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.

2006

Long-Term Changes in Labor Supply and Taxes: Evidence from OECD Countries, 1956-2004

By Lee Ohanian, Andrea Raffo, and Richard Rogerson (RWP 06-16 December 2006)
We document large differences in trend changes in hours worked across OECD countries over the period 1956-2004. We then assess the extent to which these changes are consistent with the intratemporal first order condition from the neoclassical growth model. We find large and trending deviations from this condition, and that the model can account for virtually none of the changes in hours worked. We then extend the model to incorporate observed changes in taxes. Our findings suggest that taxes can account for much of the variation in hours worked both over time and across countries.

JEL classification: E60, H20, J22
Keywords: Labor supply, wedges, taxes

A Tale of Two Rigidities: Sticky Prices in a Sticky-Information Environment

By Edward S. Knotek (RWP 06-15 December 2006; Last Revised June 2010)
Macroeconomic models with microeconomic foundations afford the opportunity to compare the model’s behavior with empirical evidence at the macro and micro levels. This paper proposes a model that combines two strands of the literature on stickiness to match both sets of empirical facts. (1) Firms acquire information infrequently, as in Mankiw and Reis (2002), resulting in sticky information. (2) Firms face menu costs to change prices, leading to state-dependent sticky prices at the micro level. I estimate key structural parameters via indirect inference and show that a model of sticky prices in a sticky-information environment, combined with considerable real rigidity, is consistent with micro and macro evidence. In this context, sticky prices are not only useful in matching micro data on the size of price changes and the duration between adjustments; they also improve the model’s ability to fit the macro data, as embodied in an empirical Phillips curve.

JEL classification: E31, E32, E40
Keywords: Sticky prices, sticky information, indirect inference

Search Frictions: Matching Aggregate and Establishment Observations

By Russell Cooper, John Haltiwanger, and Jonathan L. Willis (RWP 06-14 December 2006; Last Revised June 2007)
We estimate a search model to match hours, employment, vacancies and unemployment at the micro and macro levels. We establish a set of facts concerning the variability of unemployment and vacancies in the aggregate and the distribution of net employment growth and the comovement of hours and employment growth at the establishment level. A search model with non-convex costs of posting vacancies, establishment-level profitability shocks and a contracting framework to set hours provides a structure to understand these observations. The estimated model is able to capture both the aggregate and establishment-level facts.
 
JEL classification: D8, E3, L16
Keywords: Sticky information, state dependent pricing

Sticky Information and Sticky Prices

By Peter J. Klenow and Jonathan L. Willis (RWP 06-13 December 2006; Last Revised June 2007)
In the U.S. and Europe, prices change at least once a year. Yet nominal macro shocks seem to have real effects lasting well beyond a year. "Sticky information" models, as posited by Mankiw and Reis (2002), Sims (2003), and Woodford (2003), can reconcile micro flexibility with macro rigidity. We simulate a sticky information model in which price setters update information on macro shocks less frequently than information on micro shocks. We then examine price changes in the micro data underlying the U.S. CPI. Empirical price changes react to old information, just as sticky information models predict.
 
JEL classification: D8, E3, L16
Keywords: Sticky information, state dependent pricing

Averaging Forecasts from VARs with Uncertain Instabilities

By Todd E. Clark and Michael W. McCracken (RWP 06-12 November 2006)
A body of recent work suggests commonly–used VAR models of output, inflation, and interest rates may be prone to instabilities. In the face of such instabilities, a variety of estimation or forecasting methods might be used to improve the accuracy of forecasts from a VAR. These methods include using different approaches to lag selection, different observation windows for estimation, (over-) differencing, intercept correction, stochastically time–varying parameters, break dating, discounted least squares, Bayesian shrinkage, and detrending of inflation and interest rates. Although each individual method could be useful, the uncertainty inherent in any single representation of instability could mean that combining forecasts from the entire range of VAR estimates will further improve forecast accuracy. Focusing on models of U.S. output, prices, and interest rates, this paper examines the effectiveness of combination in improving VAR forecasts made with real–time data. The combinations include simple averages, medians, trimmed means, and a number of weighted combinations, based on: Bates-Granger regressions, factor model estimates, regressions involving just forecast quartiles, Bayesian model averaging, and predictive least squares–based weighting. Our goal is to identify those approaches that, in real time, yield the most accurate forecasts of these variables. We use forecasts from simple univariate time series models and the Survey of Professional Forecasters as benchmarks.
 
JEL classification: C53, E37, C32
Keywords: Forecast combination, real-time data, prediction, structural change

Endogenous Monetary Policy Regime Changes

By Troy Davig and Eric M. Leeper (RWP 06-11 September 2006)
This paper makes changes in monetary policy rules (or regimes) endogenous. Changes are triggered when certain endogenous variables cross specified thresholds. Rational expectations equilibria are examined in three models of threshold switching to illustrate that (i) expectations formation effects generated by the possibility of regime change can be quantitatively important; (ii) symmetric shocks can have asymmetric effects; (iii) endogenous switching is a natural way to formally model preemptive policy actions. In a conventional calibrated model, preemptive policy shifts agents’ expectations, enhancing the ability of policy to offset demand shocks; this yields a quantitatively significant “preemption dividend.”

JEL classification: E31, E32, E52, E58
Keywords: Threshold switching, Taylor rule, asymmetry, preemptive policy

Consumption Amenities and City Population Density

By Jordan Rappaport (RWP 06-10 August 2006; Revised January 2008)
Previously titled "Consumption Amenities and City Crowdedness"
Population density varies widely among U.S. metro areas. A simple, static general equilibrium model demonstrates that moderate differences in metro areas’ consumption amenities can cause extremely large differences in their population density. Such amenities are more strongly capitalized into housing prices than into wages. Empirical results suggest that amenities do indeed help to support high density levels and that amenities are becoming a more important determinant of where people choose to live. Matching the empirical correlation between wages and density requires that amenities cause approximately one fifth of the cross-sectional variation in metro population density.

JEL classification: R00, J00, I31
Keywords: Population density, consumption amenities, quality of life, productivity, urban agglomeration

Forecasting with Small Macroeconomic VARs in the Presence of Instabilities

By Todd E. Clark and Michael W. McCracken (RWP 06-09 June 2006)
Small-scale VARs have come to be widely used in macroeconomics, for purposes ranging from forecasting output, prices, and interest rates to modeling expectations formation in theoretical models. However, a body of recent work suggests such VAR models may be prone to instabilities. In the face of such instabilities, a variety of estimation or forecasting methods might be used to improve the accuracy of forecasts from a VAR. These methods include using different approaches to lag selection, observation windows for estimation, (over-) differencing, intercept correction, stochastically time--varying parameters, break dating, discounted least squares, Bayesian shrinkage, detrending of inflation and interest rates, and model averaging. Focusing on simple models of U.S. output, prices, and interest rates, this paper compares the effectiveness of such methods. Our goal is to identify those approaches that, in real time, yield the most accurate forecasts of these variables. We use forecasts from simple univariate time series models, the Survey of Professional Forecasters and the Federal Reserve Board's Greenbook as benchmarks.
 
JEL classification: C53, E17, E37
Keywords: Real-time data, prediction, structural change

Amenities, Local Conditions, and Fiscal Determinants of Factor Growth in Rural America

By Eric Thompson, George Hammond, and Stephan Weiler (RWP 06-08 June 2006)
This paper examines how amenities, asset indicators, and fiscal factors influence the growth in factors of production from 1972 to 1999 in the 466 non-metropolitan labor market areas in the continental United States. In developing our model of non-metropolitan factor markets, we combine the emphasis of Brown et al. (2003) on the affect of taxes and public expenditure policy on labor and capital formation with the emphasis of Beeson et al. (2001) on the importance of climate and natural features on localized population growth. We develop our own measure of capital stock in non-metropolitan areas using data from the Census of Manufacturing for 1967, 1972, 1977, 1982, 1987, and 1992. Results indicate that local taxes discourage both employment growth and manufacturing capital formation, but that local public infrastructure investment and the level of local entrepreneurship encourages employment growth. Amenities such as a favorable climate and the presence of surface water encourage the growth of employment, and greater local wealth, as measured by dividend, interest, and rent income, encourages the formation of manufacturing capital stock. Results fail to support an “export base” approach for rural economies where greater manufacturing capital stock encourages greater employment in a region.
 
JEL classification: R12, R23, R42
Keywords: Regional growth, rural, manufacturing, investment, amenities, taxes, public infrastructure

Targeting Inflation and the Fiscal Balance: What is the Optimal Policy Mix?

By Marcela Meirelles Aurelio (RWP 06-07 June 2006)
This paper identifies optimal policy rules in the presence of explicit targets for both the inflation rate and public debt. This issue is investigated in the context of a dynamic stochastic general equilibrium model that describes a small open economy with capital accumulation, distortionary taxation and nominal price rigidities. The model is solved using a second-order approximation to the equilibrium conditions. Optimal policy features a strong anti-inflation stance and strict fiscal discipline. Targeting a domestic inflation index - as opposed to CPI - improves welfare because it reduces the inefficiencies that stem from both price stickiness and income taxes.
 
JEL classification: D60, E63, F41, O23
Keywords: Fiscal and inflation targets, optimal policy rules, sticky prices, distortionary taxation

A Productivity Model of City Crowdedness

By Jordan Rappaport (RWP 06-06 June 2006)
Population density varies widely across U.S. cities. A simple, static general equilibrium model suggests that moderate-sized differences in cities’ total factor productivity can account for such variation. Nevertheless, the productivity required to sustain above-average population densities considerably exceeds estimates of the increase in productivity caused by such high density. In contrast, increasing returns to scale may be able to sustain multiple equilibria at below-average population densities.
 
JEL classification: O400, R120, R130
Keywords: Population density, productivity, urban agglomeration

Regime Changes and Monetary Stagflation

By Edward S. Knotek (RWP 06-05 May 2006)
This paper examines whether monetary shocks can consistently generate stagflation in a dynamic, stochastic setting. I assume that the monetary authority can induce transitory shocks and longer-lasting monetary regime changes in its operating instrument. Firms cannot distinguish between these shocks and must learn about them using a signal extraction problem. The possibility of changes in the monetary regime greatly improves the ability of money to generate stagflation. This is true whether the regime actually changes or not. If the monetary regime changes on average once every ten years, stagflation occurs in 76% of model simulations. The intuition for this result is simple: increased output volatility due to learning coupled with inflation inertia produce conditions conducive to the emergence of stagflation. The incidence of stagflation can be reduced by a stable, transparent central bank.
 
JEL classification: E52, E31
Keywords: Stagflation, monetary regime changes, signal extraction, sticky information

How and Why Do Consumers Choose Their Payment Methods?

By Stacey L. Schreft (RWP 06-04 April 2006)
This essay provides an overview of the literature on consumer payment behavior. It considers the state of our understanding of how and why consumers choose their payment methods and what is needed to make more headway in understanding consumer payment decisions. It closes by discussing the policy issues that require that we make progress with payments research.

JEL classification: D11, D12, D14, E41
Keywords: payments, means of payment, consumer choice behavior

Real Rigidities and Nominal Price Changes

By Peter J. Klenow and Jonathan L. Willis (RWP 06-03 March 2006)
A large literature seeks to provide microfoundations of price setting for macro models. A challenge has been to develop a model in which monetary policy shocks have the highly persistent effects on real variables estimated by many studies. Nominal price stickiness has proved helpful but not sufficient without some form of "real rigidity" or "strategic complementarity." We embed a model with a real rigidity a la Kimball (1995), wherein consumers flee from relatively expensive products but do not flock to inexpensive ones. We estimate key model parameters using micro data from the U.S. CPI, which exhibit sizable movements in relative prices of substitute products. When we impose a significant degree of real rigidity, fitting the micro price facts requires very large idiosyncratic shocks and implies large movements in micro quantities.
 
JEL classification: E3, L16
Keywords: state dependent pricing, real rigidities

Combining Forecasts From Nested Models

By Todd E. Clark and Michael W. McCracken (RWP 06-02 First version March 2006; Revised September 2008)
Motivated by the common finding that linear autoregressive models often forecast better than models that incorporate additional information, this paper presents analytical, Monte Carlo, and empirical evidence on the effectiveness of combining forecasts from nested models. In our analytics, the unrestricted model is true, but a subset of the coefficients are treated as being local-to-zero. This approach captures the practical reality that the predictive content of variables of interest is often low. We derive MSE-minimizing weights for combining the restricted and unrestricted forecasts. Monte Carlo and empirical analyses verify the practical effectiveness of our combination approach.

JEL classification: C53, C52
Keywords: Forecast combination, predictability, forecast evaluation

Net Exports, Consumption Volatility and International Real Business Cycle Models

By Andrea Raffo (RWP 06-01 March 2006)  
Conventional two-country RBC models interpret countercyclical net exports as reflecting, in large part, the dynamics of capital. I show that, quantitatively, theoretical economies rely on counterfactual terms of trade effects: trade fluctuations, on the contrary, are driven primarily by consumption smoothing, thus generating procyclical net trade in goods. I then consider a class of preferences that embeds home production in a reduced form: consumption volatility increases so that countercyclical net exports reflect primarily a strong relation between income and imports, as in the data. The major discrepancy between theory and data concerns the variability of international prices.

JEL classification: E32, F32, F41
Keywords: Net exports, home production, consumption volatility.