New Economics Papers
on Financial Markets
Issue of 2006‒07‒09
53 papers chosen by
Carolina Valiente

  1. Emerging Markets, Financial Openness and Financial Development By Wei Huang
  2. The Lending Channel in Emerging Economics: Are Foreign Banks Different? By Marco Arena; Carmen Reinhart; Francisco Vázquez
  3. Banking on the principles : compliance with Basel Core Principles and bank soundness By Tressel, Thierry; Detragiache, Enrica; Demirguc-Kunt, Asli
  4. Do market-based indicators anticipate rating agencies? Evidence for international banks By Antonio Di Cesare
  5. An empirical analysis of national differences in the retail bank interest rates of the euro area By Massimiliano Affinito; Fabio Farabullini
  6. Macroeconomic and financial stability challenges for acceding and candidate countries By Adalbert Winkler; Roland Beck
  7. Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar By Elias Papaioannou; Richard Portes; Gregorios Siourounis
  8. Why do analysts continue to provide favorable coverage for seasoned stocks? By Simona Mola; Massimo Guidolin
  9. Visible and hidden risk factors for banks By Til Schuermann; Kevin J. Stiroh
  10. Liquidity Insurance in a Financially Dollarized Economy By Eduardo Levy Yeyati
  11. Internal Capital Markets and Lending by Multinational Bank Subsidiaries By Ralph de Haas; Iman van Lelyveld
  12. Competing With the NYSE By William O. Brown, Jr.; J. Harold Mulherin; Marc D. Weidenmier
  13. Fool the markets? Creative accounting, fiscal transparency and sovereign risk premia By Kerstin Bernoth; Guntram Wolff
  14. Payment cards and the unbanked: prospects and challenges. By Julia S. Cheney
  15. Bailouts, Taxation and Financial Supervision By Pereira, Luis Brites
  16. Australian Government Balance Sheet Management By Wilson Au-Yeung; Jason McDonald; Amanda Sayegh
  17. Finance and economic development : policy choices for developing countries By Demirguc-Kunt, Asli
  18. Nontraded goods, market segmentation, and exchange rates. By Michael Dotsey; Margarida Duarte
  19. Rating mutual funds By Bechmann, Ken L.; Rangvid , Jesper
  20. The Performance of International Equity Portfolios By Charles P. Thomas; Francis E. Warnock; Jon Wongswan
  21. Loan Officers and Relationship Lending By Hirofumi Uchida; Gregory F. Udell; Nobuyoshi Yamori
  22. An Upper Bound of the Sum of Risks: two Applications of Comonotonicity By Carry Mout
  23. The relation between time-series and cross-sectional effects of idiosyncratic variance on stock returns in G7 countries By Hui Guo; Robert Savickas
  24. Implicit Bands in the Yen/Dollar Exchange Rate By Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñez; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
  25. The relationship between financial knowledge and behavior : evidence from a survey of Federal Reserve Bank of Kansas City employees By Mary Gillett Fisher; Kelly Edmiston
  26. Do workers ' remittances promote financial development ? By Martinez Peria, Maria Soledad; Demirguc-Kunt, Asli; Aggarwal, Reena
  27. Capital Gains Taxes and Asset Prices: Capitalization or Lock-In? By Zhonglan Dai; Edward Maydew; Douglas A. Shackelford; Harold H. Zhang
  28. The Relationship between Risk and Expected Return in Europe. By Ángel León; Juan Nave; Gonzalo Rubio
  29. How will China ' s saving-investment balance evolve ? By Kuijs, Louis
  30. Efficiency vs. agency motivations for bank takeovers: some empirical evidence By Alessio De Vincenzo; Claudio Doria; Carmelo Salleo
  31. Price Manipulation in an Experimental Asset Market By Veiga Helena; Vorsatz Marc
  32. New evidence on state banking before the Civil War By Warren E. Weber
  33. Stock price informativeness, cross-listings and investment decisions By Foucault, Thierry; Gehrig, Thomas
  34. Optimal Monetary Policy with Real-time Signal Extraction from the Bond Market By Kristoffer Nimark
  35. International Migration, Remittances, and Household Investment: Evidence from Philippine Migrants%u2019 Exchange Rate Shocks By Dean Yang
  36. Corporate Governance and Firms' Market Values: Time Series Evidence from Russia By Bernard S. Black; Inessa Love; Andrei Rachinsky
  37. A General Stochastic Volatility Model for the Pricing and Forecasting of Interest Rate Derivatives By Anders B. Trolle; Eduardo S. Schwartz
  38. A Multinomial Approach to Early Warning Systems for Debt Crises By Alessio Ciarlone; Giorgio Trebeschi
  39. Are Government Expenditures Productive? Measuring the Effect on Private Sector Production By Jaakko Kiander; Reino Hjerppe; Matti Virén
  40. A Note on Sufficient Conditions of Cross Risk Vulnerability By Yusuke Osaki
  41. Price Leadership in the Dutch Mortgage Market By Leo de Haan; Elmer Sterken
  42. IMF Concern for Reputation and Conditional Lending Failure: Theory and Empirics By Silvia Marchesi; Laura Sabani
  43. License auctions when winning bids are financed through debt By Haan, M.A.; Toolsema, L.A.
  44. "The Spirit of Capitalism and Asset Pricing: an Empirical Investigation" By Qiang Zhang
  45. Switching Between Expectation Processes in the Foreign Exchange Market: A Probabilistic Approach Using Survey Data By Georges Prat; Remzi Uctum
  46. The Catastrophic Effects of Natural Disasters on Insurance Markets By W. Kip Viscusi; Patricia Born
  47. Public feed back for better banknote design By Hans de Heij
  48. Household Decision Making and Savings Impacts: Further Evidence from a Commitment Savings Product in the Philippines By Nava Ashraf; Dean Karlan; Wesley Yin
  49. Do Borrowing Constraints Matter? An Analysis of Why the Permanent Income Hypothesis Does Not Apply in Japan By Miki Kohara; Charles Yuji Horioka
  50. Cost of Capital for Cross-border Investment: The Fallacy of Estonia as a Tax Haven By Seppo Kari; Jouko Ylä-Liedenpohja
  51. Risk Attitudes of Nascent Entrepreneurs : New Evidence from an Experimentally-Validated Survey By Marco Caliendo; Frank M. Fossen; Alexander S. Kritikos
  52. Comparative Risk Aversion under Background Risks Revisited By Masamitsu Ohnishi; Yusuke Osaki
  53. Imperfect knowledge, adaptive learning and the bias against activist monetary policies By Alberto Locarno

  1. By: Wei Huang
    Abstract: We examine the effect of financial openness on the development of financial systems in a panel of 35 emerging markets during the period of 1976 to 2003. A group of indicators including variables from banking sector, stock market, and national capital accounts are used as measures of financial openness and financial development. In addition, aggregate index measures are developed to incorporate information from different areas of the financial system. Our empirical results generally suggest that financial openness is the key determinant of cross-country differences in the development of financial systems. When testing financial openness against the development of the banking sector and stock market separately, we found strong and robust evidence that this link between openness and development exists in stock markets. Although a similar link is sometimes found with banking sectors, it is not robust to different indicators of financial openness and model specifications.
    Keywords: emerging markets, financial openness, financial development
    JEL: F36 F37 G15
    Date: 2006–07
  2. By: Marco Arena; Carmen Reinhart; Francisco Vázquez
    Abstract: This paper assembles a dataset comprising 1,565 banks in 20 Asian and Latin American countries during 1989-2001 and compares the response of the volume of loans, deposits, and bank-specific interest rates on loans and deposits, to various measures of monetary conditions, across domestic and foreign banks. It also looks for systematic differences in the behavior of domestic and foreign banks during periods of financial distress and tranquil times. Using differences in bank ownership as a proxy for financial constraints on banks, the paper finds weak evidence that foreign banks have a lower sensitivity of credit to monetary conditions relative to their domestic competitors, with the differences driven by banks with lower asset liquidity and/or capitalization. At the same time, the lending and deposit rates of foreign banks tend to be smoother during periods of financial distress, albeit the differences with domestic banks do not appear to be strong. These results provide weak support to the existence of supply-side effects in credit markets and suggest that foreign bank entry in emerging economies may have contributed somewhat to stability in credit markets.
    JEL: E51 G21
    Date: 2006–06
  3. By: Tressel, Thierry; Detragiache, Enrica; Demirguc-Kunt, Asli
    Abstract: This paper studies whether compliance with the Basel Core Principles for Effective Banking Supervision (BCP) improves bank soundness. BCP compliance assessments provide a unique source of information about the quality of bank supervision and regulation around the world. The authors find a significant and positive relationship between bank soundness (measured with Moody ' s financial strength ratings) and compliance with principles related to information provision. Specifically, countries that require banks to report regularly and accurately their financial data to regulators and market participants have sounder banks. This relationship is robust to controlling for broad indexes of institutional quality, macroeconomic variables, sovereign ratings, as well as reverse causality. Measuring soundness through z-scores yields similar results. The findings emphasize the importance of transparency in making supervisory processes effective and strengthening market discipline. Countries aiming to upgrade banking regulation and supervision should consider giving priority to information provision over other elements of the Core Principles.
    Keywords: Banks & Banking Reform,Financial Intermediation,Corporate Law,Financial Crisis Management & Restructuring,Insurance & Risk Mitigation
    Date: 2006–06–01
  4. By: Antonio Di Cesare (Banca d'Italia)
    Abstract: This paper analyzes the ability of credit default swap spreads, bond spreads and stock prices to anticipate the decisions of the main rating agencies, for the largest international banks. Conditional on negative rating events, all the three indicators show signi¯cant abnormal changes before both announcements of review and actual credit rating changes, but rating actions still seem to convey new information to the market. Results for positive rating events are less clear-cut with the market indicators generally showing abnormal behaviors only in conjunction with the events. As for the predictive power of the ¯nancial indicators examined, the CDS market is particularly useful for negative events and stock prices for positive events. However, all indicators also send many false signals and are to be interpreted with care.
    Keywords: Credit derivatives, credit default swaps, option-adjusted spreads,credit ratingss
    JEL: G14 G21
    Date: 2006–05
  5. By: Massimiliano Affinito (Banca d'Italia); Fabio Farabullini (Banca d'Italia)
    Abstract: The availability of new harmonized data on bank interest rates allows a rigorous assessment to be made of cross-country price homogeneity/heterogeneity in euro area retail credit markets. Econometric analysis shows that the banking market is still highly segmented and that the degree of integration in a single country (Italy, taken as a benchmark for integration) is greater than in the euro area. However, national differences can be partially explained by variables reflecting the characteristics of domestic depositors and borrowers (“demand side” regressors, such as risk exposure, disposable income, alternative financing sources, average firm size) and the characteristics of the banking systems (“supply side” regressors, such as banking market concentration, asset and liability structure). The euro area prices appear different because national banking products appear different or because they are differentiated by national factors. Once these factors have been controlled for, many differences disappear.
    Keywords: bank interest rates, convergence, integration
    JEL: E43 E44 G21
    Date: 2006–05
  6. By: Adalbert Winkler (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany); Roland Beck (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany)
    Abstract: This paper – based on a report by a Task Force established by the International Relations Committee (IRC) of the European System of Central Banks (ESCB) – reviews macroeconomic and financial stability challenges for acceding (Bulgaria and Romania) and candidate countries (Croatia and Turkey). In an environment characterised by strong growth and capital inflows, the main macroeconomic challenges relate to the recent pick-up of inflation and the large and widening current account deficits. Moreover, rapid credit growth has been a recent feature of financial development in all countries and thus constitutes the main financial stability challenge. In general, monetary authorities have responded to these challenges by tightening monetary conditions and prudential standards, with concrete measures also reflecting the different monetary and exchange rate regimes in the region. The paper also highlights four specific features of financial development in the countries under review, namely the dominance of banks in financial intermediation, the strong participation of foreign-owned banks, the widespread use of foreign currencies and the strengthening of supervisory frameworks. JEL Classification: E65, G21, G38, O16, P27.
    Keywords: South-East Europe, macroeconomic performance, credit growth, financial stability.
    Date: 2006–07
  7. By: Elias Papaioannou; Richard Portes; Gregorios Siourounis
    Abstract: Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ("punching above its weight"). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important.
    JEL: F02 F30 G11 G15
    Date: 2006–06
  8. By: Simona Mola; Massimo Guidolin
    Abstract: Research has documented that the first report an investment bank affiliated analyst issues on a newly listed stock tends to be favorable. Our analysis of 16,824 relationships between analyst teams and established listed companies during 1995-2003 indicates that analyst coverage decisions of seasoned stocks are influenced by their affiliations with investment banks and mutual funds. Controlling for market returns, stock characteristics, and a variety of performance indicators, we find analysts are more likely to issue favorable reports when the stock is held by affiliated mutual funds. The more invested by affiliated mutual funds, the more optimistic the analyst rating compared to the consensus.
    Keywords: Mutual funds ; Financial institutions
    Date: 2006
  9. By: Til Schuermann; Kevin J. Stiroh
    Abstract: This paper examines the common factors that drive the returns of U.S. bank holding companies from 1997 to 2005. We compare a range of market models from a basic one-factor model to a nine-factor model that includes the standard Fama-French factors and additional factors thought to be particularly relevant for banks such as interest and credit variables. We show that the market factor clearly dominates in explaining bank returns, followed by the Fama-French factors. The bank-specific factors are not informative, particularly for the largest banks, which take advantage of protection in the form of interest rate and credit derivatives. Even in our broadest model, however, considerable residual variation remains, with the mean pairwise correlation of residuals for the largest banks near 0.25. This finding suggests that important hidden factors remain. A principal component analysis shows that this residual variance is relatively diffuse, although the largest banks do tend to load in the same direction on the first component. Relative to the returns of large firms in other sectors, bank returns are relatively well explained with standard risk factors, and both the residual correlation and degree of factor loading agreement are not particularly large. These results have clear implications both for public policymakers seeking to quantify those shared bank exposures that create systemic risk and to portfolio managers seeking to devise optimal diversification strategies.
    Keywords: Bank holding companies ; Bank profits ; Rate of return ; Bank investments
    Date: 2006
  10. By: Eduardo Levy Yeyati
    Abstract: Unlike the financial dollarization (FD) of external liabilities, the dollarization of domestic financial assets (domestic FD) has received comparatively less attention until very recently, when it has been increasingly seen as a key source of balance sheet exposure. This paper focuses on a complementary –and often overlooked– angle of domestic FD: the limit it imposes on the central bank as domestic lender of last resort, and the resulting exposure to dollar liquidity runs. The paper discusses the incidence of FD on banking crisis propensity, shows that FD has been an important motive for self insurance in the form of international reserves, and highlights the moral hazard associated with centralized reserve accumulation. Next, it illustrates the authorities’ belated recourse to suspension of convertibility in two recent banking crises (Argentina 2001 and Uruguay 2002). Finally, it argues for a combined scheme of decentralized reserves (liquid asset requirements on individual banks) to limit moral hazard, and an ex-ante suspension-of-convertibility clause (“circuit breakers”) to reduce self-insurance costs while limiting bank losses in the event of a run.
    JEL: G2 F3
    Date: 2006–06
  11. By: Ralph de Haas; Iman van Lelyveld
    Abstract: We use panel data on the intra-group ownership structure and balance sheets of 45 of the largest banking groups from 1992 to 2004 to analyse what determines the credit growth of multinational bank subsidiaries. Both home- and host-country conditions and characteristics of the subsidiaries themselves and their parent banks are taken into account. We find that the lending of multinational bank subsidiaries is influenced by substitution effects, in which parent banks trade-off lending in several countries, as well as support effects, in which parent banks support weak subsidiaries. This provides strong evidence for the existence of internal capital markets through which multinational banks manage the credit growth of their subsidiaries. We also find that greenfield subsidiaries are more closely integrated into internal capital markets than subsidiaries that result from a take-over.
    Keywords: multinational banks; credit supply; internal capital markets
    JEL: F15 F23 F36 G21
    Date: 2006–06
  12. By: William O. Brown, Jr.; J. Harold Mulherin; Marc D. Weidenmier
    Abstract: We study the stock exchange rivalry between the New York Stock Exchange (NYSE) and the Consolidated Stock Exchange (Consolidated) from 1885 to 1926 using a new database of bid-ask spreads and stock data collected from The New York Times and other primary sources. The magnitude of this important, but largely forgotten rivalry was substantial. From 1885 to 1895, the ratio of Consolidated to NYSE volume averaged 40 percent and reached as high as 60 percent. The market share of the Consolidated averaged 23 percent for approximately 40 years. The Consolidated focused on the relatively liquid securities on the NYSE as measured by bid-ask spreads and trading volume. Our results suggest that NYSE bid-ask spreads fell by more than 10 percent when the Consolidated began to trade NYSE stocks while bid-ask spreads for our quasicontrol group of stocks trading on the Boston Stock Exchange remain unchanged. The effect persisted over the entire history of the stock market rivalry until a series of scandals and investigations of the Consolidated by state regulators led to the demise of the exchange in the 1920s. The analysis suggests three conclusions: (1) the NYSE has faced significant long-run competition (2) the NYSE may be susceptible to a similar level of competition in the future and (3) that the Consolidated may have improved the efficiency of stock prices by contributing to the price discovery process.
    JEL: G1 G2 N2
    Date: 2006–06
  13. By: Kerstin Bernoth; Guntram Wolff
    Abstract: We investigate the effects of official fiscal data and creative accounting signals on interest rate spreads between bond yields in the European Union. Our model predicts that risk premia contained in government bond spreads should increase in both, the official fiscal position and the expected ”creative” part of fiscal policy. The relative importance of these two signals depends on the transparency of the country. Greater transparency reduces risk premia. The empirical results confirm the hypotheses. Creative accounting increases the spread. The increase of the risk premium is stronger if financial markets are unsure about the true extent of creative accounting. Fiscal transparency reduces risk premia. Instrumental variable egressions confirm these results by addressing potential reverse causality problems and measurement bias.
    Keywords: Risk premia; government bond yields; creative accounting; stock-flow adjustments; gimmickry; transparency
    JEL: G12 E43 E62 H6 F34
    Date: 2006–06
  14. By: Julia S. Cheney
    Abstract: On July 13-14, 2005, the Payment Cards Center of the Federal Reserve Bank of Philadelphia hosted a conference to better understand the ways in which electronic payment tools are being adapted to meet the financial needs of underserved consumers. This event, “Payment Cards and the Unbanked: Prospects and Challenges,” brought together a range of perspectives from the banking industry, community development arena, academic community, and regulatory groups, as well as providers of new and emerging payment technologies. These participants examined the opportunities and challenges in providing financial tools that are less costly than those offered in the alternative financial sector — check cashers, money transmitters, payday lenders, and the like — but that, at the same time, meet the financial needs of underserved consumers and are economically viable for traditional and emerging providers.
    Keywords: Payment systems ; Unbanked
    Date: 2005
  15. By: Pereira, Luis Brites
    Date: 2006
  16. By: Wilson Au-Yeung; Jason McDonald; Amanda Sayegh
    Abstract: Since almost eliminating net debt, the Australian Government’s attention has turned to the financing of broader balance sheet liabilities, such as public sector superannuation. Australia will be developing a significant financial asset portfolio in the ‘Future Fund’ to smooth the financing of expenses through time. This raises the significant policy question of how best to manage the government balance sheet to reduce risk. This paper provides a framework for optimal balance sheet management. The major conclusions are that: – fiscal sustainability depends on both the expected path of future taxation and the risks around that path; – optimal balance sheet management requires knowledge of how risks affect the balance sheet (and therefore volatility in tax rates); and – the government’s financial investment strategy should reduce the risk to government finances from macroeconomic shocks that permanently affect the budget. Based on this framework, we find that a Future Fund portfolio that included (amongst other potential investments) domestic nominal securities and equities of selected countries would reduce overall balance sheet risk.
    JEL: H5 H6
    Date: 2006–06
  17. By: Demirguc-Kunt, Asli
    Abstract: The empirical literature on finance and development suggests that countries with better developed financial systems experience faster economic growth. Financial development-as captured by size, depth, efficiency, and reach of financial systems-varies sharply around the world, with large differences among countries at similar levels of income. This paper argues that governments play an important role in building effective financial systems and discusses different policy options to make finance work for development.
    Keywords: Banks & Banking Reform,Economic Theory & Research,Macroeconomic Management,Pro-Poor Growth and Inequality,Inequality
    Date: 2006–06–01
  18. By: Michael Dotsey; Margarida Duarte
    Abstract: Empirical evidence suggests that movements in international relative prices (such as the real exchange rate) are large and persistent. Nontraded goods, both in the form of final consumption goods and as an input into the production of final tradable goods, are an important aspect behind international relative price movements. In this paper we show that nontraded goods have important implications for exchange rate behavior, even though fluctuations in the relative price of nontraded goods account for a relatively small fraction of real exchange rate movements. In our quantitative study nontraded goods magnify the volatility of exchange rates when compared to the model without nontraded goods. Cross-country correlations and the correlation of exchange rates with other macro variables are closer in line with the data. In addition, contrary to a large literature, standard alternative assumptions about the currency in which firms price their goods are virtually inconsequential for the properties of aggregate variables in our model, other than the terms of trade.
    Keywords: Markets ; Foreign exchange rates
    Date: 2006
  19. By: Bechmann, Ken L. (Department of Finance, Copenhagen Business School); Rangvid , Jesper (Department of Finance, Copenhagen Business School)
    Abstract: We develop a new rating of mutual funds: the atpRating. The atpRating assigns crowns to each individual mutual fund based upon the costs an investor pays when investing in the fund in relation to what it would cost to invest in the fund’s peers. Within each investment category, the rating assigns five crowns to funds with the lowest costs and one crown to funds with the highest costs. We investigate the ability of the atpRating to predict the future performance of a fund. We find that an investor who has invested in the funds with the lowest costs within an investment category would have obtained an annual risk-adjusted excess return that is approximately 3-4 percentage points higher per annum than if the funds with the highest costs had been invested in. We compare the atpRating with the Morningstar Rating. We show that one reason why the atpRating and the Morningstar Rating contain different information is that the returns Morningstar uses as inputs when rating funds are highly volatile whereas the costs the atpRating uses as inputs when rating funds are highly persistent. In other words, a fund that has low costs one year will most likely also have low costs the following year, whereas the return of a fund in a certain year generally contains only little information about the future return that the fund will generate. Finally, we have information on the investments in different mutual funds made by a small subgroup of investors known to have been exposed to both the atpRating and the Morningstar Rating, i.e. information is provided on how investors use the two ratings. We find that investors have a clear preference for high-rated funds.
    Keywords: investor-cost based rating; funds
    JEL: G00
    Date: 2006–06–29
  20. By: Charles P. Thomas; Francis E. Warnock; Jon Wongswan
    Abstract: This paper evaluates the ability of U.S. investors to allocate their foreign equity portfolios across 44 countries over a 25-year period. We find that U.S. portfolios achieved a significantly higher Sharpe ratio than foreign benchmarks, especially since 1990. We test whether this strong performance owed to trading expertise or longer-term allocation expertise. The evidence is overwhelmingly against trading expertise. While U.S. investors did abstain from momentum trading and instead sold past winners, we find no evidence that these past winners subsequently underperformed. In addition, conditional performance measures, which directly test reallocating into (out of) markets that subsequently outperformed (underperformed), suggest no significant trading expertise. In contrast, we offer strong evidence of longer-term allocation expertise: If we fix portfolio weights at the end of 1989 and do not allow reallocations, we still find superior performance in the recent period.
    JEL: G11 G12 F21
    Date: 2006–07
  21. By: Hirofumi Uchida; Gregory F. Udell; Nobuyoshi Yamori
    Abstract: Theoretical and empirical work suggests that commercial loan officers play a critical role in relationship lending by producing soft information about their SME borrowers. We test whether loan officers in the Japanese SME loan market perform this role in a manner that is consistent with the theoretical predictions in the relationship lending literature. While we find limited evidence that soft information may benefit SME borrowers, we do not find evidence that is on balance consistent with theoretical predictions that loan officers produce soft information that is not easily transmitted to others within the bank. These results are consistent with alternative explanations including the possibility that the social environment in Japan leads to a credit culture where it is easier to transmit soft information from one loan officer to another. It could also be consistent with the possibility that the relationship lending may not be particularly important in the Japanese SME loan market.
    Date: 2006–06
  22. By: Carry Mout
    Abstract: This paper discusses the method of comonotonicity to estimate the sum of risks. Two applications are presented. First, we estimate a property insurer.s exposure to claims after a severe storm. Second, we apply our approach to a pension fund.s investment risk to estimate the prospective total assets and the conditional prospective funding rate. Both applications show that comonotonicity can be a useful tool to assess the upper bound for the risk exposure of financial institutions.
    Keywords: estimate, sum of risks, investment
    JEL: C13 G22 G23
    Date: 2006–06
  23. By: Hui Guo; Robert Savickas
    Abstract: This paper suggests that CAPM-based idiosyncratic variance (IV) correlates negatively with future stock returns because it is a proxy for loadings on discount-rate shocks in Campbell*s (1993) ICAPM. The ICAPM also implies that there are important links between the time-series and cross-sectional IV effects. For example, the coefficients on conditional stock market variance and value-weighted average IV obtained from the time-series regressions reflect loadings on stock market returns and discount-rate shocks, respectively; therefore, they should help explain the cross section of stock returns. Moreover, we expect a close relation between the IV and book-to-market effects because recent studies show that the latter also reflects intertemporal pricing. These conjectures are strongly supported by the G7 countries* data.
    Keywords: Stock exchanges
    Date: 2006
  24. By: Francisco Ledesma-Rodríguez; Manuel Navarro-Ibáñez; Jorge Pérez-Rodríguez; Simón Sosvilla-Rivero
    Abstract: This paper attempts to identify implicit exchange rate regimes for the Yen/Dollar exchange rate. To that end, we apply a sequential procedure that considers both the dynamics of exchange rates and central bank interventions to data covering the period from 1971 to 2003. Our results would suggest that implicit bands existed in two subperiods: April-December 1980 and March-December 1987, the latter coinciding with the Louvre Accord. Furthermore, the study of the credibility of such implicit bands indicates the high degree of confidence attributed by economic agents to the evolution of the Yen/Dollar exchange rate within the detected implicit band rate, thus lending further support to the relevance of such implicit bands.
  25. By: Mary Gillett Fisher; Kelly Edmiston
    Abstract: The changing income and debt patterns among Americans and an increasingly complex financial services environment have led many to wonder about the average consumer’s ability to make good personal financial decisions without formal training.  This paper introduces a new theoretical model to explain the increased incidence of overspending and under-saving in the United States. The model is influenced by the level of advertising put forth by firms and consumers’ level of financial knowledge.  Analysis of an original dataset collected at the Federal Reserve Bank of Kansas City is used as support for the influence of financial knowledge in this conceptual framework.  The effects of financial education are discussed at great length as it is a likely means of increasing financial knowledge. On the whole, study results support our contention that financially literate individuals demonstrate financial behaviors that are considered to be more optimal in the context of our theoretical model.
    Keywords: Financial literacy
    Date: 2006
  26. By: Martinez Peria, Maria Soledad; Demirguc-Kunt, Asli; Aggarwal, Reena
    Abstract: Workers ' remittances to developing countries have become the second largest type of flows after foreign direct investment. The authors use data on workers ' remittance flows to 99 developing countries from 1975-2003 to study the impact of remittances on financial sector development. In particular, they examine whether remittances contribute to increasing the aggregate level of deposits and credit intermediated by the local banking sector. This is an important question considering the extensive literature that has documented the growth-enhancing and poverty-reducing effects of financial development. The findings provide strong support for the notion that remittances promote financial development in developing countries.
    Keywords: Remittances,Economic Theory & Research,Pro-Poor Growth and Inequality,Banks & Banking Reform,Financial Economics
    Date: 2006–07–01
  27. By: Zhonglan Dai; Edward Maydew; Douglas A. Shackelford; Harold H. Zhang
    Abstract: This paper examines the impact on asset prices from a reduction in the long-term capital gains tax rate using an equilibrium approach that considers both demand and supply responses. We demonstrate that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock-in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock-in effect in the week after the rate reduction became effective. Nondividend paying stocks (whose shareholders only face capital gains taxes) experience higher average returns during the week the capitalization effect dominates and stocks with large embedded capital gains and high tax sensitive investor ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume during the week immediately before and after the tax cut becomes effective and in stocks with large embedded capital gains and high tax sensitive ownership during the dominant lock-in week.
    JEL: H2 G1 D4 M4
    Date: 2006–06
  28. By: Ángel León (University of Alicante); Juan Nave (University of Castilla La Mancha); Gonzalo Rubio (University of the Basque Country)
    Abstract: We employ MIDAS (Mixed Data Sampling) to study the risk-expected return trade-off in several European stock indices. Using MIDAS, we report that, in most indices, there is a significant and positive relationship between risk and expected return. This strongly contrasts with the result we obtain when we employ both symmetric and asymmetric GARCH models for conditional variance. We also find that asymmetric specifications of the variance process within the MIDAS framework improve the relationship between risk and expected return. Finally, we introduce bivariate MIDAS and find some evidence of significant pricing of the hedging component for the intertemporal riskreturn trade-off.
    Keywords: Risk-return trade-off, hedging component, MIDAS, conditional variance
    JEL: G12 C22
    Date: 2005–07–04
  29. By: Kuijs, Louis
    Abstract: This paper investigates how China ' s saving, investment, and saving-investment balance will evolve in the decades ahead. Household saving in China is relatively high compared with OECD countries. However, much of China ' s high economywide saving, and the difference between China and other countries, are due to unusually high enterprise and government saving. Moreover, cross-country empirical analysis shows that economywide saving and investment in China are higher than what would be expected, even adjusting for differences in economic structure. Combined, these findings suggest that much of China ' s high saving is the result of policies particular to China. Looking ahead, the econometric results suggest that purely on the basis of projected structural developments-including development, changes in economic structure, urbanization, and demographics-saving and investment would both decline only mildly in the coming two decades, with ambiguous impact on the current account surplus. However, the potential effect on saving, investment, and the saving-investment balance of several policy adjustments could be large. Several of these policies are identified and their likely impact assessed and quantified. This exercise suggests that rebalancing along these lines should reduce both saving and the current account surplus over time, although the surplus is unlikely to turn into a deficit soon.
    Keywords: Economic Theory & Research,Investment and Investment Climate,Economic Investment & Savings,Non Bank Financial Institutions,Contractual Savings
    Date: 2006–07–01
  30. By: Alessio De Vincenzo (Bank of Italy); Claudio Doria (Bank of Italy); Carmelo Salleo (Bank of Italy)
    Abstract: Bank takeovers result on average in little improvements in performance. This may be due to conflicting driving forces behind them; however these have seldom been studied. We study directly the motivations for bank acquisitions by analyzing the prices paid for them, under the assumption that bankers are willing to pay for what they want. We find that there is no evidence that bankers are ready to pay for possible economies of scale and scope; on the other hand buyers expect to transfer their superior managerial skills to targets. Market power seems to hold little value while entry (or diversification) commands a premium. Agency issues at the buyer are also an important motivation for takeovers: other things being equal acquirers with more free capital are willing to pay more.
    Keywords: banking, M&As, pricing, corporate governance, market power
    JEL: G21 G34 L21
    Date: 2006–05
  31. By: Veiga Helena; Vorsatz Marc (METEOR)
    Abstract: We analyze in the laboratory whether an uninformed trader is able to manipulate the price of a financial asset. To do so, we compare the results of two different experimental treatments. In the Benchmark Treatment, twelve subjects trade a common value asset that takes either a high or a low value. Information is distributed asymmetrically, only three outof twelve subjects know the actual value of the asset. The Manipulation Treatment is identical to the Benchmark Treatment apart from the fact that we introduce a computer program as an additional trader. This manipulation program buys a fixed number of shares in the beginning of a trading period and sells them afterwards again. Our results show that the last contract price is significantly higher in the Manipulation Treatment if the asset takes a low value and that there are no price differences between the two treatments if the value of the asset is high. Moreover, this simple manipulation program is, at least in some instances, profitable.
    Keywords: financial economics and financial management ;
    Date: 2006
  32. By: Warren E. Weber
    Abstract: Prior to the Civil War there were three major differences among states in how U.S. banks were regulated: (1) Whether they were established by charter or under free-banking laws. (2) Whether they were permitted to branch. (3) Whether the state established a state-owned bank. I use a census of the state banks that existed in the United States prior to the Civil War that I recently constructed to determine how these differences in state regulation affected the banking outcomes in these states. Specifically, I determine differences in banks per capita by state over time; bank longevities (survival rates) by state, size, and type of organization; and bank failure probabilities also by state, size, and type of organization. In addition, I estimate the losses experienced by note holders and determine whether there were systematic differences in these depending on whether or not a bank was organized under a free banking law.
    Date: 2006
  33. By: Foucault, Thierry; Gehrig, Thomas
    Abstract: In this paper, the authors show that a cross-listing allows a firm to make better investment decisions because it enhances stock price informativeness.
    Keywords: Cross-listings; cross-listings premium; price informativeness; investment decisions; flow-back; ownership.
    JEL: D92 G11
    Date: 2006–04–01
  34. By: Kristoffer Nimark (Reserve Bank of Australia)
    Abstract: Monetary policy is conducted in an environment of uncertainty. This paper sets up a model where the central bank uses real-time data from the bond market together with standard macroeconomic indicators to estimate the current state of the economy more efficiently, while taking into account that its own actions influence what it observes. The timeliness of bond market data allows for quicker responses of monetary policy to disturbances compared to the case when the central bank has to rely solely on collected aggregate data. The information content of the term structure creates a link between the bond market and the macroeconomy that is novel to the literature. To quantify the importance of the bond market as a source of information, the model is estimated on data for the United States and Australia using Bayesian methods. The empirical exercise suggests that there is some information in the US term structure that helps the Federal Reserve to identify shocks to the economy on a timely basis. Australian bond prices seem to be less informative than their US counterparts, perhaps because Australia is a relatively small and open economy.
    Keywords: monetary policy; imperfect information; bond market; term structure of interest rates
    JEL: E32 E43 E52
    Date: 2006–06
  35. By: Dean Yang
    Abstract: Millions of households in developing countries receive financial support from family members working overseas. How do migrant earnings affect origin-household investments? This paper examines Philippine households’ responses to overseas members’ economic shocks. Overseas Filipinos work in dozens of foreign countries, which experienced sudden (and heterogeneous) changes in exchange rates due to the 1997 Asian financial crisis. Appreciation of a migrant’s currency against the Philippine peso leads to increases in household remittances received from overseas. The estimated elasticity of Philippine-peso remittances with respect to the Philippine/foreign exchange rate is 0.60. These positive income shocks lead to enhanced human capital accumulation and entrepreneurship in migrants’ origin households. Child schooling and educational expenditure rise, while child labor falls. In the area of entrepreneurship, households raise hours worked in self-employment, and become more likely to start relatively capital-intensive household enterprises.
    JEL: D13 F22 I2 I3 J22 J23 J24 O12 O15
    Date: 2006–06
  36. By: Bernard S. Black (University of Texas at Austin); Inessa Love (The World Bank); Andrei Rachinsky (New Economic School/CEFIR)
    Abstract: There is increasing evidence that broad measures of firm-level corporate governance predict higher share prices. However, almost all prior work relies on cross-sectional data. This work leaves open the possibility that endogeneity or omitted firm-level variables explain the observed correlations. We address the second possibility by offering time-series evidence from Russia for 1999-present, exploiting a number of available governance indices. We find an economically important and statistically strong correlation between governance and market value in OLS with firm clusters and in firm random effects and firm fixed effects regressions. We also find significant differences in the predictive power of different indices, and in the components of these indices. How one measures governance matters.
    Keywords: Russia, corporate governance, corporate governance index, law and finance, firm valuation, disclosure, emerging markets
    JEL: G32 G34
    Date: 2005–11
  37. By: Anders B. Trolle; Eduardo S. Schwartz
    Abstract: We develop a tractable and flexible stochastic volatility multi-factor model of the term structure of interest rates. It features correlations between innovations to forward rates and volatilities, quasi-analytical prices of zero-coupon bond options and dynamics of the forward rate curve, under both the actual and risk-neutral measure, in terms of a finite-dimensional affine state vector. The model has a very good fit to an extensive panel data set of interest rates, swaptions and caps. In particular, the model matches the implied cap skews and the dynamics of implied volatilities. The model also performs well in forecasting interest rates and derivatives.
    JEL: E43 G13
    Date: 2006–06
  38. By: Alessio Ciarlone (Bank of Italy); Giorgio Trebeschi (Bank of Italy)
    Abstract: This paper develops an early warning system for sovereign debt crises, broadly defined as episodes of outright default, failure of a country to be current on external obligations and substantial access to IMF resources. It estimates a multinomial logit model that makes it possible to differentiate between three regimes labelled ‘tranquil’, ‘pre-crisis’ and ‘adjustment’. The model includes a large set of macroeconomic variables and is able to predict, in-sample, 78 per cent of onsets of crisis while sending false alarms in 34 per cent of tranquil cases; its out-of-sample performance is very similar, with 70 per cent of entries into crisis correctly predicted and 20 per cent of tranquil cases triggering false alarms.
    Keywords: emerging markets, early warning systems, debt crises, default
    JEL: H63 E66
    Date: 2006–05
  39. By: Jaakko Kiander; Reino Hjerppe; Matti Virén
    Abstract: This paper analyses the productivity of public expenditures. It follows the branch of literature originated by Aschauer but has also some novel features. First of all, it focuses on the effect of both public investment and public consumption (investment part of public consumption) on private sector productivity. Secondly, empirical evidence is derived from relative large cross-country data that cover more than three decades. For the testing purpose, it uses a production function approach in which (alternative definitions of) public sector capital stocks are allowed to affect total factor productivity. The production relationships are estimated from a panel data that are derived from the data banks of OECD and the World Bank. Empirical findings suggest that, to some extent, the significant deceleration of economic growth in many OECD countries during the last two decades can, in the same way as in the original Aschauer analysis with the US data, be explained by a secular decrease in public sector investment.
    Keywords: Public sector, productivity, growth accounting, capital stock
    Date: 2006–03–03
  40. By: Yusuke Osaki (JSPS Research Fellow)
    Abstract: This note gives sufficient conditions of cross risk vulnerability introduced by Malevergne and Rey (2005), which is the equivalent condition to guarantee that an unfair non-monetary background risk makes decision makers more risk averse. The sufficient conditions determined by this note expand the results for univariate utility function into bivariate utility functions.
    Keywords: Background risk, cross risk vulnerabiilty, risk aversion.
    JEL: D81
    Date: 2006–06
  41. By: Leo de Haan; Elmer Sterken
    Abstract: We study competitive price setting behavior in the Dutch mortgage market, using daily observations on advertised 5- and 10-year mortgage interest rates for a sample of the four largest Dutch banks. We (1) estimate a VECM model, (2) a discrete choice model and (3) a structural conjectural variation model. The results indicate that one of the banks is a price leader, but that waiting for the leader to set the first step does not exclude competitive pricing by the followers.
    Keywords: Mortgage market; Competition; Price leadership; VECM; Probit; Conjectural variation.
    JEL: G21 L13
    Date: 2006–06
  42. By: Silvia Marchesi (University of Siena and University of Florence); Laura Sabani (University of Siena and University of Florence)
    Abstract: In this paper we suggest that the dual role played by the IMF, as a creditor and as a monitor of economic reforms, might explain the lack of credibility of the Fund threat of sanctioning non-compliance with conditionality. Specifically, we show that the IMF desire to preserve its reputation as a good monitor may distort its lending decisions towards some laxity. Moreover, such distortionary incentives may be exacerbated by the length of the relationship between a country and the Fund. Estimating a dynamic panel of 53 middle-income countries, for the period 1982-2001, we find that a longer relationship does increase IMF disbursements.
    Keywords: IMF programmes, conditionality, incomplete information, reputation, dynamic panel
    JEL: C23 D82 F34 N2
    Date: 2005
  43. By: Haan, M.A.; Toolsema, L.A. (Groningen University)
    Abstract: We study an auction where two licenses to operate on a new market are sold, and winning bidders finance their bids on the debt market. Higher bids imply higher debts, which affects product market competition. We compare our results to those of a beauty contest and a standard auction. For the case that debt induces firms to compete more aggressively, we find that consumer prices are lower, and expected firm profits are strictly positive although firms are a priori identical. When debt induces firms to compete less aggressively, we find that firms make zero profits, and consumer prices are higher.
    Date: 2006
  44. By: Qiang Zhang (Department of Economics, Fogelman College of Business & Economics, University of Memphis)
    Abstract: We extend and test two models of aggregate asset pricing that feature status-seeking through accumulation of not only financial assets but also human capital. We use weak-identification robust tests to confront these models with U.S. data. Contrary to previous results, we find that the spirit of capitalism hypothesis, modeled as either direct preference for wealth or pursuit of relative wealth status, is rejected in the aggregate data. Therefore, adding status motive alone to an otherwise standard model may not be sufficient to resolve the equity premium puzzle.
    Date: 2006–06
  45. By: Georges Prat (EconomiX - [CNRS : UMR7166] - [Université de Paris X - Nanterre]); Remzi Uctum (EconomiX - [CNRS : UMR7166] - [Université de Paris X - Nanterre])
    Abstract: This paper relaxes a fundamental hypothesis commonly accepted in the expectation formation literature: expectations are, unchangingly, either rational or generated by one of the three simple extrapolative, regressive or adaptive processes. Using expectations survey data provided by Consensus Forecasts on six European exchange rates against US Dollar, we find that the rational expectation hypothesis is rejected at the aggregate level. By implementing a switching regression methodology with stochastic choice of regime, we show that the expectation generating process is given at any time by some combination of the three simple processes. An interpretation of this framework in terms of economically rational expectations is suggested.
    Keywords: expectation formation; switching-regime; exchange rates; survey data; cost and advantage analysis
    Date: 2006–06–23
  46. By: W. Kip Viscusi; Patricia Born
    Abstract: Natural catastrophes often have catastrophic risks on insurance companies as well as on the insured. Using a very large dataset on homeowners’ insurance coverage by state, by firm, and by year for the 1984 to 2004 period, this paper documents the positive effect on losses and loss ratios of both unexpected catastrophes as well as large events that the authors term “blockbuster catastrophes.” Insurers adapt to these catastrophic risks by raising insurance rates, leading to lower loss ratios after the catastrophic event. There is a widespread event of unexpected catastrophes and blockbuster catastrophes that reduces total premiums earned in the state, reduces the total number writing insurance coverage in the state, and leads to the exit of firms from the state. Firms with low levels of homeowners’ premiums are most adversely affected by the catastrophes.
    JEL: D8 G22 K13
    Date: 2006–07
  47. By: Hans de Heij
    Abstract: The euro banknotes recently celebrated their 4th year anniversary (2002 – 2006)! DNB has monitored the Dutch public’s acceptance of the euro banknotes through surveys in 2002, 2003 and 2005, contrasting its findings with those for the former guilder notes as well as the results of other recent consumer surveys conducted by the US Treasury (2002), Bank of Canada (2003) and several others. A unique time line is presented of the public’s knowledge of security features in the Netherlands over the years 1983- 2005. Keywords : market research, consumer research, public information , public awareness of banknotes, measuring method for the public’s awareness of security features, measuring method for the public's appreciation of banknotes, questionnaire/public opinion poll on banknotes, design of banknotes.</td>
    Date: 2006–06
  48. By: Nava Ashraf (Harvard Business School); Dean Karlan (Economic Growth Center, Yale University); Wesley Yin (University of Chicago)
    Abstract: Commitment devices for savings could benefit those with self-control as well as familial or spousal control issues. We find evidence to support both motivations. We examine the impact of a commitment savings product in the Philippines on household decision making power and self-perception of savings behavior, as well as actual savings. The product leads to more decision making power in the household for women, and likewise more purchases of female-oriented durable goods. We also find that the product leads women who appear time-inconsistent in a baseline survey to self-report being a disciplined saver in the follow-up survey. For impact on savings balances, we find that the 81% increase in savings after one year did not crowd out savings held outside of the participating bank, but that the longer-term impact over two and a half years on bank savings dissipated to only a 33% increase, which is no longer statistically significant. We discuss reasons why the effect dissipated and the implications for designing and implementing sustainable, equilibrium-shifting interventions.
    Keywords: Savings, Microfinance, Female empowerment, Household Decision making, Commitment
    JEL: D12 D63 D91 J16 O12 O16
  49. By: Miki Kohara; Charles Yuji Horioka
    Abstract: We use micro data on young married households from the Japanese Panel Survey of Consumers in order to analyze the importance of borrowing constraints in Japan. We find (1) that 8 to 15 percent of young married Japanese households are borrowing-constrained, (2) that household assets and the husband’s educational attainment are the most important determinants of whether or not a household is borrowing-constrained, and (3) that the Euler equation implication is rejected for both the full sample and for the subsample of unconstrained households. These results suggest that the life cycle/permanent income hypothesis does not apply in Japan and that the presence of borrowing constraints is not the main reason why it does not apply.
    JEL: D1 D9 E2 G1
    Date: 2006–06
  50. By: Seppo Kari; Jouko Ylä-Liedenpohja
    Abstract: The initial cost of capital of a foreign subsidiary, financed by its parent from abroad, is dependent on repatriation taxes and this also applies to all follow-up investments financed from marginal foreign profits, representing the required return on the initial investment. Only investments financed from intra-marginal foreign profits are independent of repatriation taxes, but their cost of capital depends inversely on the dividend tax of the home-country parent?s owners. We calibrate the cost of capital formulae to the Estonian and Finnish parameters of taxing international investment income. The calculations show that Estonian subsidiaries, which pay no tax on undistributed profits but a corporate dividend tax, offer tax benefits to their parents only in terms of intra-marginal profits.
    Keywords: Direct investment, tax incentives, corporate tax
    JEL: H87 H32 H25
    Date: 2005–04–28
  51. By: Marco Caliendo; Frank M. Fossen; Alexander S. Kritikos
    Abstract: The influence of risk aversion on the decision to become self-employed is a much discussed topic in the entrepreneurial literature. Conventional wisdom asserts that the role model of an entrepreneur requires to make risky decisions in uncertain environments and hence that more risk-averse individuals are less likely to become an entrepreneur. Empirical tests of this assumption are scarce however, mainly because reliable measures for risk-aversion are not available. We base our analysis on the most recent waves of the German Socio-Economic Panel (SOEP) which allow us to use experimentally-validated measures of risk attitudes. Most importantly and in contrast to previous research, we are able to examine whether the decision of starting a business is influenced by objectively measurable risk attitudes at the time when this decision is made. Our results show that in general individuals with lower risk aversion are more likely to become self-employed. Sensitivity analysis reveals, however, that this is true only for people coming out of regular employment, whereas for individuals coming out of unemployment or inactivity risk attitudes do not seem to play a role in the decision process.
    Keywords: Risk attitudes, entrepreneurship, self-employment.
    JEL: D81 J23 M13
    Date: 2006
  52. By: Masamitsu Ohnishi (Graduate School of Economics, Osaka University); Yusuke Osaki (JSPS Research Fellow)
    Abstract: This note determines a sufficient condition on (von Neumann-Morgenstern) utility functions to preserve (reserve) comparative risk aversion under general background risks. Our condition is weaker than the one determined by Nachman (1982, Journal of Economic Theory). Nachmanfs condition requires the monotonicity in the global sense, in other hand our condition only requires it in the local sense. And this generalization may make the condition on utility functions to hold the desirable property consisitent with the recent empirical observation.
    Keywords: Background risk, comparative risk aversion, single crossing condition.
    JEL: D81
    Date: 2006–06
  53. By: Alberto Locarno (Banca d'Italia)
    Abstract: When the economy is subject to recurrent structural shifts, the monetary authority cannot credibly commit to a systematic approach to policy, since consistency between promises and actions is not easily verifiable; moreover, since agents have incomplete knowledge of the surrounding environment, they form expectations that may deviate substantially from the full-information case. The present paper studies the implications for the effectiveness of discretionary monetary policymaking of departing from the benchmark of rational expectations and assuming instead that agents learn adaptively. It focuses on two issues, namely whether imperfect knowledge generates a bias against stabilisation policies and whether the optimal monetary strategy takes the form of an inflation cap. Rules featuring an inflation cap are not only justified on theoretical grounds, but are also appealing because they seem appropriate to deal with imperfect knowledge and learning: by setting explicit bounds on inflation, they seem better suited to restrain expectations from drifting significantly away from target, thus removing one of the main sources of policy ineffectiveness. The main findings of the paper are the following. First, when agents do not possess complete knowledge on the structure of the economy and rely on an adaptive learning technology, a bias toward conservativeness arises. Second, a policy that involves a cap on inflation is helpful in reducing output and inflation variability, but it is not uniformly superior to a strategy aimed at minimising a quadratic loss function. Third, the bias against stabilisation policies and towards conservativeness does not depend on whether agents have finite or infinite memory.
    Keywords: Adaptive learning, optimal degree of monetary policy discretion, bias against activist policies
    JEL: E52 E31 D84
    Date: 2006–05

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