Showing papers in "The Review of Economic Studies in 2005"

Time Varying Structural Vector Autoregressions and Monetary Policy

Abstract: Monetary policy and the private sector behavior of the US economy are modeled as a time varying structural vector autoregression, where the sources of time variation are both the coefficients and the variance covariance matrix of the innovations. The paper develops a new, simple modeling strategy for the law of motion of the variance covariance matrix and proposes an efficient Markov chain Monte Carlo algorithm for the model likelihood/posterior numerical evaluation. The main empirical conclusions are: 1) both systematic and non-systematic monetary policy have changed during the last forty years. In particular, systematic responses of the interest rate to inflation and unemployment exhibit a trend toward a more aggressive behavior, despite remarkable oscillations; 2) this has had a negligible effect on the rest of the economy. The role played by exogenous non-policy shocks seems more important than interest rate policy in explaining the high inflation and unemployment episodes in recent US economic history.

Semiparametric Difference-in-Differences Estimators

Abstract: The use of natural experiments to evaluate treatment effects in the absence of truly experimental data has gained wide acceptance in empirical research in economics and other social sciences. Simple comparisons of pre-treatment and post-treatment outcomes for those individuals exposed to a treatment are likely to be contaminated by temporal trends in the outcome variable or by the effect of events, other than the treatment, that occurred between both periods. However, when only a fraction of the population is exposed to the treatment, an untreated comparison group can be used to identify temporal variation in the outcome that is not due to treatment exposure. The difference-in-differences (DID) estimator is based on this simple idea. Card and Krueger (1994) assess the employment effects of a raise in the minimum wage in New Jersey using a neighbouring state, Pennsylvania, to identify the variation in employment that New Jersey would have experienced in the absence of a raise in the minimum wage. Other applications of DID include studies of the effects of immigration on native wages and employment (Card, 1990), the effects of temporary disability benefits on time out of work after an injury (Meyer, Viscusi and Durbin, 1995), and the effect of anti-takeover laws on firms' leverage (Garvey and Hanka, 1999). It is well known that the conventional DID estimator is based on strong assumptions.

The Relationship Between Education and Adult Mortality in the United States

Abstract: Prior research has uncovered a large and positive correlation between education and health. This paper examines whether education has a causal impact on health. I follow synthetic cohorts using successive U.S. censuses to estimate the impact of educational attainment on mortality rates. I use compulsory education laws from 1915 to 1939 as instruments for education. The results suggest that education has a causal impact on mortality, and that this effect is perhaps larger than has been previously estimated in the literature. Copyright 2005, Wiley-Blackwell.

Outsourcing in a Global Economy

Abstract: We study the determinants of the location of subcontracted activity in a general equilibrium model of outsourcing and trade. We model outsourcing as an activity that requires search for a partner and relationship-specific investments that are governed by incomplete contracts. The extent of international outsourcing depends inter alia on the thickness of the domestic and foreign market for input suppliers, the relative cost of searching in each market, the relative cost of customizing inputs and the nature of the contracting environment in each country.

The Effects of Health, Wealth, and Wages on Labour Supply and Retirement Behaviour

Abstract: This paper estimates a life cycle model of labour supply, retirement, and savings behaviour in which future health status and wages are uncertain. Individuals face a fixed cost of work and cannot borrow against future labour, pension, or Social Security income. The method of simulated moments is used to match the life cycle profiles of labour force participation, hours worked, and assets that are estimated from the data to those that are generated by the model. The model establishes that the tax structure of the Social Security system and pensions are key determinants of the high observed job exit rates at ages 62 and 65. Removing the tax wedge embedded in the Social Security earnings test for individuals aged 65 and older would delay job exit by almost one year. By contrast, Social Security benefit levels, health, and borrowing constraints are less important determinants of job exit at older ages. For example, reducing Social Security benefits by 20% would cause workers to delay exit from the labour force by only three months.

Testing for localization using micro-geographic data

Abstract: To study the detailed location patterns of industries, and particularly the tendency for industries to cluster relative to overall manufacturing, we develop distance-based tests of localisation. In contrast to previous studies, our approach allows us to assess the statistical significance of departures from randomness. In addition, we treat space as continuous instead of using an arbitrary collection of geographical units. This avoids problems relating to scale and borders. We apply these tests to an exhaustive UK data set. For four-digit industries, we find that (i) 52% of them are localised at a 5% confidence level, (ii) localisation mostly takes place at small scales below 50 kilometres, (iii) the degree of localisation is very skewed, and (iv) industries follow broad sectoral patterns with respect to localisation. Depending on the industry, smaller establishments can be the main drivers of both localisation and dispersion. Three-digit sectors show similar patterns of localisation at small scales as well as a tendency to localise at medium scales.

Engines of Liberation

Abstract: Electricity was born at the dawn of the last century. Households were inundated with a flood of new consumer durables. What was the impact of this consumer durable goods revolution? It is argued here that the consumer goods revolution was conducive to liberating women from the home. To analyse this hypothesis, a Beckerian model of household production is developed. Households must decide whether or not to adopt the new technologies, and whether a married woman should work. Can such a model help to explain the rise in married female labour-force participation that occurred in the last century? Yes. The housewife of the future will be neither a slave to servants nor herself a drudge. She will give less attention to the home, because the home will need less; she will be rather a domestic engineer than a domestic labourer, with the greatest of all handmaidens, electricity, at her service. This and other mechanical forces will so revolutionize the woman’s world that a large portion of the aggregate of woman’s energy will be conserved for use in broader, more constructive fields. Thomas Alva Edison, as interviewed in Good Housekeeping Magazine , LV, no. 4 (October 1912, p. 436)

Market Provision of Broadcasting: A Welfare Analysis ∗

Abstract: This paper presents a theory of the market provision of broadcasting and uses it to address the nature of market failure in the industry. Advertising levels may be too low or too high, depending on the nuisance cost to viewers, the substitutability of programs, and the expected benefits to advertisers from contacting viewers. Market provision may allocate too few or too many resources to programming and these resources may be used to produce programs of the wrong type. Monopoly ownership may produce higher social surplus than competitive ownership and the ability to price programming may reduce social surplus.

Judgemental Overconfidence, Self-Monitoring, and Trading Performance in an Experimental Financial Market

Abstract: We measure the degree of overconfidence in judgment (in the form of miscalibration, i.e., the tendency to overestimate the precision of one’s information) and self-monitoring (a form of attentiveness to social cues) of 245 participants and also observe their behaviour in an experimental financial market under asymmetric information. Miscalibrated traders, underestimating the conditional uncertainty about the asset value, are expected to be especially vulnerable to the winner’s curse. High self-monitors are expected to behave strategically and achieve superior results. Our empirical results show that miscalibration reduces and self-monitoring enhances trading performance. The effect of the psychological variables is strong for men but non-existent for women.

Household Electricity Demand, Revisited

Abstract: respond to price changes. This paper develops a model for evaluating the effects of alternative tariff designs on electricity use. The model concurrently addresses several interrelated difficulties posed by nonlinear pricing, heterogeneity in consumer price sensitivity, and consumption aggregation over appliances and time. We estimate the model using extensive data for a representative sample of 1300 California households. The results imply a strikingly skewed distribution of household electricity price elasticities in the population, with a small fraction of households accounting for most aggregate demand response. We then estimate the aggregate and distributional consequences of recent tariff structure changes Recent efforts to restructure electricity markets have renewed interest in electricity demand and pricing. This interest reflects a broad desire to improve the efficiency of electricity markets, and policy-makers' concerns over the impact of price changes on consumers. How new pricing mechanisms would affect households' consumption and expenditures is a matter of considerable uncertainty, however. This uncertainty has provoked controversy and debate in the regulatory policy arena, hampering market reforms. Using econometric methods to assess the effects of electricity price changes presents several challenges. These include the nonlinear structure of tariff schedules, aggregation of metered consumption behaviour over time and appliances, and the interdependence of energy use with longer-term household decisions over appliance ownership and dwelling characteristics. The first two issues introduce complex simultaneity problems between marginal prices and consumption. The third issue imposes high data requirements (information on household-specific appliance holdings and residence features), and creates heterogeneity in consumption responses related to the characteristics of these durable goods. When the researcher's objective is to develop a model for simulating the effects of prospective tariff changes, ignoring these issues will provide an incomplete assessment of demand responses and potentially misleading predictions of a new tariff's consumption and revenue consequences. In this paper, we estimate a model of household electricity demand that can be used

Poverty and Witch Killing

Abstract: Many observers have noted that poverty and violence go hand in hand. There is a strong negative relationship between economic growth and crime across countries, as well as across districts in India, and a link between low income and the occurrence of civil war.1 Yet existing studies are typically unable to resolve the key econometric identification issues of omitted variable bias and endogeneity. To illustrate, the unobserved quality of local government institutions may affect both income growth and crime rates, and poverty could lead to violence if desperate people with "nothing to lose" commit more crimes, but violence itself may in turn affect economic productivity. This paper uses local rainfall variation to identify the impact of income shocks on murder in a rural Tanzanian district.2 Extreme rainfall-resulting in drought or floods-is exogenous and is associated with poor harvests and near-famine conditions in the region, and a large increase in the murder of "witches": there are twice as many witch murders in years of extreme rainfall as in other years. The victims are nearly all elderly women, typically killed by relatives. These econometric results, across 11 years in 67 villages, provide novel evidence on the role of income shocks in causing violent crime, and religious violence in particular, and also provide insights into witchcraft-an important social phenomenon in Africa rarely studied by economists. The view that economic conditions are a driving force behind witch murders is bolstered by the fact that most witch killing in Tanzania takes place in poor rural areas largely dependent on rain-fed agriculture, and that most victims in our sample are from poor households. However, it is difficult to definitively disentangle this income shock theory from alternative socio-cultural explanations. The concentration of Tanzanian witch murders in a region dominated by one particular ethnic group (the Sukuma), and the especially high number of witch murders in villages where indigenous religious beliefs are strong both point to the important role of non-economic factors. Economic theories and cultural theories are perhaps best viewed as complements: the empirical findings demonstrate the power of economics to rationalize a phenomenon that has previously been understood almost solely through a socio-cultural lens.3

Consistent Testing for Stochastic Dominance under General Sampling Schemes

Abstract: We propose a procedure for estimating the critical values of the extended Kolmogorov‐Smirnov tests of Stochastic Dominance of arbitrary order in the general K -prospect case. We allow for the observations to be serially dependent and, for the first time, we can accommodate general dependence amongst the prospects which are to be ranked. Also, the prospects may be the residuals from certain conditional models, opening the way for conditional ranking. We also propose a test of Prospect Stochastic Dominance. Our method is based on subsampling and we show that the resulting tests are consistent and powerful against some N 1/2 local alternatives. We also propose some heuristic methods for selecting subsample size and demonstrate in simulations that they perform reasonably. We describe an alternative method for obtaining critical values based on recentring the test statistic and using full-sample bootstrap methods. We compare the two methods in theory and in practice.

Estimation and Testing of Forecast Rationality under Flexible Loss

Abstract: In situations where a sequence of forecasts is observed, a common strategy is to examine “rationality” conditional on a given loss function. We examine this from a different perspective— supposing that we have a family of loss functions indexed by unknown shape parameters, then given the forecasts can we back out the loss function parameters consistent with the forecasts being rational even when we do not observe the underlying forecasting model? We establish identification of the parameters of a general class of loss functions that nest popular loss functions as special cases and provide estimation methods and asymptotic distributional results for these parameters. This allows us to construct new tests of forecast rationality that allow for asymmetric loss. The methods are applied in an empirical analysis of IMF and OECD forecasts of budget deficits for the G7 countries. We find that allowing for asymmetric loss can significantly change the outcome of empirical tests of forecast rationality.

Fiscal Policy with Heterogeneous Agents and Incomplete Markets

Abstract: I undertake a quantitative investigation into the short run effects of changes in the timing of proportional income taxes for model economies in which heterogeneous households face a borrowing constraint. Temporary tax changes are found to have large real effects. In the benchmark model, a temporary tax cut increases aggregate consumption on impact by around 29 cents for every dollar of tax revenue lost. Comparing the benchmark incomplete-markets model to a complete-markets economy, income tax cuts provide a larger boost to consumption and a smaller investment stimulus when asset markets are incomplete. Copyright 2005, Wiley-Blackwell.

Taxes, Regulations, and the Value of U.S. and U.K. Corporations

Abstract: We derive the quantitative implications of growth theory for U.S. corporate equity plus net debt over the period 1960{2001. There were large secular movements in corporate equity values relative to GDP, with dramatic declines in the 1970s and dramatic increases starting in the 1980s and continuing throughout the 1990s. During the same period, there was little change in the capital-output ratio or earnings share of output. We ask specically whether the theory accounts for these observations. We nd that it does, with the critical factor being changes in the U.S. tax and regulatory system. We nd that the theory also accounts for the even larger movements in U.K. equity values relative to GDP in this period.

Dynamic Seemingly Unrelated Cointegrating Regressions

Abstract: We propose the parametric Dynamic Seemingly Unrelated Regression (DSUR) estimator for simultaneous estimation of multiple cointegrating regressions. DSUR is efficient when the equilibrium errors are correlated across equations and is applicable for panel cointegration estimation in environments where the cross section is small relative to the available time series. We study the asymptotic and small sample properties of the DSUR estimator for both heterogeneous and homogeneous cointegrating vectors. We then apply the method to analyse two long-standing problems in international economics. Our first application revisits the estimation of long-run correlations between national investment and national saving. Our second application revisits the question of whether the forward exchange rate is an unbiased predictor of the future spot rate.

Partisan Social Happiness

Abstract: We use a new approach to study questions in political economy that relies on data on the subjective well-being of a large sample of people living in the OECD over the period 1975‐1992. Controlling for the personal characteristics of the respondents, year and country fixed effects and country-specific time trends, we find that the data describe social happiness functions for left-wing and right-wing individuals where inflation and unemployment enter negatively. We use these functions to test the root assumption of partisan business cycle models. The evidence is consistent with the hypothesis that left-wing individuals care more about unemployment relative to inflation than right-wingers. Interestingly, we find that individuals declare themselves to be happier when the party they support is in power, even after controlling for macroeconomic variables. The effect of politics is large. Finally, we find that these partisan differences cannot be traced back to income differences. That is, it is misleading to assume—as it is done in the previous literature—that the poor (rich) behave similarly to the left (right). For example, inflation and unemployment do not have differential effects across rich and poor and the happiness levels of these two groups are unaffected by the identity of the party in power. Our findings are hard to explain using median voter models but are to be expected in a partisan world.

Measurement Error Models with Auxiliary Data

Abstract: We study the problem of parameter inference in (possibly non-linear and non-smooth) econometric models when the data are measured with error. We allow for arbitrary correlation between the true variables and the measurement errors. To solve the identification problem, we require the existence of an auxiliary data-set that contains information about the conditional distribution of the true variables given the mismeasured variables. Our main assumption requires that the conditional distribution of the true variables given the mismeasured variables is the same in the primary and auxiliary data. Our methods allow the auxiliary data to be a validation sample, where the primary and validation data are from the same distribution, and more importantly, a stratified sample where the auxiliary data-set is not from the same distribution as the primary data. We also show how to combine the two data-sets to obtain a more efficient estimator of the parameter of interest. We establish the large sample properties of the sieve based estimators under verifiable conditions. In particular, we allow for the mismeasured variables to have unbounded supports without employing the tedious trimming scheme typically used in kernel based methods. We illustrate our methods by estimating a returns to schooling censored quantile regression using the CPS/SSR 1978 exact match files where the dependent variable is measured with error of arbitrary kind.

The Intergenerational State Education and Pensions

Abstract: allocation is inefficient. When generations overlap, this failure can be mitigated by properly designed social arrangements. We show that public financing of education and public pensions can be designed to implement an intergenerational transfer scheme supporting the complete market allocation. Neither the public financing of education nor the pension scheme we consider resemble standard ones. In our mechanism, via the public education system, the young borrow from the middle aged to invest in human capital. They pay back the debt via a social security tax, the proceedings of which finance pension payments. When the complete market allocation is achieved, the rate of return implicit in this borrowinglending scheme should equal the market rate of return.

Optimal Taxation When Consumers Have Endogenous Benchmark Levels of Consumption

Abstract: I examine optimal taxes in an overlapping generations economy in which each consumer’s utility depends on consumption relative to a weighted average of consumption by others (the benchmark level of consumption) as well as on the level of the consumer’s own consumption. The socially optimal balanced growth path is characterized by the ModiÞed Golden Rule and by a condition on the intergenerational allocation of consumption in each period. A competitive economy can be induced to attain the social optimum by a lump-sum pay-as-you-go social security system and a tax on capital income.

Compensating variation and Hicksian choice probabilities in random utility models that are nonlinear in income

Abstract: In this paper we discuss Hicksian demand and compensating variation in the context of discrete choice. We first derive Hicksian choice probabilities and the distribution of the (random) expenditure function in the general case when the utilities are nonlinear in income. We subsequently derive exact and simple formulae for the expenditure and choice probabilities under price (policy) changes conditional on the initial utility level. This is of particular interest for welfare measurement because it enables the researcher to compute the distribution of compensating variation in a simple way. We also derive formulae for the joint distribution of expenditure, the choice before and after a policy change has been introduced.

Self-Regulation and Government Oversight

Abstract: Self-regulation is a feature of a number of professions. For example, in the U.S. the government delegates aspects of financial market regulation to self-regulatory organizations (SROs) like the New York Stock Exchange and the National Association of Securities Dealers. We analyse one regulatory task of an SRO, enforcing antifraud rules so agents will not cheat customers. Specifically, we model contracting/enforcement as a two-tier problem. An SRO chooses its enforcement policy: the likelihood that an agent is investigated for fraud and a penalty schedule. Given an enforcement policy, agents compete by offering contracts that maximize customers' expected utility. We assume that the SRO's objective is to maximize the welfare of its members, the agents. We show that the SRO chooses a more lax enforcement policy—meaning less frequent investigations—than what customers would choose. A general conclusion is that control of the enforcement policy governing contracts confers substantial market power to a group of otherwise competitive agents. We also investigate government oversight of the self-regulatory process. The threat of government enforcement leads to more enforcement by the SRO, just enough to pre-empt any government enforcement. Copyright 2005, Wiley-Blackwell.

Uncertainty and Consumer Durables Adjustment

Abstract: We characterize infrequent durables stock adjustment by consumers who also derive utility from non-durable consumption flows in the presence of idiosyncratic income uncertainty. The data we analyse include subjective future income uncertainty measures, which we use as instruments in the estimation of relevant parameters of heterogeneous consumers' dynamic adjustment problems. The data feature two conceptually distinct sources of variation: cross-sectional heterogeneity of the sampled households' dynamic problems, and history-dependent heterogeneity in their situation during the observation period. We note that the latter should affect the likelihood but not the size of stock adjustment decisions, and find broad support for theoretical predictions in formal selection-controlled regressions based on this insight.

Endogenous games and mechanisms: Side payments among players

Abstract: We characterize the outcomes of games when players may make binding offers of strategy contingent side payments before the game is played. This does not always lead to efficient outcomes, despite complete information and costless contracting. The characterizations are illustrated in a series of examples, including voluntary contribution public good games, Cournot and Bertrand oligopoly, principal-agent problems, and commons games, among others.

The Cost of Recessions Revisited: A Reverse-Liquidationist View

Abstract: The observation that liquidations are concentrated in recessions has long been the subject of controversy. One view holds that liquidations are beneficial in that they result in increased restructuring. Another view holds that this rise in restructuring is costly since liquidations are privately inefficient and essentially wasteful. This paper proposes an alternative perspective. On the basis of a combination of theory with empirical evidence on gross job flows and on financial and labour market rents, we find that, cumulatively, recessions result in reduced rather than increased restructuring, and that this is likely to be socially costly once we consider inefficiencies on both the creation and destruction margins. Copyright 2005, Wiley-Blackwell.

Generalized Spectral Tests for Conditional Mean Models in Time Series with Conditional Heteroscedasticity of Unknown Form

Abstract: Economic theories in time series contexts usually have implications on and only on the conditional mean dynamics of underlying economic variables We propose a new class of specification tests for time series conditional mean models, where the dimension of the conditioning information set may be infinite Both linear and nonlinear conditional mean specifications are covered The tests can detect a wide range of model misspecifications in mean while being robust to conditional heteroscedasticity and higher order time-varying moments of unknown form They check a large number of lags, but naturally discount higher order lags, which is consistent with the stylized fact that economic behaviours are more affected by the recent past events than by the remote past events No specific estimation method is required, and the tests have the appealing "nuisance parameter free" property that parameter estimation uncertainty has no impact on the limit distribution of the tests A simulation study shows that it is important to take into account the impact of conditional heteroscedasticity; failure to do so will cause overrejection of a correct conditional mean model In a horse race competition on testing linearity in mean, our tests have omnibus and robust power against a variety of alternatives relative to some existing tests In an application, we find that after removing significant but possibly spurious autocorrelations due to nonsynchronous trading, there still exists significant predictable nonlinearity in mean for S&P 500 and NASDAQ daily returns

Negative Externalities and Evolutionary Implementation

Abstract: In this paper, we model externality abatement as an implementation problem. Our model incorporates techniques from evolutionary game theory, assuming that agents dynamically adjust their choices in response to the incentives they currently face. We offer a simple condition on aggregate payoffs under which a planner with limited information about preferences can nevertheless ensure that efficient behaviour is globally stable. Finally, we present a series of applications that show that our sufficient condition holds in a variety of models involving negative externalities.

The Economics of Clear Advice and Extreme Options

Abstract: I study a principal-agent model in which the agent collects information and then chooses a verifiable action. I show that the principal can find it desirable to constrain the agent's action set even though there is no disagreement about the ranking of actions ex post. The elimination or penalization of "intermediate" actions, which are optimal when information is poor, improves incentives for information collection. I characterize optimal action sets when the agent is infinitely risk averse with respect to income shocks and optimal incentive schemes when the agent is risk neutral. Copyright 2005, Wiley-Blackwell.

Gross Credit Flows

Abstract: The paper estimates gross credit flows for the U.S. banking system between 1979 and 1999 and shows that sizable gross flows coexist at any phase of the cycle, even within narrowly defined loan categories, bank size categories, and regional units. To investigate the macroeconomic dimensions of gross credit flows, the paper studies the cyclical behavior of aggregate credit flows and documents three key cyclical facts. First, excess credit reallocation is countercyclical: for any given rate of change of net credit, gross flows are larger in a recession than in a boom. Second, gross credit flows are highly volatile, with a cyclical volatility which appears more than an order of magnitude larger than GDP volatility. Third, credit contraction is more volatile than credit expansion. Furthermore, the behavior of gross flows over the 1991 recession suggests that persistent and historically high credit contraction is a key feature of the relatively mild cyclical downturn. The results lends some support to aggregate models that emphasize the asymmetric behavior of credit expansion and credit contractions.

Environmental protection: A theory of direct and indirect competition for political influence

Abstract: How is it that environmental groups can have a strong impact on environmental policy but without much lobbying? This paper develops a model of "direct" (lobbying the government) and "indirect" (persuading the public) competition for political influence and finds that they are complementary. However, an increase in the effectiveness of public persuasion, or a rise of public environmental awareness, induces substitution between the two. The findings establish that the empirical phenomenon of lack of political contribution from environmental groups may not be related to financial constraints, but to their greater effectiveness in public persuasion and growing public environmental awareness. the size of its economic stake (and hence the associated lobbying effort), and the efficiency of its organization in exerting political influence. How then can we explain why some environmental groups have been very successful against polluting industries, when the latter's economic stakes seem very high (and they lobby more) and their interests are more efficiently organized? Some might suggest that the reason for the success of the environmental movement is that environmental groups have large memberships and can provide block votes. 2 However, according to Olson (1965), a large membership of an interest group is not necessarily an advantage, and it is still uncertain whether environmental groups are able to mobilize their members to cast votes based on such affiliations. This paper suggests an alternative explanation by developing a theory of "direct" and "indirect" competition between special interests for political influence rather than marshalling block votes. A primary feature of our framework is that two opposing interest groups—an environmentalist group and an industrialist group—compete directly and indirectly for political influence in a three-stage game. The "indirect" competition takes place in the first stage, in which interest groups exert effort in persuading the public to indirectly influence government policy. The "direct" competition takes place in the second stage, in which interest groups exert effort in