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Journal Article
Special repo rates: an introduction
Transactions involving repurchase agreements (known as repos and reverses) are important tools the Federal Reserve uses in implementing monetary policy. By undertaking such transactions with primary dealers, the Fed can temporarily increase or decrease the quantity of reserves in the banking system. The focus of this article is the repo market, especially the role the market plays in the financing and hedging activities of primary dealers. The author explains the close relation between the price premium that newly auctioned, or on-the-run, Treasury securities command and the special repo ...
Journal Article
Happy hour economics, or how an increase in demand can produce a decrease in price
The standard supply-and-demand model is typically an economist?s most important analytical tool, but in some situations it does not capture the features of interest. For example, during ?happy hour,? bars near workplaces sell a higher-than-usual quantity of alcoholic beverages at a lower-than-usual price. This practice makes little sense using the standard competitive model, but an alternative model?the model of monopolistic competition?provides the needed analytic framework. ; This article provides a step-by-step construction of a monopolistic competition model in which many firms each ...
Working Paper
Consumption and asset prices with recursive preferences: Continuous-time approximations to discrete-time models
This paper presents tractable and efficient numerical solutions to general equilibrium models of asset prices and consumption where the representative agent has recursive preferences. It provides a discrete-time presentation of the approach of Fisher and Gilles (1999), treating continuous-time representations as approximations to discrete-time "truth." First, exact discrete-time solutions are derived, illustrating the following ideas: (i) The price-dividend ratio (such as the wealth-consumption ratio) is a perpetuity (the canonical infinitely lived asset), the value of which is the sum of ...
Working Paper
Fitting a distribution to survey data for the half-life of deviations from PPP
This note presents a nonparametric Bayesian approach to fitting a distribution to the survey data provided in Kilian and Zha (2002) regarding the prior for the half-life of deviations from purchasing power parity (PPP). A point mass at infinity is included. The unknown density is represented as an average of shape-restricted Bernstein polynomials, each of which has been skewed according to a preliminary parametric fit. A sparsity prior is adopted for regularization.
Working Paper
Consumption and asset prices and recursive preferences
We analyze consumption and asset pricing with recursive preferences given by Kreps--Porteus stochastic differential utility (K--P SDU). We show that utility depends on two state variables: current consumption and a second variable (related to the wealth--consumption ratio) that captures all information about future opportunities. This representation of utility reduces the internal consistency condition for K--P SDU to a restriction on the second variable in terms of the dynamics of a forcing process (consumption, the state--price deflator, or the return on the market portfolio). Solving the ...
Working Paper
Forces that shape the yield curve: Parts 1 and 2
The yield curve is shaped by (1) expectations of the future path of short-term interest rates and (2) uncertainty about the path. Uncertainty affects the yield curve through two channels: (1) investors? attitudes toward risk as reflected in risk premia, and (2) the nonlinear relation between yields and bond prices (known as convexity). The way in which these forces simultaneously work to shape the yield curve can be understood in terms of the conditions that guarantee the absence of arbitrage opportunities. ; The purpose of this paper is to provide an introduction to the modern theory of the ...
Journal Article
Modeling the term structure of interest rates: an introduction
The yield curve, or the term structure of interest rates, plays a central role in the economy. Monetary policy is conducted by targeting rates at the short end of the curve, and longer-term yields reflect expectations of future changes in short rates. ; This article presents a model of the term structure that builds on a simpler model outlined in one of the author?s earlier Economic Review articles. The more complex model presented here takes into account the ongoing uncertainty about an asset?s price over time. The article focuses on modeling the dynamics of the state-price deflator, which ...
Working Paper
Around and around: the expectations hypothesis
We show how to construct arbitrage-free models of the term structure of interest rates in which various expectations hypotheses can hold. McCulloch (1993) provided a Gaussian non-Markovian example of the unbiased expectations hypothesis (U--EH), thereby contradicting the assertion by Cox, Ingersoll, and Ross (CIR, 1981) that only the so-called local expectations hypothesis could hold. We generalize that example in three ways: (i) We characterize the U--EH in terms of forward rates; (ii) we extend this characterization to a class of expectations hypotheses that includes all of those considered ...
Working Paper
Inflation and monetary regimes
Correlations of inflation with the growth rate of money increase when data are averaged over longer time periods. Correlations of inflation with the growth of money also are higher when high-inflation as well as low-inflation countries are included in the analysis. We show that serial correlation in the underlying inflation rate ties these two observations together and explains them. We present evidence that averaging increases the correlation of inflation and money growth more when the underlying inflation rate has higher serial correlation.