Federal Reserve Chairman Research Articles

Monetary policy and long-term US interest rates

This paper assesses the effect of federal funds rate innovations on longer-term US nominal interest rates across different periods. The evidence suggests that these responses change with changes in the monetary policy regime. Time periods considered are pre- and post-1979 and different Federal Reserve Chairman’s tenure. The response of longer-term interest rates to federal funds rate innovations are shown to be smaller and less persistent in the post-1979 period when the Federal Reserve placed more emphasis on inflation.

Sources of Time Variation in the Covariance Matrix of Interest Rates*

The main objective of this paper is to study the sources of time variation in the covariance matrix of interest rates. We depart from the traditional standard deviation–correlation decomposition of covariances and investigate whether time variation in the covariance matrix of bond yield changes is caused by time-varying eigenvalues and/or eigenvectors. On the basis of a formal testing procedure, we find that common factors display a clear time-varying volatility over the past three decades. Most notably, we observe that the switches in monetary policy that take place with the appointment of a new Federal Reserve chairman play an important role in characterizing the time variation in the loadings on the common factors that drive interest rates.

Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?

Abstract: The roles of Fannie Mae and Freddie Mac have become increasingly controversial in the modern world of residential mortgage finance. The authors describe the special features of these two companies and their roles in the mortgage markets and then discuss the controversies that surround the companies and offer recommendations for improvements in public policy. JEL classification: G21, G28. Key words: Fannie Mae, Freddie Mac, government-sponsored enterprises, residential mortgages, securitization, regulation The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation--commonly known as Fannie Mae and Freddie Mac, respectively (1)--have led the way in dramatic changes that have taken place in the structure of the U.S. residential mortgage markets since the 1970s. Fannie Mae and Freddie Mac are quasi-private/quasi-public: for example, they have federal charters that confer unique regulatory provisions; but their shares are publicly traded on the New York Stock Exchange. The biggest advantage of Fannie Mae's and Freddie Mac's anomalous legal status arises because financial markets treat their obligations as if those obligations are backed by the federal government--even though the federal government explicitly does not do so. With the benefit of this special status, Fannie Mae and Freddie Mac have grown into enormous financial institutions, with combined total assets of over $1.8 trillion in 2003. One critic, Richard Carnell (2004), a former Assistant Secretary of the Treasury, has suggested that the two companies' growth is at least partially a consequence of a double game that they play: [They] tell Congress and the news media, 'Don't worry, the government is not on the hook'--and then turn around and tell Wall Street, 'Don't worry, the government really is on the hook.' The preferential legal status of Fannie Mae and Freddie Mac serves as one of a number of mechanisms by which the federal government encourages the consumption (and, arguably, the over-consumption) of housing in the U.S. economy--this one with an on-budget cost of zero. But economists are congenitally suspicious of programs that seem to offer something for nothing. After all, a federal of the deposits in savings and loans cost nothing for many decades--until the early 1990s, when it cost taxpayers about $150 billion (U.S. Federal Deposit Insurance Corporation, 1997). Furthermore, Federal Reserve Chairman Alan Greenspan (2004), among others, has suggested that the anomalous situation of Fannie Mae and Freddie Mac may even pose systemic risks to the financial sector. This article will offer a generalist's guide to the functions that Fannie Mae and Freddie Mac perform in the residential mortgage financial markets and the controversies that swirl around them. Along the way we will highlight some important--and perhaps under-appreciated--changes that are occurring in the structure of U.S. residential mortgage markets. Some Background What Do Fannie Mae and Freddie Mac Do? Fannie Mae and Freddie Mac participate in the secondary mortgage market: Mortgage originators come to them with pools (bundles) of mortgages and either these assets for securities or sell them outright to one of the two companies. Under Fannie Mae's and Freddie Mac's swap programs, an originator exchanges a mortgage pool for a mortgage-backed security that is issued and guaranteed by one of the two companies and that represents an interest in the same pool. Fannie Mae and Freddie Mac promise the security holders that the latter will receive timely payment of interest and principal on the underlying mortgages, less an annual guarantee fee of about 20 basis points (0.20 percent) on the remaining principal. In essence, Fannie Mae and Freddie Mac are providing insurance to holders of mortgage-backed securities against default risk on the underlying mortgages and are thus bearing that risk themselves. …

Comments and Discussion

Comments and Discussion Barry Eichengreen and Jeffrey A. Frankel Barry Eichengreen: The first rule of forecasting is, "Give them a forecast or give them a date, but never give them both."1 Michael Dooley and Peter Garber have given us a forecast, namely, that the dollar will fall and U.S. Treasury yields will rise. Bravely, they have also given us a date. Unfortunately for those of us interested in the future, that date is 1971. Like Dooley and Garber, I agree that what cannot go on forever generally will not. But unlike them I do not believe that recent events in financial markets can help us pin down the timing. The middle of March, just before the Brookings Panel meeting, saw an increase in noise about the possibility that foreign central banks might diversify out of dollars. The governor of the Bank of Korea made some widely reported comments about the need for more-active reserve management. Prime Minister Junichiro Koizumi of Japan told a parliamentary committee that reserve diversification was "necessary."2 Y. V. Reddy, governor of the Reserve Bank of India, said that the diversification of reserves was under active discussion.3 Ukrainian economy minister Sergiy Teriokhin argued publicly that the country should diversify its reserves out of dollars and into euros.4 This upsurge in noise was associated with an eight-month high in Treasury yields, reinforcing the belief that reserve diversification could eventually force the dollar down and Treasury yields up. At the same time, that eight-month high in Treasury yields was not all that high. I would acknowledge that this is a troubling point. I am not alone, of [End Page 188] course: Federal Reserve Chairman Alan Greenspan has commented on this issue extensively, to the point where it is now known as the Greenspan conundrum. Factors invoked to help explain it include the relatively short supply of new long-term Treasury debt coming onto the market as the debt managers at the U.S. Treasury shorten maturities, and the inelastic demands of various institutional investors for government securities. In Dooley and Garber's view, the proper interpretation is that financial market participants are attaching a positive probability to Asian central banks continuing to support the dollar by making massive purchases of Treasury bonds. This is the substance of the first of the authors' three notes. Who am I to second-guess the markets, much less to second-guess our esteemed authors? Well, I'm an economic historian who can recall a substantial number of previous episodes where major imbalances leading to sharp changes in exchange rates were not obviously factored into financial markets until immediately before the event. For example, the January March 1933 run on the dollar, a suggestive precedent, had virtually no discernible impact on interest rate differentials or forward exchange rates until almost immediately before it occurred, despite the fact that the possibility had been actively discussed for the better part of a year.5 The 1992 attacks on the pound sterling, a currency that commentators regularly cited as ready for a fall, were similarly not preceded by the emergence of noticeable interest rate differentials or a forward discount in the foreign exchange market until a couple of weeks before the denouement.6 Particularly interesting, given the context, is that in 1968-71, in the run-up to the collapse of the Bretton Woods system, the forward discount on the dollar was very modest, as was the interest rate differential between the United States and Germany.7 Then, in the summer of 1971, the forward discount jumped upward. Although one can always ascribe such behavior to the arrival of new information, it is not as if people failed to see the collapse of the Bretton Woods system and a substantial devaluation of the dollar coming. To the contrary, there was an immense contemporary literature warning [End Page 189] that the system would dissolve and that the dollar would have to fall substantially. Yet there seemed to be a striking reluctance to take a position on this basis until one minute before the clock struck midnight. This behavior may be hard to reconcile with perfect foresight, but, if it exists...

The IMF on Policies Responding to Demographic Change

In its semiannual report World Economic Outlook, the International Monetary Fund presents its analysis of major economic policy issues and assessment of economic prospects, along with more detailed treatment of a selected current topic. The special topic in the 300‐page report published in September 2004 is “The Global Demographic Transition,” treated in Chapter III of the document. An excerpt from the section of that chapter titled “Policies to Meet the Challenges of Global Demographic Change” is reproduced below with the permission of the IMF. Footnotes and the figure included in the excerpt have been renumbered.The title of Chapter III is “How Will Demographic Change Affect the Global Economy?” The tone of the discussion is set by the opening epigraph, a quotation from the UK's 1949 Report of the Royal Commission on Population: “It seems possible that a society in which the proportion of young people is diminishing will become dangerously unprogressive, falling behind other communities not only in technical efficiency and economic welfare, but in intellectual and artistic achievement as well.” Accordingly, the focus of the analysis, like that of the commentary by US Federal Reserve Chairman Alan Greenspan reprinted in the preceding Document item in this issue, is on the consequences of population aging and on the desirable policy responses to that process. The discussion broadly parallels Greenspan's but with a wider compass, including some consideration of the effects of aging in developing countries. It emphasizes the need for counteracting adverse effects of demographic change through a combination of policy measures, since “the size of the reforms” (such as increasing labor force participation, inducing later retirement, and attracting more immigrants) “that would be needed in any single area [is] sufficiently large that they would be politically and economically difficult to achieve.”

DID TIME INCONSISTENCY CONTRIBUTE TO THE GREAT INFLATION? EVIDENCE FROM THE FOMC TRANSCRIPTS

We use evidence from detailed records of FOMC deliberations to argue that time inconsistency theory can help explain the excessive monetary expansion that characterized Arthur Burns's tenure as Federal Reserve Chairman (1970–1978). The records suggest that the Fed perceived a Phillips curve tradeoff and political pressures that made it difficult to adopt disinflationary policies; the tendency toward excessively expansionary policy was exacerbated by the short‐run planning horizon the Committee faced in each of its meetings. We argue that comparative static predictions of the time inconsistency model are consistent with the rise of inflation during the Burns years and its subsequent fall.

Shocks and Government Beliefs: The Rise and Fall of American Inflation

We use a Bayesian Markov Chain Monte Carlo algorithm to estimate the parameters of a “true” data-generating mechanism and those of a sequence of approximating models that a monetary authority uses to guide its decisions. Gaps between a true expectational Phillips curve and the monetary authority's approximating nonexpectational Phillips curve models unleash inflation that a monetary authority that knows the true model would avoid. A sequence of dynamic programming problems implies that the monetary authority's inflation target evolves as its estimated Phillips curve moves. Our estimates attribute the rise and fall of post-WWII inflation in the United States to an intricate interaction between the monetary authority's beliefs and economic shocks. Shocks in the 1970s made the monetary authority perceive a tradeoff between inflation and unemployment which ignited big inflation. The monetary authority's beliefs about the Phillips curve changed in ways that account for former Federal Reserve Chairman Paul Volcker's conquest of U.S. inflation.

Inferring Policy Objectives from Economic Outcomes*

AbstractEstimated policy rules are reduced‐form equations that are silent on many important policy questions. However, a structural understanding of monetary policy can be obtained by estimating a policymaker's objective function. The paper derives conditions under which the parameters in a policymaker's policy objective function can be identified and estimated. We apply these conditions to a New Keynesian sticky‐price model of the US economy. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined when Paul Volcker was appointed Federal Reserve chairman.

The Policy Preferences of the U.S. Federal Reserve

This paper uses a small data-consistent model of the United States to identify and estimate the Federal Reserve's policy preferences. We find critical differences between the policy regimes in operation during the Burns-Miller and Volcker-Greenspan periods. Over the Volcker-Greenspan period we estimate the inflation target to be 2.0% and find that policymakers were willing to allow the real interest rate to change in order to keep overall changes in the nominal interest rate relatively small. In contrast, for the Burns-Miller period the inflation target is estimated to be 5.9%, and we find that policy makers were much more prepared to tolerate changes in the nominal interest rate than they were changes in the real interest rate. Consequently, over this period policymakers tended to accommodate movements in inflation. We find statistical evidence that a policy regime shift occurred with Volcker's appointment to Federal Reserve chairman.

High Schools and Reform

IN CASE you haven't noticed, the traditional American public high school is on the chopping block. During the past two decades, school reformers have sighed when speaking of change in secondary schools, saying they were the hardest -- and would be the last -- nutshell they would seek to crack in making significant improvements in the education of young people. Efforts in secondary schools would need to be incremental, most experts thought. Instead, a sudden burst of talk, money, and policy proposals has made it obvious that those in high schools are going to have to act -- and soon. In a recent speech to a Chamber of Commerce audience, even the dour, academic Federal Reserve Chairman Alan Greenspan provided historical and economic justifications for moving high schools from their comprehensive focus toward an exclusive emphasis on what now passes for an honors program. The expansion of high schools with a broad curriculum in the first half of the 20th century, Greenspan said, served the needs of the economy well. A high school diploma represented the training needed to be successful in most sectors of the American economy. Thus the economic returns of a diploma rose, as did high school completion rates. Today, the country is in a new era, when higher skills are an international commodity, and, instead of defending protectionism, Greenspan argued, we need to discover the means to enhance the skills of our work force, especially those workers lower on the skill ladder. That effort needs to begin in kindergarten, he added. But it is critical for high schools and community colleges. Similar economic arguments for transforming high schools were used by Susan Sclafani, long-time advisor to U.S. Secretary of Education Rod Paige and now assistant secretary for vocational and adult education. In describing the proposals for reauthorization of the Carl D. Perkins Vocational and Technical Education Act, she made it obvious that the department wants to use this program to push an agenda for high school reform. Barely mentioning career or technology goals in remarks to a forum in Washington, D.C., she outlined an accountability-based, academic-focused direction under a reauthorized Perkins Act. High school transformation is taking place, however, without federal intrusion. A nascent school movement has turned into a national cause because of the infusion of billions of dollars by the Bill and Melinda Gates Foundation. Foundation funds are stimulating the break-up of large high schools into smaller ones as well as the creation of new, smaller learning environments. More than that, money from the Gates Foundation is putting small high schools on the agendas of governors and state legislators, national organizations, and evaluators. Not even past reform efforts by such stalwart foundation heavyweights as Ford and the Carnegie Corporation matched the depth and focus of what the Gates Foundation is accomplishing. While the Gates approach tends to see personal support as key to student success, Ready or Not: Creating a High School Diploma That Counts, a report released in February by the American Diploma Project, defines student success exclusively in terms of meeting high academic standards. Not only that, under its proposals, all states would be working from the same set of standards. This call for states to rework their standards and assessments into more consistent national benchmarks comes from an interesting combination of national groups. The sponsors of the American Diploma Project are the Education Trust, a policy and advocacy group focused on the needs of poor kids; the Thomas B. Fordham Foundation, headed by Chester Finn, who supports more competition for public education; and Achieve, Inc., a national group focused on helping states with standards-based accountability efforts. …

Efficient Markets and Information Processing: A One-Hour Classroom Trading Simulation

This paper describes the implementation of a one hour classroom trading simulation originally developed by the author when he was a trader at the Chicago Board of Trade. Pre-requisite student knowledge consists of market efficiency concepts, and the market making process. The simulation involves putting students into teams of 4 or 5 (7 or 8 teams maximum) which function as OTC dealers/market makers in a novel asset market. The students have intimate knowledge of certain characteristics of this asset, but not full information. The simulation begins when each team posts a bid and ask price for the asset which is displayed for all market participants. Trading commences as each team is allowed to make one and only one trade with a competing market maker. Trades as well as bid/ask spreads are posted by the moderator who also interjects with commentary tailored to the knowledge level of the students (active versus passive trading, market maker risk, long and short concepts, price discovery concepts). After each round of trading, the teams are allowed to revise their bid/ask spreads. Inevitably, students find that the effective bid/ask spread in the market narrows purely as a function of trading since no new is provided. Depending on the class and students, variations can be introduced including informed outside traders (Mr. Arbitrage), economic releases and comments by the Federal Reserve Chairman (suitably vague, of course). These variations allow the students to see first hand the impact of new on the market as bid/ask spreads widen, volatility increases and invariably there is over-reaction to information. The simulation concludes when the bid/ask spreads have effectively bracketed the true value of the asset known only to the instructor. The instructor concludes with a discussion of what it means for the market to process information as demonstrated in the simulation as well as reinforcing the concepts of market making, risk, market behavior and trading.

Women and the Internet

As the pervasiveness of the Internet spreads rapidly, Peter Drucker’s prediction about the coming of the new organization, labeled as the “knowledge society” [7] or the “virtual corporation” [9] is now a reality. In an information-based economy, any radical shift in our approach toward information and knowledge influences more than an elite group of individuals or firms—it has a far-reaching effect on national and global economies. The Internet is viewed by many as a paradigm shift forcing individuals, firms, businesses, and even societies to rapidly adapt to a newfound virtual world in which agility and responsiveness are the hallmarks of success [5]. At a 1999 meeting of Congress’s Joint Economic Committee Microsoft Chairman Bill Gates told committee members: “We will absolutely see productivity increases coming out of the use of technology for many years to come.” At same meeting, Federal Reserve Chairman Alan Greenspan told the panel that “something special has happened to the American economy in recent years because of computerization.” That “something special” was the increased productivity generated by the Internet and information technology [10]. Bureau of Labor Statistics data at least superficially support this linkage showing the share of employees using a computer at work rising from 25% in 1984 to 52% in 1997. Computer usage, in this context, refers to the use of computers to perform any work-related function, such as word processing, information retrieval, data analysis, and other related tasks. In addition to enhancing productivity, revolutionary technologies such as the Internet revive hopes of removing barriers to economic prosperity, increasing workplace productivity, and improving quality of life. The much-proclaimed anonymity of the Internet user leads to the hypothesis that the Internet may help close racial and gender-based wage gaps. The significant increase in women using the Web since its early origins [8] suggests a relationship between the Internet, gender, and the wage structure, but little or no research has been done in this area. Could the Internet lead to a full realization of the legal concept of equal pay for equal work?

2000–2003 real estate bubble in the UK but not in the USA

In the aftermath of the burst of the “new economy” bubble in 2000, the Federal Reserve aggressively reduced short-term rates yields in less than 2 years from 6 1/2 to 1 1/4% in an attempt to coax forth a stronger recovery of the US economy. But, there is growing apprehension that this is creating a new bubble in real estate, as strong housing demand is fuelled by historically low mortgage rates. Are we going from Charybdis to Scylla? This question is all the more excruciating at a time when many other indicators suggest a significant deflationary risk. Using economic data, Federal Reserve Chairman A. Greenspan and Governor D.L. Kohn dismissed recently this possibility. Using the theory of critical phenomena resulting from positive feedbacks in markets, we confirm this view point for the US but find that mayhem may be in store for the UK: we unearth the unmistakable signatures (log-periodicity and power law super-exponential acceleration) of a strong unsustainable bubble there, which could burst around the end of the year 2003.

Inferring Policy Objectives from Economic Outcomes

This paper stresses that estimated policy rules are reduced form equations that are silent on many important policy questions. To obtain a structural understanding of monetary policy it is necessary to estimate the policymaker's objective function, rather than its policy reaction function. With these issues in mind, this paper proposes a system-based estimation approach that uses the solution to the policymaker's optimization problem to infer the underlying policy regime from the economy's evolution over time. The paper derives conditions under which the parameters in a policymaker's policy objective function can be identified and estimated. These identification conditions apply to forward-looking rational-expectations models as well as to backward-looking models, extending existing results. We apply these conditions to a New Keynesian sticky-price model of the US economy, estimating jointly all of the model's behavioral parameters and the policy regime parameters. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined with Volcker's appointment to Federal Reserve chairman. However, the estimates reveal that other - non-monetary-policy - parameters have changed over time also.

2000-2003 Real Estate Bubble in the UK but not in the USA

In the aftermath of the burst of the economy bubble in 2000, the Federal Reserve aggressively reduced short-term rates yields in less than two years from 6 1/2 to 1 1/4 % in an attempt to coax forth a stronger recovery of the US economy. But, there is growing apprehension that this is creating a new bubble in real estate, as strong housing demand is fuelled by historically low mortgage rates. Are we going from Charybdis to Scylla? This question is all the more excruciating at a time when many other indicators suggest a significant deflationary risk. Using economic data, Federal Reserve Chairman A. Greenspan and Governor D.L. Kohn dismissed recently this possibility. Using the theory of critical phenomena resulting from positive feedbacks in markets, we confirm this view point for the US but find that mayhem may be in store for the UK: we unearth the unmistakable signatures (log-periodicity and power law super-exponential acceleration) of a strong unsustainable bubble there, which could burst before the end of the year 2003.

Inferring Policy Objectives from Economic Outcomes

This paper stresses that estimated policy rules are reduced form equations that are silent on many important policy questions. To obtain a structural understanding of monetary policy it is necessary to estimate the policymaker's objective function, rather than its policy reaction function. With these issues in mind, this paper proposes a system-based estimation approach that uses the solution to the policymaker's optimization problem to infer the underlying policy regime from the economy's evolution over time. The paper derives conditions under which the parameters in a policymaker's policy objective function can be identified and estimated. These identification conditions apply to forward-looking rational-expectations models as well as to backward-looking models, extending existing results. We apply these conditions to a New Keynesian sticky-price model of the US economy, estimating jointly all of the model's behavioral parameters and the policy regime parameters. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined with Volcker's appointment to Federal Reserve chairman. However, the estimates reveal that other - non-monetary-policy - parameters have changed over time also.

Innovational progress sans thrift

Federal Reserve Chairman Alan Greenspan seemed to succumb partially to the irrational exuberance that underlay the U.S. 1995–2000 Wall Street bubble: a specified step-up in total-factor productivity à la Schumpeter, centered in the high technology sector, was believed to accelerate long-term real GDP growth and equities’ future total returns. Even without positive U.S. thrift, by 2020 when babyboomers’ retirements exploded as a demographic revolution, technological progress could allegedly atone for the worsening of thrift traceable to the massive Bush tax cuts that had earlier received Greenspan’s blessing. Here I spell out a 1912 Schumpeter scenario of “Progress sans Thrift” and show how it is unlikely to fulfill high-profit growth hopes of bubble speculators.

Notes from the Editors, April 2002

» Notes from the EditorsAs this special issue on the economy goes to the printer, the business press is full of the news that a mild recovery from the recession that began in March 2001 may already be in the works, as was suggested by Federal Reserve Chairman Alan Greenspan in testimony to Congress in late February. Whether this should prove to be the case or not, it remains true that the long-term, deepening problems of the U.S. economy are for the most part ignored in such accounts, in favor of a short-run focus on an expected cyclical upswing.This article can also be found at the Monthly Review website, where most recent articles are published in full.Click here to purchase a PDF version of this article at the Monthly Review website.

Comments and Discussion

Comments and Discussion Jonathan A. Parker and Janet L. Yellen Jonathan A. Parker: Athanasios Orphanides and John Williams have written an ambitious paper that tackles a difficult and important question: how should a central bank conduct monetary policy in practice, that is, not in a simple model of the economy, but in the complex and shifting U.S. economy? The authors focus on two related problems that the Federal Reserve confronts continuously in its attempts to stabilize economic growth. First, there is a great deal of uncertainty at any point in time about the true state of the economy, and actual policy can be based only on information available at the time. A week before this conference, at the annual symposium on monetary policy in Jackson Hole, Wyoming, Federal Reserve Chairman Alan Greenspan spoke about the difficulty the Federal Reserve had encountered in guiding the economy through the boom of the late 1990s: The struggle to understand developments in the economy and financial markets since the mid-1990s has been particularly challenging for monetary policymakers. We were confronted with forces that none of us had personally experienced . . . . As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact.1 There is even now considerable uncertainty as to whether the increase in asset prices of the late 1990s was a bubble, which tighter monetary policy should have reined in, or an optimal response to changed economic conditions, such as the possibility that the United States was in a technological revolution that would increase the rate of growth of trend [End Page 119] productivity. If one bases policy on poor estimates of the current state of the economy, estimation error becomes policy error. Stabilization policy becomes destabilizing. The second main problem that confronts policymakers is uncertainty about the response of the economy to the policies that they consider. In his speech at Jackson Hole, Greenspan went on to argue that "it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity—the very outcome we would be seeking to avoid." Thus the Federal Open Market Committee did not act to reduce equity prices in part because committee members were unsure whether those prices were or were not justified by the fundamentals, and in part because they were unsure whether they could reduce equity prices, or at least slow the increase in prices, without slowing the economy so much as to cause a recession. Of course, we now know that a recession was not avoided. Following the turnaround in the stock market, a recession began in March 2001 and probably ended late that year. This second source of uncertainty poses the following question for policy: even supposing that the data during the 1990s had been clear, would and should a more contractionary policy have smoothed out some of the observed boom and recession? If one sets interest rates according to policies that are optimal in a model that turns out to be a poor approximation of the real world, model error becomes policy error. And again, stabilization policy becomes destabilizing. Given these problems, Orphanides and Williams recommend using a policy rule that sets the federal funds rate, ft, as follows: in which the parameters (the θ's) on the inflation gap and the change in the unemployment rate are chosen so as to allow for substantial movement in the natural rate of interest and the natural rate of unemployment. The authors base this recommendation on their finding that this rule performs well in the sense of achieving close to the minimal attainable value of the following loss function: for a set of three simple models of the U.S. economy. [End Page 120] This rule deals with the first problem—that the Federal Reserve does not know the true state of the economy—because it does not depend on real-time estimates of the natural rate of interest or the full-employment level of unemployment. Rather, this rule depends only on economic variables that are observed easily and (almost) contemporaneously with their occurrence. As an example of...

Bubbles in Experimental Asset Markets: Irrational Exuberance No More

Abstract: The robustness of bubbles and crashes in markets for finitely lived assets is perplexing. This paper reports the results of experimental asset markets in which participants trade two assets. In some markets, price bubbles form. In these markets, traders will pay even higher prices for the asset with lottery characteristics, i.e., a claim on a large, unlikely payoff. However, institutional design has a significant impact on deviations in prices from fundamental values, particularly for an asset with lottery characteristics. Price run-ups and crashes are moderated when traders finance purchases of the assets themselves and are allowed to short sell. JEL classification: C92, G14 Key words: bubbles, asset markets, laboratory experiments, rational expectations ********** One of the most striking results from experimental asset markets is the tendency of asset prices to bubble above fundamental value and subsequently crash. Explaining the price pattern is a challenge. Yet extreme price movements, at odds with any reasonable economic explanation, are documented throughout history. Examples include the Dutch tulip mania (1634-1637), the Mississippi bubble (1719-1720), and the stock market boom and crash of the 1920s (see e.g., Kindelberger (1989), Garber (1990), White (1990)). More recently, in a speech made on December 5, 1996, Federal Reserve Chairman Alan Greenspan expressed concern that stock prices are inflated by irrational exuberance. The current debate over rational valuation centers largely on internet-related companies. Though downward price adjustments have been observed of late, stock prices for many of these so-called dot-coms increased at incredible rates over the last decade despite mounting accounting losses. Price to earnings multiples for some dot-coms (or price to revenues when earnings are negative) were as high as several hundred to one, something unheard of just ten years ago. Chairman Greenspan speculates that the observed price behavior might reflect a lottery effect. Market participants are willing to pay a premium for some stocks because, though the chance is small, a very significant payoff is possible. (1) This paper reports the results of experimental asset markets designed to examine whether asset prices reflect a lottery premium. The results indicate that traders will pay a premium for a claim on a large payoff, even if the payoff is unlikely. In addition, this study re-examines whether institutional design impacts upward deviations in prices from fundamental values. Unlike previous research that documents the robustness of bubbles formation, price run-ups and crashes are not observed when traders are not permitted to finance purchases with borrowed funds but are allowed to short sell the assets. The remainder of this paper is organized as follows. Section I provides background and motivation for the study. Section II describes the experimental procedures and design. Section III reports the results. Section IV contains a discussion of the results and concluding remarks. I. Regularities, Institutional Features, and New Questions Smith, Suchanek, and Williams (1988) first reported bubbles in experimental asset markets. Typically in bubbles markets, subjects trade an asset over a finite horizon. The asset has a common dividend, determined at period end based on a known, stationary probability distribution. Thus, fundamental value, assuming risk neutrality, is easily computed as the number of trading periods remaining multiplied by the expected dividend per period. In this setting trading yields large upward deviations in prices from fundamental value followed by crashes back to the asset's risk neutral value. The finding has been replicated by Porter and Smith (1995), Ackert and Church (2000), and Lei, Noussair, and Plott (2001), among others. King, Smith, Williams, and Van Boening (1993) investigate whether bubbles are moderated by several treatment variables including the ability to short sell, margin purchases, the presence of brokerage fees, equal endowments across traders, a subset of informed traders, limit price change rules, design experience, and experience in the business world. …