Purchasing Power Parity Between the UK and Germany: The Euro Era

We use the Johansen cointegration approach to assess the empirical validity of the purchasing power parity (PPP) between the UK and Germany since the introduction of the euro. We conduct the empirical analysis in the context of the global financial crisis that began in 2007 and find that it directly affects the cointegration space. We fail to validate the Johansen and Juselius (1992) original hypothesis that nonstationarity of PPP associates with the nonstationarity of interest rate differentials to produce a stationary relation. On the other hand, we do not reject PPP. We find that PPP cointegrates with inflation differentials. We also find, contrary to conventional wisdom, that (i) equilibrium adjustment occurs between the German and UK inflation rates, while weak exogeneity exists for the German and UK interest rates and the PPP condition, and (ii) three common trends associated with the German interest rate the UK interest rate, and the PPP condition “push” the system with the German interest rate and the PPP condition playing dominant roles in affecting inflation in both Germany and the UK. These results cast serious doubt on the presumed independence of the UK monetary policy.     

INCOME TAXES AND THE COMPOSITION OF PAY: EVIDENCE FROM THE BRITISH HOUSEHOLD PANEL SURVEY

According to the standard principal‐agent model, the optimal composition of pay should balance the provision of incentives with the individual demand for insurance. Do income taxes alter this balance? We show that the relative share of Performance‐related pay (PRP), on total pay is reduced by higher average and marginal income taxes. Empirical evidence based on the British Household Panel Survey is consistent with the theoretical predictions of the tax–augmented principal‐agent model. Our estimates suggest that a 10% reduction in the marginal income tax rate, holding the average tax rate constant, increases the share of PRP in total pay by 2.25–3.02%, depending on the empirical specification. Similarly, a 10% reduction in the average income tax rate, holding the marginal tax rate constant, increases the share of PRP in total pay by 5.10–5.27%.     

The Global Financial Crisis and Stochastic Convergence in the Euro Area

This paper analyzes the issue of convergence in the original Euro Area countries, and assesses the effect of the global financial crisis on the process of convergence. In particular, we consider whether the global financial crisis pulled the 12 economies of the Euro Area together or pushed them apart. We investigate the dynamics of stochastic convergence of the original Euro Area countries for inflation rates, nominal interest rates, and real interest rates. We test for convergence relative to Germany, taken as the benchmark for core EU standards, using monthly data over the period January 2001 to September 2010. We examine, in a time-series framework, three different profiles of the convergence process: linear convergence, nonlinear convergence, and linear segmented convergence. Our findings both contradict and support convergence. Stochastic convergence implies the rejection of a unit root in the inflation rate, nominal interest rate, and real interest rate differentials. We find that the differentials are consistent with a unit-root hypothesis when the alternative hypothesis is a stationary process with a linear trend. We frequently, but not always, reject the unit-root hypothesis when the alternative is a stationary process with a broken trend. We also note that the current financial crisis plays a significant role in dating the breaks.     

AN ANNUAL CHAIN INDEX OF ITALY'S "REAL" PRODUCT, 1861–1989

The construction and application of a Paasche annual chain index to the Italian GDP figures between 1861 and 1989 is the subject of this article. Comparison with product at constant prices shows, except for war periods, a revaluation of GDP in favour of the annual chain index of around 0.10 percent. The most striking differences are concentrated into periods of marked changes in relative prices, and the new index modifies the temporal pattern of the growth trend by accentuating, without altering the periodization, cyclical fluctuations.     

Special Interests and Technological Change

We study an OLG economy where productivity growth comes from two alternative sources: process innovation and learning-by-doing. There is a trade-off between the two in so far as frequent technological updates reduce the scope for learning on existing technologies. A conflict is shown to arise between the young and the old, because the former favour innovation while the latter prefer learning. We model the interaction between overlapping generations and policy makers as a dynamic common agency problem, where competing generations invest a certain amount of resources to lobby either for the maintenance of the current technology or the adoption of a new one. By focusing on truthful Markov perfect equilibria, we characterize the political equilibrium and show its dependence on the underlying demographic, technological and preference parameters.     

Informational Barriers to Entry into Credit Markets*

Economic theory suggests that asymmetric information between incumbents and entrants can generate barriers to entry into credit markets. Incumbents have superior information about their own customers and the overall economic conditions of the local credit market. This implies that entrants are likely to experience higher loan default rates than the incumbents. We test these theoretical predictions using a unique database of 7,275 observations on 729 individual banks’ lending in 95 Italian local markets. We find that informational asymmetries play a significant role in explaining entrants’ loan default rates. The default rate is significantly higher for those banks that entered local markets without opening a branch, suggesting that having a branch on site may help to reduce the informational disadvantage. We also uncover a positive correlation between banks’ loan default rates in individual local markets and the number of banks lending in that market. We argue that these informational barriers can help to explain why entry into many local credit markets by domestic and foreign banks was slow, even after substantial deregulation. * The views expressed in this article are those of the authors and do not involve the responsibility of the Bank of Italy. The authors thank Franklin Allen, Dario Focarelli, Andrea Generale, Luigi Guiso, Francesca Lotti, Marco Pagano, Alberto Franco Pozzolo, Paola Sapienza, Alessandro Secchi, two anonymous referees and seminar participants at the Bank of Italy, the Federal Reserve of Chicago, the 2003 BIS Workshop on Applied Banking Research, the 2003 EARIE Conference, the First Banca d’Italia/CEPR Conference on Money, Banking and Finance, the 2004 FIRS Conference on Banking, Insurance and Intermediation and the 2004 EEA Meeting for their comments. The usual disclaimer applies to all of them.     

Constrained Indirect Estimation

We develop generalized indirect estimation procedures that handle equality and inequality constraints on the auxiliary model parameters by extracting information from the relevant multipliers, and compare their asymptotic efficiency to maximum likelihood. We also show that, regardless of the validity of the restrictions, the asymptotic efficiency of such estimators can never decrease by explicitly considering the multipliers associated with additional equality constraints. Furthermore, we discuss the variety of effects on efficiency that can result from imposing constraints on a previously unrestricted model. As an example, we consider a stochastic volatility process estimated through a garch model with Gaussian or  t  distributed errors.     

Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle

We provide empirical evidence that deviations from the uncovered interest rate parity (UIP) condition display significant nonlinearities, consistent with theories based on transactions costs or limits to speculation. This evidence suggests that the forward bias documented in the literature may be less indicative of major market inefficiencies than previously thought. Monte Carlo experiments allow us to reconcile these results with the large empirical literature on the forward bias puzzle since we show that, if the true process of UIP deviations were of the nonlinear form we consider, estimation of conventional spot-forward regressions would generate the anomalies documented in previous research.This paper was partly written while Lucio Sarno was a Visiting Scholar at the International Monetary Fund. Financial support from the Economic and Social Research Council (Grant No. RES-000-22-0404) is gratefully acknowledged. The authors are indebted for useful conversations or constructive comments to Josef Zechner (editor), three anonymous referees, Ulf Axelson, Magnus Dahlquist, Paul De Grauwe, Hans Dewachter, John Driffill, Bob Flood, Gordon Gemmill, Campbell Harvey, Peter Kenen, Rich Lyons, Angelo Melino, Chris Neely, Anthony Neuberger, Carol Osler, David Peel, Dagfinn Rime, Piet Sercu, Per Str?mberg, Shinji Takagi, Gabriel Talmain, Mark Taylor, Timo Ter?svirta, Dan Thornton, Shang-Jin Wei, Mike Wickens and Mark Wohar, as well as to participants at the 2005 European Finance Association Annual Conference, Moscow; 2004 Society of Nonlinear Dynamics and Econometrics Annual Conference, Federal Reserve Bank of Atlanta; the 2004 European Financial Management Association Conference, Basel; and seminars at the International Monetary Fund, Swedish Institute for Financial Research, Central Bank of Norway, University of Oxford, Catholic University of Leuven, University ofWarwick, Chinese University of Hong Kong, York University, University of Exeter, University of Kent, and University of Edinburgh. The authors alone are responsible for any errors that may remain and for the views expressed in the paper.