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Working Paper Archives

Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critial comment.

2011

Inflation in the G7: Mind the Gap(s)?

We investigate the importance of trend inflation and the real-activity gap for explaining observed inflation variation in G7 countries since 1960. Our results are based on a bivariate unobserved-components model of inflation and unemployment in which inflation is decomposed into a stochastic trend and transitory component. As in recent implementations of the New Keynesian Phillips Curve, it is the transitory component of inflation, or “inflation gap”, that is driven by the real-activity gap, which we measure as the deviation of unemployment from its natural rate. Even when allowing for changes in the contributions of trend inflation and the inflation gap, we find that both are important determinants of inflation variation at business cycle horizons for all G7 countries throughout much of the past 50 years. Also, the real-activity gap explains a large fraction of the variation in the inflation gap for each country, both historically and in recent years. Taken together, the results suggest the New Keynesian Phillips Curve, once augmented to include trend inflation, is an empirically relevant model for the G7 countries. We also provide new estimates of trend inflation for the G7 that incorporate information in the real-activity gap for identification and, through formal model comparisons, new statistical evidence regarding structural breaks in the variability of trend inflation and the inflation gap.

The Distributional Burden of Instant Lottery Ticket Expenditures: An Analysis by Price Point

This article examines the distributional burden of different price-point instant lottery games. Theoretical reasons exist for expecting higher-priced instant lottery games to be less regressive than lower-priced instant games. Using county-level data on sales by price point for six states, the empirical results show that higher-priced instant games are less regressive than lower priced games. In addition, regressivity is rejected in favor of proportionality for some instant lottery games. The analysis also reveals that counties having a higher-percentage of low-income households have higher sales of lower-priced instant games, but differences in the distribution of household income have no significant impact on higher-priced instant sales. Taken together, the findings suggest that large differences in the distributional burden of individual instant games are masked if aggregated instant-lottery sales data are used.

The Low-Frequency Impact of Daily Monetary Policy Shocks

With rare exception, studies of monetary policy tend to neglect the timing of innovations to monetary policy instruments. Models which take timing seriously are often difficult to compare to standard monetary VARs because each uses different frequencies. We propose using MIDAS regressions that nests both ideas: Accurate (daily) timing of innovations to policy are embedded in a monthly-frequency VAR to determine the macroeconomic effects of high-frequency policy shocks. We find that policy have greatest effects on variables thought of as heavily expectations oriented and that, contrary to some VAR studies, the effects of policy shocks on real variables are small.

Input and Output Inventory Dynamics

This paper develops an analytically tractable general-equilibrium model of inventory dynamics based on a precautionary stockout-avoidance motive. The model’s predictions are broadly consistent with the U.S. business cycle and key features of inventory behavior. It is also shown that technological improvement of inventory management can increase, rather than decrease, the volatility of aggregate output. Key to this seemingly counterintuitive result is that a stockout-avoidance motive leads to a procyclical shadow value of inventories, which acts as an automatic stabilizer that discourages sales in booms and encourages demand in recessions, thereby reducing the variability of GDP.

Making Sense of China’s Excessive Foreign Reserves

Large uninsured risk, severe borrowing constraints, and rapid income growth can create excessively high household saving rates and large current account surpluses for emerging economies. Therefore, the massive foreign-reserve buildups by China are not necessarily the intended outcome of any government policies or an undervalued home currency, but instead a natural consequence of the country’s rapid economic growth in conjunction with an inefficient financial system (or lack of timely financial reform). A tractable growth model of precautionary saving is provided to quantitatively explain China’s extraordinary path of trade surplus and foreign-reserve accumulation in recent decades. Ironically, the analysis suggests that without a well-developed domestic financial market, the value of the renminbi (RMB) may significantly depreciate, instead of appreciate, once the Chinese government abandons the linked exchange rate and the massive amount of precautionary savings of Chinese households are unleashed toward international financial markets to search for better returns.

Negative Correlation between Stock and Futures Returns: An Unexploited Hedging Opportunity?

The negative correlation between equity and commodity futures returns is widely perceived by investors as an unexploited hedging opportunity. A Lucas (1982) two-country asset-pricing model is adapted to analyze the fundamentals driving equity and commodity futures returns. Using the model we argue that such a negative correlation could arise as an equilibrium relationship which reflects traders’ perceptions about the shocks driving the fundamentals such as energy and consumables, and does not necessarily indicate any hedging opportunity.

Foreign Direct Investment, Aid and Terrorism: An Analysis of Developing Countries

Using a dynamic panel data framework, we investigate the relationship between the two major forms of terrorism and foreign direct investment (FDI). We then analyze how these relationships are affected by foreign aid flows. The analysis focuses on 78 developing countries for 1984- 2008. Our findings suggest that all types of terrorism depress FDI. In addition, aid mitigates the negative effects of total and domestic terrorism on FDI; however, this is not the case for transnational terrorism. This finding highlights that different forms of terrorism call for tailoring mitigating strategies. Foreign aid apparently cannot address the causes and supply lines of transnational terrorism. Aid’s ability to curb the risk to FDI for total and domestic terrorism is extremely important because (i) domestic terrorism is an overwhelming fraction of the total terrorism for many developing nations, and (ii) FDI is an important engine of development for these nations.

A Bayesian Multi-Factor Model of Instability in Prices and Quantities of Risk in U.S. Financial Markets

This paper analyzes the empirical performance of two alternative ways in which multi-factor models with time-varying risk exposures and premia may be estimated. The first method echoes the seminal two-pass approach advocated by Fama and MacBeth (1973). The second approach extends previous work by Ouysse and Kohn (2010) and is based on a Bayesian approach to modelling the latent process followed by risk exposures and idiosynchratic volatility. Our application to monthly, 1979-2008 U.S. data for stock, bond, and publicly traded real estate returns shows that the classical, two-stage approach that relies on a nonparametric, rolling window modelling of time-varying betas yields results that are unreasonable. There is evidence that all the portfolios of stocks, bonds, and REITs have been grossly over-priced. On the contrary, the Bayesian approach yields sensible results as most portfolios do not appear to have been misspriced and a few risk premia are precisely estimated with a plausibile sign. Real consumption growth risk turns out to be the only factor that is persistently priced throughout the sample.

Did Doubling Reserve Requirements Cause the Recession of 1937-1938? A Microeconomic Approach

In 1936-37, the Federal Reserve doubled the reserve requirements imposed on member banks. Ever since, the question of whether the doubling of reserve requirements increased reserve demand and produced a contraction of money and credit, and thereby helped to cause the recession of 1937-1938, has been a matter of controversy. Using microeconomic data to gauge the fundamental reserve demands of Fed member banks, we find that despite being doubled, reserve requirements were not binding on bank reserve demand in 1936 and 1937, and therefore could not have produced a significant contraction in the money multiplier. To the extent that increases in reserve demand occurred from 1935 to 1937, they reflected fundamental changes in the determinants of reserve demand and not changes in reserve requirements.

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