FEDS 1999-1
Partial Adjustment and Staggered Price Setting


This paper compares staggered price setting to partial adjustment of prices in a small optimizing IS/LM model. In contrast to the overwhelming perception in the literature, the models are not similar for most parameterizations. These results clarify some confusion in recent work regarding the persistence of output responses to monetary shocks, reveal important quantitative differences between the stabilizing properties of different monetary policies across sticky price specifications, and highlight the role for more research on new-Keynesian real rigidities in DGE models.

FEDS 1999-68
Credit Constraints, Consumer Leasing and the Automobile Replacement Decision


This paper presents a model of consumer automobile replacement in the presence of leasing. The model incorporates credit constraints to distinguish between the leasing and purchasing options. It demonstrates how leasing increases the probability that a household replaces its automobile and how households that lease choose higher quality automobiles. The qualitative choice model of the household's decision to lease provides support for the observation that households that lease face credit constraints. It also shows that although households that lease new automobiles are quite similar to those that purchase, they exhibit differences consistent with the theory. In particular, they prefer newer, more expensive automobiles.

Full paper (821 KB Postscript)

Keywords: Consumer, automobile, leasing

FEDS 1999-67
Efficient Monetary Policy Design Near Price Stability

Athanasios Orphanides and Volker Wieland


We study the design of monetary policy in a low inflation environment taking into account the limitations imposed by the zero bound on nominal interest rates. Using numerical dynamic programming methods, we compute optimal policies in a simple, calibrated open-economy model and evaluate the effect of the liquidity trap generated by the zero bound. We consider the possibility that the quantity of base money may affect output and inflation even when the interest rate is constrained at zero and explicitly account for the substantial degree of uncertainty regarding such quantity effects. As an example of such a quantity effect, we focus on the portfolio balance channel through which changes in relative money supplies influence the exchange rate. We find that the optimal policy near price stability is asymmetric, that is, as inflation declines, policy turns expansionary sooner and more aggressively than would be optimal in the absence of the zero bound. As a consequence, the average level of inflation is biased upwards. These results indicate that policymakers are faced with a tradeoff between the level of inflation and economic stabilization performance when the economy is operating near the zero bound. Finally, we discuss operational issues associated with the interpretation and implementation of policy at the zero bound in relation to the recent situation in Japan.

Full paper (1326 KB Postscript)

Keywords: Price stability, zero bound, optimal monetary policy, liquidity trap

FEDS 1999-66
Temporary Employment and the Natural Rate of Unemployment


This paper examines the determinants of the natural rate of unemployment using a combined cross section and time series data set. The results suggest that industry composition affects the natural rate. In particular, a higher share of temporary employment in a local labor market tends to lower the natural rate of unemployment--most likely through the matching function. The results suggest that the increase in the share of temporary employment may have reduced the natural rate as much as 1/4 percentage point. The results also indicate that unemployment insurance benefits tend to boost the natural rate, while having a more highly educated work force tends to lower it. However, the degree of union presence in a local labor market had little impact on the natural rate.

Keywords: Natural rate, temporary employment, matching function

FEDS 1999-65
Are Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications versus Changes in Regime

Mark A. Hooker


This paper estimates the effects of oil price changes on U.S. inflation in a Phillips curve framework, allowing for some of the asymmetries, nonlinearities, and structural breaks that have been found in the literature on the real effects of oil price shocks. It finds that since around 1980, oil price changes seem to affect inflation only through their direct share in a price index, with little or no pass-through into core measures, while before 1980, oil shocks contributed substantially to core inflation. This structural-break characterization appears robust to a variety of respecifications and to fit the data better than asymmetric and nonlinear oil price alternatives. Preliminary evidence suggests that a change in the reaction of monetary policy to oil shocks is part of the explanation.

Full paper (819 KB Postscript)

Keywords: Oil shocks, Phillips curve, regime shifts, nonlinearity

FEDS 1999-64
The Automatic Stabilizers: Quietly Doing their Thing

Darrel S. Cohen and Glenn R. Follette


This paper presents theoretical and empirical analysis of automatic fiscal stabilizers, such as the income tax and unemployment insurance benefits. Using the modern theory of consumption behavior, we identify several channels--insurance effects, wealth effects and liquidity constraints- -through which the optimal reaction of household consumption plans to aggregate income shocks is tempered by the automatic fiscal stabilizers. In addition we identify a cash flow channel for investment. The empirical importance of automatic stabilizers is addressed in several ways. We estimate elasticities of the various federal taxes with respect to their tax bases and responses of certain components of federal spending to changes in the unemployment rate. Such estimates are useful for analysts who forecast federal revenues and spending; the estimates also allow high- employment or cyclically-adjusted federal tax receipts and expenditures to be estimated. Using frequency domain techniques, we confirm that the relationships found in the time domain are strong at the business cycle frequencies. Using the FRB/US macro-econometric model of the United States economy, the automatic fiscal stabilizers are found to play a modest role at damping the short-run effect of aggregate demand shocks on real GDP, reducing the "multiplier" by about 10 percent. Very little stabilization is provided in the case of an aggregate supply shock.

Keywords: Automatic stabilizers, high-employment budget, spectral analysis

FEDS 1999-63
Is Corporate Governance Ineffective in Emerging Markets?


I test whether corporate governance is ineffective in emerging markets by estimating the link between CEO turnover and firm performance for over 1,200 firms in eight emerging markets. I find two main results. First, CEOs of emerging market firms are more likely to lose their jobs when their firm's performance is poor, suggesting that corporate governance is not ineffective in emerging markets. Second, for the subset of firms with a large domestic shareholder, there is no link between CEO turnover and firm performance. For this subset of emerging market firms, corporate governance appears to be ineffective.

Keywords: Management turnover, performance, ownership, concentration

FEDS 1999-62
Nonparametric Estimation of Multifactor Continuous-Time Interest Rate Models

Chris Downing


This paper studies the finite sample properties of the kernel regression method of Boudoukh et al. (1998) for estimating multifactor continuous-time term structure models. Monte Carlo simulations are employed, with a grid-search technique to find the optimal kernel bandwidth. The estimator exhibits truncation and correlated residuals biases near the boundaries of the data. However, the variance of the estimator is so high that the biases are unlikely to be relevant from a hypothesis testing point of view. The performance of the estimator is also studied under model misspecification. Irrelevant regressors reduce efficiency and induce additional biases in the estimates. Using Treasury bill data, I test whether the estimates produced by the nonparametric estimator are statistically distinguishable from estimates obtained under a parametric model. The kernel regressions pick up nonlinearities in the data that the parametric model cannot capture.

Keywords: Interest rate, multifactor, nonparametric

FEDS 1999-61
Do Pension Plans with Participant Investment Choice Teach Households to Hold More Equity?

Scott Weisbenner


Some retirement plans allow the participant to choose how funds are invested. Having to direct investments may provide the participant with financial education. This paper finds that households covered by pension plans in which the employee chooses investments are significantly more apt to hold stock outside of their retirement plan than are households with pension plans offering no such choice. The effect of investment choice upon non-pension asset allocation cannot be explained by portfolio rebalancing or differences in income and saving preferences across households. This provides some evidence that the design of a pension plan can influence an employee's financial decisions.

Keywords: Participant-directed plan, portfolio choice

FEDS 1999-60
Consumer Sentiment and the Stock Market


This paper examines the relationship between movements in consumer sentiment and stock prices. At the aggregate level, the two share a strong contemporaneous relationship: an increase in equity values boosts sentiment. However, I examined the nature of the relationship between the two. Does an increase in stock prices raise aggregate sentiment because people are wealthier or because they use movements in stock prices as an indicator of future economic activity and potential labor income growth? Using individual observations from the Michigan survey I found results more consistent with the view that people use movements in equity prices as a leading indicator. Although the findings do not rule out a traditional wealth effect, they do raise some questions about the causal role of wealth in aggregate spending.

Keywords: Consumer sentiment, stock market, Michigan survey

FEDS 1999-59
Share Repurchases and Employee Stock Options and their Implications for S&P 500 Share Retirements and Expected Returns


We provide evidence on the validity of the conglomeration hypothesis versus the strategic focus hypothesis for financial institutions using data on U.S. insurance companies. We distinguish between the hypotheses using profit scope economies, which measure the relative efficiency of joint versus specialized production, taking both costs and revenues into account. The results suggest that the conglomeration hypothesis dominates for some types of financial service providers and the strategic focus hypothesis dominates for other types. This may explain the empirical puzzle of why joint producers and specialists both appear to be competitively viable in the long run.

Keywords: Share repurchases, stock options, expected returns

FEDS 1999-58
The Evolution of the Demand for Temporary Help Supply Employment in the United States

Marcello Estevao and Saul Lach


The level of temporary help supply (THS) employment surged during the late 1980s and the 1990s. However, we know little about where these workers were placed and, thus, there is a gap in our understanding of cyclical and trend industry employment in the U.S. To close this gap, we estimate the proportion of THS employees in each major U.S. industry during 1977-97 using information from input-output tables and from the Contingent Worker Supplements to the CPS surveys of February 1995 and February 1997. Our estimates indicate that almost all of the growth in THS employment is attributed to a change in the hiring behavior of firms, rather than to a disproportional increase in the size of more THS-intensive industries. In fact, the proportion of THS employees in each major American industry, except the public sector, increased during our sample period. These increases were particularly large in services and in manufacturing where by 1997 close to 4 percent of all employees were THS workers. The public sector, which had demanded almost 40 percent of all THS workers in 1982, hired a negligibly small number of THS workers in 1997.

Full paper (971 KB Postscript)

Keywords: Contingent workers, adjustment margin, new economy, structural changes, sectoral effects

FEDS 1999-57
Measuring Temporary Labor Outsourcing in U.S. Manufacturing

Marcello Estevao and Saul Lach


Several analysts claim that firms have been using more flexible work arrangements in order to contain the costly adjustment of labor to changes in economic conditions. In particular, temporary help supply (THS) employment has increased dramatically in the last ten years. However, there is only scant evidence on the industries that are hiring this type of worker. In particular, some anecdotal evidence points to the fact that manufacturing industries have substantially stepped up their demand for THS workers since the mid-1980s. If this is true, not accounting for this flow of workers from the service sector to manufacturing may lead to misleading conclusions about the cyclical and long-term path of manufacturing employment and hours of work. We close this gap by providing several estimates of the number of individuals employed by temporary help supply (THS) firms who worked in the manufacturing sector from 1972 to 1997. One estimate, in particular, is based on a new methodology that uses minimal assumptions to put bounds on the probability that a manufacturing worker is employed by a THS firm. The bounds rely on readily available data on workers' individual characteristics observable in the CPS. We show that manufacturers have been using THS workers more intensively in the 1990s. In addition, the apparent flatness of manufacturing employment in the 1990s can be explained in part by this type of outsourcing from the service sector. Finally, not accounting for THS hours overstated the increase in average annual manufacturing labor productivity by 1/2 percentage point during the 1991-1997 period.

Full paper (3121 KB Postscript)

Keywords: Outsourcing, contingent workers, adjustment margin, productivity, new economy, structural changes

FEDS 1999-56
Is Hysteresis Important for U.S. Unemployment?


We look for evidence of "hysteresis" in the U.S. unemployment rate - that is, that current labor market outcomes affect the future equilibrium level of the unemployment rate. We first examine (using a variety of econometric tests for unit roots) whether the unemployment rate tends to come back to a long-run average over time. On balance, our results suggest that the unemployment rate tends to return to a long-run value, ruling out the possibility of permanent hysteresis. We look for evidence of temporary hysteresis by examining whether lagged unemployment enters a standard Phillips-curve model of U.S. inflation. We find week evidence in support of temporary hysteresis, but the effect is not large, suggesting that hysteresis is not very important for U.S. unemployment.

Keywords: Hysteresis, unemployment, Phillips curve, unit roots

FEDS 1999-55
Tests for Non-Linear Dynamics in Systems of Non-Stationary Economic Time Series: The Case of Short-Term U.S. Interest Rates

Barry E. Jones and Travis D. Nesmith


Using Hall and Heyde's (1980) representation theorem, we show that the stationary co-integration relations of an integrated system are generally non-linear stochastic processes. We propose a sequential non-parametric procedure to test stationary co-integration relations for non-linear dynamics, and apply this procedure to short term U.S. interest rates as an illustration. We demonstrate that the weekly federal funds rate is co-integrated with Treasury bill and commercial paper rates and that the co-integration relations are non-linear.

Keywords: Non-linear dynamics, co-integration interest rates, bispectrum

FEDS 1999-54
Measurement Error in General Equilibrium: The Aggregate Effects of Noisy Economic Indicators

Antulio N. Bomfim


I analyze the business cycle implications of noisy economic indicators in the context of a dynamic general equilibrium model. Two main results emerge. First, measurement error in preliminary data releases can have a quantitatively important effect on economic fluctuations. For instance, under efficient signal-extraction, the introduction of accurate economic indicators would make aggregate output 10 to 30 percent more volatile than suggested by the post-war experience of the U.S. economy. Second, the sign---but not the magnitude---of the measurement error effect depends crucially on the signal processing capabilities of agents. In particular, if agents take the noisy data at face value, significant improvements in the quality of key economic indicators would lead to considerably less cyclical volatility.

Full paper (235 KB Postscript)

Keywords: Cyclical volatility, signal extraction bounded rationality, production externalities

FEDS 1999-53
The Causes of Business Cycles and the Cyclicality of Real Wages


A model's ability to explain procyclical movements in real wages has become an important benchmark by which macroeconomists judge business cycle theories. Because Keynesian models with sticky nominal wages predict countercyclical real wages, they have been criticized and dismissed in favor of Real Business Cycle models or New Keynesian models based on price stickiness or countercyclical markups. The bulk of the evidence for procyclical real wages, however, comes from studies using panel data that estimate the unconditional, contemporaneous correlation between real wages and the unemployment rate. These studies constrain real wage cyclicality to be the same irrespective of the source of the business cycle fluctuations. This paper relaxes this constraint and estimates a structural VAR identified by long-run restrictions on the responses of hours and output to labor supply, technology, oil price, and aggregate demand shocks. It finds that real wages are procyclical in response to technology shocks and oil price shocks, but are countercyclical in response to labor supply shocks and aggregate demand shocks. The procyclicality of real wages during the periods covered by the panel data sets may be explained by the importance of the productivity slowdown and the 1970s oil price shocks. The results highlight the limitations of using the unconditional, contemporaneous correlation between real wages and business cycle indicators to sort out competing theories of the business cycle, and cast strong doubt on the appropriateness of the rejection of sticky wage models.

Full paper (1516 KB Postscript)

Keywords: Real wages, cyclicality, busines cycles, structural VAR

FEDS 1999-52
Measuring the Cyclicality of Real Wages: How Important is Aggregation Across Industries?

Eric T. Swanson


There is a growing consensus among economists that real wages in the postwar U.S. have been moderately to strongly procyclical, particularly in panel data on workers. From the point of view of hiring decisions of firms, however, this conclusion may be premature or even erroneous. Whether a firm's labor demand curve is stable or shifting at business cycle frequencies should be tested with a wage that is deflated by the firm's own price of output, with appropriate controls for the prices of intermediate inputs, and with respect to the cyclical state of the firm's own industry, as opposed to the state of the aggregate economy. I find that failing to control for these factors has led to a substantial procyclical bias in previous estimates of wage cyclicality. In two-digit and four-digit level (SIC) industry data on wages, with controls for changes in worker composition, I find that a substantial majority of sectors have paid real product wages that vary inversely (i.e., countercyclically) with the state of their industry.

Keywords: Real wages, cyclicality, sectoral data, aggregation, composition bias

FEDS 1999-51
Optimal Control of Large, Forward-Looking Models: Efficient Solutions and Two Examples

Frederico S. Finan and Robert Tetlow


An optimal control tool is described that is particularly useful for computing rules of large-scale models where users might otherwise have difficulty determining the state vector a priori and where the inversion of large, sparse matrices is involved. A small-scale demonstration is presented, as are data on performance with the Board of Governors large-scale rational expectations macroeconometric model, FRB/US.

Full paper (152 KB Postscript)

Keywords: Optimal control, mathematical programs, simple rules

FEDS 1999-50
Do Noisy Data Exacerbate Cyclical Volatility?

Antulio N. Bomfim


How does the additional uncertainty associated with noisy economic data affect business cycle fluctuations? I use a simple variant of the neoclassical growth model to show that the answer depends crucially on the assumed expectation-formation capabilities of agents. Under efficient signal extracting, noisy economic indicators dampen cyclical volatility. The opposite occurs when agents follow a simple bounded rational strategy.

Keywords: Volatility, measurement error, signal extraction, expectations, bounded rationality

FEDS 1999-49
What's Happened to the Phillips Curve?

Flint Brayton, John M. Roberts, and John C. Williams


The simultaneous occurrence in the second half of the 1990s of low and falling price inflation and low unemployment appears to be at odds with the properties of a standard Phillips curve. We find this result in a model in which inflation depends on the unemployment rate, past inflation, and conventional measures of price supply shocks. We show that, in such a model, long lags of past inflation are preferred to short lags, and that with long lags, the NAIRU is estimated precisely but is unstable in the 1990s. Two alternative modifications to the standard Phillips curve restore stability. One replaces the unemployment rate with capacity utilization. Although this change leads to more accurate inflation predictions in the recent period, the predictive ability of the utilization rate is not superior to that of the unemployment rate for the 1955 to 1998 sample as a whole. The second, and preferred, modification augments the standard Phillips curve to include an "error-correction" mechanism involving the markup of prices over trend unit labor costs. With the markup relatively high through much of the 1990s, this channel is estimated to have held down inflation over this period, and thus provides an explanation of the recent low inflation.

Full paper (799 KB Postscript)

Keywords: Inflation, NAIRU, Phillips curve

FEDS 1999-48
Monetary Policy, Parameter Uncertainty and Optimal Learning

Volker Wieland


Since central banks have limited information concerning the transmission channel of monetary policy, they are faced with the difficult task of simultaneously controlling the policy target and estimating the impact of policy actions. A tradeoff between estimation and control arises because policy actions influence estimation and provide information which may improve future performance. I analyze this tradeoff in a simple model with parameter uncertainty and conduct dynamics simulations of the policymaker's decision problem in the presence of the type of uncertainties that arose in the wake of German reunification. A policy that separates learning from control may induce a persistent upward bias in money growth and inflation, just as observed after unification. In contrast, the optimal learning strategy which exploits the tradeoff between control and estimation significantly improves stabilization performance and reduces the likelihood of inflationary bias.

Keywords: Optimal control with unknown parameters, Bayesian learning, monetary policy, inflation targeting

FEDS 1999-47
Option Prices with Uncertain Fundamentals Theory and Evidence on the Dynamics of Implied Volatilities

Alexander David and Pietro Veronesi


In an incomplete information model, investors' uncertainty about the underlying drift rate of a firm's fundamentals affects option prices through (i) endogenous and belief-dependent stochastic volatility, (ii) stochastic covariance between returns and volatility, and (iii) a market price of "belief risk." For the special case where the drift takes only two values, we provide an option pricing formula using Fourier Transforms. The model calibrated to 1960-1998 S&P 500 real earnings growth shows that investors' uncertainty explains intertemporal variation in the slope and curvature of implied volatility curves as well as the conditional moments of the state-return density obtained from option data. The calibrated model generates hedging `violations' of one-factor markov and deterministic volatility function models with roughly empirical frequencies.

Full paper (849 KB Postscript)

Keywords: Uncertainty, changing return-volatility correlation, belief risk, put-call ratio, butterfly spread, hedging violations

FEDS 1999-46
Minimum Wage Careers?

William J. Carrington and Bruce C. Fallick


This paper investigates the extent to which people spend careers on minimum wage jobs. We find that a small but non-trivial number of NLSY respondents spend 25%, 50%, or even 75% of the first ten years of their career on minimum or near-minimum wage jobs. Workers with these minimum wage careers tend to be drawn from groups such as women, blacks, and the less-educated that are generally overrepresented in the low-wage population. The results indicate that lifetime incomes of some workers may be supported by a minimum wage. At the same time, these same groups would be disproportionately affected by any minimum wage-induced disemployment. The results suggest that minimum wage legislation has non-negligible effects on the lifetime opportunities of a significant minority of workers.

Keywords: Minimum wage, NLSY

FEDS 1999-45
Errors in the Measurement of the Output Gap and the Design of Monetary Policy

Athanasios Orphanides, Richard D. Porter, David Reifschneider, Robert Tetlow, and Frederico Finan


We exploit data on historical revisions to real-time estimates of the output gap to examine the implications of measurement error for the design of monetary policy, using the Federal Reserve's model of the U.S. economy, FRB/US. Measurement error brings about a substantial deterioration in economic performance, although the problem can be mitigated somewhat by reducing the coefficient on the output gap in policy rules. We also show that it is usually optimal to place some weight on the level of the output gap in the conduct of policy, but under extreme conditions it may be preferable to focus on output growth.

Full paper (1706 KB Postscript)

Keywords: Interest rate rules, policy evaluation, output gap measurement

FEDS 1999-44
Three Lessons for Monetary Policy in a Low Inflation Era

David L. Reifschneider and John C. Williams


The zero lower bound on nominal interest rates constrains the central bank's ability to stimulate the economy during downturns. We use the FRB/US model to quantify the effects of the bound on macroeconomic stabilization and to explore how policy can be designed to minimize these effects. During particularly severe contractions, open-market operations alone may be insufficient to restore equilibrium; some other stimulus is needed. Abstracting from such rare events, if policy follows the Taylor rule and targets a zero inflation rate, there is a significant increase in the variability of output but not inflation. However, a simple modification to the Taylor rule yields a dramatic reduction in the detrimental effects of the zero bound.

Full paper (4750 KB Postscript)

Keywords: Monetary policy, macroeconomic models, liquidity trap

FEDS 1999-43
Oil and the Macroeconomy Revisited

Mark Hooker


The relationship between oil price shocks and U.S. macroeconomic fluctuations advocated by Hamilton (1983) broke down in the 1980s amidst a new regime of highly volatile oil price movements. Several authors have argued that asymmetric and nonlinear transformations of oil prices restore that relationship and thus that the economy responds asymmetrically and nonlinearly to oil price shocks. In this paper, I show that this is only part of the story: the two leading such transformations do not in fact Granger cause output or unemployment in the post-1980 period without further refinements, and they derive much of their apparent success from data in the 1950s. If output is expressed in year-over-year changes, which are smoother than the usual quarterly changes, and the equations exclude variables like interest rates and inflation, then asymmetric and nonlinear oil prices predict output but not unemployment, while the real level of oil prices predicts unemployment but not output. I interpret this evidence as supportive of significant oil price effects on the macroeconomy which a) are at relatively low frequencies, b) are indirect, through variables like interest rates and inflation, c) can induce departures from Okun's law, and d) changed qualitatively around 1980.

Full paper (783 KB Postscript)

Keywords: Macroeconomic fluctuations, oil price shocks, Granger causality

FEDS 1999-42
Optimal Discretion

Yvan Lengwiler and Athanasios Orphanides


This paper investigates the desirability of adopting a rule in favor of discretionary monetary policy in a model exhibiting Kydland and Prescott's dynamic inconsistency problem. We deviate from earlier work by adopting assumptions regarding policymaker preferences and inflation dynamics that are compatible with empirically motivated models used for macroeconomic policy evaluation. In particular, we dispense with the notion of a fundamental incompatibility between the policymaker's price stability and full employment objectives and allow for stickiness in the determination of inflation. In this setting, we show that if discretion provides a policy flexibility benefit, adoption of a rule remains optimal but only under certain circumstances. If the central bank's preference to contain inflation is fully credible, then a rule is optimal only when inflation exceeds an endogenously determined threshold. This setup gives rise to a discretionary policy zone for inflation with the central bank taking more drastic action towards stabilizing inflation when inflation veers outside the zone. We also examine optimal policy when the central bank's inflation fighting determination is not fully credible. Then, adopting a rule becomes optimal even when inflation is lower. This result provides a reconciliation of the theory regarding the optimality of adopting a rule with the empirical observation that policymakers appear more willing to abandon discretion when facing either low credibility or high inflation but are less inclined to do so otherwise.

Full paper (451 KB Postscript)

Keywords: Rules, discretion, credibility, dynamic inconsistency, disinflation, inflation targeting

FEDS 1999-41
The Dynamics of Market Entry: The Effects of Mergers and Acquisitions on De Novo Entry and Small Business Lending in the Banking Industry

Allen N. Berger, Seth D. Bonime, Lawrence G. Goldberg, and Lawrence J. White


We study the dynamics of market entry following mergers and acquisitions (M&As) and the behavior of recent entrants in supplying output that might be withdrawn by the consolidating firms. The data, drawn from the banking industry, suggest that M&As are associated with subsequent increases in the probability of entry. The estimates suggest that M&As explain more than 20% of entry in metropolitan markets and more than 10% of entry in rural markets. Additional results suggest that bank age has a strong negative effect on the small business lending of small banks but that M&As have little influence on this lending.

Keywords: Entry, barriers to entry, bank, mergers, small business

FEDS 1999-40
Conglomeration Versus Strategic Focus: Evidence from the Insurance Industry

Allen N. Berger, J. David Cummins, Mary A. Weiss, and Hongmin Zi


We use data on U.S. insurance companies to examine the validity of the conglomeration hypothesis versus the strategic focus hypothesis for finanical institutions. We distinguish between the hypotheses using profit scope economies, which measures the relative efficiency of joint versus specialized production, taking both costs and revenues into account. The results suggest that the conglomeration hypothesis dominates for some types of financial service providers and the strategic focus hypothesis dominates for other types. This may explain the empirical puzzle of why joint producers and specialists both appear to be competitively viable in the long run.

Keywords: Insurance, conglomeration, focus, mergers, scope economies

FEDS 1999-39
Interest-Rate Smoothing and Optimal Monetary Policy: A Review of Recent Empirical Evidence

Brian Sack and Volker Wieland


The Federal Reserve and other central banks tend to change short-term interest rates in sequences of small steps in the same direction and reverse the direction of interest rate movements only infrequently. These characteristics, often referred to as interest-rate smoothing, have led to criticism that policy responds too little and too late to macroeconomic developments, suggesting to some observers that the Federal Reserve has an objective of minimizing interest-rate volatility. This paper, however, argues that the observed degree of interest-rate smoothing may well represent optimal behavior on the part of central banks whose only objectives are to stabilize output and inflation. We summarize recent research on three different explanations of interest-rate smoothing: forward-looking behavior by market participants, measurement error associated with key macroeconomic variables, and uncertainty regarding relevant structural parameters.

Full paper (1259 KB Postscript)

Keywords: Interest-rate smoothing, monetary policy rules

FEDS 1999-38
The Reliability of Output Gap Estimates in Real Time

Athanasios Orphanides and Simon van Norden


Compared to its central role in policy discussions in the United States and most other developed countries, the reliability of the measurement of the output gap has attracted relatively little academic study. Furthermore, both the academic literature and the debate among practitioners have tended to neglect a key factor. Although in a policy setting it is necessary to estimate the current (i.e. end-of-sample) output gap without the benefit of knowing the future, most studies concentrate on measurement that employs data that only become available later. In this paper we examine the reliability of alternative output detrending methods, with special attention to the accuracy of real-time estimates. We show that ex post revisions of the output gap are of the same order of magnitude as the output gap itself, that these ex post revisions are highly persistent and that real-time estimates tend to be severely biased around business cycle turning points, when the cost of policy induced errors due to incorrect measurement is at its greatest. We investigate the reasons for these ex post revisions, and find that, although important, the ex post revision of published data is not the primary source of revisions in output gap measurements. The bulk of the problem is due to the pervasive unreliability of end-of-sample estimates of the trend in output.

Full paper (1014 KB Postscript)

Keywords: Real-time data, output gap, business cycle measurement

FEDS 1999-37
Monitoring, Moral Hazard, and Market Power: A Model of Bank Lending


We model the relationship between market power and both loan interest rates and bank risk without placing strong restrictions on the moral hazard problems between borrowers and banks and between banks and a government guarantor. Our results suggest that these relationships hinge on intuitive parameterizations of the overlapping moral hazard problems. Surprisingly, for lending markets with a high degree of borrower moral hazard but limited bank moral hazard, we find that banks with market power charge lower interest rates than competitive banks. We also find that competition makes banking industry risk highly sensitive to macroeconomic fluctuations by making banks more vulnerable to borrower moral hazard. This finding offers an explanation for the dramatic rise and subsequent decline in bank failure rates during the 1980s and 1990s.

Full paper (244 KB Postscript)

Keywords: Banking, deposit insurance, moral hazard, bank risk, interest rates, monitoring

FEDS 1999-36
Computers and Growth with Costs of Adjustment: Will the Future Look Like the Past?


This paper augments the traditional growth accounting framework by including a common specification of investment adjustment costs and uses the new framework to examine the past and likely future growth in nonfarm business output in the United States. The inclusion of adjustment costs can have large effects on the growth-accounting exercise when a new investment good is introduced--such as computers in the last thirty years. The new framework indicates that the contribution of computers to economic growth has been held down by the large adjustment costs required to incorporate a new investment good into the economy's capital stock. Alternative calibrations of the model suggest that these adjustment costs have lowered measured growth in multifactor productivity since 1974 by about 1/2 percentage point--a nontrivial percentage of the productivity slowdown. Combining the adjustments to multifactor productivity and the impact of computers implied by the model with adjustment costs boosts long-run growth in output per hour 3/4 percentage point above the 1974-1991 average.

Keywords: Computers, productivity

FEDS 1999-35
Finance and Growth: Theory and New Evidence

Paul Harrison, Oren Sussman, and Joseph Zeira


This paper describes a feedback effect between real and financial development. The paper presents a new variable, which we call the cost of financial intermediation, through which the feedback between finance and growth operates. The theoretical part of the paper describes how specialization of financial intermediaries leads to such a feedback effect. The main result of this feedback is that differences in productivity across countries are amplified by financial intermediation. The empirical part of the paper uses U.S. cross-state data from banks' income statements to measure the cost of financial intermediation and to provide evidence for the feedback effect between finance and growth.

Keywords: Cost of financial intermediation, economic growth, banks, financial development

FEDS 1999-34
The Banking Industry and the Safety Net Subsidy


Governments use monetary policies to counteract the effects of financial crises. In this paper we examine the subsidy that such "safety net" policies provide to the banking industry. Using a model of uncertainty-driven financial crises, we show that any monetary policy designed to maintain risky investment in the face of investor uncertainty (and thus promote economic growth and stability) will subsidize the banking industry. In addition, we show that the mere presence of a monetary authority willing to support a failing banking system in bad times subsidizes the banking industry, even if those bad times do not occur. A conditional bailout policy that does not extend equally to all financial institutions creates a greater subsidy for those institutions perceived as being "close" to the central bank, possibly giving these institutions a competitive advantage. Economic profits, in this model, are required to cover fixed costs of entry into the banking system.

Full paper (148 KB Postscript)

Keywords: Knightian uncertainty, safety-net subsidy, monetary and fiscal policy

FEDS 1999-33
Pricing Systemic Crises: Monetary and Fiscal Policy When Savers are Uncertain


The return on assets depends on the joint behavior of all savers; if all sell the asset simultaneously, then there will be a financial "Armageddon." We assume that risk-neutral savers' information about aggregate investment is too vague to form precise probability estimates, so they have Knightian uncertainty, and thus act to maximize their minimum payoff. Savers invest in a risky asset (economy-wide production) and in a riskless asset (government bonds). In times of high uncertainty, savers hold too many government bonds, lowering output. A monetary policy of lowering the risk-free rate causes savers to save less in total but to invest more in the risky asset, and the policy is shown to be Pareto-improving; but the policy is unable to recapture the optimal allocations. To restore investment and total savings to their optimal levels, the government must also use a fiscal policy of distortionary taxes to discourage current consumption and leisure.

Full paper (270 KB Postscript)

Keywords: Knightian uncertainty, financial crisis, monetary and fiscal policy

FEDS 1999-32
Recent Trends in Compensation Practices

David E. Lebow, Louise Sheiner, Larry Slifman, and Martha Starr-McCluer


According to some accounts, compensation practices have recently been undergoing marked changes, with an increasing number of firms said to be substituting lump-sum payments for regular pay increases, allowing for greater variability of remuneration across individuals or groups, and making greater use of profit sharing or stock options. Many of these practices are outside the scope of the typical measures of economywide compensation growth. Moreover, intensified use of these schemes ought to heighten the responsiveness of overall compensation costs to business conditions and could also, in theory, boost productivity. We find that the spreading use of these practices could be leading to an understatement of the annual growth rate of actual employment costs (relative to the published employment cost index) that is not insignificant--perhaps on the order of three-tenths of a percentage point currently. Moreover, the changes have apparently helped to increase the flexibility of pay both across time and across workers. In addition, by linking pay more closely to performance, the firms we contacted seemed to think that their employees were working more efficiently and with an eye to enhancing the "bottom line" of the company.

Keywords: Compensation, variable pay, stock options

FEDS 1999-31
Downward Nominal Wage Rigidity: Evidence from the Employment Cost Index


We examine the extent of downward nominal wage rigidity using the microdata underlying the BLS employment cost index--an extensive, establishment-based dataset with detailed information on wage and benefit costs. We find stronger evidence of downward nominal wage rigidity than did previous studies using panel data on individuals. Firms appear able to circumvent part, but not all, of this rigidity by varying benefits: Total compensation displays modestly less rigidity than do wages alone. Given our estimated amount of rigidity, a simple model predicts that the disinflation over the 1980s would have raised equilibrium unemployment notably. This prediction stands in contrast to the actual behavior of unemployment over this period: The addition of a term capturing the cost of rigidity (that rises as inflation falls) has no additional explanatory power in a standard Phillips Curve equation.

Full paper (1062 KB Postscript)

Keywords: Nominal wage rigidity, benefits, inflation

FEDS 1999-30
Intra-Household Allocation and the Mental Health of Children: Structural Estimation Analysis

Morris A. Davis and E. Michael Foster


This paper estimates the structural parameters of a dynamic model where parents with one child periodically decide whether or not their child uses various mental health services. In this model, mental health services improve a child's mental health (which parents care about), however, mental health services may be costly to the parents both in terms of utility and household consumption. Using a panel data set collected as part of the Fort Bragg Mental Health Demonstration, we estimate the model with a maximum likelihood procedure that accounts for unobservable differences in mental health endowments of children and population heterogeneity in parental preferences and in the effectiveness of mental health services. We estimate that parents experience relatively high disutility when a child uses mental health services, implying parents enroll their children in mental health services only if these services have multi-period effects on their child's mental health. Correspondingly, we find that outpatient and inpatient mental health services have permanent effects on a child's mental health. We conclude that the improvement over time of the mental health of the children in our data is, in a large part, the outcome of forward looking parents choosing to increase their child's mental health.

Full paper (1692 KB Postscript)

Keywords: Intra-household allocation, health, mental health, dynamic programming, structural estimation, child endowments

FEDS 1999-29
A Coherent Framework for Stress-Testing

Jeremy Berkowitz


In recent months and years both practitioners and regulators have embraced the ideal of supplementing VaR estimates with "stress-testing". Risk managers are beginning to place an emphasis and expend resources on developing more and better stress-tests. In the present paper, we hold the standard approach to stress-testing up to a critical light. The current practice is to stress-test outside the basic risk model. Such an approach yields two sets of forecasts -- one from the stress-tests and one from the basic model. The stress scenarios, conducted outside the model, are never explicitly assigned probabilities. As such, there is no guidance as to the importance or revelance of the results of stress-tests. Moreover, how to combine the two forecasts into a usable risk metric is not known. Instead, we suggest folding the stress-tests into the risk model, thereby requiring all scenarios to be assigned probabilities.

Full paper (500 KB Postscript)

Keywords: Risk, stress-test

FEDS 1999-28
Why Are Bank Profits So Persistent? The Roles of Product Market Competition, Informational Opacity, and Regional/Macroeconomic Shocks

Allen N. Berger, Seth D. Bonime, Daniel M. Covitz, and Diana Hancock


We investigate how banking market competition, informational opacity, and sensitivity to shocks have changed over the last three decades by examining the persistence of firm-level rents. We develop propagation mechanisms with testable implications to isolate the sources of persistence. Our analysis suggests that different processes underlie persistent performance at the high and low ends of the distribution. Our tests suggest that impediments to competition and informational opacity continue to be strong determinants of performance; that the reduction in geographic regulatory restrictions had little effect on competitiveness; and that performance remains sensitive to regional/macroeconomic shocks. The findings also suggest reasons for the recent record profitability of the industry.

Keywords: Bank, persistence, profits, regulation

FEDS 1999-27
Investment Behavior, Observable Expectations, and Internal Funds

Jason G. Cummins, Kevin A. Hassett, and Stephen D. Oliner


We use earnings forecasts from securities analysts to construct more accurate measures of the fundamentals that affect the expected returns to investment. We find that investment responds significantly -- in both economic and statistical terms -- to our new measures of fundamentals. Our estimates imply that the elasticity of the investment-capital ratio with respect to a change in fundamentals is generally greater than unity. In addition, we find that internal funds are uncorrelated with investment spending, even for selected subsamples of firms -- those paying no dividends and those without bond ratings -- that have been found to be "liquidity constrained" in previous studies. Our results cast doubt on the evidence for liquidity constraints from the many studies that have used Tobin's Q to control for the expected returns to investment.

Full paper (761 KB Postscript)

Keywords: Investment, Tobin's Q, cash flow, liquidity constraints

FEDS 1999-26
An Analysis of Government Spending in the Frequency Domain

Darrel Cohen


This paper utilizes frequency-domain techniques to identify and characterize economically important properties of government spending. Using post-war data for the United States, the paper first identifies peaks in the estimated spectra of the major components of fiscal spending. Second, the paper examines the relationship between these fiscal variables and various measures of aggregate economic activity. The analysis reveals that defense spending is best modeled as exogenous with respect to the aggregate economy and that nondefense spending (growth) appears to be white noise. Further, the unemployment rate has a very high coherency at the business cycle frequencies with unemployment insurance but far smaller coherency with other transfer payments. Finally, the paper finds a moderate degree of direct substitutability between certain types of government spending and private consumption and in the process illustrates how spectral techniques can be readily combined with a standard intertemporal optimizing model.

Keywords: Government spending, spectral analysis

FEDS 1999-25
Competition, Small Business Financing, and Discrimination: Evidence from a New Survey

Ken Cavalluzzo, Linda Cavalluzzo, and John D. Wolken


Using data from the 1993 National Survey of Small Business Finances, we examine some of the factors influencing differences in small business credit market experiences across demographic groups. We analyze credit applications, loan denials, and interest rates paid across gender, race and ethnicity of small business owners. In addition, we analyze data gathered from small business owners who said they did not apply for credit because they believed that their application would have been turned down. This set of analyses, in combination with important new information on the personal credit history of the principal owner, the business credit history of the firm, a rich set of additional explanatory variables, and information on local bank market structure, helps us to understand better the sources of observed differentials in the credit market experiences of small business operators across demographic groups. Credit market experiences often differ markedly among demographic groups. However, so do the characteristics of firms and owners. Results of our multivariate analyses show that many of the factors we consider help to explain the observed differences in credit market experiences However, even after controlling for a large number of firm and owner characteristics, substantial differences often remained. There was also evidence that some of the differentials were associated with the degree of lender market concentration in the firm's local area.

Full paper (4527 KB Postscript)

Keywords: Discrimination, small business finance, market structure

FEDS 1999-24
Consumption Smoothing Among Working-Class American Families Before Social Insurance

Michael G. Palumbo, John A. James, and Mark Thomas


This paper examines whether the saving decisions of a large sample of working-class American families around the turn of the twentieth century are consistent with consumption smoothing tendencies in the spirit of the permanent income hypothesis. We develop two econometric models to decompose reported annual incomes from micro-data into expected and unexpected components, then we estimate marginal propensities to save out of each component of income. The two methodologies deliver similar regression estimates and reveal empirical patterns consistent with those reported in other recent research based on quite different contemporary household data. Marginal propensities to save out of unexpected income shocks are large relative to propensities based on expected income movements, though the former lie much below one and the latter much above zero. While these data reject strict parameterizations of the permanent income hypothesis, we nonetheless conclude that families' saving decisions in the historical period look quite "modern."

Full paper (1503 KB Postscript)

Keywords: Unemployment risk, permanent income hypothesis, precautionary saving

FEDS 1999-23
Corporate Payout Policy and Managerial Stock Incentives

George W. Fenn and Nellie Liang


We examine how corporate payout policy is affected by managerial stock incentives using data on more than 1100 nonfinancial firms during 1993-97. We find that management share ownership encourages higher payouts by firms with potentially the greatest agency problems--those with low market-to-book ratios and low management stock ownership. We also find that management stock options change the composition of payouts. We find a strong negative relationship between dividends and management stock options, as predicted by Lambert, Lannen, and Larcker (1989), and a positive relatinship between repurchases and management stock options. Our results suggest that the growth in stock options may help to explain the rise in repurchases at the expense of dividends.

Full paper (1291 KB Postscript)

Keywords: Dividends, share repurchases, executive stock options, stock incentives

FEDS 1999-22
Wage Rigidity: A Look Inside the Firm


This paper tests for nominal salary rigidity using panel data from two large service-sector firms. Distributions of the firms' salary changes exhibit nominal rigidity: few nominal pay cuts, a pile-up of observations at zero, and positive skewness and asymmetry. In addition, these characteristics become more pronounced in periods of low inflation. These results are much stronger than those found in the previous literature. Further analysis shows that the sizable measurement error in the PSID and the fact that establishment surveys typically follow average wages within jobs may bias the results in the previous literature toward rejecting downward nominal wage rigidity.

Full paper (838 KB Postscript)

Keywords: Nominal wage rigidity

FEDS 1999-21
Tax Incentives, Material Inputs, and the Supply Curve for Capital Equipment

Karl Whelan


The slope of the supply curve for capital equipment has important implications for the macroeconomics of investment and the effects of tax reform on capital accumulation. Goolsbee (1998) has used changes in investment tax incentives to identify whether this supply curve is significantly upward-sloping and has concluded that it is. This paper shows that investment tax incentives are a poor instrument for identifying this supply curve because they are spuriously correlated with supply shocks for equipment producers. Once input costs for equipment producers are controlled for, there is no evidence of a relationship between tax incentives and equipment prices. In fact, the evidence favors the interpretation that the supply curve is flat.

Full paper (483 KB Postscript)

Keywords: Investment tax incentives, equipment investment

FEDS 1999-20
Demographics and Medical Care Spending: Standard and Non-Standard Effects

David Cutler and Louise Sheiner


In this paper, we examine the effects of likely demographic changes on medical spending for the elderly. Standard forecasts highlight the potential for greater life expectancy to increase costs: medical costs generally increase with age, and greater life expectancy means that more of the elderly will be in the older age groups. Two factors work in the other direction, however. First, increases in life expectancy mean that a smaller share of the elderly will be in the last year of life, when medical costs generally are very high. Furthermore, more of the elderly will be dying at older ages, and end-of-life costs typically decline with age at death. Second, disability rates among the surviving population have been declining in recent years by 0.5 to 1.5 percent annually. Reductions in disability, if sustained, will also reduce medical spending. Thus, changes in disability and mortality should, on net, reduce average medical spending on the elderly. However, these effects are not as large as the projected increase in medical spending stemming from increases in overall medical costs. Technological change in medicine at anywhere near its historic rate would still result in a substantial public sector burden for medical costs.

Keywords: Demographics, medicare

FEDS 1999-19
Health Care Costs, Wages, and Aging

Louise Sheiner


While economists generally agree that workers pay for their health insurance costs through reduced wages, there has been little thought devoted to the level at which these costs are passed on: Is each employee's wage reduced by the amount of his or her own health costs, by the average health costs of employees in the firm, or by some amount in between? This paper analyzes one dimension of the question of how firms pass health costs to workers. Using cross-city variation in health costs, I test whether older workers pay for their higher health costs in the form of lower wages. I find that in cities where health insurance costs are high, the age/wage profile is flatter, indicating that older workers do pay for their higher health costs in the form of reduced wages. This finding is robust to the inclusion of several other city-specific variables that might also affect age/wage profiles and that could be correlated with health insurance costs. I also find that workers who choose family health insurance coverage pay for the added employer costs through reduced wages.

Keywords: Health insurance, employee benefits, incidence

FEDS 1999-18
The Geography of Medicare

David Cutler and Louise Sheiner


There is a great deal of geographic variation in Medicare spending. For example, while the average Medicare cost per beneficiary was around $5200 in 1996, Medicare spending, adjusted for differences in regional prices and demographic composition, was about $8000 per person in Miami, but only $3500 in Minneapolis. In this paper, we explore the source of this variation. We find that a substantial amount can be explained by differences across areas in the health of the elderly population. This finding suggests that some of the geographic variation in Medicare spending is efficient. But even accounting for differences in the health of the population, significant variation remains. We have been able to explain some of the remaining variation. The strongest factors are supply variables: for-profit hospitals and specialist physicians both increase Medicare spending. If these factors are exogenous, public policy may want to consider the supply of medical services more than it currently does. We do not find that expensive places spend a disproportionate amount on those near death.

Keywords: Medicare, geographic variation

FEDS 1999-17
The Measurement of Consumer Expectations Using Survey Data

Martha Starr-McCluer


Surveys of consumers collect considerable information on consumer expectations. However, the simple categorical structure of the questions -- such as "Do you expect your income to rise, fall, or stay the same?" -- makes their value for research uncertain. This paper analyzes the information content of the survey measures. I draw on Manski's finding that, while categorical questions do not identify the probability of an event occurring, they do provide information on probability bounds. I analyze data from two well-known surveys, showing that, although the bounds are often wide, for some measures they move closely with the series they are intended to track or predict.

Keywords: Consumption, household behavior, expectations

FEDS 1999-16
Net Migration and State Labor Market Dynamics


I present a simple model of migration in which the net migration rate into a state depends on the expected present value of labor market conditions and amenities. I show that though this is a common model, existing empirical estimates do not separately identify the underlying parameters. The identification problem can be thought of as an omitted variable bias because no explicit measure of expected future labor market conditions is included. I use state-level data to estimate empirical models in which the underlying parameters are identified. I find that high wages and low unemployment encourage in-migration, but that the omitted variable bias can be large. For example, when I control for future conditions in one model, the strength of the relationship between current wages and net migration is less than half as large. I integrate the migration model into a simple labor supply and demand framework and use my estimates of the migration model to simulate a labor market's response to permanent and transitory demand shocks. In the short run, net migration responds more to permanent shocks and current wages and employment rates respond more to transitory ones.

Full paper (279 KB Postscript)

Keywords: Migration, Local Labor Markets

FEDS 1999-15
Unemployment Risk and Precautionary Wealth: Evidence from Households' Balance Sheets

Christopher D. Carroll, Karen E. Dynan, and Spencer D. Krane


Recent empirical work on the strength of precautionary saving has yielded widely varying conclusions. The mixed findings may reflect a number of difficulties in proxying uncertainty, executing instrumental variables estimation, and incorporating theoretical restrictions into empirical models. For each of these problems, this paper uses existing best-practice techniques and some new strategies to relate unemployment probabilities from the Current Population Survey to net worth data from the Survey of Consumer Finances. We find that increases in unemployment risk do not boost saving by households with relatively low permanent income, but that a statistically significant precautionary effect emerges for households at a moderate level of income. This finding is robust to certain restrictions on the sample, but not robust across measures of wealth: We generally find a significant precautionary motive in broad measures of wealth that include home equity, but not in narrower subaggregates comprised only of financial assets and liabilities.

Keywords: Precautionary saving, life-cycle consumption under uncertainty, wealth accumulation

FEDS 1999-14
Short Rate Expectations, Term Premiums, and Central Bank Use of Derivatives to Reduce Policy Uncertainty

P.A. Tinsley


The term structure of interest rates is the primary transmission channel of monetary policy. Under the expectations hypothesis, anticipated settings of the short-term interest rate controlled by the central bank are the main determinants of nominal bond rates. Historical experience suggests that bond rates may remain relatively high even if the short-term interest rate is reduced to zero, in part due to term premiums reflecting uncertainty about future policy. Term spreads due to policy uncertainty may be reduced by central bank trading desk options that provide insurance against future deviations from an announced interest rate policy.

Full paper (472 KB Postscript)

Keywords: Bond options, nominal rate zero bound, term premiums

FEDS 1999-13
What Explains the Dramatic Changes in Cost and Profit Performance of the U.S. Banking Industry?

Allen N. Berger and Loretta J. Mester


We investigate the sources of recent changes in the performance of U.S. banks using concepts and techniques borrowed from the cross-section efficiency literature. Our most striking result is that during 1991-1997, cost productivity worsened while profit productivity improved substantially, particularly for banks engaging in mergers. The data are consistent with the hypothesis that banks tried to maximize profits by raising revenues as well as reducing costs, and that banks provided additional services or higher service quality that raised costs but also raised revenues by more than the cost increases. The results suggest that methods that exclude revenues may be misleading.

Keywords: Bank, productivity, efficiency, cost, profit

FEDS 1999-12
Simple Rules for Monetary Policy

John C. Williams


What is a good monetary policy rule for stabilizing the economy? In this paper, efficient policy rules are computed using the FRB/US large-scale open-economy macroeconometric model. Simple three-parameter policy rules are found to be very effective at minimizing fluctuations in inflation, output, and interest rates: Increases in rule complexity yield only trivial reductions in aggregate variability. Under rational expectations, efficient policies smooth the interest rate response to shocks and use the feedback from anticipated policy actions to stabilize inflation and output and to moderate movements in short-term interest rates. Policy should react to a multi-period inflation rate rather than the current quarter inflation rate; in fact, targeting the price level, as opposed to the inflation rate, involves only small additional stabilization costs. These results are robust to parameter and model uncertainty and the imposition of the non-negativity constraint on nominal interest rates. However, if expectations formation is invariant to policy, as in backward-looking models, the expectations channel is shut off and the performance of policies that are efficient under rational expectations may, as a result, deteriorate markedly; efficient policies, in contrast, exploit systematic expectational errors.

Full paper (711 KB Postscript)

Keywords: Monetary policy rules, macroeconometric models, rational expectations

FEDS 1999-11
Evaluating the Forecasts of Risk Models

Jeremy Berkowitz


The forecast evaluation literature has traditionally focused on methods for assessing point-forecasts. However, in the context of risk models, interest centers on more than just a single point of the forecast distribution. For example, value-at-risk (VaR) models, which are currently in extremely wide, use form interval forecasts. Many other important financial calculations also involve estimates not summarized by a point-forecast. Although some techniques are currently available for assessing interval and density forecasts, none are suitable for sample sizes typically available. This paper suggests a new approach to evaluating such forecasts. It requires evaluation of the entire forecast distribution, rather than a value-at-risk quantity. The information content of forecast distributions combined with ex post loss realizations is enough to construct a powerful test even with sample sizes as small as 100.

Full paper (1112 KB Postscript)

Keywords: Forecast, evaluation, risk, VaR

FEDS 1999-10
Simplicity Versus Optimality: The Choice of Monetary Policy Rules When Agents Must Learn

Robert J. Tetlow and Peter von zur Muehlen


The monetary policy rules that are widely discussed--notably the Taylor rule--are remarkable for their simplicity. One reason for the apparant preference for simple ad hoc rules over optimal rules might be the assumption of full information maintained in the computation of an optimal rule. Arguably this makes optimal control rules less robust to model specification errors. In this paper, we drop the full-information assumption and investigate the choice of policy rules when agents must learn the rule that is in use. To do this, we conduct stochastic simulations on a small, estimated forward-looking model, with agents following a strategy of least- squares learning or discounted least-squares learning. We find that the costs of learning a new rule can, under some circumstances, be substantial. These circumstances vary with the preferences of the monetary authority and with the rule initially in place. Policymakers with strong preferences for inflation control must incur substantial costs when they change the rule; but they are nearly always willing to bear those costs. Policymakers with weak preferences for inflation control, on the other hand, may actually benefit from agents' prior belief that a strong rule is in place.

Keywords: Monetary policy, learning

FEDS 1999-9
Asymmetric Information in the Labor Market: New Evidence on Layoffs, Recalls, and Unemployment

Nuria Rodriguez-Planas


In the United States, many laid-off workers are recalled to their former employer. I develop an asymmetric information model of layoffs in which high-productivity workers are more likely to be recalled and may choose to remain unemployed rather than accept a low-wage job. In this case, unemployment can serve as a signal of productivity, and unemployment duration may be positively related to post-layoff wages even among workers who are not recalled. In contrast, since workers whose plant closed cannot be recalled, longer unemployment duration should not have a positive signaling benefit for such workers. Analysis of the data from January 1988-1992 Displaced Workers Supplements to the Current Population Survey reveals that the wage/unemployment duration relation differs between the two groups in the predicted way, and finds evidence consistent with asymmetric information in the U.S. labor market.

Keywords: Permanently and temporarily laid-off workers, signaling unemployment and wages

FEDS 1999-8
The Aggregate Change in Shares and the Level of Stock Prices


The average change in shares of equity is negatively correlated with estimates of the equity premium calculated using the dividend-ratio model of Campbell and Shiller, as well as with a variant of the model written in terms of the earnings-price ratio. This correlation is consistent with corporations issuing equity when it is a relatively inexpensive source of finance and repurchasing equity when it is a relatively good investment. However, when the retirement of shares resulting from mergers are included, the average change in shares is no longer significantly correlated with the equity premium.

Full paper (45688 KB Postscript)

Keywords: Equity issuance, equity repurchase, dividend-ratio model, earnings-price ratio

FEDS 1999-7
Why Does the Change in Shares Predict Stock Returns


The stock of firms that issue equity has, on average, performed poorly in subsequent years, while the stock of firms that repurchase has typically done well. One explanation for this pattern is that firms are exploiting their superior knowledge about the value of their stock by buying it when it is undervalued and selling it when it is overvalued. This paper presents supporting evidence for this explanation of the excess returns: The change in shares outstanding is positively correlated with proxies for the deviation of current stock price from fundamental value; the excess returns following the change in shares remain significant after controlling for these proxies; and the changes in shares that can be explained by the proxies predict stock returns more powerfully than changes in shares explained by other reasons.

Full paper (309 KB Postscript)

Keywords: Equity issuance, equity repurchase, excess returns

FEDS 1999-6
Evidence of Excess Returns on Firms That Issue or Repurchase Equity


Between 1927 and 1992, portfolios of the stock of the 5 percent of firms with the lowest annual change in shares experienced returns over the subsequent five years that averaged 12 percentage points more per year than the returns to portfolios of the 5 percent of firms with the highest change in shares. The difference in returns is greater in more recent years and was positive for all of the final 33 years of the sample. The difference is apparent for portfolios of firms of all sizes and industries. The market beta of the returns to the portfolios of repurchasers exceeds only slightly that of the returns to the portfolios of issuers, insufficiently to account for more than a small part of the difference in average returns.

Keywords: Equity issuance, equity repurchase, excess returns

FEDS 1999-5
Workers' Knowledge of their Pension Coverage: A Reevaluation

Martha Starr-McCluer and Annika Sunden


Because employer-provided pensions represent an important source of income during retirement, accurate information on pension coverage would seem to be crucial for making sound decisions on retirement timing, saving, and portfolio allocation. However, previous research suggests that workers' knowledge of their pension provisions is often incomplete or incorrect. This paper reexamines workers' knowledge of their pension coverage, using matched employer-employee data from the Federal Reserve Board's Survey of Consumer Finances. We find that, while most workers in our sample accurately reported the general features of their pension coverage, their knowledge of the detailed features was often fairly limited.

Full paper (109 KB Postscript)

Keywords: Pensions, saving, household behavior

FEDS 1999-4
On the Finite-Sample Accuracy of Nonparametric Resampling Algorithms for Economic Time Series

Jeremy Berkowitz, Ionel Birgean, and Lutz Kilian


In recent years, there has been increasing interest in nonparametric bootstrap inference for economic time series. Nonparametric resampling techniques help protect against overly optimistic inference in time series models of unknown structure. They are particularly useful for evaluating the fit of dynamic economic models in terms of their spectra, impulse responses, and related statistics, because they do not require a correctly specified economic model. Notwithstanding the potential advantages of nonparametric bootstrap methods, their reliability in small samples is questionable. In this paper, we provide a benchmark for the relative accuracy of several nonparametric resampling algorithms based on ARMA representations of four macroeconomic time series. For each algorithm, we evaluate the effective coverage accuracy of impulse response and spectral density bootstrap confidence intervals for standard sample sizes. We find that the autoregressive sieve approach based on the encompassing model is most accurate. However, care must be exercised in selecting the lag order of the autoregressive approximation.

Full paper (1313 KB Postscript)

Keywords: Bootstrap, nonparametric, time series

FEDS 1999-3
Models of Sectoral Reallocation

Eric T. Swanson


This paper demonstrates several strengths and shortcomings of models of sectoral reallocation. Although such models demonstrate that sectoral reallocation can be an important amplification and propagation mechanism for exogenous shocks, they are essentially unable to explain any effects of sectoral reallocation on aggregate productivity or related quantities (such as the real wage or observations of aggregate increasing returns to scale), unless a wedge is introduced into the model that drives the marginal products of inputs in different sectors apart in steady state. In particular, costs of adjustment and lags to adjustment are not sufficient. This paper offers a solution to the problem in the form of variable sectoral capital utilization, the marginal product of which can differ across sectors in steady state. Reallocations of production between sectors in this setting are then shown to have first-order effects on aggregate productivity and real wages, and can explain the procyclicality of these variables without reliance on large, exogenous, and persistent shocks to technology.

Full paper (710 KB Postscript)

Keywords: Sectoral reallocation, sectoral shifts, procyclical productivity, capital utilization

FEDS 1999-2
Reexamining Stock Valuation and Inflation: The Implications of Analysts' Earnings Forecasts


This paper examines the effect of expected inflation on stock prices and expected long-run returns. An ex ante estimates measure of expected long-run returns is derived by incorporating estimates of expected of future corporate cash flows into a variant of the Campbell-Shiller dividend-price ratio model. In this model, the log earnings-price ratio is expressed as a linear function of expected future returns, expected earnings growth rates, and the log of the current dividend-payout ratio. Expectations of earnings growth are inferred from equity analysts' earnings forecasts, while inflation expectations are drawn from surveys of professional forecasters. I find that the negative relation between equity valuations and expected inflation results from two effects: higher expected inflation coincides with (i) lower expected real earnings growth and (ii) higher required real returns. The earnings channel is not merely a reflection of inflation's recession-signalling properties; rather, much of the negative valuation effect results from a negative relation between expected inflation and expected longer-term real earnings growth. The effect of expected inflation on required (long-run) real stock returns is also substantial. A one percentage point increase in expected inflation raises required real stock returns about one percentage point, which on average implies a 20 percent decline in the level of stock prices. The inflation-related component of expected real stock returns is closely related to the component explained by real long-term bond yields.

Keywords: Stock returns, inflation, price-earnings ratio

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Last Update: December 01, 2023