Economic Research Working Papers

Working papers from the Federal Reserve Bank of Dallas are preliminary drafts circulated for professional comment.

2008 | 2007 | 2006 | 2005 | 2004 | 2003 | 2002 | 2001 | 2000 | 1999 | 1998 and earlier

2008 Working Papers

0813
Keynesian Economics without the LM and IS Curves: A Dynamic Generalization of the Taylor-Romer Model
Evan F. Koenig
Abstract: John Taylor and David Romer champion an approach to teaching undergraduate macroeconomics that dispenses with the LM half of the IS-LM model and replaces it with a rule for setting the interest rate as a function of inflation and the output gap—i.e., a Taylor rule. But
the IS curve is problematic, too. It is consistent with the permanent-income hypothesis only when the interest rate that enters the IS equation is a long-term rate—not the short-term rate controlled by the monetary authority. This article shows how the Taylor-Romer framework can be readily modified to eliminate this maturity mismatch. The modified model is a dynamic system in output and inflation, with a unique stable path that behaves very much like Taylor and Romer’s aggregate demand (AD) schedule. Many—but not all—of the original Taylor-Romer model’s predictions carry over to the new framework. It helps bridge the gap between the Taylor-Romer analysis and the more sophisticated models taught in graduate-level courses.

0812
The Elasticity of Intertemporal Substitution: New Evidence from 401(k) Participation
Gary V. Engelhardt and Anil Kumar
Abstract: A key parameter in economics is the elasticity of intertemporal substitution (EIS), which measures the extent to which consumers shift total expenditures across time in response to changes in the effective rate of return. In contrast to the previous literature, which primarily has relied on Euler equation methods and generated a wide range of estimates, we show how a life-cycle-consistent econometric specification of employee 401(k) participation along with plausibly exogenous variation in rates of return due to employer matching contributions can be used to generate new estimates of the EIS. Because firms often cap the generosity of the match, employer matching generates nonlinearities in household budget sets. We draw on non-linear budget-set estimation methods rooted in the public economics literature, and using detailed administrative contribution, earnings, and pension-plan data for a sample of 401(k)-eligible households from the Health and Retirement Study, we estimate the EIS to be 0.74 in our richest specification, with a 95% confidence interval that ranges from 0.37 to 1.21.

0811
Stationarity and the Term Structure of Interest Rates: A Characterisation of Stationary and Unit Root Yield Curves
Clive G. Bowsher and Roland Meeks
Abstract: The nature of yield curve dynamics and the determinants of the integration order of yields are investigated using a benchmark economy in which the logarithmic expectations theory holds and the regularity condition of a limiting yield and limiting term premium is satisfied. By considering a zero-coupon yield curve with a complete term structure of maturities, a linear vector autoregressive process is constructed that provides an arbitrarily accurate moving average representation of the complete yield curve as its cross-sectional dimension (n) goes to infinity. We use this to prove the following novel results. First, any I(2) component vanishes owing to the almost sure (a.s.) convergence of the innovations to yields, v_t(n), as n. Second, the yield curve is stationary if and only if nv_t(n) converges a.s., or equivalently the innovations to log discount bond prices converge a.s.; otherwise yields are I(1). A necessary condition for either stationarity or the absence of arbitrage is that the limiting yield is constant over time. Since the time-varying component of term premia is small in various fixed-income markets, these results provide insight into the critical determinants of the stationarity properties of the term structure.

0810
Globalization of Production and the Technology Transfer Paradox
Edwin Lai
Abstract: This paper develops a growth model aimed at understanding the effects of globalization of production on rate of innovation, distribution of labor income between the North and South and welfare of workers in both regions. We adopt a dynamic general equilibrium productcycle model, assuming that the North specializes in innovation and the South specializes in imitation. Globalization of production resulting from trade liberalization and imitation of the North’s technology by the South increases the rate of innovation. When the South’s participation in the product cycle is not too deep, further deepening of globalization of production lowers the wage of Southern labor relative to that of its counterpart in the North. This poses a technology transfer paradox similar to that discovered by Jones and Ruffin (forthcoming, JIE): an increase in the uncompensated technology transfer from the North to the South makes the North better off. However, a point will be reached where further deepening of globalization leads to increases in relative wage of the South. For this reason, the North would eventually lose from uncompensated technology transfer as globalization deepens.

0809
The External Finance Premium and the Macroeconomy: US Post–WWII Evidence
Ferre De Graeve
Abstract: The central variable of theories of financial frictions—the external finance premium—is unobservable. This paper distils the external finance premium from a DSGE model estimated on U.S. macroeconomic data. Within the DSGE framework, movements in the premium can be given an interpretation in terms of shocks driving business cycles. A key result is that the estimate—based solely on nonfinancial macroeconomic data—picks up over 70 percent of the dynamics of lower grade corporate bond spreads. The paper also identifies a gain in fitting key macroeconomic aggregates by including financial frictions in the model and documents how shock transmission is affected.

0808
On the Effectiveness of the Federal Reserve's New Liquidity Facilities
Tao Wu
Abstract: This paper examines the effectiveness of the new liquidity facilities that the Federal Reserve established in response to the recent financial crisis. I develop a noarbitrage based affine term structure model with default risk and conduct a thorough factor analysis of the counterparty default risk among major financial institutions and the underlying mortgage default risk. The new facilities’ effectiveness is examined, by first separately examining their effects in relieving financial institutions’ liquidity concerns and reducing the counterparty risk premiums, and then quantifying their overall effects in reducing financial strains in the inter-bank money market.

Empirical results indicate that the Term Auction Facility (TAF) has a strong effect in reducing financial strains in the inter-bank money market, primarily through relieving financial institutions’ liquidity concerns. Heightened uncertainty regarding the macroeconomy, financial markets, and mortgage default risk have significantly raised counterparty risk premiums among financial institutions, but have had little effect on their liquidity premiums. The Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF), however, are found to have had less discernible effects so far in relieving financial strains in the Libor market. This is consistent with market observations of a weaker interest from primary dealers in participating in the TSLF auctions than banks have shown in tapping the TAF.

0807
Regulation and the Neo-Wicksellian Approach to Monetary Policy
John V. Duca and Tao Wu
Abstract: Laubach and Williams (2003) employ a Kalman filter approach to jointly estimate the neutral real federal funds rate and trend output growth using an IS relationship and an output gap based inflation equation. They find a positive link between these two variables, but also much error surrounding neutral real rate estimates. We modify their approach by including variables for regulations on deposit interest rates and on wages and prices. These variables are statistically significant and notably affect estimates of two policy relevant coefficients: the sensitivity of output to the real interest rate and that of inflation to the output gap.

0806 (Globalization and Monetary Policy Institute Working Paper No. 15)
Variety, Globalization, and Social Efficiency
W. Michael Cox and Roy J. Ruffin
Abstract: This paper puts recent work on the benefits of variety into the context of a more complete quantitative analysis of the Dixit-Stiglitz-Krugman model of monopolistic competition.  We show how the gains from globalization are reflected in the increase in variety and the exploitation of economies of scale, and that the social efficiency question is quantitatively insignificant.  These results follow from examining a Bertrand-Nash equilibrium that allows for a finite number of varieties to affect the elasticity of demand facing each firm.  We develop a precise expression for per capita real income with any number of sectors where globalization increases productivity through economies of scale.

0805
The Effect of Minimum Wages on Immigrants' Employment and Earnings
Pia Orrenius and Madeline Zavodny
Abstract: This study examines how minimum wage laws affect the employment and earnings of low-skilled immigrants and natives in the U.S. Minimum wage increases might have larger effects among low-skilled immigrants than among natives because, on average, immigrants earn less than natives due to lower levels of education, limited English skills, and less social capital. Results based on data from the Current Population Survey for the years 1994–2005 do not indicate that minimum wages have adverse employment effects among adult immigrants or natives who did not complete high school. However, low-skilled immigrants may have been discouraged from settling in states that set wage floors substantially above the federal minimum.

0804
The Dynamics of Economic Functions: Modelling and Forecasting the Yield Curve
Clive G. Bowsher and Roland Meeks
Abstract: The class of Functional Signal plus Noise (FSN) models is introduced that provides a new, general method for modelling and forecasting time series of economic functions. The underlying, continuous economic function (or "signal") is a natural cubic spline whose dynamic evolution is driven by a cointegrated vector autoregression for the ordinates (or "y-values") at the knots of the spline. The natural cubic spline provides flexible cross-sectional fit and results in a linear, state space model. This FSN model achieves dimension reduction, provides a coherent description of the observed yield curve and its dynamics as the cross-sectional dimension N becomes large, and can feasibly be estimated and used for forecasting when N is large. The integration and cointegration properties of the model are derived. The FSN models are then applied to forecasting 36-dimensional yield curves for US Treasury bonds at the one month ahead horizon. The method consistently outperforms the Diebold and Li (2006) and random walk forecasts on the basis of both mean square forecast error criteria and economically relevant loss functions derived from the realised profits of pairs trading algorithms. The analysis also highlights in a concrete setting the dangers of attempts to infer the relative economic value of model forecasts on the basis of their associated mean square forecast errors.

0803
Why Stop There? Mexican Migration to the U.S. Border Region
Pia M. Orrenius, Madeline Zavodny and Leslie Lukens
Abstract: The transformation of the U.S. border economy since the 1980s provides a fascinating backdrop to explore how migration to the U.S-side of the Mexican border has changed vis-à-vis migration to the U.S. interior. Some long-standing patterns of border migrants remained unchanged during this period while others underwent drastic changes. For example, border migrants are consistently more likely to be female, to have migrated within Mexico, and to lack migrant networks as compared with migrants to the U.S. interior. Meanwhile, the occupational profile of border migrants has changed drastically from being predominately agricultural work to being largely made up of service-sector and sales-related work. Border migration is more sensitive to Mexican and U.S. business cycles than migration to the U.S. interior throughout the period and, while the data suggest border migrant wages may have caught up to other migrants’ wages by the early 2000s, multivariate analysis indicates that border migrants who are female and/or undocumented continue to earn far less than such migrants who work in the U.S. interior.

0802
Deliverability and Regional Pricing in U.S. Natural Gas Markets
Stephen P. A. Brown and Mine K. Yücel
Abstract: During the 1980s and early '90s, interstate natural gas markets in the United States made a transition away from the regulation that characterized the previous three decades. With abundant supplies and plentiful pipeline capacity, a new order emerged in which freer markets and arbitrage closely linked natural gas price movements throughout the country. After the mid-1990s, however, U.S. natural gas markets tightened and some pipelines were pushed to capacity. We look for the pricing effects of limited arbitrage through causality testing between prices at nodes on the U.S. natural gas transportation system and interchange prices at regional nodes on North American electricity grids. Our tests do reveal limited arbitrage, which is indicative of bottlenecks in the U.S. natural gas pipeline system.

0801
The Poor, the Rich and the Enforcer: Institutional Choice and Growth
Erwan Quintin, Thorsten Koeppl and Cyril Monnet
Abstract: We study economies where improving the quality of institutions—modeled as im proving contract enforcement—requires resources, but enables trade that raises output by reducing the dispersion of marginal products of capital. We find that in this type of environment it is optimal to combine institutional building with endowment redistribution, and that more ex-ante dispersion in marginal products increases the incentives to invest in enforcement. In addition, we show that institutional investments lead over time to a progressive reduction in inequality. Finally, the framework we describe enables us to formalize the hypothesis formulated by Engerman and Sokoloff (2002) that the initial concentration of human and physical capital can explain the divergence of different countries’ institutional history.