Bank of England Working Papers - Abstracts 2010 (no. 379 - 400)

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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 400
Liquidity-saving mechanisms and bank behaviour
Marco Galbiati and Kimmo Soramäki
(939k)

This paper investigates the effect of liquidity-saving mechanisms (LSMs) in interbank payment systems. We model a stylised two-stream payment system where banks choose (a) how much liquidity to post and (b) which payments to route into each of two ‘streams’: the RTGS stream, and an LSM stream. Looking at equilibrium choices we find that, when liquidity is expensive, the two-stream system is more efficient than the vanilla RTGS system without an LSM. This is because the LSM achieves better co-ordination of payments, without introducing settlement risk. However, the two-stream system still only achieves a second-best in terms of efficiency: in many cases, a central planner could further decrease system-wide costs by imposing higher liquidity holdings, and without using the LSM at all. Hence, the appeal of the LSM resides in its ability to ease (but not completely solve) strategic inefficiencies stemming from externalities and free-riding. Second, ‘bad’ equilibria too are theoretically possible in the two-stream system. In these equilibria banks post large amounts of liquidity and at the same time overuse the LSM. The existence of such equilibria suggests that some co-ordination device may be needed to reap the full benefits of an LSM. In all cases, these results are valid for this particular model of an RTGS payment system and the particular LSM.

Working Paper No 399
Liquidity costs and tiering in large-value payment systems
Mark Adams, Marco Galbiati and Simone Giansante
(770k)

This paper develops and simulates a model of the emergence of networks in an interbank, RTGS payment system. A number of banks, faced with random streams of payment orders, choose whether to link directly to the payment system, or to use a correspondent bank. Settling payments directly on the system imposes liquidity costs which depend on the maximum liquidity overdraft incurred during the day. On the other hand, using a correspondent entails paying a flat fee, charged by the correspondent to recoup liquidity costs and to extract a profit. We specify a protocol whereby one bank in each period can revisit its choice whether to link directly to the system, or to become clients of other banks, thus generating a dynamic client-correspondent network. We simulate this protocol, observing the emergence of different network structures. The liquidity pricing regime chosen by a central bank is found to affect the tiering process and the network structures it produces. A calibration exercise on data from the UK CHAPS system suggests that the model is able to generate realistic predictions, ie a network topology similar to that observed in reality, driven solely by the underlying pattern of payments and the structure of liquidity costs.

Working Paper No 398
The sterling unsecured loan market during 2006-08: insights from network theory
Anne Wetherilt, Peter Zimmerman and Kimmo Soramäki
(870k)

We model the unsecured overnight market in the United Kingdom as a network of relationships and examine how the structure has changed over the recent period of crisis. Using established network techniques, we find strong evidence of the existence of a core of highly connected banks alongside a periphery. We find that membership of this core expanded during the crisis and suggest that this is due to a few intermediate banks becoming more connected. The widened reserve target bands may have also had an effect, by partially alleviating the need to manage reserve accounts close to a target and therefore allowing banks to exercise more discretion in forming relationships. However, there is an asymmetry between borrowers and lenders in the overnight market, with borrowers more reliant on the most established of the core banks during the crisis.

Working Paper No 397
Evolving macroeconomic dynamics in a small open economy: an estimated Markov-switching DSGE model for the United Kingdom
Philip Liu and Haroon Mumtaz
(737k)

This paper carries out a systematic investigation into the possibility of structural shifts in the UK economy using a Markov-switching dynamic stochastic general equilibrium (DSGE) model. We find strong evidence for shifts in the structural parameters of several equations of the DSGE model. In addition, our results indicate that the volatility of structural shocks has also changed over time. However, a version of the model that allows for a change in the coefficients of the Taylor rule and shock volatilities provides the best model fit. Estimates from the selected DSGE model suggest that the mid-1970s were associated with a regime characterised by a smaller reaction by the monetary authorities to inflation developments.

Working Paper No 396
Using estimated models to assess nominal and real rigidities in the United Kingdom
Gunes Kamber and Stephen Millard
(505k)

This paper aims to contribute to our understanding of inflation dynamics in the United Kingdom by estimating two dynamic stochastic general equilibrium models and assessing the role of nominal and real rigidities within them. We first obtain an empirical representation of the monetary transmission mechanism in the United Kingdom and then estimate the models by minimising the difference between this representation and its model equivalents. We find that both models can explain the data reasonably well without relying on undue amounts of price and wage stickiness.

Working Paper No 395
New insights into price-setting behaviour in the United Kingdom
Jennifer Greenslade and Miles Parker
(853k)

It is important to understand how companies set prices, since price-setting behaviour plays a key role in the monetary policy transmission mechanism. Many surveys have been conducted in a range of countries to shed light on this issue by asking companies directly about how they set prices. This paper reviews the results of a new survey of the price-setting behaviour by the Bank of England of around 700 UK firms. In terms of how companies set prices, the survey evidence supported the use of the mark-up over costs form of pricing. Firms reviewed prices more frequently than actually changing them, with the median firm changing price only once per year, but the frequency with which companies changed their prices varied considerably across sectors. Over the past decade a significant number of firms had increased the frequency of price changes. Different factors influenced price rises and price falls. Higher costs – in particular, labour costs and raw materials – were the most important driver behind price rises, whereas lower demand and competitors' prices were the main factor resulting in price falls. Nearly half of firms changed their prices within three months of an increase in costs or a fall in demand.

Working Paper No 394
How do individual UK producer prices behave?
Philip Bunn and Colin Ellis
(389k)

This paper examines the behaviour of individual producer prices in the United Kingdom, and uncovers a number of stylised facts about pricing behaviour. First, on average 26% of producer prices change each month, although there is considerable heterogeneity between sectors and price changes occur less frequently when measured by the average for individual products. Second, the probability of price changes is not constant over time: prices are most likely to change one, four and twelve months after they were previously set. Third, the distribution of price changes is wide, although a significant number of changes are relatively small and close to zero. Fourth, prices that change more frequently tend to do so by less. And fifth, price changes are much less persistent at the disaggregated level than aggregate inflation data imply. We find that conventional pricing theories struggle to match these results, particularly the marked heterogeneity.

Working Paper No 393
The financial market impact of quantitative easing
Michael Joyce, Ana Lasaosa, Ibrahim Stevens and Matthew Tong
(748k)

As part of its response to the global banking crisis and a sharp downturn in domestic economic prospects, the Bank of England' s Monetary Policy Committee (MPC) began a programme of large-scale asset purchases (commonly referred to as quantitative easing or QE) in March 2009, with the aim of injecting additional money into the economy and so increasing nominal spending growth to a rate consistent with meeting the CPI inflation target in the medium term. By February 2010, the MPC had made £200 billion of purchases, most of which had been of UK government securities (gilts). Based on analysis of the reaction of financial market prices and econometric estimates, this paper attempts to assess the impact of the Bank' s QE policy on asset prices. Our estimates of the reaction of gilt prices to the programme suggest that QE may have depressed gilt yields by about 100 basis points. On balance the evidence seems to suggest that the largest part of the impact of QE came through a portfolio rebalancing channel. The wider impact on other asset prices is more difficult to disentangle from other influences: the initial impact was muted but the overall effects were potentially much larger, though subject to considerable uncertainty.

Working Paper No 392
Time-varying inflation expectations and economic fluctuations in the United Kingdom: a structural VAR analysis
Alina Barnett, Jan J J Groen and Haroon Mumtaz
(2.1mb)

This paper examines how the interaction between inflation expectations and nominal and real macroeconomic variables has evolved for the United Kingdom over the post-WWII period until 2007. We model time-variation through a Markov-switching structural vector autoregressive framework with variants of the sign restriction identification scheme to back out the time-varying effect of different structural shocks. We investigate the following questions: (i) How has the impact of the mix of real and nominal shocks on the UK economy evolved over time and did this have a specific impact on UK inflation expectations? and (ii) Has there been an autonomous impact of inflation expectations on the UK economy and has it changed over time? Our results suggest that shocks to inflation expectations had important effects on actual inflation in the 1970s, but this impact had significantly declined towards the end of our sample. This seems to be mainly due to a relatively slower response of monetary policy to these shocks in the 1970s compared to later years. Similarly, oil price shocks and real demand shocks led to important changes in macroeconomic variables in the 1970s. Beyond that period and up to the end of our sample oil price shocks became less significant for the dynamics of actual inflation and output growth. However real demand shocks became a relatively more important determinant for fluctuations in those series during the 1990s and the beginning of the 2000s. The changing response of monetary policy to this type of shock appears to be crucial for this result.

Working Paper No 391
Deep habits and the cyclical behaviour of equilibrium unemployment and vacancies
Federico di Pace and Renato Faccini
(239k)

We extend the standard textbook search and matching model by introducing deep habits in consumption. The cyclical fluctuations of vacancies and unemployment in our model can replicate those observed in the US data, with labour market tightness being 20 times more volatile than consumption. Vacancies display a hump-shaped response to technology shocks as well as autocorrelation coefficients that are in line with the empirical evidence. Our model preserves the assumption of fully flexible wages for the new hires and the calibration is consistent with the estimated elasticity of unemployment to unemployment benefits. The numerical simulations generate an artificial Beveridge curve which is in line with the data.

Working Paper No 390
Technology shocks, employment and labour market frictions
Federico S Mandelman and Francesco Zanetti
(839k)

Recent empirical evidence suggests that a positive technology shock leads to a decline in labour inputs. However, the standard real business model fails to account for this empirical regularity. Can the presence of labour market frictions address this problem, without otherwise altering the functioning of the model? We develop and estimate a real business cycle model using Bayesian techniques that allows, but does not require, labour market frictions to generate a negative response of employment to a technology shock. The results of the estimation support the hypothesis that labour market frictions are the factor responsible for the negative response of employment.

Working Paper No 389
Liquidity-saving mechanisms in collateral-based RTGS payment systems
Marius Jurgilas and Antoine Martin
(308k)

This paper studies banks' incentives regarding the timing of payment submissions in a collateral-based RTGS payment system and how these incentives change with the introduction of a liquidity-saving mechanism (LSM). We show that an LSM allows banks to economise on collateral while also providing incentives to submit payments earlier. This is because in our model an LSM allows payments to be matched and offset in real time without any or very minimal funds. Under a collateral-based RTGS payment system, introduction of the LSM always improves welfare. The result contrasts with earlier work, which shows that under a fee-based RTGS system, the introduction of an LSM in some circumstances may reduce welfare.

Working Paper No 388
An economic capital model integrating credit and interest rate risk in the banking book
Piergiorgio Alessandri and Mathias Drehmann
(565k)

Banks often measure credit and interest rate risk separately and then add the two risk measures to determine their overall economic capital. This approach misses complex interactions between the two risks. We develop a framework where credit and interest rate risks are analysed jointly. We focus on a traditional banking book where all positions are held to maturity and subject to book value accounting. Our simulations show that interactions between risks matter, and that their implications depend on the structure of the balance sheet and on the repricing characteristics of assets and liabilities. The analysis suggests that a joint analysis of risks can deliver substantially different results relative to a piece-wise approach: risk integration is challenging but feasible and worthwhile.

Working Paper No 387
Shocks to bank capital: evidence from UK banks at home and away
Nada Mora and Andrew Logan
(785k)

This paper assesses how shocks to bank capital may influence a bank's portfolio behaviour using novel evidence from a UK bank panel data set from a period that pre-dates the recent financial crisis. Focusing on the behaviour of bank loans, we extract the dynamic response of a bank to innovations in its capital and in its regulatory capital buffer. We find that innovations in a bank's capital in this (pre-crisis) sample period were coupled with a loan response that lasted up to three years. Banks also responded to scarce regulatory capital by raising their deposit rate to attract funds. The international presence of UK banks allows us to identify a specific driver of capital shocks in our data, independent of bank lending to UK residents. Specifically, we use write-offs on loans to non-residents to instrument bank capital's impact on UK resident lending. A fall in capital brought about a significant drop in lending in particular, to private non-financial corporations. In contrast, household lending increased when capital fell, which may indicate that – in this pre-crisis period – banks substituted into less risky assets when capital was short.

Working Paper No 386
Evolving UK macroeconomic dynamics: a time-varying factor augmented VAR
Haroon Mumtaz
(559k)

Changes in monetary policy and shifts in dynamics of the macroeconomy are typically described using empirical models that only include a limited amount of information. Examples of such models include time-varying vector autoregressions that are estimated using output growth, inflation and a short-term interest rate. This paper extends these models by incorporating a larger amount of information in these tri-variate VARs. In particular, we use a factor augmented vector autoregression extended to incorporate time-varying coefficients and stochastic volatility in the innovation variances. The reduced-form results not only confirm the finding that the great stability period in the United Kingdom is characterised by low persistence and volatility of inflation and output but also suggest that these findings extend to money growth and asset prices. The impulse response functions display little evidence of a price puzzle indicating that the extra information incorporated in our model leads to more robust structural estimates.

Working Paper No 385
Imperfect credit markets: implications for monetary policy
Gertjan W Vlieghe
(447k)

I develop a model for monetary policy analysis that features significant feedback from asset prices to macroeconomic quantities. The feedback is caused by credit market imperfections, which dynamically affect how efficiently labour and capital are being used in aggregate. I then analyse what implications this mechanism has for monetary policy. The paper offers three insights. First, the monetary transmission mechanism works not only via nominal rigidities but also via a reallocation of productive resources away from the most productive agents. Second, following an adverse productivity shock there is a dynamic trade-off between the immediate fall in output, which is an efficient response to the productivity fall, and the fall in output thereafter, which is caused by a reallocation of resources away from the most productive agents. The more the initial output fall is dampened with a temporary rise in inflation, the more the adverse future effects of the reallocation of resources are mitigated. Third, in a full welfare-based analysis of optimal monetary policy I show that it is optimal to have some inflation variability, even if the only shocks in the economy are productivity shocks. The optimal variability of inflation is small, but the costs of stabilising inflation too aggressively can be large.

Working Paper No 384
The geographical composition of national external balance sheets: 1980-2005
Chris Kubelec and Filipa Sá
(2.6mb)

This paper constructs a data set on stocks of bilateral external assets and liabilities for a group of 18 countries, including developed and emerging economies. The data set covers the years 1980 to 2005 and distinguishes between four asset classes: foreign direct investment, portfolio equity, debt, and foreign exchange reserves. A number of stylised facts emerge from it. There has been a remarkable increase in interconnectivity over the past two decades. Financial links have become larger and more frequent and countries have become more open. The global financial network is centred around a small number of nodes, which have many and large links. In addition, the network exhibits ‘small-world' properties, such as high clustering and low average path length. The combination of high interconnectivity, a small number of hubs, and ‘small-world' properties makes for a robust-yet-fragile system, in which disturbances to the key hubs would be rapidly and widely transmitted. The global financial network is centred around the United States and the United Kingdom, which have large links and are connected to most other countries. This contrasts with the global trade network, which is arranged in three clusters: a European cluster (centred on Germany), an Asian cluster (centred on China), and an American cluster (centred on the United States).

Working Paper No 383
Contagion in financial networks
Prasanna Gai and Sujit Kapadia
(766k)

This paper develops an analytical model of contagion in financial networks with arbitrary structure. We explore how the probability and potential impact of contagion is influenced by aggregate and idiosyncratic shocks, changes in network structure, and asset market liquidity. Our findings suggest that financial systems exhibit a robust-yet-fragile tendency: while the probability of contagion may be low, the effects can be extremely widespread when problems occur. And we suggest why the resilience of the system in withstanding fairly large shocks prior to 2007 should not have been taken as a reliable guide to its future robustness.

Working Paper No 382
Time-varying dynamics of the real exchange rate. A structural VAR analysis
Haroon Mumtaz and Laura Sunder-Plassmann
(2.2mb)

The aim of this paper is to explore the evolution of real exchange rate dynamics over time. We use a time-varying structural vector autoregression to investigate the role of demand, supply and nominal shocks and consider their impact on, and contribution to fluctuations in, the real exchange rate, output growth and inflation in four major economies over the past four decades. Our analysis therefore extends recent empirical research on evolving macroeconomic dynamics which has primarily focused on inflation and output and the time-varying impact of monetary policy on these variables. In addition we generalise recent VAR studies on exchange rate dynamics where the analysis is limited to a time-invariant setting. Our main results are as follows. The transmission of demand, supply and nominal shocks to the real exchange rate, output and inflation has changed substantially over time. Demand shocks have a larger impact on the real exchange rate after the mid-1980s for the United Kingdom, euro area and Japan and after the mid-1990s for Canada. Nominal shocks had a larger impact on output and inflation during the 1970s relative to the recent past. The forecast error variance of the real exchange rate is explained mainly by demand shocks with a smaller role for nominal shocks.

Working Paper No 381
All together now: do international factors explain relative price comovements?
Özer Karagedikli, Haroon Mumtaz and Misa Tanaka
(773k)

Recent research has found evidence of increasing comovement in CPI inflation rates across industrialised countries. This paper considers whether this can be attributed to greater global integration of product markets. To examine this question, we build a data set of 28 matched product category price indices for fourteen advanced economies for 1998 Q1 to 2008 Q2, and decompose the inflation rates into a world factor, country-specific factors, and category-specific factors using a Bayesian dynamic factor model with Gibbs sampling. We find that the category-specific factors account for a large part of the comovement in the prices of goods which are intensive in internationally traded primary commodities; but this is less evident for other traded goods. We also find that both the world factor and the category-specific factors become more significant in explaining the movement in the relative prices in the second half of our sample.

Working Paper No 380
Evaluating and estimating a DSGE model for the United Kingdom
Richard Harrison and Özlem Oomen
(1.6mb)

We build a small open economy dynamic stochastic general equilibrium model, featuring many types of nominal and real frictions that have become standard in the literature. In recent years it has become possible to estimate such models using Bayesian methods. These exercises typically involve augmenting a stochastically singular model with a number of shocks to structural equations to make estimation feasible, even though the motivation for the choice of these shocks is often unspecified. In an attempt to put this approach on a more formal basis, we estimate the model in two stages. First, we evaluate a calibrated version of the stochastically singular model. Then, we augment the model with structural shocks motivated by the results of the evaluation stage and estimate the resulting model using UK data using a Bayesian approach. Finally, we reassess the adequacy of this augmented and estimated model in reconciling the dynamics of the model with the data. Our findings suggest that the shock processes play a crucial role in helping to match the data.

Technical Annex to accompany Working Paper No. 380 (910k)

Working Paper No 379
Household debt, house prices and consumption in the United Kingdom: a quantitative theoretical analysis
Matt Waldron and Fabrizio Zampolli
(815k)

Household debt and house prices in the United Kingdom rose substantially between 1987 and 2006. In this paper we use a calibrated overlapping generations model of the household sector to examine the extent to which changes in demographics, lower inflation, and a lower long-run real interest rate may explain the build-up of debt and the rise in house prices over that period. Our model suggests that lower real interest rates were particularly important. If households expected lower real interest rates to persist, then the model can more than explain the rise in debt and can explain most of the rise in house prices. However, the model leaves a puzzle because it predicts that an unanticipated fall in real interest rates should lead to a consumption boom that did not materialise in the data.