Many observers believe that turbulence in asset prices results from bouts of optimism and pessimism among investors that have little to do with economic reality. While psychology and emotions are no doubt important motivators of human actions, an explanation for asset price booms and busts that ignores the fact that humans are also thinking animals does not seem entirely satisfactory or plausible. In “A Theory of Asset Price Booms and Bust and the Uncertain Return to Innovation,” (245 KB, 8 pages) Satyajit Chatterjee presents a counterpoint to the view that “it’s all psychology.” He reports on a theory of asset price booms and busts that is based entirely on rational decision-making and devoid of psychological elements. The explanation suggests that asset price booms and crashes are most likely to occur when the value of the asset in question depends on an innovation whose full profit potential is initially unknown to investors.
Most economic theories of hiring and job seeking assume that businesses post vacancies when they demand more labor. Workers then apply for the job, and the most qualified candidate is hired. However, as those who have ever recruited or applied for a job know, the recruiting process is considerably more complex. In “How Do Businesses Recruit?,” (319 KB, 9 pages) Jason Faberman discusses some recent research on how employers recruit. It shows that the extent to which a business uses various recruiting channels depends on the characteristics of the employer, how fast the employer is growing (or contracting), and the overall state of the economy.
How would you feel if even though you were making regular monthly payments, your mortgage bank sold your house? This may seem like an odd question, but this type of situation happens every day in financial markets in a practice known as rehypothecation. Although such practices may be hard for nontraders to understand, rehypothecation is widespread in financial markets. Following the crisis of 2007-2009, the Dodd-Frank Act put restrictions on rehypothecation for derivatives. To understand the scope of these restrictions, we need to understand the role of rehypothecation in financial trades. In “Rehypothecation,” (273 KB, 8 pages) Cyril Monnet discusses questions such as: Which party to a financial trade does rehypothecation benefit? Are there limits to its advantages? And how should it be regulated? There are no hard and fast answers to the last question, but the author notes that we can make a more informed decision about the pros and cons of various forms of regulation if we understand the underlying economics.
See also the latest issue of Research Rap (181 KB, 7 pages).
Metropolitan areas in the U.S. contain almost 80 percent of the nation’s population and nearly 85 percent of its jobs. This high degree of spatial concentration of people and jobs leads to congestion costs and higher housing costs. To offset these costs, workers must receive higher wages, and higher wages increase firms’ costs. So why do firms continue to produce in cities where the cost of doing business is so high? Economists offer three main explanations. First, cities developed and grew because of some natural advantage, such as a port. Second, as cities grew, the resulting concentration of people and jobs led to efficiency gains and cost savings for firms, creating agglomeration economies. Finally, the presence of a talented and flexible labor force made it feasible for entrepreneurs to start new businesses. This third reason for the growth of cities is called sorting. In “Three Keys to the City: Resources, Agglomeration Economies, and Sorting,” (351 KB, 13 pages) Jerry Carlino looks at recent developments in measuring each of the sources of city productivity and discusses the policy implications of this research.
As the recent recession unfolded, policymakers in the U.S. and abroad employed both monetary and fiscal stabilization tools to help mitigate the downturn. One of the tools that can be used by fiscal policymakers is to actively purchase more goods and services: the idea being that the government’s demand can offset the weak demand by households and firms. For such a policy to be effective, one needs to know the extent to which government spending can stimulate the economy. One of the models frequently used by economists who study business cycles suggests that the answer depends very much on the extent to which monetary policy can be employed to stabilize the economy. In “The Effectiveness of Government Spending in Deep Recessions: A New Keynesian Perspective,” (226 KB, 7 pages) Keith Kuester reviews the literature on the effectiveness of government spending during severe recessions.
Residential property taxes are both a major source of local government financing and a significant cost of owning a home. Tax limitation measures and relatively moderate gains in house prices during most of the 1990s tended to keep property taxes from rising rapidly in those years. But from the late 1990s to the mid-2000s, house prices once again rose sharply. Property taxes followed a similar path, bringing them to greater public attention once again. Now that house prices appear to have shifted to a level or downward trend in most parts of the country, there seems to be increasing concern that real estate valuations for property taxes are not promptly reflecting declining values. In “What’s It Worth? Property Taxes and Assessment Practices,” (256 KB, 10 pages) Tim Schiller focuses on how tax authorities measure value and calculate tax liabilities, the shortcomings of some of these processes, and the remedies that have been, or can be, implemented to make real estate assessment more accurate and equitable.
Bank capital has been much in the news during the recent financial crisis. In 2008 and 2009 the U.S. government injected $235 billion of capital into the banking system as part of the Troubled Asset Relief Program (TARP). In 2009, bank regulators carried out a full-scale evaluation of the capital adequacy of 19 large banking organizations, ultimately requiring 10 of these organizations to increase their capital levels. While most commentators agree that regulatory capital levels are too low for large organizations — especially large organizations that create systemic risks — financial economists have only recently been paying attention to what factors actually govern banks’ capital choices. In “Can We Explain Banks’ Capital Structures?,” (310 KB, 11 pages) Mitchell Berlin discusses how understanding bank capital decisions over the 20-year period prior to the recent crisis can provide insights that may help us to evaluate reform proposals.
In normal times, investors buy and sell financial assets because there are gains from trade. However, markets do not always function properly — they sometimes “freeze.” An example is the collapse of trading in mortgage-backed securities during the recent financial crisis. Why does trade break down despite the potential gains from trade? Can the government intervene to restore the normal functioning of markets? In “Why Do Markets Freeze?,” (253 KB, 8 pages) Yaron Leitner explains what a market freeze is and some of the theories as to why these freezes occur.
For most homeowners, housing is the single most important component of their nonpension wealth. Therefore, a change in house prices greatly affects the total wealth of many households. Furthermore, movements in house prices can affect people’s lives indirectly. For example, the surge in the number of mortgage defaults and foreclosures during the recent recession was triggered in part by a drop in house prices, and this surge damaged the health of the financial institutions that either directly or indirectly owned mortgage loans. In turn, the deteriorating health of the financial sector was one of the factors contributing to the recession. Naturally, for both policymakers and for people who want to make sound financial decisions, it is important to understand how and why house prices move. In “Understanding House-Price Dynamics,” (323 KB, 9 pages) Makoto Nakajima explains a simple theory that helps us better understand house-price dynamics. The theory — called the user cost-rent equivalence — is based on the close relationship between user costs, which are the costs of owning a house for a year, and rents.
See also the latest issue of Research Rap. (174 KB, 4 pages)
The concept of resource slack is central to understanding the dynamics between employment, output, and inflation. But what amount of slack is consistent with price stability? To answer this question, economists define baseline values for unemployment and output known as the natural rate of unemployment and potential output. The concepts of output and employment gaps can be useful to economists in several ways. First, they often guide the inflation forecasts of Federal Reserve staff and other researchers and market participants. Second, some economists argue that employment gaps are a useful guide for policy aimed at achieving maximum sustainable employment and price stability. In “Output Gaps: Uses and Limitation,” (312 KB, 8 pages) Roc Armenter briefly discusses two important examples of sophisticated measures of resource slack that are grounded in economic theory: the nonaccelerating inflation rate of unemployment and the output gap measure published quarterly by the Congressional Budget Office.
Densely populated areas tend to be more productive. Of course, the cost of living and producing in these locations is higher because congestion raises the cost of scarce fixed resources such as land. But despite the higher prices, many people and businesses continue to live and work in these areas. Why? One explanation is that these locations have natural advantages, such as proximity to a river. Another says that this concentration of households and businesses by itself generates productivity advantages in the form of agglomeration economies. In studying these agglomeration economies, economists have pursued two other questions. Do agglomeration economies exist and how big are they? And what are the precise sources of these agglomeration economies? In “Urban Productivity Advantages from Job Search and Matching,” (330 KB, 8 pages) Jeffrey Lin describes the evidence for agglomeration economies from job search and matching and then asks whether it may be large enough to offer meaningful explanations for differences in productivity and density.
A 1977 amendment to the Federal Reserve Act states that the Fed’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Moderate long-term interest rates require low and stable inflation. Monetary policymakers use instruments such as a short-term interest rate to guide the economy with the aim of achieving an inflation objective. To help guide their decisions, monetary policymakers benefit from having a reliable theory of how inflation is determined, one that relates the setting of their instrument to the unexpected events that hit the economy and consequently to the rate of inflation and other economic variables. In “Inflation Dynamics and the New Keynesian Phillips Curve,” (340 KB, 9 pages) Keith Sill examines a prominent theory of how inflation is determined, as articulated in what is called the New Keynesian Phillips curve. He also investigates some of the implications of the theory for the conduct of monetary policy.
See also the latest issue of Research Rap. (214 KB, 3 pages)