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Finance and Economics Discussion Series

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Abstract: Basel II bank capital regulations are designed to be substantially more risk sensitive than the current regulations. In the United States, only the largest banks would be required to adopt Basel II; other depositories could choose to adopt such standards or to remain under the Basel I capital standards. We consider possible effects of this two-pronged or "bifurcated" approach on the market for residential mortgages. Specifically, we analyze whether those institutions that adopt Basel II will enjoy lower costs than nonadopters and whether they have an incentive to retain mortgages in their own portfolios. We find that (1) despite the large differences in regulatory capital requirements between adopters and nonadopters, it is unlikely that there will be any measurable effect of Basel II implementation on most mortgage rates and, consequently, any direct impact on the competition between adopters and nonadopters for originating or holding residential mortgages; (2) the most significant competitive impact may be felt among mortgage securitizers; and (3) adopters might have increased profits from some mortgages relative to nonadopters because they will capture some of the deadweight losses that occur under the current regulatory regime, but nonadopters would likely retain their market shares.

Keywords: Bank capital regulation, mortgages, market competition, government-sponsored enterprises, GSEs

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Abstract: I estimate sticky-price and sticky-information models of price setting for the United States via maximum-likelihood techniques, reaching several conclusions. First, the sticky-price model fits best, and captures inflation dynamics as well as reduced-form equations once hybrid-behavior is allowed. Second, the importance of hybrid behavior in sticky-price models is potentially consistent with a role for some information imperfections, such as sticky information, as a complement to nominal price rigidities. Finally, the favorable results herein for the hybrid sticky-price model when evaluated by statistics that summarize the relative fit of different models is consistent with the existing literature that is both supportive and dismissive of such models, as this literature has largely ignored fit in evaluating such models. Many previous studies have focused on ancillary issues, such as the standard errors associated with certain parameters or Granger-causality tests that may not provide much information about sticky-price models.

Keywords: Phillips curve, new-keynesian model, inflation persistence

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feds 2006-44
December 2006

Shifting Trends in Semiconductor Prices and the Pace of Technological Progress (PDF)

Ana Aizcorbe, Stephen D. Oliner, and Daniel E. Sichel

Abstract: This paper examines three questions motivated by previous research on semiconductors and productivity growth: Why did semiconductor prices fall so rapidly in the second half of the 1990s, why has the rate of price decline slowed since 2001, and to what extent are these price swings associated with changes in the rate of advance in semiconductor technology? We show that the price swings are statistically significant and that they reflect changes in both price-cost markups and cost trends. Further analysis indicates that the shift to faster cost declines in the mid-1990s likely corresponded to a speed-up in the pace of advance in semiconductor technology; however, the slower cost declines since 2001 appear not to have been mirrored by a deceleration in technology. Consequently, researchers should be cautious about associating price or cost movements for semiconductors with changes in the pace of underlying technology even over moderately long periods.

Keywords: Semiconductor prices, productivity growth, technological progress, technology trends

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Abstract: Inflation measurement is the process through which changes in the prices of individual goods and services are combined to yield a measure of general price change. This paper discusses the conceptual framework for thinking about inflation measurement and considers practical issues associated with determining an inflation measure's scope; with measuring individual prices; and with combining these individual prices into a measure of aggregate inflation. We also discuss the concept of "core inflation," and summarize the implications of inflation measurement for economic theory and policy.

Keywords: Index numbers, price indexes, cost-of-living index

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Abstract: This paper decomposes nominal Treasury yields into expected real rates, expected inflation rates, real risk premiums, and inflation risk premiums by separately calibrating a three-factor affine term structure model to the nominal Treasury and TIPS yield curves. Although this particular application seems to produce expected real short rates and inflation rates that are somewhat static, there are theoretical advantages to calibrating the model to nominal and real yields separately. Moreover, the estimates correlate positively with back-of-the-envelope measures of the inflation risk premium. With respect to the current environment, monetary policy uncertainty does not seem to have contributed to the apparent increase in the inflation risk premium since the beginning of 2006. Also, in purely nominal terms, the increase in term premiums thus far this year might be just as much a global as a domestic phenomenon, given that nominal term premiums have also increased in Germany and the United Kingdom.

Keywords: Affine term structure model, inflation risk premium

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Abstract: This paper examines the relationship between multimarket bank presence and the profitability (and therefore viability) of small, single-market banks. We find that increased presence of multimarket banks is associated with a significant reduction in the profitability of small, single-market banks operating in rural banking markets, but not of those operating in urban markets. We explore this relationship by breaking single-market bank profits down into several components in order to shed light on the mechanisms through which multimarket bank presence might influence the profitability of single-market banks.

Keywords: Banks, competition, pricing

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feds 2006-40
November 2006

Acquistion Targets and Motives in the Banking Industry (PDF)

Timothy H. Hannan and Steven J. Pilloff

Abstract: This paper uses a large sample of individual banking organizations, observed from 1996 to 2003, to investigate the characteristics that made them more likely to be acquired. We use a definition of acquisition that we consider preferable to that used in much of the previous literature, and we employ a competing-risk hazard model that reveals important differences that depend on the type of acquirer. Since interstate acquisitions became more numerous during this period, we also investigate differences in the determinants of acquisition between in-state and out-of-state acquirers. The hypothesis that acquisitions serve to transfer resources from less efficient to more efficient uses receives substantial support from our results, as do a number of other relevant hypotheses.

Keywords: Banking acquisitions mergers

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feds 2006-39
November 2006

Incorporating Judgement in Fan Charts (PDF)

Pär Österholm

Abstract: Within a decision-making group, such as the monetary-policy committee of a central bank, group members often hold differing views about the future of key economic variables. Such differences of opinion can be thought of as reflecting differing sets of judgement. This paper suggests modelling each agent's judgement as one scenario in a macroeconomic model. Each judgement set has a specific dynamic impact on the system, and accordingly, a particular predictive density - or fan chart - associated with it. A weighted linear combination of the predictive densities yields a final predictive density that correctly reflects the uncertainty perceived by the agents generating the forecast. In a model-based environment, this framework allows judgement to be incorporated into fan charts in a formalised manner.

Keywords: Forecasts, predictive density, linear opinion pool

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Abstract: I present an environment for which both outside and inside money are essential as means of payment. The key model feature is that there is imperfect monitoring of issuers of inside money. I use a random matching model of money where some agents have private trading histories and others have trading histories that can be publicly observed only after a lag. I show via an example that for lags that are neither too long nor too short, there exist allocations that use both types of money that cannot be duplicated when only one type is used. Inside money provides liquidity that increases the frequency of trades, but incentive constraints restrict the amount of output that can be traded. Outside money is immune to such constraints and can trade for higher levels of output.

Keywords: Inside and outside money

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Abstract: This paper presents estimates of the impact of Social Security's Delayed Retirement Credit on the employment rates of older men. The credit raises lifetime social security benefit payments for recipients who delay receiving benefits after age 65 and offers a rare and important test of whether labor supply incentives built in to the program can promote work at older ages. The results suggest that the increased incentives raised employment among workers over age 65. In addition, the recent increases in social security's Normal Retirement Age also appear to be pushing up labor supply.

Keywords: Social security, labor supply, aging, retirement

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feds 2006-36
November 2006

Incompatibility and Investment in ATM Networks (PDF)

Timothy H. Hannan and Ron Borzekowski

Abstract: The literature on network industries and network effects notes that incompatibility across rival systems can influence firms' incentives to invest in product changes that are beneficial to the consumer. We investigate this phenomenon in the case of bank ATM networks, where the number of ATM locations serves as the measure of product quality and surcharge fees serve as an index of incompatibility. Using as a natural experiment the lifting of a surcharge ban in Iowa (and not in neighboring states), we find that the associated increase in incompatibility for Iowa banks caused a substantial increase in the number of ATM locations offered to customers. This effect is found to be larger (in percentage terms) for larger banks than for smaller ones.

Keywords: ATM networks, banks, compatibility

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feds 2006-35
November 2006

Realized Jumps on Financial Markets and Predicting Credit Spreads (PDF)

George Tauchen and Hao Zhou

Abstract: This paper extends the jump detection method based on bi-power variation to identify realized jumps on financial markets and to estimate parametrically the jump intensity, mean, and variance. Finite sample evidence suggests that jump parameters can be accurately estimated and that the statistical inferences can be reliable, assuming that jumps are rare and large. Applications to equity market, treasury bond, and exchange rate reveal important differences in jump frequencies and volatilities across asset classes over time. For investment grade bond spread indices, the estimated jump volatility has more forecasting power than interest rate factors and volatility factors including option-implied volatility, with control for systematic risk factors. A market jump risk factor seems to capture the low frequency movements in credit spreads.

Keywords: Jump-Diffusion Process, Realized variance, bi-power variation, realized jumps, jump volatility, credit risk premium

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Abstract: The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Public Law 109-8, April 2005) made significant changes to procedures for managing consumer bankruptcy petitions, but it also included amendments to the Truth in Lending Act. Notable among the Truth in Lending changes is a section providing for new disclosures on the length of time it will take consumers to repay open end credit accounts in full if they make only the minimum required payments. This paper explores the range of assumptions necessary for the calculations underlying the new required disclosures, examines the sensitivity of the disclosures to variations in the assumptions, and explores the potential for inaccuracy in the required disclosures based upon consumers' use of their open end credit accounts. For the latter exploration, the paper examines consumer survey evidence and employs a large longitudinal sample of credit card accounts to measure how often consumers' actual patterns of use of their credit card accounts match the assumptions of the new disclosure.

Keywords: Truth in Lending, consumer credit, credit cards

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feds 2006-33
October 2006

The Relocation Decisions of Working Couples (PDF)

Jonathan F. Pingle

Abstract: Most prime-age married couples in the U.S. today have two labor force participants. Migration decisions are more complicated for two-earner couples than for one-earner couples because any gain from moving that accrues to one spouse must be great enough to offset any loss to the other spouse. This paper estimates the extent to which internal migration is depressed by rising earnings equality among spouses. The results indicate that couples' migration propensities are substantially lower the more equal spouses' labor incomes.

Keywords: Relocation, domestic migration

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feds 2006-32
October 2006

What Do Financial Asset Prices Say About the Housing Market? (PDF)

J. Benson Durham

Abstract: This paper examines the first three moments of investors' expectations for the housing sector. That is, first, what do financial markets imply about expected future home prices? Second, how much confidence do investors have in their forecast? And, third, do market participants see more downside than upside risk? Housing futures and options, which trade on the Chicago Mercantile Exchange (CME), are not yet deep and liquid, and derivatives on homebuilders' shares reflect considerable idiosyncratic information and are therefore an imperfect proxy. Nonetheless, prices suggest that investors currently expect some mild depreciation in home values within the next year. Also, uncertainty has increased, but, generally inconsistent with the perception of a "bubble," the implied risks do not seem particularly tilted to the downside. Probability density functions derived from options on homebuilders' stocks are not appreciably skewed to the left in general, vis-à-vis the broader market, or with respect to recent history.

Keywords: Home prices, financial assets

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Abstract: Because plant deaths destroy specific capital with large local economic impacts and potentially important macroeconomic effects, understanding the causes of deaths and, in particular, why they are concentrated in cyclical downturns, is important. The reallocation-timing hypothesis posits that plants suffering adverse permanent demand/productivity shocks delay shutdowns until cyclical downturns when plant capacity is less valuable, while the fragility hypothesis posits that shutdowns occur in downturns because the option value of maintaining the plant through weak demand periods is too low. I show that the effect that a plant's specific capital has on the timing of plant deaths differs across these two hypotheses and then use this insight to test the hypotheses' relative importance. I find that fragility is the dominant cause of the countercyclical behavior of plant deaths. This suggests that the endogenous destruction of capital is likely an important amplification and propagation mechanism for cyclical shocks and that stabilization policies have the benefit of reduced capital destruction.

Keywords: Plant deaths, business cycle

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Abstract: Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that securitize mortgages and issue mortgage-backed securities (MBS). In addition, the GSEs are active participants in the secondary mortgage market on behalf of their own investment portfolios. Because these portfolios have grown quite large, portfolio purchases (in addition to MBS issuance) are often thought to be an important force in the mortgage market. Using monthly data from 1993 to 2005 we estimate a VAR model of the relationship between GSE secondary market activities and mortgage interest rate spreads. We find that GSE portfolio purchases have no significant effects on either primary or secondary mortgage rate spreads. Further, we examine GSE activities and mortgage rate spreads in the wake of the 1998 debt crisis, and find that GSE portfolio purchases did little to affect interest rates paid by new mortgage borrowers. This empirical finding is robust to alternative identification assumptions and to alternative model and variable specifications.

Keywords: Mortgage finance, government-sponsored enterprises, financial stability

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Abstract: We use the dynamic Gordon-growth model to decompose the rent-price ratio for owner-occupied housing in the U.S., four Census regions, and twenty-three metropolitan areas into three components: The expected present value of real rental growth, real interest rates, and future housing premia. We use these components to decompose the trend and variance in rent-price ratios for 1975-2005, for an early sub-sample (1975-1996), and for the recent housing boom (1997-2005). We have three main findings. First, variation in expected future real rents accounts for a small share of variation in our sample rent-price ratios; variation in real interest rates and housing premia account for most of the variability. Second, expected future real rates and housing premia were so strongly negatively correlated prior to 1997 that changes to real interest rates did not affect the rent-price ratio. After 1997, rates and premia have been positively correlated, and the decline in the rent-price ratio that has occurred in almost every geographic area in our sample since 1997 reflects both declining real rates and declining premia. Third, we show that in the recent housing boom, 65 percent of the decline in the aggregate rent-price ratio is due to a declining housing premium.

Keywords: Rent-price ratio, house price, housing rents, interest rate

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feds 2006-28
December 2011

The U.S. Treasury Yield Curve: 1961 to the Present (PDF)

Refet S. Gurkaynak, Brian Sack, and Jonathan H. Wright

Data - Excel file (30 MB XLS) | Data - Screen reader | Data - XML (sdmx/zip)

Abstract: The discount function, which determines the value of all future nominal payments, is the most basic building block of finance and is usually inferred from the Treasury yield curve. It is therefore surprising that researchers and practitioners do not have available to them a long history of high-frequency yield curve estimates. This paper fills that void by making public the Treasury yield curve estimates of the Federal Reserve Board at a daily frequency from 1961 to the present. We use a well-known and simple smoothing method that is shown to fit the data very well. The resulting estimates can be used to compute yields or forward rates for any horizon. We hope that the data, which are posted on the website /pubs/feds/2006 and which will be updated periodically, will provide a benchmark yield curve that will be useful to applied economists.

Keywords: Yield curve, forward rates, on-the-run premium, treasury market

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Abstract: We test the widely held assumption that longer restructurings are more costly. In contrast to earlier studies, we use instrumental variables to control for the endogeneity of restructuring time and creditor return. Instrumenting proves critical to our finding that creditor recovery rates increase with duration for roughly 1½ years following default, but decrease thereafter. This, and similar results using the likelihood of reentering bankruptcy, suggest that there may be an optimal time in default. Moreover, the default duration of almost half of our sample is well outside the optimal default duration implied by our estimates. We also find that creditors benefit from more experienced judges and from oversight by only one judge. The results have implications for the reform and design of bankruptcy systems.

Keywords: Bankruptcy cost, bankruptcy reorganization, recovery rate, credit risk

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Abstract: This paper compares the functionality, accuracy, computational efficiency, and practicalities of alternative approaches to solving linear rational expectations models, including the procedures of (Sims, 1996), (Anderson and Moore, 1983), (Binder and Pesaran, 1994), (King and Watson, 1998), (Klein, 1999), and (Uhlig, 1999). While all six prcedures yield similar results for models with a unique stationary solution, the AIM algorithm of (Anderson and Moore, 1983) provides the highest accuracy; furthermore, this procedure exhibits significant gains in computational efficiency for larger-scale models.

Keywords: Linear Rational Expectations, Blanchard-Kahn, Saddle Point Solution

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Abstract: Combining data from several sources, we build a database of home values, the cost of housing structures, and residential land values for 46 large U.S. metropolitan areas from 1984 to 2004. Our analysis of these new data reveal that since the mid-1980s residential land values have appreciated over a much wider range of cities than is commonly believed. And, since 1998, almost all large U.S. cities have seen significant increases in real residential land prices. Averaging across the cities in our sample, by year-end 2004, the value of residential land accounted for about 50 percent of the total market value of housing, up from 32 percent in 1984. An implication of our results is that the future course of home prices--their average rate of appreciation and their volatility--is likely to be determined even more by the course of land prices than used to be the case.

Keywords: Home prices, land prices, construction costs, value of residential land, metropolitan areas

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feds 2006-24
June 2006

Intangible Capital and Economic Growth (PDF)

Carol Corrado, Charles Hulten, and Daniel Sichel

Abstract: Published macroeconomic data traditionally exclude most intangible investment from measured GDP. This situation is beginning to change, but our estimates suggest that as much as $800 billion is still excluded from U.S. published data (as of 2003), and that this leads to the exclusion of more than $3 trillion of business intangible capital stock. To assess the importance of this omission, we add intangible capital to the standard sources-of-growth framework used by the BLS, and find that the inclusion of our list of intangible assets makes a significant difference in the observed patterns of U.S. economic growth. The rate of change of output per worker increases more rapidly when intangibles are counted as capital, and capital deepening becomes the unambiguously dominant source of growth in labor productivity. The role of multifactor productivity is correspondingly diminished, and labor's income share is found to have decreased significantly over the last 50 years.

Keywords: Economic growth, investment, intangibles, capital, productivity, economic measurement

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Abstract: An important step in understanding why employment fluctuates cyclically is determining the relative importance of cyclical movements in permanent and temporary plant-level employment changes. If movements in permanent employment changes are important, then recessions are times when the destruction of job specific capital picks up and/or investment in new job capital slows. If movements in temporary employment changes are important, then employment fluctuations are related to the temporary movement of workers across activities (e.g., from work to home production or search and back again) as the relative costs/benefits of these activities change. I estimate that in the manufacturing sector temporary employment changes account for approximately 60 percent of the change in employment growth over the cycle. However, if permanent employment changes create and destroy more capital than temporary employment changes, then their economic consequences would be relatively greater. The correlation between gross permanent employment changes and capital intensity across industries supports the hypothesis that permanent employment changes do create and destroy more capital than temporary employment changes.

Keywords: Cyclical employment changes, permanent and temporary employment changes

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Abstract: Most central banks now implement monetary policy by trying to hit a target overnight interest rate using one of two types of frameworks. The first involves arrangements for depository institutions to hold a minimum account balance over a multi-day averaging period. The second uses the central bank's lending rate as a ceiling and its deposit rate as a floor for overnight interest rates. Either averaging or a rate corridor can help a central bank hit a target interest rate, but each framework can also have weaknesses in achieving that goal and, in some cases, other associated drawbacks. This paper discusses an alternative possible policy implementation regime, involving a specially designed facility for the payment of interest on a daily basis on balances held at the central bank. This new type of regime could potentially allow smooth monetary policy implementation without the problems associated with averaging or a rate corridor.

Keywords: Policy implementation, overnight interest rate

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Abstract: Cointegration theory provides a flexible class of statistical models that combine long-run relationships and short-run dynamics. This paper presents three likelihood ratio (LR) tests for simultaneously testing restrictions on cointegrating relationships and on how quickly the system reacts to the deviation from equilibrium implied by the cointegrating relationships. Both the orthogonal complements of the cointegrating vectors and of the vectors of adjustment speeds have been used to define the common stochastic trends of a nonstationary system. The restrictions implicitly placed on the orthogonal complements of the cointegrating vectors and of the adjustment speeds are identified for a class of LR tests, including those developed in this paper. It is shown how these tests can be interpreted as tests for restrictions on the orthogonal complements of the cointegrating relationships and adjustment vectors, which allow one to combine and test for economically meaningful restrictions on cointegrating relationships and on common stochastic trends.

Keywords: Cointegration, stochastic trends

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feds 2006-20
May 2006

Inflation Targeting under Imperfect Knowledge (PDF)

Athanasios Orphanides and John C. Williams

Abstract: A central tenet of inflation targeting is that establishing and maintaining well-anchored inflation expectations are essential. In this paper, we reexamine the role of key elements of the inflation targeting framework towards this end, in the context of an economy where economic agents have an imperfect understanding of the macroeconomic landscape within which the public forms expectations and policymakers must formulate and implement monetary policy. Using an estimated model of the U.S. economy, we show that monetary policy rules that would perform well under the assumption of rational expectations can perform very poorly when we introduce imperfect knowledge. We then examine the performance of an easily implemented policy rule that incorporates three key characteristics of inflation targeting: transparency, commitment to maintaining price stability, and close monitoring of inflation expectations, and find that all three play an important role in assuring its success. Our analysis suggests that simple difference rules in the spirit of Knut Wicksell excel at tethering inflation expectations to the central bank's goal and in so doing achieve superior stabilization of inflation and economic activity in an environment of imperfect knowledge.

Keywords: Learning, natural rate of interest, natural rate of unemployment, rational expectations, monetary policy rules, uncertainty, bond prices

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feds 2006-19
May 2006

A Retrospective Evaluation of the Effects of Temporary Partial Expensing (PDF)

Darrel Cohen and Jason Cummins

Abstract: This paper examines how business investment responded to temporary partial expensing, first enacted in 2002 and expanded in 2003. In principle, partial expensing boosted the incentive to invest which should have had a discernable impact on spending. However, the tax changes did not occur in a vacuum, so it is challenging to isolate their impact. Our empirical approach exploits a feature of the tax change which, under certain assumptions, allows us to cleanly estimate its impact. Specifically, partial expensing provided relatively generous tax treatment for long-lived assets. We use this insight in order to construct a difference-in-difference estimator of the tax effects. In addition, the standard model of investment with capital adjustment costs predicts a run up in investment spending prior to expiration and a pothole just after. Our examination of the details of expenditure patterns before, during, and after partial expensing using both monthly and quarterly data suggests considerable ambiguity as to whether the model's predictions were borne out. In addition, anecdotal evidence provides only limited support for the effectiveness of temporary partial expensing.

Keywords: Partial expensing, bonus depreciation, difference-in-difference estimation

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Abstract: This paper measures the impact of crime on firm investment by exploiting variation in kidnappings in Colombia from 1996 to 2002. Our central result is that firms invest less when kidnappings directly target firms. We also find that broader forms of crime--homicides, guerrilla attacks, and general kidnappings--have no significant effect on investment. This finding alleviates concerns that our main result may be driven by unobserved variables that explain both overall criminal activity and investment. Furthermore, kidnappings that target firms reduce not only the investment of firms that sell in local markets, but also the investment of firms that sell in foreign markets. Thus, an unobservable correlation between poor demand conditions and criminal activity is unlikely to explain the negative impact of firm-related kidnappings on investment. Our results are consistent with the hypothesis that managers are reluctant to invest when their freedom and life are at risk, although we cannot completely discard alternative explanations.

Keywords: Crime, kidnappings, investment, Colombia

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Abstract: Dramatic changes have occurred in the U.S. payment system over the past two decades, most notably an explosion in electronic card-based payments. Not surprisingly, this shift has been accompanied by a series of policy debates, all of which hinge critically on understanding consumer behavior at the point of sale. Using a new nationally representative survey, we transform consumers' responses to open-ended questions on reasons for using debit cards to estimate a characteristics-based discrete-choice demand model that includes debit cards, cash, checks, and credit cards. Market shares computed using this model line up well with aggregate shares from other sources. The estimates are used to conduct several counterfactual experiments that predict consumer responses to alternative payment choices. We find that consumers respond strongly to elapsed time at the checkout counter and to whether the payment instrument draws from debt or liquidity. In addition, substitution patterns vary substantially with demographics. New "contactless" payment methods designed to replace debit cards are predicted to draw market share from cash, checks, and credit, in that order. Finally, although we find an effect of cohort on payment technology adoption, this effect is unlikely to diminish substantially over a 10-year horizon.

Keywords: Payments, debit, price response

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Abstract: Debit card use at the point of sale has grown dramatically in recent years in the U.S., and now exceeds the number of credit card transactions. However, many questions remain regarding patterns of debit card use, consumer preferences when using debit, and how consumers might respond to explicit pricing of card transactions. Using a new nationally representative consumer survey, this paper describes the current use of debit cards by U.S. consumers, including how demographics affect use. In addition, consumers' stated reasons for using debit cards are used to analyze how consumers substitute between debit and other payment instruments. We also examine the relationship between household financial conditions and payment choice. Finally, we use a key variable on bank-imposed transaction fees to analyze price sensitivity of card use, and find a 12 percent decline in overall use in reaction to a mean 1.8 percent fee charged on certain debit card transactions; we believe this represents the first microeconomic evidence in the United States on price sensitivity for a card payment at the point of sale.

Keywords: Payments, debit, price response

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Abstract: Surveys do! We examine the forecasting power of four alternative methods of forecasting U.S. inflation out-of-sample: time series ARIMA models; regressions using real activity measures motivated from the Phillips curve; term structure models that include linear, non-linear, and arbitrage-free specifications; and survey-based measures. We also investigate several methods of combining forecasts. Our results show that surveys outperform the other forecasting methods and that the term structure specifications perform relatively poorly. We find little evidence that combining forecasts produces superior forecasts to survey information alone. When combining forecasts, the data consistently places the highest weights on survey information.

Keywords: ARIMA, Phillips curve, forecasting, term structure models

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Abstract: Using the 2003 reduction in dividend tax rates to identify an exogenous change in the after-tax value of dividends to shareholders, we test whether stock holdings among company executives is an important determinant of payout policy. We have three primary findings. First, we find that when top executives have greater stock ownership, and thus an incentive to increase dividends for personal liquidity reasons, there is a significantly greater likelihood of a dividend increase following the 2003 dividend tax cut, whereas no such relation existed in the prior decade when the dividend tax rate was much higher. This finding is strongest for dividend initiations, and is robust to a rich set of firm and shareholder characteristics. Second, we provide evidence that approximately one-third of the firms that initiated dividends in 2003, a higher share than in previous years, scaled back share repurchases by an amount sufficient to reduce their total payouts. This offset potentially raised the total tax burden on shareholders at these firms because share repurchases are still tax-advantaged relative to dividends. Third, we find that while dividend-paying firms with a larger fraction of individual shareholders had greater stock price gains in response to the tax cut, the market appears to have at least partially anticipated that executives with high stock ownership might raise dividends at the expense of share repurchases and increase the average tax burden for individuals, which is consistent with the presence of agency conflicts within the firm.

Keywords: Payout policy, Dividends, Share Repurchases, Executive Ownership, Executive Compensation, Agency Costs

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Abstract: This paper considers changes in the distribution of the wealth of U.S. families over the 1989-2004 period using data from the Survey of Consumer Finances (SCF). Real net worth grew broadly over this period. At the same time, there are indications that wealth became more concentrated, but the result does not hold unambiguously across a set of plausible measures. For example, the Gini coefficient shows significant increases in the concentration of wealth from 1989 to 2004, but the wealth share of the wealthiest one percent of families did not change significantly. Graphical analysis suggests that there was a shift in favor of the top of the distribution, while for the broad middle of the distribution increases were about in proportion to earlier wealth. Within this period, there are other interesting patterns. For example, from 1992 to 2004 the wealth share of the least wealthy half of the population fell significantly to 2.5 percent of total wealth. The data show little in the way of significant distributional shifts since the 2001 survey. The paper also presents some information on underlying factors that may explain a part of the distribution of wealth, including capital gains, saving behavior and income, inheritances, and other factors. There are two special topic sections in the paper. The first presents information on the distributions of wealth of African American and Hispanic families. The second presents information on the use of debt across the distribution of wealth.

Keywords: Wealth distribution, SCF

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Abstract: I present a fully-rational symmetric-information model of an IPO, and a dynamic imperfectly competitive model of trading in the IPO aftermarket. The model helps to explain IPO underpricing, underperformance, and why share allocations favor large institutional investors. In the model, underwriters need to sell a fixed number of shares at the IPO or in the aftermarket. To maximize revenue and avoid selling into the aftermarket where they can be exploited by large investors, underwriters distort share allocations towards investors with market power, and set the IPO offer price below the aftermarket trading price. Large investors who receive IPO share allocations sell them slowly afterwards to reduce their trade's price-impact. This curtails the shares that are available to small price-taking investors, causing them to bid up prices and bid down returns. In some simulations, the distorted share allocations and slow unwinding behavior generate post-IPO return underperformance that persists for several years.

Keywords: Liquidity, IPO, asset pricing, market microstructure

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feds 2006-11
April 2006

Credit Market Competition and Capital Regulation (PDF)

Franklin Allen, Elena Carletti, and Robert Marquez

Abstract: Market discipline for financial institutions can be imposed not only from the liability side, as has often been stressed in the literature on the use of subordinated debt, but also from the asset side. This will be particularly true if good lending opportunities are in short supply, so that banks have to compete for projects. In such a setting, borrowers may demand that banks commit to monitoring by requiring that they use some of their own capital in lending, thus creating an asset market-based incentive for banks to hold capital. Borrowers can also provide banks with incentives to monitor by allowing them to reap some of the benefits from the loans, which accure only if the loans are in fact paid off. Since borrowers do not fully internalize the cost of raising capital to the banks, the level of capital demanded by market participants may be above the one chosen by a regulator, even when capital is a relatively costly source of funds. This implies that the capital requirement may not be binding, as recent evidence seems to indicate.

Keywords: Capital regulation, credit market competition

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feds 2006-10
April 2006

Forecasting Professional Forecasters (PDF)

Eric Ghysels and Jonathan H. Wright

Abstract: Survey of forecasters, containing respondents' predictions of future values of growth, inflation and other key macroeconomic variables, receive a lot of attention in the financial press, from investors, and from policy makers. They are apparently widely perceived to provide useful information about agents' expectations. Nonetheless, these survey forecasts suffer from the crucial disadvantage that they are often quite stale, as they are released only infrequently, such as on a quarterly basis. In this paper, we propose methods for using asset price data to construct daily forecasts of upcoming survey releases, which we can then evaluate. Our methods allow us to estimate what professional forecasters would predict if they were asked to make a forecast each day, making it possible to measure the effects of events and news announcements on expectations. We apply these methods to forecasts for several macroeconomic variables from both the Survey of Professional Forecasters and Consensus Forecasts.

Keywords: Survey forecasts, mixed frequency data sampling, forecast evaluation, rational expectations, Kalman filter, Kalman smoother, news announcement

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Abstract: We address the construction of price indexes for consumer vehicles using data collected from a national sample of dealerships. The dataset contains highly disaggregate data on actual sales prices and quantities, along with information on customer cash rebates, financing terms, and much more. Using these data, we are able to capture the actual cash and financing incentives taken by consumers, and we demonstrate that their inclusion in measures of consumer vehicle prices is important. We also document other features of retail vehicle markets that interact and overlap with price measurement issues. In particular, we construct vehicle price indexes under different assumptions about what constitutes a "new" product in moving from one model year to the next. For the period that we study (1999 to 2003), a period during which incentives became more widespread and new model introductions rose, our preferred price index drops faster than the CPI for new vehicles.

Keywords: Price indexes, motor vehicles, motor-vehicle financing

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Abstract: We study 30 vintages of FRB/US, the principal macro model used by the Federal Reserve Board staff for forecasting and policy analysis. To do this, we exploit archives of the model code, coefficients, baseline databases and stochastic shock sets stored after each FOMC meeting from the model's inception in July 1996 until November 2003. The period of study was one of important changes in the U.S. economy with a productivity boom, a stock market boom and bust, a recession, the Asia crisis, the Russian debt default, and an abrupt change in fiscal policy. We document the surprisingly large and consequential changes in model properties that occurred during this period and compute optimal Taylor-type rules for each vintage. We compare these optimal rules against plausible alternatives. Model uncertainty is shown to be a substantial problem; the efficacy of purportedly optimal policy rules should not be taken on faith. We also find that previous findings that simple rules are robust to model uncertainty may be an overly sanguine conclusion.

Keywords: Monetary policy, model uncertainty, real-time analysis

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feds 2006-07
March 2006

The Yield Curve and Predicting Recessions (PDF)

Jonathan H. Wright

Abstract: The slope of the Treasury yield curve has often been cited as a leading economic indicator, with inversion of the curve being thought of as a harbinger of a recession. In this paper, I consider a number of probit models using the yield curve to forecast recessions. Models that use both the level of the federal funds rate and the term spread give better in-sample fit, and better out-of-sample predictive performance, than models with the term spread alone. There is some evidence that controlling for a term premium proxy as well may also help. I discuss the implications of the current shape of the yield curve in the light of these results, and report results of some tests for structural stability and an evaluation of out-of-sample predictive performance.

Keywords: Interest rates, forecasting, GDP growth, term premiums, probit

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Abstract: Economic theory predicts that unconditional intergovernmental grant income and private income are perfectly fungible. Despite this prediction, the literature on fiscal federalism documents that grant and private income are empirically non-equivalent. A large scale school finance reform in New Hampshire--the typical school district experienced a 200 percent increase in grant income--provides an unusually compelling test of the equivalence prediction. Most theoretical explanations for non-equivalence focus on mechanisms which produce public good provision levels which differ from the decisive voter's preferences. New Hampshire determines local public goods provision via a form of direct democracy--a setting which rules out these explanations. In contrast to the general support in the literature for non-equivalence, the empirical estimates in this paper suggest that approximately 92 cents per grant dollar are spent on tax reduction. These results not only document that equivalence holds in a setting with a strong presumption that public good provision decisions reflect the preferences of voters, but also directly confirm the prediction of the seminal work of Bradford and Oates (1971) that lump-sum grant income is equivalent to a tax reduction. In addition, the paper presents theoretical arguments that grant income capitalization and heterogeneity in the marginal propensity to spend on public goods may generate spurious rejections of the equivalence prediction. The heterogeneity argument is confirmed empirically. Specifically, the results indicate that lower income communities spend more of the grant income on education than wealthier communities, a finding interpreted as revealing that the Engel curve for education is concave.

Keywords: Intergovernmental grants, fiscal federalism, flypaper

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feds 2006-05
March 2006

The Road to Price Stability (PDF)

Athanasios Orphanides

Abstract: Nearly a quarter-century after Paul Volcker's declaration of war on inflation on October 6, 1979, Alan Greenspan declared that the goal had been achieved. Drawing on the extensive historical record, I examine the views of Chairmen Volcker and Greenspan on some aspects of the evolving monetary policy debate and explore some of the distinguishing characteristics of the disinflation.

Keywords: Price stability, monetary policy, Paul Volcker, Alan Greenspan

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Abstract: This paper examines the differences in characteristics between outsourcers and non-outsourcers with a particular focus on productivity. The measure of outsourcing comes from a question in the 1987 and 1992 Census of Manufactures regarding plant-level purchases of foreign intermediate materials. There are two key findings. First, outsourcers are "outstanding." That is, all else equal, outsourcers tend to have premia for plant and firm characteristics, such as being larger, more capital intensive, and more productive. One exception to this outsourcing premia is that wages tend to be the same for both outsourcers and non-outsourcers. Second, outsourcing firms, but not plants, have significantly higher productivity growth.

Keywords: Outsourcing, Productivity, Exporter, Plant-Level, and Multinational

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Abstract: To assess whether homeowners know their house values and mortgage terms, we compare the distributions of these variables in the household-reported 2001 Survey of Consumer Finances (SCF) to the distributions in lender-reported data. We also examine the share of SCF respondents who report not knowing these variables. We find that most homeowners appear to report their house values and broad mortgage terms reasonably accurately. Some adjustable-rate mortgage borrowers, though, and especially those with below-median income, appear to underestimate or not know how much their interest rates could change.

Keywords: Mortgages, house prices, Survey of Consumer Finances, financial literacy

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Abstract: Time is a significant cost of conducting transactions, and theoretical models predict that transactions costs significantly affect the type of media of exchange buyers use. However, there is little empirical work documenting the magnitude of this effect. This paper uses grocery store scanner data to examine how time affects consumer choices of checks and debit cards. On average, check transactions take thirty percent longer than debit card transactions. This time difference is a significant factor in the choice to use a debit card over a check and offers empirical evidence for transactions costs affecting the use of media of exchange.

Keywords: Payment systems, consumer behavior, checks, debit cards

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Abstract: In the U.S., the share of payments made "electronically"--with credit cards, debit cards, and direct payments--grew from 25 percent in 1995 to over 50 percent in 2002 (BIS, 2004). This paper frames this aggregate change in the context of individual behavior. Family level data indicate that the share of families using or holding these instruments also increased over the same period. The personal characteristics that predict use and holdings are relatively constant over time. Furthermore, the results indicate that the aggregate change may be correlated with a greater incidence in "multihoming", or use of multiple payment instruments. In addition, the paper offers evidence that the dimensions over which families multihome differ across payment instruments. The results presented in this paper document a significant change in the payment system, inform payment system policies, and provide evidence of technology adoption behavior more generally.

Keywords: Payment systems, consumer choice, technology adoption, multihoming

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