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Finance and Economics Discussion Series

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Abstract: I study the effect of improved financial intermediation on the process of capital accumulation by augmenting a standard model with a general contract space. With the extra contracts, intermediaries endogenously begin using ROSCAs, or Rotating Savings and Credit Associations. These contracts allow poor agents, previously credit rationed, access to credit. As a result, agents work harder and total economy-wide output increases; however, these gains come at the cost of increased inequality. I provide sufficient conditions for the allocations to be Pareto optimal, and for there to be a unique invariant distribution of wealth. I provide an analytic characterization of a simple model and use numerical techniques to study more general models.

Keywords: Asset pooling, credit rationing, roscas, growth

Full paper (608 KB Postscript)

Abstract: In recent years many banks have attempted to improve the measurement and management of credit risk by assigning risk ratings to business loans. Virtually all large banks now assign such ratings. However, until recently there has been little information on the use of risk ratings by smaller banks. Recent revisions to the Federal Reserve's Survey of Terms of Business Lending and telephone consultations with more than 100 banks on the survey panel provide data on the prevalence and precision of risk rating systems at banks of all sizes. We find that the use of risk rating systems is quite widespread, but that smaller banks generally have less detailed systems than do larger banks. In addition, the new survey data allow us to asses the relationships between loan risk ratings and loan terms. Not surprisingly, riskier loans generally carry higher interest rates, even after taking account of other loan terms. There are more complex relationships between loan risk and other loan terms. Regression results indicate that banks of all sizes price for risk. We do not find a relationship between reported loan risk and delinquency and charge-off rates. However, this may reflect how recently the risk rating data have become available.

Keywords: Business loans, risk ratings

feds 1998-50
January 1999

Monetary Policy Evaluation with Noisy Information (PDF)

Athanasios Orphanides

Abstract: This paper investigates the implications of noisy information regarding the measurement of economic activity for the evaluation of monetary policy. A common implicit assumption in such evaluations is that policymakers observe the current state of the economy promptly and accurately and can therefore adjust policy based on this information. However, in reality, decisions are made in real time when there is considerable uncertainty about the true state of affairs in the economy. Policy must be made with partial information. Using a simple model of the U.S. economy, I show that failing to account for the actual level of information noise in the historical data provides a seriously distorted picture of feasible macroeconomic outcomes and produces inefficient policy rules. Naive adoption of policies identified as efficient when such information noise is ignored results in macroeconomic performance worse than actual experience. When the noise content of the data is properly taken into account, policy reactions are cautious and less sensitive to the apparent imbalances in the unfiltered data. The resulting policy prescriptions reflect the recognition that excessively activist policy can increase rather than decrease economic instability.

Keywords: Policy evaluation, interest rate rules, data revisions, real-time data, optimal control, observation noise, inflation targeting

Full paper (303 KB Postscript)

Abstract: In this paper household level data are used to explore whether unemployment risk is an important factor in the timing of consumers' durable goods purchase decisions. A theoretical model is presented in which both income uncertainty and household debt play a direct role, offering a potential explanation for fluctuations in durable goods spending over the business cycle. The model predicts that consumers respond to increases in unemployment risk by postponing purchases of the durable good and reducing their spending on nondurable goods in order to bolster their precautionary buffer-stock of liquid assets. Consistent with the model, there is evidence that unemployment risk has a direct effect on the timing of home purchases: households with a higher probability of becoming unemployed are less likely to have recently purchased a home or a car, even after controlling for demographic variables. A prediction that the consumption decisions of older consumers are relatively less sensitive to unemployment risk is also validated. Another finding consistent with the theoretical model is that consumers who are observed to have bought a house despite facing high unemployment risk tend to have more liquid assets left over than homebuyers who face ordinary or low unemployment risks.

Keywords: Precautionary saving, income uncertainty, durable goods

Full paper (505 KB Postscript)
feds 1998-48
August 2000

A Rational Expectations Model of Financial Contagion (PDF)

Laura E. Kodres and Matthew Pritsker

Abstract: We develop a multiple rational expectations model of securities prices to explain the determinants of financial market contagion. Although the model allows contagion through several channels, our primary focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios' exposures to macroeconomic risks which are shared across markets. The pattern and severity of financial contagion depends on markets' sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, and between markets that do not directly share macroeconomic risks.

Keywords: Rational expectations, contagion, emerging markets

feds 1998-47
January 1999

A Comparative Anatomy of Credit Risk Models (PDF)

Michael B. Gordy

Abstract: Within the past two years, important advances have been made in modeling credit risk at the portfolio level. Practitioners and policy makers have invested in implementing and exploring a variety of new models individually. Less progress has been made, however, with comparative analyses. Direct comparison often is not straightforward, because the different models may be presented within rather different mathematical frameworks. This paper offers a comparative anatomy of two especially influential benchmarks for credit risk models, J.P. Morgan's CreditMetrics and Credit Suisse Financial Product's CreditRisk+. We show that, despite differences on the surface, the underlying mathematical structures are similar. The structural parallels provide intuition for the relationship between the two models and allow us to describe quite precisely where the models differ in functional form, distributional assumptions, and reliance on approximation formulae. We then design simulation exercises which evaluate the effect of each of these differences individually.

Keywords: Credit risk models

feds 1998-46
January 1999

The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future (6 MB PDF)

Allen N. Berger, Rebecca S. Demsetz, and Philip E. Strahan

Abstract: This article designs a framework for evaluating the causes, consequences, and future implications of financial consolidation, reviews the extant research literature within the context of this framework (over 250 references), and suggests fruitful avenues for future research. The evidence is consistent with increases in market power from some types of consolidation; improvements in profit efficiency and diversification of risks, but little or no cost efficiency improvements; relatively little effect on the availability of services to small customers; potential improvements in payments system efficiency; and potential costs on the financial system from increasing systemic risk or expanding the financial safety net.

Keywords: Banks, mergers, payments, small business

feds 1998-45
January 1999

Robustness of Simple Monetary Policy Rules under Model Uncertainty (PDF)

Andrew Levin, Volker Wieland, and John C. Williams

Abstract: In this paper, we investigate the properties of alternative monetary policy rules using four structural macroeconometric models: the Fuhrer-Moore model, Taylor's Multi-Country Model, the MSR model of Orphanides and Wieland, and the FRB staff model. All four models incorporate the assumptions of rational expectations, short-run nominal inertia, and long-run monetary neutrality, but differ in many other respects (e.g., the dynamics of prices and real expenditures). We compute the output-inflation volatility frontier of each model for alternative specifications of the interest rate rule, subject to an upper bound on nominal interest rate volatility. Our analysis provides strong support for rules in which the first-difference of the federal funds rate responds to the current output gap and the deviation of the one-year average inflation rate from a specified target. In all four models, first-difference rules perform much better than rules of the type proposed by Taylor (1993) and Henderson and McKibbin (1993), in which the level of the federal funds rate responds to the output gap and the deviation from target. Furthermore, first-difference rules generate essentially the same policy frontier as more complicated rules (i.e., rules that respond to a larger number of variables and/or additional lags of output and inflation). Finally, this class of rules is robust to model uncertainty, in the sense that a first-difference rule taken from the policy frontier of one model is very close to the policy frontier of each of the other three models. In contrast, more complicated rules are less robust to model uncertainty: rules with additional parameters can be fine-tuned to the dynamics of a specified model, but typically perform poorly in the other models.

Keywords: Monetary policy, policy rules, model uncertainty, rational expectation models

Full paper (464 KB Postscript)
feds 1998-44
January 1999

Investment, Capacity, and Output: A Putty-Clay Approach (PDF)

John C. Williams and Simon Gilchrist

Abstract: In this paper, we embed the microeconomic decisions associated with investment under uncertainty, capacity utilization, and machine replacement in a general equilibrium model based on putty-clay technology. We show that the combination of log-normally distributed idiosyncratic productivity uncertainty and Leontief utilization choice yields an aggregate production function that is easily characterized in terms of hazard rates for the standard normal distribution. At low levels of idiosyncratic uncertainty, the short-run elasticity of supply is substantially lower than the elasticity of supply obtained from a fully-flexible Cobb-Douglas alternative. In the presence of irreversible factor proportions, an increase in idiosyncratic uncertainty typically reduces investment at the micro level but increases aggregate investment. Finally, we study the relationship between growth and uncertainty on aggregate capacity utilization and rates of machine replacement and investigate the factors that affect the magnitude of replacement echoes.

Keywords: Putty-clay, vintage capital, irreversibility, capacity utilization

Full paper (658 KB Postscript)

Abstract: New Keynesian models with sticky prices and rational expectations have a difficult time explaining why reducing inflation usually requires a recession. An explanation for the costliness of reducing inflation is that inflation expectations are less than perfectly rational. To explore this possibility, I estimate the degree of nonrationality implicit in two survey measures of inflation expectations. I find that the surveys reflect an intermediate degree of rationality: Expectations are nether perfectly rational nor as unsophisticated as simple autoregressive models would suggest. I also find that a structural New Keynesian model with expectations formation based on the survey results is able to match closely the empirical costs of reducing inflation.

Keywords: Inflation expectations, monetary policy

Abstract: Recent research indicates that results of variance-bounds tests of stock price volatility may depend on the definition of cash flows deemed relevant to shareholders: Tests using regular (or "narrow") dividends repeatedly have suggested that stock prices fluctuate more than can be explained by a simple present value hypothesis, while some tests using "broad dividends" (i.e., narrow dividends plus proceeds from share liquidations) do not detect such excess price volatility. Researchers disagree as to the cause and meaning of these differences. This paper derives and analyzes the broad-dividend version of the present value hypothesis to show that under common assumptions, these differences in variance-bounds tests have only two possible causes: Either narrow-dividend tests have rejected the present value hypothesis because of bubbles (either rational bubbles, or "empirical" bubbles as might be effected by dividend-smoothing or dividend-nonpayment); or broad-dividend tests simply have lacked power to detect mispricing. Using simulation and results from previous studies, this paper demonstrates that the second possible cause -- the lack of power in broad-dividend tests -- most likely explains the differences between narrow- and broad-dividend variance-bounds tests.

Keywords: Volatility, variance bounds, stock prices

Full paper (984 KB Postscript)

Abstract: Cagan's classic currency ratio suggests that underground economic activity in the United States surged starting in 1994. In contrast, we show that a ratio adjusted to take care of two distorting developments -- retail sweep programs and overseas demand for U.S. currency -- did not surge and that movements in the adjusted ratio to result primarily from the differential effects of interest rates on currency and checkable deposits. As a result, we are skeptical of monetary-based claims that the underground economy has expanded significantly in recent years and believe that any claims that it has must rely on other evidence.

Keywords: Currency ratios, underground economic activity, retail sweep programs, overseas U.S. currency

feds 1998-40
October 1998

Consumption and Asset Prices with Recursive Preferences (PDF)

Mark Fisher and Christian Gilles

Abstract: We analyze consumption and asset pricing with recursive preferences given by Kreps--Porteus stochastic differential utility (K--P SDU). We show that utility depends on two state variables: current consumption and a second variable (related to the wealth--consumption ratio) that captures all information about future opportunities. This representation of utility reduces the internal consistency condition for K--P SDU to a restriction on the second variable in terms of the dynamics of a forcing process (consumption, the state--price deflator, or the return on the market portfolio). Solving the model for (i) optimal consumption, (ii) the optimal portfolio, and (iii) asset prices in general equilibrium amounts to finding the process for the second variable that satisfies this restriction. We show that the wealth--consumption ratio is the value of an annuity when the numeraire is changed from units of the consumption good to units of the consumption process, and we characterize certain features of the solution in a non-Markovian setting. In a Markovian setting, we provide a solution method that is quite general and can be used to produce fast, accurate numerical solutions that converge to the Taylor expansion.

Keywords: Recursive preferences, stochastic differential utility, general equilibrium, optimal consumption, optimal portfolio, equity premium, term structure of interest rates, asset pricing

Full paper (1421 KB Postscript)

Abstract: This paper formulates and compares various specifications of investment adjustment costs in a simple dynamic general-equilibrium model and studies their implications by showing some analytic results. One way to introduce adjustment costs is to incorporate them as a constant elasticity of substitution between investment and capital in the capital accumulation equation. Another way is as a nonlinear transformation between consumption and investment in the national income identity. We observe that there is a problem in identifying the two types of adjustment costs and show how to solve the problem. The properties of persistence and volatility are analytically discussed with an emphasis on the size of adjustment costs.

Keywords: Investment adjustment costs, identification, persistence, volatility,constant relative risk aversion, elastic labor supply

Full paper (169 KB Postscript)
feds 1998-38
August 1998

Indeterminacy and Investment Adjustment Costs (PDF)

Jinill Kim

Abstract: It is widely known that a neoclassical growth model with sufficient increasing returns to production may feature an indeterminate steady state. This note shows how investment adjustment costs increase the degree of increasing returns required for indeterminacy to arise. We also argue that sector-specific externalities are observationally equivalent to negative adjustment costs.

Keywords: Indeterminacy, investment adjustment costs, two-sector models

feds 1998-37
August 1998

Rational Error Correction (PDF)

P.A. Tinsley

Abstract: Under general conditions, linear decision rules of agents with rational expectations are equivalent to restricted error corrections. However, empirical rejections of rational expectation restrictions are the rule, rather than the exception, in macroeconomics. Rejections often are conditioned on the assumption that agents aim to smooth only the levels of actions or are subject to geometric random delays. Generalizations of dynamic frictions on agent activities are suggested that yield closed-form, higher-order decision rules with improved statistical fits and infrequent rejections of rational expectations restrictions. Properties of these generalized "rational" error corrections are illustrated for producer pricing in manufacturing industries.

Keywords: Companion systems, error correction, producer pricing, rational expectations

Abstract: The certainty equivalence principle states that only the mean of a random variable is relevant to a decision maker facing uncertainty. This principle considerably simplifies the application of the idea of rational expectations considerably. Yet, certainty equivalence does not in general apply outside of the special case of the quadratic objective function subject to linear constraints. I use the standard augmented Phillips Curve to demonstrate the significant effects that occur with the breakdown of certainty equivalence.

Keywords: Rational expectations, expected utility maximization, certainty equivalence, Jensen's inequality, natural rate, long run Phillips Curve

Abstract: This paper employs stochastic simulations of a small structural rational expectations model to investigate the consequences of the zero bound constraint on nominal interest rates. We find that if the economy is subject to stochastic shocks similar in magnitude to those experienced in the U.S. over the 1980s and 1990s, the consequences of the zero bound are negligible for target inflation rates as low as 2 percent. However, the effects of the constraint are very non-linear with respect to the inflation target and produce a quantitatively significant deterioration of the performance of the economy with targets between 0 and 1 percent. The variability of output increases significantly and that of inflation also rises somewhat. The stationary distribution of output is distorted, with recessions becoming somewhat more frequent and longer lasting. Our model also uncovers the fact the asymmetry of the policy ineffectiveness induced by the zero bound constraint generates a non-vertical long run Phillips curve. Output falls increasingly short of potential, with lower inflation targets. At zero average inflation, the output loss is on the order of 0.1 percentage points. We also investigate the consequences of the constraint on the analysis of optimal policy based on the inflation-output variability frontier. We demonstrate that in the presence of the zero bound, the variability frontier is distorted as the inflation target approaches zero. As a result, comparisons of alternative policy rules that ignore the zero bound can be seriously misleading.

Keywords: Monetary policy, price stability, zero interest rate bound, liquidity trap, rational expectations

Full paper (1485 KB Postscript)
feds 1998-34
August 1998

Uncertainty, Learning, and Gradual Monetary Policy (PDF)

Brian Sack

Abstract: This paper argues that interest-rate smoothing may be optimal when the effect of monetary policy is uncertain. A model is presented in which the Federal Reserve rationally learns about the policy multiplier by observing the reaction of the economy to recent choices of the interest rate. As a result of this learning process, the Fed faces greater uncertainty about the impact of its policy as it moves the interest rate away from its previous level. The optimal policy response to macroeconomic developments therefore involves gradual adjustment of the interest rate over a period of time during which the Fed is learning about the effect of its policy; consistent with the smoothness of interest rate movements found in estimated policy rules. The model also suggests that periods of active interest rate movements, by allowing the Fed to learn more effectively, may be followed by a more aggressive policy rule.

Keywords: Interest-rate smoothing, gradualism, parameter uncertainty, monetary policy

Full paper (4202 KB Postscript)
feds 1998-33
August 1998

Dealer Polling in the Presence of Possibly Noisy Reporting (PDF)

Jeremy Berkowitz

Abstract: The value of a vast array of financial assets are functions of rates or prices determined in OTC, interbank, or other off-exchange markets. In order to price such derivative assets, underlying rate and price indexes are routinely sampled and estimated. To guard against misreporting, whether unintentional or for market manipulation, many standard contracts utilize a technique known as trimmed-means. This paper points out that this polling problem falls within the statistical framework of robust estimation. Intuitive criteria for choosing among robust valuation procedures are discussed. In particular, the approach taken is to minimize the worst-case scenario arising from a false report. The finite sample performance of the procedures that qualify, the trimmed-mean and the Huber-estimator, are examined in a set of simulation experiments.

Keywords: Dealer, polling, robust

Full paper (450 KB Postscript)

Abstract: We compare the timeliness and accuracy of government supervisors versus market participants in assessing the condition of large U.S. bank holding companies. We find that supervisors and bond rating agencies both have some prior information that is useful to the other. In contrast, supervisory assessments and equity market indicators are not strongly interrelated. We also find that supervisory assessments are much less accurate overall than both bond and equity market assessments in predicting future changes in performance, but supervisors may be more accurate when inspections are recent. To some extent, these results may reflect differing incentives of the parties.

Keywords: Bank, supervision, market discipline

feds 1998-31
August 1998

Interbank Payments and the Daily Federal Funds Rate (PDF)

Craig Furfine

Abstract: This paper develops a model of bank reserve management and federal funds rate determination that incorporates the role of interbank payments. In the model, uncertainty in the receipt of payments generates a precautionary demand for bank reserves as banks face both reserve requirements and penalties for overnight overdrafts. Days with higher payment volume are assumed to create more uncertainty in a bank's reserve account that accentuates this precautionary motive. As a result, upward pressure is placed on the equilibrium funds rate. Implications of the model are then estimated using a panel of large banking institutions. Using the parameter estimates, simulations of the model suggest that patterns in payment activity explain many intra-maintenance period movements in both the level and volatility of the federal funds rate.

Keywords: Federal funds rate, payments, bank reserves

feds 1998-30
August 1998

Putty-Clay and Investment: A Business Cycle Analysis (PDF)

Simon Gilchrist and John C. Williams

Abstract: This paper develops a dynamic stochastic general equilibrium model with putty-clay technology that incorporates embodied technology, investment irreversibility, and variable capacity utilization. Low short-run capital-labor substitutability native to the putty-clay framework induces the putty-clay effect of a tight link between changes in capacity and movements in employment and output. As a result, persistent shocks to technology or factor prices generate business cycle dynamics absent in standard neoclassical models, including a prolonged hump-shaped response of hours, persistence in output growth, and positive comovement in the forecastable components of output and hours. Capacity constraints result in a nonlinear aggregate production function that implies asymmetric responses to large shocks with recessions steeper and deeper than expansions. Minimum distance estimation of a two-sector model that nests putty-clay and neoclassical production technologies supports a significant role for putty-clay capital in explaining business cycle and medium-run dynamics.

Keywords: Putty-clay, vintage capital, business cycle, irreversibility, capacity utilization

Full paper (957 KB Postscript)
feds 1998-29
August 1998

Monetary Policy and Multiple Equilibria (PDF)

Jess Benhabib, Stephanie Schmitt-Grohe, and Martin Uribe

Abstract: In this paper, we characterize conditions under which interest rate feedback rules whereby the nominal interest rate is set as an increasing function of the inflation rate generate multiple equilibria. We show that these conditions depend not only on the fiscal regime (as emphasized in the fiscal theory of the price level) but also on the way in which money is assumed to enter preferences and technology. We analyze this issue in flexible and sticky price environments. We provide a number of examples in which, contrary to what is commonly believed, active monetary policy in combination with a fiscal policy that preserves government solvency gives rise to multiple equilibria and passive monetary policy renders the equilibrium unique.

Keywords: Interest rate feedback rules, multiple equilibria, sticky prices

Full paper (325 KB Postscript)
feds 1998-28
June 1998

The Multiple Unit Auction with Variable Supply (PDF)

Yvan Lengwiler

Abstract: The theory of multiple unit auctions traditionally assumes that the offered quantity is fixed. I argue that this assumption is not appropriate for many applications because the seller may be able and willing to adjust the supply to the bidding. In this paper I address this shortcoming by analyzing a multi-unit auction game between a monopolistic seller who can produce arbitrary quantities at constant unit cost, and oligopolistic bidders. I establish the existence of a subgame-perfect equilibrium for price discriminating and for uniform price auctions. I also show that bidders have an incentive to misreport their true demand in both auction formats, but they do that in different ways and for different reasons. Furthermore, both auction formats are inefficient, but there is no unambiguous ordering among them. Finally, the more competitive the bidders are, the more likely the seller is to prefer uniform pricing over price discrimination, yet increased competition among bidders may or may not enhance efficiency.

Keywords: Multiple unit auction, uniform price, price discrimination, elastic supply, decreasing valuation

Full paper (240 KB Postscript)

Abstract: This paper compares discretionary monetary policy under two Phillips curves. Previous work uses a Phillips curve consistent with "Neoclassical" models of price adjustment. Sticky price models imply a "New-Keynesian" Phillips curve based on staggered price setting that delivers familiar results on an inflationary bias and inflation contracts. However, the comparison of price level and inflation targeting reveals an output/price stability tradeoff under the New-Keynesian model that does not arise under the Neoclassical specification, illustrating the usefulness of considering the New-Keynesian model. Given the empirical support for the New-Keynesian specification, a stability tradeoff likely exists.

Keywords: Time-inconsistency, rules, base drift

Full paper (163 KB Postscript)
feds 1998-26
June 1998

P* Revisited: Money-Based Inflation Forecasts with a Changing Equilibrium Velocity (PDF)

Athanasios Orphanides and Richard Porter

Abstract: This paper implements recursive techniques to estimate the equilibrium level of M2 velocity and to forecast inflation using the P* model. The recursive estimates of equilibrium velocity are obtained by applying regression trees and least squares methods to a standard representation of M2 demand, namely a model in which the velocity of M2 depends on the opportunity cost of holding M2 instruments. Equilibrium velocity is defined as the level of velocity that would be expected to obtain if deposit rates were at their long-run average (equilibrium) value. We simulate the alternative models to obtain real-time forecasts of inflation and evaluate the performance of the forecasts obtained from the alternative models. We find that while a $P^*$ model assuming a constant equilibrium velocity does not provide accurate inflation forecasts in the 1990s, a model based on our time-varying equilibrium velocity estimates does quite well.

Keywords: Inflation, M2 velocity, quantity equation

Full paper (460 KB Postscript)

Abstract: In this paper, we investigate whether elimination of the savings association charter might reduce lending to nontraditional mortgage borrowers. We present a theoretical model of lender portfolio choice, in which nontraditional lenders have some market power and traditional lenders are price-takers in the mortgage market. The comparative statics indicate differences between nontraditional and traditional lenders in terms of their asset allocation responses to changes in borrower income and house prices. Empirical tests indicate the absence of such differences between savings associations and commercial banks, suggesting that elimination of the savings association charter would not impair lending to nontraditional mortgage borrowers.

Keywords: Savings and loans, savings associations, mortgages, commercial banks, community lending

feds 1998-24
June 1998

The Effect of Stock Prices on the Demand for Money Market Mutual Funds (PDF)

James P. Dow, Jr., and Douglas W. Elmendorf

Abstract: During the 1990s, households have sharply increased the share of their portfolios held in equities and mutual funds and sharply reduced the share held in bank accounts. We show that this reallocation has substantially increased the impact of financial-market developments on the demand for money. Specifically, both increases and decreases in the Wilshire 5000 have boosted the demand for money funds during the 1990s, although they had little effect on money funds during the 1980s. The estimated effects in the 1990s are generally statistically significant and economically important.

Keywords: Money, stock prices

Full paper (221 KB Postscript)

Abstract: This paper uses a competitive equilibrium model to study how institutional investors influence the volatility and the informativeness of asset prices. Institutional investors are assumed to be "rational" informed traders, while individual investors are supposed to be "naive" informed traders, insofar as the former use the equilibrium price to extract information while the latter do not. The paper compares the informativeness and the volatility of the equilibrium price in an economy in which the informed traders are naive and in one where they are rational; the paper also investigates how the price characteristics react to changes in the parameters, in particular in the number of informed traders.

Keywords: Institutional investors, rational expectations, asymmetric information

Full paper (1066 KB Postscript)

Abstract: This paper studies the optimal monetary policy in the presence of uncertainty about the natural rate and the short-run inflation-unemployment tradeoff. Two conflicting motives drive policy. In the static version of the model, uncertainty provides a motive for the policymaker to move cautiously. In the dynamic version, uncertainty motivates an element of experimentation. I find that the optimal policy that balances these motives typically still exhibits gradualism, i.e., is less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and inflation close to target.

Keywords: Monetary policy, gradualism, parameter uncertainty, learning experimentation, NAIRU

Full paper (437 KB Postscript)

Abstract: We discuss the ability of standard estimates of the correlation of wages and employment to measure the relative strength of aggregate demand and supply shocks, given that the choice of time period, deflator, and explanatory variables inherently biases the estimated cyclical coefficients toward identifying labor supply or demand. We determine that a closer look at the standard wage/labor correlation shows that it can neither provide information on the relative strength of supply and demand shocks, nor give an indication of the response of wages to aggregate demand shocks. Following this, we test the predictions of a neo-Keynesian model for the correlation of employment and wages using restrictions generated by the model to identify movements along or shifts in labor demand. Our results are consistent with the theory of nominal wage rigidity and we find no reason to reject the neo-Keynesian model based on the correlation of wages and employment.

Keywords: Business cycles, labor demand, labor supply, rigidities

Full paper (218 KB Postscript)
feds 1998-20
May 1998

Stock Market Wealth and Consumer Spending (PDF)

Martha Starr-McCluer

Abstract: This paper investigates the effects of stock market wealth on consumer spending. Traditional macroeconometric models estimate that a dollar's increase in stock market wealth boosts consumer spending by 3-7 cents per year. With the substantial 1990s rise in stock prices, the nature and magnitude of this "wealth effect" have been much debated. After describing the issues and reviewing previous research, I present new evidence from the SRC Surveys of Consumers. The survey results are broadly consistent with lifecycle saving and a modest wealth effect: Most stockholders reported no appreciable effect of stock prices on their saving or spending, but many mentioned "retirement saving" in explaining their behavior.

Keywords: Consumption, saving, stock market wealth

Full paper (201 KB Postscript)

Abstract: This paper studies the business-cycle fluctuations predicted by a two-sector endogenous-business-cycle model with sector-specific external increasing returns to scale. It focuses on aspects of actual fluctuations that have been identified both as defining features of the business cycle and as ones that standard real-business-cycle models cannot explain: the autocorrelation function of output growth, the impulse response function of output to demand shocks, and the forecastable movements of output, hours, and consumption. For empirically realistic calibrations of the degree of sector-specific external returns to scale, the results suggest that endogenous fluctuations do not provide the dynamic element that is missing in existing real-business-cycle models.

Keywords: Business cycles, expectations-driven fluctuations

Full paper (362 KB Postscript)

Abstract: This paper introduces the "compound confluent hypergeometric" (CCH) distribution. The CCH unifies and generalizes three recently introduced generalizations of the beta distribution: the Gauss hypergeometric (GH) distribution of Armero and Bayarri (1994), the generalized beta (GB) distribution of McDonald and Xu (1995), and the confluent hypergeometric (CH) distribution of Gordy (forthcoming). Unlike the beta, GB and GH, the CCH allows for conditioning on explanatory variables in a natural and convenient way. The CCH family is conjugate for gamma distributed signals, and so may also prove useful in Bayesian analysis. Application of the CCH is demonstrated with two measures of household liquid assets. In each case, the CCH yields a statistically significant improvement in fit over the more restrictive alternatives.

Keywords: Beta distribution, hypergeometric functions

Full paper (339 KB Postscript)
feds 1998-17
April 1998

Does the Fed Act Gradually? A VAR Analysis (PDF)

Brian Sack

Abstract: The tendency for changes in the federal funds rate to be implemented gradually has been considered evidence of an interest-rate smoothing objective for the Federal Reserve. This paper investigates whether gradual movements in the federal funds rate can be explained by the dynamic structure of the economy and the uncertainty that the Fed faces regarding this structure, without recourse to including an ad-hoc interest rate smoothing argument in the objective function of the Fed. The analysis calculates the optimal funds rate policy given the structural form of the economy estimated in a VAR. In the absence of parameter uncertainty, the calculated policy responds more aggressively to changes in the economy than the observed policy, resulting in a substantially higher volatility of the funds rate than observed. Parameter uncertainty, however, limits the willingness of the Fed to deviate from the policy rule that has been previously implemented. Because the Fed has historically smoothed interest rates, the calculated policy under parameter uncertainty can account for a considerable portion of the gradualism observed in funds rate movements.

Keywords: Gradualism, interest-rate smoothing, parameter uncertainty

Full paper (393 KB Postscript)
feds 1998-16
April 1998

Part-Time Work and Industry Growth (PDF)

Bruce C. Fallick

Abstract: The impression that employment in the U.S. has become more part-time intensive may be driven by a tendency for faster-growing industries to use more part-time work. I document this association over 1983-1993, and demonstrate that it is robust to alternative measures. Similar relationships are discernable in several countries. However, the association does not emerge clearly in the U.S. until the 1980s. Moreover, both relative growth rates and relative part-time intensities of industries have changed markedly since 1940. Part-time work at fast-growing industries is not more likely to be involuntary, although this may be true for entering workers, nor is there a trend in that direction.

Keywords: Part-time, full-time

Full paper (388 KB Postscript)

Abstract: We examine the economics of financing small business in private equity and debt markets. Firms are viewed through a financial growth cycle paradigm in which different capital structures are optimal at different points in the cycle. We show the sources of small business finance,and how capital structure varies with firm size and age. The interconnectedness of small firm finance is discussed along with the impact of the macroeconomic environment. We also analyze a number of research and policy issues, review the literature, and suggest topics for future research.

Keywords: Venture capital, small business lending, bank, mergers

Abstract: The purpose of this study is to determine whether, from a public policy standpoint, divestitures constitute an effective antitrust remedy in bank merger cases. A number of findings emerge from the study: Divested branches have a remarkable survival record; structural changes effected by divestitures tend to persist over time; larger buyers of divested branches tended to be more successful than smaller buyers; divestiture of the target institutions' branches rather than those of applicants proved preferable from an antitrust standpoint; and divested branches selected by the Department of Justice do not perform better than others. The findings suggest that divestitures of bank offices have generally provided an effective public policy remedy.

Keywords: Bank mergers, antitrust, divestiture

Full paper (79 KB Postscript)
feds 1998-13
July 1998

Who Holds Cash? And Why? (PDF)

Calvin Schnure

Abstract: Cash holdings of nonfinancial firms range widely, and are related to firm size, industry and access to the public bond market. Cash holdings are positively correlated with agency proxies, suggesting that firms that cannot borrow easily due to agency problems hold greater cash stocks--perhaps as a cushion to prevent shortfalls in cash flow from impinging on investment. However, this correlation holds only for the very highest cash holders, especially small firms. The group of afflicted firms appears to be less than one-quarter of COMPUSTAT firms. Agency proxies are irrelevant for a large majority of firms.

Keywords: Cash flow, cash stocks

Abstract: In recent years, a handful of countries have converted the financing of their social security systems from pay-as-you-go (PAYGO) to partial or full funding. Privatization is viewed as one way to insulate social security from the political and demographic pressures that currently threaten the financial stability of PAYGO systems. However, privatization would improve a nation's situation only if such a reform increases domestic saving. In this paper I use evidence from Chile, where social security was privatized in 1981, to assess the impact of such a reform on household saving rates. I find that the reform provided a significant stimulus for saving among higher income households, increasing their saving rates by more than seven percentage points. This increase in saving at the household level translates into an increase in national saving of more than two percent of GDP.

Keywords: Social security, privatization, household saving

feds 1998-11
February 1998

The Auctions of Swiss Government Bonds: Should the Treasury Price Discriminate or Not? (PDF)

Daniel Heller and Yvan Lengwiler

Abstract: Ever since Friedman's (1960) contribution, there has been an ongoing controversy about whether the Treasury should auction off its government debt with a discriminatory or with a uniform price format. Many industrialized countries, the United States or Germany, for instance, use discriminatory auctions, while Switzerland applies to uniform price rule. Using recent contributions to multi-unit auction theory, we analyze data on the bids submitted to Swiss Treasury bond auctions over the last three years. We then construct hypothetical bid functions that would occur under price discrimination. Based on these bid functions, we determine which auction format minimizes the government's costs of financing its debt.

Keywords: Government bonds, multi-unit auctions, price discrimination, uniform price

Full paper (286 KB Postscript)

Abstract: This study analyzes alternative bank regulatory polices within a theoretical framework that can encompass many policy design issues. Consequences of generalizing banks' investment and financing opportunities for results in the existing literature are examined. Under costless equity issuance, a narrow banking requirement costlessly resolves moral hazard and insurance pricing problems addressed in the literature. With costly equity, minimum capital requirements can be effective but optimal policy design is complicated by its dependence on equity issuance costs, heterogenous bank investment opportunities, and the information requirements these dependencies create. Incentive compatible policy mechanisms appear limited in their ability to resolve the information problems.

Keywords: Banks, deposit insurance, incentive-compatible

Full paper (420 KB Postscript)
feds 1998-09
February 1998

Government Debt (PDF)

Douglas W. Elmendorf and N. Gregory Mankiw

Abstract: This paper surveys the literature on the macroeconomic effects of government debt. It begins by discussing the data on debt and deficits, including the historical time series, measurement issues, and projections of future fiscal policy. The paper then presents the conventional theory of government debt, which emphasizes aggregate demand in the short run and crowding out in the long run. It next examines the theoretical and empirical debate over the theory of debt neutrality called Ricardian equivalence. Finally, the paper considers the various normative perspectives about how the government should use its ability to borrow.

Keywords: Government debt, Ricardian equivalence

Full paper (351 KB Postscript)

Abstract: Menezes and Monteiro, Math. Soc. Sci. (1995), show that a multi-unit discriminatory price auction does not have a pure strategy equilibrium unless one imposes some rather special conditions on the demand functions. This non-existence result might indicate a problem either wirh the underlying auction procedure (as Menezes and Monteiro suggest) or with the modelling approach (as we suggest). We observe that the non-existence problem disappears if bids must come in multiples of smallest units -- a realistic feature. Moreover, we show that most of the analysis can be recast in a discrete action model.

Keywords: Discriminatory price auction, mixed strategies, existence of equilibrium, integer constraints

Full paper (241 KB Postscript)
feds 1998-07
February 1998

Bankruptcy Exemptions and the Market for Mortgage Loans (PDF)

Richard M. Hynes and Jeremy Berkowitz

Abstract: The recent explosion in personal bankruptcy filings has motivated research into whether credit markets are being adversely afected by generous legal provisions. Empirically, this question is examined by comparing credit conditions and bankruptcy exemptions across states. We note that the literature has focused on aggregate household credit, making no distinction between secured and unsecured credit. We argue that such aggregation obscures important differences in forms of credit. Most significantly, property exemptions do not prevent the home mortgage lender from foreclosing on the home if not fully repaid.

Keywords: Bankruptcy, mortgages, secured credit

Full paper (691 KB Postscript)
feds 1998-06
February 1998

Pricing the Strategic Value of Poison Put Bonds (PDF)

Alexander David

Abstract: In times of low liquidity for a firm, poison put bondholders can threaten to either force the company into a reorganization or to raise its borrowing costs. A multilateral bargaining solution for the strategic value is formulated at the time of exercise. Even infinitesimal bondholders, putting non-cooperatively, are able to extract more than the intrinsic value whenever the amount of putable debt exceeds the firm's effective liquidity. Prior to the crisis all financial assets are priced in a continous-time framework when interest rates follow the Vasicek process and firm's debtholders are subject to a sharp price decline due to an LBO. The model is calibrated to one such recent crisis -- that of Kmart Corp.

Keywords: Covenants, effective liquidity, multilateral-bargaining, rating boundaries

Full paper (993 KB Postscript)

Abstract: This paper examines the underlying state of the labor market, assuming data in the monthly "Employment Situation" are contaminated by measurement error and other transient noise. To better filter out unobserved noise, the methodology exploits correlations among labor-market series. Household employment and labor force have cross-correlated sampling errors; establishment employment and hours-worked may, also. The Kalman filtering procedure also exploits fundamental economic relationships among these series. Error cross-correlations and economic relationships shape a multivariate labor-market model where observed variables embody unobserved components: trend, cycle and noise. Maximum-likelihood estimation enables construction of labor series from which noise components have been removed.

Keywords: Signal extraction, kalman filter, employment situation

Full paper (197 KB Postscript)
feds 1998-04
January 1998

Good News and Bad News about Share Repurchases (PDF)

George W. Fenn and Nellie Liang

Abstract: We estimate the cross-sectional relationship between open market repurchases and accounting data for a large sample of dividend- paying and non-dividend paying firms over a twelve year period (1984-95). Consistent with the hypothesis that firms use open market repurchases to reduce the agency costs of free cash flow, we find that repurchases are positively related to proxies for free cash flow and negatively related to proxies for marginal financing costs. We also examine the extent to which management stock options influence the choice between open market repurchases and dividend payments. Because the value of management stock options--like any call option--is negatively related to expected future dividend payments, management can increase the value of its stock options by substituting share repurchases for dividend growth. We find evidence that such substitution occurs: for dividend-paying firms, share repurchases are positively related and dividend increases are negatively related to a proxy for management stock options, whereas for non-dividend-paying firms, the relationship between repurchases and options is weak and statistically insignificant.

Keywords: Share repurchases, free cash flow, stock options, dividend increases

Full paper (224 KB Postscript)
feds 1998-03
January 1998

Monetary Policy Rules Based on Real-Time Data (PDF)

Athanasios Orphanides

Abstract: In recent years, simple policy rules have received attention as a means to a more transparent and effective monetary policy. Often, however, the analysis is based on unrealistic assumptions about the timeliness of data availability. This permits rule specifications that are not operational and ignore difficulties associated with data revisions. This paper examines the magnitude of these informational problems using Taylor's rule as an example. I demonstrate that the real-time policy recommendations differ considerably from those obtained with the ex post revised data and are revised substantially even a year after the relevant quarter. Further, I show that estimated policy reaction functions obtained using the ex post revised data can yield misleading descriptions of historical policy. Using Federal Reserve staff forecasts I show that in the 1987-1992 period simple forward-looking specifications describe policy better than comparable Taylor-type specifications, a fact that is largely obscured when the analysis is based on the ex post revised data.

Keywords: Monetary policy rules, federal funds rate, Taylor rule, real-time data

Full paper (634 KB Postscript)

Abstract: A dynamic stochastic general-equilibrium (DSGE) model with real and nominal rigidities succeeds in capturing some key nominal features of U.S. business cycles. Additive technology shocks, as well as multiplicative shocks, are introduced. Monetary policy is specified following the developments in the structural vector autoregression (VAR) literature. Interaction between real and nominal rigidities is essential to reproduce the liquidity effect of monetary policy. The model is estimated by maximum likelihood on U.S. data, and its fit is comparable to that of an unrestricted first-order VAR. Besides producing reasonable impulse responses and second moments, this model replicates a feature of U.S. business cycles, never captured by previous research with DSGE models, that an increase in interest rates predicts a decrease in output two to six quarters in the future. Finally, some policy implications are discussed.

Keywords: Monetary policy, maximum likelihood estimation, additive technology shocks, liquidity effect

Full paper (628 KB Postscript)
feds 1998-01
January 1998

Opportunistic and Deliberate Disinflation under Imperfect Credibility (PDF)

Antulio N. Bomfim and Glenn D. Rudebusch

Abstract: One strategy for disinflation prescribes a deliberate path towards low inflation. A contrasting opportunistic approach eschews deliberate action and instead waits for unforeseen shocks to reduce inflation. This paper compares the ability of these two approaches to achieve disinflation---and at what cost. We analyze these issues using the Federal Reserve's FRB/US model, which allows alternative assumptions to be made about expectations held by agents in the economy; hence, the credibility of the central bank can be considered in assessing the cost of deliberate and opportunistic disinflations.

Keywords: Monetary policy, inflation expectations, policy rules, inflation targets

Full paper (223 KB Postscript)

 

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