Stability with regime switching

The purpose of this paper is to analyze the stability of systems of piecewise continuous differential equations, and to apply the results to a disequilibrium economic model. The discontinuity problem appears in disequilibrium models because of the so-called “short-side” rule. The concept of Filippov solution makes it possible to analyze the dynamic evolution of such a model. This paper demonstrates that (i) stability conditions for each subsystem are neither necessary nor sufficient for overall stability, except in special cases such as a system of linear differential equations in R² with two regimes separated by a linear boundary; (ii) several sufficient conditions for overall stability with many regimes are available; and (iii) stability theorems with regime switching are useful for disequilibrium economic models with several regimes.     

Irreversible investment with regime shifts

Under the real options approach to investment under uncertainty, agents formulate optimal policies under the assumption that firms’ growth prospects do not vary over time. This paper proposes and solves a model of investment decisions in which the growth rate and volatility of the decision variable shift between different states at random times. A value-maximizing investment policy is derived such that in each regime the firm's investment policy is optimal and recognizes the possibility of a regime shift. Under this policy, investment is intermittent and increases with marginal q. Moreover, investment typically is very small but, in some states, the capital stock jumps. Implications for marginal q and the user cost of capital are also examined.     

The trade-off between innovation and defense industrial policy: A simulation model analysis of the Norwegian defense industry

The paper investigates the trade-off between innovation and defense industrial policy. It presents an agent-based simulation model calibrated for the Norwegian defense industry that compares different policy scenarios and examines the effects of a pending EU market liberalization process. The paper points to two main results. (1) It finds that a pure scenario where national authorities focus on, and provide support exclusively for, either a) international competitiveness or b) national defense and security objectives, is more Pareto efficient than a corresponding mixed strategy where policy makers simultaneously pursue both international competitiveness and defense and security objectives. (2) Under the conditions of the new EU liberalization regime, it finds that a stronger and more visible trade-off will emerge between international competitiveness and national defense and security objectives. Policy makers will have to choose which to prioritize, and set a clear agenda focusing on one of the two objectives.     

Credible communication in dynastic government

This paper studies information disclosure in a model of dynastic government. When information about past policy choices comes exclusively from the reports of previous administrations, each administration has an incentive to choose its (suboptimal) one-shot expenditure policy, and then misrepresent its choice to its successor. Consequently, it has been suggested that “horizontal accountability,” i.e., a system of governance where auditing functions lie outside the executive branch, can ensure credible disclosure of a government's activities. This paper suggests a cautious approach to that view.The baseline model examines the reporting incentives of an external auditor who can independently verify the information each period. Even with auditing, credible disclosure is shown to be problematic. Various extensions to this baseline model are examined. In one extension, “liberal” (i.e., those prefering larger government expenditures) and “conservative” (those prefering smaller expenditures) regimes and auditors evolve over time. It is shown that “conservative” (“liberal”) auditors are not credible when the current regime is also “conservative” (“liberal”). Moreover, because information transmission stops when the auditor's and the regime's biases coincide, effective deterrents even in the “good” periods (when the auditor's and the administration's biases differ) are difficult to construct. In all periods the equilibrium requirement of auditor neutrality constrains the dynamic incentives for efficient policy choices. These constraints are shown to bind away from optimal policies in standard constructions of equilibrium. Various ways in which auditing protocols can overcome these problems are discussed.     

Capital requirements and business cycles with credit market imperfections

The business cycle effects of bank capital regulatory regimes are examined in a New Keynesian model with credit market imperfections and a cost channel of monetary policy. Bank capital increases incentives for banks to monitor borrowers, thereby raising the repayment probability, and excess capital generates benefits in terms of reduced regulatory scrutiny. Basel I- and Basel II-type regulatory regimes are defined, and the model is calibrated for a middle-income country. Simulations of a supply shock show that, depending on the elasticity that relates the repayment probability to the bank capital–loan ratio, the Basel II regime may be less procyclical than a Basel I regime.     

Exports,capabilities, and industrial policy in India

An extensive literature argues that India’s manufacturing sector has underperformed, and that the country has failed to industrialize; in particular, it has failed to take advantage of its labor–abundant comparative advantage. India’s manufacturing sector is smaller as a share of GDP than that of East Asian countries, even after controlling for GDP per capita. Hence, its contribution to overall GDP growth is modest. Without greater participation of the secondary sector, the argument goes, the country will not be able to develop and become a modern economy. Standard arguments blame the “license-permit raj”, the small-scale industrial policy, and the labor laws. All these were part of the industrial policy regime instituted after independence. This regime favored the heavy-machinery subsector. We argue that despite its shortcomings and misallocations, the bias towards machinery, metals, chemicals, and other capital- and skilled labor-intensive products allowed Indian manufacturing to accumulate a wide range of capabilities. We show that India’s manufacturing sector is more diversified and sophisticated than one would expect given the country’s income per capita. This positions India well to continue expanding its exports of other sophisticated products. India’s failure, however, lies in not being able to diversify into labor-intensive sectors and generate the type of structural transformation seen in China.     

Impact of foreign prices and interest rates on canadian economy under alternative monetary and exchange rate regimes

The main objective of this paper is to analyze the impact of U.S. short- and long-term monetary policy under both flexible and managed floating systems, using the new CANDIDE Model 2.0. We have also examined the role of domestic monetary policy in the Canadian economy under both fixed and flexible exchange rate systems. The following are some of the important findings of our study:

1. Our results support the traditional view that under the fixed exchange rate regime, monetary authorities cannot successfully pursue an independent monetary policy from its trading partners — an effort to increase money supply will be almost offset by increases in the balance of payments deficit. In contrast, in the flexible exchange rate regime, monetary policy is more effective in producing an increased growth in output and employment. However the increased output growth comes at the cost of higher prices induced by increased wages and a depreciation of the Canadian dollar.
2. Our results suggest that the impact of U.S. interest rates on investment, GNE, employment, productivity, and government debt is less severe in a pure floating exchange rate regime, compared to the managed floating system. However, the impact of U.S. interest rate policy on the Canadian inflation rate is worse in the case of flexible exchange rate regime. Even though real income and inflation are less favourable in both cases, our results indicate a trade-off between output growth and inflation.
3. Our results imply that under a pure floating monetary authorities can determine the long-run rate of inflation in Canada independent of others. However, the United States and Canadian economies are interrelated during the adjustment process, even under the flexible exchange rates, through the terms of trade and the wage-price spiral channels.

     

Using the multi-level perspective on socio-technical transitions to assess innovation policy

In recent years a growing literature on socio-technical transitions towards sustainability has emerged. Scholars have explored ways through which configurations of technologies, infrastructures, social practices, institutions and markets can change to fulfil their functions in a more sustainable way. A multi-level perspective (MLP) has been developed to describe and analyse these complex, long-term processes. It has also been used to help design policy for example in the Netherlands. In this paper the MLP is used in a novel way: as a heuristic to ex ante assess policies to stimulate socio-technical transitions. Instead of using it for policy development, the MLP is used here for an assessment of policy. The analysis focuses on a particular policy initiative intended to stimulate the transition to a low carbon economy in the UK: the Carbon Trust. This paper makes two contributions to the socio-technical transitions literature: Conceptually, the paper demonstrates the usefulness of the socio-technical multi-level perspective to analyse policies and assess their likely impact ex ante against the background of theorising about the patterns of large scale, socio-technical change. Empirically, the paper finds that the activities of the Carbon Trust consist of a variety of well targeted ways to stimulate the development of socio-technical niches as well as to change regime practices directly. Nevertheless, the paper argues that this model also faces difficulties in promoting a transition towards a low carbon economy.     

Estimating the effects of forward guidance in rational expectations models

Simulations of forward guidance in rational expectations models should be assessed using the “modest policy interventions” framework introduced by Eric Leeper and Tao Zha. That is, the estimated effects of a policy intervention should be considered reliable only if that intervention is unlikely to trigger a revision in private sector beliefs about the way that monetary policy will be conducted. I show how to constrain simulations of forward guidance to ensure that they are regarded as modest policy interventions and illustrate the technique using a medium-scale DSGE model estimated on US data. I find that many experiments that generate the large responses of macroeconomic variables deemed implausible by many economists – the so-called “forward guidance puzzle” – are not modest policy interventions. Those experiments should therefore be treated with caution, since they may prompt agents to believe that there has been a change in the monetary policy regime that is not accounted for within the model. More reliable results can be obtained by constraining the experiment to be a modest policy intervention. In the cases I study, the quantitative effects on macroeconomic variables are more plausible when this constraint is imposed.     

Do we now collect any revenue from taxing capital income?

The U.S. income tax system has long been recognized as a hybrid of an income and consumption tax system, with elements that do not fit naturally into either pure system. What it actually is has important policy implications for, among other things, understanding the impact of moving closer to a pure consumption tax regime. In this paper, we examine the nature of the U.S. income tax system by calculating the revenue and distributional implications of switching from the current system to one form of consumption tax, a modified cash flow tax.     

Quasi-Monte Carlo methods in stochastic simulations: An application to policy simulations using a disequilibrium model of the West German economy 1960–1994

Different stochastic simulation methods are used in order to check the robustness of the outcome of policy simulations. The application of a macroeconometric disequilibrium model of the West German economy to a fiscal policy simulation is taken as an example. Due to nonlinearities arising from regime specific reactions inside the model, confidence intervals for the simulation results have to be obtained by means of stochastic simulations. The robustness of the results is assessed using different methodologies. In particular, different methods for the generation of uniform error terms and their conversion to normal variates are applied. These methods include standard approaches as well as quasi-Monte Carlo methods. First version received: May 1998/final version accepted: August 1999     

A note on the average propensity to consume,wealth and threshold adjustment

We explore the connection between the average propensity to consume (APC) and wealth to income ratio (WY) in the US. We find evidence of a long-run relationship characterised by threshold error correction. It is the APC that responds to long-run disequilibrium where the speed of adjustment is asymmetric insofar as being most likely fastest in regimes characterised by a high APC and low WY.     

What to stabilize in the open economy*

We consider the question how “best” to maintain price‐level stability in an open economy, and evaluate three possible policy choices: (a) a constant money growth rate rule; (b) a fixed exchange rate; and (c) a policy of explicit commitment to a price‐level target. In each case we assume that policy is conducted by injecting reserves into or withdrawing reserves from the “banking system.” In evaluating the three regimes, we adopt the criterion that the “best” policy should leave the least scope for indeterminacy and “excessive” economic volatility. In a steady‐state equilibrium, the choice of regime is largely irrelevant; any steady‐state equilibrium under one regime can be duplicated by an appropriate choice of the “control” variable under any other regime. However, we show that the sets of equilibria under the three regimes are dramatically different. When all countries follow the policy of fixing a constant rate of money growth, there are no equilibria displaying endogenously arising volatility and there is no indeterminacy of equilibrium. Under a regime of fixed exchange rates, indeterminacies and endogenously arising fluctuations are impossible if and only if the country with the low “reserve‐to‐deposit” ratio is charged with maintaining the fixed rate. Finally, when one country targets the time path of its price level, under very weak conditions, there will be indeterminacy of equilibrium and endogenously arising volatility driven by expectations.     

IS-LM stability and economic policy effectiveness: A note

Accepting the findings of Weber (1970) and Yarrow (1975), Cebula finds that conventional fiscal policy has its usual positive effect on the level of income while monetary policy has a negative impact. This paper shows that if a budget constraint of the specific, simplified form G ? T = ΔM is added to the model, the results differ from Cebula's.     

MODELLING DEMAND FOR BROAD MONEY IN AUSTRALIA*

The existence of a valid long‐run money demand function is still important for the conduct of monetary policy. It is argued that previous work on the demand for money in Australia has not been very satisfactory in a number of ways. This paper examines the long‐ and short‐run determinants of the demand for broad money employing the Johansen cointegration technique. Using quarterly data for the period 1976:3–2002:2, this paper finds, inter alia, that the demand for broad money is cointegrated with real income, the rate of return on 10‐year Treasury bonds, the cash rate and inflation. It appears that a disequilibrium in the demand for money can affect the efficacy of interest rate policy in the long run via its impact on future output growth and output gap.     

Switching error-correction models of house prices in the United Kingdom

This paper develops error-correction models of real house prices in the UK in which the adjustment coefficient switches stochastically between a stable regime where disequilibrium correction takes place and an unstable regime where such a correction does not occur. The generating mechanism of the shifts is modelled as a Markov process with transition probabilities which are either time-invariant or depend on the extent to which the system is out of disequilibrium. Estimation of error-correction models for the UK reveals that the observed booms in real house prices are associated with an unstable regime. We also find that the probability that the system remains in an unstable regime decreases as deviations from equilibrium increase.     

A simple auctioneerless mechanism with Walrasian properties

A simple mechanism for reallocating holdings is described, in which no auctioneer is required: outcomes are determined solely from traders' actions and without any requirement that the mechanism be in equilibrium. The mechanism is shown to exactly duplicate the performance of the Walrasian auctioneer (both in its equilibria and in its disequilibrium path) if individuals are price takers, and, if the number of individuals is large, to approximately duplicate the auctioneer's performance even when individuals behave strategically, each taking account of his own influence on prices.     

Macroeconomic environment,country risk and stock market performance: Evidence for Brazil

The paper aims at providing empirical evidence about (i) the influence of macroeconomic variables and economic policies on country risk and (ii) the influence of macroeconomic variables and country risk on the main Brazilian index of the stock market (Ibovespa). The study analyzes the role that macroeconomic fundamentals plays, but also the role that the credibility of the regime of inflation targeting and the reputation of the central bank play in lessening country risk and in the improvement of the stock market performance. The empirical evidence was obtained through the application of ordinary least squares (OLS), generalized method of moments (GMM) and GMM systems. The results found suggest that monetary policy and public debt management, as well as credibility and reputation affect country risk and the performance of the Brazilian stock market.     

Optimal monetary–fiscal policy in the euro area liquidity crisis

We build an euro-area level DSGE model featuring a liquidity shock in the sovereign bonds market to simulate the strong contraction in economic activity observed during the 2008–2009 crisis. In the model, a sudden deterioration of the liquidity property of sovereign bonds is associated with deep recession and deflation. Against this background we characterize optimal monetary and fiscal policy with full commitment. We find that the optimal policy contains three features: (i) the policy rate is lowered until hitting the zero lower bound (ZLB) and then is kept at the ZLB for more periods; (ii) a prolonged central bank’s balance-sheet expansion aimed at restoring the liquidity deteriorated; (iii) a counter-cyclical fiscal stimulus which offsets, to a large extent, the fall in private spending caused by the liquidity shock. Policy regimes involving (i), but not (ii) and (iii), are quite weak in stabilizing output gap and inflation. Monetary policy regimes such as full inflation-targeting or nominal GDP targeting perform remarkably well insofar as they are complemented with an optimally-implemented counter-cyclical fiscal policy. Our results tend to favour the view that, in case of recession, an euro-wide coordinated fiscal policy should supplement the role of the ECB in achieving its primary objective.