Bank of England Working Papers -
Abstracts 2000 (no. 106-124)

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The following are brief abstracts of working papers. Those papers that are out of print are marked as such (oop). For details of how to obtain copies of working papers, both in and out of print, see the Working Papers main page.

You can also view the full text of working papers 23 and 24 (from 1994) and working papers since 1997 as PDF files, readable with the latest version of Adobe Acrobat (this is available free from Adobe's Website ). The working papers are listed with the most recent papers first.

Working Paper No 124
Age structure and the UK unemployment rate
by Richard Barwell (169k)

The proportion of youths in the labour force has fallen dramatically over the past 15 years, following the collapse in the fertility rate in the 1970s ('the baby bust'). Given that youths always have higher unemployment rates than adults, this shift in the composition of the labour force towards those with lower unemployment rates may have been responsible for a fall in the aggregate unemployment rate. Using data from the Labour Force Survey, it is estimated that about 55 basis points of the 565 basis point fall in the UK unemployment rate between 1984 and 1998 can be accounted for by changes in the age structure of the labour force. Changes in the fraction of each age group that is economically active will also affect the composition of the labour force (and therefore potentially the unemployment rate); however, even controlling for changing labour force participation rates by age, demographically driven shifts in the age composition of the labour force still explain about 40 basis points of the fall in the unemployment rate. Finally, it is estimated that demographic change will have a negligible impact on the unemployment rate over the next decade, on the basis of recent labour force projections.

Working Paper No 123
An analysis of the relationship between international bond markets
by Andrew Clare and Ilias Lekkos (303k)

It is frequently suggested that the globalisation of financial markets has been responsible for reducing the scope for independent monetary policy action by strengthening the relationship between national fixed income markets. An associated concern is that the linkages between these markets become stronger in times of financial market stress. This paper reports a decomposition of the relationship between the government bond markets of Germany, the United Kingdom and the United States. It is found that the yield curves for each of these markets are influenced by international factors. Furthermore the impact of these increases significantly during times of financial stress. It is also found that while the total covariation between these markets is relatively stable, components of the covariance can vary substantially over time.

Working Paper No 122
Direct effects of base money on aggregate demand: theory and evidence
by Edward Nelson (235k)

Meltzer (1999a) shows that real monetary base growth is a significant determinant of consumption growth in the United States, controlling for the short-term real interest rate. In this paper, it is shown that the same property of base money holds for total output (relative to trend or potential) in both the United States and the United Kingdom. The standard optimising IS-LM model cannot account for this result, but it is shown that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky.

Working Paper No 121
Sovereign liquidity crises: analytics and implications for monetary policy
by Michael Chui, Prasanna Gai and Andrew G Haldane (457k)

This paper offers an analytical framework with which to assess some recent proposals for strengthening the international financial architecture. A model is developed of sovereign liquidity crises that reflect two sources of financial stress—weak fundamentals and self-fulfilling expectations. The nature of the underlying co-ordination game is investigated, as are the properties of the unique equilibrium. In so doing, the paper characterises the welfare costs of belief-driven crises, which are found to be potentially significant. Some recent policy proposals are also evaluated, including prudent debt and liquidity management, capital controls, greater information disclosure, and the efficacy of monetary policy tightening in the midst of crisis.

Working Paper No 120
UK monetary policy 1972-97: a guide using Taylor rules
by Edward Nelson (390k)

This paper estimates simple interest rate reaction functions or 'Taylor rules' for different UK monetary policy regimes. In the period between the floating of sterling in June 1972 and the Bank of England receiving operational independence in May 1997, UK monetary policy went through several regimes, including: the early 1970s, when monetary policy was subordinate to incomes policy as the primary weapon against inflation; £M3 targeting in the late 1970s and early 1980s; moves in the late 1980s toward greater exchange rate management, culminating in UK membership of the ERM from 1990 to 1992; and inflation targeting from October 1992.

Working Paper No 119
Optimal horizons for inflation targeting
by Nicoletta Batini and Edward Nelson (138k)

This paper investigates the problem of selecting an optimal horizon for inflation targeting in the United Kingdom. There are two key ways of thinking about an optimal horizon, so the paper looks at optimal horizons for both of these interpretations. In addition, to see whether the results are robust in the face of model uncertainty, optimal horizons are computed for two different models with divergent structural and dynamic characteristics.

Working Paper No 118
How well does a limited participation model of the monetary transmission mechanism match UK data?
by Shamik Dhar and Stephen Millard (99k)

This paper analyses how well a 'limited participation' model of the moentary transmission mechanism is able to match important aspects of the UK economy. Given that the endogenous monetary policy rule being followed by the monetary authority is not explicitly modelled, the model might not be expected to match the correlations and variances in the data. However, subject to this caveat, the model is able to reproduce the stylised fact that there is little relationship between monetary aggregates and either output or inflation, even though the underlying cause of inflation is money growth. The money-income and money-inflation relationships vary substantially within the model depending on what type of shock is hitting the economy, a strong argument for using structural models of the monetary transmission mechanism in which shocks are identified. The model is also able to capture important features of the monetary transmission mechanism in the United Kingdom, as embodied in the responses of variables to monetary policy shocks.

Working Paper No 117
A limited participation model of the monetary transmission mechanism in the United Kingdom
by Shamik Dhar and Stephen Millard (132k)

In this paper, a model of the UK economy is developed in which monetary growth determines inflation, but in which multiple shocks obscure the relationship between money and inflation. The model is a Dynamic Stochastic General Equilibrium model in which consumers can only participate in financial markets before shocks are observed; in other words, has the feature of 'limited participation'. The particular version of the model used in the paper is similar to other models of this class but with the additional feature of costs of adjusting the capital stock. The model is able to capture important features of the monetary transmission mechanism in the United Kingdom, as embodied in the responses of variables to monetary policy shocks.

Working Paper No 116
Persistence and volatility in short-term interest rates
by Nikolaos Panigirtzoglou, James Proudman and John Spicer
(192k)

It is important for monetary policy makers to know how closely money market rates follow the policy rates they set. This paper looks at the volatility and persistence of divergences between short-term market interest rates away from policy rates. This may also offer insights into the effectiveness of various approaches that central banks employ to smooth interest rate volatility, such as requiring minimum reserves. Using data for Germany, Italy and the United Kingdom, it is found that in all three countries there are significant temporary divergences, although the average divergence is close to zero.

Working Paper No 115
Trade credit and the monetary transmission mechanism
by Marion Kohler, Erik Britton and Tony Yates (76k)

This paper investigates whether firms with direct access to capital markets "help out" firms who are reliant on credit from banks by extending more trade credit when times are hard. In other words, is there a ‘trade credit channel’ that offsets the bank credit channel more familiar to monetary economists? Using a panel of UK firms quoted on the UK stock exchange it is found that there is. This might explain why, to date, evidence on the bank credit channel has been equivocal.

Working Paper No 114
Testing the stability of implied probability density functions
by Robert R Bliss and Nikolaos Panigirtzoglou (99k)

Implied probability density functions (PDFs) estimated from cross-sections of observed option prices are gaining increasing attention amongst academics and practitioners. To date, however, little attention has been paid to the robustness of these estimates or to the confidence that users can place in the summary statistics (for example the skewness or the 99th percentile) derived from fitted PDFs. This paper begins to address these questions by examining the absolute and relative robustness of two of the most common methods for estimating implied PDFs - the double-lognormal approximating function and the smoothed implied volatility smile methods. The changes resulting from randomly perturbing quoted prices by no more than a half tick provide a lower bound on the confidence intervals of the summary statistics derived from the estimated PDFs. Tests are conducted using options contracts tied to short sterling futures and the FTSE 100 index - both trading on the London International Financial Futures and Options Exchange. The tests show that the smoothed implied volatility smile method dominates the double-lognormal as a technique for estimating implied PDFs when average goodness-of-fits for both methods are comparable.

Working Paper No 113
A small structural empirical model of the UK monetary transmission mechanism
by Shamik Dhar, Darren Pain and Ryland Thomas (310k)

In this paper a structural empirical model of the UK monetary transmission mechanism is estimated, which can be used for policy analysis and forecasting. A small system is estimated containing eight variables that theoretically have an important role in the transmission mechanism. The paper then attempts to decompose the movements of each of these variables into a small number of independent underlying forcing processes or 'shocks', with a well-defined economic interpretation. In addition to identifying shocks to productivity, domestic demand, external demand and the foreign exchange risk premium, the paper distinguishes between several types of monetary shock. In particular, a distinction is made between 'permanent' monetary policy shocks, attributable to changes in the underlying nominal target of the authorities, and "temporary"policy shocks, reflecting either policy "errors"or transitory deviations from the authorities' reaction function. A financial intermediation shock is also identified reflecting changes in the provision of credit by the banking system and the degree of financial liberalisation. The paper goes on to demonstrate some of the practical uses of the model, which include estimating output and liquidity gaps, historical decompositions of the data and conditional forecasting.

Working Paper No 112
Inventory investment and cash flow
by Ian Small (295k)

This paper uses a panel of UK manufacturing firms to examine whether the effect of cash flow on inventory investment reflects the presence of financially constrained firms. Financially constrained firms are identified using a number of criteria, including the criterion suggested by Bond and Meghir (1994) based on the firm's financial policy. The main finding is that the effect of cash flow on inventory investment is concentrated among firms identified as financially constrained using either their financial policy or a criterion based on their current ratio. This suggests that there is no unique criterion for identifying financially constrained firms using financial information in company accounts. Contrary to what previous studies have found, using firm size or the coverage ratio to define financially constrained firms does not reduce the effect of cash flow on the inventory investment of unconstrained firms. This raises doubts about whether these are accurate indicators of whether a firm is financially constrained. Combined with Bond and Meghir's similar findings for fixed investment, the results in this paper suggest that cash flow effects form part of the monetary transmission mechanism.

Working Paper No 111
Liquidity traps: how to avoid them and how to escape them
by Willem H Buiter and Nikolaos Panigirtzoglou (295k)

An economy is in a liquidity trap when monetary policy cannot influence either real or nominal variables of interest. A necessary condition for this is that the short nominal interest rate is constrained by its lower bound, typically zero. The paper develops a small analytical model to show how an economy can get into a liquidity trap, how it can avoid getting into one and how it can get out. The empirical likelihood of the UK economy hitting the zero nominal rate bound is considered by investigating the relationship between the level of the short nominal interest rate and its volatility. The empirical evidence on this issue is mixed. To reduce the risk of falling into a liquidity trap, the authorities have two options. The first is to raise the inflation target. The second is to lower the zero nominal interest rate floor. This second option involves paying negative interest on government 'bearer bonds' - coin and currency - ie 'taxing money', as advocated by Gesell. Once in a liquidity trap, there are two means of escape. The first is to use expansionary fiscal policy. The second is, again, to lower the zero nominal interest rate floor. There are likely to be significant shoe leather costs associated with any scheme to tax currency.

Working Paper No 110
Imperfect competition and the dynamics of mark-ups”
by Erik Britton, Jens D J Larsen and Ian Small (600k)

This paper investigates the behaviour of the mark-up of prices over marginal costs under two different assumptions about market structure. In the customer market model firms lower their mark-up when current output is low relative to future profits, foregoing current profits in order to capture future market share. In markets characterised by implicit collusion, firms lower their mark-ups when current output is high relative to future profits in order to lower the incentives to undercut the implicit cartel. Only the customer market model generates predictions consistent with UK evidence, but this in inconsistent with evidence from the United States. It may be necessary to use more than one model to explain all the facts.

Working Paper No 109
The effects of increased labour market flexibility in the United Kingdom: theory and practice”
by Stephen P Millard (99k)

This paper uses the increase in labour market flexibility in the United Kingdom in recent years to see how well the predictions of a couple of recently developed labour market models can account for data. The two models examined are an 'equilibrium business cycle' model of the labour market and a 'search' model. The models do well in predicting the fall in the level and persistence of the unemployment rate and average hours since about 1985 as well as the step increase in consumption and output that seems to have occured. Conversely, unemployment incidence has fallen and the volatilities of output, consumption, employment and unemployment have all increased in the most recent cycle contrary to the predictions of the models.

Working Paper No 108
The sensitivity of aggregate consumption to human wealth”
by Hasan Bakhshi (99k)

The Permanent Income Hypothesis (PIH) assumes that individuals base their decisions on lifetime wealth, not current income. Textbook versions of the PIH predict that the elasticity of consumption with respect to human wealth is equal to the share of human wealth in total wealth. Comparing calibrated wealth shares with econometrically estimated elasticities amounts to a simple test of the PIH. In the United Kingdom, aggregate consumption is found to be more sensitive to changes in human wealth than is predicted by the PIH. This does not appear to be explained by a simple, but common, treatment of credit constraints.

Working Paper No 107
Must the growth rate decline? Baumol's unbalanced growth revisited”
by Nicholas Oulton (264k)

According to Baumol's model of unbalanced growth, if resources are shifting towards industries where productivity is growing relatively slowly, the aggregate productivity growth rate will slow down. This conclusion is often applied to the advanced industrial economies, where resources are indeed shifting towards the relatively stagnant service industries. This paper shows that Baumol's conclusion only follows if the stagnant industries produce final products. This is important empirically, since the most rapidly expanding service industries are those such as financial and business services, which are large producers of intermediate products. Even if such industries are stagnant, it is shown that a movement of resources into them may be associated with rising, not falling, aggregate productivity growth.

Working Paper No 106
Monetary policy surprises and the yield curve”
by Andrew G Haldane and Vicky Read (198k)

This paper presents a theoretical framework that allows a decomposition of 'surprises' along the yield curve at the time of monetary policy changes. These surprises can be decomposed into news about policy variables and news about policy preferences, depending on where along the yield curve these surprises occur. On this interpretation, news about policy variables shows up in movements at the short end of the yield curve and is a signal of imperfect monetary policy transparency. News about policy preferences shows up in movements at the long end of the yield curve and is a signal of imperfect monetary policy credibility.

The paper considers empirical case studies of the response of the yield curve in the United Kingdom, the United States, Germany and Italy at the time of monetary policy changes. It finds that the introduction of inflation targeting in the United Kingdom has had a significantly dampening effect on yield curve surprises at the short end. This is consistent with @ and illustrates one of the tangible benefits of @ the increased transparency of the United Kingdom's monetary policy framework under inflation targeting.