What do interest rates reveal about the functioning of real business cycle models?

This paper begins by documenting the extent to which the predictions of standard Real Business Cycle (RBC) models are incompatible with observed movements in real interest rates. The main finding of the paper is that extending the baseline model to include habit persistence in consumption and adjustment costs to capital significantly improves the model's empirical performance. In our evaluation of the model's performance, we take special care of estimating and testing predictions of the model using both moments drawn directly from the data and moments calculated after identifying shocks to the stochastic trend.     

Inflation,interest and exchange rates in the transition1

Central and Eastern European economies have made extraordinary progress in their trade and exchange regimes. Surprisingly, instant convertibility was established for a great variety of exchange rate regimes. In spite of diversity, all these countries have followed a common pattern: severe initial undervaluation - the cost of speed and unrestricted trade - followed by rapid real revaluation and incipient protectionism. Since 1994 in many cases an embarrass de richesse has appeared: high capital inflows which are either inflationary or costly to sterilize. A major cause of these flows - or at any rate of the high cost of sterilization - is the presence of significant interest rate differentials higher than required to cover the risk of devaluation. These are the necessary consequence of a policy of positive real interest rates and of real revaluation from excessively undervalued exchange rates. Lower interest rates are recommended, both to stem financial capital inflows and to reduce the cost of their sterilization.     

Do high interest rates defend currencies during speculative attacks?

Do high interest rates defend currencies during speculative attacks? Or do they have the perverse effect of increasing the probability of a devaluation of the currency under attack? Drawing on evidence from a large sample of speculative attacks in developed and developing economies, this paper argues that the answer to both questions is ‘no’. In particular, this paper documents a striking lack of any systematic association whatsoever between interest rates and the outcome of speculative attacks. The lack of clear empirical evidence on the effects of high interest rates during speculative attacks mirrors the theoretical ambiguities on this issue.     

Real exchange rate targeting and macroeconomic instability

Using an optimizing model of a small open economy, this paper studies the macroeconomic effects of PPP rules whereby the government increases the devaluation rate when the real exchange rate—defined as the price of tradables in terms of nontradables—is below its long-run level and reduces the devaluation rate when the real exchange rate is above its long-run level. The paper shows that the mere existence of such a rule can generate aggregate instability due to self-fulfilling expectations. The result is shown to obtain in both flexible- and sluggish-price environments.     

Generalizations of Ho–Lee’s binomial interest rate model I: from one- to multi-factor

In this paper a multi-factor generalization of Ho–Lee model is proposed. In sharp contrast to the classical Ho–Lee, this generalization allows for those movements other than parallel shifts, while it still is described by a recombining tree, and is a process with stationary independent increments to be compatible with principal component analysis. Based on the model, generalizations of duration-based hedging are proposed. A continuous-time limit of the model is also discussed. This research was supported by Open Research Center Project for Private Universities: matching fund subsidy from MEXT, 2004–2008 and also by Grants-in-Aids for Scientific Research (No. 18540146) from the Japan Society for Promotion of Sciences.     

Sources of Bank Interest Rate Risk

We investigate bank stocks'sensitivity to changes in interest rates and the factors affecting this sensitivity. We focus on whether the exposure of commercial banks to interest rate risk is conditioned on certain balance sheet and income statement ratios. We find a significantly negative relation between bank stock returns and changes in interest rates over the period 1991–1996. We also find that bank characteristics measured from basic financial statement information explain bank stocks'sensitivity to interest rate changes. These results suggest that bank managers, analysts, and regulators can use this information to assess the relative risk exposure of banks.     

Price Rigidity and the Selection of the Exchange Rate Regime

We evaluate and qualify Friedman's, 1953, “case for flexible exchange rates” in the presence of sticky prices in a two country model. We find that a flexible regime performs indeed better when the degree of nominal price rigidity is high while a bilateral peg does better when prices are fairly flexible. This result obtains independent of whether monetary policy is activistic or not and is mostly due to the negative relationship between employment and productivity shocks when prices are relatively sluggish (Gali, 1999). A unilateral peg tends to produce the lowest level of world welfare but it sometimes represents the best monetary arrangement for the pegger. JEL Classification Numbers: E32, E52, F33, F42     

Likelihood-based specification analysis of continuous-time models of the short-term interest rate

An extensive collection of continuous-time models of the short-term interest rate is evaluated over data sets that have appeared previously in the literature. The analysis, which uses the simulated maximum likelihood procedure proposed by Durham and Gallant (2002), provides new insights regarding several previously unresolved questions. For single factor models, I find that the volatility, not the drift, is the critical component in model specification. Allowing for additional flexibility beyond a constant term in the drift provides negligible benefit. While constant drift would appear to imply that the short rate is nonstationary, in fact, stationarity is volatility-induced. The simple constant elasticity of volatility model fits weekly observations of the three-month Treasury bill rate remarkably well but is easily rejected when compared with more flexible volatility specifications over daily data. The methodology of Durham and Gallant can also be used to estimate stochastic volatility models. While adding the latent volatility component provides a large improvement in the likelihood for the physical process, it does little to improve bond-pricing performance.     

A Critical Look at SFAS 34: Capitalization of Interest Cost

In 1974, the Securities and Exchange Commission (SEC) noted that an increasing number of companies were capitalizing interest costs, and that this practice was not being adequately disclosed (FASB, 1979, par. 26). In light of the alternative practices concerning the accounting for interest and lack of adequate disclosure by companies that were already capitalizing interest, the SEC recommended that the Financial Accounting Standards Board (FASB) consider the issue of accounting for interest cost. As a result of the SEC's initiative, in 1979 the FASB issued Statement of Financial Accounting Standards [SFAS] No. 34, Capitalization of Interest Cost, which mandated uniform interest capitalization rules in accounting for interest costs associated with the acquisition of qualifying non-current assets. The purpose of this article is to examine SFAS 34 in terms of its financial statement impact, the congruence of its assumptions with economic behaviour, its effect on subsequent standards related to interest capitalization, and its implications on financial accounting standard setting. To explore these issues we first illustrate the extent to which interest capitalization affects financial statements. We then empirically analyse the measure employed in SFAS 34 for the capitalization of interest cost in cases where debt is not directly linked with the acquisition of qualifying non-current assets. In addition, we critically examine the treatment accorded interest cost in subsequent FASB standards. Our research suggests that SFAS 34′s rationale for interest capitalization is incompatible with firm behaviour, and that the rules for interest capitalization as reflected in various accounting standards are inconsistent. These findings suggest that in the case of interest capitalization the benefits of comparability in financial reporting are not realized. A policy recommendation is then offered to alleviate some of these difficulties. The recommendation is to disallow the capitalization of interest cost in the absence of a direct link between the debt and the acquisition of qualifying assets.