Board of Governors of the Federal Reserve System

Abstract:

This paper studies the sources of economic fluctuations and their implications for exchange rate regime choice in key Latin American countries. In general, external shocks play a limited role in driving output fluctuations in these countries; this absence of common business cycles undermines the case for fixed exchange rates. On the other hand, although there is some evidence that real exchange rates depreciate in response to adverse external shocks, this depreciation, in turn, tends to contract output in the short run. This suggests that exchange rate rigidity may not be as costly for these economies as conventional economic theory predicts.

Keywords: Economic fluctuations, exchange rate regimes, Latin America, dollarization

Abstract:

This paper provides cumulative distribution functions, densities, and finite sample critical values for the single-equation error correction statistic for testing cointegration. Graphs and response surfaces summarize extensive Monte Carlo simulations and highlight simple dependencies of the statistic's quantiles on the number of variables in the error correction model, the choice of deterministic components, and the estimation sample size. The response surfaces provide a convenient way for calculating finite sample critical values at standard levels; and a computer program, freely available over the Internet, can be used to calculate both critical values and p-values. Three empirical examples illustrate these tools.

Keywords: Critical value, distribution function, Monte Carlo, response surface.

Abstract:

Cointegration requires all the variables in the system to have exact unit roots; accordingly it is conventional for researchers to test for a unit root in each variable prior to a cointegration analysis. Unfortunately, these unit root tests are not powerful. Meanwhile, conventional cointegration methods are not at all robust to slight violations of the requirement that each variable have a unit root. In this paper I show how this difficulty may be circumvented by instrumenting the regressors in the cointegrating regression by deterministic polynomial time trends or by artificially generated random walks.

Keywords: Cointegration, Local to Unit Roots, Robustness, Instrumental Variables

Abstract:

This paper develops measures of emerging market credit spreads for the 1990s, based on data on new bond issues and bank loans, that cover a broader range of borrowers than the Brady bond spreads most commonly used to date. These measures are used to identify the impacts of credit ratings, maturity and currency denomination on spreads. We find important regional differences in spreads across the developing world, even after controlling for risk and maturity. We also identify the evolution of spreads during the 1990s up until the advent of the Asian financial crisis, holding other determinants constant, and find that emerging market spreads declined by more than can be explained by improvements in risk. However, for emerging market instruments with relatively favourable credit ratings, trends in spreads differed considerably from those experienced by Brady bonds. Finally, and in contrast to much market commentary, we find that variations in industrial country short-term interest rates explain relatively little of the decline in emerging market bond spreads. Longer-term trends, perhaps reflecting globalisation, along with the temporary impact of the Mexican financial crisis, may have been more important factors in the behaviour of emerging market spreads.

Keywords: Emerging markets, credit spreads, credit ratings

Abstract:

While much empirical work has addressed the role of monetary policy shocks in exchange rate behavior, conclusions have been clouded by the lack of plausible identifying assumptions. We apply a recently developed inference procedure allowing us to relax dubious identifying assumptions. This work overturns some earlier results and strengthens others: i) Contrary to earlier findings of "delayed overshooting," the peak exchange rate effect of policy shocks may come nearly immediately after the shock; ii) In every otherwise reasonable identification, monetary policy shocks lead to large uncovered interest rate parity (UIP) deviations; iii) Monetary policy shocks may account for a smaller portion of the variance of exchange rates than found in earlier estimates. While (i) is consistent with overshooting, (ii) implies that the overshooting cannot be driven by Dornbusch's mechanism, and (iii) gives reason to doubt whether monetary policy shocks are the main source of exchange rate volatility.

Keywords: Exchange rates, overshooting, forward premium bias, monetary policy, identification

Abstract:

We examine a central bank's endogenous choice of degree of control and degree of transparency, under both commitment and discretion. Under commitment, we find that the deliberate choice of sloppy control is far less likely under a standard central-bank loss function than reported for a less-standard loss function by Cukierman and Meltzer. Under discretion, the maximum degree of control is the only equilibrium. With regard to the degree of transparency, under commitment, a sufficiently patient bank with sufficiently low average inflation bias will always choose minimum transparency. Under discretion, both minimum and maximum transparency are equilibria. We argue that discretion is the more realistic assumption for the choice of control and that commitment is more realistic for the choice of transparency. A maximum feasible degree of control with a minimum degree of transparency is then a likely outcome. The Bundesbank and the Federal Reserve System are, arguably, examples of this outcome.

Keywords: Credibility, transparency, dynamic game

Abstract:

Many authors have investigated the possibility of long memory in asset returns. Generally, very little evidence has been found for long memory in either stock returns or exchange rate returns. This paper applies the log-periodogram regression to a wide range of emerging market stock returns and finds some evidence for positive long memory in 7 of the 17 series considered.

Keywords: Long Memory, Stock Returns, Frequency Domain, Emerging Markets

Abstract:

While it is clear that the volatility of asset returns is serially correlated, there is no general agreement as to the most appropriate parametric model for characterizing this temporal dependence. In this paper, we propose a simple way of modeling financial market volatility using high frequency data. The method avoids using a tight parametric model, by instead simply fitting a long autoregression to log-squared, squared or absolute high frequency returns. This can either be estimated by the usual time domain method, or alternatively the autoregressive coefficients can be backed out from the smoothed periodogram estimate of the spectrum of log-squared, squared or absolute returns. We show how this approach can be used to construct volatility forecasts, which compare favorably with some leading alternatives in an out-of-sample forecasting exercise.

Keywords: Autoregression, Spectrum, Volatility Forecasting, Wiener-Kolmogorov Filter, High Frequency Data, Exchange Rates

Abstract:

I study the potential effects on student performance to be expected from setting mandatory standards in primary and secondary education. To that end, I present a model in which investment in education is indivisible. Thus, if demand exceeds supply at any level of education, allocation is carried out--at least in part--via test scores. The model highlights how the effectiveness of educational standards in altering student performance depends on the college and secondary school education premia, the stringency of standards, and the supply of college education--factors which together determine the competitiveness of college admissions. A relatively high college education premium raises the incentive to finish high school and apply to college, but the marginal benefit of meeting standards or the cost of non-compliance depend on the secondary education premium. Thus, the effects on student performance if education standards are raised may be relatively small when the secondary education premium is relatively low. Moreover, when the supply of higher education is relatively abundant so that college entrance is a non-competitive process, students' incentive to make their best effort diminishes, and in that case, the role of education premia--and therefore of standards--as incentives may be limited.

Keywords: Tests, student performance, education premia, unskilled wage rate

Abstract:

Theoretical models of the relationship between investment and the current account impose restrictions on the joint dynamic behavior of these variables. These restrictions come in two forms. One imposes causal orderings on investment and the current account. The other restriction concerns the permanent responses of these variables to different shocks. We use these restrictions to identify empirically structural shocks from vector autoregressions of investment and the current account for Canada. Under certain identifications, our results support the implications of the intertemporal, small open economy model. However, these results are sensitive to perturbations of the identifications.

Keywords: Small Open Economy, Intertemporal Model, Identification

Abstract:

In this paper the class of admissable tests for unit roots in panel data sets of autoregressive, Gaussian time series will be partially characterized. Using this characterization, several recently suggested tests are shown to be inadmissable. Since the sufficient statistic for this testing problem is multidimensional, there is no uniformly most powerful test; however, in light of the inadmissability result, a new test is proposed that appears to do well relative to existing tests. The test is parameterized in a way that allows the choice of different directional deviations from the null hypothesis over which power is to be maximized, giving added flexibility to researchers.

Keywords: Admissable tests, nonstationarity, panel data

Abstract:

In this paper we develop a modified “early warning system” (EWS) approach to identifying the roles of domestic and external factors in Latin America’s crises. Several probit models of balance-of-payments crises, based on different identified sets of crisis dates, were estimated for six Latin American countries. These models were then used to identify the separate contributions to the probabilities of crisis of domestic and external variables. Our basic finding is that, when the effect of adverse external shocks is removed from the simulated probabilities of devaluation in Latin America, the resultant simulated devaluation probabilities are still high. Taken at face value, these results indicate that devaluation crises in Latin America primarily have been a function of domestic policy and economic imbalances, with exogenous external factors playing only a secondary role. All else equal, this suggests that the adoption of strongly fixed exchange rate regimes in the region may not be too costly in terms of diminished ability to respond to exogenous external shocks.

Keywords: Exchange rate regimes

Abstract:

We use new disaggregated data on consumer prices to determine why there is variability in prices of similar goods across U.S. cities. We address questions similar to those that have arisen in the international context: is this variability purely a result of market segmentation or do sticky nominal prices play a role? We also examine how the degree of tradability of a good influences price variability. Surprisingly, we find that variability is larger for traded goods. We attribute this finding to greater price stickiness for non-traded goods. Distance between cities accounts for a significant amount of the variation in prices between pairs of cities. But we also find that nominal price stickiness plays an even more significant role.

Keywords: Prices, exchange rates, cities

Abstract:

This paper presents a break-down of the export and import performance of select East Asian countries into price and volume effects. The results show that in aggregate, the decline in export revenue experienced by these countries in 1998 was largely due to a 9.1 percent fall in prices, and that export volume actually rose. Similarly, while the import volume of these countries did fall in 1998, the decline was not as great as in the dollar value of those imports, but reflected a greater slide in import prices of 10.8 percent. The fall in import and export prices in the East Asian region began in 1996, before the crisis, but intensified in the Summer and Fall of 1997 as the currency crisis unfolded and has continued through the Spring of 1999. Since the fall in import prices was apparently greater than the corresponding fall in export prices, these countries have collectively seen an improvement in their terms of trade during the crisis, reversing pre-crisis declines. The six countries that form the heart of this study were the source of 12.5 percent of US non-oil imports in 1998, and the accrued benefit to the United States of this price collapse may have been as much as a quarter of the value of these imports over two years.

Keywords: Asian Crisis, Trade Prices

Abstract:

We distinguish learning in a static environment from that in a dynamic environment to show the existence of an important interaction between the development of new technologies and human capital accumulation. Since technological progress creates a more dynamic and uncertain environment, it not only increases the rewards to education and ability but also enhances adaptive skills. The latter in turn determine how effectively new technologies are utilized in production because they help the workforce to innovate and improve new technologies. Thus, the adaptive skills of a workforce are an important link with which inventions and innovations play complementary roles in technological progress. Our results suggest why countries that have comparable levels of aggregate human capital and that are in similar stages of development may differ significantly in how successful they are in implementing new technologies. They also show how the intergenerational transmission of knowledge evolves endogenously with technological change. If technology changes rapidly during the process of development, learning fosters the intergenerational propogation of adaptive skills. In contrast, if technological progress is slow during development, the education of the young reinforces the learning of long-held norms.

Keywords: Inventions, innovations, learning, human capital, growth.

Abstract:

This paper explores issues that arise in implementing monetary policy under conditions of sustained price stability. We discuss several issues that concern the selection of a central bank's inflation objective under such conditions: price measurement; the behavior of other key variables, particularly wages; and the possible existence of other channels through which low inflation could change relationships within the real economy. We present a framework for analyzing monetary policy reaction functions that can illuminate the choices facing policy makers in a regime of price stability. The zero lower bound on nominal interest rates is a potential constraint on monetary policy when nominal interest rates are low on average, which will tend to be the case when long-term inflation is low. We summarize the results of research done at the Federal Reserve to clarify these issues for the United States and consider the availability and effectiveness of alternative policy tools when the nominal interest rate is at the zero bound.

Keywords: Inflation, interest rate policy, zero lower bound, Taylor rules

Abstract:

We formulate an optimizing-agent model in which both labor and product markets exhibit monopolistic competition and staggered nominal contracts. The unconditional expectation of average household utility can be expressed in terms of the unconditional variances of the output gap, price inflation, and wage inflation. Monetary policy cannot replicate the Pareto-optimal equilibrium that would occur under completely flexible wages and prices; that is, the model exhibits a tradeoff between stabilizing the output gap, price inflation, and wage inflation. The Pareto optimum is attainable only if either wages or prices are completely flexible. For reasonable calibrations of the model, we characterize the optimal policy rule. Furthermore, strict price inflation targeting is clearly suboptimal, whereas rules that also respond to either the output gap or wage inflation are nearly optimal.

Keywords: Inflation targeting, sticky wages, sticky prices, staggered contracts

Abstract:

We investigate the role of "country risk" in determining the default risk of firms in emerging markets. In particular, we study the relationship between the secondary market spreads (over hard-currency government bond yields) of bonds issued by emerging market firms and bonds issued by their home governments over the past 3 1/2 years. Our results indicate that market participants do not strictly apply the "sovereign ceiling," under which no firm is more creditworthy than its government. We do find that the spreads of emerging market corporate and government bonds over hard-currency government bonds are highly correlated. The correlation is higher for some industries than for others, and we find no evidence that banks face greater country risk.

Keywords: Credit rating, sovereign ceiling, default risk, emerging market, corporate bond

Abstract:

Productivity rises in booms and falls in recessions. There are four main explanations for procyclical productivity: (i) procyclical technology shocks, (ii) widespread imperfect competition and increasing returns, (iii) variable utilization of inputs over the cycle, and (iv) resource reallocations. Each of these explanations has important implications for macroeconomic modeling. In this paper, we discuss empirical methods for assessing the importance of these explanations. We provide microfoundations for our preferred approach of estimating a first-order approximation to the production function, using a theoretically motivated proxy for utilization. When we implement this approach, we find that variable utilization and resource reallocations are particularly important in explaining procyclical productivity. We argue that the reallocation effects that we identify are not "biases" - instead, they reflect changes in an economy’s ability to produce goods and services for final consumption from given primary inputs of capital and labor. Thus, from a normative viewpoint, reallocations are significant for welfare, and from a positive viewpoint, they constitute potentially important amplification and propagation mechanisms for macroeconomic modeling.

Keywords: Productivity, business cycles, markups

Abstract:

This paper studies the dynamics of trade reorientation experienced when a country joins a regional trade bloc. We find that the joining country's trade orientation toward bloc countries typically rises along an `S'-shaped path. We estimate the size, speed, and timing of this adjustment path for a `typical' joining country, for four trade agreements. We find that, in the European Union (EU), the incumbent bloc countries' share of the joining country's trade typically rose by eighteen percentage points over the course of the adjustment; that this took twelve years; and that the adjustment began four years before the date of accession. MERCOSUR shows a similar pattern in progress, but NAFTA and EFTA are more idiosyncratic. We argue that the data provide strong evidence of anticipatory sunk investments made to prepare for accession.

Keywords: Regionalism, sunk costs

Abstract:

The paper surveys a broad array of data to compare the scope and impact of three emerging-market financial crises: the debt crisis of the 1980s, the Mexican financial crisis of 1994-95, and the current international financial crisis. While certain conventional views regarding the three episodes are supported by the data examined in this paper, we find that in several respects, the current crisis is more similar to prior emerging-market crisis episodes than is commonly believed.

Keywords: Devaluations, financial crises

Abstract:

We construct an optimizing-agent model of a closed economy which is simple enough that we can use it to make exact utility calculations. There is a stabilization problem because there are one-period nominal contracts for wages, or prices, or both and shocks that are unknown at the time when contracts are signed. We evaluate alternative monetary policy rules using the utility function of the representative agent. Fully optimal policy can attain the Pareto-optimal equilibrium. Fully optimal policy is contrasted with both 'naive' and 'sophisticated' simple rules that involve, respectively, complete stabilization and optimal stabilization of one variable or a combination of two variables. With wage contracts, outcomes depend crucially on whether there are also price contracts. For example, if labor supply is relatively inelastic, for productivity shocks, nominal income stabilization yields higher welfare when there are no price contracts. However, with price contracts, outcomes are independent of whether there are wage contracts, except, of course, for the nominal wage.

Keywords: Monetary policy, stabilization, sticky wages, sticky prices, wage contracts, price contracts, inflation targeting, price level targeting, money supply targeting, disequilibrium models

Abstract:

In the chaotic financial environment of Asia in 1997-1998, daily changes in stock prices of about 10 percent became commonplace. This paper analyzes what type of news moved the markets in those days of market jitters. We find that movements were triggered by local and neighbor-country news, with news about agreements with international organizations and credit rating agencies having had the most weight. However, some of those large changes cannot be explained by any apparent substantial news, but seem to have been driven by herd instincts of the markets itself. The evidence suggests that investors over-reacted to bad news.

Keywords: Financial markets, currency crises, news, herding behavior, contagion, crisis management

Abstract:

China's strong growth in the midst of the Asian crisis is striking. We explore features of China’s financial system that helped insulate it from the crisis, and then try to assess whether China has avoided crisis or simply deferred it. We argue that regardless of whether the Asian crisis resulted from weak fundamentals or from "country runs" by investors, it is not surprising that China has survived so far. In a market-oriented system, pressures generally force rapid adjustment when institutions are, or are perceived to be, insolvent; these mechanisms do not operate fully in China. In addition, China’s external accounts remain strong. Even in the absence of capital controls, the strength of these external fundamentals would plausibly preclude a self-fulfilling "country run" on China. Whatever their other effects, capital controls may have played a role in preventing Chinese financial institutions from borrowing excessively abroad, and hence may have helped keep China's external fundamentals strong. Clear risks remain for China’s outlook.

Keywords: China, financial crisis, financial markets, international finance, monetary policy