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1997 Working Papers

  • WP 97-15 | Depositor Preference Legislation and Failed Banks' Resolution Costs

    William Osterberg James Thomson


    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. Read More

  • WP 97-14 | Interest Rate Option Pricing with Volatility Humps

    Peter Ritchken Iyuan Chuang


    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 incorporate 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. Read More

  • WP 97-13 | Expectations, Credibility, and Disinflation in a Small Macroeconomic Model

    Chan Huh Kevin Lansing


    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. Read More

  • WP FSRG 04-97 | The Evolution of Cash Transactions: Some Implications for Monetary Policy

    Stacey Schreft Bruce Smith


    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. Read More

  • WP FSRG 03-97 | Reliability Analysis of the Federal Reserve Automated Payments Systems

    Apostolos Burnetas Gregory Reynolds James Thomson


    This paper proposes an analytic framework for the reliability assessment of the automated payments systems used by the Federal Reserve Banks. The failure/recovery behavior of the system currently in operation is modeled as a continuous time Markov process with varying levels of detail, and the availability is calculated for a wide range of component failure frequencies. Furthermore, alternative system configurations are proposed and analyzed. Read More

  • WP FSRG 01-97 | The Effect of Pricing on Demand and Revenue in Federal Reserve ACH Payment Processing

    Joanna Stavins Paul Bauer


    Because the automated clearinghouse (ACH) has been found to have lower social costs than paper checks, the Federal Reserve has been promoting more widespread use of ACH by lowering ACH processing fees. In this paper we have obtained 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 were employed to estimate the demand elasticities. Read More

  • WP 97-11 | Algorithms for Solving Dynamic Models with Occasionally Binding Constraints

    Lawrence Christiano D.M. Fisher-Jonas


    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. Read More

  • WP 97-12 | Simulating U.S. Tax Reform

    David Altig Alan Auerbach Laurence Kotlikoff Kent Smetters Jan Walliser


    This paper uses a new large-scale dynamic simulation model to compare the equity, efficiency, and macroeconomic effects of five alternatives to the current U.S. federal income tax. These reforms are 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.” Read More

  • WP 97-10 | Absolute Priority Rule Violations, Credit Rationing, and Efficiency

    Stanley Longhofer


    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. Read More

  • WP 97-09 | A Note on Purifying Mixed Strategy Equilibria in the Search Model of Money

    Randall Wright


    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 ε (0,1). Here we construct a nonsymmetric pure strategy equilibrium, payoff-equivalent to the symmetric mixed strategy equilibrium, where a fraction N ε (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. Read More

  • WP 97-16 | Electronic Money

    Barbara Good


    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. Read More

  • WP 97-08 | Indeterminacy and Stabilization Policy

    Jang-Ting Guo Kevin Lansing


    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. Read More

  • WP 97-07 | Efficient Inflation Estimation

    Michael Bryan Stephen Cecchetti Rodney Wiggins II


    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. Read More

  • WP 97-05 | Identifying Inflation's Grease and Sand Effects in the Labor Market

    Erica Groshen Mark E. Schweitzer


    Inflation has been accused of causing distortionary price and wage fluctuations (sand) as well as lauded for facilitating adjustments to shocks when wages are rigid downwards (grease). This paper investigates whether these two effects can be distinguished from each other in a labor market by the following identification strategy: inflation-induced deviations among employers’ mean wage-changes represent unintended intramarket distortions (sand), while inflation-induced, inter-occupational wage-changes reflect intended alignments with intermarket forces (grease). Using a unique 40-year panel of wage changes made by large mid-western employers, we find a wide variety of evidence to support the identification strategy. We also find some indications that occupational wages in large firms gained flexibility in the past four years. Read More

  • WP 97-04 | Securities Activities in Banking Conglomerates: Should their Location be Regulated?

    João dos Santos


    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' 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. Read More

  • WP 97-03 | Social Security Privatization: A Simple Proposal

    David Altig Jagadeesh Gokhale


    This paper proposes a Social Security reform for the United States 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. As such it is both economically and politically feasible.The paper demonstrates that the transition to a privatized system can be financed without any additional taxation, including additional payroll taxation. Our approach is likely to improve U.S. national saving and work incentives compared to the current system. It also has advantages over other privatization proposals that recommend or may require additional taxation to finance the transition. The paper points out, however, that there is only a limited window of opportunity for implementing such a reform of the U.S. Social Security system. Read More

  • WP 97-02 | Credit Rationing, Bankruptcy Cost and the Optimal Debt Contract for Small Business

    Ying Yan


    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. Read More

  • WP 97-01 | Estimating the Cost of U.S. Indexed Bonds

    Silverio Foresi Alessandro Penati George Pennacchi


    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. Read More

  • WP 97-06 | Trust and Investment Corporations in China

    Zhaohui Hong


    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. Read More

  • WP FSRG 02-97 | Consistency Conditions for Regulatory Analysis of Financial Institutions: A Comparison of Frontier Efficiency Methods

    Paul Bauer Gary Ferrier David Humphrey


    We propose a set of consistency conditions that frontier efficiency measures should meet to be most useful for regulatory analysis or other purposes. The efficiency estimates should be consistent in their efficiency levels, rankings, and identification of best and worst firms, consistent over time and with competitive conditions in the market, and consistent with standard nonfrontier measures of performance. We provide evidence on these conditions by evaluating and comparing efficiency estimates on U.S. bank efficiency from variants of all four of the major approaches -- DEA, SFA, TFA, and DFA -- and find mixed results. Read More