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.

2002

Alternative Sources of the Lag Dynamics of Inflation

By Sharon Kozicki and P.A. Tinsley (RWP 02-12 December 2002)
This paper discusses four potential sources of lag dynamics in inflation: non-rational behavior, staggered contracting, frictions on price adjustment, and shifts in the long-run inflation anchor of agent expectations (the perceived inflation target). Expressions for inflation dynamics from structural models which admit these different sources of lag dynamics are contrasted. Empirical results are provided for the U.S. and Canada. The empirical evidence suggests that shifts in the perceived inflation target of monetary policy, less than full policy credibility, and inflation stickiness have all been important features of the historical behavior of inflation.

JEL Codes: E31, E52, D8
Keywords: Inflation persistence, policy credibility, Phillips curve, perceived inflation target, shifting endpoint, staggered contracts, adjustment costs

The Cost of Labor Adjustment: Inferences from the Gap

By Russell Cooper and Jonathan L. Willis (RWP 02-11 December 2002; Last Revised July 2004)
The paper studies labor adjustment costs. Our focus is on inferring the structure of adjustment costs at the micro-level from aggregate observations of employment and hours growth. We specify a dynamic optimization problem at the plant level, allowing for both convex and non-convex adjustment costs. We estimate the parameters of the adjustment process using an indirect inference procedure in which simulated moments are matched with data moments. For this study we use estimates of reduced-form adjustment functions obtained by the "gap methodology" reported in Caballero and Engel (1993) as data moments. Contrary to evidence at the micro level in support of non-convex adjustment costs, our findings indicate that piecewise quadratic adjustment costs are sufficient to match these aggregate moments.

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

Reconciling Bagehot with the Fed's Response to September 11

By Antoine Martin (RWP 02-10 December 2002; Last Revised September 2004)
Bagehot (1873) states that in order to prevent bank panics a central bank should provide liquidity to the market at a "very high rate of interest." This seems to be in sharp contrast with the policy adopted by the Federal Reserve after September 11 when, for a few days, the federal funds rate was very close to zero. This paper shows that Bagehot’s recommendation can be reconciled with the Fed’s policy if one recognizes that Bagehot has in mind a commodity money regime so that the amount of reserves available is limited. A high price for this liquidity allows banks that need it most to self-select. In contrast, the Fed has a virtually unlimited ability to temporarily expand the money supply.

JEL Codes: E4, E5, G2
Keywords: Liquidity Provision, Lender of Last Resort, Bagehot, September 11

Why Does the Cyclical Behavior of Real Wages Change Over Time?

By Kevin X.D. Huang, Zheng Liu, and Louis Phaneuf (RWP 02-09 December 2002)
This paper seeks to understand the evolution of the cyclical behavior of U.S. real wage rates from the interwar period to the post World War II period using a dynamic general equilibrium model that emphasizes demand-driven business cycle fluctuations. In the model, changes in the cyclical behavior of real wages arise endogenously from the interactions between nominal wage and price rigidities and an evolving input-output structure.

JEL Codes: E24, E32, E52
Keywords: Real Wage Cyclicality; Staggered Price and Wage Setting; Input-Output Structure

Implementing Arrow-Debreu Equilibria by Trading Infinitely-Lived Securities

By Kevin X.D. Huang and Jan Werner (RWP 02-08 December 2002)
We show that Arrow-Debreu equilibria with countably additive prices in infinite-time economy under uncertainty can be implemented by trading infinitely-lived securities in complete sequential markets under two different portfolio feasibility constraints: wealth constraint, and essentially bounded portfolios. Sequential equilibria with no price bubbles implement Arrow-Debreu equilibria, while those with price bubbles implement Arrow-Debreu equilibria with transfers. Transfers are equal to price bubbles on initial portfolio holdings. Price bubbles arise in sequential equilibrium under the wealth constraint if some securities are in zero supply or negative prices are permitted, but cannot arise with essentially bounded portfolios.

JEL Codes: D50, G12, E44
Keywords: Arrow-Debreu equilibrium; security markets equilibrium; price bubbles; transfers

Term Premia: Endogenous Constraints on Monetary Policy

By Sharon Kozicki and P.A. Tinsley (RWP 02-07 December 2002)
Monetary policy evaluation using structural macro models suggests that historical monetary policy responds less aggressively to inflation and the output gap than would an optimal policy rule. However, these results are obtained using models with constant term premia. This paper shows how term premia may depend on the policy rule specification and policy rate uncertainty. A more aggressive policy rule involves an economically important increase in term premia. Consequently, conclusions about the specification of optimal monetary policy rules based on counterfactual simulations of models that exclude term premia effects may not be valid.

JEL Codes: E4, E5, G1
Keywords: optimal policy; term structure of interest rates; monetary policy transmission

Measuring R&D Spillovers: On the Importance of Geographic and Technological Proximity

By Michael J. Orlando (RWP 02-06 July 2000, Last Revised September 2002)
Evidence is presented which suggest that an important measure of the apparent geographic localization of R&D spillovers may be an artifact of industrial agglomeration. A production function framework is used to examine the role of geographic and technological proximity for inter-firm spillovers from R&D. The largest spillovers are found to flow between firms in the same industry. However, spillovers within narrowly defined technological groups do not appear to be attenuated by distance. Geographic proximity does appear to attenuate spillovers that cross narrowly defined technological boundaries, suggesting these spillovers may play a role in the agglomeration of a diversity of industrial activity.

JEL Codes: O3, R1, L6
Keywords: R&D, spillovers, industrial agglomeration, geography, empirical studies

Forecast-Based Model Selection in the Presence of Structural Breaks

By Todd E. Clark and Michael W. McCracken (RWP 02-05 August 2002)
This paper presents analytical, Monte Carlo, and empirical evidence on the effects of structural breaks on tests for equal forecast accuracy and forecast encompassing. The forecasts are generated from two parametric, linear models that are nested under the null. The alternative hypotheses allow a causal relationship that is subject to breaks during the sample. With this framework, we show that in-sample explanatory power is readily found because the usual F-test will indicate causality if it existed for any portion of the sample. Out-of-sample predictive power can be harder to find because the results of out-of-sample tests are highly dependent on the timing of the predictive ability. Moreover, out-of-sample predictive power is harder to find with some tests than with others: the power of F-type tests of equal forecast accuracy and encompassing often dominates that of the more commonly-used t-type alternatives. Overall, out-of-sample tests are effective at revealing whether one variable has predictive power for another at the end of the sample. Based on these results and additional evidence from two empirical applications, we conclude that structural breaks can explain why researchers often find evidence of in-sample, but not out-of-sample, predictive content. Keywords: R&D, spillovers, industrial agglomeration, geography, empirical studies

JEL Codes: C53, C12, C52
Keywords: R&D, spillovers, industrial agglomeration, geography, empirical studies

Coyote Crossings: The Role of Smugglers in Illegal Immigration and Border Enforcement

By Joseph H. Haslag, Mark G. Guzman, and Pia M. Orrenius (RWP 02-04 July 2002)
Illegal immigration and border enforcement in the United States have increased concomitantly for over thirty years. One interpretation is that U.S. border policies have been ineffective. We offer an alternative view, extending the current immigration-enforcement literature by incorporating both the practice of people smuggling and a role for non-wage income into a two-country, dynamic general equilibrium model. We state conditions under which two steady state equilibria exist: one with a low level of capital and high amount of illegal immigration and the other with a high level of capital, but relatively little migration. We then analyze two shocks: a positive technology shock to smuggling services and an increase in border enforcement. In the low-capital steady state, the capital-labor ratio declines with technological progress in smuggling, while illegal immigration increases. In the high-capital steady state, a technology shock causes the capital-labor ratio to rise while the effect on migration is indeterminate. We show that an increase in border enforcement is qualitatively equivalent to a negative technology shock to smuggling. Finally we show that a developed country would never choose small levels of border enforcement over an open border. Moreover, a high level of border enforcement is optimal only if it significantly decreases capital accumulation. In addition, we provide conditions under which an increase in smuggler technology will lead to a decline in the optimal level of enforcement.

JEL Codes: E61, F22, J61, O15
Keywords: Smuggling, Illegal Immigration, Border Enforcement, Economic Growth

Endogenous Multiple Currencies

By Antoine Martin (RWP 02-03 May 2002)
I study a model of multiple currencies in which sellers can choose the currency they will accept. I provide conditions that are necessary and sufficient to avoid indeterminacy of the exchange rate. Under these assumptions, all stable equilibria have the property that all sellers in the same country accept the same currency. Thus stable equilibria are either single currency or national currencies equilibria. I also show that currency substitution occurs as an endogenous response to high growth in the stock of a currency.

JEL Codes: F31, F41
Keywords: Multiple Currencies, Currency Substitution

Optimal Pricing of Intra-Day Liquidity

By Antoine Martin (RWP 02-02 May 2002; Last Revised February 2003)
This paper presents a general equilibrium model where intraday liquidity is needed because the timing of payments is uncertain. A necessary and sufficient condition for an equilibrium to be efficient is that the nominal intraday interest rate be zero, even when the overnight rate is strictly positive. Because a market for liquidity may not achieve efficiency, this creates a role for the central bank. I allow for the possibility of moral hazard and study policies commonly used by central banks to reduce their exposure to risk. I show that collateralized lending achieves the efficient allocation, while, for certain parameters, caps cannot prevent moral hazard.

JEL Codes: E42; E58; G21
Keywords: Liquidity Provision, Intraday Interest Rate; Moral Hazard

Market-Timing Strategies That Worked

By Pu Shen (RWP 02-01 May 2002)
In this paper, we present a few simple market-timing strategies that appear to outperform the "buy-and-hold" strategy, with real-time data from 1970 to 2000. Our focus is on spreads between the E/P ratio of the S&P 500 index and interest rates. Extremely low spreads, as compared to their historical ranges, appear to predict higher frequencies of subsequent market downturns in monthly data. We construct "horse races" between switching strategies based on extremely low spreads and the market index. Switching strategies call for investing in the stock market index unless spreads are lower than predefined thresholds. We find that switching strategies outperformed the market index in the sense that they provide higher mean returns and lower variances. In particular, the strategy based on the spread between the E/P ratio and a short-term interest rate comfortably and robustly beat the market index even when transaction costs are incorporated.

JEL Codes: G10, G11, G14
Keywords: Investment, stock market, earning yields