Bank of England Working Papers -
Abstracts 1998 (no. 74-89)

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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 89
“Optimal currency areas and customs unions: are they connected?”
by Marion Kohler (561k)

This paper examines the link between currency areas and customs unions. The size of a bloc of countries practising some form of co-ordination of monetary policy is limited by the incentive to free-ride that formation of the bloc creates. However, when the threat of a trade war is introduced, the stable size of the bloc increases. This suggests that a large currency area is more likely to emerge where it combines with a customs union, and that the stability of both currency area and customs union are closely related, because the threat of tariff penalties can enforce co-operation.

Working Paper No 88
“Incentive schemes for central bankers under uncertainty: inflation targets versus contracts”
by Eric Schaling, Marco Hoeberichts and Sylvester Eijffinger (132k)

The implications of uncertain policy preferences for the targeting and contracting approaches to monetary policy are investigated. It is shown that, in the presence of uncertain preferences, a linear incentive contract in the sense of Walsh performs better than an explicit inflation target as proposed by Svensson. The reason is that an inflation target produces a higher variance of inflation. It is also shown that it is optimal to offer a linear inflation contract that does not depend on the degree of preference uncertainty.

Working Paper No 87
“Why has the female unemployment rate fallen so much in Britain?”
by Phil Evans (132k)

A decrease in female unemployment wholly accounts for the fall in total UK unemployment between its 1984 and 1993 peaks. This fall is associated with a fall in the female inflow rate, is concentrated among women with young children, and is equally evident for all skill groups. These trends cannot be explained by cyclical factors, rather, it is argued that improvements in the provision of workplace childcare have made it easier for mothers with young children to return to work. This reduction in labour market frictions could mean that the natural rate of unemployment has fallen.

Working Paper No 86
“Shoe-leather costs reconsidered”
by Jagjit S Chadha, Andrew G Haldane and Norbert G J Janssen
(858k)

It has recently been suggested by Robert Lucas that 'shoe-leather' costs of inflation may amount to as much as 1% of GNP in the United States. This paper assesses the UK evidence for the period 1970-94. Similar estimates to those of Lucas are found using his original specification, but a preferred functional form using a semi-log interest elasticity of demand for money reveals a 0.22 % of GNP gain in perpetuity following a sustained fall in nominal interest rates from 6% to 2%.

Working Paper No 85
“Exchange rates and prices: sources of sterling real exchange rate fluctuations”
by Mark S Astley and Anthony Garratt (413k)

This paper attempts to identify the sources of UK exchange rate and relative consumer price fluctuations between 1973 and 1994. We follow Clarida and Gali (1994) in using the Blanchard and Quah (1989) structural VAR (SVAR) method to identify the effects of three structural shocks within a Dornbusch (1976)/Obstfeld (1995) model. We find that IS shocks underlay the majority of the variance of sterling real and nominal exchange rates. Aggregate supply (AS) shocks were the second most important source of such variations, while LM shocks played an extremely limited role. In contrast, the variance of UK relative consumer prices was primarily attributed to LM shocks. Combining those results with the estimated impulse response functions indicates that the sterling exchange rate depreciations over the floating rate period were largely associated with falls in UK relative consumer prices. But it would be inappropriate for policy-makers to base any future policy response to sterling fluctuations on that finding because: (a) the Lucas critique applies to it; and (b) it represents the average dynamic interaction over the sample period. We also find that: (i) the estimated impulse responses following each of the shocks are highly theory-consistent; and (ii) the periods in which the SVARs suggest that particular shocks were especially important can be linked to observed macroeconomic developments. both those findings indicate that the SVAR representations of the data have a high economic content.

Working Paper No 84
“Averaging in a framework of zero reserve requirements: implications for the operation of monetary policy”
by Haydn Davies (182k)

If a central bank is unable to forecast accurately the banking system's demand for reserves, then the volatility of the money-market interest rate is likely to increase. Although reserve averaging is one possible means of dealing with this, positive reserve requirements may have undesirable properties. In this paper, we examine the operational implications of combining averaging with a zero reserve requirement. We then examine the optimum system of penalty charges for overnight overdrafts and for missing the averaging requirement, as well as the consequent behaviour of the money-market interest rate relative to the central bank's target rate.

Working Paper No 83
“The demand for M0 in the United Kingdom reconsidered: some specification issues”
by Norbert Janssen (165k)

This paper provides tests of an econometric model of the demand for UK M0. The existence of a long-run cointegrating relationship between M0 and key economic variables is established and a plausible dynamic error-correction model is estimated. A model that passes standard specification tests is achieved without resort to arbitrary proxies for financial innovation. Some of the recent decline in M0 velocity is explained by the move to a lower inflation environment.

Working Paper No 82
“Downward nominal rigidity and monetary policy”
by Anthony Yates (215k)

This paper addresses the question of whether there is downward rigidity in money wages and prices. It is an issue that is relevant to the choice of the level of the inflation target, as it has been argued that targeting too low a level of inflation will be harmful when downward rigidities exist. The existence of such rigidities is questioned from a theoretical perspective on the basis of the very strict conditions that would have to apply. Also it is argued that concern for 'fairness' or the presence of 'money illusion' do not in themselves justify positive inflation. Empirical evidence is investigated and it is found that the existence of downward rigidities is not proven.

Working Paper No 81
“Are UK inflation expectations rational?”
by Hasan Bakhshi and Anthony Yates (104k)

This paper tests for unbiasedness in inflation expectations drawn from a survey of UK employees by Gallup. It focuses on the econometric difficulties presented by having a small sample, there being overlapping forecast horizons and by trying to make inference when the data appear to be non-stationary. Applying a method of inference suggested by Inder (1993) the paper concludes that measured expectations systematically overstate inflation. The paper checks the robustness of this result by looking at alternative survey data and by using alternative techniques for modelling the long run.

Working Paper No 80
“Are there downward nominal rigidities in product markets?”
by Simon Hall and Anthony Yates (128k)

This paper looks at disaggregated price data in the UK to see if there is evidence of downward nominal rigidity: are prices less likely to fall after a downward shock than they are to rise after an upward shock? The test is to see if, as the mean inflation rate falls, the skewness, or the tendency for price changes to bunch-up at zero, rises. The paper finds no convincing evidence of downward nominal rigidity.

Working Paper No 79
“Bank Capital and Value at Risk”
by Patricia Jackson, David Maude and William Perraudin (575k)

To measure the risks involved in their trading operations, major banks are increasingly employing Value-at-Risk (VaR) models. In an important regulatory innovation, the Basle Committee has accepted that such models can be used in the determination of the capital that banks must hold to back their securities trading. This paper examines the empirical performance of different VaR models using data on the actual fixed income, foreign exchange and equity security holdings of a large bank. It also examines how a bank applying the models would have fared in the past if the proposed rules had been in operation.

Working Paper No 78
“Some costs and benefits of price stability in the UK”
by Hasan Bakhshi, Andrew Haldane and Neal Hatch (242k)

This paper quantifies some of the costs of inflation in the United Kingdom. It focuses in particular on inflation distortions under an imperfectly indexed tax system and distortions to money demand. In the United States, an earlier study by Feldstein found that lowering inflation by 2 percentage points could generate welfare benefits of as much as 1% of GDP per year forever. In the United Kingdom, the benefits are found to be smaller, but still substantial, at 0.2% of GDP per year.

Working Paper No 77
“Productivity convergence and international openness”
by Stephen Redding and James Proudman (393k)

There is a strong partial correlation between openness and rates of productivity growth across UK manufacturing sectors. The paper investigates the relationship more formally, within a theoretical model of productivity catch-up. The model identifies three potential effects of international openness: openness may affect (a) domestic rates of innovation, (b) the quantity of technological know-how that may be transferred from the frontier to the less advanced economy, (c) the rate at which this technology transfer occurs. From the theoretical framework, an econometric equation is derived which is used to estimate the relationship between UK productivity growth, the UK-US productivity gap and the degree of international openness. International openness is found, primarily, to affect the rate of productivity convergence, and this relationship is robust to the inclusion of information on R&D intensity, human capital, unionisation and capacity utilisation.

Working Paper No 76
“Electronic versus open outcry markets: The case of the Bund futures contract”
by Francis Breedon and Allison Holland (75k)

The Bund (10 year German Government Bond) futures contract is the most actively traded bond contract in Europe; it is traded in both London (LIFFE) and Frankfurt (DTB) on open outcry and electronic trading platforms respectively. In an attempt to reconcile the conflicting results of earlier studies this paper evalutes the relative liquidity and price discovery roles of these two markets using data from 1995 Q2. The paper finds that this conflict is largely a product of the price data used. Using both transactions prices and quotes data (on a minute by minute basis), variable transaction costs, i.e. spreads, are found to be similar on both markets. There is some evidence to suggest that the order processing component of the spread is larger on LIFFE, but that the compensation required for adverse selection risk is greater on the DTB. Also, the contribution to price formation of each market is found to be similar; there is no clear leader/follower relationship. The main differences between the two markets are the larger trade size on the open outcry market and a tendency for trading to move toward the open outcry market during volatile periods.

Working Paper No 75
“The Information Content of the Inflation Term Structure”
by Francis Breedon and Jag Chadha (79k)

This paper examines the information content of inflation forecasts derived using index-linked and conventional bonds. The paper finds that the derived inflation term structure (ITS) gives a somewhat better indication of the bond market's inflation expectation than can be derived using either the nominal term structure or a variant employing strong assumptions about real interest rate behaviour. The inflation forecasts of the ITS also seem at least as good at forecasting future changes in inflation as forecasts derived from macroeconometric models.

These characteristics of the ITS and its timeliness tend to make its inflation forecasts a useful addition to policy analysis. Because the real term structure tends to underpredict the level of future real interest rates, index-linked bonds have proved, ex post, to be cheap funding for the UK government. But we cannot be sure whether this underprediction results from an inflation risk premium or expectational error and also cannot know whether this overprediction will persist.

Working Paper No 74
“Some Issues in Inflation Targeting”
by Andrew Haldane (158k)

This paper discusses some of the operational issues relevant to the implementation of an inflation-targeting regime. In particular it focuses on: whether inflation targeting is 'new'; whether (and how) the forward-looking nature of inflation-targeting helps to prevent instabilities in inflation; whether inflation-targeting potentially destabilises output; and whether it requires too much knowledge on the part of the authorities. The paper argues that none of these propositions is in general correct.

It goes on to discuss the use of inflation forecasts in general, and inflation probability distributions in particular, in the context of inflation targeting in the United Kingdom. It also discusses the important role greater transparency plays among inflation targeters and discusses some evidence on this. Finally, a preliminary evaluation of inflation targeters' performance to date is given.