Cardiff Economics Working Papers

ISSN 1749-6101

The Economics section contributes to the Cardiff Economics Working Paper series. The series is archived at RePEc, IDEAS and EconPapers. The series abstracts can be searched via IDEAS. Click here to see this information with the abstracts displayed.

Please send any enquiries about the Cardiff Economics Working Papers series to EconWP@Cardiff.ac.uk. Members of Cardiff Business School Economics Section should register with RePEc at http://authors.repec.org/new-user and submit working papers to EconWP@Cardiff.ac.uk

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E2014/12

Yan Yang and Laurence Copeland (July 2014)
The Effects of Sentiment on Market Return and Volatility and The Cross-Sectional Risk Premium of Sentiment-affected Volatility (1095K, 33 pages)
We construct investor sentiment of UK stock market using the procedure of principal component analysis. Using sentiment-augmented EGARCH component model, we analyse the impacts of sentiment on market excess return, the permanent component of market volatility and the transitory component of market volatility. Bullish sentiment leads to higher market excess return while bearish sentiment leads to lower excess return. Sentiment-augmented EGARCH component model compares favourably to the original EGARCH component model which does not take investor sentiment into account. Furthermore, we test the cross-sectional risk premia of the permanent and transitory components of sentiment-affected volatility in the framework of ICAPM.
Keywords: investor sentiment; principal component analysis; EGARCH component model; ICAPM; cross-sectional risk premium
JEL Classification: G12; G15

E2014/11

Patrick Minford, Yongden Xu and Peng Zhou (July 2014)
How good are out of sample forecasting Tests on DSGE models? (373K, 24 pages)
Out-of-sample forecasting tests of DSGE models against time-series benchmarks such as an unrestricted VAR are increasingly used to check a) the specification b) the forecasting capacity of these models. We carry out a Monte Carlo experiment on a widely-used DSGE model to investigate the power of these tests. We find that in specification testing they have weak power relative to an in-sample indirect inference test; this implies that a DSGE model may be badly mis-specified and still improve forecasts from an unrestricted VAR. In testing forecasting capacity they also have quite weak power, particularly on the lefthand tail. By contrast a model that passes an indirect inference test of specification will almost definitely also improve on VAR forecasts.
Keywords: Out of sample forecasts; DSGE; VAR; specification tests; indirect inference; forecast performance
JEL Classification: E10; E17

E2014/10

Samuli Leppälä (July 2014)
Theoretical Perspectives on Localised Knowledge Spillovers and Agglomeration (401K, 17 pages)
There is substantial empirical evidence that innovation is geographically concentrated. Unlike what is generally assumed, however, it is not clear that localised knowledge spillovers provide a theoretically valid explanation for this. Studying spillovers of cost-reducing technology between Cournot oligopolists we show that 1) localised knowledge spillovers of any level do encourage agglomeration, but 2) whether this leads to higher levels of effective R&D depends on the type and level of knowledge spillovers, the number of firms, and the industry's R&D efficiency.
Keywords: knowledge spillovers; agglomeration economies; innovation; location
JEL Classification: O33; R32; L13

E2014/9

Iain W. Long and Vito Polito (July 2014)
Unemployment, Crime and Social Insurance (677K, 38 pages)
We study an individual's incentive to search for a job in the presence of random criminal opportunities. These opportunities extenuate moral hazard, as the individual sometimes commits crime rather than searching. Even when he searches, he applies less effort. We then revisit the design of optimal unemployment insurance in this environment. If the individual is more likely to remain unemployed and unpunished when he commits crime than when he searches for a job (as suggested by empirical studies), declining unemployment benefits reduce the payoff from crime relative to that from searching. Compared to the canonical models of optimal unemployment insurance, this provides a further incentive to reduce benefits over time.
Keywords: Unemployment insurance; Moral hazard; Crime; Recursive contracts
JEL Classification: C61; D82; H55; J65; K42

E2014/8

Iain W. Long (July 2014)
The Storm Before the Calm? Adverse Effects of Tackling Organised Crime (497K, 30 pages)
Policies targeted at high-crime neighbourhoods may have unintended consequences in the presence of organised crime. Whilst they reduce the incentive to commit crime at the margin, those who still choose to join the criminal organisation are hardened criminals. Large organisations take advantage of this, substituting away from membership size towards increased individual criminal activity. Aggregate crime may rise. However, as more would-be recruits move into the formal labour market, falling revenue causes a reversal of this effect. Thereafter, the policy reduces both size and individual activity simultaneously.
Keywords: Organised crime; crime policy; occupational choice
JEL Classification: D82; J24; J28; K42; L21

E2014/7

Huw David Dixon, Kul B Luintel and Kun Tian (June 2014)
The impact of the 2008 crisis on UK prices: what we can learn from the CPI microdata (967K, 76 pages)
This paper takes the locally collected price-quotes used to construct the CPI index in the UK for the period 1996-2013 to explore the impact of the crisis on the pricing behavior of firms. We develop a time-series framework which is able to capture the link between macro- economic variables (in?ation and output) and the behavior of prices in terms of the frequency of price change, the dispersion of price levels and the dispersion of price-growth. Whilst these effects are present, they are small and do not have significant effects for monetary policy.
Keywords: Price-spell; steady state; duration
JEL Classification: E50

E2014/6

James Foreman-Peck and Peng Zhou (June 2014)
Firm-Level Evidence for the Language Investment Effect on SME Exporters (789K, 38 pages)
Both analysis of international trade and the knowledge resource theory of the firm imply that language skills should play a vital role in exporting. This may be apparent to large multinationals with sites in many different linguistic locations, but we show it is less obvious to smaller companies. With data on the language used by each of a large sample of European small and medium sized enterprises in their export markets we test and estimate the effects of language assets on language performance in export markets and on export sales. Controlling for the possibility that language skills may be acquired by exporting, we find a very substantial export return to linguistic expertise, indicative of unexploited gains from investment in languages. There is also evidence of greater under-investment in language skills in English-speaking Europe, which we show can be a prediction of Konya’s (2006) trade model.
Keywords: Internationalisation; language skills; SMEs
JEL Classification: D22; F13; H52; R42

E2014/5

Jesus Lopez-Rodriguez and Diego Martinez (June 2014)
Looking beyond the R&D effects on innovation: The contribution of non-R&D activities to total factor productivity growth in the EU (272K, 29 pages)
Although non-R&D innovation activities account for a significant portion of innovation efforts carried out across very heterogeneous economies in Europe, how to incorporate them in to economic models is not always straightforward. For instance, the traditional macro approach to estimating the determinants of total factor productivity (TFP) does not handle them well. To counter these problems, this paper proposes applying an augmented macro-theoretical model to estimate the determinants of TFP by jointly considering the effects of R&D and the impact of non-R&D innovation activities on the productivity levels of firms. Estimations from a model of a sample of EU-26 countries covering the period 2004-2008 show that the distinction between R&D and non-R&D effects is significant for a number of different issues. First, the results show a sizeable impact on TFP growth, as the impact of R&D is twice that of non-R&D. Second, absorptive capacity is only linked to R&D endowments. And third, the two types of endowments cannot strictly been seen as complementary, at least for the case of countries with high R&D intensities or high non-R&D intensities.
Keywords: TFP; R&D; non-R&D expenditures; EU countries
JEL Classification: O0; O3; O4

E2014/4

Li Dai, Patrick Minford and Peng Zhou (May 2014)
A DSGE Model of China (743K, 32 pages)
We use available methods for testing macro models to evaluate a model of China over the period from Deng Xiaoping’s reforms up until the crisis period. Bayesian ranking methods are heavily influenced by controversial priors on the degree of price/wage rigidity. When the overall models are tested by Likelihood or Indirect Inference methods, the New Keynesian model is rejected in favour of one with a fair-sized competitive product market sector. This model behaves quite a lot more ‘flexibly’ than the New Keynesian.
Keywords: China; DSGE; Bayesian Inference; Indirect Inference
JEL Classification: C11; C15; C18; E27

E2014/3

James Foreman-Peck and Peng Zhou (April 2014)
The Rise of the English Economy 1300-1900: A Lasting Response to Demographic Shocks (2156K, 39 pages)
We construct a Dynamic Stochastic General Equilibrium model of the interaction between demography and the economy for six centuries of English history. At the core of the four overlapping generations, rational expectations model is household choice about target number and quality of children, as well as female age at first marriage. The parameters are formally estimated rather than calibrated. Data on births, deaths, population and the real wage, and data moments can be closely matched by the estimated model. We show that the marriage age rises to reach that typical of the Western European Marriage Pattern at the end of the high mortality epoch of the 14th century. Higher marriage age lowers costs of child quality so that human capital gradually accumulates over the generations. But it does so more slowly than that of population initially, so that there is a negative correlation between population and wage. Ultimately the growth of human capital catches up with that of population and triggers a break out from the Malthusian equilibrium at the end of the 18th century. Without the contribution of late female age to human capital, human capital would have been about 20% of what it actually was around 1800, and real wages would only have attained about half their actual value.
Keywords: Economic development; Demography; DGSE model; English economy
JEL Classification: O11; J11; N13

E2014/2

Charlotte Pointon and Kent Matthews (April 2014)
Dynamic Efficiency in the English and Welsh Water and Sewerage Industry (964K, 30 pages)
The English and Welsh water and sewerage industry is characterised by indivisible capital which has a long service life. Previous studies of efficiency of the English and Welsh water and sewerage industry take a static framework, assuming all inputs can be adjusted instantaneously. This paper measures efficiency dynamically by incorporating intertemporal links of capital within the production function for the English and Welsh water and sewerage industry for the period 1996-2011. Dynamic DEA considers capital as a quasi-fixed input and is modelled as a contemporaneous output into current production and an input from past production. The results show that the inadequate intertemporal allocation of quasi-fixed inputs is the largest contributor of inefficiency and the ignorance of intertemporal effects leads to an over-estimation of allocative inefficiency.
Keywords: Dynamic efficiency; water and sewage industry; DEA; intertemporal allocation
JEL Classification: D24; L23; L31

E2014/1

James Foreman-Peck and Peng Zhou (January 2014)
Cultures of Female Entrepreneurship (995K, 30 pages)
The present research shows how entrepreneurial culture contributes to the widely noted difference in entrepreneurial propensities between men and women. The consequences of the assumed differential importance of household and family generate testable hypotheses about the gender effects of entrepreneurial culture. The principal hypothesis is that there is a greater chance of females in ‘unentrepreneurial’ cultures being relatively entrepreneurial compared to males. Also women from different entrepreneurial cultures show greater similarity of behaviour (lower variance) than men. But proportionate gender gaps within entrepreneurial cultures are less than those between males of different cultures. These hypotheses are tested on US immigrant data from the 2000 census and are not rejected.
Keywords: Entrepreneurship; Culture; Gender; Migrants
JEL Classification: D01; J15; J23; J61; J16

E2013/14

Michael C. Hatcher and Patrick Minford (December 2013)
Stabilization policy, rational expectations and price-level versus inflation targeting: a survey (450K, 37 pages)
We survey recent literature comparing inflation targeting (IT) and price-level targeting (PT) as macroeconomic stabilization policies. Our focus is on New Keynesian models and areas which have seen significant developments since Ambler’s (2009) survey: the zero lower bound on nominal interest rates; financial frictions; and optimal monetary policy. Ambler’s main conclusion that PT improves the inflation-output volatility trade-off in New Keynesian models is reasonably robust to these extensions, several of which are attempts to address issues raised by the recent financial crisis. The beneficial effects of PT therefore appear to hang on the joint assumption that agents are rational and the economy New Keynesian. Accordingly, we discuss recent experimental and survey evidence on whether expectations are rational, as well as the applied macro literature on the empirical performance of New Keynesian models. In addition, we discuss a more recent strand of applied literature that has formally tested New Keynesian models with rational expectations. Overall the evidence is not conclusive, but we note that New Keynesian models are able to match a number of dynamic features in the data and that behavioural models of the macroeconomy are outperformed by those with rational expectations in formal statistical tests. Accordingly, we argue that policymakers should continue to pay attention to PT.
JEL Classification: E52

E2013/13

Lorant Kaszab and Ales Marsal (November 2013)
Fiscal Policy and the Nominal Term Premium (299K, 14 pages)
Distortionary income taxation in a standard New Keynesian model substantially increases the nominal term-premium on long-term bonds relative to a model with lumpsum taxes. Also the empirical level of the nominal term premium can be matched with lower risk-aversion coefficient in case of a model with income taxes relative to a model with long-run inflation risks.
Keywords: zero-coupon bond; nominal term premium; third-order approximation; distortionary income taxation
JEL Classification: E13; E31; E43; E44; E62

E2013/12

Jingwen Fan, Patrick Minford and Zhirong Ou (November 2013)
The Fiscal Theory of the Price Level - identification and testing for the UK in the 1970s (575K, 33 pages)
We investigate whether the Fiscal Theory of the Price Level (FTPL) can explain UK inflation in the 1970s. We confront the identification problem involved by setting up the FTPL as a structural model for the episode and pitting it against an alternative Orthodox model; the models have a reduced form that is common in form but, because each model is over-identified, numerically distinct. We use indirect inference to test which model could be generating the VECM approximation to the reduced form that we estimate on the data for the episode. Neither model is rejected, though the Orthodox model outperforms the FTPL. But the best account of the period assumes that expectations were a probability-weighted combination of the two regimes.
Keywords: UK Inflation; Fiscal Theory of the Price Level; Identification; Testing; Indirect inference
JEL Classification: E31; E37; E62; E65

E2013/11

Laurence Copeland and Wenna Lu (November 2013, updated December 2013)
Dodging the Steamroller: Fundamentals versus the Carry Trade (675K, 41 pages)
Although, according to uncovered interest rate parity, exchange rates should move so as to prevent the carry trade being systematically profitable, there is a vast empirical literature demonstrating the opposite. High interest currencies more often tend to appreciate rather than depreciate, as noted by Fama (1983). In this paper, we treat volatility as the critical state variable and show that positive returns to the carry trade are overwhelmingly generated in the low-volatility "normal" state, whereas the high-volatility state is associated with lower returns or with losses as currencies revert to the long run level approximated by their mean real exchange rate – in other words, purchasing-power parity (PPP) tends to reassert itself, at least to some extent, during periods of turbulence. We confirm these results by comparing the returns from three possible monthly trading strategies: the carry trade, a strategy which is long the undervalued and short the overvalued currencies (the "fundamental" strategy) and a mixed strategy which involves switching from carry trade to fundamentals whenever volatility is in the top quartile. The mixed strategy generates positive returns greater than for either of the pure strategies.
Keywords: carry trade; trading strategies; currency portfolios
JEL Classification: F3; G21; G15

E2013/10

Iain W. Long (October 2013)
Recruitment to Organised Crime (697K, 41 pages)
Organised crime is unique within the underground economy. Unlike individual criminals, criminal organisations can substitute between a variety of inputs; chiefly labour and effort. This paper considers the effect of several popular anti-crime policies in such an environment. Using a profit maximisation framework, I find that certain policies may cause the organisation to reduce its membership in favour of more intensive activity. Others may lead to increases in membership. Consequently, policies designed to reduce the social loss suffered as a result of criminal activities may actually increase it. Results prove robust to differences in hiring practices on the part of the criminal organisation.
Keywords: Organised crime; Crime policy; Occupational choice
JEL Classification: J24; J28; K42

E2013/9

David R. Collie and George Norman (September 2013)
Partial Collusion and Foreign Direct Investment (950K, 25 pages)
We show that the static duopoly model in which firms choose between exporting and foreign direct investment is often a prisoners' dilemma game in which a switch from exporting to foreign direct investment reduces profits. By contrast, we show that when the game is repeated there is a range of parameters for which the firms can partially collude by choosing to export rather than invest. In this range, a reduction in export costs may undermine the partial collusion, causing a switch from export to investment.
Keywords: Foreign Direct Investment; Trade Liberalization; Partial Collusion
JEL Classification: F12; F13; F23

E2013/8

Vo Phuong Mai Le and David Meenagh (June 2013)
Testing and Estimating Models Using Indirect Inference (278K, 4 pages)
In this short article we explain how to test an economic model using Indirect Inference. We then go on to show how you can use this test to estimate the model.
JEL Classification: C01; C13; C52; E27

E2013/7

Yongdeng Xu (April 2013)
The dynamics of trading duration, volume and price volatility – a vector MEM model (4269K, 41 pages)
We propose a general form of vector Multiplicative Error Model (MEM) for the dynamics of duration, volume and price volatility. The vector MEM relaxes the two restrictions often imposed by previous empirical work in market microstructure research, by allowing interdependence among the variables and relaxing weak exogeneity restrictions. We further propose a multivariate lognormal distribution for the vector MEM. The model is applied to the trade and quote data from the New York Stock Exchange (NYSE). The empirical results show that the vector MEM captures the dynamics of the trivariate system successfully. We find that times of greater activity or trades with larger size coincide with a higher number of informed traders present in the market. But we highlight that it is unexpected component of trading duration or trading volume that carry the information content. Moreover, our empirical results also suggest a significant feedback effect from price process to trading intensity, while the persistent quote changes and transient quote changes affect trading intensity in different direction, confirming Hasbrouck (1988,1991).
Keywords: Vector MEM; ACD; GARCH; intraday trading process; duration; volume; volatility
JEL Classification: C15; C32; C52

E2013/6

Yongdeng Xu (April 2013)
Weak exogeneity in the financial point processes (535K, 33 pages)
This paper analyses issues related to weak exogeneity in a financial point process. We extend the Hausman test of weak exogeneity in a time series model and propose three cases in which weak exogeneity conditions will break down. The simulation study suggested that a failure of the exogeneity assumption implied biased estimators. The bias is very large in the third case non-weak exogeneity, which makes the econometric inferences on the parameters unreliable or even misleading. We then derive an LM test for weak exogeneity. The LM test is attractive because it only requires estimation of the restricted model. The empirical results indicate that the weak exogneity of duration is often rejected for frequently traded stocks, but is less likely to be rejected for infrequently traded stocks.
Keywords: Weak exogeneity; ACD model; LM test; point process; market microstructure

E2013/5

Vo Phuong Mai Le, Kent Matthews, David Meenagh, Patrick Minford and Zhigui Xiao (April 2013)
Banking and the Macroeconomy in China: A Banking Crisis Deferred? (656K, 34 pages)
The downturn in the world economy following the global banking crisis has left the Chinese economy relatively unscathed. This paper develops a model of the Chinese economy using a DSGE framework with a banking sector to shed light on this episode. It differs from other applications in the use of indirect inference procedure to test the ?tted model. The model finds that the main shocks hitting China in the crisis were international and that domestic banking shocks were unimportant. However, directed bank lending and direct government spending was used to supplement monetary policy to aggressively offset shocks to demand. The model finds that government expenditure feedback reduces the frequency of a business cycle crisis but that any feedback effect on investment creates excess capacity and instability in output.
Keywords: DSGE model; Financial Frictions; China; Crises; Indirect Inference
JEL Classification: E3; E44; E52; C1

E2013/4

Vo Phuong Mai Le, Patrick Minford and Michael Wickens (March 2013)
A Monte Carlo procedure for checking identification in DSGE models (413K, 20 pages)
We propose a numerical method, based on indirect inference, for checking the identification of a DSGE model. Monte Carlo samples are generated from the model's true structural parameters and a VAR approximation to the reduced form estimated for each sample. We then search for a different set of structural parameters that could potentially also generate these VAR parameters. If we can find such a set, the model is not identified.
Keywords: Identification; DSGE model; Monte Carlo; Indirect Inference
JEL Classification: C13; C51; C52; E32

E2013/3

Vo Phuong Mai Le, David Meenagh, Patrick Minford and Zhirong Ou (March 2013, updated May 2013)
What causes banking crises? An empirical investigation for the world economy (1244K, 35 pages)
We add the Bernanke-Gertler-Gilchrist model to a world model consisting of the US, the Eurozone and the Rest of the World in order to explore the causes of the banking crisis. We test the model against linear-detrended data and reestimate it by indirect inference; the resulting model passes the Wald test only on outputs in the two countries. We then extract the model's implied residuals on unfiltered data to replicate how the model predicts the crisis. Banking shocks worsen the crisis but 'traditional' shocks explain the bulk of the crisis; the non-stationarity of the productivity shocks plays a key role. Crises occur when there is a 'run' of bad shocks; based on this sample Great Recessions occur on average once every quarter century. Financial shocks on their own, even when extreme, do not cause crises - provided the government acts swiftly to counteract such a shock as happened in this sample.
Keywords: DSGE model; Financial Frictions; China; Crises; Indirect Inference
JEL Classification: E3; E44; E52; C1

E2013/2

Samuli Leppälä (February 2013)
Arrow's paradox and markets for nonproprietary information (1413K, 27 pages)
Arrow's information paradox asserts that demand for undisclosed information is undefined. Reassessing the paradox, I argue that the value of information for the buyer depends on its relevance, which can be known ex ante, and the uncertainty shifts to the capability of the seller to acquire the knowledge and her reliability in disclosing it. These three together form the buyer’s reservation price. Consequently, differences in capability and reliability between the sellers may revoke the appropriation problem of nonproprietary information, where the original source loses her monopoly after the first purchase.
Keywords: Arrow’s information paradox; markets for information; knowledge; reliability; appropriability
JEL Classification: D83; L15; O31; O34

E2013/1

Huw David Dixon and Kun Tian (January 2013)
What we can learn about the behavior of firms from the average monthly frequency of price-changes: an application to the UK CPI data. (814K, 46 pages)
The monthly frequency of price-changes is a prominent feature of many studies of the CPI micro-data. In this paper, we see how much this ties down the behavior of price-setters ("firms") in steady-state in terms of the average length of price-spells across firms. We are able to divide an upper and lower bound for the mean duration of price-spells averaged across firms. We use the UK CPI data at the aggregate and sectoral level and find that the actual mean is about twice the theoretical minimum consistent with the observed frequency. We estimate the distribution using the hazard function and find that although the estimated hazard differs significantly from the Calvo distribution, the means and medians are similar. However, despite the micro differences, we find that the artificial Calvo distributions generated using the sectoral frequencies result in very similar impulse responses to the estimated hazards when used in the Smets-Wouters (2003) model.
Keywords: Price-spell; steady state; duration
JEL Classification: E50

E2012/23

Paulo Brito, Bipasa Datta and Huw David Dixon (December 2012)
The evolution of mixed conjectures in the rent-extraction game (4603K, 54 pages)
This paper adopts an evolutionary perspective on the rent-extraction model with conjectural variations (CV). We analyze the global dynamics of the model with three CVs under the replicator equation. We find that the end points of the evolutionary dynamics include the pure-strategy consistent CVs. However, there are also mixed-strategy equilibria that occur. These are on the boundaries between the basins of attraction of the pure-strategy sinks. We develop a more general notion of consistency which applies to mixed-strategy equilibria. In a three conjecture example, we find that in contrast to the pure-strategy equilibria, the mixed-strategy equilibria are not ESS: under the replicator dynamics, there are three or four mixed equilibria that may either be totally unstable, or saddle-stable. There also exist heteroclinic orbits that link equilibria together.
Keywords: Rent-extraction; evolutionary dynamics; consistent conjectures; global dynamics; mixed-strategy
JEL Classification: D03; L15; H0

E2012/22

Chunping Liu and Patrick Minford (August 2012, updated December 2013)
How important is the credit channel? An empirical study of the US banking crisis (1169K, 32 pages)
We examine whether by adding a credit channel to the standard New Keynesian model we can account better for the behaviour of US macroeconomic data up to and including the banking crisis. We use the method of indirect inference which evaluates statistically how far a model's simulated behaviour mimics the behaviour of the data. We find that the model with credit dominates the standard model by a substantial margin. Credit shocks are the main contributor to the variation in the output gap during the crisis.
Keywords: financial frictions; credit channel; bank crisis; indirect inference
JEL Classification: C12; C52; E12; G01; G1

E2012/21

Chunping Liu and Patrick Minford (August 2012)
Comparing behavioural and rational expectations for the US post-war economy (1059K, 19 pages)
The banking crisis has caused a resurgence of interest in behavioural models of expectations in macroeconomics. Here we evaluate behavioural and rational expectations econometrically in a New Keynesian framework, using US post-war data and the method of indirect inference. We find that after full re-estimation the model with behavioural expectations is strongly rejected by the data, whereas the standard rational expectations version passes the tests by a substantial margin.
Keywords: behavioural expectation; rational expectation; bank crisis; indirect inference

E2012/20

Ceri Davies, Max Gillman and Michal Kejak (August 2012)
Deriving the Taylor Principle when the Central Bank Supplies Money (1176K, 36 pages)
The paper presents a human-capital-based endogenous growth, cash-in-advance economy with endogenous velocity where exchange credit is produced in a decentralized banking sector, and money is supplied stochastically by the central bank. From this it derives an exact functional form for a general equilibrium “Taylor rule”. The inflation coefficient is always greater than one when the velocity of money exceeds one; velocity growth enters the equilibrium condition as a separate variable. The paper then successfully estimates the magnitude of the coefficient on inflation from 1000 samples of Monte Carlo simulated data. This shows that it would be spurious to conclude that the central bank has a reaction function with a strong response to inflation in a ‘Taylor principle’ sense, since it is only meeting fiscal needs through the inflation tax. The paper also estimates several deliberately misspecified models to show how an inflation coefficient of less than one can result from model misspecification. An inflation coefficient greater than one holds theoretically along the balanced growth path equilibrium, making it a sharply robust principle based on the economy’s underlying structural parameters.
Keywords: Taylor rule; velocity; forward-looking; misspecification bias
JEL Classification: E13; E31; E43; E52

E2012/19

Panagiotis Tziogkidis (August 2012, updated November 2012)
The Simar and Wilson’s Bootstrap DEA approach: a critique
This paper has been removed for revision
JEL Classification: C14; C15; C61; C67

E2012/18

Panagiotis Tziogkidis (August 2012)
Bootstrap DEA and Hypothesis Testing
This paper has been removed for revision
Keywords: Data Envelopment Analysis; Efficiency; Bootstrap; Bootstrap DEA; Hypothesis Testing
JEL Classification: C12; C14; C15; C61; C67

E2012/17

David Meenagh, Patrick Minford and Michael Wickens (July 2012)
Testing macroeconomic models by indirect inference on unfiltered data (1238K, 22 pages)
We extend the method of indirect inference testing to data that is not filtered and so may be non-stationary. We apply the method to an open economy real business cycle model on UK data. We review the method using a Monte Carlo experiment and find that it performs accurately and has good power.
Keywords: Bootstrap; DSGE; VECM; indirect inference; Monte Carlo
JEL Classification: C12; C32; C52; E1

E2012/16

Patrick Minford and Naveen Srinivasan (July 2012)
Can the learnability criterion ensure determinacy in New Keynesian Models? (1058K, 16 pages)
Forward-looking RE models such as the popular New Keynesian (NK) model do not provide a unique prediction about how the model economy behaves. We need some mechanism that ensures determinacy. McCallum (2011) says it is not needed because models are learnable only with the determinate solution and so the NK model, once learnt in this way, will be determinate. We agree: the only learnable solution that has agents converge on the true NK model is the bubble-free one. But once they have converged they must then understand the model and its full solution therefore including the bubble. Hence the learnability criterion still fails to pick a unique RE solution in NK models.
Keywords: New-Keynesian; Taylor Rule; Determinacy; E-stability; Learnability
JEL Classification: C62; D84

E2012/15

Vo Phuong Mai Le, David Meenagh, Patrick Minford and Michael Wickens (June 2012)
Testing DSGE models by Indirect inference and other methods: some Monte Carlo experiments (1387K, 35 pages)
Using Monte Carlo experiments, we examine the performance of Indirect Inference tests of DSGE models, usually versions of the Smets-Wouters New Keynesian model of the US postwar period. We compare these with tests based on direct inference (using the Likelihood Ratio), and on the Del Negro–Schorfheide DSGE–VAR weight. We ?nd that the power of all three tests is substantial so that a false model will tend to be rejected by all three; but that the power of the indirect inference tests are by far the greatest, necessitating re-estimation by indirect inference to ensure that the model is tested in its fullest sense.
Keywords: Bootstrap; DSGE; New Keynesian; New Classical; indirect inference; Wald statistic; likelihood ratio; DSGE-VAR weight
JEL Classification: C12; C32; C52; E1

E2012/14

Vo Phuong Mai Le, David Meenagh and Patrick Minford (June 2012, updated April 2013)
What causes banking crises? An empirical investigation (508K, 31 pages)
We add the Bernanke-Gertler-Gilchrist model to a modified version of the Smets-Wouters model of the US in order to explore the causes of the banking crisis. We test the model against the data on HP-detrended data and reestimate it by indirect inference; the resulting model passes the Wald test on output, inflation and interest rates. We then extract the model’s implied residuals on US unfiltered data since 1984 to replicate how the model predicts the crisis. The main banking shock tracks the unfolding ‘sub-prime’ shock, which appears to have been authored mainly by US government intervention. This shock worsens the banking crisis but ‘traditional’ shocks explain the bulk of the crisis; the non-stationarity of the productivity shock plays a key role. Crises occur when there is a ‘run’ of bad shocks; based on this sample they occur on average once every 40 years and when they occur around half are accompanied by financial crisis. Financial shocks on their own, even when extreme, do not cause crises — provided the government acts swiftly to counteract such a shock as happened in this sample.
Keywords: DSGE; Banking; Crisis; Bootstrap
JEL Classification: C32; C52; E1

E2012/13

Lorant Kaszab (June 2012, updated April 2013)
Rule-of-Thumb Consumers and Labor Tax Cut Policy in the Zero Lower Bound (523K, 29 pages)
This paper finds that labor tax cut can be an effective policy tool to mitigate the negative effects of a shock that made the zero lower bound on the nominal interest rate binding if the economy features rule-of-thumb households (besides Ricardian ones) and nominal rigidities in prices and wages. Our results are meant to contribute to the discussion initiated by Eggertsson (2010a) who found labor tax cut policy destabilising under zero nominal interest rate in a New Keynesian economy consisting only Ricardian consumers.
Keywords: Fiscal policy; zero lower bound; labor tax cut; New Keynesian
JEL Classification: E52; E62

E2012/12

Max Gillman (May 2012)
AS-AD in the Standard Dynamic Neoclassical Model: Business Cycles and Growth Trends (618K, 41 pages)
The paper shows how a dynamic neoclassical AS-AD can be derived and used to describe business cycles and growth trends to undergraduates. Derived within the Ramsey-Cass-Koopmans (RCK) model, the AS-AD is the stationary equilibrium of the deterministic dynamic general equilibrium framework. Allowing Solow exogenous growth, the AS-AD is derived along the balanced growth path equilibrium. The derivation first builds consumption demand, aggregate demand, and then aggregate supply through the equilibrium conditions and a closed form solution for the capital stock. Through a comparative static change in goods sector productivity, the paper shows the basic failing of the standard RBC model. Allowing a second comparative static change in the consumer's time endowment, this captures a change in the "external margin" of labor supply. These comparative statics enable explanation of the business cycle, and "Solow-plus" growth trends including education time and working time. In extension of RCK, the paper shows beyond the undergraduate level, how to derive AS-AD when including human capital and endogenous growth. This allows an endogenous change in the time endowment for work and leisure through a change in human capital productivity, with a similar but more fundamental AS-AD story of business cycles and growth trends.
Keywords: Ramsey-Cass-Koopmans; supply; demand; state variable
JEL Classification: A22; A23; E13

E2012/11

Helmuts Azacis and Péter Vida (May 2012)
Collusive Communication Schemes in a First-Price Auction (518K, 50 pages)
We study optimal bidder collusion at first-price auctions when the collusive mechanism only relies on signals about bidders’ valuations. We build on Fang and Morris (2006) when two bidders have low or high private valuation of a single object and additionally each receives a private noisy signal from an incentiveless center about the opponent’s valuation. We derive the unique symmetric equilibrium of the first price auction for any symmetric, possibly correlated, distribution of signals, when these can only take two values. Next, we find the distribution of 2-valued signals, which maximizes the joint payoffs of bidders. We prove that allowing signals to take more than two values will not increase bidders’ payoffs if the signals are restricted to be public. We also investigate the case when the signals are chosen conditionally independently and identically out of n = 2 possible values. We demonstrate that bidders are strictly better off as signals can take on more and more possible values. Finally, we look at another special case of the correlated signals, namely, when these are independent of the bidders’ valuations. We show that in any symmetric 2-valued strategy correlated equilibrium, the bidders bid as if there were no signals at all and, hence, are not able to collude.
Keywords: Bidder-optimal signal structure; Collusion; (Bayes) correlated equilibrium; First price auction; Public and private signals
JEL Classification: D44; D82

E2012/10

Péter Vida and Helmuts Azacis (May 2012)
A Detail-Free Mediator (589K, 28 pages)
We present an extension to any finite complete information game with two players. In the extension, players are allowed to communicate directly and, additionally, send private messages to a simple, detail-free mediator, which, in turn, makes public announcements as a deterministic function of the private messages. The extension captures situations in which people engage in face-to-face communication and can observe the opponent's face during the conversation before choosing actions in some underlying game. We prove that the set of Nash equilibrium payoffs of the extended game approximately coincides with the set of correlated equilibrium payoffs of any underlying game.
Keywords: Correlated equilibrium; detail-free mechanism; mediated pre-play communication
JEL Classification: C72

E2012/9

Patrick Minford, Zhirong Ou and Michael Wickens (May 2012, updated April 2014)
Revisiting the Great Moderation: policy or luck? (484K, 43 pages)
We investigate the relative roles of monetary policy and shocks in causing the Great Moderation, using indirect inference where a DSGE model is tested for its ability to mimic a VAR describing the data. A New Keynesian model with a Taylor Rule and one with the Optimal Timeless Rule are both tested. The latter easily dominates, whether calibrated or estimated, implying that the Fed’s policy in the 1970s was neither inadequate nor a cause of indeterminacy; it was both optimal and essentially unchanged during the 1980s. By implication it was largely the reduced shocks that caused the Great Moderation – among them monetary policy shocks the Fed injected into inflation.
Keywords: Great Moderation; Causes; Indirect inference; Test; Wald statistics
JEL Classification: E42; E52; E58
See also: Supporting Annex

E2012/8

Huw David Dixon and Engin Kara (April 2012)
Taking Multi-Sector Dynamic General Equilibrium Models to the Data (483K, 43 pages)
We estimate and compare two models, the Generalized Taylor Economy (GTE) and the Multiple Calvo model (MC), that have been built to model the distributions of contract lengths observed in the data. We compare the performances of these models to those of the standard models such as the Calvo and its popular variant, using the ad hoc device of indexation. The estimations are made with Bayesian techniques for the US data. The results indicate that the data strongly favour the GTE.
Keywords: DSGE models; Calvo; Taylor; price-setting
JEL Classification: E32; E52; E58

E2012/7

Paulo Brito and Huw David Dixon (April 2012)
Fiscal policy, entry and capital accumulation: hump-shaped responses (1278K, 48 pages)
In this paper we consider the entry and exit of firms in a Ramsey model with capital and an endogenous labour supply. At the firm level, there is a fixed cost combined with increasing marginal cost, which gives a standard U-shaped cost curve with optimal firm size. The costs of entry (exit) are quadratic in the flow of new firms. The number of firms becomes a second state variable and the entry dynamics gives rise to a richer set of dynamics than in the standard case: in particular, there is likely to be a hump shaped response of output to a fiscal shock with maximum impact after impact and before steady-state is reached. Output and capital per firm are also likely to be hump shaped.
Keywords: Entry; Ramsey; fiscal policy; macroeconomic dynamics
JEL Classification: E22; D92; E32; D92

E2012/6

Kul B Luintel and Mosahid Kahn (March 2012)
Ideas Production in Emerging Economies (305K, 13 pages)
We model ‘new ideas’ production in a panel of 17 emerging countries. Our results reveal: (i) ideas production is duplicative, (ii) externality associated with domestic knowledge stocks is of above unit factor proportionality, (iii) OECD countries raise the innovation-bar for emerging countries, (iv) there is no significant knowledge diffusion across emerging countries, and (v) growth in emerging countries appear far from a balanced growth path.
Keywords: Ideas Production; Knowledge Diffusion; Panel Co-integration
JEL Classification: C2; O3; O4

E2012/4

James Foreman-Peck (January 2012)
Effectiveness and Efficiency of SME Innovation Policy (1183K, 44 pages)
Forthcoming in Small Business Economics
This paper assesses UK innovation policy impact on a large, population weighted, sample of both service and manufacturing SMEs. By focussing on self-reported innovation the study achieves a wider coverage of the effects of SME innovation policy than possible with more traditional indicators. Propensity score matching indicates that SMEs receiving UK state support for innovation were more likely to innovate than unsupported comparable enterprises. Innovating enterprises are shown to have grown significantly faster over the years 2002-4 when other growth influences are appropriately controlled. Combining these two results and comparing the outlays on SME innovation policy with the estimated effects suggests that policy was efficient as well as effective. There is evidence that SME tax credits were expensive compared with earlier support instruments. But the overall high returns estimated suggest that, even in times of public spending cuts, persisting with SME innovation policy would be prudent.
Keywords: Innovation; State Aid; SME; Policy Evaluation
JEL Classification: L25; R38

E2012/3

Huw David Dixon and Panayiotis M. Pourpourides (January 2012)
On Imperfect Competition with Occasionally Binding Cash-in-Advance Constraints (532K, 61 pages)
We depart from the assumption of perfect competition in the final goods sector, commonly used in cash-in-advance (CIA) models, providing extensive theoretical analysis of the general equilibrium of an economy with imperfect competition, endogenous production and fully flexible prices in the presence of occasionally binding CIA constraints, under general assumptions about the velocity of money. Homothetic preferences generate Marshallian demands which are linear in own price allowing for any combination of equilibrium number of firms and demand elasticity. Whether the CIA constraint binds or not depends, among others, on the degree of imperfect competition. As the market becomes more competitive it is certainly no less likely that the CIA constraint will bind. The degree of imperfect competition directly affects the distribution of consumption and indirectly the level of output and work effort via the CIA constraint. With perfect foresight, there is an optimal negative steady-state inflation rate. We also consider how the introduction of capital and bonds would fit into the framework.

E2012/2

Erhan Artuç and Panayiotis M. Pourpourides (January 2012)
R&D and Aggregate Fluctuations (557K, 51 pages)
Using US data for the period 1959-2007, we identify sectoral productivity shocks and capital investment-specific shocks by employing a Vector Autoregression whose shock structure is disciplined by a general equilibrium model. Controlling for real and nominal factors, we find that capital investment-specific shocks explain 70 percent of fluctuations of R&D investment while R&D technology shocks explain 30 percent of the variation of aggregate output net of R&D investment (i.e. the output of the non-R&D sector). Technology shocks jointly explain almost all the variation of output in the R&D sector and 78 percent of the variation of output in the non-R&D sector.
Keywords: Productivity Shocks; Investment-specific Shocks; R&D; VAR
JEL Classification: C13; C32; C68; E32; O3

E2012/1

Cemil Selcuk (January 2012)
Seasonal Cycles in the Housing Market (427K, 10 pages)
The housing market exhibits a puzzling yet repetitive seasonal boom and bust cycle where prices and trade volume rise in summers and fall in winters. This paper presents a search model that analytically generates the observed deterministic cycle.
Keywords: housing; search; thin and thick markets; seasonality
JEL Classification: D39; D49; D83

E2011/29

Tianshu Zhao, Kent Matthews and Victor Murinde (November 2011)
Cross-Selling, Switching Costs and Imperfect Competition in British Banks (961K, 32 pages)
This paper attempts to evaluate the competitiveness of British banking in the presence of cross-selling and switching costs during 1993-2008. It presents estimates of a model of banking behaviour that encompasses switching costs as well as cross-selling of loans and off-balance sheet transactions. The evidence from panel estimation of the model lends support to our theoretical priors on the cross-selling behaviour of British banks, which helps explain the rapid growth of non-interest income during the last two decades. We also find that the consumer faced high switching costs in the loan market in the latter part of the sample period, as a result of lower competitiveness.
JEL Classification: G21; L13

E2011/28

Jenifer Daley and Kent Matthews (November 2011)
Competitive Conditions in the Jamaican Banking Market 1998-2009 (679K, 18 pages)
This paper presents an empirical assessment of the degree of competition within the Jamaican banking sector during the period 1998 to 2009. We employ a dynamic version of the Panzar-Rosse Model to estimate market power among the sample of banks that constitute over 90 percent of the banking market. Using the conventional statistical tests, we are unable to reject monopoly/perfect collusion for the merchant banking sector in Jamaica but find competitive conditions in the commercial banking sector. This contrasts with earlier findings using alternative estimators that find monopolistic competition in the market as a whole.
Keywords: Competition; banking; Rosse-Panzar H statistic; dynamic panel estimation; Jamaica
JEL Classification: G21; G28

E2011/27

Jenifer Daley, Kent Matthews and Tiantian Zhang (November 2011)
Post-crisis cost efficiency of Jamaican banks (761K, 26 pages)
Deregulation, re-regulation and continuing globalisation embody an imperative that banks increase efficiency in order to survive. We employ the Simar-Wilson (2007) two-step double bootstrap Data Envelopment Analysis method to measure whether cost efficiency among Jamaican banks has improved between 1999 and 2009 following a number of post-crisis responses aimed at strengthening and improving the sector. Efficiency is extracted from a meta-frontier construction for the full sample period. In addition we conduct tests for unconditional beta- and sigma-convergence and overall, the results suggest that there has been a tendency towards improvement in bank efficiency levels for the industry as a whole but there is also evidence that foreign banks show a higher trend improvement in efficiency.
Keywords: Bank efficiency; DEA; bootstrap; convergence; Jamaica
JEL Classification: G21; G28

E2011/26

David R. Collie and Vo Phuong Mai Le (November 2011)
Product Differentiation, the Volume of Trade and Profits under Cournot and Bertrand Duopoly (456K, 24 pages)
This paper analyses how product differentiation affects the volume of trade under duopoly using Shubik-Levitan demand functions rather than the Bowley demand functions used by Bernhofen (2001). The Shubik-Levitan demand functions have the advantage that an increase in product differentiation does not increase the size of the market as happens with the Bowley demand functions. It is shown that the volume of trade in terms of quantities is decreasing in the degree of product differentiation when the trade cost is relatively low, but increasing in the degree of product differentiation when the trade cost is relatively high.
Keywords: Product Differentiation; Cournot Oligopoly; Bertrand Oligopoly
JEL Classification: F12; F13

E2011/25

Huw David Dixon and Hervé Le Bihan (October 2011)
Generalized Taylor and Generalized Calvo price and wage-setting: micro evidence with macro implications (483K, 38 pages)
The Generalized Calvo and the Generalized Taylor models of price and wage-setting are, unlike the standard Calvo and Taylor counterparts, exactly consistent with the distribution of durations observed in the data. Using price and wage micro-data from a major euro-area economy (France), we develop calibrated versions of these models. We assess the consequences for monetary policy transmission by embedding these calibrated models in a standard DSGE model. The Generalized Taylor model is found to help rationalizing the humpshaped and persistent response of inflation, without resorting to the counterfactual assumption of systematic wage and price indexation.
Keywords: Contract length; steady state; hazard rate; Calvo; Taylor; wage-setting; price-setting
JEL Classification: E31; E32; E52; J30

E2011/24

Michael C. Hatcher (October 2011)
Inflation versus price-level targeting and the zero lower bound: Stochastic simulations from the Smets-Wouters US model (546K, 28 pages)
Using a version of the Smets-Wouters model of the US economy augmented to include both New Keynesian and New Classical sectors, this paper investigates the performance of inflation targeting and price-level targeting when the zero lower bound on nominal interest rates is occasionally-binding. Several notable results emerge. First, the unconditional probability of hitting the lower bound is lower under price-level targeting than inflation targeting, with 'lower bound episodes' being less frequent and lasting for shorter periods of time. Second, the volatilities of key macroeconomic variables are lower under price-level targeting than inflation targeting. Third, the lower frequency and severity of lower bound episodes under price-level targeting appears to have a first-order impact on consumption, investment and output, raising their mean values. Intuitively, price-level targeting performs well because inflation expectations act as automatic stabilisers, reducing the chance of hitting or remaining at the lower bound whilst also providing stability when the economy is away from the lower bound.
Keywords: Zero lower bound; occasionally-binding constraint; price-level targeting; inflation targeting
JEL Classification: E52; E58

E2011/23

Vito Polito and Peter Spencer (September 2011)
UK Macroeconomic Volatility and the Welfare Costs of Inflation (902K, 60 pages)
This paper explores the implications of time varying volatility for optimal monetary policy and the measurement of welfare costs. We show how macroeconomic models with linear and quadratic state dependence in their variance structure can be used for the analysis of optimal policy within the framework of an optimal linear regulator problem. We use this framework to study optimal monetary policy under inflation conditional volatility and Find that the quadratic component of the variance makes policy more responsive to inflation shocks in the same way that an increase in the welfare weight attached to inflation does, while the linear component reduces the steady state rate of inflation. Empirical results for the period 1979-2010 underline the statistical significance of inflation-dependent UK macroeconomic volatility. Analysis of the welfare losses associated with inflation and macroeconomic volatility shows that the conventional homoskedastic model seriously underestimates both the welfare costs of inflation and the potential gains from policy optimization.
Keywords: Monetary policy; Macroeconomic volatility; Optimal control; Welfare costs of inflation
JEL Classification: C32; C61; E52

E2011/22

Michael C. Hatcher (August 2011)
Comparing inflation and price-level targeting: A comprehensive review of the literature (601K, 54 pages)
This paper provides a detailed survey of the economic literature comparing inflation and price-level targeting as macroeconomic stabilisation policies. Its contributions relative to past surveys are as follows. First, rather than focusing on any particular topic, the survey gives equal emphasis to all key areas of the literature. Second, the paper discusses 'new results' in several areas, including the zero lower bound on nominal interest rates; the long-term impact of price-level targeting; and financial market considerations. Finally, the survey is written in such a way that it can be understood by economists with little or no prior knowledge of price-level targeting and the related academic literature. The survey concludes that whilst price-level targeting has a number of potential advantages, further research is needed to accurately quantify its costs and benefits and to test robustness. Potential obstacles to the introduction of price-level targeting in practice include: concerns about its credibility; lack of public understanding; and lack of prior experience with price-level targeting regimes.
Keywords: Price-level targeting; inflation targeting; macroeconomic stabilisation
JEL Classification: E52; E58

E2011/21

James Foreman-Peck and Leslie Hannah (August 2011)
Extreme Divorce: the Managerial Revolution in UK Companies before 1914 (273K, 54 pages)
We present the first broadly representative study for any early twentieth century economy of the extent to which quoted company ownership was already divorced from managerial control. In the 337 largest, independent, UK companies in the Investor's Year Book (those with \pounds 1m or more share capital in 1911) the two million outside shareholders were fewer than today's shareholding population, but they held 97.5% of the shares in the median company and their directors only 2.5%. This indicates a lower level of personal ownership by boards, and of director voting control, in the largest securities market of the early twentieth century than in any of the world.s major securities markets toward the end of that century. Berle, Means, Gordon and others later quantified the USA's delayed (and on this dimension less advanced) managerial "revolution." Their evidence has been widely misinterpreted: some erroneously concluded that America pioneered this aspect of "modernity" and that the "divorce" of ownership from control, globally, was a new and continuing trend.

E2011/20

Garry D.A. Phillips and Gareth Liu-Evans (August 2011)
The Robustness of the Higher-Order 2SLS and General k-Class Bias Approximations to Non-Normal Disturbances (280K, 28 pages)
In a seminal paper Nagar (1959) obtained first and second moment approximations for the k-class of estimators in a general static simultaneous equation model under the assumption that the structural disturbances were i.i.d and normally distributed. Later Mikhail (1972) obtained a higher-order bias approximation for 2SLS under the same assumptions as Nagar while Iglesias and Phillips (2010) obtained the higher order approximation for the general k-class of estimators. These approximations show that the higher order biases can be important especially in highly overidentified cases. In this paper we show that Mikhail.s higher order bias approximation for 2SLS continues to be valid under symmetric, but not necessarily normal, disturbances with an arbitrary degree of kurtosis but not when the disturbances are asymmetric. A modified approximation for the 2SLS bias is then obtained which includes the case of asymmetric disturbances. The results are then extended to the general k-class of estimators.

E2011/19

Emma M. Iglesias and Garry D.A. Phillips (August 2011)
Almost Unbiased Estimation in Simultaneous Equations Models with Strong and / or Weak Instruments (366K, 38 pages)
We propose two simple bias reduction procedures that apply to estimators in a general static simultaneous equation model and which are valid under reatively weak distributional assumptions for the errors. Standard jackknife estimators, as applied to 2SLS, may not reduce the bias of the exogenous variable coefficient estimators since the estimator biases are not monotonically non-increasing with sample size (a necessary condition for successful bias reduction) and they have moments only up to the order of overidentification. Our proposed approaches do not have either of these drawbacks. (1) In the first procedure, both endogenous and exogenous variable parameter estimators are unbiased to order T-2 and when implemented for k-class estimators for which k < 1, the higher order moments will exist. (2) An alternative second approach is based on taking linear combinations of k-class estimators for k < 1. In general, this yields estimators which are unbiased to order T-1 and which possess higher moments. We also prove theoretically how the combined k-class estimator produces a smaller mean squared error than 2SLS when the degree of overidentification of the system is larger than 8. Moreover, the combined k-class estimators remain unbiased to order T-1 even if there are redundant variables (including weak instruments) in any part of the simultaneous equation system, and we can allow for any number of endogenous variables. The performance of the two procedures is compared with 2SLS in a number of Monte Carlo experiments using a simple two equation model. Finally, an application shows the usefulness of our new estimator in practice versus competitor estimators.
Keywords: Combined k-class estimators; Bias correction; Weak instruments; Endogenous and exogenous parameter estimators; Permanent Income Hypothesis
JEL Classification: C12; C13; C30; C51; D12; D31; D91; E21; E40

E2011/18

Hao Hong (July 2011)
Money, interest rates and the real activity (293K, 25 pages)
This paper examines the effectiveness of monetary aggregates through various nominal interest rates by integrating the financial sector into the Cash-in-Advance (CIA) economy. The model assumes that there are two types of representative agents in the financial sector, which are: productive banks and financial intermediates. The productive banks supply a financial service, which is an exchange technology service to households and financial intermediates receive savings fund from savers and offer loans to borrowers. The monetary expansions are increased banking costs through the rate of inflation. It leads households to use more exchange credit relative to cash at the goods market. Since the number of savings funds is equal to the number of exchange credits used at the goods market, money injections are lower the nominal interest rate on saving as the saving fund increases with exchange credit. By assuming that firms are the only borrowers at the capital market from Fuerst (1992), a lower nominal interest rate on the saving fund reduces the marginal cost of labour and increases labour demand. Meanwhile, the increasing marginal cost of money through the expected inflation effect has a negative effect on labour supply. With labour demand dominating labour supply effects, both output and employment increase with monetary expansion. The paper is able to generate a decreasing nominal interest rate with an increasing money supply with an absence of limited participation monetary shocks from Lucas (1990); and by allowing firms to borrow wage bills payment from financial intermediates, it examines the positive response of aggregate output subject to monetary expansion under flexible price framework.
Keywords: monetary transmission; business cycles; banking sector; interest rates
JEL Classification: E10; E44; E51

E2011/17

Kateryna Onishchenko (June 2011)
Can a pure real business cycle model explain the real exchange rate: the case of Ukraine (1125K, 30 pages)
Real exchange rate (RER) is an important instrument for restoring sustainable economic growth in the small open economy with large export share. RER of Ukrainian currency can be explained within the real business cycle (RBC) framework without any forms of nominal rigidities. Fitting Ukrainian quarterly data for the period of 1996:Q1-2009:Q3 into the small open economy real business cycle model and testing it by method of indirect inference shows that RER can be reproduced by RBC framework. The generated pseudo-samples for RER by method of bootstrapping allow to obtain the distribution of the best fit ARIMA(2,1,4) parameters and to show with the Wald statistics that those parameters lie within 95% confidence intervals of those estimated for bootstrapped pseudo Q parameters.
Keywords: sustainable economic growth; business cycle; real exchange rates; small open economy; indirect inference; ARIMA
JEL Classification: E31; E32; E37; F31; F37

E2011/16

Hao Hong (June 2011)
Monetary aggregates, financial intermediate and the business cycle (407K, 17 pages)
This paper explains and evaluates the transmissions and effectiveness of monetary policy shock in a simple Cash-in-Advance (CIA) economy with financial intermediates. Lucas-Fuerst's (1992) limited participation CIA models are able to explain decreasing nominal interest rates and increasing real economic activity with monetary expansion through limited participation monetary shock and the cost channel of monetary policy. Calvo's (1983) sticky price monetary model examines the real effects of money injections through firms price setting behaviour, but it fails to generate a negative correlation between nominal interest rates and money growth rate, which has been observed in the data. This paper employs McCandless (2008) financial intermediates CIA model to explain the transmissions and impacts of monetary shocks. The model does not request limited participation monetary shock or Keynesian type of sticky price/wage, to examine the lower nominal interest rate and increasing real economic activity with monetary expansion. By extending the model with Stockman's (1981) CIA constraint, it is able to account for both positive response of consumption subject to monetary innovations, which has been found in Leeper et al. (1996) and the positive correlation between output and consumption which has been observed in the data.
Keywords: Monetary business cycle; financial intermediate; cash-in-advance model
JEL Classification: E44; E52

E2011/15

Ernesto Longobardi and Vito Polito (June 2011)
Capital income taxation incentives during economic downturns: re-thinking theory and evidence (641K, 39 pages)
This paper studies the effectiveness of corporate tax incentives in reducing the effective tax rate (ETR) on income from capital to stimulate business investment during economic downturns. We focus on tax rate incentives (TRIs), such as corporate tax rate cuts, and tax base incentives (TBIs), such as increased capital allowances. The standard economic theory states that TRIs reduce the ETR by decreasing tax payments on corporate profits. TBIs instead reduce the ETR as they defer firms tax payments, in turn increasing the present value of dividend distribution. However, this theory does not consider that, in reality, firms face accounting constraints preventing any distribution of cash flows arising from TBIs. For this reason, the standard economic analysis overstates the benefit of any TBI relative to that of TRIs. The paper incorporates accounting constraints on dividend policy into the model for the computation of the ETR and employs the new model to recalculate ETRs in the US and in the UK during 1980-2010. The empirical results confirm that the benefit of TBIs is significantly overstated by the standard theory, and tax rate cuts are more effective in reducing the ETR. We show that this result holds regardless of the form of investment finance (retained earning, new equity and debt), the type capital asset (building and plant and machinery), the level of capital income taxation (corporate and shareholders), and the value of accounting depreciation relative to economic depreciation.
Keywords: Capital income taxation; dividend policy; effective marginal tax rates; financial constraints
JEL Classification: H3

E2011/14

Vito Polito (June 2011)
Deferred Taxation and Effective Tax Rates on Income from Capital in the United States, 2000-2010 (516K, 43 pages)
The accounting and economic literature have long highlighted the potential implications of deferred taxation for tax policy analysis. This paper incorporates deferred taxation into the neoclassical investment model for the computation of the Effective Tax Rate (ETR) on business investment and revisits the empirical evidence on the evolution of ETRs in the United States over the last decade. The numerical results show that after including deferred taxation there is little differential in the ETRs across assets; ETRs in the 2000s have been essentially in line with statutory rates; and partial expensing had little effect on ETRs. These results hold whether investment is financed by equity or debt; profits are distributed to individual shareholders through dividends, interests or capital gains; and regardless of the differential between book and economic depreciation.
Keywords: Deferred taxation; effective marginal tax rates; taxation of income from capital
JEL Classification: H3

E2011/13

Vito Polito (June 2011)
Up or down? Capital income taxation in the United States and the United Kingdom (479K, 29 pages)
Empirical evidence suggests that the Effective Marginal Tax Rate (EMTR) on income from capital has increased considerably in both the United States and the United Kingdom over the period 1982-2005. This evidence contradicts the corporate tax literature which predicts that the EMTR should instead fall over time as a result of increasing international capital mobility and higher tax competition between governments. This paper argues that this inconsistency is entirely due to the fact that EMTRs on income from capital are currently computed from versions of the neoclassical investment model which do not take into account financial constraints on dividend policy faced by firms investing in both the United States and the United Kingdom. The paper incorporates financial constraints on dividend policy into the analytical framework for the computation of the EMTR and employs the new model to re-calculate time series of the EMTRs in both countries. The new empirical results show that, in contrast to the existing evidence, the EMTR on investment financed by either retained earnings or new equity has indeed declined over time in both countries, while the EMTR on debt-financed investment has remained relatively stable.
Keywords: Capital income taxation; dividend policy; effective marginal tax rates; financial constraints
JEL Classification: H3

E2011/12

Tiantian Zhang and Kent Matthews (April 2011)
Efficiency Convergence Properties of Indonesian Banks 1992-2007 (799K, 28 pages)
This paper examines the convergence properties of cost efficiency for Indonesian banks for the period 1992-2007. It employs the Simar and Wilson's (2007) two stage semi-parametric double bootstrap DEA procedure to estimate cost efficiency. Using panel data estimation, the paper examines ß-convergence and σ-convergence, to test the speed at which Indonesian banks are converging, towards the best practice and country average. We find evidence that in general the post-crisis structural reform process improved the average level of efficiency and improved the distribution of efficiency across banks significantly. The Asian financial crisis and the structural reform had the effect of slowing the adjustment speed of bank efficiency.
Keywords: Banks; Efficiency; Indonesia; Convergence
JEL Classification: G21; G28

E2011/11

Lorant Kaszab (April 2011)
Fiscal Policy Multipliers in a New Keynesian Model under Positive and Zero Nominal Interest Rate (645K, 42 pages)
This paper uses a simple new-Keynesian model (with and without capital) and calculates multipliers of four types. That is, we assume either an increase in government spending or a cut in sales/labor/capital tax that is financed by lump-sum taxes (Ricardian evidence holds). We argue that multipliers of a temporary fiscal stimulus for separable preferences and zero nominal interest rate results in lower values than what is obtained by Eggertsson (2010). Using Christiano et al. (2009) non-separable utility framework which they used to calculate spending multipliers we study tax cuts as well and find that sales tax cut multiplier can be well above one (joint with government spending) when zero lower bound on nominal interest binds. In case of a permanent stimulus we show in the model without capital and assuming non-separable preferences that it is the spending and wage tax cut which produce the highest multipliers with values lower than one. In the model with capital and assuming that the nominal rate is fixed for a one-year (or two-year) duration we present an impact multiplier of government spending that is very close to the one in Bernstein and Romer (2009) but later declines with horizon in contrast to their finding and in line with the one of Cogan et al. (2010). We also demonstrate that the long-run spending multiplier calculated similarly to Campolmi et al. (2010) implies roughly the same value for both types of preferences for particular calibrations. For comparison, we also provide long-run multipliers using the method proposed by Uhlig (2010).
Keywords: New-Keynesian model; fiscal multipliers; zero lower bound; monetary policy; government spending; tax cut; permanent; transitory
JEL Classification: E52; E62

E2011/10

Lucun Yang (April 2011)
An Empirical Analysis of Current Account Determinants in Emerging Asian Economies (673K, 49 pages)
Limited empirical work has been done to the diverging current account balances of the individual emerging Asian economies. Based on the intertemporal approach to current account, this paper empirically examines both the long-run and short-run impacts of initial stock of net foreign assets, degree of openness to international trade, real exchange rate and relative income on current account balances for eight selected emerging Asian economies over the period 1980-2009, making use of the cointegrated VAR (Vector Autoregression) methodology. This paper finds that current account behaviours in emerging Asian economies are heterogeneous. Initial stock of net foreign assets and degree of openness to international trade are important factors in explaining the long-run behaviour of current accounts. Moreover, the current accounts of all sample economies have a self-adjusting mechanism except China. Short-run current account adjustment towards long-run equilibrium path is gradual, with the disequilibrium term being the main determinant of the short-run current account variations.
Keywords: Current account; Emerging Asia; Structural and macroeconomic determinants; Saving-investment balance; Cointegration
JEL Classification: E21; F10; F32; F41

E2011/9

Jingwen Fan and Michael G Arghyrou (March 2011)
UK Fiscal Policy Sustainability, 1955-2006 (478K, 26 pages)
We test for fiscal policy sustainability in the UK for the period 1955-2006. We find evidence of sustainability with three structural breaks, respectively occurring in the early 1970s, early 1980s and late 1990s. UK fiscal policy has been sustainable throughout the sample period except from 1973-1981 when a non-Ricardian regime applied. For the remaining periods correction of fiscal disequilibrium occurs through adjustments in public revenue rather than expenditure. Finally, we find evidence of non-linear fiscal adjustment, with UK authorities not reacting to relatively small deficits; but correcting exceedingly large deficits and any temporary surpluses relatively fast.
Keywords: Fiscal policy; Sustainability; UK; Structural breaks; Non-linear adjustment
JEL Classification: E62; H60

E2011/8

Jing Dang, Max Gillman and Michal Kejak (March 2011)
Real Business Cycles with a Human Capital Investment Sector and Endogenous Growth: Persistence, Volatility and Labor Puzzles (566K, 43 pages)
A positive joint two-sector productivity shock causes Rybczynski (1955) and Stolper and Samuelson (1941) effects that release leisure time and initially raises the relative price of human capital investment so as to favor it over goods production. This enables a basic RBC model, modified by having the household sector produce human capital investment sector, to succeed along related major dimensions of output, consumption, investment and labor, similar to the international approach of Maodifying the dynamics relative to the important work of Jones et al. (2005), two key US facts stressed by Cogley and Nason (1995) are captured: persistent movements in the growth rates of output and hump-shaped impulse responses of output. Further, physical capital investment has data consistent persistence within a hump-shaped impulse response. And Gali's (1999) challenging empirical finding that labour supply decreases upon impact of a positive productivity shock is reproduced, while volatility in working hours is also data-consistent because of the substitution between market and nonmarket sectors.
Keywords: Real business cycle; human capital; persistence; volatility; labor
JEL Classification: E24; E32; O41

E2011/7

Hongru Zhang (March 2011)
Financial Sector Shocks, External Finance Premium and Business Cycle . (587K, 45 pages)
This paper extends Nolan and Thoenissen (2009), hence NT, model with an explicit financial intermediary that transfer funds from households to entrepreneurs subject to a well defined loan production function. The loan productivity shock is treated as the supply side financial disturbance. Together with NT.s net worth shock that resembles the credit demand perturbation, both of the two-sided shocks are robustly extracted by combining the model with US quarterly data. The two shocks are found to be tightly linked with the post-war recessions. Each recession happens when both of the two shocks become contractionary. A few potential economic downturns seem to have been avoided because of the expansion of credit which offset the simultaneous contraction of entrepreneurial net wealth. This new introduced shock has significant explanatory power for the variance of EFP and the model simulated EFP holds high correlation with various spreads as proxies for empirical EFP.
Keywords: DSGE modeling; corporate net wealth shock; loan productivity shock; external financing; shock construction; historical decomposition; variance decomposition
JEL Classification: E32; E44; G21

E2011/6

Sheikh Selim (March 2011)
Optimal Taxation and Redistribution in a Two Sector Two Class Agents' Economy (407K, 19 pages)
We examine the optimal taxation problem in a two sector neoclassical economy with workers and capitalists. We show that in a steady state of this economy the optimal policy may involve a capital income tax or subsidy, differential taxation of labour income and redistribution. The level and the direction of the redistribution associated with such an optimal policy depends on the pre tax allocation of capital but not on the social weights attached to the different groups of taxpayers. Excess production of consumption goods creates a difference between the social marginal values of consumption and investment which in turns violates the production efficiency condition. Such a difference can be undone by taxing capital income from the consumption sector, and with this optimal policy the government can implement a redistribution scheme where both workers and capitalists bear the burden of distorting taxes. On the contrary, an optimal policy that involves a capital income subsidy in the production of consumption can implement allocations that minimize the relative price difference between consumption and investment that resulted from the excess production of investment goods.
Keywords: Optimal taxation; Ramsey problem; Two Sector Economy; Redistribution
JEL Classification: C61; E13; E62; H21

E2011/5

Michael C. Hatcher (March 2011)
Price-level targeting versus inflation targeting over the long-term (721K, 50 pages)
This paper investigates the long-term impact of price-level targeting on social welfare in an overlapping generations model in which the young save for old age by investing in productive capital and indexed and nominal government bonds. A key feature of the model is that the extent of bond indexation is determined endogenously in response to monetary policy as part of an optimal commitment Ramsey policy. Due to the absence of base-level drift under price-level targeting, long-term inflation risk is reduced by an order of magnitude compared to inflation targeting. Consequently, real bond returns are stabilised somewhat, and consumption volatility for old generations is reduced by around 15 per cent. The baseline welfare gain from price- level targeting is equivalent to a permanent increase in aggregate consumption of only 0.01 per cent, but this estimate is strongly sensitive on the upside.
Keywords: inflation targeting; price-level targeting; optimal indexation; government bonds
JEL Classification: E52; E58

E2011/4

Max Gillman (February 2011, updated May 2011)
A Simple Theory of Structural Transformation (475K, 40 pages)
The paper presents a theory of the industrial transformation amongst sectors using endogenous growth theory. Allowing only a slight upward trend in the productivity of the human capital sector, combined with ascending degrees of human capital shares of sectoral output, in say, agriculture, manufacturing and services, output gradually shifts relatively over time from agriculture to manufacturing and to services. Abstracting from international trade theory, sectors intensive in the factor that is becoming relatively more plentiful find their relative outputs expanding. Adding more sectors of greater human capital intensity causes labor time to decrease within each sector, as shown for agriculture, and in general for any number of sectors.
Keywords: Human Capital Intensity; Sectoral Allocation; Labor Shares; Secular Endogenous Growth
JEL Classification: E25; F11; J24; O14

E2011/3

Michael C. Hatcher (January 2011, updated March 2011)
Optimal indexation of government bonds and monetary policy (705K, 46 pages)
Using an overlapping generations model in which the young save for old age using indexed and nominal government bonds, this paper investigates how optimal indexation is influenced by monetary policy. In order to do so, two monetary policies with markedly different long run implications are examined: inflation targeting and price-level targeting. Optimal indexation differs significantly under the two regimes. Under inflation targeting, long-term inflation uncertainty is substantial due to base-level drift in the price level. Nominal bonds are thus a poor store of value and optimal indexation is relatively high (76 per cent). With price-level targeting, by contrast, long-term inflation uncertainty is minimal because the price level is trend-stationary. This makes nominal bonds a better store of value compared to indexed bonds, reducing optimal indexation somewhat (26 per cent). Importantly for these results, the model captures two imperfections of indexation (indexation bias and lagged indexation) that are calibrated to the UK case.
Keywords: optimal indexation; government bonds; inflation targeting; price-level targeting
JEL Classification: E52; E58

E2011/2

Sheikh Selim (January 2011)
The Impact of Price Regulations on Regional Welfare and Agricultural Productivity in China (332K, 9 pages)
The nineties' agricultural reform in China that was aimed at deregulating the agricultural market eventually resulted in a huge drop in agricultural production and a high rate of inflation in agricultural prices; this apparently motivated the government to take over the control of agricultural prices in 1998. We examine how and to what extent this reform affected the productivity and welfare of grain farmers in China at the regional level. We find that the price regulation that destroyed the incentive to exert more effort adversely affected the growth in agricultural productivity but contributed to the growth in farmers. welfare. Although the price regulations resulted in short term improvement in welfare across all the regions, for the long run such regulations can result in larger drop in agricultural production because of its negative impact on incentives to produce more.
Keywords: China; Welfare; TFP; Agriculture; Grain Production
JEL Classification: N55; O13; O53; Q12

E2011/1

Kul B Luintel and Mosahid Kahn (January 2011)
Basic, Applied and Experimental Knowledge and Productivity: Further Evidence (133K, 11 pages)
Analyzing a novel dataset we find significantly positive effects of basic, and applied and experimental knowledge stocks on domestic output and productivity for a panel of 10 OECD countries. This letter updates the work of, among others, Mansfield (1980), Griliches (1986) and Adams (1990), at an international setting.
Keywords: Basic and Applied Research; TFP; Panel Co-integration
JEL Classification: F12; F2; O3

E2010/17

Sheikh Selim, Naima Parvin and Vasita Patel (December 2010)
Interaction and Non-neutral Effects of Factors in Chinese Wheat Production (326K, 26 pages)
In this paper we examine the role of the interaction between labour productivity and the use of factors in explaining the recent (1998-2007) 11% decline in wheat production in China. We employ a non-neutral stochastic production frontier approach that enables us to identify the interaction and non-neutral effects of factors that are used in wheat production. For regional level wheat production in China we find that identifying the technical inefficiency effects and the non-neutral effects of factors assist big time in explaining the recent decline in wheat production. A higher level of labour productivity can stimulate efficiency gains in production, but adding more labour to the workforce or adding to the stock of machinery power can depress this potential marginal efficiency gain. We also find significant marginal efficiency gain of land reforms that add to the stock of cultivable land. Our results indicate that future agricultural reforms in China should address the incentive scheme for labour.
Keywords: China; Stochastic Frontier; Factor Interaction; Non neutrality; Agriculture; Wheat Production
JEL Classification: N55; O13; O53; Q12

E2010/16

Vasita Patel and Sheikh Selim (December 2010, updated January 2011)
Reforms, Incentives, Welfare and Productivity Growth in Chinese Wheat Production (378K, 32 pages)
Following the rural reform in 1978 a series of agricultural reforms were introduced in China with an aim to create incentives for the farmers to produce more. The nineties. price reform that was aimed at deregulating the agricultural market eventually resulted in a huge drop in agricultural production; this apparently motivated the government to take over the control of agricultural prices in 1998. For a dataset that covers all the major rural reforms undertaken in China, we examine how and to what extent these reforms affected the productivity and welfare of wheat farmers in China. We find that the nineties. price reforms resulted in a high magnitude of effort-response from wheat farmers which led to a faster growth of the incentive component of productivity. Due to random weather shocks this response did not result in the expected level of profit and as a result the farmers suffered a decline in welfare. The regulations introduced in 1998 destroyed the incentive-induced growth in TFP. In general wheat farmers in China responded highly when markets were made more competitive, and their effort-response for flat subsidies (e.g. the ones introduced in the eighties) was very marginal.
Keywords: China; Incentives; TFP; Agriculture; Wheat Production
JEL Classification: N55; O13; O53; Q12

E2010/15

Sheikh Selim (November 2010)
Optimal Tax Policy and Wage Subsidy in an Imperfectly Competitive Economy (183K, 9 pages)
In an imperfectly competitive economy with direct and indirect taxes, the first best wage subsidy overcompensates workers and provides the incentive to misreport working hours. We show that in the second best optimum where the government cannot use a wage subsidy, the optimal policy is to tax labour income at a zero rate. This policy is optimal because it minimizes the incentive to misreport working hours.
Keywords: Optimal Taxation; Ramsey Problem; Wage Subsidy
JEL Classification: D42; E62; H21; H30

E2010/14

Michael G Arghyrou and John D. Tsoukalas (November 2010)
The Option Of Last Resort: A Two-Currency Emu (214K, 5 pages)
This article, originally published at www.roubini.com on 7 February 2010, spells out our two-currency EMU proposal as a plan of last resort for resolving the present EMU sovereign-debt crisis. The key ingredients of our proposal involve a temporary split of the euro into two currencies, both run by the European Central Bank. The hard euro will be maintained by the core-EMU members whereas periphery EMU countries will adopt for a suitable period of time the weak euro. All existing debts will continue to be denominated in strong-euro terms. The plan involves a one-off devaluation of the weak euro versus the strong one, simultaneously with the introduction of far-reaching reforms and rapid fiscal consolidation in the periphery EMU countries. We argue that due to enhanced market credibility, our two-tier euro plan has a realistic chance of success in resolving the EMU crisis, if all other approaches fail.
Keywords: euro; two-currency EMU
JEL Classification: E44; F30; G01

E2010/13

James Davidson, David Meenagh, Patrick Minford and Michael Wickens (November 2010)
Why crises happen - nonstationary macroeconomics (689K, 27 pages)
A Real Business Cycle model of the UK is developed to account for the behaviour of UK nonstationary macro data. The model is tested by the method of indirect inference, bootstrapping the errors to generate 95% confidence limits for a VECM representation of the data; we find the model can explain the behaviour of main variables (GDP, real exchange rate, real interest rate) but not that of detailed GDP components. We use the model to explain how `crisis' and `euphoria' are endemic in capitalist behaviour due to nonstationarity; and we draw some policy lessons.
Keywords: Nonstationarity; Productivity; Real Business Cycle; Bootstrap; Indirect Inference; Banking Crisis; Banking Regulation
JEL Classification: E32; F32; F41

E2010/12

Kent Matthews (November 2010)
Banking Efficiency in Emerging Market Economies (421K, 19 pages)
This paper reviews the different ways to measure bank efficiency and highlight the results of research on bank efficiency in Asian emerging economies. In particular it will outline the extent of research thus far conducted on the efficiency of banks in Pakistan and comment on how to build and improve upon them.
Keywords: bank efficiency; bootstrap; Pakistan
JEL Classification: G20; G21

E2010/11

Peng Zhou (October 2010, updated November 2010)
An Empirical Study on Price Rigidity (1208K, 32 pages)
This paper uses unpublished retailer-level microdata underlying UK consumer price indices to investigate price rigidity. Based on the conventional method, little rigidity is found in frequency of price change, since the implied price duration is only 5.5 months. However, it significantly underestimates the true duration (9.3 months) as suggested by cross-sectional method. Results also exhibit conspicuous heterogeneities in rigidity across sectors and shop types but weak difference across regions and time. The overall distribution of duration can be decomposed by sector into a decreasing component and a cyclical component with 4-month cycles. Both time and state dependent features exist in pricing. These findings support New Keynesian theories and enable a better calibration to improve the performances of macroeconomic models.
Keywords: Price Rigidity; Price Duration; Microdata; Cross-Sectional
JEL Classification: C41; D22; E31; L11

E2010/10

Patrick Minford and Zhirong Ou (October 2010)
US post-war monetary policy: what caused the Great Moderation? (1329K, 34 pages)
Using indirect inference based on a VAR we confront US data from 1972 to 2007 with a standard New Keynesian model in which an optimal timeless policy is substituted for a Taylor rule. We find the model explains the data both for the Great Acceleration and the Great Moderation. The implication is that changing variances of shocks caused the reduction of volatility. Smaller Fed policy errors accounted for the fall in inflation volatility. Smaller supply shocks accounted for the fall in output volatility and smaller demand shocks for lower interest rate volatility. The same model with differing Taylor rules of the standard sorts cannot explain the data of either episode. But the model with timeless optimal policy could have generated data in which Taylor rule regressions could have been found, creating an illusion that monetary policy was following such rules.
Keywords: Great Moderation; Shocks; Monetary policy; New Keynesian model; Bootstrap; VAR; Indirect inference; Wald statistic
JEL Classification: E32; E42; E52; E58

E2010/9

Michael G Arghyrou and Alexandros Kontonikas (September 2010)
The EMU sovereign-debt crisis: Fundamentals, expectations and contagion (864K, 48 pages)
We offer a detailed empirical investigation of the European sovereign debt crisis based on the theoretical model by Arghyrou and Tsoukalas (2010). We find evidence of a marked shift in market pricing behaviour from a 'convergence-trade' model before August 2007 to one driven by macro-fundamentals and international risk thereafter. The majority of EMU countries have experienced contagion from Greece. There is no evidence of significant speculation effects originating from CDS markets. Finally, the escalation of the Greek debt crisis since November 2009 is confirmed as the result of an unfavourable shift in country specific market expectations. Our findings highlight the necessity of structural, competitiveness-inducing reforms in periphery EMU countries and institutional reforms at the EMU level enhancing intra-EMU economic monitoring and policy co-ordination.
Keywords: euro-area; crisis; spreads; fundamentals; expectations; contagion; speculation
JEL Classification: E43; E44; F30; G01; G12

E2010/8

Michael G Arghyrou (September 2010)
Corruption as a form of extreme individualism: An economic explanation based on geography and climate conditions (561K, 42 pages)
We present a simple model explaining corruption on geography and climate conditions. We test the model's validity in a cross-section of 115 countries. Controlling for all other corruption's determinants we find evidence supporting the model's predictions. Corruption increases with temperature and declines with precipitation and non-cultivatable land. Corruption also declines with per capita GDP, democracy, median age and British colonial heritage; and increases with natural resources, bureaucracy and communist past. Finally, corruption declines with the ratio of internet users to total population. This new finding is interpreted as capturing the beneficial interaction of economic development, human capital/education and independent news.
Keywords: individualism; fairness; corruption; geography and climate conditions
JEL Classification: D73; H11

E2010/7

Kul B Luintel, Mosahid Khan and Konstantinos Theodoridis (September 2010)
How Robust is the R&D-Productivity relationship? Evidence from OECD Countries (418K, 44 pages)
We examine the robustness of R&D and productivity relationship in a panel of 16 OECD countries. We control for fifteen productivity determinants predicted by different theoretical models. Following the advances in non-stationary panel data econometrics, we estimate four variants of thirteen specifications. All models appear co-integrated. Results are rigorously scrutinized through extensive bootstrap simulations and sensitivity checks. R&D and human capital emerge robust in all specifications making them universal drivers of productivity across nations. Most other determinants are also significant. Productivity relationships are heterogonous across countries depending on their accumulated stocks of knowledge and human capital.
Keywords: R&D Capital Stocks; Multifactor Productivity; Heterogeneity; Panel Cointegration; Bootstrap Simulations
JEL Classification: F12; F2:; O3; O4; C15

E2010/6

Huw David Dixon and Panayiotis M. Pourpourides (July 2010)
General Equilibrium with Monopolistic Firms and Occasionally Binding Cash-in-Advance Constraints (239K, 28 pages)
We show a simple way to introduce monopolistic competition in a general equilibrium model where prices are fully flexible, the velocity of money is variable and cash-in-advance (CIA) constraints occasionally bind. We establish the conditions under which money has real effects and demonstrate that an equilibrium that occurs at a binding CIA constraint is welfare inferior to any equilibrium that occurs at a non-binding CIA constraint with the same level of technology. We argue that even though the probability of a binding CIA constraint can be increasing with money supply, under certain conditions, expansionary money supply is welfare improving.
Keywords: general equilibrium; monopolistic competition
JEL Classification: D43; E31; E41; E51

E2010/5

Stefano Battilossi, Regina Escario and James Foreman-Peck (July 2010)
Economic Policy and Output Volatility in Spain, 1950-1998: Was Fiscal Policy Destabilizing? (1919K, 39 pages)
Was Spanish fiscal policy destabilizing? We estimate policy reaction functions and test the impact of fiscal shocks on growth volatility over the period 1950-1998. We find that a transition from pro-cyclical to countercyclical fiscal policy occurred in the late years of the Franco regime, contributing to the stabilization of the growth pattern. The timing of the shift, between the late 1960s and early 1970s, was not determined by a single policy change, but rather by gradual pressure from economic liberalization, the external constraint imposed by a fixed exchange rate regime and the modernization of fiscal policy instruments. The aggressiveness of fiscal shocks also decreased over time, thus contributing to the progressive stabilization of output growth. There appears to be little necessity to appeal to a 'Great Moderation' of monetary policy to understand the greater stability of the Spanish economy from the 1980s
Keywords: fiscal reaction function; fiscal shocks; SVAR; growth volatility
JEL Classification: E32; E62; N14

E2010/4

David R. Collie (June 2010)
Multilateral Trade Liberalisation, Foreign Direct Investment and the Volume of World Trade (232K, 11 pages)
Forthcoming in Economics Letters
A paradox in international trade is that multilateral trade liberalisation has resulted in increases in both the volume of world trade and the amount of foreign direct investment (FDI). This note presents a Cournot duopoly model with two regions, each consisting of two countries, and with an inter-regional transport cost. It is shown that multilateral trade liberalisation may lead firms to switch from exporting to undertaking export-platform FDI when the interregional transport cost is high. Also, when the inter-regional transport cost is high, the switch to FDI leads to an increase in the volume of world trade in this industry.
Keywords: Trade Liberalisation; Foreign Direct Investment; Cournot oligopoly
JEL Classification: F12; F13; F23

E2010/3

Michael G Arghyrou and John D. Tsoukalas (April 2010)
The Greek Debt Crisis: Likely Causes, Mechanics and Outcomes (419K, 32 pages)
Forthcoming in The World economy
We use insights from the literature on currency crises to offer an analytical treatment of the crisis in the market for Greek government bonds. We argue that the crisis itself and its escalating nature are very likely to be the result of: (a) steady deterioration of Greek macroeconomic fundamentals over 2001-2009 to levels inconsistent with longterm EMU participation; and (b) a double shift in markets. expectations, from a regime of credible commitment to future EMU participation under an implicit EMU/German guarantee of Greek fiscal liabilities, to a regime of non-credible EMU commitment without fiscal guarantees, respectively occurring in November 2009 and February/March 2010. We argue that the risk of contagion to other periphery EMU countries is significant; and that without extensive structural reforms the sustainability of the EMU is in question.
Keywords: Currency crises; bonds market; expectations; fiscal guarantees; contagion
JEL Classification: F31; F33; F34; F41; F42; F50

E2010/2

Cemil Selcuk (March 2010)
Motivated Sellers in the Housing Market (378K, 29 pages)
We present a search-and-matching model of the housing market where potential buyers' willingness to pay is private information and sellers may become desperate as they are unable to sell. A unique steady state equilibrium exists where desperate sellers offer sizeable price cuts and sell faster. If the number of distressed sales rises then even relaxed sellers are forced to lower their prices. Buyers, on the other hand, become more selective and search longer for better deals. The model yields a theoretical density function of the time-to-sale, which is positively skewed and may be hump-shaped. These results are consistent with recent empirical findings.
Keywords: housing; private information; random search; motivated sellers
JEL Classification: D39; D49; D83;

E2010/1

Kent Matthews (February 2010, updated April 2010)
Risk Management and Managerial Efficiency in Chinese Banks: A Network DEA Framework (294K, 38 pages)
Risk Management in Chinese banks has traditionally been the Cinderella of its internal functions. Political stricture and developmental imperative have often overridden standard practice of risk management resulting in large non-performing loan (NPL) ratios. One of the stated aims of opening up the Chinese banks to foreign strategic investment is the development of risk management functions. In recent years NPL ratios have declined through a mixture of recovery, asset management operation and expanded balance sheets. However, the training and practice of risk managers remain second class compared with foreign banks operating in China. This paper evaluates bank performance using a Network DEA approach where an index of risk management practice and an index of risk management organisation are used as intermediate inputs in the production process. The two indices are constructed from a survey of risk managers in domestic banks and foreign banks operating in China. The use of network DEA can aid the manager in identifying the stages of production that need attention.
Keywords: Risk management; risk organisation; managerial efficiency; Network DEA
JEL Classification: D23; G21; G28;

E2009/32

James Foreman-Peck and Peng Zhou (December 2009, updated August 2010)
The Strength and Persistence of Entrepreneurial Cultures (445K, 34 pages)
The twentieth century United States provides a natural experiment to measure the strength and persistence of entrepreneurial cultures. Assuming immigrants bear the cultures of their birth place, comparison of revealed entrepreneurial propensities of US immigrant groups in 1910 and 2000 reflected these backgrounds. According to this test North-western Europe, where modern economic growth is widely held to have originated, did not host unusually strong entrepreneurial cultures. Instead such cultures were carried by persons originating from Greece, Turkey and Italy, together with Jews. The rise of widespread female entrepreneurship provides additional evidence by showing that this trait systematically responded less strongly, but in the same way, to cultural background as did male entrepreneurship.
Keywords: Entrepreneurship; Culture; Migration
JEL Classification: D01; J15; J23; J61

E2009/31

Vo Phuong Mai Le, Patrick Minford and Michael Wickens (December 2009)
Some problems in the testing of DSGE models (112K, 6 pages)
We review the methods used in many papers to evaluate DSGE models by comparing their simulated moments and other features with data equivalents. We note that they select, scale and characterise the shocks without reference to the data; crucially they fail to use the joint distribution of the features under comparison. We illustrate this point by recomputing an assessment of a two-country model in a recent paper; we find that the paper's conclusions are essentially reversed.
Keywords: Boostrap; US-EU model; DSGE; VAR; indirect inference; Wald statistic; anomaly; puzzle
JEL Classification: C12; C32; C52; E1

E2009/30

Jenifer Daley and Kent Matthews (December 2009)
Efficiency and Convergence in the Jamaican banking sector 1998-2007 (372K, 24 pages)
Deregulation, re-regulation and continuing globalisation embody an imperative that banks increase efficiency to survive. We employ non-parametric bootstrap DEA to measure technical efficiency among Jamaican banks between 1998 and 2007. In addition, we test for conditional convergence to identify pointing variables for technical efficiency. Overall, the results suggest that there has been a tendency towards improvement in bank efficiency levels for the largest banks. The findings show strong evidence of conditional convergence, which means that each bank is converging to its own steady-state and that GDP growth, ownership and size are the major influences on levels of technical efficiency.
Keywords: Bank efficiency; DEA; bootstrap; convergence; Jamaica
JEL Classification: G21; G28

E2009/29

Jenifer Daley and Kent Matthews (December 2009)
Measuring post-crisis productivity for Jamaican banks (554K, 22 pages)
The study examines the changes to total factor productivity of Jamaican banks between 1998 and 2007. Using Data Envelopment Analysis with bootstrap to construct a Malmquist index, bank productivity is measured and decomposed into technical progress and efficiency. The results suggest an inconsistent growth pattern for banks between 1998 and 2007 driven mainly by efficiency gains in the immediate post-crisis period to 2002, and by technological progress towards the end of the sample period. The second largest banks along with merchant and locally-owned banks showed significant productivity growth in some models, with modest growth for commercial and foreign-owned banks.
Keywords: Bank productivity; Malmquist Productivity index; DEA; bootstrapping; Jamaica
JEL Classification: G21; G28

E2009/28

Jenifer Daley and Kent Matthews (December 2009)
Out of many, dominance by a few? Market power in the Jamaican banking sector. (356K, 23 pages)
This paper presents an empirical assessment of the degree of competition within the Jamaican banking sector during the period 1998 to 2007. The popular H-statistic by Panzar and Rosse is utilised to estimate market power among the sample of banks. Using usual statistical tests, we are unable to reject monopoly/perfect collusion for the banking market in Jamaica. This contrasts with earlier findings using alternative estimators. Therefore, the use of a dynamic reformulation of the model with a dynamic estimator highlights some collusive behaviour among banks.
Keywords: Competition; banking; Rosse-Panzar H-statistic; Dynamic panel estimation; Jamaica
JEL Classification: G21; G28

E2009/27

Kent Matthews and Owen Matthews (December 2009)
Controlling Banker's Bonuses: Efficient Regulation or Politics of Envy? (136K, 21 pages)
Published in Economic Affairs, 30, 1, March, 2010, 71-76
The positive relationship between bank CEO compensation and risk taking is a well established empirical fact. The global banking crisis has resulted in a chorus of demands to control banker's bonuses and thereby curtail their risk taking activities in the hope that the world can avoid a repeat in the future. However, the positive relationship is not a causative one. In this paper we argue that the cushioning of banks downside risks provide the incentive for banks to take excessive risk and design compensation packages to deliver high returns. Macro-prudential regulation will have a better chance of curbing excess risk taking than controlling banker's compensation.
Keywords: Banker's bonus; risk taking; Too-big-to-Fail; macro-prudential regulation
JEL Classification: G21; G28

E2009/26

Jingwen Fan and Patrick Minford (November 2009, updated March 2011)
Can the Fiscal Theory of the price level explain UK inflation in the 1970s? (561K, 28 pages)
We investigate whether the Fiscal Theory of the Price Level can explain UK inflation in the 1970s. We find that fiscal policy was non-Ricardian and money growth entirely endogenous in this period. The implied model of inflation is tested in two ways: for its trend using cointegration analysis and for its dynamics using the method of indirect inference. We find that it is not rejected. We also find that the model's errors indicate omitted dynamics which merit further research.
Keywords: UK Inflation; Fiscal Theory of the Price Level; Bootstrap simulation; Indirect inference; Wald statistic
JEL Classification: E31; E37; E62; E65

E2009/25

Szilárd Benk, Max Gillman and Michal Kejak (November 2009)
A Banking Explanation of the US Velocity of Money: 1919-2004 (449K, 33 pages)
The paper shows that US GDP velocity of M1 money has exhibited long cycles around a 1.25% per year upward trend, during the 1919-2004 period. It explains the velocity cycles through shocks constructed from a DSGE model and annual time series data (Ingram et al., 1994). Model velocity is stable along the balanced growth path, which features endogenous growth and decentralized banking that produces exchange credit. Positive shocks to credit productivity and money supply increase velocity, as money demand falls, while a positive goods productivity shock raises temporary output and velocity. The paper explains such velocity volatility at both business cycle and long run frequencies. With filtered velocity turning negative, starting during the 1930s and the 1987 crashes, and again around 2003, results suggest that the money and credit shocks appear to be more important for velocity during less stable times and the goods productivity shock more important during stable times.
Keywords: Volatility; business cycle; credit shocks; velocity
JEL Classification: E13; E32; E44

E2009/24

Jenifer Daley and Kent Matthews (November 2009)
Measuring bank efficiency: tradition or sophistication? - A note (335K, 11 pages)
The recent literature on measuring bank performance indicates a preference for sophisticated techniques over simple accounting ratios. We explore the results and relationships between bank efficiency estimates using accounting ratios and Data Envelope Analysis (DEA) with bootstrap among Jamaican banks between 1998 and 2007. The results indicate different outcomes for the traditional accounting ratios and the sophisticated DEA methodology in the measurement of bank efficiency. GLS random effects two-variable regression tests for superiority using a risk index for insolvency suggest an advantage in favour of the DEA.
Keywords: Bank efficiency; Jamaica; Accounting Ratios
JEL Classification: G21; G28; G29

E2009/23

Michael G Arghyrou, Andros Gregoriou and Panayiotis M. Pourpourides (November 2009)
Exchange rate uncertainty and deviations from Purchasing Power Parity: Evidence from the G7 area (355K, 14 pages)
Arghyrou, Gregoriou and Pourpourides (2009) argue that exchange rate uncertainty causes deviations from the law of one price. We test this hypothesis on aggregate data from the G7-area. We find that exchange rate uncertainty explains to a significant degree deviations from Purchasing Power Parity.
Keywords: Purchasing power parity; exchange rate uncertainty
JEL Classification: F31; F41

E2009/22

Vo Phuong Mai Le, Patrick Minford and Michael Wickens (November 2009)
The 'Puzzles' methodology: en route to Indirect Inference? (535K, 24 pages)
We review the methods used in many papers to evaluate DSGE models by comparing their simulated moments with data moments. We compare these with the method of Indirect Inference to which they are closely related. We illustrate the comparison with contrasting assessments of a two-country model in two recent papers. We conclude that Indirect Inference is the proper end point of the puzzles methodology.
Keywords: Bootstrap; US-EU model; DSGE; VAR; indirect inference; Wald statistic; anomaly; puzzle
JEL Classification: C12; C32; C52; E1

E2009/21

Patrick Minford and Naveen Srinivasan (October 2009, updated April 2011)
Determinacy in New Keynesian models: a role for money after all? (451K, 25 pages)
The New-Keynesian Taylor-Rule model of inflation determination with no role for money is incomplete. As Cochrane (2007a) argues, it has no credible mechanism for ruling out bubbles and as a results fails to provide a reason for private agents to pick a unique stable path. We propose a way forward. Our proposal is in effect that the New-Keynesian model should be formulated with a money demand and money supply function. It should also embody a terminal condition for money supply behaviour. If an unstable path occurred the central bank would switch to a money supply Rule explicitly designed to stop it via the terminal condition. This would be therefore a 'threat/trigger strategy' complementing the Taylor Rule - only to be invoked if inflation misbehaved. Thus we answer the criticisms levelled at the Taylor Rule that it has no credible mechanism for ruling out bubbles. However it does imply that money cannot be avoided int he New Keynesian set-up, contrary to Woodford (2008).
Keywords: New-Keynesian; Taylor Rule; Determinacy
JEL Classification: E31; E52; E58

E2009/20

Huw David Dixon (October 2009)
A unified framework for understanding and comparing dynamic wage and price setting models (336K, 45 pages)
This paper argues that the cross-sectional approach to durations is essential to understand nominal rigidity because this captures the fact that price-spells are generated by firms' price-setting behavior. Since the distribution of durations is dominated by a proliferation of short contracts, the cross-sectional measure corrects for this by length-biased sampling. Modelling the price-spell durations in this way enables us to see how Taylor, Calvo and their generalizations relate to each other, and enable us to compare price-setting behavior for a given distribution of durations. We also show how the micro-data can be directly related to the macroeconomic pricing models in this setting.
Keywords: Price-spell; steady state; hazard rate; Calvo; Taylor
JEL Classification: E50

E2009/19

Patrick Minford and Zhirong Ou (September 2009, updated May 2010)
Taylor Rule or Optimal Timeless Policy? Reconsidering the Fed's behaviour since 1982 (1606K, 37 pages)
We calibrate a standard New Keynesian model with three alternative representations of monetary policy - an optimal timeless rule, a Taylor rule and another with interest rate smoothing - with the aim of testing which if any can match the data according to the method of indirect inference. We find that the only model version that fails to be strongly rejected is the optimal timeless rule. Furthermore this version can also account for the widespread finding of apparent 'Taylor rules' and 'interest rate smoothing' in the data, even though neither represents the true monetary policy
Keywords: Monetary policy; Kew Keynesian model; the 'target rule'; Taylor-type rules; Bootstrap simulation; VAR; Indirect inference; Wald statistic
JEL Classification: E12; E17; E42; E52; E58
See also: Supporting Annex

E2009/18

Rhys ap Gwilym (September 2009)
The Monetary Policy Implications of Behavioral Asset Bubbles (624K, 39 pages)
I introduce behavioral asset pricing rules into a wider dynamic stochastic general equilibrium framework. Asset price bubbles emerge endogenously within the model. I find that in this model the only monetary policy that would be likely to enhance welfare is a counter-intuitive 'running with the wind' policy. I conclude that the optimal policy is highly dependent on the nature of the behavioral rules that are stipulated. Given that monetary authorities have limited information about the ways in which agents actually behave, a systematic monetary policy response to asset price misalignments is unlikely to enhance welfare.

E2009/17

Rhys ap Gwilym (September 2009)
Can behavioral finance models account for historical asset prices? (359K, 10 pages)
I construct a behavioral model of asset pricing in which agents choose whether to base their expectations on chartist or fundamental forecasts. I simulate the model in order to test its efficacy in explaining the moments and time series properties of the FTSE All-Share index, and find that the model cannot be rejected as the data generating process.
Keywords: Behavioral finance; Asset pricing
JEL Classification: G12; D03

E2009/16

Parantap Basu, Max Gillman and Joseph Pearlman (September 2009)
Inflation, Human Capital and Tobin's q (261K, 36 pages)
A pervasive empirical finding for the US economy is that inflation is negatively correlated with the normalized market price of capital (Tobin's q) and growth. A dynamic stochastic general equilibrium model of endogenous growth is developed to explain these stylized facts. In this model, human capital is the principal driver of self-sustained growth. Long run comparative statics analysis suggests that inflation diverts scarce time resource to leisure which lowers human capital utilization. This impacts growth adversely and modulates capital adjustment cost downward resulting in a decline in Tobin's q. For the short run, a Tobin effect of inflation on growth weakens the negative association between inflation and q.

E2009/15

James Foreman-Peck (September 2009)
The Western European Marriage Pattern and Economic Development (273K, 32 pages)
For several centuries, women's age at first marriage in Western Europe was higher than in the east (and in the rest of the world). Over the same period Western Europe began slow but sustained economic development relative to elsewhere. A model based on the economics of the household explains this association in two related ways. Both connect mortality, and the exercise of fertility restraint through higher marriage age, with greater human capital accumulation. The first explanation is simply an association but the second proposes a causal link where higher age of motherhood reduced the cost of investment in children. Evidence is provided that the causal process was operative in later nineteenth century Europe
Keywords: Human Capital; Household Production; Economic Development; 19th Century Europe
JEL Classification: N13; N33; O15; J12; J24

E2009/14

Kent Matthews and Nina Zhang (September 2009)
Bank Productivity in China 1997-2007: An Exercise in Measurement (514K, 41 pages)
This study examines the productivity growth of the nationwide banks of China and a sample of city commercial, banks for the eleven years to 2007. Estimates of total factor productivity growth are constructed with appropriate confidence intervals, using a bootstrap method for the Malmquist index. The study adjusts for the quality of the output by accounting for the non-performing loans on the balance sheets of the banks and tests for the robustness of the results by examining alternative sets of outputs. The productivity growth of the state-owned commercial banks (SOCBs) is compared with the joint-stock banks (JSCBs) and city commercial banks (CCBs). The results show that average total factor productivity for the joint-stock banks was better than that of the state-owned banks for some models of measurement but not others. But the average city commercial banks improved its productivity growth both in terms of frontier shift and efficiency gain throughout the whole period. The study also shows that individual state-owned and joint-stock banks did improve their productivity growth and defined an improving production frontier. Most other banks lagged behind so that the gap between the inefficient banks and the most efficient banks widened. While individual banks improved their productivity growth there is no evidence that the average productivity growth of Chinese banks as a whole improved in the run-up to WTO.
Keywords: Bank Efficiency; Productivity; Malmquist index; Bootstrap
JEL Classification: D24; G21;

E2009/13

Kent Matthews, Zhiguo Xiao and Xu Zhang (September 2009)
Rational Cost Inefficiency in Chinese Banks (497K, 34 pages)
According to a frequently cited finding by Berger et al (1993), X-inefficiency contributes 20% to cost-inefficiency in western banks. Empirical studies of Chinese banks tend to place cost-inefficiency in the region of 50%. Such estimates would suggest that Chinese banks suffer from gross cost inefficiency. Using a non-parametric bootstrapping method, this study decomposes cost-inefficiency in Chinese banks into X-inefficiency and allocative-inefficiency. It argues that allocative inefficiency is the optimal outcome of input resource allocation subject to enforced employment constraints. The resulting analysis suggests that allowing for rational allocative inefficiency; Chinese banks are no better or worse than their western counterparts.
Keywords: Bank Efficiency; China; X-inefficiency; DEA; Bootstrapping
JEL Classification: D23; G21; G28

E2009/12

James Foreman-Peck and Simon Moore (August 2009)
Gratuitous Violence and the Rational Offender Model (445K, 32 pages)
Rational offender models assume that individuals choose whether to offend by weighing the rewards against the chances of apprehension and the penalty if caught. While evidence indicates that rational theory is applicable to acquisitive crimes, the explanatory power for gratuitous non-fatal violent offending has not been evaluated. Lottery-type questions elicited risk attitudes and time preferences from respondents in a street survey. Admitted violent behaviour was predictable on the basis of some of these responses. Consistent with the rational model, less risk averse and more impatient individuals were more liable to violence. Such people were also more likely to be victims of violence. In line with a 'subjective' version of the rational model, respondents with lower estimates of average violence conviction chances and of fines were more prone to be violent.
Keywords: Violence; alcohol; risk; intertemporal choice; rational offending
JEL Classification: D81; D9; K14

E2009/11

David R. Collie (July 2009)
Immiserizing Growth and the Metzler Paradox in the Ricardian Model (284K, 25 pages)
Forthcoming in International Economic Journal
Conditions for the occurrence of immiserizing growth and the Metzler paradox are analysed in the Ricardian model when consumers in the foreign country have Leontief preferences while consumers in the home country have Cobb-Douglas preferences. By using specific functional forms, the conditions for the occurrence of the two paradoxes are defined in terms of the exogenous parameters of the model rather than endogenous variables such as the elasticity of demand for exports in the conditions of Bhagwati (1958) and Metzler (1949a and b). It is shown that the simultaneous occurrence of both paradoxical results is possible for some parameter values.
Keywords: Immiserizing Growth; Metzler Paradox; Import Tariffs; Ricardian Model
JEL Classification: F11; F13

E2009/10

Patrick Minford (July 2009)
The Banking Crisis - A Rational Interpretation (136K, 9 pages)
Published in Political Studies Review, vol. 8(1) (2010), 40-54
Modern macroeconomic models have been widely criticised as relying too much on rationality and market efficiency. However, basically their predictions about this crisis are being borne out by events. 'Crashes' are an integral part of an 'efficient market' capitalism and are brought on by swings in the news about productivity growth; this time nearly two decades of strong computer-based productivity growth were brought to a crashing halt by raw material shortages. This presages a slow recovery until innovation in material use frees growth up again as it did in the 1990s after the shortages of the 1970s.
Keywords: Macroeconomic models; Banking Crisis
JEL Classification: E0

E2009/9

Mark A Clatworthy, Christopher K.M. Pong and Woon K. Wong (August 2009, updated October 2011)
Auditor Quality and the Role of Accounting Information in Explaining UK Stock Returns (720K, 34 pages)
In this paper, we examine the relative importance of the cash flow and accruals components of earnings in explaining the variation in UK company equity returns, together with the extent to which these relationships vary by auditor quality. We use a multivariate time-series approach that can be reconciled to a log-linear theoretical valuation model and, unlike the standard linear regression of returns on earnings components, accommodates time varying discount rates. Based on a decomposition of the variance of equity returns, cash flows and accruals, our results indicate that both cash flow news and accruals news are important drivers of equity returns, though cash flows are more influential than accruals. We also find that auditor quality moderates these relationships, since variation in both earnings components has a more significant effect for clients of large auditors. Finally, our results indicate that the impact of auditor quality is highest for the accruals component of earnings.

E2009/8

David R. Collie (June 2009)
Tacit Collusion over Foreign Direct Investment under Oligopoly (439K, 36 pages)
A two-country model of the FDI versus export decisions of firms is analysed. The analysis considers both the Cournot duopoly and the Bertrand duopoly models with differentiated products. It is shown that the static game is often a prisoners' dilemma where both firms are worse off when they both undertake FDI. To avoid the prisoners' dilemma, in an infinitely-repeated game, the firms can collude over their FDI versus export decisions. Then, a reduction in trade costs may lead firms to switch from exporting to undertaking FDI when trade costs are relatively high. Also, collusion over FDI may increase welfare.
Keywords: Collusion; Trade Liberalisation; Foreign Direct Investment; Cournot Oligopoly; Bertrand Oligopoly; Infinitely-Repeated Game
JEL Classification: F12; F23; L13; L41; M16

E2009/7

Saeed Al-Muharrami and Kent Matthews (June 2009)
Market Power versus Efficient-Structure in Arab GCC Banking (110K, 21 pages)
Copyright NoticeAuthor Posting. (c) 'Copyright Holder', 2009.
This is the author's version of the work. It is posted here by permission of 'Copyright Holder' for personal use, not for redistribution.
The definitive version was published in Applied Financial Economics, Volume 19 Issue 18, September 2009. doi:10.1080/09603100902845478

Published in Applied Financial Economics, Volume 19 Issue 18, September 2009, pp. 1487-1496.
This paper evaluates the performance of the Arab GCC banking industry in the context of the Structure-Conduct-Performance hypothesis in the period 1993-2002. The paper uses panel estimation differentiating between bank fixed effects and country fixed effects. It examines the Relative-Market-Power and the Efficient-Structure hypotheses differentiating between the two by employing a non-parametric measure of technical efficiency, and finds that the banking industry in the Arab GCC countries is best explained by the mainstream SCP hypothesis. The empirical results do not find any support for the Hicks (1935) "Quiet Life" version of the market power hypothesis.
Keywords: GCC Banking; Structure Conduct Performance
JEL Classification: G2; L1

E2009/6

GuangJie Li and Roberto Leon-Gonzalez (March 2009)
A Correction Function Approach to Solve the Incidental Parameter Problem (662K, 44 pages)
Following Lancaster (2002), we propose a strategy to solve the incidental parameter problem. The method is demonstrated under a simple panel Poisson count model. We also extend the strategy to accomodate cases when information orthogonality is unavailable, such as the linear AR(p) panel model. For the AR(p) model, there exists a correction function to fix the incidental parameter problem when the model is stationary with strictly exogenous regressors. MCMC algorithms are developed for parameter estimation and model comparison. The results based on the simulated data sets suggest that our method could achieve consistency in both parameter estimation and model selection.
Keywords: dynamic panel data model with fixed effect; incidental parameter problem; consistency in estimation; model selection; Bayesian model averaging; Markov chain Monte Carlo (MCMC)
JEL Classification: C52; C11; C12; C13; C15

E2009/5

GuangJie Li (March 2009)
Consistent Estimation, Model Selection and Averaging of Dynamic Panel Data Models with Fixed Effect (574K, 44 pages)
In the context of an autoregressive panel data model with fixed effect, we examine the relationship between consistent parameter estimation and consistent model selection. Consistency in parameter estimation is achieved by using the transformation of the fixed effect proposed by Lancaster (2002). We find that such transformation does not necessarily lead to consistent estimation of the autoregressive coefficient when the wrong set of exogenous regressors are included. To estimate our model consistently and to measure its goodness of fit, we argue for comparing different model specifications using the Bayes factor rather than the Bayesian information criterion based on the biased maximum likelihood estimates. When the model uncertainty is substantial, we recommend the use of Bayesian Model Averaging. Finally, we apply our method to study the relationship between financial development and economic growth. Our findings reveal that stock market development is positively related to economic growth, while the effect of bank development is not as significant as the classical literature suggests.
Keywords: dynamic panel data model with fixed effect; incidental parameter problem; consistency in estimation; model selection; Bayesian Model Averaging; finance and growth
JEL Classification: C52; C11; C13; C15

E2009/4

GuangJie Li (March 2009, updated August 2009)
The Horizon Effect of Stock Return Predictability and Model Uncertainty on Portfolio Choice: UK Evidence (543K, 44 pages)
We study how stock return's predictability and model uncertainty affect a rational buy-and-hold investor.s decision to allocate her wealth for different lengths of investment horizons in the UK market. We consider the FTSE All-Share Index as the risky asset, and the UK Treasury bill as the risk free asset in forming the investor's portfolio. We identify the most powerful predictors of the stock return by accounting for model uncertainty. We find that though stock return predictability is weak, it can still affect the investor's optimal portfolio decision over different investment horizons.
Keywords: stock return predictability; portfolio choice; Bayesian Model Averaging; SUR model
JEL Classification: C11; G11; G15

E2009/3

Vo Phuong Mai Le, David Meenagh, Patrick Minford and Michael Wickens (March 2009, updated December 2009)
Two Orthogonal Continents: Testing a Two-country DSGE Model of the US and EU Using Indirect Inference (899K, 51 pages)
Published in Open Economies Review 21(1) pp. 23-44 February 2010.
We examine a two country model of the EU and the US. Each has a small sector of the labour and product markets in which there is wage/price ridigity, but otherwise enjoys flexible wages and prices with a one quarter information lag. Using a VAR to represent the data, we find the model as a whole rejected. Howerver it is accepted for particular features of the data, such as output and (marginally) inflation behaviour. The model highlights a lack of spillovers between the US and the EU.
Keywords: Bootstrap; Open economy model; DGSE; VAR; New Keynesian; New Classical; indirect inference; Wald statistic
JEL Classification: C12; C32; C52; E1

E2009/2

Michael G Arghyrou, Andros Gregoriou and Panayiotis M. Pourpourides (January 2009, updated July 2009)
A new solution to the purchasing power parity puzzles? Risk-aversion, exchange rate uncertainty and the law of one price: Insights from the market of online air-travel tickets (424K, 27 pages)
Forthcoming in Canadian Journal of Economics
We argue that even in perfectly frictionless markets risk aversion driven by exchange rate uncertainty may cause a wedge between the domestic and foreign price of a totally homogeneous good. We test our hypothesis using a natural experiment based on a unique micro-data set from a market with minimum imperfections. The empirical findings validate our hypothesis, as accounting for exchange rate uncertainty we are able to explain a substantial proportion of deviations from the law of one price. Overall, our analysis suggests the possibility of a new solution to the purchasing power parity puzzles.
Keywords: Law of one price; purchasing power parity; risk aversion; exchange rate uncertainty
JEL Classification: F31; F41

E2009/1

Vo Phuong Mai Le, Patrick Minford and Eric Nowell (January 2009)
Economic Policy: protectionism as an elite strategy (258K, 22 pages)
Published in The European Union and World Politics (eds. Andrew Gamble and David Lane), Palgrave Macmillan, ISBN 9780230221499, 2009
The EU has pursued protectionist policies not merely in food but also in manufacturing at the customs union level. In services it has not dismantled much of the existing national protectionism. The economic costs are calculated here at some 3% of GDP for the UK and some 4% for the rest of the EU - or much larger under liberal planning assumptions. Added to its social interventionism, these costs suggest that the EU has put political integration before economic efficiency. This policymaking pattern suggests that European elites believe their position would be threatened by the domestic effects of world competition.
Keywords: protectionism; manufactures; anti-dumping; tariff equivalent; customs union; competition
JEL Classification: F13; F14

E2008/32

Vo Phuong Mai Le, David Meenagh, Patrick Minford and Michael Wickens (December 2008, updated July 2011)
How much nominal rigidity is there in the US economy? Testing a New Keynesian DSGE Model using indirect inference (585K, 37 pages)
Forthcoming in Journal of Economic Dynamics and Control
We evaluate the Smets-Wouters New Keynesian model of the US postwar period, using indirect inference, the bootstrap and a VAR representation of the data. We find that the model is strongly rejected. While an alternative (New Classical) version of the model fares no better, adding limited nominal rigidity to it produces a `weighted' model version closest to the data. But on data from 1984 onwards - the `great moderation' - the best model version is one with a high degree of nominal rigidity, close to New Keynesian. Our results are robust to a variety of methodological and numerical issues.
Keywords: Bootstrap; US model; DGSE; VAR; New Keynesian; New Classical; indirect inference; Wald statistic; regime change; structural break; great moderation
JEL Classification: C12; C32; C52; E1
See also: Supporting Annex

E2008/31

Eric Scheffel (December 2008)
Consumption Velocity in a Cash Costly-Credit Model (580K, 34 pages)
In a seminal study Hodrick et al. (1991) evaluate the ability of a simple cash-credit model to produce realistic variability in consumption velocity while at the same time successfully explaining other key statistics. Sufficient variability in the latter is found to be associated with far too volatile interest rate behaviour. Introducing habit-formation in consumption into a production-based cash costly-credit model (see Gillman and Benk, 2007) makes the evolution of deposits more rigid relative to credit. The same deposit rigidity leads to a more volatile price of credit, causing credit production overshooting relative to deposits. But only by introducing adjustment costs to investment in addition to habit persistence does credit production overshoot sufficiently to produce realistic variability in consumption velocity. The model succeeds in capturing sufficient variability in consumption velocity without obtaining too volatile interest rates. Also, this model of endogenous velocity does not suffer from indeterminacy problems discussed in Auray et al. (2005). In contrast to Gillmand and Benk (2007), the present study examies the role of the price-channel of credit production at business cycle frequency, ignoring or holding fixed the marginal cost channel stemming from credit productivity shocks.
Keywords: Velocity; Consumption; Interest Rates
JEL Classification: E0; E2; E3; E4

E2008/30

Eric Scheffel (December 2008)
A Credit-Banking Explanation of the Equity Premium, Term Premium, and Risk-Free Rate Puzzles (858K, 67 pages)
Micro-founded de-centralized financial intermediation in a cash and costly-credit model (see Gillmand and Kejak, 2008) results in a cost-distortion of returns implying a lower average nominal and real risk-free rate when compared to standard cah-in-advance RBC models. Failure of both short-run and long-run Fisher equation relationships based on observable real and nominal rates and inflation are obtained. The cost-distortion also leads to an unconditionally upward-sloping average yield curve of interest rates which is also convex in shape. The model is capable of producing a positive correlation between the nominal rate and velocity, and a negative correlation between the ex-post real rate and inflation. More importantly, the model also predicts a negative correlation between the ex-ante real rate and the ex-ante expected rate of inflation. Finally, the condition spread between the usual CCAPM rate as defined by Canzoneri and Diba (2005) and the model-implied money market rate is positively correlated with the stance of monetary policy, offering a new perspective on this systematic link recently studied empirically by Canzoneri et al. (2007a) and theoretically by Canzoneri and Diba (2005).
Keywords: Business cycles; Money; Term structure of interest rates
JEL Classification: E4; E44

E2008/29

Kul B Luintel and Mosahid Khan (December 2008)
Heterogeneous Ideas Production and Endogenous Growth: An Empirical Investigation (336K, 47 pages)
Published in Canadian Journal of Economics, vol. 42 (2009), 1176-1205
We examine the dynamics of ideas production and knowledge-productivity relationship in a panel of 19 OECD countries. A new data set of triadic patents is used. We rigorously address the issues of cross-country heterogeneity and endogeneity. Domestic and foreign ideas stocks exert positive but heterogeneous effects on ideas production. We find evidence of duplicate R&D but little support for endogenous growth. Countries with low domestic ideas bases could considerably improve productivity through ideas accumulation; however, this effect is modest for countries with sizeable ideas bases. An implication is that country-specific R&D policy appears potentially more effective than the one-size-fits-all approach.
Keywords: Knowledge Stocks; Dynamic Heterogeneity; TFP; Methods of Moments
JEL Classification: F12; F2; O3; O4; C15

E2008/28

Szilárd Benk, Max Gillman and Michal Kejak (November 2008)
US Volatility Cycles of Output and Inflation, 1919-2004: A Money and Banking Approach to a Puzzle (762K, 43 pages)
The post-1983 moderation coincided with an ahistorical divergence in the money aggregate growth and velocity volatilities away from the downward trending GDP and inflation volatilities. Using an endogenous growth monetary DSGE model, with micro-based banking production, enables a contrasting characterization of the two great volatility cycles over the historical period of 1919-2004, and enables this puzzle to be addressed more easily. The volatility divergence is explained by the upswing in the credit volatility that kept money supply variability from translating into inflation and GDP volatility.
Keywords: Volatility; money and credit shocks; growth; inflation
JEL Classification: E13; E32; E44

E2008/27

David R. Collie and Vo Phuong Mai Le (November 2008)
Anti-Dumping Regulations: Anti-Competitive and Anti-Export (237K, 20 pages)
Published in Review of International Economics, Vol. 18, No. 5, 2010, pp. 796-806.
In a Bertrand duopoly model, it is shown that an anti-dumping regulation can be strategically exploited by the domestic firm to reduce the degree of competition in the domestic market. The domestic firm commits not to export to the foreign market which gives the foreign firm a monopoly in its own market. As a result the foreign firm will increase its price allowing the domestic firm to increase its price and its profits. If the products are sufficiently close substitutes then the higher profits in the domestic market are large enough to compensate for the loss of profits on exports.
Keywords: anti-dumping regulations; Bertrand oligopoly; strategic behaviour
JEL Classification: F13; L13

E2008/26

Kent Matthews, Jianguang Guo and Xu Zhang (November 2008)
X-efficiency versus Rent Seeking in Chinese banks: 1997-2006 (313K, 34 pages)
This study demarcates cost-inefficiency in Chinese banks into X-inefficiency and rent-seeking-inefficiency. A protected banking market not only encourages weak management and X-inefficiency but also public ownership and state directed lending encourages moral hazard and bureaucratic rent seeking. This paper uses bootstrap non-parametric techniques to estimate measures of X-inefficiency and rent-seeking inefficiency for the 4 state owned banks and 10 joint-stock banks over the period 1997-2006. The paper adjusts for the quality of loans by treating NPLs as a negative output. The paper shows that Chinese banks have reduced cost inefficiency and reduced X-inefficiency at a faster rate than rent-seeking inefficiency.
Keywords: Bank Efficiency; China; X-inefficiency; DEA; Bootstrapping
JEL Classification: D23; G21; G28;

E2008/25

Max Gillman and Mark N. Harris (October 2008)
The Effect of Inflation on Growth: Evidence from a Panel of Transition Countries (251K, 20 pages)
Published in Economics of Transition, Volume 18, Issue 4 (October), pages 697-714.
The paper examines the effect of inflation on growth in transition countries. It presents panel data evidence for 13 transition countries over the 1990-2003 period; it uses a fixed effects, full-information maximum likelihood, panel approach to account for possible bias from correlations among the unobserved effects and the observed country heterogeniety. The results find a strong, robust, negative effect of inflation on growth, and one that declines in magnitude as the inflation rate increases. These results include a role for a normalized money demand, by itself and as part of a nonlinearity in the inflation-growth effect. And these results derive from both a baseline single equation model and one that is then expanded into a three equation simultaneous system. This allows for possible simultaneity bias in the baseline model.
Keywords: Growth; transition; panel data; inflation; money demand; endogeneity
JEL Classification: C23; E44; O16; O42

E2008/24

Soubarna Pal (October 2008)
Does Public Investment Boost Economic Growth? Evidence from An Open-Economy Macro Model for India (230K, 30 pages)
Using annual data for India for the period 1984-2003 and employing parametric technique (GMM), the present paper jointly determines GDP growth, real exchange rate and net foreign assets in Indian economy. There is evidence that public investment exerts a significant influence on real exchange rate and the growth rate and does so non-linearly. A comparison of the Indian estimates with those available for the UK and the USA economies is also revealing and highlights the role of governance on the effects of public investment.
Keywords: Public investment; Economic growth; Real exchange rate; Simultaneous model; Generalised method of moments

E2008/23

Michael G Arghyrou and Maria Dolores Gadea (October 2008)
The single monetary policy and domestic macro-fundamentals: Evidence from Spain (435K, 33 pages)
We model pre-euro Spanish monetary policy and use our findings to assess the compatibility of the interest rates set by the ECB since 1999 with Spanish macrofundamentals. We find that in the 1990s Spain implemented successfully a monetary strategy tailored to its own domestic fundamentals; and by abolishing it to join the euro she has paid a cost in the form of a sub-optimal monetary policy. Spain.s experience suggests a cautious approach with regards to the timing of further EMU enlargement.
Keywords: Spain; ECB; monetary policy; domestic fundamentals; compatibility
JEL Classification: C51; C52; E43; E58; F37

E2008/22

Huw David Dixon and Engin Kara (September 2008)
Can we explain inflation persistence in a way that is consistent with the micro-evidence on nominal rigidity? (340K, 27 pages)
Published in Journal of Money, Credit and Banking, Volume 42, Number 1, February 2010 , pp. 151-170.
This paper adopts the Impulse-Response methodology to understand inflation persistence. It has often been argued that existing models of pricing fail to explain the persistence that we observe. We adopt a common general framework which allows for an explicit modelling of the distribution of contract lengths and for different types of price setting. We also evaluate how far the theories are consistent with recent evidence on price and wage rigidity. We find that allowing for a distribution of durations can take us a long way to solving the puzzle of inflation persistence, but not all the way yet.
Keywords: DSGE models; inflation; persistence; price-setting
JEL Classification: E17; E3

E2008/21

Paulo Brito, Luís F. Costa and Huw David Dixon (September 2008, updated July 2010)
Non-smooth Dynamics and Multiple Equilibria in a Cournot-Ramsey Model with Endogenous Markups (462K, 47 pages)
We consider a Ramsey model with a continuum of Cournotian industries where free entry generates an endogenous markup. The model produces two different regimes: monopoly and oligopoly. We study the non-smooth dynamics and analyze the global dynamics of the model, demonstrating the model exhibits robust heteroclinic orbits, either of the smooth or the non-smooth type. Similar economies may be in any of these regimes and they may change regime along its convergence path. Productivity, fixed costs and elasticities of demand, play a crucial role and changing their values may induce a discontinuous transition or hysteresis.
Keywords: endogenous mark-ups; non-smooth dynamics; discontinuous induced bifurcations; heteroclinic orbits
JEL Classification: C62; D43; E32

E2008/20

Michael C. Hatcher (September 2008)
Speed Limit Policies versus Inflation Targeting: A Free Lunch? (218K, 13 pages)
Inflation targeting is currently popular with central banks. Is this popularity justified? I investigate this question by comparing a speed limit policy and inflation targeting with a Lucas-type Phillips curve capturing output gap persistence. If the output gap is at least moderately persistent, a speed limit policy can: (1) partly eliminate the state-contingent inflation bias, and (2) reduce inflation variability at no output gap variability cost.
Keywords: inflation targeting; speed limit policy; inflation bias; discretion; stabilisation
JEL Classification: E50; E52; E58

E2008/19

Christopher Otrok and Panayiotis M. Pourpourides (August 2008, updated March 2009)
On The Cyclicality of Real Wages and Wage Differentials (324K, 34 pages)
We show that two models of the labor market, a Walrasian model and a labor contracting model, both have an approximate dynamic factor structure. We use this result to motivate our empirical approach to estimating the cyclical properties of real wages, which does not impose any structure between real wages and observed cyclical indicators. In particular, we employ a Bayesian dynamic factor model and longitudinal microdata to estimate common latent factors driving real wages. We find that the comovement of real wages is related to a common factor that exhibits a mild correlation with the national unemployment rate. Our findings indicate that overall, roughly half of the wages move procyclically while half move countercyclically. In addition, we find that the estimated common factor can explain only a small portion of wage variability. We conclude that these facts are inconsistent with the prediction of a Walrasian labor market model, but consistent with the prediction of a labor contracting model. Finally, our findings suggest that although skilled and unskilled wages are driven by different common skill factors, these factors cannot explain a significant portion of wage variability.
Keywords: Wages; Wage Differentials; Business Cycles; Bayesian Analysis
JEL Classification: C11; C13; C22; C23; C81; C82; J31

E2008/18

Max Gillman and Michal Kejak (August 2008, updated October 2008)
Inflation, Investment and Growth: a Banking Approach (809K, 35 pages)
Published in Economica, 78 (310, April 2011): 260-282.
Output growth, investment and the real interest rate are all found empirically to be negatively affected by inflation. But a seeming puzzle arises of opposite Tobin-like inflation effects because theory indicates a negative Tobin effect when investment falls and a positive Tobin effect when the real interest rate rises. We define inflation's Tobin effect more specifically in terms of the effect on the capital to effective labor ratio and resolve the puzzle by showing the simultaneous occurrence of all three negative inflation effects, on growth, investment and real interest rates, in a model calibrated to postwar US data. Here, investment along with consumption are exchanged for within a monetary endogenous growth economy with human capital and a decentralized credit-producing sector.
Keywords: Inflation; investment; growth; Tobin
JEL Classification: C23; E44; O16; O42

E2008/17

Kent Matthews, Jianguang Guo and Nina Zhang (November 2007, updated August 2008)
Non-Performing Loans and Productivity in Chinese Banks: 1997-2006 (307K, 43 pages)
Published in The Chinese Economy, 42, 2, pp. 30-47
This study examines the productivity growth of the nationwide banks of China over the ten years to 2006. Using a bootstrap method for the Malmquist index estimates of productivity growth are constructed with appropriate confidence intervals. The paper adjusts for the quality of the output by accounting for the non-performing loans on the balance sheets and test for the robustness of the results by examining alternative sets of outputs. The productivity growth of the state-owned banks is compared with the Joint-stock banks and it determinants evaluated. The paper finds that average productivity of the Chinese banks improved modestly over this period. Adjusting for the quality of loans, by treating NPLs as an undesirable output, the average productivity growth of the state-owned banks was zero or negative while productivity of the Joint-Stock banks was markedly higher.
Keywords: Bank Efficiency; Productivity; Malmquist index; Bootstrapping
JEL Classification: D24; G21;

E2008/16

Patrick Minford (July 2008)
Commentary on Economic Projections and Rules of Thumb for Monetary Policy (by Athanasios Orphanides and Volker Wieland)
The Taylor rule is widely seen as a good summary of what the Federal Reserve does. Though the rule cannot easily be fitted to actual data as subsequently revised, at least for a full postwar sample, it can be fitted to real-time data (i.e., data as seen at the time), as shown by earlier work by Orphanides (2003). But in practice the Fed.s Federal Open Market Committee (FOMC), if it is using a Taylor rule, will look at its own forecasts or projections. Orphanides and Wieland (2008) examine whether a Taylor rule can be fitted to the FOMC.s own projections since 1988. They find that it can with appropriate parameters that satisfy the Taylor principle.that is, that give a unique stable solution under rational expectations. Furthermore, they find that the rule works better with these projections and resolves various puzzles regarding the data on outcomes.

E2008/15

Max Gillman and Anton Nakov (July 2008, updated November 2009)
Monetary Effects on Nominal Oil Prices (284K, 30 pages)
Published in North American Journal of Economics and Finance, December 2009, Vol 20, Issue 3, pp. 239-254
The paper presents a theory of nominal asset prices for competitively owned oil. Focusing on monetary effects, with flexible oil prices the US dollar oil price should follow the aggregate US price level. But with rigid nominal oil prices, the nominal oil price jumps proportionally to nominal interest rate increases. We find evidence for structural breaks in the nominal oil price that are used to illustrate the theory of oil price jumps. The evidence also indicates strong Granger causality of the oil price by US inflation as is consistent with the theory.
Keywords: oil prices; inflation; cash-in-advance; multiple structural breaks; Granger causality
JEL Classification: E31; E4;

E2008/14

Woon K Wong and Laurence Copeland (July 2008)
Risk Measurement and Management in a Crisis-Prone World (255K, 27 pages)
The current subprime crisis has prompted us to look again into the nature of risk at the tail of the distribution. In particular, we investigate the risk contribution of an asset, which has infrequent but huge losses, to a portfolio using two risk measures, namely Value-at-Risk (VaR) and Expected Shortfall (ES). While ES is found to measure the tail risk contribution effectively, VaR is consistent with intuition only if the underlying return distribution is well behaved. To facilitate the use of ES, we present a power function formula that can calculate accurately the critical values of the ES test statistic. This in turn enables us to derive a size-based multiplication factor for risk capital requirement.
Keywords: Value-at-Risk; expected shortfall; tail risk contribution; saddle point technique; risk capital
JEL Classification: G11; G32

E2008/13

Yanhui Zhu and Laurence Copeland (July 2008, updated October 2008)
The Credit Risk Premium in a Disaster-Prone World (755K, 22 pages)
The seminal Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") allowed for leverage in the form of risky corporate debt which defaulted only in states when the Government defaulted on its debt. The probability of default was therefore exogenous and independent of the degree of leverage. In this paper, we take the model a step closer to reality by assuming that, on the one hand, the Government never defaults, and on the other hand, that the .corporate sector. in the form of the Lucas tree owner pays its debts in full if and only if its asset value is sufficient, which is always the case in non-crisis states. Otherwise, in exceptionally severe crises, it defaults and hands over the whole .firm. to its creditors. The probability of default by the tree owner is thus endogenous, dependent both on the volume of debt issued (taken as exogenous) and on the uncertain value of output. We show, using data from both Barro (2006) and Barro and Ursua (2008), that the model can generate values of the riskless rate, equity risk premium and credit risk spread broadly consistent with those typically observed in the data.
Keywords: equity risk premium; default risk; credit spread; leverage; corporate debt
JEL Classification: F3; G1

E2008/12

Woon K Wong, Laurence Copeland and Ralph Lu (July 2008)
The Other Side of the Trading Story: Evidence from NYSE (186K, 24 pages)
We analyse the well-known TORQ dataset of trades on the NYSE over a 3-month period, breaking down transactions depending on whether the active or passive side was institutional or private. This allows us to compare the returns on the different trade categories. We find that, however we analyse the results, institutions are best informed, and earn highest returns when trading with individuals as counter party. We also confirm the conclusions found elsewhere in the literature that informed traders often place limit orders, especially towards the end of the day (as predicted on the basis of laboratory experiments in Bloomfield, O.Hara, and Saar (2005)). Finally, we find that trading between institutions accounts for the bulk of trading volume, but carries little information and seems to be largely liquidity-driven.
Keywords: liquidity trade; informed trades
JEL Classification: G14; G12

E2008/11

David Meenagh, Patrick Minford and Michael Wickens (May 2008, updated December 2008)
Testing a DSGE model of the EU using indirect inference (602K, 41 pages)
Published in Open Economies Review, vol. 20(4) (2009), 435-471
We use the method of indirect inference, using the bootstrap, to test the Smets and Wouters model of the EU against a VAR auxiliary equation describing their data; the test is based on the Wald statistic. We find that their model generates excessive variance compared with the data. But their model passes the Wald test easily if the errors have the properties assumed by SW but scaled down. We compare a New Classical version of the model which also passes the test easily if error properties are chosen using New Classical priors (notably excluding shocks to preferences). Both versions have (different) difficulties fitting the data if the actual error properties are used. However, a version embedding a small sector with Calvo contracts in an otherwise New Classical economy fits the data well without any scaling.
Keywords: Bootstrap; DSGE Model; VAR model; Model of EU; indirect inference; Wald statistic
JEL Classification: C12; C32
See also: Supporting Annex

E2008/10

Woon K Wong (April 2008)
A Unique Orthogonal Variance Decomposition (266K, 19 pages)
Let e and Σ be respectively the vector of shocks and its variance covariance matrix in a linear system of equations in reduced form. This article shows that a unique orthogonal variance decomposition can be obtained if we impose a restriction that maximizes the trace of A, a positive definite matrix such that Az = e where z is vector of uncorrelated shocks with unit variance. Such a restriction is meaningful in that it associates the largest possible weight for each element in e with its corresponding element in z. It turns out that A = Σ1/2, the square root of Σ.
Keywords: Variance decomposition; Cholesky decomposition; unique orthogonal decomposition and square root matrix
JEL Classification: C01

E2008/9

James Foreman-Peck and Tom Nicholls (April 2008, updated July 2012)
Peripherality and the Impact of SME Takeovers (271K, 42 pages)
New Economic Geography models typically predict centripetal economic development. One process by which this might be brought about is if large companies based in the core of the economy buy up and remove small dynamic enterprises from peripheral regions, thereby suppressing development outside the core. This hypothesis is investigated by analysing the very large UK administrative firm-level Business Structure Database. Contrary to the experience of big firms, more productive small businesses are more subject to takeover - although this effect is weaker if they are located in peripheral regions than in the core. Takeovers also increase the chances of a small and medium size enterprise (SME) closing, but the exit consequence is greater for the core region. Takeovers raise productivity after acquisition in all regions but by less for the most productive SMEs. Ignoring any productivity gains to acquiring firms, the positive impact in the core region during the years considered is slightly larger than in the periphery, principally because takeovers are more common in the core. As this impact is a contributor to regional divergence, policy should aim to improve the operation of the market for SMEs in the periphery.
Keywords: SMEs; takeovers; regional development; exits
JEL Classification: L23; D21; R11

E2008/8

Woon K Wong, Dijun Tan and Yixiang Tian (April 2008)
Nonlinear ACD Model and Informed Trading: Evidence from Shanghai Stock Exchange (312K, 31 pages)
Dufour and Engle (J. Finance (2000) 2467) find evidence of an increased presence of informed traders when the NYSE markets are most active. No such evidence, however, can be found by Manganelli (J. Financial Markets (2005) 377) for the infrequently traded stocks. In this paper, we fit a nonlinear log-ACD model to stocks listed on Shanghai Stock Exchange. When trading volume is high, empirical findings suggest presence of informed trading in both liquid and illiquid stocks. When volume is low, market activity is likely due to liquidity trading. Finally, for the actively traded stocks, our results support the price formation model of Foster and Viswanathan (Rev. Financial Studies (1990) 593).
Keywords: Informed trading; Liquidity trading; Duration; Volume; Volatility
JEL Classification: G11; G14; G15

E2008/7

David Meenagh, Patrick Minford, Eric Nowell, Prakriti Sofat and Naveen Srinivasan (April 2008, updated April 2010)
Can the Facts of UK Inflation Persistence be Explained by Nominal Rigidity? (2105K, 21 pages)
Published in Economic Modelling, vol. 26(5) (2009), 978-992
It has been widely argued that inflation persistence since WWII has been widespread and durable and that it can only be accounted for by models with a high degree of nominal rigidity. We examine UK post-war data where after confirming previous studies, findings of varying persistence due to changing monetary regimes, we find that models with little nominal rigidity are best equipped to explain it.
Keywords: inflation persistence; New Keynesian; New Classical; nominal rigidity; monetary regime shifts
JEL Classification: E31; E37
See also: Supporting Annex

E2008/6

Helmuts Azacis and Max Gillman (February 2008, updated October 2008)
Baltic Tax Reform (456K, 52 pages)
Forthcoming in Journal of Macroeconomics
The paper presents an endogenous growth economy with a representation of the tax rate system in the Baltic countries. Assuming that government spending is a given fraction of output, the paper shows how a flat tax system balanced between labor and corporate tax rates can be second best optimal. It then computes how actual Baltic tax reforms from 2000 to 2007 affect the growth rate and welfare, including transition dynamics. Comparing the actual reform effects to hypothetical tax experiments, it results that equal flat tax rates on personal and corporate income would have increased welfare in all three Baltic countries by 24% more on average than the actual reforms. This shows how equal, balanced, flat rate taxes can be optimal in both theory and practice. Further, movement towards a more equal balance between labor and capital tax rates, through changing just one tax rate, achieved almost as high or higher utility gains as in actual law for all three countries under both open and closed economy cases. This shows benefits of moving towards the optimum.
Keywords: tax reforms; endogenous growth; transitional dynamics; flat taxes
JEL Classification: E13; H20; O11; O14

E2008/5

Patrick Minford and Naveen Srinivasan (February 2008)
Are Central Bank Preferences Asymmetric? A Comment (279K, 13 pages)
Published in Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 37(1) (2008), 119-126
A recent paper by Ruge-Murcia [European Economic Review 48 (2004), 91-107] on asymmetric central bank objectives provides a new perspective on the policy roots of inflation in developed economies. More precisely, the paper demonstrates that if the distribution of the supply shocks is normal, then the reduced form solution for inflation implies a positive (or negative) relation between average inflation and the variance of shocks. We argue that the evidence offered in support of this hypothesis suffers from lack of identification because Phillips curve nonlinearity combined with quadratic central bank preferences yield the same reduced form solution for inflation. If so, estimating reduced form for inflation will not be able to discriminate between these models. Yet they have quite different implications for policy. Other, structural, evidence is needed.
Keywords: Preference asymmetry; Phillips curve nonlinearity; Identification
JEL Classification: E52; E58; E61

E2008/4

Kyriacos Kyriacou, Kul B Luintel and Bryan Mase (February 2008)
Private Information in Executives' Option Trades: Evidence from the UK (245K, 45 pages)
Published in Economica, vol. 77 (2010), 751-774
This paper investigates whether UK executives use private information in the trading decisions associated with the exercise of their executive stock options. We find that UK executives' exercise and sell decisions are motivated by their private information but not by their anticipation of future return volatility. These findings appear robust when we control for additional motivating factors that include option moneyness, the previous stock return and the value of the exercise. We argue that the disparity in the informativeness of US and UK executives' trades at exercise is related to important differences in executive remuneration, and in the regulation and taxation of executive stock options.
Keywords: Executive remuneration; executive stock options; trade informativeness
JEL Classification: G14; G18

E2008/3

Kul B Luintel, Mosahid Khan, Philip Arestis and Konstantinos Theodoridis (January 2008)
Financial Structure and Economic Growth (259K, 43 pages)
Published in Journal of Development Economics, 86 (2008) 181-200
Recent empirical work on financial structure and economic growth analyzes multicountry dataset in panel and/or cross-section frameworks and conclude that financial structure is irrelevant. We highlight their shortcomings and re-examine this issue utilizing a time series and a dynamic heterogeneous panel methods. Our sample consists of fourteen countries. Tests reveal that cross-country data cannot be pooled. Financial structure significantly explains output levels in most countries. The results are rigorously scrutinized through bootstrap exercises and they are robust to extensive sensitivity tests. We also test for several hypotheses about the prospective role of financial structure and financial development on economic growth.
Keywords: Financial Structure; Economic Growth; Co-integration; Bootstrap; Dynamic Heterogeneous Panels
JEL Classification: O16; G18; G28

E2008/2

Laurence Copeland, Woon K Wong and Y Zeng (January 2008)
Information-Based Trade in the Shanghai StockMarket (341K, 20 pages)
We show that the probability of information-based trade (PIN) played a significant role in explaining monthly returns on Shanghai A shares over the period 2001 to 2006. In particular, PIN, as approximated by order imbalance as a proportion of total transactions, appears to explain returns even after controlling for risk in the much-cited Fama and French (1992) three-factor model. However, we also find that some of the PIN effect appears to be indistinguishable from a turnover effect.

E2008/1

Patrick Minford and Soubarna Pal (January 2008)
Real Exchange Rate Overshooting in Real Business Cycle Model - An Empirical Evidence From India (587K, 63 pages)
The objective of this paper is to establish the ability of a Real Business Cycle (RBC) model to account for the behaviour of the real exchange rate, using Indian data (1966-1997). We calibrate the dynamic general equilibrium open economy model (Minford, Sofat 2004) based on optimising decisions of rational agents, using annual data for India. The first order conditions from the households' and firms' optimisation problem are used to derive the behavioural equations of the model. The interaction with the rest of the world comes in the form of uncovered real interest rate parity and current account both of which are explicitly micro-founded. The paper discusses the simulation results of 1 percent per annum productivity growth shock, which shows that the real exchange rate appreciates and then goes back to a new equilibrium (lower than the previous one), producing a business cycle. Thus the behaviour of the real exchange rate may be explicable within the RBC context. Finally we test our model and evaluate statistically whether our calibrated model is seriously consistent with the real exchange rate data, using bootstrapping procedure. We bootstrap our model to generate pseudo real exchange rate series and find that the ARIMA parameters estimated for the actual real exchange rate data lie within the 95% confidence limits constructed by bootstrapping. We find the same result for the nominal rigidity version of the RBC model. So we conclude that the behaviour of the Indian real exchange rate (US $ / Indian Rupees) can be explained by RBC.

E2007/30

Kent Matthews, Jianguang Guo and Nina Zhang (November 2007)
Non-Performing Loans and Productivity in Chinese Banks: 1997-2006 (329K, 29 pages)
This study examines the productivity growth of the nationwide banks of China over the ten years to 2006. Using a bootstrap method for the Malmquist index estimates of productivity growth are constructed with appropriate confidence intervals. The paper adjusts for the quality of the output by accounting for the non-performing loans on the balance sheets and test for the robustness of the results by examining alternative sets of outputs. The productivity growth of the state-owned banks is compared with the Joint-stock banks and it determinants evaluated. The paper finds that average productivity of the Chinese banks improved modestly over this period. Adjusting for the quality of loans, by treating NPLs as an undesirable output, the average productivity growth of the state-owned banks was zero or negative while productivity of the Joint-Stock banks was markedly higher.
Keywords: Bank Efficiency; Productivity; Malmquist index; Bootstrapping
JEL Classification: D24; G21;

E2007/29

Vo Phuong Mai Le, Max Gillman and Patrick Minford (November 2007)
An Endogenous Taylor Condition in an Endogenous Growth Monetary Policy Model (317K, 20 pages)
The paper derives a Taylor condition as part of the agent's equilibrium behavior in an endogenous growth monetary economy. It shows the assumptions necessary to make it almost identical to the original Taylor rule, and that it can interchangably take a money supply growth rate form. From the money supply form, simple policy experiments are conducted. A full central bank policy model is derived that includes the Taylor condition along with equations comparable to the standard aggregate-demand/aggregate-supply model.
Keywords: Taylor Rule; endogenous growth; money supply; policy model
JEL Classification: E51; E52; O0

E2007/28

Luís F. Costa and Huw David Dixon (October 2007)
A Simple Business-Cycle Model with Shumpeterian Features (251K, 45 pages)
We develop a dynamic general equilibrium model of imperfect competition where a sunk cost of creating a new product regulates the type of entry that dominates in the economy: new products or more competition in existing industries. Considering the process of product innovation is irreversible, introduces hysteresis in the business cycle. Expansionary shocks may lead the economy to a new 'prosperity plateau,' but contractionary shocks only affect the market power of mature industries.
Keywords: Entry; Hysteresis; Mark-up
JEL Classification: E62; L13; L16

E2007/27

Helmuts Azacis and David R. Collie (October 2007)
The optimality of optimal punishments in Cournot supergames (214K, 10 pages)
Published in Economics Letters, Vol. 105, 2009, pp. 56-57.
The result of Colombo and Labrecciosa (2006) that optimal punishments are inferior to Nash-reversion trigger strategies with decreasing marginal costs is due to the output when a firm deviates from the punishment path being allowed to become negative.
Keywords: Optimal punishments; trigger strategies; collusion; cartels
JEL Classification: C73; D43; L13

E2007/26

Michael G Arghyrou, Andros Gregoriou and Alexandros Kontonikas (September 2007)
Do real interest rates converge? Evidence from the European Union (545K, 35 pages)
Published in Journal of International Financial Markets, Institutions & Money, vol. 19, July 2009, 447-460
We test for real interest parity (RIP) in the EU25 area. Our contribution is two-fold: First, we account for the previously overlooked effects of structural breaks on real interest rate differentials. Second, we test for RIP against the EMU average. For the majority of our sample countries we obtain evidence of real interest rate convergence towards the latter. Convergence, however, is a gradual process subject to structural breaks, typically falling close to the launch of the euro. Our findings have important implications relating to the single monetary policy and the progress new EU members have achieved towards joining the euro.
Keywords: real interest rate parity; convergence; structural breaks; EU; EMU
JEL Classification: F21; F32; C15; C22

E2007/25

David R. Collie (August 2007)
Auctioning Immigration Visas (78K, 15 pages)
Published in Review of Development Economics, Vol. 13, 2009, pp. 687-694.
Freeman (2006) suggested that auctioning immigration visas and redistributing the revenue to native residents in the host country would increase migration from low-income to high-income countries. The effect of the auctioning of immigration visas, in the Ricardian model from Findlay (1982), on the optimal level of immigration for the host country is considered. It is shown that auctioning immigration visas will lead to a positive level of immigration only if the initial wage difference between the host country and the source country is substantial. The cost of the immigration visa is more than half the earnings of the immigrant worker.
Keywords: Immigration; migration; international trade
JEL Classification: F22; F12; J61

E2007/24

Qaisar Abbas and James Foreman-Peck (August 2007)
The Mincer Human Capital Model in Pakistan: Implications for Education Policy (152K, 32 pages)
Published in South Asian Economic Journal (2008), Vol 9, 2, 435-462
This paper estimates and interprets returns to education for three sub-sectors of labour market by gender in Pakistan, using the most recent data set of Pakistan Social and Living Standards Measurement (PSLM) Survey 2004-05. The results show two distinctive features of Pakistani education, the high apparent returns to female education outside agriculture, and the remarkable increase of returns with successive levels of education, are to be explained primarily by two departures from the basic Mincer model; generally poor quality primary schooling and family unwillingness to invest in female education because of lack of earning opportunities. There is some signaling in Pakistani education investment but mainly the education is productivity-enhancing investment in human capital, according to a comparison of self-employed and paid employed earnings equations. Returns to public spending of education are extremely high, suggesting very considerable state underinvestment. The policy challenge is in the low wages and high education in the female paid employment sector, and the low participation rate.
Keywords: Rates of return; gender; occupation; Pakistan
JEL Classification: J16; J18; J24

E2007/23

David R. Collie (August 2007)
Migration and trade with external economies of scale (242K, 34 pages)
The analysis of migration in Findlay (1982) is extended by adding external economies of scale to the Ricardian model as in Ethier (1982). With external economies, the larger country always gains from trade but the smaller country may lose from trade unless the external economies of scale are sufficiently strong. The smaller country will always gain from emigration but the larger country may lose from immigration unless the external economies of scale are sufficiently strong. Both countries gain from complete economic integration (free labour migration with free trade). Finally, the optimal migration policies of the two countries are derived.
Keywords: Immigration; emigration; international trade; factor mobility
JEL Classification: F22; F12; J61

E2007/22

Qaisar Abbas and James Foreman-Peck (July 2007, updated December 2007)
Human Capital and Economic Growth: Pakistan, 1960-2003 (532K, 22 pages)
Published in The Lahore Journal of Economics, (2008), Vol. 13, No.1, 1-27.
This paper investigates the relationship between human capital and economic growth in Pakistan with time series data. Estimated with the Johansen (1991) approach, the aggregate production function rejects one version of the endogenous growth formulation. But the fitted model indicates that the output elasticity of human capital may be expected to increase with foreign technical progress. Higher productivity of secondary schooling than in OECD economies is consistent with the low levels so far attained in Pakistan. High returns to health spending compare very favourably with industrial investment. Human capital is estimated to have accounted for just under one fifth of the increase in GDP per head, a figure that is probably biased downwards because of the unmeasured dimensions of human capital.
Keywords: Human Capital; Economic Growth; Cointegration; Pakistan
JEL Classification: C13; C22; C51; O15; O53

E2007/19

Panayiotis M. Pourpourides (June 2007, updated April 2010)
Implicit Contracts and the Cyclicality of the Skill-Premium (400K, 47 pages)
Published in Journal of Economic Dynamics and Control, Volume 35, 2011, 963-979
To examine the cyclical behavior of the skill-premium, this paper introduces implicit labor contracts in a DSGE model where production is characterized by capital-skill complementarity and the utilization of capital is endogenous. It is shown that this model can reproduce the observed cyclical patterns of wages and the skill-premium. The feature of capital-skill complementarity coupled with variable capital utilization rates does not come at odds with the acyclical behavior of the skill-premium. The paper argues that the skill-complementarity of capital is not a quantitatively significant factor at high frequencies. The key aspects are the contracts and the capital utilization margin.
Keywords: Implicit Contracts; Wages; Skill-Premium; Business Cycles; Capital-Skill Complementarity
JEL Classification: E13; E24; E32

E2007/18

Sheikh Selim (June 2007)
Optimal Taxation in a Two Sector Economy with Heterogeneous Agents (182K, 23 pages)
In this paper we show that in a two sector economy with heterogeneous agents and competitive markets, in a steady state the optimal capital income tax rate is in general different from zero. The optimal tax policy in this setting depends on the relative price difference. In a two sector economy capital and labour margins are interdependent, which is why a difference between investment good's price and consumption good's price allows the government to tax capital income in one sector and undo the tax distortion by differential labour income taxation. This policy serves efficiency purpose as it restores production efficiency. For instance, if investment goods are more expensive than consumption goods, it is optimal to tax capital income in consumption sector, and set zero capital income tax and lower labour income tax in investment sector. This policy discourages work and investment in consumption sector, and encourages agents to shift capital and working time to investment sector. This increases production in investment sector and restores production efficiency. In a model with two classes of agents, we show that this policy can also serve redistributive purpose.
Keywords: Optimal taxation; Ramsey problem; Two Sector model
JEL Classification: C61; E13; E62; H21

E2007/17

Juan Páez-Farrell (June 2007)
Optimal Monetary Policy Under Inflation Targeting: Is Zero the Optimal Perception of Inflation Inertia? (408K, 13 pages)
Recent research has suggested that in deriving optimal policy under discretion, policymakers should react as if there were no structural inflation persistence in order to improve welfare. This paper considers whether such a strong result extends to an inflation targeting central bank with a more general Phillips curve formulation. The findings indicate that if anything, a central banker that assumes a high degree of inflation inertia is often preferable.
Keywords: optimal monetary policy; discretion; uncertainty; inflation persistence
JEL Classification: E31; E52; E61; E63

E2007/16

Paulo Brito and Huw David Dixon (June 2007, updated October 2007)
Entry and the accumulation of capital: a two state-variable extension to the Ramsey model (3351K, 60 pages)
Published in International Journal of Economic Theory,, 5, 333-357
In this paper we consider the entry and exit of firms in a dynamic general equilibrium model with capital. At the firm level, there is a fixed cost combined with increasing marginal cost, which gives a standard U-shaped cost curve with optimal firm size. Entry is determined by a free entry condition such that the costs of entry are equal to the present value of incumbent firms, the cost of entry (exit) depends on the flow of entry (exit). Then equilibrium is saddle-point stable and the stable manifold is two-dimensional. Transitional dynamics can, under certain circumstances, be non-monotonic.
Keywords: Entry; dynamics; Ramsey
JEL Classification: D92; C62; E32; O41

E2007/15

Konstantinos Theodoridis (June 2007)
Dynamic Stochastic General Equilibrium (DSGE) Priors for Bayesian Vector Autoregressive (BVAR) Models: DSGE Model Comparison (193K, 8 pages)
This Paper describes a procedure for constructing theory restricted prior distributions for BVAR models. The Bayes Factor, which is obtained without any additional computational effort, can be used to assess the plausibility of the restrictions imposed on the VAR parameter vector by competing DSGE models. In other words, it is possible to rank the amount of abstraction implied by each DSGE model from the historical data.
Keywords: BVAR; DSGE Model Evaluation; Gibbs Sampling; Bayes Factor
JEL Classification: C11; C13; C32; C52

E2007/14

Szilárd Benk, Max Gillman and Michal Kejak (May 2007)
Money Velocity in an Endogenous Growth Business Cycle with Credit Shocks (234K, 18 pages)
Published in Journal of Money Credit and Banking Vol. 40, No. 6 (September 2008): 1281-1293.
The explanation of velocity in neoclassical monetary business cycle models relies on a goods productivity shocks to mimic the data's procyclic velocity feature; money shocks are not important; and the financial sector plays no role. This paper sets the model within endogenous growth, adds exchange credit shocks, and finds that money and credit shocks explain much of the velocity variation. The role of the shocks varies across sub-periods in an intuitive fashion. Endogenous growth is key to the construction of the money and credit shocks since these have similar effects on velocity, but opposite effects upon growth. The model matches the data's average velocity and simulates most of the velocity volatility that is found in the data. Its underlying money demand is Cagan-like in its interest elasticity, so that money and credit shocks cause greater velocity variation the higher is the nominal interest rate.
Keywords: Velocity; business cycle; credit shocks; endogenous growth
JEL Classification: E13; E32; E44

E2007/13

Juan Páez-Farrell (May 2007)
Monetary Policy Rules in Theory and in Practice: Evidence from the UK and the US (204K, 30 pages)
Given the large amount of interaction between research on monetary policy and its practice, this paper examines whether some simple monetary policy rules that have been proposed in the academic literature, part of which has originated from within central banks, provide a reasonable characterisation of actual policy in the UK and the US. The paper finds that the simple rule that describes best actual US monetary policy is a speed limit rule with dynamics, whilst for the UK it is a forward-looking rule. The simpler dynamics in the UK's monetary policy rule are reflective of the lower persistence of inflation as a result of its policy of inflation targeting.

E2007/12

Patrick Minford, David Meenagh and Jiang Wang (April 2007)
Growth and relative living standards - testing Barriers to Riches on post-war panel data (714K, 40 pages)
The effect of business tax and regulation on growth, together with potential effects of government spending on education and R&D, is embodied in a model of a small open economy with growth choices. The structural model is estimated on post-war panel data for 76 countries and the bootstrap is used to produce the model's sampling variation for the analysis of panel regressions of growth. Statistical rejection can occur at either the structural or the growth regression stage. The models featuring government spending on education and R&D are rejected while that with business taxation is accepted.
Keywords: growth; living standards; business regulation; business taxation; public education; government R&D; structural model; bootstrap testing
JEL Classification: O41; O57; C52

E2007/11

Sheikh Selim and Naima Parvin (April 2007)
Policy Reforms and Incentives in Rice Production in Bangladesh (72K, 12 pages)
We estimate an institutional production function to capture incentive induced growth in total factor productivity (TFP) of rice production in Bangladesh. The incentive component of TFP assists in explaining farmers' response to incentives due to major policy reforms during 1980s and 1990s.
Keywords: Bangladesh; Incentives; TFP
JEL Classification: C33; C51; O13; Q12

E2007/10

Sheikh Selim (April 2007, updated February 2010)
Labour Productivity and Rice Production in Bangladesh: A Stochastic Frontier Approach (306K, 22 pages)
In this paper we examine the significance of labour productivity and use of inputs in explaining technical efficiency of rice production in Bangladesh. We find that higher labour productivity can stimulate high efficiency gains, but increased use of inputs (except land) induces negative marginal effect on technical efficiency. While more use of land, improved seeds and fertilizers contributes to the rate of labour-productivity induced marginal efficiency gain, any additional labour depresses this rate. Given the agricultural policy reform history in Bangladesh, our findings imply that rather than providing input subsidy or output price support, future reforms should put more emphasis on providing incentives to enhance labour productivity and encourage formalization of the agricultural labour market.
Keywords: Stochastic frontier; non-neutral frontier; technical efficiency
JEL Classification: C33; C51; O13; Q12

E2007/9

Sheikh Selim (April 2007)
Optimal Capital Income Taxation in a Two Sector Economy (138K, 26 pages)
We extend the celebrated Chamley-Judd result of zero capital income tax and show that the steady state optimal capital income tax is nonzero, in general. In particular, we find that the optimal plan involves zero capital income tax in investment sector and a nonzero capital income tax in consumption sector. In a two sector neoclassical economy, interdependence of labour and capital margins allows the government to choose an optimal policy that involves nonzero tax on capital income. The distortion created by capital income tax in consumption sector can be undone by setting different rates of labour income taxes. The optimal plan thus involves zero capital income tax in both sectors only if optimal labour income taxes are equal. This may not be the optimal policy if marginal disutility of work is different across sectors and/or the social marginal value of capital is different across sectors. The difference in social marginal value of capital can be undone by setting different labour income taxes across sectors. We also show that if the government faces a constraint of keeping same capital and labour income tax rates across sectors, optimal capital income tax is nonzero.
Keywords: Optimal taxation; Ramsey problem; Primal approach; Two-sector model
JEL Classification: C61; E13; E62; H21

E2007/8

Vo Phuong Mai Le and Patrick Minford (March 2007, updated October 2008)
Calvo Contracts - Optimal Indexation in General Equilibrium (273K, 38 pages)
Calvo contracts, which are the basis of the current generation of New Keynesian models, widely include indexation to general inflation. We argue that the indexing formula should be expected inflation rather than lagged inflation. This is likely to optimise the welfare of the representative agent in a general equilibrium model of the New Keynesian type. The economy's behaviour under rational indexation is similar to that of a New Classical model, with shocks producing an immediate fluctuation in both prices and output followed by a fairly rapid return to steady state. A monetary policy that targets the price level increases economic stability.
Keywords: Calvo contracts; general equilibrium; rational indexation
JEL Classification: F41; F42; E42

E2007/7

Vo Phuong Mai Le and Patrick Minford (March 2007)
Optimising indexation arrangements under Calvo contracts and their implications for monetary policy (262K, 21 pages)
This paper investigates optimal indexation in the New Keynesian model, when the indexation choice includes the possibility of partial indexation and of varying weights on rational and lagged indexation. It finds that the Calvo contract adjusted for rationally expected indexation under both inflation and price level targeting regimes delivers the highest expected welfare under both restricted and full current information. Rational indexation eliminates the effectiveness of monetary policy on welfare when there is only price-level targeting under the current micro information. If including both wage setting and full current information, monetary policy is effective; and a price-level targeting rule delivers the highest benefits because it minimises the size of shocks to prices and thus dispersion. However, even less than full rational indexation ensures that there is very little nominal rigidity in the adapted world of Calvo contracts.
Keywords: optimal indexation; price-level target; inflation target; Calvo contracts; rational expectation; New Keynesian model
JEL Classification: E50; E52

E2007/6

Laurence Copeland and Yanhui Zhu (March 2007)
Rare Disasters and the Equity Premium in a Two-Country World (245K, 22 pages)
We extend the Barro (2006) closed-economy model of the equity risk premium in the presence of extreme events ("disasters") to a two-country world. In this more general setting, both the output risk of rare disasters and the associated risk of a default on Government debt, can be diversified. The extent to which agents in one country can diversify away the risk of extreme events depends on the relative size of the two countries, and critically on the probability of a disaster in one country conditional on a disaster in the other. We show that, using Barro's own calibration in combination with a broad range of plausible values for the additional parameters, the model implies levels of the equity risk premium far lower than those typically observed in the data. We conclude that the model is unlikely to explain the equity risk premium
Keywords: equity risk premium; default risk; international diversification
JEL Classification: F3; G1

E2007/5

Kent Matthews, Jianguang Guo and Nina Zhang (February 2007)
Rational Inefficiency and non-performing loans in Chinese Banking: A non-parametric Bootstrapping Approach. (118K, 29 pages)
Published in China Finance Review, 2007, 3, 1 , 55-75
The existing Chinese banking system was born out of a state-planning framework focussed on the funding of state-owned enterprises. Despite the development of a modern banking system, numerous studies of Chinese banking point to its high level of average inefficiency. Much of this inefficiency relates to the high level of non-performing loans held on the banks books. This study argues that a significant component of inefficiency relates to a defunct bureaucratic incentive structure. Using bootstrap non-parametric techniques the paper decomposes cost-inefficiency into X-inefficiency and rational inefficiency caused by bureaucratic rent seeking. In contrast to other studies of the Chinese banking sector, the paper argues that a change in the incentive structure and the competitive threat of the opening up of the banking market in 2007 has produced reduced inefficiency and improved performance.
Keywords: Bank Efficiency; China; X-inefficiency; DEA
JEL Classification: D23; G21; G28;

E2007/4

Kent Matthews, Jianguang Guo, Nina Zhang and Lina Wang (February 2007, updated March 2007)
Bank Efficiency in China, Rent Seeking versus X-inefficiency: A non-parametric Bootstrapping Approach. (146K, 39 pages)
This study demarcates cost-inefficiency in Chinese banks into X-inefficiency and rent-seeking-inefficiency. A protected banking market not only encourages weak management and X-inefficiency but also public ownership and state directed lending encourages moral hazard and bureaucratic rent seeking. This paper uses bootstrap non-parametric techniques to estimate measures of X-inefficiency and rent-seeking inefficiency for the 4 state owned banks and 11 joint-stock banks over the period 1997-2004. In contrast to other studies of the Chinese banking sector, the paper argues that reduced inefficiency is an indicator that the competitive threat of the opening up of the banking market in 2007 has produced tangible benefits in improved performance. This paper finds evidence of declining trend in both types of inefficiency.
Keywords: Bank Efficiency; China; X-inefficiency; DEA; Bootstrapping
JEL Classification: D23; G21; G28;

E2007/3

Huw David Dixon (February 2007)
New Keynesian macroeconomics: Entry For New Palgrave Dictionary of Economics, 2nd Edition (165K, 11 pages)
Forthcoming in New Palgrave Dictionary of Economics and Law, 2nd Edition
This dictionary entry defines the development of new Keynesian macroeconomics (NKM) since the 1980s. I argue that the key defining feature NKM is the introduction of imperfect competition, making price and/or wage setting endogenous and hence allowing for a rigorous understanding of nominal rigidity. This has led to a shift away from perfect competition in macroeconomics. The combination of NKM with dynamic macroeconomic modelling has led to the current orthodoxy: the new-neoclassical synthesis. Dynamic wage and price models lead to monetary neutrality in steady-state, non-neutrality out of steady-state. Other themes in NKM include efficiency wage theory and coordination failure.
Keywords: Keynesian; nominal; rigidity; new
JEL Classification: E1; E3; E4; B22

E2007/2

Patrick Minford, Konstantinos Theodoridis and David Meenagh (January 2007, updated April 2008)
Testing a model of the UK by the method of indirect inference (518K, 31 pages)
Published in Open Economies Review, vol. 20(2) (2009), 265-291
We use the method of indirect inference to test a full open economy model of the UK that has been in forecasting use for three decades. The test establishes, using a Wald statistic, whether the parameters of a time-series representation estimated on the actual data lie within some confidence interval of the model-implied distribution. Various forms of time-series representations that could deal with the UK's various changes of monetary regime are tried; two are retained as adequate. The model is rejected under one but marginally accepted under the other, suggesting that with some modifications it could achieve general acceptability and that the testing method is worth investigating further.
Keywords: Bootstrap; Model Evaluation; Non-Linear Time Series Models; Indirect inference; open economy models; UK models
JEL Classification: C12; C32

E2007/1

Huw David Dixon and Engin Kara (January 2007)
Persistence and Nominal Inertia in a Generalized Taylor Economy: How Longer Contracts Dominate Shorter Contracts (407K, 41 pages)
Forthcoming in European Economic Review
We develop the Generalized Taylor Economy (GTE) in which there are many sectors with overlapping contracts of different lengths. In economies with the same average contract length, monetary shocks will be more persistent when longer contracts are present. Using the Bils-Klenow distribution of contract lengths, we find that the corresponding GTE tracks the US data well. When we choose a GTE with the same distribution of completed contract lengths as the Calvo, the economies behave in a similar manner.
Keywords: Persistence; Taylor contract; Calvo
JEL Classification: E50; E24; E32; E52

E2006/26

Michael G Arghyrou (November 2006)
Monetary policy before and after the euro: Evidence from Greece (241K, 38 pages)
Published in Empirical Economics, vol. 36, June 2009, 621-643.
We model Greek monetary policy in the 1990s and use our findings to address two interrelated questions. First, how was monetary policy conducted in the 1990s so that the hitherto highest-inflation EU country managed to join the euro by 2001? Second, how compatible is the current ECB monetary policy with Greek economic conditions? We find that Greek monetary policy in the 1990s was: (i) primarily determined by foreign (German/ECB) interest rates though still influenced, to some degree, by domestic fundamentals; (ii) involving non-linear output gap effects; (iii) subject to a deficit of credibility culminating in the 1998 devaluation. On the question of compatibility our findings depend on the value assumed for the equilibrium post-euro real interest rate and overall indicate both a reduction in the pre-euro risk premium and some degree of monetary policy incompatibility. Our analysis has policy implications for the new EU members and motivates further research on fast-growing EMU economies.
Keywords: monetary policy; reaction function; non-linear; compatibility; Greece; EMU
JEL Classification: C51; C52; E43; E58; F37

E2006/25

Kent Matthews, Patrick Minford and Ruthira Naraidoo (January 2006, updated November 2006)
Vicious and Virtuous Circles - The Political Economy of Unemployment in Interwar UK and USA (509K, 33 pages)
Published in European Journal of Political Economy Volume 24, Issue 3, September 2008, Pages 605-614
This paper develops a political economy model of multiple unemployment equilibria to provide a theory of an endogenous natural rate of unemployment. This model is applied to the UK and the US interwar period which is remembered as the decade of mass unemployment. The theory here sees the natural rate and the associated path of unemployment as a reaction to shocks (mainly demand in nature) and the institutional structure of the economy. The channel through which these two forces feed on each other is a political economy process whereby voters with limited information on the natural rate react to shocks by demanding more or less social protection. The reduced form results obtained confirm a pattern of unemployment behaviour in which unemployment moves between high and low equilibria in response to shocks.
Keywords: Equilibrium unemployment; political economy; 'vicious' and 'virtuous' circles; bootstrapping
JEL Classification: E24; E27; P16

E2006/24

Max Gillman and Glen Otto (September 2006, updated October 2006)
Money Demand in General Equilibrium Endogenous Growth: Estimating the Role of a Variable Interest Elasticity (236K, 32 pages)
Published in Quantitative and Qualitative Analysis in Social Sciences (QASS). Vol. 1 (1), Spring, 2007, 1-25, http://www.qass.org.uk/2007/vol1_1/p1-gillman_07_apr2.pdf
The paper presents and tests a theory of the demand for money that is derived from a general equilibrium, endogenous growth economy, which in effect combines a special case of the shopping time exchange economy with the cash-in-advance framework. The model predicts that both higher inflation and financial innovation - that reduces the cost of credit - induce agents to substitute away from money towards exchange credit. The implied interest elasticity of money demand rises with the inflation rate and financial innovation rather than being constant as is typical in shopping time specifications. Using quarterly data for the US and Australia, we find evidence of cointegration for the money demand model. This money demand stability results because of the extra series that capture financial innovation; included are robustness checks and comparison to a standard money demand specification.
JEL Classification: C23; E41; O42

E2006/23

Michael G Arghyrou and Georgios Chortareas (September 2006)
Current Account Imbalances and Real Exchange Rates in the Euro Area (136K, 29 pages)
Global current account imbalances have been one of the focal points of interest for policymakers during the last few years. Less attention has been paid, however, to the diverging current account balances of the individual euro area countries. In this paper we consider the dynamics of current account adjustment and the role of real exchange rates in current account determination in the EMU. After controlling for the effects of income growth, we find the relationship between real exchange rates and the current account to be substantial in size and subject to non-linear effects. Overall, we argue that real exchange rates can offer further insights, beyond the effects of the income catch-up process, relevant to current account determination in the EMU.
Keywords: current account; real exchange rate; EMU; nonlinearities
JEL Classification: C51; C52; F31; F32; F41

E2006/22

Roger Clarke and David R. Collie (August 2006)
Maximum-Revenue versus Optimum-Welfare Export Taxes (376K, 31 pages)
Published in Review of International Economics, Vol. 16, No. 5, pp. 919-929.
In a game between two exporting countries, both countries may be better off if they both delegate to policymakers who maximise tax revenue rather than welfare. However, both countries delegating to policymakers who maximise revenue is not necessarily a Nash equilibrium. The game may be a prisoner's dilemma where both countries are better off delegating to policymakers who maximise revenue, but both will delegate to policymakers who maximise welfare in the Nash equilibrium. This result is obtained in the Bertrand duopoly model of Eaton and Grossman (1986) and the perfectly competitive model of Panagariya and Schiff (1995).
Keywords: Trade Policy; Export Taxes; Game Theory; Delegation
JEL Classification: C72; F11; F12; F13

E2006/21

Laurence Copeland and Saeed Heravi (July 2006)
Structural Breaks in the Real Exchange Rate Adjustment Mechanism (638K, 35 pages)
Published in Applied Financial Economics,19:2,121-134. DOI: 10.1080/09603100701765216
We show that the behaviour of the real exchange rates of the UK, Germany, France and Japan has been characterised by structural breaks which changed the adjustment mechanism. In the context of a Time-Varying Smooth Transition AutoRegressive of the kind introduced by Lundbergh et al (2003), we show that the real exchange rate process shifted in the aftermath of Black Wednesday in the case of the Pound, in 1984-5 in the case of the Franc and, more tentatively, during the Asian crisis of 1997-8 in the case of the Yen.

E2006/20

Sheikh Selim (April 2006, updated February 2010)
Revisiting the Capital Tax Ambiguity Result (409K, 16 pages)
We provide a welfare based interpretation of the capital tax ambiguity result (due to Guo & Lansing, 1999). We show that the sign ambiguity of optimal capital tax rate in an imperfectly competitive economy is mainly due to the welfare cost of investment. The substitution and income effects of profit seeking investment reinforce each other which create a deadweight loss in welfare. Investors cannot perceive this effect and never invest at the right level. This loss is perceived only by the government which motivates capital taxation.
Keywords: Optimal taxation; Monopoly power; Ramsey policy
JEL Classification: D42; E62; H21; H30

E2006/19

Sheikh Selim (March 2006, updated July 2006)
On Policy Relevance of Ramsey Tax Rules (148K, 34 pages)
Published in economics-ejournal economics discussion Papers, No 2007-31. http://www.economics-ejournal.org/economics/discussionpapers/2007-31
The Ramsey approach to optimal taxation and Ramsey tax rules have amassed substance in economic theory. However, they are often criticized on grounds of practicality, fairness, feasibility and some other aspects of designing actual tax policy. This paper contests these criticisms; it discusses how closely or remotely Ramsey rules are followed in designing tax policy. It argues that the most of these common criticisms, be it realistic, such as administrative and compliance costs, or be it rather abstract, such as fairness, are either unimportant or irrelevant for Ramsey taxation. The more important inadequacy of the traditional Ramsey tax models is the selective modelling of incentive effects of tax reforms and their limited applicability for designing tax policy in developing countries.
Keywords: Optimal taxation; Ramsey tax rules; Policy relevance
JEL Classification: E61; E62; H21; H30

E2006/18

Juan Páez-Farrell (March 2006)
Output and Inflation in Models of the Business Cycle with Nominal Rigidities: Some Counterfactual Evidence (172K, 28 pages)
Published in Scottish Journal of Political Economy, September 2007 pp. 479-495, Vol. 54, No. 4
This paper examines the relationship between cyclical output and inflation in models commonly used for monetary policy analysis. This includes models that incorporate the New Keynesian, Fuhrer-Moore and backward-looking Phillips curves. The main finding is that these models imply a strong negative relationship between inflation and output, a result that is at odds with the data. The fact that New Keynesian models yield counterfactual implications is not new; the novelty of the paper lies in the fact that the finding extends to the other variants, such as the backward-looking Phillips Curve, which has been put forward as displaying superior dynamics.
Keywords: nominal rigidities; monetary policy; Phillips Curve; Output; Inflation; Correlation
JEL Classification: E20; E31; E32; E52; E61

E2006/17

Juan Páez-Farrell (March 2006)
Assessing Sticky Price Models Using the Burns and Mitchell Approach (103K, 27 pages)
Forthcoming in Applied Economics
This paper evaluates sticky-price models using the methods proposed by Burns and Mitchell, focusing on the monetary aspects of the business cycle. Recent research has emphasised the responses of models to shocks at the expense its systematic component. Whereas sticky-price models have been successful at replicating impulse response functions from VARs, this paper highlights that they are unable to mimic the data for nominal variables. Moreover, the results are robust to the specification of the Phillips curve, including its backward-looking variant; calibrated values and the inclusion of fiscal policy shocks. Since being able to mimic the data is the lowest hurdle a model must pass, these results pose a challenge for New Keynesian-type models.
Keywords: New Keynesian Models; Business Cycles; Correlations; Burns and Mitchell
JEL Classification: E32; E52; E58

E2006/16

Roger Clarke and David R. Collie (February 2006)
Welfare in the Nash Equilibrium in Export Taxes under Bertrand Duopoly (192K, 9 pages)
Published in Bulletin of Economic Research, Vol. 60, Issue 2, pp. 183-189.
In the Eaton and Grossman (1986) model of export taxes under Bertrand duopoly, it is shown that welfare in the Nash equilibrium in export taxes is always higher than welfare under free trade for both countries.
Keywords: Trade Policy; Imperfect Competition; Oligopoly
JEL Classification: F12; F13; L13

E2006/15

Roger Clarke and David R. Collie (February 2006)
Export Taxes under Bertrand Duopoly (300K, 17 pages)
Published in Economics Bulletin, Vol. 6, No. 6, pp. 1-8, 2006.
This article analyses export taxes in a Bertrand duopoly with product differentiation, where a home and a foreign firm both export to a third-country market. It is shown that the maximum-revenue export tax always exceeds the optimum-welfare export tax. In a Nash equilibrium in export taxes, the country with the low cost firm imposes the largest export tax. The results under Bertrand duopoly are compared with those under Cournot duopoly. It is shown that the absolute value of the export subsidy or tax under Cournot duopoly exceeds the export tax under Bertrand duopoly.
Keywords: Trade Policy; Imperfect Competition; Oligopoly
JEL Classification: F12; F13; L13

E2006/14

Helen Robinson and Jonathan Wadsworth (February 2006)
The Impact of the Minimum Wage on the Incidence of Second Job Holding in Britain (260K, 34 pages)
The advent of any earnings boost, such as provided by the introduction of a minimum wage, might be expected to reduce the supply of low paid individuals wanting to hold a second job. This paper uses difference-in-differences estimation on a panel of individuals matched across successive Labour Force Surveys around the time of the introduction of the national minimum wage in the United Kingdom in order to estimate the impact of the minimum wage and its subsequent upratings on second job working. There is little evidence to suggest that the extra pay provided by the introduction of the minimum wage was sufficient to affect the incidence of second job holding significantly. However, hours worked in the main job by second job holders may have risen relative to those not covered by the minimum wage; and hours worked in second jobs may have fallen for those whose second job was initially below the minimum.
Keywords: Second jobs; minimum wages
JEL Classification: J23; J31

E2006/13

David Meenagh, Patrick Minford and David Peel (February 2006)
Simulating Stock Returns under switching regimes - a new test of market efficiency (136K, 9 pages)
Published in Economics Letters, 94 (2007), pp. 235-239
A model of profits switches between four regimes with fixed probabilities; the rationally expected profits stream implies the stock market value. This efficient market model is not rejected by UK post-war time-series behaviour of either profits or the FTSE index.
Keywords: regime switching; stock returns; efficient markets; rational expectations
JEL Classification: C15; C5; G14

E2006/12

Kent Matthews, David Meenagh, Patrick Minford and Bruce Webb (February 2006)
Monetary regimes: is there a trade-off between consumption and employment variability? (252K, 40 pages)
Macro models generally assume away heterogeneous welfare in assessing policies. We investigate here within two aggregative models - one with a representative agent, the other a long-used forecasting model of the UK - whether allowing for differences in welfare functions (specifically between those in continuous employment and those with frequent unemployment spells) alters the rankings of monetary policies. We find that it does but that a set of policies (money supply targeting implemented by money supply control) can be found that are robust in the sense of avoiding very poor outcomes for either of the two groups.
Keywords: Robustness; heterogenous welfare; money supply rules; interest rate setting; price level targeting
JEL Classification: E52

E2006/11

Laurence Copeland (February 2006)
Arbitrage Bounds and the Time Series Properties of the Discount on UK Closed-End Mutual Funds (384K, 37 pages)
In a dataset of weekly observations over the period since 1990, the discount on UK closed-end mutual funds is shown to be nonstationary, but reverting to a nonzero long run mean. Although the long run discount could be explained by factors like management expenses etc., its short run arbitrage-free equilibrium. In time series terms, there is evidence of long memory in discounts consistent with a bounded random walk. This conclusion is supported by explicit nonlinearity tests, and by results which suggest the behaviour of the discount is perhaps best represented by one of the class of Smooth-Transition Autoregressive (STAR) models.
Keywords: Mutual Funds; ESTAR

E2006/10

Laurence Copeland and Yanhui Zhu (February 2006)
Hedging Effectiveness in the Index Futures Market
Forthcoming in Gregoriou, G.N. and R. Pascalau (eds.) Financial Econometrics Modelling: Derivatives Pricing and Hedge Funds and Term Structure Models, Palgrave-MacMillan, 2011.
This paper addresses the question of how far hedging effectiveness can be improved by the use of more sophisticated models of the relationship between futures and spot prices. Working with daily data from six major index futures markets, we show that, when the cost of carry is incorporated in to the model, the two series are cointegrated, as anticipated. Fitting an ECM with a GJR-GARCH model of the variance process, we derive the implied optimal hedge ratios and compare their out-of-sample hedging effectiveness with OLS-based hedges. The results suggest little or no improvement over OLS.

E2006/9

Sheikh Selim (January 2006)
Current Account Dynamics and Capital Mobility in Asian Small Economies (269K, 30 pages)
Published in ICFAI Journal of Financial Economics, 4(2), pp. 66-86, June 2006.
This paper explores current account dynamics in eight small economies of Asia to examine whether or not capital flows have been excessive in these countries. Standard assumptions of perfect capital mobility and small open economy are jointly instrumental in simplifying theoretical tractability of many open economy models. In empirical estimations, however, the identification of a small open economy is often oversimplified, which makes celebrated results, such as excessive or too low capital flows in OECD economies, questionable. This paper establishes that the actual extent of capital mobility in small open economies cannot be generally too high or too low. This in turns implies that the general idea of excessive capital flows in small open economies requires revision.
Keywords: Current account dynamics; intertemporal approach; consumption-smoothing; capital mobility

E2006/8

Saeed Al-Muharrami, Kent Matthews and Yusuf Khabari (January 2006)
Market Structure and Competitive Conditions in the Arab GCC Banking System (109K, 25 pages)
Published in Journal of Banking and Finance, 30, 2006, pp. 3487-3501.
This paper investigates the market structure of Arab GCC banking industry during the years of 1993 to 2002 using the most frequently applied measures of concentration k-bank concentration ratio (CRk) and Herfindahl-Hirschman Index (HHI) and evaluates the monopoly power of banks over the ten years period using the "H statistic" by Panzar and Rosse. The results show that Kuwait, Saudi Arabia and UAE have moderately concentrated markets and are moving to less concentrated positions. The measures of concentration also show that Qatar, Bahrain and Oman are highly concentrated markets. The Panzar-Rosse H-statistics suggest that banks in Kuwait, Saudi Arabia and the UAE operate under perfect competition; banks in Bahrain and Qatar operate under conditions of monopolistic competition; and we are unable to reject monopolistic competition for the banking market in Oman.
Keywords: GCC countries; Concentration; Market structure; Competition; Panzar-Rosse model; k-bank concentration ratio (CRk) and Herfindahl-Hirschman Index (HHI)
JEL Classification: G21; L1; D40

E2006/7

Kent Matthews, Patrick Minford and Ruthira Naraidoo (January 2006)
Vicious and Virtuous Circles - The Political Economy of Unemployment in Interwar UK and USA
Published in European Journal of Political Economy, vol. 24() (2008), 605-614
The 1930s in the UK and USA is remembered as the decade of mass unemployment. We develop a model of equilibrium unemployment based on the Meltzer and Richard (1981) model of redistribution financed by distortionary taxation. This model is extended to the UK and the US interwar period to provide a theory of an endogenous natural rate of unemployment. The theory here sees the natural rate and the associated equilibrium path of unemployment as a reaction to shocks (mainly demand in nature) and the institutional structure of the economy. The channel through which these two forces feed on each other is a political economy process whereby voters react to shocks by demanding more or less social protection. The reduced form results obtained confirm a pattern of unemployment behaviour in which unemployment moves between high and low equilibria in response to shocks; and further evidence is obtained by structural estimates for the UK.
Keywords: Equilibrium unemployment; political economy; 'vicious' and 'virtuous' circles; threshold model; bootstrapping
JEL Classification: E24; C10

E2006/6

Kent Matthews, Victor Murinde and Tianshu Zhao (January 2006)
Competitiveness and Market Contestability of Major UK Banks (226K, 33 pages)
Published in Journal of Banking and Finance 2007, 31, 7, pp. 2025-2042.
We undertake an empirical assessment of the competitiveness and market contestability of the major British banks post-1980 - a period of major structural changes, mergers, demutualizations and acquisitions. Specifically, we estimate and test the Rosse-Panzar model on a panel of 12 banks for the period 1980-2004; furthermore, we buttress the Rosse-Panzar methodology by estimating the ratio of Lerner indices obtained from interest rate setting equations. The sample of banks corresponds closely to the major British Banking Groups as specified by the British Banking Association. Our results confirm the consensus finding that the British banking market can be described as monopolistically competitive. We also find that on the core business of balance sheet activity, British banks have remained as competitive in the 1990s as in the 1980s. This finding is further supported by evidence from the ratio of Lerner indices for loans and deposits. However, we find a significant worsening of competitiveness on the non-core (off-balance sheet) business of the banks.
Keywords: Competitive conditions in banking; market contestability; UK
JEL Classification: G210; D240

E2006/5

Kent Matthews, Jonathan Shepherd, Vaseekaran Sivarajasingham and Sally Benbow (January 2006)
Violence, Gender and the Price of Beer in England and Wales (110K, 25 pages)
This paper examines the influence of the real price of beer on violence-related injuries split by gender across the economic regions in England and Wales. It was concluded that alcohol prices and injury sustained in violence is causally related in both males and females. Injury of females is causally related to poverty but injury of males. However, nationwide sports events were associated only with male assault injury. Violence-related harm was significantly and independently linked to other socio-economic and demographic factors. Our results suggest that the real price of alcohol (using beer as an example) has a part to play in controlling the consumption of alcohol and the incidence of violent injury.
Keywords: Alcohol; gender; violence; price of beer
JEL Classification: K40; I30; C50;

E2006/4

J Daley, Kent Matthews and Keith Whitfield (January 2006)
Too-Big-To-Fail: Bank Failure and Banking Policy in Jamaica (98K, 26 pages)
Research on the causes of bank failure has focused on developed countries, particularly the United States of America. Relatively little empirical work has examined developing countries. We examine the total population of banks in Jamaica between 1992 and 1998 and find that real GDP growth, size, and managerial efficiency were the most significant factors contributing to the failure of banks. Bank failure is defined to include bailout and regulator-induced or supervised merger. Our results suggest that there were implicit 'Too-big-to-Fail' policies during this period.
Keywords: Bank failures; Too-big-to-Fail; developing economies; Jamaica
JEL Classification: G21; G28

E2006/3

Kent Matthews, Jonathan Shepherd and Vaseekaran Sivarajasingham (January 2006)
Violence-related injury and the Price of Beer in England and Wales (100K, 21 pages)
Published in Applied Economics 38, 2006, pp. 661-670.
This paper examines the influence of the real price of beer on violence-related injuries across the economic regions in England and Wales. The data are monthly frequency of violent-injury collected from a stratified sample of 58 National Health Service Emergency Departments 1995-2000. An econometric model based on economic, socio-demographic and environmental factors was estimated using panel techniques. We show that the rate of violence-related injury is negatively related to the real price beer, as well as economic, sporting and socio-demographic factors. The principal conclusion of the paper is that the regional distribution of the incidence of violent injury is related to the regional distribution of the price of beer. The major policy conclusion is that increased alcohol prices would result in substantially fewer violent injuries and reduced demand on trauma services.
Keywords: Violence; Alcohol; Price of Beer
JEL Classification: I18; K42

E2006/2

Kent Matthews and Mahadzir Ismail (January 2006)
Efficiency and Productivity Growth of Domestic and Foreign Commercial Banks in Malaysia (149K, 24 pages)
This study examines the technical efficiency and productivity of domestic and foreign commercial banks in Malaysia 1994-2000. We find that foreign banks have a higher efficiency level than domestic banks, and that efficient banks are characterised by size but not profitability or loan quality. The main source of productivity growth is technical change rather than improvement in efficiency. The productivity of domestic banks is more susceptible to macroeconomic shocks than foreign banks but over the medium term foreign banks are only marginally superior to domestic banks.
Keywords: domestic and foreign banks; technical efficiency; Malmquist productivity index
JEL Classification: D2; G2;

E2006/1

Laurian Lungu, Kent Matthews and Patrick Minford (January 2006)
Partial Current Information and Signal Extraction in a Rational Expectations Macroeconomic Model: A Computational Solution. (262K, 29 pages)
Published in Economic Modelling, 25(2), March 2008, pp. 255-273
Previous attempts at modelling current observed endogenous financial variables in a macroeconomic model have concentrated on only one observed endogenous variable - namely the short-term rate of interest. The solution method for dealing with more than one observed endogenous variable has thus far been computationally intractable. This paper applies a general search algorithm to a macroeconomic model with an observed interest rate and exchange rate to solve the signal extraction problem. The informational advantage of applying the signal extraction algorithm to all the current observed endogenous variables is examined in terms of the implication for policy from the misperceptions of specific macroeconomic shocks.
Keywords: Rational Expectations; Partial Current Information; Signal Extraction; Macroeconomic modelling
JEL Classification: E370

E2005/16

Simon Feeny, Max Gillman and Mark N. Harris (December 2005)
Econometric Accounting of the Australian Corporate Tax Rates: a Firm Panel Example (180K, 25 pages)
The paper presents an econometric accounting of the effective corporate tax rate in Australia for the years 1993 to 1996. The estimation is a panel of Australian firms that uses a specially gathered financial data base. Using fixed and random effects, the model specifies that the statutory tax rate is estimated as the constant term of the model. An ability to find an estimated statutory tax rate that is close to the actual rate suggests a certain confidence in the estimated effects of the others factors affecting the effective tax rate. The results show importance for interest expenses, depreciation allowances, debt/asset structures, and the foreign ownership of firms. There is support for an Australian role as a preferential tax location.
Keywords: Effective tax rate; accounting model; panel data; random and fixed effects
JEL Classification: H25; E62

E2005/15

Max Gillman and Michal Kejak (December 2005)
Inflation and Balanced-Path Growth with Alternative Payment Mechanisms (352K, 36 pages)
Published in Economic Journal, Vol 115 (January): 247-270.
The paper shows that contrary to conventional wisdom an endogenous growth economy with human capital and alternative payment mechanisms can robustly explain major facets of the long run inflation experience. A negative inflation-growth relation is explained, including a striking non-linearity found repeatedly in empirical studies. A set of Tobin (1965) effects are also explained and, further, linked in magnitude to the growth effects through the interest elasticity of money demand. Undisclosed previously, this link helps fill out the intuition of how the inflation experience can be plausibly explained in a robust fashion with a model extended to include credit as a payment mechanism.
Keywords: Human capital; cash-in-advance; interest-elasticity; credit production
JEL Classification: O42; E31; E22

E2005/14

Szilárd Benk, Max Gillman and Michal Kejak (December 2005)
A Comparison of Exchange Economies within a Monetary Business Cycle (218K, 28 pages)
Published in The Manchester School
The paper sets out a monetary business cycle model with three alternative exchange technologies, the cash-only, shopping time, and credit production models. The goods productivity and money shocks affect all three models, while the credit model has in addition a credit productivity shock. The paper compares the performance of the models in explaining the puzzles of the monetary business cycle theory. The credit model improves the ability to explain the procyclic movement of monetary aggregates, inflation and the nominal interest rate.
Keywords: Cash-in-advance; credit production; cycle; inflation
JEL Classification: E13; E32; E44

E2005/13

Szilárd Benk, Max Gillman and Michal Kejak (December 2005)
Credit Shocks in the Financial Deregulatory Era: Not the Usual Suspects (329K, 30 pages)
Published in Review of Economic Dynamics
The paper constructs credit shocks using data and the solution to a monetary business cycle model. The model extends the standard stochastic cash-in-advance economy by including the production of credit that serves as an alternative to money in exchange. Shocks to goods productivity, money, and credit productivity are constructed robustly using the solution to the model and quarterly US data on key variables. The contribution of the credit shock to US GDP movements is found, and this is interpreted in terms of changes in banking legislation during the US financial deregulation era. The results put forth the credit shock as a candidate shock that matters in determining GDP, including in the sense of Uhlig (2003).
Keywords: Business cycle; credit shocks; financial deregulation
JEL Classification: E32; E44

E2005/12

Patrick Minford, Eric Nowell and Bruce Webb (December 2005)
Would price-level targeting destabilise the economy? (360K, 26 pages)
When indexation is endogenous price level targeting slightly adds to economic stability, contrary to widespread fears to the contrary. The aggregate supply curve flattens and the aggregate demand curve steepens, increasing stability in the face of supply shocks.
Keywords: Inflation; targeting; price-level rule; Price level target; indexation; monetary regime; endogenous contracts; stationarity; stability
JEL Classification: E31; E42; E52

E2005/11

Helmuts Azacis and Roberto Burguet (December 2005)
Incumbency and Entry in License Auctions: The Anglo-Dutch Auction Meets Other Simple Alternatives (247K, 32 pages)
Published in International Journal of Industrial Organization, 26(3), pp. 730-745, May 2008
The existence of ex-ante strong incumbents may constitute a barrier to entry in auctions for goods such as licenses. Introducing inefficiencies that favor entrants is a way to induce entry and thus create competition. Designs such as the Anglo-Dutch auction have been proposed with this goal in mind. We first show that indeed the Anglo- Dutch auction fosters entry and increases the revenues of the seller. However, we argue that a more eective way could be to stage the allocation of the good so that each stage reveals information about the participants. We show that a sequence of English auctions, with high reserve prices in early rounds, is a procedure with this property that is more efficient than any one-stage entry auction. Moreover, it also dominates the Anglo-Dutch auction in terms of seller's revenues.

E2005/10

Helmuts Azacis (December 2005)
Double Implementation in a Market for Indivisible Goods with a Price Constraint (220K, 22 pages)
Published in Games and Economic Behaviour, 62(1), pp. 140-154, January 2008.
I consider the problem of assigning agents to indivisible objects, in which each agent pays a price for his object and all prices sum to a given constant. The objective is to select an assignment-price pair that is envy-free with respect to the agents' true preferences. I propose a simple mechanism whereby agents announce valuations for all objects and an envy-free allocation is selected with respect to these announced preferences. I prove that the proposed mechanism implements both in Nash and strong Nash equilibrium the set of true envy-free allocations.
Keywords: Indivisible Goods; Envy-Freeness; Implementation; Strong Nash Equilibrium
JEL Classification: C78; C71; D78

E2005/9

Patrick Minford and Naveen Srinivasan (December 2005)
Opportunistic Monetary Policy: an Alternative Rationalization (205K, 17 pages)
Published in Journal of Economics and Business, 58, October-November 2006, pp. 366-372
This paper offers an alternative rationalization for opportunistic behaviour i.e., a gradual disinflation strategy where policymakers react asymmetrically to supply shocks, opting to disinflate only in recessionary period. Specifically, we show that adaptive expectations combined with asymmetry in the Phillips curve of a specific sort together provide an optimizing justification for opportunism. However, the empirical basis for these conditions to be satisfied in the current low-inflation context of most OECD countries remains however to be established.
Keywords: Deliberate disinflation; Opportunistic disinflation
JEL Classification: E52; E58

E2005/8

James Foreman-Peck and Laurian Lungu (December 2005)
Fiscal Devolution and Dependency (117K, 31 pages)
Forthcoming in Applied Economics
Public spending devolution in practice is widely seen as more appropriate for addressing varied political aspirations within state boundaries than is tax devolution. A drawback is that devolved public spending may be subject to irresistible upward pressure, as illustrated by 'formula drift' of the United Kingdom devolved administrations. By crowding out the private sector such public spending can exacerbate the problem it was originally intended to alleviate. When taxpayers do not value increases in government output at least as highly as the private goods and services they must forgo to finance them, then the public sector is too large. This paper estimates a three sector Hecksher-Ohlin model of the economy with the greatest relative rise of the public spending ratio in the United Kingdom, Wales. Simulation of the model shows a net gain in emp loyment from a one percent cut in income tax matched by a corresponding reduction in government spending. This result is consistent with the current level of intergovernmental transfers being excessive.
Keywords: Fiscal Devolution; Small Open Economy Modelling; Crowding Out
JEL Classification: R15; R58

E2005/7

Max Gillman and Dario Cziráky (December 2005)
Money Demand in an EU Accession Country: A VECM Study of Croatia (232K, 32 pages)
Published in Bulletin of Economic Research, April 2006 58(2) pp. 73-159
The paper estimates the money demand in Croatia using monthly data from 1994 to 2002. A failure of the Fisher equation is found and adjustment to the standard money demand function is made to include the inflation rate as well as the nominal interest rate. In a two-equation cointegrated system, a stable money demand shows rapid convergence back to equilibrium after shocks. This function performs better than an alternative using the exchange rate instead of the inflation rate, as in the "pass-through" literature on exchange rates. The results provide a basis for inflaton rate forecasting and suggest the ability to use inflation targeting goals in transition countries during the EU accession process. Finding a stable money demand also limits the scope for central bank "inflation bias".

E2005/6

Sheikh Selim (November 2005, updated November 2010)
The Social Cost of Optimal Taxes in an Imperfectly Competitive Economy (604K, 33 pages)
In this paper we calibrate the social cost of optimal taxes in a class of imperfectly competitive economies and examine the correspondence of this social cost with the number of tax instruments and the number and the sources of distortions. We calibrate the Ramsey equilibrium for three standard models of imperfect competition. These settings are different in number of sources of market distortion and number of tax instruments. Our calibration clearly shows that optimal taxes in an imperfectly competitive economy incur lower social cost than those in a competitive economy, implying that they are generally more efficient as competition enhancing policy tools. We find that optimal taxes in our models can cost up to 48% less forgone consumption relative to those in a competitive market economy.
Keywords: Optimal taxation; Ramsey Problem; Welfare Cost
JEL Classification: D42; E62; H21; H30

E2005/5

Sheikh Selim (November 2005, updated July 2006)
Taxing Capital in an Imperfectly Competitive Economy (343K, 30 pages)
Evidence of declining trend in OECD economies' income tax rates and the concern of enhancing competition in the US and the EU product markets subtly motivate the question if low income tax rates are optimal in an imperfectly competitive economy. This paper examines optimal income tax policy in a dynamic neoclassical model with monopoly distortions. A capital subsidy, motivated by low private returns to capital, provides strong incentive to invest, but the adverse welfare effect of investment is not perceived by capital owners. Since profit seeking investment worsens second best welfare, and this effect is only perceived by the government, there is a strong motivation to tax capital. The paper presents a numerical characterization of the Ramsey policy and shows that switching to a Ramsey policy involving a capital tax is welfare improving.
Keywords: Optimal taxation; Monopoly power; Ramsey policy
JEL Classification: D42; E62; H21; H30

E2005/4

James Foreman-Peck (November 2005)
Lessons from Italian Monetary Unification (200K, 24 pages)
This paper examines whether the states brought together in the Italian monetary union of the nineteenth century constituted an optimum monetary area, either before or after unification. Interest rate shocks indicate close relations between states in northern Italy but negative correlations between the North and the South before unification, suggesting some advantages of continued Southern monetary independence. The proportion of Southern Italian trade with the North was small, in contrast to intra- Northern trade, and therefore monetary independence imposed a light burden. Changes in the wheat market indicate that the South and North after unification (though not probably because of it) increasingly specialised according to their comparative advantages. Coupled with differences in economic behaviour of the Southern economy, this meant that monetary policies appropriate for the North were less so for the South. In the face of agricultural shocks originating in the New World and in France, the South would have gained from depreciating its exchange rate against the North or against the non-Italian world. As it was, nineteenth century Italian monetary union did not create the conditions for its own success, contrary to the findings of Frankel and Rose (1998) for the later twentieth century.
JEL Classification: E42; N23; F15; F33

E2005/3

Patrick Minford and David Peel (November 2005)
On the equality of Real Interest Rates across borders in Integrated Capital Markets (164K, 9 pages)
Published in Open Economies Review, 18(1), 2007
The purpose in this letter is first to review briefly the empirical results on the relationship between real interest rates and real exchange rates; this empirical literature provides little support for the hypothesis of Roll that expected real interest rates are equal in general. Our second aim is to discuss the theoretical conditions that have to be met for his hypothesis to hold.
Keywords: Real interest rates; Real Exchange rates; Roll
JEL Classification: F31; C22; C51

E2005/2

David Meenagh, Patrick Minford, Eric Nowell and Prakriti Sofat (November 2005, updated March 2010)
Can a Real Business Cycle Model without price and wage stickiness explain UK real exchange rate behaviour? (528K, 21 pages, previously published as "Can a pure Real Business Cycle Model explain the real exchange rate?")
This paper establishes the ability of a Real Business Cycle model to account for real exchange rate behaviour, using UK data. We show that a productivity simulation is capable of explaining initial real appreciation with subsequent depreciation to a lower steady state. The model is tested by the method of indirect inference, bootstrapping the errors to generate 95% confidence limits for a time-series representation of the real exchange rate, as well as for various key data moments. The results suggest RBC models can explain real exchange rate movements.
Keywords: Real Exchange Rate; Productivity; Real Business Cycle; Bootstrap; Indirect Inference
JEL Classification: E32; F31; F41