Bank of England Working Papers -
Abstracts 2002 (no. 152-171)

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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 171
Leading indicators of balance-of-payments crises: a partial review
by Michael Chui (681k)

This paper reviews the theory of balance-of-payments crises, and its implications for identifying potential leading indicators of crises. It discusses and evaluates three different empirical approaches to balance-of-payments crises: the signalling, discrete-choice, and structural approaches. Despite claims of success in predicting currency crises, we note some serious theoretical and empirical qualifications which throw these claims into question. Nevertheless, we conclude that a range of indicators supported by theory may still be useful for policy-makers interested in preventing financial instability.

Working Paper No 170
Base rate pass-through: evidence from banks' and building societies' retail rates
by Paul Mizen and Boris Hofmann (351k)

Official interest rate changes are intended to influence short rates on money market instruments and retail products, such as deposit accounts and mortgages, and complete pass-through is often simply taken for granted. In this paper a theoretical and econometric framework for assessing the evidence for this assumption is provided, using 14 years of monthly data for interest rates on deposit and mortgage products offered by UK banks and building societies. The method employed allows for asymmetries and non-linearities in adjustment and the results show that the speed of adjustment in retail rates depends on whether the perceived 'gap' between retail and base rates is widening or narrowing.

Working Paper No 169
House prices, consumption, and monetary policy: a financial accelerator approach
by Kosuke Aoki, James Proudman and Gertjan Vlieghe (342k)

There is a live debate about the role of house prices in the transmission mechanism of monetary policy. Do house prices merely reflect macroeconomic conditions, or are there important feedback effects from house prices to other economic variables? A general equilibrium model is considered, where asymmetric information problems create frictions in credit markets used by households. In particular, the financial accelerator mechanism of Bernanke, Gertler and Gilchrist is applied to the household sector. In the economy modelled, houses serve two purposes: they provide a stream of housing services to consumers, and they serve as collateral to lower the agency costs related to borrowing. It is shown that under certain conditions this amplifies and propagates the effect of monetary policy shocks on housing investment, house prices and consumption. The effect of a structural change in credit markets that lowers the transaction costs of additional borrowing against housing equity is also considered. It is shown that such a change would increase the effect of monetary policy shocks on consumption, but would decrease the effect of monetary policy shocks on house prices and housing investment.

Working Paper No 168
Financial pressure and balance sheet adjustment by UK firms
by Andrew Benito and Garry Young (272k)

In this paper the financial policies and balance sheet adjustment of companies are examined. Using a large panel of quoted UK firms, models for dividends, new equity issuance and investment are estimated, relating them to debt adjustment. The results suggest that while dividends are sticky in the short run, they are an important means of balance sheet adjustment in the long run. Other evidence supports the idea that companies actively target their balance sheet by variation in dividends, new equity issues and investment.

Working Paper No 167
The role of short-run inflation targets and forecasts in disinflation
by Lavan Mahadeva and Gabriel Sterne (448k)

Globally, the majority of countries using inflation targets have done so when inflation was neither low nor stable. Many such countries have changed their target each year, and the empirical estimates reported in this paper support theoretical predictions that annual changes to the target are endogenous to outcomes. A unique cross-country panel dataset of inflation targets and outcomes in 60 countries in the 1990s is used. The estimates suggest the target revision may be predicted according to a simple 'forecasting' rule, and depends upon the outcome's deviation from both the short-run and long-run target. During disinflation, policy-makers may therefore be characterised as using two types of policy rule; one for setting interest rates, the other for revising annual targets. In designing roles for the legislator and the central bank in the monetary framework, it is necessary to take into account the likelihood that the process of setting the target may, in some circumstances, be inseparable from that of setting policy instruments. In the light of other literature, it is also argued that during disinflation, short-run targets may help central banks to build credibility because they may increase transparency.

Working Paper No 166
The role of corporate balance sheets and bank lending policies in a financial accelerator framework
by Simon Hall and Anne Vila Wetherilt (571k)

In this paper the popular Bernanke, Gertler and Gilchrist (BGG) model is used to explore links between the financial health of the non-financial corporate sector and bank lending behaviour on the one hand, and the effectiveness of monetary policy on the other. The model's microeconomic contracting framework is used to generate specific financial scenarios, defined in terms of steady-state credit spreads, bank lending policies and corporate sector financial health. These scenarios are embedded in the macroeconomic BGG model, and an investigation carried out into how they affect dynamic responses of the real economy to monetary and real shocks.

The simulations show that in the context of the BGG model, the balance sheet positions of the financial and non-financial corporate sectors can affect the monetary transmission mechanism. It is illustrated that in certain financial scenarios in the model the financial accelerator mechanism is very potent, whereas in others it has little incremental impact. This implies that, for a given shock, monetary policy can be less or more proactive, respectively. In addition, the model simulation results suggest that certain parameters may merit particular attention. For example, the sensitivity of bank lending policy to news about corporate financial health has an especially marked impact in the model's dynamics. And as illustrated in previous work, corporate leverage also plays an important role in amplifying and propagating shocks.

Working Paper No 165
Committees versus individuals: an experimental analysis of monetary policy decision-making
by Clare Lombardelli, James Proudman and James Talbot (466k)

The results of an experimental analysis of monetary policy decision-making under uncertainty are reported. A large sample of economically literate undergraduate and postgraduate students from the London School of Economics was used to play a simple monetary policy game, both as individuals and in committees of five players. The findings - that groups make better decisions than individuals - accord with previous work by Blinder and Morgan. An attempt was also made to establish why group decision-making is superior.

The results show that some of the benefit is related to the ability of committees to strip out the effect of bad play in any given period. But there is a significant additional improvement, which is argued to be associated with the ability of committee members to share information and learn from each other by observing other members' interest rate responses. One surprising result is that the superiority of committee decision-making does not appear to be related to the ability to discuss the interest rate decision.

Working Paper No 164
Understanding UK inflation: the role of openness
by Ravi Balakrishnan and J David López-Salido (525k)

In this paper, inflation dynamics in the United Kingdom are re-examined. Standard specifications of traditional Phillips curves have tended to overpredict inflation in the recent low inflation, low unemployment era in the United States, the United Kingdom and the euro area. This has stimulated the 'New Phillips Curve' approach, which has had success for the United States and the euro area, both less open economies than the United Kingdom. The paper is divided into two parts. First, the overprediction problem is documented for the United Kingdom, and an attempt is made to solve it in a traditional Phillips curve framework by introducing external shocks (terms of trade shocks or domestically generated inflation). This does not fully solve the problem. It is argued that there is a further misspecification problem with traditional Phillips curve estimates, due to the presence of the regime changes and structural change in the UK economy. Second, 'New Phillips Curve' estimates are examined. They perform badly; real marginal cost is not significant in the baseline specification. The relationship between marginal cost and inflation disappears in the mid-1980s. When a labour share measure is used, real marginal cost becomes significant, but goodness of fit based on fundamental inflation remains poor. The 'New Phillips Curve' model is then extended to allow for open economy influences, taking into account imported intermediate goods. This is found to mitigate substantially the breakdown of the relationship between inflation and marginal cost. Fit improves, but a tendency to underpredict and then overpredict inflation remains. Finally, the open-economy measure of marginal cost is decomposed. The wage mark-up component is important and highly countercyclical. Relative price movements, of taxes relative to overall prices and of imported intermediate goods relative to wages, are found to have been a negative influence on marginal costs over the 1990s. Understanding likely future developments in these relative prices could contribute to the assessment of prospects for marginal costs and the pressures on inflation .

Working Paper No 163
Productivity versus welfare: or, GDP versus Weitzman's NDP
by Nicholas Oulton (474k)

How should productivity and welfare be measured when the composition of the capital stock is shifting towards assets with shorter lives? What sort of adjustment, if any, should be made for depreciation? While GDP is still appropriate as a measure of output, in this paper it is argued that NDP (WNDP)—nominal net domestic product deflated by the price index for consumption—is the appropriate measure of welfare. The rate at which the WNDP frontier is shifting out over time is analogous to the rate of growth of aggregate total factor productivity (TFP). Like the latter, it may be decomposed into the contributions made by TFP growth in individual industries, though with a different pattern of weights. The argument is illustrated by the experience of the United States in the 1990s. Here net investment increased more rapidly than gross investment and both grew faster than GDP, while the aggregate depreciation rate rose. Nevertheless the aggregate capital stock grew more slowly than GDP, and depreciation as a proportion of GDP was flat. Both official NDP and WNDP have been growing a little more slowly than GDP. But the acceleration of WNDP post 1995 was as great as that of GDP. Also, the rise in the growth rate of the WNDP frontier was equal to that of aggregate TFP.

Working Paper No 162
Factor utilisation and productivity estimates for the United Kingdom
by Jens Larsen, Katharine Neiss and Fergal Shortall (279k)

In this paper series are derived for capital utilisation, labour effort and total factor productivity (TFP) from a general equilibrium model with variable factor utilisation and labour adjustment costs. Impulse responses from the model show that firms initially respond to unanticipated shocks by altering factor utilisation rates. In subsequent periods, firms adjust observable inputs such as physical capital and employment. As a result, utilisation rates are a leading indicator of firms hiring of both capital and labour. The estimate of capital utilisation is found to track survey-based measures quite closely, while movements in total hours worked drive the labour effort series. The estimate of TFP growth is found to be less cyclical than the rate of growth of a traditional Solow residual. Nevertheless, a weighted average of capital utilisation and labour effort aggregate factor utilisation is not closely related to the detrended Solow residual. This suggests that measures that conflate capacity utilisation and temporary deviations in TFP from its steady-state growth rate may be misleading indicators of excess demand pressure. Rather, the measure of aggregate factor utilisation is correlated with detrended labour productivity, providing more evidence that differences in average and marginal labour productivity may be linked to factor hoarding. Labour productivity, when calculated as output per unit of effective labour input, is less cyclical than a simple measure of output per hour.

Working Paper No 161
Regulatory and 'economic' solvency standards for internationally active banks
by Patricia Jackson, William Perraudin and Victoria Saporta (123k)

One of the most important policy issues for financial authorities is to decide at what level average capital charges should be set. The decision may alternatively be expressed as the choice of an appropriate survival probability for representative banks over a horizon such as a year, often termed a solvency standard. In this paper, light is shed on the solvency standards implied by current and possible future G10 bank regulation, and on the economic solvency standard that banks choose themselves by their own capital-setting decisions. In particular, a credit risk model is employed to show that the survival probability implied by the 1988 Basel Accord is between 99.0% and 99.9%. It is then demonstrated that if a new Basel Accord were calibrated to such a standard, it would not represent a binding constraint on banks current operations, since most banks employ a solvency standard significantly higher than 99.9%. To show this, a statistical analysis of bank ratings is employed, adjusted for the impact of official or other support, as well as credit risk model calculations. Lastly, a possible explanation is advanced for the conservative capital choices made by banks, by showing that swap volumes are highly correlated with credit quality for given bank size. This suggests that banks access to important credit markets like the swap markets may provide a significant discipline in the choice of solvency standard.

Working Paper No 160
On gross worker flows in the United Kingdom: evidence from the Labour Force Survey
by Brian Bell and James Smith (120k)

Empirical studies of worker flows in the United States and Europe have found that these flows are large when compared with the change in the stocks of employment and non-employment, and have a distinct cyclical pattern. In the United Kingdom, studies of this kind have been hampered by limitations in the available data. In this paper use is made of newly released longitudinal data from the Labour Force Survey. It is shown that, on average, since 1993 7.3% of those in the working-age population have changed labour market state in a given three-month period. This compares with a consistently calculated annual figure of 12.5%. In addition, an array of evidence is presented to show that UK gross flows appear to follow a cyclical pattern similar to those found in other countries. Evidence is also presented on the potential problems that previous research may suffer from with their use of recall data to determine prior labour market status. While stocks are similar using recall or recorded labour market state, flows inferred from recall data are severely biased by recall error.

Working Paper No 159
The implications of an ageing population for the UK economy
by Garry Young (160k)

In this paper the likely development of aggregate living standards in the United Kingdom over the course of this century are considered, and some of the risks to this outlook. It is argued that even under relatively cautious assumptions about technological progress and capital accumulation, aggregate living standards (as measured by GDP per head) are set to double over the next 50 years. While there are clear risks to this aggregate outlook, these would be present even without demographic change. The risks to the living standards of individuals and individual cohorts are also discussed. These risks have changed in three main ways as a result of demographic change. First, ageing has been a factor throughout the world in encouraging a shift from public to private provision for old age, increasing the proportion of retired people exposed to risks to market prices and rates of return. Second, the size of the group exposed to such risks is growing larger as a direct result of ageing. Third, any adverse effects of demographic change are most likely to be felt in old age; one of the effects of people living longer is that they have to spread their lifetime incomes over more years of life, implying a need for more saving when working. If this does not occur, then consumption has to be considerably lower in old age than would have been the case had proper provision been made for retirement.

Working Paper No 158
Soft liquidity constraints and precautionary saving
by Emilio Fernandez-Corugedo (218k)

The implications for consumption and saving behaviour are explored, when households are allowed to borrow, but face penalties which increase with the amount borrowed. It is shown that the introduction of this type of constraints (soft liquidity constraints) does not lead to consumers behaving very differently from consumers who face constraints which prevent them from borrowing at any time (hard liquidity constraints). However, when hard constraints are relaxed and become soft, the amount of precautionary saving falls.

Working Paper No 157
Financial liberalisation and consumers' expenditure: 'FLIB' re-examined
by Emilio Fernandez-Corugedo and Simon Price (237k)

The methodology used in papers by Darby and Ireland and Caporale and Williams is examined, to see whether it continues to explain UK consumption behaviour. First, Muellbauer and Murphy's proxy for financial liberalisation (FLIB) is updated. Then a forward-looking consumption model is re-estimated, using FLIB as a variable affecting the proportion of liquidity-constrained individuals. It is found that this implementation of the model, incorporating joint hypotheses about consumption behaviour and the measurement of financial liberalisation, is not robust and is not able to give a consistent picture of the number of people who were liquidity constrained in the 1990s.

Working Paper No 156
Equilibrium exchange rates and supply-side performance
by Gianluca Benigno and Christoph Thoenissen (272k)

A two-country, optimising, sticky price model of real exchange rate determination in the new open macroeconomics tradition is developed, allowing several different forms of deviation from purchasing power parity (PPP), both along the adjustment path and in the steady state. The model has a rich structure, and is designed to provide a flexible tool for policy analysis. Unlike much of the literature, both of the key components of the real exchange rate—the relative price of non-tradables, and the terms of trade—are made endogenous, allowing a more complete analysis of the impact of structural shocks. To illustrate one possible application, the model is calibrated to match key elements of the UK and euro-area economies, and used to examine the extent to which possible improvements in the United Kingdom's relative supply-side performance might account for the sharp and persistent appreciation in sterling since 1996. The results are not supportive of this hypothesis. In the model, improvements in productivity, goods market and labour market competitiveness are all associated with a depreciation in both the spot and the equilibrium real sterling exchange rates. Two potential supply-side sources of an equilibrium appreciation are considered: a productivity improvement biased towards traded goods (Balassa-Samuelson effect); and an anticipated future productivity rise. However, each is insufficient to account for a long-run equilibrium appreciation, although the latter may account for an initial appreciation of the real exchange rate. The paper is concluded by considering further mechanisms that could affect the results.

Working Paper No 155
Monetary policy and stagflation in the UK
by Edward Nelson and Kalin Nikolov (170k)

The volatile data for inflation, output, and interest rates in the United Kingdom prior to the 1990s, and the relative macroeconomic stability associated with inflation targeting, provide a rich basis for discriminating between rival explanations for the outbreak of stagflation. Alternative hypotheses are examined with the aid of a New Keynesian model of aggregate demand and inflation determination, estimated on quarterly UK data for 1959-2000. The model features IS and Phillips curves based on optimising behaviour, and fully incorporates the distinction between detrended output and the output gap stressed by optimising analysis. Using model simulations as well as information on the real-time views of policy-makers, alternative explanations are tested for the outbreak of inflation in the United Kingdom in the 1960s and 1970s. Inaccurate estimates of the degree of excess demand in the economy are found to have contributed significantly to the outbreak. But there is also evidence of a major role following from the failure at the time to recognise the importance of monetary policy, as opposed to non-monetary devices, in controlling inflation.

Working Paper No 154
A monetary model of factor utilisation
by Katharine S Neiss and Evi Pappa (337k)

The propagation mechanism of monetary shocks in an otherwise standard sticky-price model is examined, modified to incorporate factor hoarding in the form of variable capital utilisation rates and labour effort. In contrast to previous studies, it is found that real effects of monetary shocks can be generated at relatively low degrees of nominal rigidity. Factor hoarding enriches the propagation mechanism by flattening the marginal cost responses to monetary shocks. The assumption of labour hoarding is crucial for generating persistence, while the assumption of variable capital utilisation allows the generation of realistic investment volatility, without having to introduce capital adjustment costs.

Working Paper No 153
Do changes in structural factors explain movements in the equilibrium rate of unemployment?
by Vincenzo Cassino and Richard Thornton (128k)

This paper examines the role played by various structural economic changes in explaining movements in the equilibrium rate of unemployment. The theoretical framework developed by Layard, Nickell and Jackman (LNJ) is employed to explain changes in the equilibrium unemployment rate. In the LNJ framework, equilibrium unemployment is determined by the interaction of the price and wage-setting behaviour of firms and workers. The natural rate is a function of structural variables such as the replacement ratio and union power that affect the size of firms and workers mark-ups. A wide range of equations with different combinations of structural variables is examined. It proves extremely difficult to find robust coefficient estimates that are statistically significant and have the expected signs on structural variables, unless a trended variable such as the owner-occupied housing rate is included. However, it is likely that these variables are simply capturing the upward trend in actual unemployment over most of the sample period in response to exogenous shocks. These results are found to be robust over different sample periods and different equation specifications. Therefore the results indicate that it is not possible accurately to explain movements in the natural rate using this approach, supporting the findings of other recent studies that suggest focusing on alternative, less structural, methods for estimating the equilibrium unemployment rate.

Working Paper No 152
How uncertain are the welfare costs of inflation?
by Hasan Bakhshi, Ben Martin and Tony Yates (145k)

This paper quantifies for the United Kingdom the general equilibrium costs of individuals holding cash to economise on 'shopping time'. These are a subset of a wider range of costs caused by inflation. The paper tests whether or not money balances tend to a finite number as nominal interest rates tend to zero, and investigates how sensitive to this test are the welfare implications of rates of inflation above the Friedman rule (a zero nominal interest rate). The paper then explores how uncertainties about the shape of the money demand curve translate into uncertainties about these welfare costs of inflation. A key uncertainty is the existence of a satiation point for money balances. Using Monte Carlo tests, it is shown that without observations at nominal interest rates very close to zero, the power of satiation tests can be very low. This finding may also be important for evaluating whether/how monetary policy could stabilise the economy in the event of a shock large enough to require that nominal interest rates are driven close to zero.