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2003 Working Papers

  • WP 03-21 | Capital Trading, Stock Trading, and the Inflation Tax on Equity: A Note


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    In "Capital Trading, Stock Trading, and the Inflation Tax on Equity," Chami, Cosimano, and Fullenkamp (2001) (hereafter, CCF) analyze a cash-in-advance model in which capital goods are explicitly traded. The authors show that there is more responsiveness of consumption and output to changes in the money supply than exists in the standard neoclassical growth models. This note demonstrates that this arises because CCF implicitly imposed an additional equilibrium restriction on the Cooley and Hansen (1989) model. This restriction can be imposed only if the Cooley and Hansen model is subject to real indeterminacy which occurs whenever the risk aversion coefficient (denoted by γ in the Chami et al paper) exceeds 2. Read More

  • WP 03-20 | Investment and Interest Rate Policy: A Discrete Time Analysis


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    This paper analyzes the restrictions necessary to ensure that the interest rate policy rule used by the central bank does not introduce local real indeterminacy into the economy. It conducts the analysis in a Calvo-style sticky price model. A key innovation is to add investment spending to the analysis. In this environment, local real indeterminacy is much more likely. In particular, all forward-looking interest rate rules are subject to real indeterminacy. Read More

  • WP 03-19 | Comments on Backward-Looking Interest-Rate Rules, Interest-Rate Smoothing, and Macroeconomic Instability


    Charles T. Carlstrom Timothy Fuerst

    Abstract

    Benhabib, Schmitt-Grohe, and Uribe (2003) argue that if you relied solely on local analysis you would be led to believe that aggressive, backward-looking interest rate rules are sufficient for determinacy. But from the perspective of global analysis, backward-looking rules do not guarantee uniqueness of equilibrium and indeed may lead to cyclic and even chaotic equilibria. This comment argues that this result is premature. We utilize a discrete time model and make two observations. First, compared to their continuous time model, the cyclic equilibria under a backward-looking rule are much less likely to arise in a discrete time model. Second, pure backward-looking rules are less likely to suffer from these global indeterminacy problems than rules that also include current or future inflation. Read More

  • WP 03-18 | The Great Depression and the Friedman-Schwartz Hypothesis


    Lawrence Christiano Roberto Motto Massimo Rostagno

    Abstract

    We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild. Read More

  • WP 03-17 | Inflation and Financial Market Performance: What Have We Learned in the Last Ten Years?


    John Boyd Bruce Champ

    Abstract

    The last decade has witnessed a great deal of theoretical and empirical research on the relationships between inflation, financial market performance, and economic growth. This paper provides a survey of that literature and presents new cross-country empirical results on this topic. We find that inflation is negatively associated with banking industry size, real returns on financial assets, and bank profitability. We also discover a positive relationship between asset return volatility and inflation. Read More

  • WP 03-16 | Resolving the National Banking System Note-Issue Puzzle


    Bruce Champ Neil Wallace

    Abstract

    Under the National Banking System, 1863-1914, national banks that deposited sufficient collateral could issue notes provided they paid a tax on notes in circulation: 1 percent per year before 1900 and ½ percent thereafter. Because note issue was far below the allowed maximum, an arbitrage argument predicts that short-term nominal interest rates should have been bounded above by the tax rate. They were not. That is the note-issue puzzle. Our resolution takes the form of a model in which notes play a role, but in which the profitability of note issue is not tied to anything that resembles a market rate of interest. Read More

  • WP 03-15 | Government Intervention in the Foreign Exchange Market


    Owen F. Humpage

    Abstract

    This article offers a survey of the literature on foreign exchange intervention, including sections on the theoretical channels through which intervention might affect exchange rates and a summary of the empirical findings. The survey emphasizes that intervention is intended to provide monetary authorities with an means of influencing their exchange rates independent from monetary policy, and tends to evaluate theoretical channels and empirical results from this perspective. Read More

  • WP 03-14 | On Credit Spread Slopes and Predicting Bank Risk


    C.N.V. Krishnan Peter Ritchken James Thomson

    Abstract

    We examine whether credit-spread curves, engendered by a mandatory subordinated-debt requirement for banks, would help predict bank risk. We extract the credit-spread curves each quarter for each bank in our sample, and analyze the information content of credit-spread slopes. We find that credit-spread slopes are significant predictors of future credit spreads. However, credit-spread slopes do not provide significant additional information on future bank-risk variables, over and above other bank-specific and market-wide information. Read More

  • WP 03-13 | The Empirical Performance of Option-Based Densities of Foreign Exchange


    Ben R. Craig Joachim Keller

    Abstract

    In this paper, we calculate risk-neutral densities (RND) by estimating the daily diffusion process of the underlying futures contract for foreign exchange, based on the price of the American puts and calls reported on the Chicago Mercantile Exchange for the end of the day. Our quick and accurate method of calculating the prices of the American options uses higher-order lattices and smoothing of the option’s value function at the boundaries to mitigate the nondifferentiability of the payoff boundary at expiration and the early exercise boundary. We estimate the diffusion process by minimizing the squared distance between the calculated prices and the observed prices in the data. We also test whether the densities provided from American options provide a good forecasting tool. We use a nonparametric test of the densities that depends on inverse probabilities. We modify the test to compensate for an inherent problem that arises from the time-series nature of the transformed variables when the forecasting windows overlap. We find that the densities based on the American option prices for foreign exchange do considerably well for the longer time horizons. Read More

  • WP 03-12 | The Forecasting Performance of German Stock Option Densities


    Ben R. Craig Ernst Glatzer Joachim Keller Martin Scheicher

    Abstract

    In this paper we will be estimating risk-neutral densities (RND) for the largest euro area stock market (the index of which is the German DAX), reporting their statistical properties, and evaluating their forecasting performance. We have applied an innovative test procedure to a new, rich, and accurate data set. We have two main results. First, we have recorded strong negative skewness in the densities. Second, we find evidence for significant difference between the actual density and the risk-neutral density, leading to the conclusion that market participants were surprised by the extent of both the rise and the fall of the DAX. Read More

  • WP 03-11 | Currency Competition in a Fundamental Model of Money


    Gabriele Camera Ben R. Craig Christopher Waller

    Abstract

    We study how two fiat monies, one safe and one risky, compete in a decentralized trading environment. The equilibrium value of the two currencies, their transaction velocities and agents' spending patterns are endogenously determined. We derive conditions under which agents holding diversified currency portfolios spend the safe currency first and hold the risky one for later purchases. We also examine when the reverse spending pattern is optimal. Traders generally favor dealing in the safe currency, unless trade frictions and the currency risk is low. As risk increases or trading becomes more difficult, the transaction velocity and value of the safe money increases. Read More

  • WP 03-10 | A Theory of Money and Banking


    David Andolfatto Ed Nosal

    Abstract

    We construct a simple environment that combines a limited communication friction and a limited information friction in order to generate a role for money and intermediation. We ask whether there is any reason to expect the emergence of a banking sector (i.e., institutions that combine the business of money creation with the business of intermediation). In our model the unique equilibrium is characterized, in part, by the existence of an agent that: (1) creates money (a debt instrument that circulates as a means of payment); (2) lends it out (swapping it for less liquid forms of debt); (3) is responsible for monitoring those agents in control of the capital backing the illiquid debt; and (4) collects on money loans as they come due. Furthermore, the bank money in our model is a debt instrument that embeds within it important stipulations that are found in actual private money instruments. Thus, our model goes some way in addressing the questions of why private money takes the form that it does, as well as why private money is typically supplied by banks. Read More

  • WP 03-09 | An Analysis of Japanese Foreign Exchange Interventions


    Alain Chaboud Owen F. Humpage

    Abstract

    The effectiveness of Japanese interventions over the past decade depended in large part on the frequency and size of the transactions. Prior to June 1995, Japanese interventions only had value as a forecast that the previous day's yen appreciation or depreciation would moderate during the current day. After June 1995, Japanese purchases of dollars had value as a forecast that the yen would depreciate. Probit analysis confirms that large, infrequent interventions, which characterized the later period, had a higher likelihood of success than small, frequent interventions. Read More

  • WP 03-08 | Pricing Kernels, Inflation, and the Term Structure of Interest Rates


    Ben R. Craig Joseph G. Haubrich

    Abstract

    We estimate a discrete-time multivariate pricing kernel for the term structure of interest rates, using both yields and inflation rates. This gives a separate estimate of the real kernel and the nominal kernel, taking into account a relatively sophisticated dynamical structure and mutual interaction between the real and nominal side of the economy. Along with obtaining an estimate of the real term structure, we use the estimates to obtain a new perspective on how real and nominal influences interact to produce the observed term structure. Read More

  • WP 03-07 | Information Gathering by a Principal


    Ed Nosal

    Abstract

    In the standard principal-agent model, the information structure is fixed. In this paper I allow the principal to choose his level of "informedness" before he contracts with the agent. During the contracting phase, the agent never learns what the principal knows about the state of the world. I examine the cases where the agent observes and does not observe the level of informedness that the principal chooses. The strategic nature of the model environment implies that there are both direct and indirect costs associated with the existence of high quality information. The implications for information gathering, investment and welfare are examined for both cases. Read More

  • WP 03-06 | A Deposit Insurance System for Armenia


    Artak Manukyan

    Abstract

    We provide an overview of the design for a system of official deposit guarantees for the Republic of Armenia. This proposed design takes into consideration the overall structure of the Armenian economy, its official institutions and the financial system. Furthermore, we outline specific design features for the Armenian deposit insurance system that are consistent with the social welfare objectives that underpin arguments for its adoption, while minimizing the distortions of these government guarantees on incentives. Key among the design features are limited coverage of deposits, separation of deposit insurance from central banking, and extended liability of banks for losses incurred by the deposit insurance fund. Read More

  • WP 03-05 | Financial System Structure and Economic Development: Structure Matters


    O. Emre Ergungor

    Abstract

    This paper investigates how the structure of a financial system—whether it is bank or market oriented— affects economic growth. In contrast to earlier research, which indicates that the financial system’s structure is irrelevant for growth, I find that countries grow faster when they have flexible judicial system and more market-oriented financial systems. Read More

  • WP 03-04 | Nearsighted Justice


    Ed Nosal

    Abstract

    Chapter 11 structures complex negotiations between creditors and debtors that are overseen by a bankruptcy court. This paper identifies conditions under which it is optimal for the court to sometimes err in determining whether a firm should be liquidated. Such errors can affect the optimal action choices by both good and bad entrepreneurs. We first characterize the optimal error rate without renegotiation, providing conditions under which it is optimal for the court both to sometimes mistakenly liquidate "good firms," but not "bad firms." When creditors and debtors can renegotiate to circumvent an error-riven court and creditors have all of the bargaining power, we show that for a broad class of action choices, a blind court—one that ignores all information and hence is equally likely to liquidate a good firm as a bad one—is optimal. For another class of action choices, the optimal court design places the burden of proof on the entrepreneur. The robust feature is that in the optimal court design, the court sometimes errs in determining whether a firm should be liquidated. Read More

  • WP 03-03 | Ready, Willing, and Able? Measuring Labor Availability in the UK


    Mark E. Schweitzer

    Abstract

    The unemployment rate is commonly assumed to measure labour availability, but this ignores the fact that potential workers frequently come from outside the current set of labour market participants, the so-called inactive. The UK Longitudinal Labour Force Survey includes information that can be used to predict impending employment transitions. Using this unique dataset, new measures of labour availability, and indicators based on the more familiar unemployment rate alternatives, can be constructed and are reported here. The micro and macroeconomic performance of these labour force availability measures is compared. Two simplified models, which include several categories of reasons for not working as well as demographic variables, perform particularly well in all of the tests. The implications of these preferred models are further studied in the context of regional regressions and comparisons with alternative data sources. These results together illustrate the important role that some groups of the inactive can play as a source of potential workers. Read More

  • WP 03-02 | How Amenities Affect Job and Wage Choices over the Life Cycle


    Ed Nosal Peter Rupert

    Abstract

    Observing the current wage at a job may not fully reflect the "value" of that job. For example, a job with a low starting wage may be preferred to a high starting wage job if the growth rate of wages in the former exceeds the latter. In fact, differences in wage growth can potentially explain why a worker might want to quit a high paying job for a job with a lower initial wage. Job amenities are shown to be another important factor that not only influence the value of a job but also provide an independent rationale for why workers change jobs. The inclusion of a job amenity as part of the "value" can also generate a move from either high-paying to low-paying or low-paying to high-paying jobs as part of an optimal consumption plan over the life cycle. Both the direction of movement and the timing of a job change are shown to depend critically on the relationship between the worker's rate of time preference and the market interest rate. Read More

  • WP 03-01 | Monitoring and Controlling Bank Risk: Does Risky Debt Serve Any Purpose?


    C.N.V. Krishnan Peter Ritchken James Thomson

    Abstract

    We examine whether mandating banks to issue subordinated debt would serve to enhance market monitoring and control risk taking. To evaluate whether subordinated debt enhances risk monitoring, we extract the credit-spread curve for each banking firm in our sample and examine whether changes in credit spreads reflect changes in bank risk variables, after controlling for changes in market and liquidity variables. We find that they do not. Our result is robust to firm type, examination rating, size, leverage and profitability, as well as to different model specifications. To evaluate whether subordinated debt controls risk taking, we examine whether issuing subordinated debt changes the risk-taking behavior of a bank. We find that it does not. We conclude that a mandatory subordinated debt requirement for banks is unlikely to provide the purported benefits of enhancing risk monitoring or controlling risk-taking. Read More