Bank of England Working Papers - Abstracts 2001 (no. 125-151)

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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 151
Other financial corporations: Cinderella or ugly sister of empirical monetary economics?
by K Alec Chrystal and Paul Mizen (117k)

This paper reports estimates of an econometric model of the determinants of OFCs' broad money holding and M4 lending to OFCs. This is of interest as it gives information about a component of UK money and credit aggregates, and also because it provides some evidence of the link between financial activity and growth of the real economy. The long-run equilibria for money holding and lending to this sector are modelled as being driven by GDP, wealth, the return to financial services and various interest rate spreads. The dynamics of OFCs' money and lending are shown to be interdependent. The evidence for interactions between OFCs and other sectors are then considered. The results indicate that M4 lending to OFCs is significantly related to aggregate investment in the long run, but is largely unrelated to the spending of households.

Working Paper No 150
Financial accelerator effects in UK business cycles
by Simon Hall (170k)

This paper uses a dynamic general equilibrium model incorporating financial accelerator effects to examine interactions between corporate investment and financial conditions in recent UK business cycles. The paper notes correspondences in recent recessions between the behaviour of business investment, the financial health of the corporate sector and some indicators of the availability of finance. It then investigates whether a financial accelerator model, developed by Bernanke, Gertier and Gilchrist (1999), can shed light on key features of recent recessions. The model is calibrated to broadly match UK financial conditions prevailing at the start of recent recessions, and is simulated with and without its financial accelerator mechanism. Simulations of the model incorporating financial accelerator effects seem consistent with some of the observed features of corporate real and financial behaviour in previous downturns.

Working Paper No 149
Monetary policy rules for an open economy
by Nicoletta Batini, Richard Harrison and Stephen P Millard (485k)

The most popular simple rule for the interest rate, due to Taylor, is meant to inform monetary policy in closed economies. On the other hand, its main open-economy alternative, Ball's rule based on a monetary conditions index (MCI), may perform poorly in the face of specific types of exchange rate shocks, and thus cannot offer guidance for the day-to-day conduct of monetary policy. In this paper, a comprehensive set of simple monetary policy rules (including the MCI-based and Taylor versions) is specified and evaluated, all suitable for small open economies in general, and for the United Kingdom in particular. The asymptotic properties of a two-sector open-economy dynamic stochastic general equilibrium model calibrated on UK data are compared under the different rules. It is found that an inflation-forecast-based rule (IFB), i.e., one that reacts to deviations of expected inflation from target, performs well. Adding a separate response to the level of the real exchange rate (contemporaneous and lagged) appears to reduce the difference in adjustment between output gaps in the two sectors of the economy, but the improvement is only marginal. Importantly, an IFB rule, with or without exchange rate adjustment, appears robust to different shocks, in contrast to naive or Ball's MCI-based rules.

Working Paper No 148
UK inflation in the 1970s and 1980s: the role of output gap mismeasurement
by Edward Nelson and Kalin Nikolov (207k)

Understanding the degree of measurement error in the estimates of the output gap available to policy-makers in 'real time' is important both for the formulation of monetary policy and for the study of inflation behaviour. For the United Kingdom, no official output gap series exists, but an approximate series can be deduced from analysis of statistical releases and policy-makers' statements. On this basis, a real-time UK output gap series is constructed, beginning in 1965, and it is therefore possible to obtain estimates of the extent of real-time output gap mismeasurement in the 1970s and 1980s. Monetary policy errors due to output gap mismeasurement are found to have contributed approximately 3.0 to 7.1 percentage points to average UK inflation in the 1970s and 0.7 to 5.5 percentage points to inflation in the 1980s.

Working Paper No 147
Hard Times or Great Expectations?: Dividend omissions and dividend cuts by UK firms
by Andrew Benito and Garry Young (133k)

The payment of dividends is one of the key unresolved puzzles of company financial behaviour. This paper uncovers a more recent dividend puzzle; that of an increasing proportion of quoted UK companies omitting cash dividends. Also motivated by a desire to understand corporate balance sheet adjustment, models for the incidence of dividend omissions and cuts are estimated as functions of financial characteristics including cash flow, leverage, investment opportunities, investment and company size. These financial variables can account for most of the increase in omissions since 1995. There is relatively little evidence to link this to the major tax reform of 1997 that abolished tax refunds on dividend income payable to tax-exempt institutions. Significant persistence effects indicate that companies are slow to adjust their balance sheets through dividends.

Working Paper No 146
Indicators of fragility in the UK corporate sector
by Gertjan W. Vlieghe (123k)

The determinants of the aggregate corporate liquidation rate in the United Kingdom are estimated from a sample of quarterly data using an autoregressive distributed lag (ARDL) approach which allows for non-stationarity of the variables. The paper investigates what the appropriate measures of indebtedness are, and examines whether the unprecedented spike in the corporate liquidation rate in the United Kingdom in 1992 caused a breakdown in the relationship between the variables. The debt-to-GDP ratio, the real interest rate, deviations of GDP from trend and real wages are found to be long-run determinants of the liquidation rate. The birth rate of new companies, an index of property prices and nominal interest rates have significant short-term effects. The estimated equation is robust to changes in the sample period. The rapidly increasing level of indebtedness in the late 1980s was the main determinant of the subsequent increase in the liquidation rate. The decrease in the liquidation rate after 1992 was primarily due to lower real interest rates, lower real wages and the cyclical recovery of GDP.

Working Paper No 145
Skill imbalances in the UK labour market: 1979-99
by Pablo Burriel-Llombart and Jonathan Thomas (139k)

In this paper the evolution of skill imbalances in the UK labour market over the past two decades is investigated. Movements in the relative ease with which firms can recruit skilled workers can affect unemployment, inflation, and productivity. Any assessment of changes in the skill balance is complicated by the fact that different indicators often send conflicting messages. Such conflicts could reflect the underlying definitions of skilled and unskilled workers, as well as differences in the sensitivities of each measure to alternative market shocks. The analysis casts doubt on the reliability of standard measures of unemployment dispersion across educational groups, and the Confederation of British Industry ratio of skilled and unskilled labour shortages, as measures of skill imbalance. The gap between the demand for, and the supply of, educated labour has in fact increased steadily over the past two decades, particularly for those workers with graduate-level qualifications. So the apparent decline in the NAIRU over the recent cyclical upswing cannot be attributed to an improvement in the relative ease with which firms can hire educated workers.

Working Paper No 144
Costs of banking system instability: some empirical evidence
by Glenn Hoggarth, Ricardo Reis and Victoria Saporta (122k)

This paper assesses the cross-country 'stylised facts' on empirical measures of the losses incurred during periods of banking crises. Firstly, the direct resolution costs to the government are considered, and then the broader costs to the welfare of the economy (proxied by losses in GDP). The cumulative output losses incurred during crisis periods are found to be large, roughly 15%-20% of annual GDP, on average. In contrast to previous research, it is also found that output losses incurred during crises in developed countries are as high, or higher, on average, than those in emerging market economies. Moreover, output losses during crisis periods in developed countries also appear to be significantly larger—10%-15%—than in neighbouring countries that did not at the time experience severe banking problems. In emerging market economies, by contrast, banking crises appear to be costly only when accompanied by a currency crisis. These results seem robust to allowing for macroeconomic conditions at the outset of crisis—in particular low and declining output growth—that have also contributed to future output losses during episodes.

Working Paper No 143
Does it pay to be transparent? International evidence from central bank forecasts
by Georgios Chortareas, David Stasavage and Gabriel Stern (137k)

Is central bank transparency associated with variation in macroeconomic outcomes? Cross-country data covering 87 countries is used to construct an index for transparency based upon the detail in central banks' published forecasts. After controlling for a number of other institutional and macroeconomic variables it is found that an increase in the detail that central banks include in their published forecasts is associated with lower average inflation. The result holds regardless of whether the domestic nominal anchor is based more on an inflation or money target, but not for exchange rate targeting countries. Furthermore, no evidence is found that the publication of forecasts is associated with greater output volatility.

Working Paper No 142
Band-pass filtering, cointegration, and business cycle analysis
by Luca Benati (202k)

This paper critically assesses the practice of band-pass filtering (the non-structural, frequency-domain based decomposition of economic time series into trend and cyclical components), making two main points. First, it is shown that: (a) depending on the stochastic properties of the filtered process, the band-pass filtered cyclical component is entirely authentic, partly or mostly spurious, or even entirely spurious; and (b) as a simple consequence of the Lucas critique, the degree of authenticity of band-pass filtered cyclical components crucially depends on the monetary rule followed by the policy-maker.

Second, taking a number of macroeconomic models as data-generation processes it is shown that band-pass filtering: (a) may markedly distort key business cycle stylised facts, as captured by the cross-correlations and the cross-spectral statistics between the cyclical components of the variables of interest and the cyclical component of GDP; and (b) may well create entirely spurious stylised facts. For example: both productivity and the money supply may appear procyclical even when they follow random walks by construction; the real wage may appear procyclical when in fact it is countercyclical; in general, the Phillips correlation between inflation and the cyclical component of economic activity will appear weaker than it is in reality. Again, the degree of authenticity of business cycle stylised facts uncovered via band-pass filtering crucially depends on the monetary rule followed by the policy-maker.

Working Paper No 141
The fallacy of the fiscal theory of the price level, again
by Willem H. Buiter (222k)

This paper argues that the 'fiscal theory of the price level' (FTPL) is fallacious. The source of the fallacy is an elementary economic misspecification. The FTPL denies a fundamental property of any model of a market economy, that the budget constraint of any agent, private or public, must be satisfied identically, ie for all admissible values of the variables entering the budget constraint. Instead the FTPL requires the government's inter-temporal budget constraint to be satisfied only in equilibrium. The FTPL looks for equilibria in which the government can meet its contractual debt obligations exactly, despite having an overdetermined financial-fiscal monetary programme. The economic misspecification has implications for the mathematical properties of the equilibria supported by models that impose the structure of the FTPL. For example, the FTPL implies the anomaly that it can price money in an economy without money. The FTPL has an exact analogue in a 'household budget constraint theory of the price level', which is perhaps more readily recognised as a nonsense.

Working Paper No 140
ICT and productivity growth in the United Kingdom
by Nicholas Oulton (451k)

This paper develops new estimates of investment in and output of information and communications technology (ICT). These new estimates imply that GDP growth has been significantly understated, particularly since 1994. A growth accounting approach is employed to measure the contribution of ICT to the growth of both aggregate output and aggregate input. On both counts, the contribution of ICT has been rising over time. From 1989 to 1998, ICT output contributed a fifth of overall GDP growth. Since 1989, 55% of capital deepening has been contributed by ICT capital, and 90% since 1994. ICT capital deepening accounts for 25 % of the growth of labour productivity over 1989-98 and 48% over 1994-98. But even when output growth is adjusted for the new ICT estimates, both labour productivity and TFP growth are still found to slow after 1994.

Working Paper No 139
The United Kingdom's small banks' crisis of the early 1990s: what were the leading indicators of failure?
by Andrew Logan (173k)

The announcement of BCCI's closure on 5 July 1991 rapidly accelerated the withdrawal of wholesale funds from small and medium-sized UK banks. Within three years, a quarter of the banks in this sector had, in some sense, failed. This study employs a logit model to analyse at two points prior to the crisis the distinct characteristics of the banks that failed compared with those that survived. Perhaps not surprisingly, a number of measures of bank weakness—low loan growth, poor profitability and illiquidity—are found to be good short-term predictors of failure, as are a high dependence on net interest income and low leverage. The best longer-term leading indicator of future failure, however, is rapid loan growth at the peak of the previous boom.

Working Paper No 138
PPP and the real exchange rate—real interest rate differential puzzle revisited: evidence from non-stationary panel data
by Georgios E. Chortareas and Rebecca L. Driver (236k)

This paper examines the evidence for two of the relationships that underpin (explicitly or implicitly) much of international macroeconomics. The first is purchasing power parity (PPP), or the hypothesis that there exists a constant long-run equilibrium real exchange rate. The second establishes a relationship between real exchange rates and real interest rate differentials. The tests are conducted on a panel of 18 OECD economies using the United States as a numeraire for the post-Bretton Woods era. The results are obtained using new non-stationary panel estimation techniques, which significantly increase the power of the tests. All the tests suggest that there is little evidence supporting PPP when it is tested directly. This contrasts with earlier panel data studies, which tended to find that the real exchange rate was stationary. The results supporting a long-run relationship between real exchange rates and real interest rate differentials appear to be more positive. This again provides a contrast with earlier results, which tended to find no evidence of cointegration. Such studies concentrated on G7 economies. To investigate this further the panel was split into two groups: the G7 and eleven small open economies. For the panel of small open economies strong evidence in favour of cointegration is found. In contrast, there is no evidence of cointegration in a panel that consists purely of the G7 economies.

Working Paper No 137
Leading indicator information in UK equity prices: an assessment of economic tracking portfolios
by Simon Hayes (124k)

An economic tracking portfolio (ETP) is a portfolio of financial assets whose returns are correlated with some macroeconomic variable of interest. Specifically, an ETP is designed to track revisions to investors' expectations about the target macroeconomic variable. This paper evaluates whether ETPs provide information about expectations of future macroeconomic outcomes, and are thus a useful tool for conjunctural economic assessment. A set of ETPs is estimated using UK equity returns for three target variables: inflation, industrial production growth, and growth in the volume of retail sales. In sample, it is possible to track all three of the target variables with equity returns. But the out-of-sample results are poor. Although some ETPs retain significant explanatory power, most do not, and in all cases there is a substantial deterioration in the relationship between the ETPs and the target variables. Covariances between equity returns and macroeconomic variables appear to change substantially over time, and the consequent instability in portfolio weights significantly diminishes the usefulness of ETPs for conjunctural analysis.

Working Paper No 136
Crisis costs and debtor discipline: the efficacy of public policy in sovereign debt crises
by Prasanna Gai, Simon Hayes and Hyun Song Shin (393k)

Recent debate on the reform of the international financial architecture has highlighted the potentially important role of the official sector in crisis management. This paper examines how such public intervention in sovereign debt crises affects efficiency, ex ante and ex post. The results shed light on the scale of capital inflows in such a regime, and the analysis establishes conditions under which this leads to an improvement in debtor country welfare. The efficacy of measures such as officially sanctioned stays on creditor litigation depend critically on the quality of public sector surveillance and the size of the costs of sovereign debt crises.

Working Paper No 135
Hybrid inflation and price level targeting
by Nicoletta Batini and Anthony Yates (165k)

The previous literature on the benefits of price level versus inflation targeting has, with some qualifications, established that price level targeting entails lower price level variance at the expense of higher inflation and output variance. This paper investigates the properties of monetary regimes that combine price level and inflation targeting. It offers two characterisations of these regimes: a set of optimal control rules obtained assuming that policy-makers minimise a loss function that penalises a mixed price level/inflation target; and a set of simple rules feeding back from alternative combinations of (current and future-dated) price level and inflation deviations from target. Asymptotic variances are derived of the price level, inflation and output associated with each of these regimes when the economy is modelled as a small-scale open-economy RE model calibrated on UK data. The conclusions are that: (i) the relative merits of price level and inflation targeting, as well as of mixes of these two, are a function of several modelling and policy assumptions; and (ii) these merits do not change monotonically in the move from one regime to another. It appears also that the probability of nominal interest rates hitting a 'zero bound' under the alternative regimes is model-specific and varies non-monotonically among them.

Working Paper No 134
Consumption, money and lending: a joint model for the UK household sector
by K Alec Chrystal and Paul Mizen (187k)

Previous research has investigated consumers' expenditure and money demand as separable equations. This study estimates them jointly as driven by the same influences. Credit is also included as a potential third variable that might provide a source of additional information about the monetary transmission mechanism. Consumption, money and lending equations are modelled as an interdependent system, and the significance of lending for consumption and money is tested. The results using UK household sector data show that a stable credit equation does exist in parallel with money demand and consumption equations, and that interactions modelled in a conditional vector equilibrium correction system are favoured over independent equations.

Working Paper No 133
Stability of ratings transitions
by Pamela Nickell, William Perraudin and Simone Varotto (285k)

The distribution of ratings changes plays a crucial role in many credit risk models. As is well known, these distributions vary across time and different issuer types. Ignoring such dependencies may lead to inaccurate assessments of credit risk. In this paper, a quantification is provided of the dependence of ratings transition probabilities on the industry and domicile of the obligor, and on the stage of the business cycle. The incremental impact of these factors is identified using ordered probit models. This approach gives a clearer picture (than is obtained by comparing transition matrices estimated from different sub-samples) of which conditioning factors are important.

Working Paper No 132
Ratings versus equity-based credit risk modelling: an empirical analysis
by Pamela Nickell, William Perraudin and Simone Varotto (515k)

Banks have recently developed new techniques for gauging the credit risk associated with portfolios of illiquid, defaultable instruments. These techniques could revolutionise banks' management of credit risk and could in the longer term serve as a more risk-sensitive basis for calculating regulatory capital on banks' loan books than the current 8% capital charge. In this paper, examples are implemented of the two main types of credit risk model developed so far: ratings-based and equity-based approaches. Using price data on large eurobond portfolios, the paper assesses, on an out-of-sample basis, how well these models track the risks they claim to measure.

Working Paper No 131
The structure of credit risk: spread volatility and ratings transitions
by Rudiger Kiesel, William Perraudin and Alex Taylor (438k)

Knowing the relative riskiness of different types of credit exposure is important for policy-makers designing regulatory capital requirements and for firms allocating economic capital. This paper analyses the risk structure of credit exposures with different maturities and credit qualities. It focuses particularly on risks associated with (i) ratings transitions and (ii) spread changes for given ratings. The analysis shows that, for high-quality debt, most risk stems from spread changes. This is significant because several recently proposed credit risk models assume no spread risk.

Working Paper No 130
The real interest rate gap as an inflation indicator
by Katharine S. Neiss and Edward Nelson (680k)

A long-standing area of research and policy interest is the construction of a measure of monetary policy stance. One measure that has been proposed, as an alternative to indices that employ monetary aggregates or exchange rates, is the spread between the actual real interest rate and its flexible-price, or natural-rate, counterpart. This study examines the properties of the natural real interest rate and 'real interest rate gap' using a dynamic stochastic general equilibrium model. Issues investigated include: (1) the response of the gap and its components to fundamental economic shocks; and (2) the indicator and forecasting properties of the real interest gap for inflation, both in the model and in the data. The results suggest that the real interest rate gap has value as an inflation indicator, supporting the 'neo-Wicksellian framework' advocated by Woodford.

Working Paper No 129
Investment-specific technological progress in the United Kingdom
by Hasan Bakhshi and Jens Larsen (1.1M)

This paper analyses the impact of rapid technological change in the information and communications technology (ICT) sector on economic growth. Technological change in the ICT sector leads to a fall in the relative price of ICT goods, which leads firms to invest more heavily in high-tech goods. The approach is to build a dynamic general equilibrium model that is consistent with key stylised facts of the UK economy. The model is used to quantify the contribution to long-run growth of technological progress that is specific to the ICT sector. It is found that technological progress that is specific to the ICT sector might account for around 20%-30% of long-run labour productivity growth. But this conclusion depends crucially on how ICT prices are measured. It is shown that shocks to technological progress that is specific to production of ICT investment goods can have very different macroeconomic implications from a shock that applies to production of all goods. It is demonstrated that a permanent increase in the growth rate of ICT-specific technological progress will increase the investment expenditure share of GDP but lower the aggregate depreciation rate, while an increase in the return to investment in ICT will increase both the expenditure share and the depreciation rate.

Working Paper No 128
'Oscillate Wildly': asymmetries and persistence in company-level profitability
by Andrew Benito (138k)

This paper examines company-level persistence in profitability over the period 1975-98. The competitive forces that act to compete away abnormal returns need not act symmetrically and may differ at different points in the distribution of profitability. This suggestion is tested empirically on an unbalanced panel of 2,129 companies. First, evidence for both asymmetries and non-linearities in the persistence of company profitability is found. The results are consistent with the notion that competitive forces act less swiftly to eliminate superior returns than inferior returns and/or that companies attempts to allocate a positive result to more years than they would allocate a poor result. Second, by imposing a linear specification, previous studies are likely to have understated the extent of persistence of superior profitability. Third, industry variation in the extent of profit persistence is considered. Under the standard linear model such variation across industries is quite small. A greater degree of variation between industries is found when allowing for persistence in a non-linear fashion. But the finding that higher profitability persists more than low profitability is common across each industry.

Working Paper No 127
Sticky prices and volatile output
by Martin Ellison and Andrew Scott (99k)

This paper examines the effect of introducing a specific type of price stickiness into a stochastic growth model subject to a cash-in-advance constraint. As in previous studies, it is found that the introduction of price rigidities provides a substantial source of monetary non-neutrality that contributes significantly to output volatility. It is shown that the introduction of this form of sticky prices improves the model's performance at explaining inflation, but worsens it for output. The most dramatic failure of the model is the extremely high-frequency fluctuations in output that it generates. Sticky prices not only fail to produce persistent business cycle fluctuations but they generate volatility at very high frequencies.

Working Paper No 126
New estimates of the UK real and nominal yield curves
by Nicola Anderson and John Sleath (293k)

This paper presents some new estimates of the UK real and nominal yield curves. These estimates are derived using a spline-based technique modified for the UK government bond markets. At the short end of the nominal yield curve, additional data are included from the GC repo market. Estimates of the real yield curve are derived from the prices of index-linked gilts. It is found that the new yield curves outperform existing methods on a number if criteria that are designed to examine the suitability of estimates for the purpose of assessing monetary conditions. In particular, the estimates are found to be smooth across maturity while having sufficient flexibility to describe the shape of the curve at shorter maturities where expectations are relatively precise. The curves are also robust to small errors in the data.

Working Paper No 125
Assessing the impact of macroeconomic news announcements on securities prices under different monetary policy regimes
by Andrew Clare and Roger Courtenay (316k)

This paper investigates the impact of UK macroeconomic news announcements on selected futures contracts and exchange rates. A wide set of scheduled public news announcements is included in the study, including: official interest rate decisions, the publication of the Bank of England's Inflation Report, and the minutes of the Bank's Monetary Policy Committee meetings. The study investigates whether the reaction to these announcements has changed since the Bank of England was granted operational independence in May 1997. The results indicate that there may well have been changes in the way that financial markets incorporate key economic data into securities prices. In particular, an increase in the speed of the reaction to interest rate announcements is discovered, but also there is evidence of a fall in the size of the full reaction.