EconSouth (Fourth Quarter 2001)

Research Notes & News highlights recently published research as well as other news from the Federal Reserve Bank of Atlanta. For complete text of summarized articles and publications, see the links below.

Can information cost explain equity home bias?

Most stock market investors believe that the ideal equity portfolio should be well diversified to lower overall portfolio risk. International financial markets offer a means for diversification, but most investors do not exploit this risk-sharing opportunity and instead hold large shares of their portfolios in domestic stocks — a tendency called home bias.

In a recent article, Karsten Jeske introduces a method of measuring how severe home bias is. He uses a simple asset allocation model to determine the shadow cost of foreign investment — that is, the perceived annual cost of foreign equity necessary to create a bias away from perfect international risk sharing and toward domestic equity. The model shows that in most industrialized nations the shadow costs would have to be unrealistically high to account for home bias. In the United States the home bias is almost 150 basis points per year, by far the lowest among all industrialized nations.

Jeske then discusses a popular explanation for home bias: information cost. This theory argues that investors face lower costs for gathering information on their domestic assets than on foreign assets and are therefore biased toward holding domestic equity. While this explanation is intuitive, the author demonstrates, using both a naive model and a rational expectations model, that the theory is unable to account for observed patterns of home bias. Jeske thus concludes that home bias is still a puzzle.

Economic Review
Third Quarter 2001

Rating the performance of international mutual funds

The 1990s witnessed tremendous growth in the assets of international mutual funds. This growth is likely to continue as more investors seek the diversification benefits of foreign assets, which have relatively low correlations with domestic stock portfolios. Investors may also be attracted to international funds in the popular belief that such funds can earn abnormally high returns because of the relative inefficiency of these markets. But there is little evidence that this notion is valid.

A recent Atlanta Fed study sets the stage for investigating whether exploitable foreign market inefficiencies exist by studying the performance of a large sample of international open-end mutual funds during the 1990s. Author Paula Tkac sorts funds into 32 categories and then applies four commonly used performance measures to characterize the funds’ return distributions.

Her results show that a large percentage of well-diversified international funds outperform their passive benchmarks in a statistically significant manner, but regional and country funds do not. In addition, emerging markets funds exhibit volatilities that are generally higher than those of developed market funds but do not exhibit significantly higher average or abnormal returns.

These findings indicate that the attractiveness of emerging markets investment should be revisited in more detail. Tkac suggests that the next step is to formulate data tests that can disentangle competing models of international capital markets and thus identify the underlying factors driving the results.

Economic Review
Third Quarter 2001

Atlanta Fed Dollar Index

The dollar continued its rise in July 2001 against the 15 major currencies tracked by the Atlanta Fed. A decline against the European subindex was offset by gains versus the Pacific and other subindexes. In August, the dollar dropped, led by declines against all of the subindexes except the Americas subindex. The dollar rose in September as a result of a gain versus the Americas subindex although most of the other subindexes registered declines.

Note: For more detailed, monthly updates and historical data on the dollar index, see the Atlanta Fed’s World Wide Web site at

Do policies influence business cycles’ effects?

Since the third quarter of 2000, the U.S. economy began to experience a slowdown in its rate of growth. This slowdown serves as a reminder that the business cycle is still alive and raises the following questions: What do we know about the driving forces behind the business cycle? What should policymakers do in the face of economic fluctuations?

Authors Marco Espinosa-Vega and Jang-Ting Guo examine two explanations for business cycles that are well-known in academic circles: the animal spirits theory and the real business cycle theory. The former theory is closely connected with the Keynesian economic tradition and identifies market participants’ mood swings as the key source of economic fluctuations. The second explanation is rooted in the classical economic tradition and views productivity shocks as the driving force behind economic fluctuations. The article then looks at what these theories suggest about countercyclical policies, which try to eliminate business cycle fluctuations or insulate market participants from their effects. The authors conclude that neither theory makes an unambiguous case supporting countercyclical policies.

This conclusion may come as a surprise to government and business economists who have an ingrained belief in the benefits of such policies. It is important to remember, however, that attempts to understand business cycles and the effects and desirability of policies that may or may not moderate them are still at a very early stage.

Economic Review
Fourth Quarter 2001

What remains of monetarism?

In October 1979 the Federal Reserve, in an attempt to curb double-digit inflation, announced that it would place more weight on monetary aggregates in policy deliberations. This policy shift helped reduce inflation but sent the economy into a recession. Three years later the Fed abandoned monetary targets and returned to targeting the federal funds rate.

Monetary growth targets currently play no official role in the setting of U.S. monetary policy. Is such disregard justified by the data any more today than it was 20 years ago? An article by R.W. Hafer provides a historical perspective on the development and apparent failure of monetarism as a policy guide.

Hafer also explores whether the basic monetarist propositions still hold true for a sample of 15 countries. His analysis suggests that it is premature to dismiss monetary aggregates as uninformative. The data from the economies studied indicate that, in general, nominal income growth and inflation are positively related to money growth.

While these results do not support short-term manipulation of the monetary aggregates to deliver precise control over movements in income and prices, they also do not reject the notion that changes in money growth have important effects on the economy. What the results suggest, therefore, is that failure to acknowledge this empirical fact could lead to undesirable policy consequences.

Economic Review
Fourth Quarter 2001

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