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Richmond Fed's Economic Quarterly Looks at Discretionary Policymaking and Its Predictive Challenges

"Discretionary Policy and Multiple Equilibria"

Interactions between government policy and private sector decisions can lead to multiple equilibria when the government cannot commit to its future policies. Robert G. King, economics professor at Boston University and a visiting scholar at the Federal Reserve Bank of Richmond, studies a simple example of a government that must decide whether to build a dam to prevent adverse effects of floods on the incomes of floodplain residents. In this example, it is socially inefficient to build the dam and for people to live on the floodplain, with this outcome being the unique equilibrium under policy commitment. Without commitment, there is also a second equilibrium where citizens know that the government will choose to build the dam, and even small benefits of living on the floodplain will lead them to choose that location. In this second equilibrium, all individuals are worse off.

You can find the full text of this article and others in the latest issue of Economic Quarterly at http://www.richmondfed.org/publications/economic_research/economic_quarterly/.

Also in the Winter 2006 issue:

"Credit Exclusion in Quantitative Models of Bankruptcy: Does It Matter?"

This article evaluates a commonly used assumption in recent quantitative analyses of unsecured household borrowing -- the temporary exclusion of defaulting borrowers from credit markets. Exclusion from credit markets is an attractive modeling device for tractably modeling default on both consumer and sovereign debt. Nonetheless, such exclusion is not easily supported and deserves more justification than that provided in the available literature. In this paper, Richmond Fed economist Kartik B. Athreya and assistant economist Hubert P. Janicki perform a set of experiments in a standard model of bankruptcy to clarify the circumstances in which exclusion is, or is not, likely to be an innocuous simplification.

"The 3-6-3 Rule: An Urban Myth?"

The banking industry of the 1950s, 1960s, and 1970s is often described as operating according to a 3-6-3 rule: Bankers gathered deposits at 3 percent, lent them at 6 percent, and were on the golf course by 3 p.m. The implication is that the banking industry was less competitive during those years than in the period following, mostly because of the tight regulations that were loosened only in the 1980s. The regulations in place during those decades often were not binding, or in some cases, were sidestepped by banks and their nonbank competitors. Consequently, says Richmond Fed economist John R. Walter, the competitive effect may have been less far-reaching than is often assumed.

"Are We Working Too Hard or Should We Be Working Harder? A Simple Model of Career Concerns"

In modern corporations, ownership is typically separate from control and, given that employees are motivated by self interest, incentive problems arise. Employees are disciplined, in part, by their career concerns. The labor market learns about employees' future productivity by observing their performance, and their compensation depends on their reputations -- the labor market's beliefs about their future productivity. Therefore, when the employees decide their actions, they care about their performance (and the performance of the firms they work for) because it influences their reputation. However, according to Richmond Fed assistant economist Andrew Foerster and economist Leonardo Martinez, career concerns do not necessarily eliminate the inefficiencies created by the separation of ownership and control.

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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