Showing papers in "Journal of Money, Credit and Banking in 1997"

Postwar U.S. Business Cycles: An Empirical Investigation

Abstract: A study documents some features of aggregate economic fluctuations sometimes referred to as business cycles. The investigation uses quarterly data from the postwar US economy. The fluctuations studied are those that are too rapid to be accounted for by slowly changing demographic and technological factors and changes in the stocks of capital that produce secular growth in output per capita. The study proposes a procedure for representing a times series as the sum of a smoothly varying trend component and a cyclical component. The nature of the comovements of the cyclical components of a variety of macroeconomic time series is documented. It is found that these comovements are very different than the corresponding comovements of the slowly varying trend components.

Diversification, Size, and Risk at Bank Holding Companies

Abstract: This paper shows that large bank holding companies (BHCs) are better diversified than small BHCs based on market measures of diversification. The authors find, however, that better diversification does not translate into reductions in risk. The risk-reducing potential of diversification at large BHCs is offset by their lower capital ratios and larger commercial and industrial loan portfolios. The authors' results suggest that diversification may provide an important motive for consolidation by allowing BHCs to pursue riskier lending while operating with greater leverage. Copyright 1997 by Ohio State University Press.

The [un]importance of forward-looking behavior in price specifications

Abstract: The seminal work of Edmund S. Phelps (1978), John B. Taylor (1980), and Guillermo A. Calvo (1983) developed forward-looking models of price determination that imparted inertia to the price level. These models incorporate expectations of future prices and excess demand by imposing constraints (typically lag-lead symmetry constraints) that force future variables to enter the specification. In this paper, the author tests the empirical significance of future prices in specifications like those of Taylor. He finds that expectations of future prices are empirically unimportant in explaining price and inflation behavior. However, the dynamics of a model that includes a purely backward-looking inflation specification differ substantially--and not altogether pleasingly--from those with a forward-looking specification. Copyright 1997 by Ohio State University Press.

Inflation Forecasts and Monetary Policy

Abstract: Proposals for 'inflation targeting' as a strategy for monetary policy leave open the important operational question of how to determine whether current policies are consistent with the long-run inflation target. An interesting possibility is that the central bank might target current private-sector forecasts of inflation, either those made explicitly by professional forecasters or those implicit in asset prices. We address the issue of existence and uniqueness of rational expectations equilibria when the central bank uses private-sector forecasts as a guide to policy actions. In a dynamic model which incorporates both sluggish price adjustment and shocks to aggregate demand and aggregate supply, we show that strict targeting of inflation forecasts is typically inconsistent with the existence of rational expectations equilibrium, and that policies approximating strict inflation-forecast targeting are likely to have undesirable properties. We also show that economies with more general forecast-based policy rules are particularly susceptible to indeterminacy of rational expectations equilibria. We conclude that, although private-sector forecasts may contain information useful to the central bank, ultimately the monetary authorities must rely on an explicit structural model of the economy to guide their policy decisions.

Banks' Responses to Deregulation: Profits, Technology, and Efficiency

Abstract: The deregulation of interest rates in the early 1980s raised bank funding costs and lowered profits. In response, banks raised fees for deposit services, reduced branch operating costs, and shifted to higher earning assets. Rates of return did not regain their prederegulation levels until the early 1990s. Our goal is to decompose the change in bank profits following deregulation into (i) intemal, bank-initiated adjustments to the new regulatory structure and (ii) external, contemporaneous changes in banks' business environment. This decomposition will depend, in part, on the assumed competitive structure of the banking industry. With perfect competition, output and input prices are part of the external environment and banks' responses are limited to changes in output and input quantities. An alternative approach assumes imperfect competition where banks have some control over output prices (deposit fees, minimum balance requirements, and interest rates on certain loans) and output quantities and input prices comprise the external environment. The altemative model is supported by the data. Using this model, large banks-but not smaller banks-are found to have relied primarily on changing output prices and input use to mitigate and reverse the negative effects of deregulation on profits. The adjustment to deregulation was essentially complete after four years. Following this, additional changes in bank profitability (during the late 1980s) were primarily due to changes in banks' business environment.

Do Mergers Improve the X-Efficiency and Scale Efficiency of U.S. Banks? Evidence from the 1980s

Abstract: A central issue currently debated among bank analysts and economists is whether mergers enhance the efficiency of surviving banks. This paper investigates the postmerger performance of acquiring banks that participated in a merger during the period 1980-90. The evidence suggests that acquirers failed to improve X-efficiency after the merger. Acquiring banks, however, experienced moderate gains in scale efficiency relative to a control sample. The second part of the paper uses regression analysis to identify factors influencing the performance of merging banks. The regression results suggest that improvements in postmerger performance depend on the ability of the bank to strengthen asset quality. The author finds no evidence to support the theory that in-market mergers lead to significant improvements in efficiency. Copyright 1997 by Ohio State University Press.

Is There Endogenous Long-Run Growth? Evidence from the United States and the United Kingdom.

Abstract: The key feature of endogenous growth models is that they imply that perrnanent changes in government policy can have permanent effects on growth rates. In this paper we develop and implement an empirical framework to test this implication. In a regression of growth rates on current and lagged policy variables the sum of the slope coefficients for each policy variable should be nonzero (zero) for endogenous (exogenous) growth models. In our estimation we use time series data spanning up to 100 years for the United States and 160 years for the United Kingdom. We find that the implication for exogenous growth is usually rejected when both a tax variable and a public capital variable are included in the regression; failing to include both variables biases the results in favor of exogenous growth models. Our findings show that it is possible to have endogenous growth even when U.S. and U.K. GDP growth rates appear to be stable over time. We conclude that at the aggregate level, the production function appears to exhibit constant returns to scale in reproducible inputs.

Inflation/output Variance Trade-Offs and Optimal Monetary Policy

Abstract: The author estimates the inflation/output-gap variance trade-off faced by monetary policymakers in the United States. For policymakers who care about deviations of inflation around target and output around potential, the estimated trade-off represents the 'optimal policy frontier.' Given the structure of the economy, policymakers can do no better than to attain weighted variances of inflation and output that lie on the frontier. The author finds that the variance trade-off becomes quite severe when the standard deviation of inflation or output drops much below 2 percent. This suggests that approximately balanced responses to policy goals are consistent with reasonable preferences over inflation and output variability. Copyright 1997 by Ohio State University Press.

Bank Loan Commitment Contracts: Data, Theory, and Tests

Abstract: Over 80 per cent of all commercial bank lending to corporations in the U.S. is done via bank loan commitments. Yet the authors have little empirical knowledge of loan commitment contracts. In this paper they describe the rich contractual structure of bank loan commitments based on data pertaining to over 2,500 contracts. The authors then develop a model which demonstrates that the observed complex structure of bank loan commitment contracts (which typically include multiple fee structures borrower-specific contracting variables, and the standard 'material adverse change clause') is important when the bank faces borrower adverse selection and moral hazard problems. Finally, the authors verify the robustness of their model by confronting its additional testable predictions with the data. Copyright 1997 by Ohio State University Press.

Pricing mortgage default and foreclosure delay

Abstract: This paper extends current mortgage pricing models to recognize the impact that delays between default and foreclosure have on the value of default to the borrower and the resulting value of the mortgage to investors. The model explicitly captures potential costs (through postforeclosure deficiency judgments) and benefits (in the elimination of negative equity and 'free' rent) that must be weighed at the time of default in determining whether the ultimate put option (via allowing foreclosure) is in-the-money. The results provide policy implications concerning the operation of the FHA insurance program. Copyright 1997 by Ohio State University Press.

Erratum [Oil and the Macroeconomy: A Markov State-Switching Approach]

Abstract: This paper analyzes the relationship between oil price shocks and postwar U.S. business cycle fluctuations. The authors develop a generalized Markov switching model of output that includes a measure of net real oil price increases and examine the capabilities of this variable to generate shifts in the mean of GDP growth and to predict transitions between dichotomous growth phases. The results indicate that, while the behavior of oil prices has been a contributing factor to the mean of low growth phases of output, movements in oil prices generally have not been a principal determinant in the historical evidence of these phases. Copyright 1997 by Ohio State University Press.

Oil and the Macroeconomy: A Markov State-Switching Approach

Abstract: This paper analyzes the relationship between oil price shocks and postwar U.S. business cycle fluctuations. The authors develop a generalized Markov switching model of output that includes a measure of net real oil price increases and examine the capabilities of this variable to generate shifts in the mean of GDP growth and to predict transitions between dichotomous growth phases. The results indicate that, while the behavior of oil prices has been a contributing factor to the mean of low growth phases of output, movements in oil prices generally have not been a principal determinant in the historical evidence of these phases. Copyright 1997 by Ohio State University Press.

Excess Sensitivity and Asymmetries in Consumption: An Empirical Investigation

Abstract: Most empirical studies on liquidity constraints classify a consumer as being constrained on the basis of a single indicator such as the asset to income ratio. In this analysis, the authors model the probability that a consumer faces liquidity constraints as a function of multiple social and economic factors. This probability function is estimated simultaneously with the degree of excess sensitivity of consumption to income in a switching regressions framework. The switching regressions apply optimal weights to the densities for the Euler equations in the two states and are less susceptible to sample misclassification. Our results based on data from the CEX confirm that liquidity constrained consumers are excessively sensitive to variables already known to economic agents. However, there is also evidence that the unconstrained consumers exhibit behavior that is inconsistent with the theoretical predictions. Further analysis suggests that such behavior could be explained by time non-separable preferences. Copyright 1997 by Ohio State University Press.

Explaining the Failures of the Term Spread Models of the Rational Expectations Hypothesis of the Term Structure

Abstract: Contrary to the predictions of the rational expectations hypothesis of the term structure of interest rates, empirical evidence suggests that the term spread between long and short rates fails to forecast future movements of long-term rates although its forecasts of future short-term rates are in the correct direction. In this paper, the authors show that this puzzling behavior of the term spread alone can be explained by a time-varying term premium that is correlated with the term spread. Once this is accounted for, neither expression of the expectations hypothesis is against the predictions of the theory. Copyright 1997 by Ohio State University Press.

Collateral damage: Refinancing constraints and regional recessions

Abstract: In the current structure of the U.S. residential mortgage market, a decrease in property values may make it very difficult for homeowners to refinance their mortgages to take advantage of declining interest rates. In this papr, we show that this form of collateral constraint has greatly reduced refinancing in statds with depressed property markets. We outline the interaction between regional recessions and refinancing constraints. WHEN ADVERSE ECONOMIC SHOCKS cause property values in a region to decrease, the damage to the collateral makes it difficult or impossible for some homeowners to obtain new mortgages. In the recent period, this has meant that homeowners in economically depressed regions have been unable to refinance their mortgages to take advantage of declining interest rates. This inability to refinance has further economic impacts on the region through lowering the wealth and the discretionary income of local homeowners, thereby deepening the regional recession. While the possible link between regional declines in property values and refinancing activity has been understood for some time (for example, Monsen 1992), the subject has received very little empirical attention. We provide the first quantitative assessment of the impact of constraints arising from regional property market dynamics on refinancing activity. To accomplish this, we use a new data set on more than thirty-five thousand individual mortgages. The sample consists of all mortgages serviced by Chemical Bank with originations between June 1989 and May 1992.

Rogoff's 'conservative' central banker restored

Abstract: We show that delegation of monetary policy to a weight-conservative central banker can be desirable, although the government can also use an inflation contract, an employment target, an inflation target, or any combination of these to control the central banker. The key feature of our model is a stochastic inflation bias, arising when wage setters receive some information about a supply shock prior to signing nominal wage contracts. Weight-conservatism is found to be desirable if fully state-contingent delegation is not possible and the stochastic inflation bias cannot be eliminated by optimal choice of the delegation parameters.

The Effects of Military Spending on Economic Activity: Evidence from State Procurement Spending

Abstract: The authors use state data from the period 1963-94 to estimate the response of employment growth to military procurement spending. The state-year panel provides greater variation in both variables than aggregate data. There are two main findings. First, military procurement spending does explain a statistically significant degree of the variation in employment growth across states, even in the presence of fixed effects for time and state and other controls. Second, the authors find evidence in support of a nonlinear relationship between procurement spending and employment growth. In particular, large adverse state procurement shocks have proportionately larger effects on state employment growth rates. Copyright 1997 by Ohio State University Press.

Monetary Aggregation and the Demand for Assets

Abstract: In this paper we consider and illustrate a solution to the inter-related problems of monetary aggregation and estimation of money demand. The problem with the definition of money is that the relative prices of the monetary components fluctuate over time, rendering simple-sum aggregates inefficient. The authors apply Revealed Preference tests to the U.S. monthly data to determine admissible and separable components. These components are then aggregated using the Divisia technique. To deal with the problem of money demand, the dynamic Fourier expenditure system is used to provide estimates of the elasticities of substitution. These, while showing general substitution among the liquid assets studied, are quite variable over time. This finding underscores the inefficiency of both simple-sum aggregation and single-equation, log-linear money-demand estimation. Copyright 1997 by Ohio State University Press.

Asymmetric Information and Loan Contracts in a Neoclassical Growth Model

Abstract: The authors consider a neoclassical growth model with risky investment projects in which a borrower's (an investor's) risk type is private information. Their innovation is to determine jointly the equilibrium loan contract and the economy's growth path and the steady state capital stock. The authors show that as capital accumulates, credit rationing may fall as an increasing number of lenders choose to acquire costly information to separate borrowers as to type. This transition from credit rationing to screening in turn results in a higher capital accumulation path and a higher steady state capital stock. They also investigate the effects of a decrease in the cost of information on the economy's capital accumulation path and steady state capital stock. The authors show that the cost of information must fall below a threshold level before the economy moves from a credit rationing equilibrium to a screening one. Thus a threshold must be crossed before the steady state capital stock is increased with a decrease in the cost of information. Copyright 1997 by Ohio State University Press.

Do noise traders influence stock prices

Abstract: This paper tests a smart money-noise trader model directly by comparing its predictions with the behavior of actual investors. It assumes that individual probability of being a noise trader is diminishing in income: high income households are smart money, lower income households are noise traders, with passive investors in between. Market data behave as predicted: high participation by the general population is a negative predictor of one year returns and is associated with low participation by very high income groups. The implications for the equity premium puzzle of the low returns earned by noise traders are discussed. Copyright 1997 by Ohio State University Press.

State-Contingent Inflation Contracts and Unemployment Persistence

Abstract: This paper shows that, if unemployment (or some other real variable) follows a dynamic autoregressive process, the government can still achieve its precommitment outcome in monetary policy by offering the central banker a linear inflation contract, where the penalty for incremental inflation depends positively on lagged unemployment. This note, therefore, offers an extension of recent results of C. Walsh (1995) to the case of persistence in real economic variables such as output or unemployment. Copyright 1997 by Ohio State University Press.

Interpreting the Procyclical Productivity of Manufacturing Sectors: External Effects of Labor Hoarding?

Abstract: This paper investigates whether procyclical productivity is due to cyclical variations in the rate of utilization of labor or to technological externalities. By looking at the relation between sectoral productivity and the level of aggregate activity, empirical evidence is presented to distinguish the two hypotheses. Analysis of two-digit U.S. manufacturing industries shows that sectoral productivity is more closely related to the rate of change of aggregate activity than to its level. This result is consistent with the interpretation that cyclical productivity is due to cyclical variations in the rate of utilization of labor, which responds to expected future industry conditions. Aggregate variables in production-function regressions have therefore the role of forecasting variables for future industry conditions. Copyright 1997 by Ohio State University Press.

Analyzing Alternative Intraday Credit Policies in Real-Time Gross Settlement Systems

Abstract: This paper examines a central bank's choice of intraday credit policy for Real-Time Gross Settlement (RTGS) systems. Formal analysis of central bank objectives and commercial bank payment activity provides insight into both the choice and effects of several possible intraday credit policies. Observed intraday credit policies are interpreted within the context of the model. Among G-10 central banks, different combinations of prices, collateral, and quantity limits have been chosen to manage the supply of intraday credit. Conditions that rationalize these choices are shown to rely on a) central bank preferences regarding credit risk and systemic risk, b) liquidity management technologies, and c) the cost of collateral.

A Simple Model of the Gold Standard

Abstract: This paper presents a model of the gold standard in which technology and preferences are modeled explicitly and account is taken of both the durability of gold and the exhaustibility of gold ore. The authors examine the steady state and its associated dynamics and show how the steady-state price level responds to changes in exogenous factors. Provided they have an interior solution with unmined gold in the steady state, this price level rises with technological progress in gold mining and falls with increases in real income and the discount rate. However, the steady-state price level behaves somewhat differently if the authors have a corner solution. Copyright 1997 by Ohio State University Press.

Mechanisms for achieving monetary stability: inflation targeting versus the ERM

Abstract: First we modify the Barro-Gordon model so that a credibility-stabilization trade-off will remain even when a performance contract of the type envisaged by Walsh (1995) is imposed on the central bank governor. We do this by modeling a real interest rate bias along with the inflation bias. Then we discuss how various inflation penalties might actually be imposed on a central bank and ask whether "inflation targeting (supported by one or another of the penalties) is likely to bring a better resolution to the credibility-stabilization trade-off than the ERM.

Adam Smith's Support for Money and Banking Regulation: A Case of Inconsistency

Abstract: The Bank of England onginated in a deal between monopoly-seeking financiers and a revenue-hungry government with war-seeking propensities. The ultimate payee of the loans that the government secured from the new bank was, of course, the tavcpayer, and it is sutpnsing that Smith did not focus more on this fact. Indeed, ffie actual regulation of pnvate banks of which Smiffi approved, appears to have aided and abetted the further development of the government alliance with the monopolizing bank. The suppression of small notes had the effect of reducing enty into banking while the legal obligation of the option clauses, which Smith also wanted, made pnvate banks more vulnerable to runs on their liquidity.

The Cyclical Relationship between Output and Prices: An Analysis in the Frequency Domain

Abstract: Research showing a negative correlation between output and prices has brought into question the conventional wisdom that prices are procyclical. However, this finding has been shown to be sensitive to the sample period considered. This paper examines the relationship in the frequency domain: the covariance of output and prices is decomposed into spectral components to investigate whether differences in the price-output relationship across sample periods reflect changes in the importance of various frequencies embedded within the correlations, or whether they reflect more fundamental changes in the entire spectral relationship. Some implications for model evaluation are also considered.

Asymmetric Information and Commodity Money: Tickling the Tolerance in Medieval France

Abstract: An important development in Europe was the emergence of nationally circulating commodity money. Asymmetric information between coin producers and users provided rulers with an opportunity to supply a public good: standard universally accepted coins. The authors describe the development of a sophisticated monetary system (bureaucracy) in medieval France. In the monitoring, scheme employed by the crown, fines were levied against private mint masters when coins did not meet the standards. Yet, fineness or quality of the coin was measured in a way favorable to the mint master. The show that this method implicitly encouraged the mint masters to produce low quality coins in such a way that the crown earned rents and we measure these rents. Copyright 1997 by Ohio State University Press.

The Optimal Denomination of Currency

Abstract: L. G. Telser (1995) and Scott Sumner (1993) argue that the optimal system of denominations of currency would consist of a sequence of denominations that differed from each other by a factor of three. The fact is that today no currency follows the powers-of-three principle. The author argues that existing currency systems are the result of an evolution over time that is subject to historical influences and social factors, especially the counting systems that societies use. Copyright 1997 by Ohio State University Press.

The Option Clause in Scottish Banking

Abstract: A key question raised by the modern literature on laissez-faire money and banking is whether unregulated fractional-reserve banks could protect themselves from bank runs by purely contractual means. If so, banking stability would not require government to provide deposit insurance or to act as a lender of last resort. One possible run-proofing device discussed in the literature is an "option clause" or "notice of withdrawal clause" allowing a bank temporarily to suspend the redeemability of some or all of its liabilities (notes or demand deposits) provided the bank pays a prespecified (penalty) rate of interest on the suspended liabilities. Before the practice was outlawed in 1765, many Scottish banks issued notes bearing option clauses. In an informative "reappraisal" of the option clause in Scottish banking, James A. Gherity (1995) suggests that his findings contradict other recent discussions. In particular, Gherity disputes three propositions that he attributes to us and others: 1. that option clauses were vital to preventing runs in Scotland; 2. that run-proofing was the purpose that motivated Scottish banks to employ option clauses; and 3. that option-clause notes were accepted by the public without prejudice. To set the record straight, we note here that we and several other authors Gherity cites have in fact avoided making claims 1 and 2. The conflict between Gherity's view and ours is thus much smaller than he suggests. We would defend claim 3, however, and argue that the evidence Gherity offers against it does not suffice to refute that claim. 1. The Potential and Historical Roles of the Option Clause An option clause can keep a solvent bank from being run upon by providing a contractual "circuit breaker." By allowing an illiquid bank to suspend for enough time to liquidate assets without fire-sale losses, it prevents a run from forcing a sol-