FEDS 2007-68
Continuous Time Extraction of a Nonstationary Signal with Illustrations in Continuous Low-pass and Band-pass Filtering (PDF)

Tucker S. McElroy and Thomas M. Trimbur

Abstract: This paper sets out the theoretical foundations for continuous-time signal extraction in econometrics. Continuous-time modeling gives an effective strategy for treating stock and flow data, irregularly spaced data, and changing frequency of observation. We rigorously derive the optimal continuous-lag filter when the signal component is nonstationary, and provide several illustrations, including a new class of continuous-lag Butterworth filters for trend and cycle estimation.

Keywords: Continuous time processes, cycles, Hodrick-Prescott filter, linear filtering, signal extraction, turning points

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FEDS 2007-67
Nominal Mortgage Contracts and the Effects of Inflation on Portfolio Allocation (PDF)

Abstract: Households who wish to extract home equity through refinancing their mortgage face a hidden transaction cost. The real value of the fixed nominal mortgage payment declines over time with inflation. The change in the real value of the mortgage payments from taking on a new mortgage is positive and an increasing function of inflation; higher inflation thus discourages households from re-balancing their portfolio as frequently as they would otherwise. The life cycle model developed in this paper demonstrates how the share of total wealth held in housing is sensitive to the rate of inflation, even when perfectly anticipated. Households hold larger positions in home equity earlier in the life cycle and smaller positions later in the life cycle as the rate of inflation increases.

Keywords: Mortgages, inflation, portfolio allocation, life-cycle

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FEDS 2007-66
How Much Does Risk Tolerance Change? (PDF)

Abstract: Stability of preferences is central to how economists study behavior. This paper uses panel data on hypothetical gambles over lifetime income in the Health and Retirement Study to quantify changes in risk tolerance over time and differences across individuals. The maximum-likelihood estimation of a correlated random effects model utilizes information from 12,000 respondents in the 1992-2002 HRS. The results are consistent with constant relative risk aversion and career selection based on preferences. While risk tolerance changes with age and macroeconomic conditions, persistent differences across individuals account for 73% of the systematic variation.

Keywords: Risk tolerance, risk aversion, correlated random effects, interval regression

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FEDS 2007-65
Bank Core Deposits and the Mitigation of Monetary Policy (PDF)

Lamont Black, Diana Hancock, and Wayne Passmore

Abstract: We consider the business strategy of some banks that provide relationship loans (where they have loan origination and monitoring advantages relative to capital markets) with core deposit funding (where they can pass along the benefit of a sticky price on deposits). These "traditional banks" tend to lend out less than the deposits they take in, so they have a "buffer stock" of core deposits. This buffer stock of core deposits can be used to mitigate the full effect of tighter monetary policy on their bank-dependent borrowers. In this manner, the business strategy of "traditional banks" acts as a "core deposit mitigation channel" to provide funds to bank-dependent borrowers when there are monetary shocks. In effect, there is no bank lending channel of monetary policy associated with these traditional banks.

In contrast, other banks mainly rely on managed liabilities that are priced at market rates. These banks do not have to shift from insured deposits to managed liabilities in response to tighter monetary policy. At the margin, their loans are already funded with managed liabilities. For these banks as well, there is no unique bank lending channel of monetary policy.

The only banks that are likely to raise loan rates substantially in response to an increase in the federal funds rate are banks with a high proportion of relationship loans that are close to a loan-to-core deposit ratio of one. These banks must substitute higher cost nondeposit liabilities, which have an external finance premium, for core deposits, which do not because of deposit insurance. Some of these banks may also face higher marginal costs as their loan-to-core deposit ratio approaches one because of the costs associated with lending to default-prone relationship borrowers. It is among these banks (which we refer to as high relationship lenders), and only these banks, that we find evidence of a bank lending channel - they significantly reduce lending in response to a monetary contraction. Importantly, these banks hold only a small fraction of U.S. banking assets. Thus, in the United States, the bank lending channel seems limited in scope and importance, mainly because so few banks that specialize in relationship lending switch from core deposits to managed liabilities in response to changes in interest rates.

Keywords: Bank channel, monetary policy, banks, core deposits, relationship lending, interest rates

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FEDS 2007-64
Two Pitfalls of Linearization Methods (PDF)

Jinill Kim and Sunghyun Henry Kim

Abstract: This paper illustrates two types of pitfalls in using linearization methods. First, if constraints are linearized before deriving optimality conditions, the derived conditions are not correct up to first order. Second, even when the behavior of the economy is correct to the first order, applying this behavior to welfare implications may lead to incorrect results.

Keywords: Linearization, linear-quadratic method, second-order approximation, welfare

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FEDS 2007-63
Explaining a Productive Decade (PDF)

Stephen D. Oliner, Daniel E. Sichel, and Kevin J. Stiroh

Abstract: This paper analyzes the sources of U.S. productivity growth in recent years using both aggregate and industry-level data. We confirm the central role for information technology (IT) in the productivity revival during 1995-2000 and show that IT played a significant, though smaller, role after 2000. Productivity growth after 2000 appears to have been boosted by industry restructuring and cost cutting in response to profit pressures, an unlikely source of future strength. In addition, the incorporation of intangible capital into the growth accounting framework takes some of the luster off the performance of labor productivity since 2000 and makes the gain during 1995-2000 look larger than in the official data. Finally, we examine the outlook for trend growth in labor productivity; our estimate, though subject to much uncertainty, is centered at 2-1/4 percent a year, faster than the lackluster pace that prevailed before 1995 but somewhat slower than the 1995-2006 average.

Keywords: Productivity, information technology, total factor productivity, sources of growth, intangible capital

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FEDS 2007-62
Risk and Concentration in Payment and Securities Settlement Systems (PDF)

Abstract: Large value payment and securities settlement systems are important components of an economy's financial system. Many such systems are operated by central banks and are liquidity intensive. Central banks often provide inexpensive liquidity to facilitate settlement. This leads to a number of policy questions about the provision of such liquidity. To answer these questions, central banks need to understand what factors influence the timing of settlement. This paper offers a model to better understand intraday patterns of settlement and identifies three factors that influence the timing of settlement: the cost of intraday liquidity, a participant's exposure to settlement risk, and system design. Incorporating all three factors enables our model to explain a number of stylized facts concerning behavior within the Federal Reserve's Fedwire fund and securities systems around a major policy change. In particular, the model captures the different responses of the two systems in both the pattern of settlement and the use of intraday liquidity. The results map out how policy interacts with participants' incentives to influence the use of intraday liquidity and the resultant credit exposure of a central bank. The model, therefore, can inform decision-making at central banks.

Keywords: Interbank payments, securities settlement, strategic games, bank behavior

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FEDS 2007-61
The Evolution of Household Income Volatility (PDF)

Karen E. Dynan, Douglas W. Elmendorf, and Daniel E. Sichel

Abstract: Using data from the PSID, we find that household income has become noticeably more volatile during the past thirty years. We estimate that the standard deviation of percent changes in household income rose one-fourth between the early 1970s and early 2000s. This widening in the distribution of percent changes is concentrated in the tails of the distribution, and especially in the lower tail: Changes between the 25th and 75th percentiles are almost the same size now as thirty years ago, but changes at the 10th percentile look substantially more negative. The boost in volatility occurred throughout the 1970s, 1980s, and 1990s, albeit not at a steady pace. Households' labor earnings and transfer payments have both become more volatile over time.

Keywords: Household income, labor income, volatility, PSID, Great Moderation

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FEDS 2007-60
Gauging the Uncertainty of the Economic Outlook from Historical Forecasting Errors (PDF)

David Reifschneider and Peter Tulip

Abstract: Participants in meetings of the Federal Open Market Committee (FOMC) regularly produce individual projections of real activity and inflation that are published in summary form. These summaries indicate participants' views about the most likely course for the macroeconomy but, by themselves, are not enough to gauge the full range of possible outcomes -- that is, the uncertainty surrounding the outlook. To this end, FOMC participants will now provide qualitative assessments of how they view the degree of current uncertainty relative to that which prevailed on average in the past. This paper discusses a method for gauging the average magnitude of historical uncertainty using information on the predictive accuracy of a number of private and government forecasters. The results suggest that, if past performance is a reasonable guide to the accuracy of future forecasts, considerable uncertainty surrounds all macroeconomic projections, including those of FOMC participants.

Keywords: Uncertainty, forecasting, FOMC, monetary policy, prediction errors

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FEDS 2007-59
Hyperbolic Discounting and Uniform Savings Floors (PDF)

Benjamin A. Malin

Abstract: Previous research suggests that, in partial equilibrium, individuals whose decision-making exhibits a present-bias--such as hyperbolic discounters who tend to over-consume--will be in favor of having a floor imposed on their savings. In this paper, I show it is quite difficult for the introduction of a savings floor to be Pareto-improving in general equilibrium. Indeed, a necessary condition for the floor to be Pareto-improving is that it is high enough to be binding for all individuals. Even in that case, because the equilibrium interest rate is affected by the level of the savings floor, some individuals may prefer to commit to a future time path of consumption by facing a high interest rate (and no floor) rather than a high floor.

Keywords: Hyperbolic discounting, general equilibrium, commitment

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FEDS 2007-58
Imperfect Monitoring and the Discounting of Inside Money (PDF)

Abstract: One of the fundamental questions concerning inside money is whether its issuers should be regulated and how. This paper evaluates the efficiency of one prevalent regulatory recommendation -- a requirement that private issuers redeem inside money on demand at par -- in a random-matching model of money where the issuers of inside money are only imperfectly monitored. I find that for sufficiently imperfect monitoring, a par redemption requirement leads to lower social welfare than if private money were redeemed at a discount. A central message of the paper is that if inside money and outside money are not perfect substitutes for one another, as is the case if there is sufficiently imperfect monitoring, a par redemption requirement may not be socially optimal because such a requirement effectively binds them to circulate as if they are. Such an outcome is a version of Gresham's law that bad money drives out good money.

Keywords: Inside and outside money, electronic money, imperfect monitoring, Gresham's law

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FEDS 2007-57
Financial Market Perceptions of Recession Risk (PDF)

Thomas B. King, Andrew T. Levin, and Roberto Perli

Abstract: Over the Great Moderation period in the United States, we find that corporate credit spreads embed crucial information about the one-year-ahead probability of recession, as evidenced by both in- and out-of-sample fit. Furthermore, the incidence of "false positive" predictions of recession is dramatically reduced by utilizing a bivariate model that includes a measure of credit spreads along with the slope of the yield curve; indeed, these bivariate models provide much better forecasting performance than any combination of univariate models. We also find that optimal (Bayesian) model combination strongly dominates simple averaging of model forecasts in predicting recessions.

Keywords: Recession forecasting, yield curve, term spread, credit spread

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FEDS 2007-56
Welfare-Maximizing Monetary Policy under Parameter Uncertainty (PDF)

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

Abstract: This paper examines welfare-maximizing monetary policy in an estimated micro-founded general equilibrium model of the U.S. economy where the policymaker faces uncertainty about model parameters. Uncertainty about parameters describing preferences and technology implies not only uncertainty about the dynamics of the economy. It also implies uncertainty about the model's utility-based welfare criterion and about the economy's natural rate measures of interest and output. We analyze the characteristics and performance of alternative monetary policy rules given the estimated uncertainty regarding parameter estimates. We find that the natural rates of interest and output are imprecisely estimated. We then show that, relative to the case of known parameters, optimal policy under parameter uncertainty responds less to natural-rate terms and more to other variables, such as price and wage inflation and measures of tightness or slack that do not depend on natural rates.

Keywords: Technology shocks, monetary policy rules, natural rate of output, natural rate of interest

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FEDS 2007-55
Implied Interest Rate Skew, Term Premiums, and the "Conundrum" (PDF)

J. Benson Durham

Abstract: The skew, irrespective of the mean and variance, of investors' interest rate expectations may affect required bond yields over expected short rates. Indeed, evidence suggests that the near-term skew of the option-implied distribution of expected short-term interest rates correlates with distant-horizon term premiums, as derived from a latent-factor affine term structure model (ATSM). Reduced-form models that include skew generally fit the data well and actually better "explain" variation in the term premium during the so-called "conundrum" than during other periods of the May 1989 to May 2006 sample. Moreover, estimates suggest that skew accounts for over half of the movement in term premiums during the "conundrum," considerably more than any other correlate. Caveats regard the term structure of skew as well as alternative measures of the term premium. Indeed, regression analysis of movements in term premiums is plagued by specification bias on both the left- and right-hand-side of the equation.

Keywords: Implied skew, term premiums, affine term structure model, conundrum

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FEDS 2007-54
Reserve Requirement Systems in OECD Countries (PDF)

Yueh-Yun C. O'Brien

Abstract: This paper compares the reserve requirements of OECD countries. Reserve requirements are the minimum percentages or amounts of liabilities that depository institutions are required to keep in cash or as deposits with their central banks. To facilitate monetary policy implementation, twenty-four of the thirty OECD countries impose reserve requirements to influence their banking systems’ demand for liquidity. These include twelve OECD countries that are also members of the European Economic and Monetary Union (EMU) and twelve non-EMU OECD countries. All EMU countries employ a single reserve requirement system, which is treated as one entity.

The reserve requirement system for each of the twelve non-EMU countries is discussed separately. The similarities and differences among the thirteen reserve requirement systems are highlighted. The features of reserve requirements covered include: reservable liabilities, required reserve ratios, reserve computation periods, reserve maintenance periods, types of reserve requirements, calculations of required reserves, eligible assets for satisfying reserve requirements, remuneration on reserve balances, non-compliance penalties, carry-over of reserve balances, and required clearing balances.

Keywords: Reservable liabilities, required reserve ratios, reserve computation periods, reserve maintenance periods, lagged reserve requirements, remuneration

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FEDS 2007-53
Documentation of the Research and Statistics Division's Estimated DSGE Model of the U.S. Economy: 2006 Version (PDF)

Abstract: This paper provides documentation for the large-scale estimated DSGE model of the U.S. economy used in Edge, Kiley, and Laforte (2007). The model represents part of an ongoing research project (the Federal Reserve Board's Estimated, Dynamic, Optimization-based--FRB/EDO--model project) in the Macroeconomic and Quantitative Studies section of the Federal Reserve Board aimed at developing a DSGE model that can be used to address practical policy questions and the model documented here is the version that was current at the end of 2006. The paper discusses the model's specification, estimated parameters, and key properties.

Keywords: Two-sector growth model, sticky-prices, sticky-wages, habit-persistence, investment adjustment costs, variable utilization, Bayesian estimation

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FEDS 2007-52
Do High Debt Payments Hinder Household Consumption Smoothing? (PDF)

Abstract: Recently, U.S. households have committed a rising share of disposable personal income to required principal and interest payments on household debt. Studies of the direct link between the household debt service ratio (DSR) and consumption show mixed results—perhaps because debt may instead alter the relationship between consumption and income. We explore this possibility by comparing the consumption smoothing behavior of households over the DSR distribution. We find that a high DSR alone does not indicate higher sensitivity of consumption to a change in income. However, we find evidence that the DSR may help identify borrowing constrained households. In particular, the consumption of households with low liquid assets and high DSRs is more sensitive than the consumption of other low liquid asset households. Although this effect of high DSR is not precisely estimated, it is large and robust to changes in the specification, suggesting that more work is warranted.

Keywords: Household debt, consumer finance, consumer spending

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FEDS 2007-51
The Effects of Past Entry, Market Consolidation, and Expansion by Incumbents on the Probability of Entry (PDF)

Abstract: The threat of entry is an important factor in the evaluation of the potential competitive effects of proposed mergers and acquisitions. In the evaluation of proposed bank mergers, a high probability of entry, or strong potential competition, is often found to mitigate the potential anticompetitive effect of a proposed horizontal merger. Because the probability of entry is not directly observed for each local market, variables such as per capita income, population growth and past entry are typically used to predict the probability of future entry. This study extends previous research on the determinants of entry into local banking markets. In addition to variables considered by past research, such as market demographic characteristics, branching deregulation and past merger activity, this study considers the effects on future entry of past entry and strategic barriers to entry, which are proxied by changes in incumbent branching, the presence of small incumbent firms and market concentration. The analysis uses data that allow a broader definition of entry than that used in most past research. In most of the previous studies, bank entry is defined as the creation of a new banking institution. We show that this definition is problematic and misses entry due to branch network extension by existing banks, which is substantial. Results of our analysis are consistent with past research where past research exists. In addition, we find significant negative relationships between strategic barriers to entry and entry. Assessment of the quantitative significance of the results, however, finds that very large changes in the explanatory variables are needed to cause substantial changes in the probability of entry into banking markets.

Keywords: Banking, industrial organization, entry, competition

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FEDS 2007-50
Choice of Mortgage Contracts: Evidence from the Survey of Consumer Finances (PDF)

Abstract: This study revisits the empirical question of the determinants of the choice between fixed and adjustable-rate mortgages using more comprehensive data from the Survey of Consumer Finances (SCF) that overcome some of the data limitations in previous studies. The results from a Logit model of mortgage choice indicate that pricing variables and affordability are important considerations. We also find that factors such as mobility expectations, income volatility, and attitudes toward financial risk largely influence mortgage choice, with more risk-averse borrowers preferring fixed-rate mortgages. For households that are less risk averse, the mortgage type choice decision is less sensitive to pricing variables and income volatility, and affordability factors are not significant. These findings provide empirical support that underscore the importance of attitudes toward risks in mortgage choice.

Keywords: Mortgage contracts, risk aversion, household finance, fixed-rate, adjustable-rate

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FEDS 2007-49
Operational Problems and Aggregate Uncertainty in the Federal Funds Market (PDF)

Abstract: This paper uses operational problems at commercial banks in sending Fedwire payments as a proxy for aggregate uncertainty in end-of-day Fed account positions and then examines funds market behavior on those days. The results suggest that increased uncertainty is associated with a deviation of the federal funds rate from the FOMC’s target rate, the magnitude depending on the severity of the difficulty, the payment volume of the affected participant, and the time of day. Moreover, discount window borrowing picks up on days with operational difficulties. These effects are generally transitory, and markets revert back to previous levels the next day.

Keywords: Federal funds market, monetary policy implementation, payment systems

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FEDS 2007-48
Habit Persistence, Non-separability Between Consumption and Leisure, or Rule-of-Thumb Consumers: Which Accounts for the Predictability of Consumption Growth? (PDF)

Abstract: Consumption growth is predictable, a basic violation of the permanent-income hypothesis. This paper examines three possible explanations: rule-of-thumb behavior, in which households allow consumption to track per-period income flows rather than permanent income; habit persistence; and non-separability in preferences over consumption and leisure. The data appear most consistent with non-separable preferences over consumption and leisure.

Keywords: Habit persistence, inattention, excess sensitivity, excess smoothness

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FEDS 2007-47
Credit Derivatives and Risk Management (PDF)

Abstract: The striking growth of credit derivatives suggests that market participants find them to be useful tools for risk management. I illustrate the value of credit derivatives with three examples. A commercial bank can use credit derivatives to manage the risk of its loan portfolio. An investment bank can use credit derivatives to manage the risks it incurs when underwriting securities. An investor, such as an insurance company, asset manager, or hedge fund, can use credit derivatives to align its credit risk exposure with its desired credit risk profile.

However, credit derivatives pose risk management challenges of their own. I discuss five of these challenges. Credit derivatives can transform credit risk in intricate ways that may not be easy to understand. They can create counterparty credit risk that itself must be managed. Complex credit derivatives rely on complex models, leading to model risk. Credit rating agencies interpret this complexity for investors, but their ratings can be misunderstood, creating rating agency risk. The settlement of a credit derivative contract following a default can have its own complications, creating settlement risk. For the credit derivatives market to continue its rapid growth, market participants must meet these risk management challenges.

Keywords: Credit risk, credit index tranches, counterparty risk, rating agencies, model risk

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FEDS 2007-46
Cracking the Conundrum (PDF)

David Backus and Jonathan H. Wright

Abstract: From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle.

Keywords: Yield curve, forward rates, volatility, term premium, affine models, monetary policy

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FEDS 2007-45
Does Health Affect Portfolio Choice? (PDF)

Paul Smith and David Love

Abstract: Previous studies find a strong and positive empirical connection between health status and the share of risky assets held in household portfolios. But is this relationship truly causal, in the sense that households respond to changes in health by altering their portfolio allocation, or does it simply reflect unobserved differences across households? We find that most of the variation by health is on the extensive margin of stock ownership (rather than the marginal allocation conditional on ownership), which more plausibly points to non-causal explanations. Moreover, we find that any link between health and risky assets depends crucially on the econometric treatment of unobserved heterogeneity. Once we account adequately for unobserved household differences, there is no longer a statistically significant relationship between any of our health measures and household portfolio decisions.

Keywords: Household portfolios, health, risk

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FEDS 2007-44
Will Monetary Policy Become More of a Science? (PDF)

Frederic S. Mishkin

Abstract: This paper reviews the progress that the science of monetary policy has made over recent decades. This progress has significantly expanded the degree to which the practice of monetary policy reflects the application of a core set of "scientific" principles. However, there remains, and will likely always remain, elements of art in the conduct of monetary policy.

Keywords: Central banking, monetary policy

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FEDS 2007-43
Combining Forecasts From Nested Models (PDF)

Todd E. Clark and Michael W. McCracken

Abstract: Motivated by the common finding that linear autoregressive models forecast better than models that incorporate additional information, this paper presents analytical, Monte Carlo, and empirical evidence on the effectiveness of combining forecasts from nested models. In our analytics, the unrestricted model is true, but as the sample size grows, the data generating process converges to the restricted model. This approach captures the practical reality that the predictive content of variables of interest is often low. We derive MSE-minimizing weights for combining the restricted and unrestricted forecasts. Monte Carlo and empirical analyses verify the practical effectiveness of our combination approach.

Keywords: Forecast combination, predictability, forecast evaluation

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FEDS 2007-42
Averaging Forecasts from VARs with Uncertain Instabilities (PDF)

Todd E. Clark and Michael W. McCracken

Abstract: A body of recent work suggests commonly-used VAR models of output, inflation, and interest rates may be prone to instabilities. In the face of such instabilities, a variety of estimation or forecasting methods might be used to improve the accuracy of forecasts from a VAR. These methods include using different approaches to lag selection, different observation windows for estimation, (over-) differencing, intercept correction, stochastically time-varying parameters, break dating, discounted least squares, Bayesian shrinkage, and detrending of inflation and interest rates. Although each individual method could be useful, the uncertainty inherent in any single representation of instability could mean that combining forecasts from the entire range of VAR estimates will further improve forecast accuracy. Focusing on models of U.S. output, prices, and interest rates, this paper examines the effectiveness of combination in improving VAR forecasts made with real-time data. The combinations include simple averages, medians, trimmed means, and a number of weighted combinations, based on: Bates-Granger regressions, factor model estimates, regressions involving forecast quartiles, Bayesian model averaging, and predictive least squares-based weighting. Our goal is to identify those approaches that, in real time, yield the most accurate forecasts of these variables. We use forecasts from simple univariate time series models as benchmarks.

Keywords: Forecast combination, real-time data, prediction, structural change

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FEDS 2007-41
Forecasting with Small Macroeconomic VARs in the Presence of Instabilities (PDF)

Todd E. Clark and Michael W. McCracken

Abstract: Small-scale VARs are widely used in macroeconomics for forecasting U.S. output, prices, and interest rates. However, recent work suggests these models may exhibit instabilities. As such, a variety of estimation or forecasting methods might be used to improve their forecast accuracy. These include using different observation windows for estimation, intercept correction, time-varying parameters, break dating, Bayesian shrinkage, model averaging, etc. This paper compares the effectiveness of such methods in real time forecasting. We use forecasts from univariate time series models, the Survey of Professional Forecasters and the Federal Reserve Board's Greenbook as benchmarks.

Keywords: Real-time data, prediction, structural change

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FEDS 2007-40
Housing and the Monetary Transmission Mechanism (PDF)

Frederic S. Mishkin

Abstract: The housing market is of central concern to monetary policy makers. To achieve the dual goals of price stability and maximum sustainable employment, monetary policy makers must understand the role that housing plays in the monetary transmission mechanism if they are to set policy instruments appropriately. In this paper, I examine what we know about the role of housing in the monetary transmission mechanism and then explore the implications of this knowledge for the conduct of monetary policy. I begin with a theoretical and empirical review of the main housing-related channels of the transmission mechanism. These channels include the ways interest rates directly influence the user cost of housing capital, expectations of future house-price movements, and housing supply; and indirectly influence the real economy through standard wealth effects from house prices, balance sheet, credit-channel effects on consumer spending, and balance sheet, credit-channel effects on housing demand. I then consider the interaction of financial stability with the monetary transmission mechanism, and discuss the ways in which the housing sector might be a source of financial instability, and whether such instability could affect the ability of a central bank to stabilize the overall macroeconomy. I conclude with a discussion of two key policy issues. First, how can monetary policy makers deal with the uncertainty with regard to housing-related monetary transmission mechanisms? And second, how can monetary policy best respond to fluctuations in asset prices, especially house prices, and to possible asset-price bubbles?

Keywords: Housing, monetary transmission mechanism, monetary policy, financial stability

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FEDS 2007-39
An Efficiency Perspective on the Gains from Mergers and Asset Purchases (PDF)

Sugata Ray and Missaka Warusawitharana

Abstract: A simple efficiency-based view states that acquisitions shift assets to more productive owners. This implies that expected returns from acquisitions increase with transaction value. We propose using the sensitivity of abnormal returns to scaled transaction value as a measure of efficiency gains. Using this method, we find that the average acquirer obtains an increase of 3% - 5% in the value of the acquired assets. However, efficiency gains vary sharply across acquirer and deal characteristics. We find statistical significance for interactions of relative value and variables known to affect acquirer normal returns. The inclusion of the interaction term sometimes drives away the significance of the variable of interest. These results suggest that improving productivity via capital reallocation plays an important role in understanding acquirer returns from acquisitions.

Keywords: Acquisitions, efficiency gains, event study

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FEDS 2007-38
Transaction Costs and Consumption (PDF)

Abstract: The Rational Expectations Permanent Income Hypothesis (RE-PIH) fails to explain several features of consumption behavior documented by previous researchers. First, the marginal propensity to consume (MPC) out of unanticipated income shocks tends to decrease as the size of the shocks becomes larger. Second, the MPC out of small income shocks is well above what the RE-PIH predicts. Third, consumption responds to small anticipated income changes, but not to large ones. This paper argues that these findings can be reconciled within a RE-PIH framework that includes a cash-in-advance constraint. In the model, the representative agent is assumed to be fully rational with perfect information and is able to borrow against future income. The agent can hold cash and interest-bearing assets, but has to pay a fixed transaction cost to transfer wealth between cash and assets. I show that the agent follows an s-S rule with respect to cash holdings in making wealth-transfer decisions. The MPC within the no-transfer band is higher than that out of the band. It can be lower than or exactly equal to 1. The model also predicts that agents smooth consumption in response to news of large future income changes but not to small ones. Furthermore the model sheds light on the demand for liquid assets and the equity premium puzzle.

Keywords: Transaction costs, marginal propensity to consume, consumption sensitivity

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FEDS 2007-37
The Rise in U.S. Household Indebtedness: Causes and Consequences (PDF)

Karen E. Dynan and Donald L. Kohn

Abstract: The ratio of total household debt to aggregate personal income in the United States has risen from an average of 0.6 in the 1980s to an average of 1.0 so far this decade. In this paper we explore the causes and consequences of this dramatic increase. Demographic shifts, house price increases, and financial innovation all appear to have contributed to the rise. Households have become more exposed to shocks to asset prices through the greater leverage in their balance sheets, and more exposed to unexpected changes in income and interest rates because of higher debt payments relative to income. At the same time, an increase in access to credit and higher levels of assets should give households, on average, a greater ability to smooth through shocks. We conclude by discussing some of the risks associated with some households having become very highly indebted relative to their assets.

Keywords: Household debt, consumer finance, personal saving

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FEDS 2007-36
Why Do Firms Offer Risky Defined Benefit Pension Plans? (PDF)

David A. Love, Paul A. Smith, and David Wilcox

Abstract: Even risky pension sponsors could offer essentially riskless pension promises by contributing a sufficient level of resources to their pension trust funds and by investing those resources in fixed-income securities designed to deliver their payoffs just as pension obligations are coming due. However, almost no firm has chosen to fund its plan in this manner. We study the optimal funding choice for plan sponsors by developing a simple model of pension financing in which the total compensation offered to workers must clear the labor market. We find that if workers understand the implications of pension risk, they will demand greater compensation for riskier pension promises than for safer ones, all else equal. Indeed, in our model, pension sponsors maximize their value by making their pension promises free of risk. We close by positing some explanations for why no real-world firm follows the prescription of our model.

Keywords: Pensions, risk, compensation, corporate finance

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FEDS 2007-35
Executive Compensation: A New View from a Long-Term Perspective, 1936-2005 (PDF)

Carola Frydman and Raven E. Saks

Appendix associated with the version forthcoming in the Review of Financial Studies: Appendix (PDF) | Appendix (Screen Reader Version)

Abstract: We analyze the long-run trends in executive compensation using a new panel dataset of top executives in large firms from 1936 to 2005. In sharp contrast to the well-known steep upward trajectory of pay of the past 30 years, the median real value of compensation was remarkably flat from the late 1940s to the mid-1970s, highlighting a weak relationship between compensation and aggregate firm size. While this correlation has changed considerably over the century, the cross-sectional relationship between pay and firm size has remained stable. Another surprising finding is that the sensitivity of changes in an executive's wealth to firm performance was not inconsequentially small for most of our sample period. Thus, recent years were not the first time when compensation arrangements served to align managerial incentives with those of shareholders. Overall, these trends pose a challenge to several common explanations for the recent surge in executive pay.

Keywords: Migration, business cycles

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FEDS 2007-34
News, Noise, and Estimates of the "True" Unobserved State of the Economy (PDF)

Dennis J. Fixler and Jeremy J. Nalewaik

Abstract: Which provides a better estimate of the "true" state of the U.S. economy, gross domestic product (GDP) or gross domestic income (GDI)? Past work has assumed the idiosyncratic variation in each estimate is pure noise, taking greater variability to imply lower reliability. We develop models that relax this assumption, allowing the idiosyncratic variation in the estimates to be partly or pure news; then greater variability may imply higher information content and greater reliability. Based on evidence from revisions, we reject the pure noise assumption for GDI growth, and our results favor placing a higher weight on GDI due to its relatively large idiosyncratic variability. This calls into question the suitability of the pure noise assumption in other contexts, including dynamic factor models.

Keywords: GDP, statistical discrepancy, news and noise, signal-to-noise ratios, optimal combination of estimates, business cycles

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FEDS 2007-33
Robust Monetary Policy with Imperfect Knowledge (PDF)

Athanasios Orphanides and John C. Williams

Abstract: We examine the performance and robustness properties of monetary policy rules in an estimated macroeconomic model in which the economy undergoes structural change and where private agents and the central bank possess imperfect knowledge about the true structure of the economy. Policymakers follow an interest rate rule aiming to maintain price stability and to minimize fluctuations of unemployment around its natural rate but are uncertain about the economy's natural rates of interest and unemployment and how private agents form expectations. In particular, we consider two models of expectations formation: rational expectations and learning. We show that in this environment the ability to stabilize the real side of the economy is significantly reduced relative to an economy under rational expectations with perfect knowledge. Furthermore, policies that would be optimal under perfect knowledge can perform very poorly if knowledge is imperfect. Efficient policies that take account of private learning and misperceptions of natural rates call for greater policy inertia, a more aggressive response to inflation, and a smaller response to the perceived unemployment gap than would be optimal if everyone had perfect knowledge of the economy. We show that such policies are quite robust to potential misspecification of private sector learning and the magnitude of variation in natural rates.

Keywords: Monetary Policy, natural rate misperceptions, rational expectations, learning

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FEDS 2007-32
Labor Reallocation over the Business Cycle: New Evidence from Internal Migration (PDF)

Raven E. Saks and Abigail Wozniak

Abstract: This paper establishes the cyclical properties of a novel measure of worker reallocation: long-distance migration rates within the U.S. This internal migration offers a bird's eye view of worker reallocation in the economy, as long-distance migrants often change jobs or employment status. We examine gross migration patterns during the entire postwar era using historical reports of the Current Population Survey, and supplement this analysis with statistics compiled by the Internal Revenue Service on inter-state and inter-metropolitan population flows since 1975. We find that internal migration within the U.S. is strongly procyclical, even after accounting for variation in relative local economic conditions. This procyclicality is common across most major demographic and labor force groups, although it is strongest for younger workers. Our findings suggest that cyclical fluctuations in internal migration are driven by economy-wide changes in the net cost to worker reallocation with a major role for the job finding rate of young workers.

Keywords: Migration, Business Cycles

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FEDS 2007-31
Federal Home Loan Bank Advances and Commercial Bank Portfolio Composition (PDF)

W. Scott Frame, Diana Hancock, and Wayne Passmore

Abstract: The primary mission of the 12 cooperatively owned Federal Home Loan Banks (FHLBs) is to provide their members financial products and services to assist and enhance member housing finance. In this paper, we consider the role of the FHLBs' traditional product--"advances," or collateralized loans to members--in stabilizing commercial bank members' residential mortgage lending activities.

Our theoretical model shows that using membership criteria (such as a minimum of 10 percent of the portfolio being in mortgage-related assets) or using mortgage-related assets as collateral does not ensure that FHLB advances will be put to use for stabilizing members' financing of housing. Indeed, our model demonstrates that advances--a relatively low cost managed liability--are most likely to influence lending only when such liabilities are used to finance "relationship" loans (i.e., loans to bank-dependent borrowers) that will be held on a bank's balance sheet and are least likely to influence lending for loans where the loan rate is heavily influenced by securitization activities, like mortgages.

Using panel vector autoregression (VAR) techniques, we estimate recent dynamic responses of U.S. bank portfolios to FHLB advance shocks, to bank lending shocks, and to macroeconomic shocks. Our empirical findings are consistent with the predictions of our theoretical model. First, recent bank portfolio responses to FHLB advance shocks are of similar magnitude for mortgages, for commercial and industrial loans, and for other real estate loans. This suggests that advances are just as likely to fund other types of bank credit as to fund single-family mortgages. Second, unexpected changes in all types of bank lending are accommodated using FHLB advances. Third, FHLB advances do not appear to reduce variability in bank residential mortgage lending resulting from macroeconomic shocks. However, some banks appear to have used FHLB advances to reduce variability in commercial and industrial lending in response to such macroeconomic shocks. Thus, relatively low cost managed liabilities may be used to finance "relationship" borrowers (which are typically business borrowers, rather than residential mortgage borrowers), although this use for advances appears to have diminished over time.

Keywords: Advances, Government-Sponsored Enterprises, GSE, Portfolio shocks, Panel-VAR

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FEDS 2007-30
Employer-to-Employer Flows in the United States: Estimates Using Linked Employer-Employee Data (PDF)

Melissa Bjelland, Bruce Fallick, John Haltiwanger, and Erika McEntarfer

Abstract: We use administrative data linking workers and firms to study employer-to-employer flows. After discussing how to identify such flows in quarterly data, we investigate their basic empirical patterns. We find that the pace of employer-to-employer flows is high, representing about 4 percent of employment and 30 percent of separations each quarter. The pace of employer-to-employer flows is highly procyclical, and varies systematically across worker, job and employer characteristics. Our findings regarding job tenure and earnings dynamics suggest that for those workers moving directly to new jobs, the new jobs are generally better jobs; however, this pattern is highly procyclical. There are rich patterns in terms of origin and destination of industries. We find somewhat surprisingly that more than half of the workers making employer-to-employer transitions switch even broadly-defined industries (NAICS super-sectors).

Keywords: Employer-to-employer flows, jobs flows, worker flows, turnover

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FEDS 2007-29
Bank Commercial Loan Fair Value Practices (PDF)

John Tschirhart, James O'Brien, Michael Moise, and Emily Yang

Abstract: Recent accounting changes, for the first time, permit the use of fair value in the primary financial statements for held-to-maturity (HTM) bank loans. While the use of fair value has historically attracted significant discussion and debate, there is little information in the public domain on how banks would measure fair value or use it in loan management. This study presents and analyzes results from in-depth discussions with seven large internationally-active banks on their fair value use and measurement for HTM commercial loans and commitments. The objectives of the discussions and those of the study are to: identify the extent to which fair value is used for HTM commercial loan facilities and how it is used; describe valuation methodologies used and consider the roles of market price sources and modeling and their relative importance in fair value estimation; consider model validation and price verification; draw conclusions as permitted and suggest areas for future research.

Keywords: Commercial banks, Commercial loan fair valuation

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FEDS 2007-28
Racial Dispersion in Consumer Credit Interest Rates (PDF)

Wendy Edelberg

Abstract: Most of the literature exploring racial disparities in consumer credit markets focuses on the issue of access to loans. But the disparate terms on which loans are issued are equally revealing. In this paper, I examine disparities in a variety of consumer loan interest rates using a reduced-form framework. I find that interest rates on loans issued before the 1995 show a statistically significant degree of unexplained racial heterogeneity even after controlling for the financial costs of issuing debt. However, racial dispersion in rates falls off for loans originated after 1995.

The unexplainable racial disparity in consumer loan rates issued before 1995 implies that in this earlier period minorities faced unaccountably higher interest-rate premiums on the order of--in two examples--20 basis points for first mortgages and 80 basis points for automobile loans. Overall, evidence of unexplainable racial dispersion in interest rates is more robust among homeowners than renters.

Keywords: Consumer debt, Consumer loan terms, racial discrimination

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FEDS 2007-27
Corporate Asset Purchases and Sales: Theory and Evidence (PDF)

Abstract: Purchases and sales of operating assets by firms generated $162 billion for shareholders over the past 20 years. This contrasts sharply with the evidence on mergers. This paper characterizes the behavior of value-maximizing firms, which may grow organically, purchase existing assets or sell assets. The approach yields an endogenous selection model that links asset purchases and sales to fundamental properties of the firm. Empirical tests confirm the predictions of the model. In particular, return on assets and size strongly predict when firms purchase or sell assets, and the transaction size covaries with the value of capital employed by the firm. These findings indicate that corporate asset purchases and sales are consistent with efficient investment decisions.

Keywords: Acquisitions, asset sales, Tobin's Q, selection models

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FEDS 2007-26
The Rise and Fall of U.S. Inflation Persistence (PDF)

Meredith Beechey and Par Osterholm

Abstract: This paper estimates the path of inflation persistence in the United States over the last 50 years and draws implications about the evolution of the Federal Reserve's monetary-policy preferences. Standard models of central-bank optimization predict persistent inflation outcomes. Time variation of the central bank's preference for output stability should be reflected in changes in inflation persistence. We estimate an ARMA(1,q) model with a time-varying autoregressive parameter for monthly U.S. inflation data from 1955 to 2006. The coefficients provide an estimate of the inflation target and the path of inflation persistence. The estimated inflation target over the sample is approximately 2.8 percent and we find that inflation persistence declined substantially during Volcker and Greenspan's tenures to a level significantly less than one and significantly below that of the 1970s and early 1980s.

Keywords: Monetary policy, central bank preferences, inflation persistence, time-varying parameters, Kalman filter

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FEDS 2007-25
The 'Elusive' Capital-User Cost Elasticity Revisited (PDF)

Abstract: This paper sheds new light on the estimation of the long-run elasticity of the demand for business capital--for a measure that includes both equipment and structure--to changes in its user cost using a quarterly panel of two-digit manufacturing industries from South Africa from 1970 to 2000. For a variety of regression specifications, we find highly significant estimates of the user cost elasticity in the vicinity of -1.0 as implied by a Cobb-Douglas production function. These estimates contrast sharply with many previous studies that obtained small and/or statistically insignificant estimates of the user cost elasticity. This difference in findings may owe to the fact that the capital demand curve is better identified in a small open economy because shocks to capital supply are more likely to be exogenous. The economic embargo imposed on South Africa from 1985 to early 1994 temporarily forced its economy to become more closed and therefore provides a unique opportunity to assess the importance of identification in the estimation of the user cost elasticity. We find that the estimated magnitude of the user cost elasticity is considerably smaller over the embargo period. These findings suggest that the true elasticity is in the vicinity of the Cobb-Douglas benchmark, and that identification is important to uncovering this estimate.

Keywords: User cost elasticity, fixed investment, capital accumulation, price of capital, interest rate

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FEDS 2007-24
Sectoral Productivity in the United States: Recent Developments and the Role of IT (PDF)

Carol Corrado, Paul Lengermann, Eric J. Bartelsman, and J. Joseph Beaulieu

Abstract: This paper introduces new estimates of recent productivity developments in the United States, using an appropriate theoretical framework for aggregating industry MFP to sectors and the total economy. Our work sheds light on the sources of the continued strong performance of U.S. productivity since 2000. We find that the major sectoral players in the late 1990s pickup were not contributors to the more recent surge in productivity. Rather, striking gains in MFP in the finance and business service sector, a resurgence in MFP growth in the industrial sector, and an end to drops elsewhere more than account for the aggregate acceleration in productivity in recent years. Further, some evidence is found for a link between IT intensity and the recent productivity acceleration.

Keywords: Economic growth, aggregate productivity, sectoral productivity, industry productivity, information technology, and productivity

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FEDS 2007-23
Incorporating Vintage Differences and Forecasts into Markov Switching Models (PDF)

Abstract: This paper discusses extensions of standard Markov switching models that allow estimated probabilities to reflect parameter breaks at or close to the end of the sample, too close for standard maximum likelihood techniques to produce precise parameter estimates. The basic technique is a supplementary estimation procedure, bringing additional information to bear to estimate the statistical properties of the end-of-sample observations that behave differently from the rest. Empirical results using real-time data show that these techniques improve the ability of a Markov switching model based on GDP and GDI to recognize the start of the 2001 recession.

Keywords: Recessions, Markov Switching Models

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FEDS 2007-22
Bond Risk Premia and Realized Jump Volatility (PDF)

Jonathan Wright and Hao Zhou

Abstract: We find that adding a measure of market jump volatility risk to a regression of excess bond returns on the term structure of forward rates nearly doubles the R2 of the regression. Our market jump volatility measure is based on the realized jumps identified from high-frequency stock market returns using the bi-power variation technique. The significant enhancement of bond return predictability is robust to different forecasting horizons, to using non-overlapping returns and to the choice of different window sizes in computing the jump volatility. This market jump volatility factor also crowds out the price-dividend ratio in explaining much of the countercyclical movement in bond risk premia. We argue that this finding provides support for the unspanned stochastic volatility hypothesis according to which the conditional distribution of excess bond returns is affected by state variables that are not in the span of the term structure of yields and forward rates.

Keywords: Unspanned Stochastic Volatility, Expected Excess Bond Returns, Expectations Hypothesis, Countercyclical Risk Premia, Realized Jump Volatility, Bi-Power Variation

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FEDS 2007-21
The Contribution of Multinational Corporations to U.S. Productivity Growth, 1977-2000 (PDF)

Carol Corrado, Paul Lengermann, and Larry Slifman

Abstract: In this paper, we decompose aggregate labor productivity growth in order to gauge the relative importance of multinational corporations (MNCs) to the economic performance of the United States in the 1990s. As we define it, the MNC sector refers to the U.S. activities of multinational corporations operating in the United States. We develop productivity estimates for MNCs using (1) published and unpublished industry-level data from two surveys conducted by the Bureau of Economic Analysis and (2) productivity data for industries and major sectors from the FRB productivity system (Bartelsman and Beaulieu 2003, 2004). The resulting MNC sector accounted for about 40 percent of the gross product of all nonfinancial corporations and all of the pickup in nonfinancial corporate labor productivity in the late 1990s. Accordingly, the MNC sector accounted for more than half of the acceleration in labor productivity growth of all U.S. nonfarm private businesses.

Keywords: Productivity, multinational corporations, nonfinancial corporations

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FEDS 2007-20
Sources and Uses of Equity Extracted from Homes (PDF)

Alan Greenspan and James Kennedy

Abstract: In this paper, we present estimates of the disposition of the free cash generated by home equity extraction to finance consumer spending, outlays for home improvements, debt repayment, acquisition of assets, and other uses. We estimate free cash as cash available net of closing costs and repayment of other mortgage debt. We also have extended the quarterly data series for gross equity extraction, presented in our earlier paper, back to 1968.

Keywords: Macroeconomics, personal consumption, home equity extraction

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FEDS 2007-19
The Value Of Medicare Managed Care Plans and Their Prescription Drug Benefits (PDF)

Anne E. Hall

Abstract: I estimate the welfare, both gross and net, provided by the Medicare managed care program in 1999 through 2002. First, I estimate a model of demand for the benefits offered by managed care plans to Medicare beneficiaries. I then use the demand estimates to form estimates of welfare provided by the program. Medicare beneficiaries derived $14.9 billion of gross welfare per year from the Medicare HMO program. Depending on the amount of selection in the program, the Medicare managed care program provided from -$10.3 billion to $35.1 billion of net welfare total over the four-year period. I also estimate the welfare that beneficiaries receive from the prescription drug benefits offered by Medicare HMOs. HMO enrollees in plans offering drugs received on average $13 of consumer surplus per month from the drug benefits in 1999, and this estimate drops to $10 by 2002.

Keywords: Medicare, demand analysis, prescription drug, health insurance

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FEDS 2007-18
Taylor Rules (PDF)

Athanasios Orphanides

Abstract: Taylor rules are simple monetary policy rules that prescribe how a central bank should adjust its interest rate policy instrument in a systematic manner in response to developments in inflation and macroeconomic activity. This paper reviews the development and characteristics of Taylor rules in relation to alternative monetary policy guides and discusses their role for positive and normative monetary policy analysis.

Keywords: Monetary policy, simple rules

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FEDS 2007-17
Do Households Have Enough Wealth for Retirement? (PDF)

David A. Love, Paul A. Smith, and Lucy C. McNair

Abstract: Dramatic structural changes in the U.S. pension system, along with the impending wave of retiring baby boomers, have given rise to a broad policy discussion of the adequacy of household retirement wealth. We construct a uniquely comprehensive measure of wealth for households aged 51 and older in 2004 that includes expected wealth from Social Security, defined benefit pensions, life insurance, annuities, welfare payments, and future labor earnings. Abstracting from the uncertainty surrounding asset returns, length of life and medical expenses, we assess the adequacy of wealth using two expected values: an annuitized value of comprehensive wealth and the ratio of comprehensive wealth to the actuarial present value of future poverty lines. We find that most households in these older cohorts can expect to have sufficient total resources to finance adequate consumption throughout retirement, taking as given expected lifetimes and current Social Security benefits. We find a median annuity value of wealth equal to $32,000 per person per year in expected value and a median ratio of comprehensive wealth to poverty-line wealth of 3.56. About 12 percent of households, however, do not have sufficient wealth to finance consumption equal to the poverty line over their expected lifetimes, even after including the value of Social Security and welfare benefits, and an additional 9 percent can expect to be relatively close to the poverty line.

Keywords: Household saving, household wealth, retirement, Social Security, pensions, poverty

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FEDS 2007-16
Studying Consumption with the Panel Study of Income Dynamics: Comparisons with the Consumer Expenditure Survey and an Application to the Intergenerational Transmission of Well-being (PDF)

Kerwin Kofi Charles, Sheldon Danziger, Geng Li, and Robert F. Schoeni

Abstract: Beginning in 1999, the Panel Study of Income Dynamics (PSID) added new questions about several categories of consumption expenditure. The PSID now covers items that constitute more than seventy percent of total expenditure measured in the Consumer Expenditure Survey (CE). We show that expenditure for each of the broad categories in the PSID aligns closely with corresponding measures from the CE. Using the new PSID data, we impute total expenditure in the PSID and show that this is also very close to total measured CE expenditure. For several distinct categories and for total consumption, we show that cross-sectional life cycle estimates of household expenditure activity are very similar across the two surveys. Finally, we illustrate the unique research value of the PSID for studying consumption by exploiting the survey's longitudinal design and genealogical structure to estimate the intergenerational elasticity of consumption expenditure, which is found to be in the range of 0.32-0.34.

Keywords: Panel Study of Income Dynamics, Consumer Expenditure Survey, Intergenerational Consumption Correlation

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FEDS 2007-15
Learning By Investing--Embodied Technology and Business Cycles (PDF)

Abstract: In the last decade of the 20th century, the U.S. economy witnessed a persistent and substantial increase in private investment. The boom was sharply reversed in 2001, and a great deal of evidence suggests that the capital stock had become excessive. Standard equilibrium business cycle models have difficulties in predicting the investment boom and overshooting. An embodied technology model is constructed to replicate the pattern of investment boom and collapse. Unlike previous models of embodiment, the present model assumes that new technology increases the productivity of capital of all vintages, but only new capital can facilitate the adoption of the new technology. Further, although agents in this model know about the advent of a new technology, they have imperfect information about its magnitude. Agents learn the magnitude by investing in new capital. I present a sufficient condition for having a persistent investment boom and overshooting. I also solve the model numerically in a dynamic general equilibrium (DGE) setup. The model presented in this paper extends the standard DGE business cycle models in two ways: First, it presents a strong internal propagation mechanism with respect to technology shocks; second, it generates endogenous recessions without invoking technological regress. The model also offers a possible explanation on why consumption growth was strong during the last recession.

Keywords: Embodied Technology, Learning, Overinvestment

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FEDS 2007-14
Diagnosing and Treating Bifurcations in Perturbation Analysis of Dynamic Macro Models (PDF)

Jinill Kim, Andrew T. Levin, and Tack Yun

Abstract: In perturbation analysis of nonlinear dynamic systems, the presence of a bifurcation implies that the first-order behavior of the economy cannot be characterized solely in terms of the first-order derivatives of the model equations. In this paper, we use two simple examples to illustrate how to detect the existence of a bifurcation. Following the general approach of Judd (1998), we then show how to apply l'Hospital's rule to characterize the solution of each model in terms of its higher-order derivatives. We also show that in some cases the bifurcation can be eliminated through renormalization of model variables; furthermore, renormalization may yield a more accurate first-order solution than applying l'Hospital's rule to the original formulation.

Keywords: Bifurcation, perturbation, relative price distortion, optimal monetary policy

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FEDS 2007-13
A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response (PDF)

Abstract: The 1987 stock market crash was a major systemic shock. Not only did the prices of many financial assets tumble, but market functioning was severely impaired. This paper reviews the events surrounding the crash and discusses the response of the Federal Reserve, which responded in a number of ways to support the operation of financial markets, including the provision of liquidity, in a highly visible fashion.

Keywords: Lender of last resort, financial stability, Federal Reserve, stock market crash

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FEDS 2007-12
Anchoring Bias in Consensus Forecasts and its Effect on Market Prices (PDF)

Abstract: Previous empirical studies that test for the "rationality" of economic and financial forecasts generally test for generic properties such as bias or autocorrelated errors, and provide limited insight into the behavior behind inefficient forecasts. In this paper we test for a specific behavioral bias -- the anchoring bias described by Tversky and Kahneman (1974). In particular, we examine whether expert consensus forecasts of monthly economic releases from Money Market Services surveys from 1990-2006 have a tendency to be systematically biased toward the value of previous months' data releases. We find broad-based and significant evidence for the anchoring hypothesis; consensus forecasts are biased towards the values of previous months' data releases, which in some cases results in sizable predictable forecast errors. Then, to investigate whether the market participants anticipate the bias, we examine the response of interest rates to economic news. We find that bond yields react only to the residual, or unpredictable, component of the surprise and not to the expected piece of the forecast error apparently induced by anchoring. This suggests market participants anticipate the anchoring bias embedded in expert forecasts.

Keywords: Forecasts, anchoring bias, bond yields

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FEDS 2007-11
Expected Stock Returns and Variance Risk Premia (PDF)

Tim Bollerslev and Hao Zhou

Abstract: We find that the difference between implied and realized variances, or the variance risk premium, is able to explain more than fifteen percent of the ex-post time series variation in quarterly excess returns on the market portfolio over the 1990 to 2005 sample period, with high (low) premia predicting high (low) future returns. The magnitude of the return predictability of the variance risk premium easily dominates that afforded by standard predictor variables like the P/E ratio, the dividend yield, the default spread, and the consumption-wealth ratio (CAY). Moreover, combining the variance risk premium with the P/E ratio results in an R2 for the quarterly returns of more than twenty-five percent. The results depend crucially on the use of "model-free", as opposed to standard Black-Scholes, implied variances, and realized variances constructed from high-frequency intraday, as opposed to daily, data. Our findings suggest that temporal variation in risk and risk-aversion both play an important role in determining stock market returns.

Keywords: Return Predictability, Implied Variance, Realized Variance, Equity Risk Premium, Variance Risk Premium, Time-Varying Risk Aversion

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FEDS 2007-10
Alternative Methods of Unit Nonresponse Weighting Adjustments: An Application from the 2003 Survey of Small Business Finances (PDF)

Lieu N. Hazelwood, Traci L. Mach, and John D. Wolken

Abstract: The 2003 Survey of Small Business Finances (SSBF) screening interview had significant unit nonresponse and therefore some type of nonresponse adjustment was deemed necessary. The approach used in the 2003 survey differed from that used in previous surveys. The current paper examines the impact of this technique on weights, point estimates and variance of the estimates by comparing the approach ultimately implemented for the 2003 survey to alternative approaches. The results using the 2003 SSBF hybrid method are very similar to the traditional weighting class method and the propensity stratification methods. Even though the hybrid technique did in some instances increase the variance of the weights over the traditional weighting class adjustment method, the differences were quite small. In addition the hybrid method decreased the variance for the weights as well as the some of the point estimates.

Keywords: Weighting class, direct propensity, propensity stratification, 2003 SSBF hybrid propensity stratification method, "non response", "response adjustment", unit nonresponse

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FEDS 2007-09
A Cohort-Based Model of Labor Force Participation (PDF)

Bruce Fallick and Jonathan Pingle

Abstract: The probability that an individual participates in the labor force declines precipitously beyond age 50. This feature of labor supply suggests that ongoing shifts in the age distribution of the population will put substantial downward pressure on the aggregate labor force participation rate. However, the aggregate rate is also influenced by trends within age groups. Neglecting to model both within-group influences and shifting population shares will doom any estimate of aggregate labor supply. We develop a model that identifies birth cohorts' propensities to participate, uses these propensities to derive age-specific trends in participation rates, and explicitly incorporates the influence of shifting population shares in estimating aggregate labor force participation.

Keywords: Labor force, aging, labor supply, labor force participation

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FEDS 2007-08
Natural Rate Measures in an Estimated DSGE Model of the U.S. Economy (PDF)

Abstract: This paper presents a monetary DSGE model of the U.S. economy. The model captures the most important production, expenditure, and nominal-contracting decisions underlying economic data while remaining sufficiently small to allow it to provide a clear interpretation of the data. We emphasize the role of model-based analyses as vehicles for storytelling by providing several examples--based around the evolution of natural rates of production and interest--of how our model can provide narratives to explain recent macroeconomic fluctuations. The stories obtained from our model are both similar to and quite different from conventional accounts.

Keywords: Potential output, Natural rate of interest, Two-sector growth model, Bayesian estimation

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FEDS 2007-07
Estimating Probabilities of Recession in Real Time Using GDP and GDI (PDF)

Abstract: This work estimates Markov switching models on real time data and shows that the growth rate of gross domestic income (GDI), deflated by the GDP deflator, has done a better job recognizing the start of recessions than has the growth rate of real GDP. This result suggests that placing an increased focus on GDI may be useful in assessing the current state of the economy. In addition, the paper shows that the definition of a low-growth phase in the Markov switching models has changed over the past couple of decades. The models increasingly define this phase as an extended period of around zero rather than negative growth, diverging somewhat from the traditional definition of a recession.

Keywords: Recessions, Markov Switching Models

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FEDS 2007-06
A Closer Look at the Sensitivity Puzzle: The Sensitivity of Expected Future Short Rates and Term Premia to Macroeconomic News (PDF)

Meredith Beechey

Abstract: Nominal forward rates are sensitive at surprisingly long horizons to macroeconomic news and monetary-policy surprises. This paper takes advantage of affine term-structure modelling to demonstrate that movements in term premia, not expected future short rates, account for most of the reaction of forward rates at long horizons. Specifically, term premia account for about three quarters of the reaction of nominal forward rates 10 to 15 years hence to the surprise component of numerous macroeconomic news announcements. This has strong implications for the interpretation of interest-rate sensitivity. Contrary to some recent conjectures, long-horizon expectations of the level of inflation and real rates appear reasonably well anchored in the United States, but the associated term premia are quite variable.

Keywords: Forward rates, sensitivity puzzle, affine term structure model, risk premia

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FEDS 2007-05
Rounding and the Impact of News: A Simple Test of Market Rationality (PDF)

Meredith Beechey and Jonathan H. Wright

Abstract: Certain prominent scheduled macroeconomic news releases contain a rounded number on the first page of the release that is widely cited by newswires and the press and a more precise number in the text of the release. The whole release comes out at once. We propose a simple test of whether markets are paying attention to the rounded or unrounded numbers by studying the high-frequency market reaction to such news announcements. In the case of inflation releases, we find evidence that markets systematically ignore some of the information in the unrounded number. This is most pronounced for core CPI, a prominent release for which the rounding in the headline number is large relative to the information content of the release.

Keywords: News Announcements, Rounding, Market Efficiency, Rational Inattention

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FEDS 2007-04
Rational Seasonality (PDF)

Abstract: Seasonal adjustment usually relies on statistical models of seasonality that treat seasonal fluctuations as noise corrupting the `true' data. But seasonality in economic series often stems from economic behavior such as Christmas-time spending. Such economic seasonality invalidates the separability assumptions that justify the construction of aggregate economic indexes. To solve this problem, Diewert (1980, 1983, 1998, 1999) incorporates seasonal behavior into aggregation theory. Using duality theory, I extend these results to a larger class of decision problems. I also relax Diewert's assumption of homotheticity. I provide support for Diewert's preferred seasonally-adjusted economic index using weak separability assumptions that are shown to be sufficient.

Keywords: Seasonality, index, numbers, separability, aggregation, duality theory

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FEDS 2007-03
Linear Cointegration of Nonlinear Time Series with an Application to Interest Rate Dynamics (PDF)

Barry E. Jones and Travis D. Nesmith

Abstract: We derive a definition of linear cointegration for nonlinear stochastic processes using a martingale representation theorem. The result shows that stationary linear cointegrations can exhibit nonlinear dynamics, in contrast with the normal assumption of linearity. We propose a sequential nonparametric method to test first for cointegration and second for nonlinear dynamics in the cointegrated system. We apply this method to weekly U.S. interest rates constructed using a multirate filter rather than averaging. The Treasury Bill, Commerical Paper and Federal Funds rates are cointegrated, with two cointegrating vectors. Both cointegrations behave nonlinearly. Consequently, linear models will not fully replicate the dynamics of monetary policy transmission.

Keywords: Cointegration; nonlinearity; interest rates; nonparametric estimation

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FEDS 2007-02
Measurement of Monetary Aggregates across Countries (PDF)

Yueh-Yun C. O'Brien

Abstract: This paper compares the compositions and definitions of monetary aggregates being published by the 30 countries belonging to the Organization for Economic Co-operation and Development (OECD) and 10 non-OCED countries. These countries are divided into 5 groups according to the similarity of their monetary aggregates and their membership in the European Union (EU) and/or OECD. The first three groups are countries in the EU who have adopted the European Central Bank's definitions of the monetary aggregates with some variations. Their monetary aggregates are discussed together and presented in one table. The monetary aggregates for the countries in the other two groups are very heterogeneous and each country is discussed separately. The criteria used to classify and define monetary aggregates by individual countries are compared and summarized. Variations among the countries' monetary aggregates resulting from emphasis on different criteria for money definitions are also addressed.

Keywords: M1, M2, M3, M4, currency in circulation, demand deposits, savings deposits, time deposits, money market mutual funds, repurchase agreements

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FEDS 2007-01
A Primer on the Macroeconomic Implications of Population Aging (PDF)

Louise Sheiner, Daniel Sichel, and Lawrence Slifman

Abstract: The composition of the U.S. population will change significantly in coming decades as the decline in fertility rates following the baby boom, coupled with increasing longevity, leads to an older population. This demographic shift will likely have a dramatic effect on the long-run prospects for living standards. Moreover, as has been widely discussed in the media and by policymakers, population aging also has significant implications for social programs for the elderly, such as Social Security and Medicare. In this paper, we discuss the consequences of population aging from a macroeconomic perspective and consider alternative paths the economy could follow in response to population aging. The choices society makes among those alternatives will be closely linked to decisions about how to reform entitlement programs for the elderly. The fundamental conclusion of our study is that, barring a significant increase in labor force participation, population aging will lead to a reduction in per capita consumption relative to a baseline in which the demographic composition of the population does not change. The size of any consumption reduction depends critically on whether the adjustment happens sooner or later and on whether the labor force participation of the elderly changes. Important policy questions, then, are whose consumption path falls, by how much, when, and by what means? Decisions about Social Security and Medicare reform are integrally bound up with these fundamental policy questions.

Keywords: Population aging, social security, medicare, living standards

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Last Update: August 24, 2018