FEDS 2004-70
The Magnitude and Cyclical Behavior of Financial Market Frictions

Andrew T. Levin, Fabio M. Natalucci, and Egon Zakrajsek


We quantify the cross-sectional and time-series behavior of the wedge between the cost of external and internal finance by estimating the structural parameters of a canonical debt-contracting model with informational frictions. For this purpose, we construct a new dataset that includes balance sheet information, measures of expected default risk, and credit spreads on publicly traded debt for about 900 U.S. firms over the period 1997Q1 to 2003Q3. Using nonlinear least squares, we obtain precise time-specific estimates of the bankruptcy cost parameter and consistently reject the null hypothesis of frictionless financial markets. For most of the firms in our sample, the estimated premium on external finance was very low during the expansionary period 1997-99, but rose sharply in 2000--especially for firms with higher ratios of debt to equity--and remained elevated until early 2003.

Keywords: External finance premium, bankruptcy costs, financial accelerator

FEDS 2004-69
Alternative Estimates of the Presidential Premium


Since the early 1980s much research, including the most recent contribution of Santa-Clara and Valkanov (2003), has concluded that there is a stable, robust and significant relationship between Democratic presidential administrations and robust stock returns. Moreover, the difference in returns does not appear to be accompanied by any significant differences in risk across the presidential cycle. These conclusions are largely based on OLS estimates of the difference in returns across the presidential cycle. We re-examine this issue using more efficient estimators of the presidential premium. Specifically, we exploit the considerable and persistent heteroskedasticity in stock returns to construct more efficient weighted least squares (WLS) and generalized autoregressive conditional heteroskedasticity (GARCH) estimators of the difference in expected excess stock returns across the presidential cycle. Our findings provide considerable contrast to the findings of previous research. Across the different WLS and GARCH estimates we find that the point estimates are considerably smaller than the OLS estimates and fluctuate considerably across different sub samples. We show that the large difference between the WLS, GARCH and OLS estimates is driven by differing stock market performance during very volatile market environments. During periods of elevated market volatility, excess stock returns have been markedly higher under Democratic than Republican administrations. Accordingly, the WLS and GARCH estimators are less sensitive to these episodes than the OLS estimator. Ultimately, these results are consistent with the conclusion that neither risk nor return varies significantly across the presidential cycle.

Keywords: Presidential puzzle, realized volatility, range based volatility

FEDS 2004-68
The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time

Athanasios Orphanides and Simon van Norden


A stable predictive relationship between inflation and the output gap, often referred to as a Phillips curve, provides the basis for countercyclical monetary policy in many models. In this paper, we evaluate the usefulness of alternative univariate and multivariate estimates of the output gap for predicting inflation. Many of the ex post output gap measures we examine appear to be quite useful for predicting inflation. However, forecasts using real-time estimates of the same measures do not perform nearly as well. The relative usefulness of real-time output gap estimates diminishes further when compared to simple bivariate forecasting models which use past inflation and output growth. Forecast performance also appears to be unstable over time, with models often performing differently over periods of high and low inflation. These results call into question the practical usefulness of the output gap concept for forecasting inflation.

Keywords: Phillips curve, output gap, inflation forecasts, real-time data

FEDS 2004-67
Learning Dynamics with Private and Public Signals

Adam Copeland


This paper studies the evolution of firms' beliefs in a dynamic model of technology adoption. Firms play a simple variant of the classic two-armed bandit problem, where one arm represents a known, deterministic production technology and the other arm an unknown, stochastic technology. Firms learn about the unknown technology by observing both private and public signals. I find that because of the externality associated with the public signal, the evolution of beliefs under a market equilibrium can differ significantly from that under a planner. In particular, firms experiment earlier under the planner than they do under the market equilibrium and thus firms under the planner generate more information at the start of the model. This intertemporal effect brings about the unusual result that, on a per period basis, there exist cases where firms in a market equilibrium over-experiment relative to the planner in the latter periods of the model.

Keywords: Informational public good, free-rider problem, two-armed bandit problem

FEDS 2004-66
Do Actions Speak Louder Than Words? The Response of Asset Prices to Monetary Policy Actions and Statements

Refet Gurkaynak, Brian Sack, and Eric Swanson


We investigate the effects of U.S. monetary policy on asset prices using a high-frequency event-study analysis. We test whether these effects are adequately captured by a single factor--changes in the federal funds rate target-and find that they are not. Instead, we find that two factors are required. These factors have a structural interpretation as a "current federal funds rate target" factor and a "future path of policy" factor, with the latter closely associated with FOMC statements. We measure the effects of these two factors on bond yields and stock prices using a new intraday dataset going back to 1990. According to our estimates, both monetary policy actions and statements have important but differing effects on asset prices, with statements having a much greater impact on longer-term Treasury yields.

Keywords: Measuring monetary policy surprises, FOMC statement, factor models, assest prices

FEDS 2004-65
Measuring Capital and Technology: An Expanded Framework

Carol Corrado, Charles Hulten, and Daniel Sichel


Business outlays on intangible assets are usually expensed in economic and financial accounts. Following Hulten (1979), this paper develops an intertemporal framework for measuring capital in which consumer utility maximization governs the expenditures that are current consumption versus those that are capital investment. This framework suggests that any business outlay that is intended to increase future rather than current consumption should be treated as capital investment. Applying this principle to newly developed estimates of business spending on intangibles, we find that, by about the mid-1990s, business investment in intangible capital was as large as business investment in traditional, tangible capital. Relative to official measures, our framework portrays the U.S. economy as having had higher gross private saving and, under plausible assumptions, fractionally higher average annual rates of change in real output and labor productivity from 1995 to 2002.

Keywords: Investment, capital, productivity, economic measurement, economic growth

FEDS 2004-64
Reading the Minds of Investors: An Empirical Term Structure Model for Policy Analysis

Jim Clouse


Building on the recent macro finance literature, this paper develops an empirical term structure model in which investors' judgmental forecasts of macro variables play an important role. The model allows for a limited form of time-variation in the dynamics describing the behavior of short-term interest rates and macro variables. As a result, changes in economic forecasts over time reflect the influence of both economic shocks and perceived changes in economic structure. The latter, in particular, are shown to be important in explaining the evolution of the yield curve over time. An interest rate accounting framework based on the model is applied in parsing changes in long-term interest rates into portions associated with changes in term premiums and changes in expected future short-rates. The changes in expected future short rates are then further decomposed into portions attributable to changes in the expected future paths for inflation, the unemployment rate, and GDP growth and also to a fourth factor interpreted as changes in the "stance of monetary policy." The model results indicate that changes in long-term interest rates, on average, have been about equal parts changes in term premia and changes in expected future short rates. Changes in expected future short rates seem to be driven largely by changes in the stance of monetary policy and in the outlook for inflation while the estimated influence of changes in the outlook for the unemployment rate and GDP growth is more muted.

Keywords: Term structure, policy expectations

FEDS 2004-63
Housing, Consumption, and Credit Constraints


I test the credit-market effects of housing wealth shocks by estimating the consumption elasticity of house price shocks among households in different age quintiles. Younger households face faster expected income growth and hence would like to borrow more than older households. I estimate consumption elasticities from housing wealth by age quintile to be {4; 0; 3; 8; 3} percent. As predicted by theory, the youngest group has a higher elasticity of consumption than the next two age quintiles. That the consumption of the age quintile on the verge of retirement is responsive to housing wealth is also not surprising: I show that these households are likeliest to "downsize" their house and thus realize any capital gains.

Keywords: Consumption, wealth effect, housing, house prices

FEDS 2004-62
Monetary Policy and Inflation Dynamics


Since the early 1980s, the United States economy has changed in some important ways: Inflation now rises considerably less when unemployment falls and the volatility of output and inflation have fallen sharply. This paper examines whether changes in monetary policy can account for these phenomena. The results suggest that changes in the parameters and shock volatility of monetary policy reaction functions can account for most or all of the change in the inflation-unemployment relationship. As in other work, monetary-policy changes can explain only a small portion of the output growth volatility decline. However, changes in policy can explain a large proportion of the reduction in the volatility of the output gap. In addition, a broader concept of monetary-policy changes--one that includes improvements in the central bank's ability to measure potential output--enhances the ability of monetary policy to account for the changes in the economy.

Keywords: Inflation, monetary policy, Phillips curve, volatility

FEDS 2004-61
The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations

Seth Carpenter and Selva Demiralp


We use forecast errors made by the Federal Reserve while preparing open market operations to identify a liquidity effect at a daily frequency in the federal funds market. Unlike Hamilton (1997), we find a liquidity effect on many days of the reserve maintenance period besides settlement day. The effect is non-linear; large changes in supply have a measurable effect, but small changes do not. In addition, a higher aggregate level of reserve balances in the banking system is associated with a smaller liquidity effect during the maintenance period but a larger liquidity effect on the last days of the period.

Keywords: Liquidity effect, federal funds market

FEDS 2004-60
Debt Maturity, Risk, and Asymmetric Information

Allen N. Berger, Marco A. Espinosa-Vega, W. Scott Frame, and Nathan H. Miller


We test the implications of Flannery's (1986) and Diamond's (1991) models concerning the effects of risk and asymmetric information in determining debt maturity, and we examine the overall importance of informational asymmetries in debt maturity choices. We employ data on over 6,000 commercial loans from 53 large U.S. banks. Our results for low-risk firms are consistent with the predictions of both theoretical models, but our findings for high-risk firms conflict with the predictions of Diamond's model and with much of the empirical literature. Our findings also suggest a strong quantitative role for asymmetric information in explaining debt maturity.

Keywords: Debt maturity, risk, asymmetric information, banks, credit scoring

FEDS 2004-59
Workweek Flexibility and Hours Variation


I use the term workweek flexibility to describe the ease of changing output by altering the number of hours per worker. Despite the fact that workweek flexibility is potentially important for understanding the cyclical behavior of marginal cost and prices, as well as cyclical movements in hours and output, it has received little attention. Using insights from a simple model of employment and the workweek, I use mean workweek levels to identify the effect of workweek flexibility and then show that it is an important determinant of firms' marginal cost schedules and the variance of industry workweeks and hours. I use the same identification scheme with panel data to see if an increase in workweek flexibility has been behind the rise in hours per worker over the past 30 years and find that it has not.

Keywords: Workweek, hours adjustment

FEDS 2004-58
Diverging Measures of Capacity Utilization: An Explanation


In the wake of the recent recovery in manufacturing production, the capacity utilization rates published by the Federal Reserve Board (FRB) have rebounded much more slowly than those published by the Institute for Supply Management (ISM). As a result, some observers have speculated that the manufacturing sector may have considerably less slack than is indicated by the FRB measures. Our view is that the two characterizations of manufacturing slack are not as incongruent as they first appear. This paper discusses the practical and conceptual differences between these measures of capacity utilization, and concludes that the recent divergence simply reflects the character of the latest business cycle.

Keywords: Capacity, utilization

FEDS 2004-57
Quantitative Monetary Easing and Risk in Financial Asset Markets

Takeshi Kimura and David Small


In this paper, we empirically examine the portfolio-rebalancing effects stemming from the policy of "quantitative monetary easing" recently undertaken by the Bank of Japan when the nominal short-term interest rate was virtually at zero. Portfolio-rebalancing effects resulting from the open market purchase of long-term government bonds under this policy have been statistically significant. Our results also show that the portfolio-rebalancing effects were beneficial in that they reduced risk premiums on assets with counter-cyclical returns, such as government and high-grade corporate bonds. But, they may have generated the adverse effects of increasing risk premiums on assets with pro-cyclical returns, such as equities and low-grade corporate bonds. These results are consistent with a CAPM framework in which business-cycle risk importantly affects risk premiums. Our estimates capture only some of the effects of quantitative easing and thus do not imply that the complete set of effects were adverse on net for Japan's economy. However, our analysis counsels caution in accepting the view that, ceteris paribus, a massive large-scale purchase of long-term government bonds by a central bank provides unambiguously positive net benefits to financial markets at zero short-term interest rates.

Keywords: Bank of Japan, CAPM, portfolio-rebalancing effect, quantitative monetary easing, risk premium, zero interest-rate bound

FEDS 2004-56
Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and Realized Volatilities

Tim Bollerslev, Michael Gibson, and Hao Zhou


This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment suggests that the procedure works well in practice. Implementing the procedure with actual S&P 500 option-implied volatilities and high-frequency five-minute-based realized volatilities results in significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of underlying macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns.

Keywords: Stochastic volatility risk premium, model-free implied volatility, model-free realized volatility, Black-Scholes, GMM estimation, Monte Carlo, return predictability

FEDS 2004-55
A Consistent Accounting of U.S. Productivity Growth

Eric J. Bartelsman and J. Joseph Beaulieu


This paper is an exploration in the relative performance and sources of productivity growth of U.S. private businesses across industries and legal structure. In order to assemble the disparate data from various sources to develop a coherent productivity database, we developed a general system to manage data. The paper describes this system and then applies it by building such a database. The paper presents updated estimates of gross output, intermediate input use, and value added using the BEA's GPO data set. It supplements these data with estimates of missing data on intermediate input use and prices for the 1977-1986 period, and it concords these data, which are organized on a 1972 SIC basis, to the 1987 SIC in order to have consistent time series covering the last twenty-four years. It further refines these data by disaggregating them by legal form of organization. The paper also presents estimates of labor hours, labor quality, investment, capital services and, consequently, multifactor productivity disaggregated by industry and legal form of organization, and it analyzes the contribution of various industries and business organizations to aggregate productivity. The paper also reconsiders these estimates in light of the surge in spending in advance of the century-date change.

Keywords: Databases, legal form of organization, productivity

FEDS 2004-54
Integrated Macroeconomic Accounts for the United States: Draft SNA-USA

Rochelle Antoniewicz, Susan Hume McIntosh, Charles Ian Mead, Karin Moses, Brent Moulton, Michael Palumbo, Genevieve Solomon, and Albert M. Teplin


This paper presents integrated macroeconomic accounts for the United States for the period 1985 to 2002 and discusses issues related to their construction and use. Specifically, it focuses on tying together the national income and product accounts (NIPAs) and international transaction accounts (ITA) published by the Bureau of Economic Analysis and the flow of funds accounts (FFA) published by the Federal Reserve Board. The paper provides integrated accounts for seven sectors: households and nonprofit organizations serving households, nonfinancial noncorporate businesses, nonfinancial corporate businesses, financial businesses, federal government, state and local governments, and the rest of the world. Each sector table has a full complement of accounts: current accounts (production and income accounts), accumulation accounts (capital account, financial account, and other changes in volume account), revaluation account, and balance sheet account. As a result, the sector statements trace the factors leading to changes in sector net worth. Relative to current publications of the two agencies, the tables go quite a bit further toward providing for the United States the sequence of accounts suggested in the System of National Accounts 1993 (SNA93), the recognized international standard. The tables use official data as of June 10, 2004; however, a few series have been created by the authors, and they are unofficial preliminary estimates at this time.

Keywords: System of National Accounts, national income and product accounts, flow of funds accounts

FEDS 2004-53
Market Discipline in Banking Reconsidered: The Roles of Funding Manager Decisions and Deposit Insurance Reform

Daniel M. Covitz, Diana Hancock, and Myron L. Kwast


We find that the risk-sensitivity of bank holding company subordinated debt spreads at issuance increased with regulatory reforms that were designed to reduce conjectural government guarantees, but declined somewhat with subsequent reforms that were aimed in part at reducing regulatory forbearance. In addition, we test and find evidence for a straightforward form of "market discipline:" The extent to which bond issuance penalizes relatively risky banks. Evidence for such discipline only appears in the periods after conjectural government guarantees were reduced.

Keywords: Debt issuance, subordinated bonds

FEDS 2004-52
Macroeconomic Volatility, Predictability and Uncertainty in the Great Moderation: Evidence from the Survey of Professional Forecasters


An emerging and influential literature finds a large and significant decline in macroeconomic volatility since the middle of the 1980's. In this paper, I examine the extent to which the decline in annual and quarterly real output volatility since the onset of this period of Great Moderation can be attributed to changes in macroeconomic uncertainty and macroeconomic predictability. I use point forecasts of future real output growth from the Survey of Professional Forecasters (SPF) between 1969 and 2003 as a proxy for the predictable component of real output growth. The results indicate that declining predictability has played a significant role in the Great Moderation. Prior to the Great Moderation, professional forecasts explained roughly 30 percent of the variance in output growth. Post-moderation, the predictive ability of professional forecasts quickly vanished. This decline in predictability implies that interpreting the decline in the volatility of output shocks identified from a fixed parameter autoregressive model overstates the decline in macroeconomic uncertainty by between 20-40 percent. I also examine forecasts of the probability of a decline in real output from the SPF. Consistent with the findings from the point forecast data, these probability forecasts indicate that the decline in macroeconomic uncertainty as measured from an autoregressive model is overstated. While both the average probability of a decline in output and the uncertainty surrounding future declines in output computed from an autoregressive model decrease sharply after the mid-1980's, the SPF probability forecasts exhibit no such decrease. I assess the economic significance of the overstatement in the decline of macroeconomic uncertainty in terms of its effects on forecasts of the future equity premium. These results indicate that using the decline in the total volatility of real output growth along with the standard CCAPM model overstates the decline in the future equity premium by roughly 20 percent.

Keywords: Equity premium, forecasting, great moderation, predictability, uncertainty, volatility

FEDS 2004-51
Consumer Sentiment, the Economy, and the News Media

Mark Doms and Norman Morin


The news media affects consumers' perceptions of the economy through three channels. First, the news media conveys the latest economic data and the opinions of professionals to consumers. Second, consumers receive a signal about the economy through the tone and volume of economic reporting. Last, the greater the volume of news about the economy, the greater the likelihood that consumers will update their expectations about the economy. We find evidence that all three of these channels affect consumer sentiment. We derive measures of the tone and volume of economic reporting, building upon the R-word index of The Economist. We find that there are periods when reporting on the economy has not been consistent with actual economic events, especially during the early 1990s. As a consequence, there are times during which consumer sentiment is driven away from what economic fundamentals would suggest. We also find evidence supporting that consumers update their expectations about the economy much more frequently during periods of high news coverage than in periods of low news coverage; high news coverage of the economy is concentrated during recessions and immediately after recessions, implying that "stickiness" in expectations is countercyclical. Finally, because the model of consumer sentiment is highly nonlinear, month-to-month changes in sentiment are difficult to interpret. For instance, although an increase in the number of articles that mention "recession" typically is associated with a decline in sentiment, under certain conditions it can actually result in an increase in various sentiment indexes.

Keywords: Consumer sentiment, expectations, information

FEDS 2004-50
The Long-Run Relationship between House Prices and Rents


I show that when house prices are high relative to rents (that is, when the rent-price ratio is low) changes in real rents tend to be larger than usual and changes in real prices tend to be smaller than usual. Standard error-correction models provide inconclusive results about the predictive power of the rent-price ratio at a quarterly frequency. I use a long-horizon regression approach to show that the rent-price ratio helps predict changes in real rents and real prices over three-year periods. This result withstands the inclusion of a measure of the user cost of capital. I show that a long- horizon regression approach can yield biased estimates of the degree of error correction if prices have a unit root but do not follow a random walk. I construct bootstrap distributions to conduct appropriate inference in the presence of this bias. The results lend empirical support to the view that the rent-price ratio is an indicator of valuation in the housing market.

Keywords: House prices, rent, error correction

FEDS 2004-49
Estimating Capacity Utilization from Survey Data


In this paper, we review the history and concepts behind the Federal Reserve's measures of capacity and capacity utilization, summarize the methods used to construct the measures, and describe the principal source data for these measures--the Census Bureau's Survey of Plant Capacity. We show that the aggregate manufacturing utilization rate from the Survey of Plant Capacity does not exhibit the "cyclical bias" possessed by utilization rates from the less statistically rigorous utilization rate surveys previously used to estimate the Federal Reserve's measures. At the detailed industry level, utilization rates from the Survey of Plant Capacity for several industries do appear to possess a cyclical bias, but we demonstrate that this bias is removed in the construction of the Federal Reserve capacity measures. We further show that the Federal Reserve measures, by combining the Census survey utilization rates with other indicators of capacity, do not discard significant information contained in the Census rates. In fact, the Federal Reserve procedures add to the predictive content of the Census utilization rates in models of capital spending, capacity expansion, and changes in price inflation.

Keywords: Capacity, utilization, investment, price

FEDS 2004-48
Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

Ben S. Bernanke, Vincent R. Reinhart, and Brian P. Sack


The success over the years in reducing inflation and, consequently, the average level of nominal interest rates has increased the likelihood that the nominal policy interest rate may become constrained by the zero lower bound. When that happens, a central bank can no longer stimulate aggregate demand by further interest-rate reductions and must rely on "non-standard" policy alternatives. To assess the potential effectiveness of such policies, we analyze the behavior of selected asset prices over short periods surrounding central bank statements or other types of financial or economic news and estimate "no-arbitrage" models of the term structure for the United States and Japan. There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset.

Keywords: Deflation, zero bound, monetary policy, term structure, policy expectations

FEDS 2004-47
Convenience or Necessity? Understanding the Recent Rise in Credit Card Debt


Economist disagree whether the recent increase in credit card debt has been detrimental to U.S. households. However, many rely on a measure of revolving credit published by the Federal Reserve, which captures transactions in which a credit card is used because of its advantages over cash or a check. An increase in debt stemming from such convenience use likely would not signal greater financial vulnerabiltiy for households. In this paper, I present evidence that some of the significant increase in both the level of credit card debt and its growth from 1992 to 2001 was due to convenience use.

Keywords: Household debt, credit cards, credit aggregates

FEDS 2004-46
Competition, Product Differentiation and Quality Provision: An Empirical Equilibrium Analysis of Bank Branching Decisions

Andrew Cohen and Michael J. Mazzeo


We analyze the effects of market structure on the branching decisions of three types of depository institution: multimarket banks, single-market banks, and thrift institutions. We argue that additional branches increase quality for an institution's consumers, and examine the interaction between market structure and this particular measure of quality. We account for endogenous market structure using an equilibrium structural model, which corrects for bias caused by correlation in the unobservables that may drive entry and branching activity. We estimate the model using data from over 1,750 concentrated rural markets. Our results demonstrate the importance of product differentiation, as competition from multimarket banks is associated with denser branch networks for all types of firm while the opposite correlation holds when competitors are single-market banks or thrifts.

Keywords: Market structure, entry, bank, thrifts

FEDS 2004-45
Expectation Traps in a New Keynesian Open Economy Model


This paper illustrates that the introduction of a money demand distortion into an otherwise standard New Keynesian Open Economy model generates multiple discretionary equilibria. These equilibria arise in the form of expectations traps whereby the monetary authority is trapped into validating expectations of the private sector because failing to do so is costly. One implication of the model is that provided initial inflation expectations are sufficiently anchored the global Friedman rule emerges as an equilibrium under discretion. It is therefore a time-consistent outcome and hence fully sustainable even in absence of a commitment device or reputational considerations.

Keywords: Discretionary monetary policy, expectation traps, Friedman rule, time consistency problem

FEDS 2004-44
Monetary Policy and the Information Content of the Yield Spread

Michael Feroli


This paper demonstrates that the ability of the yield spread to predict output fluctuations is contingent on the monetary authority's reaction function. In particular, expectations of monetary policy actions are crucial for the spread to predict output conditional on the short-rate. Furthermore, numerical experiments suggest that the post-1979 decrease in the yield spread's predictive power is due to a shift in the monetary policy reaction function at that time.

Keywords: Yield spread, business cycles, monetary policy

FEDS 2004-43
Is Moderate-To-High Inflation Inherently Unstable?


The data across time and countries suggest the level and variance of inflation are highly correlated. This paper examines the effect of trend inflation on the ability of the monetary authority to ensure a determinate equilibrium and macroeconomic stability in a sticky-price model. Trend inflation increases the importance of future marginal costs for current price-setters in a staggered price-setting model. The greater importance of expectations makes it more difficult for the monetary authority to ensure stability; in fact, equilibrium determinacy cannot be achieved through reasonable specifications of nominal interest rate (Taylor) rules at moderate-to-high levels of inflation (for example, at levels around 4 percent per year). If monetary policymakers have followed these types of policy rules in the past, this result may explain why moderate-to-high inflation is associated with inflation volatility. It also suggests a revision to interpretations of the 1970s. At that time, inflation in many countries was at least moderate, which can contribute to economic instability. The results suggest that some moderate-inflation countries that have recently adopted inflation targeting may want to commit to low target inflation rates.

Keywords: Monetary policy; equilibrium determinacy; Taylor rule; sunspot fluctuations

FEDS 2004-42
Do Liquidity Constraints Matter for New Entrepreneurs?


Numerous studies have found a positive relationship between wealth and entering entrepreneurship, and interpret this as evidence of the existence of liquidity constraints. However, recent research has shown that the relationship between wealth and entering entrepreneurship may be non-linear and only significant for high-wealth households; this result cannot be interpreted as evidence of liquidity constraints. Using data from the SCF, we construct a proxy for wealth based on the household's home equity wealth at the time of the entrepreneurial decision. The results provide further evidence that the relationship between wealth and entering entrepreneurship is only significant for high-wealth households and that liquidity constraints do not appear to bind for the majority of new entrepreneurs. Possible explanations for the relationship between wealth and becoming an entrepreneur include lower risk aversion and differences in the types of businesses started by high-wealth households.

Keywords: Entrepreneurship, wealth, liquidity constraints

FEDS 2004-41
Limited Network Connections and the Distribution of Wages

Kenneth J. Arrow and Ron Borzekowski


It is well-known that 50% or more of all jobs are obtained through informal channels i.e. connections to family or friends. As well, statistical studies show that observable individual factors account for only about 50% of the very wide variation in earnings. We seek to explain these two facts by assuming that the linking of workers and firms is mediated by limited network connections. The model implies that essentially similar workers can have markedly different wages and further that the inequality of wages is partly explained by variations in the sizes of workers' networks. Our results indicate that differences in the number of ties can induce substantial inequality and can explain roughly 15% of the unexplained variation in wages. We also show that reasonable differences in the average number of links between blacks and whites can explain the disparity in black and white income distributions.

Keywords: Wages, labor markets, social networks, inequality

FEDS 2004-40
The Scope of Monetary Policy Actions Authorized under the Federal Reserve Act


The Federal Reserve Act authorizes the Federal Reserve to undertake various types of discount window loans and open market operations. While the Federal Reserve generally has not found it necessary to use all types of such authority, there could be circumstances in which the Federal Reserve might need to consider utilizing its statutory authority more broadly than it has in the past. We examine the limits imposed by the Federal Reserve Act along two dimensions: those types of counterparties and financial instruments with which the Federal Reserve may conduct monetary policy. In doing so, we develop a theme not commonly pursued in the literature--the ways and extent to which the Federal Reserve Act limits the Federal Reserve from taking credit risk onto its balance sheet. We also provide some historical perspective on how the current powers of the Federal Reserve came to be authorized.

Keywords: Monetary policy, Federal Reserve Act, discount window, open market operations

FEDS 2004-39
Integrating Expenditure and Income Data: What To Do With the Statistical Discrepancy?

J. Joseph Beaulieu and Eric J. Bartelsman


The purpose of this paper is to build consistent, integrated datasets to investigate whether various disaggregated data can shed light on the possible sources of the statistical discrepancy. Our strategy is first to use disaggregated data to estimate consistent sets of input-output models that sum to either GDP or GDI and compare the two in order to see where the discrepancy resides. We find a few "problem" industries that appear to explain most of the statistical discrepancy. Second, we explore what combination of the expenditure data and the income data seem to produce the most sensible data according to a few economic criteria. A mixture of data that do not aggregate either to GDP or to GDI appears optimal.

Keywords: Industry data, input-output, national accounts, statistical discrepancy

FEDS 2004-38
Multimarket Bank Pricing: An Empirical Investigation of Deposit Interest Rates

Timothy H. Hannan and Robin A. Prager


In recent years, the number of large, geographically diversified banking organizations operating in the U.S. has grown. Empirical studies have found that, at least in the case of deposit interest rates, many of these banks offer the same rate for a given type of account throughout a state, or, in some cases, a broader geographical area. This phenomenon of uniform pricing raises questions as to what competitive factors are relevant in explaining the deposit interest rates offered by large multimarket banks. In this paper, we provide empirical evidence regarding the determinants of the deposit interest rates offered by these banking organizations.

Keywords: Banks, competition, pricing

FEDS 2004-37
The Price and Quantity of Residential Land in the United States

Morris A. Davis and Jonathan Heathcote


We combine publicly available data from Freddie Mac, the Decennial Census of Housing, and the Bureau of Economic Analysis to construct the first constant-quality aggregate price index for the stock of residential land in the United States. We uncover five main results: (a) since 1970, residential land prices have grown faster but (b) have also been twice as volatile as existing home prices; (c) averaged from 1970 to 2003, the nominal stock of residential land under 1-4 unit structures accounts for 38% of the market value of the housing stock and is equal to 50% of nominal annual GDP; (d) the real stock of residential land under 1-4 unit structures has increased an average of 0.6% per year since 1970; and (e) residential investment leads the price of residential land by three quarters. We also estimate that in 2003:Q3 the nominal value of the entire stock of residential land is the same as annual GDP. Finally, we show for the US data that the logarithms of the nominal price index for residential land, disposable income, and interest rates are cointegrated.

Keywords: Land, housing, house prices, land prices

FEDS 2004-36
Understanding the Risk of Synthetic CDOs


Synthetic collateralized debt obligations, or synthetic CDOs, are popular vehicles for trading the credit risk of a portfolio of assets. Following a brief summary of the development of the synthetic CDO market, I draw on recent innovations in modeling to present a pricing model for CDO tranches that does not require Monte Carlo simulation. I use the model to analyze the risk characteristics of the tranches of synthetic CDOs. The analysis shows that although the more junior CDO tranches -- equity and mezzanine tranches -- typically contain a small fraction of the notional amount of the CDO's reference portfolio, they bear a majority of the credit risk. One implication is that credit risk disclosures relying on notional amounts are especially inadequate for firms that invest in CDOs. I show how the equity and mezzanine tranches can be viewed as leveraged exposures to the underlying credit risk of the CDO's reference portfolio. Even though mezzanine tranches are typically rated investment-grade, the leverage they possess implies their risk (and expected return) can be many times that of an investment-grade corporate bond. The paper goes on to show how CDO tranches and other innovative credit products, such as single-tranche CDOs and first-to-default basket swaps, are sensitive to the correlation of defaults among the credits in the reference portfolio. Differences of opinion among market participants as to the correct default correlation can create trading opportunities. Finally, the paper shows how the dependence of CDO tranches on default correlation can also be characterized and measured as an exposure to the business cycle, or as "business cycle risk." A mezzanine tranche, in particular, is highly sensitive to business cycle risk.

Keywords: Credit derivatives, credit risk, collateralized debt obligation

FEDS 2004-35
Transparency and Monetary Policy: What Does the Academic Literature tell Policymakers?

Seth B. Carpenter


Transparency in monetary policy has become a popular topic over the past decade. However, the majority of the economic research is theoretical, calling into question its value as a practical guide to monetary policy. This paper surveys the literature to assess what conclusions a central bank can draw from the academic study of transparency and how beneficial transparency may be.

Keywords: Monetary Policy, transparency

FEDS 2004-34
Employer-to-Employer Flows in the U.S. Labor Market: The Complete Picture of Gross Worker Flows

Bruce Fallick and Charles A. Fleischman

Data - Excel file (50 KB XLS) | Data - Screen reader


Despite the importance of employer-to-employer (EE) flows to our understanding of labor market and business cycle dynamics, the literature has lacked a comprehensive and representative measure of the size and character of these flows. To construct the first reliable measures of EE flows for the United States, this paper exploits the "dependent interviewing" techniques introduced in the Current Population Survey in 1994. The paper concludes that EE flows are large: On average 2.6 percent of employed persons change employers each month, a flow more than twice as large as that from employment to unemployment. Indeed, on-the-job search appears to be an important element in hiring, as nearly two-fifths of new jobs started between 1994 and 2003 represented employer changes. EE flows are also markedly procyclical, although the cyclicality is concentrated around the recession: EE flows did not increase as the labor market tightened between 1994 and 2000, but they did drop sharply as the labor market loosened during the period 2001 through 2003. We view the uneven cyclical pattern of EE flows as a pattern to be incorporated into future models.

Keywords: Accessions, business cycle, gross flows, job creation, job destruction, job-to-job, on-the-job search, separations, turnover, worker flows

FEDS 2004-33
To Leave or Not to Leave: The Distribution of Bequest Motives

Wojciech Kopczuk and Joseph P. Lupton


In this paper, we examine the effect of observed and unobserved heterogeneity in the desire to die with positive net worth. Using a structural life-cycle model nested in a switching regression with unknown sample separation, we find that roughly 70 percent of the elderly single population has a bequest motive that may or may not be active depending on the level of resources at a given age. Both the presence and the magnitude of the bequest motive are statistically and economically significant. All else being equal, households with an operative bequest motive spend between $4,000 and $9,000 a year less on consumption expenditures on average. We conclude that, among the elderly single households in our sample, approximately half of bequeathed wealth will be due to a bequest motive.

Keywords: Bequest, bequest motive, heterogeneous preferences, wealth, saving

FEDS 2004-32
The Decline in Household Saving and the Wealth Effect

F. Thomas Juster, Joseph P. Lupton, James P. Smith, and Frank Stafford


Using a unique set of household level panel data, we estimate the effect of capital gains on saving by asset type, controlling for observable and unobservable household specific fixed effects. The results suggest that the decline in the personal saving rate since 1984 is largely due to the significant capital gains in corporate equities experienced over this period. Over five-year periods, the effect of capital gains in corporate equities on saving is substantially larger than the effect of capital gains in housing or other assets. Failure to differentiate wealth affects across asset types results in a significant understatement or overstatement of the size of their impact, depending on the asset.

Keywords: Personal saving, wealth effect, capital gains

FEDS 2004-31
How Fast Do Personal Computers Depreciate? Concepts and New Estimates

Mark E. Doms, Wendy E. Dunn, Stephen D. Oliner, and Daniel E. Sichel


This paper provides new estimates of depreciation rates for personal computers using an extensive database of prices of used PCs. Our results show that PCs lose roughly half their remaining value, on average, with each additional year of use. We decompose that decline into age-related depreciation and a revaluation effect, where the latter effect is driven by the steep ongoing drop in the constant-quality prices of newly-introduced PCs. Our results are directly applicable for measuring the depreciation of PCs in the National Income and Product Accounts (NIPAs) and were incorporated into the December 2003 comprehensive NIPA revision. Regarding tax policy, our estimates suggest that the current tax depreciation schedule for PCs closely tracks the actual loss of value in a zero-inflation environment. However, because the tax code is not indexed for inflation, the tax allowances would be too small in present value for inflation rates above the very low level now prevailing.

Keywords: Depreciation, computers, capital measurement

FEDS 2004-30
Technology, Capital Spending, and Capacity Utilization

Cynthia Bansak, Norman Morin, and Martha Starr


This paper examines the relationships between technology, capital spending, and capacity utilization. Recent technological changes have increased the flexibility of relationships between inputs and outputs in manufacturing, which may have eroded the predictive value of the utilization rate. This paper considers how technology might be expected to affect utilization. We show that recent changes could either lower average utilization by making it cheaper to hold excess capacity, or raise utilization by making further changes in capacity less costly and time-consuming. We then examine the effects of technology on utilization, using data on 111 manufacturing industries from 1974 to 2000. The results suggest that, for the average industry, the technological change of that period had a modest but appreciable effect, shaving between 0.2 percentage point and 2.3 percentage points off the utilization rate.

Keywords: Capacity, investment, utilization, technology

FEDS 2004-29
Overnight Interbank Loan Markets

Selva Demiralp, Brian Preslopsky, and William Whitesell


This paper investigates transactions and interest rates on brokered and direct trades in federal funds, Eurodollar transactions, and repurchase agreements, all of which are used by banks in overnight funding. We expand on earlier work on calendar-day effects in these markets, investigating also volumes of funding in recent years. Our data include daily trades in federal funds reported by major brokers and also records of uncollateralized transactions over the wire transfer system operated by the Federal Reserve. We find that the share of the overnight interbank loan market represented by brokered fed funds has decreased and is now only about one-third of the total. We also show evidence of close but incomplete arbitrage among the major segments of the overnight interbank market, though the specific calendarday patterns of spreads and volatilities have evolved relative to the literature using earlier sample periods.

Keywords: Federal funds, Eurodollar, repo, arbitrage

FEDS 2004-28
Fresh Start or Head Start? The Effect of Filing for Personal Bankruptcy on the Labor Supply

Song Han and Wenli Li


The key feature of the modern U.S. personal bankruptcy law is to provide debtors a financial fresh start through debt discharge. The primary justification for the discharge policy is to preserve human capital by maintaining incentives for work. In this paper, we test this fresh start argument by providing the first estimate of the effect of personal bankruptcy filing on the labor supply using data from the Panel Study of Income Dynamics (PSID). Our econometric approach controls for the endogenous self-selection of bankruptcy filing and allows for dependence over time for the same household. We find that filing for bankruptcy does not have a positive impact on annual hours worked by bankrupt households, a result mainly due to the wealth effects of debt discharge. The finding is robust to a number of alternative model specifications and sample selections. Therefore, our analysis does not find supporting evidence for the human capital argument for bankruptcy discharge.

Keywords: Labor supply, personal bankruptcy

FEDS 2004-27
Loan Commitments and Private Firms

Sumit Agarwal, Souphala Chomsisengphet, and John C. Driscoll


Bank lending is an important source of funding for firms. Most loans are in the form of credit lines. Empirical studies of line demand have been complicated by their use of data on publicly traded firms, which have a wide menu of financing options. We avoid this problem by using a unique proprietary data set from a large financial institution of loan commitments made to 712 privately-held firms. We test Martin and Santomero's (1997) model, in which lines give firms the speed and flexibility to pursue investment opportunities. Our findings are consistent with their predictions. Firms facing higher rates and fees have smaller credit lines. Firms with higher growth commit to larger lines of credit and have a higher rate of line utilization. Firms experiencing more uncertainty in their funding needs commit to smaller credit lines. Almost all firms convert unused credit line portions into spot loans and take out new lines.

Keywords: Bank loan commitment; credit lines, private firms

FEDS 2004-26
Cross-Border Diversification in Bank Asset Portfolios

Claudia M. Buch, John C. Driscoll, and Charlotte Ostergaard


Taking the mean-variance portfolio model as a benchmark, we compute the optimally diversified portfolio for banks located in France, Germany, the U.K., and the U.S. under different assumptions about currency hedging. We compare these optimal portfolios to the actual cross-border assets of banks from 1995-1999 and try to explain the deviations. We find that banks over-invest domestically to a considerable extent and that cross-border diversification entails considerable gain. Banks underweight countries which are culturally less similar or have capital controls in place. Capital controls have a strong impact on the degree of underinvestment whereas less political risk increases the degree of over-investment.

Keywords: International banking, portfolio diversification, international integration

FEDS 2004-25
Optimal Inflation in an Open Economy with Imperfect Competition


This paper uses a two-country, monetary general equilibrium model with imperfect competition to study the optimal rate of inflation in an open economy. In contrast with the closed economy literature, when policy is set non-cooperatively in the open economy, the optimality of the Friedman rule is not a general result. Monetary authorities face an incentive to use the inflation tax to gain a "beggar-thy-neighbor" advantage over the terms of trade. Strategic use of the inflation tax, however, results in coordination failure. International monetary cooperation helps to mitigate this coordination failure and, as a result, can lead to more efficient equilibria. Monetary union ensures the maximum gain from cooperation by restoring the optimality of the global Friedman rule, placing the world economy at the Pareto frontier.

Keywords: Optimal monetary policy, Friedman rule, international monetary policy coordination

FEDS 2004-24
Commercial Lending and Distance: Evidence from Community Reinvestment Act Data

Kenneth P. Brevoort and Timothy H. Hannan


Innovations such as credit scoring have increased the ability of banks to lend to distant business borrowers, which could expand the geographic market for small business loans. However, if this effect is limited to a few large banks, the market may become segmented and lending distance at local banks actually decreases. This paper, using a new data source and a spatial econometric model, empirically estimates the relationship between distance and commercial lending and how this relationship is evolving over time. We find distance is negatively associated with the likelihood of a local commercial loan being made and that the deterrent effect of distance is consistently more important, the smaller the size of the bank. We find no evidence that distance is becoming less important in the United States in recent years. In fact, the bulk of the evidence suggests that distance may be of increasing importance in local market lending.

Keywords: Commercial lending, spatial probit

FEDS 2004-23
401(k) Matching Contributions in Company Stock: Costs and Benefits for Firms and Workers

Jeffrey R. Brown, Nellie Liang, and Scott Weisbenner


This paper examines why some employers provide matching contributions to 401(k) plans in company stock and explores the implications of match policy for employee retirement wealth. Unlike stock option grants to non-executives, a firm's decision to match in company stock does not appear to be strongly correlated with cash flow or with measures of the benefits of aligning incentives of employees and employers. Rather, we find evidence that firms are more likely to provide the match in company stock if firm risk is low (i.e. lower stock price volatility and lower bankruptcy risk) and employees are also covered by a defined benefit plan. These findings suggest that firms consider the retirement security of their workers in making the match decision, either because firms want to minimize the risk of violating their fiduciary responsibility or because employees more fully value company stock at companies with lower firm-specific risk. Evidence also indicates that firms may want to match in company stock to boost employee ownership, perhaps to help deter takeovers, or because of the tax advantages for dividends on the company stock match. Simulation results suggest that sufficiently risk-tolerant individuals actually prefer a 401(k) plan at a company with a company stock match to a plan at a company with an unrestricted match, unless the equity premium is reduced substantially.

Keywords: Pension, 401(k) plan, ESOP, company stock, match policy

FEDS 2004-22
The Geography of Stock Market Participation: The Influence of Communities and Local Firms

Jeffrey R. Brown, Zoran Ivkovic, Paul A. Smith, and Scott Weisbenner


This paper is the first to investigate the importance of geography in explaining equity market participation. We provide evidence to support two distinct local area effects. The first is a community ownership effect, that is, individuals are influenced by the investment behavior of members of their community. Specifically, a ten percentage-point increase in equity market participation of the other members of one's community makes it two percentage points more likely that the individual will invest in stocks, conditional on a rich set of controls. We find further evidence that the influence of community members is strongest for less financially sophisticated households and strongest within "peer groups" as defined by age and income categories. The second is that proximity to publicly-traded firms also increases equity market participation. In particular, the presence of publicly-traded firms within 50 miles and the share of U.S. market value headquartered within the community are significantly correlated with equity ownership of individuals. These results are quite robust, holding up in the presence of a wide range of individual and community controls, the inclusion of individual fixed effects, and specification checks to rule out that the relations are driven solely by ownership of the stock of one's employer.

Keywords: Stock market participation, peer effects, geography

FEDS 2004-21
Learning and Shifts in Long-Run Productivity Growth

Rochelle M. Edge, Thomas Laubach, and John C. Williams


Shifts in the long-run rate of productivity growth--such as those experienced by the U.S. economy in the 1970s and 1990s--are difficult, in real time, to distinguish from transitory fluctuations. In this paper, we analyze the evolution of forecasts of long-run productivity growth during the 1970s and 1990s and examine in the context of a dynamic general equilibrium model the consequences of gradual real-time learning on the responses to shifts in the long-run productivity growth rate. We find that a simple updating rule based on an estimated Kalman filter model using real-time data describes economists' long-run productivity growth forecasts during these periods extremely well. We then show that incorporating this process of learning has profound implications for the effects of shifts in trend productivity growth and can dramatically improve the model's ability to generate responses that resemble historical experience. If immediately recognized, an increase in the long-run growth rate causes long-term interest rates to rise and produces a sharp decline in employment and investment, contrary to the experiences of the 1970s and 1990s. In contrast, with learning, a rise in the long-run rate of productivity growth sets off a sustained boom in employment and investment, with long-term interest rates rising only gradually. We find the characterization of learning to be crucial regardless of whether shifts in long-run productivity growth owe to movements in TFP growth concentrated in the investment goods sector or economy-wide TFP.

Keywords: DGE models, Kalman-filter, Real-time data, Learning, Productivity growth

FEDS 2004-20
Uncertainty and Investment: An Empirical Investigation Using Data on Analysts' Profits Forecasts

Stephen R. Bond and Jason G. Cummins


We investigate the empirical relationship between company investment and measures of uncertainty, controlling for the effect of expected future profitability on current investment decisions. We consider three measures of uncertainty derived from (1) the volatility in the firm's stock returns; (2) disagreement among securities analysts in their forecasts of the firm's future profits; and (3) the variance of forecast errors in analysts' forecasts of the firm's future profits. We consider two controls for expected profitability: (1) a standard measure of Brainard-Tobin's q constructed from the firm's stock market valuation; and (2) an alternative measure of the q ratio constructed from discounted forecasts of the firm's future profits. Our sample consists of publicly-traded U.S. companies that were tracked by two or more securities analysts for at least four consecutive years between 1982 and 1999. The results show that all three measures of uncertainty are positively correlated and appear to pick up underlying movements in uncertainty. When we consider these measures individually, we find a significantly negative long-run effect of higher uncertainty on capital accumulation, which is robust to the inclusion of either of our controls for expected profitability. When we consider our uncertainty measures jointly, we find that the level of disagreement among analysts provides the most informative indicator for identifying this long-run effect of uncertainty on capital accumulation. In addition, we find a significantly negative short-run interaction term between share price volatility and current sales growth, consistent with the idea that investment will respond less to a given demand shock at higher levels of uncertainty. These effects of uncertainty on investment are shown to be quantitatively as well as statistically significant.

Keywords: Irreversibility, real options, adjustment costs

FEDS 2004-19
What Does the Yield on Subordinated Bank Debt Measure?

Urs W. Birchler and Diana Hancock


We provide evidence that a bank's subordinated debt yield spread is not, by itself, a sufficient measure of default risk. We use a model in which subordinated debt is held by investors with superior knowledge ("informed investor hypothesis"). First, we show that in theory the yield spread on subordinated debt must compensate investors for expected loss plus give them an incentive not to prefer senior debt. Second we present strong empirical evidence in favor of the informed investor hypothesis and of the existence of the incentive premium predicted by the model. Using data on the timing and pricing of public debt issues made by large U.S. banking organizations during the 1985-2002 period, we find that banks issue relatively more subordinated debt in good times, i.e. when informed investors have good news. Spreads at issuance (corrected for sample selection bias) react to (superior) private and to public information, in line with the comparative statics of the postulated incentive premium. Interestingly, as the model predicts, the influence of sophisticated investors' information on the subordinated yield spread became weaker after the introduction of prompt corrective action and depositor preference reforms, while the influence of public risk perception grew stronger. Finally, our model explains anomalies from the empirical literature on subordinated debt spreads and from market interviews (e.g. limited sensitivity to bank-specific risk and the "ballooning" of spreads in bad times). We conclude that a bank's subordinated yield spread conveys important information if interpreted together with its senior spread and with other banks' subordinated yield spreads.

Keywords: Market discipline, subordinated debt, bank supervision

FEDS 2004-18
The Term Structure of Commercial Paper Rates

Chris Downing and Stephen Oliner


This paper tests the expectations hypothesis in the market for commercial paper. Our main dataset, which is new to the literature, consists of daily indexes constructed from the actual market yields for nearly all commercial paper issued by U.S. corporations between January 1998 and August 2003. We show that the term premia built into commercial paper yields rise dramatically at year-end, causing the expectations hypothesis to be rejected. However, once we control for these predictable year-end effects, we find the reverse--that commercial paper yields largely conform with the expectations hypothesis.

Keywords: Term structure, expectations hypothesis, commercial paper

FEDS 2004-17
A New Approach to the Valuation of Intangible Capital

Jason G. Cummins


Intangible capital is not a distinct factor of production as is physical capital or labor. Rather it is the "glue" that creates value from other factor inputs. This perspective naturally suggests an empirical model in which intangible capital is defined in terms of adjustment costs. My estimates of these adjustment costs from firm-level panel data suggest that no appreciable intangibles are associated with R&D and advertising, whereas information technology creates intangibles with a 72% annual rate of return--a sizable figure that is nevertheless much smaller than that reported in previous studies. To build a bridge to previous research, I show that much larger estimates can be obtained with ordinary least squares, a method that ignores the possibility that the value of the firm and its investment policy are simultaneously determined.

Keywords: Organizational capital, intellectual property, adjustment costs

FEDS 2004-16
What Explains the Stock Market's Reaction to Federal Reserve Policy?

Ben S. Bernanke and Kenneth N. Kuttner


This paper analyzes the impact of changes in monetary policy on equity prices, with the objectives both of measuring the average reaction of the stock market and also of understanding the economic sources of that reaction. We find that, on average, a hypothetical unanticipated 25-basis-point cut in the federal funds rate target is associated with about a one percent increase in broad stock indexes. Adapting a methodology due to Campbell (1991) and Campbell and Ammer (1993), we find that the effects of unanticipated monetary policy actions on expected excess returns account for the largest part of the response of stock prices.

Keywords: Monetary policy, equity prices

FEDS 2004-15
Medicaid's Nursing Home Coverage and Asset Transfers


Medicaid covers the costs of a long nursing home stay. This coverage may create an incentive for the elderly to transfer their assets to their children in order to qualify for Medicaid before entering a nursing home. Previous researchers had found little evidence that such behavior was widespread or that asset transfers were large. However, data from AHEAD suggest that the self-assessed probability of entering a nursing home is a significant determinant of the likelihood of making an asset transfer. The budgetary implications of these Medicaid-induced asset transfers are probably fairly small, but not insignificant.

Keywords: Medicaid, nursing home, financial planning, aging, asset transfers

FEDS 2004-14
The Effects of Technology on the Age Distribution of Health Spending: A Cross-Country Perspective

Louise Sheiner


The conventional method used to project a country's future health care expenditures is to assume that relative health spending by age remains constant. This method has been criticized as being too pessimistic, on the one hand, because of continued improvements in the health status of older people, and as too optimistic, on the other, because of the effects of technological innovations on increasing health spending on the elderly relative to the nonelderly. This paper uses cross-country data to shed light on this question. I find that, contrary to conventional wisdom, the theoretical effects of technology on health spending are to decrease the concentration of health spending on the elderly. Empirically, I find that relative health spending by age has been quite stable over time. I also find that countries with the most technologically intensive health sectors spend relatively less on the oldest old compared to the younger old.

Keywords: Health spending, technology, international

FEDS 2004-13
Will the Proposed Application of Basel II in the United States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity

Timothy H. Hannan and Steven J. Pilloff


This paper presents two tests of the hypothesis that adoption of the internal ratings-based approach to determining minimum capital requirements, as proposed in applying the Basel II capital accord in the United States, will cause adopting banking organizations to increase acquisition activity. The first test estimates the relationship between excess regulatory capital and subsequent merger activity, including organization and time fixed effects, while the second test employs a "difference in difference" analysis of the change in merger activity that occurred the last time regulatory capital standards were changed. Estimated coefficients and observed differences have signs consistent with the hypothesis, but results are either statistically insignificant or imply differences that are small in magnitude.

Keywords: Mergers, Capitalization

FEDS 2004-12
Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the United States

Allen N. Berger


We examine the likely competitive effects of the proposed implementation of the Basel II capital requirements on banks in the market for credit to SMEs in the U.S. Specifically, we address whether reduced risk weights for SME credits extended by large banking organizations that adopt the Advanced Internal Ratings-Based (A-IRB) approach of Basel II might significantly adversely affect the competitive positions of organizations that do not adopt A-IRB. The analyses suggest only a relatively minor competitive effect on the majority of community banks primarily because the organizations that are likely to adopt A-IRB tend to make very different types of SME loans to different types of borrowers than community banks. However, the analyses suggest the possibility of significant adverse effects on the competitive positions of large banking organizations that do not adopt A-IRB because the data do not suggest any strong segmentation in SME credit markets among large organizations.

Keywords: Banks, Capital Requirements, SMEs, Basel II

FEDS 2004-11
Housing and the Business Cycle

Morris Davis and Jonathan Heathcote


In the United States, the percentage standard deviation of residential investment is more than twice that of non-residential investment. In addition, GDP, consumption, and both types of investment co-move positively. We reproduce these facts in a calibrated multi-sector growth model where construction, manufacturing and services are combined, in different proportions, to produce consumption, business investment and residential structures. New housing requires land in addition to new structures. The model can also account for important features of industry-level data. In particular, hours and output in all industries are positively correlated, and are most volatile in construction.

Keywords: Residential investment, co-movement, home production, multisector models

FEDS 2004-10
Identifying Price Discrimination when Product Menus are Endogenous


The standard approach to identifying second degree price discrimination is based on examining correlations between product menus and prices. When product menus are endogenous, however, tests for price discrimination may be biased by the fact that unobservables affecting costs or demand may jointly determine product menus and prices leading one to falsely infer price discrimination. Attempts to correct for this potential bias using observed product characteristics or fixed effects are shown to potentially confound inference on price discrimination leading one to reject it when firms are actually price discriminating. I propose a difference in differences type test that exploits the potential correlation between unobserved product attributes, product menus, and prices.

Keywords: Price discrimination, non-linear pricing, package size

FEDS 2004-09
Testing for Adverse Selection and Moral Hazard in Consumer Loan Markets

Wendy Edelberg


This paper explores the significance of unobservable default risk in mortgage and automobile loan markets. I develop and estimate a two-period model that allows for heterogeneous forms of simultaneous adverse selection and moral hazard. Controlling for income levels, loan size and risk aversion, I find robust evidence of adverse selection, with borrowers self-selecting into contracts with varying interest rates and collateral requirements. For example, ex-post higher-risk borrowers pledge less collateral and pay higher interest rates. Moreover, there is strongly suggestive evidence of moral hazard such that collateral is used to induce a borrower's effort to avoid repayment problems. Thus, loan terms may have a feedback effect on behavior. Also, higher-risk borrowers are more difficult to induce into exerting effort, explaining the counter-intuitive result that higher-risk borrowers sometimes pay lower interest rates than observably lower-risk borrowers.

Keywords: Asymmetric information, consumer loans, household finances

FEDS 2004-08
Valuation, Investment and the Pure Profit Share

Pierre Lafourcade


This paper explores some implications for valuation and investment of challenging the standard assumption that there are no aggregate pure profits in the US economy. First, it highlights the theoretical importance of monopoly rents for fluctuations in average Q. A series for such rents is then computed by assuming that production is Cobb-Douglas, as fluctuations in the output share of pure profits may be inferred from variations in the labor share. Consequently, the paper focuses on the correlation between a measure of rents and observable average Q. It also reassesses the empirical disconnection between investment and a measure of marginal q purged of monopoly rents. The paper finds that the existence of pure profits as constructed from unit labor costs only accounts for about 5% of fluctuations in observed Q, and alters only minimally the empirical relationship between q and investment.

Keywords: Tobin's q, investment, markup, scale, rents

FEDS 2004-07
Modeling the Whole Firm: The Effect of Multiple Inputs and Financial Intermediation on Bank Deposit Rates


Empirical studies of price competition typically analyze the direct effects of market structure, cost, and local demand on prices; this approach has been applied widely to studies of bank deposit rates. However, the theory of the banking firm suggests that substitutability between sources of deposits and conditions in the bank loan market should also affect the pricing of retail deposits. This paper develops a theoretical model to incorporate these effects, and tests the predictions empirically using institution-level deposit rate data from Bank Rate Monitor. The results suggest that the cost of large-scale deposits affects how banks price retail deposits, and that conditions in lending markets feed back into retail deposit rates.

Keywords: Financial intermediation, deposit rates

FEDS 2004-06
Federal Reserve Transparency and Financial Market Forecasts of Short-Term Interest Rates

Eric T. Swanson


The 1990s and early 2000s witnessed an unprecedented increase in central bank transparency around the world, yet there has been little empirical work that convincingly demonstrates any economic benefits of increased central bank transparency. This paper shows that, since the late 1980s, U.S, financial markets and private sector forecasters have become: 1) better able to forecast the federal funds rate at horizons out to several months, 2) less surprised by Federal Reserve announcements, 3) more certain of their interest rate forecasts ex ante, as measured by interest rate options, and 4) less diverse in the cross-sectional variety of their interest rate forecasts. We also show that increases in Federal Reserve transparency are likely to have played a role: for example, private sector forecasts of GDP and inflation have not experienced similar improvements over the same period, indicating that the improvement in interest rate forecasts has been special.

Keywords: Transparency, monetary policy, forecasts

FEDS 2004-05
The Effects of the 1986 and 1993 Tax Reforms on Self-Employment


This paper adds a new dimension to the literature that uses individual level data to assess the effects of tax policy on self-employment. Specifically, this study uses repeated cross-section data from the Surveys of Consumer Finances (SCF) against the background of the tax reforms of 1986 and 1993 to gauge the influence of taxes on self-employment. Using the 1986 and 1993 tax rate reforms as natural experiments allows for the identification of the effect of taxes on the choice to become self-employed. The findings of this paper indicate that marginal and average tax rates are negatively related to the propensity to become self-employed. However, these effects are only significant for the 1986 tax reforms and are sensitive to the model specification. Other factors, such as education, industry, wealth, and attitude toward risks, are consistently more important influences on the choice to become self-employed.

Keywords: Self-employment, marginal tax rates, average tax rates

FEDS 2004-04
Market Structure and Competition Among Retail Depository Institutions

Andrew Cohen and Michael Mazzeo


We assess the competitive impact that single-market banks and thrift institutions have on multi-market banks (and vice-versa) in 1,884 non- MSA markets. We estimate a model of equilibrium market structure which endogenizes entry for three types: multi-market banks, single-market banks, and thrift institutions. Observed market structures and the solution to an entry-type game identify the parameters of a latent (unobserved) profit function. We find significant evidence of product differentiation-- particularly in the case of thrifts. Furthermore, product differentiation appears to depend upon differences in market geography.

Keywords: Market structure, entry, bank, thrift

FEDS 2004-03
Measuring the Effects of Monetary Policy: A Factor-Augmented Vector Autoregressive (FAVAR) Approach

Ben S. Bernanke, Jean Boivin, and Piotr Eliasz


Structural vector autoregressions (VARs) are widely used to trace out the effect of monetary policy innovations on the economy. However, the sparse information sets typically used in these empirical models lead to at least two potential problems with the results. First, to the extent that central banks and the private sector have information not reflected in the VAR, the measurement of policy innovations is likely to be contaminated. A second problem is that impulse responses can be observed only for the included variables, which generally constitute only a small subset of the variables that the researcher and policymaker care about. In this paper we investigate one potential solution to this limited information problem, which combines the standard structural VAR analysis with recent developments in factor analysis for large data sets. We find that the information that our factor-augmented VAR (FAVAR) methodology exploits is indeed important to properly identify the monetary transmission mechanism. Overall, our results provide a comprehensive and coherent picture of the effect of monetary policy on the economy.

Keywords: Monetary policy, factor-augmented vector autoregressive

FEDS 2004-02
Market Structure and Market Definition: The Case of Small Market Banks and Thrifts


This paper introduces a simple method to test between two general approaches to defining bank and thrift product markets. I estimate two models that endogenize market structure using data on banks and thrifts from 1,884 rural markets for the year 2000. The first model assumes that banks and thrifts are in "independent product markets," i.e., that bank profitability depends only on competition from other banks and that thrift profitability depends only on competition from other thrifts. An alternative model is then estimated assuming that banks and thrifts are "perfect strategic substitutes," i.e., that a bank's equilibrium profitability falls equally with the presence of another bank or an additional thrift (and vice-versa). A transformation of the likelihood for the "independent markets" model allows me to test it against the "perfect strategic substitutes" model using Vuong's (1989) non-nested likelihood ratio test. The hypothesis that banks and thrifts compete in independent product markets is soundly rejected against the hypothesis that banks and thrifts are perfect strategic substitutes.

Keywords: Non-nested hypothesis testing, bank competition, market definition

FEDS 2004-01
Monetary Policy in Deflation: The Liquidity Trap in History and Practice

Athanasios Orphanides


The experience of the U.S. economy during the mid-1930s, when short-term nominal interest rates were continuously close to zero, is sometimes taken as evidence that monetary policy was ineffective and the economy was in a "liquidity trap." Close examination of the historical policy record for the period indicates that the evidence does not support such assertions. The incomplete and erratic recovery from the Great Depression can be traced to a failure to pursue consistently expansionary policy resulting from an incorrect understanding of monetary policy in an environment of very low short-term nominal interest rates. Commonalities with the Japanese experience during the late 1990s and the inadequacy of short-term interest rates as indicators of the stance of monetary policy are discussed, and a robust operating procedure for implementing monetary policy in a low interest rate environment by adjusting the maturity of targeted interest rate instruments is described.

Keywords: Zero interest-rate bound, liquidity trap, Great Depression, Japan

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Last Update: June 30, 2022