Bank of England Working Papers -
Abstracts 1993 (no. 6-21)
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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 21 (oop)
“An Empirical Analysis
of M4 in the United Kingdom”
by Paul Fisher and Juna Vega
This paper presents some econometric modelling of M4 balances. It extends earlier Bank research on M4 by looking separately at personal and corporate holdings of money, and applies some recent advances in econometric methodology.
The results confirm the importance of sectoral analysis. The results are especially encouraging for the personal sector where a significant role is found for wealth, interest rates and inflation. More surprising is the finding that simultaneous estimation of money demand and a consumption function improves both specification - the dynamic interaction of money and consumption may have an important role to play in explaining the recent behaviour of both variables.
Corporate sector analysis is more problematic. The analysis and empirical results both suggest that interest rates must be explained simultaneously with corporate sector M4 balances. But no stable model of interest rates is found. Nevertheless a relatively simple model can be estimated for corporate sector M4.
The results suggest that the effects of financial liberalisation can be captured by a combination of wealth and interest rate differentials. To the extent that wealth/income ratios become more stable, M4 velocity may also stabilise in the future.
Working Paper No 20
“M0:
Causes and Consequences”
by Francis Breedon and Paul Fisher
This paper analyses four aspects of the determination and effects of M0 using annual, quarterly and monthly data. First it analyses the issue of the correct scale variable for determining M0. A combination of survey evidence and statistical tests indicate that retail sales is the most appropriate scale variable to use in looking at M0.
Second, the paper looks at the best way to explain the trend in M0 velocity. It confirms earlier results showing that a cumulative interest rate term gives an adequate representation of the trend and is better than a linear time trend for this purpose.
Third, the paper looks at the short-run interest-elasticity of demand for M0. It finds that this elasticity is highly variable across models and suggests that the analysis of M0 is problematic following substantial changes in interest rates.
Lastly, and probably most controversially, it looks at the leading indicator of properties in M0 for inflation. It finds that these are particularly robust and cannot be matched simply by the product of the explanatory terms in the M0 equation. Although this result is implicit in previous work done in the Bank (eg 'VAR models of inflation' Bank of England Quarterly Bulletin, May 1993) this paper makes an explicit empirical link between M0 and inflation.
Working Paper No 19 (oop)
“The
Effect of Futures Trading on Cash Market Volatility: Evidence from the London
Stock Exchange”
by Gary Robinson
The stock market crash of October 1987 and the growing importance of index arbitrage and portfolio insurance helped to focus the attention of academics, practitioners and regulators on the possibly destabilising role of equity index futures on the underlying cash market. Although theoretical evidence on this question is somewhat ambiguous, empirical evidence, relating particularly to US markets, has been less equivocal: typically, no significant effect of futures trading has been found. This paper presents an analysis of daily stock price volatility on the London Stock Exchange for the period 1980-93. The measure of volatility produced is appropriate, given the distribution of returns and the time-varying nature of stock price volatility, and changes in monetary policy regime. The impact of futures on stock price volatility is measured within an augmented ARCH framework and the principal result is striking: rather than increasing volatility, index futures contracts are found to have reduced volatility significantly by around 17%.
Working Paper No 18 (oop)
“Interest rates and the channels of monetary transmission: some
sectoral estimates”
by Spencer Dale and Andrew Haldane
The monetary transmission mechanism describes the channels through which changes in monetary policy affect the policy target, price inflation. Understanding the transmission mechanism is thus central to the successful conduct of monetary policy.
This paper uses a Vector AutoRegressive (VAR) methodology to uncover a number of stylised features of the monetary transmission process in the UK. In particular, close attention is paid to the role played by money and credit as intermediate channels. The possibility that the transmission mechanism may differ across sectors is allowed for by estimating separate VARs for the personal and corporate sectors.
Three policy conclusions emerge. First, as suggested by Classical theory, monetary policy is output neutral over the longer term. Second, the lags between changes in monetary policy and its effect upon prices are lengthy (at least 18 months). And third, that aggregate measures of money and credit may provide blurred signals of the impact of monetary policy in final variables. Sectoral measures of bank deposits (for companies) and bank credit (for persons) provide the more timely intermediate indicators.
Working Paper No 17 (oop)
“Interest rate control in a model of monetary policy”
by Spencer Dale and Andrew Haldane
A monetary economy comprises a vast array of market-clearing interest rates. Central banks exert a direct influence over only a narrow subset of these rates: the rate at which they supply marginal funds to the commercial banking system. Accordingly, the market interest rates which impinge upon real activity are typically distinct form - though not independent of - the official interest rate.
This paper develops a formal model of the interactions between the central bank, commercial banks and the non-bank private sector. This model is then used to analyse the relationship between the official interest rate and 'other' market rates. Some illustrative evidence on the extent of the imperfection in the UK authorities' interest rate control is also considered.
Two policy conclusions emerge. First, the authorities must understand the nature of the feed-through of official interest rates into market rates when deciding on the appropriate level of the monetary instrument. Second, the possibility that interest rates may not all move perfectly in line, implies that policy-makers and commentators alike need to be conscious of this plurality of interest rates when assessing the overall tightness or looseness of monetary conditions.
Working Paper No 16 (oop)
“The
Statistical Distribution of Short-Term Libor Rates Under Two Monetary
Regimes”
by Bahram Pesaran and Gary Robinson
The paper presents a statistical analysis of sterling libor interest rates in two monetary regimes: free-floating of sterling prior to ERM-entry, and the recent ERM regime. It is found that short-term libor rates follow a random walk with time-varying volatility and with interest rate changes drawn from a distribution with fat tails, (sic). The nature of interest rate changes is sensitive to monetary regime: interest rate changes in the pre-ERM regime are drawn from a distribution with much faster tails than for the ERM regime.
These statistical characterisations of libor rates are inconsistent with existing models for pricing interest rate and bond options, which assume either that interest rates follow a random walk with constant volatility, or that interest rates are mean-reverting.
Working Paper No 15 (oop)
“Tradable and non-tradable prices in the UK and EC: measurement and
explanation”
by C L Melliss
A market divergence in inflation rates between the tradables and non-tradables sectors has been a feature of some EC economies, especially those of Italy, Spain and the UK, since the early 1980s. Sectoral productivity differences, international competitive pressures - perhaps linked to ERM membership, and government demand for non tradables are possible reasons. Empirical estimates of sectoral price equations are presented for the UK, using especially constructed RPI-based series. Competing import prices, unit labour costs, and input prices are found to be the main determinants of tradable prices. For non-tradables government demand is important. Tests show that tradable prices Granger-cause non-tradable prices in France, Germany and Italy as well as the UK.
Working Paper No 14 (oop)
“House prices, arrears and possessions: A three equation model for the
UK”
by F J Breedon and M A S Joyce
The current slump in the UK housing market has coincided with record increases in mortgage arrears and possessions. Falling nominal house prices reduce the amount of unwithdrawn equity in housing and, under certain conditions, provide incentives for borrowers to accumulate arrears and for lenders to possess. However, possessions may themselves depress house prices. This paper attempts to analyse and quantify these interactions by estimating a three equation econometric model of UK mortgage arrears, possessions and house prices, in which expectations of future house prices are formed according to the rational expectations hypothesis. The model is simulated to examine the implications of interest rate changes and policies to reduce possessions.
Working Paper No 13 (oop)
“Temporary cycles or volatile trends? Economic fluctuations in 21 OECD
economies”
by Gabriel Sterne and Tamim Bayoumi
Whether it is feasible to use various types of economic policy measures to reduce fluctuations in economic activity will depend on the source of the fluctuations. In particular, policy should respond in different ways to transitory disturbances to aggregate demand and more permanent shifts in aggregate supply.
The paper uses small structural vector autoregressions (VARs) to distinguish between these two types of disturbances. The models utilise price and output data in each of 21 OECD economies.
The results indicate the supply and demand disturbances are of roughly equal importance in explaining fluctuations in growth and inflation across this wide range of economies. This supports the view that economic fluctuations cannot be characterised as a cyclical changes around a fixed trend (the Keynesian synthesis) or as continual movements in underlying supply potential (a view of real business cycle theorists). Rather, they are an amalgam of both effects. Amongst the G7 economies, demand shocks have the greatest effect on output in the UK and US, and weakest in Japan and Germany. These results support the general view of activeness of government policy in these countries and provide little evidence of successful stabilisation.
A method of distinguishing the effects of output and inflation on each type of disturbance is then outlined. This makes it possible to measure 'supply potential' for each economy; there is evidence of a steady decline in the rate of increase in supply potential over time, a view consistent with the 'catch up' theory of post-war economic growth.
Working Paper No 12 (oop)
“Regional Trading Blocs, Mobile Capital and Exchange Rate
Co-ordination”
by Gabriel Sterne and Tamim Bayoumi
Two recent issues in the world economy have been the emergence of regional trade blocs and the increasing extent of international financial deregulation. Direction of trade data are used to look at the evolution of regional trade patterns in Europe, North America and East Asia, and saving investment data are used to examine the extent of international capital mobility. The results indicate some trend toward increasing regional insularity of trade together with increasing international capital mobility. The policy implications of these trends are then discussed.
Working Paper No 11 (oop)
“Tax
Specific Term Structures of Interest Rates in the UK Government Bond
Market”
by Andrew Derry and Mahmood Pradhan
Coupon income and capital gain on UK Government bonds are taxed differently, so some investors do not regard all bonds as perfect substitutes. This paper examines the extent to which term structures of interest rates derived from the UK bond market are tax specific, using a linear programming technique to select the optimal portfolios for investors facing different tax treatment. Despite the tax reforms of the mid-nineteen eighties - designed to reduce arbitrage opportunities in the gilts market - divergences between yield curves of the main categories of tax payers are found to remain.
Working Paper No 10 (oop)
“The
effect of changes in official UK rates on market interest rates since
1987”
by Spencer Dale
It is widely accepted that a central bank, such as the Bank of England, has the ability to control very short-term interest rates. Moreover, a number of studies have documented the very close relationship between Bank-administered rates (notably the Band 1 stop rate) and their market analogues. This paper investigates the extent to which the Bank is able to influence market interest rates more generally, as opposed to just very short-term interest rates, by analysing the reaction of market interest rates to the thirty movements in the Bank's Band 1 stop rate between the beginning of 1987 and July 1991. The movements of interest rates at seven different maturities (1, 3, 6 and 12-months and 5, 10 and 20-years) were considered.
The results suggest that changes in the Bank of England's Band 1 stop rate lead to significant responses in market interest rates ranging in maturity from 1-month to 5-years. These findings are supportive of the proposition that longer maturity rates are influenced by expectations of the future path of short rates, and hence in part by the current level of official rates. In addition, there was evidence of systematic movements in money market interest rates both in the days leading up to the policy change and, more surprisingly, on the day immediately following the changes.
Finally, preliminary estimates suggest that the reaction of market rates increases when the change in interest rates coincides with a switch in the direction of these official changes. This may reflect the markets' recognition that when the direction of interest rate changes has just switched, the probability that this change will be reversed in the near future is lessened.
Working Paper No 9 (oop)
“Divisia Indices for Money: An Appraisal of Theory and Practice”
by Paul Fisher, Suzanne Hudson and Mahmood Pradhan
Increasing interest has been shown in recent years in index number measures of money which weight the different components within each monetary aggregate. An assessment of Divisia measures of money including an appraisal of the theoretical arguments for the Divisia approach to monetary aggregation is presented. Also the construction of a Divisia index for the United Kingdom is described and the potential relevance of Divisia for the assessment of monetary conditions discussed.
Working Paper No 8 (oop)
“Bank
Credit Risk”
by E P Davis
The paper evaluates the contribution industrial-sector data on loan losses could make to diversifying and pricing bank risk.
It derives the mean, variance and cyclical sensitivity of sectoral provisions and write offs, then assesses implications for loan pricing; standards of capital adequacy; risk borne by sectorally-concentrated banks; and bank risk over time. Complementary econometric estimates for aggregate losses highlight the role of corporate gearing and rapid balance sheet growth.
It is suggested all banks should collect and employ sectoral loss data, and the analysis could be borne in mind for any future renegotiation of the Basle Accord.
Working Paper No 7 (oop)
“A
simple model of money, credit and aggregate demand”
by Spencer
Dale and Andrew Haldane
The paper presents a theoretical model of how banks and the non-bank private sector respond to changes in monetary policy. Unlike many textbook models in which banks play no active role, the banking sector is recognised here as playing a key part in transmitting changes in monetary policy to the real economy.
In a conventional IS/LM model the impact of a change in monetary policy arises from the response of expenditure to changes in interest rates (the "monetary" channel). If, however, bank and non-bank sources of credit are not perfect substitutes (for example because some borrowers have only limited access to capital markets) then changes in monetary policy could also have an effect through their impact on the availability or the relative price of bank credit (a "credit" channel). The paper sets out the conditions under which this credit channel reinforces or weakens the impact of changes in monetary policy on the behaviour of the non-bank private sector.
One example of the case where the credit channel could weaken the impact of changes in monetary policy would be where banks do not pass on changes in official interest rates fully or immediately to some of their customers. In this context the paper acknowledges the results of the two Bank studies of bank lending to small businesses.
Working Paper No 6 (oop)
“An
investigation of the effect of funding on the slope of the yield
curve”
by D M Egginton and S G Hall
Market practitioners often have a firm view that funding operations have clearly observable effects on the slope of the yield curve. The standard theory of the expectations model of the yield curve, however, suggests that the sole determinant of the slope of the yield curve is expectations of future short-rates and so funding policy, ceteris paribus, should have no effect. This paper develops a high frequency set of data for the UK yield curve. Principal components are used to decompose the yield curve into a set of factors which represent the level of returns, the slope of the curve and higher order effects. The paper concentrates on the determinants of the second principal component as a measure of the slope and use a GARCH-M model to investigate the effects of funding on this variable. Strongly significant effects are found from the stock of government bonds of varying maturity bands on the slope of the yield curve. This supports the practitioners view and argues that factors such as market segmentation are more important than simple theories might suggest.
