Skip to main content

1998 Working Papers

  • WP 98-23 | Central Bank Intervention and Overnight Uncovered Interest Rate Parity


    Richard Baillie William Osterberg

    Abstract

    This paper considers the impact of U.S. and German central bank intervention on the risk premium in forward foreign exchange markets. The model estimation is facilitated with the use of daily data on overnight Eurocurrency deposit rates, so that the interest rate maturity time of one day matches the sampling interval of the data. We also use the official net daily purchases and sales of dollars vis-à-vis the German Mark by the Federal Reserve System and the Bundesbank. The model involves FIGARCH innovations to model the degree of long term dependence in the volatility process. Some support is found for the intervention variables affecting the risk premium as predicted by theory. The impact of intervention in the two years immediately following the meltdown of the equity markets in October 1987 is particularly strong. Read More

  • WP 98-22 | Sources of Business Cycles in Korea and the United States


    David Altig Alan Stockman

    Abstract

    The authors estimate common and nation-specific components of technology shocks, real demand shocks, and combined (common and nation-specific) monetary shocks using quarterly data for Korea and the United States. Read More

  • WP 98-21 | Private Money Creation and the Suffolk Banking System


    Bruce Smith Warren Weber

    Abstract

    While much has been written on the history of the Suffolk Banking System, somewhat surprisingly (to our knowledge) no attempt has been made to formally model its monetary consequences. In this paper we attempt to fill this gap. Read More

  • WP 98-20 | Will Electronic Money be Adopted in the United States?


    Barbara Good

    Abstract

    Although the cashless society has been predicted for at least twenty years, the new forms of card-based and software-based electronic money may prove to be a partial alternative to the current forms of payments. This paper examines their possible adoption, primarily in the United States. Read More

  • WP 98-17 | Non-Par Banking: Competition and Monopoly in Markets for Payments Services


    Edward Stevens

    Abstract

    Much of the literature treats the existence of non-par banking as a legal matter, emphasizing the Board of Governors’ legal struggle to force non-par banks to pay Reserve banks at par. This treatment is not satisfactory. In competitive markets, par paying banks should have been able to undercut non par banks’ prices, once the Reserve banks had eliminated exchange charges by integrating their balance sheets. More likely, the survival of non-par banking reflected the absence of competition in the markets in which non-par banks operated. Past empirical evidence is consistent with this conclusion: non-par banks typically were monopolists in isolated rural markets for banking services. Read More

  • WP 98-16 | Evolutionary Programming as a Solution Technique for the Bellman Equation


    Paul Gomme

    Abstract

    Evolutionary programming is a stochastic optimization procedure which has proved useful in optimizing difficult functions. It is shown that evolutionary programing can be used to solve the Bellman equation problem with a high degree of accuracy and substantially less CPU time than Bellman equation iteration. Future applications will focus on sometimes binding constraints – a class of problem for which standard solutions techniques are not applicable. Read More

  • WP 98-18R | Real Indeterminacy in Monetary Models with Nominal Interest Rate Distortions: The Problem with Inflation Targets


    Charles T. Carlstrom Timothy Fuerst

    Original Paper: WP 98-18

    Abstract

    This paper demonstrates that in a standard monetary model there exists real indeterminacy whenever the nominal interest rate moves too closely with the real rate. A particular example of such a policy is if the central bank were to target the inflation rate. This is not a knife-edge result. The conclusion is robust to (1) a wide range of calibrations, (2) a more general monetary policy that targets a varying path for the inflation rate, and (3) a monetary environment that allows for endogenous velocity. Read More

  • WP 98-18 | Real Indeterminacy in Monetary Models with Nominal Interest Rate Distortions: The Problem with Inflation Targets


    Charles T. Carlstrom Timothy Fuerst

    Revisions: WP 98-18R

    Abstract

    This paper demonstrates that in a standard monetary model there exists real indeterminacy whenever the nominal interest rate moves too closely with the real rate. A particular example of such a policy is if the central bank were to target the inflation rate. This is not a knife-edge result. The conclusion is robust to (1) a wide range of calibrations, (2) a more general monetary policy that targets a varying path for the inflation rate, and (3) a monetary environment that allows for endogenous velocity. Read More

  • WP 98-15 | The Federal Reserve as an Informed Foreign-Exchange Trader


    Owen F. Humpage

    Abstract

    U.S. exchange-market interventions have no apparent effect on market fundamentals, but may influence expectations. If intervention can accurately forecast exchange-rate movements, knowledge that the Federal Reserve was trading will cause traders to alter their prior estimates of the distribution of exchange-rate changes. This paper finds that U.S. intervention has value only as a forecast that recent exchange-rate movements will moderate, but not that they will reverse. Less than half of the interventions, however, seem successful, and the favorable results are generally confined to two relatively short periods that are characterized by uncertainty about future Federal Reserve policies. Read More

  • WP 98-14 | Earnings and Wealth Inequality and Income Taxation: Quantifying the Trade-Offs of Switching to a Proportional Income Tax in the U.S.


    Ana Castaneda Diaz Gimenez Javier Victor Rios Rull Jose

    Abstract

    This paper quantifies the steady-state aggregate, distributional and mobility effects of switching the U.S. to a proportional income tax system. As a prerequisite to the analysis, we propose a theory of earnings and wealth inequality capable of accounting quantitatively for the key aggregate and inequality facts of the U.S. economy. This theory is based on savings to smooth uninsured household-specific risk, for dynastic households that also have some life-cycle characteristics. A suitable calibration of our model economy replicates the U.S. growth facts, earnings and wealth distributions, the progressivity of the tax system and the size of the U.S. government. We also solve a similar model economy in which the government levies a proportional income tax to finance the same flow of government expenditures and public transfers. Read More

  • WP 98-13 | Monetary Aggregates and Output


    Scott Freeman Finn Kydland

    Abstract

    <div>Series Title: <b><em>Working Paper, FRB</em></b><br/>Title: <b>Monetary Aggregates and Output</b><br/>Date: <br/>Publication: Federal Reserve Bank of Cleveland, Working Paper no. 9813<br/>Author(s):Scott Freeman<br/>Finn Kydland<br/>Type: Working Paper, FRB<br/>Topics(s): US Economy<br/></div> Read More

  • WP 98-12 | Expectations, Credibility, and Time-Consistent Monetary Policy


    Peter Ireland

    Abstract

    This paper addresses the problem of multiple equilibria in a model of time-consistent monetary policy. It suggests that this problem originates in the assumption that agents have rational expectations and proposes several alternative restrictions on expectations that allow the monetary authority to build credibility for a disinflationary policy by demonstrating that it will stick to that policy even if it imposes short-run costs on the economy. Starting with these restrictions, the paper derives conditions that guarantee the uniqueness of the model’s steady state; monetary policy in this unique steady state involves the constant deflation advocated by Milton Friedman. Read More

  • WP 98-11 | Simulating the Transmission of Wealth Inequality via Bequests


    Jagadeesh Gokhale Laurence Kotlikoff James Sefton Martin Weale

    Abstract

    Answering the question of how much wealth inequality arises from inheritance inequality requires data that are unavailable and potentially uncollectable. The alternative approach taken here (from Blinder [1974, 1976] and Davies [1982]) is to simulate the transmission of inequality via bequests. Read More

  • WP 98-19 | Price-Level and Interest-Rate Targeting in a Model with Sticky Prices


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    This paper examines a standard sticky price monetary model. The equilibrium conditions of the model are perturbed relative to the canonical real business cycle model by two varying distortions: marginal cost and the nominal rate of interest. The paper explores the implications of two monetary policies that are frequently advocated: (1) an inflation target and (2) an interest rate target. Under an inflation rate target, marginal cost is stabilized while the nominal rate is variable. In contrast, under an interest rate target, the nominal rate is stabilized but marginal cost is (in general) variable. Both policies are subject to sunspot fluctuations arising from the endogenous movement of the money stock. These fluctuations can be avoided by eliminating the contemporaneous response of the money stock to innovations in the environment. Read More

  • WP 98-10 | Optimal Employment of Scale Economies in the Federal Reserve's Currency Infrastructure


    Paul Bauer Apostolos Burnetas Viswanath CVSA Gregory Reynolds

    Abstract

    This paper investigates whether the Federal Reserve might lower its currency processing costs by reallocating high-speed currency sorting volume among its processing sites. Although scale economy estimates from Bauer, Bohn, and Hancock (1998) suggests that consolidation might permit some processing cost savings, it can be very expensive to ship currency due to security and insurance requirements and these costs increase rapidly as currency is transported further and further from a given processing site. Given estimates of currency shipping costs and scale economies for high-speed sorting, our model determines the distribution of sorting volumes across possible processing sites that minimizes the Federal Reserve's overall costs. These cost savings are achieved while leaving service levels to depository institutions roughly constant. The sensitivity of our results is explored by employing a range of estimates for shipping costs and scale economies. Read More

  • WP 98-09 | Self-Selection and Discrimination in Credit Markets


    Stanley Longhofer Stephen Peters

    Abstract

    In this paper we make two contributions toward a better understanding of the causes and consequences of discrimination in credit markets. First, we develop an explicit theoretical model of the underwriting process in which lenders use a simple Bayesian updating process to evaluate applicant creditworthiness. Using a signal correlated with an applicant’s true creditworthiness and their prior beliefs about the distribution of credit risk in the applicant pool, lenders are able to evaluate an applicant’s expected or “inferred” creditworthiness to determine which loans to approve and which ones to deny. Second, we explicitly model the self-selection behavior of individuals to show how market frictions like bigotry can affect application decisions. Because these decisions shape banks’ prior beliefs about the distribution of credit risk, they also affect the Bayesian posterior from which banks compute an applicant’s inferred creditworthiness, implying that statistical discrimination can arise endogenously. In a market in which only some lenders have “tastes for discrimination,” we show that there are conditions under which lenders without racial animus will also discriminate. Read More

  • WP 98-08 | The Importance of Bank Seniority for Relationship Lending


    Stanley Longhofer João dos Santos

    Abstract

    The idea that banks exist to reduce the costs of monitoring is central to modern theories of financial intermediation. The fact that banks are generally granted senior positions on their small-business loans, however, is hard to reconcile with the typical view that junior lenders have the best incentives to engage in this costly monitoring. Our paper addresses this puzzling contradiction by showing that bank seniority plays an important role in encouraging the formation of valuable bank-firm relationships. Read More

  • WP 98-07 | Money and Dynamic Arrangements with Private Information


    S. Rao Aiyagari Stephen Williamson

    Abstract

    We construct a model with private information in which consumers write dynamic contracts with financial intermediaries. A role for money arises due to random limited participation of consumers in the financial market. Without defection constraints, a Friedman rule is optimal, the mean and variability of wealth tend to fall in the steady state, and the welfare effects of inflation are very small. With defection constraints, the effects of inflation on the distribution of welfare and consumption are large, but the effect on average welfare is still small. Also, the relaxation of defection constraints resulting from higher inflation causes a substantial increase in the real interest rate. Read More

  • WP 98-06 | Measuring the Rate of Technological Progress in Structures


    Michael Gort Jeremy Greenwood Peter Rupert

    Abstract

    Banking problems in the 1980s led to passage of the FDICIA (1991). The purpose of this legislation was to improve market and regulatory discipline of banks’ performance through changes in incentive structures. This paper looks at how the FDICIA changes bank CEOs’ pay–performance relationship. It finds that the FDICIA improves healthy banks’ growth opportunities, making their CEOs’ tot al compensation less sensitive to performance. Meanwhile, the FDICIA restricts unhealthy banks’ growth opportunities, making their CEOs’ total compensation more sensitive to performance. These results support the agency-cost-of-debt theory developed in John and John (1993). This paper shows that since enactment of the FDICIA, CEOs’ compensation structure has become more incentive-based for both healthy and unhealthy banks. At the same time, the main components of CEOs’ compensation, salary and bonus, have become more sensitive to accounting earnings, while stock-based compensation has become more responsive to stock returns. Read More

  • WP 98-05 | The FDICIA and Bank CEOs Pay-Performance Relationship: An Empirical Investigation


    Ying Yan

    Abstract

    Banking problems in the 1980s led to passage of the FDICIA (1991). The purpose of this legislation was to improve market and regulatory discipline of banks’ performance through changes in incentive structures. This paper looks at how the FDICIA changes bank CEOs’ pay–performance relationship. It finds that the FDICIA improves healthy banks’ growth opportunities, making their CEOs’ tot al compensation less sensitive to performance. Meanwhile, the FDICIA restricts unhealthy banks’ growth opportunities, making their CEOs’ total compensation more sensitive to performance. These results support the agency-cost-of-debt theory developed in John and John (1993). This paper shows that since enactment of the FDICIA, CEOs’ compensation structure has become more incentive-based for both healthy and unhealthy banks. At the same time, the main components of CEOs’ compensation, salary and bonus, have become more sensitive to accounting earnings, while stock-based compensation has become more responsive to stock returns. Read More

  • WP 98-04 | Solving Dynamic Equilibrium Models by a Method of Undetermined Coefficients


    Lawrence Christiano

    Abstract

    This paper presents an undetermined-coefficients method for obtaining a linear approximation to the solution of a dynamic rational-expectations model. It also showshow that solution can be used to compute the model?s implications for impulse responsefunctions and for second moments. Read More

  • WP 98-03 | Large Shareholders and Market Discipline in a Regulated Industry: A Clinical Study of Mellon Bank


    Joseph G. Haubrich James Thomson

    Abstract

    The change in control at Mellon Bank in 1987 sheds a unique light on several aspects of corporate control, because Mellon was one of only a few banks with a large shareholder. We find that the large shareholder did not monitor the firm extensively before it experienced performance difficulties, but was able to enforce a management change when problems arose. Contrary to some theoretical models, the shareholder did not have to acquire a majority stake to effect the change. Mellon’s rapid recovery relative to peer banks’ reveals the inability of regulatory intervention to substitute fully for market-based forms of corporate control. Read More

  • WP 98-02 | Appointing the Median Voter of a Policy Board


    Christopher Waller

    Abstract

    Partisan politics and elector uncertainty generate policy uncertainty and partisan business cycles. To reduce policy uncertainty, society must design the policy-making environment to overcome electoral uncertainty and partisanship without ignoring the electorate’s wishes. I show that delegating policy to an independent policy board with discretionary powers substantially reduces policy uncertainty while maintaining political accountability. Board members are chosen in a partisan, noncooperative environment yet, in the benchmark model, policy uncertainty is eliminated and the policy rule is replicated. Thus, a political “invisible hand” is at work—by setting up the policy institution properly and having the participants pursue their own self-interest, the social “optimum” prevails. Read More

  • WP 98-01 | Reducing Working Hours: A General Equilibrium Analysis


    Terry Fitzgerald

    Abstract

    This paper examines the effects of restricting the weekly hours of workers in a heterogeneous-agent, general equilibrium framework. The framework presented here contains two types of workers, which allows the author to explore the consequences of a mismatch between the skills of the nonemployed and the skills of the employed. Previous studies of these issues have been based on partial equilibrium models. The main findings are that restricting weekly hours increases employment substantially, but may also lead to large declines in wages, productivity, output, and consumption, and can result in an increased wage disparity between skilled and unskilled workers. In one case, the policy raises the wages and consumption of skilled workers, while lowering them for the unskilled. A skills mismatch is shown to have dramatic effects on the aggregate and distributional consequences of the policy. Read More