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Richmond Fed's Economic Quarterly Looks at Business Cycle Indicators

How Well Do Diffusion Indexes Capture Business Cycles? A Spectral Analysis

The potential benefits of regional economic surveys are well known -- they can supply measures of economic activity quickly and at a relatively low cost. However, because regional survey samples are small, and the data are collected at relatively high frequency, the applicability of the information towards gauging business cycle conditions can be questioned. Richmond Fed Economists Raymond Owens and Pierre-Daniel Sarte show that the Federal Reserve Bank of Richmond's surveys and other similar diffusion indexes mostly capture cyclical variations of business cycle lengths.

Also in the Fall 2005 issue:

Technological Design and Moral Hazard. The principal-agent model with moral hazard is an important tool used to study many topics including labor contracts, insurance contracts, and bank regulation. In this article, Richmond Fed Economist Edward S. Prescott expands the basic model to include a choice by the principal of properties of the production technology. He provides two examples in which this choice has significant implications. In the first one, it drastically simplifies the optimal contract to more closely resemble contracts in practice. In the second one, it demonstrates that the principal may be willing to choose a technologically inferior means of production to ease incentive problems.

Trend Inflation, Firm-Specific Capital, and Sticky Prices. Early empirical studies of the New Keynesian Phillips Curve imply implausibly high levels of price stickiness for standard monetary models with Calvo-type nominal rigidities. More recently, researchers have found that the addition of real rigidities through firm-specific capital adjustment costs allows for a reinterpretation of estimated New Keynesian Phillips Curves that makes the implied price stickiness more plausible. Richmond Fed Economists Alexander Wolman and Andreas Hornstein, vice president, study the impact of nonzero average inflation in a Taylor-type staggered pricing model with firm-specific capital adjustment costs. They find that in this framework, the widely accepted Taylor principle is no longer sufficient to guarantee that monetary policy does not become a source of unnecessary fluctuations.

Monetary Policy and the Term Structure of Interest Rates. A major puzzle in financial economics is the apparent drastic inconsistency of U.S. data with the expectations theory of the term structure of interest rates. Both short changes in long rates and long changes in short rates fail to be related to existing long-short spreads in even approximately the manner implied by the expectations theory together with rational expectations. In his article, Bennett T. McCallum, H. J. Heinz Professor of Economics at Carnegie-Mellon University and Richmond Fed visiting scholar, argues that this failure is a plausible consequence of monetary policy behavior that features interest rate smoothing in combination with policy responses to movements in the long-short spread.

The Economic Quarterly is a free publication containing economic analysis pertinent to Federal Reserve monetary and banking policy. For free copies or more information, contact the Federal Reserve Bank of Richmond's Public Affairs office at (804) 697-8109. The articles are available online at http://www.richmondfed.org/publications/economic_research/economic_quarterly/index.cfm

The Federal Reserve Bank of Richmond is one of 12 District Reserve Banks that together with the Board of Governors in Washington, D.C., make up the Federal Reserve System. The Richmond Fed serves the Fifth Federal Reserve District, which encompasses the District of Columbia, Maryland, North Carolina, South Carolina, Virginia and most of West Virginia.

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