PDFTarget's Corporate Governance and Bank Merger Payoff
By Elijah Brewer III, William E. Jackson III, and Julapa A. Jagtiani
RWP 07-13, December 2007

Commercial bank merger and acquisition (M&A) transactions are especially informative for analyzing the impact of differing corporate governance structures on the balance of corporate control between managers and shareholders. We exploit these special characteristics to investigate the balance of control between top-tier managers and shareholders using data from bank M&A transactions over the period 1990-2004. Unlike research on non-financial firms, the impacts of independent directors, managerial share ownership, and independent blockholders on bank merger purchase premiums in this environment are likely to be measured more consistently because of industry operating standards and regulations. It is also the case that research on banks in this area has not received adequate attention. Our model controls for risk characteristics of the target and the acquiring banks, the deal characteristics, and the economic environment. The results are robust. Our results are consistent with those found for non-financial firms, and are consistent with the hypothesis that independent directors could provide an important internal governance mechanism for protecting shareholders’ interests especially in large scale transactions such as mergers and takeovers. We also find results consistent with the conflict of interest argument, where top-tier managers tend to trade potential takeover gains in return for their own personal benefits, such as job security and other employment related perquisites. Our overall findings would support policies that promote independent outside directors on the board of commercial banking firms in order to provide protection for shareholders and investors at large.

JEL Classification: G2, G21, G28, G3
Keywords: Corporate governance, bank merger, merger purchase premium, performance, bank holding companies

PDFPhillips Curves, Monetary Policy, and a Labor Market Transmission Mechanism
By Robert R. Reed and Stacey L. Schreft
RWP 07-12, December 2007

This paper develops a general equilibrium monetary model with performance incentives to study the inflation-unemployment relationship. A long-run downward-sloping Phillips curve can exist with perfectly anticipated inflation because workers’ incentive to exert effort depend on financial market returns. Consequently, higher inflation rates can reduce wages and stimulate employment. An upward-sloping or vertical Phillips Curve can arise instead, depending on agents’ risk aversion and the possibility of capital formation. Welfare might be higher away from the Friedman rule and with a central bank putting some weight on employment.

JEL Classification: E24, E31, E52, E58, J21, J64, M5
Keywords: Phillips curve, efficiency wages, involuntary unemployment, labor and financial market frictions, central bank mandate

PDFThe Taylor Rule and the Transformation of Monetary Policy
By Pier Francesco Asso, George A. Kahn, Robert Leeson
RWP 07-11, December 2007

This paper examines the intellectual history of the Taylor Rule and its considerable influence on macroeconomic research and monetary policy. The paper traces the historical antecedents to the Taylor rule, emphasizing the contributions of three prominent advocates of rules--Henry Simons, A.W. H. Phillips, and Milton Friedman. The paper then examines the evolution of John Taylor's thinking as an academic and policy advisor leading up to his formulation of the Taylor rule. Finally, the paper documents the influence of the Taylor rule on macroeconomic research and the Federal Reserve's conduct of monetary policy.

JEL Classification: B22, B31, E52
Keywords: Taylor rule, monetary policy, rules versus discretion

PDFWhat Does the Yield Curve Tell Us About the Federal Reserve's Implicit Inflation Target?
By Taeyoung Doh
RWP 07-10, December 2007; updated July 2009

This paper uses a dynamic stochastic general equilibrium (DSGE) model to explore the additional information from the yield curve about the Federal Reserve’s implicit inflation target. In the model, monetary policy follows a nominal interest rate rule with a drifting target inflation rate. Three main finding emerge from this study. First, the estimated inflation target using both macro and yield curve data captures a common trend in inflation and nominal interest rates. This common trend is not identified when the model is estimated using only macro data. Second, DSGE models with a drifting inflation target estimated using yield curve data generate long-horizon inflation expectations that are consistent with survey data evidence. Finally, the model estimated with both macro and yield curve data overpredicts inflation during the 1980s when inflation fell rapidly but long-term rates moved down more slowly. Incorporating time-varying volatility into the model alleviates this overprediction of inflation. Adding imperfect information and learning by private agents about inflation target to the model with time-varying volatility makes little difference because agents learn quickly.

JEL Classification: C32, E43, G12
Keywords: inflation targeting, DSGE model, term structure of interest rates

PDFAdaptive Learning in Regime-Switching Models
By William A. Branch, Troy Davig, and Bruce McGough
RWP 07-09, November 2007; updated June 2008

This paper studies adaptive learning in economic environments subject to recurring structural change. Stochastically evolving institutional and policy-making features can be described by regime-switching rational expectations models whose parameters evolve according to a finite state Markov process. We demonstrate that in non-linear models of this form, two natural schemes emerge for learning the conditional means of endogenous variables: under mean value learning, the equilibrium’s lag structure is assumed exogenous and therefore known to agents; whereas, under vector autoregession learning (VAR learning), the equilibrium lag structure depends endogenously on agents’ beliefs and must be learned. We show that an intuitive condition, analogous to the ‘Long-run Taylor Principle’ of Davig and Leeper (2007), ensures convergence to a regime-switching rational expectations equilibrium. However, the stability of sunspot equilibria, when they exist, depends on whether agents adopt mean value or VAR learning. Coordinating on sunspot equilibria via a VAR learning rule is not possible. These results show that, when assessing the plausibility of rational expectations equilibria in non-linear models, out of equilibrium behavior is important.

JEL Classification: E52, E31, D83, D84
Keywords: e-stability, adaptive learning, regime switching, sunspots

PDFRisk-Adjusted Futures and Intermeeting Moves
By Brent Bundick
RWP 07-08, October 2007; updated June 2008

Piazzesi and Swanson (2006) argues that the monthly excess returns on federal funds futures contracts are significantly positive on average; predictable using business cycle and financial market indicators; and that futures rates need significant adjustment for these excess returns. This paper shows that intermeeting moves of the federal funds rate by the FOMC can explain much of the variation in the excess returns. After accounting for these intermeeting moves, business cycle variables, corporate credit and Treasure spreads, and federal funds rate momentum have little marginal predictive power and have smaller and generally less significant coefficient estimates. Both in-sample and out-of-sample results suggest that, after removing influential outliers, futures rates are a useful measure of monetary policy expectations and only require a small adjustment of about 1 basis point per month for excess returns.

JEL Classification: E44, G13
Keywords: federal funds futures, monetary policy

PDFThe Potential Role of Subordinated Debt Programs In Enhancing Market Discipline in Banking
By Douglas D. Evanoff, Julapa A. Jagtiani, and Taisuke Nakata
RWP 07-07, September 2007

Previous studies have found that subordinated debt (sub-debt) markets do differentiate between banks with different risk profiles. This finding satisfies a necessary condition for regulatory proposals which would mandate increased reliance on sub-debt in the bank capital structure to discipline banks’ risk taking. Such proposals, however, have not been implemented, partially because there are still concerns about the quality of the signal generated in current debt markets. We argue that previous studies evaluating the potential usefulness of sub-debt proposals have evaluated spreads in an environment that is very different from the one that will characterize a fully implemented sub-debt program. With a fully implemented program, the market will become deeper, issuance will be more frequent, debt will be viewed as a more viable means to raise capital, bond dealers will be less reluctant to publicly disclose more details on debt transactions, and generally, the market will be more closely followed. As a test to see how the quality of the signal may change, we evaluate the risk-spread relationship, accounting for the enhanced market transparency surrounding new debt issues. Our empirical results indicate a superior risk-spread relationship surrounding the period of new debt issuance due, we posit, to greater liquidity and transparency. Our results overall suggest that the degree of market discipline would likely be enhanced by a mandatory sub-debt program requiring banks to regularly approach the market to issue sub-debt.

JEL Classification: G21, G28, G38, L51
Keywords: Financial regulation, market discipline, subordinated debt, bank capital

PDFTests of Equal Predictive Ability with Real-Time Data
By Todd E. Clark and Michael W. McCracken
RWP 07-06, July 2007

This paper examines the asymptotic and finite-sample properties of tests of equal forecast accuracy applied to direct, multi-step predictions from both non-nested and nested linear regression models. In contrast to earlier work -- including West (1996), Clark and McCracken (2001, 2005),and McCracken (2006) -- our asymptotics take account of the real-time, revised nature of the data. Monte Carlo simulations indicate that our asymptotic approximations yield reasonable size and power properties in most circumstances. The paper concludes with an examination of the real-time predictive content of various measures of economic activity for inflation.

JEL Classification: C53, C12, C52
Keywords: prediction, real-time data, causality

PDFHow Much Would Banks Be Willing to Pay to Become "Too-Big-to-Fail" and to Capture Other Benefits?
By Elijah Brewer III and Julapa Jagtiani
RWP 07-05, July 2007

This paper examines an important aspect of the “too-big-to-fail” (TBTF) policy employed by regulatory agencies in the United States. How much is it worth to become TBTF? How much has the TBTF status added to bank shareholders’ wealth? Using market and accounting data during the merger boom (1991-2004) when larger banks greatly expanded their size through mergers and acquisitions, we find that banking organizations are willing to pay an added premium for mergers that will put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. We estimate at least $14 billion in added premiums for the nine merger deals that brought the organizations over $100 billion in total assets. These added premiums may reflect that perceived benefits of being TBTF and/or other potential benefits associated with size.

JEL Classification: G21, G28, G34
Keywords: bank merger, too-big-to-fail, TBTF subsidy, large bank subsidy

PDFPhillips Curve Instability and Optimal Monetary Policy
By Troy Davig
RWP 07-04, July 2007; updated August 2015

This paper assesses the implications for optimal discretionary monetary policy if the slope of the Phillips curve changes. The paper first derives a Phillips curve from the optimal pricing decision of a monopolistic firm that faces a changing cost of price adjustment. The second aspect of the paper constructs a utility-based welfare criterion. A novel feature of this criterion is that is has a relative weight on output gap deviations that changes synchronously with changes in the cost of price adjustment. The systematic component of the targeting rule that implements the optimal discretionary policy under the utility-based criteria is constant. In contrast, the systematic component of the targeting rule under an ad-hoc criteria changes along with changes in the slope of the Phillips curve.

JEL Classification: E52, E58, E61
Keywords: optimal monetary policy, Phillips curve, regime-switching

PDFOptimal Inflation for the U.S. Economy
By Roberto M. Billi
RWP 07-03, April 2007; updated December 2010

This paper studies the optimal long-run inflation rate (OIR) in a small New-Keynesian model, where the only policy instrument is a short-term nominal interest rate that may occasionally run against a zero lower bound (ZLB). The model allows for worst-case scenarios of misspecification. The analysis shows first, if the government optimally commits, the OIR is below 1 percent annually, and the policy rate is expected to hit the ZLB as often as 7 percent of the time. Second, if the government re-optimizes each period, the OIR rises markedly to 17 percent, which suggests a discretionary policymaker is willing to tolerate a very large “inflation bias” of 16 percent to avoid hitting the ZLB. Third, if the government commits only to an inertial Taylor rule, the inflation bias is eliminated at very low cost in terms of welfare for the representative household. The analysis suggest that if governments cannot make credible commitments about future policy decisions, a 2 percent long-run inflation goal may provide inadequate insurance against the ZLB.

JEL Classification: C63, E31, E52
Keywords: zero lower bound, commitment, discretion, Taylor rule, robust control

PDFThe Increasing Importance of Quality of Life
By Jordan Rappaport
RWP 07-02, March 2007; updated October 2008

The U.S. population has been migrating to places with high perceived quality of life. With homothetic preferences, such migration can follow from the increased demand for amenities that accompanies broad-based technological progress. Under the baseline calibration of a general equilibrium model, a place with amenities for which individuals would initially pay five percent of their income grows slightly faster than an otherwise identical place. As quality of life becomes more important in determining relative population density, productivity independently becomes less important. Asymptotically, local amenities are the sole determinant of relative density. High quality of life together with low relative productivity can boost metropolitan population growth by several percentage points.

JEL Classification: O40, R12, R13
Keywords: migration, consumption amenities, quality of life, productivity, urban agglomeration

PDFMonetary Conservatism and Fiscal Policy
By Klaus Adam and Roberto M. Billi
RWP 07-01, February 2007; updated July 2008

Does an inflation conservative central bank à la Rogoff (1985) remain desirable in a setting with endogenous fiscal policy? To provide an answer we study monetary and fiscal policy games without commitment in a dynamic, stochastic sticky-price economy with monopolistic distortions. Monetary policy determines nominal interest rates and fiscal policy provides public goods generating private utility. We find that lack of fiscal commitment gives rise to excessive public spending. The optimal inflation rate internalizing this distortion is positive, but lack of monetary commitment generates too much inflation. A conservative monetary authority thus remains desirable. When fiscal policy is determined before monetary policy each period, the monetary authority should focus exclusively on stabilizing inflation. Monetary conservatism then eliminates the steady state biases associated with lack of monetary and fiscal commitment and leads to stabilization policy that is close to optimal.

JEL Classification: E52, E62, E63
Keywords: sequential non-cooperative policy games, discretionary policy, time consistent policy, conservative monetary policy