance and share price are the primary determinants of percentage spreads in both periods analyzed. This suggests that the liquidity of REIT securities is similar to that of non-REIT securities with similar prices and return variance. In addition, we find that spreads are wider for REITs trading on NASDAQ. In contrast with an earlier study, we find that market capitalization is not a significant determinant of REIT spreads.

Full paper (508 KB Postscript)

Keywords: Bid-ask spread, liquidity, REIT

FEDS 1996-21
Compensation Incentives and Risk Taking Behavior: Evidence from Mutual Funds

Athanasios Orphanides


This paper examines the role of compensation contracts in determining risk taking decisions by money managers in the financial industry. A methodology is developed for empirically testing and assessing the magnitude of the effect that incentive contracts have on risk taking in the mutual fund industry using panel data. The methodology exploits the within-year cross sectional variation in the performance of mutual funds to identify systematic time series variation in risk taking. Growth and growth and income mutual funds in the 1976 to 1993 period are examined. The evidence suggests that incentive compensation has substantial influence on risk decisions. A strong seasonal component on average risk is present with risk reaching a peak in the first quarter of the year. However the relationship between within-year performance, especially towards year-end, appears to have changed over time. For losing managers, excess risk taking appears early in the sample but not in later years. For winning managers, reductions in risk taking appears towards year-end in later years but not early in the sample.

Full paper (260 KB Postscript)

Keywords: Risk taking, compensation incentives, mutual fund performance

FEDS 1996-20
Treasury Yields and Corporate Bond Yield Spreads: An Empirical Analysis

Gregory R. Duffee


This paper empirically examines the relation between the Treasury term structure and spreads of investment grade corporate bond yields over Treasuries. I find that noncallable bond yield spreads fall when the level of the Treasury term structure rises. The extent of this decline depends on the initial credit quality of the bond; the decline is small for Aaa-rated bonds and large for Baa-rated bonds. The role of the business cycle in generating this pattern is explored, as is the link between yield spreads and default risk. I also argue that yield spreads based on commonly-used bond yield indexes are contaminated in two important ways. The first is that they are "refreshed" indexes, which hold credit ratings constant over time; the second is that they usually are constructed with both callable and noncallable bonds. The impact of both of these problems is examined.

Full paper (450 KB Postscript)

Keywords: Credit risk, yield spreads, business cycles

FEDS 1996-19
Inflation, Volatility, and Growth

Ruth Judson and Athanasios Orphanides


This paper re-examines the relationship between inflation, inflation volatility and growth using cross-country panel data for the past 30 years. With regard to the level of inflation, we find that in contrast to current findings which are based on cross-sectional time-average regression comparisons, exploiting the time dimension of the data reveals a strong negative correlation between inflation and income growth for all but very low inflation countries. To examine the role of inflation uncertainty on growth, we use intra-year inflation data to construct an annual measure of inflation volatility. Using this measure, we find that inflation volatility is also robustly negatively correlated with growth even after the effect of the level of inflation is controlled for.

Full paper (171 KB Postscript)

Keywords: Growth, inflation, volatility, panel data

FEDS 1996-18
Household Saving and Portfolio Change: Evidence from the 1983-89 SCF Panel

Arthur B. Kennickell and Martha Starr-McCluer


There are very few sources of high-quality data on the dynamics of wealth accumulation. This paper uses newly-available data from the 1983-89 panel of the Survey of Consumer Finances to examine household saving and portfolio change over the 1980s. The 1983 SCF collected detailed information on households' assets, liabilities, income and other characteristics for a sample of 4,103 families. In 1989, 1,479 of these families were re-interviewed using a similar questionnaire. After describing the sample and methodology of the panel survey, we analyze changes in household wealth over the 1983-89 period. We also investigate changes in the structure of households' assets and liabilities.

Keywords: Household saving, portfolios, panel data

FEDS 1996-17
Around and Around: The Expectations Hypothesis

Mark Fisher and Christian Gilles


We show how to construct arbitrage-free models of he term structure of interest rates in which various expectations hypotheses can hold. McCulloch (1993) provided a Gaussian non-Markovian example of the unbiased expectations hypothesis (U--EH), thereby contradicting the assertion by Cox, Ingersoll, and Ross (CIR, 1981) that only the so-called local expectations hypothesis could hold. We generalize that example in three ways: (i) We characterize the U--EH in terms of forward rates; (ii) we extend this characterization to a class of expectations hypotheses that includes all of those considered by CIR; and (iii) we construct stationary Markovian and non-Gaussian economies. The building block is a maturity-dependent vector that travels around a circle at a constant speed as maturity increases.

Full paper (267 KB Postscript)

Keywords: Expectations hypothesis, yield curve, arbitrage

FEDS 1996-16
Inflation and Financial Sector Size


Traditionally the cost of expected inflation has been seen as the “shoeleathercost” of going to the bank more often. This paper focuses on the other side of these transactions--i.e., on the increased production of financial services by financial firms. I construct a model in which households must make purchases either with cash or with costly transactions services produced by firms in the financial services sector. One can think of these services as being the use of a credit card or other method of paying without cash. In the model, a higher inflation rate leads households to substitute purchased transactions services for money balances. As a result, the financial services sector gets larger. A test of the model using cross-sectionaldata finds that the size of a nation’s financial sector is strongly affected by its inflation rate. The empirical results provide an alternativeway to measure the costs of inflation. These costs appear to be large.

Keywords: Inflation, transactions services, financial sector, money demand

FEDS 1996-15
Commercial Banks and Real Estate Lending: The Texas Experience

Rebel A. Cole, Robert A. Eisenbeis, and Paul M. Horvitz


This study analyzes the performance of Texas commercial banks specializing in mortgage lending during the late 1980s and early 1990s to investigate how representative was their experience as compared with that of banks across the country concentrating in real estate lending. The results show that Texas real estate banks (REBs) performed very poorly during the 1980s and early 1990s, but this was because the Texas REBs were clearly different from the majority of the banks classified as REBs in the rest of the country. Texas REBs invested more heavily in commercial mortgages than did other banks. In a poor real estate market, these loans performed very poorly. The analysis indicates that the Texas experience is not a basis for rejecting the view that the commercial banking industry can safely replace the declining thrift industry as a major source of residential mortgage financing.

Full paper (589 KB Postscript)

Keywords: Bank, mortgage lending, real estate, real estate bank, Texas

FEDS 1996-14
Solving an Empirical Puzzle in the Capital Asset Pricing Model

John Leusner, Jalal D. Akhavein, and P.A.V.B. Swamy


A long standing puzzle in the Capital Asset Pricing Model (CAPM) has been the inability of empirical work to validate it. Roll (1977) was the first to point out this problem, and recently, Fama and French (1992, 1993) bolstered Roll’s original critique with additional empirical results. Does this mean the CAPM is dead? This paper presents a new empirical approach to estimating the CAPM, taking into account the differences between observable and expected returns for risky assets and for the market portfolio of all traded assets, as well as inherent nonlinearities and the effects of excluded variables. Using this approach, we provide evidence that the CAPM is alive and well.

Keywords: Asset pricing, measurement errors, excluded variables

FEDS 1996-13
Do Low Human Capital Coefficients Make Sense? A Puzzle and Some Answers


In this paper, I develop a new measure of human capital stock that has two advantages over previous measures. First, it allows for the fact that the cost of education varies across time, countries, and levels. Second, the unit of measurement is dollars, which allows comparison of human capital stocks with other macroeconomic variables, including national income (GDP) and physical capital stocks. Using cross-country panel regression analysis, I find that human capital accumulation accounts for a relatively small (about ten percent) of per-capita GDP growth. I further find that, unlike physical capital, the stock of human capital as a share of GDP increases with GDP.

Full paper (1413 KB Postscript)

Keywords: Growth, human capital, panel data

FEDS 1996-12
The Impact of Capital-Based Regulation on Bank Risk-Taking: A Dynamic Model

Paul S. Calem and Rafael Rob


In this paper, we model the dynamic portfolio choice problem facing banks, calibrate the model using empirical data from the banking industry for 1984-1993, and assess quantitatively the impact of recent regulatory developments related to bank capital. The model suggests that two aspects of the new regulatory environment may have unintended effects: higher capital requirements may lead to increased portfolio risk, and capital-based premia do not deter risk-taking by well-capitalized banks. On the other hand, risk-based capital standards may have favorable effects provided the requirements are stringent enough.

Full paper (249 KB Postscript)

FEDS 1996-11
Regulatory Competition and the Efficiency of Alternative Derivative Product Margining Systems

Paul H. Kupiec and A. Patricia White


Although margin requirements would arise naturally in the context of unregulated trading of clearinghouse-guaranteed derivative contracts, the margin requirements on U.S. exchange-traded derivative products are subject to government regulatory oversight. At present, two alternative methodologies are used for margining exchange-traded derivative contracts. Customer positions in securities and securities options are margined using a strategy-based approach. Futures, futures-options, and securities-option clearinghouse margins are set using a portfolio margining system. This study evaluates the relative efficiency of these alternative margining techniques using data on S&P500 futures-option contracts traded on the Chicago Mercantile Exchange. The results indicate that the portfolio margining approach is a much more efficient system for collateralizing the one-day risk exposures of equity derivative portfolios. Given the overwhelming efficiency advantage of the portfolio approach, the simultaneous existence of these alternative margining methods is somewhat puzzling. It is argued that the co-existence of these systems can in part be explained in the context of Kane's (1984) model of regulatory competition. The efficiency comparison also provides insight into other industry and regulatory issues including the design of bilateral collateralization agreements and the efficiency of alternative schemes that have been proposed for setting regulatory capital requirements for market risk in banks and other financial institutions.

Full paper (246 KB Postscript)

Keywords: Margin requirements, regulatory competition

FEDS 1996-10
Labor Productivity: Structural Change and Cyclical Dynamics

Martin N. Baily, Eric J. Bartelsman, and John Haltiwanger


A longstanding puzzle of empirical economics is that average labor productivity declines during recessions and increases during booms. This paper provides a framework to assess the empirical importance of competing hypotheses for explaining the observed procyclicality. For each competing hypothesis we derive the implications for cyclical productivity conditional on expectations of future demand and supply conditions. The novelty of the paper is that we exploit the tremendous heterogeneity in long-run structural changes across individual plants to identify the short-run sources of procyclical productivity. Our findings favor an adjustment cost model which involves a productivity penalty for downsizing as the largest source of procyclical labor productivity.

Keywords: Procyclical labor productivity, structural change, downsizing

FEDS 1996-09
Bubbles as Payoffs at Infinity

Christian Gilles and Stephen F. LeRoy


We define rational bubbles to be securities with payoffs occurring in the infinitely distant future and investigate the behavior of bubble values. We extend our analysis to a setting of uncertainty. In an infinite-horizon arbitrage-free model of asset prices, we interpret the money market account as the value of a particular bubble; a similar interpretation holds for other assets related to the state-price deflator and to payoffs on bonds maturing in the distant future. We present three applications of this characterization of bubbles.

Full paper (259 KB Postscript)

Keywords: Asset prices, money-market account, state-price deflator

FEDS 1996-08
Why Are Estimates of Agricultural Supply Response so Variable?

Francis X. Diebold and Russell L. Lamb


Estimates of the response of agricultural supply to movements in expected price display curiously large variation across crops, regions, and time periods. We argue that this anomoly may be traced, at least in part, to the statistical properties of the commonly-used econometric estimator, which has infinite moments of all orders and may have a bimodal distribution. We propose an alternative minimum- expected-loss estimator, establish its improved sampling properties, and argue for its usefulness in the empirical analysis of agricultural supply response.

Full paper (849 KB Postscript)

Keywords: Agricultural supply response, Bayesian estimation, MELO estimation

FEDS 1996-07
A Minor Redefinition of M2

William Whitesell and Sean Collins


This paper recommends redefining M2 by shifting overnight wholesale RPs and overnight Eurodollars from non-M1 M2 to non-M2 M3. The overnight components are quite volatile and difficult to measure accurately. Their movements no longer exhibit the negative correlation with demand deposits that had been observed in 1980, when these components were originally included in M2. The redefinition does not affect the quarterly and annual behavior of M2, nor its relationship to interest rates and income.

Keywords: Definition of money, M2

FEDS 1996-06
The Effect of Changes in Ownership Structure on Performance: Evidence from the Thrift Industry

Rebel A. Cole and Hamid Mehran


Restrictions on the ownership structure of a public company may harm the company's performance by preventing owners from choosing the best structure. We examine the stock-price performance and ownership structure, before and after the expiration of anti-takeover regulations, of a sample of thrift institutions that converted from mutual to stock ownership. We find that after the anti-takeover provisions expire, firm performance improves significantly, and the portions of the firm owned by managers, noninstitutional outside blockholders, and the firm's employee stock ownership plan increase. Changes in performance are positively associated with changes in ownership by managers and by noninstitutional outside blockholders but negatively associated with changes in ownership by employee stock ownership plans.

Full paper (419 KB Postscript)

Keywords: Corporate control, regulation, ownership structure, anti-takeover provisions

FEDS 1996-05
Learning by Doing and the Value of Experimentation

Volker Wieland


Research on the implications of learning-by-doing has typically been restricted to specifications of the agent's decision problem for which estimation and control can be treated separately. Recent work has provided the limit properties of beliefs and actions for learning problems under more general conditions, for which experimentation is an important aspect of optimal control. However under these conditions the optimal policy cannot be derived analytically, because Bayesian learning introduces a nonlinearity in the dynamic programming problem. This paper utilizes numerical algorithms to characterize the optimal policy function for such a general learning-by-doing problem. In contrast to previous work on calculating such policies, we find that the optimal policy incorporates a substantial degree of experimentation under a wide range of initial beliefs about the unknown parameters. Dynamic simulations indicate that optimal experimentation dramatically improves the speed of learning and the stream of future payoffs. Furthermore dynamic simulations reveal that a policy, which separates control and estimation and does not incorporate experimentation, frequently induces a long-lasting bias in the control and target variables. While these sequences tend to converge steadily under the optimal policy, they frequently exhibit non-stationary behavior when estimation and control are treated separately.

Full paper (1582 KB Postscript)

Keywords: Bayesian optimal control, learning by doing, experimentation, dynamic programming

FEDS 1996-04
Forecasting Long- and Short-Horizon Stock Returns in a Unified Framework

Chunsheng Zhou


If stock prices do not follow random walks, what processes do they follow? This question is important not only for forecasting purpose, but also for theoretical analyses and derivative pricing where a tractable model of the movement of underlying stock prices is needed. Although several models have been proposed to capture the predictability of stock returns, their empirical performances have not been evaluated. This paper evaluates some popular models using a Kalman Filter technique and finds that they have serious flaws. The paper then proposes an alternative parsimonious state-space model in which state variables characterize the stochastic movements of stock returns. Using equal-weighted CRSP monthly index, the paper shows that (1) this model fits the autocorrelations of returns well over both short and longer horizons and (2) although the forecasts obtained with the state-space model are based solely on past returns, they subsume the information in other potential predictor variables such as dividend yields.

Full paper (218 KB Postscript)

Keywords: State-space model, stock returns

FEDS 1996-03
Stock Market Fluctuations and the Term Structure

Chunsheng Zhou


This paper uses the term structure of interest rates to explain the variations of stock prices and stock returns. It shows that interest rates have an important impact on stock returns, especially at long horizons. The hypothesis that expected stock returns move one-for-one with ex ante interest rates, which has been rejected strongly in other studies using short horizon data, is supported by long horizon data. The paper proposes, for the first time, a single measure---the present value of forward interest rates---to summarize the information of the term structure that is useful in characterizing the comovements of the equity market and the bond market, and finds that such a single measure explains a significant part of variation in dividend-price ratios. The paper also suggests that the high volatility of the stock market is related to the high volatility of long-term bond yields and may be accounted for by changing forecasts of discount rates. The findings of this paper are quite different from the typical findings of the previous work and may provide a reasonable economic explanation for the predictability of long-horizon stock returns.

Full paper (203 KB Postscript)

Keywords: Comovement, stock market, term structure

FEDS 1996-02
Measurement Error and Time Aggregation: A Closer Look at Estimates of Output-Labor Elasticities

Marcello Estevao


This paper analyzes the effect of time aggregation on estimates of the elasticities of output with respect to employment and to average hours of work. The main goal is to get accurate estimates of production function parameters. Low frequency data generate better estimates of output-employment elasticity while high frequency data generate better estimates of output-average hours elasticity. This result comes from the fact that time aggregation increases (decreases) the bias in the estimate of the elasticity with respect to average hours (employment). Estimations of these elasticities at different data frequencies and numerical simulations illustrate this point. In addition, this estimation methodology shows that the elasticity of output with respect to employment is bigger than the elasticity of output with respect to average hours, as theory predicts, contradicting an established result in the literature.

Keywords: Labor elasticity, production function, time aggregation, hours, employment

FEDS 1996-01
Saving and Financial Planning: Some Findings from a Focus Group

Arthur B. Kennickell, Martha Starr-McCluer, and Annika E. Sunden


This paper summarizes the results of a focus group on saving and financial planning. The group consisted of eight individuals with relatively high income and wealth. The savings behavior of such people is of interest partly due to their large contribution to total personal saving. The participants expressed concerns about how their circumstances will change as they age, and about uncertainties in income and health. While these concerns are consistent with theories emphasizing life-cycle and precautionary motives, the idea that saving involves self-control was also mentioned repeatedly.

Full paper (81 KB Postscript)

Keywords: Financial planning, saving

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Last Update: December 01, 2023