| Banking and Finance |
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| No. 402, November 2009 |
| What Fiscal Policy Is Effective at Zero Interest Rates? |
| Gauti B. Eggertsson |
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| Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save rather than spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include: 1) a temporary increase in government spending and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today. |
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| No. 403, November 2009 |
| A Bayesian Approach to Estimating Tax and Spending Multipliers |
| Matthew Denes and Gauti B. Eggertsson |
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| This paper outlines a simple Bayesian methodology for estimating tax and spending multipliers in a dynamic stochastic general equilibrium model. After forming priors about the parameters of the model and the relevant shock, Denes and Eggertsson use the model to exactly match only one data point: the trough of the Great Depression, that is, an output collapse of 30 percent, deflation of 10 percent, and a zero short-term nominal interest rate. Because the authors form their priors as distributions, their key economic inferences—the multipliers of tax and spending—are well-defined probability distributions derived from the posterior of the model. While the Bayesian methods used are standard, the application is slightly unusual. Denes and Eggertsson conjecture that this methodology can be applied in several different settings with severe data limitations and where more informal calibrations have been the norm. Applying their simple estimation method to the American Recovery and Reinvestment Act, they find that the Act increased output by 3.6 percent in 2009 and 2010. |
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| No. 406, November 2009 |
| Broker-Dealer Risk Appetite and Commodity Returns |
| Erkko Etula |
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This paper shows that the risk-bearing capacity of securities brokers and dealers is a strong determinant of risk premia and the volatility of returns in commodity markets. Etula measures risk-bearing capacity as the fraction of broker-dealer financial assets relative to the total financial assets of broker-dealers and households. This variable has particularly strong power to forecast energy returns, both in sample and out of sample: It forecasts approximately 30 percent of the variation in quarterly crude oil returns. These findings are rationalized in a simple asset-pricing model where the economic role of broker-dealers is to provide insurance against commodity price fluctuations. The author estimates cross-sectional prices of risk using an arbitrage-free
asset-pricing approach and shows that broker-dealer risk-bearing capacity forecasts commodity returns because of its association with the price of risk. |
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| No. 409, November 2009 |
| Macroprudential Supervision of Financial Institutions: Lessons from the SCAP |
| Beverly Hirtle, Til Schuermann, and Kevin Stiroh |
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| A fundamental conclusion drawn from the recent financial crisis is that the supervision and regulation of financial firms in isolation—a purely microprudential perspective—are not sufficient to maintain financial stability. Rather, a macroprudential perspective, which evaluates and responds to the financial system as a whole, seems necessary, and the ongoing discussions of regulatory reform in the United States underscore this view. The recently concluded Supervisory Capital Assessment Program (SCAP), better known as the bank “stress test,” is one example of how the macro- and microprudential perspectives can be joined to create a stronger supervisory framework that addresses a wider range of supervisory objectives. This paper reviews the key features of the SCAP and discusses how they can be leveraged to improve bank supervision in the future. |
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| No. 413, December 2009 |
| Valuing the Treasury’s Capital Assistance Program |
| Paul Glasserman and Zhenyu Wang |
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| This study develops a contingent claims framework to estimate market values of the Treasury’s Capital Assistance Program (CAP). The interaction between the competing options held by the buyer and issuer of these securities creates a game between them; the authors’ approach captures this strategic element of the joint valuation problem and clarifies the incentives it creates. Glasserman and Wang apply their method to eighteen bank holding companies that participated in the Supervisory Capital Assessment Program (the bank “stress test”) launched with the CAP. On average, they estimate that compared with a market transaction, the CAP securities carry a net value of approximately 30 percent of the capital invested for a bank participating to the maximum extent allowed under the program’s terms. Net value is also found to vary widely across banks. The results suggest that the authors’ valuation aligns with shareholder perceptions of the program’s value. |
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| No. 414, December 2009 |
| The Microstructure of the TIPS Market |
| Michael J. Fleming and Neel Krishnan |
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| Fleming and Krishnan characterize the microstructure of the market for Treasury inflation-protected securities (TIPS) using novel tick data from the interdealer market. The authors find a marked difference in trading activity between on-the-run and off-the-run securities, as in the nominal Treasury securities market. They find little difference in bid-ask spreads or quoted depth between on-the-run and off-the-run securities, in contrast to the nominal market, but they do find a sharp difference in the incidence of posted quotes. Intraday activity differs strikingly from the nominal market, with activity peaking in the mid-to-late morning. Announcement effects also differ from the nominal market, with auction results and consumer price index announcements eliciting particularly sharp increases in trading activity. |
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| No. 416, December 2009 |
| The Mechanics of a Graceful Exit: Interest on Reserves and Segmentation in the Federal Funds Market |
| Morten L. Bech and Elizabeth Klee |
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| To combat the financial crisis that intensified in fall 2008, the Federal Reserve injected a substantial amount of liquidity into the banking system. The resulting increase in reserve balances exerted downward price pressure in the federal funds market, and the effective federal funds rate began to deviate from the target rate set by the Federal Open Market Committee. In response, the Federal Reserve revised its operational framework for implementing monetary policy and began to pay interest on reserve balances in an attempt to provide a floor for the federal funds rate. Nevertheless, following the policy change, the effective federal funds rate remained below not only the target but also the rate paid on reserve balances. This study develops a model to explain this phenomenon and uses federal funds market data to evaluate it empirically. The authors show how successful the Federal Reserve may be in raising the federal funds rate even in an environment with substantial reserve balances. |
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