Knowledge that Transforms

A stochastic financial model is developed which derives the reserve levels on financial assets which minimize price level fluctuations. It is shown that these levels of reserves are a function of the structure of unanticipated shocks to asset demands and are, in general, quite different from the levels which minimize the fluctuations of either the nominal or real value of these assets. Application of the model to currency and demand deposits in the U.S.A. suggest that the price‐Stablizing reserve ratio on demand deposits is approximately one‐half of the 12% currently mandated by the Monetary Control Act of 1980.

This paper is concerned with the problem of price regulation when demand is uncertain. Uncertainty gives rise to substantial difficulties in determining both the return a firm's owners should be provided and a set of prices capable of producing that return. We argue that conventional approaches to price regulation are incapable of attaining the economically desirable objectives of efficiency and an equitable return to investors. The deficiencies in current practices are attributable to the separation of the risk measurement‐return determination and price setting activities in the conventional approach. We present a model of the regulated firm that synthesizes contemporary financial market theory and the theory of the firm under uncertainty. 1 In our approach, the income stream produced by the firm is valued ex ante in the financial market according to investors' perceptions and preferences over riskreturn characteristics. We portray the firm as producing risk and return by choosing among available production technologies to maximize its market value, given the prices set by regulators. Within this framework, it is shown that regulators can choose the lowest prices consistent with an equitable return to investors. We also show that prices so chosen induce the choice of the optimal technology by the firm.

The variance bounds on exchange rate movements implied by the monetary approach to exchange rate in an efficient foreign exchange market is shown to be violated by sample data. The paper also presents evidence showing that the forecast errors implied by the monetary model can be forecasted using historical data. The results are interpreted to suggest either the incompatibility of the monetary approach with sample data, or an inefficient foreign exchange market or both.

The existence of transaction costs explains why investors do not fully diversify their portfolios. This paper examines the implications of such limited diversification on equilibrium asset prices in the framework of the capital asset pricing model. In the pricing equation obtained here an asset's risk premium depends on a weighted average of its covariance with the market and its own variance.