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Economics Working Papers, 1997


"Autocorrelated Returns and Optimal Intertemporal Portfolio Choice." Published in Management Science.

Abstract: In recent years it has been shown empirically that stock returns exhibit positive or negative autocorrelation, depending on observation frequency. In this context of autocorrelated returns the present paper is the first to derive an explicit analytical solution to the dynamic portfolio problem of an individual agent saving for retirement (or other change of status, like the purchase of a house or starting college). Using a normal ARMA(1,1) process, dynamic programming techniques combined with the use of Stein's Lemma are employed to examine "dollar-cost-averaging" and "age effects" in intertemporal portfolio choice with CARA preferences. We show that with a positive moving average parameter and positive risk-free rates, if first-order serial correlation is non-negative, then the expected value of the optimal risky investment is increasing over time, while if first-order serial correlation is negative this path can be increasing or decreasing over time. Thus a necessary but not sufficient condition to obtain the conventional age effect of increasing conservatism over time is that first-order serial correlation be negative. Further, dollar-cost averaging in the general sense of gradual entry into the risky asset does not emerge as an optimal policy. Simulation results for U.S. data are used to illustrate optimal portfolio paths.


"Portfolio Response to a Shift in a Return Distribution: The Case of n Dependent Assets." Forthcoming in the International Economic Review.

Abstract: Recent papers have shown utility function conditions which are sufficient, in a two-asset context with or without stochastic dependence, for a conditional first-order stochastically dominating shift (or a conditional mean-preserving contraction) of one asset's return distribution never to result in a decline in holdings of that asset. The present paper shows that these conditions are sufficient even when there are an arbitrary number of assets.


"The Effect of Deposit Insurance on Depositors' Risk Sensitivity: A Theoretical Framework."

Abstract: This paper focuses on a theoretical analysis of the effect of a lower deposit insurance limit on the risk sensitivity of aggregate deposits. Given the reasonable assumption of decreasing absolute risk aversion on the part of depositors, the results contradict the conventional wisdom that a lower deposit insurance limit will necessarily and unconditionally increase the sensitivity of aggregate deposits to bank risk.


"Single-Peaked Utility Functions Under Risk."

Abstract: This paper analyzes concave single-peaked utility functions, which are commonly used in macro policy analysis. Like the quadratic, quartic utility is shown to be analytically tractable. The quadratic is shown to be the only utility function giving additive-risk-insensitive decisions, the only utility function for which policy always "shoots in the right direction," and the only utility function possessing two other properties of note. Properties possessed by all, or by no, concave single-peaked utility functions are also identified. Implications for choice of a utility function are discussed.


"The Incidence of a Lottery Tax: New Evidence from the West Virginia State Lottery."

Abstract: As states have become increasingly reliant on lottery revenue, the issue of whether state lotteries are regressive has become more important. This paper provides new evidence on this issue using county-level data. The results suggest that the incidence of the West Virginia Lottery is progressive. However, when examined separately, on-line games are progressive and instant games are regressive. This has important policy implications for state lottery structure and suggests that additional studies need to be done on a state-by-state basis in order to determine the tax incidence of different lottery games in a particular state.


"Broadly Decreasing Risk Aversion."

Abstract: This paper considers decision-making in the presence of two risk sources, with no restrictions on the relation between the two risks. A utility function is said to exhibit broad DARA if and only if a rise in wealth always decreases the magnitude of the risk premium for one of the risks vis-a-vis the other. A condition on utility functions giving this property is derived: utility must be of the linear-plus-exponential form. It is shown that certain problems involving portfolios and risk-averse firms give unambiguous comparative statics if and only if utility exhibits broad DARA.


"Government Expenditures and Equilibrium Real Exchange Rates."

Abstract: Economists have long investigated theoretically and empirically the relationship between government spending and (long-run equilibrium) real exchange rates. As Frenkel and Razin (1992) summarize for a small open economy, government expenditures (financed by lump-sum taxes) influence real exchange rates via a resource-withdrawal channel and a consumption-tilting channel. Recent theoretical and empirical studies, such as Froot and Rogoff (1991), Rogoff (1992), De Gregorio, Giovannini, and Krueger (1994), De Gregorio, Giovannini, and Wolf (1994), De Gregorio and Wolf (1994), and Chinn and Johnston (1996), have focused upon the effects of government spending through the resource withdrawal channel only. Extending Frenkel and Razin (1992), this paper generates closed-form theoretical solutions for the relationships among the real exchange rate, relative per capita (private) consumption, relative per capita government consumption, and relative per capita tradables and non-tradables production in a two-country stochastic, dynamic, general equilibrium model. Application to the model's structural equations of relative price level, private and government consumption, and relative productivity data from Summers and Heston (1991) and OECD Annual National Accounts (1996) for a sample of OECD countries relative to the United States suggests that government expenditures influence long-run equilibrium exchange rates approximately equally via the resource-withdrawal and consumption-tilting channels.


"Nontradable Goods, Nonseparable Utility, and Global Portfolio Diversification."

Abstract: One of the most prominent explanations proposed for the observed strong home bias in investors? portfolios is the consumption of non-tradable goods. In the presence of non-tradable goods consumption, researchers have explained home bias either by assuming that non-tradable goods are separable in utility from tradable goods (cf., Stockman and Dellas, 1989) or that non-tradable goods? equities cannot be traded internationally (cf., Tesar, 1993). However, separability in utility between tradable and non-tradable goods is a limiting assumption and equities of non-tradable goods are traded internationally. This paper provides a theoretical analysis to demonstrate that -- in the presence of non-tradable goods -- investors should diversify portfolios completely among all tradable and non-tradable goods? claims, even if we assume non-separable utility and frictionless exchange of tradable and non-tradable goods? equities internationally. The results suggest that non-tradable goods with non-separable utility do not constitute a possible source of home bias when capital is perfectly mobile, as Lewis (1996) demonstrates empirically.


"Exchange Rate Fluctuations and the Speed of Trade Price Adjustment."

Abstract: A quantity adjustment cost model is developed in the context of international trade, along the lines proposed by Krugman (1987). The model implies that prices adjust slowly to exchange rate fluctuations. The price adjustment speed is determined endogenously as a function of foreign demand responsiveness, the appropriate discount rate, and an adjustment cost parameter. Empirical analysis based on disaggregated data first finds the speed of price adjustment from the time series for each industry and then in a cross-sectional regression relates the obtained adjustment speeds to their theoretical determinants. Results tentatively support the quantity adjustment cost view against plausible alternative explanations.


"In Defense of the Articles of Confederation and the Contribution Mechanism as a Means of Government Finance: A General Comment on the Literature." Published in Public Choice.

Abstract: I attempt to dispel several widely-held myths regarding government finance under the Articles of Confederation, some of which were reiterated in Dougherty and Cain (1997). I defend the contribution mechanism as a method of government finance that is superior to direct taxation by the federal government, and present evidence contradicting the belief that revenue collections under the Articles were poor. A proper comparison is with alternatives at that time, such as state tax collections and the federal governments own tax collections under the new U.S. Constitution, both of which were lower than the collection rate from states under the Articles.


"Public Policy Toward Pecuniary Externalities."

Abstract: This paper explores the role of pecuniary externalities in the efficiency of the market and political processes. Pecuniary externalities are shown to result from an undefined property right to the value of assets. Outcomes in the political process under a unanimity rule differ from market outcomes because they would require compensation for pecuniary externalities. We show that the internalization of pecuniary externalities creates a market failure, inherently making the political process less efficient that private markets. For efficiency, rights to the use property need to be clearly defined, but rights to the value of that property should not be assigned or enforced. Pecuniary externalities inflicted by one firm on another play an important role in assuring efficiency in a competitive market process. Monopoly industries are inefficient because of the internalization of pecuniary externalities, and within this framework innovate less than competitive firms due to this problem.


"Theory and Evidence on the Political Economy of the Minimum Wage."

Abstract: Interest group pressure has been shown to affect congressional voting on minimum wage legislation. I find that other characteristics of minimum wage legislation, such as the timing of changes and the level of the minimum wage, are also manipulated for political gain. As examples, the most recent change became effective one month before an election, and the 1938 act creating the minimum wage became effective just eight days before an election. I estimate that a wage of approximately $5.25 is consistent with stated goals of policy and show that interest group pressure explains the level of the minimum wage.


"Endogenous Risk and Return Lottery Game Characteristics as Determinants of Lottery Expenditures."

Abstract: Previous research into the determinants of lottery expenditures has examined the socio-economic characteristics of lottery players. This paper differs from that approach by examining how risk and return characteristics endogenous to lottery games and favored by lottery players influence lottery expenditures. The analysis uses risk and return variables for every on-line state lottery game offered in the United States in 1995. Not only is new light shed on the determinants of lottery expenditures and player preferences for risk and return, the data set presented here provides researchers with new and comprehensive information on every lottery game offered in the county.


"Lottery Players Also Love Skewness: Evidence from United States Lottery Games."

Abstract: In this Journal, Golec and Tamarkin provide new insight why risk adverse individuals gamble. They find evidence that while bettors at horse tracks are risk averse, bettors favor positive skewness of returns. We question whether these preferences are also true for lottery players. We test Golec and Tamarkin's theory using data on all state lottery games offered in the United States. Empirical analyses suggest that lottery players also prefer skewness to variance. Our findings not only expand the relevance of Golec and Tamarkin's theory, but they also provide new insight into why individuals play lottery games.


"The Anatomy of Deviations from Market Efficiency: Insights into the Favorite-Longshot Bias and Other Anomalies."

Abstract: The tendency for racetrack betters to overbet longshots and underbet favorites violates strong-form market efficiency. I show that uninformed casual bettors are responsible for the bias, and that serious betters do the opposite, overbetting favorites and underbetting longshots. This opposite bias has been found in sports betting and in the stock market. I present and test a theory that well-informed agents in simple situations have an opposite bias, but as the situation becomes more complex, or information becomes poorer, it leads to a regular favorite-longshot bias. This model provides a common framework for analyzing many other deviations from market efficiency.