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Public Policy Brief No.71
04 January 2003
Can Monetary Policy Affect the Real Economy?
AbstractCentral bankers and many economists have abandoned “activist” policies and monetarism and adopted in their place a new view of the role of monetary policy. This view draws on many of the tenets of more traditional theories of money—monetarism’s emphasis on inflation control and skepticism about the use of easy-money policies to permanently increase output, and the Keynesian view that the total stock of money is not an important driving force behind either inflation or unemployment—yet it also takes a dim view of democratic input to the policymaking process. This brief evaluates a premise subscribed to by most central bankers: that monetary policy can be effectively used to control inflation without any permanent sacrifice in the form of reduced income or job opportunities.
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Working Paper No.370
01 January 2003
Testing for Financial Contagion between Developed and Emerging Markets during the 1997 East Asian Crisis
AbstractThis paper examines whether, during the 1997 East Asian crisis, there was any contagion from the four largest economies in the region (Thailand, Indonesia, Korea, and Malaysia) to a number of developed countries (Japan, the United States, the United Kingdom, Germany, and France). Following Forbes and Rigobon (2002) and Rigobon (2003), we test for contagion as a positive significant shift in the degree of comovement between asset returns, taking into account heteroscedasticity and endogeneity bias. However, we improve on earlier empirical studies by taking the approach introduced by Caporale et al. (2002), and employ a full sample test of the stability of the system that relies on more plausible (over)identifying restrictions. The estimation results show that the impact of the East Asian crisis on developed financial markets was small (Japan being the only exception), while the drastic reduction in international lending to the region severely affected it.
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Working Paper No.369
01 January 2003
On the Effectiveness of Monetary Policy and Fiscal Policy
AbstractWithin the framework of macroeconomic policy and theory over the past 20 years or so, a major shift has occurred regarding the relative importance given of monetary policy versus fiscal policy. The former has gained considerably in stature, while the latter is rarely mentioned. Further, monetary policy no longer focuses on attempts to control some monetary aggregate, as it did in the first half of the 1980s, but instead focuses on the setting of interest rates as the key policy instrument. There has also been a general shift toward the adoption of inflation targets and the use of monetary policy to target inflation. This paper considers the significance of this shift in the emphasis of monetary policy, questions its effectiveness, and explores the role of fiscal policy. We examine these subjects from the point of view of the “new consensus” in monetary economics and suggest that its analysis is rather limited. When the analysis is broadened to embrace empirical issues and evidence, the conclusion clearly emerges that monetary policy is relatively impotent. We argue that fiscal policy (under specified conditions) remains a powerful tool for macroeconomic policy, particularly under current economic conditions.
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Working Paper No.368
01 January 2003
How Far Can US Equity Prices Fall under Asset and Debt Deflation
AbstractEquity prices have been falling since March 2000. How far can they fall before they reach bottom? The current bear market differs from the mid-1970s plunge in equity prices in terms of the causes and, consequently, the factors that should be monitored to test its progress. In the 1970s, the bear market was caused by soaring inflation resulting from a surge in the price of oil. It eroded households’ real disposable income and corporate profits. That was a supply-led business cycle. Now, the bear market is caused by asset and debt deflation triggered by the burst of the “new economy” bubble. This working paper argues that on current economic fundamentals, the Standard & Poor’s (S&P) index is fairly valued at 871, but the fair value may fall if the economy has a double-dip recession that triggers a property market crash. We suggest that the US economy is heading for such a recession, as the poor prospects of the corporate sector are affecting the real disposable income of the personal sector. The forces that drive the economy back to recession are related to imbalances in the corporate and personal sectors that have started infecting the balance sheet of the commercial banks. The final stage of the asset-and-debt-deflation process involves a spiral between banks and the nonbank private sector (personal and corporate). Banks cut lending to the nonbank private sector, creating a credit crunch that worsens the economic health of the latter, which is reflected subsequently as a further deterioration of banks’ balance sheets.
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Policy Notes No.1
01 January 2003
The Big Fix
AbstractKeynesian economics is back. As John Maynard Keynes stressed, total spending matters—and not who does it or for what purpose. Tax cuts and deficit spending are, therefore, on the agenda; low interest rates seem here to stay. Stimulus is the watchword of the day. It remains only to fill in the details, or so it seems.
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Working Paper No.367
01 December 2002
The Persistence of Hardship over the Life Course
AbstractThis paper focuses on the persistence of hardship from middle age to old age. Proposed status maintenance models suggest that stratification of economic status occurs over the life course (for example, little mobility is seen within the income distribution). Some studies have found evidence to support this, but none have looked at broader measures of well-being. Using 29 years (1968–96) of data from the Panel Study of Income Dynamics (PSID), the author employs hypothesis tests (t-tests) and logistic regression techniques to examine the relationship between middle-age chronic hardships and adverse old-age outcomes. In almost every case, individuals who experience middle-age chronic hardships are significantly (statistically) more likely to experience adverse old-age outcomes.
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Working Paper No.366
01 December 2002
Why the Tobin Tax Can Be Stabilizing
AbstractThis paper clarifies why a transaction tax of the type proposed by James Tobin can have a stabilizing influence in financial markets. It argues that such a tax is potentially stabilizing, not because it reduces the “excessive” volume of transactions, but because it can slow the speed with which market traders react to price changes. To the extent that a Tobin tax causes financial market traders to delay their decisions a few “grains of sand in the wheels of international finance” can indeed be stabilizing. Whether that is sufficient, or whether boulders-not just grains-are needed to prevent speculative attacks on currencies, is, however, a different matter.
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Working Paper No.365
01 December 2002
Is There an American Way of Aging?
AbstractThis study examines income dynamics during individuals’ first 12 years of retirement. Two questions are asked: (1) Are the economic experiences of the elderly in the United States unique, or are they similar to those of the elderly in Germany? and (2) What is the role of Social Security in shaping these economic experiences? The results show major differences in the experiences of retired individuals as they age in the respective countries. Retired Germans generally maintain their accustomed living standards, whereas retired Americans experience a declining standard of living.
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Working Paper No.364
01 December 2002
“New Consensus,” New Keynesianism, and the Economics of the “Third Way”
AbstractIn this paper we seek first to set out the economic analysis that underpins the ideas of what has been termed the “third way.” The explicit mention of the “third way” is much diminished since the early days of the Blair government in the UK and the Schroeder government in Germany. We argue that the ideas associated with the “third way” continue to influence these governments and, more broadly, other governments and the European Union, and that these ideas are firmly embedded in New Keynesian economics. Our paper then focuses on some particular aspects of New Keynesian economics and its emphasis on the role of monetary policy and the downgrading of fiscal policy. There has emerged a so-called “new consensus” on macroeconomic policy (specifically, monetary policy), which we regard as an outgrowth of New Keynesian economics. We review this “new consensus” and argue that the empirical evidence on the operation of monetary policy reveals that such a policy is rather impotent. Insofar as it does have an effect, it operates to influence the level of investment, which in turn affects the future level and distribution of productive capacity. Thus, contrary to the prevailing view, monetary policy is not an effective way to control inflation, but it can have effects on the real side of the economy. The lack of attention to fiscal policy and the overemphasis on monetary policy leaves the European Union and its member countries without the means to tackle any serious recession or upsurge of inflation.
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Working Paper No.363
01 December 2002
Does the Stock of Money Have Any Causal Significance?
AbstractRecent developments in macroeconomics, and in economic policy in general, have produced a “new consensus” economy-wide model. In this model, the stock of money does not play any causal role, but operates as a mere residual in the economic process. The absence of the stock of money in many current debates over monetary policy has prompted the deputy governor of the Bank of England to note the irony of the situation: as central banks became more and more concerned with price stability, less and less attention is paid to money. Indeed in several countries, the decline of interest in money appears to have coincided with low inflation. In turn, a number of contributions have attempted, wittingly or unwittingly, to “reinstate” a more substantial role for money in this “new” macroeconomics. In this paper we argue that these attempts to “reinstate” money in current macroeconomic thinking entail two important problems. First, they contradict an important theoretical property of the new “consensus” macroeconomic model, namely, that of dichotomy between the monetary and the real sector. Second, some of these attempts either fail in terms of their objective or merely reintroduce the problem rather than solve it. We conclude that if money is to be given a causal role in the “new” consensus model, more substantial research is needed.
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Public Policy Brief No.70
03 November 2002
Physician Incentives In Managed Care Organizations
AbstractThis brief considers the interaction between physician incentive systems and product market competition in the delivery of medical services via managed care organizations. At the center of the analysis is the process by which health maintenance organizations (HMOs) assemble physician networks and the role these networks play in the competition for customers. The authors find that although physician practice styles respond to financial incentives, there is little evidence that HMO cost-containment incentives cause a discernable reduction in care quality. They propose a model of the managed care marketplace that solves for both physician incentive contracts and HMO product market strategies in an environment of extreme information asymmetry: physicians perceive the quality of care they offer perfectly and their patients do not perceive it at all.
Download Public Policy Brief No. 70, 2002 PDF (180.20 KB) -
Public Policy Brief No.69
02 November 2002
Should Banks Be “Narrowed”?
AbstractIn this brief, Biagio Bossone of the International Monetary Fund evaluates narrow banking from the perspective of modern theories of financial intermediation. These theories portray the status quo banking system as a solution to otherwise intractable problems of imperfect information, risk, and even moral hazard. The system’s characteristic coupling of liquid liabilities with illiquid assets—seen by some as an undesirable “mismatch”—in fact contributes greatly to the efficiency of the economy. Bossone argues that these efficiency gains outweigh the disadvantages associated with the existing legal framework.
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Working Paper No.361
01 November 2002
Credibility of EMS Interest Rate Policies
AbstractThe primary objective of this paper is to use the Markov regime-switching modeling framework to study the credibility of monetary policy in five member countries of the European Monetary System (EMS) during the period 1979 to 1998. The five countries examined for this purpose are Austria, Belgium, France, Italy, and the Netherlands. The major innovation of this paper is the use of a Markov regime-switching model with time-varying transition probabilities. The output-gap variability and the inflation variability variables are incorporated into the determination of the monetary policy preferences of individual member countries of the EMS. Empirical evidence is provided to show that although all the countries in our sample followed a credible monetary policy regarding price stability, they had different preferences regarding the trade-off between the stabilization of output-gap variability and inflation variability.
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Book Series
01 November 2002
The Mind of Wall Street
AbstractAs stock prices and investor confidence have collapsed in the wake of Enron, WorldCom, and the dot-com crash, people want to know how this happened and how to make sense of the uncertain times to come.
Into the breach comes one of Wall Street’s legendary investors, Leon Levy, to explain why the market so often confounds us, and why those who ought to understand it tend to get chewed up and spat out. Levy, who pioneered many of the innovations and investment instruments that we now take for granted, has prospered in every market for the past fifty years, particularly in today’s bear market. In The Mind of Wall Street he recounts stories of his successes and failures to illustrate how investor psychology and willful self-deception so often play critical roles in the process. Like his peers George Soros and Warren Buffett, Levy takes a long and broad view of the rhythms of the markets and the economy. He also offers a provocative analysis of the spectacular Internet bubble, showing that the market has not yet completely recovered from its bout of “irrational exuberance.”
The Mind of Wall Street is essential reading for all of us, whether we are active traders or simply modest contributors to our 401(k) plans, as volatile and unnerving markets come to define so much of our net worth.
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Strategic Analysis
01 November 2002
Is Personal Debt Sustainable?
AbstractThe long economic expansion was fueled by an unprecedented rise in private expenditure relative to income, financed by a growing flow of net credit to the private. On the surface, it seemed that the growing burden of the household sector’s debt was counterbalanced by a spectacular rise in the relative value of its financial assets, but this was never a match among equals, and the great meltdown in the financial markets has proved this imbalance to be true. The private sector has dramatically cut back its acquisition of new credit and reversed the path of its financial balance, but this adjustment has been uneven within the sector: the business sector has suffered a huge drop in investment while the household sector has continued to borrow.
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Working Paper No.362
01 November 2002
Financial Policies and the Aggregate Productivity of the Capital Stock
AbstractWe collect data on a number of financial restraints, including restrictions on interest rates and capital flows and reserve and liquidity requirements, and capital adequacy requirements from central banks of 14 countries. We estimate the effects of these policies on the aggregate productivity of the capital stock, controlling for the effects of inputs and financial development and using modern econometric techniques. We find that financial development has positive effects on productivity, while the effects of financial policies vary considerably across countries. Our findings demonstrate that financial liberalization is a much more complex process than has been assumed by earlier literature, and its effects on macroeconomic aggregates are ambiguous.
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Working Paper No.360
01 October 2002
Financial Globalization
AbstractIn recent years free movement of financial capital following financial liberalization has given the impression that financial markets are truly globalized. In this paper we argue that free movement of financial capital alone does not constitute financial globalization. To achieve true financial globalization, an important requirement is the creation of a worldwide single currency, managed by a single international monetary authority. This condition, however, is not met under current institutional arrangements.
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Working Paper No.359
01 October 2002
Is There a Trade-Off between Inflation Variability and Output-gap Variability in the EMU Countries?
AbstractThis paper examines two issues. First, we compare, based on the ratio of output-gap variability to inflation variability, the monetary policy performance of eleven EMU countries for the whole period of the EMS. Second, we examine whether the introduction of an implicit inflation-targeting by the EMU member countries after the Maastricht Treaty changed the trade-off between inflation variability and output-gap variability. We employ a stochastic volatility model for the whole period of the EMS and for two sub-periods (i.e., before and after the Maastricht Treaty). We find that for the whole period the trade-off ratio varies among EMU countries, especially in the case where industrial production is utilized to construct the output-gap variable. The results also vary from the point of view of how the trade-off variabilities change for each country before and after the Maastricht Treaty. The implication of these findings is that asymmetries exist in the euro area as a result of either different monetary policy preferences or different economic structures among the EMU’s member countries.
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Working Paper No.358
01 October 2002
Threshold Effects in the US Budget Deficit
AbstractThis paper contributes to the debate on whether the United States’ large federal budget deficits are sustainable in the long run. The authors model the government deficit per capita as a threshold autoregressive process, finding evidence that the deficit is sustainable in the long run and that economic policymakers will intervene to reduce the per capita deficit only when it reaches a certain threshold.
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Working Paper No.357
01 October 2002
The Euro, Public Expenditure, and Taxation
AbstractThis paper explores the probable consequences for public expenditure in the United Kingdom if Britain were to join the euro. It focuses on the effects of sterling joining the euro (and the associated implications, such as monetary policy being governed by the European Central Bank). It does not consider any broader questions of the effects of membership in the European Union and the policies pursued by the EU and the European Commission. Since the fiscal stance of government influences the level of demand in the economy, there are also important implications for the level of employment more generally. While the general deflationary nature of the economic policy of the eurozone (an issue we have explored elsewhere on many occasions) should not be overlooked, the focus of this paper is on the implications for public expenditure of the eurozone and the UK’s possible entry into the euro.
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Working Paper No.356
01 October 2002
Asset Poverty in the United States, 1984–1999
AbstractUsing PSID data for the years 1984 to 1999, we estimate the level and severity of asset poverty. Our results indicate that the share of asset-poor households remained almost the same and the severity of poverty increased during this period, despite the growth in the economy and the financial markets. The race, age, education, and marital status of the household head, and homeownership, are important determinants of asset poverty. There seems to be a downward trend in the contribution to asset poverty of being a college graduate, a married elderly or a black head of household, a single mother, or a married person with children. The contributions of not having a college degree, being a 35-to-49 year-old household head, being a childless nonelderly couple, or being an unmarried elderly person seem to have increased. The contribution to net worth poverty of being a homeowner also went up. Descriptive statistics suggest that changes in the value of assets are more effective in transitions into and out of asset poverty than are changes in debt. Some lifetime events, such as changes in marital, homeownership, or business ownership status, are also correlated with the transitions.
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Working Paper No.355
01 October 2002
Can Monetary Policy Affect the Real Economy?
AbstractCurrent monetary policy involves the manipulation of the central bank interest rate (the repo rate), with the specific objective of achieving the goal(s) of monetary policy. The latter is normally the inflation rate, although in a number of instances this may include the level of economic activity (the monetary policy of the United States’ Federal Reserve is a good example of this category). This raises two issues. The first is the theoretical underpinnings of this mode of monetary policy. The second is the channels of monetary policy or, more concretely, the channels through which changes in the rate of interest may affect the ultimate goal(s) of policy. Both aspects are investigated in this paper. Furthermore, we suggest that it is imperative to consider the empirical estimates of the effects of monetary policy. We summarise results drawn from the eurozone, the US and the UK and suggest that these empirical results point to a relatively weak effect of interest rate changes on inflation. We also suggest, on the basis of the evidence adduced in the paper, that monetary policy can have long-run effects on real magnitudes. This particular result does not fit comfortably with the theoretical basis of current thinking on monetary policy.
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Working Paper No.354
01 October 2002
Should Banks Be Narrowed?
AbstractOver the past 70 years, a proposal to narrow the scope of banks has emerged more and more frequently in financial debates and research. Narrow banking would prevent deposit-issuing banks from lending to the private sector and restrict nonbank intermediaries from funding investments with demand deposits. Proponents of narrow banking defend it as a step toward greater financial stability and efficiency. This study reviews the literature on the subject, contrasts the concept of narrow banking with contemporary banking theories, and evaluates the potential effects of narrow banking on finance and the real economy. The study also delineates an empirical exercise to estimate the costs of bank narrowness and draws policy conclusions based on those estimates.
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Working Paper No.353
01 September 2002
Managed Care, Physician Incentives, and Norms of Medical Practice
AbstractThe incentive contracts that managed care organizations write with physicians have generated considerable controversy. Critics fear that if informational asymmetries inhibit patients from directly assessing the quality of care provided by their physician, competition will lead to a “race to the bottom” in which managed care plans induce physicians to offer only minimal levels of care. To analyze this issue we propose a model of competition between managed care organizations. The model serves for both physician incentive contracts and HMO product market strategies in an environment of extreme information asymmetry–physicians perceive quality of care perfectly, and patients don’t perceive it at all. We find that even in this stark setting, managed care organizations need not race to the bottom. Rather, the combination of product differentiation and physician practice norms causes managed care organizations to race to differing market niches, with some providing high levels of care as a means of assembling large physician networks. We also find that relative physician practice norms, defined endogenously by the standards of medical care prevailing in a market, exert a “pull to the top” that raises the quality of care provided by all managed care organizations in the market. We conclude by considering the implications of our model for public policies designed to limit the influence of HMO incentive systems.
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