Working Papers 2013: Abstracts

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13-20: Subsidizing Price Discovery by Braz Camargo, Kyungmin (Teddy) Kim, and Benjamin Lester

When markets freeze, not only are gains from trade left unrealized, but the process of information production through prices, or price discovery, is disrupted as well. Though this latter effect has received much less attention than the former, it constitutes an important source of inefficiency during times of crisis. The authors provide a formal model of price discovery and use it to study a government program designed explicitly to restore the process of information production in frozen markets. This program, which provided buyers with partial insurance against acquiring low-quality assets, reveals a fundamental trade-off for policymakers: while some insurance encourages buyers to bid for assets when they otherwise would not, thus promoting price discovery, too much insurance erodes the informational content of these bids, which hurts price discovery.
(550 KB, 43 pages)

13-19: Estimating Dynamic Equilibrium Models with Stochastic Volatility by Jesús Fernandez-Villaverde, Pablo Guerron-Quintana, and Juan F. Rubio-Ramírez

The authors propose a novel method to estimate dynamic equilibrium models with stochastic volatility. First, they characterize the properties of the solution to this class of models. Second, the authors take advantage of the results about the structure of the solution to build a sequential Monte Carlo algorithm to evaluate the likelihood function of the model. The approach, which exploits the profusion of shocks in stochastic volatility models, is versatile and computationally tractable even in large-scale models, such as those often employed by policy-making institutions. As an application, the authors use their algorithm and Bayesian methods to estimate a business cycle model of the U.S. economy with both stochastic volatility and parameter drifting in monetary policy. Their application shows the importance of stochastic volatility in accounting for the dynamics of the data.
(707 KB, 72 pages)

13-18: Dynamics of Investment, Debt, and Default by Grey Gordon and Pablo Guerron-Quintana

How does physical capital accumulation affect the decision to default in developing small open economies? The authors find that, conditional on a level of foreign indebtedness, more capital improves the sovereign’s ability to meet its obligations, reducing the likelihood of default and the risk premium. This effect, however, is diminishing in the stock of capital because capital also tames the severity of the contraction following default, making autarky more appealing. Access to long-term debt and costly capital adjustment are crucial for matching business cycles. Their quantitative model delivers default episodes that mimic those observed in the data.
(524 KB, 36 pages)

13-17: Competition in Bank-Provided Payment Services by Wilko Bolt and David Humphrey

Banks supply payment services that underpin the smooth operation of the economy. To ensure an efficient payment system, it is important to maintain competition among payment service providers, but data available to gauge the degree of competition are quite limited. The authors propose and implement a frontier-based method to assess relative competition in bank-provided payment services. Billion dollar banks account for around 90 percent of assets in the U.S., and those with around $4 to $7 billion in assets turn out to be both the most and the least competitive in payment services, not the very largest banks.
(340 KB, 28 pages)

13-16: Improving GDP Measurement: A Measurement-Error Perspective by S. Boragan Aruoba, Francis X. Diebold, Jeremy Nalewaik, Frank Schorfheide, and Dongho Song

The authors provide a new and superior measure of U.S. GDP, obtained by applying optimal signal-extraction techniques to the (noisy) expenditure-side and income-side estimates. Its properties — particularly as regards serial correlation — differ markedly from those of the standard expenditure-side measure and lead to substantially revised views regarding the properties of GDP.
(753 KB, 36 pages)

13-15: The Cost of Delay by Larry Cordell, Liang Geng, Laurie Goodman, and Lidan Yang

In this study, the authors make use of a massive database of mortgage defaults to estimate REO liquidation timelines and time-related costs resulting from the recent post-crisis interventions in the mortgage market and the freezing of foreclosures due to "robo-signing" revelations. The cost of delay, estimated by comparing today's time-related costs to those before the start of the financial crisis, is eight percentage points, with enormous variation among states. While costs are estimated to be four percentage points higher in statutory foreclosure states, they are estimated to be 13 percentage points higher in judicial foreclosure states and 19 percentage points higher in the highest-cost state, New York. They discuss the policy implications of these extraordinary increases in time-related costs, including recent actions by the GSEs to raise their guarantee fees 15-30 basis points in five high-cost judicial states. Combined with evidence that foreclosure delays do not improve outcomes for borrowers and that increased delays can have large negative externalities in neighborhoods, the weight of the evidence is that current foreclosure practices merit the urgent attention of policymakers.
(666 KB, 29 pages)

13-14: Market Run-Ups, Market Freezes, Inventories, and Leverage by Philip Bond and Yaron Leitner

The authors study trade between an informed seller and an uninformed buyer who have existing inventories of assets similar to those being traded. They show that these inventories may lead to prices that increase even absent changes in fundamentals (a "run-up"), but may also make trade impossible (a "freeze") and hamper information dissemination. Competition may amplify the run-up by inducing buyers to enter loss-making trades at high prices to prevent a competitor from purchasing at a lower price and releasing bad news about inventory values. Inventories also prevent seller competition from delivering the Bertrand outcome, in which prices match sellers' valuations. The authors discuss both empirical implications and implications for regulatory intervention in illiquid markets.
Supersedes Working Paper 12-8.
(517 KB, 52 pages)

13-13: Who Said Large Banks Don’t Experience Scale Economies? Evidence from a Risk-Return-Driven Cost Function by Joseph P. Hughes and Loretta J. Mester

The Great Recession focused attention on large financial institutions and systemic risk. The authors investigate whether large size provides any cost advantages to the economy and, if so, whether these cost advantages are due to technological scale economies or too-big-to-fail subsidies. Estimating scale economies is made more complex by risk-taking. Better diversification resulting from larger scale generates scale economies but also incentives to take more risk. When this additional risk-taking adds to cost, it can obscure the underlying scale economies and engender misleading econometric estimates of them. Using data pre- and post-crisis, they estimate scale economies using two production models. The standard model ignores endogenous risk-taking and finds little evidence of scale economies. The model accounting for managerial risk preferences and endogenous risk-taking finds large scale economies, which are not driven by too-big-to-fail considerations. The authors evaluate the costs and competitive implications of breaking up the largest banks into smaller banks.
(500 KB, 48 pages)

13-12: Modeling the Credit Card Revolution: The Role of Debt Collection and Informal Bankruptcy by Lukasz A. Drozd and Ricardo Serrano-Padial

In the data, most consumer defaults on unsecured credit are informal and the lending industry devotes significant resources to debt collection. The authors develop a new theory of credit card lending that takes these two features into account. The two key elements of their model are moral hazard and costly state verification that relies on the use of information technology. They show that the model gives rise to a novel channel through which IT progress can affect outcomes in the credit markets, and argue that this channel can be critical to understand the trends associated with the rapid expansion of credit card borrowing in the 1980s and over the 1990s. Independently, the mechanism of the model helps reconcile high levels of defaults and indebtedness observed in the US data.
(566 KB, 50 pages)

13-11: Local Deficits and Local Jobs: Can U.S. States Stabilize Their Own Economies? by Gerald Carlino and Robert Inman

Using a sample of the 48 mainland U.S. states for the period 1973-2009, the authors study the ability of U.S. states to expand their own state employment through the use of state deficit policies. The analysis allows for the facts that U.S. states are part of a wider monetary and economic union with free factor mobility across all states and that state residents and firms may purchase goods from "neighboring" states. Those purchases may generate economic spillovers across neighbors. Estimates suggest that states can increase their own state employment by increasing their own deficits. There is evidence of spillovers to employment in neighboring states defined by common cyclical patterns among state economies. For large states, aggregate spillovers to its economic neighbors are approximately two thirds of the large state's job growth. Because of significant spillovers and possible incentives to free-ride, there is a potential case to actively coordinate (i.e., centralize) the management of stabilization policies. Finally, when these deficits are scheduled for repayment the job effects of a temporary increase in state own deficits persist for at most one to two years and there is evidence of a negative impact of state jobs.
(395 KB, 42 pages)

13-10: Risk, Economic Growth, and the Value of U.S. Corporations by Luigi Bocola and Nils Gornemann

This paper documents a strong association between total factor productivity (TFP) growth and the value of U.S. corporations (measured as the value of equities and net debt for the U.S. corporate sector) throughout the postwar period. Persistent fluctuations in the first two moments of TFP growth predict two-thirds of the medium-term variation in the value of U.S. corporations relative to gross domestic product (henceforth value-output ratio). An increase in the conditional mean of TFP growth by 1 percent is associated with a 21 percent increase in the value-output ratio, while this indicator declines by 12 percent following a 1 percent increase in the standard deviation of TFP growth. A possible explanation for these findings is that movements in the first two moments of aggregate productivity affect the expectations that investors have regarding future corporate payouts as well as their perceived risk. The authors develop a dynamic stochastic general equilibrium model with the aim of verifying how sensible this interpretation is. The model features recursive preferences for the households, Markov-Switching regimes in the first two moments of TFP growth, incomplete information, and monopolistic rents. Under a plausible calibration and including all these features, the model can account for a sizable fraction of the elasticity of the value-output ratio to the first two moments of TFP growth.
(712 KB, 48 pages)

13-9: Worker Flows and Job Flows: A Quantitative Investigation by Shigeru Fujita and Makoto Nakajima

This paper studies the quantitative properties of a multiple-worker firm matching model with on-the-job search where heterogeneous firms operate decreasing-returns-to-scale production technology. The authors focus on the model's ability to replicate the business cycle features of job flows, worker flows between employment and unemployment, and job-to-job transitions. The calibrated model successfully replicates (i) countercyclical worker flows between employment and unemployment, (ii) procyclical job-to-job transitions, and (iii) opposite movements of job creation and destruction rates over the business cycle. The cyclical properties of worker flows between employment and unemployment differ from those of job flows, partly because of the presence of job-to-job transitions. The authors also show, however, that job flows measured by net employment changes differ significantly from total worker separation and accession rates, because separations also occur at firms with positive net employment changes, and similarly firms that are shrinking on net may hire workers to partially offset attritions. The presence of job-to-job transitions is the key to producing these differences.
PDF Icon (508 KB, 39 pages)

13-8: Understanding and Measuring Risks in Agency CMOs by Nicholas Arcidiacono, Larry Cordell, Andrew Davidson, and Alex Levin

The Agency CMO market, an often overlooked corner of mortgage finance, has experienced tremendous growth over the past decade. This paper explains the rationale behind the construction of Agency CMOs, quantifies risks embedded in Agency CMOs using a traditional and a novel approach, and offers valuable lessons learned when interpreting these risk measures. Among these lessons is that to fully understand the risks in Agency CMOs a full bond-by-bond analysis is necessary and that interest rate risk is not the only risk that needs to be considered when conducting risk management with CMOs.
PDF Icon (481 KB, 28 pages)

13-7: Competing with Asking Prices by Benjamin Lester, Ludo Visschers, and Ronald Wolthoff

In many markets, sellers advertise their good with an asking price. This is a price at which the seller is willing to take his good off the market and trade immediately, though it is understood that a buyer can submit an offer below the asking price and that this offer may be accepted if the seller receives no better offers. Despite their prevalence in a variety of real world markets, asking prices have received little attention in the academic literature. The authors construct an environment with a few simple, realistic ingredients and demonstrate that using an asking price is optimal: it is the pricing mechanism that maximizes sellers’ revenues and it implements the efficient outcome in equilibrium. They provide a complete characterization of this equilibrium and use it to explore the positive implications of this pricing mechanism for transaction prices and allocations.
PDF Icon (678 KB, 44 pages)

13-6: Dichotomy Between Macroprudential Policy and Monetary Policy on Credit and Inflation by Hyunduk Suh

This paper examines the different effects of macroprudential policy and monetary policy on credit and inflation using a simple New Keynesian model with credit. In this model, macroprudential policy is effective in stabilizing credit but has a limited effect on inflation. Monetary policy with an interest rate rule stabilizes inflation, but this rule is ‘too blunt’ an instrument to stabilize credit. The determinacy of the model requires the interest rate’s response to inflation to be greater than one for one and independent of macroprudential policy. That is, the ‘Taylor principle’ applies to monetary policy. This dichotomy between macroprudential policy and monetary policy arises because each policy is designed to differently affect the saving and borrowing decisions of households.
PDF Icon (733 KB, 25 pages)

13-5: Interest Rates and Prices in an Inventory Model of Money with Credit by Michael Dotsey and Pablo Guerron-Quintana

Using a segmented market model that includes state-dependent asset market decisions along with access to credit, the authors analyze the impact that transactions credit has on interest rates and prices. They find that the availability of credit substantially changes the dynamics in the model, allowing agents to significantly smooth consumption and reduce the movements in velocity. As a result, prices become quite flexible and liquidity effects are dampened. Thus, adding another medium of exchange whose use is calibrated to U.S. data has important implications for economic behavior in a segmented markets model.
PDF Icon (394 KB, 43 pages)

13-4: On the Timing of Monetary Policy Reform by Roc Armenter

This paper argues that there is a normative case for delaying policy reform. Policy design in dynamic economies typically faces a trade-off between the policy effects in the short and long term, and possibly across future states of nature. When the economy is in an atypical state or available policies are less flexible than ideal, this trade-off can be steep enough that retaining the status-quo policy in the short term and taking on the reform at a later date is welfare improving. In a simple New Keynesian economy, the author considers monetary policy reform from discretion to the optimal targeting rule. The author finds that the policy reform should be postponed if a sharp drop in output drives the nominal interest rate to the zero lower bound but only modest deflation pressures are observed under the status-quo policy.
PDF Icon (534 KB, 37 pages)

13-3: Does Junior Inherit? Refinancing and the Blocking Power of Second Mortgages by Philip Bond, Ronel Elul, Sharon Garyn-Tal, and David K. Musto

Refinancing a first mortgage puts legal principles in conflict when other, junior, liens also exist. On one hand, the principle that seniority follows time priority leaves the new refinancing mortgage junior to mortgages that were junior to the original, refinanced first mortgage. On the other hand, the principle of equitable subrogation gives the refinancing mortgage the seniority of the claim it paid down. States resolve this tension differently, thus differentiating how much a second mortgage impedes refinancing of the first. The authors exploit this cross-state variation to identify the impact on mortgage refinancing and find that refinancing is significantly more likely in the states following the principle of equitable subrogation when the homeowner also has a second mortgage.
PDF Icon (540 KB, 34 pages)

13-2: Durable Financial Regulation: Monitoring Financial Instruments as a Counterpart to Regulating Financial Institutions, by Leonard Nakamura

This paper sets forth a discussion framework for the information requirements of systemic financial regulation. It specifically describes a potential large macro-micro database for the U.S. based on an extended version of the Flow of Funds. The author argues that such a database would have been of material value to U.S. regulators in ameliorating the recent financial crisis and could be of aid in understanding the potential vulnerabilities of an innovative financial system in the future. The author also suggests that making these data available to the academic research community, under strict confidentiality restrictions, would enhance the detection and measurement of systemic risk.
PDF Icon (225 KB, 23 pages)

13-1: Regional Resilience, by Jeffrey Lin

In this paper, the author studies long-run population changes across U.S. metropolitan areas. First, the author argues that changes over a long period of time in the geographic distribution of population can be informative about the so-called “resilience” of regions. Using the censuses of population from 1790 to 2010, the author finds that persistent declines, lasting two decades or more, are somewhat rare among metropolitan areas in U.S. history, though more common recently. Incorporating data on historical factors, the author finds that metropolitan areas that have experienced extended periods of weak population growth tend to be smaller in population, less industrially diverse, and less educated. These historical correlations inform the construction of a regional resilience index.
PDF Icon (515 KB, 31 pages)

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