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Economic Review

Economic Review
C O N T E N T S
First Quarter 1998/Volume 83, Number 1

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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Policy Credibility and the Design of Central Banks A Dynamic Multivariate Model for Use in Formulating Policy
Roberto Chang 4 Tao Zha 16

In recent years several countries have granted greater independence to their central banks; others have made price stability the only objective of monetary policy. These two trends can be seen as social responses to a fundamental problem of central bank credibility called the time inconsistency of monetary policy. The theory and some empirical aspects of time inconsistency are the subject of this article.

The theory emphasizes that expected and actual inflation will be larger if a central bank cannot credibly commit to honor commitments to keep inflation low than if it can. To ameliorate this "inflation bias," institutions such as central bank independence and price stability rules may emerge. These institutional reforms may be unnecessary, however, when a central bank develops an anti-inflationary reputation over time.

The empirical evidence reviewed in this article does not provide strong confirmation of the hypothesis that central bank independence lowers inflation. The results may reflect that reputation has played a role in ameliorating time inconsistency or that the degree of central bank independence is determined by reasons other than eliminating inflation bias.

A policy action by the Federal Reserve consists of using any one of various instruments, such as the federal funds rate and different measures of money, to pursue its multiple objectives. Because of long and variable lags in the effects of policy actions, the process of anticipating the future is indispensable in formulating sound monetary policy. For the same reason, projecting policy effects accurately is a challenging task. An essential step is to develop good forecasting models.

This article presents a forecasting model that seems to overcome conceptual and empirical difficulties encountered in other models and promises to provide policymakers with a more useful tool for anticipating policy effects. For clarity, the author concentrates on changes in the federal funds rate and on only one of the Fed's objectives—low and stable inflation. The model introduces new techniques that offer two distinctive advantages. One is the ability to forecast the values of key macroeconomic variables such as inflation beyond a period over which these values are known. The other is the model's explicit structure that allows empirically coherent ways to assess the uncertainty of forecasts.

The Rise of Risk Management The Impact of Fraud on New Methods of Retail Payment
J. David Cummins,
Richard D. Phillips,
and Stephen D. Smith
30 William Roberds 42

Risk management is nothing new, despite the increased attention given to the subject over the past decade or two. For well over one hundred years farmers have engaged in risk management, hedging their risks against price fluctuations in commodity markets. Unlike a family farmer, however, a corporation is owned by shareholders, who can, if they so wish, greatly reduce or eliminate the risk of low prices simply by holding a diversified portfolio.

Why, then, are managers doing for shareholders what shareholders apparently can do for themselves? This article provides a review of the rationales concerning why corporations might engage in risk-management practices. The authors also cite some empirical evidence consistent with the idea that managers use derivative securities, a particular form of risk management, to reduce the volatility of their own income stream. However, a growing body of literature suggests that at least a portion of total derivatives contracting is related to activities known to increase firms' value—for example, avoiding costly external finance and lowering expected tax bills.

Currency fraud (counterfeiting), check fraud, and credit card fraud are serious problems, costing the U.S. economy billions of dollars each year. But with each of these traditional payments methods, the problem of fraud has been kept at a manageable level. To be successful in the marketplace, newer forms of payment such as electronic cash and stored-value cards will need to hold fraud risk to similarly low levels.

Will fraud hinder development of the new payments media? The natural advantages of electronic systems for storing, copying, and manipulating data can be a drawback when it comes to the risk of fraud. This article considers how certain features of new forms of payment differ from more traditional forms and whether these features will detract from marketplace acceptance of the new media. The author concludes that successful payments systems will have to confront various trade-offs posed by the risk of fraud. They will need to balance the costs and benefits of fraud abatement, balance security of payments systems with consumers' desire for privacy, and encourage development of new, more efficient payments systems while ensuring equitable treatment of participants.