A Panic Attack on Unit Roots and Cointegration

This paper develops a new methodology that makes use of the factor structure of large dimensional panels to understand the nature of non-stationarity in the data. We refer to it as PANIC - a 'Panel Analysis of Non-stationarity in Idiosyncratic and Common components'. PANIC consists of univariate and panel tests with a number of novel features. It can detect whether the nonstationarity is pervasive, or variable-specific, or both. It tests the components of the data instead of the observed series. Inference is therefore more accurate when the components have different orders of integration. PANIC also permits the construction of valid panel tests even when cross-section correlation invalidates pooling of statistics constructed using the observed data. The key to PANIC is consistent estimation of the components even when the regressions are individually spurious. We provide a rigorous theory for estimation and inference. In Monte Carlo simulations, the tests have very good size and power. PANIC is applied to a panel of inflation series.

Can Sticky Prices Account for the Variations and Persistence in Real Exchange Rates?

This paper provides an empirical assessment of the importance of sticky prices in accounting for the variations and the persistence in real exchange rates. Vector autoregressions with five variables from two countries that always include the United States are estimated. Restrictions are imposed to identify a global shock, and two sets of country specific output shocks. One set of shocks is associated with instantaneous price adjustments, while the other has delayed effects on prices. Data from the G7 countries reveal that U.S. sticky price shocks are the dominant source of real exchange rate variations. But these shocks have reasonably short half-lives and cannot account for the observed real exchange rate persistence. Non-sticky price shocks can induce very persistent real exchange rate dynamics, even though they account for little of the historical real exchange rate variations.

A New Look at Panel Testing of Stationarity and the PPP Hypothesis

This paper uses a decomposition of the data into common and idiosyncratic components to develop procedures that test if these components satisfy the null hypothesis of stationarity. The decomposition also allows us to construct pooled tests that satisfy the cross-section independence assumption. In simulations, tests on the components separately generally have better properties than testing the observed series. However, the results are less than satisfactory, especially in comparison with similar procedures developed for unit root tests. The problem can be traced to the properties of the stationarity test, and is not due to the weakness of the common-idiosyncratic decomposition. We apply both panel stationarity and unit root tests to real exchange rates. We found evidence in support of a large stationary common factor. Rejections of PPP are likely due to non-stationarity of country-specific variations.

PPP May not Hold After all: A Further Investigation

In a recent paper, Engel (1999b) presents monte-carlo evidence to suggest that unit root tests can not detect a non-stationary component in the real exchange rate even when this component accounts for almost half of its long-horizon forecast error variance. This hidden non-stationary component led to the conclusion that long run purchasing power parity might not hold after all. In this note, we first point out some conceptual difficulties with the statistic being used to measure the size of the non-stationary component, and then argue that it bears no systematic relationship with rejection rates in unit root tests. The problems stem from near observational equivalence of the simulated model in not one, but two dimensions. We then discuss the steps a practitioner can take to minimize Type I error in cases when the non-stationary component is hard to detect. Real exchange rate data for 19 countries are examined and estimates are obtained for the duration of the real exchange rate shocks.

The Fed and the New Economy

This paper seeks to understand the behavior of Greenspan’s Federal Reserve in the late 1990s. Some authors suggest that the Fed followed a simple "Taylor rule," while others argue that it deviated from such a rule because it recognized that the "New Economy" permitted an easing of policy. We find that a Taylor rule based on inflation and unemployment does break down in the late 1990s. However, the Fed’s behavior appears stable once one accounts for the falling NAIRU of the period. A rule based on inflation and the deviation of unemployment from the NAIRU captures the Fed’s behavior through the entire period from 1987 to 2000.

Economic Effects of Means-Tested Transfers in the U.S.

The system of means-tested transfers in the U.S. has evolved in important ways over the last decade, with significant expansions of Medicaid, the Earned Income Tax Credit, and the Supplemental Security Income program, and with significant contraction in Aid to Families with Dependent Children, now titled the Temporary Assistance for Needy Families program. To determine where we are in our understanding of each of these programs, as well as the other major programs in the system of means-tested transfers, a volume is under preparation by the National Bureau of Economic Research that surveys the current structure and historical evolution of each of these programs and that synthesizes the results of the research that has been conducted on their economic effects. In addition to the AFDC-TANF, Medicaid, EITC, and SSI programs, reviews have been conducted for the Food Stamp program and for housing, child care, job training, and child support programs. This paper summarizes the results of those reviews and highlights the large number of important findings from existing research.

The Temporary Assistance for Needy Families Program

The Temporary Assistance for Needy Families (TANF) program was created in 1996 from what was previously named the Aid to Families with Dependent Children (AFDC) program. The TANF program is intended to serve low-income families, primarily those with only a single parent present, as did the AFDC program. The TANF program is distinguished from AFDC by strong work requirements, time limits on receipt, options for the provision of noncash assistance, and by a block grant financing structure. This paper reviews the rules of the TANF program and the research that has been conducted on it and on the AFDC program.

The Epidemiology of Macroeconomic Expectations

Since the foundational work of Keynes (1936), macroeconomists have emphasized the importance of agents' expectations in determining macroeconomic outcomes. Yet in recent decades macroeconomists have devoted almost no effort to modeling actual empirical expectations data, instead assuming all agents' expectations are "rational." This paper takes up the challenge of modeling empirical household expectations data, and shows that a simple, standard model from epidemiology does a remarkably good job of explaining the deviations of household inflation and unemployment expectations from the "rational expectations" benchmark. Furthermore, a microfoundations or "agent-based" version of the model may be able to explain, in a way that still permits aggregation, stark rejections of the pure rational expectations framework like Souleles's (2002) finding that members of different demographic groups have sharply different predictions for macroeconomic aggregates like the inflation rate.

A Semiparametric Estimator for Dynamic Optimization Models

We develop a new estimation methodology for dynamic optimization models with unobserved state variables. Our approach is semiparametric in the sense of not requiring explicit parametric assumptions to be made concerning the distribution of these unobserved state variables. We propose a two-step pairwise-difference estimator which exploits two common features of dynamic optimization problems: (1) the weak monotonicity of the agent's decision (policy) function in the unobserved state variables, conditional on the observed state variables; and (2) the state-contingent nature of optimal decision-making which implies that, conditional on the observed state variables, the variation in observed choices across agents must be due to randomness in the unobserved state variables across agents. We apply our estimator to a model of dynamic competitive equilibrium in the market for milk production quota in Ontario, Canada.

Optimal Cartel Pricing in the Presence of an Antitrust Authority

Price dynamics are characterized when a price-fixing cartel is concerned about creating suspicions of the presence of a cartel. A dynamical extension of static models yields the counterfactual prediction that the cartel initially raises price and then gradually lowers it. An alternative specification generates a more plausible result that the cartel gradually raises price. For that specification, the long-run cartel price is found to be decreasing in the damage multiple but is independent of the level of fixed fines. A more stringent standard for calculating damages is shown to induce the cartel to price higher.

Empirical Likelihood-Based Selection Criteria for Moment Condition Models

In this note we propose model selection criteria (MSC) for unconditional moment models using empirical likelihood (EL) statistics in the construction of the MSC. The use of EL-statistics in lieu of the more common J-statistics leads to a much more transparent interpretation of the MSC by providing a closer analogy with MSC in standard parametric likelihood models and underlying the common likelihood- (or information-) based underlying model selection procedures for bothe parametric as well as semi-parametric models.

Sentiment, Predictable Income, and Habits in the Dynamics of Aggregate Consumption

This paper explores whether habit formation in the representative agent’s preferences can explain two failures of the standard permanent income model with intertemporally separable utility: the sensitivity of consumption to lagged consumer sentiment, and to predictable changes in current income. I show that in a habit formation model, the sensitivity of consumption growth to predicted income can be to a large extent reinterpreted as a sluggish response of consumption to news. Moreover, the sensitivity of consumption growth to lagged sentiment merely reflects the serial corre-lation in consumption growth generated by habits. I study the model’s predictions for the effect of the recent tax cut on aggregate consumption. Contrary to the PIH model, consumers with habits respond to permanent tax cuts slowly. The estimated model predicts an immediate (first-quarter) MPC out of the permanent tax cut of only 30%.

Estimating Taylor Rules in a Real Time Setting

This paper demonstrates how the use of revised data distorts our understanding of past monetary policy decisions. Three problems are addressed - the use of (i) contemporaneous rather than lagged data, (ii) revised rather than unrevised data; and (iii) leads of data, unavailable at the time of policy setting, for estimating potential output. In order to evaluate each of these distortions separately, I have estimated Taylor rules using different sets of estimates of output gap and inflation for three sub-samples, corresponding to chairmanship terms of Arthur Burns, Paul Volcker, and Alan Greenspan. Three series of estimates are constructed -- series based on revised estimates of data for the whole post-war sample; series based on truncated (excluding leads) subsamples of revised data; and series, similar to the previous one, but based on unrevised data. Although using revised data may produce significantly misleading conclusions, the inclusion of leads of the data when estimating the potential level of the economy has a much bigger impact, producing coefficients which may have a value less than half of the true one. At the same time, the use of contemporaneous rather than lagged data does not seem to have a big effect on the final results. Among other things, I demonstrate that the U.S. monetary policy was less active during Burns' chairmanship, and much more anti-inflationary during Greenspan's, than traditional analysis would suggest.

Computing Sunspots in Linear Rational Expectations Models

We provide computationally simple methods of analyzing the effects of fundamental and sunspot shocks in linear rational expectations models when the equilibrium is indeterminate. Under indeterminacy sunspots can affect model dynamics through endogenous forecast errors that do not completely adjust to fundamental shocks alone. Moreover, the effect of fundamental shocks on forecast errors is not uniquely determined. We characterize the full set of equilibria and show that some solution methods only generate subsets of all the rational expectations equilibria by imposing specific restrictions on the forecast errors. However, in most cases it is possible to recover the full set of equilibria from the output of these methods. The solution algorithms are illustrated with a New Keynesian dynamic stochastic equilibrium model that can be solved analytically. We show that under a passive interest-rate rule the response of output and inflation to an unanticipated interest rate cut is ambiguous: while output rises, there are some equilibria in which inflation increases and other in which prices fall.

Liquidity Constraints and Precautionary Saving

Economists working with numerical solutions to the optimal consumption/saving problem under uncertainty have long known that there are quantitatively important interactions between liquidity constraints and precautionary saving behavior. This paper provides the analytical basis for those interactions. First, we explain why the introduction of a liquidity constraint increases the precautionary saving motive around levels of wealth where the constraint becomes binding. Second,we provide a rigorous basis for the oft-noted similarity between the effects of introducing uncertainty and introducing constraints, by showing that in both cases the effects spring from the concavity in the consumption function which either uncertainty or constraints can induce. We further show that consumption function concavity, once created, propagates back to consumption functions in prior periods. Finally, our most surprising result is that the introduction of additional constraints beyond the first one, or the introduction of additional risks beyond a first risk, can actually reduce the precautionary saving motive, because the new constraint or risk can ‘hide’ the effects of the preexisting constraints or risks.

Durable-Goods Oligopoly with Secondary Markets: Theory and an Empirical Application to the Automobile Market

We examine the effects of durability on equilibrium producer behavior in the car market. In this setting, forward-looking producers take into account the effect that their current production decisions have on their current and future profits, due to the existence of a secondary market. First, we construct a dynamic oligopoly model of a vertically-differentiated product market to understand the equilibrium production dynamics which arise from the durability of the goods and their active trade in secondary markets. Second, we use data from the automobile industry to estimate a tractable linear-quadratic version of this model. One result suggests that durability may be a particularly desirable car feature for high-quality car producers since, by overproducing today, they can exploit durability and the existence of a secondary market to potentially reduce their lower-quality competitors' future production: planned obsolescence appears to be a more profitable strategy for lower-end than higher-end producers.

Econometric Models of Asymmetric Ascending Auctions

We develop econometric models of ascending (English) auctions which allow for both bidder asymmetries as well as common and/or private value components in bidders' underlying valuations. We show that the equilibrium inverse bid functions in each round of the auction are implicitly defined (pointwise) by a system of nonlinear equations, so that conditions for the existence and uniqueness of an increasing-strategy equilibrium are essentially identical to those which ensure a unique and increasing solution to the system of equations. We exploit the computational tractability of this characterization in order to develop an econometric model, thus extending the literature on structural estimation of auction models. Finally, an empirical example illustrates how equilibrium learning affects bidding during the course of the auction.

Individual Sense of Fairness: An Experimental Study

This paper presents an experimental test of the theory of individual sense of fairness of Karni and Safra (2000) using a modiÞed 3-player dictator game. The dictator is asked to allocate chances to win a single indivisible $15 dollar prize among himself and two others. His choice is restricted to a chord in the probability simplex. If the dictator chooses an interior point along the chord, this involves giving up own probability to win in exchange for a fairer allocation procedure. The results indicate that a strong preference for fairness exists in some subjects but not others. The chords used in the experiment were also constructed to allow the investigation of other properties of the subjects preferences for fairness.

On The Representation of Beliefs by Probabilities

This paper explores two axiomatic structures of subjective expected utility assuming a finite state-space and state-dependent, connected, topological outcome-spaces. Building on the work of Karni and Schmeidler (1981) the analytical framework includes, in addition to the preference relation on acts, introspective preferences on hypothetical lotteries that are linked to the preference relation on acts by consistency axioms. The two models accommodate state-dependent preferences and yield subjective probabilities that correctly represent the decision-maker’s beliefs. State-independent preferences are a special case.

Firm Adaptation, Consumer Sorting, and Market Dominance

Consider a setting in which firms randomly discover new ideas that affect their products or services and implement only those ideas which increase current profit. At the same time that firms are adapting their offerings, consumers are searching among firms for the best match. It is shown that implicit in these dual dynamics is an increasing returns mechanism which can result in one firm dominating the market in the long run. The conditions under which there is sustained market dominance are characterized.

Increasing Competition and the Winner's Curse: Evidence from Procurement

We empirically measure the effects of increasing competition on equilibrium bidding in procurement auctions. In common-value auctions, the winner's curse counsels more conservative bidding, as the number of competitors increases. First, we estimate the structural parameters of an equilibrium bidding model and test for the importance of common-value components in bidders' preferences. Second, we use these estimates to calculate the effects of increasing competition on both individual bids as well as winning bids, i.e., procurement costs.
We analyze bid data from construction procurement auctions run by the New Jersey transportation department. Our results indicate that, for a large subset of these auctions, the median procurement cost rises as competition intensifies: increasing the number of bidders from 3 to 6 raises median procurement costs by about 15%. In this setting, then, asymmetric information overturns the common economic wisdom that more competition is always desirable.

Sacrifice Ratios with Long-Lived Effects

This paper contains a theoretical and empirical study of sacrifice ratios with long-lived effects, including possible strong persistence effects, or even hysteresis effects. The empirical analysis is based on G-7 quarterly output data as well as unemployment data from 1960 to 1999. In this paper, I develop some new methods to measure sacrifice ratios with long-lived effects. I reach four conclusions: First, sacrifice ratios with long-lived effects are larger than sacrifice ratios that do not account for long-lived effects. Second, from a theoretical model and simulation, the "standard method" of measuring sacrifice ratios by Ball (1994) has a larger downward bias for countries with larger long-lived effects. Third, both random and fixed effect models show that there is a negative relationship between sacrifice ratios and initial inflations, which can provide one explanation of the large magnitude of sacrifice ratios with long-lived effects in the 1990s, compared with other periods. Fourth, there is no significant negative relationship between sacrifice ratios with long-lived effects and nominal wage rigidities.

Precautionary Saving and the Marginal Propensity To Consume Out of Permanent Income

The budget constraint requires that, eventually, consumption must adjust fully to any permanent shock to income. Intuition suggests that, knowing this, optimizing agents will fully adjust their spending immediately upon experiencing a permanent shock. However, this paper shows that if consumers are impatient and are subject to transitory as well as permanent shocks, the optimal marginal propensity to consume out of permanent shocks (the MPCP) is strictly less than 1, because buffer stock savers have a target wealth-to-permanent-income ratio; a positive shock to permanent income moves the ratio below its target, temporarily boosting saving.

Individual Learning About Consumption

The standard approach to modelling consumption/saving problems is to assume that the decisionmaker is solving a dynamic stochastic optimization problem. However, under realistic descriptions of utility and uncertainty, the optimal consumption/saving decision is so difficult that only recently economists have managed to find solutions, using numerical methods that require previously infeasible amounts of computation. Yet empirical evidence suggests that household behavior conforms fairly well with the prescriptions of the optimal solution, raising the question of how average households can solve problems that economists, until recently, could not. This paper examines whether consumers might be able to find a reasonably good ’rule-of-thumb’ approximation to optimal behavior by trial-and-error methods, as Friedman (1953) proposed long ago. We find that such individual learning methods can reliably identify reasonably good rules of thumb only if the consumer is able to spend absurdly large amounts of time searching for a good rule.

Intensity of the Sense of Fairness: Measurement and Behavioral Characterization

The analysis of the behavioral and social implications of the intensity of moral sentiments requires that these emotions be quanti…ed. In this paper we quantify the intensity of individual sense of fairness in the context of the model of Karni and Safra (2000). That model depicts self-interest seeking individuals endowed with intrinsic sense of fairness, who must choose among alternative random allocation procedures to determine who, among a group of eligible individuals, will be given ownership of an indivisible good . For such individuals we develop measures of the intensity of their sense of fairness and explore their behavioral characterization.