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2001 Working Papers

  • wp 99-10R | Timing and Real Indeterminacy in Monetary Models


    Charles T. Carlstrom Timothy Fuerst

    Original Paper: WP 99-10

    Abstract

    An increasingly common approach to the theoretical analysis of monetary policy is to ensure that a proposed policy does not introduce real indeterminacy and thus sunspot fluctuations into the model economy. Policy is typically conducted in terms of directives for the nominal interest rate. This paper uses a discrete-time money-in-the-utility function model to demonstrate how seemingly minor modifications in the trading environment result in dramatic differences in the policy restrictions needed to ensure real determinacy. These differences arise because of the differing pricing equations for the nominal interest rate. Read More

  • WP 01-18 | The U.S. Demographic Transition Perfect Capital Markets


    Jeremy Greenwood Ananth Seshradi

    Abstract

    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. Read More

  • WP 01-19 | A Strategic Approach to Hedging and Contracting


    David Downie Ed Nosal

    Abstract

    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. Read More

  • WP 01-15 | Monetary Policy in a World Without Perfect Capital Markets


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    This working paper examines a theoretical model in which an entrepreneur's net worth affects 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, the central bank plays a welfare-improving role by responding to asset price and technology shocks. Read More

  • WP 01-16 | Taylor Rules in a Model that Satisfies the Natural Rate Hypothesis


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    The authors analyze the restrictions necessary to ensure that the interest-rate policy rule used by the central bank does not introduce real indeterminacy into the economy. They conduct 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 that there must 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. Read More

  • WP 01-17 | Learning and the Central Bank


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    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. Read More

  • WP 01-14 | Who Gets Paid to Save?


    Jagadeesh Gokhale Laurence Kotlikoff

    Abstract

    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 will gain 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, who 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. Read More

  • WP 01-13 | Will the Valuation Ratios Revert to their Historical Means ?Some Evidence from Breakpoint Tests


    John Carlson Eduard Pelz Mark Wohar

    Abstract

    If valuation ratios return to their historical means any time soon, then equity prices must fall substantially, or earnings and dividends must accelerate sharply, or some combination of these events must occur. Historical patterns over the past century 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, which allow for multiple breakpoints at unknown break dates. The authors also review alternative explanations for changes in the ratios. They conclude that although no single explanation may be convincing by itself, taken in toto with empirical evidence of structural change, 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. Read More

  • WP 01-11 | PSAF, Economic Capital, and the New Basel Accord


    James Thomson

    Abstract

    The 1980 Monetary Control Act requires 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 were allocated to each service according to its risk. Read More

  • WP 01-12 | Federal Home Loan Bank Lending to Community Banks. Are Targeted Subsidies Necessary?


    Ben R. Craig James Thomson

    Abstract

    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. Read More

  • WP 01-09 | The Mismatch Between Life Insurance Holdings and Financial Vulnerabilities: Evidence from the Health and Retirement Survey


    Douglas Bernheim Lorenzo Forni Jagadeesh Gokhale Laurence Kotlikoff

    Abstract

    Using data on older workers from the 1992 Health and Retirement Survey, along with an elaborate life-cycle planning model, the authors quantify the effect of each individual's death on the financial status of his or her survivors and 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 without insurance. However, this average obscures a startling mismatch between insurance holdings and underlying vulnerabilities. For many of the most vulnerable, the amounts purchased are surprisingly small, and for many of the least vulnerable, the amounts are surprisingly large. As a result, uninsured vulnerabilities are quite 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. Read More

  • WP 01-10 | Sterilized Intervention, Nonsterilized Intervention, and Monetary Policy


    Ben R. Craig Owen F. Humpage

    Abstract

    Sterilized intervention is generally ineffective. Countries that conduct monetary policy using an overnight, interbank rate as an intermediate target automatically sterilize their interventions. Nonsterilized 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. Nonsterilized interventions, however, are unnecessary since standard open-market operations can achieve the same result. Read More

  • WP 01-08 | Does Participating in a 401(k) Raise Your Lifetime Taxes?


    Jagadeesh Gokhale Laurence Kotlikoff Todd Neumann

    Abstract

    This paper uses ESPlanner, a detailed, life-cycle personal financial planning model, to study the lifetime tax advantage gained by stylized young couples when they participate in a 401(k) plan.Assuming a 6 percent real return on assets, we find that low- and moderate-income households actually raise their lifetime taxes and lower their lifetime expenditures by saving in a 401(k) plan. In the case of a couple with $50,000 in annual earnings, partaking fully in the typical 401(k) plan raises lifetime tax payments by 1.1 percent and lowers lifetime expenditures by 0.4 percent. The lifetime tax hike is 6.4 percent and the lifetime spending reduction is 1.7 percent for such households if they receive an 8 percent real rate of return. These figures rise to 7.3 percent and 2.3 percent, respectively, if taxes increase 20 percent after the couple retires. These findings are driven, in large part, by the additional taxation of Social Security benefits induced by 401(k)withdrawals. The picture is quite Read More

  • WP 01-07 | Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy


    Lawrence Christiano Martin Eichenbaum Charles Evans

    Abstract

    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 thosethat prevent a sharp rise in marginal costs after an expansionary shock to monetary policy. Ofthese features, the most important are staggered wage contracts of average duration threequarters, and variable capital utilization. Read More

  • WP 01-05 | Efficient Investment in Children


    S. Rao Aiyagari Jeremy Greenwood Ananth Seshradi

    Abstract

    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. Read More

  • WP 01-04 | Marriage and Consumption Insurance: What's Love Got to Do With It?


    Gregory Hess

    Abstract

    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. Read More

  • WP 01-03 | Coalitions, Power, and the FOMC


    Joseph G. Haubrich Owen F. Humpage

    Abstract

    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. Read More

  • WP 01-06 | Maximum Likelihood in the Frequency Domain: The Importance of Time-to-Plan


    Lawrence Christiano Robert Vigfusson

    Abstract

    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. Read More

  • WP 01-02 | Life-Cycle Saving, Limits on Contributions to DC Pension Plans, and Lifetime Tax Benefits


    Jagadeesh Gokhale Laurence Kotlikoff Mark Warshawsky

    Abstract

    This paper analyzes questions related to defined contribution (DC) plans. For what types of households are statutory contribution limits likely to bind?How large is the lifetime tax benefit from participating in a DC plan and how does it vary with lifetime income? The authors find that contribution limits bind for households that begin their plan participation late in life or wish to retire early, single-earner households, those who are not borrowing-constrained, those with rapid rates of real wage growth, and those with high levels of earnings regardless of age.Setting contribution rates at the average maximum level allowed by employers and assuming a 4% real return on assets, the lifetime benefit rises from 2% of lifetime consumption for households earning $25,000 per year, to 9.8% for those earning $300,000 per year.Contribution ceilings limit the benefit for high earners and are sensitive to the assumed rate of return. Read More

  • WP 01-01 | Market- vs. Bank-Based Financial Systems: Do Investor Rights Really Matter?


    O. Emre Ergungor

    Revisions: WP 01-01R

    Abstract

    Why are common-law countries market-dominated and civil-lawcountries bank-dominated? This paper provides an explanationtied to legal traditions. Civil-law courts have been lesseffective in resolving conflicts than common-law courtsbecause civil-law judges traditionally refrain frominterpreting the codes and creating new rules. In a civil-lawenvironment, where potential conflicts between borrowers andindividual lenders inhibit the development of markets becausethe courts are unable to penalize defrauding borrowers, Ishow that banks can induce borrowers to honor theirobligations by threatening to withhold services that onlybanks can provide. In other words, banks emerge as theprimary contract enforcers in economies where courts areimperfect. Read More

  • WP 99-05R | Monetary Policy Regimes and Beliefs


    David Andolfatto Paul Gomme

    Original Paper: WP 99-05

    Abstract

    Revised. This paper investigates the role of beliefs over monetary policy in propagating the effects of monetary policy shocks within the context of a dynamic, stochastic general equilibrium model. In this model, monetary policy periodically switches between low- and high-money-growth regimes.When individuals cannot observe the regime directly, they must draw inferences over regime type based on historical money growth rates.The authors show that for an empirically plausible money growth process, beliefs evolve slowly in the wake of a regime change.As a result, their model is able to capture some of the observed persistence of real and nominal variables following such a regime change. Read More