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.

2001

Magazine Prices Revisited

By Jonathan L. Willis (RWP 01-15 December 2001)
This paper examines price adjustment behavior in the magazine industry. In a frequently cited study, Cecchetti (1986) constructs a reduced-form (S,s) model for firms. Cecchetti assumes that a firm's pricing rules are fixed for non-overlapping three-year intervals and estimates the model using a conditional logit specification from Chamberlain (1980). The estimates are inconsistent, however, due to the state-dependent specification of the model. I illustrate the econometric problems in Cecchetti's results through a Monte Carlo exercise and then suggest a method for producing consistent estimates based upon Heckman and Singer (1984). The corrected results provide strong support for models of state-dependent pricing.

JEL Codes: C14, D40, and L16
Keywords: Menu costs, price adjustment, nonparametric methods

Evaluating Direct Multi-Step Forecasts

By Todd E. Clark and Michael W. McCracken (RWP 01-14 December 2001; Last Revised April 2005)
This paper examines the asymptotic and finite-sample properties of tests of equal forecast accuracy and encompassing applied to direct, multi--step predictions from nested regression models. We first derive the asymptotic distributions of a set of tests of equal forecast accuracy and encompassing, showing that the tests have non-standard distributions that depend on the parameters of the data-generating process. We then conduct a range of Monte Carlo simulations to examine the finite-sample size and power of the tests. In these simulations, our asymptotic approximation yields good finite--sample size and power properties for some, but not all, of the tests; a bootstrap works reasonably well for all tests. The paper concludes with a reexamination of the predictive content of capacity utilization for core inflation.

JEL Codes: C53, C12, C52
Keywords: Prediction, long horizon, causality

The Birth and Growth of the Social-Insurance State: Explaining Old-Age and Medical Insurance Across Countries

By David M. Cutler and Richard Johnson (RWP 01-13 December 2001)
We seek to explain why countries have adopted national Old-Age Insurance and Health Insurance programs. Theoretical work has posited several factors that could lead to this adoption: the strain from expanding capitalism; the need for political legitimacy; the desire to transfer to similar people; increased wealth; and the outcome of leviathan government. We relate the probability of a country’s creating social insurance to proxies for each of these theories. We find weak evidence that the probability of adopting a system declines with increases in wealth and with greater ethnic heterogeneity. Still, none of the theories is very strongly related to system adoption. We conclude that social insurance can be politically expedient for many different reasons.

JEL Codes: H11, H51, H55, J14, N00
Keywords: Structure and Scope of Government, Government Expenditures and Health, Social Security and Public Pensions, Economics of the Elderly, Economic History

Implications of Real-Time Data for Forecasting and Modeling Expectations

By Sharon Kozicki (RWP 01-12 November 2001)
This note extends the analysis in Stark and Croushore (2001) with an emphasis on the importance of data vintage for survey forecasts and modeling expectations. For both of these types of empirical exercises, results suggest that the choice of latest available or real-time data is critical for variables subject to large level revisions, but almost irrelevant for variables subject to only small revisions. Other forecasting practices were examined, with some surprising results.

JEL Codes: C5
Keywords: Forecasting, real-time data, modeling expectations, survey data, data vintage

The U.S. as a Coastal Nation

By Jordan Rappaport and Jeffrey Sachs (RWP 01-11 November 2001, Last Revised October 2002)
U.S. economic activity is overwhelmingly concentrated at its ocean and Great Lakes coasts. Economic theory suggests four possible explanations: a present-day productivity effect, a present-day quality-of-life effect, delayed adjustment following a historical productivity or quality-of-life effect, and an agglomeration effect following a historical productivity or quality-of-life effect. Controlling for correlated natural attributes such as the weather and including proximity measures which a priori do not influence quality-of-life, linear regressions suggest that the high coastal concentration of economic activity is primarily due to a productivity effect. Extensively controlling for historical economic density suggests that such a productivity effect continues to be operative today..

JEL Codes: O40, O51, R11, R12
Keywords: Economic Growth, Population Density, Productivity, Quality of Life

A Bottleneck Capital Model of Development

By Jordan Rappaport (RWP 01-10 November 2001; Last Revised July 2005)
A simple augmentation of the Ramsey-Cass-Koopmans growth model allows it to match observed transitions by initially poor economies. A high-convexity installation cost directly dampens investment demand for a first capital input. The resulting scarcity acts as a bottleneck, strongly dampening demand for investment in a complementary capital input as well. The match to observed transitions holds both for narrow and broad interpretations of capital. In either case, the bottleneck capital's share of factor income need not be large.

JEL Codes: E100, O410
Keywords: General Aggregate Models; One, Two, and Multisector Growth Models

The Conduct of Monetary Policy with a Shrinking Stock of Government Debt

By Stacey L. Schreft and Bruce D. Smith (RWP 01-09 October 2001)
In many countries, government-budget surpluses have led to a decline in the amount of federal government debt outstanding. This paper considers the consequences of this development for a central bank that conducts monetary policy through open market operations in treasury debt. A model is presented in which a treasury taxes, spends, and issues debt; a central bank conducts monetary policy through open market operations; and banks are intermediaries for all private savings. The model suggests potentially severe consequences from a shrinking stock of government debt in the absence of a change in the conduct of monetary policy. Specifically, the nominal interest rate and the inflation rate cannot be below their seigniorage-maximizing levels. In effect, a small stock of debt combined with restrictions on a central bank’s portfolio can put the economy on the Pareto inferior side of the seigniorage Laffer curve, with an unnecessarily high inflation rate and nominal interest rate. Moreover, if the government also runs a primary budget deficit, equilibrium can fail to exist. The model presented can yield estimates of how much debt must be outstanding to avoid each situation. Discount-window lending is a feasible—and desirable— alternative method for conducting monetary policy. It relaxes any restrictions on the attainable set of interest rates and inflation rates implied by a decline in the stock of government debt outstanding. Unless the economy is on the Pareto inferior side of the Laffer curve, welfare is higher when discount-window loans are made at market-determined interest rates.

JEL Codes: E4, E5, E6, H6
Keywords: Monetary policy, Fiscal policy, Government debt, Discount Window

Effects of Old-Age Insurance on Female Retirement: Evidence From Cross-Country Time-Series Data

By Richard Johnson (RWP 01-08 October 2001)
I examine the effect of Old-Age Insurance (OAI) on older women’s labour-force participation in fourteen countries since around 1930. Older women’s participation has risen in the US, but has fallen over time in some European countries. The discontinuity of incentives at the state pension age helps separate OAI’s effects from those of social mores and husbands’ retirements. Clear effects of OAI on female retirement emerge slowly in time series. I find that, were Germany to adopt the US Social Security system, the participation rate of German women aged 60-4 would increase by 7 percentage points.

JEL classification: H55, J14, J21, J26
Keywords: Social Security, public pensions, economics of the elderly, labor force and employment, retirement policies.

When Should Labor Contracts be Nominal?

By Antoine Martin and Cyril Monnet (RWP 01-07 September 2001)
We propose a theory to explain the choice between nominal and indexed labor contracts. We find that contracts should be indexed if prices are difficult to forecast and nominal otherwise. Our analysis is based on a principal-agent model developed by Jovanovic and Ueda (1997) in which renegotiation can take place once the nominal value of the agent's output is observed. Their model assumes that agents use pure strategy, with the strong result that only nominal contracts can be written without being renegotiated. But, in reality, we do observe indexed contracts. We resolve this weakness of their model by allowing agents to choose mixed strategies, and find that the optimal contract is indeed nominal for certain parameters. For other parameters, however, we show that the optimal contract is indexed. Our findings are consistent with two empirical regularities: that prices are more volatile with higher inflation, and that countries with high inflation tend to have indexed contracts.

JEL classification: D8, E3, J4
Keywords: Nominal Contracts; Theory of Uncertainty and Information

The Economics of Labor Adjustment: Mind the Gap

By Jonathan L. Willis (RWP 01-06 August 2001)
We study the inferences about labor adjustment costs obtained by the "gap methodology" of Caballero and Engel [1993] and Caballero, Engel and Haltiwanger [1997]. In that approach, the policy function of a manufacturing plant is assumed to depend on the gap between a target and the current level of employment. Using time series observations, these studies reject the quadratic cost of adjustment model and find that aggregate employment dynamics depend on the cross sectional distribution of employment gaps. We argue that these conclusions may not be justified. Instead these findings may reflect difficulties measuring the gap. Thus it appears that the gap methodology as currently employed, may be unable to: (i) identify the costs of labor adjustment and (ii) assess the aggregate implications of labor adjustment costs.

JEL classification: E24, J23, J6
Keywords: Aggregate Employment, Employment, Adjustment Costs

Liquidity Provision vs. Deposit Insurance: Preventing Bank Panics Without Moral Hazard

By Antoine Martin (RWP 01-05 August 2001; Last Revised September 2004)
In this paper I ask whether a central bank policy of providing liquidity to banks during panics can prevent bank runs without causing moral hazard. This kind of policy has been widely advocated, most notably by Bagehot (1873). I show a particular central bank liquidity provision policy can prevent bank panics without moral hazard problems. A key feature of this policy is that the central bank has priority over the assets of the banks it lends to, if they default. I also show that a deposit insurance policy, while preventing runs, can create moral hazard problems.

JEL classification: E58; G21
Keywords: Bank Panics; Liquidity Provision; Deposit Insurance; Moral Hazard.

Should Monetary Policy Respond to Asset Price Bubbles? Some Experimental Results

By Andrew J. Filardo (RWP 01-04 July 2001)
Should central banks respond to asset price bubbles? This paper explores this monetary policy question in a hypothetical economy subject to asset price bubbles. Despite the highly stylized structure of the model, the results reveal several practical monetary policy lessons. First, a monetary authority should generally respond to asset prices as long as asset prices contain reliable information about inflation and output. Second, this finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. Third, a monetary authority’s desire to respond to asset prices falls dramatically as its preference to smooth interest rates rises. Finally, a monetary authority should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices.

JEL classification: E5, G1
Keywords: Monetary policy, asset prices

Dynamic Specifications in Optimizing Trend-Deviation Macro Models

By Sharon Kozicki and P.A. Tinsley (RWP 01-03 July 2001)
As noted in surveys by Goodfriend and King (1997) and Walsh (1998) and exemplified by models analyzed in Taylor (1999), there is encouraging progress in developing optimizing trend-deviation macro models that provide useful insights into the transmission and design of monetary policy. Several controversial features of a minimalist trend-deviation model, with optimizing households, firms, and bond traders, are examined. Dynamic specifications are suggested to improve the data-based realism, while preserving the simplicity, of the minimalist model.

JEL Classification: E3, E5 Keywords: New-Keynesian macro models; optimizing IS; Phillips curve; time-varying term premiums.

What Do You Expect?  Imperfect Policy Credibility and Tests of the Expectations Hypothesis

By Sharon Kozicki and P.A. Tinsley (RWP 01-02 April 2001)
The expectations hypothesis is a theory of the term structure of interest rates that describes a conventional view of the transmission mechanism of monetary policy. According to the expectations hypothesis, bond rates are related to current and expected movements in the policy-controlled rate. However, empirical rejections of the expectations hypothesis are commonplace and lead many to question this description of policy transmission. This paper argues that failure to account for imperfect policy credibility may explain empirical rejections. Empirical rejections may occur even when changing anticipations of future short rates are the primary source of variation in bond rates and the standard term structure transmission channel remains valid.

JEL Classification: E43, E52, E47 Key words: Changepoints, expectations hypothesis, nonstationary inflation, shifting endpoint

Fiscal Reaction Rules in Numerical Macro Models

By Richard Johnson (RWP 01-01 February 2001)
To avoid exploding government debt, numerical macro models require ‘fiscal reaction rules’. Present rules impose arbitrary, backward-looking reaction of taxes to deviations of the debt ratio from a target. Arbitrary models may be poor guides to monetary policy. An optimising fiscal policy-maker would look forward, and maximise an objective function. A simple optimising model implies the future tax rate should be constant. I implement the constant-future-tax rule in the IMF’s MULTIMOD model. Simulations show model outcomes’ sensitivity to the choice of fiscal rule. A constant tax rate induces smoother and hence preferable consumption paths to MULTIMOD’s existing rule.

JEL Classification: C63, E17, E62, H21, H63 Key words: Computational techniques, forecasting and simulation, fiscal policy, optimal taxation, government debt