The Federal Reserve Bank of Kansas City's Research staff produces a series of working papers presenting results of the department's economic research. These technical papers cover a wide range of economic research topics.


How Does Openness to Capital Flows Affect Growth?

By Jordan Rappaport (RWP 00-11 December 2000)
An average adjustment cost which is convex with respect to the rate of gross investment success-fully calibrates a neoclassical growth model to match real world observables including the transition paths of convergence speed, the shadow value of capital, interest rates, and savings rates. Comparing the open-economy and closed-economy versions of the calibrated model shows that relaxing the constraint that domestic savings finance domestic investment effects only a small increase in the growth rate of output per capita: less than one percentage point per year for an economy with current output 20 percent its steady-state level and less than one-half percentage point for an economy with current output 60 percent its steady-state level. Rather than higher growth, the main effect of openness to capital flows is higher current levels of consumption financed by large trade deficits.

JEL Classification: E10, F43, O41C
Key words: General Aggregative Models; Economic Growth of Open Economies; One, Two, and Multi-sector Growth Models

Is the Speed of Convergence Constant?

By Jordan Rappaport (RWP 00-10 December 2000)
Empirical attempts to measure the speed of convergence -- the rate at which a country's per capita income approaches its steady state relative to its distance from its steady state -- have started from the assumption that it is constant. In contrast, neoclassical models of capital accumulation usually predict that the speed of convergence decreases as income approaches its steady state. Estimating a flexible functional form which allows the speed of convergence to vary suggests that the speed of convergence actually increases as income approaches its steady state. An increasing speed of convergence calls into question structural interpretations of coefficients on conditioning variables in cross-sectional growth regressions. Instead, excluding initial income from cross-sectional growth regressions allows coefficients on exogenous variables to be interpreted as measuring changes in underlying structural relationships.

JEL Classification: O41, O47
Key words: Economic Growth, Income Convergence, Cross-Country Growth Empirics

The Effect of Old-Age Insurance on Male Retirement: Evidence from Historical Cross-Country Data

By Richard Johnson (RWP 00-09 December 2000)
I examine the effect of Old-Age Insurance systems on the labour supply of older men. Male retirement ages are crucial to the solvency of OAI systems. Historical data on participation rates and OAI rules in thirteen developed countries show rapid falls in participation among men aged 60-4 after pensions were extended to them. I estimate participation elasticities of -0.06 with respect to replacement rates and 0.19 to the net-of-tax wage. It does not appear that endogenous OAI changes bias the regression coefficients. The growth of OAI explains about 11 percent of the reduction in participation of men aged 60-4 since 1920; greater wealth probably explains most of the remainder.

JEL Classification: H55, J14, J21, J26
Key words: Social Security, public pensions, economics of the elderly, labor force and employment, retirement policies

Government Budgetary Policies, Economic Growth, and Currency Substitution in a Small Open Economy

By Jill A. Holman (RWP 00-08 December 2000; Last Revised: June 2001)
This paper compares the macroeconomic consequences of alternative government budgetary policies in a small open economy where agents transact in both domestic and foreign currencies. An endogenous growth model is used to rank the effects of income-tax-financed and inflation-tax-financed government expenditures on the economy’s growth and inflation rates. Currency substitution provides an avenue for inflation-tax evasion and affects the rankings of the two modes of government finance. The analysis reveals that an increase in the size of government reduces the growth rate of the economy regardless of the government’s budgetary policy. Inflation taxes hinder growth more than income taxes. Income-tax financing is also the preferred policy in terms of its effect on the economy’s inflation rate. Under the growth-maximizing tax mix, the government relies on both forms of finance but receives most of its revenue from income taxes.

JEL classification: E63 and F43
Keywords: Inflation taxes; income taxes; economic growth; currency substitution

Estimation of Adjustment Costs in a Model of State-Dependent Pricing

By Jonathan Willis (RWP 00-07 December 2000)
This paper provides a framework for direct analysis of the underlying price adjustment costs in an industry. A dynamic programming problem is specified for monopolistically competitive firms that face idiosyncratic costs of price adjustment. A numerical solution is calculated using value function iteration. I estimate the structural parameters of the model using data on magazine cover prices. Among the parameters estimated are the mean, variance, and persistence of the adjustment cost process. The estimated distribution of adjustment costs is nondegenerate, and the average adjustment cost paid by firms is large in comparison to other results in the literature.

JEL classification: E31, D40, and L11
Keywords: state-dependent pricing, menu costs, price adjustment, indirect inference

Risk Sharing and Industrial Specialization: Regional and International Evidence

By Bent Sorensen, Sebnem Kalemli-Ozcan, & Oved Yosha (RWP 00-06 December 2000)
We provide empirical evidence that risk sharing enhances specialization in production. To the best of our knowledge, this well-established and important theoretical proposition has not been tested before. Our empirical procedure is summarized as follows. First, we construct a measure of specialization in production, and calculate an index of specialization for each of the European Community (EC) and non-EC OECD countries, U.S. states, Canadian provinces, Japanese prefectures, Latin American countries, and regions of Italy, Spain, and the United Kingdom. Then, we estimate the degree of capital market integration (a measure of risk sharing) within each of these groups of regions: the EC countries, the non-EC OECD countries, the United States, Canada, Japan, Italy, Spain, and the United Kingdom (and rely on another author's estimate for Latin America). Finally, we perform a regression of the specialization index on the degree of risk sharing, controlling for relevant economic variables. We find a positive and significant relation between the degree of specialization of individual members of a group of countries, provinces, states, or prefectures, and the amount of risk that is shared within the group. We perform regressions using variables such as shareholder rights and the size of the financial sector (relative to GDP) as instruments for the amount of inter-regional risk sharing. These regressions confirm that risk sharing--facilitated by a favorable legal environment and a developed financial system--is a direct causal determinant of industrial specialization.

JEL Classification: F15, F2, F36, F43
Keywords: financial integration, regional specialization, international specialization, finance and macroeconomics.

Can Out-of-Sample Forecast Comparisons Help Prevent Overfitting?

By Todd Clark (RWP 00-05 December 2000)
This paper shows that out-of-sample forecast comparisons can help prevent data mining-induced overfitting. The basic results are drawn from simulations of a simple Monte Carlo design and a real data-based design similar to those in Lovell (1983) and Hoover and Perez (1999). In each simulation, a general-to-specific procedure is used to arrive at a model. If the selected specification includes any of the candidate explanatory variables, forecasts from the model are compared to forecasts from a benchmark model that is nested within the selected model. In particular, the competing forecasts are tested for equal MSE and encompassing. The simulations indicate most of the post-sample tests are roughly correctly sized, as long as just the in-sample portion of the data are used in model selection. Moreover, the tests have relatively good power, although some are consistently more powerful than others. The paper concludes with an application, modeling quarterly U.S. inflation.

JEL Nos.: C52, C53, E37
Keywords: forecasts, overfitting, model selection, causality

Consumption and Aggregate Constraints: Evidence from US States and Canadian Provinces

By Bent Sorensen, Charlotte Ostergaard, & Oved Yosha (RWP 00-04 November 2000)
State-level consumption exhibits excess sensitivity to lagged income to the same extent as US aggregate data, but state-specific (idiosyncratic) consumption exhibits substantially less sensitivity to lagged state-specific income---a result that also holds for Canadian provinces. We propose the following interpretation: borrowing and lending in response to changes in consumer demand is easier for an individual US state than it is for the US as a whole. The PIH may thus be a good model for describing the reaction of consumption to idiosyncratic disposable income shocks even if it fails at the aggregate US level. Further analysis, centered on the persistence of income shocks and on the consumption/income ratio, is consistent with this interpretation but suggests that the PIH still requires qualification. We contrast our results with tests of full inter-state risk sharing.

JEL classification : E 21
Key words: Permanent Income, Consumption, Regional Macroeconomics, Excess Sensitivity, Excess Smoothness, Risk Sharing, US states, Canadian provinces

Market Makers' Supply and Pricing of Financial Market Liquidity

By Pu Shen & Ross M. Starr (RWP 00-03 November 2000)
This study models the bid-ask spread in financial markets as a function of asset price variability and order flow. The market-maker is characterized as passively accepting orders to buy and to sell a security at the market's prevailing price (plus or minus half the bid-ask spread). The bid-ask spread adjusts to cover market-makers' average costs. The bid-ask spread then varies positively with: the security's price volatility, the volatility of order flow, and the absolute value of the market-maker's net inventory position. Each of these variables increases average cost and hence is priced in the bid-ask spread. Thus market liquidity (varying inversely with the bid-ask spread) declines with increasing price and volume volatility and with increasing size of market-maker net inventory positions. The model hence provides a particularly simple explanation for declining market liquidity during periods of large price movements and trading imbalances that increase the size of market-makers' net inventory.

JEL Classification: G12

On the Importance of Geographic and Technological Proximity for R&D Spillovers: an Empirical Investigation

By Michael Orlando (RWP 00-02 July 2000)
Empirical studies of the external effects of R&D suggest that both geographic and technological distance attenuate inter-firm spillovers from innovative activity. The results presented here indicate that the tendency for R&D spillovers to localize economic activity is conditional on the technological relation between spillover generating and receiving firms. The production function framework is generalized to control for correlation between measures of geographic and technological proximity. Coefficient estimates confirm that R&D spillovers are largest among technological neighbors. However, spillovers within narrowly defined technological groups do not appear to be attenuated by distance. Geographic proximity serves to attenuate only those inter-firm spillovers that cross narrowly defined technological boundaries.

JEL classification: O3, L6
Key words: R&D, spillovers, innovation, industrial agglomeration, geography, firm-level, empirical studies.

Private Money, Settlement, and Discount: A Comment

By Stacey L. Schreft (RWP 00-01 April 2000)
Temzelides and Williamson present a model of private currency issuance to study the effect of clearing arrangements on the prices at which private currencies trade, on the volume of exchange, and on welfare. Their findings hinge on three factors: the location of the issuers relative to the area in which their currencies circulate, whether there is an arrangement for clearing nonlocally issued currencies, and whether agents are fully informed about the quality of the currencies. This paper finds that the Temzelides-Williamson model provides valuable insights about historical experiences with private paper monies, but it raises more questions than it answers regarding electronic currencies. The model can, however, serve as a useful point of departure for further research.