International business cycles and the relative price of investment goods

Abstract Is the relative price of investment goods a good proxy for investment specific technology? We model this relative price in a flexible price international economy with two fundamental shocks, namely, the total factor productivity (TFP) shock and the investment‐specific technology (IST) shock. We show that the one‐to‐one correspondence between the IST shock and the relative price of investment goods breaks down in an international economy because of the short‐run correlation between the terms of trade and the relative price of investment goods. The data congruent negative correlation between the investment rate and the relative price of investment goods thus does not necessarily reflect decline in investment frictions (rise in IST), as suggested by many studies. A calibration experiment with the US data demonstrates that such an inverse relation between rate of investment and the relative price of investment goods basically reflects the positive effect of TFP on the terms of trade for a broad range of economies where the home bias in consumption exceeds investment and there is a sizable adjustment cost of investment.     

UNDERSTANDING REAL EXCHANGE RATE MOVEMENTS WITH TRADE IN INTERMEDIATE PRODUCTS

We suggest that it may be ‘too easy’ to attribute real exchange rate movements to deviations from the law of one price. We show that it is immaterial whether one uses seemingly traded goods, nontraded goods, or even a single, unimportant consumer good, say beer. The ease of attributing the variation to any such deviations is explained using a model with intermediate goods trade. In the model, the stage of production determines the traded/nontraded distinction. We find empirical substantiation for the model: law of one price deviations lose explanatory power and, defined appropriately in terms of intermediate goods, relative prices matter.     

Franchise fee,contract bargaining,and economic growth

This paper combines the industrial organization (IO) theory and the R&D-based endogenous growth theory in a model of a successive imperfect competitive economy. The current study assumes that firms between upstream and downstream industries bargain over both the price of intermediate goods and the franchise fee. Findings show that the intermediate goods firm with a R&D sector charges the price equal to the marginal cost. Economic rent may also be partly transferred into the franchise fee determined by the relative bargaining power. In particular, the traditional double marginalization result, such as in Spengler (1950), does not take place here due to the above-mentioned bargaining scheme. Finally, this work shows that final goods firms in vertically linked industries play an important role in an economic growth model. The more bargaining power the final goods firms have (or the more returns to specialization upstream firms have, or the less substitution elasticity the final goods have), the more the economy grows. However, the consumer preference for diversity seemingly does not affect economic growth rate.     

Technological-knowledge bias and the industrial structure under costly investment and complementarities

We develop an extended directed technological change model with vertical and horizontal R&D to analyze the economic growth rate, the technological-knowledge bias and the industrial structure, assuming: (i) complementarities between intermediate goods, and (ii) internal costly investment. We find that complementarities directly affect long-run technological-knowledge bias and relative production, both elements influence the economic growth rate and neither affects the skill premium and the relative number of firms. We also verify that the relationship between the relative supply of skills and both economic growth and the industrial structure suggested by our model is qualitatively consistent with recent empirical data for a number of developed countries.     

The cost of capital,asset prices,and the effects of monetary policy

The primary objective of this paper is to study the interaction between monetary policy, asset prices, and the cost of capital. In particular, we explore this issue in a setting where individuals face idiosyncratic risk. Incomplete information also provides a transactions role for money so that monetary policy can be studied. In contrast to standard monetary growth models which focus on the transmission of monetary policy to the demand for capital goods, we incorporate a separate capital goods sector so that the supply response to monetary policy is taken into account. Consequently, in contrast to the standard monetary growth model, monetary policy plays an important role in investment activity through the relative price of capital goods. Moreover, different sources of productivity can affect the degree of risk sharing. Although the optimal money growth rate falls in response to an increase in productivity in either sector of the economy, monetary policy should react more aggressively to the level of productivity in the capital sector.     

Schumpeterian Growth with Gradual Product Obsolescence

The model in this article captures several important aspects of the real world: gradual obsolescence of goods in the form of gradually declining net profit derived from each product until it is phased out, expanding variety of goods over time, and both dynamic and static internal increasing returns to scale of production. To eliminate the scale effect, Jones's specification that gives rise to a semiendogenous rate of innovation is adopted. The most interesting finding of the article is that, when the research duplication effect is small (large) relative to the intertemporal knowledge spillover effect in R and D, the decentralized market delivers insufficient (excessive) obsolescence and allocates too little (much) labor to R and D, while a small subsidy (tax) to innovation is welfare-improving. All these results hold because the positive knowledge spillover externality overwhelms (is overwhelmed by) the negative research duplication externality.     

DO INVESTMENT‐SPECIFIC TECHNOLOGICAL CHANGES MATTER FOR BUSINESS FLUCTUATIONS? EVIDENCE FROM JAPAN

The observed decline in the relative price of investment goods to consumption goods in Japan suggests the existence of investment‐specific technological (IST) changes. We examine whether IST changes are a major source of business fluctuations in Japan, by estimating a dynamic stochastic general equilibrium model using Bayesian methods. We show that IST changes are less important than neutral technological changes in explaining output fluctuations. We also demonstrate that investment fluctuations are mainly driven by shocks to investment adjustment costs. Such shocks represent variations of costs involved in changing investment spending, such as financial intermediation costs. We find that the estimated series of the investment adjustment cost shock correlates strongly with the diffusion index of firms' financial position in the Tankan (Short‐term Economic Survey of Enterprises in Japan). Therefore, we argue that the large decline in investment growth in the early 1990s was due to an increase in investment adjustment costs stemming from firms' financial constraints after the collapse of Japan's asset price bubble.     

RAMSEY TAXES MEET PRICE RIGIDITY

‘Ramsey taxes’ are commodity taxes that minimize deadweight loss. Evidence has shown dramatic differences in the extent of price rigidity across goods: while the prices of some goods change frequently, the prices of other goods seldom change. This paper examines Ramsey taxes in the presence of heterogeneous price rigidity. We find that, to minimize deadweight loss, lower (higher) tax rates should be imposed on goods with rigid prices if their relative prices are too high (low) relative to the would‐be situation of no price stickiness. Intuitively, Ramsey taxes remedy the relative price distortion caused by the price rigidity of some goods. We calibrate our model to data from Taiwan and the USA, showing a significant cut in welfare cost if Ramsey rather than uniform taxes are applied.     

The demand and supply for investment goods: does the market clear?

Standard theoretical considerations suggest that the quantity and price of a good are jointly determined by supply and demand. In the literature on physical investment, however, attention has been focused almost exclusively on the demand side. This paper considers the theoretical and statistical problems that arise when the demand and supply sides of the market for investment goods are estimated simultaneously. One of the important problems is dealing with the possibility that the price may not adjust instantaneously to clear the market.The model is estimated using data from post-war Japan. The two most important results that emerge are: 1) The long-run supply curve of investment goods is virtually horizontal; and 2) The market appears to be characterized by equilibrium.     

Optimal labor income taxation in a two-sector dynamic general equilibrium model

This paper presents a new approach to the two-sector optimal taxation problem. We derive the optimal labor income tax rate which depends on factor intensity across sectors. It is the labor intensity that determines the initial wage rate, and therefore the optimal labor tax rate. We show that an increase in the initial relative price of consumption goods decreases the optimal tax rate on labor income in the case that the consumption goods sector is capital-intensive while it increases the optimal tax rate on labor income in the case that the investment goods sector is capital-intensive.     

Real exchange rates,asset prices and terms of trade: A theoretical analysis

This paper develops a continuous-time two-country dynamic equilibrium model, in which the real exchange rates, asset prices, and terms of trade are jointly determined in the presence of nontradable goods. The model determines the relation between the financial markets and real goods markets in the world economy and their responses to various shocks under the home bias assumption. A positive domestic supply shock induces a positive return on the domestic asset markets and a deterioration of terms of trade that improves the foreign output and boosts the foreign asset markets. Demand shocks act in the opposite way. This model also analyses the impact of change in the relative price of nontradable to tradable goods on the terms of trade and asset markets. A higher productivity growth in tradable goods than in nontradable goods leads to a higher relative price of nontradable to tradable goods, which appreciates the real exchange rate, deteriorates the terms of trade, and depresses the domestic and foreign asset markets. A lower relative price of nontradable goods depreciates the real exchange rate, improves the terms of trade, and lifts both the domestic and foreign asset markets.     

Foreign Direct Investment in Australia Following the Australia–US Free Trade Agreement

A model of inward foreign direct investment for Australia is estimated. Foreign direct investment is found to be positively related to economic and productivity growth and negatively related to foreign portfolio investment, trade openness, the exchange rate and the foreign real interest rate. Foreign direct investment is found to be a substitute for both portfolio investment and trade in goods and services. The exchange rate and the US bond rate affect foreign direct investment through the relative attractiveness of domestic assets. Actual foreign direct investment outperforms a model‐derived forecast in recent years, consistent with the liberalisation of foreign investment screening rules following the Australia–US Free Trade Agreement.     

Relative importance of sectoral and aggregate sources of price changes

This paper estimates a dynamic common factor model to assess relative importance of the aggregate and the sector-specific factors that determine changes in the prices of individual products. It also examines how aggregate price changes are affected by these factors. Two different specifications of the model are estimated: the baseline model with one aggregate factor, and a second specification with two aggregate factors. In the one-actor model, the aggregate factor contributes little to the movements of changes in prices, mostly of nondurable goods whereas it seems to have important contributions to the movements of changes in prices of commodity groups mainly used as intermediate or capital goods. In the specification with two aggregate factors, the additional factor has significant effects on changes in prices of ‘farm products’ and ‘processed foods and feeds’ only. Forecast-error variance decompositions of both aggregate and disaggregate price changes suggest that sectoral factors account for most of the variability at short horizons while the contributions of the aggregate factors increase as the time horizon lengthens. The results also show that sectoral factors are not only important for relative price changes but also have significant impact on aggregate inflation. The estimated common factors have statistically significant correlations with money growth and changes in the unemployment rate.     

International transmission of the business cycle in a multi-sector model

Standard multi-country models do not replicate important features of the international transmission of business cycles, predicting cross-country correlations of output and consumption which are, respectively, too low and too high. In this paper we modify the supply side of a two-country model by adding multiple sectors and trade in intermediate goods. The model generates a higher cross-country correlation of output than standard one-sector models. It also predicts cross-country correlations of employment and investment that are closer to the data. We analyze the relative impact of multiple sectors, trade in intermediate goods, imperfect substitution between domestic and foreign goods, home preference, capital adjustment costs, and capital depreciation in order to pinpoint the features which move the model's predictions closer to the data.     

Costly investment, complementarities and the skill premium

We propose a new framework to analyse the relationship between the relative high-skilled labour endowment, the skill premium and economic growth. Building on Acemoglu and Zilibotti (2001), we introduce physical capital; internal costly investment in both capital and R&D; and complementarities between intermediate goods. We only find a positive relationship between the relative labour endowment and both the skill premium and economic growth within determined intervals of relative labour endowment values, which vary with the absolute productive advantage of high over low-skilled labour. The model thus accommodates theoretically mixed empirical results on the relative labour endowment-skill premium relationship. We further find that the impact on both the relative labour endowment and the skill premium of a rise in investment costs or in the complementarities degree depends on: (i) the absolute productivity advantage of high over low-skilled labour; and (ii) the relative labour endowment.     

Wage bargaining,trade and growth

We construct a North-South product-cycle model of trade with fully-endogenous growth and union wage bargaining. Economic growth is driven by Northern entrepreneurs who conduct R&D to innovate higher quality products. Northern production technologies can leak to the South upon successful imitation. The North has two sectors: a tradable industrial goods sector (manufacturing) where wages are determined via a bargaining process and a non-tradable sector (services) where wages are flexible. The South has only a tradable industrial goods sector where wages are flexible.We find that unilateral Northern trade liberalization, in the form of lower Northern tariffs on industrial goods, increases the rate of innovation but decreases both the bargained wage in the industrial sector and the flexible wage in the service sector. The wage effects are relative to the Southern wage rate. We also consider a variant of the model with Northern unemployment, driven by a binding minimum wage in the non-tradable service sector. In this case, Northern tariff cuts decrease the innovation rate and the bargained wage rate. In addition, the Northern unemployment rate increases. The model thus highlights the role of labor market institutions in determining the growth and labor market effects of tariff reductions. We also study the effects of unilateral Southern trade liberalization.     

Home bias, distribution services and determinants of real exchange rates

This paper examines empirically how exogenous changes in the terms of trade affect the real exchange rate through the relative price of traded goods with Canada–US data. The relative price of traded goods is constructed using prices at the dock and retail prices. The first measure emphasizes the importance of home bias in consumption of traded goods. The second measure highlights the importance of distribution services required for consumption of traded goods. It is found that terms of trade shocks affect the relative price of traded goods using both measures. A possible interpretation of empirical findings is that home bias and distribution services are important for understanding the relative price of traded goods.     

Roads out of poverty? Assessing the links between aid,public investment,growth, and poverty reduction

This paper presents a dynamic macroeconomic model that captures key linkages between foreign aid, public investment, growth, and poverty. Public capital is disaggregated into education, core infrastructure, and health. Dutch disease effects associated with aid are accounted for by endogenizing changes in the relative price of domestic goods. The impact of shocks on poverty is assessed through partial elasticities and household survey data. The model is calibrated for Ethiopia and changes in the level of nonfood aid are simulated. The amount by which (nonfood) aid should increase to reach the poverty targets of the Millennium Development Goals is also calculated, under alternative assumptions about the degree of efficiency of public investment.     

Sustained Comparative Advantage and Semi-Endogenous Growth

This paper constructs a two-country (Home and Foreign) general-equilibrium model of Schumpeterian growth without scale effects. The scale effects property is removed by introducing a distinct specification in the knowledge production function which generates semi-endogenous growth. In this model of semi-endogenous growth, an increase in the rate of population growth rate raises Home's relative wage and lowers its range of goods exported to Foreign. An increase in the size of innovations increases Home's relative wage but with an ambiguous effect on its comparative advantage. The model generates a unique steady-state equilibrium in which there is complete specialization in both goods and R&D production within each country.     

Legal Institutions, Sectoral Heterogeneity, and Economic Development

Poor countries have lower PPP-adjusted investment rates and face higher relative prices of investment goods. It has been suggested that this happens either because these countries have a relatively lower TFP in industries producing capital goods or because they are subject to greater investment distortions. This paper provides a micro-foundation for the cross-country dispersion in investment distortions. We first document that firms producing capital goods face a higher level of idiosyncratic risk than their counterparts producing consumption goods. In a model of capital accumulation where the protection of investors' rights is incomplete, this difference in risk induces a wedge between the returns on investment in the two sectors. The wedge is bigger, the poorer the investor protection. In turn, this implies that countries endowed with weaker institutions face higher relative prices of investment goods, invest a lower fraction of their income, and end up being poorer. We find that our mechanism may be quantitatively important.