David D. VanHoose

Openness, Central Bank Independence, and the Sacrifice Ratio

Traditional explanations of the negative correlation between openness and inflation presume that an inverse relationship between the degree of openness and the sacrifice ratio reduces the inflation bias of descretionary monetary policy. Temple (2002) concludes, however, that such a relationship fails to emerge in cross-country data. Our analysis of the same cross-country data considered by Temple indicates that once the degree of central bank independence and its interaction with greater openness and the sacrifice ratio. In addition, increased openness lessens the positive effect of central bank independence on the sacrifice ratio.

A model of the monetary sector with and without binding capital requirements

Abstract Bank equity is exogenous in the standard deposit-and-loan-expansion multiplier model, so that model is inappropriate for analyzing the interaction between monetary and bank regulatory policies. This paper examines the effect of a binding capital requirement on the loan expansion process. We evaluate how the conflict between the monetary and regulatory authorities evolves when bank equity adjusts to a binding capital requirement. We find that capital requirements are not innocuous for monetary policy. Nevertheless, the monetary authority can assert control over the loan expansion process in the long run, although multiplier values will differ considerably from those in the standard multiplier model.

Discretionary Monetary Policy and Socially Efficient Wage Indexation

It is not uncommon for policy-makers, especially when they are trying to reduce inflation, to create incentives or restrictions that change individual decisions regarding nominal wage indexation. This raises a very interesting question for economists: if indexation of nominal contracts is the result of utility-maximizing behavior, why would policy-makers try to alter private indexation decisions? The usual rationale for governmental involvement in markets provided by microeconomic theory is that individual decisions may cause externalities that create a conflict between individual and social optima. Extending this logic to the case of indexation suggests that private indexation decisions may create an inflation externality and, thus, are not socially efficient. Blanchard [1979] and Ball [1988] have investigated the social efficiency of private decisions to index to the price level. They find that the equilibrium degree of wage indexation to the price level is socially inefficient if indexation to other relevant variables is costly. Since indexation costs do not appear to be empirically significant, these models do not provide a very convincing argument for governmental involvement in the indexation process. Furthermore, these models do not tie the degree of indexation to the trend inflation rate, which seems to be the crucial element for justifying governmental intervention. Thus, in order to pinpoint the exact nature of this externality, a model is required that considers endogenous wage indexation but links indexation to the trend inflation rate. Devereux [1987, 1989] uses such a model to examine the relationship between indexation and mean inflation. By combining a Gray [1976] indexation model with a Barro-Gordon [1983] inflation model, he shows that wage indexation affects the mean inflation rate, but he does not address the issue of indexation efficiency. In this paper we use a synthesis of Ball and Devereuxs models to demonstrate that individual indexation decisions are, in general, socially inefficient. However, in contrast to Blanchard and Balls

Optimal Wage Indexation in a Multisector Economy

Optimal wage indexation is analyzed in an economy subject to common and sector-specific supply shocks and aggregate demand shocks where one sector has wage contracts and the other has a Walrasian labor market. It is shown that it is optimal in this setting to index wages partially to unanticipated economywide inflation and to industry-specific profits. Consequently, this study provides possible theoretical explanations for observation of both CPI indexation and profit-sharing contracts, and for the failure of purely aggregative indexation models to explain disaggregate-level behavior. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Sweep accounts, reserve management, and interest rate volatility1

Abstract Retail sweep accounts have reduced required bank reserve balances by more than 70% since 1995, raising concerns in some quarters about increased volatility of interest rates and reduced monetary policy effectiveness. We develop a model of bank reserve management and daily payment flows that indicates that the effect of lower reserve balances on funds rate volatility is theoretically ambiguous. We empirically test the relationships among reserve balances, federal funds-rate volatility, and the variation in short-term money market rates. Our conclusion is that reductions in reserve balances have not impinged on the ability of the Federal Reserve to conduct monetary policy in the manner that it has in recent years.

Has Greater Competition Restrained U.S. Inflation

This paper shows how increased goods market competition affects the behavior of inflation in a multisector economy. By raising the price elasticity of demand, increased goods market competition theoretically lowers inflation and makes the aggregate price level less sensitive to aggregate demand shocks. We find that proxies for the aggregate degree of goods market competition are statistically and economically significant in short-run Phillips curve models of core inflation. Evidence indicates that heightened goods market competition has flattened the slope of the short-run, expectations-augmented Phillips curve and slightly lowered the nonaccelerating inflation rate of unemployment (NAIRU).

Bank Behavior under Capital Regulation: What Does the Academic Literature Tell Us?

This paper reviews academic studies of bank capital regulation in an effort to evaluate the intellectual foundation for the imposition of the Basel I and Basel II systems of risk-based capital requirements. The theoretical literature yields general agreement about the immediate effects of capital requirements on bank lending and loan rates and the longer-term impacts on bank ratios of equity to total or risk-adjusted assets. This literature produces highly mixed predictions, however, regarding the effects of capital regulation on bank asset risk and overall safety and soundness. Research also indicates that bank capital regulation can have procyclical macroeconomic effects and can impinge on the effectiveness of monetary policy. Although empirical research provides some support for the macroeconomic and monetary policy implications of risk-based capital requirements, conclusions about actual bank balance-sheet and risk adjustments to capital regulation are also mixed. Thus, the intellectual foundation for the present capital-regulation regime is not particularly strong. The mixed conclusions in the academic literature on banking certainly does not provide unqualified support for moving to an even more stringent and costly system of capital requirements.

Two-Country Models of Monetary and Fiscal Policy: What Have We Learned? What More Can We Learn?

This paper surveys the literature that uses two-country models to analyze monetary and fiscal policy issues faced in interdependent economies. We discuss sources of structural interdependence that researchers typically include in these models. We describe many of the types of policy interactions that researchers have considered and summarize the key results that they have obtained. Finally, we briefly explain the limitations of two-country models and outline directions that this literature might usefully be extended.

Bank Balance Sheet Dynamics Under a Regulatory Liquidity-Coverage-Ratio Constraint

The Basel III standards include a liquidity-coverage-ratio (LCR) constraint that creates an intertemporal link between contemporaneous bank balance-sheet choices and lagged deposits. Assessing the effects of an LCR constraint for banks’ optimal deposit and loan choices requires an intertemporal framework. Our analysis of a dynamic banking model shows that imposing an LCR constraint generally has theoretically ambiguous effects on the stability of banks’ optimal dynamic balance-sheet paths. Even in special cases, such as a situation in which regulators prohibit banks from applying securities to fulfill the LCR constraint or in which banks simultaneously confront risk-based capital regulation while facing rigidities in their equity capital positions, optimal bank deposit paths exhibit increased intertemporal persistence but become more responsive to shocks to market interest rates.

Systemic Risks and Macroprudential Bank Regulation: A Critical Appraisal

This paper discusses and critically appraises recent developments in the definition, measurement, and regulation of systemic risks. Although the issue of systemic risks has been subjected to considerable study, there is not widespread agreement on how to define the concept of systemic risk. Initial efforts to measure systemic risks emphasized aggregate financial ratios, and only recently have a variety of institution-level systemic-risk measurement techniques been proposed and studied. Thus, regulators charged with conducting macroprudential regulation, such as the Financial Stability Oversight Council created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, must act without a consensus about how to define and measure the form of risk they are charged with limiting. Furthermore, there are three largely unexplored pitfalls associated with establishing a macroprudential-supervision apparatus: (1) An enlarged potential for regulatory capture and associated welfare losses; (2) A danger of over-relying on centralized governmental command-and-control mechanisms that might be at least as subject to breakdowns as private markets while under-relying on private market discipline; and (3) Failures to contemplate a role for private contractual (Coasian) solutions to externality problems that contribute to systemic-risk problems and to recognize that a broadened scope of regulations can actually undermine the incentives for financial institutions to contain these externality problems. Future research should explore these issues, which have generally not been addressed in the literature on systemic risk and macroprudential regulation.