The MTFS or the EMS: Which Way for Credible Monetary Policy?

Since the latter part of 1988, the primary policy objective has been to head off a rise to double digit inflation. To this end, interest rates have been raised from 7112 per cent to 14per cent, while the public sector is running a large fiscal surplus. Despite this apparently very tight policy stance, policy is deficient in a crucial respect: it lacks credibility. The all too public divisions within government have weakened the efficacy of monetary policy, especially in financial markets. The ongoing uncertainty over who is in charge of the conduct of policy - No. 10 or No. 11 - further undermines confidence. The most urgent priority must be to reassert clear priorities and guidelines. In this Viewpoint, we consider how best to restore the credibility of monetary policy. There are two main possibilities: first, to reassert the Medium Term Financial Strategy (MTFS) in an appropriate form; or to join the (Exchange Rate Mechanism of the) European Monetary System (EMS). We argue that it will be very hard to derive credibility benefits from a reassertion of the MTFS: because of the inflation record of the past decade and the twists and turns of past versions of the MTFS, a mere restatement will not resolve the uncertainties that result from known differences within the government. In particular, any restatement will rely on discretion and judgement in its implementation and this will weaken its beneficial effects on expectations. Instead we argue that entry into the EMS offers a tougher and more credible commitment for monetary policy. The Chancellor has been pushed to rule out UK entry until the second half of 1990 at the earliest, but the government should make a virtue of this by announcing a firm dale for entry next year. In the interim, it should encourage a debate about the appropriate rate for entry, a debate which will increasingly guide the foreign exchange market. The government should make it clear that in choosing this rate it will do so with the commitment to low inflation very much in mind, favouring a high exchange rate. Once in the EMS, the government should rule out the possibility of devaluing the pound in an EMS realignment. This provides a firm non- discretionary anchor for both monetary policy and inflation expectations. With this commitment, the principal gain from EMS entry will be establishing a regime of low inflation for the next decade: in this, choice of the exchange rate will be less crucial than the fact of entry.     

Expectations and the Treasury Bill-Federal Funds Rate Spread over Recent Monetary Policy Regimes

This paper shows that the spread between the 3–month Treasury bill and the federal funds rate has significant predictive power for the future change in the federal funds rate during the volatile nonborrowed reserves operating regime, but it has less and no predictive power during the borrowed reserves regime and the federal funds targeting regime, respectively. These findings suggest that Treasury bill rates forecast future federal funds rates most accurately when the Federal Reserve follows a well-defined rule that does not smooth the impact of shocks on the federal funds rate.     

ARMY RECRUITING IN A CHANGING ENVIRONMENT

Army recruiting is sensitive to fluctuations in labor market conditions. Declines in unemployment over the past several years have led to decreases in the number and quality of enlistments. The Army has several discretionary policy tools that it can use to reduce cyclical variations in recruiting. However, budget constraints and other external requirements often limit the flexibility of these tools. More recently, the recruiting outlook turned favorable for the Army, primarily due to planned reductions in end strength. These reductions imply a 20 to 30 percent drop in total enlistment requirements over the next several years compared with 1989 levels. The danger is that dramatic budget cuts will impair the manpower quality goals of recruiting. Recruiting cuts alone should not be the only means of meeting end-strength reductions to 1995.     

Decision theory analysis of audit discovery sampling*

Abstract. Discovery sampling is a frequently used auditing technique. The objective of discovery sampling is to decide whether to accept or reject an audit population for which acceptance is appropriate only if the occurrence rate of serious errors is very low. This objective is met by auditing a sample and accepting only if the sample is free of serious errors. This paper first develops a Bayesian decision theory approach to the discovery sampling problem. Using this approach the auditor optimizes sampling effort according to a decision model that explicitly includes such factors as risk of failure of accepting too high an error rate, losses from wrong decisions, sampling costs, and prior distribution of the error rate. The form of the loss function used includes both linear and quadratic loss functions as special cases. Methods and formulas applicable to various prior distributions for the error rate are obtained. Detailed results are derived for two state-prior and gamma-prior distributions. A minimax approach that removes the need to elicit a complete prior distribution is then developed. Explicit formulas are obtained for both the admissible sample size range and for the minimax sample size. A comparison of results indicates that the minimax approach is nearly as efficient as approaches that require elicitation of prior problem rate distributions. Further analysis generalizes the methods by showing that for the Bayesian and minimax methods, analytical results can be derived for various forms of loss functions. Résumé. Le sondage de dépistage est une technique fréquemment utilisée en vérification qui a pour objectif de déterminer s'il faut accepter ou rejeter une population pour laquelle l'acceptation n'est appropriée que si la fréquence d'erreurs graves est très faible. L'objectif est réalisé au moyen de la vérification d'un échantillon et de son acceptation seulement si l'échantillon est exempt d'erreurs graves. L'auteur met d'abord au point une méthode inspirée de la théorie bayesienne de la décision, adaptée au problème du sondage de dépistage. En utilisant cette méthode, le vérificateur optimise le travail d'échantillonnage conformément à un modèle de décision qui comprend explicitement des facteurs tels que le risque d'échec ou le risque d'acceptation d'un taux d'erreur trop élevé, les pertes attribuables à de mauvaises décisions, les coûts d'échantillonnage et la distribution a priori du taux d'erreur. Des formes de fonction de perte utilisées, celles linéaires et quadratiques constituent des cas spéciaux. L'auteur obtient des méthodes et des formules applicables aux diverses distributions a priori du taux d'erreur. Il dérive les résultats analytiques pour les distributions a priori binômiale et gamma. L'auteur met ensuite au point une méthode minimax supprimant la nécessité d'obtenir une distribution a priori complète. Il obtient des formules explicites pour la fourchette de tailles d'échantillons admissibles ainsi que pour la taille de l'échantillon minimax. Une comparaison des résultats indique que la méthode minimax est presque aussi efficace que les méthodes qui exigent l'obtention de distributions a priori de taux d'erreurs. Le prolongement de l'analyse permet de généraliser les méthodes; il démontre en effet que pour les méthodes bayesienne aussi bien que minimax, les résultats analytiques peuvent être dérivés pour diverses formes de fonctions de perte.     

Original Issue High Yield Bonds: Aging Analyses of Defaults,Exchanges, and Calls

This paper presents an aging analysis of 741 high yield bonds and finds default, exchange, and call percentages substantially higher than reported in earlier studies. By December 31, 1988, cumulative defaults are 34 percent for bonds issued in 1977 and 1978 and range from 19 to 27 percent for issue years 1979–1983 and from 3 to 9 percent for issue years 1984–1986. Exchanges are also a significant factor although they often are followed by default. Moreover, a significant percentage of high yield debt, 26–47 percent for 1977–1982, has been called. By December 31, 1988, approximately one third of the bonds issued in 1977–1982 has defaulted or been exchanged, and an additional one third had been called. On average, only 28 percent of these issues are still outstanding. There is no evidence that early results for more recent issue years differ markedly from issue years 1977 to 1982.     

Enforcement Mechanisms Discouraging Black–American Presence in Suburban Detroit

In metropolitan Detroit, scholars have long observed that geographic space is racialized in the sense that black Americans are not welcome in many suburban communities. This extends beyond housing segregation: black drivers are not wanted on many suburban streets. While the existence of racial animosity has been documented, the enforcement mechanisms utilized to ‘protect’ certain geographic areas from black presence have rarely been quantified and dissected. This study examines police behavior toward black motorists who were arrested during routine traffic stops in the Detroit suburb of Eastpointe. Comparison of search, arrest, and handcuff patterns of white and black motorists indicates that police bias harms blacks. Rather than simply being anti‐black, patterns of police behavior in Eastpointe enforce racialized space, signaling where black presence is tolerated and where it is discouraged. Depuis longtemps, les intellectuels observent la racialisation de l’espace géographique, au sens que les Américains noirs ne sont pas les bienvenus dans de nombreuses communautés de banlieue de la métropole de Détroit. La tendance dépasse la ségrégation des logements: les automobilistes noirs sont indésirables dans bien des rues de banlieue. Si l’existence d’une animosité raciale a été documentée, les mécanismes coercitifs utilisés pour ‘protéger’ certaines zones géographiques d’une présence noire ont rarement été quantifiés ou disséqués. Cette étude examine l’attitude policière vis‐à‐vis des conducteurs noirs arrêtés au cours de contrôles de routine dans la banlieue de Eastpointe, à Détroit. Une comparaison des types de fouilles, arrestations et menottages d’automobilistes blancs et noirs révèle un préjugé de la police au détriment des noirs. Au lieu d’être simplement anti‐noirs, les types de comportement policier à Eastpointe impose un espace racialisé, indiquant là où la présence noire est tolérée et là où elle est dissuadée.     

Earnings Quality, Insider Trading, and Cost of Capital

Previous research argues that earnings quality, measured as the unsigned abnormal accruals, proxies for information asymmetries that affect cost of capital. We examine this argument directly in two stages. In the first stage, we estimate firms' exposure to an earnings quality factor in the context of a Fama‐French three‐factor model augmented by the return on a factor‐mimicking portfolio that is long in low earnings quality firms and short in high earnings quality firms. In the second stage, we examine whether the earnings quality factor is priced and whether insider trading is more profitable for firms with higher exposure to that factor. Generally speaking, we find evidence consistent with pricing of the earnings quality factor and insiders trading more profitably in firms with higher exposure to that factor.     

Chaos and Nonlinear Dynamics: Application to Financial Markets

After the stock market crash of October 19, 1987, interest in nonlinear dynamics, especially deterministic chaotic dynamics, has increased in both the financial press and the academic literature. This has come about because the frequency of large moves in stock markets is greater than would be expected under a normal distribution. There are a number of possible explanations. A popular one is that the stock market is governed by chaotic dynamics. What exactly is chaos and how is it related to nonlinear dynamics? How does one detect chaos? Is there chaos in financial markets? Are there other explanations of the movements of financial prices other than chaos? The purpose of this paper is to explore these issues.     

Symposium on Public Policy Issues in Finance

The thesis of this symposium, organized by James Bicksler, was that while finance theory will surely inform practitioners, it seems appropriate to pay some attention to the opposite flow: practitioners can inform theory. Contributors include a distinguished group of practitioners with extensive backgrounds in economics, and economists with extensive public policy experience: Martin Feldstein, Robert Glauber, David Mullins, and Steven Wallman. Their topics range from privatizing social security, to managing market crashes, to the regulatory agency cost problem, to regulatory constraints in a technologically advanced world.