Working Papers

Authors: Neil Shephard

Feb 2013

I discuss models which allow the local level model, which rationalised exponentially weighted moving averages, to have a time-varying signal/noise ratio.  I call this a martingale component model.  This makes the rate of discounting of data local.  I show how to handle such models effectively using an auxiliary particle filter which deploys M Kalman filters run in parallel competing against one another.  Here one thinks of M as being 1,000 or more.  The model applied to inflation forecasting.  The model generalises to unobserved component models where Gaussian shocks are replaced by martingale difference sequences.

Keywords: Auxiliary particle filter, EM algorithm, EWMA, forecasting, Kalman filter, likelihood, martingale unobserved component model, particle filter, stochastic volatility

Reference: 2013-W01

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Authors: David Gill, Victoria Prowse

Jan 2013

In this paper we investigate how cognitive ability influences behavior, success and the
evolution of play towards Nash equilibrium in repeated strategic interactions. We study behavior
in a p-beauty contest experiment and find striking differences according to cognitive
ability: more cognitively able subjects choose numbers closer to equilibrium, converge more
frequently to equilibrium play and earn more even as behavior approaches the equilibrium
prediction. To understand better how subjects with different cognitive abilities learn differently,
we estimate a structural model of learning based on level-k reasoning. We find a
systematic positive relationship between cognitive ability and levels; furthermore, the average
level of more cognitively able subjects responds positively to the cognitive ability of their
opponents, while the average level of less cognitively able subjects does not respond at all.
Our results suggest that, in strategic environments, higher cognitive ability translates into
better analytic reasoning and a better ‘theory of mind

JEL Codes: C92, C73, D83

Keywords: Cognitive ability, bounded rationality, level-k, convergence, learning non-equilibrium behavior, beauty contest, repeated games, structural modeling, theory of mind, intelligence, Raven test

Reference: 641

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Authors: Margaret Meyer, Florian Ederer, Richard Holden

Jan 2013


It is often suggested that incentive schemes under moral hazard can be gamed by an agent with superior knowledge of the environment and that deliberate lack of transparency about the incentive scheme can reduce gaming. We formally investigate these arguments in a two-task moral hazard model in which the agent is privately informed about which task is less costly for him. We examine a simple class of incentive schemes that are "opaque" in that they make the agent uncertain ex ante about the incentive coefficients in the linear payment rule. Relative to transparent menus of linear contracts, these opaque schemes induce more balanced efforts, but they also impose more risk on the agent per unit of aggregate effort induced. We identify specific settings in which optimally designed opaque schemes not only strictly dominate the best transparent menu but also eliminate the efficiency losses from the agent's hidden information. Opaque schemes are more likely to be preferred to transparent ones when (i) the agent's privately known preference between the tasks is weak; (ii) the agent's risk aversion is significant; (iii) efforts on the tasks are highly complementary for the principal; or (iv) the errors in measuring performance have large correlation or small variance.

Revised April 2018

JEL Codes: D86, D21, L22

Keywords: Contracts, incentives, gaming, opacity, randomization

Reference: 640

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Authors: Anthony Venables, Torfinn Harding

Jan 2013

Foreign exchange windfalls such as those from natural resource revenues change non-resource exports, imports, and the capital account. We study the balance between these responses and show that the response to $1 of resource revenue is, for our preferred estimates, to decrease non-resource exports by 74 cents and increase imports by 23 cents, implying a negligible effect on foreign saving. The negative per $1 impact on exports is larger for manufactures than for other sectors, and particularly large for internationally mobile manufacturing sectors. While standard Dutch disease analysis points to contraction of the tradable sector as a whole, division into non-resource exports and imports is important if, as suggested by much development literature, a higher share of exports to GDP is associated with faster growth. The large negative impact of resources on these exports points to the difficulty resource rich economies face in diversifying their exports.

JEL Codes: E21, E62, F43, H63, O11, Q33

Keywords: natural resources, Dutch disease, resource curse, trade, exports, imports

Reference: 103

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Authors: David Gill,John Thanassoulis

Jan 2013

In this paper we study price competition between firms when some consumers attempt to
bargain while others buy at the public list or posted prices. Even though bargainers succeed in
negotiating discounts off the list prices, their presence dampens competitive pressure in the market
by reducing the incentive to undercut a rival

JEL Codes: C78, D43, L13

Keywords: Posted prices, list prices, collusion, bargaining, negotiation, haggling, discounts, outside option, price takers, Hotelling line

Reference: 639

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Authors: Ferdinand Rauch, Guy Michaels, Stephen J. Redding

Jan 2013

We develop a new methodology for quantifying the tasks undertaken within occupations using 3,000 verbs from around 12,000 occupational descriptions in the Dictionary of Occupational Titles (DOTs).  Using micro-data from the United States from 1880-2000, we find an increase in the employment share of interactive occupations within sectors over time that is larger in metro areas than non-metro areas.  We provide evidence that this increase in the interactiveness of employment is related to the dissemination of improvements in transport and communication technologies.  Our findings highlight a change in the nature of agglomeration over time towards an increased emphasis on human interaction.

JEL Codes: N92, O18, R12

Keywords: Economic development, human interaction, urbanization

Reference: 638

Individual View

The paper studies the long-run effects of shocks to resource rents on the economy using a structural vector error correction model for 37 developing countries. First, the long-run relations involving resource rents and the economy differ for resource importers and exporters. Second, there is an indirect effect from resource rents to output through public capital accumulation for resource exporters. Third, although resource rents have a positive long-run impact on output, good public investment management is required for resource rents to improve non-resource output.

JEL Codes: O13; O43; Q32

Keywords: Resource rents; Resource exporters; PIMI

Reference: 105

Individual View

Authors: Charles F Mason

Jan 2013

As addressing climate change becomes a high priority it seems likely that there will be a surge in interest in deploying nuclear power. Other fuel bases are too dirty (coal), too expensive (oil, natural gas) or too speculative (solar, wind) to completely supply the energy needs of the global economy. To the extent that the global society does in fact choose to expand nuclear power there will be a need for additional production.  That increase in demand for nuclear power will inevitably lead to an increase in demand for uranium. While some of the increased demand for uranium will be satisfied by expanding production from existing deposits, there will undoubtedly be pressure to find and develop new deposits, perhaps quite rapidly. Looking forward, it is important that policies be put in place that encourage an optimal allocation of future resources towards exploration. In particular, I argue there is a valid concern that privately optimal levels of industrial activity will fail to fully capture all potential social gains; these sub-optimal exploration levels are linked to an departure between the private and social values of exploration information.

Reference: 104

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Authors: Beata Javorcik, Yue Li

Jan 2013

Interconnections among financial institutions create potential channels for contagion
and amplification of shocks to the financial system. Contagion occurs when a shock to
the assets of a single firm causes other firms to default through the network of obligations.
We say that contagion is weak if the probability of default through contagion is no greater
than the probability of default through independent direct shocks to the defaulting nodes.
We derive a general formula which shows that, for a wide variety of shock distributions,
contagion is weak unless the triggering node is very large and/or highly leveraged compared
to the nodes it topples through contagion. We derive our results in the Eisenberg-Noe
(2001) framework with the addition of stochastic shocks. A distinguishing feature of our
approach is that our conditions do not depend on the topology of interconnections: they
hold for any financial network with a given distribution of bank sizes and leverage levels.
The likelihood of contagion increases when one augments the model to include bankruptcy
costs and mark-to-market losses from credit quality deterioration.

JEL Codes: F23, F14, L81, D24

Keywords: Global retail chains, productivity, services liberalization, foreign direct investment, backward linkages, reallocation, allocation efficiency

Reference: 637

Individual View

Authors: Ohad Raveh

Dec 2012

Do reduced costs of factor mobility mitigate Dutch Disease effects, to the extent that they are reversed? The case of federations provides an indication they do. We observe Resource Blessing effects at the federal-state level (within federations) yet rather

Resource Curse ones at the federal level (between federations), and argue the difference in outcomes stems from the difference in factor mobility costs. Through a two-region tax competition model we show that with sufficiently low factor mobility costs a resourceboom triggers an Alberta Effect –where resource abundant regions exploit the fiscal advantage, provided by resource rents, to compete more aggressively in the inter-regional competition over capital, and as a result attract vast amounts of capital– that mitigates, and possibly reverses, Dutch Disease symptoms, so that Resource Curse effects do not apply. Thus, this paper emphasizes the significance of the mitigating role of factor mobility in Dutch Disease theory, and presents a novel mechanism (Alberta Effect) through which this mitigation, and possible reversion, process occurs. The paper concludes with empirical evidence for the main implications of the model.

JEL Codes: O13, O18, O57, Q33

Keywords: Natural Resources, Factor Mobility, Dutch Disease, Resource Curse, Tax Competition

Reference: 100

Individual View

Authors: Roland Hodler

Dec 2012

The Arab Spring has led to very different outcomes across the Arab world. I present a highly stylized model of the Arab Spring to better understand these differences. In this model, dictators from the ethnic or religious majority group concede power if their country is oil-poor, but can stay in power by bribing the people if their country is oil-rich. Dictators from the minority group often rely on other members of their group to repress protests and to ght the majority group if necessary. These predictions are consistent with observed outcomes in Egypt, Libya, Saudi Arabia, Syria, Tunisia, and elsewhere.

JEL Codes: D72, D74

Keywords: Arab Spring, political transitions, repression, civil conflict, oil, divided societies

Reference: 101

Individual View

Authors: John Thanassoulis

Dec 2012

This paper studies the consequences of a regulatory pay cap in proportion to assets on
bank risk, bank value, and bank asset allocations. The cap is shown to lower banks' risk
and raise banks' values by acting against a competitive externality in the labour market.
The risk reduction is achieved without the possibility of reduced lending from a Tier 1
increase. The cap encourages diversi cation and reduces the need a bank has to focus on
a limited number of asset classes. The cap can be used for Macroprudential Regulation
to encourage banks to move resources away from wholesale banking to the retail banking
sector. Such an intervention would be targeted: in 2009 a 20% reduction in remuneration
would have been equivalent to more than 150 basis points of extra tier 1 for UBS, for

JEL Codes: G01, G21, G28, G32

Keywords: Remuneration, compensation, bonuses, capital conservation, systemic bank risk

Reference: 636

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Authors: H Peyton Young, Thomas Noe

Dec 2012

In recent years bonuses tied to performance have become commonplace in banks and other financial institutions; indeed they now constitute a major part of employee compensation.  The practice was originally justified by academic work on principal-agent contracts, which argued that performance bonuses would better align the interests of managers and shareholders.  In this article we argue that such schemes are not well-suited to aligning these interests in the financial sector.  There are two reasons for this failure.  First, new financial products make it easy to create the appearance of superior performance over long periods of time even though the outsize returns are merely being driven by hidden tail risk.  We show that it is virtually impossible to create performance contracts that get around this problem.  Second, the complexity of new products and the size of modern financial institutions make it extremely difficult (and costly) to monitor risky activities directly.  As in the first case, compensation schemes, including deferred compensation, are inefficient substitutes because it is easy to escape detection for long periods of time.  This opens the door for outright fraud.  We argue that a greater emphasis on ethical values, e.g., a duty of care to customers and shareholders, is more likely to produce effective reforms.

JEL Codes: G20, G28, D86

Keywords: Performance bonus, incentive contract, tail risk

Reference: 635

Individual View

In this paper, I use an event study approach to investigate the claim that conflict minerals legislation in the United States (US) led to a ban on some mining exports from the Democratic Republic of the Congo (DRC), and that the passage of US regulation caused a ban on both production and trade by regulators in the DRC several months later. I also consider the assertion that conflict minerals legislation imposed severe costs for companies that report to the Securities and Exchange Commission in the US.

I find that returns for some companies traded on US stock exchanges were sensitive to changes in production in the DRC after the proposed legislation became law in the US. This either suggests that some financial market participants did not expect an immediate full embargo on newly-regulated Congolese mining and trading activities, or that market participants did not expect trade to be halted indefinitely. Reactions to a DRC-imposed ban on production were statistically significant; indicating that additional reductions in trade were not fully anticipated by financial market participants after regulations became law in the US.

I also find that among metal and gold mining companies traded on US exchanges, returns were abnormally high when conflict mineral legislation became more probable. Electronic communication manufacturing firms, which as a group were a target for many supporters of conflict mineral regulations, experienced no systematically abnormal returns corresponding to important dates in the US legislative process that I consider, but experienced abnormally positive returns coinciding with the ban on mining in the eastern DRC.

JEL Codes: F51, Q34, Q37

Keywords: Event Study, Mining, Conflict Minerals, the Democratic Republic of the Congo, Trade Regulations, Natural Resources

Reference: 102

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Authors: James Malcomson

Dec 2012

This paper extends Levin’s (2003) relational contract model by having not only the agent’s cost of effort (agent’s type), but also the value of that effort to the principal (principal’s type) subject to i.i.d. shocks. When optimal effort is fully pooled across agent types for multiple principal types, it is also pooled across those principal types. When optimal effort separates some agent types for multiple principal types, efforts of those agent types may be separated across principal types. But then, somewhat perversely, some agent type’s effort is decreasing in the principal’s value of effort. When agent type is uniformly distributed, that applies to agent types with lower effort cost, so reducing the difference in effort between low and high effort cost types. This result extends to the principal’s type being observed only by the principal if the marginal cost of effort to the agent is sufficiently convex.

JEL Codes: C73, D82, D86

Keywords: Relational incentive contracts, shocks, principal types, agent types

Reference: 634

Individual View

Authors: James Malcomson

Dec 2012

This paper investigates relational incentive contracts with a continuum of privately observed
agent types that are persistent over time. For a sufficiently productive relationship,
a pooling contract exists in which all agent types continuing the relationship
choose the same action. Necessary and sufficient conditions are given for some separation
to be feasible; the parties can then do better than with full pooling. When future
actions are optimal, however, separation of all types is not possible; the finest separation
achievable is into partitions each containing a non-degenerate interval of types.
Separation always involves lower output initially than after separation has occurred.

JEL Codes: C73, D82, D86

Keywords: Relational incentive contracts, private information, ratchet effect, dynamic enforcement

Reference: 633

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Authors: John Vickers

Nov 2012

Where do we stand, five years on from the start of the crisis, on progress towards banking reform? Major advances have been made, but a lot of unfinished business remains, notably on structural reform of banks. Following a stock-take of current reform initiatives, the paper reviews some economics of public policy towards banks, starting with the rationale for deposit guarantees and lender-of-last-resort support but concentrating on why governments feel compelled to provide solvency support in crisis. It then covers the economics of capital requirements

JEL Codes: G21, G28, L51

Keywords: Banking, bail-outs, capital requirements, deposit guarantees, Glass-Steagall, resolution, ring-fencing, structural reform, Volcker rule

Reference: 632

Individual View

Authors: Dilyana Dimova

Nov 2012

Consumer leverage can generate financial crises characterized by increased bankruptcy, tightened credit access and reduced demand for goods.  This paper embeds financial frictions in the mortgage contracts of homeowners within a two-sector economy to show that even at moderate initial levels, household indebtedness can create a lasting financial downturn such as the subprime mortgage crisis.  Using two seemingly positive disturbances that triggered the subprime mortgage crisis - an increased housing supply and a relaxation of borrowing conditions - the model demonstrated that the subprime downturn was not a precedent but the natural consequence of financial frictions.  The oversupply of houses lowers asset prices and reduces the value of the real estate collateral used in the mortgage.  This worsens the leverage of indebted consumers and raised their bankruptcy prospects generating a pro-cyclical risk premium.  A relaxation of borrowing conditions turns credit-constrained households into a potential source of disturbances themselves when market optimism allows them to overleverage with little downpayment.  In both cases, the resulting excessive consumer leverage impairs household credit access for a lengthy after-shock period and diverts resources from their consumption.  Their reduced demand for goods may propagate the downturn to the rest of the economy depressing output in other sectors.  Adding credit constraints in the financial sector that provides housing mortgages deepens the negative impact of the shocks and makes recovery even more protracted.

JEL Codes: E21, E27, E44, G21, G33

Keywords: Financial frictions, consumer leverage, credit-constrained consumers, subprime mortgage crisis, pro-cyclical risk-premium

Reference: 631

Individual View

Authors: Chloe Qianzi Zeng

Nov 2012

This paper studies a marriage market with two-sided information asymmetry in which
the gains from marriage are stochastic. Contracts specify divisions of ex-post realized
marital surplus. I first study a game in which one side of the matching market offers
contracts. I show that when expected marital surplus is strictly monotonic in agents

JEL Codes: C78, D82, J12, D13

Keywords: Matching, two-sided information asymmetry, endogenous sharing rule, marriage market, stochastic marital surplus

Reference: 630

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Authors: Rick Van der Ploeg

Nov 2012

The political economy of natural resource extraction is analysed in three different contexts. First, if an incumbent faces a threat of being removed once and for all by a rival faction, extraction becomes more voracious, especially if the rebel faction shares rents much more than the incumbent. Second, perennial political conflict cycles are more inefficient if cohesiveness of the constitution or the partisan in-office bias is large and political instability is high. Third, resource wars are more intense if the political system is less cohesive, there is a partisan in-office bias of the incumbent, oil reserves are high, the wage is low, governments can be less frequently removed from office, and fighting technology has less decreasing returns to scale. Resource depletion in such wars is more rapacious if there is more government instability, the political system is less cohesive, and the partisan in-office bias is smaller.

JEL Codes: D81, H20, Q31, Q38

Keywords: political conflict; cohesiveness; partisan bias; dynamic resource wars; contests; rapacious depletion; exploitation investment; hold-up problem

Reference: 97

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