Working Papers
Stimulating discussion and critical comment on research in progress.
1997
- FSRG WP 97-04
- The Evolution of Cash Transactions: Some Implications for Monetary Policy
- This paper considers the implications of a decreasing demand for cash transactions under several monetary policy regimes. A policy of nominal-interest-rate targeting implies that a secular decline in the volume of cash transactions unambiguously leads to accelerating inflation. A policy of maintaining a fixed composition of government liabilities leads to accelerating (decelerating) inflation if agents have sufficiently high (low) levels of risk aversion. A policy of inflation targeting produces falling nominal and real interest rates, while a policy of fixing the rate of money growth can easily lead to indeterminacy and endogenous oscillation in interest rates. (PDF)
- WP 97-16
- Electronic Money
- This paper will attempt to identify the issues that need to be addressed in order for stored-value cards and other electronic money systems to become a major payment mechanism in the global financial market. These new payments devices require a thorough evaluation of the appropriate regulatory, legal, and policy responses, as well as an estimate of the market acceptance (diffusion of this technology) throughout the financial and social system. These types of cards have the potential to have far reaching effects, if they are accepted by both consumers and merchants. (PDF)
- WP 97-15
- Depositor Preference Legislation and Failed Banks’ Resolution Costs
- Included in the Omnibus Budget Reconciliation Act of 1993 was a provision that improved the priority of depositors and thus of the FDIC in the event of a depository institution’s failure. While intended to reduce the FDIC’s cost of resolving commercial bank failures, this provision might have induced general creditors to react so as to offset the intended benefit. Depositor preference legislation (DPL) might also have affected the FDIC’s choice of resolution type. Here we examine the empirical impact of DPL on resolution type and on resolution costs for commercial banks. Given the short time period since the passage of national DPL in 1993, we focus on the impact of state DPL statutes, utilizing call-report data and FDIC data on resolution costs and resolution types for all operating FDIC-BIF insured commercial banks that were closed or required FDIC financial assistance from January 1986 through December 1992. We improve on previous studies by controlling for the endogeneity of book capital and by adjusting for the sample selection bias induced by regulatory closure rules. We find that DPL has 1) tended to increase, rather than reduce, FDIC resolution costs and 2) induced the FDIC to choose assisted mergers over liquidations. However, the source of the higher resolution costs is unclear and there is no evidence that general creditors reacted by increasing collateralization. (PDF)
- WP 97-14
- Interest Rate Option Pricing with Volatility Humps
- This paper develops a simple model for pricing interest rate options. Analytical solutions are developed for European claims and extremely efficient algorithms exist for tile pricing of American options. The interest rate claims are priced in the Heath-Jarrow-Morton paradigm, and hence incorporated full information on the term structure. The volatility. structure for forward rates is humped, and includes as a special case the exponentially dampened volatility structure used in tile Generalized Vasicek model. The structure of volatilities is captured without using time varying parameters. As a result, the volatility structure is stationary. It is not possible to have all the above properties hold in a Heath Jarrow Morton model with a single state variable. It is shown that the full dynamics of the term structure can, however, be captured by a three state Markovian system. As a result, simple path reconnecting lattices cannot be constructed to price American claims. Nonetheless, we provide extremely efficient lattice based algorithms for pricing claims, which rely on carrying small matrices of information at each node. Empirical support for the models developed are provided. (PDF)
- WP 97-13
- Expectations, Credibility, and Disinflation in a Small Macroeconomic Model
- We use a version of the Fuhrer-Moore model to study the effects of expectations and central bank credibility on the economy?s dynamic transition path during a disinflation. Simulations are compared under four different specifications of the model that vary according to the way that expectations are formed (rational versus adaptive) and the degree of central bank credibility (full versus partial). In general, the various specifications exhibit qualitatively similar behavior and can reasonably approximate the trend movements in U.S. macro variables during the Volcker disinflation of the early 1980s. However, the specification with adaptive expectations and partial credibility is the only one to capture the temporary rise in the long-term nominal interest rate observed in U.S. data at the start of the disinflation. Our simulations also show that incremental reductions in the sacrifice ratio are largest at the low end of the credibility range, suggesting that a central bank may face diminishing returns in its efforts to enhance credibility. (PDF)
- WP 97-12
- Simulating U.S. tax reform
- A presentation of a large-scale, dynamic simulation model for comparing the equity, efficiency, and macroeconomic effects of five alternatives to the current U.S. federal income tax: a proportional income tax, a proportional consumption tax, a flat tax, a flat tax with transition relief, and a progressive variant of the flat tax called the "X tax." (PDF)
- WP 97-11
- Algorithms for Solving Dynamic Models with Occasionally Binding Constraints
- We describe and compare several algorithms for approximating the solution to a model in which inequality constraints occasionally bind. Their performance is evaluated and compared using various parameterizations of the one sector growth model with irreversible investment. We develop parameterized expectation algorithms which, on the basis of speed, accuracy and convenience of implementation, appear to dominate the other algorithms. (PDF)
- WP 97-10
- Absolute Priority Rule Violations, Credit Rationing, and Efficiency
- Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting. (PDF)
- WP 97-09
- A Note on Purifying Mixed Strategy Equilibria in the Search Model of Money
- The simple search-theoretic model of fiat money has three symmetric Nash equilibria: all agents accept money with probability 1; all agents accept money with probability 0; and all agents accept money with probability y ? (0,1). Here we construct a nonsymmetric pure strategy equilibrium, payoff-equivalent to the symmetric mixed strategy equilibrium, where a fraction N ? (0,1) of agents always accept money and 1-N never accept money. Count to what has been conjectured previously, we find N>y. We also study evolutionary dynamics, and show that the economy converges to monetary exchange if the initial proportion of agents accepting money exceeds N. (PDF)
- WP 97-08
- Indeterminacy and Stabilization Policy
- It has been shown that a one-sector real business cycle model with sufficient increasing returns in production may possess an indeterminate steady state that can be exploited to generate business cycles driven by "animal spirits" of agents. This note shows how an income tax schedule that exhibits a progressivity feature can ensure saddle path stability in such a framework and thereby stabilize the economy against sunspot fluctuations. Conversely, and economy that exhibits a flat or regressive tax schedule is more susceptible to indeterminacy. (PDF)
- WP 97-07
- Efficient Inflation Expectation
- This paper investigates the use of trimmed means as high-frequency estimators of inflation. The known characteristics of price change distributions, specifically the . observation that they generally exhibit high levels of kurtosis, imply that simple averages of price data are unlikely to produce efficient estimates of inflation. Trimmed means produce superior estimates of ’core inflation,’ which we define as a long-run centered moving average of CPI and PPI inflation. We find that trimming 9% from each tail of the CPI price-change distribution, or 45% from the tails of the PPI price-change distribution, yields an efficient estimator of core inflation for these two series, although lesser trims also produce substantial efficiency gains. Historically, the optimal trimmed estimators are found to be nearly 23% more efficient (in terms of root-mean-square error) than the standard mean CPI, and 45% more efficient than the mean PPI. Moreover, the efficient estimators are robust to sample period and to the definition of the presumed underlying long-run trend in inflation. (PDF)
- WP 97-06
- Trust and Investment Corporations in China
- Trust and investment corporations (TICs) have played a very important role in China?s economic reform. However, this sector is now in a chaotic situation because it lacks proper regulation and clear distinction from other financial sectors. Substantial reform is imperative in order to sustain TICs? financial stability and avoid an adverse effect on the economy. This paper gives a detailed description of Chinese TICs? formation and expansion. After pointing out the problems and their sources, we suggest that TICs in China should resume the international standard trust services instead of conducting businesses that overlap with the banking and securities industries. Chinese settlors should be treated as shareholders instead of debtholders. To smooth out the process of transition, we propose an intermediate scheme that takes into account both the realities in China and the international trust operation standard. (PDF)
- WP 97-05
- Identifying inflation’s grease and sand effects in the labor market
- An effort to distinguish inflation’s distortionary effects from its facilitation of adjustments to shocks when wages are rigid downward. It uses the following identification strategy: Inflation-induced deviations among employers’ mean wage changes represent unintended intramarket distortions (sand), while inflation-induced, interoccupational wage changes reflect adjustments that might have been prevented by nominal wage rigidity (grease). (PDF)
- WP 97-04
- Securities Activities in Banking Conglomerates: Should their Location be Regulated?
- This paper reviews the arguments as to whether the location of the securities unit in a banking conglomerate should be subject to regulation. This review is complemented with evidence on the regulations and on securities units’ predominate location in the G-10 countries and in the.United States before the Glass-Steagall Act. The paper argues that correcting the safety net’s distortions and allowing banks to choose where to locate their securities units is a better alternative than retaining such distortions and relying on corporate separateness to limit the problems they may create. Separateness imposes costs and provides banks with insulation that is more apparent than real. However, if authorities opt for requiring separateness, a regulation allowing banks to choose between the bank-parent model and the holding-company model seems more appropriate than a regulation requiring them to adopt either one of these models (PDF)
- FSRG WP 03-97
- Reliability analysis of the Federal Reserve automated payments systems
- A description of an analytic framework for the reliability assessment of the automated payments systems used by the Federal Reserve Banks. Alternative system configurations are also proposed and analyzed. (PDF)
- WP 97-03
- Social Security privatization: a simple proposal
- A proposal for a U.S. Social Security reform that gradually, but ultimately fully, privatizes the system. This proposal follows the "no-harm, no-foul" principle in that it preserves the benefits of older generations and yet promises the same or higher retirement benefits for the young. (PDF)
- WP 97-02
- Credit Rationing, Bankruptcy Cost and the Optimal Debt Contract for Small Business
- This paper examines whether the costly random verification scheme affects the optimal debt contract for small business. It finds, contrary to Townsend (1979) and Williamson (1986, 1987), that the standard debt contract is the optimal debt contract with the costly random verification scheme. Credit rationing, characterized as a loan granted in an amount less than requested, becomes more severe as the bankruptcy cost rises. This result supports the 1994 amendments to the Bankruptcy Code, since it shows that simplifying the bankruptcy procedure for small business reduces credit rationing and therefore enhances lending. (PDF)
- WP 97-01
- Estimating the Cost of U.S. Indexed Bonds
- This paper presents an equilibrium bond pricing model driven by two stochastic factors: the real interest rate and the expected rate of inflation. The model?s parameters are estimated using a maximum likelihood technique based on a Kalman filter. Data on nominal U.S. Treasury securities and Survey of Professional Forecasters predictions of the GDP deflator are employed to identify the separate effects of real and nominal variables. The market prices of real interest rate risk and inflation risk are estimated, which allows us to construct yield curves for nominal and indexed U.S. Treasury securities. The relative costs of nominal and indexed bonds can then be assessed. (PDF)
- FSRG WP 01-97
- The effect of pricing on demand and revenue in Federal Reserve ACH payment processing
- A presentation of the first numerical estimates of ACH demand elasticities, a measure of the responsiveness of ACH demand to price changes. In order to determine how robust the estimates are, various methods are employed to estimate the demand elasticities. The results show that the volume of ACH items processed by the Federal Reserve does respond to changes in per item fees and that demand for ACH credit is elastic, while demand for ACH debit is inelastic. (PDF)