Board of Governors of the Federal Reserve System

Abstract:

Psychological evidence indicates that a person's well-being depends not only on his current consumption of goods, but on a reference level determined by his past consumption. According to Kahneman and Tversky's (1979) prospect theory, people care much more about losses relative to their reference points than about gains, are risk­-averse over gains, and risk-loving over losses. We define these characteristics as loss aversion. We incorporate an extended form of loss aversion into a simple two-period savings model. Our main conclusion is that, when there is sufficient income uncertainty, a person resists lowering consumption in response to bad news about future income, and this resistance is greater than the resistance to increasing consumption in response to good news. We discuss some recent empirical research that confirms this predicted asymmetry in behavior, which seems inconsistent with other models of consumption.

Abstract:

This paper examines a neoclassical stochastic endogenous growth model in which terms-of-trade uncertainty affects savings and consumption growth. The model explains the positive link between growth and the average rate of change of terms of trade found in recent empirical studies. In addition, terms-of-trade variability, as an indicator of risk, is found to be a key determinant of growth. This implies that welfare costs of uncertainty are much larger than conventional measures of costs of consumption instability. The model's key predictions are strongly supported by results of panel regressions.

Abstract:

Few economists or laymen would deny that political events can have an important, sometimes even overwhelming, impact on economic decisions in general, and investment decisions in particular. The first goal of this paper was to integrate a number of political and non-traditional economic variables into the standard theory of investment based on the maximization of the expected value of the firm. The second goal was to test this generalized investment theory on a particularly fertile field for gauging the interaction of political and economic factors: the plant and equipment spending of foreign manufacturing affiliates of U.S. multinationals in Argentina, Brazil, and Mexico. The results of these tests show that the generalized theory is far superior to the traditional alternatives in explaining the real investment of the sample for the 1958-89 period.

Abstract:

There is now a substantial body of evidence that suggests business cycles are asymmetric. However, the evidence has been accumulated using a wide array of statistical techniques and, consequently, is based on various definitions of asymmetry. This paper examines several parametric models that have been used to study asymmetries in real GNP. Although these models capture asymmetries in very different ways, their dynamic properties are remarkably similar.

Abstract:

This paper demonstrates two advantages of well-known block variants of standard algorithms for solving nonlinear systems. First, if a problem is suf­ficiently close to block-diagonal, block algorithms may offer significant speed advantages on a single processor. Second, block Jacobi algorithms can easily and efficiently be distributed across multiple processors. We illustrate the use of a distributed block Jacobi algorithm to solve a large nonlinear macroe­conometric model. For our application, on a four-processor Unix server, the algorithm achieves a speedup factor of more than 6 over the standard algo­rithm on a single processor. A speedup factor of about 2 is due to the added efficiency of the block algorithm on a single processor, and the remaining factor of 3 results from distributing the work over four processors.

Abstract:

A "structural" error correction model (in Boswijk's sense) is a rep­resentation of a conditional error correction model that satisfies certain restrictions. This paper examines the conditions under which such a struc­tural error correction model exists and when the associated representation is of interest. To clarify the nature of such models, several analytical and empirical examples are considered, which violate those conditions. Structural error correction models are economically appealing, but their limitations imply that some care must be taken when applying them in practice.

Keywords: Boswijk, cointegration, conditional models, dynamic specification, encompassing, error correction, exogeneity, general-to-specific modeling, sequential reduction, structural models, vector autoregression.

Abstract:

Using data on the foreign exchange positions of five leading financial institutions, this paper attempts to determine whether the recent profitability of banks' foreign exchange trading is due to superior abilities to forecast exchange rate movements. Overall, the position data provide evidence that the performances of some financial institutions are 1) better than one might expect if their forecasts were purely random and 2) consistent with the possibility that they may possess information that would be valuable in forecasting changes in exchange rates. The conclusions are limited, however, by the possibility that there exists a time-varying risk premium which is correlated with the positions.

Abstract:

Japanese government planners use the average age of the manufacturing capital stock as one measure of their country's international "competitiveness." Compared to the U.S., the data show that Japanese depreciation rates are higher and that capital stocks are younger.

In much of economic analysis, higher rates of depreciation are assumed to result in poorer economic performance. A high depreciation rate lowers the net capital stock, and decreases the level of output.

In this paper, we argue that Japan's high depreciation rate is caused by that country's high rate of technological progress. Hiqh depreciation rates may be a symptom of a rapidly growing economy.

Our results have implications for the international comparison of investment rates. Many economists have compared U.S. and Japanese investment rates net of the depreciation of capital. Presumably, economists are interested in investment rates because of the belief that high rates are positively correlated with a high level of economic performance.

If technological progress causes depreciation rates to be high, however, net investment rates may not be informative about a nation's welfare. Two countries with the same net investment rate can have different rates of per capita output growth if their rates of technological progress are different. We show that the investment rate gross of depreciation may be a better indicator of welfare.

Abstract:

We analyze the foreign exchange trading earnings of large U.S commercial banks over the past several years. In particular, we use several approaches to try to determine to what extent these profits can be attributed either to position-taking by banks or to the provision of intermediation services to bank customers. The results can be summarized as follows. First, banks appear to generate a substantial portion of their foreign exchange earnings from making markets in conventional spot and forward foreign exchange contracts. In addition, some indirect evidence supports anecdotal reports that intermediation in volatility-related products (e.g., options contracts) has been a significantly profitable activity. Finally, on average, positions in currencies do not appear to contribute to profits. Tests applied to monthly and daily data on banks' portfolio positions suggest that banks cannot accurately forecast changes in exchange rates, and that these currency positions account for only a small fraction (if any) of the banks' foreign exchange earnings.

Abstract:

We estimate that returns to scale are close to constant in two-digit gross output data. Value-added data appear instead to give significant increasing returns. We show why, with imperfect competition, value-added estimates are in general meaningless. We use data on intermediate inputs to correct the value-added estimates, and find that returns to scale again appear close to constant. Given that profits are small, our results imply that markups of price over marginal cost are also small.

Abstract:

We study the determinants of the dollar/pound real exchange rate from 1879 to 1914 focusing on the role of fiscal policy. We present a simple dynamic model of the real exchange rate to frame our analysis. The econometric results are based upon the decomposition of the sources of the innovation of the real exchange rate drawn from a structural vector autoregression model. We find little evidence that changes in tariffs and government spending affected the real exchange rate. There is some stronger empirical evidence that shocks to deficits were associated with the fluctuations in the real exchange rate.

Abstract:

One of the salient characteristics of the 1980s is the growth collapse of the Latin American debtor countries. The debt-overhang literature claims that the debt crisis is the main reason for the growth collapse. However, previous empirical work has failed to support this hypothesis. We reexamine this hypothesis further using simulation and econometric methods. We find that once we account for the effects of social inequality on government policy and consumption, the burden of servicing the debt becomes an important factor in explaining the collapse in investment and output growth in Latin America. We draw some conclusions for the 1990s.

Abstract:

To qualify for European Monetary Union (EMU) countries must meet convergence criteria established in the Maastricht treaty of December 1991. However, an analysis of how difficult it will be to meet the convergence criteria is not sufficient to identify the countries most likely to join EMU in 1999. This paper identifies a number of factors in addition to budget deficit reduction required to qualify for EMU such as; the persistence of inflationary expectations; the variance of output shocks; the inflationary bias to monetary policy; and, the political cost to not joining EMU. Moreover, countries follow a policy rule where a large negative output shocks can cause them to abandon the restrictive policies necessary to qualify for EMU and, instead, use policy for stabilization. Concern about such a policy shift could cause increases in interest rates similar to those observed during ERM crises. Data on the above factors are generally not available, except for budgetary data. However, the model shows that data on long-term interest rate differentials with Germany can serve as a measure of their influence. Two approaches, using implied forward interest rate differentials and econometric analysis, are used to evaluate the usefulness of this measure. Both support the use of long-term interest differentials. Overall, it appears likely that EMU will occur in stages as factors are relatively favorable for EMU in Denmark, France, Ireland and the Netherlands. In contrast, for Italy and Spain EMU appears unlikely.

Abstract:

The objectives of this paper are to determine the extent to which various factors contributed to the current recession in Japan and to assess whether the recent behavior of the Japanese economy differs from that in previous recessions. Toward that end, we develop a small, structural macroeconometric model of the Japanese economy and estimate it using data from 1971 Q1 through 1991 Q1, the period just prior to the recent downturn. The important results can be summarized as follows. First, the severity of the current recession probably does not reflect structural economic changes. Second, the poor economic performance in 1991-1993 period was to some extent predictable, reflecting the unwinding of imbalances that developed during the preceding expansion. Finally, unpredictable movements in exchange rates, land and stock prices occurring after 1991 played an important, but not predominant, part in accentuating the downturn, while unusually stimulative fiscal and monetary policies appear to have contributed substantially to GDP during the recession.

Abstract:

The notion of asset market efficiency -- that market prices "fully reflect" all available information -- requires the operation of mechanisms that rapidly incorporate new information into asset prices. Particularly problematic -- both theoretically and empirically -- has been the case where new information is not widely shared, so-called "strong-form" efficiency. This paper examines the relevance of a mechanism for attaining strong-form efficiency based on knowledgeable investors being willing to take large positions in order to eliminate unexploited profit opportunities. We examine theoretically and empirically, the latter using daily stock market data, the impact of a number of factors on the efficacy of this mechanism: the portfolio size and degree of risk aversion of potential investors, the ability to borrow, and the hedging opportunities provided by the stock market.

Abstract:

Evidence is reviewed suggesting that: (a) in market economies financial systems develop and attain maturity during the early stages of industrialization; (b) frictions caused by asymmetric information and the incompleteness of contracts are important in credit markets, and intermediaries play an important role in overcoming them; (c) for a large cross-section of countries financial indicators correlate positively with growth. It is argued that financial intermediaries matter for growth because they moderate the negative effects of incentive frictions, thereby reducing the costs of financing the accumulation of intangible assets like commercial and technical knowledge.

Abstract:

We use disaggregated data on trade flows, production, and trade barriers for 41 countries in 1988 to examine the political and economic determinants of non-tariff barriers, as well as the impact of protection (both tariff and non-tariff) on trade flows. We use an econometric framework that allows for the simultaneous detennination of trade barriers and trade flows. Our results are consistent with political-economy theories of the determinants of protection: even after accounting for industry-specific factors, nations tend to protect industries that are weak, in decline, and threatened by import competition. Countries also give more protection to large industries; these might be thought of as politically important. Nations use tariffs, non-tariff barriers, and exchange rate controls as complementary instruments of protection.

Abstract:

Virtually all we know about the behavior of U.S. imports rests on studies estimating income and price elasticities with postwar data. But anyone examining the evolution of U.S. trade cannot avoid asking whether the postwar period provides enough information to characterize that behavior. From 1890 to 1940, the United States became an increasingly closed economy and experienced the most pronounced fluctuations in income and prices of this century. Is our current understanding of the behavior of U.S. imports consistent with those features of the U.S. economy? Being consistent with the distant past might not appear as relevant for forecasting, but the literature ignoring that past offers a range of elasticity estimates wide enough to suggest that the role of income and prices in determining imports is not known with any precision. This paper offers the first analysis of that role using data since 1890. Estimating the elasticities of the most popular model in the literature with 1890-1992 data, I find that income and prices do not affect imports whereas the opposite conclusion arises with postwar data. The difference in results stems from differences in the time-series properties of the data in the two samples. As an alternative, I consider several models consistent with both optimization and the time-series properties of the data. These models predict substantial secular changes in income and price elasticities and confirm the importance of optimization for characterizing the behavior of U.S. imports. What is new about the results is that only through optimization can one recognize the implications of the evolution of U.S. trade for estimating elasticities.

Abstract:

This paper analyzes official reserve-holding behavior in the EU countries in an attempt to assess the effect EMU might have on official holdings of dollar reserves. A wide range of projections are presented for the effect of EMU on the overall demand for reserves, some based on earlier research results and some on new estimates. In the estimation and simulation of the behavior of EU countries in the last half of the 1980s, the contributions of country-specific factors appear to swamp the systematic components that had been isolated in earlier research. Earlier research results are also used to assess the effect of EMU on the currency composition of reserves. It is argued that official dollar holdings could decline on the order of 35 percent or more from current dollar holdings, although the range of uncertainty is quite large.

Abstract:

We survey the recent experiences of three industrial countries -- New Zealand, Canada, and the United Kingdom -- that have announced specific targets for inflation. Despite success on the part of the targeting central banks in attaining their inflation goals thus far, bond yields suggest that long-term inflation expectations for these countries persistently tended to exceed long-term targets throughout the first several years of targeting. For New Zealand and Canada, survey data generally implied that inflation also was expected to exceed its targeted level in the near term.

Abstract:

This paper surveys the performance of international capital markets and the literature on measuring international capital mobility. Three main functions of a globally integrated and efficient world capital market provide focal points for the analysis. First, asset-price arbitrage ensures that people in different countries face identical prices for a given asset. Second, to the extent that the usual market failures allow, people in different countries can pool risks to their lifetime consumption profiles. Third, new saving, regardless of its country of origin, is allocated toward the world's most productive investment opportunities. The paper evaluates the international capital market's performance of these roles by studying data on international interest-rate differences, international consumption correlations, international portfolio diversification, and the relation between national saving and investment rates. The conclusion is that while international capital mobility has increased markedly over the last two decades, international capital movements remain less free than international movements, even among the industrial countries.

Abstract:

This paper provides evidence on the importance of the credit channel in the transmission of monetary policy. Changes in reserve requirements are used to measure "credit shocks." Reserve requirement changes are often made for regulatory reasons, and hence provide a more exogenous measure of credit shocks than the measures used in previous tests. To distinguish between the "money" and "credit" channels, the significance of the reserve requirements variable is studied in an empirical model that includes other monetary aggregates (either the monetary base or M1). We find that an increase in reserve requirements lowers aggregate investment, real GNP and commercial and industrial (C&I) loans made by banks.

Abstract:

This paper quantifies roughly some potential economic developments in the former Soviet Union (FSU), if substantive economic reforms go forward, and assesses the likely implications of these developments for the rest of the world. It is assumed that a move to world prices for energy and other economic reforms result in a significant increase in FSU net oil exports. This paper develops and analyzes several alternative scenarios, including cases in which the FSU is specified to cooperate with OPEC. The simulations reported in this paper indicate that the FSU countries would be major beneficiaries of market reforms, regardless of what happens on the world oil market. However, only in the case in which the world price of oil declines markedly would the countries outside of OPEC notice to any significant extent the macroeconomic consequences of events in the FSU.

Abstract:

This paper attempts to review the different elements of the international role of the dollar and, where possible, to provide quantitative information about the current scale of dollar use and how it may be changing, including in response to European monetary union. The paper considers the exchange value of the dollar, the dollar as reserve asset, the dollar as vehicle currency, and the macroeconomic implications for the United States of the fiscal actions likely to be required for the participating EU countries to meet the fiscal convergence criteria specified in the Maastricht Treaty. The paper finds that if Federal Reserve policy continues to contribute to confidence in the long-term value of the dollar and the process of change remains gradual, then European monetary union does not pose serious negative consequences for the international role of the dollar.

Abstract:

This paper uses the recent history of the ERM to gain insights into what might happen to exchange rates on the road to EMU. To do this, the paper examines the variability of exchange rates, the transmission of monetary policy between countries, the role of the dollar in ERM exchange rate crises, and ERM members' credibility as measured by the realignment probabilities prior to the September 1992 crisis. We find that behavior of exchange rates has changed over time and differs between ERM and non-ERM currencies. We identify two factors that might have contributed to the September 1992 crisis: high German interest rates and weakness of the U.S. dollar.

Abstract:

Some writers have proposed that under European Monetary Union fiscal policies should be coordinated to reduce the degree of fiscal activism required for macroeconomic stabilization. The paper shows that, in theory, fiscal policy coordination may lower the degree of fiscal flexibility needed to stabilize a common supply shock. However, fiscal policy coordination may raise the degree of fiscal flexibility needed to stabilize an asymmetric demand shock. These theoretical findings are supported by simulations performed with the Multi-Country Model of the Federal Reserve Board. The results suggest that fiscal policy coordination under EMU may require more fiscal activism rather than less. The results also show that, regardless of the shock, fiscal policy coordination among EMU members provides more macroeconomic stabilization to the United States. However, due to the small spillovers between the EC and the United States, the magnitude of this increased stabilization is relatively trivial.

Abstract:

Several recent studies have reached quite different conclusions about which variable is the best indicator of the stance of monetary policy. These differences likely reflect varying assumptions about bank and Federal Reserve behavior. This paper takes a detailed and comprehensive look at the implementation of monetary policy and the identification of monetary policy shocks. The paper first outlines a general analytical model for studying and evaluating monetary policy procedures. The model is then used to estimate both the Fed's operational policy objectives and its intermediate objectives. The results can be summarized as follows: First, monetary policy shocks over the past several years have primarily affected the federal funds rate, even during periods when the Fed was reportedly targeting reserves. In addition, the paper finds a statistically-significant liquidity effect in all periods examined, although the effect is quite small. Finally, there is statistical evidence that suggests that the Fed's intermediate objectives have not been stable over time, and these differences appear to be economically important. Taken together, these results indicate that while monetary policy shocks can be uncovered by regressing the funds rate on appropriate variables in the Fed's information set, the reaction function should be estimated over subperiods rather than over the entire 1959-1993 period.

Abstract:

This paper investigates the empirical relation between inflation and stock returns in ten industrialized countries, with a focus on the implications for links between inflation and the macroeconomy. The stock return decomposition of Campbell and Shiller (1988) is used to determine the extent to which the negative contemporaneous stock return associated with a positive inflation surprise is due to (a) lower future real dividends and (b) higher future required real equity returns. The empirical results suggest that generally higher inflation is associated with both lower real dividends and lower required real equity returns in the future. The evidences favors corporate tax-related theories (e.g. Feldstein (1980))--in which distortions in the tax system cause an increase in inflation to raise the firm's effective cost of capital relative to the return earned by investors in the firm--relative to the "risk premium story" that has been credited to Tobin (1958). However, for the United States and the United Kingdom, estimates of the arbitrage pricing theory (APT) model with a conditionally heteroscedastic inflation risk factor suggest that inflation may have increased the average real cost of equity capital by as much as fifty basis points.

Abstract:

Using data on gross output for two-digit manufacturing industries, we find that an increase in the output of one manufacturing sector has little or no significant effect on the productivity of other sectors. Using value-added data, however, we confirm the results of previous studies which find that output spillovers instead appear large. We provide an explanation for these differences, showing why, with imperfect competition, the use of value-added data leads to a spurious finding of large apparent external effects.

Abstract:

Many recent papers have tried to identify behavioral disturbances in vector autoregressions (VAR's) by imposing restrictions on the long-run effects of shocks. This paper argues that this approach will support reliable struc­tured inferences only if the underlying economy satisfies strong restrictions. Absent restrictions linking long-run and short-run dynamics, every decompo­sition of a VAR is essentially equally consistent with any long-run restriction. Further, dynamic common factor restrictions must hold if the scheme is to work properly in small models estimated using time-aggregated data. The paper illustrates possible consequences of failure of these assumptions using bivariate models to identify aggregate supply and demand disturbances.