Bank of England Working Papers -
Abstracts 2003 (no. 172-210)

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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 210
Company accounts based modelling of business failures and the implications for financial stability
by Philip Bunn and Victoria Redwood (732k)

In this paper the determinants of failure among individual UK public and private companies are examined, over the period from 1991 to 2001. Using information on profitability, interest cover, capital gearing, liquidity, company size, industry, whether a firm is a subsidiary and overall economic conditions, it is possible to construct estimates of the probability of failure for individual companies. These are used to calculate each company's debt at risk: the probability of failure multiplied by its outstanding debt. By summing the firm-level debt at risk over all companies it is possible to produce an aggregate measure of financial risk that takes account of how debt is distributed across individual companies. Aggregate debt at risk, as a percentage of total debt, has fallen from the levels reached in the early 1990s and has remained relatively stable despite the build-up in corporate debt since then.

Working Paper No 209
Settlement bank behaviour and throughput rules in an RTGS payment system with collateralised intraday credit
by Simon Buckle and Erin Campbell (304k)

A simple two-period, two-bank model of an RTGS system with collateralised intraday credit is presented. It is shown that two types of outcome are possible - inefficient or efficient - depending on whether banks care about payments imbalances between them in the first period. If they do, banks delay payments to each other, increasing their aggregate liquidity requirements. It is argued that efficiency is not guaranteed even when banks face repeated interaction in a real payment system, largely because of imperfect information and the competitive dynamics of the payment industry. An efficient outcome can be achieved by the imposition of throughput rules on the value of payments banks must make by a certain deadline. These can both reduce aggregate liquidity requirements and increase the contestability of the payments market, encouraging a higher degree of direct access to payment systems. Throughput rules could therefore also have risk-reduction benefits if they help to reduce the level of tiering in the financial system. The detailed characteristics of these rules are shown to be important, and a number of design issues are addressed, such as how frequently requirements should be set, and whether throughput rules should apply on an aggregate or bilateral basis.

Working Paper No 208
A matching model of non-employment and wage pressure
by Andrew Brigden and Jonathan Thomas (301k)

In this paper a matching model with variable search intensity that incorporates the inactive is developed and calibrated. The model is used to look at possible explanations for the recent sharp decline in the UK working-age unemployment rate, which has been accompanied by only a moderate reduction in the working-age inactivity rate. From the range of different shocks considered, the most plausible combination consists of a significant reduction in unemployment benefits, perhaps reflecting reduced coverage, coupled with an increase in the student population. According to the model, these shocks would not have produced an increase in aggregate wage pressure.

Working Paper No 207
A quantitative framework for commercial property and its relationship to the analysis of the financial stability of the corporate sector
by John Whitley and Richard Windram (697k)

In this paper a quantitative framework for analysis of the UK commercial property sector is developed, and the possible implications explored for the financial stability of this sector, and for the corporate sector as a whole. There is little previous empirical literature. But where there is, models have either studied particular markets or have developed single-equation approaches. Lack of suitable data has been a major impediment. A model of the real estate sector is constructed using econometric analysis of rental values and bank lending, supplemented by a calibrated model of the remainder of the financial accounts of real estate companies (using data for private and public real estate companies). Using related work on company-failure models, it is possible to extend the analysis to provide an equation for the probability of default of real estate companies. The empirical results fail to find a role for borrowing costs in the bank lending equation before 1999, but unless borrowing costs are included after this period, the equation breaks down and systematically underestimates the growth in lending to real estate from then on. Various potential explanations are examined for this breakdown, including the importance of sale and lease-backs. The estimated rental equation appears more stable. The historical tracking performance of the estimated real estate model fails to capture the full extent of the swings in capital values and bank lending in the early 1990s. This is attributed to shifts in the discount rate applied to property income, possibly reflecting a temporary shift in risk premia during this period. The property sector links to the rest of the private non-financial corporate sector through its role as collateral. Since the property model relies partly on macroeconomic influences it can be used in conjunction with macro models to provide forecasts of property values and the probability of default of property companies. Simulations that use this model with the Bank of England macroeconometric model show not only the sensitivity of the probability of default of real estate companies to selected macroeconomic shocks, but also the potential links between the commercial property sector and the financial health of the rest of the corporate sector.

Working Paper No 206
The rise in US household debt: assessing its causes and sustainability
by Sebastian Barnes and Garry Young (396k)

In this paper the causes of the rise in US household debt since the early 1970s are considered, using a calibrated partial equilibrium overlapping generations model. The model explains indebtedness in terms of a consumption-income motive, associated with consumption smoothing, and a housing-finance motive. A credit constraint on borrowing by the old is also introduced to explain why they do not borrow to finance homeownership late in life. Shocks to real interest rates and income growth expectations, combined with demographic changes, are considered to explain the rise in US household debt. The calibrated model is found to be able to explain many features of US household borrowing, both in aggregate and cross-section. In particular, it predicts that the debt to income ratio would have increased substantially during the 1990s and would be expected to continue to grow in coming years. However, the model is unable to account for rising indebtedness during the 1980s when high interest rates, lower income growth and an ageing population would have tended to reduce aggregate borrowing. Alternative explanations, possibly associated with financial liberalisation, may account for borrowing growth during that period.

Working Paper No 205
Empirical determinants of emerging market economies' sovereign bond spreads
by Gianluigi Ferrucci (302k)

In this paper the empirical determinants of emerging market sovereign bond spreads are estimated, using a ragged-edge panel of JP Morgan EMBI and EMBI Global secondary market spreads and a set of common macro-prudential indicators. The panel is estimated using the pooled mean group technique of Pesaran, Shin and Smith. This is essentially a dynamic error correction model where cross-sectional coefficients are allowed to vary in the short run but are required to be homogeneous in the long run. It allows a separation of short-run dynamics and adjustment towards the equilibrium. The model is used to benchmark market spreads and assess whether sovereign risk was overpriced or underpriced during different periods over the past decade. The results suggest that a debtor country's fundamentals and external liquidity conditions are important determinants of market spreads. However, the diagnostic statistics also indicate that the market assessment of a country's creditworthiness is more broad based than that provided by the set of fundamentals included in the model. It is found that the generalised fall in sovereign spreads seen between 1995 and 1997 cannot be entirely explained in terms of improved fundamentals.

Working Paper No 204
The dynamics of consumers' expenditure: the UK consumption ECM redux
by Emilio Fernandez-Corugedo, Simon Price and Andrew Blake
(333k)

Simple intertemporal consumption theory implies that non-durable consumption is a random walk, but that consumption cointegrates with income and wealth. By the Granger representation theorem, there must be a (vector) error correction mechanism ((V)ECM) representation of the data; but from the theory, the equilibrating ECM cannot be in consumption. Instead, even with generalisations such as habit persistence, this equilibration should take place via income or wealth. Furthermore, unless the relative price of durables and non-durables is constant, the relative price needs to be taken into account in modelling. In this paper, the short-run dynamics and long-run relationship between non-durable consumption, non-asset income, wealth and the relative price of durable goods are examined. A cointegrating relationship is found to exist. Estimating VECMs, it is found that the adjustment towards the long-run common trend does indeed occur partly via changes in wealth, consistent with forward-looking behaviour on the part of agents. The result implies that consumption will predict asset returns, and this is confirmed by a regression of excess equity returns on the lagged disequilibrium term. A decomposition of shocks hitting the system reveals that between 30% and 90% of fluctuations in non-human wealth are transitory. Even if the lower figure applies, this means a substantial part of short-term fluctuations in wealth is decoupled from permanent consumption.

Working Paper No 203
Analytics of sovereign debt restructuring
by Andrew G Haldane, Adrian Penalver, Victoria Saporta and Hyun Song Shin (263k)

Over the past few years there has been an active debate among policy-makers on appropriate mechanisms for restructuring sovereign debt, particularly international bonds. In this paper a simple theoretical model is developed to analyse the merits of these proposals. The analysis suggests that collective action clauses (CACs) can resolve the inefficiencies caused by intra-creditor coordination problems, provided that all parties have complete information about each others preferences. In such a world, statutory mechanisms are unnecessary. This is no longer the case, however, when the benefits from reaching a restructuring agreement are private information to the debtor and its creditors. In this case, the inefficiencies induced by strategic behaviour the debtor-creditor bargaining problem cannot be resolved by the parties themselves: removing these inefficiencies would require the intervention of a third party.

Working Paper No 202
Credit spreads on sterling corporate bonds and the term structure of UK interest rates
by Jeremy Leake (292k)

In this paper the relationship between credit spreads on sterling corporate bonds and the term structure of UK interest rates is explored. In particular, the question of whether credit spreads are a reliable indicator of corporate bond default risk is examined. Using daily price quotes from 1990 to 1998, a small negative relationship is identified between credit spreads on sterling investment-grade corporate bonds and the level and slope of the term structure of UK interest rates. The results are weaker than those found by some previous studies which examined the relationship between US corporate bond credit spreads and the term structure of US interest rates. The weakness of the relationship suggests that credit spreads on sterling investment-grade corporate bonds have been driven by factors other than default risk. If so, we should be cautious in interpreting such credit spreads as measures of bond default risk. This result is important to both those in the field of financial stability interested in leading indicators of corporate defaults, and to monetary policy makers interested in the impact of interest rate changes on corporate bond default risk. Similar work should be repeated for sterling sub investment-grade corporate bonds once a sufficiently large data set can be assembled.

Working Paper No 201
Debt maturity structure with pre-emptive creditors
by Prasanna Gai and Hyun Song Shin (322k)

Recent experience with financial crises has led to scepticism about the efficacy of crisis management measures that target short-term debt, such as the voluntary/concerted rollovers of interbank lines. Such measures, it is suggested, heighten financial fragility by encouraging creditors to pre-empt each other by lending at ever shorter maturities. Pre-emptive behaviour of this type is modelled explicitly and the implications for the maturity profile of debt explored. It is found that crisis management instruments designed to improve the recovery process for claimholders do not necessarily skew the maturity structure towards the shorter term.

Working Paper No 200
Estimating real interest rates for the United Kingdom
by Jens Larsen, Ben May and James Talbot (906k)

Any monetary policy maker using a short-term nominal interest rate as the primary policy tool will have an interest in understanding developments in ex-ante real interest rates. In this paper, several methods for calculating real interest rates for the United Kingdom are explored. These include: yields on index-linked bonds; yields on nominal bonds minus an appropriate measure of inflation expectations; and a consumption-based measure derived from manipulating the first-order condition of a standard household intertemporal optimisation problem. It is found that the basic (power utility) version of the consumption-based model suffers from the standard problems outlined in the literature, so the basic framework is augmented to allow for (external) habit formation in consumption, and a general k -period real interest rate is derived. Interestingly, although the different approaches outlined above can sometimes yield very different estimates of real interest rates, all the measures move more closely together during the post-1992 inflation-targeting period than before. Before 1992, uncertainty about the monetary regime, coupled with persistent expectational errors, may have made it more difficult for agents to forecast real interest rates and inflation.

Working Paper No 199
Credit risk diversification: evidence from the eurobond market
by Simone Varotto (391k)

This paper studies the role of diversification in reducing the volatility of corporate bond returns induced by changes in credit spreads. Specifically, it looks at how credit risk can be diminished when a portfolio is diversified across countries, industry sectors, maturities, seniority types and credit ratings. The role of national industrial structures for international diversification is also investigated. The results suggest that geographical diversification is more effective in reducing portfolio risk than alternative investment strategies considered, and that industry effects are not material to this result. Finally, the paper explores the implications of these findings for credit risk capital regulation in banks.

Working Paper No 198
Non-interest income and total income stability
by Rosie Smith, Christos Staikouras and Geoffrey Wood (289k)

Banks can differ markedly in their sources of income. Some focus on business lending, some on household lending, and some on fee-earning activities. Increasingly, however, most banks are diversifying into fee-earning activities. Such diversification is either justified (by the bank) or welcomed (by commentators), or both, as reducing the bank's exposure to risk. Diversification across various sources of earnings is welcomed for, it is claimed, diversification reduces risk. Whether it does of course depends on how independent of each other the various earnings sources are. Traditionally fee income has been very stable; but, also traditionally, it has been a small part of the earnings stream of most banks. Has non-interest income remained stable, or at least uncorrelated with interest income, as banks have increased its importance in their earnings? This paper examines the variability of interest and non-interest income, and their correlation, for the banking systems of EU countries for the years 1994-98. It is found that the increased importance of non-interest income did, for most but not all categories of bank, stabilise profits in the European banking industry in those years. It is not, however, invariably more stable than interest income.

Working Paper No 197
E-barter versus fiat money: will central banks survive?
by F H Capie, Dimitrios P Tsomocos and Geoffrey E Wood (337k)

New technology in computing has led some to suggest that the ability to settle transactions electronically will develop to such an extent that money will disappear from use. Two versions of this belief exist. One maintains that there will be 'e-money', issued conceivably by many organisations, and that this will replace central bank money. The other, on which this paper focuses, suggests a further development - that the very concept of a medium of exchange may become redundant, as assets or goods can be exchanged directly for other assets or goods through use of computing. In this paper we argue that the information-economising properties that allowed money to develop will also allow it to survive, despite actual and hypothesised technical progress which reduces the cost of electronic barter.

Working Paper No 196
UK business investment: long-run elasticities and short-run dynamics
by Colin Ellis and Simon Price (343k)

Theory tells us that output, the capital stock and the user cost of capital are related. From the capital accumulation identity, it also follows that the capital stock and investment have a long-run proportional relationship. The dynamic structure thus implies a multi-cointegrating framework, in which separate cointegrating relationships are identifiable. This has been used to justify the estimation of investment equations embodying a reduced-form long-run relationship between investment and output (rather than between the capital stock and output). In this paper, a new investment equation is estimated in the full structural framework, exploiting a measure of the capital stock constructed by the Bank, and a long series for the cost of capital. A CES production function is assumed, and a well-determined estimate of the elasticity of substitution is obtained by a variety of measures. The robust result is that the elasticity of substitution is significantly different from unity (the Cobb-Douglas case), at about 0.45. Overidentifying restrictions on the long-run relationship are all accepted. Although the key long-run parameter (the elasticity of substitution) is highly robust to alternative specifications, single-equation investment relationships may obscure the dynamics. There is evidence that the Johansen method is oversized, but given this, a test for excluding the capital accumulation identity from the investment equation is much better than using a single-equation ECM.

Working Paper No 195
Forecasting inflation using labour market indicators
by Vincenzo Cassino and Michael Joyce (460k)

There are a large number of labour market indicators that could be used by monetary policy makers to assess the state of the labour market and the associated implications for inflationary pressure. This paper attempts to assess their relative merits by evaluating their past performance in forecasting movements in price and wage inflation. This is done by considering both their ex post performance in predicting inflation using conventional in-sample Granger causality tests and their performance ex ante using simulated out-of-sample forecasting tests over the period 1985-2000, based on both recursive and rolling-window estimation. These criteria lead to rather different conclusions. In sample, most labour market indicators appear to be statistically significant in an inflation-forecasting equation, but out of sample a much smaller number of labour market indicator models are better at forecasting inflation than a simple autoregression, with virtually none outperforming this benchmark over the period since 1995. The labour market indicator models that perform relatively well out of sample tend to be sensitive to the precise choice of inflation measure, sample period and estimation method, though there is some evidence that pooling across individual forecasts produces more reliable results. One apparently robust result, however, is that the unemployment rate gap, the most commonly used measure of labour market tightness, performs poorly in out-of-sample forecasts across a range of specifications.

Working Paper No 194
A Merton-model approach to assessing the default risk of UK public companies
by Merxe Tudela and Garry Young (376k)

In this paper it is shown how a Merton-model approach can be used to develop measures of the probability of failure of individual quoted UK companies. Probability estimates are then constructed for a group of failed companies and their properties as leading indicators of failure assessed. Probability estimates of failure for a control group of surviving companies are also constructed. These are used in probit regressions to evaluate the information content of the Merton-based estimates relative to information available in company accounts and in assessing Type I and Type II errors. Power curves and accuracy ratios are also examined. It is shown that there is much useful information in the Merton-style estimates.

Working Paper No 193
Implicit interest rates and corporate balance sheets: an analysis using aggregate and disaggregated UK data
by Andrew Benito and John Whitley (304k)

Credit channel models emphasise the importance of financial variables in macroeconomic responses to unanticipated economic events. In this paper empirical models are developed that relate implicit interest rates paid by firms to measures of their financial health (principally capital gearing) using both aggregate data and information from individual company accounts. Both aggregate and disaggregated approaches confirm a significant influence on interest rates from changes in the financial health of companies. The aggregate relationship finds support for the hypothesis that implicit interest rates depend on the initial level of indebtedness in a non-linear way. The estimated equation is used within the Bank of England's macroeconomic model (extended to incorporate the balance sheets of the corporate and household sectors) to simulate the role of the credit channel mechanism in response to shocks.

Working Paper No 192
Capital stocks, capital services, and depreciation: an integrated framework
by Nicholas Oulton and Sylaja Srinivasan (920k)

Neo-classical theory provides an integrated framework by means of which we can measure capital stocks, capital services and depreciation. In this paper the theory is set out and reviewed. It is found that the theory is quite robust and can deal with assets like computers that are subject to rapid obsolescence. Using the framework, estimates are presented of aggregate wealth, aggregate capital services and aggregate depreciation for the United Kingdom between 1979 Q1 and 2002 Q2, and the results are tested for sensitivity to the assumptions. The principal source of uncertainty in estimating capital stocks and capital services is found to relate to the treatment and measurement of investment in computers and software. Applying US methods for these assets to UK data has a substantial effect on the growth rate of capital services and on the ratio of depreciation to GDP.

Estimates to accompany Working Paper No. 192

(35k)

Working Paper No 191
Endogenous price stickiness, trend inflation, and the New Keynesian Phillips curve
by Hasan Bakhshi, Pablo Burriel-Llombart, Hashmat Khan and Barbara Rudolf (389k)

For standard calibration, this paper shows that the optimal price, in a model with Calvo form of price stickiness and strategic complementarities, is only defined for annualised trend inflation rates of under 5.5%. This critical inflation rate is below the average inflation rate over recent decades. Furthermore, over the range for which the optimal price is defined, the slope of the New Keynesian Phillips curve generated by this model is decreasing in trend inflation. That contradicts the stylised fact that Phillips curves are flatter in low-inflation environments. Substituting endogenous price stickiness for the Calvo form of time-dependent pricing can help avoid these implications.

Working Paper No 190
What caused the 2000/01 slowdown? Results from a VAR analysis of G7 GDP components
by Vincent Labhard (389k)

In this paper a VAR-based analysis of shocks to G7 GDP components during the 2000/01 slowdown is presented. The patterns of shocks across the components and across the G7 countries are documented, and measures provided of their persistence. The shocks during the preceding expansion are also considered, and are used to discuss possible business cycle asymmetries, and a comparison made with the pattern of shocks during the previous slowdown in 1990. The analysis is then extended to derive shocks to components that explicitly take into account the roles played by monetary policy and oil prices in 2000/01.

Working Paper No 189
Modelling investment when relative prices are trending: theory and evidence for the United Kingdom
by Hasan Bakhshi, Nicholas Oulton and Jamie Thompson (344k)

In recent work, Stacey Tevlin and Karl Whelan argue that aggregate econometric models fail to capture the US investment boom in plant and machinery in the second half of the 1990s, whereas a disaggregated approach does much better. In particular, they show that aggregate models do not capture the increase in replacement investment associated with compositional shifts in the capital stock towards high depreciation rate assets, such as computers. And aggregate models invariably find little or no role for the real user cost, so do not pick up the strong effects of relative price declines on investment in computers. In this paper, a data set for the United Kingdom is constructed in order to investigate the ability of different equations to account for the UK boom in plant and machinery investment in the second half of the 1990s. The findings are similar to those of Tevlin and Whelan, whose analysis is extended in two main ways. First, the failure of the aggregate equations is explained more formally in terms of misspecification when relative prices are trending downwards. Second, the econometric analysis is conducted in a formal cointegration framework. As in the United States, the paper shows that asset-level equations can explain the investment boom in plant and machinery in the second half of the 1990s in the United Kingdom, whereas the aggregate equation fails completely.

Working Paper No 188
The role of asset prices in transmitting monetary and other shocks
by Stephen P Millard and Simon J Wells (446k)

In this paper framework is constructed within which the ability of asset prices to convey information about the underlying shocks hitting the economy can be assessed. An identified VAR is used to establish a set of stylised facts as to how asset prices respond to exogenous monetary policy movements. A theoretical model of the economy is then developed, and used to analyse how asset prices modelled within it respond to different shocks. Consumers in the model consume both market-produced and home-produced goods. There are two types of firms: those producing traded goods sold on competitive world markets and those producing non-traded goods. Non-traded goods producers face costs of adjusting their capital stocks and can only reset their prices once a year in a staggered fashion. It is shown that the model is able to replicate the stylised facts found in the empirical exercise. It is then shown how asset prices respond to shocks to productivity in the traded, non-traded and household production sectors and a shock to the world price of traded goods. With these results, it is possible to assess what information asset prices may give us about the shocks affecting the economy at any particular time.

Working Paper No 187
Sovereign debt workouts with the IMF as delegated monitor - a common agency approach
by Prasanna Gai and Nicholas Vause (352k)

IMF programmes are frequently criticised for lacking focus and being ineffective in helping maintain private credit lines following a debt crisis. A theoretical model is developed to explore the interlinkages between result-based conditionality and creditor collective action problems. The strategic interactions between official and private creditors are highlighted, and some of the trade-offs that underpin the design of IMF programmes are clarified. Conditions under which official creditors are able to limit the efficiency losses generated by creditor non-cooperation and debtor moral hazard are identified. The circumstances under which official lending is able to catalyse private sector finance are also analysed.

Working Paper No 186
Ready, willing, and able? Measuring labour availability in the UK
by Mark E Schweitzer (493k)

The unemployment rate is commonly assumed to measure labour availability, but this ignores the fact that potential workers frequently come from outside the current set of labour market participants, the so-called inactive. The UK Longitudinal Labour Force Survey includes information that can be used to predict impending employment transitions. Using this unique dataset, new measures of labour availability, and indicators based on the more familiar unemployment rate alternatives, can be constructed and are reported here. The micro and macroeconomic performance of these labour force availability measures are compared. Two simplified models, which include several categories of reasons for not working as well as demographic variables, perform particularly well in all of the tests. The implications of these preferred models are further studied in the context of regional regressions and comparisons with alternative data sources. These results together illustrate the important role that some groups of the inactive can play as a source of potential workers.

Working Paper No 185
What does economic theory tell us about labour market tightness?
by Andrew Brigden and Jonathan Thomas (511k)

Labour market tightness is a phrase often used by commentators and policy-makers, but it is rarely defined. In this paper, the phrase labour market tightness is interpreted as describing the balance between the demand for, and the supply of, labour. A logical consequence of this approach is that tightness is not a helpful concept in those models of the labour market, such as the standard competitive and the basic matching model, where there are insufficient rigidities to create imbalances between labour demand and supply. It is proposed that changes in the labour share of income are a convenient yardstick for measuring changes in labour market tightness. In response to certain kinds of shock, changes in the labour share will give misleading signals, but this is likely to occur less frequently than with other oft-cited tightness indicators such as the unemployment rate or the employment rate. The paper concludes by considering the links between labour market tightness and inflation. A key lesson from this analysis is that any attempt to infer the relationships between labour market tightness, various market indicators of it, and inflation, requires both a clear definition of tightness and depends on the specific model of the labour market.

Working Paper No 184
The effect of payments standstills on yields and the maturity structure of international debt
by Benjamin Martin and Adrian Penalver (488k)

Payments standstills have been suggested as a tool for the resolution of financial crises in emerging markets economies. A simple model is developed here to examine the implications of standstills for yields and the maturity structure of debt. An emerging market country chooses to sell short and long-term debt to risk-neutral international investors. The key assumptions are that the level of short-term debt increases the probability of crisis, that crises have costs that spill over into the next period, and that the orderly resolution of financial crises will reduce the cost of crises. A standstill is depicted as an orderly rollover of short-term debt. Standstills have the benefit of reducing the proportion of short-term debt and so lower the probability of crisis. This comes at the cost of generally lower expected output.

Working Paper No 183
Capital flows to emerging markets
by Adrian Penalver (350k)

Capital flows to emerging market economies have occurred in cycles, with booms in lending often followed by financial crises. Economic theory, though, has had little to say on the optimal rate at which capital should flow. In this paper a model due to Barro, Mankiw and Sala-i-Martin is extended to make it more appropriate for analysis of emerging market economies, and optimal capital flows based on an estimated Barro-style conditional convergence growth equation are calculated. Flows derived from the model are lower than actually observed over the estimation period (1988-97) but the results are sensitive to the parameters chosen.

Working Paper No 182
Import prices and exchange rate pass-through: theory and evidence from the United Kingdom
by Valerie Herzberg, George Kapetanios and Simon Price (302k)

The appreciation of sterling that began in 1996 appeared to pass through into import prices very slowly, an apparent example of incomplete exchange rate pass-through. Incomplete pass-through has typically been explained by a combination of sticky prices and pricing to market. This can have implications for the monetary transmission mechanism, making it important to establish whether this phenomenon exists in practice. One implication for firms' import (and domestic) price setting is that competitors' prices might affect the mark-up, although this is not a necessary condition. Some of the factors supporting pricing to market may also introduce non-linear responses to exchange rate shocks. It is established that a model of pricing to market including a role for competitors' prices fits the data, but no evidence of non-linearity is found.

Working Paper No 181
Procyclicality and the new Basel Accord - banks' choice of loan rating system
by Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos (520k)

The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. In this article the implications of this new risk-based regime for procyclicality of minimum capital requirements are examined - in particular, whether the choice of particular loan rating system by the banks would significantly increase the likelihood of sharp increases in capital requirements in recessions, creating the potential for classic credit crunches. It is found that rating schemes that are designed to be more stable over the cycle, akin to those of the external rating agencies, would not increase procyclicality, but ratings that are conditioned on the current point in the cycle, akin in some respects to a Merton approach, could substantially increase procyclicality. This makes the question of which rating schemes banks will use very important. A general equilibrium model of the financial system is used to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committees latest proposals, in October 2002.

Working Paper No 180
The role of expectations in estimates of the NAIRU in the United States and the United Kingdom
by Rebecca L Driver, Jennifer V Greenslade and Richard G Pierse
(370k)

During the second half of the 1990s the US economy was characterised as the Goldilocks economy: not too hot, nor too cold, but just right. It was argued that this represented a new paradigm, enabling unemployment to remain low without igniting inflationary pressure. In this paper the evidence for a change in the relationship between inflation and unemployment is examined and the US experience compared with that of the United Kingdom within a common analytical framework. To that end, Phillips-curve models are employed based on estimates of time-varying NAIRUs, obtained using the Kalman filter. The impact of including explicit inflation expectations is also considered. This channel has not been explored in previous work based on Kalman filter estimates of the NAIRU for the United States and United Kingdom. Inflation expectations are found to play a particularly important role in the United States. When expectations are included there is still evidence that the NAIRU steadily declined during the late 1990s, although this decline in the US NAIRU is not found solely in the 1990s.

Working Paper No 179
A Kalman filter approach to estimating the UK NAIRU
by Jennifer V Greenslade, Richard G Pierse and Jumana Saleheen
(398k)

In this paper, the Kalman filter method is applied to UK Phillips-curve models and estimates are derived for the NAIRU from 1973 to 2000. The resulting profiles suggest that the NAIRU peaked around the mid-1980s and fell back thereafter. Structural changes in the labour market have reduced inflationary pressure from that source, and we suggest that temporary effects from real import prices and real oil prices were an important additional downward influence on inflation in the latter half of the 1990s. Some of the uncertainties around our NAIRU estimates are shown. But, even though there may be uncertainty about exactly where the NAIRU is, a variety of models suggest that unemployment was below the NAIRU for much of the second half of the 1990s.

Working Paper No 178
The impact of price competitiveness on UK producer price behaviour
by Colin Ellis and Simon Price (298k)

Modern open-economy macro models emphasise pricing-to-market behaviour. It is possible that domestic pricing behaviour might be affected by import (competitors') prices, and this is a commonly used variable in empirical work on pricing. But there is theoretical ambiguity and a potential identification problem. Cointegrating techniques are used in an attempt to resolve this, using the most appropriate data set (producer prices). Some evidence is found for the existence of two long-run relationships. The first of these is interpretable as a price mark-up or factor demand relationship, and competitors' prices can be excluded from it. The second equation can be interpreted as a long-run equilibrium price relationship equating domestic and foreign prices. This raises the possibility that single-equation estimates indicating a role for foreign prices in domestic price determination may mislead. However, the results are for producer prices and may not necessarily be extended to other indices.

Working Paper No 177
The provisioning experience of the major UK banks: a small panel investigation
by Darren Pain (374k)

Using panel regression analysis, the factors that may help to explain increases in loan-loss provisions for the major UK banks are investigated. Explanatory variables reviewed include aggregate variables such as GDP growth as well as bank-specific factors such as the composition of the loan portfolio. The main findings are that a number of macroeconomic variables can indeed inform about banks' provisions, in particular real GDP growth, real interest rates and lagged aggregate lending growth. Bank-specific behaviour is also important - increased lending to riskier sectors, such as commercial property companies, has generally been associated with higher provisions.

Working Paper No 176
Rational expectations and fixed-event forecasts: an application to UK inflation
by Hasan Bakhshi, George Kapetanios and Anthony Yates (383k)

In this paper a version of the rational expectations hypothesis is tested using fixed-event inflation forecasts for the UK. Fixed-event forecasts consist of a panel of forecasts for a set of outturns of a series at varying horizons prior to each outturn. The forecasts are the prediction of fund managers surveyed by Merrill Lynch. Fixed-event forecasts allow tests for whether expectations are unbiased in a similar fashion to the rest of the literature. But they also permit particular tests of forecast efficiency to be conducted - whether the forecasts make best use of available information - that are not possible with rolling event data. The results show evidence of a positive bias in inflation expectations. Evidence for inefficiency is much less clear cut.

Working Paper No 175
Equilibrium analysis, banking, contagion and financial fragility
by Dimitrios P Tsomocos (1M)

In this paper a general equilibrium model of an economy with incomplete markets (GEI) with money and default is examined. The model is a simplified version of the real world consisting of a non-bank private sector, banks, a central bank, a government and a regulator. It is used to analyse actions by policy-makers and to identify policy relevant empirical work. Key analytical results are: a financially fragile system need not collapse; efficiency can be improved with policy intervention; and a system with heterogeneous banks is more stable than one with homogeneous ones. Existence of monetary equilibria allows for positive default levels in equilibrium. It also characterises contagion and financial fragility as an equilibrium phenomenon. A definition of financial fragility is proposed. Financial fragility occurs when aggregate profitability of the banking sector declines and defaults in the non-bank and banking private sectors increase. Thus, equilibria with financial fragility require financial vulnerability in the banking sector and liquidity shortages in the non-bank private sector. The model will be used as a basis to carry out empirical work on the costs of financial instability, to quantify the effectiveness of particular regulatory tools such as capital requirements, and to identify trade-offs between increasing stability through action by authorities and the efficiency of the financial system.

Working Paper No 174
Money market operations and volatility of UK money market rates
by Anne Vila Wetherilt (506k)

In this paper, the question of whether in the United Kingdom the choice of the operational framework for monetary policy has been systematically related to patterns in money market rates is examined. Attention is first focused on the Bank of England's policy target, the two-week repo rate. The tests indicate that tighter spreads between the two-week market rate and the official repo rate result in lower money market volatility at the very short end of the money market curve. The effects at the longer end are much weaker. But no evidence of transmission of two-week volatility along the money market curve is found. In contrast to many other central banks, the Bank of England does not employ an operating target for the overnight rate. No evidence is found that allowing greater variation in overnight rates undermines efforts of the central bank to keep other money market rates in alignment with the rate at which it operates when implementing its monetary policy. The results further indicate that volatility of rates at the very short end of the UK money market yield curve has declined significantly since the early 1990s. The introduction of the gilt repo market in January 1996 was associated with lower money market volatility, although there is evidence that volatility had started to fall as early as mid-1995. The effects of the 1997 reforms of the Bank of England's open market operations are less discernible in the data. In contrast, the creation of a ceiling for overnight rates in June 1998 was more clearly associated with a reduction in volatility of end-of-day overnight rates.

Working Paper No 173
Current accounts, net foreign assets and the implications of cyclical factors
by Matthieu Bussiere, Georgios Chortareas and Rebecca L Driver
(249k)

Intertemporal models of the current account suggest that temporary income shocks are fully reflected in a country's net foreign asset position, so that agents invest abroad any savings generated by a positive income shock. On the other hand, a stylised fact in international economics is that there is a disproportionately large share of domestic assets in investors' portfolios. If investment risk is high and diminishing returns are weak, then savings from temporary income shocks may, in fact, be invested according to the existing portfolio composition. This implies that any bias in portfolios persists after a temporary shock. A model is estimated that explicitly allows for the possibility that the impact of initial portfolio allocation, proxied using net foreign assets, may differ, depending on whether shocks are permanent or temporary. The results, from a panel of 18 OECD countries, suggest that initial portfolio allocation affects current account behaviour following temporary, but not permanent, shocks. These results are therefore compatible with the new rule.

Working Paper No 172
Public demand for low inflation
by Kenneth Scheve (390k)

In this paper, survey data from 20 advanced economies are used to examine individual preferences about macroeconomic priorities. The analysis gives rise to three key findings. First, the distributive consequences of inflation and unemployment are key determinants of how individuals weigh different economic objectives. New evidence is provided that nominal asset owners are relatively more inflation averse, consistent with their exposure to unanticipated inflation. Second, the findings also suggest that economic context has a substantial impact on the public's economic objectives in a way broadly consistent with the specification of utility/loss functions in the theoretical political economy literature. Third, the results suggest that there is significant cross-country variation in inflation aversion, controlling for economic context and individual attributes, and that some of this variation can be accounted for by national-level factors affecting the aggregate costs of inflation and unemployment. Cross-country variation in inflation aversion, controlling for economic context has significant implications for both optimal monetary policy making and for models of alternative institutional frameworks for policy-making.