Financial Markets,the Real Economy,and Self‐Fulfilling Uncertainties

We develop a model of informational interdependence between financial markets and the real economy, linking economic uncertainty to information production and aggregate economic activities in general equilibrium. The mutual learning between financial markets and the real economy creates a strategic complementarity in their information production, leading to self‐fulfilling surges in economic uncertainties. In a dynamic setting, our model characterizes self‐fulfilling uncertainty traps with two steady‐state equilibria and a two‐stage economic crisis in transitional dynamics.     

Moderate Inflation and the Deflation–Depression Link

Recent research has concluded that the historical evidence only provides weak support for the contention that deflation episodes are harmful to economic growth. In this paper, we revisit this relationship by allowing for inflation and growth to have a nonlinear specification dependent on inflation levels. In particular, we allow for the possibility that high inflation is negatively correlated with growth, while a positive relationship exists over the range of negative to moderate inflation. Our results confirm a positive relationship between inflation and growth at moderate inflation levels, and support the contention that the relationship between inflation and growth is nonlinear over the entire sample range.     

Optimal Regulation Under Uncertainty

This paper is concerned with the problem of price regulation when demand is uncertain. Uncertainty gives rise to substantial difficulties in determining both the return a firm's owners should be provided and a set of prices capable of producing that return. We argue that conventional approaches to price regulation are incapable of attaining the economically desirable objectives of efficiency and an equitable return to investors. The deficiencies in current practices are attributable to the separation of the risk measurement-return determination and price setting activities in the conventional approach. We present a model of the regulated firm that synthesizes contemporary financial market theory and the theory of the firm under uncertainty. ¹ 1 A recent paper by Baron 1 furnishes an excellent review of a host of diverse issues involving the behavior of the firm under uncertainty and the role of financial markets.
In our approach, the income stream produced by the firm is valued ex ante in the financial market according to investors' perceptions and preferences over riskreturn characteristics. We portray the firm as producing risk and return by choosing among available production technologies to maximize its market value, given the prices set by regulators. Within this framework, it is shown that regulators can choose the lowest prices consistent with an equitable return to investors. We also show that prices so chosen induce the choice of the optimal technology by the firm.     

Taxes,Default Risk,and Yield Spreads

This paper develops a model of bond prices and yield spreads that incorporates the effect of both taxes and differences in default probabilities. The tax loss consequences of default are recognized. Traditionally, tax-free (municipal) bond yields have been viewed as linearly related to taxable yields with a slope coefficient equal to one minus the tax rate and the intercept representing differences in default risk. While our model supports the linearity assumption, it implies that the slope and intercept are both functions of both the break-even tax rate and the default probability(ies). Clientele effects among both municipal and taxable bonds are demonstrated. Finally, the implied marginal tax rates and the implied default probabilities are estimated for different categories of municipal bonds.     

Asset Returns,Discount Rate Changes,and Market Efficiency

The primary purpose of this paper is to reconcile the previous findings of discount rate endogeneity with the presence of discount rate announcement effects in securities markets. The crux of this reconciliation is the distinction between “technical” discount rate changes that are endogenous and “nontechnical” changes which contain some informative policy implications. In essence, we attempt to separate expected discount rate changes from unexpected changes, or equivalently, the expected component of discount rate changes from the unexpected component. If markets are efficient, the former should have no announcement effects while the latter may be associated with an announcement effect. Accordingly, the focus of the empirical analysis is on the interaction between discount rate exogeneity, the specific monetary policy regime, and accouncement effects. In addition, we examine whether the behavior of these markets in the postannouncement period is consistent with the rapid price adjustment implied by market efficiency.