optimal monetary policy in an economy with inflation persistence abstract this paper studies optimal monetary policy in a model where inflation is persistent two types of price setters are assumed to exist one acts rationally given calvo type constraints on price setting the other type sets prices according to a rule of thumb this results in a phillips curve with both a forward looking term and a backward looking term the phillips curve nests a standard purely forward looking phillips curve as well as a standard purely backward looking phillips curve as special cases a cost push supply shock is derived from microfoundations by adding a time varying income tax and by making the elasticity of substitution between goods stochastic a central bank loss function for this model is derived from a second order taylor approximation of the household s welfare function optimal monetary policy for different relative values of the forward and backward looking terms is then analyzed for both the commitment case and the case of discretion

swap rates and credit quality this article presents a model for valuing claims subject to default by both contracting parties such as swaps and forwards with counterparties of different default risk the promised cash flows of a swap are discounted by a switching discount rate that at any given state and time is equal to the discount rate of the counterparty for whom the swap is currently out of the money that is a liability the impact of credit risk asymmetry and of netting is presented through both theory and numerical examples which include interest rate and currency swaps this article presents a model for valuing claims subject to default by both contracting parties such as swaps and forwards this extends the valuation model for defaultable claims proposed by duffie and singleton 1994 to cases in which the two counterparties have asymmetric default risk the extension permits a reexamination of the impact of credit risk on swap rates while the valuation model applies to all forms of contingent claims in which both contracting parties are at risk to default such as forward contracts we focus on swaps for purposes of illustration for example consider a 5 year interest rate swap between a given party paying a floating rate such as the london inter bank offered rate libor and another counterparty paying a fixed rate replacing the given fixed rate counterparty with a lower quality counterparty whose bond yields are 100 basis points higher increases the swap rate by roughly 1 basis point using our model and typical parameters for libor rate processes this credit impact on swap rates is approximately linear within the range of normally encountered credit quality for a 5 year currency swap given a foreign exchange rate with 15 percent volatility our model shows the impact of credit risk asymmetry on the market swap rate to be roughly 10 fold greater than that for interest rate swaps that is approximately 10 basis points in swap rate per 100 basis points in bond yield credit spread the main goal of this article is to provide a simple and theoretically consistent model allowing such computations

the phillips curve back to the 60s abstract this paper reexamines the behavior of inflation and unemployment and reaches four conclusions 1 the u s phillips curve is alive and well at least as well as in the past 2 inflation expectations however have become steadily more anchored 3 the slope of the curve has substantially declined but the decline dates back to the 1980s rather than to the crisis 4 the standard error of the residual in the relation is large especially in comparison to the low level of inflation each of the four conclusions presents challenges for the conduct of monetary policy

inflation dynamics and the output inflation trade off international panel data evidence we explore the impact of inflation and its variability on the output inflation trade off using a unified single step approach in a panel data context a limitation of earlier empirical approaches is that they focus on either cross country or country by country time series analyses this paper employs a dynamic heterogeneous panel data specification and uses an all encompassing estimation framework that accounts for parameter heterogeneity cross sectional dependence dynamics and non stationarity our sample covers 60 countries from 1970 to 2010 while inflation variability reduces the trade off for specific periods and country groups an unambiguous and more pronounced negative relation emerges between the inflation rate and the responsiveness of real output to nominal shocks the findings are in line with the new keynesian view of a negative association between the rate of inflation and the output inflation trade off as well as with the observed flattening of the phillips curve over the past decades

interest rate swaps abstract using quotations from two interest rate swap dealers with different credit ratings aaa and a we examine the effect of dealers credit reputations on swap quotations and bid offer spreads the aaa offer rates are significantly higher than the a offer rates and the aaa bid rates are significantly lower than the a bid rates we also document the relation between swap rates and par bond yields estimated from london interbank offered rate libor and bid rate libid data we identify some of the problems in testing the implications of swap pricing theory

the valuation of options on yields abstract many contingent claims incorporate options on yield levels i derive closed form expressions for european yield option prices using a general equilibrium model in which the underlying yield is the relevant state variable the properties of these options differ markedly from those of conventional options on traded assets for example yield call values can be less than their intrinsic value and can be decreasing functions of the underlying yield these features have important hedging implications i examine the empirical implications of the model using price data for the 13 week t bill options traded on the chicago board options exchange

sectoral shocks and aggregate fluctuations abstract this paper presents a multisector dynamic general equilibrium model of business cycles with a distinctive feature aggregate fluctuations are driven by independent sectoral shocks the model hypothesizes that trade among sectors provides a strong synchronization mechanism for these shocks due to the limited but locally intense interaction that is characteristic of such input trade flows limited interaction characterized by a sparse intermediate input use matrix reduces substitution possibilities among intermediate inputs which strengthens comovement in sectoral value added and leads to a postponement of the law of large numbers in the variance of aggregate value added the chief virtue of this model is that reliance on implausible aggregate shocks is not necessary to capture the qualitative features of macroeconomic fluctuations building on horvath 1998 review of economic dynamics 1 781 808 which establishes the theoretical foundation for the relevance of limited interaction in the context of a stylized multisector model this paper specifies a more general multisector model calibrated to the us 2 digit standard industrial code economy simulations prove the model is able to match empirical reality as closely as standard one sector business cycle models without relying on aggregate shocks

the role of inflation target adjustment in stabilization policy we study optimal monetary policy in a new keynesian model in which the monetary authority faces a trade off between inflation and output gap stabilization due to cost push shocks in particular we highlight the role of the inflation target adjustment in stabilization policy by showing that it can mitigate this policy trade off and considerably improve welfare the main findings can be summarized as follows first we find that the welfare cost of a standard taylor rule is non trivial even with optimized policy coefficients second we propose an additional policy tool of a medium run inflation target mrit rule when combined with the standard taylor rule the optimal mrit significantly reduces fluctuations in inflation originating from the cost push shocks and results in a similar level of welfare to that associated with the ramsey optimal policy third the optimal mrit needs to be adjusted in a persistent manner and in the opposite direction to the realization of a cost push shock fourth the welfare implication of the mrit is more pronounced under a flatter phillips curve finally the main findings are relevant to the current economic environment of low inflation rates under a flat phillips curve implying that the monetary authority should increase the inflation target in such an environment

nominal price rigidity money supply endogeneity and business cycles abstract this paper investigates the ability of nominal price rigidity to explain the co movement of inflation with the cyclical component of output observed in the post war u s data a dynamic general equilibrium model is constructed with the introduction of monopolistic competition and nominal price rigidity in a standard real business cycle model allowing for an endogenous money supply rule it is then demonstrated that sticky price models can explain the observed associations between movements in inflation and output much better than flexible price models this result depends little on whether money supply is assumed to be endogenous or not

do job to job transitions drive wage fluctuations over the business cycle we investigate the importance of job to job jj transitions for cyclical wage dynamics by exploiting cross state variation we find that wage growth is tightly linked to variation in the jj transition probability and conditional on this the job finding probability of the unemployed has no explanatory power we investigate the robustness of our results to several caveats and find the result to hold finally we discuss the implications of our findings for competing theories of wage dynamics

speed and quality of collective decision making imperfect information processing abstract this paper studies efficient programmed hierarchies as introduced by radner the organization of decentralized information processing econometrica 61 5 1993 1109 1146 in which agents cannot process information perfectly a group of p identical managers has to make a choice between n alternatives in order to learn which is the best option the alternatives have to be compared the evaluation of an alternative takes time and managers are only able to identify the better one of two alternatives with a positive probability the skip level reporting tree proposed by radner is found to be efficient in terms of the dimensions decision cost decision delay and decision quality

average inflation targeting the analysis of this paper demonstrates that when the phillips curve has forward looking components a goal for average inflation i e targeting a j period average of one period inflation rates will cause inflation expectations to change in a way that improves the short run trade off faced by the monetary policymaker average inflation targeting is thus an example of a modified loss function which when implemented in a discretionary fashion results in more efficient outcomes from the standpoint of the true social objective inflation targeting under commitment than the discretionary pursuit of the true objective itself in purely forward looking models average inflation targeting is dominated by price level targeting but we also demonstrate in a micro founded model where the phillips curve has both forward and backward looking components that there are cases when the average inflation target provides more efficient outcomes than both ordinary one period inflation targeting and price level targeting

the default risk of swaps we characterize the exchange of financial claims from risky swaps these transfers are among three groups shareholders debtholders and the swap counterparty from this analysis we derive equilibrium swap rates and relate them to debt market spreads we then show that equilibrium swaps in perfect markets transfer wealth from shareholders to debtholders in a simplified case we obtain closed form solutions for the value of the default risk in the swap for interest rate swaps we obtain numerical solutions for the equilibrium swap rate including default risk we compare these with equilibrium debt market default risk spreads swaps have been one of the most explosive and important innovations in international capital markets in the last 10 years in its simplest form a swap consists of an agreement hetween two entities called counterparties to exchange in the future two streams of cash flows in a currency swap these streams of cash flows consist of a stream of interest and principal payments in one cvtrrency exchanged for a stream of interest and principal payments of the same maturity in another currency in an interest rate swap they consist of streams of interest payments of one type fixed or floating exchanged for streams of interest payments of the other type in the same currency the two types of swap are shown in appendix 1 the economic importance of swap transactions is the fact that they can he comhined with deht issues to change the nature of the liahility for the borrower the sum of a hond issue and a currency swap gives a net liability stream which is equivalent to transforming the bond liability into a different currency a floating rate note combined with an interest rate swap results in a liability equivalent to fixed rate debt two issues have dominated the academic literature on swaps the first concerns the reasons for their use arbitrage of imperfections in capital markets was the original cause of their appearance price and henderson 1984 turnbull 1987 shows that lowering borrowing costs by a synthetic transaction involving a swap is not possible in a complete integrated capital market subsequent authors wall and pringle 1988 arak estrella groodman and silver 1988 smith smithson and wakeman 1987 observe

the analytic pricing of asymmetric defaultable swaps swaps where both parties are exposed to credit risk still lack convincing pricing mechanisms this article presents a reduced form model where the event of default is related to structural characteristics of each party the cash flows submitted to credit risk are identified before the swap is priced analytical pricing formulas for interest rate and currency swaps are computed using a gaussian model for risky bonds currency swaps exhibit additional correlation risk the benefits from netting depend on the balance between exposures and market conditions in valuation we show that sources of credit risk asymmetries are also likely to impact on credit spreads

inflation dynamics during the financial crisis using confidential product level price data underlying the u s producer price index ppi this paper analyzes the effect of changes in firms financial conditions on their price setting behavior during the great recession that surrounds the financial crisis the evidence indicates that during the height of the crisis in late 2008 firms with weak balance sheets increased prices significantly relative to industry averages whereas firms with strong balance sheets lowered prices a response consistent with an adverse demand shock these stark differences in price setting behavior are consistent with the notion that financial frictions may significantly influence the response of aggregate inflation to macroeconomic shocks we explore the implications of these empirical findings within a general equilibrium framework that allows for customer markets and departures from the frictionless financial markets in the model firms have an incentive to set a low price to invest in market share though when financial distortions are severe firms forgo these investment opportunities and maintain high prices in an effort to preserve their balance sheet capacity consistent with our empirical findings the model with financial distortions relative to the baseline model without such distortions implies a substantial attenuation of price dynamics in response to contractionary demand shocks

the architecture of economic systems hierarchies and polyarchies the authors present new ways of looking at economic organizations andsystems individuals judgments entail errors they sometimes reject good projects and accept bad projects the architecture of an economicsystem specifying how the decision making units are organized togetherwithin a system who gathers what information and who communicates what with whom affects its performance both because it influences thenature of errors that individuals make within the system and becauseit has a critical effect on the aggregation of individuals errors theperformance of two polar architectures decentralized polyarchical versus centralized hierarchical decision making authorities are analyzed and compared copyright 1986 by american economic association

monopsony with nominal rigidities an inverted phillips curve with nominal wage rigidities it is crucial to distinguish whether wages are set by workers or firms whether we have monopoly or monopsony power this paper provides a model of monopsony power in the labour market and a monopsonistic phillips curve if wages are set by firms who face nominal rigidities and there is inflation firms cannot adjust their wages fully the real wage falls and labour supply hence output decreases this provides a phillips curve where the output gap is negatively correlated with wage inflation in such a world monetary policy affects the intertemporal labour supply while the phillips curve is a labour demand curve interest rate cuts reduce the labour supply instead of boosting demand they are contractionary

the impact of default risk on the prices of options and other derivative securities abstract this paper presents a model for valuing derivative securities when there is default risk the holder of a security is assumed to recover a proportion of its no default value in the event of a default by the counterparty both the probability of default and the size of the proportional recovery are random the paper shows how data on bonds issued by the counterparty can be used to provide information about model parameters

measuring oligopsony power with shadow prices u s markets for pulpwood and sawlogs empirical estimation of input market power hindered by problems in measuring an input s value of marginal product vmp by estimating a variable profit function system however one can infer a factor s vmp through its shadow price this technique is used here to specify a structural equation system which is estimated using time series data for the u s sawmilling and paper industries to empirically measure the degree of oligopsony power for sawlog and pulpwood inputs respectively results evaluated at sample means indicate that pulpwood markets are more oligopsonistic than sawlog markets though both perform closer to perfect competition than monopsony time trends for market power differ for each product and perfect competition cannot be rejected for sawlogs in later years copyright 1995 by mit press

learning about monetary policy rules abstract we study macroeconomic systems with forward looking private sector agents and a monetary authority that is trying to control the economy through the use of a linear policy feedback rule we use stability under recursive learning a la evans and honkapohja learning and expectations in macroeconomics princeton university press princeton new jersey 2001 as a criterion for evaluating monetary policy rules in this context we find that considering learning can alter the evaluation of alternative policy rules

a model of monetary policy shocks for financial crises and normal conditions in their classic 1999 paper monetary policy shocks what have we learned and to what end christiano eichenbaum and evans cee investigate one of the most widely used methods for identifying monetary policy shocks of its time unfortunately their approach is no longer viable at least not in its original form a major problem stems from the recent behavior of two key variables in their model the fed funds rate and non borrowed reserves we develop a new identification scheme that remedies these diculties but maintains the basic cee framework our empirical specification is motivated by a standard new keynesian dsge model augmented by a simple financial structure the model provides theoretical support for variables we use in place of certain variables that were used in the classic var approach outlined in cee one significant innovation is our use of divisia m4 the broadest monetary aggregate currently available for the united states as the policy indicator variable we obtain four major empirical results that support the use of a properly measured broad monetary aggregate as the policy variable first policy shocks have significant eects on output and on the price level even when an interest rate is included in our model contradicting the new keynesian argument that monetary aggregates are redundant second we develop a model that is not subject to the output price or liquidity puzzles common to this literature contradicting the view that using the interest rate as the policy indicator generally yields more reasonable responses than a monetary aggregate third during normal conditions policy shocks from our divisia based model have similar eects on variables to those found in the fed funds model of monetary policy and where there are dierences our model with divisia m4 obtains results that are more consistent with standard economic theory fourth our preferred specification produces plausible responses to a monetary policy shock in samples that include or exclude the recent financial crisis

on measuring credit risks of derivative instruments abstract this paper critically reviews current practices for measuring credit risks of derivative instruments it argues that there are two major problems with the standard measurement approach first it uses models of the stoachstic behavior of finanacial variables while ignoring both their inherent oversimplification and the uncertainty in their parameters second it ignores the correlations among exposures in derivative intruments and the probabilities of countrypartly default this paper deomonstrates that these practices can produce large errors in the estimation of distribution of both future credit exposures and future credit losses

cross sectional versus time series estimation of term structure models empirical results for the dutch bond market abstract we compare time series and cross section estimates of the well known vasicek and cir term structure models for a dataset of daily bond prices and short term interest rates for the netherlands the main finding is the great similarity between the two models with respect to the cross sectional term structure parameter estimates and implied bond option values from a time series perspective we find that for some maturities the data reject the constant volatility vasicek model and indicate the presence of the cir volatility effects

average inflation targeting and interest rate smoothing abstract we study the welfare implication of average inflation targeting as a simple interest rate rule in which the monetary authority adjusts its short term policy rate in response to the output gap as well as average inflation deviation from its target instead of reacting to the contemporaneous inflation rate as in a taylor type rule we find that the welfare improvement achieved by switching to average inflation targeting from a standard taylor rule is modest with a high degree of interest rate smoothing whereas it is significant without interest rate smoothing we show that average inflation targeting is welfare improving in the same way as interest rate smoothing by making the conduct of monetary policy history dependent thus the high degree of monetary policy inertia in the estimated interest rate rules in many advanced economies implies that the welfare gain from adopting the average inflation targeting rule would be minimal

a phillips curve with anchored expectations and short term unemployment this paper examines the behavior of u s core inflation as measured by the weighted median of industry price changes we find that core inflation since 1985 is well explained by an expectations augmented phillips curve in which expected inflation is measured with professional forecasts and labor market slack is captured by the short term unemployment rate we also find that expected inflation was backward looking until the late 1990s but then became strongly anchored at the federal reserve s target this shift in expectations changed the relationship between inflation and unemployment from an accelerationist phillips curve to a level level phillips curve our specification explains why high unemployment during the great recession did not reduce inflation greatly partly because inflation expectations were anchored and partly because short term unemployment rose less sharply than total unemployment

credit risk exposure with interest and currency swaps abstract the increased use of financial derivatives like interest rate and currency swap contracts has drawn much attention as it exposes banks to non performance by their counterparts this credit risk exposure is of great concern to monetary authorities e g the bank for international settlements in this paper a method for the determination of credit risk exposure is developed in which the exposure is a function of interest rates exchange rates and lives of the contracts to quantify the credit risk exposure simulations of the variables have been used

credit derivatives with multiple debt issues abstract we evaluate the most actively traded types of credit derivatives within a unified pricing framework that allows for multiple debt issues since firms default on all of their obligations total debt is instrumental in the likelihood of default and therefore in credit derivatives valuation we use a single factor interest rate model where the exponential default frontier is based on total debt and is made coherent with observed bond prices analytical formulae are derived for credit default swaps total return swaps both fixed for fixed and fixed for floating and credit risk options cros price behaviors and hedging properties of all these credit derivatives are investigated simulations document that credit derivatives prices may be significantly affected by terms of debt other than those of the reference obligation the analysis of cros indicates their superior ability to fine tune the hedging of magnitude and arrival risks of default

pricing derivatives on financial securities subject to credit risk this article provides a new methodology for pricing and hedging derivative securities involving credit risk two types of credit risks are considered the first is where the asset underlying the derivative security may default the second is where the writer of the derivative security may default we apply the foreign currency analogy of jarrow and turnbull 1991 to decompose the dollar payoff from a risky security into a certain payoff and a spot exchange rate arbitrage free valuation techniques are then employed this methodology can be applied to corporate debt and over the counter derivatives such as swaps and caps the purpose of this article is to provide a new theory for pricing and hedging derivative securities involving credit risk two sources of credit risk are identified and analyzed the first is where the asset underlying the derivative security may default paying off less than promised this is the case for example with imbedded options on corporate debt the second is the credit risk introduced by the writer of the derivative security who may also default examples include over the counter writers of options on eurodollar futures swaps and swaptions for pricing derivative securities involving credit risk there are currently two approaches the first views these derivatives as contingent claims not on the financial securities themselves but as compound options on the assets underlying the financial securities this is the case for example with the pricing of imbedded options on corporate debt see merton 1974 1977 black and cox 1976 ho and singer 1982 chance 1990 and kim ramaswamy and sundaresan 1993 or the pricing of vulnerable options see johnson and stulz 1987 in practice however this valuation methodology is difficult to use first the assets underlying the financial security are often not tradeable and therefore their values are not observable this makes application of the theory and estimation of the relevant parameters problematic second as in the case of corporate debt all of the other liabilities of the firm senior to the corporate debt must first and simultaneously be valued this generates significant computational difficulties as a result this approach has not

hierarchies of processors with endogenous capacity abstract capacity is defined as the number of information items a processor can handle in a given time this note studies the properties of a hierarchy of processors in which the capacities of processors are choice variables the hierarchy must pay each processor it decides to employ a wage which is an increasing function of the processor s capacity it is shown that efficient hierarchies tend to be characterized by three simple properties i within any given level capacity is uniform ii across levels the higher the level the higher the capacity and iii no skip level reporting occurs journal of economic literatureclassification numbers d21 j31 l23

pricing interest rate options in a two factor cox ingersoll ross model of the term structure solutions are presented for prices on interest rate options in a two factor version of the cox ingersoll ross model of the term structure specific solutions are developed for caps on floating interest rates and for european options on discount bonds coupon bonds coupon bond futures and euro dollar futures the solutions for the options are expressed as multivariate integrals and we show how to reduce the calculations to univariate numerical integrations which can be calculated very quickly the two factor model provides more flexibility in fitting observed term structures and the fixed parameters of the model can be set to capture the variability of the term structure over time article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

is the unemployment inflation trade off still alive in the euro area and its member countries it seems so the unemployment inflation trade off can be interpreted as a proposition concerning the response of these two variables to aggregate demand shocks in this paper we study the possible presence of the trade off in the euro area and in a wide group of euroarea countries in the last 20 years i e since the start of emu we use the structural var methodology that allows the separation between supply and demand shocks our main finding is that the existence of a trade off is largely confirmed both at the euro area and at the national level nevertheless the size of the trade off measured at different horizons shows some heterogeneity among countries no less important when we augment the var model by introducing monetary policy in the context of an open economy we find that monetary policy shocks push inflation and unemployment in opposite directions in the currency area another interesting result concerns the evidence of a relatively flat relation between unemployment and inflation conditionally to monetary policy shocks

wage differentials employer size and unemployment the unique equilibrium solution to a game in which a continuum of individual employers choose permanent wage offers and a continuum of workers search by sequentially sampling from the set of offers is characterized wage dispersion is a robust outcome provided that workers search while employed as well as when unemployed the unique nondegenerate equilibrium distribution of wage offers is constructed for three cases 1 identical workers and employers 2 identical employers and an atomless distribution of worker supply prices and 3 identical workers and an atomless distribution of job productivities copyright 1998 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

pricing interest rate derivative securities this article shows that the one state variableinterest rate models of vasicek 1977 and cox ingersoll and ross 1985b can be extended sothat they are consistent with both the current termstructure of interest rates and either the currentvolatilities of all spot interest rates or the currentvolatilities of all forward interest rates theextended vasicek model is shown to be very tracta ble analytically the article compares option pricesobtained using the extended vasicek model withthose obtained using a number of other models