Working Paper 0119
A Strategic Approach to Hedging and Contracting
by David Downie and Ed Nosal
This paper provides a new rationale for hedging that is based, in part, on noncompetitive behavior in product markets. We identify a set of conditions which imply that a firm may want to hedge. Empirically, these conditions are not inconsistent with what is observed in the market place. The conditions are: (i) firms have some market power in their product market, (ii) firms have limited liability, and (iii) firms can contract to sell their output at a specified price before all factors which can affect their profitability are known. For some parameter specifications, however, our model predicts that firms will not want to hedge. This result is important because although a large fraction of firms do hedge their cash flows, a substantial number of firms do not.
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Working Paper 0118top
The U.S. Demographic Transition
by Jeremy Greenwood and Ananth Seshadri
Between 1800 and 1940 the United States went through a dramatic demographic transition. In 1800 the average woman had seven children, and 94 percent of the population lived in rural areas. By 1940 the average woman birthed just two kids, and only 43 percent of populace lived in the country. The question is: What accounted for this shift in the demographic landscape? The answer given here is that technological progress in agriculture and manufacturing explains these facts.
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It is well known that sunspot equilibria may arise under an interest rate operating procedure in which the central bank varies the nominal rate with movements in future inflation (a forward-looking Taylor rule). This paper demonstrates that these sunspot equilibria may be learnable in the sense of E-stability.
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This paper analyzes the restrictions necessary to ensure that the interest rate policy rule used by the central bank does not introduce real indeterminacy into the economy. It conducts this analysis in a flexible price economy and a sticky price model that satisfies the natural rate hypothesis. A necessary and sufficient condition for real determinacy in the sticky price model is for there to be nominal and real determinacy in the corresponding flexible price model. This arises if and only if the Taylor rule responds aggressively to lagged inflation rates.
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This paper examines a theoretical model in which an entrepreneur's net worth has an effect on his ability to finance current activity. Net worth, in turn, is determined by asset prices which can be affected by monetary policy. In this environment there is a welfare-improving role for the central bank to respond to asset price and technology shocks.
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Working Paper 0114top
Who Gets Paid to Save?
by Jagadeesh Gokhale and Laurence J. Kotlikoff
Thanks to recent changes in the tax law, people can contribute more to their tax-deductible and non-tax-deductible savings plans, including 401(k) and Roth IRAs. But should they? The myriad interacting provisions of the tax code make it difficult to predict who gains from government savings incentives and by how much. This study examines how new legislation affects the lifetime tax gains (or losses) of low-, middle-, and high-lifetime earners if they contribute the maximum to 401(k) accounts, traditional IRA accounts, and Roth IRA accounts. The study finds that the new legislation changes little for low- and middle-income earners. Low and middle earners paid higher lifetime taxes under the old tax law if they participated fully in tax-deferred plans and would still do so under the new law. If a new tax credit created by the legislation were extended and indexed to inflation, low earners would break even, but middle earners would still lose. In contrast, participating in a Roth IRA provides a guaranteed and nontrivial lifetime tax saving; however, one need not contribute the maximum to receive the full benefit.
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If valuation ratios return to their historical means any time soon, then either equity prices must fall substantially or earnings and dividends must accelerate sharply, or some combination of these events must happen. Historical patterns over the past century or so suggest that stock prices will fall to align valuation ratios with their means. Of course, the means of the valuation ratios could have changed. To assess the likelihood of such changes, the authors employ breakpoint tests on the means of the valuation ratios. The test procedures employed allow for multiple breakpoints at unknown break dates. The authors also review alternative explanations for changes in the ratios. Although no single explanation may be convincing by itself, taken in toto with empirical evidence of structural change, the authors conclude that the preponderance of evidence suggests that the mean of the dividend-price ratio is now somewhere between 1% and 2%, probably nearer to 1%. They also conclude that the mean price-to-earnings ratio is now somewhere between 20 and 25, perhaps even higher.
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The Gramm-Leach-Bliley Act of 1999 amended the lending authority of the Federal Home Loan Banks to include advances secured by small enterprise loans of community financial institutions. Three possible reasons for the extension of this selective credit subsidy to community banks and thrifts are examined, including the need to subsidize community depository institutions, stabilize the Federal Home Loan Banks, and address a market failure in rural markets for small enterprise loans. We empirically investigate whether funding constraints impact the small-business lending decision by rural community banks. Specifically, we estimate two empirical models of small-business lending by community banks. The data reject the hypothesis that access to increased funds will increase the amount of small-business loans made by community banks.
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The 1980 Monetary Control Act requires the Reserve Banks to recover their costs of providing payments services over time, including a normal return on capital - that is, the same after tax return on equity that a private firm would require. To date, this private sector adjustment factor has been estimated and applied as a single hurdle rate for all Reserve Bank payments services. Capital budgeting theory suggests that firms should use a different hurdle rate for each distinct type of activity according to its risks. For Reserve Bank payments services, this might entail estimating separate private sector adjustment factors for paper-based services and for electronic services. Alternatively, a single hurdle rate of capital could be used for all services if capital is allocated to each service according to its risk.
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Sterilized intervention is generally ineffective. Countries that conduct monetary policy using an overnight interbank rate as an intermediate target automatically sterilize their interventions. Unsterilized interventions can influence nominal exchange rates, but they conflict with price stability unless the underlying shocks prompting them are domestic in origin and monetary in nature. Unsterilized interventions, however, are unnecessary since standard open-market operations can achieve the same result.
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Working Paper 0109top
The Mismatch Between Life Insurance Holdings and Financial Vulnerabilities: Evidence from the Health and Retirement Survey
by B. Douglas Bernheim, Lorenzo Forni, Jagadeesh Gokhale and Laurence J. Kotlikoff
Using data on older workers from the 1992 Health and Retirement Survey along with an elaborate life-cycle planning model, we quantify the extent to which the death of each individual would affect the financial status of his or her survivors, and we measure the degree to which life insurance holdings moderate these consequences. The average change in living standard that would result from a spouse's death is small both in absolute terms and relative to the decline that would occur in the absence of insurance. However, this average obscures a startling mismatch between insurance holdings and underlying vulnerabilities. For many of those with the greatest vulnerabilities, the amounts purchased are surprisingly small, and for many of those with the smallest vulnerabilities, the amounts are surprisingly large. As a result, uninsured vulnerabilities are reasonably widespread. The magnitude of these vulnerabilities, as well as the proclivity to address any given degree of vulnerability by purchasing life insurance, vary systematically with individual and household characteristics.
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Working Paper 0108top
Does Participating in a 401(k) Raise Your Lifetime Taxes?
by Jagadeesh Gokhale, Laurence J. Kotlikoff and Todd Neumann
Contributing to 401(k)s and similar tax-deferred retirement accounts certainly lowers current taxes. But does it lower your lifetime taxes? If average and marginal tax rates were independent of income and didnt change through time, the answer would be an unambiguous yes. The reduction in current taxes would exceed the increase in future taxes when measured in present value. But tax rates may be higher when retirement account withdrawals occur, either because one moves into higher marginal federal and state tax brackets or because the government raises tax rates. In addition, reducing tax brackets when young, at the price of higher tax brackets when old, may reduce the value of mortgage deductions. Finally, and very importantly, shifting taxable income from youth to old age can substantially increase the share of Social Security benefits subject to federal income taxation.
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Working Paper 0107top
Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy
by Lawrence J. Christiano, Martin Eichenbaum and Charles Evans
We present a model embodying moderate amounts of nominal rigidities which accounts for the observed inertia in inflation and persistence in output. The key features of our model are those that prevent a sharp rise in marginal costs after an expansionary shock to monetary policy. Of these features, the most important are staggered wage contracts of average duration three quarters, and variable capital utilization.
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Working Paper 0106top
Maximum Likelihood in the Frequency Domain: The Importance of Time-to-Plan
by Lawrence J. Christiano and Robert J. Vigfusson
We illustrate the use of various frequency domain tools for estimating and testing dynamic, stochastic general equilibrium models. Our substantive results confirm other findings which suggest that time-to-plan in the investment technology has potentially useful role to play in business cycle models.
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Working Paper 0105top
Efficient Investment in Children
by S. Rao Aiyagari, Jeremy Greenwood, Anath Seshardi
Many would say that children are society's most precious resource. So, how should we invest in them? To gain insight into this question, a dynamic general equilibrium model is developed where children differ by ability. Parents invest time and money in their offspring, depending on their altruism. This allows their children to grow up as more productive adults. First, the efficient allocation is characterized. Next, this is compared with the outcome that arises when financial markets are incomplete. The situation where childcare markets are also lacking is then examined. Additionally, the consequences of impure altruism are analyzed.
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Working Paper 0104top
Marriage and Consumption Insurance: What's Love Got to Do with It?
by Gregory D. Hess
This paper explores the role of marriage when markets are incomplete so that individuals cannot diversify their idiosyncratic labor income risk. Ceteris paribus, an individual would prefer to marry a "hedge" (i.e. a spouse whose income is negatively correlated with her own) as it raises her expected utility. However, the existence of love complicates the picture: while marrying a hedge is important, an individual may not do so if she finds someone with whom she shares a great deal of love. Is love more important to a lasting marriage than economic compatibility? To answer this question, I develop a simple model where rational individuals meet, enjoy the economic and non-pecuniary benefits of marriage (i.e. love), and then must decide whether to remain married or divorce.
The model predicts that if love is persistent and the resolution of uncertainty to agents' income is early, then those who in fact married hedges (and for good reason) are the ones most likely to be caught short with too little love in order to save a marriage in the event of an adverse shock. Consequently, under these conditions individuals who are good hedges for one another are more likely to marry one another, although once married, they will be more likely to divorce.
In contrast, if love is temporary (in the sense of reverting to a common mean) and the resolution of uncertainty to agents' income is predominantly later, then those who in fact marry hedges will in fact be less likely to subsequently divorce. Evidence is provided to distinguish which of these alternative scenarios is in support of these aspects of the decision to stay married. Additional hypotheses regarding the effect of differences in the expected means and volatilities of partners' incomes are also derived from the theory and tested.
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We apply a notion of power defined for coalitions derived from the Shapley value. We calculate the power of coalitions within a twelve-person committee, meant to correspond to the FOMC.
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Working Paper 0102top
Life-Cycle Saving, Limits on Contributions to DC Pension Plans, and Lifetime Tax Benefits
by Jagadeesh Gokhale, Laurence J. Kotlikoff and Mark J. Warshawsky
This paper addresses three questions related to limits on DC contributions. The first is whether statutory limits on tax-deductible contributions to defined contribution (DC) plans are likely to be binding, focusing on households in various economic situations. The second is how large is the tax benefit from participating in defined contribution plans. The third is how does the defined contribution tax benefit depend on the level of lifetime income. We find that the statutory limits bind those older middle-income households who started their pension savings programs late in life, those who plan to retire early, single-earner households, those who are not borrowing constrained, and those with rapid rates of real wage growth. Most households with high levels of earnings, regardless of age or situation, are also constrained by the contribution limits.
Lower or middle-income two-earner households that can look forward to modest real earnings growth are likely to be borrowing constrained for most of their pre-retirement years because of the costs of paying a mortgage and sending children to college. These households are not in a position to save the 25 percent of earnings allowed as a contribution to DC plans. Some of these middle-income households, however, are constrained by the $10,500 limit on elective employee contributions to 401(k) plans if the households have access to only these plans and their employers make no pension contributions for them. The borrowing constraints faced by many lower- and middle-income Americans means that contributions to DC plans must come at the price of lower consumption when young and the benefit of higher consumption when old. Indeed, for a stylized household earning $50,000, consistently contributing 10 percent of salary to a DC plans that earns a 4 percent real return means consuming almost two times more when old than when young.
Measured as a share of lifetime consumption, the tax benefit from participating in a DC plan can be significant. Assuming annual contribution rates at the average of the maximum levels allowed by employers in 401(k) plans and assuming a 4 percent real return on DC and non-DC assets, the benefit is 2 percent for two-earner households earning $25,000 per year, 3.4 percent for those earning $100,000 per year, and 9.8 percent for those earning $300,000 per year. Contribution ceilings limit the benefit at the highest regions of the household earnings distribution. The extent of the benefit is also quite sensitive to the assumed rate of return on DC and non-DC assets.
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Revised March 2002: Why are common-law countries market-dominated and civil-law countries bank-dominated? This paper provides an explanation tied to legal traditions. Civil-law courts have been less effective in resolving conflicts than common-law courts because civil-law judges traditionally refrain from interpreting the codes and creating new rules. In a civil-law environment, where potential conflicts between borrowers and individual lenders inhibit the development of markets because the courts are unable to penalize defrauding borrowers, I show that banks can induce borrowers to honor their obligations by threatening to withhold services that only banks can provide. In other words, banks emerge as the primary contract enforcers in economies where courts are imperfect.
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