Further analysis of the expectations hypothesis using very short-term rates

Longstaff [Longstaff, F., 2000. The term structure of very short-term rates: new evidence for the expectations hypothesis. Journal of Financial Economics 58, 397–415] finds support for the expectations hypothesis at the very short end of the repurchase agreement (repo) term structure while other studies find calendar-time-based regularities cause rejection of the expectations hypothesis. Using Longstaff’s methods on a sample of repo rates that pre-dates Longstaff’s sample, we reject the expectations hypothesis for every maturity. The pre-Longstaff-sample repo data comes from a time period where the behavior of short-term interest rates is similar to the long-run average behavior of short-term interest rates. Our results imply that expectations hold when rates are less volatile and/or that we may be entering a period of lower volatility.     

Trends,random walks,and tests of the permanent income hypothesis

Recent studies find that consumption is excessively sensitive to income. These studies assume that income is stationary around a deterministic trend. The data, however, do not reject the hypothesis that disposable personal income is a random walk with drift. If income is indeed a random walk, then the standard testing procedure is greatly biased toward finding excess sensitivity. Moreover, if income follows either a more general non-stationary process or a borderline stationary process, this procedure is also seriously biased.     

Precautionary saving and partially observed income

I propose an intertemporal precautionary saving model in which the agent's labor income is subject to (possibly correlated) shocks with different degrees of persistence and volatility. However, he only observes his total income, not individual components. I show that partial observability of individual components of income gives rise to additional precautionary saving due to estimation risk, the error associated with estimating individual components of income. This additional precautionary saving is higher, when estimation risk is greater. Compared with a precautionary agent who is otherwise identical, but ignores estimation risk, the rational agent consumes less at the beginning of his life, but consumes more later, because of larger wealth accumulated from savings for estimation risk. The utility cost of ignoring estimation risk is also quantified in closed form.     

Current consumption and future income growth: Synthetic panel evidence

Using group means computed from 20 years of high quality survey data, I show a strong and robust relation between households’ consumption growth and subsequent realizations of their income growth, including realizations as distant as six years later. The relation appears in multiple types of variation in income growth: in variation across cohort-education groups, in variation over the life cycle, and in variation over the business cycle. While other explanations are explored, the results are likely due to forward-looking households altering their current consumption in response to information they receive about their income years into the future, information that turns out to be accurate.     

Testing the expectations hypothesis of the term structure with permanent-transitory component models

This study proposes a new application of Permanent-Transitory Component Models (PTCMs) to test the Expectation Hypothesis of the Term Structure (EHTS). Unlike previous approaches, tests based on PTCMs can simultaneously detect departures from rational expectations and time varying term premia. We set out analytically and empirically the links across previous tests and PTCMs. We also show that PTCMs identify an additional restriction for rational expectations, on top of the one-to-one relationship between forward and spot rates, that must be imposed in estimations of term premia. Data for the short-end of the US term structure suggest that both factors contribute to the rejection of the EHTS. Moreover, the empirical estimates of term premia are persistent and exhibit sign fluctuations. Their stochastic properties depend crucially on whether the additional restriction for rational expectations is imposed in estimation.     

Heterogeneous life-cycle profiles, income risk and consumption inequality

Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use Consumer Expenditure Survey (CEX) repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model fits the joint evolution of consumption and income inequality well and delivers two main results. First, we find that permanent changes in income explain all of the increase in inequality in the 1980s and 1990s. Second, we reconcile this finding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income profiles.     

Future labor income growth and the cross-section of equity returns

This paper examines the equilibrium relation between future labor income growth and expected asset returns; it proposes revisions in the expectation of future labor income growth as a macroeconomic state variable and suggests a three-factor model, including a factor related to this variable, along with the consumption growth factor and the market factor. The proposed future labor income growth factor is positively associated with the Fama-French factors and subsumes their explanatory power in explaining the cross-section of stock returns. These results provide a possible economic explanation for the roles of the Fama-French factors: they are compensation for higher exposure to the risk related to changes in the value of human capital. This paper also compares the performance of the proposed three-factor model with other competing models and finds that the proposed model specification better captures cross-sectional variation in average returns than any of the competing asset pricing models considered.     

Risk preferences in multi-period consumption models, the equity premium puzzle, and habit formation utility

The relationship between the relative risk aversion measure for the utility function for consumption and that for the value function for wealth is a derived relationship whose properties depend on how consumption and wealth are defined and measured. This fact together with information concerning estimates for these two relative risk aversion measures is used to give another perspective on the equity premium puzzle, and to explain why it is that the habit formation utility function is effective in eliminating that puzzle. A time separable utility function that can serve as an alternative to the assumption of habit formation is also presented.     

Bank income structure and risk: An empirical analysis of European banks

The purpose of this paper is to investigate the relationship between bank risk and product diversification in the changing structure of the European banking industry. Based on a broad set of European banks for the period 1996–2002, our study first shows that banks expanding into non-interest income activities present higher risk and higher insolvency risk than banks which mainly supply loans. However, considering size effects and splitting non-interest activities into both trading activities and commission and fee activities we show that the positive link with risk is mostly accurate for small banks and essentially driven by commission and fee activities. A higher share of trading activities is never associated with higher risk and for small banks it implies, in some cases, lower asset and default risks.     

Reconsidering the natural rate hypothesis in a New Keynesian framework

This paper formulates a stylized New Keynesian model in which each individual firm can select the frequency of its price adjustments. The endogeneity of contract duration has a dramatic impact on the magnitude of the aggregate effects of steady-state inflation. With a plausible calibration of the magnitude of menu costs and other structural parameters, this model predicts a relationship between steady-state inflation and the frequency of price adjustment that is reasonably close to the empirical findings of cross-country studies. Furthermore, at moderate inflation rates, steady-state inflation generates relative price distortions that have a non-trivial impact on aggregate output, but this impact wanes and eventually disappears at much higher annual inflation rates because the frequency of price adjustment approaches that of the flexible-price economy.     

On the time-consistency of optimal capital taxes

This paper studies the time-inconsistency problem of optimal capital taxes. In the absence of full-commitment, it is well known that debt restructuring cannot solve the time-inconsistency problem for economies with a private stock of capital. We re-examine this result by exploring the role of institutional delays in government policies. We show that, when the implementation of government policy requires time, debt restructuring can enforce commitment to the optimal capital taxes. We conclude that, since institutional delays characterize democratic decision making, the time-inconsistency problem of capital taxes is not so severe.     

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.     

Bank panics and the endogeneity of central banking

Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets, so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with well-diversified big banks are less prone to inefficient bank runs because diversification alleviates the information asymmetry. In addition, big banks can self-monitor through publicly observable branch closure. Systems of many small banks form incentive-compatible bank coalitions to emulate the big banks during times of crisis. Such coalitions improve efficiency by monitoring member banks and issuing money that is a kind of deposit insurance—a precursor of central banking.     

Identifying the balance sheet and the lending channels of monetary transmission: A loan-level analysis

We make a novel attempt at comparing the strength of the lending and balance sheet channels of monetary transmission. To make this comparison, we use loan-level data to determine how borrower balance sheets and bank liquidity are related to bank lending decisions and how monetary policy can affect these relationships. The key innovation in this paper is the use of loan-level data. This enables us to measure the independent effects of the two channels and directly account for borrower balance sheets and lender liquidity instead of using proxies. Our results show that the balance sheet channel is the main mechanism through which monetary policy shocks are transmitted to the economy and that the lending channel does not play a significant role.     

A leisurely reading of the life-cycle consumption data

A puzzle in consumption theory is the observation of a hump in age-consumption profiles. This paper studies a general equilibrium life-cycle economy with capital in which households include both consumption and leisure in their period utility function. A calibrated version of the model shows that a significant hump in life-cycle consumption is a feature of the equilibrium. Thus inclusion of leisure in household preferences may provide part of the explanation of observed life-cycle consumption humps.     

A computational approach to the optimal structure of bank input prices

Most bank deposits contain an embedded option which permits the depositor to withdraw funds at will. Demand deposits generally allow costless withdrawal, while time deposits often require payment of an early withdrawal penalty. Managing the risk that depositors will exercise their withdrawal option is an important aspect of input pricing. This paper acknowledges the threat of deposit withdrawal and then solves for the optimal structure of bank deposit rates.     

Consolidation in banking and the lending channel of monetary transmission: Evidence from Asia and Latin America

This paper examines the relationship between increased consolidation in banking and monetary policy transmission in eighteen Asian and Latin American economies, using bank-level data from 1996 to 2006. Our results provide consistent evidence that as concentration in banking increases, the bank lending channel is weakened, leading the monetary policy transmission mechanism to be less effective. We also investigate how this relationship between concentration and the strength of the lending channel depends on bank-specific characteristics. Using bank-level balance sheet and income statement data allows us, first, to better identify the effects of banking consolidation on the supply-side bank lending channel from those of the demand-side interest rate channel, and second, to test for any systematic differences in the impact of consolidation on monetary policy transmission across banks of different size and financial strength. We also discuss potential explanations for and policy implications of the main findings of this paper.     

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.     

Consumption and risk sharing over the life cycle

A striking feature of U.S. data on income and consumption is that inequality increases with age. This paper asks if individual-specific earnings risk can provide a coherent explanation. We find that it can. We construct an overlapping generations general equilibrium model in which households face uninsurable earnings shocks over the course of their lifetimes. Earnings inequality is exogenous and is calibrated to match data from the U.S. Panel Study on Income Dynamics. Consumption inequality is endogenous and matches well data from the U.S. Consumer Expenditure Survey. The total risk households face is decomposed into that realized before entering the labor market and that realized throughout the working years. In welfare terms, the latter is found to be more important than the former.