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This paper investigates the role that imperfect knowledge about the structure of the economy plays in the formation of expectations, macroeconomic dynamics, and the efficient formulation of monetary policy. Economic agents rely on an adaptive learning technology to form expectations and to update continuously their beliefs regarding the dynamic structure of the economy based on incoming data. The process of perpetual learning introduces an additional layer of dynamic interaction between monetary policy and economic outcomes. We find that policies that would be efficient under rational expectations can perform poorly when knowledge is imperfect. In particular, policies that fail to maintain tight control over inflation are prone to episodes in which the public's expectations of inflation become uncoupled from the policy objective and stagflation results, in a pattern similar to that experienced in the United States during the 1970s. Our results highlight the value of effective communication of a central bank's inflation objective and of continued vigilance against inflation in anchoring inflation expectations and fostering macroeconomic stability. July 2003.
Monetary policy is sometimes formulated in terms of a target level of inflation, a fixed time horizon and a constant interest rate that is anticipated to achieve the target at the specified horizon. These requirements lead to constant interest rate (CIR)instrument rules. Using the standard New Keynesian model, it is shown that some forms of CIR policy lead to both indeterminacy of equilibria and instability under adaptive learning. However, some other forms of CIR policy perform better. We also examine the properties of the different policy rules in the presence of inertial demand and price behaviour.
Escapist policy rules
(2003)
We study a simple, microfounded macroeconomic system in which the monetary authority employs a Taylor-type policy rule. We analyze situations in which the self-confirming equilibrium is unique and learnable according to Bullard and Mitra (2002). We explore the prospects for the use of 'large deviation' theory in this context, as employed by Sargent (1999) and Cho, Williams, and Sargent (2002). We show that our system can sometimes depart from the self-confirming equilibrium towards a non-equilibrium outcome characterized by persistently low nominal interest rates and persistently low inflation. Thus we generate events that have some of the properties of "liquidity traps" observed in the data, even though the policymaker remains committed to a Taylor-type policy rule which otherwise has desirable stabilization properties.
The development of tractable forward looking models of monetary policy has lead to an explosion of research on the implications of adopting Taylor-type interest rate rules. Indeterminacies have been found to arise for some specifications of the interest rate rule, raising the possibility of inefficient fluctuations due to the dependence of expectations on extraneous "sunspots ". Separately, recent work by a number of authors has shown that sunspot equilibria previously thought to be unstable under private agent learning can in some cases be stable when the observed sunspot has a suitable time series structure. In this paper we generalize the "common factor "technique, used in this analysis, to examine standard monetary models that combine forward looking expectations and predetermined variables. We consider a variety of specifications that incorporate both lagged and expected inflation in the Phillips Curve, and both expected inflation and inertial elements in the policy rule. We find that some policy rules can indeed lead to learnable sunspot solutions and we investigate the conditions under which this phenomenon arises.
A financial system can only perform its function of channelling funds from savers to investors if it offers sufficient assurance to the providers of the funds that they will reap the rewards which have been promised to them. To the extent that this assurance is not provided by contracts alone, potential financiers will want to monitor and influence managerial decisions. This is why corporate governance is an essential part of any financial system. It is almost obvious that providers of equity have a genuine interest in the functioning of corporate governance. However, corporate governance encompasses more than investor protection. Similar considerations also apply to other stakeholders who invest their resources in a firm and whose expectations of later receiving an appropriate return on their investment also depend on decisions at the level of the individual firm which would be extremely difficult to anticipate and prescribe in a set of complete contingent contracts. Lenders, especially long-term lenders, are one such group of stakeholders who may also want to play a role in corporate governance; employees, especially those with high skill levels and firm-specific knowledge, are another. The German corporate governance system is different from that of the Anglo-Saxon countries because it foresees the possibility, and even the necessity, to integrate lenders and employees in the governance of large corporations. The German corporate governance system is generally regarded as the standard example of an insider-controlled and stakeholder-oriented system. Moreover, only a few years ago it was a consistent system in the sense of being composed of complementary elements which fit together well. The first objective of this paper is to show why and in which respect these characterisations were once appropriate. However, the past decade has seen a wave of developments in the German corporate governance system, which make it worthwhile and indeed necessary to investigate whether German corporate governance has recently changed in a fundamental way. More specifically one can ask which elements and features of German corporate governance have in fact changed, why they have changed and whether those changes which did occur constitute a structural change which would have converted the old insider-controlled system into an outsider-controlled and shareholder-oriented system and/or would have deprived it of its former consistency. It is the second purpose of this paper to answer these questions. Revised version forthcoming in "The German Financial System", edited by Jan P. Krahnen and Reinhard H. Schmidt, Oxford University Press.
A rapidly growing literature has documented important improvements in volatility measurement and forecasting performance through the use of realized volatilities constructed from high-frequency returns coupled with relatively simple reduced-form time series modeling procedures. Building on recent theoretical results from Barndorff-Nielsen and Shephard (2003c,d) for related bi-power variation measures involving the sum of high-frequency absolute returns, the present paper provides a practical framework for non-parametrically measuring the jump component in realized volatility measurements. Exploiting these ideas for a decade of high-frequency five-minute returns for the DM/$ exchange rate, the S&P500 market index, and the 30-year U.S. Treasury bond yield, we find the jump component of the price process to be distinctly less persistent than the continuous sample path component. Explicitly including the jump measure as an additional explanatory variable in an easy-to-implement reduced form model for realized volatility results in highly significant jump coefficient estimates at the daily, weekly and quarterly forecast horizons. As such, our results hold promise for improved financial asset allocation, risk management, and derivatives pricing, by separate modeling, forecasting and pricing of the continuous and jump components of total return variability.
While focusing on the protection of distressed sovereigns, the current debate intended to reform the International Financial Architecture has hardly addressed the protection of creditors rights that varies among laws. I suspect however that this constitutes an essential determinant of the success of suggested solutions, especially under the contractual approach. Based on a sample of bonds issued by developing countries states in the period, January 1987 to December 1997, I find that, for given contract characteristics (e.g. listing markets and currency), the governing law is selected according to its ability to enforce repayment. However, although the New York law seems looser and incur larger enforcement costs than the England&Wales law, the former permits equivalent yearly credit amounts. I interpret this as a consequence of the existence of a larger set of valuable assets (e.g. trade) in the US that constitute implicit securities. My findings yield important implications for the reforms. In particular, provided that there exists a seemingly equivalent enforcement credibility between England and New York laws, the prompt implementation of the contractual approach solution should constitute a valuable first step toward efficient sovereign debt markets. October 2003.
The paper suggests an innovative contribution to the investigation of banking liabilities pricing contracted by sovereign agents. To address fundamental issues of banking, the study focuses on the determinants of the up-front fees (the up-front fee is a charge paid out at the signature of the loan arrangement). The investigation is based on a uniquely extensive sample of bank loans contracted or guaranteed by 58 less-developed countries sovereigns in the period from 1983 to 1997. The well detailed reports allow for the calculation of the equivalent yearly margin on the utilization period for all individual loan. The main findings suggest a significant impact of the renegotiation and agency costs on front-end borrowing payments. Unlike the sole interest spread, the all-in interest margin better takes account of these costs. The model estimates however suggest the non-linear pricing is hardly associated with an exogenous split-up intended by the borrower and his banker to cover up information. Instead the up-front payment is a liquidity transfer as described by Gorton and Kahn (2000) to compensate for renegotiation and monitoring costs. The second interesting result is that banks demand payment for all types of sovereign risk in an identical manner public debt holders do. The difference is that, unlike bond holders, bankers have the possibility to charge an up-front fee to compensate for renegotiation costs. Hence, beyond the information related issues, the higher complexity of the pricing design makes bank loan optimal for lenders on sovereign capital markets, especially relative to public debt, thus motivating for their presence. The paper contributes to the expanding literature on loan syndication and banking related issues. The study also has relevance for the investigation of the developing countries debt pricing.
We present an analysis of VaR forecasts and P&L-series of all 13 German banks that used internal models for regulatory purposes in the year 2001. To this end, we introduce the notion of well-behaved forecast systems. Furthermore, we provide a series of statistical tools to perform our analyses. The results shed light on the forecast quality of VaR models of the individual banks, the regulator's portfolio as a whole, and the main ingredients of the computation of the regulatory capital required by the Basel rules.
We estimate a model with latent factors that summarize the yield curve (namely, level, slope, and curvature) as well as observable macroeconomic variables (real activity, inflation, and the stance of monetary policy). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and much weaker evidence for a reverse influence. We also relate our results to a traditional macroeconomic approach based on the expectations hypothesis.