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Economic Review

Economic Review
C O N T E N T S
Third Quarter 1999/Volume 84, Number 3

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.

These files are in PDF format, which requires Adobe Acrobat Software (links off-site)

PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
B. FRANK KING
Vice President and
Associate Director of Research

THOMAS J. CUNNINGHAM
Vice President, Regional

GERALD P. DWYER JR.
Vice President, Financial

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

ROBERTO CHANG
Research Officer, Macropolicy

WILLIAM ROBERDS
Research Officer, Macropolicy

LARRY D. WALL
Research Officer, Financial

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

JOYCELYN TRIGG WOOLFOLK
Editor

LYNN H. FOLEY
Managing Editor

ELLEN TABER
Editorial Assistant

CAROLE L. STARKEY AND
KRISTIN E. SHELTON
Designers

TAQIYYAH MUHAMMAD
Circulation

LINDA MUNDY AND
LISA LEE-FOGARTY
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank's Public Affairs Department with a copy of any publication containing reprinted material.

Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713 (404/498-8020). Internet: http://www.frbatlanta.org. Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new information.

ISSN 0732-1813

What Do Asset Prices Tell Us about the Future?
Stephen D. Smith

It is fairly obvious that in market-based economies prices act as a constraint on individual behavior, providing a means by which goods and services flow to those most willing and able to pay for them. But prices play an additional role in the economy—that of signaling the present and expected future state of affairs. Having accurate forecast information is particularly important to policymakers, who are concerned with acting in advance to avoid bad economic outcomes rather than simply reacting to events.

This article reviews the theoretical literature regarding the extent to which asset prices aggregate information and examines evidence on the ability of financial asset prices to forecast inflation, real output or consumption, and recessions. Given the available evidence, the author finds it difficult to argue that monetary policymakers should give more weight to financial market variables. What can be argued is that, according to theory, financial asset prices should aggregate at least some information about future performance of economically important variables.

The author concludes that more work is needed along both theoretical and statistical lines for collectively figuring out what role, if any, financial asset prices or yields should play in forecasts used in conducting policy. Meanwhile, these variables will remain at most a source of information that policymakers can choose to use as a supplement to more traditional indicators.


The Banking Sector Rescue in Mexico
Elizabeth McQuerry

In Mexico the December 1994 peso devaluation provoked a profound economic downturn in that country and revealed a fragile banking sector. Fearful that the financial system would collapse under a rising level of past due loans, the Mexican government mounted a rescue of the banking sector by intervening in the daily operations of some problem banks while establishing a series of capitalization and restructuring programs available to all banks.

This article examines Mexico's bank rescue efforts (1995–98) with a particular focus on the role of the deposit insurance fund, the Bank Fund for the Protection of Savings. According to the author, the governmental rescue programs prevented a systemic collapse of the banking sector but cost more than $55 billion dollars. The rescue was not entirely successful in restoring the banking sector's credit functions to a productive role in the Mexican economy.

The article also attempts to place the overall rescue effort within a larger context by looking at its economic and political consequences. The Mexican experience suggests that country-specific factors can profoundly affect the success of government policies. The outcome of the bailout in Mexico was significantly shaped by the process of political democratization under way there. The polemical debate surfacing out of the legislative battle over the costs of the bank rescue demonstrates the need for governments to pay more attention to political matters, even when the problems appear economic or technical in nature.


The Design of Wholesale Payments Networks: The Importance of Incentives
Charles M. Kahn and William Roberds

Most people are familiar with retail payments systems such as checks and credit cards. Less familiar are wholesale payments systems, which consist of electronic networks used for sending large sums among banks. A feature common to all wholesale networks is that settlement is carried out by exchange of funds held in banks' reserve accounts at a central bank, though the rules for settlement vary. This article considers the question of what is the best design for a wholesale payments system, in particular whether it should settle on a net or a real-time gross basis, and some of the difficult policy questions facing both participants and regulators of wholesale systems.

The authors show that for the benchmark case in which bank asset quality is fixed and bank assets can always be liquidated at book value, the advantages of some type of net settlement dominate real-time gross settlement. However, the optimal net settlement scheme may necessarily involve some chance of default. The discussion also examines the case in which the quality of bank assets is a choice variable and finds that the potential costs of net settlement rise because of negative effects on bank asset quality. The authors conclude that the design of a wholesale payments system must take into account numerous policy trade-offs, the most critical being the one between the costs of liquidity versus the costs of default.


Revising the Atlanta Fed Dollar Index
Bryan Acree

For more than a decade the Federal Reserve Bank of Atlanta's trade-weighted dollar index has served as a summary statistic for foreign exchange movements of the dollar. Recent revisions acknowledging significant changes in the worldwide economy ensure that the index will continue to contribute valuable information into the future.

One significant revision to the Atlanta Fed index is to include all eleven countries that adopted the euro on January 4, 1999. Other revisions take into account that the spread of market-based economics, together with deregulation and privatization in many developed and emerging markets, has totally reshaped the trade environment in which U.S. firms do business. Trade agreements like the North American Free Trade Agreement and the liberalization of financial flows have reduced many barriers to trade. Consequently, the revised index updates various countries' trade weights and introduces some important trading partners not included in the original formulation of the index, thereby enhancing its value as a summary statistic of the dollar's value.

In addition to explaining the revisions and the rationale for construction of the Atlanta Fed currency index, the author discusses it in comparison with recently revised indexes created by the Federal Reserve Board of Governors and the Federal Reserve Bank of Dallas. He points out that users should seek out the index that provides measurements best suited to their needs.