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Why Does the Paper-Bill Spread Predict Real Economic Activity?

  • Benjamin M. Friedman
  • Kenneth N. Kuttner

Evidence based on the past three decades of U.S. experience shows that the difference between the interest rates on commercial paper and Treasury bills has consistently borne a systematic relationship to subsequent fluctuations of nonfinancial economic activity. This interest rate spread typically widens in advance of recessions, and narrows again before recoveries. The relationship remains valid even after allowance for other financial variables that previous researchers have often advanced as potential business cycle predictors. This paper provides support for each of three different explanations for this predictive power of the paper?bill spread. First, changing perceptions of default risk exert a clearly recognizable influence on the spread. This influence is all the more discernable after allowance for effects associated with the changing volume of paper issuance when investors view commercial paper and Treasury bills as imperfect portfolio substitutes -- a key assumption for which the evidence introduced here provides support. Second, again under conditions of imperfect substitutability, a widening paper-bill spread is also a symptom of the contraction in bank lending due to tighter monetary policy. Third, there is also evidence of a further role for independent changes in the behavior of borrowers in the commercial paper market due to their changing cash requirements over the course of the business cycle.

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File URL: http://www.nber.org/papers/w3879.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3879.

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Date of creation: Oct 1991
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Publication status: published as Business Cycles, Indicators and Forecasting, Edited by James Stock and Mark Watson, Studies in Business Cycles Vol. 28, Chicago: University of Chicago Press, 1993
Handle: RePEc:nbr:nberwo:3879
Note: ME
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  1. Ben S. Bernanke, 1990. "On the predictive power of interest rates and interest rate spreads," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 51-68.
  2. Christina D. Romer & David H. Romer, 1989. "Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz," NBER Chapters, in: NBER Macroeconomics Annual 1989, Volume 4, pages 121-184 National Bureau of Economic Research, Inc.
  3. Benjamin M. Friedman, 1990. "Implications of Corporate Indebtedness for Monetary Policy," NBER Working Papers 3266, National Bureau of Economic Research, Inc.
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