Bank of England Working Papers -
Abstracts 1995 (no. 28-41)
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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 41
“Optimal
Commitment in an Open Economy: Credibility vs. Flexibility”
By Sylvester Eijffinger and Eric Schaling
The theoretical argument for central bank independence is based on the idea that even if the government represents people's preferences over inflation and output it has an incentive to renege from prearranged plans to gain a short run boost to output. This incentive leads to higher than desired inflation. One solution to this credibility problem is to give control of monetary policy to an independent central bank that is more averse to inflation than society. Central bank independence thus reduces society's credibility problem but this may be at the expense of less flexible countercyclical monetary policy. The aim of this paper is to find the correct balance between credibility and flexibility, ie the optimal degree of central bank independence.
The first part of the paper sets out an open economy model and identifies some macroeconomic factors that influence the optimal degree of independence. It finds that the optimal degree of independence increases when;
- the NAIRU is higher,
- the benefits of unanticipated inflation are greater,
- society is less inflation-averse,
- productivity shocks have smaller variance,
- the real exchange rate has less variability,
- the economy is less open.
The second part of the paper estimates the relationship between these six factors and measures of central bank independence for 19 industrial countries using a latent variables estimation technique. It finds that, in general, the actual degree of independence is related to these six factors and so the institutional arrangements in most countries are close to the optimum. The main exceptions are Germany and Switzerland - that seem to have an excessively high degree of independence - and Australia, Norway, Sweden and the UK - which have a lower than optimal degree of independence.
Working Paper No 40 (oop)
“Rules, Discretion and the United Kingdom's New Monetary
Framework”
By Andrew G Haldane
This paper aims to juxtapose the theoretical and empirical literature on policy rules and targeting procedures alongside the United Kingdom's new monetary framework. For example, how does inflation targeting, as practised in the United Kingdom, compare with the optimal feedback rule for monetary policy? Or, conversely, how does it compare with Friedmans k% rule? Is an inflation target akin to an optimal central bank contract - an analogy drawn by Walsh (1995)? Or is it better characterised as giving rise to a (second-best) inflation-averse central bank - such as Rogoffs celebrated conservative central banker?`
Working Paper No 39
“Valuation
of underwriting agreements for UK rights issues: evidence from the traded
option market”
by Francis Breedon and Ian Twinn
A recent study by Professor Marsh of the London Business School has estimated that sub-underwriters of rights issues (firms that commit to buy up any remaining shares at the end of a rights issue) make an excess profit of 86% of the fee they charge. Because of this study, the OFT (who originally commissioned it) have argued that underwriting is too expensive and have encouraged firms to reconsider their issuance techniques.
Marsh's study, however, is based on a number of assumptions that are unlikely to hold in practice. In particular, Marsh used the Black and Scholes option pricing formula to value the economic cost of underwriting (underwriting is like a put option since it gives the firm the right but not the obligation to sell shares to the underwriter). But it is well known that the Black and Scholes formula is based on a high unrealistic view of financial markets with no transactions costs and no information asymmetries.
To make a more realistic estimate of the economic cost of underwriting, this paper looks at the cost of buying put options in the traded option market. This does not mean that buying a put option in the traded option market is a viable alternative to underwriting it simply allows for a more realistic measure of transactions costs. By looking at the price of put options on firms who have just announced a rights issue the paper funds, unsurprisingly, that the true cost of put options was much higher than the Black and Scholes formula predicted. However, it still found that underwriters made an abnormal profit, even if it was only 40% of the fee rather than 86%.
Working Paper No 38
“The
Microstructure of the UK gilt market”
by James Proudman
This paper is a detailed study of trading patterns in the gilt market - based on all transactions in three gilts (6% Treasury 1999, 9½% Treasury 2005, and 2½% Index-linked 2016) from October 1993 to October 1994. The main finding of the paper is that order flow in the gilt market does not appear to have any significant effect on prices, market makers seem to use other information (such as public announcements and the price of the long gilt future) to set prices. The paper also finds that spreads are far narrower in the gilt market than in the equity market and that there is some tendency for spreads to fall with trade size (rather than rise as is found in the equity markets). Both these findings are consistent with a lack of information in order flow (since market makers are unlikely to lose money to more informed traders in the gilt market and so can offer better prices).
Other findings include a tendency for turnover to be highest on Wednesdays and for intra-day turnover to show a 'U'-shaped pattern with trading concentrated in the early morning and late afternoon. It also finds a tendency for spreads to be wider when turnover is high.
Working Paper No 37
“Wage
Interactions: Comparisons or Fall-back Options?”
by Jennifer
Smith
It is widely accepted that wage comparisons with other firms play an important part in wage bargaining, but what is less clear is precisely why these comparisons are important. There are two main explanations. First, that fairness considerations mean workers are unwilling to see their wage fall below that offered in other similar firms. Second, that wages in other firms constitute a worker's fall-back option since if the worker leaves his current firm he will probably seek employment in the same industry. Unfortunately, it is difficult to distinguish between these two explanations since both offer similar predictions.
This paper proposes that these two explanations can be differentiated by looking at the role of 'pay leaders' (firms that set the standard for later settlements and which, anecdotal evidence suggests, dominate changes in pay and conditions in an industry) in wage bargaining. If the fall back option is important then the pay leader should only influence wages in other firms to the extent that the pay leader firm constitutes one of many firms that workers could move to. If, on the other hand, fairness is important then the pay leader can have a disproportionate influence by creating the standard for other wage negotiations.
Using a unique panel of data covering 321 unionised bargaining units in the UK chemical industry between 1978 and 1989, the paper then looks at the influence of the pay leader in that industry (ICI) on wage setting in other firms. It finds that the ICI wage does indeed have a disproportion effect on wage bargains in other firms; indeed ICI's wage dominates all other measures that capture the worker's fall-back option. This supports the notion that it is fairness considerations that drive wage interactions.
Working Paper No 36
“Testing for convergence: evidence from non-parametric multimodality
tests”
by Marco Bianchi
The convergence hypothesis in growth theory implies that the frequency of the density distribution of GDP in a cross-section of countries tends to approach unimodality as we move forward in time. The convergence theory in a cross-section of 119 countries is tested by means of bootstrap multimodality tests and non parametric density estimation techniques. By looking at the density distribution of GDP across countries in 1970, 1980 and 1989, increasing evidence for bimodality is found. The finding stands in contrast with the convergence prediction.
Working Paper No 35
“Money as
an Indicator”
by Mark S Astley and Andrew G Haldane
The leading indicator properties of various of the money and credit aggregates over real activity and inflation is assessed, using Granger-causality tests and impulse response functions. The approach is explicitly disaggregated, looking at sectoral measures of money and credit and various disaggregations of activity - in line with the results of earlier Bank research. Strong and significant effects from narrow money through to nominal GDP and, in particular, prices are found. Broader measures of money/credit - M4, M4 lending to Divisia - do much less well at an aggregate level. But sectoral disaggregation helps matters: for example, corporate M4 and Divisia appear to have a reliable mapping with investment and production and some measures of prices. However, none of the monetary aggregates offer sufficiently robust early warning signals to justify intermediate target status. Rather the message is that, when used alongside other information variables such as the Banks inflation projection, some of the monetary aggregates offer useful corroborative information about incipient activity and price developments.
Working Paper No 34
“How
Cyclical is the PSBR?”
by Joanna Paisley and Chris Salmon
This paper examines the methodology of cyclical adjustment of fiscal balances. The crucial assumption underlying any estimates of the cyclically-adjusted balance (CAB) is found to be the measure of the output gap. Estimates for the UK are presented, suggesting that when the economy returns to trend the PSBR should fall by between 3% to 4.5% of GDP from its position at the end of 1992.
Working Paper No 33
“Granger
causality tests in the presence of structural changes”
by Marco
Bianchi
Granger causality tests are widely used in applied economics as a way of establishing if a variable has been a leading indicator of another over the past. However, like most statistical tests, Granger causality tests require that the relationship between the variables remains stable over the sample period being tested. This paper illustrates that, if significant structural change occurs, these tests can provide misleading results.
The paper then goes on to describe a statistical method that identifies structural breaks in a given data sample. Having identified them, Granger Causality tests are adjusted to make them 'robust' to those breaks. The paper also presents an application of the method to Canadian GNP and M1.
Working Paper No 32
“An
assessment of the relative importance of real interest rates, inflation and
term premia in determining the prices of real and nominal UK bonds”
by David Barr and Bahram Pesaran
This paper uses a dynamic accounting identity developed by Campbell to decompose movements in bond prices into elements due to changes in real interest rates, expected term premia and expected inflation. This decomposition is applied to UK short and long-maturity nominal bonds and index-linked bonds using data between 1983 and 1993.
The main findings are that changes in expected inflation are by far the most important determinant of bond price movements. So much so that even for index-linked bonds changes in expected inflation (which have an effect due to the eight month indexation lag) are a more important factor than changes in real interest rates (which contribute less than 3% to the variance of index-linked bond prices).
The paper also finds that changes in expected term premia are an important determinant of changes in both nominal and index-linked bond prices. However, the term premia appears to be a common factor which has little influence on the relative price of the two types of bond (ie break-even inflation rates). This suggests that changes in the relative price of the two type of bonds offer a reliable measure of changes in market expectations of inflation with about 95% of the variance of relative yields being due to revisions to expected inflation.
Working Paper No 31
“Measuring
Core Inflation”
by Danny Quah and Shaun Vahey
Many alternative measures of core, or underlying, inflation have been proposed that are based on stripping out some unwanted or excessively volatile elements from the headline rate. A potential drawback of such measures is that they are necessarily atheoretic - based largely on purely statistical procedures. This paper proposes an alternative method of measuring core inflation utilising an explicit economic definition. It defines core inflation as that part of measured inflation that has no medium or long term impact on real output - a notion that is consistent with the vertical long-run Phillips curve. This definition captures the commonly held view that moderate movements in inflation can have no impact on the real economy once financial and wage contracts have been written taking it into account.
Using this definition the paper estimates a measure of core inflation using the VAR identification technique developed by Blanchard and Quah. The estimated measure indicates that core inflation was higher than measured inflation in the early 80s suggesting that measured inflation was depressed by beneficial supply shocks. The opposite effect occurred in the late 80s. Currently, core inflation is above measured inflation.
Working Paper No 30
“Modelling
UK Inflation Uncertainty: The Impact of News and the Relationship with
Inflation”
by Mike Joyce
Uncertainty about future inflation is often claimed to be one of the most important costs of inflation, since it distorts the workings of the price system and leads to allocational inefficiencies. This paper analyses UK inflation between 1950 and 1994 using the ARCH methodology, which enables inflation uncertainty to be modelled directly. It examines two questions; first, what is the precise form of the relationship between shocks to the level of inflation and future inflation uncertainty? Second, what is the relationship between inflation uncertainty and the level of inflation?
The paper finds that future inflation uncertainty is much more sensitive to 'bad' news (unexpected increases in inflation) than 'good' news. In fact, uncertainty appears almost unaffected when inflation outturns are lower than expected. It also finds that inflation uncertainty is indeed higher when inflation is high though the precise form of this relationship is difficult to estimate.
Working Paper No 29
“Pricing
Deposit Insurance in the United Kingdom”
by David Maude and
William Perraudin
This paper outlines a method for estimating the value of deposit insurance based on option pricing theory. It follows the approach of Merton who viewed deposit insurance as, essentially, a put option on the value of the bank's assets. Three models are analysed, each embodying a different assumption about the bank closure rule. First, it is assumed that closures occur on given (annual) audit dates if the banks assets are less than its total insured deposits. Second, an endogenous closure rule is considered where the authorities allow the ailing bank to continue operating as long as the shareholders are willing to meet its operating losses. Third, an extension of model two is analysed where the authorities themselves can subsidise the ailing bank, thus postponing liquidation.
The paper then estimates the value of deposit insurance in these three models using share price data from eight large UK banks. For each model the deposit insurance premiums vary significantly across banks and across models (though bank rankings across models was relatively stable).
The paper concludes that option pricing models do not provide a useful guide for setting the level of deposit insurance premiums. They could, however, give insights as to the relative cost of deposit insurance across banks.
Working Paper No 28
“The
Construction of RPIY”
by Roger Beaton and Paul Fisher
This paper outlines the calculations used to construct the Bank of England's measure of retail price inflation, RPIY, which excludes the effects of indirect taxes on final consumption, mortgage interest payments and local authority taxation. This measure of inflation has been constructed in order to gain more insight into the movements in the Government's target measure of retail price inflation, RPIX, which excludes only mortgage interest payments.
The technical reason for wanting to strip out the effects of taxation is similar to that for excluding mortgage interest payments from the target measure. An increase in indirect taxes will usually cause a step rise in the RPIX level (although often spread over a period of two or three months). This in turn will lead to a temporary increase in the 12 month inflation rate for at least a year. Hence tax changes introduce a "noise" element in the inflation rate. If one is concerned, with price inflation in the medium term then it is useful to know what the effect of this noise is.
Starting with the May 1993 Inflation Report, we have been developing the RPIY so that we can understand how indirect tax changes are impacting on RPIX inflation. The paper represents our "signing off" from the responsibility for both calculating and publishing RPIY, as the CSO will be undertaking this from March 1995.
