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Is the Armed Forces Qualifying Test (AFQT) a measure of achievement or ability?
The answer to this question is critical for drawing inferences from studies in
which it is employed. In this paper, the authors test for a relationship
between schooling and AFQT performance in the NLSY 79 by comparing test-takers
with birthdays near state cutoff dates for school entry. They instrument for
schooling at the test date with academic cohort—the year in which an
individual should have entered first grade—in a model that allows age at
the test date to have a direct effect on AFQT performance. This identification
strategy reveals large impacts of schooling on the AFQT performance of racial
minorities, providing support for the hypothesis that the AFQT measures school
(768 KB, 49 pages)
State-dependent pricing (SDP) models treat the
timing of price changes as a profit-maximizing choice, symmetrically with other
decisions of firms. Using quantitative general equilibrium models that
incorporate a “generalized (S,s) approach,” the authors investigate
the implications of SDP for topics in two major areas of macroeconomic
research: the early 1990s SDP literature and more recent work on persistence
mechanisms. First, they show that state-dependent pricing leads to unusual
macroeconomic dynamics, which occur because of the timing of price adjustments
chosen by firms as in the earlier literature. In particular, they display an
example in which output responses peak at about a year, while inflation
responses peak at about two years after the shock. Second, the authors examine
whether the persistence-enhancing effects of two New Keynesian model features,
namely, specific factor markets and variable elasticity demand curves, depend
importantly on whether pricing is state dependent. In an SDP setting, they
provide examples in which specific factor markets perversely work to lower
persistence, while variable elasticity demand raises it.
(692 KB, 64 pages)
Recent empirical research finds that
pairs of countries with stronger trade linkages tend to have more highly
correlated business cycles. The authors assess whether the standard
international business cycle framework can replicate this intuitive result.
They employ a three-country model with transportation costs, and they simulate
the effects of increased goods market integration under two asset market
structures: complete markets and international financial autarky. The main
finding is that under both asset market structures the model can generate
stronger correlations for pairs of countries that trade more, but the increased
correlation falls far short of the empirical findings. Even when the authors
control for the fact that most country pairs are small with respect to the rest
of the world, the model continues to fall short. They also conduct additional
simulations that allow for increased trade with the third country or increased
TFP shock comovement to affect the country pair’s business cycle
comovement. These simulations are helpful in highlighting channels that could
narrow the gap between the empirical findings and the predictions of the
(536 KB, 39 pages)
Though built with
increasingly precise microfoundations, modern optimizing sticky price models
have displayed a chronic inability to generate large and persistent real
responses to monetary shocks, as recently stressed by Chari, Kehoe, and
McGrattan . This is an ironic finding, since Taylor  and other
researchers were motivated to study sticky price models in part by the
objective of generating large and persistent business fluctuations.
The authors trace this lack of persistence to a standard view of the cyclical behavior of real marginal cost built into current sticky price macro models. Using a fully-articulated general equilibrium model, they show how an alternative view of real marginal cost can lead to substantial persistence. This alternative view is based on three features of the "supply side" of the economy that they believe are realistic: an important role for produced inputs, variable capacity utilization, and labor supply variability through changes in employment. Importantly, these "real flexibilities" work together to dramatically reduce the elasticity of marginal cost with respect to output, from levels much larger than unity in CKM to values much smaller than unity in this analysis. These "real flexibilities" consequently reduce the extent of price adjustments by firms in time-dependent pricing economies and the incentives for paying fixed costs of adjustment in state-dependent pricing economies. The structural features also lead the sticky price model to display volatility and comovement of factor inputs and factor prices that are more closely in line with conventional wisdom about business cycles and various empirical studies of the dynamic effects of monetary shocks.
(743 KB, 42 pages)
The authors find that
technology's effect on employment varies greatly across manufacturing
industries. Some industries exhibit a temporary reduction in employment in
response to a permanent increase in TFP, whereas far more industries exhibit an
employment increase in response to a permanent TFP shock. This raises serious
questions about existing work that finds that a labor productivity shock has a
strong negative effect on employment. There are tantalizing and interesting
differences between TFP and labor productivity. The authors argue that TFP is a more
natural measure of technology because labor productivity reflects shifts in the
input mix as well as in technology.
(434 KB, 33 pages)
Initially published estimates of the personal saving
rate from 1965 Q3 to 1999 Q2, which averaged 5.3 percent, have been revised up
2.8 percentage points, to 8.1 percent, as the authors document. They show that
much of the initial variation in the personal saving rate across time was
meaningless noise. Nominal disposable personal income has been revised upward
an average of 8.4 percent: one dollar in 12 was originally missing! The authors
use both conventional and real-time estimates of the personal saving rate to
forecast real disposable income, gross domestic product, and personal
consumption and show that the personal saving rate in real-time almost
invariably makes forecasts worse. Thus, while the personal saving rate may have
some forecasting power once one knows the true saving rate, as Campbell (1987)
and Ireland (1995) have argued, as a practical matter it is useless to
(450 KB, 37 pages)
The authors develop a life-cycle model to study the effects of
house price changes on household consumption and welfare. The model explicitly
incorporates the dual feature of housing as both a consumption good and an
investment asset and allows for costly adjustments in housing and mortgage
positions. Li and Yao's analysis indicates that although house price changes
have small aggregate effects, their consumption and welfare consequences on
individual households vary significantly. In particular, the non-housing
consumption of young and old homeowners is much more sensitive to house price
changes than that of middle-aged homeowners. More importantly, while house
price appreciation increases the net worth and consumption of all homeowners,
it only improves the welfare of middle-aged and old homeowners. Young
homeowners and renters are worse off due to higher life-cycle housing
(748 KB, 39 pages)
Using detailed plant-level data from the 1988 and 1993 Surveys of
Manufacturing Technology, this paper examines the impact of skill mix in U.S.
local labor markets on the use and adoption of automation technologies in
manufacturing. The level of automation differs widely across U.S. metropolitan
areas. In both 1988 and 1993, in markets with a higher relative availability of
less skilled labor, comparable plants – even plants in the same narrow
(4-digit SIC) industries – used systematically less automation. Moreover,
between 1988 and 1993 plants in areas experiencing faster less-skilled relative
labor supply growth adopted automation technology more slowly, both overall and
relative to expectations, and even de-adoption was not uncommon. This
relationship is stronger when examining an arguably exogenous component of
local less-skilled labor supply derived from historical regional settlement
patterns of immigrants from different parts of the
These results have implications for two long-standing puzzles in economics. First, they potentially explain why research has repeatedly found that immigration has little impact on the wages of competing native-born workers at the local level. It might be that the technologies of local firms – rather than the wages that they offer – respond to changes in local skill mix associated with immigration. A modified two-sector model demonstrates this theoretical possibility. Second, the results raise doubts about the extent to which the spread of new technologies have raised demand for skills, one frequently forwarded hypothesis for the cause of rising wage inequality in the United States. Causality appears to at least partly run in the opposite direction, where skill supply drives the spread of skill-complementary technology.
(436 KB, 61 pages)
This paper develops a model of consumer search consistent with the evidence of substantial price
dispersion within countries. This model is used to study international relative price fluctuations.
Consumer search frictions permit firms to price discriminate across markets based on the local wage
of consumers. With price dispersion, the market price of a good does not measure its resource cost.
This breaks the tight link between relative quantities and relative prices implied by most models.
The authors show that volatile and persistent fluctuations in relative wages lead to volatile and persistent
fluctuations in relative prices at the disaggregate level. These deviations from the law of one price
substantially increase international relative price volatility. With productivity and taste shocks, the
model generates international business cycles that closely match the data.
(409 KB, 47 pages)
The conventional wisdom that homeownership is very risky ignores the fact that the alternative, renting, is also risky. Owning a house provides a hedge against fluctuations in housing costs, but in turn introduces asset price risk. In a simple model of tenure choice with endogenous house prices, the authors show that the net risk of owning declines with a household’s expected horizon in its house and with the correlation in housing costs in future locations. Empirically, they find that both house prices, relative to rents, and the probability of homeownership increase with net rent risk.
(760 KB, 35 pages)
This paper addresses two aspects of advertising: its role in supporting entertainment and news, and its role as an investment. The author argues that in both roles advertising’s contribution to output is being undermeasured in the national income accounts. In some cases one unit of nominal advertising input should be counted as two units of real output. In rough orders of magnitude, he argues that it is plausible that two-thirds of advertising expenditure represents unmeasured contributions to output, and the level of real GDP should be increased accordingly.
(287 KB, 30 pages)
05-12/R Yaron Leitner, "A Theory of an Intermediary with Nonexclusive Contracts"
Superseded by Working Paper 10-28
In the United States today, there is at least one credit bureau file, and probably three, for every credit-using individual in the country. Over 2 billion items of information are added to these files every month, and over 3 million credit reports are issued every day. Real-time access to credit bureau information has reduced the time required to approve a loan from a few weeks to just a few minutes. But credit bureaus have also been criticized for furnishing erroneous information and for compromising privacy. The result has been 30 years of regulation at the state and federal levels.
This paper describes how the consumer credit reporting industry evolved from a few joint ventures of local retailers around 1900 to a high-technology industry that plays a supporting role in America’s trillion dollar consumer credit market. In many ways the development of the industry reflects the intuition developed in the theoretical literature on information-sharing arrangements. But the story is richer than the models. Credit bureaus have changed as retail and lending markets changed, and the impressive gains in productivity at credit bureaus are the result of their substantial investments in technology.
Credit bureaus obviously benefit when their data are more reliable, but should we expect them to attain the socially efficient degree of accuracy? There are plausible reasons to think not, and this is the principal economic rationale for regulating the industry. An examination of the requirements of the Fair Credit Reporting Act reveals an attempt to attain an appropriate economic balancing of the benefits of a voluntary information sharing arrangement against the cost of any resulting mistakes. Subsequent litigation and amendments to the act reveal how this balance has evolved over time.
(611 KB, 57 pages)
05-14 Loretta J. Mester, Leonard I. Nakamura, and Micheline Renault, "Transactions Accounts and Loan Monitoring"
Forthcoming in Review of Financial Studies
The authors provide evidence that transactions accounts help financial intermediaries monitor borrowers by offering lenders a continuous stream of data on borrowers' account balances. This information is most readily available to commercial banks, but other intermediaries, such as finance companies, also have access to such information at a cost. Using a unique set of data that includes monthly and annual information on small-business borrowers at an anonymous Canadian bank, the authors find a significant relationship between loans becoming troubled and the number of prior borrowings in excess of collateral. Since the bank monitors the value of collateral (defined as accounts receivable plus inventory) at high frequency through the transactions account of the borrower, this unique access to useful information gives banks an advantage over other lenders. The authors also find that banks more intensively monitor loans that have a higher number of violations of the collateral limit.
(1.12 MB, 45 pages)
05-15 Kevin X.D. Huang and Zheng Liu, "Vertical Production and Trade Interdependence and Welfare"
A version of this paper is forthcoming in the Journal of Economic Dynamics and Control under the title: "Sellers' Local Currency Pricing or Buyers' Local Currency Pricing: Does It Matter for International Welfare Analysis?"
The authors study international transmissions and welfare implications of monetary shocks in a two-country world with multiple stages of production and multiple boarder-crossings of intermediate goods. This empirically relevant feature is important, as it has opposite implications for two external spillover effects of a unilateral monetary expansion. If all production and trade are assumed to occur in a single stage, the confict-of-interest terms-of-trade effect tends to dominate the common-interest efficiency-improvement effect for reasonable parameter values, so that the international welfare effects would depend in general on the underlying assumptions about the currencies of price setting. The stretch of production and trade across multiple stages of processing magnifes the effciency-improvement effect and dampens the terms-of-trade effect. Thus, a monetary expansion can be mutually benefcial regardless of its source or the pricing assumptions.
(1.45 MB, 40 pages)
05-16 Paul S. Calem, Michael B. Gordy, and Loretta J. Mester, "Switching Costs and Adverse Selection in the Market for Credit Cards: New Evidence"
A version of this paper is forthcoming in the Journal of Banking and Finance
To explain persistence of credit card interest rates at relatively high levels, Calem and Mester (AER, 1995) argued that informational barriers create switching costs for high-balance customers. As evidence, using data from the 1989 Survey of Consumer Finances, they showed that these households were more likely to be rejected when applying for new credit. In this paper, they revisit the question using the 1998 and 2001 SCF. Further, they use new information on card interest rates to test for pricing effects consistent with information-based switching costs. The authors find that informational barriers to competition persist, although their role may have declined.
(732 KB, 46 pages)
This paper explores whether there was an economically significant differential in market-based risk between bank holding companies (BHCs) with Section 20 subsidiaries — subsidiaries that were authorized by the Federal Reserve to conduct bank-ineligible securities activities — and BHCs without such subsidiaries. Using market returns over a period of time in which BHCs expanded into securities activities, from 1985 through 1999, this study finds evidence that BHCs that participated in investment banking exhibited significantly lower total and unsystematic risk, suggesting that banks’ participation in the securities business resulted in diversification gains. However, BHCs with Section 20 subsidiaries exhibited higher systematic risk.
(963 KB, 26 pages)
05-18 Satyajit Chatterjee, Dean Corbae, Makoto Nakajima, and Jose-Victor Rios-Rull, "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default"
Superseded by Working Paper 07-16.
(1.2 MB, 69 pages)
The puzzle of underissuance of national bank notes disappears when one disaggregates
data, takes account of regulatory limits, and considers differences in opportunity costs.
Banks with poor lending opportunities maximized their issuance. Other banks chose to
limit issuance. Redemption costs do not explain cross-sectional variation in issuance, and
the observed relationship between note issuance and excess reserves is inconsistent with
the redemption risk hypothesis of underissuance. National banks did not enter primarily
to issue national bank notes, and a “pure arbitrage” strategy of chartering a national bank
only to issue national bank notes would not have been profitable. Indeed, new entrants
issued less while banks exiting were often maximum issuers. Economies of scope
between note issuing and deposit banking included shared overhead costs and the ability
to reduce costs of mandatory minimum reserve and capital requirements.
(616 KB, 61 pages)
05-20 George Alessandria and Horag Choi "Do Sunk Costs of Exporting Matter for Net Export Dynamics?"
Revision forthcoming in Quarterly Journal of Economics
Not all firms export every period. Firms enter and exit foreign markets. Previous research has
suggested that these export participation decisions have significant aggregate implications. In particular, it has been argued that these export decisions are important for the comovements of net
exports and the real exchange rate. In this paper, the authors evaluate these predictions in a general equilibrium environment. Specifically, assuming that firms face an up-front, sunk cost of entering foreign
markets and a smaller period-by-period continuation cost, they derive the discrete entry and exit
decisions yielding exporter dynamics in an otherwise standard equilibrium open economy business
cycle model. The authors show that the export decisions of firms in the model are infuenced by the business
cycle in a manner consistent with evidence presented for U.S. exporters. However, in contrast to
previous partial equilibrium analyses, model results reveal that the aggregate effects of these export
decisions are negligible.
(831 KB, 50 pages)
This paper analyzes securitization and more generally “special purpose vehicles”
(SPVs), which are now pervasive in corporate finance. The first part of the paper provides an
overview of the institutional features of SPVs and securitization. The second part provides a
model to analyze the motivations for using SPVs and the conditions under which SPVs are
sustainable. The authors argue that a key source of value to using SPVs is that they help reduce
bankruptcy costs. Off-balance sheet financing involves transferring assets to SPVs, which reduces
the amount of assets that are subject to bankruptcy costs, since SPVs are carefully designed to
avoid bankruptcy. Off-balance sheet financing is most advantageous for sponsoring firms that are
risky or face large bankruptcy costs. SPVs become sustainable in a repeated SPV game, because
firms can implicitly “commit” to subsidize or “bail out” their SPVs when the SPV would
otherwise not honor its debt commitments, despite legal and accounting restrictions to the
contrary. The third part of the paper tests two key implications of the model using unique data on
credit card securitizations. First, riskier firms should securitize more, ceteris paribus. Second,
since investors know that SPV sponsors can bail out their SPVs if there is a need, in pricing the
debt of the SPV investors will care about the risk of the sponsor defaulting, above and beyond the
risk of the SPVs assets. The authors find evidence consistent with these implications.
(352 KB, 64 pages)
In aggregate U.S. data, exogenous shocks to labor productivity induce highly
persistent and hump-shaped responses to both the vacancy-unemployment ratio
and employment. The authors show that the standard version of the Mortensen-Pissarides
matching model fails to replicate this dynamic pattern due to the rapid responses
of vacancies. They extend the model by introducing a sunk cost for creating new
job positions, motivated by the well-known fact that worker turnover exceeds job
turnover. In the matching model with sunk costs, vacancies react sluggishly to
shocks, leading to highly realistic dynamics.
(346 KB, 44 pages)
This paper develops a simple model in which financial imperfections can serve to stabilize aggregate fluctuations and not merely aggravate them as in much of the previous literature; this is termed a financial decelerator.
In this model agents borrow to purchase housing and secure their loans with this long-lived asset. There are two financial imperfections in this model. First, agents are unable to commit to repay their loans — that is, they can strategically default. This limits the amount that lenders are willing to offer. In addition, however, lenders are also imperfectly informed as to a borrower's propensity to default; that is, there is adverse selection. The latter imperfection implies that default may actually occur in equilibrium, unlike in much of the previous literature.
For relatively high house prices the commitment problem ensures that the equilibrium is typically characterized by a standard financial accelerator; that is, the borrowing constraints which prevent default become tighter as falling prices reduce the wealth with which agents can collateralize future loans, thereby exacerbating aggregate fluctuations. However, it is shown that when prices are low, agents will default, which serves as a stabilizing force.
(282 KB, 45 pages)
05-24 Kei-Mu Yi, "Vertical Specialization and the Border Effect Puzzle"
Superseded by Working Paper 08-12.
(461 KB, 49 pages)
This paper takes a portfolio view of consumer credit. Default models (credit-risk scores) estimate the probability of default of individual loans. But to compute risk-adjusted returns, lenders also need to know the covariances of the returns on their loans with aggregate returns.
Covariances are independently relevant for lenders who care directly about the volatility of their
portfolios, e.g., because of Value-at-Risk considerations or the structure of the securitization
market. Cross-sectional differences in these covariances also provide insight into the nature of
the shocks hitting different types of consumers.
The authors use a unique panel dataset of credit bureau records to measure the ‘covariance risk’ of individual consumers, i.e., the covariance of their default risk with aggregate consumer default rates, and more generally to analyze the cross-sectional distribution of credit, including the effects of credit scores. They obtain two key sets of results. First, there is significant systematic heterogeneity in covariance risk across consumers with different characteristics. Consumers with high covariance risk tend to also have low credit scores (high default probabilities). Second, the amount of credit obtained by consumers significantly increases with their credit scores, and significantly decreases with their covariance risk (especially revolving credit), though the effect of covariance risk is smaller in magnitude. It appears that some lenders take covariance risk into account, at least in part, in determining the amount of credit they provide.
(623 KB, 43 pages)
This paper examines risk-adjusted performance measures in banking, which are used as a guide for efficient asset allocation, performance evaluation, and capital structure decisions in complex, multidivisional financial institutions. Traditional measures of performance are contrasted with the portfolio-based risk-adjusted measures using a unique detailed micro data set for a sample of domestic bank holding companies (BHCs) that engaged in both commercial banking and investment banking activities between 1990 and 1999. This paper finds evidence that traditional stand-alone performance measures can lead to results substantially different from those of the portfolio models. This study also examines BHCs’ optimal portfolios consisting of traditional and nontraditional banking activities derived from the efficient frontiers. These results show that there are gains from diversification as indicated by the composition of optimal portfolios.
(1.08 MB, 40 pages)
The authors explore a model in which agents enter into a contract but are uncertain about
how a judge will enforce it. The judge can consider a wide range of evidence, or instead,
use more limited information to identify essential elements of the case. They focus on
the following tradeoff: Considering a wide range of evidence increases the likelihood of
a correct ruling in the case at hand but undermines the formation of precedents that
resolve legal uncertainty for subsequent agents.
In a model of contractual innovation, the authors show that the use of evidence increases the likelihood of innovation in any period, while precedents increase the rate of diffusion of the innovation. When courts can use a mixture of evidence and precedents, the minimum amount of evidence that induces adoption is (weakly) decreasing over time. They also examine the breadth of precedents. Overlapping jurisdictions reduce the optimal breadth of precedents because broad precedents are more likely to introduce conflict. Accordingly, overlapping jurisdictions increase the value of using evidence. The authors use their model to interpret differences between the legal systems in the U.S. and England.
(1.07 MB, 31 pages)
Pricing should speed up the substitution of low cost electronic payments for expensive
paper-based transactions and cash. But by how much? Norway has explicitly priced
individual payment transactions and rapidly shifted to electronic payments while the
Netherlands has experienced the same shift without direct pricing. Controlling for differences
between countries, the authors estimate the incremental effect of pricing on the shift to
electronic payments. If users strongly value the improved convenience or security of
electronic payments, pricing—viewed negatively by most consumers—may not be necessary
to ensure rapid adoption of electronic payments.
(743 KB, 28 pages)
05-29 William W. Lang, Loretta J. Mester, and Todd A. Vermilyea, "Potential Competitive Effects on U.S. Bank Credit Card Lending from the Proposed Bifurcated Application of Basel II"
Superseded by Working Paper 07-9.
(853 KB, 60 pages)