The Federal Reserve Bank of Kansas City's Research staff produces a series of working papers presenting results of the department's economic research. These technical papers cover a wide range of economic research topics.


Why are Population Flows so Persistent?

By Jordan Rappaport (RWP 99-13 November 1999; Last Revised:July 2004)
A neoclassical model of local growth is developed by integrating the static equilibrium underlying compensating differential theory as the steady state of a neoclassical growth model. Numerical results show that even very small frictions to labor and capital mobility along with small changes in local productivity or local quality of life suffice to cause highly persistent population flows. Wages and house prices, in contrast, jump most of the way to their new steady state. The model suggests that cross-sectional regressions of local population growth can help to identify past and present changes in the determinants of representative-agent welfare. More generally, it provides a framework for interpreting observed local growth rates.

How Does Labor Mobility Affect Income Convergence?

By Jordan Rappaport (RWP 99-12 December 1999; Last Revised: April 2004)
The neoclassical growth model is extended to allow for mobile labor. Following a negative shock to a small economy's capital stock, capital and labor frictions effect an equilibrium transition path during which wages remain below their steady-state level. Outmigration directly contributes to faster income convergence but also creates a disincentive for gross capital formation. The net result is that across a wide range of calibrations, the speed of income convergence is relatively insensitive to the degree of labor mobility.

Tests of Equal Forecast Accuracy and Encompassing for Nested Models

By Todd E. Clark & Michael W. McCracken (RWP 99-11 October 1999; Last Revised: November 2000)
We examine the asymptotic and finite-sample properties of tests for equal forecast accuracy and encompassing applied to 1-step ahead forecasts from nested parametric models. We first derive the asymptotic distributions of two standard tests and one new test of encompassing. Tables of asymptotically valid critical values are provided. Monte Carlo methods are then used to evaluate the size and power of the tests of equal forecast accuracy and encompassing. The simulations indicate that post-sample tests can be reasonably well sized. Of the post-sample tests considered, the encompassing test proposed in this paper is the most powerful. We conclude with an empirical application regarding the predictive content of unemployment for inflation.

Forecast-Based Monetary Policy

By Jeffery D. Amato & Thomas Laubach (RWP 99-10 October 1999)
A number of central banks use (published or unpublished) forecasts of goal variables as key ingredients in their decisions for instrument settings. This use of forecasts is modelled as a particular form of objective with the minimization of which the central bank is charged. We use an estimated optimization-based model with staggered price and wage setting to analyze the welfare properties of such objectives and their implications for the form of instrument rules. We find that stabilizing expected price inflation at a horizon of two years around target dominates policies of stabilizing inflation at shorter or longer horizons. However, stabilizing all fluctuations, not just forecastable ones, in both wage and price inflation leads to the closest approximation to the welfare-optimal rule.

Monetary Policy in an Estimated Optimization-Based Model with Sticky Prices and Wages

By Jeffery D. Amato & Thomas Laubach (RWP 99-09 October 1999)
This paper serves two purposes. First, it provides estimates of an optimization-based equilibrium model with sticky prices and wages. Second, the estimated model is used to analyze the welfare properties of various interest rate rules for conducting monetary policy. As shown by Erceg et al. (1999), an important feature of this model is that it involves a tradeoff between the variances of price and wage inflation and the output gap. This tradeoff implies that it is desirable for the monetary authority to respond to more than inflation, output, and past interest rates when setting the current interest rate. Indeed, the welfare optimal policy can be approximated with responses to both price and wage inflation and the past interest rate. By contrast, rules that call for a strong response to either detrended output or the output gap result in a much lower level of welfare.

Implications of Rounding and Rebasing for Empircal Analysis Using Consumer Price Inflation

By Sharon Kozicki (RWP 99-08 October 1999)
Monthly CPI inflation rates can be spuriously choppy when constructed using the official CPI, rebased with 1982-84=100. The problem can be traced to rounding that occurs when only one digit after the decimal place is reported in rebased CPI data. This paper compares three CPI measures to illustrate how rounding and rebasing introduce distortions that affect variance properties, alter lag specification in autoregressive models, and "flip" results of unit root tests. To reduce distortions, the paper recommends using either original release data or the CPI rebased with 1967=100.

Borders and Business Cycles

By Todd E. Clark & Eric von Wincoop (RWP 99-07 September 1999)
We document that business cycles of U.S. Census regions are substantially more synchronized than those of European Union countries, both over the past four decades and the past two decades. Data from regions within the four largest European countries confirm the presence of a European border effect --within-country correlations are substantially larger than cross-country correlations. These results continue to hold after controlling for exogenous factors such as distance and size. We consider the role of four factors that have received a lot of attention in the debate about EMU: sectoral specialization, the level of trade, monetary policy and fiscal policy. We find that the lower level of trade between European countries, and to a lesser extent the higher degree of sectoral specialization, can explain most of the observed border effect.

Industrial Specialization and the Asymmetry of Shocks Across Regions

By Sebnem Kalemli-Ozcan, Bent E. Sorenson, & Oved Yosha (RWP 99-06 August 1999; Last Revised: October 2000)
An average adjustment cost which is convex with respect to the rate of gross investment success-fully calibrates a neoclassical growth model to match real world observables including the transition paths of convergence speed, the shadow value of capital, interest rates, and savings rates. Comparing the open-economy and closed-economy versions of the calibrated model shows that relaxing the constraint that domestic savings finance domestic investment effects only a small increase in the growth rate of output per capita: less than one percentage point per year for an economy with current output 20 percent its steady-state level and less than one-half percentage point for an economy with current output 60 percent its steady-state level. Rather than higher growth, the main effect of openness to capital flows is higher current levels of consumption financed by large trade deficits.

JEL Classification: E10, F43, O41
Key words: General Aggregative Models; Economic Growth of Open Economies; One, Two, and Multi-sector Growth Models

Output Fluctuations and Fiscal Policy: U.S. State and Local Governments 1978-1994

By Bent E. Sorenson, Lisa Wu, & Oved Yosha (RWP 99-05 September 1999; Last Revised: December 2000)
What are the cyclical properties of U.S. state and local government fiscal policy? The budget surplus of local and, in particular, state governments is procyclical, smoothing disposable income and consumption of state residents. This happens over both short- and medium-term horizons. Procyclical surpluses are the result of strongly procyclical revenues, and weakly procyclical expenditures. The budgets of trust funds and utilities are procyclical. Federal grants are procyclical, exacerbating the cyclical amplitude of state level income movements; although they smooth the idiosyncratic component of shocks to state output. State and local budget surpluses are affected by balanced budget rules at the short- but not at the medium-term horizon. Further, budgets are less procyclical in conservative states.
JEL Classification: E6, H72

International Transmission of Anticipated Inflation Under Alternative Exchange-Rate Regimes

By Jill A. Holman & Felix K. Rioja (RWP 99-04 December 1998; Last revised: August 1999)
This paper studies the international transmission of anticipated inflation. A two-country, two-good, two-currency, cash-in-advance model is used to examine analytically and numerically the consequences of changes in a country's inflation rate. Domestic monetary policy influences real activity at home through an inflation-tax channel. These real effects are transmitted to the foreign country via fluctuations in the real exchange rate. Under a flexible nominal exchange rate, inflation is a beggar-thy-neighbor policy. Under a fixed nominal exchange rate, each country suffers a welfare loss when one country inflates. The quantitative results are fairly insensitive to variations in the cash-credit mix used to finance investment expenditures.

Do the Spreads Between the E/P Ratio and Interest Rates Contain Information on Future Equity Market Movements?

By Douglas Rolph & Pu Shen (RWP 99-03 March 1999)
We examine the usefulness of the spreads between the e/p ratio of the S&P 500 index and the yields on 3-month and 10-year Treasury securities as indicators of future market conditions. We find that while spreads are not particularly useful in a regression framework, the extreme values of the spreads do contain information on the market outlook. Specifically, for the period of 1967 to 1997, portfolios that only invested in the stock index when the spreads were above their historical tenth percentile levels produced higher average returns (not statistically significant) and lower variances (statistically significant) than the stock index.

The Evolution of Cash Transactions: Some Implications for Monetary Policy

By Stacey L. Schreft & Bruce D. Smith (RWP 99-02 November 1997; Last Revised: February 1999)
This paper considers the implications for monetary policy of a decreasing demand for outside money. It finds that even perpetual declines in the demand for base money pose no threat to the traditional methods employed for conducting monetary policy. The effects of such reductions in the demand for central bank liabilities, however, do depend on how monetary policy is conducted. Four monetary policy regimes are analyzed. With a policy of nominal-interest-rate targeting, a secular decline in the volume of cash transactions unambiguously leads to accelerating inflation. A policy of maintaining a fixed composition of government liabilities leads to accelerating (decelerating) inflation if agents have sufficiently high (low) levels of risk aversion. Inflation targeting produces falling nominal and real interest rates, while a policy of fixing the rate of money growth can easily lead to indeterminacy and endogenous oscillation in interest rates. It is argued that a policy of fixing the composition of government liabilities has several advantages if it is known that agents are not too risk averse and that the asymptotic demand for base money is small. If this information is not known, then interest-rate or inflation targeting have an advantage because their consequences are not sensitive to such environmental features.

Financial Fragility with Rational and Irrational Exuberance

By Roger D. Lagunoff & Stacey L. Schreft (RWP 99-01 October 1998; Last Revised: January 1999)
This article formalizes investor rationality and irrationality, exuberance and apprehension, to consider the implications of belief formation for the fragility of an economy's financial structure. The model presented generates a financial structure with portfolio linkages that make it susceptible to contagious financial crises, despite the absence of coordination failures. Investors forecast the likelihood of loss from contagion and may shift preemptively to safer portfolios, breaking portfolio linkages in the process. The entire financial structure collapses when the last group of investors reallocates their portfolios. If some investors are irrationally exuberant, the financial structure remains intact longer. In fact, financial collapse occurs sooner when almost all investors are rationally exuberant than when they are irrationally exuberant. Additionally, a financial crisis initiated by real shocks is indistinguishable from one caused solely by the presence of rationally apprehensive investors in a fundamentally sound economy. Policies that make portfolio linkages more resilient can improve welfare.

JEL Codes: E44, G1, C73
Keywords: financial fragility, contagion, irrational exuberance, financial crises