Showing papers by "Federal Reserve System published in 1996"

The Financial Accelerator and the Flight to Quality

Abstract: Adverse shocks to the economy may be amplified by worsening credit-market conditions-- the financial 'accelerator'. Theoretically, we interpret the financial accelerator as resulting from endogenous changes over the business cycle in the agency costs of lending. An implication of the theory is that, at the onset of a recession, borrowers facing high agency costs should receive a relatively lower share of credit extended (the flight to quality) and hence should account for a proportionally greater part of the decline in economic activity. We review the evidence for these predictions and present new evidence drawn from a panel of large and small manufacturing firms.

Agency Costs, Net Worth, and Business Fluctuations: A Computable General Equilibrium Analysis

Abstract: An analysis of the quantitative effects of agency costs in a real business cycle model, showing that these costs can explain why output growth displays positive autocorrelation at short horizons.

Estimating the Price of Default Risk

Abstract: The risk of default affects virtually every financial contract. Therefore the pricing of default risk has received much attention; both from traders, who have a strong interest in pricing transactions accurately, and from financial economists, who have much to learn from the way such risks are priced in markets. The standard theoretical paradigm for modeling credit risks is the contingent claims approach pioneered by Black and Scholes. Much of the literature follows Merton (1974) by explicitly linking the risk of a firm’s default to the variability in the firm’s asset value. Although this line of research has proven very useful in addressing the qualitatively important aspects of

Small business and job creation: Dissecting the myth and reassessing the facts

Abstract: This paper investigates how job creation and destruction behavior varies by employer size in the U.S. manufacturing sector during the period 1972 to 1988. The paper also evaluates the empirical basis for conventional claims about the job-creating prowess of small businesses. The chief findings and conclusions fall into five categories:

An Analysis of Out-of-Wedlock Childbearing in the United States

Abstract: This paper relates the erosion of the custom of shotgun marriage to the legalization of abortion and the increased availability of contraception to unmarried women in the United States. The decline in shotgun marriage accounts for a significant fraction of the increase in out-of-wedlock first births. Several models illustrate the analogy between women who do not adopt either birth control or abortion and the hand-loom weavers both victims of changing technology. Mechanisms causing female immiseration are modeled and historically described. This technology-shock hypothesis is an alternative to welfare and job-shortage theories of the feminization of poverty. (EXCERPT)

Does Corporate Lending by Banks and Finance Companies Differ? Evidence on Specialization in Private Debt Contracting

Abstract: This paper establishes empirically the existence of specialization in private-market corporate lending, adding a new dimension to the public versus private debt distinctions now common in the literature. Comparing corporate loans made by banks and by finance companies, we find that the two types of intermediaries are equally likely to finance information-problematic firms. However, finance companies tend to serve observably riskier borrowers, particularly more leveraged borrowers. Evidence supports both regulatory and reputation-based explanations for this specialization. In passing, we shed light on various theories of debt contracting and intermediation and present facts about finance companies.

The Computational Experiment: an Econometric Tool

Abstract: An economic experiment consists of the act of placing people in an environment desired by the experimenter, who then records the time paths of their economic behavior. Performing experiments that use actual people at the level of national economies is obviously not practical, but constructing a model economy and computing the economic behavior of the model's people is. Such experiments are termed computational. This essay specifies the steps in designing a computational experiment to address some well-posed quantitative question. The authors emphasize that the computational experiment is an econometric tool used in the task of deriving the quantitative implications of theory.

Recent Developments in Bootstrapping Time Series

Abstract: In recent years, several new parametric and nonparametric bootstrap methods have been proposed for time series data. Which of these methods should applied researchers use? We provide evidence that for many applications in time series econometrics parametric methods are more accurate, and we identify directions for future research on improving nonparametric methods. We explicitly address the important but often neglected issue of model selection in bootstrapping. In particular, we emphasize the advantages of the AIC over other lag order selection criteria and the need to account for lag order uncertainty in resampling. We also show that the block size plays an important role in determining the success of the block bootstrap, and we propose a data-based block size selection procedure.

The Illusory Effects of Saving Incentives on Saving

Abstract: American saving rates fell dramatically in the 1980s and have remained low since then. The decline in saving has raised concerns that the economy may be unable to finance investment and sustain growth and that households may not be saving adequately for retirement. One response to these concerns has been the development of special saving accounts, such as Individual Retirement Accounts, 401 (k) plans and Keogh plans. These voluntary accounts, which we refer to as "saving incentives," feature preferential tax treatment of contributions and investment earnings, annual contribution limits and penalties for early withdrawals.The question addressed in this paper is the extent to which saving incentives have raised private and national (public plus private) saving. Contributions and investment earnings are typically tax deferred, thus reducing public saving (increasing the budget deficit) in the short run. The long-run impact on public saving is less obvious; if the incentives increase private saving, they may also increase income and tax revenue.

Inflation Targeting in a St. Louis Model of the 21st Century

Abstract: Inflation targeting is a monetary policy rule that has implications for both the average performance of an economy and its business cycle behavior. We use a modern, rational expectations model to study the twin effects of this policy rule. The model highlights forward- looking consumption and labor supply decisions by households and forward-looking investment and price-setting decisions by firms. In it, monetary policy has real effects because imperfectly competitive firms are constrained to adjust prices only infrequently and satisfy all demand at posted prices. In this 'sticky price' model, there are also effects of the average rate of inflation on the amount of time that individuals must devote to shopping activity and on the average markup of price over cost that firms can charge. However, in terms of the welfare effects of long-run inflation, it is optimal to set monetary policy so that the nominal interest rate is close to zero, replicating in an imperfectly competitive model the result that Friedman found under perfect competition. A perfect inflation target has desirable effects on the response of the macroeconomy to permanent shocks to productivity and money demand. Under such a policy rule, the monetary authority makes the money supply evolve so a model with sticky prices behaves much like one with flexible prices.

Judging Instrument Relevance in Instrumental Variables Estimation

Abstract: Recent research has emphasized the poor finite-sample performance of the instrumental variables (IV) estimator when the instruments are weakly correlated with the regressors. We show how the canonical correlations between regressors and instruments can provide a measure of instrument relevance in the general multiple-instrument-multiple-regressor case. However, our simulation results indicate that any such relevance measure probably has little practical merit, as its use may actually exacerbate the poor finite-sample properties of the IV estimator.

Inflation, Volatility and Growth

Abstract: This paper re-examines the relationship between inflation, inflation volatility and growth, using cross-country panel data for the past 30 years. With regard to the level of inflation, we find that exploiting the time dimension of the data reveals a strong negative correlation between inflation and income growth for all but low inflation countries. To examine the role of inflation uncertainty on growth, we use intra-year inflation data to construct an annual measure of inflation volatility. Using this measure, we find that inflation volatility is also robustly negatively correlated with growth, even after the effect of the level of inflation is controlled for.

The Illusory Effects of Saving Incentives on Saving

Abstract: The authors evaluate research on how tax-based saving incentives (IRAs and 401(k)s) affect saving. Previous research overstates the impact of the incentives on saving by failing to account for several issues: households with saving incentives have stronger tastes for saving than others; saving incentives have interacted with debt, nonfinancial assets, financial markets, and pensions; and saving incentives represent pretax balances, whereas taxable accounts represent posttax balances. Accounting for these issues essentially eliminates the impact of saving incentives on saving. The authors conclude that little if any of the contributions to existing saving incentives have raised saving.

The Opportunistic Approach to Disinflation

Abstract: This paper explores the theoretical foundations of a new approach to monetary policy. Proponents of this approach hold that, when inflation is moderate but still above the long-run objective, the central bank should not take deliberate anti-inflation action but, rather, should wait for exogenous circumstances – such as favourable supply shocks and unforeseen recessions – to deliver the desired reduction in inflation. While waiting for such circumstances to arise, the central bank should aggressively resist incipient increases in inflation. This strategy has come to be known as ‘the opportunistic approach to disinflation’. We deduce policy maker preferences that rationalize the opportunistic approach as the optimal strategy for disinflation in the context of a model that is standard in other respects. The policy maker who is endowed with these preferences tends to focus on stabilizing output when inflation is low, but on fighting inflation when inflation is high. We contrast the opportunistic approach to a more conventional strategy derived from strictly quadratic preferences.

Measuring International Economic Linkages with Stock Market Data

Abstract: This article develops a new framework for measuring financial and real economic linkages between countries. Using United States and United Kingdom data from 1957 to 1989, we find closer financial linkages after the Bretton Woods currency arrangement was abandoned and Britain suspended exchange controls. In a pairwise application to fifteen countries over a shorter period, we also find that news about future dividend growth is more highly correlated between countries than contemporaneous output measures. This suggests that there are lags in the international transmission of economic shocks and that contemporaneous output correlation may understate the magnitude of integration. THE DEGREE OF INTEGRATION among different economies is an important issue in international economics. Much of the literature in this area has concentrated on measuring international financial integration. The most direct methods apply the law of one price to financial assets. For example, Mishkin (1984) uses an interest rate parity relation, and Kleidon and Werner (1993) look for arbitrage opportunities associated with cross-listed stocks. However, these strategies are limited by their dependence on the existence of assets in different countries with the same risk. Other studies focus on one-period returns and the conditional means and variances of one-period returns in characterizing international financial integration. (See, for instance, Wheatley (1988), Gultekin, Gultekin, and Penati (1989), Campbell and Hamao (1992), Bekaert and Hodrick (1992), Chan, Karolyi, and Stulz (1992), King, Sentana, and Wadhwani (1994), and Heston and Rouwenhorst (1994)). One weakness of this sort of approach is that one may overlook persistent comovements in long-term expected returns that could be quite important in asset pricing- comovements of short-term (expected) returns may be obfuscated by transitory shocks that

The Coevolution of the Real and Financial Sectors in the Growth Process

Abstract: The role of debt and equity changes over time and with the level of development. What are these changes, and why should they systematically occur across different countries and time periods? This article characterizes financial innovation as a dynamic process that both influences and is influenced by the development of the real sector. It focuses on the emergence and development of equity markets, using a model that allows for growth and for capital accumulation that is financed externally through a combination of debt and equity. As an economy develops, the aggregate ratio of debt to equity will generally fall; yet, debt and equity remain complementary sources for the financing of capital investments. The results suggest how various government policy actions might affect capital 'accumulation and equity market activity.

A Guide to FRB/US: A Macroeconomic Model of the United States

Abstract: FRB/US is a large-scale quarterly econometric model of the U.S. economy, developed to replace the MPS model. Most behavioral equations are based on specifications of optimizing behavior containing explicit expectations of firms, households, and financial markets. Although expectations are explicit, the empirical fits of the structural descriptions of macroeconomic behavior are comparable to those of reduced-form time series models. In most instances, tests do not reject overidentifying restrictions of rational expectations or the hypothesis of serially independent residuals. As modeled, private sector expectations of policy constitute a major transmission channel of monetary policy.

"The Minimum Wage and the Employment of Youth: Evidence from the NLSY"

Abstract: Using panel data on individuals from the National Longitudinal Survey of Youth, we find that employed individuals who were affected by the increases in the federal minimum wage in 1979 and 1980 were about 3 percent less likely to be employed a year later, even after accounting for the fact that workers employed at the minimum wage may differ from their peers in unobserved ways.

Downsizing and productivity growth: Myth or reality?

Abstract: The conventional wisdom is that the rising productivity in the U.S. manufacturing sector in the 1980s has been driven by the apparently pervasive downsizing over this period. Aggregate evidence clearly shows falling employment accompanying the rise in productivity. In this paper, we examine the microeconomic evidence using the plant level data from the Longitudinal Research Database (LRD). In contrast to the conventional wisdom, we find that plants that increased employment as well as productivity contribute almost as much to overall productivity growth in the 1980s as the plants that increased productivity at the expense of employment. Further, there are striking differences by sector (defined by industry, size, region, wages, and ownership type) in the allocation of plants in terms of whether they upsize or downsize and whether they increase or decrease productivity. Nevertheless, in spite of the striking differences across sectors defined in a variety of ways, most of the variance of productivity and employment growth is accounted for by idiosyncratic factors.

Mismeasurement in the Consumer Price Index: An Evaluation

Abstract: A number of analysts have claimed recently that the consumer price index overstates the annual increase in the cost of living. This paper develops a framework for studying measurement problems in the consumer price index and systematically analyzes the available evidence concerning the magnitude of these problems. It concludes that the CPI overstates increases in the cost of living. The evidence suggests that the bias is centered on 1.0 percentage point per year. The extent of this bias is not known exactly. To take into account this uncertainty, the estimated bias is presented in terms of a probability distribution rather than a point estimate or range. We estimate that there is a 10 percent chance that the bias is less than 0.6 percentage point and a 10 percent chance that it is greater than 1.5 percentage points per year. CPI procedures overstate the rate of inflation for medical procedures that are subject to technological improvement. To illustrate this point and to show how better to measure medical care prices, the paper presents a prototypical price index for cataract surgery. This price index grows much more slowly than a price index for cataract surgery constructed using the methodology of the CPI. The paper discusses implications of CPI mismeasurement for monetary and fiscal policy as well as for other official statistics. It also offers some suggestions for improving the CPI.

Limits on Interest Rate Rules in the IS Model

Abstract: There are a few limits on interest rate rules in the textbook sticky price macroeconomic model. A central bank can even use a 'pure' rule that sets the interest rate arbitrarily. However, modern consumption and investment theory suggests that expectations of future output enter the IS schedule. With this modification, a pure interest rate rule is either infeasible or undesirable. Yet, interest rate rules that target the price level or the inflation rate can be feasible.

Expectation Traps and Discretion

Abstract: We argue that discretionary monetary policy exposes the economy to welfare-decreasing instability. It does so by creating the potential for private expectations about the response of monetary policy to exogenous shocks to be self-fulfilling. Among the many equilibria that are possible, some have good welfare properties. But others exhibit welfare-decreasing volatility in output and employment. We refer to the latter type of equilibria as expectation traps. In effect, our paper presents a new argument for commitment in monetary policy because commitment eliminates these bad equilibria. We show that full commitment is not necessary to achieve the best outcome, and that more limited forms of commitment suffice.

Do consumers pay for one-stop banking? Evidence from an alternative revenue function

Abstract: In providing financial services jointly, banks may reduce costs due to complementarities in production (cost economies of scope) or raise revenues from complementarities in consumption (revenue economies of scope). Cost economies of scope between bank deposits and loans have been found to be small. Revenue economies of scope are investigated here for the first time and found to be insignificant over 1978–1990 for both small and large banks and for those on or off the revenue-efficient frontier. The lack of complementarities between deposits and loans — where benefits are most likely to occur — suggests that claims of important synergies from an expansion of banking powers be taken with caution.

Technology and Jobs: Secular Changes and Cyclical Dynamics

Abstract: In this paper, we exploit plant-level data for US manufacturing for the 1970s and 1980s to explore the connections between changes in technology and the structure of employment and wages We focus on the nonproduction labor share (measured alternatively by employment and wages) as the variable of interest Our main findings are summarized as follows: (i) aggregate changes in the nonproduction of labor share at annual and longer frequencies are dominated by within plant changes; (ii) the distribution of annual within plant changes exhibits a spike at zero, tremendous heterogeneity and fat left and right tails; (iii) within plant secular changes are concentrated in recessions; and (iv) while observable indicators of changes in technology account for a significant fraction of the secular increase in the average nonproduction labor share, unobservable factors account for most of the secular increase, most of the cyclical variation and most of the cross sectional heterogeneity

Nominal Wage Stickiness and Aggregate Supply in the Great Depression

Abstract: Building on earlier work by Eichengreen and Sachs, we use data for 22 countries to study the role of wage stickiness in propagating the Great Depression. Recent research suggests that monetary shocks, transmitted internationally by the gold standard, were a major cause of the Depression. Accordingly, we use money supplies and other aggregate demand shifters as instruments to identify aggregate supply relationships. We find that nominal wages adjusted quite slowly to falling prices, and that the resulting increases in real wages depressed output. These findings leave open the question of why wages were so inertial in the face of extreme labor market conditions.