Bank of England Working Papers -
Abstracts 2008 (no. 337 - 350)

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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 350
Investigating the structural stability of the Phillips curve relationship
Jan J J Groen and Haroon Mumtaz
(543k)

The reduced-form correlation between inflation and measures of real activity has changed substantially for the main developed economies over the post-WWII period. In this paper we attempt to describe the observed inflation dynamics in the United Kingdom, the United States and the euro area with a sequence of New Keynesian Phillips Curve (NKPC) equations that are log-linearised around different, non-zero, steady-state inflation levels. In doing this, we follow a two-step estimation strategy. First, we model the time variation in the relationship between inflation and a real cost-based measure of activity through a Markov-switching vector autoregressive model. We then impose the cross-equation restrictions of a Calvo pricing-based NKPC under non-zero steady-state inflation and estimate the structural parameters by minimising for each inflation state the distance between the restricted and unrestricted vector autoregressive parameters. The structural estimation results indicate that for all the economies there is evidence for a structurally invariant NKPC, albeit with a significant backward-looking component.

Working Paper No 349
Dealing with country diversity: challenges for the IMF credit union model
Gregor Irwin, Adrian Penalver, Chris Salmon and Ashley Taylor
(985k)

We develop a model in which countries can protect themselves against shocks by subscribing to a credit union that shares the key features of the International Monetary Fund, or by self-insuring through accumulating reserves. We assess the impact of the increasing heterogeneity of the Fund’s membership on the political equilibrium Fund size and hence its effectiveness as a credit union. We find the Fund’s existing lending framework is well suited to a world in which its members have homogeneous interests, but as the membership has become more heterogeneous the Fund is increasingly unlikely to provide financing on a sufficient scale to meet the demands of higher-risk members, leading them to rely more heavily on self-insurance. We conclude that the framework governing the Fund’s lending operations may no longer be appropriate.

Working Paper No 348
The elasticity of substitution: evidence from a UK firm-level data set
Sebastian Barnes, Simon Price and María Sebastiá Barriel
(838k)

Using a panel of UK firms spanning three decades, we provide estimates of the long-run elasticity of substitution between capital and other factors of production, the (negative of the) elasticity of capital and investment with respect to the user cost. The parameter is estimated using 'time averages' (with data differenced over long periods) and pooled mean group panel methods. The robust result is that the elasticity is in the region of 0.4. This is consistent with previous results obtained using aggregate UK data, and is also in line with some recent results using US firm-level data. Estimated returns to scale exceed unity. When constant returns are imposed, the estimated elasticity of substitution is not substantially changed.

Working Paper No 347
Non-linear adjustment of import prices in the European Union
José Manuel Campa, José M González Mínguez and María Sebastiá Barriel
(1.3mb)

This paper focuses on the non-linear adjustment of import prices in national currency to shocks in exchange rates and foreign prices measured in the exporters' currency of products originating outside the euro area and imported into European Union countries (EU-15). The paper looks at three different types of non-linearities: (a) non-proportional adjustment (the size of the adjustment grows more than proportionally with the size of the misalignments), (b) asymmetric adjustment to cost-increasing and cost-decreasing shocks, and (c) the existence of thresholds in the size of misalignments below which no adjustment takes place. There is evidence of more than proportional adjustment towards long-run equilibrium in manufacturing industries. In these industries, the adjustment is faster the further away current import prices are from their implied long-run equilibrium. In contrast, a proportional linear adjustment cannot be rejected for some other imports (especially within agricultural and commodity imports). There is also strong evidence of asymmetry in the adjustment to long-run equilibrium. Deviations from long-run equilibrium due to exchange rate appreciations of the home currency result in a faster adjustment than those caused by a home currency depreciation. Finally, we also find that adjustment takes place in the industries in our sample only when deviations are above certain thresholds, and that these thresholds tend to be somewhat smaller for manufacturing industries than for commodities.

Working Paper No 346
Network models and financial stability
Erlend Nier, Jing Yang, Tanju Yorulmazer and Amadeo Alentorn
(1.1mb)

Systemic risk is a key concern for central banks charged with safeguarding overall financial stability. In this paper we investigate how systemic risk is affected by the structure of the financial system. We construct banking systems that are composed of a number of banks that are connected by interbank linkages. We then vary the key parameters that define the structure of the financial system - including its level of capitalisation, the degree to which banks are connected, the size of interbank exposures and the degree of concentration of the system - and analyse the influence of these parameters on the likelihood of contagious (knock-on) defaults. First, we find that the better capitalised banks are, the more resilient is the banking system against contagious defaults and this effect is non-linear. Second, the effect of the degree of connectivity is non-monotonic, that is, initially a small increase in connectivity increases the contagion effect; but after a certain threshold value, connectivity improves the ability of a banking system to absorb shocks. Third, the size of interbank liabilities tends to increase the risk of knock-on default, even if banks hold capital against such exposures. Fourth, more concentrated banking systems are shown to be prone to larger systemic risk, all else equal. In an extension to the main analysis we study how liquidity effects interact with banking structure to produce a greater chance of systemic breakdown. We finally consider how the risk of contagion might depend on the degree of asymmetry (tiering) inherent in the structure of the banking system. A number of our results have important implications for public policy, which this paper also draws out.

Working Paper No 345
Summary statistics of option-implied probability density functions and their properties
Damien Lynch and Nikolaos Panigirtzoglou
(839k)

The statistics that summarise probability density functions (pdfs) implied from option prices can be used to assess market expectations about future uncertainty, asymmetry and the probability of extreme movements in asset prices. A time-series analysis of these statistics for equity index and interest rate markets provides some stylised facts about the behaviour of these elements of market expectations, their historical distribution, similarity and relative stability. Relationships between them and movements in underlying asset prices are considered. Cross-asset and cross-country comparisons and the information content of the implied pdfs for future macroeconomic and financial variables are also assessed.

Working Paper No 344
International monetary co-operation in a world of imperfect information
Kang Yong Tan and Misa Tanaka
(397k)

This paper examines the welfare implications of international monetary co-operation using a stylised two-country New Keynesian general equilibrium model of imperfect information. We show that setting a self-oriented monetary policy rule generally leads to welfare gains relative to passive monetary policy even when central banks do not have perfect information about the foreign economy. However, information sharing between central banks in this set-up, by itself, has ambiguous welfare implications. Gains from monetary co-ordination are largest when productivity shocks are negatively correlated across countries.

Working Paper No 343
Efficient frameworks for sovereign borrowing
Gregor Irwin and Gregory Thwaites
(1.5mb)

This paper presents a theoretical model of strategic default to assess how national and international policymakers should seek to influence the cost of default and the distribution of bargaining power in the event of a default. We find that, in the absence of restrictions on the parameter space, deadweight costs of default should be driven to zero. Moreover, if the debtor is risk-averse, there is an optimal division of bargaining power between the debtor and its creditors. Even with restrictions on the parameter space, marginally lower deadweight costs, possibly in some combination with greater creditor bargaining power, can always raise social welfare ex ante. However, once debt has been contracted, the debtor's trade-off between creditor bargaining power and deadweight costs changes fundamentally. In equilibrium, the deadweight costs of default may therefore tend to be too high, and the allocation of bargaining power inefficiently skewed towards the debtor. The challenge for policymakers is to find credible, time-consistent combinations of policies that can both reduce deadweight costs and shift bargaining power towards creditors.

Working Paper No 342
That elusive elasticity and the ubiquitous bias: is panel data a panacea?
James Smith
(395k)

There is often assumed to be a unit elasticity of substitution between capital and labour. But estimates based on neoclassical capital demand equations frequently find a smaller value. Recent time-series work for the United States and Canada has suggested that, once the biases inherent in estimating cointegrating vectors are properly accounted for, the elasticity could indeed be close to 1. This paper investigates this possibility for the United Kingdom. First the analysis considers aggregate data where the estimated elasticity is close to 0.4. Then a unique industry-level data set for the United Kingdom is exploited in order to further pinpoint the estimated elasticity. Estimates using dynamic panel data methods are close to those from aggregate data, providing a robust statistical rejection of a unit elasticity in UK data.

Working Paper No 341
Evolving international inflation dynamics: evidence from a time-varying dynamic factor model
Haroon Mumtaz and Paolo Surico
(657k)

Several industrialised countries have had a similar inflation experience in the past 30 years, with inflation high and volatile in the 1970s and the 1980s but low and stable in the most recent period. We explore the dynamics of inflation in these countries via a time-varying factor model. This statistical model is used to describe movements in inflation that are idiosyncratic or country specific and those that are common across countries. In addition, we investigate how comovement has varied across the sample period. Our results indicate that there has been a decline in the level, persistence and volatility of inflation across our sample of industrialised countries. In addition, there has been a change in the degree of comovement, with the level and persistence of national inflation rates moving more closely together since the mid-1980s.

Working Paper No 340
Financial innovation, macroeconomic stability and systemic crises
Prasanna Gai, Sujit Kapadia, Stephen Millard and Ander Perez
(1mb)

We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and captures the spillovers associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, these spillovers can potentially generate a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past, but potentially more severe.

Working Paper No 339
The integrated impact of credit and interest rate risk on banks: an economic value and capital adequacy perspective
Mathias Drehmann, Steffen Sorensen and Marco Stringa
(898k)

Credit and interest rate risk in the banking book are the two most important risks faced by commercial banks. In this paper we derive a consistent and general framework to measure the integrated impact of both risks on banks' portfolios. The framework accounts for all sources of credit risk and interest rate risk. By modelling the whole portfolio of a bank and by taking account of the repricing characteristics of all exposures, we can assess the impact of credit and interest rate risk not only on the bank's economic value but also on its future earnings and capital adequacy. We apply our framework to a hypothetical bank in normal and stressed conditions. The simulation highlights that it is fundamental to measure the impact of interest rate and credit risk jointly. We also show that it is crucial to model the whole portfolio, including the repricing and maturity characteristics of assets, liabilities and off balance sheet items.

Working Paper No 338
Monetary policy shifts and inflation dynamics
Paolo Surico
(470k)

The New Keynesian Phillips Curve plays a central role in modern macroeconomic theory. A vast empirical literature has estimated this structural relationship over various post-war full samples. While it is well known that in a standard sticky price model a 'weak' central bank response to inflation generates sunspot fluctuations, the consequences of pooling observations from different monetary policy regimes for (i) the estimates of the structural Phillips curve and (ii) the estimates of inflation persistence had not been investigated. Using Monte Carlo simulations from a purely forward-looking model, this paper shows that indeterminacy can introduce a sizable persistence in the process of inflation. On the reduced form, our results show that inflation persistence can be endogenous to the policy regime rather than intrinsic to the structure of the economy. On the structural form, we find that by neglecting equilibrium indeterminacy the estimates of the forward-looking term of the New Keynesian Phillips Curve are biased downward. The implications are in line with the empirical evidence for the United Kingdom and United States.

Working Paper No 337
Risks and efficiency gains of a tiered structure in large-value payments: a simulation approach
Ana Lasaosa and Merxe Tudela
(134k)

The large-value payment system in the United Kingdom (CHAPS) is highly tiered: a few settlement banks make payments on behalf of many customer banks. This paper makes use of a simulation approach to quantify by how much tiering affects, on the one hand, concentration and credit risk and, on the other, the liquidity needs of CHAPS. We do so by creating scenarios where current settlement banks become customer banks and thus we increase the degree of tiering. The results show that concentration risk would rise substantially in what is already a highly concentrated system. As for credit risk, the size of intraday exposures compared with settlement banks' capital is very small and therefore the likelihood of contagion remote. More importantly, the increase in credit risk brought to the system by settlement banks leaving CHAPS bears little relationship to the values settled by each individual bank. We find that increasing the degree of tiering in CHAPS leads to substantial liquidity savings - although the liquidity saved is only a fraction of the spare liquidity currently posted in the system. Most of the savings are due to liquidity pooling rather than to internalisation of payments. There is a strong relationship between changes in values settled and liquidity needs. This relationship can be used to forecast the impact on liquidity needs if more banks were to join CHAPS. The quantification of the trade-off between risk and efficiency in different scenarios provides policymakers with a useful analytical framework for analysing the effects of tiering.