David K. Backus

International Real Business Cycles

We ask whether a two-country real business cycle model can account simultaneously for domestic and international aspects of business cycles. With this question in mind, we document a number of discrepancies between theory and data. The most striking discrepancy concerns the correlations of consumption and output across countries. In the data, outputs are generally more highly correlated across countries than consumptions. In the model we see the opposite.

Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods

We examine the possibility that nontraded goods may account for several striking features of international macroeconomic data: large, persistent deviations from purchasing power parity, small correlations of aggregate consumption fluctuations across countries, and substantial international real interest rate differentials. A dynamic, exchange economy is used to show that nontraded goods in principle can account for each of these phenomena. In the theory there is a close relation between fluctuations in consumption ratios and those in bilateral real exchange rates, but we find little evidence for this relation in time series data for eight OECD countries.

Affine Term Structure Models and the Forward Premium Anomaly

One of the most puzzling features of currency prices is the forward premium anomaly: the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings. PERHAPS THE MOST PUZZLING FEATURE of currency prices is the tendency for high interest rate currencies to appreciate when one might guess, instead, that investors would demand higher interest rates on currencies expected to fall in value. This departure from uncovered interest parity, which we term the forward premium anomaly, has been documented in dozens—and possibly hundreds—of studies, and has spawned a second generation of papers attempting to account for it. One of the most inf luential of these is Fama ~1984!, who attributes the behavior of forward and spot exchange rates to a time-varying risk premium. Fama shows that the implied risk premium on a currency must ~1! be negatively correlated with its expected rate of depreciation and ~2! have greater variance. We refer to this feature of the data as an anomaly because asset pricing theory to date has been notably unsuccessful in producing a risk premium with the requisite properties. Attempts include applications of the capital asset pricing model to currency prices ~Frankel and Engel ~1984!, Mark ~1988!!, statistical models relating risk premiums to changing second moments ~Hansen and Hodrick ~1983!, Domowitz and Hakkio ~1985!, Cumby ~1988!!, and consumption-based asset pricing theories, including departures from time

In search of scale effects in trade and growth

We look for the scale effects predicted by some theories of trade and growth based on the dynamic returns to scale that arise from learning by doing, investment in human capital, or development of new products. We find little empirical evidence of a relation between the growth rate of GDP per capita and the measures of scale implied by the theory. Restricting attention to the manufacturing sector, however, we find a significant relation between the growth rate of output per worker and the relevant scale variables. We also find that growth rates are significantly related to measures of intra-industry trade.

Rational Expectations and Policy Credibility Following a Change in Regime

We examine the dynamic path of an economy after a change in regime, when neither the policy to be followed nor the reactions of the public are known. The model is an application of Kreps and Wilsons reputation model to Barro and Gordons macroeconomic policy game. Equilibrium is defined to be the dynamically consistent solution to a game between the government and the private sector. It involves mixed strategies and Bayesian learning by both sides until the uncertainty about government and public behaviour is resolved. The absence of complete credibility of government policy and intransigence of private sector wage demands increase the output loss of disinflation. The analysis also sheds light on the strategic nature of economic policymaking and the role of information in macroeconomics.

Risk Premiums in the Term Structure: Evidence from Artificial Economies

We compare the stattstical properties of prices of US Treasury bills to those generated by a theoretical dynamic exchange economy wrth complete markets. We show that the model can account for netther the sign nor the magmtude of average risk premiums in forward prices and holding-period returns. The economy is also incapable of generating enough variation in risk premmms to account for reJections of the expectations hypotheses with Treasury bill data These conclusions add to the growing list of empiricat deficiencies of the representative agent model of asset pricmg

Empirical Models of the Exchange Rate: Separating the Wheat from the Chaff

Various popular exchange rate models (a standard monetary model, a portfolio balance model, and sticky-price models) are estimated and evaluated using U.S.-Canadian data for the 1970s. Nonnested hypothesis tests demonstrate that none are correctly specified. The data suggest: 1) the exchange rate persistence observed is not fully explained by any of the models; 2) the small Durbin-Watson statistics indicate longer lags are required; 3) the current account is a useful explanatory variable; 4) the portfolio balance model fits the data well, but has potentially serious problems measuring the stock of foreign assets.

Theoretical Relations Between Risk Premiums and Conditional Variances

Many statistical models of time-varying risk premiums, including the autoregressive conditional heteroscedasticity (ARCH)-in-mean, attempt to exploit a relation between risk premiums and conditional variances or covariances of asset returns. We examine this relation in numerical versions of a dynamic asset-pricing theory and show that it can be increasing, decreasing, flat, or nonmonotonic. Its shape depends on both the preferences of the representative agent and the stochastic structure of the economy. Without additional structure, the theory does not provide either a general foundation for ARCH-in-mean specifications or a simple interpretation of their parameters.

Long-Memory Inflation Uncertainty: Evidence from the Term Structure of Interest Rates

We use a fractional difference model to reconcile two features of yields on US government bonds with modem asset pricing theory: the persistence of the short rate and variability of the long end of the yield curve. We suggest that this process might arise from the response of the heterogeneous agents to the changes in monetary policy.

Exotic Preferences for Macroeconomists

We provide a users guide to exotic preferences: nonlinear time aggregators, departures from expected utility, preferences over time with known and unknown probabilities, risk-sensitive and robust control, hyperbolic discounting, and preferences over sets (temptations). We apply each to a number of classic problems in macroeconomics and finance, including consumption and saving, portfolio choice, asset pricing, and Pareto optimal allocations.