Board of Governors of the Federal Reserve System

Abstract:

After the Global Financial Crisis, the liquidity-supply ecosystem that underpins nonbank intermediation shifted away from traditional dealers. Instead, it started to rely more on intermediaries with fragile funding structures and opportunistic investment strategies. Over the years, stress episodes saw the sudden retrenchment of these intermediaries, which amplified liquidity imbalances and market malfunction. Efforts to reduce the risk and magnitude of liquidity imbalances have mostly focused on reducing liquidity transformation and on constraining liquidity demand. This paper highlights the importance of strengthening liquidity supply in certain non-bank segments, particularly those that allow households to conduct long-term consumption smoothing. The main argument is that the rise of non-bank intermediation, and the ensuing risk of spikes in liquidity demand, partly reflects structural changes in how households can meet fundamental financial needs. In addition, the risk-taking channel of monetary policy can affect liquidity-demand dynamics, including for some intermediaries that facilitate household consumption smoothing.

Keywords: Drivers of liquidity demand; Liquidity supply; NBFIs

DOI: https://doi.org/10.17016/IFDP.2025.1425

Abstract:

Using industry-level panel data and plausibly exogenous variation in supply conditions, we estimate the elasticity of retail price margins with respect to inventories along the retailer's optimal pricing curve. We find that this elasticity is negative and statistically significant, implying that lower finished-good inventories lead to higher price margins. We assess the implications of this channel for inflation dynamics within a New Keynesian Phillips curve (NKPC) framework that links inventories to retailers' markup behavior. Incorporating the inventory-sales ratio into the NKPC markedly improves the model's empirical fit and helps account for two notable recent inflation episodes: the missing disinflation of 2009–2011 and the COVID-era surge.

Keywords: Inflation; inventories; supply disruptions; Phillips curve.

DOI: https://doi.org/10.17016/IFDP.2025.1424

Abstract:

The unemployment rate remains elevated long after recessions, a persistence that standard search-and-matching models cannot explain. I show that noise shocks—expectational errors due to the noise in received signals about aggregate shocks—account for much of this sluggishness. Using a structural VAR, I find that absent noise shocks unemployment would have recovered to its pre-recession level six quarters earlier over 1968–2019. To interpret this evidence, I develop a search-and-matching model with on-the-job search, endogenous search effort, and wage rigidity. Embedding imperfect information generates two channels of persistence: slow learning amplifies the effects of persistent productivity shocks, and noise shocks provide an additional source of sluggishness, further magnified by sticky wages and vacancy posting. The model successfully replicates both the slow recovery of unemployment and systematic forecast errors, highlighting imperfect information as a key mechanism behind post-recession labor market dynamics.

Keywords: Imperfect Information, Labor Market, Business Cycles

DOI: https://doi.org/10.17016/IFDP.2025.1423

Abstract:

A cornerstone of the law-and-finance literature is that stronger institutions reduce financial intermediation costs. Using global data on cross-border payment costs, I show this relationship can reverse in heavily regulated sectors. Anti-money laundering risks have larger cost effects in advanced economies with strong enforcement than in developing countries with weak enforcement, despite the former having lower underlying risks. This counterintuitive pattern reflects strong institutions operating through two channels: Directly reducing costs through risk mitigation and forcing risk-based pricing that eliminates cross-subsidization. The net results demonstrate that traditional studies can miss heterogeneity by not controlling for risk levels: Strong institutions benefit low-risk jurisdictions but force high-risk ones to pay higher costs for their risk profiles. Policy implications favor improving enforcement and lowering risks rather than treating these as substitutes. The findings have implications for emerging payment rails, such as regulated payment stablecoins, which face similar AML requirements.

Keywords: Cross-border payments, anti-money laundering, institutional quality, law enforcement, compliance costs, competitive forces, risk-based pricing, regulated payment stablecoins

DOI: https://doi.org/10.17016/IFDP.2025.1422

Abstract:

We explore differences in the dynamics of core inflation between Europe and North America using a Bayesian time series filter that decomposes the level of core inflation in the major advanced economies into regional, global, and country-specific components. We find a prominent role for both regional and global factors. Historically, the two regional components have at times diverged. Using reduced-form regressions, we examine the economic drivers behind the changes in our estimated global and regional components of U.S. core inflation, focusing on the post-pandemic inflation surge and subsequent pullback. The global component is associated with global supply frictions and past energy shocks. The North American regional component is associated with labor market tightness in the region.

Keywords: Regional inflation. Dynamic Linear Model. Core inflation.

DOI: https://doi.org/10.17016/IFDP.2025.1421

Abstract:

I examine how governments have managed their holdings of gold and dollar reserves in recent decades, a period when gold’s share of aggregate international reserves rose and the dollar’s share fell. Using data on central banks’ reserve currency composition and official sector purchases of U.S. assets, I argue that gold reserve accumulation is generally not associated with de-dollarization of international reserves at the country level, except in a few prominent cases. Instead, gold purchases are more consistent with most countries pursuing a modest diversification of international reserves that does not solely target a reduced dollar share. My evidence suggests that this characterization also applies to gold reserve accumulation in 2022 and 2023. Finally, I show that, while gold’s importance as a store of value for the official sector has grown since 2000, its use as a unit of account and a medium of exchange remains limited.

Keywords: International Reserves, Gold, Dollar

DOI: https://doi.org/10.17016/IFDP.2025.1420

Abstract:

This paper studies the drivers of the US real exchange rate (RER), with a particular focus on its comovement with net trade (NT) flows. We consider the entire spectrum of frequencies, as the low-frequency variation accounts for 62 and 64 percent of the unconditional variance of the RER and NT, respectively. We develop a generalization of the standard international business cycle model that successfully rationalizes the joint dynamics of the RER and NT while accounting for the major puzzles of the RER. We find that, while financial shocks are necessary to capture high frequency variation in the RER, trade shocks are essential for the lower frequency fluctuations.

Keywords: International Business Cycles, Exchange Rates, Trade Balance, Trade Dynamics

DOI: https://doi.org/10.17016/IFDP.2025.1419

Abstract:

How do banks respond to geopolitical risk, and is this response distinct from other macroeconomic risks? Using U.S. supervisory data and new geopolitical risk indices, we show that banks reduce cross-border lending to countries with elevated geopolitical risk but continue lending to those markets through foreign affiliates—unlike their response to other macro risks. Furthermore, banks reduce domestic lending when geopolitical risk rises abroad, especially when they operate foreign affiliates. A simple banking model in which geopolitical shocks feature expropriation risk can explain these findings: Foreign funding through affiliates limits downside losses, making affiliate divestment less attractive and amplifying domestic spillovers.

Keywords: geopolitical risk, bank lending, credit risk, international spillovers

DOI: https://doi.org/10.17016/IFDP.2025.1418

Abstract:

Poorer countries (and poorer states within India) have a larger share of manufacturing employment in small plants. This paper presents empirical evidence and a theoretical model to show that this relationship is driven by greater demand for lower quality goods in poorer regions, which can be produced efficiently in small plants. First, using data for India, we show that richer households buy higher price goods and larger plants produce higher price products. Second, we develop a model that matches these facts. Finally, we find that our model explains about forty percent of the cross-state variation in the size distribution of manufacturing plants in India.

Keywords: Firm size distribution; Product quality; India

DOI: https://doi.org/10.17016/IFDP.2025.1417

Abstract:

Saving rates are significantly different across countries and remain different for long periods of time. This paper provides an explanation for this phenomenon. We formalize a model of a world economy comprised of open economies inhabited by heterogeneous agents endowed with recursive preferences. Our assumed preferences imply increasing marginal impatience of agents as their consumption rises relative to average consumption of a reference group. Using measured productivity as the sole exogenous driver, we show that the model can not only reproduce the sustained long run differences in average saving rates across countries, but also provides a good fit to the time series behavior of saving observed in the data.

Keywords: World savings, recursive preferences

DOI: https://doi.org/10.17016/IFDP.2025.1416

Abstract:

We present a principal component analysis of euro area labor market conditions by combining information from 22 labor market indicators into two comprehensive series. These two novel indicators provide a systematic view of the current state and forward-looking direction of the euro-area labor market, respectively, and demonstrate superior forecasting performance compared to existing indicators. Crucially, we find significant implications for monetary policy design: a local projection analysis reveals that ECB monetary policy shocks have attenuated effects on both inflation and unemployment when the labor market forward-looking indicator is high. The dampened inflation response calls for tighter policy rate paths than a standard Taylor rule would prescribe. Finally, we show that focusing solely on the official unemployment rate may understate the actual labor market slack, and consequently, the trade-off between labor market health and inflationary dynamics.

Keywords: employment, unemployment, labor market forecasting, European labor markets

DOI: https://doi.org/10.17016/IFDP.2025.1415

Abstract:

We estimate distributional implications of global food and oil price shocks by utilizing monthly panel data on consumption and income from India, and an IV strategy that removes variation coming from global demand shocks. While both shocks lead to stagflationary aggregate dynamics, they differ in terms of distributional consequences. Consumption of lower income deciles is affected more by exogenous increases in food prices, while consumption of both tails of the income distribution is affected similarly by exogenous increases in oil prices. These heterogeneous negative consumption responses largely mirror the pattern of heterogeneity in wage income responses. Increases in relative expenditure of food, despite a rise in the relative local price of food, provides clear evidence for non-homothetic demand in non-durable consumption. Estimating the slopes of the Engel curve by impulse response matching, we find that food, compared to fuel, is a necessary consumption good for all income groups. Comparing the model predictions with the empirical consumption responses, we decompose the role played by wage income, relative price changes, and non-homotheticity in explaining our results.

Keywords: Global Price shocks; Food prices; Oil prices; Inequality; Household heterogeneity; Household consumption; Necessary good; Non-homotheticity; India

DOI: https://doi.org/10.17016/IFDP.2025.1414

Abstract:

Rising geopolitical tensions and supply chain vulnerabilities have driven recent fragmentation of foreign direct investment (FDI). This paper provides systematic evidence of FDI fragmentation along ideological and geographic lines across five dimensions: shifting away from ideologically distant countries (ideological sorting), prioritizing politically aligned countries (friendshoring), reducing exposure to specific high-risk countries (derisking), moving production closer to the home country (nearshoring), and returning investment to the home country (reshoring). Measures of FDI based on financial transactions reveal evidence of ideological sorting and nearshoring. The capital expenditures of multinational enterprises and their affiliates display ideological sorting, derisking, nearshoring, and reshoring. Cross-border M&A deals reflect patterns of derisking, while horizontal (but not vertical) M&A exhibits broader ideological realignment. At the industry level, derisking and ideological sorting appear widely distributed. By contrast, friendshoring and nearshoring of M&A remain concentrated in goods-producing sectors.

Keywords: fragmentation, geoeconomics, foreign direct investment

DOI: https://doi.org/10.17016/IFDP.2025.1413

Abstract:

This paper examines which macroeconomic signals shape household expectations and finds that unemployment shocks play a more influential role than inflation shocks. Using daily data, we identify which announcements prompt households to revise their expectations. We construct two shock series—assuming households are either sophisticated or naive—based on the surprise components of announcements. Labor market news strongly influences both general economic sentiment and inflation expectations. Even when inflation rises and unemployment falls, households respond more to unemployment shocks. Most changes in inflation expectations are driven by labor market shocks. During negative supply and demand shocks, unemployment remains the dominant driver.

Keywords: Household expectations, macroeconomic data releases, high-frequency identification, survey data

DOI: https://doi.org/10.17016/IFDP.2025.1412

Abstract:

We study how trade cost shocks influence inflation. Using bilateral trade flows from detailed global input-output data and a gravity framework, we estimate trade cost shocks and their effects on CPI inflation. Higher trade costs for final goods cause large but short-lived inflation spikes, while increased costs for intermediate inputs trigger more persistent inflation. A multi-country model of inflation with trade in final goods and intermediate inputs replicates these patterns. We show that trade cost shocks and tariffs on imported inputs transmit through global value chains and worsen monetary policy trade-offs. We use the model to quantify the effects of trade costs during the 2018–2019 U.S.-China trade war and to estimate the contribution of trade costs during the post-pandemic inflation surge. Novel data on U.S. domestic sourcing shores allow us to estimate trade cost shocks for the U.S. using Bayesian methods.

Keywords: Inflation, international trade, trade costs, New Keynesian model, post-pandemic inflation, monetary policy, gravity equations

DOI: https://doi.org/10.17016/IFDP.2025.1411

Abstract:

This paper explores the symbiotic relationship between transformative entrepreneurs and inventors, which is crucial for economic growth. We utilize microdata from Denmark to demonstrate that while the relationship between IQ and general entrepreneurship tends to be negative, it is strongly positive among transformative entrepreneurs. Transformative entrepreneurs, often with higher IQ and education levels, significantly drive R&D and business growth, thereby providing substantial opportunities for inventors. In contrast, average entrepreneurs are more influenced by their family's entrepreneurship background. Our economic model links these dynamics to overall economic progress, highlighting how higher education influences career paths in entrepreneurship and invention. We identify talent misallocation caused by unequal education access, particularly affecting lower-income families. Our findings indicate the most effective policies strengthen the interplay between higher education, innovation, and entrepreneurship to foster transformative businesses and achieve long-run economic growth.

Keywords: Entrepreneurship, R&D Policy, Innovation, IQ, Endogenous Growth.

DOI: https://doi.org/10.17016/IFDP.2025.1410

Abstract:

Long-term debt is the main source of firm-financing in the U.S. We show that accounting for debt maturity is crucial for understanding business cycle dynamics. We develop a macroeconomic model with defaultable long-term debt and equity adjustment costs. With long-term debt, firms have an incentive to increase leverage in order to dilute the value of outstanding debt. When equity issuance is costly, this incentive helps firms raise more debt through a debt dilution channel and mitigates the decline in net worth through a balance sheet channel, dampening the decline in investment in response to a negative financial shock. Using firm-level data, we estimate equity issuance costs and incorporate our findings into an estimated medium-scale DSGE model. Accounting for debt maturity and the cost of equity financing implies that credit supply shocks are the primary drivers of business cycle fluctuations.

Keywords: Long-term debt; Financial frictions; Debt overhang; Macroeconomic activity.

DOI: https://doi.org/10.17016/IFDP.2025.1409

Abstract:

Recent geopolitical tensions have revived interest in understanding the economic consequences of geopolitical fragmentation. Using bilateral trade flows, portfolio investment data, and detailed records of economic policy interventions, we revisit widely-used geopolitical distance metrics, specifically the Ideal Point Distance (IPD) derived from United Nations General Assembly voting. We document substantial variability in measured fragmentation, driven significantly by methodological choices related to sample periods and vote categories, especially in the wake of Russia’s 2022 invasion of Ukraine. Our results show robust evidence of increasing fragmentation in both trade flows and economic policy interventions among geopolitically distant country pairs, with particularly strong effects observed in strategically important sectors and policy motives. In contrast, financial portfolio allocations exhibit weaker, more heterogeneous, and context-sensitive responses. These findings highlight the critical importance of methodological transparency and careful specification when assessing geopolitical realignments and their implications for international economic relations.

Keywords: Fragmentation; Geoeconomics; Trade; Financial Flows

DOI: https://doi.org/10.17016/IFDP.2025.1408

Abstract:

This paper introduces a monthly shortage index spanning 1900 to the present, constructed from 25 million newspaper articles. The index captures shortages across industry, labor, food, and energy, and spikes during economic crises and wars. We validate the index and show that it provides information beyond traditional macroeconomic indicators. Using predictive regressions, we find that shortages are associated with persistently high inflation and lower economic activity. A structural VAR model reveals that, compared to a traditional supply shock, surprise movements in shortages produce less inflation relative to their GDP impact, suggesting that shortages are associated with constraints on price adjustment that limit inflation but magnify the decline in real activity. We also show that post-pandemic shortages and inflation were primarily driven by supply forces, with demand factors playing a less important role.

Keywords: Inflation, Predictive Regressions, Shortages, Structural VAR Model, Textual Analysis

DOI: https://doi.org/10.17016/IFDP.2025.1407

Abstract:

We study optimal credit market policy in a stochastic, quantitative, general equilibrium, infinite-horizon economy with collateral constraints tied to housing prices. Collateral constraints yield a competitive equilibrium that is Pareto inefficient. Taxing housing in good states and subsidizing it in recessions leads to a Pareto-improving allocation for borrowers and savers. Quantitatively, the welfare gains afforded by the optimal tax are significant. The optimal tax reduces the covariance of collateral prices with consumption, and, by doing so, it increases asset prices on average, thus providing welfare gains both in steady state and around it. We also show that the welfare gains stem from mopping up after the crash rather than a pure ex-ante macroprudential aspect, aligning with prior research that emphasizes the importance of ex-post measures compared to preventive policies alone.

Keywords: Collateral Constraints, Credit Market, Financial Crises, Housing and real estate, Macroprudential Policy

DOI: https://doi.org/10.17016/IFDP.2025.1406

Abstract:

Heise et al. (2021) develop a model-based empirical measure—sellers per shipment (SPS)—to characterize how firms organize supply chains in response to a quality control problem. High SPS indicates spot-market purchasing with costly inspections, while low SPS suggests long-term relationships where buyers pay an incentive premium to prevent cheating. Here, we document intuitive variation in US importers' SPS across sectors, and that show shipping characteristics such as average price, quantity shipped and shipment frequency are in each sector consistent with the model of sourcing developed in Heise et al. (2021), providing further confidence in the measure.

Keywords: Supply Chain, Uncertainty, Trade War, Procurement

DOI: https://doi.org/10.17016/IFDP.2025.1405

Abstract:

The incidence of currency counterfeiting and the possible total stock of counterfeits in circulation are popular topics of speculation and discussion in the press and are of substantial practical interest to the Federal Reserve, the U.S. Treasury and the United States Secret Service (USSS), who are jointly responsible for U.S. banknote design, including security features, and production. This paper assembles data from Federal Reserve and USSS sources and presents a range of estimates for the number of counterfeits in circulation in the United States. In addition, the paper presents figures on counterfeit passing activity by denomination, location, and counterfeit type.

The paper has two main conclusions: first, the stock of counterfeits in the United States as a whole is at most about $30 million, or about 1 in 40,000 notes and is likely about $15 million, or on the order of 1 every 80,000 genuine notes in both piece and value terms. This estimate marks a significant decline from the estimate of 1 in 10,000 notes presented in Treasury (2006) using similar methods and data sources, and the decline is likely at least partially due to increased circulation of higher-security banknotes as well as increased public education about U.S. dollar banknote security features. Second, when counterfeit notes of reasonable quality are considered, losses to the U.S. public from only the high-quality counterfeits of the most commonly used notes, the $20 and smaller denominations, are minuscule. However, there is a range of estimates overall for counterfeits in circulation, and these estimates vary by denomination.

Keywords: Banknotes, counterfeiting, estimation, money

DOI: https://doi.org/10.17016/IFDP.2025.1404

Abstract:

We use bilateral cross-border bank claims by nationality to assess the effects of geopolitics on cross-border bank flows. We show that a rise in geopolitical tensions between countries — disagreements in UN voting, broad sanctions, or sentiments captured by geopolitical risk indices — significantly dampens cross-border bank lending. Elevated geopolitical tensions also amplify the international transmission of monetary policies of major central banks, especially when geopolitical tensions coincide with monetary policy tightening. Overall, our results suggest that geopolitics is roughly as important as monetary policy in driving cross-border lending.

Keywords: Monetary policy; Geopolitical tensions; Cross-border claims; Diff-in-diff estimations

DOI: https://doi.org/10.17016/IFDP.2025.1403