Working Papers

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

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Authors: Valpy Fitzgerald, Pablo Astorga, Ame R. Bergés

Dec 2003

Analysis of new comparable series on output and employment between 1900 and 2000 for Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela indicates that productivity growth was significantly higher and less volatile during the middle decades of the century than in the opening and closing decades. The first estimate of total factor productivity (TFP) growth for Latin America during the twentieth century as a whole, derived from the residuals of a skill-augmented production function, indicates that unembodied technical progress was low and that the accumulation of fixed and human capital accounted for almost all recorded economic progress. Sectoral disaggregation suggests that this factor accumulation was associated with increased levels of capital per worker during industrialization on the one hand; and with both out-migration from agriculture and the lagged consequences of a demographic transition on the other. The relatively low rates of human and physical capital accumulation in Latin America remain to be explained, although these are more likely to be associated with inadequate public provision of infrastructure and education than with the cycle of protection and liberalization as such.

JEL Codes: O1, O4, N3, N5, N6

Keywords: Aggregate Productivity and Growth, Agriculture, Manufacturing, Total Factor Productivity, Human Capital

Reference: 052

Individual View

Authors: Daniel John Zizzo

Dec 2003

This paper employs neurobehavioral and psychological evidence to argue that anger is an emotion arising from significant cognitive processing, one that, in relation to economic decision-making, may be subtly mediated by many factors (including intentions). Anger is an emotion implying a higher likelihood of a behavioral response directed against the object of anger. The medial and possibly other prefrontal cortex regions play an important role in anger processing, whereas the amygdala does not. Any eventual difficulty for rational choice may come more from the difficulty of understanding the cognitive underpinnings of anger than from understanding the emotional process itself.

JEL Codes: C91, D11.

Keywords: Anger, Emotions, Neuroeconomics, Rationality.

Reference: 182

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Authors: Peter Stemp, Ric D. Herbert, The University of Newcastle Callaghan, Australia.

Nov 2003

This paper investigates the success of the well-known reverse-shooting and forward-shooting algorithms in finding stable solutions for linear macroeconomic models that both possess the particular property known as saddle-path instabiity and also have highly cyclic dynamic properties. It is anticipated that assessing how well these algorithms cope with solving highly cyclic models will also provide insights into how well they are likely to cope with solving non-linear models. In this paper, a perfect foresight version of the well-known Cagan (1956) model of the monetary dynamics of hyperinflation is augmented with a labour market. Additional eignevalues are then generated through sluggish adjustment mechanisms for wages and for the supply of labour. This process provides the simplest model with stable complex-valued eigenvalues and a saddlepath: a model with two stable complex-valued eigenvalues and one unstable real-valued eigenvalue. Using this model, it is possible to define an indexing parameter that, when varied, determines a range of values for the stable eignvalues: from (i) real-valued, to (ii) complex-valued with small absolute imaginary part, to (iii) complex-valued with large absolute imaginary part. This leads to corresponding stable time-paths for the model, which are (i) either humped or monotonic, (ii) cyclic but with infrequent cycles, and (iii) cyclic but with frequent cycles. This paper then compares the properties of solutions derived using the reverse-shooting and forward-shooting approaches as the magnitude of the indexing parameter (and hence of the cycles) is allowed to vary. In the highly oscillatory case, we show that the success of both approaches is crucially dependent on the choice of ODE solver and of parameters.

JEL Codes: C63, E17.

Keywords: Macroeconomics, Complex-valued eigenvalues, Real-valued eigenvalues, Cyclic convergence, Monotonic convergence, Saddle-path instability, Computational techniques.

Reference: 178

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Authors: Neil Shephard, Ole Barndorff-Nielsen

Nov 2003

In this paper we provide an asymptotic distribution theory for some non-parametric tests of the hypothesis that asset prices have continuous sample paths. We study the behaviour of the tests using simulated data and see that certain versions of the tests have good finite sample behaviour. We also apply the tests to exchange rate data and show that the null of a continuous sample path is frequently rejected. Most of the jumps the statistics identify are associated with governmental macroeconomic announcements.

Keywords: Bipower variation, Jump process, Quadratic variation, Realised variance, Semimartingales, Stochastic volatility

Reference: 2004-FE-01

Authors: David P. Myatt, Chris Wallace

Nov 2003

Team formation will often involve a coordination problem. If no-one else is contributing to a team, there is little point in an agent exerting any effort. Similarly, once a team is formed, an agent within the team will not leave, as to do so would result in team collapse; non-contributing agents would not join, as they currently receive the benefits of the team`s efforts whilst paying none of the costs. The methods of the stochastic adjustment dynamics literature can help select between these equilibria. Team and population size, and cost and benefit parameters all play a role in determining the chances of successful team formation. Increasing the pool of agents from which to choose team members seems at first glance to have a positive impact upon team formation. However, just one bad apple within the extended pool can have a disproportionate effect on the outcome. Although an agent with high participation costs would never contribute to a successful team, their mere presence alone can result in the failure of an otherwise successful team.

JEL Codes: C72, C73, H41

Keywords: collective action, evolution, teamwork, equilibrium selection

Reference: 177

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Authors: David R. Stead

Oct 2003

This article scrutinises the claim that the residual claimant in English agriculture was the fixed-rent tenant farmer rather than the landlord. Examination of methods of agricultural insurance and risk management indicates that the income risks of farming were sizeable, not straightforward to manage, and largely borne by the tenant. Thus the farmer’s profit appears to have fluctuated by more over time and space than did the rent paid to the landlord. Attempts are made to assess changes over time in the nature and size of the production and price risks that farmers were exposed to.

Reference: 051

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

Oct 2003

Our purpose in this paper is to produce a tractable model which illuminates problems relating to individual bank behaviour and risk-taking, to possible contagious inter-relationships between banks, and to the appropriate design of prudential requirements and incentives to limit `excessive` risk-taking. Our model is rich enough to include heterogenous agents (commercial banks and investors), endogenous default, and multiple commodity, and credit and deposit markets. Yet, it is simple enough to be effectively computable. Financial fragility emerges naturally as an equilibrium phenomenon. In our model a version of the liquidity trap can occur. Moreover, the Modigliani-Miller proposition fails either through frictions in the (nominal) financial system or through incentives, arising from the imposed capital requirements, for differential investment behaviour because of capital requirements. In addition, a non-trivial quantity theory of money is derived, liquidity and default premia co-determine interest rates, and both regulatory and monetary policies have non-neutral effects. The model also indicates how monetary policy may affect financial fragility, thus highlighting the trade-off between financial stability.

Reference: 2003-FE-13

Authors: Richard Mash

Oct 2003

We analyse the derivation of optimal monetary policy under discretion and commitment when lagged expectations appear in the Phillips curve, making use of the comparatively simple MSV approach which does not require transformation of the model into state-space form.

JEL Codes: C61, E52, E58.

Keywords: Monetary Policy, Rational Expectations, Solution Methods, Minimal State Variable, Undetermined Coefficients.

Reference: 173

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Authors: Richard Mash

Oct 2003

We analyze the microfoundations of the Phillips curve and the close links between that relationship and results concerning optimal monetary policy, stabilisation bias and monetary policy delegation. Most recent literature has used a New Keynesian Phillips Curve based on Calvo pricing, often with an additional lagged inflation term motivated by rule-of-thumb behaviour. We develop a framework which encompasses this workhorse model while allowing for a richer time dependent pricing rule. This permits a more general analysis while showing that the standard model and policy conclusions derived from it are not robust to relatively minor changes in its microfoundations.

JEL Codes: E52, E58, E22, C61

Keywords: monetary policy, New Keynesian Phillips Curve, Calvo pricing, rule of thumb, stabilisation bias, Monetary Policy Delegation

Reference: 174

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Authors: Dieter Helm,Cameron Hepburn,Richard Mash

Oct 2003

Time consistency problems can arise when environmental taxes are employed to encourage firms to take irreversible abatement decisions. Setting a high carbon tax, for instance, would induce firms to invest in low-carbon technology, yet once investment has occurred the government can then reduce the carbon tax to better achieve other objectives; lower energy prices, redistribution, and electoral success. The resulting time inconsistency discourages firms from investing in the first place. We propose an institutional solution to this problem, adapted from the monetary policy literature; the commitment outcome can be achieved through delegation to an `environmental policymaker`, akin to a conservative central banker.

JEL Codes: E52, E61, Q43, Q48

Keywords: Time Inconsistency, Environmental Taxation, Monetary Policy, Delegation

Reference: 175

Authors: Daniel John Zizzo, Jonathan H.W. Tan, Institute of Microeconomics, European University Viadrina

Oct 2003

Game harmony is a generic game property describing how conflictual or non-conflictual the interests of players are. Simple and general game harmony measures can predict mean cooperation in 2 x 2 games such as the Prisoner`s Dilemma, the Chicken and trust games. Two measures can be simply computed from monetary payoffs; another, the similarity index, can also be justified by theories of similarity-based reasoning. When data from Oxford and Frankfurt-Oder are disaggregated across experiments, countries and learning history, and when the similarity index is a valid measure, parsimonious regressions can explain around half of the variance in mean cooperation rates.

JEL Codes: C72, C91, H41

Keywords: game harmony, cooperation, similarity, 2 x 2 games, Prisoner`s Dilemma

Reference: 176

Individual View

Sometimes shareholders are better off delegating to a CEO with different objectives than their own. A top manager motivated to share surpluses with workers can encourage union members to adopt efficient production methods. Bond covenants may constrain managers from acquiescing to union wage demands. Nevertheless, we argue that unions can win higher wages by altering the non-shirking constraint. Resistance to monitoring leads to deadweight losses that a â€

JEL Codes: G32, G34, J41, J50

Keywords: efficiency wages, unions, bonds, takeovers, and CEO compensation

Reference: 2003-FE-12

Authors: James Malcomson

Sep 2003

Incentive contracts for gatekeepers who control patient access to specialist medical services provide too weak incentives to investigate cost further when expected cost of treatment is greater than benefit. Making gatekeepers residual claimants with a fixed fee from which treatment costs must be met (as with full insurers who are themselves gatekeepers) provides too strong incentives when expected cost is less than benefit. Giving patients the choice between a gatekeeper with an incentive contract and one without is unstable. With one scenario, patients always prefer the latter. With another, patients have incentives to acquire information that makes incentive contracts ineffective.

JEL Codes: I11, I18.

Keywords: Gatekeepers, Patient refererrals, General practitioners, Fundholding, Medical insurance, Incentive contracts.

Reference: 169

Authors: Colin Mayer, Julian Franks, Stefano Rossi

Sep 2003

While we associate the U.K. with a high level of investor protection, this was not the case in the first half of the twentieth century - U.K. capital markets were marked by an absence of investor protection and few common law rights for minorities. Notwithstanding this, securities markets flourished. There were a large number of listed firms, companies issued substantial amounts of equity and inside ownership diminished rapidly. Much of the equity issuance arose from share exchanges in mergers and acquisitions and these in turn were the main cause of dilution of inside ownership. They relied on informal relations of trust between directors and shareholders. When formal regulation (both statutory and self-regulation) was introduced in the second half of the century, it had no effect on equity issuance or dispersion. Instead, it was associated with a much higher level of trading of shares as reflected in membership of controlling coalitions of shareholders and in the emergence of a market for corporate control. These results cast doubt on the law and finance explanation of the development of financial markets and suggest that growth of equity and dispersion of ownership in the U.K. relied more on informal relations of trust than on formal systems of regulation.

JEL Codes: G32, G34

Keywords: ownership, investor protection, stock markets and trust

Reference: 2003-FE-14

Authors: Andrew Glyn, Dean Baker, Centre for Economic and Policy Research, Washington,David Howell, New School University, New York,John Schmitt

Aug 2003

This paper provides a critical view of the cross country literature on the impact of labour market institutions and policies on the evolving pattern of unemployment in OECD countries. Such widely used indicators as the generosity of unemployment insurance or the strength of trade unions are neither strongly correlated individually with unemployment nor contribute robust and well defined impacts on unemployment within increasingly sophisticated multivariate literature. Our own tests, with a comprehensive data set covering 1960-99, show how dependent the estimated effects are to the particular indicators used and periods covered and overall suggest that a relatively minor role for the institutions and policies in accounting for unemployment patterns.

JEL Codes: E24, J68

Keywords: Unemployment, institutions, OECD

Reference: 168

Individual View

Authors: Colin Mayer, Julian Franks, Stefano Rossi

Aug 2003

Family ownership was rapidly diluted in the twentieth century in Britain. Issuance of equity in the process of acquisitions was the main cause. In the first half of the century, it occurred in the absence of minority investor protection and relied on directors of target firms protecting the interests of shareholders. Families were able to retain control by occupying a disproportionate number of seats on the boards of firms. However, in the absence of large stakes, the rise of hostile takeovers and institutional shareholders made it increasingly difficult for families to maintain control without challenge. Potential targets attempted to protect themselves through dual class shares and strategic share blocks but these were dismantled in response to opposition by institutional shareholders and the London Stock Exchange. The result was a regulated market in corporate control and a capital market that looked very different from its European counterparts. Thus, while acquisitions facilitated the growth of family controlled firms in the first half of the century, they also diluted their ownership and ultimately their control in the second half.

JEL Codes: G32

Keywords: family ownership, control, takeovers

Reference: 2003-FE-15

Authors: Daniel John Zizzo

Jul 2003

Sharing a common fate with some people but not others may affect how economic agents behave within firms and organizations. Recognizing that many bilateral transactions occur both within and between groups sharing some degree of common fate, we present an experimental test of the effect of common fate in bargaining settings. Virtually all subjects differentiating between insiders and outsiders discriminate against outsiders. Within-group cooperation was not increased, but between-group conflict was. We also test, and find support for, theories of similarity-based decision-making. We develop and use a generally applicable technique to understand framing effects, based on identifying similarity attractors.

JEL Codes: C72, C78, C81, C91

Keywords: bargaining, common fate, similarity, framing effects

Reference: 167

Individual View

We analyse a model in which bank deposits are insured and there is an exogenous cost of bank capital. The former effect results in bank overinvestment and the latter in underinvestment. Regulatory capital requirements introduce investment distortions which are a constrained optimal response to these market imperfections. We show that capital requirements which are constrained optimal for national banks result in underinvestment by multinational banks. The extent of underinvestment depends upon the home bank`s riskiness, the extent of international diversification, and the liability structure (branch or subsidiary) of the multinational. Capital requirements for international banks should therefore reflect these effects. We relate our findings to observed features of multinational banks and we discuss the possible existence of a multinational bank channel for financial contagion.

JEL Codes: G21, G28

Keywords: Capital adequacy requirements; deposit insurance; multinati

Reference: 2003-FE-11

Authors: Sujoy Mukerji, Jean-Marc Tallon, EUREQua, CNRS - Universite Paris I.

Jul 2003

This paper surveys some economic applications of the decision theoretic framework pioneered by David Schmeidler. We have organized the discussion around three themes: financial markets, contractual arrangements and game theory. The first section discusses papers that have contributed to a better understanding of financial market outcomes based on ambiguity aversion. The second section focusses on contractual arrangements and is divided into two sub-sections. The first sub-section reports research on optimal risk sharing arrangements, while in the second sub-section, discusses research on incentive contracts. The third section concentrates on strategic interaction and reviews several papers that have extended different game theoretic solution concepts to settings with ambiguity averse players. A final section deals with several contributions that are linked only at a formal level, in terms of the pure mathematical structures involved, with Schmeidler`s models of decision making under ambiguity. The contributions involve issues such as, inequality measurement, intertemporal decision making and multi-attribute choice.

JEL Codes: D81

Keywords: Ellsberg Paradox, ambiguity aversion, uncertainty aversion.

Reference: 165

Authors: Mark Rogers

Jul 2003

The rapid rise in schooling in developing countries in recent decades has been dramatic. However, many cross-country regression analyses of the impact of schooling on economic growth find low and insignificant coefficients. This empirical `puzzle` contrasts with theoretical arguments that schooling, through raising human capital, should raise income levels. This paper argues that poor resulst are to be expected when regression samples include countries that vary greatly in their ability to use schooling productively. Data on corruption, the black market premium on foreign exchange and the extent of the brain drain for developing countries are used as indicators of an economy`s productive use of schooling. Regression analysis shows that the impact of secondary schooling on economic growth is substantially higher in countries that are adjudged to use schooling productivity.

JEL Codes: I21, O15, O40

Keywords: Schooling, human capital, corruption, brain drain, economic growth

Reference: 166

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Authors: John Knight,Linda Yueh, Linda Y. Yueh

Jun 2003

The large-scale reform of the state-owned sector and the development of a private sector in the 1990s changed the nature of employment in urban China. The system of allocated, lifelong jobs (the iron rice bowl) that had previously prevailed under state planning was eroded, permitting more labour turnover and mobility. The degree of mobility of urban workers in China appears not to have been researched, no doubt because there was so little until recently. Using an urban household survey for 1999 that has rich data on job duration, job change and the reasons for it, we provide a first analysis of inter-firm mobility in the urban labour market, its evolution and its explanation. A distinction is made between the, institutionally favoured, urban residents and the rural-urban migrants. The mobility rate of migrants greatly exceeds that of urban residents. For both groups the extent, patterns, determinants and consequences of mobility are explored.

Authors: Katsushi Imai, Pasquale Scandizzo, University of Rome Tor Vergata Raghav Gaiha, University of Delhi

Jun 2003

Consistent with the theory of real options, it is argued that the value of the Employment Guarantee Scheme (EGS) in the Indian state of Maharashtra and its impact on workers` behaviour do not depend so much on its income supplementation as on enlargement of opportunities in an uncertain environment of the local labour market. The choice between the EGS and other activities in rural areas is modelled in a dynamic optimisation framework that takes into account a fixed wage rate and certainty of employment under the former and a stochastic wage rate in the latter. Besides, entry and exit costs of various employment options are taken into account. Finally, allowance is made for volatility of regular labour market activities (e.g. agricultural wage earnings). The predictions of this model are validated with the help of a panel household survey in a semi-arid region of south India. If this analysis has any validity, the incentive case for rural public works schemes such as the EGS in terms of screening and deterrent arguments, premised on a fixed wage rate differential, needs to be reformulated.

JEL Codes: D3, D8, H5, I3, J2

Keywords: options, uncertainty, entry and exit costs, incentives

Reference: 164

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Authors: Neil Shephard, Enrique Sentana, Gabriele Fiorentini

Jun 2003

GARCH models are commonly used as latent processes in econometrics, financial economics and macroeconomics. Yet no exact likelihood analysis of these models has been provided so far. In this paper we outline the issues and suggest a Markov chain Monte Carlo algorithm which allows the calculation of a classical estimator via the simulated EM algorithm or a Bayesian solution in O(T) computational operations, where T denotes the sample size. We assess the performance of our proposed algorithm in the context of both artificial examples and an empirical application to 26 UK sectorial stock returns, and compare it to existing approximate solutions. GARCH models are commonly used as latent processes in econometrics, financial economics and macroeconomics.

Keywords: Bayesian inference, Dynamic Heteroskedasticity, Factor models, Markov chain

Reference: 2004-FE-02

Authors: Cameron Hepburn

May 2003

This paper shows that the use of hyperbolic discounting in environmental regulation can have unfortunate consequences. In a three-period model we demonstrate that a planner who `naively` employs hyperbolic discounting and fails to anticipate problems of dynamic inconsistency, can oversee a collapse of a renewable resource. If the regeneration rate of the resource is within a given range, and stock levels are close to the `minimum viable population`, then an unforeseen collapse will result. This basic result is shown to hold in an infinite-horizon, continuous-time model with hyperbolic discounting of the sort examined in Barro (1999) and Li and Lofgren (2001). Here, the naive planner does not anticipate extinction of its resource stock because it always plans to lower consumption (but it never does). Two conclusions follow from these results. First, the model provides an explanation for resource collapses such as that of the Peruvian anchovy and Atlantic cod. Second, governments should think carefully before they employ hyperbolic discounting in policymaking.

JEL Codes: Q21, Q28, E61

Keywords: hyperbolic discounting, time-inconsistency, renewable resources

Reference: 159

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