Bank of England Working Papers -
Abstracts 1997 (no. 58-73)

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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 73
“Deconstructing Growth in UK Manufacturing”
by Gavin Cameron, James Proudman and Stephen Redding (341k)

This paper is concerned with the nature of economic growth in 19 manufacturing industries between 1970-92. There is substantial heterogeneity (both across sectors and time) in rates of growth of value-added, hours worked, labour productivity and Total Factor Productivity during the sample period. The decline in constant price value-added in aggregate manufacturing during the sample period is associated with significant changes in the relative size of individual sectors, and with noticeable changes in performance between the two peak-to-peak business cycles 1973-79 and 1979-89. Despite changes in the relative size of sectors, the vast majority of aggregate productivity growth is explained by within-sector productivity growth. An analysis of productivity levels also reveals considerable heterogeneity. The distribution of productivity levels across sectors exhibits an increase in dispersion and becomes increasingly positively skewed during the sample period. There is evidence of productivity levels in a number of industries converging at values just below the mean; productivity levels in a few sectors persistently remain above and rise away from mean values.

Working Paper No 72
“The cyclicality of Mark-ups and Profit Margins: Some Evidence for Manufacturing and Services”
by Ian Small (101k)

This paper uses industry and firm data to look at price cost mark-ups and firm profit margins in UK manufacturing and services. In particular it examines how they behave over the business cycle. It has two main findings. First, the estimated average mark-ups and the profit margin results both suggest that there is imperfect competition in manufacturing and services. Second, mark-ups are pro-cyclical, as are profit margins even after allowing for movements in their standard determinants. This suggests that price pressures may increase during recovery periods and decrease during recessions. One possible explanation for this is Kreps and Scheinkman's argument that the pro-cyclicality of capacity constraints means that firms move between Cournot and Bertrand competition over the cycle. The finding that mark-ups are pro-cyclical also raises doubts about macroeconomic models that assume that demand shocks may affect employment via counter-cyclical mark-ups.

Working Paper No 71
“The effects of Stamp Duty on the Level and Volatility of Equity Prices”
by Victoria Saporta and Kamhon Kan (716k)

This paper investigates the effects of stamp duty -the UK securities transaction tax - on the level and volatility of equity prices. The authors examine the response of the equity market to announcements of changes in stamp duty rates and compare the prices of two assets which are similar in all respects apart from their treatment for stamp duty purposes: American Depositary Receipts (ADRs) and their London Stock Exchange-traded stocks. The findings are consistent with the hypothesis that stamp duty is capitalised in prices. Using univariate GARCH models, the authors find that stamp duty has no effect on volatility, contradicting the key hypothesis put forward by proponents of transaction taxes.

Working Paper No 70
“The Determinants of Successful Financial Innovation: an Empirical Analysis of Futures Innovation on LIFFE”
by Jo Corkish, Allison Holland and Anne Fremault Vila (78k)

This paper documents futures innovation on LIFFE by empirically analyzing the individual growth profiles of its futures contracts and the factors that determine contract success or failure. The paper documents considerable heterogeneity across contracts, and finds that contract success can not easily be inferred from the contract's first years of trading. As expected, contract success is highly correlated with the size of the underlying market, as well as with its volatility. The paper also confirms the existence of a first-mover advantage.

There is little systematic correlation, however, between bid-ask spreads and futures volume. This suggests that there may be a critical level of trading activity beyond which bid-ask spreads and execution risk vary relatively little. It is further argued that liquidity seems less a cause of contract success (or lack of liquidity a cause of failure), but rather a consequence.

These results may provide a useful perspective as exchanges prepare themselves for the planned monetary unification. Successful product innovation will be critical since exchanges may face a drop in demand with reduced monetary uncertainty, and a reduction of the current spectrum of interest rate contracts to Euro contracts only. A related question is whether a futures markets needs a well developed spot market to succeed, or whether the creation of a futures market could help to boost liquidity in a fledgling spot market.

Working Paper No 69
“Agency Incentives and Reputational Distortions: a Comparison of the Effectiveness of Value-at-Risk and Pre-commitment in Regulating Market Risk”
by Arupratan Daripa and Simone Varotto (254k)

In regulating the market risk exposure of banks, the approach taken to date is (in either the Standard or the Value-at-Risk methodology) to use a 'hard-link' regime that sets a fixed relation between exposure and capital requirement exogenously. A new 'Pre-commitment' approach (PCA) proposes the use of a 'soft-link'. Such a link is not externally imposed, but arises endogenously. In other words, it relies on the interaction between the bank owner and managers which is based on the preferences of both parties and the compensation scheme offered to the managers. Such an approach is of much greater economic appeal, as it is incentive-based and so less prescriptive.

But, this paper argues that there is a trade-off. The use of incentives by the new approach implies that a whole host of strategic interactions in the bank are relevant in evaluating its effectiveness. This aspect of a soft-link regulation such as PCA seems to have received little attention. We attempt to clarify the precise nature of the trade-off by analysing two potential sources of distortion: agency and reputational.

In the context of a simple principal-agent model, the paper studies the incentives generated by PCA on managerial risk-taking when the level of risk is not directly contractable. We identify contexts in which a distortion might arise. Second, it studies the effect of reputational concerns under public disclosure of a breach. The paper shows that this might lead to a perverse pattern in the relative size of the trading activities compared with the size of bank as a whole. A hard-link approach avoids such distortions.

The results form a first step towards modifying PCA to construct optimal incentive-compatible regulatory schemes. How PCA might be modified to rectify the distortions identified here, is discussed informally.

Working Paper No 68
“The Industrial Impact of Monetary Policy Shocks: Some Stylised Facts”
by Joe Ganley and Chris Salmon (849k)

This paper investigates the disaggregated effects of monetary policy shocks on the output of 24 sectors of the UK economy. The paper's principal aim is to provide stylised facts about the sectoral responses to unexpected changes in monetary policy and to help assess how monetary policy developments feed through the economy. It also provides indirect evidence about the underlying nature of the transmission mechanism.

The first set of results relates to the largest industrial sectors - construction, services, production industries (including utilities and manufacturing) - which sum together to form the output measure of GDP. Thereafter the paper focuses on the manufacturing sector alone. Data sources for manufacturing are richer than for other sectors of the economy, which allows a more detailed analysis of the factors that might account for the pattern of responses to monetary shocks which we observe across manufacturing.

Focusing first on the main industrial sectors, the paper finds that the effects of an unanticipated monetary policy tightening seem to be unevenly distributed across sectors of the economy. As might be expected, sectors such as construction show a sizeable and rapid decline in output, whereas others, like services, show a much more muted reaction. Manufacturing as a whole also responds quite sharply to a monetary tightening, but some large industrial sectors, notably the utilities, show a subdued reaction.

Turning finally to the manufacturing sector alone, the paper shows that the (2 digit SIC) sectors that comprise manufacturing also exhibit diverse responses to a monetary shock. The paper shows the pattern of manufacturing sector responses seems correlated with the size characteristics of the firms in each sector. In particular, sectors which mainly comprise "small" firms tend to exhibit a stronger reaction to monetary shocks than sectors that mainly comprise "larger" firms. This might indicate that credit market imperfections play a role in the monetary policy transmission process.

Working Paper No 67
“How do UK companies set prices?”
by Simon Hall, Mark Walsh and Anthony Yates (135k)

This paper reports the main results of a survey carried out by the Bank in the autumn of 1995 of the price-setting behaviour of 654 UK companies. It elaborates on an article in the May 1996 Bank of England Quarterly Bulletin. In the year preceding the survey, the average company reviewed its prices once a month. The extent and source of price rigidity varied across different types of company and market. Retailers reviewed and changed their prices more frequently than manufacturers. Companies operating in more competitive markets reviewed prices more often than companies with few direct competitors; but long-term relationships with customers appeared to reduce price flexibility. Despite the frequency of reviews, actual prices were only changed twice on average, indicating that there may be substantial costs of changing prices. Companies stated that the need to preserve customer relationships (due to explicit or implicit contractual arrangements) or to maintain market share were important sources of price rigidity. In addition, the overwhelming majority of companies indicated that they would be more likely to increase overtime and capacity than change their price in response to a boom in demand. There were substantial asymmetries in the factors which drive prices up and those that push prices down. Time-dependent pricing rules appeared to be much more widespread than state-dependent pricing rules, suggesting that the short-run real effects of monetary policy could increase at lower rates of inflation. Overall, the survey results indicate that UK markets do not behave as if prices are costlessly and instantaneously determined. It appears that uncertainty about the extent or permanence of changes in market conditions combined with costs of adjusting prices means that many companies' short-run response to a change in demand is to adjust output rather than price. Taking account of such behaviour could be important in explaining the short-run real effects of monetary policy.

Working Paper No 66
“Implied risk-neutral probability density functions from option prices: theory and application”
by Bhupinder Bahra (177k)

Due to their forward-looking nature, derivative markets provide monetary authorities with a rich source of information for gauging market sentiment. For example, a futures price gives a widely used measure of the market's views about the future value of an asset, namely its mean or expected value at the maturity date of the futures contract. Moreover, the information available from futures prices can be extended by using option prices to estimate the market's entire probability distribution of the future value of an asset.

This paper develops various techniques for estimating the market's probability distribution of the future value of an underlying asset from the prices of options on that asset. It discusses the relative merits and drawbacks of each approach, and shows how our preferred approach can be applied to estimate ex ante probability distributions using LIFFE equity and interest rate options, and Philadelphia Stock Exchange currency options. The paper then illustrates the potential value of this type of information to the policy-maker in assessing monetary conditions and conducting monetary operations. Finally, the paper looks at the limitations in data availability and highlights some areas for future research.

Working Paper No 65
“Real Interest Rate Linkages: Testing for Common Trends and Cycles”
by Darren Pain and Ryland Thomas (250k)

This paper formed part of the Bank of England's contribution to a study by the G10 Deputies on saving, investment and real interest rates. It investigates a technique which allows economic times series to be decomposed into common trends and common cycles. This is applied to the movements of industrial countries' real interest rates. Two sets of real interest rates are considered: European short maturity rates and G3 long maturity rates. The analysis of European short rates reveals statistical evidence that the German real interest rate is the single dominant common trend and that the two common cycles are represented by the spreads of French and UK rates over German rates. The single common trend remains when the United States is added, but German leadership is then rejected in favour of US leadership. In the G3 long rate system, a single common trend appears to exist only after 1980.

Working Paper No 64
“Persistence and Mobility in International Trade”
by James Proudman and Stephen Redding (243k)

This paper examines changing patterns of specialisation in international trade in manufactured goods in the United Kingdom and Germany between 1970 and 1993. The analysis is motivated by a simple theoretical model of endogenous economic growth, in which patterns of comparative advantage are determined by the history of technological change and help determine current rates of innovation. Learning by doing that is specific to a manufacturing sector provides a reason why initial patterns of comparative advantage and international specialisation will persist over time. In contrast, spillovers of technological knowledge between economies are a source of mobility in patterns of international specialisation. We present an empirical measure of the degree of specialisation in exports of a given sector termed Revealed Comparative Advantage. The distribution of this measure across sectors provides information on international specialisation at a point in time. Analysing how the distribution evolves over time yields insights into changes in international specialisation. By explicitly modelling the dynamics of Revealed Comparative Advantage across sectors and over time, the degree of persistence and mobility in actual patterns of international trade is evaluated. The degree of mobility over the sample period is found to be surprisingly high, with the pattern of international specialisation in the United Kingdom more mobile than that in Germany.

Working Paper No 63
“Is International Openness associated with faster economic growth?”
by James Proudman, Stephen Redding and Marco Bianchi (243k)

This paper considers the role of international openness in facilitating the convergence of average income per capita between countries. The statistical technique of Discriminant Analysis is used to sort economies into groups of open and closed on the basis of a number of measures of the stance of international trade policy. The evolution of the cross-section distribution of average income per capita across countries is modelled both for the whole world, and then for the groups of open and closed economies separately. Open economies are found to exhibit substantially different income dynamics and to converge to higher levels of income compared to their closed counterparts. These differences remain even after making allowance for differences in countries’ relative levels of investment.

Working Papers No.s 61 & 62
“ The Demand for M4: A Sectoral Analysis.
Part 1 - The Personal Sector and Part 2 The Corporate Sector"
by Ryland Thomas

Part 1 Full text no.61 (934k)
Interpreting movements in monetary aggregates is an important part of the assessment of inflationary pressures in the UK's current monetary policy framework. This paper is the first part of a follow-up study to Fisher and Vega in 1993 (Working Paper No 21) , examining the determinants of personal sector holdings of M4 in the UK and the role they play in the transmission mechanism. A joint-model of personal sector M4 and consumption is developed which offers some useful insights into the role of money in the economy. In the long run both money and consumption are found to be related to income, wealth and interest rates, the estimated relationships being fairly standard theoretical specifications. But the model also reveals that money and consumption interact strongly in the short run, the nature of the interaction depending on the type of disturbance that has occurred. Positive disturbances to consumption initially lead to a fall in money balances, so that there is a negative relationship between money and consumption in the short-run. This is consistent with money's role as a "buffer-stock" which absorbs short-term fluctuations in spending. Positive disturbances to money, on the other hand, lead to a rise in consumption in the first instance, so that the short-run relationship is positive. This would be consistent with a number of possible liquidity and credit effects on consumption. These different relationships have important implications for interpreting movements in personal sector money holdings. Faster money growth may be consistent with a number of different underlying disturbances, each requiring its own policy response.

Part 2 Full text no.62 (1.14M)
This paper is the second part of a study on the determinants of the broad money aggregate M4, following a similar analysis of the personal sector developed in Working Paper No 61. It models the broad money holdings of both industrial and commercial companies (ICCs) and other financial institutions (OFIs) in the UK, and examines what role they play in the transmission mechanism. ICCs are shown to have both a transactions and a portfolio motive for holding money. A three-equation model of money, investment and the cost of capital is estimated, and the results suggest the existence of a corporate sector liquidity channel whereby firms' "excess" money balances have a negative influence on the cost of capital and a positive impact on investment spending. OFIs' money holdings are shown to depend upon wealth and relative rates of return, in line with standard portfolio models of money demand. But as OFIs are the chief counterparts to banks' liability management activity, their money holdings are also modelled jointly with deposit rates.

Working Paper No 60
“Testing the predictive power of dividend yields: non-parametric evidence from t he G5”
by Francis Breedon, Marco Bianchi, and Darren Sharma (665k)

This paper extends US evidence on the ability of current dividend yields to predict future equity returns in the G5 countries. By using non-parametric methods, evidence of a similar non-linear structure is found in all the countries analysed. This casts doubt on the linear framework adopted in earlier studies. The paper also finds that there is a strong relationship between extremes of dividends and future returns (in that very low/high dividends do predict low/high returns whilst intermediate levels of dividends do not). This non-linear structure strengthens the statistical evidence of a relationship between dividend yields and future returns and may help explain why previous studies have found mixed evidence.

Working Paper No 59
“Which Inter-dealer Market Prevails? An analysis of inter-dealer trading in opaque markets”
by Victoria Saporta (382k)

A number of dealership markets share three common features: customer-dealer trades remain undisclosed, inter-dealer trading forms a substantial part of total trading and dealers have a choice, when dealing with eachother, between doing so directly and using an inter-dealer broker (IDB). Using a three-stage market microstructure model, we show that for dealers who have executed undisclosed customer trades, their choice depends on the number of firms who operate as dealers: trading through the IDB being preferable when more than a critical number of dealers participate in the industry and vice versa. Comparative static effects of information asymmetry and market transparency on the critical number of dealers are derived. Subject to a monotonicity constraint, a condition is derived determining which form of inter-dealer market will prevail.

Working Paper No 58
“The determinants of UK business cycles”
By Allison Holland and Andrew Scott (150k)

This paper considers the ultimate causes of post-war UK business cycles. Using an extended stochastic growth model the authors construct estimates of productivity and preference shocks both of which are highly persistent, volatile and potentially capable of explaining UK business cycles. They find the productivity term is the dominant explanation of UK output fluctuations but that changes in underlying preferences are crucial in understanding employment movements. Holland and Scott use a variety of Granger causality tests to establish whether these productivity and preference terms are predictable and so can be potentially considered as the cause of UK business cycles or whether they are themselves Granger caused by other variables. They find that their estimated productivity term is not predicted by any demand-side variable including various fiscal and monetary policy instruments, but is to a limited extent by oil prices and the share of taxes in GDP. This suggests that their "productivity" shock may also reflect other supply-side influences. In contrast they find their "preference" shift is predicted to a substantial extent by real variables, such as the terms of trade and oil prices, and nominal variables, such as the money supply and the price level. The implications of these findings for competing theories of the business cycles and for the monetary transmission mechanism are discussed.