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Finance and Economics Discussion Series

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Abstract: The empirical evidence on stock market participation and portfolio choice defies the predictions of standard life-cycle theory. In this paper we develop and estimate a model of portfolio choice that can account for the limited stock market participation and substantial portfolio diversification seen in the data. We present three realistic extensions to the basic framework: per period fixed costs, public pension provision, and a small chance of a disastrous event in the stock market. The estimated model is able to explain observed patterns at reasonable wealth levels, while keeping to a fairly simple framework. We demonstrate that it is no longer necessary to assume counterfactual asset holdings, heterogeneity in preferences, or implausible parameter values, in order to match key financial statistics.

Keywords: Rare disasters, precautionary saving, portfolio choice, stock market participation, uninsurable labor income risk

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Abstract: This paper models the historical default and prepayment behavior for subprime mortgages using data on securitized mortgages originated from 2000 to 2007. I find that more recently originated subprime loans are more likely to default, well ahead of their first mortgage rate resets, and less likely to prepay (i.e., refinance). This rise in mortgage defaults stems largely from unprecedented declines in house prices, along with slack underwriting and tight credit market conditions. I estimate a competing hazards model to quantify the effects of (1) house price appreciation, (2) underwriting standards, (3) mortgage rate resets, and (4) household cash flow shocks, such as job loss and oil price increases, on the likelihood of borrowers with subprime mortgages to default or prepay. Ultimately, I find that borrower leverage is one of the most important factors explaining both default and prepayment for borrowers with subprime mortgages. Then, using several different assumptions about the future path of house prices, I simulate potential trajectories for subprime mortgage defaults between 2008 and 2010. Further, I explore the short-term sensitivities of default and prepayment to house prices and various mortgage characteristics.

Keywords: Subprime mortgages, default, prepayment

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Abstract: This paper studies the implications of information-processing limits on the consumption and savings behavior of households through time. It presents a dynamic model in which consumers rationally choose the size and scope of the information they want to process concerning their financial possibilities, constrained by a Shannon channel. The model predicts that people with higher degrees of risk aversion rationally choose more information. This happens for precautionary reasons since, with finite processing rate, risk averse consumers prefer to be well informed about their financial possibilities before implementing a consumption plan. Moreover, numerical results show that consumers with processing capacity constraints have asymmetric responses to shocks, with negative shocks producing more persistent effects than positive ones. This asymmetry results in more savings. I show that the predictions of the model can be effectively used to study the impact of tax reforms on consumers spending.

Keywords: Rational inattention, dynamic programming, consumption

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Abstract: I identify and quantify the mortgage supply effect of the Community Reinvestment Act (CRA), a law mandating that banks help provide credit in lower-income neighborhoods, by exploiting a discontinuity in the selection rule determining which census tracts CRA targets. Using a comprehensive source of micro data on MSA mortgage applications, I find that CRA affects bank lending primarily in large MSA's, where banks are most scrutinized. The analysis indicates that CRA's effect on bank originations was about 4% between 1994 and 1996, and expanded to 8% in 1997-2002, consistent with the timing of a reform strengthening CRA. I provide some evidence that marginal loans go to atypical, potentially higher-risk borrowers. The results also indicate net "crowd-in": lending to targeted tracts by unregulated institutions rises in post-reform years, in particular to those areas that have had relatively low home purchase volume in the recent past, consistent with a model of information externalities in credit markets. Finally, using changes in tract eligibility status following the release of Census 2000 data as an additional source of variation, I find that CRA increased bank lending to newly targeted tracts in large MSA's by 4-5% in 2004 and 2005.

Keywords: Community reinvestment act, regression discontinuity, low and moderate income, mortgage, information externality, home ownership

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Abstract: This paper uses data from the Federal Reserve Board's 1998 and 2003 Surveys of Small Business Finances (SSBFs) to examine the evolving relationship between community banks and small businesses. The SSBFs provide extensive data on the types of financial services used by small businesses and the sources of those services. These data allow us to answer a number of interesting questions regarding small business usage of community banks, including the following: To what extent do small businesses rely on community banks as providers of at least some financial services? What types of financial services are small businesses most likely to obtain from a community bank? What types of small businesses are most likely to obtain some or all of their financial services from a community bank? How have the answers to these questions changed between 1998 and 2003? In addition to providing detailed descriptions of the patterns of community bank usage observed in the data, we develop a simple reduced form model that uses both firm and local banking market characteristics to explain these patterns. We test a number of hypotheses regarding the extent to which community banks and larger banks differ with respect to the types of financial services provided to small businesses and the types of firms served. Finally, we discuss the implications of our findings for the future of community banking.

Keywords: Small businesses, community banks, financial services

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feds 2008-59
November 2008

The Rise in Mortgage Defaults (PDF)

Christopher J. Mayer, Karen M. Pence, and Shane M. Sherlund

Abstract: The main factors underlying the rise in mortgage defaults appear to be declines in house prices and deteriorated underwriting standards, in particular an increase in loan-to-value ratios and in the share of mortgages with little or no documentation of income. Contrary to popular perception, the growth in unconventional mortgages products, such as those with prepayment penalties, interest-only periods, and teaser interest rates, does not appear to be a significant factor in defaults through mid-2008 because borrowers who had problems with these products could refinance into different mortgages. However, as markets realized the extent of the poor underwriting, underwriting standards tightened and borrowers began to face difficulties refinancing; this dynamic suggests that these unconventional products could pose problems going forward.

Keywords: Subprime mortgages, mortgage default, mortgage delinquency

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Abstract: This paper examines the role of multiple aggregate shocks in monetary models with imperfect information. Because agents can draw mistaken inferences about which shock has occurred, the existence of multiple aggregate shocks profoundly influences macroeconomic dynamics. In particular, after a contractionary monetary shock these models can generate an initial increase in inflation (the "price puzzle") and a delayed disinflation (a "hump"). A conservative numerical illustration exhibits these patterns. In addition, the model shows that increased price flexibility is potentially destabilizing.

Keywords: Imperfect information, price puzzle, inflation inertia

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Abstract: This paper examines the residential location and school choice responses to desegregation of large public school districts. Unique data and variation in the timing of desegregation orders facilitate the analysis. The 16 percent decline in white public enrollment due to desegregation primarily led to migration to suburban districts in the South and increased private enrollment in other regions. Desegregation caused black public enrollment to increase by 20 percent outside the South largely due to population changes. The spatial distributions of responses by race to desegregation orders closely match those predicted by a model of residential location and private school choice.

Keywords: Desegregation, suburbanization

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feds 2008-56
November 2008

Uncertainty and Disagreement in Economic Forecasting (PDF)

Stefania D'Amico and Athanasios Orphanides

Abstract: Using the probabilistic responses from the Survey of Professional Forecasters, we study the evolution of uncertainty and disagreement associated with inflation forecasts in the United States since 1968. We compare and contrast alternative measures summarizing the distributions of mean forecasts and forecast uncertainty across individuals at an approximate one-year-ahead horizon. In light of the heterogeneity in individual uncertainty reflected in the survey responses, we provide quarterly estimates for both average uncertainty and disagreement regarding uncertainty. We propose direct estimation of parametric distributions characterizing the uncertainty across individuals in a manner that mitigates errors associated with rounding and approximation of responses when individual uncertainty is small. Our results indicate that higher average expected inflation is associated with both higher average inflation uncertainty and greater disagreement about the inflation outlook. Disagreement about the mean forecast, however, may be a weak proxy for forecast uncertainty. We also examine the relationship of these measures with the term premia embedded in the term-structure of interest rates.

Keywords: Survey expectations, probabilistic forecasts, inflation, uncertainty

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feds 2008-55
November 2008

Specification Analysis of Structural Credit Risk Models (PDF)

Jing-zhi Huang and Hao Zhou

Abstract: In this paper we conduct a specification analysis of structural credit risk models, using term structure of credit default swap (CDS) spreads and equity volatility from high-frequency return data. Our study provides consistent econometric estimation of the pricing model parameters and specification tests based on the joint behavior of time-series asset dynamics and cross-sectional pricing errors. Our empirical tests reject strongly the standard Merton (1974) model, the Black and Cox (1976) barrier model, and the Longstaff and Schwartz (1995) model with stochastic interest rates. The double exponential jump-diffusion barrier model (Huang and Huang, 2003) improves significantly over the three models. The best model is the stationary leverage model of Collin-Dufresne and Goldstein (2001), which we cannot reject in more than half of our sample firms. However, our empirical results document the inability of the existing structural models to capture the dynamic behavior of CDS spreads and equity volatility, especially for investment grade names. This points to a potential role of time-varying asset volatility, a feature that is missing in the standard structural models.

Keywords: Structural credit risk models, credit default swap spreads, high frequency equity volatility, consistent specification analysis, pricing error diagnostics

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feds 2008-54
November 2008

Does Credit Supply Affect Small-Firm Finance? (PDF)

Tara Rice and Philip E. Strahan

Abstract: States were granted authority to limit interstate branching following passage of Federal legislation in 1994, relaxing restrictions on geographical expansion by banks. We show that differences in state's branching restrictions affect credit supply. In states more open to branching, small firms borrow at interest rates 25 to 45 basis points lower than firms operating in less open states. Firms in open states also are more likely to borrow from banks. Despite this evidence that interstate branch openness expands credit supply, we find no effect of variation in state restrictions on branching on small-firm borrowing or other indicators of credit constraints.

Keywords: Financial institutions, small business, credit supply

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Abstract: The Taxpayer Relief Act of 1997 (TRA97) significantly changed the tax treatment of housing capital gains in the United States. Before 1997, homeowners were subject to capital gains taxation when they sold their houses unless they purchased replacement homes of equal or greater value. Since 1997, homeowners can exclude $500,000 of capital gains when they sell their houses. Such drastic changes provide a good opportunity to study the lock-in effect of capital gains taxation on home sales. Using ZIP-code level housing price indexes and sales on single-family houses data from 1982 to 2006 in 16 affluent towns within the Boston metropolitan area, this paper finds that TRA97 reversed the lock-in effect of capital gains taxes on houses with low and moderate capital gains. However, TRA97 may have generated an unintended lock-in effect on houses with capital gains over the maximum exclusion amount. In addition, this paper exploits legislative changes in capital gains tax rate to estimate the tax elasticity of home sales during the post-TRA97 period.

Keywords: Housing, taxation, capital gains

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Abstract: Is the return to private R&D as high as believed? This study identifies a flaw in the production function approach to estimating the return to R&D. I provide new estimates based on a structural estimation approach that incorporates uncertainty about the outcome from R&D. The results shed light on the rate of innovation, the impact of an innovation on profits, and the market value of the R&D stock. The parameter estimates imply a mean return to R&D of 3.7-5.5%, much lower than previous values. The analysis also demonstrates the unsuitability of using the return to R&D as a basis for policy decisions on tax subsidies to R&D.

Keywords: Research and development, structural estimation

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feds 2008-51
October 2008

Property Taxes and Elderly Labor Supply (PDF)

Hui Shan

Abstract: The recent housing market boom in the U.S. has caused sharp increases in residential property taxes. Anecdotal evidence suggests that rising property taxes have induced elderly homeowners to increase their labor supply. This paper uses 1992-2004 panel data from the Health and Retirement Study (HRS) as well as a newly collected dataset on state-provided property tax relief programs to investigate the effect of property taxes on the labor supply of elderly homeowners. It is the first rigorous study on the link between property taxes and elderly labor supply. I examine both the extensive margin - whether elderly homeowners delay retirement or reenter the labor market in the face of rising property taxes, and the intensive margin - whether elderly homeowners work longer hours when property taxes increase. A simulated IV approach is used to address the potential endogeneity problem associated with property taxes. I find little evidence that property taxes have a significant impact on elderly homeowners' decisions to retire, to re-enter the labor force, or to increase working hours.

Keywords: Property tax, property tax relief program, elderly, Labor supply

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feds 2008-50
October 2008

Property Taxes and Elderly Mobility (PDF)

Hui Shan

Abstract: The recent housing market boom in the U.S. has caused sharp increases in residential property taxes. Housing-rich but income-poor elderly homeowners often complain about rising tax burdens, and anecdotal evidence suggests that some move to reduce their tax burden. There has been little systematic analysis, however, of the link between property tax levels and the mobility rate of elderly homeowners. This paper investigates this link using household-level panel data from the Health and Retirement Study (HRS) and a newly collected dataset on state-provided property tax relief programs. These relief programs generate variation in effective property tax burdens that is not due solely to arguably endogenous local community choices about taxes and expenditure programs. The findings provide evidence suggesting that higher property taxes raise mobility among elderly homeowners. The point estimates from instrumental variable estimation using relief programs to generate instruments suggest that a $100 increase in annual property taxes is associated with a 0.76 percentage point increase in the two-year mobility rate for homeowners over the age of 50. This is an eight percent increase from the baseline two-year mobility rate of nine percent. These results are robust to alternative specifications.

Keywords: Property tax, elderly mobility, property tax relief program

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feds 2008-49
October 2008

Do Behavioral Biases Adversely Affect the Macro-Economy? (PDF)

George M. Korniotis and Alok Kumar

Abstract: This study investigates whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. We focus on the risk sharing (or income smoothing) role of financial markets and demonstrate that risk sharing levels are higher in U.S. states in which investors have higher cognitive abilities and exhibit weaker behavioral biases. Further, states with better risk sharing opportunities achieve higher levels of risk sharing if investors in those states exhibit greater financial sophistication. Among the various determinants of risk sharing, behavioral factors have the strongest effects. The average level of risk sharing in states with unsophisticated investors (= 0.121) is less than half of the average risk sharing level in states with financially sophisticated investors (= 0.308). Collectively, our evidence indicates that the high risk sharing potential of financial markets is not fully realized because the aggregate behavioral biases of individual investors impede state-level risk sharing.

Keywords: Risk sharing, income risk, financial markets, cognitive abilities, behavioral biases, investor sophistication

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Abstract: This paper explores two aspects of the connection between property tax revenues and house prices. First, I estimate the elasticity of property tax revenues with respect to house prices. This elasticity does not necessarily equal one as governments may adjust effective tax rates to offset changes in property values. Second, I examine the timing of the relationship. Institutional features of the property tax make it unlikely that changes in house prices will immediately influence tax revenues. The results suggest that the elasticity eventually equals 0.4 and that it takes three years for house price changes to impact tax revenues.

Keywords: Property tax, house prices, local government

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feds 2008-47
October 2008

Productivity, Aggregate Demand and Unemployment Fluctuations (PDF)

Regis Barnichon

Abstract: This paper presents new empirical evidence on the cyclical behavior of US unemployment that poses a challenge to standard search and matching models. The correlation between cyclical unemployment and the cyclical component of labor productivity switched sign in the mid 80s: from negative it became positive, while standard search models imply a negative correlation. I argue that the inconsistency arises because search models do not allow output to be demand determined in the short run, and I present a search model with nominal rigidities that can rationalize the empirical findings. In addition, I show that the interaction of hiring frictions and nominal frictions can generate a new propagation mechanism absent in standard New-Keynesian models.

Keywords: Unemployment fluctuations, labor productivity, search and matching model, New-Keynesian model

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feds 2008-46
November 2008

The Incentives of Mortgage Servicers: Myths and Realities (PDF)

Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen Mauskopf

Abstract: As foreclosure initiations have soared over the past couple of years, many have questioned whether mortgage servicers have the right incentives to work out troubled subprime mortgages so that borrowers can avoid foreclosure and remain in their homes. Some critics claim that because servicers, unlike investors, do not bear the losses associated with foreclosure, they have little incentive to modify troubled loans by reducing interest rates or principal, or by extending the term. Our analysis suggests that while servicers have substantially improved borrower outreach and increased loss mitigation efforts, some foreclosures still occur where both borrower and investor would benefit if such an outcome were avoided. We discuss servicers' incentives and the obstacles to working out delinquent mortgages. We find that loss mitigation is costly for servicers, in large part because servicers currently lack adequate staff and technology; unfortunately, servicers have few financial incentives to expand capacity. Two additional factors appear to be damping workouts of nonprime loans, the group that has seen the largest increase in delinquencies. First, affordable solutions are more difficult to achieve for borrowers with these loans than for those with prime mortgages. Second, these loans are generally funded by private-label mortgage backed securities, for which investors provide little or no guidance to servicers about what modifications are appropriate. More generally, investors are wary that modifications might turn out to be unsuccessful, thus delaying and increasing ultimate losses. Given the significant deadweight losses incorporated in recent quarters' loss rates of 50 percent or more, we present options for further improving servicer performance. We discuss supporting further industry efforts to expand borrower outreach and establish servicing guidelines, educating investors, paying servicers fees for appropriate loan workouts, and improving measures of servicer performance.

Keywords: Mortgage, loss-mitigation, mortgage-backed-securities, mortgage-servicing, foreclosures, mortgage-servicers, subprime

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Abstract: According to the CPS, employees in alternative work arrangements make up over 10 percent of U.S. workers. Because of the pervasiveness of these types of arrangements, it is important to understand why firms are choosing to use them. Using data from the 2003 Survey of Small Business Finances, we model the firm's decision to use alternative employment arrangements using a large representative sample of small businesses in the U.S. In general, our results are similar to previous establishment-level studies that have examined the use of these types of employment arrangements. However, many of these previous studies have been narrow in scope because of data limitations. We find evidence to support each of the following hypotheses: 1) firms may be using alternative employment arrangements (AEA) in an attempt to generate cost savings by substituting standard employees with AEA employees when internal wages and benefit costs are high; 2) firms may be using AEA to meet irregular product demand constraints; and 3) firms may be using AEA to take advantage of economies of scale for certain tasks or services. Additionally, we present some additional findings that add to the relatively limited establishment level literature on alternative employment arrangements.

Keywords: Alternative employment arrangements, Survey of Small Business Finances

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Abstract: Inflation targeting as practiced by the Bank of England has undergone several changes since its adoption in 1992, including redefinition of the goal, measures to increase transparency and the granting of independence to the central bank. These changes are likely to have affected long-run inflation expectations and perceptions of future inflation risk. To that end, this paper estimates a no-arbitrage, affine, factor model of the term structure of inflation compensation in the United Kingdom. The model yields time series of expected inflation and inflation risk premia at short and long horizons estimated in a theoretically consistent manner. The results reveal that long-run inflation expectations drifted down slowly during the first five years of inflation targeting, but inflation risk premia moved down abruptly only once the Bank of England was granted independence. This event, which arguably signalled more credible commitment by the central bank to its inflation anchor, appears to have been more important in shaping inflation expectations and perceptions of inflation risk than changes in the definition of the target or measures to increase transparency.

Keywords: Inflation targeting, inflation compensation, term structure, factor model, risk premia

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Abstract: This paper explores the relationship between the health of the financial sector and the rest of the economy. We develop an index of financial sector health using a distance-to-default measure based on a Merton-style option pricing model. Our index spans over three decades and appears to capture periods when financial sector institutions were strong and when they were weak. We then use vector autoregressions to assess whether our index of financial-sector health affects the real economy, in particular non-residential investment. The results indicate that our index has a considerable impact. Moreover, we find that this financial channel amplifies changes in investment resulting from shocks to non-financial firm profitability.

Keywords: Bank distress, financial accelerator, credit channel

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Abstract: We examine 401(k) borrowing since 1992 and identify a puzzle: despite potential gains from borrowing against 401(k) assets instead of from other sources, most eligible households eschew 401(k) loans, including many who carry relatively expensive balances on credit cards and auto loans. We estimate that households with access to 401(k) loans could have saved about $3.3 billion in 2004--about $200 per household--by shifting debt to 401(k) loans. We find that liquidity constrained households are most likely to borrow against their accounts; however, the fastest growth has been among higher income, less liquidity constrained households. From 1992 to 2004, we do not find significantly different growth in wealth between households eligible for loans and those ineligible for loans. The recent tightening of terms and standards in mortgage and consumer lending has likely increased 401(k) borrowing, which could improve household balance sheets, if handled correctly. However, the improvement could be short-lived if the economic downturn leads to reduced contributions or significantly higher 401(k) loan defaults.

Keywords: 401(k) loans, household debt, household wealth, consumption

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Abstract: A number of industries underwent large and permanent reductions in employment growth at the beginning of this decade, a process we label as restructuring. We describe how restructuring occurred and what its consequences were for the economy. In particular, we find that restructuring stemmed largely from relative demand shocks (though technology shocks were important in some industries) and that elevated levels of permanent job destruction and permanent layoffs were distinguishing features of industries subject to restructuring. In addition, most workers displaced in restructuring industries relocated to other sectors. While this process of reallocation led to large increases in productivity (and a reduction in labor's share) in industries shedding workers, it also resulted in prolonged periods of unemployment for displaced workers. Moreover, relocating workers suffered sizable reductions in earnings, consistent with substantial losses in their specific human capital. Putting these pieces together, we estimate the cost of restructuring to have been between 1/2 and 1 percent of aggregate income per year.

Keywords: Industrial restructuring, permanent job loss

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Abstract: We estimate the nondefault component of corporate bond yield spreads and examine its relationship with bond liquidity. We measure bond liquidity using intraday transactions data and estimate the default component using the term structure of credit default swaps spreads. With swap rate as the risk free rate, the estimated nondefault component is generally moderate but statistically significant for AA-, A-, and BBB-rated bonds and increasing in this order. With Treasury rate as the risk free rate, the estimated nondefault component is the largest in basis points for BBB-rated bonds but, as a fraction of yield spreads, it is the largest for AAA-rated bonds. We find a positive and significant relationship between the nondefault component and illiquidity for investment-grade bonds but no significant relationship for speculative-grade bonds. In addition, the nondefault component comoves with macroeconomic conditions--negatively with the Treasury term structure and positively with the stock market implied volatility.

Keywords: Corporate bond yield spreads, credit default swaps, liquidity

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feds 2008-39
August 2008

The High-Frequency Impact of News on Long-Term Yields and Forward Rates: Is It Real? (PDF)

Meredith J. Beechey and Jonathan H. Wright

Abstract: This paper uses high-frequency intradaily data to estimate the effects of macroeconomic news announcements on yields and forward rates on nominal and index-linked bonds, and on inflation compensation. To our knowledge, it is the first study in the macro announcements literature to use intradaily real yield data, which allow us to parse the effects of news announcements on real rates and inflation compensation far more precisely than we can using daily data. Long-term nominal yields and forward rates are very sensitive to macroeconomic news announcements. We find that inflation compensation is sensitive to announcements about price indices and monetary policy. However, for news announcements about real economic activity, such as nonfarm payrolls, the vast majority of the sensitivity is concentrated in real rates. Accordingly, we conclude that most of the sizeable impact of news about real economic activity on the nominal term structure of interest rates represents changes in expected future real short-term interest rates and/or real risk premia rather than changes in expected future inflation and/or inflation risk premia. This suggests that explanations for the puzzling sensitivity of long-term nominal rates need to look beyond just inflation expectations and toward models that encompass uncertainty about the long-run real rate of interest.

Keywords: Intradaily data, news announcements, inflation compensation, real interest rates, high frequency

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Abstract: I examine the common trend in inflation for consumer prices and consumer prices excluding prices of food and energy. Both the personal consumption expenditure (PCE) indexes and the consumer price indexes (CPI) are examined. The statistical model employed is a bivariate integrated moving average process; this model extends a univariate model that fits the data on inflation very well. The bivariate model forecasts as well as the univariate models. The results suggest that the relationship between overall consumer prices, consumer prices excluding the prices of food and energy, and the common trend has changed significantly over time. In the 1970s and early 1980s, movements in overall prices and prices excluding food and energy prices both contained information about the trend; in recent data, the trend is best gauged by focusing solely on prices excluding food and energy prices.

Keywords: Core inflation, food and energy prices

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Abstract: Agents with standard, time-separable preferences do not care about the temporal distribution of risk. This is a strong assumption. For example, it seems plausible that a consumer may find persistent shocks to consumption less desirable than uncorrelated fluctuations. Such a consumer is said to exhibit temporal risk aversion. This paper examines the implications of temporal risk aversion for asset prices. The innovation is to work with expected utility preferences that (i) are not time-separable, (ii) exhibit temporal risk aversion, (iii) separate risk aversion from the intertemporal elasticity of substitution, (iv) separate short-run from long-run risk aversion and (v) yield stationary asset pricing implications in the context of an endowment economy. Closed form solutions are derived for the equity premium and the risk free rate. The equity premium depends only on a parameter indexing long-run risk aversion. The risk-free rate instead depends primarily on a separate parameter indexing the desire to smooth consumption over time and the rate of time preference.

Keywords: Temporal risk aversion, intertemporal substitution, equity premium, risk free rate

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feds 2008-36
August 2008

Insider Rates vs. Outsider Rates in Lending (PDF)

Lamont K. Black

Abstract: The presence of private information about a firm can affect the competition among potential lenders. In the Sharpe (1990) model of information asymmetry among lenders (with the von Thadden (2004) correction), an uninformed outside bank faces a winner's curse when competing with an informed inside bank. This paper examines the model's prediction for observed interest rates at an inside vs. outside bank. Although the outside bank wins more bad firms than the inside bank, the winner's curse also causes the outside rate conditional on firm type to be lower in expectation than the inside rate conditional on firm type. I show analytically that the expected interest rate at the outsider can be either higher or lower than the expected interest rate at the insider, depending on the net of these two effects. Under the assumption that the banks split the firms in a tie bid, a numerical solution shows that the outside expected interest rate is higher than the inside expected interest rate for high quality borrower pools, but the outside expected interest rate is lower for low quality borrower pools.

Keywords: Banking relationships, competition under asymmetric information, informational lock-in, auctions

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Abstract: This paper uses data from the triennial waves of the Survey of Consumer Finances from 1992 to 2004 to examine changes in the use of financial services with implications for the definition of banking markets. Despite powerful technological and regulatory shifts over this period, households' banking markets overall remained largely local--the median distance to a provider of financial services remained under four miles. However, there has been rapid growth in the use of non-depository financial institutions over the period, particularly non-local ones. This increase occurred across a wide variety of demographic and other household classifications. The evidence on the clustering of financial services is mixed. Households showed a slightly greater tendency to buy multiple banking services from their primary provider of such services in 2004 than in 1992, while they also became much more likely to procure services from firms that were not their primary provider.

Keywords: Survey of Consumer Finances, banking markets, household finances, antitrust policy

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feds 2008-34
July 2008

Does Distance Matter in Banking? (PDF)

Kenneth P. Brevoort and John D. Wolken

Abstract: Deregulation and technological change have reduced the transactions costs that led to the dominance of local financial service suppliers, leading some to question if distance still matters in banking. This debate has been particularly acute in small business banking, where transactions costs are believed to be particularly high. This paper provides a detailed review of the literature on distance in banking markets, highlighting the reasons why geographic proximity is believed to be important and examining the changes that may have affected its importance. Relying on new data from the 2003 Survey of Small Business Finances, we examine how distances between small firms and their financial service suppliers changed over the 1993-2003 decade. Our analysis reveals that distances increased, though the extent varied substantially across financial services and supplier types. Generally, increases were observed in the early half of the decade, while distances declined in the following five years. There was also a trend towards less in person interaction between small firms and their suppliers of financial services. Nevertheless, most relationships remained local, with a median distance of 5 miles in 2003. The results suggest that distance, while perhaps not as tyrannical as in the past, remains an important factor in banking.

Keywords: Banking markets, distance, geographic markets, small business, survey of small business finances

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Abstract: This paper examines the implications for monetary policy of sticky prices in both final and intermediate goods in a New Keynesian model. Both optimal policy under commitment and discretionary policy, which is the minimization of a simple loss function, are studied. Consumer utility losses under alternative simple loss functions are compared, including their robustness to model and shock misperceptions, and parameter uncertainty. Targeting inflation in both consumer and intermediate goods performs better than targeting a single price index; price-level targeting of both consumer and intermediate goods prices performs significantly better. Moreover, targeting prices in both sectors yields superior robustness properties.

Keywords: Monetary policy, intermediate goods, inflation targeting, price-level targeting

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Abstract: This paper employs extensive information on bank deposit rates and county migration patterns to test for pricing relationships implied by the existence of switching costs. While these relationships are derived formally, the intuition for them can be readily stated. Because some areas experience more in-migration than others, banks, in addressing the trade-off between attracting new customers and exploiting old ones, offer higher deposit rates in areas (and at times) experiencing more in-migration. Further, because out-migration implies that on average a locked-in customer will not be with the bank as many periods, greater out-migration should change the bank's assessment of this trade-off such that the bank will offer lower deposit rates in areas (and during periods) exhibiting greater out-migration, all else equal. Also, because this effect of out-migration logically depends on the existence and extent of in-migration, an interaction effect is implied. Evidence strongly supporting these implied relationships is reported. Other tests of the implications of switching costs in the banking industry are also conducted.

Keywords: Switching costs, banks, prices

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Abstract: This paper points out that several known ways of modeling non-negative nominal interest rates lead to different implications for the risk-neutral distribution of the short rate that can be checked with options data. In particular, Black's boundary models ("interest rates as options") imply a probability density function (pdf) that contains a Dirac delta function and a cumulative distribution function (cdf) that is nonzero at the zero boundary, while models like the CIR and positive-definite quadratic-Gaussian (QG) models have a zero cdf at the boundary. Eurodollar futures options data are found to favor Black's boundary models: the CIR/QG models, even multifactor versions, have difficulty capturing option prices accurately not only in low interest rate environments but also in higher interest rate environments, and data in early 2008 provide an almost tangible signature of the Dirac delta function in Black's boundary pdf models. Options data also contradict the prediction of well-known models whose cdf is zero at the zero boundary, namely that the risk-neutral pdf is always positively skewed.

Keywords: Zero bound, term structure of interest rates, options, probability density functions

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Abstract: We examine the informational content of TIPS yields from the viewpoint of a general 3-factor no-arbitrage term structure model of inflation and interest rates. Our empirical results indicate that TIPS yields contained a "liquidity premium" that was until recently quite large (~ 1%). Key features of this premium are difficult to account for in a rational pricing framework, suggesting that TIPS may not have been priced efficiently in its early years. Besides the liquidity premium, a time-varying inflation risk premium complicates the interpretation of the TIPS breakeven inflation rate (the difference between the nominal and TIPS yields). Nonetheless, high-frequency variation in the TIPS breakeven rates is similar to the variation in inflation expectations implied by the model, lending support to the view that TIPS breakeven inflation rates are a useful proxy for inflation expectations.

Keywords: Term structure model, inflation expectation, inflation risk premium, SPF, Treasury Inflation-Protected Securities (TIPS)

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feds 2008-29
June 2008

Subprime Mortgages: What, Where, and to Whom? (PDF)

Chris Mayer and Karen Pence

Abstract: We explore the types of data used to characterize risky subprime lending and consider the geographic dispersion of subprime lending. First, we describe the strengths and weaknesses of three different datasets on subprime mortgages using information from LoanPerformance, HUD, and HMDA. These datasets embody different definitions of subprime mortgages. We show that estimates of the number of subprime originations are somewhat sensitive to which types of mortgages are categorized as subprime. Second, we describe what parts of the country and what sorts of neighborhoods had more subprime originations in 2005, and how these patterns differed for purchase and refinance mortgages. Subprime originations appear to be heavily concentrated in fast-growing parts of the country with considerable new construction, such as Florida, California, Nevada, and the Washington DC area. These locations saw house prices rise at faster-than-average rates relative to their own history and relative to the rest of the country. However, this link between construction, house prices, and subprime lending is not universal, as other markets with high house price growth such as the Northeast did not see especially high rates of subprime usage. Subprime loans were also heavily concentrated in Zip codes with more residents in the moderate credit score category and more black and Hispanic residents. Areas with lower income and higher unemployment had more subprime lending, but these associations are smaller in magnitude.

Keywords: Mortgages, subprime, house prices

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feds 2008-28
June 2008

Market Conditions and Hedge Fund Survival (PDF)

Mark Carlson and Jason Steinman

Abstract: As the hedge fund industry has grown, there has been increased concern that, during sharp market moves, hedge fund failures could exacerbate the deterioration in financial conditions and deepen a crisis. However, there has not been much formal analysis regarding the impact of financial market conditions on hedge fund survival. To help fill this gap, this paper examines the relationship between financial market conditions and the likelihood of hedge fund failure after controlling for performance and other characteristics. The analysis is conducted using data on individual funds and industry aggregates. We find that market returns and volatility influence fund failures, although the impact depends on the funds' investment strategies. The results of the analysis are then used to predict hedge fund failures based on actual market returns and on stress scenarios. We find that the hedge fund industry is generally robust to different shocks.

Keywords: Hedge funds, financial stability, stress testing

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feds 2008-27
June 2008

Lifecycle Dynamics of Income Uncertainty and Consumption (PDF)

James Feigenbaum and Geng Li

Abstract: Uninsurable income risk is often cited as an explanation for empirical deviations from the Lifecycle/Permanent-Income Hypothesis such as the observation that the life-cycle profile of mean consumption is hump-shaped. Most methods used for estimating income uncertainty essentially measure the cross-sectional variance of a subpopulation rather than the true uncertainty or riskiness perceived by consumers. In this paper, we employ a nonparametric approach to estimate idiosyncratic income uncertainty. We measure income uncertainties as the variance of income forecasting errors at different ages and over different time horizons. The estimated life-cycle income uncertainty profile is U-shaped and generally implies a lower degree of income uncertainty relative to the previous literature. We subsequently use these nonparametric estimates to calibrate a (time-inconsistent) lifecycle model to assess whether a consumption hump can be generated by precautionary saving given more robust measures of income uncertainty. We show that, with plausible risk aversion coefficient and discounting factors and an endogenous, rarely active borrowing limit, our refined measure of income uncertainty is large enough to generate a significant consumption hump that peaks around age 55 and closely matches with the observed magnitude of the consumption hump. We also notice that the variation in the volatility of income shocks with respect to both age and forecast horizon has a significant impact on the size and peak age of the consumption hump.

Keywords: Consumption hump, income risk, time-inconsistent expectations, forecasting errors

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Abstract: In 2003, the Survey of Small Business Finances (SSBF), conducted by the Federal Reserve Board, implemented the use of incentives to increase response rates. This study examines the effects of some of the characteristics of the implementation - such as level of effort, time in queue, and consecutively-increasing incentive amounts - on unit response. Our estimates suggest that as the number of days increase between the initial screener and main interview, the probability of completion decreases. Similarly, as the number of days increases between each consecutive incentive offer the probability of completion decreases. Additional effort, as measured by additional calls, increases the probability of completion. Finally, each consecutive offer after the initial offer decreases the probability of completion.

Keywords: Incentives, small business surveys, response rates, Survey of Small Business Finances, unit response

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Abstract: This paper provides cross-country empirical evidence on term premia, inflation uncertainty, and their relationship. It has three components. First, I construct a panel of zero-coupon nominal government bond yields spanning ten countries and eighteen years. From these, I construct forward rates and decompose these into expected future short-term interest rates and term premiums, using both statistical methods (an affine term structure model) and using surveys. Second, I construct alternative measures of time-varying inflation uncertainty for these countries, using actual inflation data and survey expectations. I discuss some possible determinants of inflation uncertainty. Finally, I use panel data methods to investigate the relationship between term premium estimates and inflation uncertainty measures, and find a strong positive relationship. The economic determinants of term premia remain mysterious; but this evidence points to uncertainty about intermediate- to long-run inflation rates being a substantial part of the explanation for why yield curves slope up.

Keywords: Term premiums, inflation uncertainty, inflation targeting, bond pricing

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Abstract: In predicting the magnitude of the labor supply response to taxation, the standard lifecycle labor supply model distinguishes between unanticipated and anticipated changes in the after-tax return to working. Exploiting age-eligibility rules for claiming a dependent on a tax return facilitates a comparison of the labor supply outcomes of households who are equivalent but for the tax schedule they face. I find that the quasi-random assignment to a tax schedule without an age-eligible dependent corresponds to a decrease in mothers' labor supply by about 40 hours per year and to no discernible effect for fathers. While having an age-ineligible dependent results in a 0.5 percentage point, or 0.3%, average decrease in a household's net-of-tax rate, further analysis of average tax rates suggests that the variation in marginal tax rates does not fully explain mothers' labor supply responses. This finding militates against interpreting this large response as an intertemporal elasticity and subsequently presents a puzzle for the lifecycle labor supply model.

Keywords: Labor supply, taxation, quasi-experimental methods

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Abstract: This paper compares the recent evolution of long-run inflation expectations in the euro area and the United States, using evidence from financial markets and surveys of professional forecasters. Survey data indicate that long-run inflation expectations are reasonably well-anchored in both economies, but also reveal substantially greater dispersion across forecasters' long-horizon projections of U.S. inflation. Daily data on inflation swaps and nominal-indexed bond spreads--which gauge compensation for expected inflation and inflation risk--also suggest that long-run inflation expectations are more firmly anchored in the euro area than in the United States. In particular, surprises in macroeconomic data releases have significant effects on U.S. forward inflation compensation, even at long horizons, whereas macroeconomic news only influences euro area inflation compensation at short horizons.

Keywords: Inflation compensation, euro area inflation, ECB, central bank communication

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Abstract: This paper demonstrates the properties of and a solution method for the more general two-period Rational Inattention model of Sims (2006). It is shown that the corresponding optimization problem is convex and can be solved very quickly. This paper also demonstrates a computational tool well-suited to solving Rational Inattention models and further illustrates a critique raised in Sims (2006) regarding Rational Inattention models whose solutions assume parametric formulations rather than solve for their optimally-derived, non-parametric counterparts.

Keywords: Rational inattention, information-processing constraints, numerical optimization

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feds 2008-21
April 2008

Nested Simulation in Portfolio Risk Measurement (PDF)

Michael B. Gordy and Sandeep Juneja

Abstract: Risk measurement for derivative portfolios almost invariably calls for nested simulation. In the outer step one draws realizations of all risk factors up to the horizon, and in the inner step one re-prices each instrument in the portfolio at the horizon conditional on the drawn risk factors. Practitioners may perceive the computational burden of such nested schemes to be unacceptable, and adopt a variety of second-best pricing techniques to avoid the inner simulation. In this paper, we question whether such short cuts are necessary. We show that a relatively small number of trials in the inner step can yield accurate estimates, and analyze how a fixed computational budget may be allocated to the inner and the outer step to minimize the mean square error of the resultant estimator. Finally, we introduce a jackknife procedure for bias reduction and a dynamic allocation scheme for improved efficiency.

Keywords: Nested simulation, loss distribution, value-at-risk, expected shortfall, jackknife estimator, dynamic allocation

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feds 2008-20
June 2008

A New Look at the Wealth Adequacy of Older U.S. Households (PDF)

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

Abstract: We construct two measures of the current wealth adequacy of older U.S. households using the 1998--2006 waves of the Health and Retirement Study (HRS). The first is the ratio of "comprehensive wealth"--defined as net worth plus the expected value of future income streams--to the wealth that would be needed to generate expected poverty-line income in future years. By this measure, we find that the median older U.S. household is reasonably well situated, with a "poverty ratio" of about 3.9 in 2006. However, we find that about 18 percent of households have less wealth than would be needed to generate 150 percent of poverty-line income over their expected future lifetimes. Our second measure is the ratio of the annuitized value of comprehensive resources to pre-retirement earnings. This measure identifies a median "replacement rate" of about 105 percent, with about 13 percent of households experiencing replacement rates of less than 50 percent. Comparing the leading edge of the baby boomers in 2006 to households of the same age in 1998, we find that the baby boomers show slightly less wealth, in real terms, than their elders did, and single boomers show a bit higher incidence of "inadequacy" than did their elders. Nonetheless, the median single boomer appears to have adequate resources. Moreover, we find a rising age profile of annualized wealth, even within households over time and after controlling for other factors, suggesting that older households are not spending their wealth as quickly as their survival probabilities are falling.

Keywords: Wealth, saving, adequacy, poverty, retirement

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Abstract: This paper constructs a simple dynamic asset pricing model which incorporates recent evidence on the influence of immediate emotions on risk preferences. Investors derive direct utility from both consumption and financial wealth and, consistent with the happiness maintenance feature documented by Isen (1999) and others, become more cautious toward their wealth in good times. Mild pro-cyclical changes in risk aversion over wealth cause large pro-cyclical fluctuations in the current price-dividend ratio which, due to general equilibrium restrictions, translate into counter-cyclical variation in the current consumption-wealth ratio and, in turn, in expected future returns. With a realistic consumption growth process and reasonable preference parameters, the model generates a sizable equity premium, a low and stable risk-free rate, volatile and predictable stock returns, and price-dividend and Sharpe ratios in line with the data.

Keywords: State-dependent utility, affect and decisionmaking, equity premium puzzle

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Abstract: This paper develops a model of the firm's choice between debt denominated in local currency and that denominated in foreign currency in a small open economy characterized by exchange rate risk and hedging possibilities. The model shows that the currency composition of debt and the level of hedging are endogenously determined as optimal firms' responses to a tradeoff between the lower cost of borrowing in foreign debt and the higher risk of such borrowing due to exchange rate uncertainty. Both the composition of debt and the level of hedging depend on common factors such as foreign exchange rate risk and the probability of financial default, interest rates, the size of firms' net worth, and the costs of managing exchange rate risk. Results of the model are broadly consistent with the lending and hedging behavior of the corporate sector in small open economies that recently experienced currency crises. In particular, unlike the predictions of previous work in the literature on currency crises, the model can explain why the collapse of the fixed exchange rate regime in Brazil, in early 1999, caused no major change in the currency composition of debt of the corporate sector.

Keywords: Exchange rate regime, debt composition, hedging

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Abstract: Data obtained from special questions on the Michigan Survey of Consumer Attitudes over several years are used to analyze stock market beliefs and portfolio choices of household investors. Consistent with other survey results, expected future returns appear to be extrapolated from past realized returns. The data also indicate that expected risk and return are strongly influenced by economic prospects. When investors believe macroeconomic conditions are more expansionary, they tend to expect both higher returns and lower volatility, which implies that household Sharpe ratios are procyclical. Separately, perceived risk in equity returns is found to be strongly influenced by household investor characteristics, consistent with documented behavioral biases. These expectations reported by respondents are given credence by the finding that the proportion of equity holdings in respondent portfolios tends to be higher for those who report higher expected returns and lower uncertainty. Finally, the finding of procyclical expected returns holds up when we instead condition on conventional business cycle proxies such as the dividend yield and CAY, which yields a stark contrast with the inferences from studies based on actual returns.

Keywords: Equity premium, investor survey, investor expectations, time-varying expected returns

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feds 2008-16
April 2008

Corporate Hedging, Investment and Value (PDF)

Jose M. Berrospide, Amiyatosh Purnanandam, and Uday Rajan

Abstract: We consider the effect of hedging with foreign currency derivatives on Brazilian firms in the period 1997 through 2004, a period that includes the Brazilian currency crisis of 1999. We find that, derivative users have valuations that are 6.7-7.8% higher than non-user firms. Hedging with currency derivatives allows firms to sustain larger capital investments, and also removes the sensitivity of investment to internally generated funds. Thus, it mitigates the underinvestment friction of Froot, Scharfstein, and Stein (1993), at a time when capital in the economy as a whole is scarce. We further show that hedging increases the foreign currency debt capacity of a firm, and that foreign debt is a cheaper source of capital than domestic debt during our period of study.

Keywords: Currency derivatives, firm value, underinvestment, debt capacity, cost of capital

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Abstract: This paper proposes a simple generalization of the classical measurement error model, introducing new measurement errors that subtract signal from the true variable of interest, in addition to the usual classical measurement errors (CME) that add noise. The effect on OLS regression of these lack of signal errors (LoSE) is opposite the conventional wisdom about CME: while CME in the explanatory variables causes attenuation bias, LoSE in the dependent variable, not the explanatory variables, causes a similar bias under some conditions. The paper provides evidence that LoSE is an important source of error in US macroeconomic quantity data such as GDP growth, illustrates downward bias in regressions of GDP growth on asset prices, and provides recommendations for econometric practice.

Keywords: Measurement error, regression, macroeconomic data

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Abstract: We propose an explanation for the rapid post-entry growth of surviving firms found in recent studies. At the core of our theory is the interaction between adjustment costs and learning by entering firms about their efficiency. We show that linear adjustment costs, i.e., proportional costs, create incentives for firms to enter smaller and for successful firms to grow faster after entry. Initial uncertainty about profitability makes entering firms prudent since they want to avoid incurring superfluous costs on jobs that prove to be excessive ex post. Because higher adjustment costs imply less pruning of inefficient firms and faster growth of surviving firms, the contribution of survivors to growth in a cohort's average size increases. For the cohort of 1988 entrants in the Portuguese economy, we conclude that survivors' growth is the main factor behind growth in the cohort's average size. However, initial selection is higher and the survivors' contribution to growth is smaller in services than in manufacturing. An estimation of the model shows that the proportional adjustment cost is the key parameter to account for the high empirical survivors' contribution. In addition, firms in manufacturing learn relatively less initially about their efficiency and are subject to larger adjustment costs than firms in services.

Keywords: Adjustment costs, learning, young firms

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Abstract: As the baby boomers begin to retire, a great deal remains unknown about the evolution of wealth toward the end of life. In this paper, we develop a new measure of household resources that converts total financial, nonfinancial, and annuitized assets into an expected annual amount of wealth per person. We use this measure, which we call "annualized comprehensive wealth," to investigate spend-down behavior among older households in the Health and Retirement Study. Our analysis indicates that, in (real) dollar terms, the median household's wealth declines more slowly than its remaining life expectancy, so that real annualized wealth actually tends to rise with age over retirement. Comparing the estimated age profiles for annualized wealth with profiles simulated from several different life cycle models, we find that a model that takes into account uncertain longevity, uncertain medical expenses, and (for higher-income retirees) intended bequests lines up best with the HRS data.

Keywords: Retirement wealth, mortality risk, precautionary saving, bequests, risk and uncertainty

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Abstract: In vertically differentiated markets, the effects of firm entry are contingent upon whether incumbent firms can respond to entry by adjusting product quality in addition to simply lowering prices. Using market-level data, I estimate a structural model of supply and demand for subscription television that takes into account the endogeneity of quality choice. Using counterfactual analysis, I decompose the effect of satellite entry on existing cable into two components: the conventional price response and the effect of endogenous quality adjustments (measured by changes in programming content). Consistent with the empirical observation that cable prices rose during the 1990s and early 2000s "in spite of" increasing competition, I find that raising both price and quality for the most comprehensive subscription package--i.e., competing "head-to-head"--is the rational response to entry by cable systems in markets with relatively homogeneous consumer types. Elsewhere, incumbents respond less aggressively and relegate themselves to being the low-end provider. When an entrant credibly commits to serving consumers with the highest preferences for quality, competition over both price and quality lowers the welfare gains due to entry, relative to pure price competition. In particular, head-to-head competition results in "crowding" of quality choices toward the high end of the market and inefficiently low product differentiation. In such cases, consumers with weak quality preferences may actually become worse off following entry. The evidence also suggests that the observed degradation of the lowest-quality cable tier in many markets during this time period--while commonly seen as an attempt to evade price regulation--may actually have been welfare-enhancing.

Keywords: Entry, endogenous quality, vertical differentiation, bundling

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Abstract: We analyze the phenomenon that low- and moderate-income (LMI) tax filers exhibit a "preference for over-withholding" their taxes, a measure we derive from a unique set of questions administered in a dataset of 1,003 households, which we collected through the Survey Research Center at the University of Michigan. We argue that the relationship between their withholding preference and portfolio allocation across liquid and illiquid assets is consistent with models with present-biased preferences, and that individuals exhibit self-control problems when making their consumption and saving decisions. Our results support a model in which individuals use commitment devices to constrain their consumption. Using data on other tax-filing behaviors, we also show that mental accounting and loss aversion explanations for tax filers' "preference for over-withholding" are unlikely to explain the patterns in the data. Present-biasedness and dynamic inconsistency among LMI tax filers have important implications for saving policies and tax administration.

Keywords: Tax withholding, present-biased preferences, saving

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Abstract: In this paper, I extend a theoretical model of the crowding out hypothesis, whereby government contributions to a public good displace private giving, in order to illustrate how dollar-for-dollar crowding out is possible even when individuals regard their own contributions and government grants as imperfect substitutes. I estimate that private charitable contributions to arts organizations increased by 60 cents to a dollar due to a major funding cut to the National Endowment for the Arts (NEA) during the mid-1990s. These increases, however, also coincided with, on average, a 25 cent increase in fund-raising expenditures by arts organizations for every dollar decrease in government grants. The estimate of crowding out found in this paper is large, particularly for a study using a micro-data set. I argue that an appropriate interpretation of an estimate of a crowding out parameter, in general, depends crucially on the context.

Keywords: Crowding out, charitable contributions, public goods

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Abstract: We implement the human capital CAPM (HCAPM) using the income growth of high income households, rather than aggregate income growth, to proxy the return to human capital (HCRT). We find that identifying the HCRT with the income growth of affluent households, those who are most likely to hold stocks, substantially improves the performance of the HCAPM. Specifically, the pricing errors, R-square's, average returns on factor mimicking portfolios, and performance relative to other macro-finance models uniformly improve as the HCRT is identified with the income growth of successively more affluent households.

Keywords: Human capital, expected stock returns, affluent income

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Abstract: This paper provides updated calculations of the relative cost to the U.S. Treasury of previously issued TIPS by comparing the payment stream on each security to that of hypothetical nominal counterpart. While the costs of the program (so measured) are large, totaling $5 to $8 billion to date, I show that they owe largely to market illiquidity in the early years of the program. Indeed, absent these market growing pains, the program would have yielded a substantial net savings to the government as investors were apparently willing to pay a substantial premium to insure against inflation risk.

Keywords: Treasury issuance, inflation risk premium, liquidity premium

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Abstract: Several studies have explored whether the banking panics of the Great Depression caused some institutions to fail that might otherwise have survived. This paper adopts a different approach and investigates whether the panics resulted in the failure and liquidation of banks that might otherwise have been able to pursue a less disruptive resolution strategies such as merging with another institution or suspending operations and recapitalizing. Using data on individual state-chartered banks, I find that many of the banks that failed during the panics appear to have been at least as financially sound as banks that were able to use alternative resolution strategies. This result supports the idea that the disruptions caused by the banking panics may have exacerbated the economic downturn.

Keywords: Great Depression, banking panics, distressed banks

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Abstract: This paper discusses various challenges in the specification and implementation of “macro-finance” models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. I classify macro-finance models into pure latent-factor models ("internal basis models") and models which have observed macroeconomic variables as state variables ("external basis models"), and examine the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macro variables and their potentially adverse effect on the specification of external basis models. I also discuss the challenge of addressing features like structural breaks and time-varying inflation uncertainty. Empirical difficulties in the estimation and evaluation of macro-finance models are also discussed in detail.

Keywords: Yield curve, term structure, unspanned factors, macro-finance

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feds 2008-05
December 2011

The TIPS Yield Curve and Inflation Compensation (PDF)

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

Data - Excel file (1.8 MB XLS) | Data - Screen reader | Data - XML (sdmx/zip)

Abstract: For over ten years, the U.S. Treasury has issued index-linked debt. Federal Reserve Board staff have fitted a yield curve to these indexed securities at the daily frequency from the start of 1999 to the present. This paper describes the methodology that is used and makes the estimates public. Comparison with the corresponding nominal yield curve allows measures of inflation compensation (or breakeven inflation rates) to be computed. We discuss the interpretation of inflation compensation and its relationship to inflation expectations and uncertainty, offering some empirical evidence that these measures are affected by an inflation risk premium that varies considerably at high frequency. In addition, we also find evidence that inflation compensation was held down in the early years of the sample by a premium associated with the illiquidity of TIPS at the time. We hope that the TIPS yield curve and inflation compensation data, which are posted here and will be updated periodically, will provide a useful tool to applied economists.

Keywords: Yield curve, treasury market, inflation compensation, risk premia

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feds 2008-04
June 2008

Footnotes Aren't Enough: The Impact of Pension Accounting on Stock Values (PDF)

Julia Coronado, Olivia S. Mitchell, Steven A. Sharpe, and S. Blake Nesbitt

Abstract: Some research has suggested that companies with defined benefit (DB) pensions are sometimes significantly misvalued by the market. This is because the measures of pension cost and pension net liabilities embedded in financial statements, taken at face value, can provide a very misleading picture of pension finances. The more pertinent information on pension finances is relegated to footnotes, but this might not receive much attention from portfolio managers. But dramatic swings in the financial conditions of large DB plans around the turn of the decade focused widespread attention on pension accounting practices, and dissatisfaction with current accounting standards has recently prompted the Financial Accounting Standards Board (FASB) to take up a project revamp DB pension accounting. Arguably, the increased attention should have made investors wise to the informational problems, thereby eliminating systematic mispricing in recent years. We test this proposition and conclude that investors continued to misvalue DB pensions, inducing sizable valuation errors in the stock of many companies. Our findings suggest that FASB's current reform efforts could substantially aid the market's ability to value firms with DB pensions.

Keywords: Pension assets, pension accounting, value-relevance, FAS 87

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Abstract: The degree to which inflation expectations are anchored at long horizons is important for many issues in macroeconomics and finance. There has been little research examining observable measures of long-run inflation expectations. We investigate the evolution of survey measures of long-run inflation expectations in the United States. Our analysis emphasizes the role of a time-varying inflation objective of monetary policymakers. This focus makes monetary policy actions a key determinant of long-run inflation expectations. Our results have important implications for work on inflation dynamics, monetary policy rules, the costs of disinflation, and the term structure of interest rates.

Keywords: Inflation objective, learning

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feds 2008-02
January 2008

Recent Trends in the Number and Size of Bank Branches: An Examination of Likely Determinants (PDF)

Timothy H. Hannan and Gerald A. Hanweck

Abstract: In this paper, we examine the role of market characteristics in explaining the much discussed phenomenon of growth in the number of banking institution branches over time, and the much less discussed phenomenon of decline in the size of the average branch. We note first that substitution of bank branches in the US for thrift branches accounts for much of the sharp rise observed for bank branches over time. Using a panel data set that consists of over 2,000 markets observed from 1988 to 2004, we report a number of findings regarding the market characteristics that are associated with the number of branches (of both commercial banks and savings associations) in a market and the average employment size of those branches.

Keywords: Banks, Branching, Location

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Abstract: This paper estimates the jumbo-conforming spread using data from the Federal Housing Finance Board's Monthly Interest Rate Survey from January 1993 to June 2007. Importantly, this paper augments the typical parametric approach by adding state-level foreclosure laws and ZIP-level demographic variables to the model, estimating the effects of loan size and loan-to-value ratio on mortgage rates nonparametrically, and including geographic location as a control for some potentially unobserved borrower and market characteristics that might vary over geography, such as credit scores, debt-to-income ratios, and house price volatility. A partial locallinear regression approach is used to estimate the jumbo-conforming spread, on the premise that loans similar to each other in terms of loan size, loan-to-value ratio, or geographic location might also be similar in other, unobservable borrower and market characteristics. I find estimates of the jumbo-conforming spread of 13 to 24 basis points—50 to 24 percent smaller since about 1996, when credit scores became widely used in mortgage underwriting, than estimates from a commonly used parametric model. I therefore attribute the difference in estimates to credit quality and other unobserved characteristics, among other potential explanations, making these controls an important issue in estimating the jumbo-conforming spread.

Keywords: Mortgages, jumbo-conforming spread, partial-linear regression, locallinear regression

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