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Economic Review

Economic Review
C O N T E N T S
Second Quarter 2003/Volume 88, Number 2

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
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

GERALD P. DWYER JR.
Vice President, Financial

ELLIS W. TALLMAN
Vice President, Macropolicy

JOHN C. ROBERTSON
Assistant Vice President, Regional

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

LYNN H. FOLEY
Editor

NANCY PEVEY
Managing Editor

CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Designers

ALISON BOUNDS
Marketing and Circulation

CHARLOTTE WESSELS
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, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470 (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

Are On-Line Currencies Virtual Banknotes?
Stephen F. Quinn and William Roberds
The history of money is marked by innovations that have expanded the role of “inside money”—money created by the private sector. For instance, the past few years have seen the development of several types of on-line payment arrangements, some of which have been dubbed “on-line currencies.”

This article examines the likely success or failure of on-line currencies by means of a historical analogy. The discussion compares the introduction of on-line currencies to the debut of the bearer banknote, the direct predecessor to modern currency, in London in the late 1600s.

The key innovation of the earliest banknotes, the authors argue, was to provide final payment under circumstances in which extant payment systems could not. The discussion considers how on-line currencies may be able to fill the same role in the context of e-commerce.

The authors note some conspicuous similarities between on-line currencies and physical banknotes. Both payment methods emerged to meet the need to conduct remote transactions (via the Internet or across physical distance), both face the risk of buyer-side fraud, and both have responded to the need for a new payment technology to allocate this risk. The authors stop short of calling on-line currencies “virtual banknotes” because it remains to be seen whether on-line currencies will gain sufficiently widespread acceptance to become a circulating medium of exchange.

Forecast Evaluation with Cross-Sectional Data: The Blue Chip Surveys
Andy Bauer, Robert A. Eisenbeis, Daniel F. Waggoner, and Tao Zha

If economic forecasts are to be used for decision making, then being able to evaluate their accuracy is essential. Assessing accuracy using single variables from a forecast is acceptable as a first pass, but this approach has inherent problems. This article addresses some of these problems by evaluating and comparing the general accuracy of a set of multivariate forecasts over time.

Using the methodology developed in Eisenbeis, Waggoner, and Zha (2002), the authors compare the economic forecasts in the Blue Chip Economic Indicators Survey. The survey, published monthly since 1977, contains forecasts of many macroeconomic variables over a relatively long time span. The forecasters are a mix of economists from major investment banks, corporations, consulting firms, and academic institutions, many of whom have participated in the survey for several years. The survey thus provides a useful set of forecasts to explore the methodologies and to investigate several aspects of forecast performance over time.

The methodology assigns each forecast a composite score based on the standard theory of probability and statistics. This single number is easy to interpret and can be used to compare forecasts even if the number of variables being forecast, or their definitions, changes over time.

The analysis shows that the Blue Chip Consensus Forecast, which is the average of the individual forecasts, performs better than any individual forecaster although several forecasters performed almost as well as the consensus.


Emotion and Financial Markets
Lucy F. Ackert, Bryan K. Church, and Richard Deaves

Psychologists and economists hold vastly different views about human behavior. Psychologists contend that economists’ models bear little relation to actual behavior. This view is supported by a large body of psychological research that shows that emotional state can significantly affect decision making.

Economists, on the other hand, argue that psychological studies have no theoretical basis and offer little empirical evidence about people’s decision-making processes. The reigning financial economics paradigm—the efficient market hypothesis (EMH)—assumes that individuals make rational investment decisions using the rules of probability and statistics. A newer branch of financial economics called behavioral finance applies lessons from psychology to financial decision making, but most of these studies have focused on cognitive biases rather than emotion.

The authors of this article argue that emotion has important, and possibly beneficial, influences on financial behavior. After defining the term emotion and describing how emotions can be categorized, the authors consider how emotions influence human behavior. The discussion focuses particularly on three aspects of emotion and financial decision making: emotional disposition and stock market pricing, the feeling of regret, and investors' emotional response to information.

No new financial economics paradigm that incorporates behavioral influences and better models actual behavior has yet emerged to replace the EMH. Yet the authors believe that emotional behavior's influence on financial decision making should be taken into account in future research.


Inflation Persistence: How Much Can We Explain?
Pau Rabanal and Juan F. Rubio-Ramírez

Until recently most macroeconomic models in which monetary policy has real effects were based on the assumption that agents in the economy do not use all available information when making a decision. Critics of these models argue that this assumption implies that agents are not rational.

In response to this criticism, a class of New Keynesian models has recently been proposed. These models combine “old” Keynesian elements with an environment in which agents form their expectations rationally. The simplest version of such models includes only one type of nominal rigidity, either sticky prices or sticky wages—that is, prices or wages that adjust only slowly to market shortages or surpluses. But these simple models have a drawback: They do not seem to be able to reproduce the persistence of inflation observed in the data.

This article explores whether adding sticky wages to the baseline sticky-price model solves the persistence-of-inflation problem when plausible durations of price and wage contracts are assumed.

The analysis confirms that the baseline sticky-price model cannot replicate the observed inflation persistence unless an implausible degree of either price stickiness or exogenous nominal interest rate persistence is assumed. The findings also show that a model with both sticky prices and sticky wages can replicate more closely the autocorrelation function of inflation, even with acceptable levels of both price and wage stickiness.