Showing papers by "Federal Reserve Bank of St. Louis published in 2001"

Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?

Abstract: In this Paper we assess the progress made by the profession in understanding whether and how exchange rate intervention works. To this end, we review the theory and evidence on official intervention, concentrating primarily on work published within the last decade or so. Our reading of the recent literature leads us to conclude that, in contrast with the profession's consensus view of the 1980s, official intervention can be effective, especially through its role as a signal of policy intentions, and especially when it is publicly announced and concerted. We also note, however, an apparent empirical puzzle concerning the secrecy of much intervention and suggest an additional way in which intervention may be effective but which has so far received little attention in the literature, namely through its role in remedying a coordination failure in the foreign exchange market.

The Less-Volatile U.S. Economy: A Bayesian Investigation of Timing, Breadth, and Potential Explanations

Abstract: Using a Bayesian model comparison strategy, we search for a volatility reduction in U.S. real gross domestic product (GDP) growth within the postwar sample. We find that aggregate real GDP growth has been less volatile since the early 1980s, and that this volatility reduction is concentrated in the cyclical component of real GDP.Sales and production growth in many of the components of real GDP display similar reductions in volatility, suggesting the aggregate volatility reduction does not have a narrow source. We also document structural breaks in inflation dynamics that occurred over a similar time frame as the GDP volatility reduction.

Can Markov switching models predict excess foreign exchange returns

Abstract: This paper merges the literature on technical trading rules with the literature on Markov switching to develop economically useful trading rules. The Markov models’ out-of-sample, excess returns modestly exceed those of standard technical rules and are profitable over the most recent subsample. A portfolio of Markov and standard technical rules outperforms either set individually, on a risk-adjusted basis. The Markov rules’ high excess returns contrast with mixed performance on statistical tests of forecast accuracy. There is no clear source for the trends, but permitting the mean to depend on higher moments of the exchange rate distribution modestly increases returns.

Evaluating Long-Horizon Forecasts

Abstract: This paper examines the asymptotic and finite-sample properties of tests of equal forecast accuracy and encompassing applied to predictions from nested long-horizon regression models. We first derive the asymptotic distributions of a set of tests of equal forecast accuracy and encompassing, showing that the tests have non-standard distributions that depend on the parameters of the data-generating process. Using a simple parametric bootstrap for inference, we then conduct Monte Carlo simulations of a range of data-generating processes to examine the finite-sample size and power of the tests. In these simulations, the bootstrap yields tests with good finite-sample size and power properties, with the encompassing test proposed by Clark and McCracken (2001a) having superior power. The paper concludes with a reexamination of the predictive content of capacity utilization for core inflation.

Regime Switching and Monetary Policy Measurement

Abstract: This paper applies regime switching methods to the problem of measuring monetary policy. Policy preferences and structural factors are specified parametrically as independent Markov processes. Interaction between the structural and preference parameters in the policy rule serves to identify the two processes. The estimates uncover policy episodes that are initiated by switches of "dove regimes," shown to Granger cause both NBER recessions and the Romer dates. These episodes imply real effects of monetary policy that are smaller than those found in previous studies.

Risk Aversion Versus Intertemporal Substitution

Abstract: Is the risk-aversion parameter in the intertemporal consumption capital asset pricing model “small” as stated by Hansen and Singleton or is its reciprocal—the intertemporal elasticity of substitution—small, as stated by Hall? We attribute the disparate estimates of this fundamental parameter not to failures of instrument admissibility as do Hall and Hansen and Singleton but rather to failures of instrumentrelevance. That is, the disparate estimates reflect near nonidentification due to the unpredictability of asset returns and consumption growth. Imposing natural identifying restrictions from the risk-aversion perspective and the intertemporal substitution perspective yields low and stable estimates in each case.

The Federal Reserve’s operating procedure, nonborrowed reserves, borrowed reserves and the liquidity effect

Abstract: Recently, a number of researchers (Christiano and Eichenbaum, 1992; Christiano et al., 1996a,b, 1997; Evans and Marshall, 1998; Strongin, 1995; Pagan and Robertson, 1995; Brunner, 1994) claim to have found evidence of a statistically significant liquidity effect in a recursive structural VAR using nonborrowed reserves (NBR). It is claimed that innovations to NBR reflect the exogenous policy actions of the Fed. This paper argues that the opposite is true. Specifically, I show that the Fed has an incentive to offset bank-initiated discount window borrowing when it implements the Federal Open Market Committee’s policy directive, and that it has done so since the late 1950s. This practice has created a negative contemporaneous covariance between NBR and the funds rate that has been incorrectly attributed to the liquidity effect. By showing that these models capture the endogenous response of the Fed to bank borrowing on NBR, rather than the effect of exogenous policy actions on the funds rate, this paper also resolves the puzzle of the vanishing liquidity effect noted by Pagan and Robertson (1995) and Christiano (1995) .

Optimal Fiscal Policy in Overlapping Generations Models

Abstract: This paper provides, from a theoretical and quantitative point of view, an explanation of why taxes on capital returns are high (around 35%) by analyzing the optimal fiscal policy in an economy with intergenerational redistribution. For this purpose, the government is modeled explicitly and can choose (and commit to) an optimal tax policy in order to maximize society's welfare. In an infinitely lived economy with heterogeneous agents, the long run optimal capital tax is zero. If heterogeneity is due to the existence of overlapping generations, this result in general is no longer true. I provide sufficient conditions for zero capital and labor taxes, and show that a general class of preferences, commonly used on the macro and public finance literature, violate these conditions. For a version of the model, calibrated to the US economy, the main results are: first, if the government is restricted to a set of instruments, the observed fiscal policy cannot be disregarded as sub optimal and capital taxes are positive and quantitatively relevant. Second, if the government can use age specific taxes for each generation, then the age profile capital tax pattern implies subsidizing asset returns of the younger generations and taxing at higher rates the asset returns of the older ones.

The British Beveridge curve: A tale of ten regions

Abstract: Recent work has suggested the possibility that the Beveridge curve can shift over the business cycle. This is in contrast with a large body of literature claiming that Beveridge curves have shifted due to structural changes alone. To test these claims, we use county-level data to estimate the timing and magnitude of shifts in aggregate and regional British Beveridge curves. We find that these shifts coincide with the business cycle rather than with hysteresis effects or with changes in regional mismatch. This implies that the Beveridge curve is a flawed device for separating the effects of structural changes from those of the business cycle.(This abstract was borrowed from another version of this item.)

Who Pays for Credit Cards

Abstract: We model side payments in a competitive credit-card market If competitive retailers charge a single (higher) price to cover the cost of accepting cards, banks must subsidize convenience users to prevent them from defecting to merchants who do not accept cards The side payment will be financed by card users who roll over balances at interest if their subjective discount rates are high enough Despite the feasibility of cross subsidies among cardholders, price discrimination without side payments is Pareto preferred because of the costliness of the card network---unless banks have other motives, such as purchasing options on future borrowing by current convenience users

Learning and excess volatility

Abstract: We introduce adaptive learning behavior into a general-equilibrium life-cycle economy with capital accumulation. Agents form forecasts of the rate of return to capital assets using least-squares autoregressions on past data. We show that, in contrast to the perfect-foresight dynamics, the dynamical system under learning possesses equilibria that are characterized by persistent excess volatility in returns to capital. We explore a quantitative case for theselearning equilibria. We use an evolutionary search algorithm to calibrate a version of the system under learning and show that this system can generate data that matches some features of the time-series data for U.S. stock returns and per-capita consumption. We argue that this finding provides support for the hypothesis that the observed excess volatility of asset returns can be explained by changes in investor expectations against a background of relatively small changes in fundamental factors.

Public Infrastructure Investment, Inter-State Spatial Spillovers and Manufacturing Costs

Abstract: The size and significance of public infrastructure investment impacts on costs and productivity of private enterprise, and thus on economic health and growth, has proven nebulous to empirically substantiate. Various studies using alternative theoretical and econometric methodologies, and for different time periods, sectors, and countries, have tentatively established that such a productive impact exists and is statistically significant. It also seems smaller and more variable over time, space, and sector than was implied by initial studies on the "public capital hypothesis". One piece of the puzzle that has received little attention, however, is the role of spatial spillovers in driving infrastructure investment benefits. Such spillovers are not only conceptually important, but could also shed light on discrepancies between studies for different data, and particularly aggregation levels. In this study we apply a cost-based model to state-level U.S. manufacturing data, for capital, production and non-production labor, and materials inputs, and for the 1982-96 time period, in an attempt to untangle the private cost-saving contributions of inter-and intra-state public infrastructure investment. We carry out two kinds of spatial adaptations-a spatial autocorrelation adjustment and a spatial spillover theoretical modification-to the estimating system consisting of a Generalized Leontief cost function and input demand equations, to address this issue. We find that intra-state public infrastructure benefits appear larger in magnitude when inter-state spillovers are directly recognized, as well as being invariably statistically significant. Inter-state spillovers are also directly beneficial to manufacturing firms, although their contribution appears smaller in size when temporal serial correlation is recognized in addition to spatial correlation.

Voting with your feet in the United Kingdom: Using cross‐migration rates to estimate relative living standards*

Abstract: This article reexamines and extends the literature on the use of migration rates to estimate compensating differentials as measures of regional quality of life. I estimate an interregional migration regression for the UK and use the results to measure regional quality of life and standard of living. The results suggest a North-South divide within England, and that Scotland and Wales have relatively high levels of both. The results also lead to a rejection of regional standard-of-living e quivalence (long-run regional equilibrium) in the UK.

Regime switching and monetary policy measurement

Abstract: This paper applies regime switching methods to the problem of measuring monetary policy. Policy preferences and structural factors are specified parametrically as independent Markov processes. Interaction between the structural and preference parameters in the policy rule serves to identify the two processes. The estimates uncover policy episodes that are initiated by switches of "dove regimes," shown to Granger cause both NBER recessions and the Romer dates. These episodes imply real effects of monetary policy that are smaller than those found in previous studies.

Forecasting macro variables with a Qual VAR business cycle turning point index

Abstract: One criticism of Vector Autoregression (VAR) forecasting is that macroeconomic variables tend not to behave as linear functions of their own past around business cycle turning points. A large amount of literature therefore focuses on nonlinear forecasting models, such as Markov switching models, which only indirectly capture the relation with turning points. This article investigates a direct approach to using information on turning points from the National Bureau of Economic Research (NBER) chronology to model and forecast macroeconomic data. Our Qual VAR model includes a truncated normal latent business cycle index that is negative during NBER recessions and positive during expansions. We motivate our forecasting exercise by demonstrating that if starting from a linear specification, a truncated normal variable is an omitted variable, then forecasts of the remaining variables will become nonlinear functions of their own past. We apply the Qual VAR model to recursive out-of-sample forecasting and find th...

What Can Bank Supervisors Learn from Equity Markets

Abstract: Much recent academic attention has focused on the relative ability of markets and bank supervisors to assess the risk of depository institutions. We add to that literature by comparing the factors influencing bank holding company risk, as gauged by equity markets, with the factors influencing the confidential BOPEC scores, as awarded by bank supervisors. Specifically, we regress stock market measures of holding company risk and BOPEC scores on a host of on- and off-balance sheet risk measures taken from the Federal Reserve's Consolidated Financial Statements for Bank Holding Companies (FR Y-9C reports). Our sample includes data from 1988 through 1993. We estimate regressions year by year on a sample of 98 holding companies, with yearly observations ranging from 69 to 79. The results suggest that both equity markets and regulators closely scrutinize credit risk. Beyond that, the results suggest that regulators pay close attention to capital strength. Taken together, the evidence supports the view that the stock market emphasizes risk-return trade-offs, whereas regulators care more about probability of failure.

UK Monetary Policy 1972-97: A Guide Using Taylor Rules

Abstract: In the period from the floating of the exchange rate in 1972 to the granting of independence to the Bank of England in 1997, UK monetary policy went through several regimes, including: the early 1970s, when monetary policy was subordinate to incomes policy as the primary weapon against inflation; Sterling M3 targeting in the late 1970s and early 1980s; moves in the late 1980s toward greater exchange rate management, culminating in the UK's membership of the ERM from 1990-92; and inflation targeting from October 1992. This Paper estimates simple interest rate reaction functions, or 'Taylor rules', for different UK monetary policy regimes. The inflation targeting regime that began in 1992 appears to be the only period that is characterised by the 'Taylor principle', namely a greater than one for one response of interest rates to fluctuations in inflation. In contrast to the US case, the early 1980s disinflation in the UK appears best characterised as an increase in the intercept of the authorities' interest rate rule rather than by an increased systematic response of monetary policy to inflation.

Nonlinear dynamics, spillovers and growth in the G7 economies: an empirical investigation

Abstract: This paper proposes an empirical growth model which is consistent with a stochastic steady-state labour productivity level varying over time and across countries, where the disequilibrium mechanism leading to long-run equilibrium follows a nonlinear equilibrium correction model. Using data for the G7 economies during the postwar period since 1950, the empirical analysis yields a long-run model which implies plausible estimates of the production function parameters. Postwar economic growth in each of the G7 countries appears to be well characterized by a nonlinear equilibrium correction model where the dynamic adjustment towards long-run equilibrium is governed by a logistic function, while also capturing spillover effects in growth dynamics.

Does Ethics Training Neutralize the Incentives of the Prisoner's Dilemma? Evidence from a Classroom Experiment

Abstract: Teaching economics has been shown to encourage students to defect in a prisoner's dilemma game. However, can ethics training reverse that effect and promote cooperation? We conducted an experiment to answer this question. We found that students who had the ethics module had higher rates of cooperation than students without the ethics module, even after controlling for communication and other factors expected to affect cooperation. We conclude that the teaching of ethics can mitigate the possible adverse incentives of the prisoner's dilemma, and, by implication, the adverse effects of economics and business training.

Enforcement, Contract Design, and Default: Exploring the Financial Markets of Costa Rica

Abstract: This paper examines the institutional determinants of incentives to repay in Costa Rica and their effects on defaults and the design of financial contracts Enforcement mechanisms help to determine how much is paid back to creditors and how much shareholders receive as dividends Theoretically, however, the most important effects will be on the observable characteristics of contracts, as rational agents foresee the incentives of other parties As courts enforce contracts and punish defaulters, they determine the form contracts take and the magnitude and direction of investments The paper contains findings on the practices of financial intermediaries that are discussed in the context of contract theory, with a focus on the formal financial intermediaries that are scattered throughout the country Much of the information comes from primary sources, including a sample of almost 1,700 civil trials and a detailed survey on the credit policies of 31 intermediaries This paper reviews the creditor-borrower relationship at all stages—ex ante, interim, and ex post The evidence supports the importance of collateral and other ex post repayment incentives The evidence also suggests that, contrary to the common view, banks are not passive lenders They remain alert to how well projects perform and rely on previous experience and a rather sophisticated informational network in granting credit

Forecasting the Treasury's balance at the Fed

Abstract: As part of the Fed's daily operating procedure, the Federal Reserve Bank of New York, the Board of Governors and the Treasury make a forecast of that day's Treasury balance at the Fed. These forecasts are an integral part of the Fed's daily operating procedure. Errors in these forecasts can generate variation in reserve supply and, consequently, the federal funds rate. This paper evaluates the accuracy of these forecasts. The evidence suggests that each agency's forecast contributes to the optimal, i.e., minimum variance, forecast and that the Trading Desk of the Federal Reserve Bank of New York incorporates information from all three of the agency forecasts in conducting daily open market operations. Moreover, these forecasts encompass the forecast of an economic model. Copyright © 2004 John Wiley & Sons, Ltd.

The value of inside and outside money

Abstract: We study dynamic economies in which agents may have incentives to hold both privately-issued (a.k.a. inside) and publicly-issued (a.k.a. outside) circulating liabilities as part of an equilibrium. Our analysis emphasizes spatial separation and limited communication as frictions that motivate monetary exchange. We isolate conditions under which a combination of inside and outside money does and does not allow the economy to achieve a first-best allocation of resources. We also study the extent to which the use of private circulating liabilities alone, or the use of public circulating liabilities alone, can address the frictions that lead to monetary exchange. We identify conditions under which both types of liabilities are essential to efficiency. However, even when these conditions are satisfied, we show that political economy considerations may lead to a prohibition against private circulating liabilities. Finally, we analyze the consequences of such a prohibition for the determinacy of equilibrium, and for endogenously arising volatility.

Risk-adjusted, ex ante, optimal technical trading rules in equity markets

Abstract: Allen and Karjalainen (1999) used genetic programming to develop optimal ex ante trading rules for the S&P 500 index. They found no evidence that the returns to these rules were higher than buy-and-hold returns but some evidence that the rules had predictive ability. This comment investigates the risk-adjusted usefulness of such rules and more fully characterizes their predictive content. These results extend Allen and Karjalainen's (1999) conclusion by showing that although the rules' relative performance improves, there is no evidence that the rules significantly outperform the buy-and-hold strategy on a risk-adjusted basis. Therefore, the results are consistent with market efficiency. Nevertheless, risk-adjustment techniques should be seriously considered when evaluating trading strategies.

Who pays for credit cards

Abstract: We model side payments in a competitive credit-card market. If competitive retailers charge a single (higher) price to cover the cost of accepting cards, banks must subsidize convenience users to prevent them from defecting to merchants who do not accept cards. The side payments will be financed by card users who roll over balances at interest if their subjective discount rates are high enough. Despite the feasibility of cross subsidies among cardholders, price discrimination without side payments is Pareto preferred because of the costliness of the card network--unless banks have other motives, such as purchasing options on future borrowing by convenience users.