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Business Review

Fourth Quarter 2003

As technological advances continue to expand the range of financial services available to consumers, money management becomes increasingly complicated. Helping consumers navigate this sea of financial products is important. When households are capable of building wealth, they are also capable of building more economically stable neighborhoods and communities. That's one reason economic education is vital to the future health of our nation's economy. In "Knowledge Is Power: The Importance of Economic Education," President Anthony Santomero outlines what the Federal Reserve is doing to promote economic education and explains why knowledge is indeed power in our ever more complex world.

Our next article discusses agglomeration economies — a concentration of workers and businesses in one location. Specifically, it looks at why employment is heavily concentrated in the cities of industrially developed countries. Most economists believe that in the absence of agglomeration economies, the spatial distribution of employment would be much more even. In "Agglomeration Economies: The Spark That Ignites a City?" Satyajit Chatterjee discusses his research, which questions this belief. He finds that while agglomeration economies are important, they're not the most important factor in the spatial concentration of employment. The combined effects of factors unrelated to agglomeration economies, such as the availability of natural resources and local economic policies, appear to account for the bulk of the spatial concentration of U.S. employment.

Historically, cities are also where most immigrants settle. Moreover, debate still rages today — as it has at other points in history — over immigrants' effect on a host country's economic and social structures. In "The Impact of Immigration on American Cities: An Introduction to the Issues," Albert Saiz discusses immigration's impact on a receiving country's labor and housing markets, fiscal systems, and social interactions.

Finally, we look at manufacturing and why an increasing number of surveys monitor its movements — despite its decline as a share of the U.S. economy. Why this continuing strong interest? Because the manufacturing sector is more cyclically sensitive than the total economy, it can serve as an indicator of cyclical fluctuations as they develop. In "Taking the Measure of Manufacturing," Tim Schiller and Mike Trebing outline several of the most important surveys and indexes that track manufacturing, describe their similarities and differences, and discuss their usefulness in providing timely and accurate data on the sector.


The idea of creating a framework for explicit inflation targeting in the U.S. has recently become a topic of considerable discussion. The key question is: Could inflation targeting improve on the U.S. economy's performance? President Anthony Santomero thinks inflation targeting makes sense for the U.S., in principle. But he cautions that several important issues must be worked out first. In this quarter's message, "Flexible Commitment or Inflation Targeting for the U.S.?" he discusses these issues, which include calibrating the target and reconciling inflation targeting with the Fed's mandate to foster not just price stability but also full employment.

In our next article, "Crises, Contagion, and Coordination," Loretta Mester summarizes last year's Policy Forum. In "Changes in the Use of Electronic Means of Payment: 1995-2001," Mester updates tables that first appeared in her article in the March/April 2000 Business Review. Mester has recently produced an update to these articles (2006)

Our next three articles cover topics as diverse as trade credit, business cycles in Third District states, and inventories and the business cycle.

Trade credit remains the single largest source of short-term business credit in the United States and other nations around the world. Why do production firms act as financial intermediaries — a role usually reserved for banks? In "Trade Credit: Why Do Production Firms Act as Financial Intermediaries?" Mitchell Berlin focuses on explanations that view trade credit as a method of monitoring and enforcing loan contracts to relatively risky firms. He also examines explanations in which a firm's long-term supply relationship helps it to make better credit decisions than a bank world.

Most discussions of business cycles focus on the national economy. But regional cycles are also important, and they can vary significantly from one region to another. Analysis of regional cycles can help businesses plan investments and project sales, among other things. A look at the economies of the Third District states — Pennsylvania, New Jersey, and Delaware -illustrates how trends and cycles can differ even among neighboring states. In "The Long and the Short of It: Recent Trends and Cycles in the Third District States," Ted Crone traces the historical patterns of the three states' economies but warns that noting such patterns is not a substitute for detailed current analysis.

Changes in the stock of firms' inventories are an important component of the business cycle. In fact, discussion about the timing of a recovery following a recession often focuses on inventories. In "The Role of Inventories in the Business Cycle," Aubhik Khan surveys the facts about inventory investment over the business cycle, then discusses two leading theories that may explain these observations.

At the back, you'll find the latest edition of Research Rap, which contains summaries of our economists' research.


In the first article this quarter, President Anthony Santomero asks: What is the root of the corporate governance problems that have recently gained the spotlight? Is it the mega-merger frenzy of the 1980s? Overly optimistic forecasts of earnings? Innovations in the financial services industry? Although these factors undoubtedly played some role, President Santomero views governance problems as having deeper roots. In "Corporate Governance and Responsibility," he points out that the central dilemma is one of conflicting interests in organizations — what economists call "the principal-agent relationship."

Our next article talks about change — as in coins. Every year, the government produces about 70 new coins for every man, woman, and child. But the economy's need for coins can vary from year to year. So how do the U.S. Mint, which makes the coins, and the Federal Reserve, which distributes them, decide how many coins the economy needs? In "U.S. Coins: Forecasting Change," Dean Croushore highlights some facts about coins and describes how demand for change is forecast.

Although people still use cash to pay for goods and services, the trend is toward payment cards. In the U.S., payment card networks coordinate the activities of thousands of financial institutions, millions of retail locations, and several hundred million consumers. This coordination may include the collective setting of certain prices and other controversial network rules. Such practices have recently come under the scrutiny of antitrust authorities in the U.S. and abroad. In "Antitrust Issues in Payment Card Networks: Can They Do That? Should We Let Them?" Bob Hunt describes the economics of the payment card industry and explains how it differs from the textbook model of competitive markets. He argues that these differences should be reflected in the antitrust analysis of payment card networks.

We end with the age-old debate of city vs. suburbs. The United States is unique in its commitment to local government as the primary provider of essential public services and in its use of local taxes as the primary means for paying for these services. The Philadelphia metropolitan area is typical of the U.S. pattern. But Philadelphia faces the burdens and responsibilities of all older central cities, including a higher proportion of poor residents than its surrounding suburbs. Such circumstances lead the city to impose higher taxes, but raising revenues through higher taxes becomes self-defeating when tax rates drive people and businesses away. The result is a weaker city and regional economy. How can Philadelphia strengthen its finances? In "Should Philadelphia's Suburbs Help Their Central City?" Bob Inman proposes a targeted program of suburban assistance to lower the commuter wage tax and presents evidence that such a program is likely to benefit city and suburban residents alike.


The banking industry and its regulators recognize that they share a vested interest in enhancing the industry's risk-management strategies. In "Process and Progress in Risk Management,” his first message of 2003, President Anthony Santomero discusses three points: risk management as its own distinct discipline; the financial industry's work to improve risk-management techniques and regulators' increased commitment to risk-focused examinations; and the need to improve risk-management systems even further.

Our other articles in this issue tackle three different questions. First, Jerry Carlino points out that the fortunes of local economies usually depend on a confluence of national, sectoral, and local shocks. That, in turn, raises the question: Does one type of shock systematically buffet local economies more than another? The answer has important implications for both academic researchers and policymakers. In "A Confluence of Events? Explaining Fluctuations in Local Employment,” Carlino examines the evidence to see which type of shock most likely explains fluctuations in local employment.

Our next article looks at a question that economists have long debated: Why did inflation increase so dramatically from the 1960s to the 1970s? One possible theory is that once people started believing inflation would rise, the Fed was forced to validate those expectations by increasing the money supply. In "How Inflation Hawks Escape Expectations Traps,” Sylvain Leduc discusses this “expectations trap” hypothesis and uses a direct measure of expectations to see if the theory is consistent with the data.

Finally, Leonard Nakamura weighs in on the question: Which is more likely to encourage creativity and innovation: a centralized or a decentralized system of support? That is, should large organizations and recognized experts determine who gets funding for their ideas? Or should small businesses, patrons, and foundations provide the primary support for innovation? In "Let a Hundred Flowers Bloom! Decentralization and Innovation,” Nakamura looks at the case for both sides using economic analysis, empirical studies, and anecdotal evidence.

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