The views expressed in these papers are solely those of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of Philadelphia or Federal Reserve System.

97-1: Inside the Black Box: What Explains Differences in the Efficiencies of Financial Institutions? by Allen N. Berger and Loretta J. Mester

Over the past several years, substantial research effort has gone into measuring the efficiency of financial institutions. Many studies have found that inefficiencies are quite large, on the order of 20 percent or more of total banking industry costs and about half of the industry's potential profits. There is no consensus on the sources of the differences in measured efficiency. This paper examines several possible sources, including differences in efficiency concepts, measurement method, and a number of bank, market, and regulatory characteristics. We review the existing literature and provide new evidence using data on U.S. banks over the period 1990-95.

97-2: On the Optimality of Eliminating Seasonality in Nominal Interest Rates by Satyajit Chatterjee

Optimal monetary policy for an economy with seasonal fluctuations and a cash-in-advance requirement on the purchase of consumption goods is studied. It is shown that the short delay in the availability of newly acquired funds for consumption purchases (the hallmark of cash-in-advance models) typically makes the seasonal steady state inefficient. It is also shown that monetary policy can overcome this inefficiency by keeping the nominal interest rate constant over the seasons. An analytical model is also presented to explore the effects of seasonal smoothing of nominal interest rates on the seasonal amplitude of other closely related variables.

97-3/R: On the Profitability and Cost of Relationship Lending by Mitchell Berlin and Loretta J. Mester

The authors provide some preliminary evidence on the costs and profitability of relationship lending by commercial banks. Drawing on recent research that has identified loan rate smoothing as a significant element in lending relationships between banks and firms, the authors carry out a two-stage procedure. In the first stage, the authors derive bank-specific measures of the extent to which the banks in their sample engage in loan rate smoothing for small business borrowers in response to exogenous shocks to their credit risk. In the second stage, the authors estimate cost and (alternative) profit functions to examine how loan rate smoothing affects a banks' costs and profits. On the whole, the authors' evidence says that loan rate smoothing is associated with lower costs and lower profits. These results do not support the hypothesis that loan rate smoothing arises as part of an optimal long-term contract between a bank and its borrower. However, we do find so me limited support for smoothing as part of an optimal contract for small banks early in our sample period.

97-4: The Measurement of Retail Output and the Retail Revolution by Leonard I. Nakamura

The computerization of retailing has made price dispersion a norm in the United States, so that any given list price or transactions price is an increasingly imperfect measure of a product's resource cost. As a consequence, measuring the real output of retailers has become increasingly difficult. Food retailing is used as a case study to examine data problems in retail productivity measurement. Crude direct measures of grocery store output suggest that the CPI for food-at-home may have been overstated by 1.4 percentage points annually from 1978 to 1996.

97-5: Efficiency and Productivity Change in the U.S. Commercial Banking Industry by Allen N. Berger and Loretta J. Mester

The authors investigate efficiency and productivity growth of the U.S. banking industry over the latter part of the 1980s and first part of the 1990s using comprehensive data on U.S. commercial banks. Cost efficiency decreased slightly between the 1980s and 1990s, and large banks showed a sizable decline in profit efficiency. Total predicted production costs increased over both the 1980s and 1990s, reflecting cost productivity declines. Changes in business conditions led to cost declines over both periods. Total predicted profits increased in the 1980s and 1990s, with the entire change reflecting increased profit productivity. Changing business conditions led to small declines in profits.

97-6: Evaluating Density Forecasts by Francis X. Diebold, Todd A. Gunther, and Anthony S. Tay

The authors propose methods for evaluating and improving density forecasts. They focus primarily on methods that are applicable regardless of the particular user's loss function, though they take explicit account of the relationships between density forecasts, action choices, and the corresponding expected loss throughout. They illustrate the methods with a detailed series of examples, and they discuss extensions to improving and combining suboptimal density forecasts, multistep-ahead density forecast evaluation, multivariate density forecast evaluation, monitoring for structural change and its relationship to density forecasting, and density forecast evaluation with known loss function.

97-7: Dynamic Equilibrium Economies: A Framework for Comparing Models and Data by Francis X. Diebold, Lee E. Ohanian, and Jeremy Berkowitz

The authors propose a constructive, multivariate framework for assessing agreement between (generally misspecified) dynamic equilibrium models and data, which enables a complete second-order comparison of the dynamic properties of models and data. They use bootstrap algorithms to evaluate the significance of deviations between models and data, and they use goodness-of-fit criteria to produce estimators that optimize economically relevant loss functions. The authors provide a detailed illustrative application to modeling the U.S. cattle cycle.

97-8: Recovering Risky Technologies Using the Almost Ideal Demand System: An Application to U.S. Banking by Joseph P. Hughes, William Lang, Loretta J. Mester, and Choon-Geol Moon

Using modern duality theory to recover technologies from data can be complicated by the risk characteristics of production. In many industries, risk influences cost and revenue and can create the potential for costly episodes of financial distress. When risk is an important consideration in production, the standard cost and profit functions may not adequately describe the firm's technology and choice of production plan. In general, standard models fail to account for risk and its endogeneity. The authors distinguish between exogenous risk, which varies over the firm's choice sets, and endogenous risk, which is chosen by the firm in conjunction with its production decision. They show that, when risk matters in production decisions, it is important to account for risk's endogeneity.

For example, better risk diversification that results, for example, from an increase in scale, improves the reward to risk-taking and may under certain conditions induce the firm to take on more risk to increase the firm's value. A choice of higher risk at a larger scale could add to costs and mask scale economies that may result from better diversification.

This paper introduces risk into the dual model of production by constructing a utility-maximizing model in which managers choose their most preferred production plan. The authors show that the utility function that ranks production plans is equivalent to a ranking of subjective probability distributions of profit that are conditional on the production plan. The most preferred production plan results from the firm's choice of an optimal profit distribution. The model is sufficiently general to incorporate risk aversion as well as risk neutrality. Hence, it can account for the case where the potential for costly financial distress makes trading profit for reduced risk a value-maximizing strategy.

The authors implement the model using the Almost Ideal Demand System to derive utility-maximizing share equations for profit and inputs, given the output vector and given sources of risk to control for choices that would affect endogenous risk. The most preferred cost function is obtained from the profit share equation and we show that, if risk neutrality is imposed, this system is identical to the standard translog cost system except that it controls for sources of risk.

The authors apply the model to the U.S. banking industry using 1989-90 data on banks with over $1 billion in assets. The authors find evidence that managers trade return for reduced risk, which is consistent with the significant regulatory and financial costs of bank distress. In addition, the authors find evidence of significant scale economies that help explain the recent wave of large bank mergers. Using these same data, the authors also estimate the standard cost function, which does not explicitly account for risk, and they obtain the usual results of essentially constant returns to scale, which contradicts the often-stated rationale for bank mergers.

97-9: Banking and Payment System Stability in an Electronic Money World by James J. McAndrews
No abstract available

97-10: Macroeconomic Forecasts and Microeconomic Forecasters in the Survey of Professional Forecasters by Tom Stark

Do professional forecasters distort their reported forecasts in a way that compromises accuracy? New research in the theory of forecasting suggests such a possibility. In a recent paper, Owen Lamont finds that forecasters in the Business Week survey make more radical forecasts as they gain experience. In this paper, the author uses forecasts from the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters to test the robustness of Lamont's results. The author's results contradict Lamont's. However, careful examination of a methodological difference in the two surveys suggests a more general theory of forecasting that accounts for both sets of results.

97-11: Optimal Prediction Under Asymmetric Loss by Peter F. Christoffersen and Francis X. Diebold

Prediction problems involving asymmetric loss functions arise routinely in many fields, yet the theory of optimal prediction under asymmetric loss is not well developed. The authors study the optimal prediction problem under general loss structures and characterize the optimal predictor. The authors compute it numerically in less tractable cases. A key theme is that the conditionally optimal forecast is biased under asymmetric loss and that the conditionally optimal amount of bias is time-varying in general and depends on higher-order conditional moments. Thus, for example, volatility dynamics (e.g., GARCH effects) are relevant for optimal point prediction under asymmetric loss. More generally, even for models with linear conditional-mean structure, the optimal point predictor is in general nonlinear under asymmetric loss, which provides a link with the broader nonlinear time series literature.

97-12/R: The Differential Regional Effects of Monetary Policy: Evidence from the U.S. States by Gerald Carlino and Robert DeFina

This paper uses time-series techniques to examine whether monetary policy has similar effects across U.S. states during the 1958-92 period. Impulse response functions from estimated structural vector autoregression models reveal differences in state policy responses, which in some cases are substantial. The paper also provides evidence on the reasons for the measured cross-state differential policy responses. The size of a state's response is significantly related to its industry mix, evidence of an interest rate channel for monetary policy. The state-level data offer no support for recently advanced credit-channel theories of the monetary policy transmission mechanism.

97-13: Does the U.S. Tax Treatment of Housing Promote Suburbanization and Central City Decline? by Joseph Gyourko and Richard Voith

This paper examines the role of U.S. housing-related tax expenditures in creating incentives for decentralization and encouraging residential sorting by income and central city decline. Tax expenditures associated with the deductibility of mortgage interest and property taxes make housing less expensive relative to other goods and, hence, increase the quantity of housing and residential land purchased and lower the density of urban areas. Because the tax expenditures increase with income and the consumption of housing services, they lower the cost of geographic sorting by income typically associated with exclusionary zoning and other land-market imperfections. A direct consequence of this sorting process is that housing-related tax expenditures are concentrated in communities with the highest incomes and house values. These effects do not arise simply because of housing-tax policies alone, but rather from the interaction of these policies and other factors that affect local real estate markets, such as zoning or fixed housing capital stocks. Three models are developed to formally analyze these issues. In the authors' base case model in which there are no land-use constraints and local amenities are fixed, tax deductions related to home ownership result in population decentralization within the metropolitan area and a less dense central city, but do not induce sorting by income. Moreover, land prices in the city increase because the subsidy increases the aggregate demand for housing in all communities. Thus, the mere presence of the federal housing tax expenditures increases decentralization, but cannot generate America's patterns of income sorting and central city decline. These conclusions change in an important way in the authors' second model in which a land-use constraint, such as the type of minimum lot-size zoning prevalent in the suburbs, is introduced. In this case, the housing subsidies foster the separation of the rich from the poor. Income sorting results, and consequently, there is an increasing concentration of the poor in the central city. However, there still is no weakening of prices in city land markets in this model. The third and final model endogenizes the production of local amenities in the sense that they are made an increasing function of community income. In this case, three characteristics common to American urban form result: population decentralization within the metropolitan area, increased concentration of the poor in the urban core, and weak city land markets. These results indicate that America's current urban form reflects, at least in part, incentives arising from the interaction of the national tax and local zoning systems, rather than unique American tastes for low-density living environments.

97-14: Cointegration and Long-Horizon Forecasting by Peter F. Christoffersen and Francis X. Diebold

It is widely believed that imposing cointegration on a forecasting system, if cointegration is, in fact, present, will improve long-horizon forecasts. The authors show that, contrary to this belief, at long horizons nothing is lost by ignoring cointegration when the forecasts are evaluated using standard multivariate forecast accuracy measures. In fact, simple univariate Box-Jenkins forecasts are just as accurate. The authors' results highlight a potentially important deficiency of standard forecast accuracy measures — they fail to value the maintenance of cointegrating relationships among variables — and the authors suggest alternatives that explicitly do so.

97-15: Minimum Consumption Requirements: Theoretical and Quantitative Implications for Growth and Distribution by Satyajit Chatterjee and B. Ravikumar

The authors study the impact of a minimum consumption requirement on the rate of economic growth and the evolution of wealth distribution. The requirement introduces a positive dependence between the intertemporal elasticity of substitution and household wealth. This dependence implies a transition phase during which the growth rate of per capita quantities rise toward their steady-state values and the distributions of wealth, consumption, and permanent income become more unequal. The authors calibrate the minimum consumption requirement to match estimates available for a sample of Indian villagers and find that these transitional effects are quantitatively significant and depend importantly on the economy's steady-state growth rate. NOTE: This paper refers to figures not currently available with this electronic version. For a hard copy of the figures, call the Research Department's Publications Desk at 215-574-6428 and ask for Working Paper 97-15.

97-16: A Model of Check Exchange by James McAndrews and William Roberds

The authors construct and simulate a model of check exchange to examine the incentives a bank (or a bank clearinghouse) has to engage in practices that limit access to its payment facilities, in particular delaying the availability of check payment. The potentially disadvantaged bank has the option of directly presenting checks to the first bank. The authors find that if the retail banking market is highly competitive, the first bank will not engage in such practices, but if the retail banking market is imperfectly competitive, it will find it advantageous to restrict access to its facilities. Lower costs of direct presentment can reduce (but not eliminate) the range over which these practices are employed. The practice of delayed presentment can either reduce or increase welfare, again depending on the degree of competition in the market. The model suggests that, were the Federal Reserve System to exit the business of check processing, practices such as delayed presentment would be more prevalent.

97-17/R: Intermediation and Vertical Integration by Mitchell Berlin and Loretta J. Mester

This paper views financial intermediaries as vertically integrated firms. The authors explore how competitive conditions in retail and wholesale funding markets affect the incentive for (upstream) originators and (downstream) fund managers to integrate. The underlying tradeoff in our model is driven by the choice between the production of an illiquid but high yielding loan and a liquid but relatively low yielding bond. The authors find that greater homogeneity among savers has two effects, both of which tend to increase the incentive to form integrated intermediaries. Greater homogeneity both increases competition between independent fund managers and reduces the likelihood of inefficient underinvestment by integrated intermediaries. The authors also find that the incentive to integrate is greater when fund managers have more power in the market for firms' securities.

97-18: Bounded Rationality and Strategic Complementarity in a Macroeconomic Model: Policy Effects, Persistence, and Multipliers by Antulio N. Bomfim and Francis X. Diebold

Motivated by recent developments in the bounded rationality and strategic complementarity literatures, we examine an intentionally simple and stylized aggregative economic model when the assumptions of fully rational expectations and no strategic interactions are relaxed. We show that small deviations from rational expectations, taken alone, lead only to small deviations from classical policy-ineffectiveness, but that the situation can change dramatically when strategic complementarity is introduced. Strategic complementarity magnifies the effects of even small departures from rational expectations, producing equilibria with policy effectiveness, output persistence, and multiplier effects.

97-19: Network Diseconomies and Optimal Structure by Sherrill Shaffer

This paper explores the effect on costs when firms within an industry must interact with each other in the normal course of business. Such interaction will generally cause the socially optimal scale of each firm to deviate from its minimum average cost scale. In addition, the socially optimal industry structure may be more concentrated than conventional firm-level cost studies would suggest and may also differ from the unregulated (free-entry) equilibrium structure. These concepts, while potentially applicable to several industries, are here made more precise for the banking industry, both theoretically and empirically.

97-20: The Past, Present, and Future of Macroeconomic Forecasting by Francis X. Diebold

Broadly defined, macroeconomic forecasting is alive and well. Nonstructural forecasting, which is based largely on reduced-form correlations, has always been well and continues to improve. Structural forecasting, which aligns itself with economic theory and, hence, rises and falls with theory, receded following the decline of Keynesian theory. In recent years, however, powerful new dynamic stochastic general equilibrium theory has been developed, and structural macroeconomic forecasting is poised for resurgence.

97-21: Dollarization Hysteresis and Network Externalities: Theory and Evidence from an Informal Bolivian Credit Market by Bettina Peiers and Jeffrey M. Wrase

This paper considers network externalities from currency acceptability as a determinant of observed persistence of dollarization in Latin American countries. A model with efficiencies from establishing a network of currency users is constructed. Model implications are then tested using a unique data set of daily loan records from an informal Bolivian credit market. Empirical results are consistent with dollarization hysteresis being driven by network externalities from currency adoption. The results also imply that credible exchange rate stabilization policy alone is not sufficient to achieve dollarization reversal.

97-22: Economic Growth in Argentina in the Period 1900-30: Some Evidence from Stock Returns by Leonard I. Nakamura and Carlos E.J.M. Zarazaga

This paper reports the first stage of a project to recover Argentine stock market data for the entire 20th century. The authors find that real rates of return on Argentine stocks and bonds after 1920 were above those in the Belle Époque, and that they were consistent with the view that in the postwar period Argentina remained firmly integrated with international financial markets.

97-23: Measuring Predictability: Theory and Macroeconomic Applications by Francis X. Diebold and Lutz Kilian

The authors propose a measure of predictability based on the ratio of the expected loss of a short-run forecast to the expected loss of a long-run forecast. This predictability measure can be tailored to the forecast horizons of interest, and it allows for general loss functions, univariate or multivariate information sets, and stationary or nonstationary data. The authors propose a simple estimator and suggest resampling methods for inference. They then provide several macroeconomic applications. First, on the basis of fitted parametric models, the authors assess the predictability of a variety of macroeconomic series. Second, they analyze the internal propagation mechanism of a standard dynamic macroeconomic model by comparing predictability of model inputs and model outputs. Third, they use predictability as a metric for assessing the similarity of data simulated from the model and actual data. Finally, the authors sketch several promising directions for future research.

97-24: Private Money and Reserve Management in a Random Matching Model by Ricardo Cavalcanti, Andres Erosa, and Ted Temzelides

The authors introduce an element of centralization in a random matching model of money that allows for private liabilities to circulate as media of exchange. Some agents, which the authors identify as banks, are endowed with the technology to issue notes and to record-keep reserves with a central clearinghouse, which they call the treasury. The liabilities are redeemed according to a stochastic process that depends on the endogenous trades. The treasury removes the banking technology from banks that are not able to meet the redemptions in a given period. This, together with the market incompleteness, gives rise to a reserve management problem for the issuing banks. The authors demonstrate that "sufficiently patient" banks will concentrate on improving their reserve position instead of pursuing additional issue. The model provides a first attempt to reconcile limited note issue with optimizing behavior by banks during the National Banking Era.

97-25: The Winner's Curse in Banking by Sherrill Shaffer

Theoretical studies have noted that loan applications rejected by one bank can apply at another bank, systematically worsening the pool of applicants faced by all banks. This paper presents the first empirical evidence of this effect and explores some additional ramifications, including the role of common filters, such as commercially available credit scoring models, in mitigating this adverse selection, implications for de novo banks, implications for banks' incentives to comply with fair lending laws, and macroeconomic effects.

97-26: On the Evolution of the Spatial Distribution of Employment in Postwar United States by Satyajit Chatterjee and Gerald Carlino

In this paper, the authors document a pronounced trend toward deconcentration of metropolitan employment during the postwar period in the United States. The employment share of initially more dense metro areas declined and those of initially less dense metro areas rose. Motivated by this finding, the authors develop a system-of-cities model in which increase in aggregate metropolitan employment causes employment to shift in favor of less dense metro areas because congestion costs increase more rapidly for the initially more dense metro areas. A calibrated version of the model shows that the more-than-twofold increase in employment experienced by MSAs during the postwar period was indeed a powerful force favoring deconcentration.

97-27: Diagnostic Evaluation of the Real Business Cycle Model with Factor Hoarding by Gwen Eudey

This paper proposes evaluating the assumptions of the RBC model rather than merely the ability of model-constrained data to mach moments of official data counterparts. Reduced-form relationships can be used to create model-consistent derivations of capital and labor input. Since several relationships exist for each input, comparison of their properties highlights weaknesses and strengths in the model assumptions. Applied to the RBC model with factor hoarding and depreciation through use, the approach highlights weaknesses in the standard utility function and casts doubt upon use of the model to improve official capital stock measures or utilization rates.

97-28: Regional Employment Dynamics by Keith Sill

There is a widespread belief that different geographic regions of the U.S. respond differently to economic shocks, perhaps because of factors such as differences in the composition of regional output, adjustment costs, or other frictions. The author investigates the comovement of regional employment series using a common features framework. Little evidence is found to suggest that regions move synchronously; rather, it takes about three quarters before regions respond in a similar fashion to a common shock. The author identifies leading and lagging regions. None of the regional employment series appears to share a common, synchronous cycle with aggregate U.S. employment.