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.

2009

Monetary-Fiscal Policy Interactions and Fiscal Stimulus

By Troy Davig and Eric M. Leeper (RWP09-12 November 2009)
Increases in government spending trigger substitution effects―both inter- and intra-temporal―and a wealth effect. The ultimate impacts on the economy hinge on current and expected monetary and fiscal policy behavior. Studies that impose active monetary policy and passive fiscal policy typically find that government consumption crowds out private consumption: higher future taxes create a strong negative wealth effect, while the active monetary response increases the real interest rate. This paper estimates Markov-switching policy rules for the United States and finds that monetary and fiscal policies fluctuate between active and passive behavior. When the estimated joint policy process is imposed on a conventional new Keynesian model, government spending generates positive consumption multipliers in some policy regimes and in simulated data in which all policy regimes are realized. The paper reports the model's predictions of the macroeconomic impacts of the American Recovery and Reinvestment Act's implied path for government spending under alternative monetary-fiscal policy combinations.

JEL Nos.: E31, E52, E6, E64
Keywords: fiscal policy, government multiplier, monetary-fiscal interactions

Nested Forecast Model Comparisons: A New Approach to Testing Equal Accuracy

By Todd E. Clark and Michael W. McCracken (RWP09-11 July 2009)
This paper develops bootstrap methods for testing whether, in a finite sample, competing out-of-sample forecasts from nested models are equally accurate. Most prior work on forecast tests for nested models has focused on a null hypothesis of equal accuracy in population ― basically, whether coefficients on the extra variables in the larger, nesting model are zero. We instead use an asymptotic approximation that treats the coefficients as non-zero but small, such that, in a finite sample, forecasts from the small model are expected to be as accurate as forecasts from the large model. Under that approximation, we derive the limiting distributions of pairwise tests of equal mean square error, and develop bootstrap methods for estimating critical values. Monte Carlo experiments show that our proposed procedures have good size and power properties for the null of equal finite-sample forecast accuracy. We illustrate the use of the procedures with applications to forecasting stock returns and inflation.

JEL Nos.: C53, C12, C52
Keywords: mean square error, prediction, reality check

In-Sample Tests of Predictive Ability: A New Approach

By Todd E. Clark and Michael W. McCracken (RWP09-10 July 2009)
This paper presents analytical, Monte Carlo, and empirical evidence linking in-sample tests of predictive content and out-of-sample forecast accuracy. Our approach focuses on the negative effect that finite-sample estimation error has on forecast accuracy despite the presence of significant population-level predictive content. Specifically, we derive simple-to-use in-sample tests that test not only whether a particular variable has predictive content but also whether this content is estimated precisely enough to improve forecast accuracy. Our tests are asymptotically non-central chi-square or non-central normal. We provide a convenient bootstrap method for computing the relevant critical values. In the Monte Carlo and empirical analysis, we compare the effectiveness of our testing procedure with more common testing procedures.

JEL Classification: C53, C52, C12
Keywords: predictability, forecast accuracy, in-sample

Reply to Generalizing the Taylor Principle: A Comment

By Troy Davig and Eric M. Leeper (RWP09-09 June 2009)
Farmer, Waggoner, and Zha (2009) show that a new Keynesian model with a regime-switching monetary policy rule can support multiple solutions that depend only on the fundamental shocks in the model. Their note appears to find solutions in regions of the parameter space where there should be no bounded solutions, according to conditions in Davig and Leeper (2007). This puzzling finding is straightforward to explain: Farmer, Waggoner, and Zha (FWZ) derive solutions using a model that differs from the one to which the Davig and Leeper (DL) conditions apply. In addition, FWZ impose cross-equation restrictions between behavioral relations and the exogenous driving process. This rather special assumption undermines the traditional sharp distinction in micro-founded general equilibrium models between 'deep' parameters and the parameters governing the exogenous processes.

JEL Classification Numbers: G21, D14
Keywords: payday lending, price ceilings, strategic pricing

Real-Time Density Forecasts from VARs with Stochastic Volatility

By Todd E. Clark (RWP09-08 June 2009)
Central banks and other forecasters are increasingly interested in various aspects of density forecasts. However, recent sharp changes in macroeconomic volatility – such as the Great Moderation and the more recent sharp rise in volatility associated with greater variation in energy prices and the deep global recession – pose significant challenges to density forecasting. Accordingly, this paper examines, with real-time data, density forecasts of U.S. GDP growth, unemployment, inflation, and the federal funds rate from BVAR models with stochastic volatility. The results indicate that adding stochastic volatility to BVARs materially improves the real-time accuracy of density forecasts.

JEL Classification: C53, C32, E37
Keywords: Steady-state prior, Prediction, Bayesian methods

Payday Loan Pricing

By Robert DeYoung and Ronnie J. Phillips (RWP09-07 February 2009)
We estimate the pricing determinants for 35,098 payday loans originated in Colorado between 2000 and 2006, and generate a number of results with implications for public policy.  We find evidence consistent with classical price competition early in the sample, but as time passed these competitive effects faded and the data become more consistent with a variety of strategic pricing practices.  On average, loan prices moved upward toward the legislated price ceiling over time, consistent with implicit collusion facilitated by price focal points.  Large multi-store payday firms tended to charge higher prices than independent single-store operators, but were less likely to exploit inelastic demand near military bases and in largely minority neighborhoods.  Of the three loan pricing measures used in our analysis, the annual percentage interest rate (APR) favored by regulators and analysts performed poorly.

JEL Classification Numbers: G21, D14
Keywords: payday lending, price ceilings, strategic pricing

Time Variation in the Inflation Passthrough of Energy Prices

By Todd E. Clark and Stephen J. Terry (RWP09-06 February 2009)
From Bayesian estimates of a vector autoregression (VAR) which allows for both coefficient drift and stochastic volatility, we obtain the following three results. First, beginning in approximately 1975, the responsiveness of core inflation to changes in energy prices in the United States fell rapidly and remains muted. Second, this decline in the passthrough of energy inflation to core prices has been sustained through a recent period of markedly higher volatility of shocks to energy inflation. Finally, reduced energy inflation passthrough has persisted in the face of monetary policy which quickly became less responsive to energy inflation starting around 1985.

JEL Classification Numbers: C11, E31, E52
Keywords: oil price shocks, monetary policy, time-varying parameters

Decomposing the Declining Volatility of Long-Term Inflation Expectations

By Todd E. Clark and Troy Davig (RWP09-05 February 2009)
The level and volatility of survey-based measures of long-term inflation expectations have come down dramatically over the past several decades. To capture these changes in inflation dynamics, we embed both short- and long-term expectations into a medium-scale VAR with stochastic volatility. The model documents a marked decline in the volatility of expectations, but also reveals a shift in the factors driving their movement. Throughout the 1980s and early 1990s, the majority of the variance in long-term expectations were driven by 'own' shocks. Beginning in the mid-1990s, however, the factors explaining the variance of long-term expectations began shifting amidst an overall decline in volatility. At the end of the sample in 2008, innovations to measures of inflation and output account for the majority of the remaining low-level of volatility in long-term expectations. We document a shift in monetary policy towards more systematic behavior that precedes the shift in the factors driving long-term expectations.
 
JEL Classification Numbers: E31, E32, E52
Keywords: Survey-based inflation expectations, stochastic volatility, Bayesian econometrics

Yield Curve in an Estimated Nonlinear Macro Model

By Taeyoung Doh (RWP09-04 February 2009; Revised February 2011)
This paper estimates a sticky price macro model with US macro and term structure data using Bayesian methods. The model is solved by a nonlinear method. I find that the degree of nominal rigidity is important for identifying macro shocks that affect the yield curve. When prices are more flexible, a slowly varying inflation target of the central bank is the main driver of the overall level of the yield curve by changing long-run inflation expectations. In contrast, when prices are more sticky, a highly persistent markup shock is the main driver. The posterior distribution of the parameters in the model is found to be bi-modal. The degree of nominal rigidity is high at one mode (“sticky price mode”) but is low at the other mode (“flexible price mode”). The posterior probability of each mode is sensitive to the use of observed proxies for inflation expectations. Ignoring additional information from survey data on inflation expectations significantly reduces the posterior probability of the flexible price mode. Incorporating this additional information suggests that yield curve fluctuations can be better understood by focusing on the flexible price mode. Considering nonlinearities of the model solution also increases the posterior probability of the flexible price mode, although to a lesser degree than using survey data information.

JEL Classification Numbers: C32, E43, G12
Keywords: Bayesian Econometrics, DSGE Model, Term Structure of Interest Rates

On-the-Job Search, Sticky Prices, and Persistence

By Willem Van Zandweghe (RWP09-03 January 2009; Revised October 2009)
Models of the monetary transmission mechanism often generate empirically implausible business fluctuations. This paper analyzes the role of on-the-job search in the propagation of monetary shocks in a sticky price model with labor market search frictions. Such frictions induce long-term employment relationships, such that the real marginal cost is determined by real wages and the cost of an employment relationship. On-the-job search opens up an extra channel of employment growth that dampens the response of these two components. Because real marginal cost rigidity induces small price adjustments, on-the-job search gives rise to a strong propagation of monetary shocks that increases output persistence.

JEL Classification: E24, E31, E32
Keywords: On-the-job search, cost of an employment relationship, sticky prices, business fluctuations

Mind the (Approximation) Gap: A Robustness Analysis

By Russell Cooper and Jonathan L. Willis (RWP09-02 January 2009)
This note continues the discussion of the results reported by Ricardo Caballero and Eduardo Engel (1993), hereafter CE, and Ricardo Caballero, Eduardo Engel, and John Haltiwanger (1997), hereafter CEH, by responding to the results reported in Christian Bayer (2008). Russell Cooper and Jonathan Willis (2004), hereafter CW, find that the aggregate nonlinearities reported in CE and CEH may be the consequence of mismeasurement of the employment gap rather than nonlinearities in plant-level adjustment. Bayer reassesses this finding in the context of the CE model in the case where static employment gaps are observed and concludes that the CW result is not robust to alternative shock processes. We concur with Bayer's assessment that the nonlinearity finding is sensitive to the aggregate profitability shock process. We argue, however, that Bayer's finding does not imply that the mismeasurement problem goes away. Instead, the nonlinearity created by mismeasurement is directly related to the level of the aggregate shock. Once the empirical specification properly incorporates the aggregate shock, the nonlinearity test is robust to alternative shock processes and confirms the results in CW. More importantly, we demonstrate that the CW findings are robust to alternative shock processes for the natural case of unobserved gaps as examined by CE and CEH.

JEL Classification: E24, J23, J64
Keywords: Aggregate Employment, Employment, Adjustment Costs

Global Inflation Dynamics

By Craig S. Hakkio (RWP09-01 January 2009)
This paper examines the dynamics of various measures of national, regional, and global inflation. The paper calculates the first two common factors for four measures of industrial country inflation rates: total CPI, core CPI, cyclical total CPI, and cyclical core CPI. The paper then demonstrates that the first common factor is sometimes helpful in forecasting national inflation rates. It also shows that the second common factor and the first common factor for cyclical inflation is sometimes helpful in forecasting national CPI inflation rates. Finally, the paper suggests that the commonality of industrial inflation rates reflects the commonality of the determinants of inflation.

JEL Classification: E31, E32, E37
Keywords: Inflation, common factor, global inflation, industrial countries.