Economic Letter

In 1999, eleven European countries adopted the euro as their common currency (Greece followed in 2001). This followed a long period of gradually tying their national currencies together more tightly by limiting exchange rate fluctuations among member countries, culminating in the European Monetary Union (EMU).

In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a nonfundamental bubble component that may reflect price speculation or irrational investor euphoria or depression. The expansion of an asset price bubble may lead to a debilitating misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy.

World financial markets paid close attention when officials from both South Korea and Japan said that their governments were considering diversifying their holdings of foreign reserves (Dougherty 2005 and Koizumi 2005). Many analysts thought these announcements were partly in response to the past depreciation of the dollar; if true, then it seemed likely that those two governments would sell some of their dollar-denominated assets, putting further downward pressure on the dollar.

Since 2002, the U.S. has seen the emergence of twin deficits—that is, a growing budget deficit along with a growing current account deficit, which reflects increasing U.S. borrowing from abroad. To some analysts, this situation seems very reminiscent of the early 1980s. In the earlier episode, there were significant tax rate cuts that were not matched by spending cuts, and between 1981 and 1986, the U.S. budget deficit went from 2.5% of GDP to about 5% of GDP and the current account went from being roughly in balance to a deficit of 3.3% of GDP.

The national unemployment rate fell slowly during the first half of 2005, reaching 5.0% in June. While this is above the lows reached in 1999-2000, it is noticeably below the rates that largely prevailed during the mid-1970s through the mid-1990s.

Risk-management practices at financial institutions have undergone a quantitative revolution over the past decade or so. Increasingly, financial firms rely on statistical models to measure and manage financial risks, ranging from market risks (such as exchange rate fluctuations) to credit risks (such as borrowers’ default probabilities) to operational risks (such as expected losses due to fraudulent transactions).

Investment in information technology (IT)—that is, business spending on computers, communications equipment, and software—has featured prominently in the ups and downs of U.S. economic growth over the last decade. In the late 1990s, double-digit growth in IT investment contributed significantly to high GDP and productivity growth rates. And in 2001, the sharp contraction in IT investment helped lead the economy into recession.

This year’s conference brought together six research papers that explore issues related to fiscal and monetary policy and their interaction. The papers ranged from a theoretical analysis of the design of fiscal policy in a monetary union to the use of long-term bond rates to estimate monetary policy reaction functions.

Policymakers at both the state and local level have long used tax incentives, in some form or other, to entice firms to locate or stay in their communities. While some economists have raised serious concerns about whether such incentives lead to socially wasteful “tax competition,” a federal appeals court decision in September 2004 has raised serious doubts about whether some are even constitutional.

Debates about health care have been a central feature of U.S. public policy discussions for at least the last 20 years. One trigger of these debates is the statistical evidence on the rising cost of health care.