Banks, private money, and government regulation

We study competition between inside and outside money in economies with trading frictions and financial intermediation. Claims on banks circulate if the redemption rate is low. When the quantity of fiat money is scarce, coexistence of inside and outside money dominates equilibria with a unique medium of exchange. If outside money is ample, banks choose to redeem claims in outside money, which increases welfare. Under binding reserve requirements, tightening monetary policy leads to credit rationing. Our results support recent trends toward lower reserve requirements. However, we also identify situations where restrictions on note issue are beneficial.     

Behavior of the money stock: Is there a puzzle?

This paper examines the factual and logical bases underlying recent proposals that the Federal Reserve should reduce the attention it attaches to the monetary aggregates and finds these arguments seriously lacking on both counts. By and large the case against the aggregates rests on the finding that some money demand functions have experienced serious difficulties in explaining recent developments. Our results suggest that the problem is not due so much to the instability in the public's asset preferences but rather to the restrictive specifications of the functions employed. Moreover, it is shown that even if the demand function for money has become less predictable, this is not sufficient to justify a reduction in the attention devoted to the aggregates. Finally, we examine the recent performance of a modified version of the St. Louis reduced-form equation for nominal income and find that the relationship that it incorporates between the growth in money and the growth in GNP has remained remarkably stable.     

The interbank market after the financial turmoil: Squeezing liquidity in a “lemons market” or asking liquidity “on tap”

After August 2007 the plumbing system that supplied banks with wholesale funding, the interbank market, failed because toxic assets obstructed the pipes. Banks were forced to squeeze liquidity in a “lemons market” or to ask for liquidity “on tap” from central banks. This paper disentangles the two components of the 3-month Euribor–Eonia swap spread, credit and liquidity risk and then evaluates the decomposition. The main finding is that credit risk increased before the key events of the crisis, while liquidity risk was mainly responsible for the subsequent increases in the Euribor spread and then reacted to the systemic responses of the central banks, especially in October 2008. Moreover, the level of the spread between May 2009 and February 2010 was influenced mainly by credit risk, suggesting that European banks were still in a “lemons market” and relied on liquidity “on tap” even before sovereign debt crisis unfolded in Europe.     

Time-to-build, time-to-plan, habit-persistence, and the liquidity effect

The inability of sticky-price monetary business cycle models to generate liquidity effects has been extensively documented by a number of authors. This paper develops a sticky-price monetary business cycle model with investment gestation lags and habit-persistence in consumption that is capable of generating an empirically plausible liquidity effect.     

Credit crises, money and contractions: An historical view

The relatively infrequent nature of major credit distress events makes an historical approach particularly useful. Using a combination of historical narrative and econometric techniques, we identify major periods of credit distress from 1875 to 2007, examine the extent to which credit distress arises as part of the transmission of monetary policy, and document the subsequent effect on output. Using turning points defined by the Harding-Pagan algorithm, we identify and compare the timing, duration, amplitude and co-movement of cycles in money, credit and output. Regressions show that financial distress events exacerbate business cycle downturns both in the 19th and 20th centuries and that a confluence of such events makes recessions even worse.     

Identifying the interdependence between US monetary policy and the stock market

We estimate the interdependence between US monetary policy and the S&P 500 using structural vector autoregressive (VAR) methodology. A solution is proposed to the simultaneity problem of identifying monetary and stock price shocks by using a combination of short-run and long-run restrictions that maintains the qualitative properties of a monetary policy shock found in the established literature [Christiano, L.J., Eichenbaum, M., Evans, C.L., 1999. Monetary policy shocks: what have we learned and to what end? In: Taylor, J.B., Woodford, M. (Eds.), Handbook of Macroeconomics, vol. 1A. Elsevier, New York, pp. 65-148]. We find great interdependence between the interest rate setting and real stock prices. Real stock prices immediately fall by seven to nine percent due to a monetary policy shock that raises the federal funds rate by 100 basis points. A stock price shock increasing real stock prices by one percent leads to an increase in the interest rate of close to 4 basis points.     

Regulation and the Neo-Wicksellian Approach to Monetary Policy

Laubach and Williams (2003) employ a Kalman filter approach to jointly estimate the neutral real federal funds rate and trend output growth using an IS relationship and an output-gap-based inflation equation. They find a positive link between these two variables, but also much error surrounding neutral real rate estimates. We modify their approach by including variables for regulations on deposit interest rates and on wages and prices. These variables are statistically significant and notably affect estimates of two policy-relevant coefficients: the sensitivity of output to the real interest rate and that of inflation to the output gap.     

Euler equations and money market interest rates: A challenge for monetary policy models

Standard macroeconomic models equate the money market rate targeted by the central bank with the interest rate implied by a consumption Euler equation. We use U.S. data to calculate the interest rates implied by Euler equations derived from a number of specifications of household preferences. Correlations between these Euler equation rates and the Federal Funds rate are generally negative. Regression results and impulse response functions imply that the spreads between the Euler equation rates and the Federal Funds rate are systematically linked to the stance of monetary policy. Our findings pose a fundamental challenge for models that equate the two.     

Flow and stock effects of large-scale treasury purchases: Evidence on the importance of local supply

The Federal Reserve’s 2009 program to purchase $300 billion of US Treasury securities represented an unprecedented intervention in the Treasury market and provides a natural experiment with the potential to shed light on the price elasticities of Treasuries and theories of supply effects in the term structure. Using security-level data on Treasury prices and quantities during the course of this program, we document a ‘local supply’ effect in the yield curve—yields within a particular maturity sector responded more to changes in the amounts outstanding in that sector than to similar changes in other sectors. We find that this phenomenon was responsible for a persistent downward shift in yields averaging about 30 basis points over the course of the program (the “stock effect”). In addition, except at very long maturities, purchase operations caused an average decline in yields in the sector purchased of 3.5 basis points on the days when those operations occurred (the “flow effect”). The sensitivity of our results to security characteristics generally supports a view of segmentation or imperfect substitution within the Treasury market during this time.     

Latent liquidity: A new measure of liquidity,with an application to corporate bonds

We present a new measure of liquidity known as “latent liquidity” and apply it to a unique corporate bond database. Latent liquidity is defined as the weighted average turnover of investors who hold a bond, in which the weights are the fractional investor holdings. It can be used to measure liquidity in markets with sparse transactions data. For bonds that trade frequently, our measure has predictive power for both transaction costs and the price impact of trading, over and above trading activity and bond-specific characteristics thought to be related to liquidity. Additionally, this measure exhibits relationships with bond characteristics similar to those of other trade-based measures.     

The solution to the forward-bias puzzle: Reply

My proposed econometric solution to the forward-bias puzzle provoked several comments. Those comments raise three primary objections to my solution. (1) It suffers from multicollinearity, miss-specification and other serious econometric problems. (2) My key test equation is a tautology or identity. (3) My econometric solution has nothing to do with either the forward-bias puzzle or uncovered interest parity. This is my reply to those objections.     

Price dispersion in OTC markets: A new measure of liquidity

In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that, in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations from expected market valuations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.     

Pricing of time-varying liquidity risk in Finnish stock market: new evidence

Using two recently developed illiquidity measures, we estimate a conditional version of liquidity-adjusted capital asset pricing model (LCAPM), which allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The total estimated annualized illiquidity premium for the Finnish equities during 1997–2015 is 1.13–1.90% depending on the illiquidity measure. Of the three systematic liquidity risk components, risk arising from hedging of wealth shocks is the most important followed by commonality in liquidity risk, whereas flight to liquidity risk is not significantly priced in the Finnish stock market. Our results show that the liquidity risk is time varying, therefore the models estimating the risk-return relationship should address the issue of conditionality.     

Asymmetric information and liquidity constraints: A new test

Using a novel measure of the degree of information asymmetry across firms, this study shows that information-related financial market imperfections do matter for a firm’s access to external finance. Prior studies of the importance of liquidity constraints faced by nonfinancial firms have suffered from a glaring weakness. They have been based on a sample of publicly traded firms, omitting precisely those firms most likely to be liquidity constrained. Furthermore, they have tended to rely on indirect measures of the degree of information asymmetry, such as firm size. We overcome these limitations by focusing on the banking sector. Unlike the nonfinancial sector, the banking sector has balance sheet and income data available for all firms, whether or not they are publicly traded. This allows the use of a superior measure of the degree of information asymmetry across firms by distinguishing between publicly traded and non-publicly traded banks.     

Liquidity and stock returns: Evidence from a pure order-driven market using a new liquidity proxy

Liquidity has been found to be a determinant of stock returns in large hybrid quote-driven markets. Liquidity proxies have ranged from trade-based measures such as turnover rate to order-based measures such as the bid-ask spread. The relationship between return and liquidity in small pure order-driven markets is less clear, with different liquidity proxies yielding conflicting results. This study adds to the existing literature by considering the return-liquidity relationship on the Australian Stock Exchange, a small pure order-driven market, using a new liquidity measure, Weighted Order Value (WOV). Liquidity is found to be an important determinant of returns.     

The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value

This paper reexamines the validity of the expectation hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to 3 months. We extend the work of Longstaff [2000b. The term structure of very short term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] in two directions: (1) we implement statistical tests designed to increase test power in this context; (2) more important, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.     

Assessing long-term fiscal developments: A new approach

We use a new approach to assess long-term fiscal developments. By analyzing the time-varying behaviour of the two components of government spending and revenue - responsiveness and persistence -, a feature not captured by automatic stabilisers, we are able to infer about the sources of fiscal deterioration (improvement). Drawing on quarterly data, we estimate recursively these components within a system of government revenue and spending equations using a Three-Stage Least Square method for eight European Union countries plus the US. The results suggest that significant changes in the fiscal stance (including those related to the current crisis) are reflected in the estimates of persistence and responsiveness.     

A quantitative analysis of oil-price shocks, systematic monetary policy, and economic downturns

Are the recessionary consequences of oil-price shocks due to oil-price shocks themselves or to the monetary policy that responds to them? We investigate this question in a calibrated general equilibrium model in which oil use is tied to capital utilization. The response to an oil-price shock is examined under a variety of monetary policy specifications. Under our benchmark calibration, which approximates the Federal Reserve's behavior since 1979, monetary policy contributes about 40 percent to the drop in output following a rise in oil prices. Moreover, none of the commonly proposed policies we examine completely offsets the recessionary consequences of oil shocks.     

In search of the liquidity effect in a modern monetary model

This paper examines the impact of a monetary policy shock in a dynamic stochastic general equilibrium model with sticky prices and financial market frictions. First, we examine the shortcomings of monetary models emphasizing these frictions individually. The model then is specified to limit the response of prices and savings to a current period monetary disturbance. Our results show that this model can account for the following key responses to an expansionary monetary policy shock: a fall in the nominal interest rate; a rise in output, consumption, and investment; and a gradual increase in the price level. Finally, a detailed sensitivity analysis shows the model's results depend on the parameters assigned to critical structural features.     

Credit market shocks and economic fluctuations: Evidence from corporate bond and stock markets

To identify disruptions in credit markets, research on the role of asset prices in economic fluctuations has focused on the information content of various corporate credit spreads. We re-examine this evidence using a broad array of credit spreads constructed directly from the secondary bond prices on outstanding senior unsecured debt issued by a large panel of nonfinancial firms. An advantage of our “ground-up” approach is that we are able to construct matched portfolios of equity returns, which allows us to examine the information content of bond spreads that is orthogonal to the information contained in stock prices of the same set of firms, as well as in macroeconomic variables measuring economic activity, inflation, interest rates, and other financial indicators. Our portfolio-based bond spreads contain substantial predictive power for economic activity and outperform—especially at longer horizons—standard default-risk indicators. Much of the predictive power of bond spreads for economic activity is embedded in securities issued by intermediate-risk rather than high-risk firms. According to impulse responses from a structural factor-augmented vector autoregression, unexpected increases in bond spreads cause large and persistent contractions in economic activity. Indeed, shocks emanating from the corporate bond market account for more than 30 percent of the forecast error variance in economic activity at the two- to four-year horizon. Overall, our results imply that credit market shocks have contributed significantly to US economic fluctuations during the 1990-2008 period.