target zones and interest rate variability abstract for narrow exchange rate bands and for reasonable parameter values the interest rate differential s asymptotic unconditional variability is increasing in the width of the exchange rate band whereas for wide exchange rate bands it is slowly decreasing in the exchange rate band the interest rate differential s instantaneous conditional variability is decreasing in the width of the exchange rate band a narrow target zone differs from a completely fixed exchange rate regime in that the interest rate differential s instantaneous standard deviation is high and even increases when the zone narrows

transactions demand for money with a stochastic time varying interest rate this paper considers a stochastic time varying interest rate in a continuous time inventory theoretic model of the demand for money the problem of minimizing expected discounted cash management costs is ascribed to an agent an optimal cash management policy exists and is of a familiar target threshold form closed form expressions for the forward looking time varying targets and thresholds are derived in special cases and implications for the dynamics of the cash balance are described

exchange rate target zones a survey of the literature this work selectively reviews the literature on exchange rate target zones and their theoretical and empirical methodologies and examines whether they can be used to clarify to what extent this type of exchange rate regime could contribute to greater exchange rate stability we discuss the main contributions of the first and second generations of exchange rate target zone models in an attempt to reconcile the poor empirical performance of the krugman model with the reality of exchange rate target zone regimes this line of research integrates target zones with alternative underlying economic models such as imperfect credibility intra marginal interventions and sticky price models it was thus possible to understand the correlations observed between the exchange rate its fundamentals determinants and the interest rate differential and to explain the fact that the statistical distribution of the exchange rate is hump shaped rather than u shaped this implies that the initial emphasis of target zone models on nonlinearities honeymoon effect smooth pasting and marginal interventions has vanished exchange rate target zones are better described as similar to managed floating regimes with intra marginal interventions with some marginal interventions when the exchange rate reaches the edges of the floating band

regulation of natural gas distribution using policy benchmarks local distribution companies ldcs play the role of purchasing and delivering natural gas to their consumers and state regulators oversee the pricing of natural gas to consumers the common method of regulation based on the cost of service provides arguably little incentive for the ldc to optimally manage their procurement activities in the light of recent deregulation and other changes benchmarking based regulatory schemes are being increasingly perceived as the right direction to pursue various states are experimenting with simple benchmark mechanisms that have inherent deficiencies and are often criticized in this paper we propose and characterize a new kind of benchmark that we call a policy benchmark as a mechanism for regulation using variance as the measure of risk we formulate the regulator s and the ldc s problems as multiple objective optimizations we provide rigorous characterizations of the dominance frontiers for a two stage model we also provide multistage formulations that take

realignment risk and currency option pricing in target zones abstract this paper extends the krugman target zone model by including a realignment mechanism various properties of that realignment mechanism are discussed the movement of the exchange rate is governed both by a wiener process on fundamental and by a poisson jump process with endogenous realignment size the realignment mechanism is such that except in cases where a speculative attack occurs no jump in fundamental is needed to accompany the jump in the exchange rate a risk neutral valuation of currency options is constructed some properties of option values under realignment risk are illustrated by numerical results

contract renewal under uncertainty abstract the incentive to adjust prices is considered from a bilateral perspective in a setting where changes in outside opportunities drive the incentive to renew contracts and costs preclude continuous renewal a model encompassing several contract forms is formulated and the existence of an equilibrium to the bilateral renewal game is established prices display inertia and the incumbent contract is found to be more resistant to changes in outside opportunities the larger the costs of contract renewal the variability of outside opportunities and the lower the discount rate the model is shown to match a number of empirical observations on contracts

evaluating natural resource investments notwithstanding impressive advances in the theory of finance over the past 2 decades practical procedures for capital budgeting have evolved only slowly the standard technique which has remained unchanged in essentials since it was originally proposed see dean 1951 bierman and smidt 1960 derives from a simple adaptation of the fisher 1907 model of valuation under certainty under this technique expected cash flows from an investment project are discounted at a rate deemed appropriate to their risk and the resulting present value is compared with the cost of the project this standard textbook technique reflects modern theoretical developments only insofar as estimates of the discount rate may be obtained from crude application of single period asset pricing theory but see brennan 1973 bogue and roll 1974 turnbull 1977 constantinides 1978 the inadequacy of this approach to capital budgeting is widely acknowledged although not widely discussed its obvious deficiency is its the evaluation of mining and other natural resource projects is made particularly difficult by the high degree of uncertainty attaching to output prices it is shown that the techniques of continuous time arbitrage and stochastic control theory may be used not only to value such projects but also to determine the optimal policies for developing managing and abandoning them the approach may be adapted to a wide variety of contexts outside the natural resource sector where uncertainty about future project revenues is a paramount concern

learning about intervention target zones abstract this paper provides a framework for evaluating how market participants beliefs about foreign exchange target zones change as they learn about central bank intervention policy we generalize the standard target zone model to allow for intra marginal intervention intra marginal intervention implies that market participants beliefs about the target zone can be determined from their beliefs about the likelihood of intervention we then estimate a daily probability of intervention model for the period following the louvre accord we find that the market s views of intervention target zones would have varied quite a bit over time even over this relatively stable period

analytical approximations in models of hysteresis decisions made under ongoing uncertainty and costly reversibility entail a range of the state variable where inaction is optimal which in turn produces hysteresis permanent effects of temporary shifts the range is usually defined by non linear equations that need numerical solutions in this paper a technique of analytical approximations is developed and applied to two models menu costs and investment the resulting explicit solutions help clarify why hysteresis is important even for small irreversibility in the menu cost model hysteresis is two orders of magnitude larger than under the akerlof yellen or mankiw assumptions when decisions that are costly to reverse are made under conditions of ongoing uncertainty the optimum policy usually entails a range of inertia the action should be taken only when the value of the underlying state variable becomes especially favourable and reversed only when it becomes especially unfavourable there is an intermediate range over which inaction is optimal this in turn gives rise to hysteresis starting from a value in the range of inertia if the state variable crosses the action trigger point and then returns to its original level the action will be taken but not reversed thus a temporary change will leave a permanent effect numerical solutions for models of irreversible investment show that the range of inaction is remarkably large even when the cost of reversal is small see brennan and schwartz 1985 constantinides 1986 and dixit 1989a b for examples of this unfortunately the equations tlhat determine the optimum policy are highly non linear they do not have analytical solutions therefore we lack a clearer and more general understanding of why hysteresis is numerically so important in this paper i derive analytical approximations for the solutions of more general problems of this kind when the costs of change are small the idea that small costs of change induce large amounts of inertia has been popularized in the model of akerlof and yellen 1985 mankiw 1985 and others in these models second order small costs of making price changes yield price stickiness in response to first order changes in the money supply this is a simple application of the envelope theorem but these models are static and their application to a dynamic reality must assume either permanent shocks or static expectations when there is ongoing uncertainty which is rationally expected by the decision maker the option value of the status quo enlarges the zone where inaction is optimal adding these features to the mankiw akerlof yellen may model i show that fourth order small costs of change generate first order inertia

target zones and exchange rates an empirical investigation this paper develops an empirical model of exchange rates in a target zone the distribution of exchange rate changes is conditioned on a latent jump variable where the probability and size of a jump vary over time as a function of financial and macroeconomic variables when there is no jump the target zone is credible and exchange rate changes are constrained to remain within the target zone band the paper revisits the empirical evidence from the european monetary system regarding the conditional distribution of exchange rate changes the credibility of the system and the size of the foreign exchange risk premia in contrast to some previous findings we conclude that the french franc deutschmark rate exhibits considerable nonlinearities realignments are somewhat predictable and the credibility of the system did not increase substantially after 1987 moreover our model implies that the foreign exchange risk premium becomes large during speculative crises

macroeconomic stabilization and intervention policy under an exchange rate band abstract macroeconomic stabilization and foreign exchange market interventions are investigated for a small open economy with a nominal exchange rate band in a first best situation a band is not advisable from a stabilization perspective even though with money demand shocks no welfare losses are incurred with goods demand shocks narrowing the band affects the optimal coefficient of intramarginal monetary accommodation with restrictions on intramarginal interventions a band may be desirable in particular with supply shocks and no intramarginal interventions a narrower band is desirable when the central bank attaches a relatively smaller weight to price as opposed to output stability

notes on the theory and evidence on aggregate purchases of durable goods the basic implications of the frictionless permanent income hypothesis for durable goods purchases are strongly rejected by the data at the aggregate level there is too much inertia at the macroeconomic level purchases are too infrequent and lumpy in principle these rejections can be simultaneously rationalized by the presence of fixed costs of adjustment at the microeconomic level this article provides a simplified overview of recent developments attempting to formalize and measure the implications of models of fixed cost of adjustment for microeconomic and especially aggregate behavior of expenditure on durable goods it contends that these efforts have paid off in terms of methodological and empirical improvements copyright 1994 by oxford university press

forward rate target zones and exchange rate dynamics abstract a target zone for the forward exchange rate is developed using a log linear monetary model exchange rates are driven by a wiener process a central bank purchases or sells foreign exchange forward to keep the target forward rate in a specified band defending such a target zone does not require regulated wiener process for the central bank s forward exchange intervention can avoid disturbing the money supply a forward rate target zone can stabilize the spot rate against a free float and its stabilizing effects become more significant if the delivery term applying to the target forward rate is shorter

permanent effects of monetary policy in a dynamic menu cost model abstract this paper investigates whether a systematic monetary policy can affect output in a dynamic menu cost model that results in s s price rules it will be shown that monetary policy potentially can affect output not only in the short run but also with regard to long run average output even though the policy rule is fully known by the rational firm perfectly anticipated monetary policy intervention may have a permanent real effect in the long run

lumpy price adjustments a microeconometric analysis based on a reduced form state dependent pricing model with random thresholds we specify and estimate a nonlinear panel data model with an unobserved factor representing the common cost or demand components of the unobserved optimal price using this model we are able to assess the relative importance of common and idiosyncratic shocks in explaining the frequency and magnitude of price changes in the case of a wide variety of consumer products in belgium and france we find that the mean level and variability of the random thresholds are key for explaining differences across products in the frequency of price changes we also find that the idiosyncratic shocks represent the most important driver of the magnitude of price changes supplementary materials for this article are available online

price setting with menu cost for multi product firms we model the decisions of a multiproduct firm that faces a fixed menu cost once it is paid the firm can adjust the price of all its products we characterize analytically the steady state firm s decisions in terms of the structural parameters the variability of the flexible prices the curvature of the profit function the size of the menu cost and the number of products sold we provide expressions for the steady state frequency of adjustment the hazard rate of price adjustments and the size distribution of price changes all in terms of the structural parameters we study analytically the impulse response of aggregate prices and output to a monetary shock the size of the output response and its duration both increase with the number of products they more than double as the number of products goes from 1 to 10 quickly converging to the response of taylor s staggered price model

an interpretation of recent research on exchange rate target zones how do exchange rate bands work compared to completely fixed rates between realignments or more precisely what are the dynamics of exchange rates interest rates and central bank interventions within exchange rate bands does the difference between bands and completely fixed exchange rates matter and if so which of the two arrangements is best or more precisely what are the tradeoffs that determine the optimal bandwidth this article will present an interpretation of some selected recent theoretical and empirical research on exchange rate target zones with emphasis on main ideas and results and without technical detail

the term structure with semi credible targeting the federal reserve sets targets for interest rates which it enforces through direct market intervention these targets are changed periodically in this paper we develop a term structure model in which the short rate is subject to a control which keeps it close to a target which changes from time to time the probability of target changes is not constant in the model but changes as a function of observables the model performs well at explaining the shifts in the yield curve that accompany target changes in u s financial markets the federal reserve bank the fed is a unique player usually we assume that market participants are price takers in financial markets however there is evidence that this is not true of the fed in fact the fed sets targets for short term rates which it attempts to maintain by market intervention injecting or withdrawing funds from the market to keep the rates near their targets targets are changed from time to time and market participants know when such a target change occurs they may in fact have some limited ability to forecast such target changes several recent papers have provided evidence that models which allow the short rate to revert toward a mean which is itself a random process perform

a currency crisis model with an optimising policymaker abstract a model is presented in which the abandonment of a fixed exchange rate regime is triggered by an optimising policymaker who wants to loosen monetary policy and boost aggregate demand agents in the foreign exchange market know the policymaker s objective function and build expectations of a regime switch into interest differentials the resulting rise in interest rates affects the policymaker s decision to switch regime it is shown that a rational expectations equilibrium exists where the fixed rate is abandoned in response to adverse demand shocks in some circumstances multiple equilibria arise which may lead to self fulfilling crises

on the design of regulatory price adjustment mechanisms abstract price adjustment mechanisms are employed in the electric utility industry to pass changes in fuel costs on to consumers without formal rate review by a regulatory commission the predictability of this pass through and the regulator s limited ability to observe the actions of a firm can create potential incentive problems associated with the choices of technology and fuel supply this paper is concerned with the regulatory design of pass through formulas when a factor price is uncertain the optimal design involves deviating from the full information optimal price formulas in order to mitigate the incentive problems

international interest rate linkages and the exchange rate regime abstract return differentials between instruments denominated in canadian dollars and instruments denominated in american dollars are investigated the study compares the properties of return differentials in the period of fixed exchange rates during the 1960s and in the period of flexible exchange rates during the 1970s and 1980s both real and nominal return differentials are investigated the results indicate that the change in exchange rate regime is not associated with a change in the average level of ex post return differentials between canada and the united states models which predict ex ante return differentials from available information in a rational expectations framework show a surprisingly large amount of structural stability across the regime change the major impact of the flexible exchange rate regime is on the variance of ex post return differentials and not on the average level of ex post or ex ante return differentials jel e42 e58 g15

simple binomial processes as diffusion approximations in financial models a binomial approximation to a diffusion is defined as computationally simple if the number of nodes grows at most linearly in the number of time intervals it is shown how to construct computationally simple binomial processes that converge weakly to commonly employed diffusions in financial models the convergence of the sequence of bond and european option prices from these processes to the corresponding values in the diffusion limit is also demonstrated numerical examples from the constant elasticity of variance stock price and the cox ingersoll and ross 1985 discount bond price are provided article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

the term structure of interest rate differentials in a target zone theory and swedish data abstract the term structure of interest rate differentials is derived in a model of a small open economy with a target zone exchange rate regime for given time to maturity the interest rate differential is decreasing in the exchange rate and for given exchange rate the interest rate differential s absolute value and its instantaneous variability are both decreasing in the time to maturity devaluation realignment risks are incorporated and imply upward shifts of the interest rate differentials several implications of the theory are found to be broadly consistent with data on swedish exchange rates and interest differentials for the period 1986 1989

a real options perspective on the future of the euro abstract a break up of the eurozone is no longer regarded as implausible this will be a costly and irreversible decision in conditions of continuing uncertainty therefore it is amenable to analysis in the real options framework we do so by solving as an n dimensional optimal stopping problem with country specific shocks and convergence of member economies we compare a complete break up with individual country departures in calibrated solutions for a symmetric case we find a non negligible but small option value furthermore we find a new theoretical result on the non monotonicity of abandonment threshold with respect to volatility

monetary shocks in models with observation and menu costs we study economies where price stickiness arises due to the simultaneous presence of both menu and information costs we identify the relative importance of these costs using firm s survey data and analyze the response of prices and output following a permanent unexpected monetary shock for a given frequency of price adjustment we find that the information friction significantly amplifies the real effect of the shock when the shock is small or when it is not known by firms instead when the shock is large and known to firms the flexibility of prices increases and the real effects gradually vanish

optimal central bank intervention in the foreign exchange market abstract we consider a currency with exchange rate dynamics modeled as a geometric brownian motion the objective of the central bank is to keep this exchange rate as close as possible to a given target so there is a running cost associated to the difference between the exchange rate and the target additionally there are also fixed and proportional costs associated with each intervention the objective of this paper is to find the optimal level of intervention and the optimal sizes of the interventions so as to minimize the total cost we solve this problem by applying the theory of stochastic impulse controls journal of economic literature classification numbers c61 d81 f31 g15

testing the basic target zone model on swedish data 1982 1990 the swedish exchange rate band is studied using daily data on exchange rates and interest rate differentials for the 1980s applying a number of different statistical and econometric techniques it is found that the first generation of target zone models cannot provide an adequate explanation of swedish data the main reasons are probably intra marginal interventions by the swedish central bank and time varying devaluation expectations

a near rational model of the business cycle with wage and price inertia this paper presents a model in which insignificantly suboptimal behavior causes aggregate demand shocks to have significant real effects the individual loss to agents with inertial price wage behavior is second order in terms of the parameter describing the shock while the effect on real economic variables is first order thus significant changes in business activity can be generated by anticipated money supply changes provided that some agents are willing to engage in nonmaximizing behavior which results in small losses

the linkage between speculative attack and target zone models of exchange rates in this paper we generalize the target zone exchange rate as model formalized by krugman 1988b to include finite sized interventions in defense of the zone the main contributions of these pages consist of linking the recent developments in the theory of target zones to the mirror image theory of speculative attacks on asset price fixing regimes and in using aspects of that linkage to give an intuitive interpretation to the smooth pasting condition usually invoked as a terminal condition this abstract was borrowed from another version of this item

the provision of incentives in firms i ncentives are the essence of economics despite many wide ranging claims about their supposed importance there has been little empirical assessment of incentive provision for workers the purpose of this paper is to critically overview existing work on the provision of incentives since the interests of workers and their employers are not always aligned a large theoretical literature has emphasized how firms design compensation contracts to induce employees to operate in the firm s interest this literature has reached into many areas of compensation and has pointed to a multitude of different mechanisms that can be used to induce workers to act in the interests of their employers these include piece rates options discretionary bonuses promotions profit sharing efficiency wages deferred compensation and so on my objective here is to evaluate this literature in the light of a growing empirical literature on compensation where possible i will address the literature from two perspectives first an underlying assumption of this literature is that individuals respond to contracts that reward performance accordingly i consider whether agents behave in this way and whether these responses are always in the firm s interest second i address whether firms write contracts with these responses in mind in other words do contracts look like the predictions of the theory incentives are provided to workers

a real options analysis of coffee planting in vietnam vietnam grew from an insignificant to the world s second largest coffee producer during the 1990s to understand this growth this article examines vietnamese coffee growers investment decisions using real options theory the study finds that producers with variable costs of 19 cents lb and total cost of 29 3 cents lb would enter coffee production at a coffee price of 47 cents lb and exit at a coffee price of 14 cents lb most vietnamese growers appear to be sufficiently efficient to continue producing coffee even at relatively depressed price levels

target zones in theory and history credibility efficiency and policy autonomy abstract an experiment with an exchange rate band in austria hungary in the early 20th century provides a rare opportunity to discuss critical aspects of the theory of target zones providing a new derivation of the target zone model as a set of nested hypotheses the inference is drawn that policy credibility and market efficiency were paramount in the success of the austro hungarian experience

imperfect credibility and risk premia in the european monetary system the paper deals with the estiamation of models for the expected rate of depreciation within the currency bands of the french franc and the italian lira against the deutshmark both unconditional and conditional upon no realignment as well as the estimastion of models for risk premia using these estimates estimates are constructed for the expected rate of depreciation the expected rate of realignment and the expected rate of devaluation of these exchange rates during their ems period by appropriate adjustment of interest rate differentials it is found that these adjustments are of non trivial magnitude

a univariate analysis of ems exchange rates using a target zone model summary the models in the literature on exchange rate target zones imply a non linear time series model for the exchange rate we show how the parameters of such models can be estimated and develop maximum likelihood and method of simulated moments estimators for the target zone model of krugman 1991 the maximum likelihood estimator is based on a computationally attractive approximation to the exact predictive density of the continuous time model monte carlo experiments are used to assess the properties of this estimator in the empirical part we estimate the model with data on recent ems exchange rates we find that the krugman 1991 target zone model is not able to explain the full observed kurtosis and conditional heteroscedasticity of the exchange rate returns

a theory of yardstick competition in the typical regulatory scheme a franchised monopoly has little incentive to reduce costs this article proposes a mechanism in which the price the regulatedfirm receives depends on the costs of identical firms in equilibrium each firm chooses a socially efficient level of cost reduction the mechanism generalizes to cover heterogeneous firms with observable differences medicare s prospective reimbursement of hospitals by using diagnostically related groups is a scheme very similar to the one outlined here

the term structure of interest rates in a sticky price target zone model abstract the term structure of interest rates in a sticky price target zone model with perfectly credible marginal central bank intervention is identified by means of an arbitage free valuation we find that an explicit credible target zone for the exchange rate is associated with an implicit target zone for the long term interest rate where the nonlinearity of the exchange rate function translates into a corresponding stabilizing nonlinearity of the long term interest rate imposing a target zone reduces the variability of short term and long term interest rates and induces a steeper term structure relative to freely floating exchange rates

playing with the band dynamic effects of target zones in an open economy this paper applies techniques of regulated brownian motion to a model of a small open economy to investigate how bands on fundamental driving variables affect the realization of the nominal exchange rate the real exchange rate prices and output the author shows that these bands mitigate the relationship between exogenous fundamentals and endogenous variables through their effects on expectations he also considers the effects of changing the width of the band and finds greater stabilization of endogenous variables with more narrow bands on exogenous fundamentals copyright 1990 by economics department of the university of pennsylvania and the osaka university institute of social and economic research association

economic theory and the world of practice a celebration of the s s model it was the question of how best to balance the costs of ordering and of running out of stock against the costs of holding excess inventory that inspired kenneth arrow theodore harris and jacob marschak to introduce the s s model in 1951 in this celebratory article we show how this model not only answered important practical questions but also opened the door to a quite startling range of important and challenging follow up questions many of great practical importance and analytic depth the s s model has become one of the touchstone models of economics opening new vistas of applied economic theory to all who internalize its structure today it is universally applied to solve questions faced in inventory control the core model elements uncertainty and fixed costs of adjustment are ubiquitous which has resulted in its becoming the general purpose economic model of discrete adjustment the s s model has also become a profound source of inspiration for macroeconomists seeking to understand the role that discrete microeconomic adjustments play in macroeconomic fluctuations looking forward we foresee rapid growth in the use of s s modeling to aid households making complex and costly financial decisions such as when and how to terminate a mortgage in the projected era of household operations research new modeling challenges will arise due to enriched feedback from the world of practice

adverse risk incentives and the design of performance bases contracts this paper uses option pricing theory to value and analyze many performance based fee contracts that are currently in use a potential problem with some of these contracts is that they may induce portfolio managers to adversely alter the risk of the portfolios they manage the paper is prescriptive in that it presents conditions for contract parameters that provide proper risk incentives for classes of investment strategies for buy and hold and rebalancing strategies adverse risk incentives are avoided when the penalties for poor performance outweigh the rewards for good performance

estimating money demand in log first difference form the purposes of this paper are to recommend a certain form for the estimation of demandfor money functions and to examine some fundamental issues using the form we provide an estimate of the demand for money that achieves a reduction in the instability so characteristic of recent estimates through examination of the time series properties of the variables in the function and adjustments to produce stationarity in them an improved form of the demand for money function is possible evidence of its greater stability is offered by a comprehensive comparison of short and long term forecasts for demand for money in loglevel and log first difference forms finally several issues are explored using the more stable form including the contribution of an interest rate ratchet variable the speed of adjustment the adjustment mechanism and the appropriate scale variable we conclude that estimation in log first difference form 1 is preferable to the log level form because of its stable time series properties 2 is superior to log level form for long term forecasts 3 implies a faster and more reasonable speed of adjustment than does the log level form and 4 suggests that the nominal adjustment mechanism and real gnp as a scale variable are appropriate section ii of the paper reviews the proolem of stationarity for a regression model of the demand for money section iii presents the demand for money equation and the adjustment mechanisms section iv compares the forecasts of log level and log first difference forms section v explores the issues of the interest rate ratchet variable speed of adjustment adjustment mechanism and the scale variable a summary and conclusions are offered in section vi

performance incentive fees an agency theoretic approach this paper employs recent developments in agency theory to study the impact that com pensation contracts have on portfolio management investment decisions in a restricted mean variance world two types of incentive contracts for mutual fund managers are ana lyzed and compared the results show that the symmetric contract while not necessar ily eliminating agency costs dominates the bonus contract in aligning the manager s interests with those ofthe investor investment companies and by extension their managers control a large and increasing percentage ofthe aggregate wealth of their clients more investors are putting their money under the control of these advisers than ever before con sequently potential conflicts of interest arise between investment company own ers and their financial management advisers the securities and exchange com mission sec has been concerned with this issue for a number of years the agency has commissioned several studies to investigate the issue and has set forth certain rulings concerning the behavior of investment company advisers of par ticular importance has been the compensation arrangement between mutual fund management and the fund owners in fact the sec has issued specific guidelines regarding allowable fee schedules for managers these guidelines have ied to a policy debate concerning whether the sec has been too stringent or not stringent enough in regulating compensation for investment managers the present study takes a new approach to this problem in an attempt to resolve this debate the fiduciary relationship between mutual fund management and the inves tors they represent may be viewed as a principal agent relationship conse quently the methodology from the agency literature can be applied to study the impact of various compensation arrangements on the potential conflict of interest between these two groups

monetary and real shocks and the optimal target zone abstract an exchange rate target zone is analysed in a model where the economy is disturbed by shocks to money demand and goods demand the stabilising properties of a target zone are compared to those of fixed and flexible exchange rate regimes it is found that a target zone offers a compromise between these two extremes it is also shown that when there are shocks to both money and goods demand a target zone is better than either a fixed rate or a floating rate in the sense that it minimises the variance of output and prices

exchange rate dynamics in anticipation of time contingent regime switching modelling the effects of a possible delay abstract the procedure of fixing a currently floating exchange rate at a given and publicly announced future date has a broad range of applications based on a continuous time monetary exchange rate model with flexible prices this paper analyzes exchange rate dynamics during the transition from floating to fixed rates in a situation in which market participants are uncertain about adherence to the fixing date and in which they take account of a possible delay in the regime switch the closed form solutions derived here allow us to quantify announcement effects as well as effects on the exchange rate variance caused by news that significantly changes the market s assessment of uncertainty

monetary contracting between central banks and the design of sustainable exchange rate zones abstract an exchange rate system is a contract which commits central banks to intervene in the foreign exchange market the design features of the system include the rules of intervention the limits placed on exchange rates and the crisis scenario describing possible transitions to new regimes this paper considers the various trade offs one faces in designing an exchange rate system one of these pertains to the amount of reserves which the central banks must have on hand in order to forestall a speculative attack and make the system sustainable the amount of reserves needed depends crucially on the assumed crisis scenario

aggregate uncertainty investment and asymmetric adjustment in the uk manufacturing sector theory suggests that the level of uncertainty facing firms should affect both the rate of adjustment to and the steady state level of investment although there is ambiguity about the sign of the effect a non linear model of investment behaviour incorporating time varying adjustment speeds with threshold effects is estimated for the uk manufacturing sector the most general non linear specification is found to be most congruent with the data uncertainty has a large and significant effect on both levels and rates of adjustment

optimal price setting with observation and menu costs we study the price setting problem of a firm in the presence of both observation and menu costs in this problem the firm optimally decides when to collect costly information on the adequacy of its price an activity which we refer to as a price review upon each review the firm chooses whether to adjust its price subject to a menu cost and when to conduct the next price review this behavior is consistent with recent survey evidence documenting that firms revise prices infrequently and that only a few price revisions yield a price adjustment the goal of the paper is to study how the firm s choices map into several observable statistics depending on the level and relative magnitude of the observation vs the menu cost the observable statistics are the frequency of price reviews the frequency of price adjustments the size distribution of price adjustments and the shape of the hazard rate of price adjustments we provide an analytical characterization of the firm s decisions and a mapping from the structural parameters to the observable statistics we compare these statistics with the ones obtained for the models with only one type of cost the predictions of the model can with suitable data be used to quantify the importance of the menu cost vs the information cost we also consider a version of the model where several price adjustment are allowed between observations a form of price plans or indexation we find that no indexation is optimal for small inflation rates

frequent price changes under menu costs abstract this paper investigates the effect of uncertainty on a single firm s pricing behaviour in a dynamic menu cost model that results in s s rules where the price is fixed inside a band it will be demonstrated that even though the band of inaction widens in response to increased uncertainty the price may be changed more frequent in the short run and in the long run it definitely will hence observing frequent price changes is not necessarily inconsistent with a firm operating under menu costs this paper relies on an article by dixit 1991 review of economic studies 58 141 151 but it offers a different solution technique in particular the solution of the model will be derived explicitly unlike dixit where approximations are resorted to

the real effects of monetary shocks in sticky price models a sufficient statistic approach abstract we prove that the ratio of kurtosis to the frequency of price changes is a sufficient statistic for the real effects of monetary shocks measured by the cumulated output response following the shock the sufficient statistic result holds in a large class of models which includes taylor 1980 calvo 1983 reis 2006 golosov and lucas 2007 nakamura and steinsson 2010 midrigan 2011 and alvarez and lippi 2014 several models in this class are able to account for the positive excess kurtosis of the size distribution of price changes that appears in the data we review empirical measures of kurtosis and frequency and conclude that a model that successfully matches the microevidence on kurtosis and frequency produces real effects that are about four times larger than in the golosov lucas model and about 30 percent below those of the calvo model we discuss the robustness of our results to changes in the setup including small inflation and leptokurtic cost shocks jel e23 e31

geology or economics testing models of irreversible investment using north sea oil data this paper tests the main implications of models of irreversible investment using data from operations in the oil fields in the north sea discrete time hazard regression models are used to ascertain the influence of economic variables the expected price of oil the variance of the price of oil and the level of reserves on the lag between the discovery of a field and the decision to develop the field we are able to control for heterogeneity in the data by incorporating variables which account for both the geological features of each field and individual operator characteristics the results indicate that the expected price of oil and the level of reserves are important in influencing the appraisal duration but that the variance of the oil price is not variables capturing the non economic features of the individual fields are also found to be significant factors affecting the appraisal lag copyright 1994 by royal economic society

big effects of small interventions the informational role of intervention in exchange rate policy abstract in this paper we demonstrate how an infintesimal unsterilized foreign exchange intervention may cause a very large discrete change in the exchange rate we analyze an example in which there is a target zone policy in place but the actual width of the target zone is not known by participants in the foreign exchange market in this case intervention both affects fundamentals and conveys information about policy the exchange rate jumps in response to intervention with the size of the jump related to the uncertainty about the true band width also in this model the relationship between the exchange rate and the fundamental depends upon both the history of the path of the exchange rate and whether or not intervention has occured

does it all add up benchmarks and the compensation of active portfolio managers in this article the authors examine theoretically the use of benchmark portfolios in the compensation of privately informed portfolio managers they find that the use of a benchmark and particularly the types of benchmarks often observed in practice cannot be easily rationalized specifically commonly used benchmark adjusted compensation schemes are generally inconsistent with optimal risk sharing and do not lead to the choice of an optimal portfolio for the investor moreover benchmarks do not help in solving potential contracting problems such as inducing the manager to expend effort or trying to screen out uninformed managers copyright 1997 by university of chicago press

aggregation and linearity in the provision of intertemporal incentives we consider the problem of providing incentives over time for an agent with constant absolute risk aversion the optimal compensation scheme is found to be a linear function of a vector of n accounts which count the number of times that each of the n kinds of observable events occurs the number n is independent of the number of time periods so the accounts may entail substantial aggregation in a continuous time version of the problem the agent controls the drift rate of a vector of accounts that is subject to frequent small random fluctuations the solution is as if the problem were the static one in which the agent controls only the mean of a multivariate normal distribution and the principal is constrained to use a linear compensation rule if the principal can observe only coarser linear aggregates such as revenues costs or profits the optimal compensation scheme is then a linear function of those aggregates the combination of exponential utility normal distributions and linear compensation schemes makes computations and comparative statics easy to do as we illustrate we interpret our linearity results as deriving in part from the richness of the agent s strategy space which makes it possible for the agent to undermine and exploit complicated nonlinear functions of the accounting aggregates

robust strategies for natural gas procurement abstract in order to serve their customers natural gas local distribution companies ldcs can select from a variety of financial and non financial contracts the present paper is concerned with the choice of an appropriate portfolio of natural gas purchases that would allow a ldc to satisfy its demand with a minimum tradeoff between cost and risk while taking into account risk associated with modeling error we propose two types of strategies for natural gas procurement dynamic strategies model the procurement problem as a mean risk stochastic program with various risk measures naive strategies hedge a fixed fraction of winter demand the hedge is allocated equally between storage futures and options we propose a simulation framework to evaluate the proposed strategies and show that i when the appropriate model for spot prices and its derivatives is used dynamic strategies provide cheaper gas with low risk compared to naive strategies ii in the presence of a modeling error dynamic strategies are unable to control the variance of the procurement cost though they provide cheaper cost on average based on these results we define robust strategies as convex combinations of dynamic and naive strategies the weight of each strategy represents the fraction of demand to be satisfied following this strategy a mean variance problem is then solved to obtain optimal weights and construct an efficient frontier of robust strategies that take advantage of the diversification effect

optimal contracts in a continuous time delegated portfolio management problem this article studies the contracting problem between an individual investor and a professional portfolio manager in a continuous time principal agent framework optimal contracts are obtained in closed form these contracts are of a symmetric form and suggest that a portfolio manager should receive a fixed fee a fraction of the total assets under management plus a bonus or a penalty depending upon the portfolio s excess return relative to a benchmark portfolio the appropriate benchmark portfolio is an active index that contains risky assets where the number of shares invested in each asset can vary over time rather than a passive index in which the number of shares invested in each asset remains constant over time fund managers compensation schemes in a delegated portfolio management setting have been of special interest to both academics and practitioners academic interest stems in part from the rapid growth of managed funds over the last two decades gompers and metrick 1998 report that by december 1996 mutual funds pension funds and other financial intermediaries held discretional control over more than half of the u s equity market it is thus of importance to study the impact of institutional trading on asset prices and to integrate into one model both asset pricing and delegated portfolio management compensation as advocated by brennan 1993 allen and santomero 1997 and allen 2001 it is also important to understand the relationship between a manager s trading strategies and his implicit incentives or career concerns see e g brown harlow and starks 1996 brown goetzmann and park 1997 chevalier and ellison 1999 and chen and pennacchi 2000 these concerns include internal promotion from a small to a large fund higher outside offers and the flow of money through the fund under management 1 the importance of fund manager compensation is also underscored by congressional passage in 1970 of the amendment to

linking individual and aggregate price changes this paper studies the implications of lumpiness and heterogeneity in microeconomic pricing decisions for dynamics in price aggregates to capture the latent deviation between actual and target prices it develops a semi structural empirical model of two sided s s price setting applying the model to a unique panel of store level retail prices reveals that fluctuations in the shape of cross sectional price deviation densities contain extra information on aggregate price change dynamics asymmetry in the density particularly matters idiosyncratic shocks magnify the size but do not alter the direction of aggregate fluctuations when the target price is proxied by the cross store mean price the link between inflation and the price deviation density disappears

linearity with project selection and controllable diffusion rate in continuous time principal agent problems i extend holmstrom and milgrom s model by allowing the agent to control privately or publicly the diffusion rate process and show that the optimal contract is still linear i discuss the conditions under which conflicts over the choice of diffusion rate do and do not arise as an application i examine project selection problems of a firm conflicts between the manager and investors arise because giving the manager too much incentive to work to increase the profit from ongoing operations can induce him to be too conservative in project selection possibly resulting in optimal contracts with low sensitivities

small menu costs and large business cycles a macroeconomic model of monopoly i introduction the conflict between modern neoclassical and traditional keynesian theories of the business cycle centers upon the pricing mechanism in neoclassical models prices are fully flexible they represent the continuous optimization of economic agents and the continuous intersection of supply and demand in keynesian models prices are often assumed to be sticky they do not necessarily equilibrate all markets at all times one of the reasons for the resurgence of the equilibrium approach to macroeconomics has been the absence of a theoretical underpinning for this keynesian price stickiness this note shows that sticky prices can be both privately efficient and socially inefficient the business cycle results from the suboptimal adjustment of prices in response to a demand shock to the extent that policy can stabilize aggregate demand it can mitigate the social loss due to this suboptimal adjustment in some keynesian models prices are simply exogenously fixed 2 in others agents must set their prices in advance of the transaction date the act of altering a posted price is certainly costly these costs include such items as printing new catalogs and informing salesmen of the new price yet these menu costs are small and therefore generally perceived as providing only a weak foundation for these fixed price models however this inference is flawed small menu costs can cause large welfare losses the claim that price adjustment costs are small does not rebut the claim that they are central to understanding economic fluctuations

the buffer stock notion in monetary economics not the least of harry johnson s contributions to our discipline was the series of survey papers on aspects of monetary economics which he produced during the 1960s and 1970s it is no exaggeration to say that the way in which the literature of monetary economics is organised even now follows the design which johnson first set out in 1962 and built on in the subsequent decade nevertheless the subject has not stood still and one of the more interesting developments of the last few years has involved the introduction of what has been variously described as the disequilibrium money shock absorber or as i prefer to call it the buffer stock notion into monetary economics the development of this line of thought was getting underway before johnson s untimely death much of it indeed under the auspices of his own research programme at the lse even so this did not happen early enough for the relevant ideas to be put in their proper niche by johnson himself and the buffer stock approach is not yet fully integrated into the mainstream of monetary economics much of the relevant literature is empirical concerned with modelling particular aspects of the monetary experience of specific countries hence it is fragmented and contains few papers which attempt a coherent account of just what this approach is and how it relates to other approaches to monetary analysis although essays by goodhart 1982a b and judd and scadding 1982a contain important discussions of these issues to the best of my knowledge only jonson 1976a and knoester 1979a have devoted entire papers solely to this central issue and these are relatively inaccessible and hence less widely known than they deserve to be in this lecture i shall attempt to give a brief account of the essentials of this approach first i shall sketch out its microeconomic background and then i shall discuss those theoretical characteristics which differentiate it from the neo austrian analysis of robert e lucas jr and his associates as well as from the conventional keynesian approach to monetary economics last but by no means least i shall argue that it yields simple theoretical insights into important empirical and policy related issues which are troublesome for alternative approaches in short my tribute to harry

a structural approach to identifying the sources of local currency price stability the inertia of the local currency prices of traded goods in the face of exchange rate changes is a well documented phenomenon in international economics this paper develops a structural model to identify the sources of this local currency price stability and applies it to micro data from the beer market the empirical procedure exploits manufacturers and retailers first order conditions in conjunction with detailed information on the frequency of price adjustments following exchange rate changes to quantify the relative importance of local non traded cost components markup adjustment by manufacturers and retailers and nominal price rigidities in the incomplete transmission of such changes to prices we find that on average approximately 60 of the incomplete exchange rate pass through is due to local non traded costs 8 to markup adjustment 30 to the existence of own brand price adjustment costs and 1 to the indirect strategic effect of such costs though these results vary considerably across individual brands according to their market shares

menu costs entry deterrence and nominal rigidity this paper studies in a model of entry deterrence conditions under which a small cost of changing nominal prices combined with a real rigidity leads to a large nominal rigidity the entry deterrence environment which generates the real rigidity provides an appealing explanation as to why firms sometimes react to shocks by changing output instead of prices as in ball and romer 1990 a large nominal rigidity arises with some parameter values it is not however monotonically increasing as real prices become more rigid the paper studies in a model of entry deterrence conditions under which a small cost of changing nominal prices combined with a real rigidity leads to a large nominal rigidity the entry deterrence environment which generates the real rigidity provides an appealing explanation as to why firms sometimes react to shocks by changing output instead of prices as in ball and romer 1990 a large nominal rigidity arises with some parameter values it is not however monotonically increasing as real prices become more rigid

analysis of exchange rate target zones using a limited dependent rational expectations model with jumps this article examines the exchange rate determination in a target zone regime when the bounds can be fixed for an extended period but are subject to occasional jumps in this case the behavior of the endogenous variable is affected by the agents expectations about both the occurrence and the size of the jump empirical results using data for the franc mark exchange rate provide support for the nonlinear model with time varying realignment probability and indicate that the agents correctly anticipated most of the observed changes in the central parity

fundamentals uncertainty bubbles and exchange rate dynamics abstract using a monetary model of exchange rate determination we study exchange rate dynamics with bubbles which depend on stochastic market fundamentals these dynamics can be either stochastically stable or unstable and either monotonic or non monotonic including cyclic in an extreme case they converge with probability one and exhibit cyclic movements implications for the analysis of time dependent regime shifts are also explored exchange rates with bubbles are likely to appear less volatile than the fundamentals in finite samples both the variance bounds and cointegration tests might thus be ineffective in testing the absence of bubbles under fundamentals uncertainty

robust optimization policy benchmarks and modeling errors in natural gas abstract the problem of regulating natural gas procurement has become a huge burden to regulators especially due to the plethora of complicated financial contracts that are now being used by local distribution companies ldcs for risk management purposes muthuraman aouam and rardin 2008 proposed a new benchmarking scheme called policy benchmarks and showed that these benchmarks do not suffer from the usual criticisms that are made against existing regulatory methods such policy benchmarks based regulation has however faced hurdles in being adopted one of the primary reasons has been concerns over its robustness we demonstrate in this paper that when modeling errors are present the policy benchmarks proposed earlier can backfire and are hence as suspected not well suited for regulation we begin our analysis with a more general model than the one that has been used earlier by accommodating the ldc s ability to reduce cost by exerting effort as in classical economics we derive solutions to the ldcos problem find closed form solutions for the regulator s optimal fee fraction along with risk sharing implications and provide insights into the policy benchmark selection we then construct a robust optimization based policy benchmarking mechanism that inherits all the original benefits we further demonstrate that these unlike the earlier benchmarks are robust against modeling errors

empirical features of the second generation target zone models mean reverting fundamentals and endogenous devaluation risk we show that within bertola and svensson s second generation target zone model mean reverting interventions and endogenous devaluation risk are closely interrelated over the period 1983 93 we analyze the degree of mean reversion in the underlying fundamental process as well as the term structure of interest rate differentials vis a vis germany for six exchange rate mechanism currencies for austria denmark and the netherlands and for belgium after 1990 our estimates are broadly in line with the first generation target zone model whereas those for france and italy are in accordance with the model that allows for endogenous devaluation risk jel f31 e43

does option compensation increase managerial risk appetite this paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls under the manager s optimal policy the option ends up either deep in or deep out of the money as the asset value goes to zero volatility goes to infinity however the option compensation does not strictly lead to greater risk seeking sometimes the manager s optimal volatility is less with the option than it would be if he were trading his own account furthermore giving the manager more options causes him to reduce volatility managers with convex compensation schemes play an important role in financial markets this paper solves for the optimal dynamic investment policy for a risk averse manager paid with a call option on the assets he controls the paper focuses on how the option compensation impacts the manager s appetite for risk when he cannot hedge the option position on one hand the convexity of the option makes the manager shun payoffs that are likely to be near the money under the optimal policy the manager either significantly outperforms his benchmark or else incurs severe losses furthermore in examples of optimal trading strategies asset volatility goes to infinity as asset value goes to zero yet option compensation does not strictly lead to greater risk seeking as asset value grows large or if the evaluation date is far away the manager moderates asset risk for example if the manager has constant relative risk aversion crra asset volatility converges to the merton constant as asset value goes to infinity in some situations the manager actually chooses a lower asset volatility than he would if he were investing on his own because the leverage inherent in his option magnifies his exposure to the asset volatility in addition with all constant or decreasing absolute risk averse utility functions from the hyperbolic absolute risk averse hara class giving the manager more options causes him to reduce asset volatility in the crra case for example the manager targets a fixed volatility for his personal

target zones and forward rates in a model with repeated realignments abstract this paper studies the term structure of forward premia in a target zone with imperfect credibility the relationship between spot and forward exchange rates which reflects the possibility of realignments of the band is studied for various intervention policies with different degrees of credibility forward market data is used to estimate the implied credibility of the french german target zone during the ems parameter estimates accord with the experience of the ff dm exchange rate during the 1980s although spot exchange rates display little sensitivity to anticipated intervention forward data can be used to detect the effects of intervention on exchange rate dynamics