What drives the cross‐country growth and inequality correlation?

Abstract.  We present a neo‐classical model that explores the determinants of growth‐inequality correlation and attempts to reconcile the seemingly conflicting evidence on the nature of the growth‐inequality relationship. The initial distribution of human capital determines the long‐run income distribution and the growth rate by influencing the occupational choice of the agents. The steady‐state proportion of adults that innovates and updates human capital is path dependent. The output elasticity of skilled‐labour, barriers to knowledge spillovers, and the degree of redistribution determine the range of steady‐state equilibria. From a calibration experiment we report that a skill‐intensive technology, low barriers to knowledge spillovers, and high degrees of redistribution characterize the industrial countries with a positive growth‐inequality correlation. A negative correlation between growth and inequality arises for the group of non‐industrial countries with the opposite characteristics. JEL classification: E1, O4     

Incomplete Information, Trading Costs and Cross‐autocorrelations in Stock Returns

This paper provides an economic rationale for the cross‐autocorrelation patterns in stock returns in the context of a microstructure model in which investors have incomplete information. The paper shows that in a market in which investors are informed about only a sub‐set of stocks, the emergence of lead‐lag, cross‐autocorrelations is a function of the cost of trading in other stocks based on information about the sub‐set of stocks. If cross‐trading costs are high, informed investors will trade only in the sub‐set of stocks they are informed about; if cross‐trading costs are moderate, informed investors will randomize between trading and not trading in other stocks; and if cross‐trading costs are low, they will trade in all stocks. When informed investors trade only in a sub‐set of stocks, prices of stocks with more informed trading will adjust to common factor information faster than the prices of stocks with less informed trading giving rise to asymmetric lead‐lag cross‐autocorrelations. When informed investors trade in all stocks, asymmetric lead‐lag cross‐autocorrelations will disappear as a result of their cross‐market arbitrage trading. These results provide a number of testable implications for lead‐lag cross‐autocorrelation patterns. The data is consistent with the empirical predictions .
(J.E.L.G12, G14).     

Money, capital, and real liquidity effects with habit formation

Abstract.  The money in utility model is reconsidered in the presence of endogenous labour and habits. With standard assumptions about preferences and a policy rule that sets the nominal interest rate by adjusting the growth rate of money, the model exhibits superneutrality in the steady state. Nevertheless, habits give rise to real liquidity effects in the short run. After an increase in the nominal interest rate, employment falls, resulting in a fall in capital accumulation and in the short‐ and long‐term real interest rates. The adjustment of the capital stock is non‐monotonic. Employment and the short‐ and long‐term real interest rates may also adjust non‐monotonically. JEL classification: E22, E52, E58     

Liquidity Dynamics Across Small and Large Firms

In this paper, we analyse cross‐sectional heterogeneity in the time‐series variation of liquidity in equity markets. Our analysis uses a broad time‐series and cross‐section of liquidity data. We find that average daily changes in liquidity exhibit significant heterogeneity in the cross‐section; the liquidity of small firms varies more on a daily basis than that of large firms. A steady increase in aggregate market liquidity over the past decade is more strongly manifest in large firms than in small firms. Absolute stock returns are an important determinant of liquidity. We investigate cross‐sectional differences in the resilience of a firm's liquidity to information shocks. We use the sensitivity of stock liquidity to absolute stock returns as an inverse measure of this resilience, and find that the measure exhibits considerable cross‐sectional variation. Firm size, return volatility, institutional holdings, and volume are all significant cross‐sectional determinants of this measure.
(J.E.L.: D82, G10, G14).     

Advancing Loss Given Default Prediction Models: How the Quiet Have Quickened

We describe LossCalc™ version 2.0: the Moody's KMV model to predict loss given default (LGD), the equivalent of (1  −  recovery rate). LossCalc is a statistical model that applies multiple predictive factors at different information levels: collateral, instrument, firm, industry, country and the macroeconomy to predict LGD. We find that distance‐to‐default measures (from the Moody's KMV structural model of default likelihood) compiled at both the industry and firm levels are predictive of LGD. We find that recovery rates worldwide are predictable within a common statistical framework, which suggests that the estimation of economic firm value (which is then available to allocate to claimants according to each country's bankruptcy laws) is a dominant step in LGD determination. LossCalc is built on a global dataset of 3,026 recovery observations for loans, bonds and preferred stock from 1981 to 2004. This dataset includes 1,424 defaults of both public and private firms – both rated and unrated instruments – in all industries. We demonstrate out‐of‐sample and out‐of‐time LGD model validation. The model significantly improves on the use of historical recovery averages to predict LGD .     

Canadian and U.S. financial markets: testing the international integration hypothesis under time‐varying conditional volatility

Abstract.  This paper evaluates the international integration hypothesis, that is, that risk‐adjusted anticipated returns are identical, even when financial instruments are traded in different countries. Under time‐varying conditional volatility, this hypothesis is tested by verifying the equality between domestic and foreign risk prices associated with a multi‐factor analytic specification. The maximum‐likelihood and Kalman‐filter estimates are used to assess the national risk prices and interpret the factors. Empirically, the integration of Canadian and U.S. financial markets depends on the risk prices of two factors, which are related to certain non‐monetary events and to the conduct of monetary policies. JEL classification: G15, C32     

Optimal Monetary Policy with Price and Wage Rigidities

In this paper, I search for an optimal configuration of parameters for variants of the Taylor rule by using an accurate second‐order welfare‐based method within a fully microfounded dynamic stochastic model, with price and wage rigidities, without capital accumulation. A version of the model with distortionary taxation is also explicitly tested. The model is solved up to second‐order solution. Optimal rules are obtained by maximizing a conditional welfare measure, differently from what has been done in the current literature. Optimal monetary policy functions turn out to be characterized by inflation targeting parameter lower than in empirical studies. In general, the optimal values for monetary policy parameters depend on the degree of nominal rigidities and on the role of fiscal policy. When nominal rigidities are higher, optimal monetary policy becomes more aggressive to inflation. With a tighter fiscal policy, optimal monetary policy turns out to be less aggressive to inflation. Impulse‐response functions based on second‐order model solution show a non‐affine pattern when the economy is hit by shocks of different magnitude .     

International macroeconomic fluctuations and the current account

Abstract.  Intertemporal models of the current account generally assume that global shocks do not affect the current account. We use this assumption to identify global and country‐specific shocks in a bivariate VAR of output and the current account. Cross‐country evidence from the G7 economies suggests that this identification works surprisingly well. We then employ our method to collect stylized facts on international macroeconomic fluctuations. We find that long‐term output growth is driven mainly by global factors in most G7 countries and that country‐specific shocks are less persistent and generally less volatile than global shocks. JEL Classification: F41, F43, C32
Fluctuations macroéconomiques internationales et compte courant.  Les modèles inter‐temporels du compte courant postulent généralement que les chocs globaux n'affectent pas le compte courant. On utilise ce postulat pour identifier les chocs globaux et ceux qui sont spécifiques à des pays donnés dans un modèle VAR du produit global et du compte courant. Les résultats transversaux pour les pays du G7 suggèrent que cette forme d'identification donne de très bons résultats. On emploie cette méthode pour examiner des faits stylisés des fluctuations macro‐économiques internationales.Il appert que la croissance à long terme du produit dépend de facteurs globaux dans la plupart des pays du G7 et que les chocs particuliers aux pays ont un impact moins permanent et moins volatile que les chocs globaux.     

The Impact of the Rating Agencies' Through‐the‐cycle Methodology on Rating Dynamics

Surveys on the use of agency credit ratings reveal that some investors believe that credit‐rating agencies are relatively slow in adjusting their ratings. A well‐accepted explanation for this perception on rating timeliness is the through‐the‐cycle methodology that agencies use. Through‐the‐cycle ratings are intended to measure default risk over long investment horizons and to respond only to changes in the permanent component of credit quality. A second aspect of the through‐the‐cycle methodology is the prudent migration policy. In a benchmark study with a financial ratio‐based credit‐scoring models – an agency‐rating prediction model and default‐prediction models with various time horizons – we confirm the exclusive focus of agencies on the permanent component of credit quality and we model and quantify the agencies' prudent migration policy. A rating migration is triggered only when the rating predicted by the agency‐rating prediction model differs by at least a threshold level of 1.8 notch steps from the actual agency rating. If triggered, ratings are only partly adjusted by 70 per cent at the downside and 60 per cent at the upside. From a 1‐year point‐in‐time perspective, weighting temporary fluctuations in credit quality, the through‐the‐cycle methodology lowers the rating‐migration probability by a factor of 3.5. Both aspects of the through‐the‐cycle methodology contribute equally to this factor. The partial adjustment of ratings lowers the rating‐reversal probabilities on short term and introduces rating drift, the known serial correlation in agency‐rating migrations.     

Decentralized Policymaking in a Long‐run Growth Model with Seigniorage and Taxes

The paper introduces decentralized policymaking into a game‐theoretic model with output growth through capital accumulation, and in which the determination of taxes, seigniorage and the long‐run growth rate of the economy reflects the strategic interactions between the government, the central bank and the private sector. The paper investigates, among other things, the impact on the long‐run growth rate of a higher degree of inflation aversion of the central bank and a higher degree of inefficiency in the tax system.     

Trade, product cycles, and inequality within and between countries

Abstract.  This paper incorporates Northern product innovation and product‐cycle‐driven technology transfer into the continuum‐of‐goods Heckscher‐Ohlin model. The creation of very skill‐intensive goods induces the North to transfer production of older, less skill‐intensive goods to the South. These relocated goods are the most skill intensive by Southern standards. Hence, product cycles raise the relative demand for skilled workers and thus wage inequality within both regions. This runs contrary to the Stolper‐Samuelson theorem, but accords well with the fact that wage inequality has risen in both Northern and Southern countries. Moreover, product cycles increase income inequality between countries. JEL classification: F1     

The performance and robustness of simple monetary policy rules in models of the Canadian economy

Abstract.  In this paper, we evaluate seven simple monetary policy rules in a wide range of models of the Canadian economy. Our results indicate that none of the seven simple policy rules we examined is robust to model uncertainty, in that no single rule performs well in all models. In fact, our results show that the performance of some of the simple rules, particularly rules with interest rate smoothing and rules with a high coefficient on the inflation gap, can substantially deviate from that of the optimal rule and can even be unstable in some models. Furthermore, we find that "open‐economy" rules do not perform well in many models. We find that adding an exchange rate term to a simple policy rule often increases the value of the policy‐maker's loss function. Although it is not robust, we find that a simple nominal Taylor‐type rule that has a coefficient of 2 on the inflation gap and 0.5 on the output gap outperforms the other simple rules in a certain class of models. However, even in those models, the loss‐function value of this simple rule can be substantially higher than that of the optimal or base‐case rule. JEL classification: E52, E58     

Implications of Singapore's CPF Scheme on Consumption Choices and Retirement Incomes

Singapore has a unique policy of allowing the use of mandatory social security contributions to finance homeownership. An intertemporal model of housing demand is employed to demonstrate analytically that the CPF scheme can distort an individual's intertemporal and intratemporal consumption choices, and induce Singaporeans to demand more housing than they would otherwise. The withdrawals for housing have also affected the adequacy of CPF balances for financing retirement. Pegging the rate of return on CPF balances to a long‐term rate is the long‐term solution to curbing excessive withdrawals for housing, and ensuring the adequacy of CPF savings for financing retirement.     

Monetary policy in a cash‐in‐advance economy: employment, capital accumulation, and the term structure of interest rates

Abstract.  In this paper we study the effects of monetary policies on employment, capital accumulation, consumption, and the term structure of interest rates in a cash‐in‐advance economy, where money is required for consumption expenditures. Monetary policy involves targeting the inflation rate. The detailed dynamics of the model are fully worked out. As no numerical analysis is involved, we are able to identify very clearly the different channels through which monetary policy will impinge on the important macroeconomic variables. The model is also used to discuss the 'Great Canadian Slump.' JEL Classification: E52 and E43     

Specification Analysis of Diffusion Models for the Italian Short Rate

In recent years, diffusion models for interest rates became very popular. In this paper, we perform a selection of a suitable diffusion model for the Italian short rate. Our data set is given by the yields on 3‐month BOT (Buoni Ordinari del Tesoro), from 1981 to 2001, for a total of 470 observations. We investigate among stochastic volatility models, paying more attention to affine models. Estimating diffusion models via maximum likelihood, which would lead to efficiency, is usually unfeasible because the transition density is not available. Recently, Gallant and Tauchen (1996) proposed a method of moments which gains full efficiency, hence its name of Efficient Method of Moments (EMM); it selects the moments as the scores of an auxiliary model, to be computed via simulation; thus, EMM is suitable to diffusions whose transition density is unknown, but which are convenient to simulate. The auxiliary model is selected among a family of densities which spans the density space. As a by‐product, EMM provides diagnostics that are easy to compute and interpret. We find evidence that one‐factor models and multi‐factor affine models are rejected, while a logarithmic specification of the volatility provides the best fit to the data .     

A Simple Characterization of the Second‐best Two‐part and Block‐rate Tariffs Theory and Applications

The general necessary optimality conditions for second‐best discrete multipart tariffs are rather complex. In this paper, we derive a simplified characterization of these conditions for two‐part tariffs and for block‐rate tariffs for given thresholds of these tariffs. The simplified necessary optimality conditions are equivalent to the necessary conditions for a Ramsey‐optimum for goods with continuously variable individually demanded quantities. We demonstrate that this characterization of second‐best multipart tariffs can be helpful, when applying the usual regulatory mechanisms to these tariffs. In particular, we consider Vogelsang–Finsinger (1979) regulation as well as a particular form of price‐cap regulation which is related to the Laspeyres index of prices.     

Patents and R&D as Real Options

This article develops and implements a simulation approach to value patents and patent‐protected R&D projects based on the Real Options approach. It takes into account uncertainty in the cost‐to‐completion of the project, uncertainty in the cash flows to be generated from the project, and the possibility of catastrophic events that could put an end to the effort before it is completed. It also allows for the possibility of abandoning the project when costs turn out to be larger than expected or when estimated cash flows turn out to be smaller than anticipated. This abandonment option represents a very substantial part of the project's value when the project is marginal or/and when uncertainty is large. The model presented can be used to evaluate the effects of regulation on the cost of innovation and the amount on innovative output. The main focus of the article is the pharmaceutical industry. The framework, however, applies just as well to other research‐intensive industries such as software or hardware development.
(J.E.L.:G31, O22, O32).     

Partial Ownership Induces Customised Investments Under Repeated Interaction: An Explanation of Japanese Manufacturer‐Suppliers Relationships

A dominant manufacturing firm often holds partial shares of its suppliers, and the suppliers are willing to make investments customised to the manufacturer. Furthermore, this type of manufacturer‐suppliers relationship is often long‐term and stable. This paper provides an explanation for this phenomenon by modelling repeated interaction between a downstream manufacturer and upstream suppliers. In the model, the manufacturer could avoid, by partially owning a supplier, hold‐up problems which would arise from the supplier's customised investment. The model distinguishes between two sources of appropriable quasi‐rents, and yields new empirical predictions concerning the relationship between appropriable quasi‐rents and vertical integration.     

Public capital, asymmetric information, and economic growth

Abstract.  We investigate the provision of public capital in an endogenous growth model with asymmetric information. In a credit market with costly screening, we show that the equilibrium contracts are characterized by the self‐selection of borrowers. Through identifying an additional adverse effect of taxation on growth, we show that the optimal tax rate in our model is smaller than the output elasticity of public capital. Therefore, our analysis justifies a more conservative tax policy in the presence of asymmetric information. Furthermore, our model suggests a number of implications that appear to be well supported by preliminary evidence in cross‐country data. JEL classification: D82, H21, O41     

International capital flows under asymmetric information and costly monitoring: implications of debt and equity financing

Abstract.  The impact of increased equity trade on a small open economy is examined. Stochastic second‐period output depends on first‐period investment. Owing to information asymmetries, domestic agents cannot reveal credibly the level of first‐period investment to international financiers. Consistent with recent proposals to strengthen the international financial system, domestic firms choose to incur self‐monitoring costs to increase capital inflows. As an alternative to borrowing, domestic agents may sell ownership claims to second‐period output. When equity claims convey information, equity trade is preferred to international borrowing, consistent with developing economies' observed reliance on international equity relative to debt in recent years. JEL Classification: F41, G15