nep-mon New Economics Papers
on Monetary Economics
Issue of 2007‒01‒23
23 papers chosen by
Bernd Hayo
Philipps-University Marburg

  1. Excess Liquidity and the Foreign Currency Constraint: The Case of Monetary Management in Guyana By Khemraj, Tarron
  2. Estimating Time-Varying Policy Neutral Rate in Real Time By Roman Horváth
  3. Quantifying and sustaining welfare gains from monetary commitment By Paul Levine; Peter McAdam; Joseph Pearlman
  4. Why should central banks be independent? By Harashima, Taiji
  5. Structural breaks in the interest rate pass-through and the euro. A cross-country study in the euro area and the UK By Giuseppe Marotta
  6. New Keynesian Model Dynamics under Heterogeneous Expectations and Adaptive Learning By Martin Fukac
  7. Some observations about the endogenous money theory By Bertocco Giancarlo
  8. The Role of Policy Rule Misspecification in Monetary Policy Inertia Debate By Jiri Podpiera
  9. The Optimal Quantity of Money Consistent with Positive Nominal Interest Rates By Harashima, Taiji
  10. A Model of Money with Multilateral Matching, Second Version By Manolis Galenianos; Philipp Kircher
  11. Ramsey monetary policy with labour market frictions By Ester Faia
  12. The dynamics of bank spreads and financial structure By Reint Gropp; Christoffer Kok Sørensen; Jung-Duk Lichtenberger
  13. Sticky Prices and Monetary Policy: Evidence from Disaggregated U.S. Data By Jean Boivin; Marc Giannoni; Ilian Mihov
  14. Discretion rather than rules? When is discretionary policy-making better than the timeless perspective? By Stephan Sauer
  15. Understanding the Relationship between Financial Development and Monetary Policy By Luis Carranza; José Enrique Galdón Sánchez; Javier Gómez Biscarri
  16. Spot and forward interest rates: Why practically homogeneous bonds of different maturities have different interest rates? By Govori, Fadil
  17. The Store-of-Value-Function of Money as a Component of Household Risk Management By Ingrid Groessl; Ulrich Fritsche
  18. Money market instruments and interest rates By Govori, Fadil
  19. Revisiting Uncovered Interest Rate Parity: Switching Between UIP and the Random Walk By Huisman, R.; Mahieu, R.J.
  20. The term structure and risk structure of interest rates By Govori, Fadil
  21. How bad is Divergence in the Euro-Zone? Lessons from the United States of America and Germany By Sebastian Dullien; Ulrich Fritsche
  22. Balance of payment crises in emerging markets - how early were the “early” warning signals? By Matthieu Bussière
  23. Regional housing market spillovers in the US - lessons from regional divergences in a common monetary policy setting By Isabel Vansteenkiste

  1. By: Khemraj, Tarron
    Abstract: The paper examines why commercial banks in Guyana demand non-remunerated excess reserves, a phenomenon that became prevalent after financial sector reforms. Banks do not invest all excess reserves in a safe foreign asset because the central bank maintains an unofficial foreign currency constraint by accumulating international reserves. This is done within an indirect monetary policy framework. Banks in Guyana do not demand excess reserves for precautionary purposes – which is the conclusion of several other studies – but rather because of the maintained constraint. The estimated sterilisation coefficient is consistent with the hypothesis of an enforced constraint. Hence, the results provide another way of looking at the monetary transmission mechanism.
    Keywords: Excess bank liquidity; monetary policy; Guyana
    JEL: F30 F31 E5
    Date: 2006–12
  2. By: Roman Horváth (Institute of Economic Studies, Faculty of Social Sciences, Charles University, Prague, Czech Republic; Czech National Bank, Prague, Czech Republic)
    Abstract: This paper examines policy neutral rate in real time for the Czech Republic in 2001:1-2006:09 estimating various specifications of simple Taylor-type monetary policy rules. First, we estimate it using GMM. Second, we apply a structural timevarying parameter model with endogenous regressors to evaluate the fluctuations of policy neutral rate over time. The results suggest that there is substantial interest rate smoothing and central bank primarily responds to inflation (forecast) developments. The estimated parameters seem to sustain the equilibrium determinacy. We find that the policy neutral rate gradually decreased over sample period to the levels comparable to those of in the euro area reflecting capital accumulation, smaller risk premium, equilibrium exchange rate appreciation as well as successful disinflation in the Czech economy.
    Keywords: policy neutral rate; Taylor rule; time-varying parameter model with endogenous regressors
    JEL: E43 E52 E58
    Date: 2007–01
  3. By: Paul Levine (Department of Economics, University of Surrey, Guildford, Surrey, GU2 7XH, United Kingdom.); Peter McAdam (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Joseph Pearlman (London Metropolitan University, 31 Jewry Street, London, EC3N 2EY, United Kingdom.)
    Abstract: The objectives of this paper are - first, to quantify the stabilization welfare gains from commitment; second, to examine how commitment to an optimal rule can be sustained as an equilibrium and third, to find a simple interest rate rule that closely approximates the optimal commitment one. We utilize an influential empirical micro-founded DSGE model, the euro area model of Smets and Wouters (2003), and a quadratic approximation of the representative household’s utility as the welfare criterion. Importantly, we impose the effect of a nominal interest rate zero lower bound. In contrast with previous studies, we find significant stabilization gains from commitment - our central estimate is a 0.4 ? 0.5% equivalent permanent increase in consumption, but in a variant with a higher degree of price stickiness, gains of over 2% are found. We also find that a simple optimized commitment rule with the nominal interest rate responding to current inflation and the real wage closely mimics the optimal rule. JEL Classification: E52, E37, E58.
    Keywords: Monetary rules, commitment, discretion, welfare gains.
    Date: 2007–01
  4. By: Harashima, Taiji
    Abstract: Most explanations for the necessity of an independent central bank rely on the time-inconsistency model and therefore assume that governments are weak, foolish, or untruthful and tend to cheat people. The model in this paper indicates, however, that an independent central bank is not necessary because governments are weak or foolish. Central banks must be independent because governments are economic Leviathans. Only by severing the link between the political will of a Leviathan government and economic activities is inflation perfectly guaranteed not to accelerate. A truly independent central bank is necessary because it severs this link.
    Keywords: Central Bank Independence; Inflation; The Fiscal Theory of the Price Level; Leviathan; Monetary Policy
    JEL: E61 E63 E52 E58
    Date: 2007–01–15
  5. By: Giuseppe Marotta
    Abstract: We search for multiple unknown structural breaks in the short term business lending rate pass-through in euro countries, possibly associated with the introduction of the single currency. One break is detected in five EMU countries, two are found in other four, and in the UK as well. The last break occurs much before the event for France, several quarters later for Austria, Germany, Italy and Portugal, and the UK, hinting at best at a loose link with the inception of EMU. Long run pass-throughs decrease (except for France), becoming even more incomplete (except for the Netherlands and the UK); though the adjustment to equilibrium has become faster, cross-country heterogeneity in the euro area has barely changed. An incomplete lending rate pass-through, even in the long run, for the least sticky bank rate and the persistence of cross-country heterogeneity make tougher for the ECB to realize an effective area-wide monetary policy.
    Keywords: Interest rates; Monetary policy; Economic and Monetary Union (EMU); Cointegration analysis; Structural breaks
    JEL: E43 E52 E58 F36
    Date: 2006–12
  6. By: Martin Fukac
    Abstract: We analyze the economic dynamics in a basic New Keynesian model adjusted for imperfect, heterogeneous knowledge and adaptive learning. The policy, represented by a forward-looking Taylor rule, is driven by the central bankŽs own internal forecasts, whereas the core economic dynamics are driven by private agentsŽ expectations. We study the implications of disagreement between those two. We find that if there is expectations heterogeneity, monetary policy should be less active in its actions in order to be short-run stability improving, and to affect positively the speed of convergence towards the first best equilibrium in the long run. This is in contrast to the homogeneous incomplete knowledge literature, which predicts the opposite. We also find that the homogeneous expectations economy is easier to operate in for monetary policy, and that policy can be more effective than in the heterogeneous expectations economy. From the perspective of incomplete, heterogeneous knowledge and adaptive learning methodology, we can thus see the importance of good communication policy and monetary policy credibility.
    Keywords: . Imperfect and heterogeneous knowledge, adaptive learning, monetary policy.
    JEL: E52
    Date: 2006–10
  7. By: Bertocco Giancarlo (Department of Economics, University of Insubria, Italy)
    Abstract: The endogenous money theory constitutes the core element of the post-keynesian monetary theory. The first formulation of this theory can be found in the works of Kaldor published in the 1970s. Taking these studies as a starting point, the post-keynesians elaborated two versions of the endogenous money theory which differ in their assumptions about the behaviour of the monetary authorities and the banking system, and hence offer different conclusions about the slope of the money supply curve. The aim of this paper is to evaluate the importance of the endogenous money theory using a criterion which can be defined on the basis of Keynes’s distinction between a real exchange economy and a monetary economy. As is well known, Keynes (1933a, 1933b) uses the former term to refer to an economy in which money is merely a tool to reduce the cost of exchange and whose presence does not alter the structure of the economic system, which remains substantially a barter economy. A monetary economy instead refers to an economic system in which the presence of fiat money radically changes the nature of exchange and the characteristics of the production process. Keynes (1933a, p. 410) notes that the classical economists formulated an explanation of how the real-exchange economy works, convinced that this explanation could be easily applied to a monetary economy. He believed that this conviction was unfounded and stressed the need to elaborate a ‘monetary theory of production, to supplement the real–exchange theories which we already possess’ (Keynes, 1933a, p. 411). The specification of the elements determining the non-neutrality of money is thus the key factor differentiating Keynes’s theory from the classical one.1 The criterion used to evaluate the significance of the endogenous money theory is whether it enables us to elaborate on and to broaden the explanation of the justification the nonneutrality of money formulated by Keynes. In The General Theory the reasons for the non-neutrality of money are grounded in the store of wealth function of money; the liquidity preference theory is the element on which the keynesian explanation of income fluctuation is based. The importance of the money endogeneity theory can therefore be assessed in relation to its ability to specify determinant factors for the non-neutrality of money that have not been highlighted by the liquidity preference theory; in other words, the significance of the endogenous money theory depends on its capacity to bring out elements of a monetary economy that have been overlooked in the liquidity preference theory. This paper presents the following results. First of all, it shows that the endogenous money theory makes it possible to extend the analysis of the factors accounting for the non-neutrality of money beyond what Keynes has done in The General Theory; in particular this paper argues that the theory of money endogeneity obtains this result by underlying the means of payment function of money. Second, the work shows that the money endogeneity theory gives credence to certain points developed by Keynes in some works published in 1933 and between 1937 and 1939. Third, the work emphasises that the novel aspects of the money endogeneity theory do not depend on the particular version of this theory, i.e. they do not depend on the slope of the credit supply curve. Finally, in the paper the most significant aspects of the money endogeneity theory are presented by means of a theoretical model that distinguishes clearly between the credit market and the money market. It is shown that an important element of the money endogeneity theory is that it elaborates an alternative credit theory to the neoclassical one. The paper is divided into three parts. In the first one, the most relevant aspects of the money endogeneity theory are presented starting from Kaldor’s work, and we bring out the consistency between that theory and the considerations formulated by Keynes in some writings which preceded and followed the publication of The General Theory. In the second part the two versions of the money endogeneity theory are analysed and it is noted that the debate between the supporters of these two versions risks overshadowing the innovative aspects of the money endogeneity theory that do not depend on the slope of the credit and money supply curves. Then in the third part, the aspects that distinguish a monetary economy from a real-exchange economy and that emerge because of the money endogeneity theory are described.
    Date: 2006–02
  8. By: Jiri Podpiera
    Abstract: Operational monetary policy rules are characterized by a parsimonious specification and are therefore prone to specification error when estimated on real data. I devise a policy rule estimation procedure, which is robust to marginal misspecification, and study the effects of specification error in least squares. I find the robust evidence of upward bias in policy inertia in least squares applied to most commonly used Taylor type rule. In effect, least squares learning of a central bank can lead to increasing monetary policy inertia over time.
    Keywords: Monetary policy inertia, policy rule.
    JEL: E4 E5
    Date: 2006–12
  9. By: Harashima, Taiji
    Abstract: The Friedman rule is strongly immune to most model modifications although it has not actually been observed. The Friedman rule implicitly assumes that a government is perfectly under the control of the representative household. This paper shows that, if a government is not perfectly under the control of the representative household, but also pursues political objectives, the optimal quantity of money generally is accompanied by positive nominal interest and inflation rates through the simultaneous optimization of government and the representative household. The fact that nominal interest and inflation rates are usually positive conversely implies that a government usually pursues political objectives.
    Keywords: The Optimal Quantity of Money; The Friedman rule; Inflation; The fiscal theory of the price level; Leviathan
    JEL: E42 E41 E51 E63
    Date: 2007–01–16
  10. By: Manolis Galenianos (Department of Economics, Penn State University); Philipp Kircher (Department of Economics)
    Abstract: We develop a model of monetary exchange that avoids several common criticisms of the recent microfoundations literature. First, rather than random matching, we assume that buyers know the location of all sellers, and hence the process of finding a partner is deterministic, although trade is still stochastic since the number of buyers visiting a given seller is random. Second, given multilateral matching, rather than bargaining, we assume that goods are allocated according to second-price auctions. Third, given this mechanism, we do not have to assume agents can observe each other’s money holdings or preferences, as is necessary for tractability with bargaining. A novel result is that homogeneous buyers hold different amounts of money, leading to equilibrium price dispersion. We find the closed-form solution for the distribution of money holdings. We characterize equilibrium and efficient monetary policy.
    Keywords: Search Theory of Money, Budget Constrained Auctions, Friedman Rule
    JEL: E41 D83
    Date: 2005–12–01
  11. By: Ester Faia (Department of Economics, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain.)
    Abstract: This paper studies the design of optimal monetary policy (in terms of unconstrained Ramsey allocation) in a framework with sticky prices and matching frictions. Furthermore I consider the role of real wage rigidities. Optimal policy features significant deviations from price stability in response to various shocks. This is so since search externalities generate an unemployment/ inflation trade-off. In response to productivity shocks optimal policy is pro-cyclical when the worker’s bargaining power is higher than the share of unemployed people in the matching technology and viceversa. This is so since when the workers’ share of surplus is high there are many searching workers and few vacancies hence the monetary authority has an incentive to increase vacancy profitability by reducing the interest rate and increasing inflation. The opposite is true when the workers’ share of surplus is high. This implies that optimal inflation volatility is U-shaped with respect to workers’ bargaining power. JEL Classification: E52, E24.
    Keywords: optimal monetary policy, matching frictions, wage rigidity.
    Date: 2007–01
  12. By: Reint Gropp (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany; Corresponding author.); Christoffer Kok Sørensen (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Jung-Duk Lichtenberger (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: This paper investigates the dynamics of the pass-through between market interest rates and bank interest rates in the euro area as a function of cyclical and structural differences in the financial system. We find that overall the speed of adjustment for loans is significantly faster than for deposits, and that the pass-through is especially sluggish for demand deposits and savings deposits. Bank soundness, credit risk and interest rate risk are found to exert a significant influence on the speed of pass through. We also find evidence of faster (slower) pass-through for loans (deposits) if the change in monetary policy was up (down). Overall, we find that competition among banks and competition from financial markets result in a faster bank interest rate pass-through. Finally, we find some evidence that financial innovation speeds up the pass-through for those market segments that are most directly affected by these innovations. JEL Classification: E43, G21.
    Keywords: Monetary transmission, banks, retail rates, financial structure.
    Date: 2007–01
  13. By: Jean Boivin; Marc Giannoni; Ilian Mihov
    Abstract: This paper disentangles fluctuations in disaggregated prices due to macroeconomic and sectoral conditions using a factor-augmented vector autoregression estimated on a large data set. On the basis of this estimation, we establish eight facts: (1) Macroeconomic shocks explain only about 15% of sectoral inflation fluctuations; (2) The persistence of sectoral inflation is driven by macroeconomic factors; (3) While disaggregated prices respond quickly to sector-specific shocks, their responses to aggregate shocks are small on impact and larger thereafter; (4) Most prices respond with a significant delay to identified monetary policy shocks, and show little evidence of a "price puzzle," contrary to existing studies based on traditional VARs; (5) Categories in which consumer prices fall the most following a monetary policy shock tend to be those in which quantities consumed fall the least; (6) The observed dispersion in the reaction of producer prices is relatively well explained by the degree of market power; (7) Prices in sectors with volatile idiosyncratic shocks react rapidly to aggregate monetary policy shocks; (8) The sector-specific components of prices and quantities move in opposite directions.
    JEL: C3 D2 E31 E4 E5
    Date: 2007–01
  14. By: Stephan Sauer (Seminar for Macroeconomics, University of Munich, Ludwigstrasse 28 Rgb., 80539 Munich, Germany.)
    Abstract: Discretionary monetary policy produces a dynamic loss in the New Keynesian model in the presence of cost-push shocks. The possibility to commit to a specific policy rule can increase welfare. A number of authors since Woodford (1999) have argued in favour of a timeless perspective rule as an optimal policy. The short-run costs associated with the time-less perspective are neglected in general, however. Rigid prices, relatively impatient households, a high preference of policy makers for output stabilisation and a deviation from the steady state all worsen the performance of the timeless perspective rule and can make it inferior to discretion. JEL Classification: E5.
    Keywords: Optimality, Timeless perspective, Policy rules.
    Date: 2007–01
  15. By: Luis Carranza (Universidad de Navarra); José Enrique Galdón Sánchez (Universidad Pública de Navarra); Javier Gómez Biscarri (Universidad de Navarra)
    Abstract: In this paper we summarize the results of a broad exploratory empirical analysis where we attempt to relate the level of financial development with the effectiveness of monetary policy. The analysis is based on a panel of sixty plus countries for whom we calculate measures both of financial development and of monetary policy effectiveness. We correlate the above measures and other macroeconomic variables to look for statistically significant relationships between the indicators of financial development, the effectiveness coefficients and other country characteristics. We present our results in the form of a list of stylized facts that deserve to be given future attention. Given the focus of the analysis on financial development, our results have important implications for emerging markets.
    Keywords: Financial Markets, Investment, Emerging Markets, Asymmetry Response of Credit, Lending Rates
    JEL: E44 E52
  16. By: Govori, Fadil
    Abstract: The term structure of interest rates is a widely discussed topic in the economic literature. One of the main questions in these discussions is why practically homogeneous bonds of different maturities have different interest rates. The discussion of present value and interest rates assumes an abstract world of frictionless (or perfect) financial markets. In practice, markets are not frictionless, that is, there are no perfect financial markets. However, frictionless markets are a necessary starting point. Borrowers are faced with the choice to borrow short-term or long-term. Short-term borrowing runs the risk of refinancing at higher interest rates. Long-term borrowing runs the risk of locking-in a higher interest rate. In an unrestricted shortsale, the shortseller can use the proceeds from the sale. In practice, most shortsellers are not able to use the proceeds because of the possibility of a shortseller absconding with the funds. In addition, shortsellers usually have to post collateral to guarantee against default. Because of the time value of money, one euro received at a future date has a present value of less than one euro. The pattern of spot interest rates for different maturities is called the term structure of interest rates. One possible term structure pattern is for all spot interest rates to be the same; this is called a flat term structure. If the spot interest rates increase with maturity, the term structure is rising. Rising term structures are the most common pattern in practice; longer maturity interest rates are typically higher than short maturity interest rates. Spot interest rates decreasing with maturity are called a declining (or inverted) term structure. One of the most important concepts in finance is the concept of arbitrage, also called the law of one price. In frictionless markets, the same asset must have one price at a particular instant in time, no matter where it is traded. The arbitrage operations drive prices toward their equilibrium values. That is, purchase of one-period bond by the arbitrager drives its price up; sale of the two-period bond forces its price down. Arbitrage provides the fundamental link between the spot and forward markets. Arbitrage forces a precise relationship between forward and spot rates of interest. Forward transactions involve a contract signed in the present to do something in the future. The parties agree right now to exchange securities in the future at a price agreed upon right now. If securities are exchanged in the forward market, the buyer, called the long, contracts right now to purchase the bond at some future date, called the delivery date, at a specified price. Futures markets are very similar to forward markets.
    Keywords: Interest Rates; Spot Interest Rates; Forward Interest Rates; Term Structure of the Interest Rates; Maturity Structure of the Interest Rates
    JEL: G31 G11 G12 G10 G14 G13
    Date: 2007–01
  17. By: Ingrid Groessl (Department for Economics and Politics, University of Hamburg); Ulrich Fritsche (Department for Economics and Politics, University of Hamburg, and DIW Berlin)
    Abstract: We analyse how money as a store of value affects the decisions of a representative household under diversifiable and non-diversifiable risks. given that the central bank successfully stabilizes the rate of inflation at a low level. Assuming exponential utility allows us to derive an explicit relationship between optimal money holdings, the household's desire to tilt, smooth and stabilize consumption as well as minimize portfolio risk. In this context we also show how the correlation between stochastic labour income and stock returns impact the store-of-value function of money. Finally we prove that the store-of-value benefits of money holdings continue to hold even if we take riskless alternatives into account.
    Keywords: Money demand, consumption, CRRA, CARA, exponential utility, households, risk, risk management
    JEL: D11 E21 E41
    Date: 2006–12
  18. By: Govori, Fadil
    Abstract: Money market is defined as the market for securities with less than 1 year to maturity at the original issue date. Issuers of these instruments are government, government agencies, municipalities, corporations, and banks. Money market instruments have maturities of less than one year. Trading in money market instruments is very active, and the total volume of transactions is huge. A variety of money market instruments exist. Each meets a special need of borrowers and lenders. Many investors find money market instruments to be highly liquid investments with relatively low default risk. An investment is liquid if it can be bought or sold rapidly without affecting the market price and if the risk of price fluctuation is small. Money market investors include individuals, corporations, banks, and other institutions with temporary excess funds, and money market mutual funds. The money market is largely a wholesale (as opposed to retail) market, with the denominations of most transactions in the hundred millions of euros. The primary participants are financial institutions and large nonfnancial businesses. Consumers play a limited role in the money market; they are buyers of some money market securities and investors in money market mutual funds. Money market instruments include the following: Treasury bills, Federal funds (Interbank loans), Repurchase agreements, Certificates of deposit, Commercial paper, Bankers’ acceptance, Eurocurrency Certificates of Deposit, and Money Market Mutual Funds. Each of these instruments has slightly different characteristics, and thus each has a slightly different interest rate. One of the peculiarities of the money market is its way of quoting interest rates. Some money market instruments are quoted on a discount basis. Other rates are quoted on an add-on basis. Each of these rates is different from the yield to maturity, the rate generally used for comparing coupon-bearing bonds. There are at least five different money market rates: • The discount rate, • The add-on rate, • The bond equivalent yield, • The semiannual, and • Annual yields to maturity.
    Keywords: Money Market; Financial Instruments; Money Market Instruments; Interest Rates; Money Market Interest Rates;
    JEL: G11 G24 G12 G10 G14 G13 G21 G15
    Date: 2007–01
  19. By: Huisman, R.; Mahieu, R.J. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)
    Abstract: In this paper, we examine in which periods uncovered interest rate parity was likely to hold. Empirical research has shown mixed evidence on UIP. The main finding is that it doesn?t hold, although some researchers were not able to reject UIP in periods with large interest differentials or high volatility. In this paper, we introduce a switching regime framework in which we assume that the exchange rate can switch between a UIP regime and a random walk regime. Our empirical results provide evidence that exchange rate movements were consistent with UIP over some periods, but not all. Consistent with the existing literature we also show that in periods with large interest differentials or increased exchange rate volatility, the exchange rate is more likely to follow UIP.
    Keywords: Markov regime switching;Uncovered interest rate parity;Exchange rate dynamics;
    Date: 2007–01–15
  20. By: Govori, Fadil
    Abstract: The relationship that exists at a given point in time between the length of time to maturity and the yield on a security is known as the term structure of interest rates. Another important factor that also has significant bearing impact on both nominal and real interest rates of a financial instrument is its default risk, that is, the risk that the lender may not recover the original principal. Both nominal and real interest rates differ by maturity, or term. A schedule of spot interest rates by maturity is called the term structure of interest rates. The term structure can be rising, flat, declining, or humped. The yield curve: a set of points plotted corresponding to the yields existing on a given day on various maturities of a particular type of instrument. A yield curve shows the relationship between interest rates and maturity for coupon-bearing bonds. Historically, upward-sloping, or ascending, yield curves have been much more common than downward-sloping, or descending, patterns. Downward-sloping yield curves have occurred at the end of the expansion phase of business cycle. To answer what determines the shape of the yield curve, we must examine four different theories of the term structure of interest rates. All these theories seek to account for the shape of the yield curve at any point in time and for changes in its shape over time. Term structure theories include the segmented markets theory, the increasing liquidity premium theory, the preferred habitat theory, the money substitute theory, and the pure expectations theory. There are enormous numbers of securities on which the interest rates can and differ. The relationship among these interest rates is called the risk structure of interest rates. A default risk is a failure to meet the terms of a contractual agreement in full amount. In the case of a debt instrument such as a bond, default may refer to the borrower’s failure to make the full interest payment as agreed or to the failure to redeem the bond at face value at maturity. The spread between the interest rates on bonds with default risk and default-free bonds, is called the risk premium, and indicates how much additional interest bond buyer must earn in order to be willing to hold a risky bond. U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes or even print money to pay off its obligations. Bonds like these with no default risk are called default-free bonds. Because default risk is so important to the size of the risk premium, purchasers of bonds need to know whether a corporation is likely to default on its bonds. For this reason there exist many investment advisory firms, that provide default risk information by rating the quality of corporate and municipal bonds in terms of the probability of default.
    Keywords: Interest Rates; Term Structure of Interest Rates; Risk Structure of Interest Rates; Yield to Maturity; Yield Curve; Term Structure Theories
    JEL: G0 G11 G24 G12 G32 G14 G13 G15
    Date: 2007–01
  21. By: Sebastian Dullien (Financial Times Deutschland); Ulrich Fritsche (Department for Economics and Politics, University of Hamburg, and DIW Berlin)
    Abstract: This paper compares relative unit labour cost developments in the countries of the euro-area since the beginning of the European Monetary Union (EMU) both with historical developments and with intra-regional unit labour cost developments in the United States of America and Germany. To this end, unit labour cost indices for the US states and census regions from 1977 to 1997 as well as for the German Länder from 1970 to 2004 have been constructed. Against this benchmark, it is found that unit labour cost increases since 1999 in Portugal and to a lesser extent in Spain and Greece can be judged as excessive, pointing at labour market rigidities which might impair smooth working of EMU in the future.
    Keywords: Unit labor costs, divergence, convergence, Euro-zone, inflation
    JEL: F2 F4 N2
    Date: 2006–10
  22. By: Matthieu Bussière (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: Although many papers have already proposed empirical models of currency crises, the timing of such crises has received relatively little attention so far. Most papers use indeed a static specification and impose the same lag structure across all explanatory variables. This, by construction, prevents from specifically timing the crisis signals sent by the leading indicators. The objective here is to fill this gap by considering a set of dynamic discrete choice models. The first contribution is to identify how early in advance each explanatory variable sends a warning signal. Some indicators are found to signal a crisis in the very short run while others signal a crisis at more distant horizons. The second contribution is to show that state dependence matters, albeit mostly in the short run. The results have important implications for crisis prevention in terms of the timeliness and usefulness of the envisaged policy response. JEL Classification: C23, F15, F14.
    Keywords: Dynamic discrete choice, panel data, currency crises, emerging markets, balance of payments, sudden stop, debt ratios.
    Date: 2007–01
  23. By: Isabel Vansteenkiste (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
    Abstract: In this paper, we seek to quantify the importance of state-level housing price spillovers and interest rate shocks to house price developments in the United States. The econometric approach involves an application of the recently developed global VAR (GVAR) as presented in Dées, DiMauro, Pesaran, and Smith (2005) and Pesaran, Schuermann, and Weiner (2004) to the 31 biggest US states over the period 1986-2005. Such an approach allows not only for the empirical derivation of the impact of common shocks (such as interest rate shocks) on US house price developments, but also for an analysis of the importance of interstate housing price spillovers. Beyond real house prices and real income per capita, each state-specific vector error correction model also includes nation-wide variables — measured as a weighted average of other states —. These individual state models are then linked in a consistent and cohesive manner. Impact elasticities indicate strong interregional linkages for both real house prices and real income per capita. An analysis of generalised impulse responses indicates that the importance of housing price spillovers is state dependent, with shocks occurring in states with relatively lower land supply elasticities having much stronger spillover effects that those in the other states. As regards real interest rates, the impact appears to be relatively small with an increase of 100 basis points in the real 10-year government bond yield resulting in a long run fall in house prices of between 0.5 and 2.5%. This would suggest, in line with DelNegro and Otrok (2005) that the decline in long-term interest rates is not the primary factor that has driven the recent surge in house prices in the United States. JEL Classification: C32, E44, R10, R31.
    Keywords: housing, monetary policy, global VAR (GVAR).
    Date: 2007–01

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