Credit risk drivers: Evaluating the contribution of firm level information and of macroeconomic dynamics

Understanding if credit risk is driven mostly by idiosyncratic firm characteristics or by systematic factors is an important issue for the assessment of financial stability. By exploring the links between credit risk and macroeconomic developments, we observe that in periods of economic growth there may be some tendency towards excessive risk-taking. Using an extensive dataset with detailed information for more than 30 000 firms, we show that default probabilities are influenced by several firm-specific characteristics. When time-effect controls or macroeconomic variables are also taken into account, the results improve substantially. Hence, though the firms’ financial situation has a central role in explaining default probabilities, macroeconomic conditions are also very important when assessing default probabilities over time.     

A present value test of habits and the current account

Forecasts derived from standard intertemporal current account (ICA) models generally fail to match the volatility of actual current accounts. This paper offers a solution to the “excess volatility” problem of standard ICA models by incorporating consumption habits into the standard model. The model, as developed in the paper, shows that significant habit formation implies increased current account volatility, as sluggishness is introduced into the consumption adjustment process that follows income shocks. A theory-consistent measure of the degree of habit formation is estimated using GMM. The estimated habit parameter is found to be statistically significant in six of eight quarterly samples.     

The Slow Adjustment of Aggregate Consumption to Permanent Income

This paper investigates the relationship between aggregate consumption and permanent income using a new approach to the estimation of cointegrated systems that builds on Stock and Watson's common stochastic trends representation. The permanent and transitory movements in aggregate income and consumption are estimated directly using the Kalman filter and are allowed to be correlated. This approach avoids any implicit restriction that permanent income be as smooth as consumption. Instead, permanent income appears to be relatively volatile, with consumption adjusting toward it only slowly over time. These results provide a clear rejection of the standard version of the permanent income hypothesis and are suggestive of alternative theories of consumption behavior such as habit formation or precautionary savings.     

The Feldstein-Horioka puzzle in the presence of structural shifts: The case of Japan versus the USA

This paper tests the Feldstein-Horioka “puzzle” for the two richest countries of the world: Japan and the USA. For this purpose it employs three different cointegration tests that are applied to the Feldstein-Horioka long-run investment-saving equation in conjunction with the Lumsdaine and Papell (1997) unit root test considering two structural shifts. A novel aspect of the paper is that it determines the number of breaks solely from a scrutiny of the data and that in constructing the dummy variables for the breaks it uses the endogenously determined break dates. It shows that allowing for structural shifts eliminates the “puzzle” both for Japan and the USA.     

Do central banks respond to exchange rate movements? A structural investigation

We estimate a small-scale, structural general equilibrium model of a small open economy using Bayesian methods. Our main focus is the conduct of monetary policy in Australia, Canada, New Zealand and the UK. We consider generic Taylor-type rules, where the monetary authority reacts in response to output, inflation, and exchange-rate movements. We perform posterior odds tests to investigate the hypothesis whether central banks do target exchange rates. The main result of this paper is that the central banks of Australia and New Zealand do not, whereas the Bank of Canada and the Bank of England do include the nominal exchange rate in its policy rule. This result is robust for various specification of the policy rule. We also find that terms-of-trade movements do not contribute significantly to domestic business cycles.     

Are there economies of scale in the demand for money by firms? Some panel data estimates

We estimate elasticities of scale in the demand for money by firms using firm level panel data from Spain, the UK, and the US. This elasticity is one for Spain and the UK but smaller for the US. We find that the errors in the money demand equations contain two terms that are correlated with sales. Firstly, a permanent firm effect that captures differences in technological sophistication. Secondly, a measurement error in sales, which becomes relevant when relying on changes in sales to account for fixed effects. Failure to control for these correlated unobservable terms results in important biases in the estimated sales elasticities.     

What causes exchange rate volatility? Evidence from selected EMU members and candidates for EMU membership countries

We allow for monetary, real, and financial variables to assess the relevant importance of each of the variables to exchange rate volatility in the case of selected EMU members and candidate countries. Ex-ante analysis shows that volatility in the Polish zloty/euro and the Hungarian forint/euro forex markets can be influenced by the monetary-side of the economy. On the other hand, ex-post analysis shows that forex markets in France, Italy and Spain had been influenced, during the pre-EMU era, by monetary and real shocks. However, the Irish pound exchange rate per ECU had been affected by only real shocks.     

On the empirics of international smoothing

By fully exploiting the statistical properties of panel data, this paper improves upon existing methodologies to estimate consumption smoothing at least in three respects. First, we model explicitly incomplete risksharing as well as incomplete intertemporal smoothing, and couch the two mechanisms in a unified framework. Second, we fully exploit simple panel data analysis in order to measure degrees of both risksharing and intertemporal smoothing taking place in a given set of economic regions. In particular, we are able to measure not only the smoothing of idiosyncratic shocks, but also the dependence on aggregate (non-diversifiable) shocks. Third, we distinguish neatly between the effects of temporary vs. permanent shocks. This can be done by taking advantage of the complementarity between the “within” estimator and the “between” estimator in a panel regression.     

Capital inflows and asset prices: Evidence from emerging Asia

The withdrawal of foreign capital from emerging countries at the height of the recent financial crisis and its quick return sparked a debate about the impact of capital flow surges on asset markets. This paper addresses the response of property prices to an inflow of foreign capital. For that purpose we estimate a panel VAR on a set of Asian emerging market economies, for which the waves of inflows were particularly pronounced, and identify capital inflow shocks based on sign restrictions. Our results suggest that capital inflow shocks have a significant effect on the appreciation of house prices and equity prices. Capital inflow shocks account for – roughly – twice the portion of overall house price changes they explain in OECD countries. We also address cross-country differences in the house price responses to shocks, which are most likely due to differences in the monetary policy response to capital inflows.     

Unconditionally optimal monetary policy

We develop a simple and intuitive approach for analytically deriving unconditionally optimal (UO) policies, a topic of enduring interest in optimal monetary policy analysis. The approach can be employed in both general linear-quadratic problems and in the underlying non-linear environments. A detailed example is provided using a canonical New Keynesian framework.     

Understanding the Backus–Smith puzzle: It's the (nominal) exchange rate,stupid

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3–4), 297–316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to ‘rule of thumb’ consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.     

Anticipated growth and business cycles in matching models

In a business cycle model that incorporates a standard matching framework, employment increases in response to news shocks, even though the wealth effect associated with the increase in expected productivity reduces labor force participation. The reason is that the matching friction induces entrepreneurs to increase investment in new projects and vacancies early. If there is underinvestment in new projects in the competitive equilibrium, then the efficiency gains associated with an increase in employment make it possible that consumption, employment, output, as well as the investment in new and existing projects jointly increase long before the actual increase in productivity materializes. If there is no underinvestment, then investment in existing projects decreases, but total investment, consumption, employment, and output still jointly increase.     

Bank-specific shocks and the real economy

Governments often justify interventions into the financial system in the form of bail outs or liquidity assistance with the systemic importance of large banks for the real economy. In this paper, we analyze whether idiosyncratic shocks to loan growth at large banks have effects on real GDP growth. We employ a measure of idiosyncratic shocks which follows Gabaix (forthcoming). He shows that idiosyncratic shocks to large firms have an impact on US GDP growth. In an application to the banking sector, we find evidence that changes in lending by large banks have a significant short-run impact on GDP growth. Episodes of negative loan growth rates and the Eastern European countries in our sample drive these results.     

Bank profitability during recessions

This paper contributes to the literature on the relation between bank profitability and economic activity. When allowing for stronger co-movement of bank profit with economic activity during deep recessions, we find a much larger impact of output growth on bank profitability than commonly found in the literature. Among the different components of bank profit, loan losses are the main driver of this result. We also find long-term interest rates in previous years to be important determinants of bank profit in times of high economic growth. Our findings are robust to the use of aggregate or individual bank data.