Working Papers

Authors: Dimitrios P Tsomocos, Charles A.E. Goodhart, Pojanart Sunirand

Jun 2004

The objective of this paper is to propose a model to assess risk for banks. Its main innovation is to incorporate endogenous interaction between banks, recognising that the actual risk to which an individual bank is exposed also depends on its interaction with other banks and other private sector agents. To this end, we develop a two-period general equilibrium model with three active heterogeneous banks, incomplete markets, and endogenous default. The setting of three heterogeneous banks allows us to study not only interaction between any two individual banks, but also their interaction with the rest of the banks in the banking system. We show that the model is analytically tractable and can be calibrated against real UK banking data and therefore can be implemented as a risk assessment tool for financial regulators and central banks. We address the impact of monetary and regulatory policy as well as credit and capital shocks in the real and financial sectors.

Authors: Andrew Glyn

Jun 2004

Renewed interest in economic growth has encouraged studies of how different sectors have contributed to convergence trends. Comparing productivity levels across countries is notoriously tricky, but one attractive approach has been to deflate sector value added by the PPP exchange rate for GDP. There is a quite fundamental problem with this approach which, by measuring the purchasing power of sectoral incomes over GDP, biases the result towards reflecting the difference in GDP per head. In less extreme form the same problem applies to the use of a PPP for gross output of that sector.

JEL Codes: C82, O47

Keywords: Productivity, International Comparisons

Reference: 195

Individual View

Authors: Oren Sussman, Stefano G. Athanasoulis

Jun 2004

We argue that ceteris paribus, introducing a habit that resolves the equity premium puzzle is equivalent to increasing the coefficient of relative risk aversion. Thus, if habit is modeled subject to the constraint that the Arrow-Pratt coefficient of relative risk aversion is held at a constant ‘acceptable’ level, the effect on the equity premium is not quantitatively significant. In a dynamic setting, the fluctuations of the habit increase the equity premium, slightly. However, modest improvement in the model’s predictive power comes at a cost of generating unrealistic fluctuations in the risk-free interest rate. Our analysis of these findings yields the following result: a habit is observationally equivalent,up to afirst order approximation, to a higher relative risk aversion and to a preference shock. Both these effects are known to be insufficient for resolving the equity-premium puzzle.

JEL Codes: G0, G1

Keywords: equity premium, risk-free interest rate, habit formation

Reference: 2004-FE-12

Authors: Valerie Lechene, Martin Browning, University of Copenhagen,Pierre-Andre Chiappori, University of Chicago

Jun 2004

In this note we identify and clarify a confusion that has arisen in the literature about the exact relationship between unitary and collective models and what enters the Pareto weight and the sharing function. We suggest that we should denote as `unitary` any model that leads to outcomes that satisfy the Slutsky conditions whether or not these outcomes depend on distribution factors. In particular, income pooling is neither necessary nor sufficient for a unitary model. We also show that the presence of prices or total expenditure in the sharing rule cannot be used as a test for a unitary model.

JEL Codes: D13.

Keywords: Unitary, Collective, Intrahousehold Allocation, Distribution Factors, Demand.

Reference: 191

Individual View

Authors: Christine Greenhalgh, Mark Rogers

Jun 2004

This paper analyses market valuations of UK companies using a new data set of their R&D and IP activities (1989-1999). In contrast to previous studies, the analysis is conducted at the sector level, where the sectors are based on the technological classification in Pavitt (1984). The first main result is that the valuation of R&D and IP varies substantially across these sectors. To explore these variations the paper links competitive conditions with the market valuation of innovation. Using profit persistence as a measure of competitive pressure, we find that the sectors that are the most competitive have the lowest market valuation of R&D. Furthermore, within the most competitive sector (`science based`), firms with larger market shares (an inverse indicator of competitive pressure) also have higher R&D valuations. Another important result is that, on average, firms that receive only UK patents tend to have no market premium. In direct contrast, patenting through the European Patent Office does raise market value, as does the registration of trade market in the UK.

JEL Codes: L10, O31, O34.

Keywords: R&D, Intellectual Property, Market Valuation, Competition.

Reference: 192

Individual View

Authors: James Malcomson

Jun 2004

This paper analyses principal-agent contracts when the agent`s action generates information not directly verifiable but used by the agent to make a risky decision. It considers a more general formulation than those studied previously, focusing on the impact on the decision made and the contract between principal and agent. It establishes a precise sense in which distorting decisions reduces the risk borne by a risk-averse agent and conditions under which implementing an optimal decision rule imposes no substantive restrictions on the contract. The paper also uses an application to bidding to supply a good or service to illustrate those results and derive additional ones. A risk-neutral agent with limited liability may optimally choose lower, less risky bids or higher, more risky bids, according to which relaxes the limited liability constraint. There are also natural conditions under which optimal contracts are monotone, possibly with flat sections, like stock option rewards.

JEL Codes: D82

Keywords: Principal-Agent Contracts, Project Selection, Optimal Bidding, Portfolio Selection, Limited Liability, Risk Aversion, Asymmetric Information.

Reference: 193

Authors: Edmund Fitzgerald, Valpy Fitzgerald

May 2004

This paper extends and modifies the Keynesian critique of inflation targeting with reference to stabilisation policy in emerging market economies. The IMF `basic monetary programming framework` for developing countries uses government borrowing and the exchange rate as policy instruments in order to achieve specific inflation and balance of payments targets. This paper first adapts this standard model in order to include short-term capital flows and the floating exchange rate arising from financial liberalisation. In this way, the macroeconomic consequences of the current Fund focus on inflation targeting and the use of a single monetary policy instrument (the interest rate, combined with rigid fiscal and reserve `rules`) in emerging market economies can be demonstrated. Second, the paper encompasses the structuralist critique of the negative effect of inflation targeting on capacity utilisation and trade competitiveness, leading to an argument for counter-cyclical monetary policy in response to external shocks. An alternative model is constructed within a comparable macroeconomic framework to that of the IMF in order to permit the shortcomings of inflation targeting to be rigorously demonstrated. A macroeconomic stabilisation policy based on real exchange rate targeting, bank credit regulation and an active fiscal stance is shown to be more effective in supporting growth and investment.

JEL Codes: C610, E120, E520, F410, O230.

Keywords: Financial Programming, Post-Keynesian Models, Monetary Policy, Open Economy Macroeconomics, Emerging Markets.

Reference: 189

Authors: Regina Grafe

May 2004

Studies of consumption in early modern Europe fall into two groups. Some have looked at the overall supply of nutritional components to the average consumer in an attempt to trace standards of living. Others have examined the changing demand for particular goods by specific consumers to understand the way in which new goods and cultural and taste changes impacted on the economy. Few have tried to look at the interactions between both. By combining the contradictory evidence coming from supply and demand sides, new interpretations of the evidence emerge. Data on the supply of dried salted codfish (bacalao) to the Iberian markets and data available on the consumption of this good by specific groups of consumers are used to explain how this fish became a staple foodstuff in the Iberian diet. The existing literature has invoked both religion and cheapness as explanatory variables. This paper argues that both played an important role but that the overall increase was ultimately driven by the slow but continuous integration of more consumers into the market between 1600 and 1800.

JEL Codes: N33

Reference: 055

Individual View

Debating the minutiae of insurance regulation without a clear understanding of why insurance companies are regulated is futile. In this non-technical essay I discuss the economic rationale for insurance business regulation. I conclude that the appropriate role of the regulator in this industry is to enforce contracts which would otherwise be broken. This implies that regulation should be optional, and that regulation need not be a monopoly activity.

JEL Codes: G22, G28

Keywords: Insurance regulation, contract enforcement

Reference: 2004-FE-09

Authors: Alan Morrison, Lucy White

Apr 2004

We model the interaction between two economies where banks exhibit both adverse selection and moral hazard and bank regulators try to resolve these problems. We find that liberalising bank capital flows between economies reduces total welfare by reducing the average size and efficiency of the banking sector. This effect can be countered by forcing international harmonisation of capital requirements across economies, a policy reminiscent of the level playing field adopted in the 1988 Basle Accord. Such a policy is good for weaker regulators whereas a laissez faire policy under which each country chooses its own capital requirement is better for the higher quality regulator. We find that imposing a level playing field among countries is globally optimal provided regulators’ abilities are not too different. We also show how shocks will be transmitted differently across the two policy regimes.

JEL Codes: F36, G21, G28

Keywords: Bank regulation, capital, multinational banks, exchange controls, international financial regulation, level playing field.

Reference: 2004-FE-10

Authors: David P. Myatt

Mar 2004

Many analyses of plurality-rule elections predict the complete coordination of strategic voting, and hence support for only two candidates. Here I suggest that stable multi-candidate support will arise in equilibrium. A group of voters must partially coordinate behind one of two challenging candidates in order to dislodge a disliked incumbent. In a departure from existing models, the popular support for each challenger is uncertain. This support must be inferred from the private observation of informative signals, such as the social communication of preferences throughout the electorate, or the imperfect observation of opinion polls. The uniquely stable voting equilibrium entails only limited strategic voting and hence incomplete coordination. This is due to the surprising presence of negative feedback: an increase in the degree of strategic voting by others reduces the incentives for an individual to vote strategically. The incentive to vote strategically is lower in relatively marginal elections, after controlling for the distance from contention of a trailing preferred challenger. A calibration of the model applied to the UK General Election of 1997 is consistent with the impact of strategic voting and the reported accuracy of voters` understanding of the electoral situation. It suggests that nearly 50 seats may have been lost by the Conservative party due to strategic voting.

JEL Codes: D72

Keywords: Strategic Voting, Tactical Voting, Duverger`s Law, Global Games

Reference: 186

Individual View

Authors: Gordon  Menzies, Daniel John Zizzo

Mar 2004

We propose that the formation of beliefs be treated as statistical hypothesis tests, and we label such beliefs inferential expectations. If a belief is overturned through the build-up of evidence, agents are assumed to switch to the rational expectation. Thus, rational expectations is a special case of inferential expectations if agents are unconcerned about mistakenly changing their beliefs (the test size á equals unity), or if there is so much information available about a parameter that it is known with certainty (the sampling distribution of the estimator collapses to a point). We present the results of an individual choice experiment showing preliminary support for inferential expectations in comparison to either rational expectations, or adaptive expectations with one degree of freedom. Depending on how the critical region is determined, either 27-35% or 57-65% of the agents display test size á < 0.9. The impact of inferential expectations is illustrated by showing how it alters a simple model of the exchange rate and a Lucas supply function.

JEL Codes: C91, D84, E50, F31.

Keywords: Expectations, Macroeconomics, Rationality.

Reference: 187

Individual View

Authors: Simon GB Cowan, Simon Cowan

Mar 2004

The effects of demand shifts on output, price and profits in imperfectly competitive industries with no entry or exit are derived. Four types of demand shift are modelled: additive and multiplicative shifts of the demand and inverse demand functions. Necessary and sufficient conditions for output, price and profits to increase with an outward demand shift are derived for each case. Either output or the price, but not both, may fall with a positive demand shift. Profits may also fall for a Cournot oligopoly. Log-concavity of the direct demand function is sufficient for the standard results to go through.

JEL Codes: D42, L12, L13.

Keywords: Comparative Statics, Monopoly, Oligopoly, Log-concavity.

Reference: 188

Authors: Ame R. Bergés, Valpy Fitzgerald

Mar 2004

Assessing the economic development of Latin America during the twentieth century requires reliable estimates of living standards as measured by per capita income, life expectancy, and literacy. New comparable series for Latin America suggest that these three indicators made the greatest strides during the period from 1940 to 1980. This progress is probably related to state-led industrialisation, improvements in public health, and urbanisation. Comparison with US levels reveals that while average per capita income has generally remained steady, relative living standards (measured by a composite welfare index) have risen gradually as life expectancy in the two regions has converged.

JEL Codes: I31, N36

Keywords: Economic History, Welfare and Poverty, Demography, Education, Income and Wealth

Reference: 054

Individual View

Deposit insurance schemes are becoming increasingly popular around the world and yet there is little understanding of how they should be designed and what their consequences are. In this paper we provide a new rationale for the provision of deposit insurance. We analyse a model in which agents choose between depositing their funds with banks and placing them in a less productive self-managed project. Bankers have valuable but costly project management skills and the banking sector exhibits both adverse selection and moral hazard. Depositors do not fully account for the social benefits accruing from bank management of projects and so too few deposits are made in equilibrium. The regulator can correct this market failure by providing deposit insurance to encourage deposits. Contrary to received opinion, we find that deposit insurance should be funded not by bankers or depositors but through general taxation.

Reference: 2004-FE-08

This paper models limit order books where each trader is uncertain of the underlying distribution in the asset`s value to others. If this uncertainty is rapidly resolved, fleeting limit orders are submitted and quickly cancelled. This enhances liquidity supply, but leaves intact established comparative statics results on spreads. However, risk neutral liquidity suppliers are averse to persistent uncertainty due to concavity in the function describing limit order utility, and spreads widen. This helps explain wide spreads in the morning. The model describes traders who in equilibrium correctly anticipate market orders` endogenous stochastic intensities. It highlights how limit orders queue for execution.

JEL Codes: D8, G1

Keywords: market microstructure, limit order book, fleeting orders, order cancellation

Reference: 2004-FE-04

Authors: Dimitrios P Tsomocos, Charles A.E. Goodhart, Pojanart Sunirand

Feb 2004

The purpose of our work is to explore contagious financial crises. To this end, we use simplified, thus numerically solvable, versions of our general model [Goodhart, Sunirand and Tsomocos (2003)]. The model incorporates heterogeneous agents, banks and endogenous default, thus allowing various feedback and contagion channels to operate in equilibrium. Such a model leads to di.erent results from those obtained when using a standard representative agent model. For example, there may be a trade-o. between e.ciency and financial stability, not only for regulatory policies, but also for monetary policy. Moreover, agents which have more investment opportunities can deal with negative shocks more effectively by transferring ‘negative externalities’ onto others.

JEL Codes: D52, E4, E5, G1, G2

Keywords: Financial Fragility, Competitive Banking, General Equilibrium, Monetary Policy, Regulatory Policy

Reference: 2004-FE-05

We present a model of cash constrained entrepreneurs who raise money from banks and from dispersed uninformed creditors. There is a moral hazard problem, which can be partially overcome through bank monitoring. However, monitoring is only effective if the bank can commit ex ante to liquidate after a poor signal. We show that this is possible only if the continuation value of a poorly performing firm is reduced for the bank by anticipated violation of the Absolute Priority Rule (APR) in favour of junior creditors. Two classes of creditors with APR violation therefore constitutes an optimal capital structure.

Reference: 2004-FE-06

Authors: Teresa da Silva Lopes

Feb 2004

This paper considers aspects of the evolution of ownership and control in global industries from 1960. The existing literature usually uses the largest firms in industrialized countries, to provide generalizations about national systems of corporate governance. In practice, this characterization is far from being comprehensive. For example, global industries which are not dominant in countries’ economies – such as alcoholic beverages – are overlooked. Including such overlooked cases, this study suggests that there is a broader range of combinations of ownership and control of firms than is usually considered. Regardless of national systems of corporate governance, family ownership may remain very important in some industries. Industry-specific factors, such as brands and marketing knowledge in alcoholic beverages, help explain why the predominant ownership and control structures of global firms are distinct from those that characterize their countries of origin.

Reference: 053

Individual View

Authors: Valerie Lechene, Jerome Adda, University College London and IFS

Feb 2004

This paper considers the identification of the effect of tobacco on mortality. If individuals select into smoking according to some unobserved health characteristic, then estimates of the effect of tobacco on health that do not account for this are biased. We show that using information on mortality, morbidity and smoking, it is possible to control for this selection effect and obtain consistent estimates of the effect of smoking on mortality. We implement our method on Swedish data. We show that there is selection into smoking, and considerable dispersion around the average effect, so that health policies that aim at decreasing smoking prevalence and quantities smoked might have less effect in terms of average number of years of life gained than previously estimated. We also empirically show that selection into smoking has increased over the last fifty years with the availability of information on the dangers of smoking, so that future studies comparing smokers and nonsmokers will spuriously reveal a worsening effect of tobacco on health if they fail to control for selection.

JEL Codes: I12

Keywords: Health, Duration, Smoking, Selection, Mortality, Life Expectancy, Causality

Reference: 184

Individual View

Authors: Oren Sussman, Javier Suarez

Jan 2004

This paper explores the business cycle implications of financial distress and bankruptcy law. We find that due to the presence of financial imperfections the effect of liquidations on the price of capital goods can generate endogenous fluctuations. We show that a law reform that ‘softens’ bankruptcy law may increase the amplitude of the cycle in the long run. In contrast, a policy of bailing out businesses during the bust, or actively managing the interest rate across the cycle, could stabilize the economy in the long run. A comprehensive welfare analysis of the policy is provided as well.

JEL Codes: E32, E44, G33

Keywords: bankruptcy law, business cycles, financial distress

Reference: 2004-FE-07

Authors: Richard Mash

Jan 2004

Much recent monetary policy literature has searched for structural models suitable for policy analysis that are both based on optimising microfoundations and consistent with the data, especially observed persistence in inflation and output. Few models do well on both criteria. We derive an optimising model of the Phillips curve based on a generalised time dependent pricing rule, calibrate it using microeconomic evidence on price changing behaviour and simulate it with a standard discretionary policy maker. The model predicts inflation and output persistence comparable to that observed without reliance on rule of thumb behaviour or serially correlated shock processes.

JEL Codes: E52, E58, E22

Keywords: Monetary Policy, Phillips Curve, Inflation Persistence, Microfoundations

Reference: 183

Individual View

Authors: Jorg Scheibe

Dec 2003

We estimate potential GDP for China comparing univariate and multivariate methods and derive a quarterly output gap series. For the multivariate, production function based estimates we employ aggregate data and data on five economic subsectors. We estimate production functions in levels as well as an EqCM specification, which we argue is better suited for identifying the long-run share of capital and labour in production. Our output gap estimates improve on earlier work which has so far been used in the emerging literature on macro-modelling of the Chinese economy. Drawing on the literature on Chinese economic growth, productivity measurement, and capital stock construction, we find that across a range of reasonable assumptions for capital and labour data specifications the output gap estimates remain correlated and robust. All our methods show that at the end of 2002 China is entering a period of economic upswing, but the current level of the output gap is much below the previous peaks in 1988/9 and 1994/5.

JEL Codes: E32, O47, O53

Keywords: output gap, growth regressions, EqCM specification of production function, Chinese capital stock data

Reference: 179

Individual View

Authors: Marcel Fafchamps, Klaus Desmet, Universidad Carlos III de Madrid and CEPR

Dec 2003

This paper examines the spatial distribution of jobs across US counties and investigates whether sectoral employment is becoming more or less concentrated. The existing literature has found deconcentration (convergence) of employment across urban areas. Cities only cover a small part of the US, though. Using county data, our results indicate that deconcentration is limited to the upper tail of the distribution. The overall picture is one of increasing concentration (divergence). While this seemingly contradicts the well documented deconcentration in manufacturing, we show that these aggregate employment dynamics are driven by services. Non-service sectors - such as manufacturing and farming - are indeed becoming more equally spread across space, but services are becoming increasingly concentrated.

JEL Codes: R11, R12, O51

Keywords: Spatial Distribution, Convergence, Sectoral Employment, US Counties

Reference: 180

Individual View

Authors: Sujit Kapadia

Dec 2003

By assuming Cobb-Douglas production technology, many well-known imperfectly competitive macroeconomic models of the labour market (e.g. Layard, Nickell and Jackman, 1991) imply that equilibrium unemployment is independent of the capital stock. This paper introduces a new notion of capacity into the standard framework. Specifically, we adapt the Cobb-Douglas production function so that when the capital-labour ratio drops below a certain threshold, the returns to labour fall while the returns to capital increase. Using this assumption, we show that equilibrium unemployment depends on the capital stock over a certain range. We also briefly discuss the generalisation for an endogenous capital stock.

JEL Codes: E22, E23, E24, E25, J64.

Keywords: Unemployment, Capital Stock, Investment, Capacity, Technology.

Reference: 181

Individual View

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