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.

2010

The Roles of Price Points and Menu Costs in Price Rigidity

By Edward S. Knotek II (RWP 10-18 December 2010)
Macroeconomic models often generate nominal price rigidity via menu costs. This paper provides empirical evidence that treating menu costs as a structural explanation for sticky prices may be spurious. Using supermarket scanner data, I note two empirical facts: (1) price points, embodied in nine-ending prices, account for more than 60 percent of prices; (2) at the conclusion of sales, post-sale prices return to their pre-sale levels nearly 90 percent of the time. I construct a model that nests roles for menu costs and price points and estimate model variants via simulated method of moments. Excluding the two facts yields a statistically and economically significant role for menu costs in generating price rigidity. Incorporating the two facts yields an incentive to set nine-ending prices two orders of magnitude larger than the menu costs in this model. In this setting, the price point model can match the two stylized facts, but menu costs are effectively irrelevant as a source of price rigidity. The choice of a mechanism for price rigidity matters for aggregate dynamics.

Robustness, Information-Processing Constraints, and the Current Account in Small Open Economies

By Yulei Luo, Jun Nie, and Eric R. Young (RWP10-17 December 2010)
We examine the effects of two types of informational frictions, robustness (RB) and finite information-processing capacity (called rational inattention or RI) on the current account, in an otherwise standard intertemporal current account (ICA) model. We show that the interaction of RB and RI has the potential to improve the model’s predictions on the joint dynamics of the current account and income: (i) the contemporaneous correlation between the current account and income, (ii) the volatility and persistence of the current account in small open emerging and developed economies. In addition, we show that the two informational frictions could also better explain consumption dynamics in small open economies: the impulse responses of consumption to income shocks and the relative volatility of consumption growth to income growth. Calibrated versions using detection probabilities fit the data better along these dimensions than the standard model does.

Robust Control, Informational Frictions, and International Consumption Correlations

By Yulei Luo, Jun Nie, and Eric R. Young (RWP10-16 December 2010; Revised September 2013)
In this paper we examine the effects of two types of information imperfections, robustness (RB) and finite information-processing capacity (called rational inattention or RI), on international consumption correlations in an otherwise standard small open economy model. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. We then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: (1) the gradual response to income shocks that increases the correlations and (2) the presence of the common noise shocks that reduce the correlations.

Determinacy under Inflation Targeting Interest Rate Policy in a Sticky Price Model with Investment

By Takushi Kurozumi and Willem Van Zandweghe (RWP10-15 December 2010)
In a sticky price model with investment spending, recent research shows that inflation-forecast targeting interest rate policy makes determinacy of equilibrium essentially impossible. We examine a necessary and sufficient condition for determinacy under interest rate policy that responds to a weighted average of an inflation forecast and current inflation. This condition demonstrates that the average-inflation targeting policy ensures determinacy as long as both the response to average inflation and the relative weight of current inflation are large enough. We also find that interest rate policy which responds solely to past inflation guarantees determinacy when its response satisfies the Taylor principle and is not large. These results still hold even when wages and hours worked are determined by Nash bargaining.

Learning about Monetary Policy Rules when Labor Market Search and Matching Frictions Matter

By Takushi Kurozumi and Willem Van Zandweghe (RWP10-14 December 2010)
This paper examines implications of incorporating labor market search and matching frictions into a sticky price model for determinacy and E-stability of rational expectations equilibrium (REE) under interest rate policy. When labor adjustment takes place solely at the extensive margin, forecast-based policy that meets the Taylor principle is likely to induce indeterminacy and E-instability, regardless of whether it is strictly or flexibly inflation targeting. When labor adjustment takes place at both the extensive and intensive margins, the strictly inflation-forecast targeting policy remains likely to induce indeterminacy, but it generates a unique E-stable fundamental REE as long as the Taylor principle is satisfied. These results suggest that introducing the search and matching frictions alter determinacy properties of the strictly inflation-forecast targeting policy, but not its E-stability properties in the presence of the intensive margin of labor.

Entrepreneurial Risk Choice and Credit Market Equilibria

By Kerstin Gerling, Michal Kowalik and Heiner Schumacher (RWP10-13 July 2010)
We analyze under what condiitons credit markets are efficient in providing loans to entrepreneurs who can start a new project after previous failure. An entrepreneur of uncertain talent chooses the riskiness of her project. If banks cannot perfectly observe the risk of previous projects, two equilibria may coexist: (1) an inefficient equilibrium in which the entrepreneur undertakes a low-risk project and has no access to finance after failure; and (2) a more efficient equilibrium in which the entrepreneur undertakes high-risk projects and gets financed even after an endogenously determined number of failures.

Lender Exposure and Effort in the Syndicated Loan Market

By Nada Mora (RWP10-12 September 2010; Revised February 2013)
This paper tests for agency problems between the lead arranger and syndicate participants in the syndicated loan market. One problem comes from adverse selection, whereby the lead arranger has a private informational advantage over participants. A second problem comes from moral hazard, whereby the lead arranger puts less effort in monitoring when it retains a smaller loan portion. Applying an instrumental variables strategy, I find that borrowers' performance is influenced by the lead's share. Dynamic tests extract active contributions made by the lead, supporting a monitoring interpretation. Loan covenants serve as a mechanism to induce the lead arranger to monitor.

The Creditworthiness of the Poor: A Model of the Grameen Bank

By Michal Kowalik and David Martinez-Miera (RWP10-11 April 2010)
This paper analyzes the role of expected income in entrepreneurial borrowing. We claim that poorer individuals are safer borrowers because they place more value on the relationship with the bank. We study the dynamics of a monopolistic bank granting loans and taking deposits from overlapping generations of entrepreneurs with different levels of expected income. Matching the evidence of the Grameen Bank we show that a bank will focus on individuals with lower expected income, and will not disburse dividends until it reaches all the potential borrowers. We find empirical support for our theoretical results using data from a household survey from Bangladesh. We show that various measures of expected income are positively and signficantly correlated with default probabilities.

Distortionary Fiscal Policy and Monetary Policy Goals

By Klaus Adam and Roberto M. Billi (RWP10-10 March 2010; Revised January 2011)
We study interactions between monetary policy, which sets nominal interest rates, and fiscal policy, which levies distortionary income taxes to finance public goods, in a standard, sticky-price economy with monopolistic competition. Policymakers? inability to commit in advance to future policies gives rise to excessive inflation and excessive public spending, resulting in welfare losses equivalent to several percent of consumption each period. We show how appointing a conservative monetary authority, which dislikes inflation more than society does, can considerably reduce these welfare losses and that optimally the monetary authority is predominantly concerned about inflation. Full conservatism, i.e., exclusive concern about inflation, entirely eliminates the welfare losses from discretionary monetary and fiscal policymaking, provided monetary policy is determined after fiscal policy each period. Full conservatism, however, is severely suboptimal when monetary policy is determined simultaneously with fiscal policy or before fiscal policy each period.

"Unfunded Liabilities" and Uncertain Fiscal Financing

By Troy Davig, Eric M. Leeper and Todd B. Walker (RWP10-09 March 2010)
A rational expectations framework is developed to study the consequences of alternative means to resolve the "unfunded liabilities" problem--unsustainable exponential growth in federal Social Security, Medicare, and Medicaid spending with no plan to finance it. Resolution requires specifying a probability distribution for how and when monetary and fiscal policies will change as the economy evolves through the 21st century.  Beliefs based on that distribution determine the existence of and the nature of equilibrium. We consider policies that in expectation combine reaching a fiscal limit, some distorting taxation, modest inflation, and some reneging on the government's promised transfers. In the equilibrium, inflation-targeting monetary policy cannot successfully anchor expected inflation. Expectational effects are always present, but need not have large impacts on inflation and interest rates in the short and medium runs.

Structural Macro-Econometric Modelling in a Policy Environment

By Martin Fukac (RWP10-08 February 2010)
In this paper we review the evolution of macroeconomic modelling in a policy environment that took place over the past sixty years. We identify and characterise four generations of macro models. Particular attention is paid to the fourth generation -- dynamic stochastic general equilibrium models. We discuss some of the problems in how these models are implemented and quantified.

Impulse Response Identification in DSGE Models

By Martin Fukac (RWP10-07 February 2010)
Dynamic stochastic general equilibrium (DSGE) models have become a widely used tool for policymakers. This paper modifies the global identification theory used for structural vectorautoregressions, and applies it to DSGE models. We use this theory to check whether a DSGE model structure allows for unique estimates of structural shocks and their dynamic effects. The potential cost of a lack of identification for policy oriented models along that specific dimension is huge, as the same model can generate a number of contrasting yet theoretically and empirically justifiable recommendations. The problem and methodology are illustrated using a simple New Keynesian business cycle model.

Discretionary Monetary Policy in the Calvo Model

By Willem Van Zandweghe and Alexander L. Wolman  (RWP10-06 February 2010)
We study discretionary equilibrium in the Calvo pricing model for a monetary authority that chooses the money supply. The steady-state inflation rate is above eight percent for a baseline calibration, and it varies non-monotonically with the degree of price stickiness. If the initial condition involves inflation higher than steady state, discretionary policy generates an immediate drop in inflation followed by a gradual increase to the steady state. Unlike the two-period Taylor model, discretionary policy in the Calvo model does not accommodate predetermined prices in a way that inevitably leads to multiple private-sector equilibria.

The Taylor Rule and the Practice of Central Banking

By Pier Francesco Asso, George A. Kahn and Robert Leeson  (RWP10-05 February 2010)
The Taylor rule has revolutionized the way many policymakers at central banks think about monetary policy. It has framed policy actions as a systematic response to incoming information about economic conditions, as opposed to a period-by-period optimization problem. It has emphasized the importance of adjusting policy rates more than one-for-one in response to an increase in inflation. And, various versions of the Taylor rule have been incorporated into macroeconomic models that are used at central banks to understand and forecast the economy.

This paper examines how the Taylor rule is used as an input in monetary policy deliberations and decision-making at central banks. The paper characterizes the policy environment at the time of the development of the Taylor rule and describes how and why the Taylor rule became integrated into policy discussions and, in some cases, the policy framework itself. Speeches by policymakers and transcripts and minutes of policy meetings are examined to explore the practical uses of the Taylor rule by central bankers. While many issues remain unresolved and views still differ about how the Taylor rule can best be applied in practice, the paper shows that the rule has advanced the practice of central banking.

Euler-Equation Estimation for Discrete Choice Models: A Capital Accumulation Application

By Russell Cooper, John Haltiwanger and Jonathan L. Willis  (RWP10-04 January 2010)
This paper studies capital adjustment at the establishment level. Our goal is to characterize capital adjustment costs, which are important for understanding both the dynamics of aggregate investment and the impact of various policies on capital accumulation. Our estimation strategy searches for parameters that minimize ex post errors in an Euler equation. This strategy is quite common in models for which adjustment occurs in each period. Here, we extend that logic to the estimation of parameters of dynamic optimization problems in which non-convexities lead to extended periods of investment inactivity. In doing so, we create a method to take into account censored observations stemming from intermittent investment. This methodology allows us to take the structural model directly to the data, avoiding time-consuming simulation-based methods. To study the effectiveness of this methodology, we first undertake several Monte Carlo exercises using data generated by the structural model. We then estimate capital adjustment costs for U.S. manufacturing establishments in two sectors.

Training or Search? Evidence and an Equilibrium Model

By Jun Nie (RWP10-03 January 2010)
Training programs are a major tool of labor market policies in OECD countries. I use a unique panel data set on the labor market experience of individual German workers between 2000 and 2002 to estimate a dynamic model of search and training, which allows me to quantify the impact of training programs and unemployment benefits on employment, unemployment, output, and the government expenditures.

The model extends Ljungqvist and Sargent (JPE, 1998) by incorporating a training decision and a broader menu of unemployment benefits. Government-sponsored training programs feature a key trade-off with respect to unemployment insurance programs: they offer more generous unemployment benefits but require more time and effort from workers to generate higher skills. As a result, unemployed workers with different human capital and benefits make different decisions about training, search, and job acceptance.

I use the model to quantitatively study the recent reforms implemented in Germany and run more counterfactual experiments. I simulate the transition path under back-to-back unexpected reforms in 2003-2006 and find the dynamics of the model's unemployment rates are close to the data. In a counterfactual experiment in which I model an economy with a German-like training system and a US-like unemployment benefit structure (roughly, benefits are lower), I find that employment and output rise substantially.

Executive Compensation and Business Policy Choices at U.S. Commercial Banks

By Robert DeYoung, Emma Y. Peng and Meng Yan (RWP10-02 January 2010)
This study examines whether and how the terms of CEO compensation contracts at large commercial banks between 1994 and 2006 influenced, or were influenced by, the risky business policy decisions made by these firms. We find strong evidence that bank CEOs responded to contractual risk-taking incentives by taking more risk; bank boards altered CEO compensation to encourage executives to exploit new growth opportunities; and bank boards set CEO incentives in a manner designed to moderate excessive risk-taking. These relationships are strongest during the second half of our sample, after deregulation and technological change had expanded banks' capacities for risk-taking.

Inflation Targeting and Private Sector Forecasts

By Stephen G. Cecchetti and Craig S. Hakkio (RWP10-01 January 2010)
Transparency is one of the biggest innovations in central bank policy of the past quarter century. Modern central bankers believe that they should be as clear about their objectives and actions as possible. However, is greater transparency always beneficial? Recent work suggests that when private agents have diverse sources of information, public information can cause them to overreact to the signals from the central bank, leading the economy to be too sensitive to common forecast errors. Greater transparency could be destabilizing. While this theoretical result has clear intuitive appeal, it turns on a combination of assumptions and conditions, so it remains to be established that it is of empirical relevance.

In this paper we study the degree to which increased information about monetary policy might lead to individuals coordinating their forecasts. Specifically, we estimate a series of simple models to measure the impact of inflation targeting on the dispersion of private sector forecasts of inflation. Using a panel data set that includes 15 countries over 20 years we find no convincing evidence that adopting an inflation targeting regime leads to a reduction in the dispersion of private sector forecasts of inflation. While for some specifications adoption of inflation target does seem to reduce the standard deviation of inflation forecasts, the impact is rarely precise and always small.