Inflation,growth and exchange rate regimes in small open economies

Summary. This paper compares the merits of alternative exchange rate regimes in small open economies where financial intermediaries perform a real allocative function, there are multiple reserve requirements, and credit market frictions may or may not cause credit rationing. Under floating exchange rates, raising domestic inflation can increase production if credit is rationed. However, there exist inflation thresholds: increasing inflation beyond the threshold level will reduce domestic output. Endogenously arising volatility may be observed independently of the exchange rate regime. Private information - with high rates of domestic inflation - increases the scope for indeterminacy and economic fluctuations.Received: 26 March 2002, Revised: 29 October 2002JEL Classification Numbers: E32, E44, F33.P.L. Hernandez-Verme: I would like to thank Leonardo Auernheimer, Valerie Bencivenga, Dean Corbae, Scott Freeman, Todd Keister, Beatrix Paal, and Maxwell Stinchcombe for very helpful comments and suggestions. Very special thanks are due to Bruce D. Smith. The paper also benefited from the discussions in the seminars in CIDE, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, Indiana University, ITAM, Purdue University, the Second Annual Missouri Economics Conference, Texas A&M, the University of Missouri and the University of Texas at Austin.     

Inflation targeting in emerging economies: Panel evidence

This paper shows there is no evidence that the inflation targeting regime (IT) improves economic performance as measured by the behavior of inflation and output growth in developing countries. The control of common time effects results in less negative and less significant IT impacts on inflation, inflation volatility and output growth volatility than previously found in the literature. Additionally, our analysis shows robust evidence of lower output growth during IT adoption. On balance, although lower long-run mean inflation signals that the central banks of emerging economies with inflation targeting are more inflation-averse, the costs of disinflation have not been lower than under other monetary regimes.     

Inflation and public debt reversals in advanced economies

This paper quantitatively assesses the effects of inflation shocks on the public debt-to-GDP ratio in 19 advanced economies using simulation and estimation approaches. The simulations suggest that 1 percentage point shock to the inflation rate can reduce the debt-to-GDP ratio by about 0.7 percentage points on average across countries, while the estimated impulse responses are a little larger and more persistent. Additional assumptions taking into account financial repression do not necessarily make these effects substantially larger. These results imply that modestly higher inflation, even if accompanied by some financial repression, could reduce the public debt burden only marginally.     

Competition policy in open economies

Abstract

This paper examines aspects of R&;D spillovers across countries, in particular, the role of international trade and human capital as the catalysts for international diffusion of technology. We present a new way of measuring foreign R&;D stocks embodied in foreign intermediate goods and capital equipment, which we argue is free from the criticism of previous measures. With the pooled panel data spanning 1970 through 1995 for 103 countries, we find that the effects of foreign R&;D on total factor productivity growth of both industrial countries and developing countries are substantial and that human capital is the most influential channel for absorbing foreign R&;D spillovers.     

Monetary policy in open economies

The recent literature on monetary policy in open economies has produced a strong presumption in favor of activistic policy and flexible exchange rates. We argue that this result may owe much to the combination of two commonly made assumptions: That nominal goods prices are rigid. And that the monetary authorities have a lot of information about the economy. When the source of nominal rigidity is found in wages and monetary policy is conducted according to less information demanding rules (such as a standard interest rate rule) policies that stabilize the money supply or the nominal exchange rate may perform better.     

Distributional conflict in small open economies

We aim at a better understanding of the inefficiencies resulting from distributional conflict in small open economies. To this end, a general equilibrium model with the following characteristics is set up: two groups of agents (capitalists and workers), an endogenous income tax, productive government expenditures, social transfers, and an outside option for capital. The overall distributional-conflict inefficiency is decomposed into three components: (i) a fundamental time inconsistency problem; (ii) strategic interaction in the political process; (iii) heterogeneity among individuals and the resulting unavoidable conflict of interest. A numerical exercise (based on OECD data) indicates that the distributional-conflict inefficiency may cause a substantial output loss.     

Inflation dynamics in open economies: Empirical evidence for G7 countries on the role of import prices and the cost channel

The supply side effects of both the nominal interest rate (i.e., the cost channel) and import prices on inflation are very important for the design of monetary policy. However, the empirical identification of the cost channel (traditionally associated with the advance payment of wages) has ignored import prices. We start by deducting a New Keynesian Phillips Curve (NKPC) which shows that ignoring import prices in the estimation of the cost channel may lead to incorrect results. Taking this into account, we study the empirical relevance of the cost channel and import prices using the NKPC for the G7 countries. We test whether the estimation of the cost channel is affected when the price of imported inputs is considered; if it is relevant to extend the cost channel given that imports of final consumption goods are also paid in advance; if imports should be treated as inputs and/or consumption goods, and if there is an immediate or slow exchange rate pass-through. Empirical results indicate that the cost channel is present in imported consumption goods in particular, and import prices play an important role in explaining inflation dynamics.     

Inflation targeting in emerging market and transition economies: Lessons after a decade

Starting in the early 1990s, several emerging market and transition economies adopted inflation targeting (IT). In this paper we discuss a number of issues that arise in this context: (a) the definition of IT, (b) the role of preconditions for IT, (c) the use of intermediate exchange rate targets, and (d) the specification of inflation targets. Our overall conclusion is that, suitably modified, IT is a useful policy strategy for EMEs.     

Market structures in small open economies: Evidence from Denmark

This paper provides some stylized facts about market structure in Denmark, a country exhibiting high rates of exports and imports as is common in small developed economies. Utilizing disaggregated data at the firm-product level for manufacturing industries, we highlight the widespread presence of industries that are neither purely oligopolistic or monopolistically competitive; rather, they contain a few domestic leaders with numerous firms having insignificant domestic market shares. We also document that, relative to the latter type of firms, leaders have greater labor productivity, are more capital intensive, and pay higher wages; additionally, they are more likely to export and import, although they exhibit a greater domestic intensity relative to exporters with negligible domestic market shares. Finally, through a model of leaders and followers, we investigate how leaders can benefit from acting strategically against small firms and quantify its potential impact on industry outcomes through a numerical exercise.     

Tariff strategies and small open economies

In this paper we examine the issue of optimal tariffs for a small economy that trades with a large economy. We define 'small' and 'large' in the sense that the world prices are determined solely by the large country, and, therefore, the small country faces exogenously given world prices. Within this framework it is shown that there exist situations in which the small country has an incentive to behave as a Stackelberg leader by committing itself to a non-zero optimal tariff. Although the small country is unable to directly affect world prices, by pre-committing to a non-zero trade tax it may induce a reduction of the large country's optimal trade tax, thereby indirectly improving its terms of trade and welfare. JEL Classification: F13, F35
Stratégies de droits de douane et petites économies ouvertes. Ce mémoire examine le problème des droits de douane optimaux pour une petite économie qui commerce avec une grande. On définit 'petit' et 'grand' en un sens économique: les prix mondiaux sont déterminés seulement par le grand pays et le petit pays fait face à des prix mondiaux exogènes. A l'intérieur de ce cadre d'analyse, les auteurs montrent qu'il existe des situations dans lesquelles le petit pays est incitéà se conduire en leader à la Stackelberg en s'engageant fermement dans une politique de droit de douane optimal différent de zéro. Même si le petit pays ne peut pas influencer directement les prix mondiaux, en adoptant une politique ferme de droits de douane positifs, il peut amener le grand pays à réduire son niveau de droit de douane optimal, et, ce faisant, améliorer ses propres termes d'échange et son propre niveau de bien-être.     

Equilibrium capital taxation in open economies under commitment

This paper analyzes equilibrium capital taxation in open economies with strategic interaction in a neo-classical growth model. Under perfect commitment, I show that non-cooperative capital taxes are zero in the long run for a large open economy, thereby generalizing the result previously established only for the special cases of a closed and a small open economy. This does not represent a race to the bottom, though, since the result is independent of the degree of capital mobility, the number of countries, or a country׳s size relative to the rest of the world. Moreover, when countries cooperate, they still set capital taxes to zero in the long run. These outcomes are robust to different equilibrium specifications, the inclusion of endogenous government spending, and heterogeneous agents and non-linear labor income taxation. Governments find it optimal to implement the efficient capital allocation in the long run, both in a closed and an open economy; this trumps incentives to tax foreigners’ domestic capital holdings by raising capital taxes and attracting capital from abroad by lowering capital taxes.     

Environmental policy and lobbying in small open economies

This paper analyzes consequences of lobby group activity for policy outcomes in economies with transboundary pollution and international environmental policies. International environmental policies are here characterized as pollution taxes determined in a negotiation between two countries. The optimal pollution taxes are characterized and comparative statics are carried out to increase the understanding of mechanisms underlying pollution taxes in the specified setup. It is found, among other things, that the presence of local lobbying may decrease, as well as increase pollution taxes - depending on, e.g. an assumption of symmetry.     

Countercyclical capital rules for small open economies

The growing literature on macroprudential regulation focuses on how a combination of monetary and macroprudential policies can boost macroeconomic and financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. In such economies, macroprudential policy could potentially play an even more relevant role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy, the scene of a recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation – in the form of Basel III-type rules – can help attenuate boom-bust cycles driven by over-optimistic expectations. We also find that more aggressive action by regulators during the release phase can bolster the economy’s ability to absorb a negative shock.     

Exchange rates and asymmetric shocks in small open economies

We study the stabilizing properties of exchange rates in five small open economies during to periods of floating exchange rates and inflation targeting. In the cases of Sweden and Canada, the nominal exchange rates behave in a stabilizing manner. Most exchange rate movements emanate from the exchange rate itself and are hence not responses to fundamental shocks. However, these non-fundamental shocks have only negligible effects on output and inflation. Our findings indicate that exchange rates display some stabilizing properties but can mainly be characterized as disconnected from the rest of the economy. We would like to thank Nils Gottfries and participants at seminars at Uppsala University and the Riksbank for helpful advice and useful comments. Post gratefully acknowledges financial support from Handelsbankens forskningsstiftelser.     

Multiple transitional growth paths in endogenously growing open economies

This paper extends research in indeterminacy literature to a small open economy, two-sector endogenous growth model. It shows that a continuum of equilibria exist in two situations, (i) the production functions exhibit social constant returns to scale with very small or even negligible externalities; and (ii) the production functions are standard constant returns to scale without externalities but the government implements asymmetric tax policies across sectors.     

Credibility and commitment of monetary policy in open economies

We study the delegation of monetary policy to independent central bankers in a two-country world with monetary spillovers. It is shown that, under the hypotheses of imperfect commitment and private information, the equilibrium degree of commitment depends on the correlation structure of the shocks hitting the economies. When the correlation is negative (as when the variance of output depends mainly on shocks to the terms of trade) there is strategic complementarity in the degree of commitment in the two countries. When the correlation is positive (common technological or demand shocks) there is strategic substitutability. In this latter case, the degree of commitment is shown to be increasing in the correlation among shocks. Common components in the international business cycle have been shown in several studies to be relatively more relevant in developed countries. Therefore, our results may contribute to explaining why the institutional solution to the inflationary bias has been adopted in the most advanced countries.     

Foreign trade,concentration and profitability in open economies

In this article a model is developed which integrates the impact of international factors, such as the degree of foreign competition, exporting opportunities, and multi-national activity with the more traditional elements of market structure in explaining cross industry differentials in price-cost margins in the industrial sector of the European Economic Community. Utilizing a simultaneous estimation procedure we conclude that the foreign factors are an important addition to domestic structural variables in the structure-profitability relationship.     

Inflation Targeting versus Nominal Income Targeting

In this paper we analyze two different target regimes, flexible inflation targeting and nominal income targeting, under discretion in a simple dynamic macro model. The key results of our paper are: First, for both targeting regimes optimal monetary policy response leads to a shock-dependent feedback rule. Second, a demand shock is completely offset by both monetary strategies. Third, in case of a supply shock there is a significant difference between the two different targeting regimes. Under inflation targeting the policy makers face a trade-off between inflation and output stabilization. This trade-off depends on the weight Φ the policy makers attach to output stabilization relative to inflation stabilization in the loss function. In contrast, under nominal income targeting policy makers face a constant trade-off between inflation and real output growth: an increase in inflation leads to a fall in real output growth by an equal amount. Furthermore, in Appendix A we analyze a (linear) commitment solution for inflation targeting and compare it with the discretionary case. Under commitment, inflation is smaller and the output gap is larger than under discretion. In Appendix B, we investigate inflation targeting in a two-period time-lag version of the model. The qualitative results on the trade-off between inflation and output growth remain the same as in the basic model without time lag. Received May 3, 2000; revised version received December 3, 2001 Published online: February 17, 2003     

Inflation and nominal tax system in an open economy

This paper provides an analysis of the implications of the interaction between inflation and a tax system which is not fully indexed within the context of an open economy. The model used is characterized by perfect foresight, full employment, imperfect substitutability between domestic and foreign assets, and an endogenous stock of capital. Three distinct channels through which an increase in the inflation rate disturbs the initial equilibrium are analysed separately. The global effect is then discussed with respect to the position of the economy as debtor or creditor to the rest of the world. The financing of the public deficit is also briefly discussed.