Board of Governors of the Federal Reserve System

Abstract:

A forecast of the correlation between two asset prices is required to price or hedge an option whose payoff depends on both asset prices or to measure the risk of a portfolio whose return depends on both asset prices. However, a number of factors make it difficult to evaluate forecasts of correlation. We develop a forecast evaluation methodology based on option pricing, extending a technique that Engle et al. (1993) introduced to evaluate volatility forecasts. A forecast of the variance-covariance matrix of joint asset returns is used to generate a trading strategy for a package of simulated options. The most accurate forecast will produce the most profitable trading strategy. The package of simulated options can be chosen to be sensitive to correlation, to volatility, or to any arbitrary combination of the two. In an empirical application, we focus on the ability to forecast the correlation between two stock market indices. We compare the correlation forecasting ability of three more sophisticated models (two GARCH models and a two-state Markov switching model) and two simple moving averages. We find that the more sophisticated models produce better correlation forecasts than the simple moving averages.

Keywords: Forecast evaluation, GARCH, Markov switching, weekend effect

Abstract:

Payments systems have grown considerably and have become increasingly complex, prompting regulators to reassess their roles and renewing interest in historical experiences with payments systems. In this paper, I study the Banco Central System of Mexico, which was a bank note par redemption and clearing system for other payments that operated in Mexico City from 1899 until 1913. I first describe the origins of the Banco Central System. I then consider whether it became prone to behavioral problems, as some observers contended. I find that although Banco Central was less well-positioned to address incentive problems relative to one of its counterparts in the United States (the Suffolk Bank of Boston), it did act to constrain bank behavior. However, considerable government intervention weakened the disciplinary role of Banco Central and thus made the system more prone to collapse.

Keywords: Payments systems, free banking, competitive currencies, central banking

Abstract:

A defining stylized fact associated with exchange-rate-based (ERB) stabilization programs is that their initial phase is characterized by several years of expansion in private consumption and a gradual appreciation of the real exchange rate. In this paper, I argue that standard optimizing models are unable to account for this empirical regularity, as they predict that, except for the date of announcement of the program, an appreciation of the real exchange rate must necessarily be accompanied by a decline in consumption. I show that this price-consumption problem can be resolved by relaxing the assumption of time separability in preferences. Specifically, under habit formation a permanent ERB program generates a smooth boom in consumption and gradual real exchange rate appreciation. A temporary program induces, in addition, a smooth boom-recession cycle with the recession beginning before the abandonment of the program.

Keywords: Inflation stabilization, fixed exchange rates, habit formation, durability

Abstract:

Correlations are crucial for pricing and hedging derivatives whose payoff depends on more than one asset. Typically, correlations computed separately for ordinary and stressful market conditions differ considerably, a pattern widely termed "correlation breakdown." As a result, risk managers worry that their hedges will be useless when they are most needed, namely during "stressful" market situations.

We show that such worries may not be justified since "correlation breakdowns" can easily be generated by data whose distribution is stationary and, in particular, whose correlation coefficient is constant. We make this point analytically, by way of several numerical examples, and via an empirical illustration.

But, risk managers should not necessarily relax. Although "correlation breakdown" can be an artifact of poor data analysis, other evidence suggests that correlations do in fact change over time, though not in a way that is correlated with "stressful" market conditions.

Keywords: Risk management, risk measurement, correlation, conditional correlation, normal distribution, foreign exchange, derivatives

Abstract:

Using annual data from Friedman and Schwartz (1982), Hendry and Ericsson (1991a) developed an empirical model of the demand for broad money in the United Kingdom over 1878-1975. We update that model over 1976-1993, accounting for changed data definitions and clarifying the concept of constancy. With appropriate measures of opportunity cost and credit deregulation, the model's parameters are empirically constant over the extended sample, which was economically turbulent. Policy implications follow for parameter nonconstancy and predictive failure, causation between money and prices, monetary targeting, deregulation and financial innovation, and the effect of policy on economic agents' behavior.

Keywords: Constancy, financial innovation, Friedman and Schwartz, money demand

Abstract:

This paper investigates the impact of globalization on productivity growth and the procyclicality of productivity growth in manufacturing industries in the United States and Germany. For U.S. industries, the analysis suggests that changes in international demand affect productivity growth differently from changes in exposure to international competition. An increase in foreign demand for U.S. exports raises trend productivity growth, but to a lesser degree than does a similar demand shock from domestic buyers. On the other hand, whereas an increase in U.S. imports reduces trend productivity growth of U.S. industries, a loss of market share to imports is associated with gains to productivity growth. For Germany, neither international demand shocks nor exposure to international competition seem to be associated with productivity growth rates, perhaps because German industries experienced a smaller increase in exposure to international competition over the time period. Comparing the U.S. and German results suggests that "going global" may affect productivity growth rates more than simply "being global." As for the procyclical characteristics of productivity growth, the U.S. and German measures evidence different procyclical behavior. For many industries, both U.S. and German labor productivity growth rates exhibit some degree of procyclicality. For German industries, this procyclicality of productivity growth disappears with broader measures of productivity growth that include utilization of capital and intermediate inputs. For U.S. industries, the degree of procyclicality increases when productivity growth is measured on these broader bases. Moreover, in the United States, procyclicality appears to be accentuated by export demand growth and dampened by import demand growth.

Keywords: Globalization, trade, productivity, procyclicality

Abstract:

This paper develops a nonlinear econometric model of the determinants of capital flight for eighteen developing countries over the period 1978 to 1988. During most of the 1980s, capital flight proved difficult to reverse. Besides an uncertain domestic policy environment, costs associated with such an investment decision might have delayed flight reversal. Costs that characterize flight reversal could generate potentially significant barriers to continual adjustment of an investment position. This in turn would generate a nonlinear relationship between flight and its determinants, which reflect the degree of domestic macroeconomic imbalance. To detect the existence, and importance, of cost-driven thresholds we model flight within the context of a friction, or two-threshold Tobit, model. Given the panel data set, we consider a country-specific error component to account for the possibility of unobserved country-specific heterogeneity. To correct for endogeneity among the regressors in the random-effects nonlinear estimation, we implement Newey (1987). While the data seemingly do not support the existence of cost-driven thresholds for flight, the central government surplus, premium for foreign exchange in the black market and the presence of an IMF adjustment program are all significantly related to flight. The negative relationship between fiscal balances and flight highlights the desire by investors to escape future taxation directly, and indirectly via monetization of fiscal deficits, by undertaking capital flight. In devising a framework for reform, that typically entails fiscal consolidation, IMF supervision, endorsement and surveillance lend credibility to reform and reassure investors.

Keywords: Capital flight, macroeconomic risk, panel data, two-threshold Tobit model

Abstract:

Aggregate productivity and aggregate technology are meaningful but distinct concepts. We show that a slightly-modified Solow productivity residual measures changes in economic welfare, even when productivity and technology differ because of distortions such as imperfect competition. We then present a general accounting framework that identifies several new non-technological gaps between productivity and technology, gaps reflecting imperfections and frictions in output and factor markets. Empirically, we find that these gaps are important, even though we abstract from variations in factor utilization and estimate only small average sectoral markups. Compared with productivity growth, our measured technology shocks are significantly less correlated with output, and are essentially uncorrelated with inputs. Our results imply that calibrating dynamic general equilibrium models as if Solow residuals were technology shocks confuses impulses and propagation mechanisms.

Keywords: Productivity, technology, aggregation, welfare

Abstract:

At a macroeconomic level, infrastructure and productivity are positively correlated in the United States and other countries. However, it remains unclear whether this correlation reflects causation, and if so, whether causation runs from infrastructure to productivity, or the reverse. This paper focuses on roads, and finds that vehicle-intensive industries benefit disproportionately from road-building: when road growth changes, productivity growth changes more in industries that are more vehicle intensive. These results suggest that causation runs from infrastructure to productivity. However, there is no evidence that at the margin, roads offer an above-average return; road-building in essence offered a one-time boost to the level of productivity in the 1950s and 1960s. Finally, it appears that congestion significantly affects road-services at the margin, although congestion does not appear important before 1973.

Keywords: Public investment, productivity, growth

Abstract:

This paper examines the ability of a simple stylized general equilibrium model that incorporates nominal wage rigidity to explain the magnitude and persistence of the Great Depression in the United States. The impulses to our analysis are money supply shocks. The Taylor contracts model is surprisingly successful in accounting for the behavior of major macroaggregates and real wages during the downturn phase of the Depression, i.e., from 1929:3 through mid-1933. Our analysis provides support for the hypothesis that a monetary contraction operating through a sticky wage channel played a significant role in accounting for the downturn, and also provides an interesting refinement to this explanation. In particular, both the absolute severity of the Depression's downturn and its relative severity compared to the 1920-21 recession are likely attributable to the price decline having a much larger unanticipated component during the Depression, as well as less flexible wage-setting practices during this latter period. Another finding casts doubt on explanations for the 1933-36 recovery that rely heavily on the substantial remonetization that began in 1933.

Keywords: Dynamic general equilibrium model, sticky wages

Abstract:

Recent research has challenged the ability of sticky price general equilibrium models to generate a contract multiplier, i.e., an effect of a monetary innovation on output that extends beyond the contract interval. We show that a simple dynamic general equilbrium model that includes "Taylor-style" (1980) wage and price contracts can account for a substantial contract multiplier under various assumptions about the structure of the capital market. Most interestingly, our results do not rely on a high intertemporal labor supply elasticity or elastic supply of capital: our preference specification is standard (logarithmic), and we can account for a strong contract multiplier even when the aggregate stock of capital is fixed. Finally, our analysis highlights the importance of the income elasticity of money demand in accounting for output persistence.

Keywords: Contract multiplier, sticky price model

Abstract:

This paper presents a general framework to address several issues that have arisen in recent work that investigates purchasing power parity (PPP) and other inter-regional relative price movements: (1) How can we model real exchange rate movements in a consistent manner, so that our model for the real exchange rate for country B relative to country C is commensurate with our models for country A/ country B and country A/ country C real exchange rates? For example, can things be modeled so that our tests do not depend on the "base country"? (2) How should we handle correlation across real exchange rates in panel tests of PPP? (3) Are speeds of adjustment toward PPP different for intra-national, cross-national and cross-continental real exchange rates? (4) Is the innovation variance different for intra-national, cross-national and cross-continental real exchange rates; and, if so, how does that influence how we model and test PPP?

Keywords: Purchasing power parity, panel unit roots tests

Abstract:

This paper describes the structure and illustrates the key features of FRB/Global, a large-scale macroeconomic model used in analyzing exogenous shocks and alternative policy responses in foreign economies and in examining the impact of these external shocks on the U.S. economy. FRB/Global imposes fiscal and national solvency constraints and utilizes error-correction mechanisms in the behavioral equations to ensure the long-run stability of the model. In FRB/Global, expectations play an important role in determining financial market variables and domestic expenditures. Simulations can be performed using either limited-information ("adaptive") or model-consistent ("rational") expectations.

Keywords: Macroeconometric models, long-run stability, rational expectations, fiscal and monetary policy, European Monetary Union

Abstract:

The goal of this study is the derivation and application of a direct characterization of the inverse of the covariance matrix central to portfolio analysis. As argued below, such a specification, in terms of a few primitive constructs, provides new and illuminating expressions for such key concepts as the optimal holdings of a given risky asset and the slope of the risk-return efficiency locus faced by the individual investor. The building blocks of the inverse turn out to be the regression coefficients and residual variance optained by regressing the asset's excess return on the set of excess returns for all other risky assets.

Keywords: Risk, uncertainty, optimal hedge

Abstract:

When per capita income is low, increases in income inequality make macroeconomic cycles less severe. We present a model in which access to credit is based on earnings potential. If low as well as middle income individuals are credit constrained, increases in income inequality lead to smaller fluctuations in aggregate consumption and output. Empirical evidence from cross-country data supports the view that greater income inequality causes lower variation of real consumption and output growth in low income countries. When per capita income is high, however, this effect is reversed.

Keywords: Business cycles, credit constraints

Abstract:

Risk management information systems are designed to overcome the problem of aggregating data across diverse trading units. The design of an information system depends on the risk measurement methodology that a firm chooses. Inherent in the design of both a risk management information system and a risk measurement methodology is a tradeoff between the accuracy of the resulting measures of risk and the burden of computing them. Technical progress will make this tradeoff more favorable over time, leading firms to implement more accurate methodologies, such as full revaluation of nonlinear positions. The current and likely future improvements in risk management information systems make feasible new ways of collecting aggregate data on firms' risk-taking activities.

Keywords: Market risk, Value at Risk, risk measurement

Abstract:

I test for the existence of a bank lending channel of monetary policy transmission. I identify bank lending channel effects with a simple model of bank behavior incorporating long-term customer relationships. The model suggests that when a large fraction of bank assets is held in loans, contractionary monetary policy shocks are more likely to cause a cutback in bank lending, in turn reducing real economic activity. This implication of the model is supported in the data. I conduct a "horse race" between the bank lending channel and two alternative non-user-cost-of-capital channels of monetary transmission. The bank lending channel is the strongest of the three. The ability of the fraction of bank assets held in loans to predict how the strength of monetary policy transmission varies over time should be of interest to both theorists and forecasters of business cycles.

Keywords: Bank loans, credit channel, two-stage regression

Abstract:

In trying to explain the balance-of-payments and banking crises of 1994-95 that erupted in Mexico, observers have pointed to various effects of the substantial capital inflows that took place in the preceding half decade. It has been argued that these inflows contributed to rapid monetary growth, real appreciation of the peso, and the widening of Mexico's current account deficit. In addition, by making available credit for consumption loans at a time when investment spending in Mexico was not yet ready to grow rapidly, these inflows may have contributed to the fall in Mexico's savings rate.

This paper looks at the effect of capital flows on macroeconomic and financial variables in Mexico during the 1980s and 1990s and compares Mexico's experience with that of a cross-section of Pacific Basin countries. In particular, we attempt to gauge the effect of capital flows on money growth, interest rates, consumption, and investment. We do find evidence of an independent effect of capital flows on monetary conditions and domestic demand, controlling for certain other domestic factors. However, these inflows appear not to have altered substantially the basic trajectories of money, consumption, and investment in the recipient countries.

Keywords: Capital flows, Mexico

Abstract:

Gold has both private uses (depletion uses and service uses) and government uses. It can be obtained from mines with high extraction costs (about $300 per ounce) or from above ground stocks with no extraction costs. Governments still store massive stocks of gold. Making government gold available for private uses through some combination of sales and loans raises welfare from private uses by removing two types of inefficiencies. For given private uses, there is a production inefficiency if costless government gold is withheld while costly gold is taken from mines. There are use inefficiencies if costless government gold is withheld from private users. We assess both qualitatively and quantitatively the gain in welfare and its distribution.

Any policy in a class maximizes welfare from private uses. One policy involves selling all government gold immediately. Another involves lending all remaining government gold in every period and selling government gold gradually after some future time. Government uses might require gold ownership but not gold storage. If so, any loss in welfare from government uses would be much smaller under the policy involving lending and selling gradually.

We construct and calibrate a model of the gold market. We prove that governments always obtain more revenue by making their gold available sooner. For a representative set of parameters, there is a gain in total welfare (discounted economic surplus) of $130 billion (1997 dollars) if governments act now instead of twenty years from now. Before any redistribution, governments gain $128 billion, and the private sector gains $2 billion. According to our measure, a large share of the gain (37%) comes from removing the production inefficiency.

Keywords: Gold, exhaustible resource, extraction of a durable

Abstract:

There has been much talk in the popular press about the difficulty of attaining credibility in the bond markets for the low-inflation policies that have been adopted by a number of central banks in recent years. This credibility problem is particularly severe for those countries that have a history of high inflation. Gaining credibilty is often viewed in the context of learning by the public about the central bank's true intentions. However, this paper argues that a more important aspect of credibility--at lease for long-term inflation expectations--may be public views about how future changes in personnel, electoral results, or economic shocks may affect central bank behavior. In other words, there is always a positive probability that the current regime will end. Views about the nature of possible future regimes are likely to be influenced by observed past regimes.

Keywords: Central bank, credibility, inflation target, monetary policy

Abstract:

Since Mexico's devaluation of the peso in 1994, some observers have called for policies designed to keep the real exchange rate highly competitive in order to promote exports and output growth. However, over the past few decades, devaluations of the real exchange rate have been associated nearly exclusively with economic contraction, while real appreciations have been followed almost invariably by expansions in economic activity. The purpose of this paper is to attempt to disentangle the possible factors underlying this correlation--(1) reverse causation from output to the real exchange rate, (2) spurious correlation with third factors such as capital account shocks, and (3) temporary contractionary effects of devaluation--and determine whether, once those factors are accounted for, a positive, long-run effect of real depreciation on output can be identified in the data. Based on the results of a VAR model designed to explore the linkages between the real exchange rate and output, we conclude that even after sources of spurious correlation and reverse causation are controlled for, real devaluation has led to high inflation and economic contraction in Mexico. While changes in Mexico's economic structure and financial situation may qualify the future applicability of this conclusion, we view our findings as pointing to substantial risks to targeting the exchange rate at too competitive a level.

Keywords: Contractionary devaluation, Mexico

Abstract:

This paper analyzes capital flight from a group of seventeen developing nations over the period 1978 to 1993. The paper briefly discusses several empirical definitions of capital flight and presents estimates of capital flight for the sample based on some of these measures. In general, the data reveal periodic episodes of dramatic flight through the late 1980s, at which point many nations began to experience strong capital inflows. Anecdotal evidence for the nations in our sample underpins our hypothesis that capital flight is driven by a heightened, pervasive risk which reflects the degree of domestic macroeconomic imbalance which is domestically undiversifiable. Our econometric model of the determinants of capital flight extends previous empirical studies of flight by expanding both the cross section of nations and time horizon of analysis. Given the panel data set, we consider a country specific error component to account for the possibility of unobserved country heterogeneity and employ fixed- effects and random-effects estimation. We instrument for potentially endogenous explanatory variables and in doing so consider a fixed-effects system. The results, based on several different measures of flight, highlight the importance of modelling flight with a country specific error component. While other proxies of the risk associated with macroeconomic imbalance are not significant, the central government surplus is negatively, statistically significantly related to flight. This highlights the motivation of investors to move capital both to escape future taxation directly and indirectly via monetization of deficits. Therefore, even when taking into account other measures of risk, the higher taxation risk, both directly and indirectly through expectations of future inflation, dominates the regressions.

Keywords: Macroeconomic risk, panel data

Abstract:

We quantify the contribution of various driving forces to state-level movements in unemployment rates and employment growth from 1956 to 1992. Our story of regional fluctuations in the U.S. economy has a large cast of players -- including government contract awards and the basing of military personnel -- but oil price shocks have been the leading actor since 1973. Beyond the magnitude and abruptness of oil price movements, the explanation for their pronounced regional effects has three essential elements: (i) regions differ in industry mix, (ii) industries differ in sensitivity to movements in the relative price of oil, and (iii) the reallocation of productive factors across industries and regions is costly and time-consuming.

Our study provides estimates of the costs of creating regional jobs and reducing regional unemployment through the awarding of military contracts. Based on the BLS measure of state employment, our baseline specifications imply that creating one local job-year requires national government purchases from local firms in the amount of $56,000 to $91,000 (measured in 1982 dollars). The estimated cost of job creation is more than twice as large for the broader CPS measure. Econometric specifications that consider demand spillovers across state boundaries deliver job creation cost estimates roughly 40-45% smaller.

We find asymmetric unemployment responses to positive and negative regional shocks. Negative shocks -- whether involving increases in oil prices, or scaling back of contract awards and military bases -- have a greater impact than equal-sized positive shocks. This evidence implies that shocks to the spatial structure of demand (e.g., a reallocation of government contract awards) cause short-run increases in aggregate unemployment.

State-level unemployment responses to regional shocks persist for several years. Net migration of people and workers between states is the dominant equilibrating mechanism that brings regional unemployment rates back into alignment.

Keywords: Regional labor markets, oil prices, defense expenditures, unemployment

Abstract:

Our paper analyses the effects of restrictions on capital mobility on the output-inflation tradeoff. Using a stochastic version of the Mundell-Fleming model, we establish a theoretical presumption that an increase in restrictions on capital mobility should make the tradeoff parameter smaller, that is, a given change in the inflation rate should be associated with smaller movements in output. To measure the extent to which countries restrict capital movements, we construct an index using data from the IMF's Annual Report on Exchange Rate Arrangements and Exchange Restrictions. The estimates of the output-inflation tradeoff parameter are obtained from studies by Lucas (1973), Ball, Mankiw and Romer (1988) and others. Consistent with the theoretical presumption, countries with greater restrictions on capital controls have a smaller tradeoff parameter, that is, a steeper Phillips curve. This result holds after controlling for the impact of variability of aggregate demand [as suggested by Lucas (1973)] and mean inflation [as suggested by Ball, Mankiw and Romer (1988)] on the tradeoff parameter.

Keywords: Output-inflation tradeoff, capital mobility, capital controls, openness

Abstract:

We characterize the LSE approach by its implications for reduced-form modeling and structural interpretations. Much of what has come to be associated with the LSE methodology involves the approach to fitting reduced forms, and can be thought of as a pragmatic solution to problems created by short samples plagued by serial correlation. The policy analysis one might be able to do with an LSE model, on the other hand, hinges on structural identification arguments which do not meet the classic Cowles Commission standards, and is thus suspect.

Keywords: Reduced form, identification, instruments