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.     

Orange County Bankruptcy: Financial Contagion in the Municipal Bond and Bank Equity Markets

We examine the spillover wealth effects of the Orange County, California bankruptcy announcement in December 1994 on municipal bonds, municipal bond funds, and bank stocks. This bankruptcy is prominent because of unprecedented losses and because it was caused by a highly leveraged derivatives strategy rather than a shortage of tax revenues and excess spending. We find contagion in the bond market with significantly negative abnormal returns for municipal bond funds without direct exposure to Orange County and for non‐Orange County municipal bonds. In addition, our findings suggest the contagion spills over to the common stocks of investment and commercial banks that deal in or use derivatives; however, the equities of banks unexposed to derivatives are not affected.     

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.     

Do homeowners achieve more household wealth in the long run?

Despite the public’s faith in homeownership as a vehicle for wealth creation, there are surprisingly few empirical studies of the independent impact of homeownership and its duration on household wealth accumulation. This paper provides the first empirical evidence that homeownership, after controlling for other drivers of wealth accumulation, is positively and significantly associated with wealth accumulation over time. Using the Panel Survey of Income Dynamics, it examines the influence of housing tenure choices between 1989 and 2001 on household net wealth levels in 2001 after controlling for initial wealth in 1989, location, income, education, and other family and personal characteristics that might influence the rate of wealth accumulation. Importantly, the models used also control for the tendency of households to accumulate wealth between 1984 and 1989 (five years prior to the studied period). This approach is used to address the possibility that an unobserved variable—the propensity to save or accumulate wealth—may be associated with both the probability and duration of homeownership and the rate of wealth accumulation. All else equal, those who owned homes and owned for longer periods of time had significantly higher household net wealth by 2001. These results are compelling because house price appreciation over the period was near its long-run average while stock gains were above and real rent increases below their long-run averages. Hence, the findings are suggestive of a positive influence of ownership over long periods on net wealth, even during a period when alternative investments produced higher than normal returns and rents grew slowly. This is especially important because the overwhelmingly majority of households do not sell their homes shortly after buying them. In our sample, those who became owners typically owned for 7 years. Furthermore, most households that bought during a period of declining real home values in the early 1990s continued to own their homes for at least eight years and came out well ahead of those who did not own.