Knowledge that Transforms

Why do democratic societies often impose legal restrictions that render various assets or entitlements inalienable to the individual? The explanation proposed here is that these constraints arise as an institutional response against financial markets that, in a sense, work “too well.” That is, I demonstrate how a well‐functioning financial market can potentially work against a social policy designed to ensure a basic minimum standard of living for all types of individuals. Inalienable property rights and debt constraints emerge as a natural institutional response to the improvident tendencies of some members of society when a majority of individuals share a common distaste for neighborhood squalor.

We use microeconomic data on households to estimate the parameters of the demand for currency derived from a generalized Baumol‐Tobin model. Our data set contains information on average currency, deposits, and other interest‐bearing assets; the number of trips to the bank; the size of withdrawals; and ownership and use of ATM cards. We model the demand for currency accounting for adoption of new transaction technologies and the decision to hold interest‐bearing assets. The interest rate and expenditure flow elasticities of the demand for currency are close to the theoretical values implied by standard inventory models. However, we find significant differences between individuals with an ATM card and those without. The estimates of the demand for currency allow us to calculate a measure of the welfare cost of inflation analogous to Bailey’s triangle, but based on a rigorous microeconometric framework. The welfare cost of inflation varies considerably within the population but never turns out to be very large (about 0.1 percent of consumption or less). Our results are robust to various changes in the econometric specification. In addition to the main results based on the average stock of currency, the model receives further support from the analysis of the number of trips to and average withdrawals from the bank and the ATM.

Leasing contracts are extensively used in durable goods markets. These contracts specify a rental rate and an option price at which the used good can be bought on termination of the lease. This option price cannot be controlled when the car is sold. We show that in a world in which quality is observable, this additional control variable is ineffective. Under adverse selection instead, leasing contracts affect equilibrium allocations in a way that matches observed behavior in the car market. Consistent with the data, our model predicts that leased cars have a higher turnover and that off‐lease used cars are of higher quality. Moreover, the model predicts that the recent increase in leasing can be explained by the observed increase in car durability. We show that leasing contracts can improve welfare but that they are imperfect tools. We also show that a producer with market power can benefit from leasing contracts for two reasons: market segmentation and better pricing of the option. Moreover, despite the fact that lessors could structure contracts to prevent adverse selection, we show that this is not in their interest.

We analyze a general equilibrium exchange economy with a continuum of agents who have “catching up with the Joneses” preferences and differ only with respect to the curvature of their utility functions. While individual risk aversion does not change over time, dynamic redistribution of wealth among the agents leads to countercyclical time variation in the Sharpe ratio of stock returns. We show that both the conditional risk premium and the return volatility are negatively related to the level of stock prices. Therefore, our model exhibits many of the empirically observed properties of aggregate stock returns, for example, patterns of autocorrelation in returns, the “leverage effect” in return volatility, and long‐horizon return predictability.

We analyze a unique data set on multiunit auctions, which contains the actual demand schedules of the bidders as well as the auction awards in over 400 Swedish Treasury auctions. First, we document that bidders vary their prices, bid dispersion, and the quantity demanded in response to increased uncertainty at the time of bidding. Second, we find that bid shading can be explained by a winner’s curse–driven model in which each bidder submits only one bid, despite the fact that the bidders in our data set use much richer bidding strategies. Third, we explore the extent to which the received theories of multiunit auctions are able to offer insights into the bidder behavior we observe. Our empirical evidence is consistent with some of the predictions of the models of auctions that emphasize private information, the winner’s curse and the champion’s plague. While the models of multiunit auctions serve as useful guideposts, our empirical findings also point to several new areas of research in multiunit auctions that are of policy and theoretical interest.

Many widely used economic models implicitly assume that income shares should be identical across time and space. Although time-series data from industrial countries appear consistent with this notion, cross-section data generally appear to contradict the assumption. A commonly used calculation suggests that labor shares of national income vary from about .05 to about .80 in international cross-section data. This paper suggests that the usual approach underestimates labor income in small firms. Several adjustments for calculating labor shares are identified and compared. They all yield labor shares for most countries in the range of .65.80.

We analyze the effects of money injections on interest rates and exchange rates when agents must pay a Baumol‐Tobin‐style fixed cost to exchange bonds and money. Asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money infrequently. When the government injects money through an open market operation, only those agents that are currently trading absorb these injections. Through their impact on these agents’ consumption, these money injections affect real interest rates and real exchange rates. The model generates the observed negative relation between expected inflation and real interest rates as well as persistent liquidity effects in interest rates and volatile and persistent exchange rates.

Proposals to use teachers’ performance incentives have recently attracted considerable attention. However, there is very little experience with applying incentives in schools. This paper provides evidence on the causal effects of two programs: the first provided the school and its teachers with monetary performance incentives and the second with additional conventional resources. The assignment of schools to the two programs was not random; therefore, identification is a central issue in the empirical analysis. The empirical results suggest that schools’ and teachers’ group monetary incentives caused significant gains in many dimensions of students’ outcomes. Endowing schools with more resources also led to improvement in student performance. However, the comparison based on cost equivalency suggests that the teachers’ incentive intervention is much more cost effective.

A security design model shows that multinational firms needing to finance their operations should issue different securities to investors in different countries in order to aggregate their disparate information about domestic and foreign cash flows. However, if the firm becomes bankrupt, investors may face uncertain costs of reorganizing assets in a foreign country and thus may value foreign assets at their average value. This penalizes superior firms with low reorganization costs. Such firms minimize the adverse selection penalty by designing securities that allocate all the cash flow in bankruptcy to investors for which the adverse selection costs are the smallest given the exchange rate. We show that this sharing rule can be implemented with currency swaps because these instruments allow the priorities of claims in bankruptcy to switch depending on the exchange rate.