FEDS 1997-59
Interest Rates and M2 in an Error-Correction Macro Model

William Whitesell


With annual data, real M2 is shown to have a surprisingly strong contemporaneous and leading relationship to GDP, that is robust to the inclusion of other explanatory variables. When combined and tested with parsimonious error correction equations for money demand, price determination, and a monetary policy reaction function, an overall macroeconometric model is revealed with an unusually good fit aside from a velocity shift adjustment needed for the early 1990s and better inflation performance than expected of late. A regime shift is evident in the stronger response of the Federal Reserve to inflation in the 1980s than in the previous two decades.

Keywords: Money, M2, macroeconometric model, p-star

FEDS 1997-58
The Subsidy Provided by the Federal Safety Net: Theory, Measurement, and Containment

Myron L. Kwast and S. Wayne Passmore


This paper presents an intuitive and analytical model of how the federal safety net affects banks' cost of funds. Emphasis is placed on distinguishing between fixed and marginal costs in banking and on the implications of the model for measuring the subsidy. Empirical results strongly suggest that the safety net has benefitted banks and that over recent years bank holding companies have tended to move activities into a bank or a bank subsidiary. We conclude that limiting extension of the safety net subsidy should be a serious concern when designing strategies for expanding bank activities.

Keywords: Banks, safety net, deposit insurance, powers

FEDS 1997-57
The Wage Curve and the Phillips Curve


Blanchflower and Oswald (1994) have argued that, in regional data, the level of unemployment is related to the level of wages. This result is at variance with the implications of the original Phillips curve for regional data, which would predict that the change in wages ought to be related to the unemployment rate. On the other hand, there is considerable empirical support for the expectations-augmented Phillips curve using macroeconomic data. I resolve this tension by showing that a standard macroeconomic expectations-augmented Phillips curve can be derived from microfoundations that begin with the wage curve.

Keywords: Phillips curve, wage curve, new keynesian economics

FEDS 1997-56
Exploring the Robustness of the Oil Price-Macroeconomy Relationship

Mark Hooker


This paper reexamines the oil price-macroeconomy relationship with rolling Granger causality and structural stability tests. It finds that this relationship broke down amidst the falling oil prices and market collapse of the 1980s, suggesting misspecification of the oil price rather than a weakened relationship. Some proposed respecifications of the oil price yield considerable improvements, although they are not sufficient to achieve Granger causality of output unless interest rates are excluded from the VAR. There is some support for the explanation that oil prices affect the economy indirectly by inducing monetary policy responses, but this is incomplete and some evidence of misspecification remains.

Full paper (778 KB Postscript)

Keywords: Oil price shocks, Granger causality

FEDS 1997-55
Pensions, Social Security, and the Distribution of Wealth

Arthur B. Kennickell and Annika E. Sunden


This paper uses the Survey of Consumer Finances (SCF) to examine pension coverage, estimate Social Security and pension wealth for U.S. households in 1989 and 1992, and estimate the effects of pension wealth on non-pension net worth. As expected, the SCF data show that including pensions and Social Security in net worth makes the distribution more even. The analysis of the effects of pension wealth on other types of savings indicates that there is a negative effect of defined benefit plan coverage on non-pension net worth. Surprisingly, the effect of defined contribution plans, such as 401(k) plans is insignificant.

Keywords: Pensions, social security, wealth distribution

FEDS 1997-54
Unemployment and the Durational Structure of Exit Rates

Karl Whelan


This paper presents a simple model of wage bargaining and employment flows designed to address the effects of policies to increase the rate of exit to employment of the long-term unemployed. Exit rates from long- and short-term unemployment have two effects on the unemployment rate: a positive one as high exit rates strengthen current employees' bargaining positions and thus wages and a negative one as faster outflows from unemployment reduce the stock of unemployed. Thus, there is a trade-off between the exit rate from long-term unemployment and the exit rate from short-term unemployment. The paper's principal result is that, in steady-state, increasing the exit rate from long-term unemployment reduces the unemployment rate. Dynamic simulations show that raising the exit rate of the long-term unemployed leads to a decrease in both the mean and variance of the unemployment rate.

Full paper (828 KB Postscript)

Keywords: Unemployment, duration dependence

FEDS 1997-53
Inflation, Taxes, and the Durability of Capital

Darrel Cohen and Kevin Hassett


Auerbach (1979, 1981) has demonstrated that inflation can lead to large inter-asset distortions, with the negative effects of higher inflation unambiguously declining with asset life. We show that this is true only if depreciation is treated as geometric for tax purposes. When depreciation is straightline, higher inflation can have the opposite effect, discouraging investment in long-lived assets. Since our current system can be thought of as a mixture of straightline and geometric, the sign of the inter-asset distortion is indeterminate. We show that under current U.S. tax rules, the "straightline" and "geometric" effects approximately cancel for equipment, causing almost no inter-asset distortions. For structures, inflation clearly causes substitution into long-lived assets.

Full paper (102 KB Postscript)

Keywords: Inflation, user cost of capital, capital durability

FEDS 1997-52
Market Definition and the Analysis of Antitrust in Banking

Myron L. Kwast, Martha Starr-McCluer, and John D. Wolken


In antitrust analysis of bank mergers, banking markets are viewed as geographically local, with a "cluster" of products as the relevant product line. This view is criticized as outdated, now that many bank products are offered by nonbank institutions and financial institutions' operations are increasingly national in scope. This paper reexamines the question of market definition in banking, using two micro data sets uniquely well-suited to the task. We find that local depositories remain the dominant supplier of key financial services to households and small businesses, with geographic proximity still important in their institution choice.

Full paper (350 KB Postscript)

Keywords: Market definition, antitrust, banking

FEDS 1997-51
Wage Curve vs. Phillips Curve: Are There Macroeconomic Implications?

Karl Whelan


The standard derivation of the accelerationist Phillips curve relates expected real wage inflation to the unemployment rate and invokes a constant price markup and adaptive expectations to generate the accelerationist price inflation formula. Blanchflower and Oswald (1994) argue that microeconomic evidence of a low autoregression coefficient in real wage regressions invalidates the macroeconomic Phillips curve. This conclusion has been disputed by a number of authors on the grounds that the true autoregression coefficient is close to 1. This paper shows that given the assumption of a constant price markup, micro-level real wage dynamics have no observable implications for macro data on wage and price inflation.

Full paper (192 KB Postscript)

Keywords: Inflation, wage curve, Phillips curve

FEDS 1997-50
Consistency Conditions for Regulatory Analysis of Financial Institutions: A Comparison of Frontier Efficiency Methods

Paul W. Bauer, Allen N. Berger, Gary D. Ferrier, and David B. Humphrey


We propose a set of consistency conditions that frontier efficiency measures should meet to be most useful for regulatory analysis or other purposes. The efficiency estimates should be consistent in their efficiency levels, rankings, and identification of best and worst firms; consistent over time and with competitive conditions in the market; and consistent with standard nonfrontier measures of performance. We provide evidence on these conditions by evaluating and comparing efficiency estimates on U.S. bank efficiency from variants of all four of the major approaches--DEA, SFA, TFA, and DFA--and find mixed results.

Keywords: Bank, financial institution, efficiency, regulation, profit, cost

FEDS 1997-49
Misspecification versus Bubbles in Hyperinflation Data: Monte Carlo and Interwar European Evidence

Mark A. Hooker


This paper analyzes tests of the Cagan hyperinflation-money demand model that have several advantages relative to those in the literature. They do not confound specification error with rational bubbles, are implementable with a linear procedure, and are frequently able to detect periodically collapsing bubbles that have challenged existing tests. After a Monte Carlo analysis, the tests are applied to data from hyperinflations in Austria, Germany, Hungary, and Poland. Strong evidence of model misspecification is found for Austria, while the model with a rational, explosive component well characterizes the Polish data. Inferences for Germany and Hungary are mixed.

Keywords: Hyperinflation, bubble, specification error

FEDS 1997-48
The Sources of Worker Anxiety: Evidence from the Michigan Survey


This paper uses individual responses from the Michigan SRC survey of consumer attitudes to examine worker anxiety. It identifies "anxious" households (those that express some concern about the job security) and analyzes some factors that might be driving this angst. It found that a little more than a quarter of households revealed concerns about job security. Also, the results suggest that less educated households (those lacking a high school diploma) were significantly more likely to be concerned about job loss as were black and Asian households.

Geographic factors were important in driving worker anxiety with largely households along the East Coast and West Coast significantly more likely to express concern over job security. The results also indicated that hearing news about layoffs or plant closings increased the likelihood that an employed household was anxious, and anxious households were more likely to hold unfavorable views on the overall economy, although the relationship was far from certain. This leaves room for the possibility that households could report favorable views about the economy in general yet harbor significant concerns about their own job security. The results also suggested that anxious, employed households might be more reluctant to take on more debt. However, job anxiety did not appear to have any impact on households' views on using savings to finance consumption. Finally, the results suggest that worker anxiety was higher in 1995 than in the late 1980s.

Full paper (490 KB Postscript)

Keywords: Job insecurity, Michigan survey

FEDS 1997-47
Restraining the Leviathan: Property Tax Limitation in Massachusetts

David M. Cutler, Douglas W. Elmendorf, and Richard Zeckhauser


Proposition 2-1/2, a ballot initiative approved by Massachusetts voters in 1980, sharply reduced local property taxes and restricted their future growth. We examine the effects of Proposition 2-1/2 on municipal finances and assess voter satisfaction with these effects. We find that Proposition 2-1/2 had a smaller impact on local revenues and spending than expected; amendments to the law and a strong economy combined to boost both property tax revenue and state aid above forecasted amounts. Proposition 2-1/2 did reduce local revenues substantially during the recession of the early 1990s. There were two reasons for voter discontent with the pre- Proposition 2-1/2 financing system: agency losses from inability to monitor government were perceived to be high, and individuals viewed government as inefficient because their own tax burden was high. Through override votes, voters approved substantial amounts of taxes above the limits imposed by the Proposition.

Full paper (431 KB Postscript)

Keywords: Property tax limits, agency problems

FEDS 1997-46
Staggered Price Setting and Real Rigidities


This paper emphasizes the notion that model features that contribute to endogenous price rigidity under staggered price setting lower the elasticity of marginal cost with respect to output, and these same model features tend to generate equilibrium indeterminacy, or "sunspot fluctuations", under price flexibility. Using this insight, staggered price setting is shown to imply persistent output responses to monetary shocks for certain parameterizations of one- and two-sector models with small increasing returns or countercyclical markups, and other model features that would contribute to persistence are discussed.

Full paper (270 KB Postscript)

Keywords: Nominal price rigidity, indeterminacy

FEDS 1997-45
The Supply of Skilled Labor and Skill-Biased Technological Progress


Rising inequality in the relative wages of skilled and unskilled labor is often attributed to skill-biased technological progress. This paper presents a model in which the adoption of skill-biased or "unskilled-biased" technologies is endogenous. Conventional wisdom states that an increase in the supply of skilled labor lowers the relative wage of skilled to unskilled labor. In this paper, an increase in the supply of skilled labor leads to temporary stagnation in the wages of unskilled workers and an expanding gap between the wages of skilled and unskilled workers through an acceleration of skill-biased technological change.

Full paper (121 KB Postscript)

Keywords: Wage inequality, endogenous growth

FEDS 1997-44
The Effects of Two-Year College on the Labor Market and Schooling Experiences of Young Men

Brian J. Surette


In 1994, nearly 40 percent of all college students attended two-year colleges. This study uses 12 years of data for young men from the NLSY to examine (1) the labor market returns to two-year college, (2) whether attendance at a two-year college helps students to transfer to four-year college, and (3) whether reducing the cost of college would alter attendance by enough to affect wages or income. I find that the returns to two-year college credits are large and positive (on the order of 7 to 10 percent), and that a student does not need to complete an associate’s degree to enjoy these benefits. Degree completion further raises wages and income. Examining the transfer role of two-year colleges, I find that one year of two-year credits has the same effect on subsequent four-year college attendance as one year of four-year credits, suggesting that the transfer role is quite important. Finally, reducing tuition is shown to raise attendance by enough to raise average wages and earnings modestly. These results are based on a Full Information Maximum Likelihood framework in which discrete factor random effects address the potential bias introduced by unobserved heterogeneity.

Keywords: Two-year college, four-year college, community college, training, returns to schooling

FEDS 1997-43
The GMM Parameter Normalization Puzzle


A feature of GMM estimation--the use of a consistent estimate of the optimal weighting matrix rather than the joint estimation of the model parameters and the weighting matrix--can lead to the sensitivity of GMM estimation to the choice of parameter normalization. In many applications, including Euler equation estimation, a model parameter multiplies the equation error in some, but not all, normalizations. But, conventional GMM estimators that either hold the estimate of the weighting matrix fixed or allow some limited iteration on the weighting matrix fail to account for the dependence of the weighting matrix on the parameter vector implied by the multiplication of the error by the parameter. In finite samples, GMM effectively minimizes the square of the parameter times the objective function that obtains from an alternative normalization where no parameter multiplies the equation error, resulting in estimates that are smaller (in absolute value) than those from the alternative normalization. Of course, normalization is irrelevant asymptotically.

Full paper (1089 KB Postscript)

Keywords: GMM, finite-sample, normalization, euler-equation, adjustment-costs--employment

FEDS 1997-42
Expectations, Learning and the Costs of Disinflation: Experiments using the FRB/US Model

Antulio Bomfim, Robert Tetlow, Peter von zur Muehlen, and John C. Williams


The macroeconomic costs of disinflation are considered for the United States in a rational expectations macroeconometric model with sticky prices and imperfect information regarding monetary policy objectives. The analysis centers on simulation experiments using the Board’s new quarterly macroeconometric model, FRB/US, within which are nested both expectations formation that is 'rational' (i.e., model consistent) and 'restricted-information rational' (i.e., where the information set is restricted to that captured by a small-scale VAR model). We characterize monetary policy as being governed by rules. Disinflations are represented by changes in the target inflation rate of a interest-rate reaction function. Two kinds of rules are considered: a version of the Taylor rule and the other being a more aggressive and richer specification estimated using data for the last 15 years. We assume agents are not fully cognizant of changes in the Fed’s inflation target and must instead adjust their perceptions of the target according to a linear updating rule. Simulation results for sacrifice ratios are compared with results from other models and with econometric results and calculations reported in the literature.

Full paper (322 KB Postscript)

Keywords: Monetary policy, disinflation, expectations, learning, macroeconomic modeling

FEDS 1997-41
Trading Volume and Information Distribution in a Market-Clearing Framework

Dominique Y. Dupont


This paper investigates the relations between aggregate trading volume and information on financial markets from a theoretical standpoint. Through numerical examples, it relates some statistics describing equilibrium price and volume{such as the variance of the price and its correlation with the true asset value, the volume mean, variance, skewness, and kurtosis{to the distribution of information across traders. The analysis is carried out in a static noisy rational expectations framework, with multiple informed traders, where both the precision and the correlation of the signals observed by the traders can be modified.

Numerical examples show that the variance of the market-clearing price, and the mean and variance of the volume are increasing in the precision of the informed trader's signals and{to a lesser extent{in the liquidity shock variance. The price informativeness is increasing in the precision of the informed traders' signals and decreasing in the liquidity shock variance. Skewness and kurtosis in the trading volume distribution are not always associated with a high precision of the informed trader' signals; the relation depends on the correlation across the informed traders' signals.

Full paper (2184 KB Postscript)

Keywords: Trading volume, information

FEDS 1997-40
Analyzing Alternative Intraday Credit Policies in Real-Time Gross Settlement Systems

Craig H. Furfine and Jeff Stehm


This paper examines a central bank's choice of intraday credit policy for Real-Time Gross Settlement (RTGS) systems. Formal analysis of central bank objectives and commercial bank payment activity provides insight into both the choice and effects of several possible intraday credit policies. Observed intraday credit policies are interpreted within the context of the model. Among G-10 central banks, different combinations of prices, collateral, and quantity limits have been chosen to manage the supply of intraday credit. Conditions that rationalize these choices are shown to rely on a) central bank preferences regarding credit risk and systemic risk, b) liquidity management technologies, and c) the cost of collateral.

Keywords: Daylight credit, payment systems, RTGS, intraday credit

FEDS 1997-39
Internal Capital Markets and Investment: Do the Cash Flow Constraints Really Bind?

Calvin Schnure


Lamont (1997) claims to find evidence of credit market imperfections that distort financing and investment decisions of a sample of oil-dependent firms, as investment by non-oil units fell when oil cash flow dropped. However, a simple test reveals that few of these firms behaved in a fashion consistent with binding cash flow constraints. In addition, most were cash rich. The data provide strong evidence against the hypothesis that investment decisions by non-oil units were significantly affected by oil cash flow, or that credit market imperfections are an important factor for this set of firms.

Keywords: Cash flow, investment, liquidity constraint

FEDS 1997-38
The Effects of Interest Rates and Taxes on New Car Prices

Maura P. Doyle


Utilizing the Consumer Expenditure Survey and state-level variation in taxes, this study finds that prices for most models of new cars shift by more than the amount of a sales tax. The evidence of an overshifting of prices offers support for the recent models of tax incidence in imperfectly competitive markets. The results also suggest that changes in the after-tax interest rate have offsetting effects on new car prices; a one percentage point increase in the after-tax real interest rate will prompt, on average, a mark-down of $106.

Full paper (297 KB Postscript)

Keywords: Sales taxes, car prices, interest rates

FEDS 1997-37
Risk, Entrepreneurship, and Human Capital Accumulation

Murat F. Iyigun and Ann L. Owen


We examine the implications for growth and development of the existense of two types of human capital: entrepreneurial and professional. While entrepreneurial human capital plays a relatively more important role in intermediate income countries, professional human capital is relatively more abundant in richer economies. Because the return in entrepreneurial ventures is risky, individuals devote less time to the accumulation of entrepreneurial human capital and more to the accumulation of professional human capital as per capita income grows, thus changing the relative stocks of these skills. We also show that those countries that initially have too little of either entrepreneurial or professional human capital may end up in a development trap. Finally, because the social marginal returns to education and experience may differ from the private marginal returns to education and experience may differ from the private marginal returns, the steady state can be characterized by either too much or too little education.

Keywords: Human capital, occupational choice, education, entrepreneurship, growth

FEDS 1997-36
A Quantitative Exploration of the Opportunistic Approach to Disinflation

Athanasios Orphanides, David H. Small, Volker Wieland, and David W. Wilcox


A number of observers have advocated recently that the Federal Reserve take an "opportunistic" approach to the conduct of monetary policy. A hallmark of this approach is that the central bank focuses on fighting inflation when inflation is high, but focuses on stabilizing output when inflation is low. The implied policy rule is nonlinear. This paper compares the behavior of inflation and output under opportunistic and conventional linear policies. Using stochastic simulations of a small-scale rational expectations model, we study the cost and time required to achieve a given disinflation, as well as the steady-state distributions of inflation and output under the various rules.

Full paper (1052 KB Postscript)

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

FEDS 1997-35
Who Uses Electronic Banking? Results from the 1995 Survey of Consumer Finances

Arthur B. Kennickell and Myron L. Kwast


This study uses the 1995 Survey of Consumer Finances to examine households' use of technologies, including electronic means, to carry out transactions at a financial institution and to gain information for making saving and borrowing decisions. Household use of various technologies is correlated with household income, financial assets, age, and years of education. Results suggest that relatively new electronic technologies are used by relatively few households, and that household use of electronic sources of information for financial decisionmaking is barely off the ground.

Keywords: Banks, banking, electronic, households, technology, information

FEDS 1997-34
Racial Differences in Short-Run Earnings Stability and Implications for Credit Markets

Raphael W. Bostic


This paper examines the claim that observed racial differences in rejection rates for mortgage applications, which persist after controlling for many relevant factors, are due to racial differences in short-run earnings stability, which has not typically been included in empirical tests. The evidence does not support the proposition that blacks suffer from greater earnings instability than comparable whites, as few consistent significant differences between black and white earnings volatility are found. Only in the case of drastic earnings shocks with persistent effects does the possibility of significant racial differences reasonably remain. In general, racial differences in earnings stability appear to be minor and are unlikely to result in substantial differences in creditworthiness.

Full paper (477 KB Postscript)

Keywords: Credit risk, race, earnings variance, mortgages

FEDS 1997-33
Premiums in Private versus Public Bank Branch Sales

James A. Berkovec, John J. Mingo, and Xuechun Zhang


This paper is the first to directly estimate the determinants of differences in premiums received by public and private sellers in the market for bank branches (deposit bases). Deposit premiums received in private sector transactions exceeded those received by the FDIC and the RTC, even after controlling for known characteristics of the transactions and after corrections for possible sample selection bias. The observed differential disappeared by 1992, suggesting improved market efficiency and/or the impact of FDICIA (1991), which mandated "least-cost" resolution procedures for failed institutions. Additionally, the evidence suggests that bank branches are independent value objects whose auctions always result in "unintended" transfers of value to the winning bidders. This result, while consistent with previous literature that found positive cumulative abnormal returns (CARs) to the winners of auctions for the branches of failed banks, nevertheless suggests that not all of the positive CARs can be due to market inefficiency.

Keywords: FDIC, auctions, deposit premiums, bank failures

FEDS 1997-32
Social Security Privatization: What It Can and Cannot Accomplish

Randall P. Mariger


This paper assesses the effect of social security privatization on the government budget, economic efficiency, national savings, and the distribution of resources across generations. It is shown that the benefits of privatization most often touted by privatization advocates can be achieved by simply altering taxes and social security pensions and leaving the basic structure of social security unchanged. In the conclusion, two simple arguments are given for why privatization might be a good idea nonetheless.

Full paper (234 KB Postscript)

Keywords: Social security, privatization

FEDS 1997-31
Asymmetric Adjustments of Price and Output

P.A. Tinsley and Reva Krieger


Asymmetries in price adjustment can reconcile contrasts between rapid price movements in inflationary episodes, consistent with classical theories of flexible pricing, and sluggish price responses in contractions, consistent with Keynesian theories of sticky price adjustments. Nonparametric analysis of SIC two-digit industry data indicates that negative asymmetries are more pronounced for real outputs than for nominal outputs, suggesting reversed positive asymmetries in producer pricing. Pricing decision rules are estimated to distinguish between asymmetries in conditioning shocks and asymmetries in producer responses. Two rational motives for asymmetric pricing are supported.

Full paper (309 KB Postscript)

Keywords: Asymmetric trend deviations, rational error correction, producer pricing

FEDS 1997-30
Declining Required Reserves and the Volatility of the Federal Funds Rate

James A. Clouse and Douglas W. Elmendorf


Low required reserve balances in 1991 led to a sharp increase in the volatility of the federal funds rate, but similarly low balances in 1996 did not. This paper develops and simulates a microeconomic model of the funds market that explains these facts. We show that reductions in reserve balances increase the volatility of the federal funds rate, but that this relationship changes over time in response to observable changes in bank behavior. The model predicts that a continued decline in required reserves could increase funds-rate volatility significantly.

Full paper (372 KB Postscript)

Keywords: Reserve requirements, federal funds rate, volatility

FEDS 1997-29
The Evolution of Macro Models at the Federal Reserve Board

Flint Brayton, Andrew Levin, Ralph Tryon, and John C. Williams


Large-scale macroeconomic models have been used at the Federal Reserve Board for nearly thirty years. After briefly reviewing the first generation of Fed models, which were based on the IS/LM/Phillips curve paradigm, the paper describes the structure and properties of a new set of models. The new models are more explicit in their treatment of expectations formation and household and firm intertemporal decisionmaking. The incorporation of more rigorous theoretical microfoundations is accomplished while maintaining a high standard of goodness of fit. Simulations illustrate the effects of alternative assumptions about the formation of expectations and policy credibility on system properties.

Full paper (634 KB Postscript)

Keywords: Macroeconometric models, monetary policy, fiscal policy

FEDS 1997-28
The Effects of Bank Mergers and Acquisitions on Small Business Lending

Allen N. Berger, Anthony Saunders, Joseph M. Scalise, and Gregory F. Udell


We examine the effects of bank M&As on small business lending. Our methodology permits empirical analysis of the great majority of U.S. bank M&As since the late 1970s -- over 6,000 M&As involving over 10,000 banks (some active banks are counted multiple times). We are the first to decompose the impact of M&As on small business lending into static effects associated with a simple melding of the antecedent institutions and dynamic effects associated with post-M&A refocusing of the consolidated institution. We are also the first to estimate the reactions of other banks in local markets to M&As. We find that the static effects of consolidation which reduce small business lending are mostly offset by the reactions of other banks in the market, and in some cases also by refocusing efforts of the consolidating institutions themselves.

Full paper (1202 KB Postscript)

Keywords: Bank, mergers, small business lending

FEDS 1997-27
Default Correlation: An Analytical Result

Chunsheng Zhou


Evaluating default correlations and the probabilities of multiple defaults is an important task in credit analysis and risk management, but it has never been an easy one because default correlations cannot be measured directly. This paper provides, for the first time, an analytical formula for calculating default correlations based on a first-passage-time model that can be easily implemented and conveniently used in a variety of financial applications. This paper also provides a theoretical justification for many empirical results found in the literature and increases our understanding of the important features of default correlations.

Full paper (243 KB Postscript)

Keywords: Default correlation, first-passage-time

FEDS 1997-26
Nonparametric Density Estimation and Tests of Continuous Time Interest Rate Models

Matt Pritsker


A number of recent papers have used nonparametric density estimation or non- parametric regression to study the instantaneous spot interest rate, and to test term structure models. However, little is known about the performance of these methods when applied to persistent time-series, such as U.S. interest rates. This paper uses the Vasicek [1977] model to study the performance of kernel density estimates of the ergodic distribution of the instantaneous spot rate. The model's tractability allows me to analyze the MISE of the kernel estimate as a function of persistence, variance of the ergodic distribution, span of the data, sampling frequency, and kernel bandwidth. Our principle result is that persistence has an important impact on optimal bandwidth selection and on infinite sample performance. We also find that sampling the data more frequently has little effect on estimator quality. We also examine one of Ait-Sahalia's [1996a] new nonparametric tests of parametric continuous-time Markov models of the instantaneous spot interest rate. The test is based on the distance between parametric and nonparametric (kernel) estimates of the ergodic distribution of the interest rate process. Our principal result is that the test rejects too often when using asymptotic critical values and 22 years of data. The reason for the high rejection rate is probably because the asymptotic distribution of the test does not depend on persistence, but the finite sample performance of the estimator does. After critical values are adjusted for size, the test has low power in distinguishing between the Vasicek and Cox-Ingersoll- Ross models when compared with a conditional moment based specification test.

Full paper (2045 KB Postscript)

Keywords: Interest rate, nonparametric, bandwidth, specification test

FEDS 1997-25
Small Business Lending by Banks Involved in Mergers


The paper uses data on the volume outstanding of small business loans from the midyear Call Reports to summarize the nature of small business lending at banks that were involved in mergers between June 1993 and June 1996. Then a model of gradual adjustment by the consolidated bank following the merger is estimated to determine whether the portfolio share of small business loans at the consolidated bank tends to move over time toward either the pre-merger share at the acquiring bank or the typical share at other banks of roughly the same size as the consolidated bank.

Full paper (399 KB Postscript)

Keywords: Bank consolidation, small business loans

FEDS 1997-24
Efficiency Wages, Nominal Rigidities, and the Cyclical Behavior of Real Wages and Marginal Cost


This paper presents a model in which efficiency wages generate acyclical real wages but do not lower the sensitivity of marginal cost to output or increase price stickiness. Consideration of previous models suggests that efficiency wages are a poor source of real rigidity.

Full paper (53 KB Postscript)

Keywords: Efficiency wages, nominal price rigidity

FEDS 1997-23
Dynamic Equilibrium Economies: A Framework for Comparing Models and Data

Francis X. Diebold, Lee E. Ohanian, and Jeremy Berkowitz


We propose a constructive, multivariate framework for assessing agreement between (generally misspecified) dynamic equilibrium models and data, which enables a complete second-order comparison of the dynamic properties of models and data. We use bootstrap algorithms to evaluate the significance of deviations between models and data, and we use goodness-of-fit criteria to produce estimators that optimize economically relevant loss functions. We provide a detailed illustrative application to modeling the U.S. cattle cycle.

Keywords: Evaluation, multivariate, frequency domain, bootstrap

FEDS 1997-22
Margin Requirements, Volatility, and Market Integrity: What Have We Learned since the Crash?

Paul H. Kupiec


This study assesses the state of the policy debate that surrounds the federal regulation of margin requirements. A relatively comprehensive review of the literature finds no undisputed evidence that supports the hypothesis that margin requirements can be used to control stock return volatility and correspondingly little evidence that suggests that margin-related leverage is an important underlying source of "excess" volatility. The evidence does not support the hypothesis that there is a stable inverse relationship between the level of Regulation T margin requirements and stock returns volatility nor does it support the hypothesis that the leverage advantage in equity derivative products is a source of additional returns volatility in the stock market.

Full paper (264 KB Postscript)

Keywords: Margin requirements, volatility, leverage

FEDS 1997-21
'Home' Base and Monetary Base Rules: Elementary Evidence from the 1980s and 1990s

Philip N. Jefferson


This paper evaluates the quantitative importance of removing U.S. currency held abroad from the monetary base. We find that a simple macroeconometric model that uses home base has more explanatory power for changes in nominal income than a model using the total base. Moreover, proposed base rules for the conduct of monetary policy perform better when the model for home base is employed. The evidence from our elementary exercises suggests that accounting for foreign holdings of U.S. currency may also be important in other contexts.

Full paper (210 KB Postscript)

Keywords: Currency abroad, monetary base, nominal income

FEDS 1997-20
Extracting Information from Trading Volume

Dominique Y. Dupont


This paper shows how to infer information about any random variable from trading volume, assuming that the random variable and the traders' demands are symmetrically (and then normally) distributed around zero. The volume-based conditional expectation of such a random variable is zero, while the covariance between its absolute value and volume is positive if the variable is jointly normally distributed with the traders' demands. In that case, numerical examples indicate that the volume-based conditional probability of extreme asset value realizations (positive or negative) increases with volume. These results, developed in a market-clearing framework, apply also to market-making frameworks. Finally, the paper develops a simple model where transaction costs can generate a positive covariance between price and trading volume.

Full paper (367 KB Postscript)

Keywords: Information, trading volume

FEDS 1997-19
The Effect of Automated Underwriting on the Profitability of Mortgage Securitization

Wayne Passmore and Roger Sparks


Over the past two years, many mortgage market analysts have praised automated underwriting as a technological innovation that will lower the costs of processing mortgage applications. However, automated underwriting is unlikely to decrease processing costs uniformly for all mortgage applications. Instead, it makes identifying and processing low-risk mortgage borrowers less costly, but may not significantly lower the costs of identifying and processing relatively high-risk applicants. Our results suggest that after the one-time cost reduction produced by automated underwriting, the resulting mortgage market equilibrium is characterized by lower mortgage rates and lower profits for the mortgage securitizer.

Full paper (312 KB Postscript)

Keywords: Automated underwriting, credit scoring, mortgages, securitization

FEDS 1997-18
Three Sources of Increasing Returns to Scale

Jinill Kim


This paper reviews various types of increasing returns from a critical perspective. Increasing returns have been introduced in a monopolistic-competition model both at the firm level and at the aggregate level. We show that the degree of the aggregate returns to scale is a linear combination of three return parameters, with the weights determined by the specification of a zero-profit condition. Identification issues are discussed with an emphasis on recent macro literature. We argue that disaggregate data give information on the market structure rather than the technology. Welfare implications explain why it is important to identify various increasing returns.

Full paper (504 KB Postscript)

Keywords: Increasing returns, monopolistic competition, returns to variety

FEDS 1997-17
Price Level Determinacy and Monetary Policy under a Balanced Budget Requirement

Stephanie Schmitt-Grohe and Martin Uribe


This paper analyzes the implications of a balanced budget fiscal policy rule for the determinacy of the price level in a cash-in-advance economy under three alternative monetary policy regimes. It shows that, in such stylized models with flexible prices and a period-by-period balanced budget requirement, the price level is determinate under a money growth rate peg and is indeterminate under a pure nominal interest rate peg. Under a feedback rule whereby the nominal interest rate is set as an increasing function of the inflation rate, the price level is determinate for intermediate values of the inflation elasticity of the feedback rule and is indeterminate for both very low and very high values of the inflation elasticity. Finally, regardless of the particular monetary policy specification, a rational expectations equilibrium consistent with the optimal quantity of money may not exist.

Full paper (304 KB Postscript)

Keywords: Balanced budget rules, price level determinacy

FEDS 1997-16
Path-Dependent Option Valuation when the Underlying Path Is Discontinuous

Chunsheng Zhou


The payoffs of path-dependent options depend not only on the final values, but also on the sample paths of the prices of the underlying assets. A rigorous modeling of the underlying asset price processes which can appropriately describe the sample paths is therefore critical for pricing path-dependent options. This paper allows for discontinuities in the sample paths of the underlying asset prices by assuming that these prices follow jump diffusion processes. A general yet tractable approach is presented to value a variety of path-dependent options with discontinuous processes. The numerical examples show that ignoring the jump risk may lead to serious biases in path-dependent option pricing.

Full paper (201 KB Postscript)

Keywords: Path-dependent, option, jump diffusion

FEDS 1997-15
A Jump-Diffusion Approach to Modeling Credit Risk and Valuing Defaultable Securities

Chunsheng Zhou


Since Black and Scholes (1973) and Merton (1974), structural models of credit risk have relied almost exclusively on diffusion processes to model the evolution of firm value. While a diffusion approach is convenient, in empirical application, it has produced very disappointing results. Jones, Mason, and Rosenfeld (1984) find that the credit spreads on corporate bonds are too high to be matched by the diffusion approach. Also, because the instantaneous default probability of a healthy firm is zero under a continuous process, the diffusion approach predicts that the term structure of credit spreads should always start at zero and slope upward for firms that are not currently in financial distress, but the empirical literature shows that the actual credit spread curves are sometimes at or even downward-sloping.

If a diffusion approach cannot capture the basic features of credit risk, what approach can? This paper develops a new structural approach to valuing default-risky securities by modeling the evolution of firm value as a jump-diffusion process. Under a jump-diffusion process, a firm can default instantaneously because of a sudden drop in its value. With this characteristic, a jump-diffusion model can match the size of credit spreads on corporate bonds and can generate various shapes of yield spread curves and marginal default rate curves, including upward-sloping, downward-sloping, at, and hump-shaped, even if the firm is currently in good financial standing. The model also links recovery rates to firm value at default in a natural way so that variation in recovery rates is endogenously generated in the model. The model is also consistent with many other stylized empirical facts in the credit-risk literature.

Full paper (397 KB Postscript)

Keywords: Credit risk, jump diffusion

FEDS 1997-14
The Pre-Commitment Approach: Using Incentives to Set Market Risk Capital Requirements

Paul H. Kupiec and James M. O'Brien


This paper develops a model of bank behavior that focuses on the interaction between the incentives created by fixed-rate deposit insurance and a bank's choice of its loan portfolio and its market-traded financial instruments. The model is used to analyze the consequences of the Federal Reserve Board's proposed pre-commitment approach (PCA) for setting market risk capital requirements for bank trading portfolios. Under the PCA, a bank determines its own market risk capital requirement and is subject to a known regulatory penalty should its trading activities generate subsequent losses that exceed its market risk capital commitment.

Full paper (535 KB Postscript)

Keywords: Bank capital, market risk, incentive regulation

FEDS 1997-13
Credit Derivatives in Banking: Useful Tools for Managing Risk?

Gregory R. Duffee and Chunsheng Zhou


We model the effects on banks of the introduction of a market for credit derivatives--in particular, credit default swaps. A bank can use such swaps to temporarily transfer credit risks of their loans to others, reducing the likelihood that defaulting loans would trigger the bank's financial distress. Because credit derivatives are more flexible at transferring risks than are other, more established tools, such as loan sales without recourse, these instruments make it easier for banks to circumvent the "lemons" problem caused by banks' superior information about the credit quality of their loans. However, we find that the introduction of a credit derivatives market is not necessarily desirable because it can cause other markets for loan risk-sharing to break down. In this case, the existence of a credit derivatives market will lead to a greater risk of bank insolvency.

Full paper (202 KB Postscript)

Keywords: Credit default swaps, bank loans, loan sales, asymmetric information

FEDS 1997-12
Measuring the Social Return to R&D

Charles I. Jones and John C. Williams


A large, empirical literature reports estimates of the rate of return to R&D ranging from 30 percent to over 100 percent, supporting the notion that there is too little private investment in research. This conclusion is challenged by the new growth theory. We derive analytically the relationship between the social rate of return to R&D and the coefficient estimates of the empirical literature. We show that these estimates represent a lower bound on the true social rate of return. Using a conservative estimate of the rate of return to R&D of about 30 percent, optimal R&D investment is at least four times larger than actual investment.

Full paper (118 KB Postscript)

Keywords: Social rate of return, research and development, endogenous growth

FEDS 1997-11
Efficiency of Financial Institutions: International Survey and Directions for Future Research

Allen N. Berger and David B. Humphrey


This paper surveys 130 studies that apply frontier efficiency analysis to financial institutions in 21 countries. The primary goals are to summarize and critically review empirical estimates of financial institution efficiency and to attempt to arrive at a consensus view. We find that the various efficiency methods do not necessarily yield consistent results, and we suggest some ways that these methods might be improved to bring about findings that are more consistent, accurate, and useful. Secondary goals are to address the implications of efficiency results for financial institutions in the areas of government policy, research, and managerial performance. Areas needing additional research are also outlined.

Keywords: Bank, merger, efficiency, profit, cost

FEDS 1997-10
Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions?

Allen N. Berger and Loretta J. Mester


Over the past several years, substantial research effort has gone into measuring the efficiency of financial institutions. Many studies have found that inefficiencies are quite large, on the order of 20 percent or more of total banking industry costs and about half of the industry's potential profits. There is no consensus on the sources of the differences in measured efficiency. This paper examines several possible sources, including differences in efficiency concept, measurement method, and a number of bank, market, and regulatory characteristics. We review the extant literature and provide new evidence using data on U.S. banks over the period 1990-95.

Keywords: Bank, efficiency, cost, profit

FEDS 1997-09
The Effects of Megamergers on Efficiency and Prices: Evidence from a Bank Profit Function

Jalal D. Akhavein, Allen N. Berger, and David B. Humphrey


This paper examines the efficiency and price effects of mergers by applying a frontier profit function to data on bank "megamergers." We find that merged banks experience a statistically significant 16 percentage point average increase in profit-efficiency rank relative to other large banks. Most of the improvement is from increasing revenues, including a shift in outputs from securities to loans, a higher-valued product. Improvements were greatest for the banks with the lowest efficiencies prior to merging, who therefore had the greatest capacity for improvement. By comparison, the effects on profits from merger-related changes in prices were found to be very small.

Keywords: Bank, merger, efficiency, profit, price, antitrust

FEDS 1997-08
Problem Loans and Cost Efficiency in Commercial Banks

Allen N. Berger and Robert DeYoung


This paper addresses a little-examined intersection between the problem-loan literature and the bank-efficiency literature. We employ Granger causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital. The data suggest that problem loans precede reductions in measured cost efficiency; that measured cost efficiency precedes reductions in problem loans; and that reductions in capital at thinly capitalized banks precede increases in problem loans. Hence, cost efficiency may be an important indicator of future problem loans and problem banks. Our results are ambiguous concerning whether or not researchers should control for problem loans in efficiency estimation.

Full paper (426 KB Postscript)

Keywords: Commercial banks, cost efficiency, loan quality, Granger causality

FEDS 1997-07
The Community Reinvestment Act and the Profitability of Mortgage-Oriented Banks

Glenn Canner and Wayne Passmore


The Community Reinvestment Act (CRA) requires lenders ``to help meet the credit needs of the local communities in which they are chartered, consistent with the safe and sound operation of such institutions.'' For proponents of efficient markets, the CRA is a threat to lender profitability. For others, the CRA has the potential to increase profitability. We examine the relative profitability of commercial banks that specialize in mortgage lending in lower-income neighborhoods or to lower-income borrowers using three different techniques, and find that lenders active in lower-income neighborhoods and with lower-income borrowers appear to be as profitable as other mortgage-oriented commercial banks.

Full paper (176 KB Postscript)

Keywords: CRA, mortgages, banking, profit

FEDS 1997-06
Earnings Forecasts and the Predictability of Stock Returns: Evidence from Trading the S&P

Joel Lander, Athanasios Orphanides, and Martha Douvogiannis


We develop a simple error-correction model, based on a well-known theory, espoused by Benjamin Graham and David Dodd and others, which presumes stock returns tend to restore an equilibrium relationship between the forecasted earnings yield on common stocks and the yield on bonds. The estimation uses I/B/E/S analysts forecasts of S&P earnings. To evaluate the model, we use rolling regressions to obtain out-of-sample forecasts of excess returns. Tests of association show the implicit timing signals to be statistically significant. Further, a strategy of investing in cash, when the excess return forecast is negative, and investing in the S&P, when the excess return forecast is positive, outperforms the S&P with higher returns and smaller volatility. Using the bootstrap methodology, we demonstrate that the findings are statistically significant.

Full paper (436 KB Postscript)

Keywords: Asset allocation, earnings yield, analyst earnings forecasts, I/B/E/S, S&P 500, market timing, regression models

FEDS 1997-05
Computationally Convenient Distributional Assumptions for Common Value Auctions


Although the mathematical foundations of common value auctions have been well understood since Milgrom & Weber (1982), equilibrium bidding strategies are computationally complex. Very few calculated examples can be found in the literature, and only for highly specialized cases. This paper introduces two sets of distributional assumptions that are flexible enough for theoretical and empirical applications and yet permit straightforward calculation of equilibrium bidding strategies.

Full paper (229 KB Postscript)

Keywords: Common value auctions

FEDS 1997-04
Information Sharing and Competition in the Motor Vehicle Industry

Maura P. Doyle and Christopher M. Snyder


Up to six months ahead of actual production, U.S. automakers announce plans for their monthly domestic production of cars. A leading industry trade journal publishes the initial plan and then a series of revisions leading up to the month in question. We analyze a panel data set spanning the years 1965--1995, matching the production forecasts with data for actual monthly production. We show that a firm's plan announcement affects competitors' later revisions of their own plans and eventual production. The interaction appears to be complementary---large plans or upward revisions cause competitors to revise plans upward and increase production. The results are consistent with models in which firms share information about common demand parameters.

Keywords: Information sharing, motor vehicle production

FEDS 1997-03
Estimating Dynamic Panel Data Models: A Practical Guide for Macroeconomists

Ruth A. Judson and Ann L. Owen


Previous research on dynamic panel estimation has focused on panels that, unlike a typical panel of macroeconomic data, have small time dimensions and large individual dimensions. We use a Monte Carlo approach to investigate the performance of several different methods designed to reduce the bias of the estimated coefficients for the longer, narrower panels commonly found for macro data. We find that the bias of the least squares dummy variable approach can be significant, even when the time dimension of the panel is as large as 30. For panels with small time dimensions, we find a corrected least squares dummy variable estimator to be the best choice. However, as the time dimension of the panel increases, the computationally simpler Anderson-Hsiao estimator performs equally well. We apply our recommendations to a panel of countries to show that increases in income growth precede increases in savings rates and increases in savings rates precede declines in income growth.

Full paper (588 KB Postscript)

Keywords: Panel data, simulation, dynamic model, macroeconomics, growth

FEDS 1997-02
The Role of Race in Mortgage Lending: Revisiting the Boston Fed Study

Raphael W. Bostic


This paper reexamines claims that non-economic discrimination persists in mortgage loan origination decisions. I find that racial differences in outcomes do exist, as minorities fare worse regarding debt-to-income requirements but better for loan-to-value requirements. Overall, significant racial differentials exist only for "marginal" applicants and are not present for those with higher incomes or those with no credit problems. Thus, the claim that non-economic discrimination is a general phenomenon is refuted. Further, I can say little regarding the existence of discrimination among "marginal" applicants. To conclude that such discrimination exists, one must prove that the observed differences are not due to economic factors.

Full paper (591 KB Postscript)

Keywords: Discrimination, mortgages, race, credit risk

FEDS 1997-01
Movements of Wages over the Business Cycle: An Intra-Firm View


This paper tests the hypothesis that firms adjust to the business cycle by altering employment through promotion and hiring and holding the salary structure and salaries assigned to jobs relatively constant. Two comprehensive firm-level panel datasets are used to examine salary setting and worker movement within firms. The salary structure is found to be rigid whereas promotion rates are cyclically sensitive. In contrast to the hypothesis, wage cyclicality in these two firms is driven by changes in salaries associated with jobs rather than by worker movement. An additional finding is that salaries in the two firms are countercyclical.

Keywords: Wage cyclicality, firm-level data

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Last Update: December 01, 2023