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.


Is Auditor Independence Endogenous: Evidence and Implications for Public Policy

By Dino Falaschetti and Michael J. Orlando (RWP 03-13 December 2003; Last Revised June 2004)
This paper examines the extent to which firm-specific levels of auditor-independence are codetermined with alternative inputs to governance production. We identify a number of governance-producing mechanisms that are causally or simultaneously related to auditor independence. These results are shown to be robust to omitted variable bias. Consequently, prescriptive regulation of auditor independence will be at least partly offset by firm adjustments on alternative governance-producing margins.

JEL Codes: G30, G38, M42
Keywords: Corporate Governance, Auditor Independence, Sarbanes-Oxley

Dynamics of Labor Demand: Evidence from Plant-level Observations and Aggregate Implications

By Russell Cooper, John Haltiwanger, and Jonathan L. Willis (RWP 03-12 December 2003)
This paper studies the dynamics of labor demand at the micro and aggregate level. The correlation of hours and employment growth is negative at the plant level and positive in aggregate time series. Further, hours and employment growth are about equally volatile at the plant level while hours growth is much less volatile than employment growth in the aggregate data. Given these differences, we specify and estimate the parameters of a plant-level dynamic optimization problem using simulated method of moments to match plant-level observations. Our findings indicate that non-convex adjustment costs are critical for explaining plant-level moments on hours and employment. Aggregation generates time-series implications which are broadly consistent with observation. Further, we find that a model with quadratic adjustment costs alone can also broadly match the aggregate facts.

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

Disaggregate Evidence on the Persistence of Consumer Price Inflation

By Todd E. Clark (RWP 03-11 December 2003)
This paper uses disaggregate inflation data spanning all of consumption to examine: (i) the persistence of disaggregate inflation relative to aggregate inflation; (ii) the distribution of persistence across consumption sectors; and (iii) whether persistence has changed. Assuming mean inflation to be unchanged within samples, the average persistence of disaggregate inflation is consistently below aggregate persistence. Taking into account an early 1990s shift in mean inflation identified by break tests—including tests applied to systems of disaggregate equations—yields much lower estimates of both aggregate and disaggregate persistence for 1984-02. But with the mean break taken into account, average disaggregate persistence is actually as great as aggregate inflation persistence. A factor model provides a natural framework for interpreting the relationship between aggregate and disaggregate persistence.

JEL Codes: E31, E52, C22
Keywords: inflation dynamics; structural breaks; relative prices; factor models

Inflation Targeting: What Inflation to Target?

By Kevin X.D. Huang and Zheng Liu (RWP 03-10 November 2003; Last Revised February 2004)
This paper derives a central bank's objective function and optimal policy rule for an economy with both CPI and PPI inflation rates. It implements constrained-optimal policy rules with minimal information requirement, and evaluates the robustness of these simple rules when the central bank may not know the exact sources of shocks or nominal rigidities. One of the main findings is that monetary policy that ignores PPI inflation rate or PPI sector shocks can result in significant welfare loss.

JEL Codes: E31, E32, E52
Keywords: Inflation targeting; CPI; PPI; Optimal monetary policy; Implementation; Welfare

Permanent and Transitory Policy Shocks in an Empirical Macro Model with Asymmetric Information

By Sharon Kozicki and P.A. Tinsley (RWP 03-09 November 2003)
Despite a large literature documenting that the efficacy of monetary policy depends on how inflation expectations are anchored, many monetary policy models assume: (1) the inflation target of monetary policy is constant; and, (2) the inflation target is known by all economic agents. This paper proposes an empirical specification with two policy shocks: permanent changes to the inflation target and transitory perturbations of the short-term real rate. The public sector cannot correctly distinguish between these two shocks and, under incomplete learning, private perceptions of the inflation target will not equal the true target. The paper shows how imperfect policy credibility can affect economic responses to structural shocks, including transition to a new inflation target—a question that cannot be addressed by many commonly used empirical and theoretical models. In contrast to models where all monetary policy actions are transient, the proposed specification implies that sizable movements in historical bond yields and inflation are attributable to perceptions of permanent shocks in target inflation.

JEL Codes: E52, D82, D83, E43
Keywords: transmission mechanism, learning, policy credibility, time-varying natural rate, shifting endpoint, inflation target, term structure of interest rates

Portfolio Choice in Tax-Deferred and Roth-Type Savings Accounts

By Richard Johnson (RWP 03-08 September 2003)
This paper uses numerical methods to compare optimal portfolios in tax-deferred and Roth-type savings accounts. Income and payroll taxes affect optimal portfolios in tax-deferred and Roth-type plans differently. For workers with assets in only one type of plan, the optimal equity share in a tax-deferred account could be higher or lower than in a Roth, depending on initial wealth. The differences in optimal portfolios between plans are large at short investment horizons but smaller at longer horizons. This paper also studies the 'asset location' decision of workers with assets in plans of both types.

JEL Codes: G11, G23, H24
Keywords: portfolio choice, retirement saving, individual retirement accounts (IRAs), 401K accounts, and Roth IRAs

Moving to Nice Weather

By Jordan Rappaport (RWP 03-07 September 2003; Last Revised January 2006)
U.S. residents have been moving en masse to places with nice weather. Well known is the migration towards places with warm winters, which is often attributed to the introduction of air conditioning. But people have also been moving to places with cooler, less-humid summers, which is the opposite of what is expected from the introduction of air conditioning. Nor can the movement to nice weather be primarily explained by shifting industrial composition or by elderly migration. Instead, a large portion of weather-related moves appear to be the result of an increased valuation of nice weather as a consumption amenity, probably due to broad-based rising per capita income.

JEL Codes: N920, O510, R110, R120, R230
Keywords: Economic Growth, Population Density, Migration, Quality of Life

The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence

By Todd E. Clark and Michael W. McCracken (RWP 03-06 August 2003)
This paper sifts through potential explanations for the weakness of the existing out-of-sample evidence on the Phillips curve relative to the in-sample evidence, focusing on models relating inflation to the output gap. The out-of-sample evidence could be weaker because, even when the models are stable over time, out-of-sample metrics are less powerful than the usual in-sample Granger causality tests. The weakness of the out-of-sample evidence could also be due to model instability—shifts in the coefficients or residual variance of the inflation-output gap model. This paper evaluates these explanations on the basis of comparisons of the sample forecasting results to results from Monte Carlo simulations of DGPs that either assume stability or allow empirically-identified breaks in the coefficients of the DGP. This analysis shows that most of the weakness of the out-of-sample evidence relative to the in-sample evidence is attributable to instabilities in the model, particularly in the coefficients on the output gap. Theoretical analysis, based on a local alternatives framework, confirms that breaks in the output gap coefficients, but not breaks in residual variances or AR coefficients, can lead to a breakdown in the power of tests of equal forecast accuracy and forecast encompassing.

JEL Codes: E37, E31, C53, C52
Keywords: Phillips curve, forecasts, causality, break test

The Economics of Labor Adjustment: Mind the Gap

By Russell Cooper and Jonathan L. Willis (RWP 03-05 July 2003)
We study inferences about the dynamics of labor adjustment obtained by the "gap methodology" of Caballero and Engel [1993] and Caballero, Engel and Haltiwanger [1997]. In that approach, the policy function for employment growth is assumed to depend on an unobservable gap between the target and current levels of employment. Using time series observations, these studies reject the partial adjustment model and find that aggregate employment dynamics depend on the cross-sectional distribution of employment gaps. Thus, nonlinear adjustment at the plant level appears to have aggregate implications. We argue that this conclusion is not justified: these findings of nonlinearities in time series data may reflect mismeasurement of the gaps rather than the aggregation of plant-level nonlinearities.

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

Currency Competition: A Partial Vindication of Hayek

By Antoine Martin and Stacey L. Schreft (RWP 03-04 July 2003; Revised April 2005)
This paper establishes the existence of equilibria for environments in which outside money is issued competitively. Such equilibria are typically believed not to exist because of a classic overissue problem: if money is valued in equilibrium, an issuer produces money until its value is driven to zero. By backward induction, money cannot have value in the first place. However, for any given finite amount of money outstanding, a monetary economy typically has two equilibria. In one, money has value; in the other, money is not valued because no one expects it to be valued. This paper takes this latter equilibrium seriously and shows that trigger strategies eliminate the overissue problem if agents have beliefs of the following type: if an issuer produces money beyond some threshold amount, then the issuer’s money has no value. This result is very general, applying to any monetary economy in which equilibria with and without valued money exist if the money supply is finite. The paper also compares the allocation achieved by a monopolist to that achieved with competitive issuance in both a search and an overlapping-generations environment. The results depend on the environment considered, but two general conclusions arise. First, it is ambiguous whether competitive issuers can achieve a more desirable allocation than a monopolist. Second, with competitive issuance, a licensing agency can always improve on pure laissez-faire and achieve the efficient allocation in the long run.

JEL Codes: E42, E51, H1
Keywords: Currency Competition, Hayek, Outside money, Private money, Fiat money

Optimality of the Friedman Rule in Overlapping Generations Model with Spatial Separation

By Joseph H. Haslag and Antoine Martin (RWP 03-03 June 2003)
Recent papers suggest that when intermediation is analyzed seriously, the Friedman rule does not maximize social welfare in overlapping generations model in which money is valued because of spatial separation and limited communication. These papers emphasize a trade-off between productive efficiency and risk sharing. We show financial intermediation or a trade-off between productive efficiency and risk sharing are neither necessary nor sufficient for that result. We give conditions under which the Friedman rule maximizes social welfare and show any feasible allocation such that money grows faster than the Friedman rule is Pareto dominated by a feasible allocation with the Friedman rule. The key to the results is the ability to make intergenerational transfers.

JEL Codes: E52, E58, H21
Keywords: Friedman rule, overlapping generations, spatial separation

The Social Value of Risk-free Government Debt

By Stacey L. Schreft and Bruce D. Smith (RWP 03-02 February 2003)
This paper considers whether eliminating the stock of government debt outstanding would reduce welfare. It models an economy with three assets—currency, government bonds, and storage, a transactions role for money, and a demand for liquidity and thus a role for banks. The Friedman rule is not optimal in this economy, so there is potentially a role for interest-bearing, risk-free government bonds. Because the government must raise enough revenue to meet its interest obligations on any bonds outstanding, the social value of government debt hinges on whether the benefits from greater portfolio diversification outweigh the costs associated with the necessary revenue-raising efforts. The paper shows that a positive stock of government debt is optimal only if interest payments on the debt are financed via money creation, agents are not too risk averse, there is a primary government budget deficit, and the economy is operating on the bad side of the Laffer curve. But under these conditions, welfare would be even higher if monetary policy were conducted to put the economy on the good side of the Laffer curve and there were no government bonds outstanding. Thus, there is little support for keeping a stock of interest-bearing, risk-free government debt outstanding.

JEL Codes: E0, E4, E5, E6, H6, G1
Keywords: Government debt, fiscal policy, monetary policy, portfolio allocation

An Examination of Rating Agencies' Actions Around the Investment-Grade Boundary

By Richard Johnson (RWP 03-01 February 2003)
Data on credit ratings by the agencies with the legal status of Nationally-Recognized Statistical Rating Organizations (NRSROs) show some tendency for one-day downgrades that start from the lowest investment grade, BBB-, to travel more grades than those from neighboring grades. This would be consistent with the lower threshold of the NRSROs’ grade BBB- being at a substantial default probability, but also could occur simply because downgrades to junk severely impair some firms’ operations. A comparison of data from a non-NRSRO agency and an NRSRO shows that the latter’s regrades from BBBmoved in the direction of the non-NRSRO’s earlier ratings. This suggests the non-NRSRO defines its grade BBB- more narrowly than the NRSRO.

K JEL Codes: G2, G28, G14
eywords: Credit rankings, default, Egan-Jones Ratings, prediction, Enron, California utilities