The driving forces of China's business cycles: Evidence from an estimated DSGE model with housing and banking

We study the approximate sources of China's business cycles in an estimated dynamic stochastic general equilibrium (DSGE) model with housing and banking. The model replicates well the volatility and cyclicality of key macroeconomic variables observed in the past two decades in China. A host of shock decomposition exercises demonstrate that, among the shocks being considered, both financial and housing shocks are driving China's business cycles, accounting for a particularly large fraction of the variance in most macroeconomic and financial variables at the business cycle frequencies. In particular, the capital quality, housing demand, and loan-to-value shocks display prominent contributions to the business cycle fluctuations. Moreover, there exists substantial interactions between the banking and housing sectors in China, where the collateral constraint and the financial constraint amplify with each other. The results shed new light in the understanding of China's business cycles, and may serve as a useful benchmark for future quantitative analyses of China's macroeconomic fluctuations using DSGE frameworks.     

供求冲击与人民币汇率的波动：基于DSGE两国模型的模拟分析

为分析人民币汇率的波动,本文应用当前新开放经济学主流的动态随机一般均衡两国模型的研究方法,通过引入垄断竞争的市场结构和粘性的价格调整方式,模拟了在以技术冲击为代表的供给冲击和以货币冲击为代表的需求冲击下汇率的波动,进而用来拟合人民币汇率的波动。结果表明相对于需求冲击,供给冲击对人民币汇率波动的拟合比较好,这表明“巴拉萨-萨缪尔森”效应是解释和预测人民币汇率波动的合理途径,也给我国的人民币汇率稳定政策提供了明确的导向。     

OUTPUT-INFLATION TRADEOFF IN CHINA

High growth and wide fluctuations in fixed investment are the main driving forces causing inflation in China during its economic reform period. Investment expansion generates strong demand pressures in the consumption goods market. Its inflationary impact is magnified further as it brings about higher wage costs during economic booms. In the paper, an implied short-run tradeoff has been derived from the dynamic simulation of a small macroeconomic model. In a given year, each additional percentage point of aggregate output growth or investment growth will bring about a 2.6 or a 0.9 per cent increase, respectively, in the rate of inflation for that year. These estimates suggest that the surge in fixed investment accounts almost fully for the 1993–95 inflationary spell.     

Policy Shocks and Macroeconomic Fluctuations in a Two‐country Dynamic Stochastic General Equilibrium Model: Evidence from China*

In this paper, we construct a two‐country dynamic stochastic general equilibrium model to investigate the sources of business cycles in China and the contributions of policy shocks in economic fluctuations. The empirical results from Bayesian estimation show that, apart from the traditional supply and demand shocks, monetary and fiscal policy shocks also play important roles in determining China's economic fluctuations. In addition, we find significant feedback effects between monetary and fiscal policies in China, indicating that policy coordination is an important feature of China's monetary and fiscal policies. Overall, these results not only shed new light on the policy factors behind China's economic fluctuations, but also provide new evidence that is helpful for understanding the policy transmission mechanisms in China.     

The saving–investment correlation and origins of productivity shocks

This paper shows how savings and investment can be positively correlated despite capital being perfectly mobile across countries. The saving-investment (SI) correlation depends on the origin and the volatility of macroeconomic (productivity) shocks, the persistence of these shocks and country-size. Simulating a two-country Real Business Cycle (RBC) model we show that as the variance of common shocks increases (relative to country-specific shocks), as the persistence of these shocks decreases and as country-size increases, the SI correlation increases. Using annual data from 1960 to 2002, productivity changes in 11 OECD countries are decomposed into common and country-specific shocks (from which foreign shocks are also constructed). The empirical findings show that the 11 countries share a statistically significant common component in productivity changes and common shocks generally account for at least half of the variations in the countries’ productivity changes. We then use the estimated variances of the shocks, in addition to each country's size, in the RBC model to compute the predicted SI correlation for each country, under the assumption that capital is perfectly mobile. The predicted SI correlation is then compared to the actual correlation to assess the relative degree of capital mobility in the 11 countries. The findings indicate that Norway, the Netherlands and the US have the highest degree of capital mobility whereas in Canada, Sweden, Belgium and Japan capital mobility has been the lowest.     

Business Cycle Fluctuations,Large Macroeconomic Shocks,and Development Aid

We examine the cyclical properties of development aid using bilateral data for 22 donors and 113 recipients during 1970–2005. We find that bilateral aid flows are on average procyclical with respect to the business cycle in both donor and recipient countries. While aid outlays contract sharply during severe downturns in donor countries, they rise steeply when aid-receiving countries experience large adverse shocks. Our findings suggest that development aid may play an important cushioning role in developing countries, but only during times of severe macroeconomic stress. Our results are robust to alternate definitions of aid flows, specifications, and estimation techniques.     

LABOUR MARKET FLEXIBILITY AND EMPLOYMENT ADJUSTMENT: MICRO EVIDENCE FROM UK ESTABLISHMENTS

In this paper we study how firms react to demand shocks, examininghow different aspects of flexibility shape their responses.Our main findings are: (i) very few firms choose to adjust pricein response to a demand shock; (ii) firms with more flexibilityare more likely to respond to demand shocks by adjusting employmentand hours. Our results provide a microeconomic explanation forrecent macroeconomic evidence that labour input has become moreclosely aligned to the business cycle.     

Terms of Trade Shocks and Inflation Targeting in Emerging Market Economies

Emerging market economies (EMEs) have persistently experienced different waves of commodity terms of trade disturbances, generating macroeconomic instabilities. The adoption of inflation targeting (IT) by many EMEs has raised questions about its relative suitability in dealing with these shocks compared with other monetary policy regimes. This paper tests the robustness of IT compared with monetary targeting and exchange rate targeting regimes in coping with commodity terms of trade shocks using the panel vector autoregressive technique. The results show that in general, IT countries respond better to commodity terms of trade shocks especially with respect to inflation and output gap. However, exchange rates are more volatile in IT countries than in exchange rate targeting countries. The results suggest that EME countries can reduce the adverse effects of commodity terms of trade fluctuations when they adopt IT, but they also need to pay attention to exchange rate movements.     

Macroeconomic effects of uncertainty shocks: Evidence from Korea

This paper proposes a new measure of economic policy uncertainty (EPU) for Korea by fine-tuning the keywords and exploiting information drawn from a wide variety of local newspapers. The uniqueness of our new EPU index lies mainly in the fact that it uses a set of keywords that correspond much more closely to actual language use and better reflect the economic environment of Korea, which is classified as a small open economy. After shocks to EPU being identified, we employ these shocks to estimate the impulse responses using local projections. Unlike the existing measure, our results show that shocks to EPU lead to a significant decline in macroeconomic aggregates such as output, consumption, investment, and employment. Thus our results suggest a refinement of the EPU index in general for other countries accordingly. We also develop policy-specific uncertainty indices and show that they capture important historical events related to the corresponding policies, such as monetary and fiscal measures.     

News shocks and Japanese macroeconomic fluctuations

Are the changes in the future technology process, the so-called “news shocks,” the main contributors to the macroeconomic fluctuations in Japan over the past forty years? In this paper, we take two structural vector-auto-regression (SVAR) approaches to answer this question. First, we quantitatively evaluate the relative importance of news shocks among candidate shocks, estimating a structural vector-error–correction model (SVECM). Our estimated results suggest that the contribution of the TFP news shocks is nonnegligible, which is in line with the findings of previous works. Furthermore, we disentangle the source of news shocks by adopting several kinds of restrictions and find that news shocks on investment-specific technology (IST) also have an important effect. Second, to minimize the gap between the SVAR approach and the Bayesian estimation of a dynamic stochastic general equilibrium model, we adopt an alternative approach: SVAR with sign restrictions. The SVAR with sign restrictions reconfirms the results that the news shocks are important in explaining the Japanese macroeconomic fluctuations.     

Japan's financial crises and lost decades

In this paper, we explore the role of financial intermediation malfunction in macroeconomic fluctuations in Japan. To this end we estimate, using Japanese data, a financial accelerator model in which the balance sheet conditions of entrepreneurs in a goods-producing sector and those of a financial intermediary affect macroeconomic activity. We find that shocks to the balance sheets of the two sectors have been quantitatively playing important role in macroeconomic fluctuations by affecting lending rates and aggregate investments. Their impacts are prominent in particular during financial crises. Shocks to the entrepreneurs’ balance sheets have played a key role in lowering investment in the bubble burst during the early 1990s and in the global financial crisis during the late 2000s. Shocks to the financial intermediaries’ balance sheets have persistently lowered investment throughout the 1990s.     

Preference shocks,international frictions,and international business cycles

Replicating the degree of cross-country comovements of macroeconomic aggregates, dynamics of prices and quantities of international trade, and the behavior of consumption and labor remains an important challenge in international business cycle literature. This paper incorporates preference shocks into a standard two-country model in which there exist international frictions, such as costs of transportation and restrictions to international asset trade. Country-specific preference shocks that generate fluctuations in each country's consumption and labor solve the puzzles, except for the discrepancy between theory and data regarding international trade variables. The presence or absence of international frictions plays a limited role in solving the puzzles.     

Measuring Chinese business cycles with dynamic factor models

The Stock–Watson method and the dynamic Markov switching factor (DMSF) model are employed to construct macroeconomic composite coincident indexes for the Chinese economy, January 1990–March 2008. Four coincident indicators, namely, industrial production, investment in fixed assets, sales revenues, and the money supply, M₁, are selected to compute the coincident index. Strong asymmetries are found with recent business cycles in China characterized by expansions of longer duration and smaller amplitude relative to the contraction stage. The two models produce similar composite index series, but the DMSF model shows frequent transitions that are difficult to interpret. A comparison of the composite coincident index and other measures of macroeconomic activity provides economic interpretations of the patterns in the index. There are notable differences between the index and GDP growth rates over this period, reflecting its more comprehensive measurement of economic activity. This more comprehensive view of macroeconomic activity increases understanding of changes in China's policies and economic fluctuations that are not shown by GDP growth rates alone.     

International Monetary Regimes and Incidence and Transmission of Macroeconomic Shocks: Evidence from the Bretton Woods and Modern Floating Periods

This paper investigates the relationship between international monetary regimes and incidence and transmission of macroeconomic shocks within the context of an open-economy macro model. Empirical results confirm monetary interdependence and lower incidence of monetary discretion under fixed exchange rates. The average magnitude and dispersion of supply shocks in Bretton Woods and the subsequent float is comparable; however, the average magnitude and dispersion of real demand shocks under Bretton Woods seems higher. Overall, the international monetary regime may pose important constraints to policymakers in open economies.     

An Evaluation of Friedman's Monetary Instability Hypothesis

In this article, I examine what I call Milton Friedman's Monetary Instability Hypothesis. Drawing on Friedman's work, I argue that there are two main components to this view. The first component is the idea that deviations between the public's demand for money and the supply of money are an important source of economic fluctuations. The second component of this view is that these deviations are primarily caused by fluctuations in the supply of money rather than the demand for money. Each of these components can be tested independently. To do so, I estimate an otherwise standard New Keynesian model, amended to include a money demand function consistent with Friedman's work and a money growth rule, for a period from 1875 to 1963. This structural model allows me to separately identify shocks to the money supply and shocks to money demand. I then use variance decompositions to assess the relative importance of shocks to the supply and demand for money. I find that shocks to the monetary base can account for up to 28% of the fluctuations in output whereas money demand shocks can account for less than 1% of such fluctuations. This provides support for Friedman's view.     

Aid Volatility and Real Business Cycles in a Developing Open Economy

This article analyzes the impact of the unpredictability of foreign aid on macroeconomic fluctuations in the recipient country. I build a small open‐economy business cycle model that accounts for foreign aid shocks, with no preference shocks. The model is calibrated to reflect the structural empirical regularities of Cote d'Ivoire, a typical aid‐dependent developing country. The parameters of the exogenous shocks are estimated using Bayesian methods and time series data for Cote d'Ivoire. The model produces business cycle patterns that are consistent with the data and key stylized facts. Specifically, the excess volatility of consumption with respect to output is successfully replicated. The results suggest that the unpredictability of foreign aid contributes to explain the volatility of business cycles in the recipient economy and has negative welfare effects.     

External shocks and Japanese business cycles: Evidence from a sign-restricted VAR model

This study investigates the sources of Japanese business fluctuations since the 1990s, taking into account both external shocks (e.g., risk premium and foreign demand shocks) and domestic supply and demand shocks. We use the sign-restricted VAR model based on the theoretical model to identify these shocks. The presented results show that approximately 30–50% of the forecast error variances in output can be explained by external shocks. Further, we demonstrate that supply shock is the main influencing factor in Japanese business fluctuations throughout the sample period and that the role of external shocks has been growing in the post-Lehman period, including the effect of the Great East Japan Earthquake.     

Inflationary shocks and real output growth in nine Muslim-majority countries: Implications for Islamic banking and finance

Low and stable inflation is important for maintaining the viability of Islamic banking and finance within a dual banking system. Inflationary shocks when transmitted to real output growth cause a shift of investment to fixed return products as a hedge against the uncertainty of returns on equity investment under Islamic profit-loss sharing contracts. This study examines the transmission of inflationary shocks to the real economy for nine Muslim-majority countries (Bahrain, Bangladesh, Egypt, Indonesia, Iran, Malaysia, Pakistan, Saudi Arabia, and Turkey) that have introduced Islamic banking, all except Iran within dual-banking systems. A structural vector autoregressive (SVAR) framework is deployed to understand macroeconomic relationships using annual data from the late 1970s to 2014. The key finding is that inflationary shocks affect real interest and exchange rates which in turn impact real output growth. The paper argues that the absorption of inflationary shocks in real interest and exchange rates is the outcome of rigidities in nominal interest and exchange rates within repressed financial systems. Policy regimes that allow for greater adjustment in nominal interest and exchange rates under a deregulated financial system would offer better shock absorption capacity which would lead to less volatility in inflation, real interest and exchange rates, and real output growth. The resulting more stable macroeconomic environment would be more conducive to the development of an Islamic financial sector that would promote economic growth.     

The Monetary Transmission Mechanism, Non-residential Fixed Investment and Housing

We specify a vector autoregression (VAR) model for the U.S. for 1980–2008 to investigate the statistical causal relationships between private non-residential fixed investment, the effective Federal funds rate, personal consumption expenditures, nonfinancial corporate profits, and the nonfinancial corporate credit market debt to test the validity of macroeconomic relationships in a macro model. The VAR utilizes the Toda-Yamamote procedure to test for Granger causality. Our preliminary results show that the transmission mechanism does not work as expected; we find that fixed investment depends on the level of demand in the economy and profits but not on the interest rate. This casts doubt on the usual assumptions about how the monetary transmission mechanism is expected to work. The second part of the paper investigates the effects of the change in the monetary regime towards low and stable interest rates, a policy pursued by the U.S. Fed since the beginning of the 1990s. We find that the new monetary policy regime has the following effects: (1) our VAR model does not support the hypothesis that low interest rates lead to higher fixed nonresidential investment; (2) low interest rates led to a search for higher yields through increasing risk, and (3) they led to an increase in the demand for securitized assets, especially mortgage-backed securities, which eventually resulted in a housing bubble. The overall results therefore raise doubts about the effectiveness of low interest rates as a policy regime designed as a component of a counter-cyclical policy.     

Commodity Prices, Inflationary Pressures, and Monetary Policy: Evidence from BRICS Economies

We assess the transmission of monetary policy and the impact of fluctuations in commodity prices on the real economy for the five biggest and fastest growing emerging market economies: Brazil, Russia, India, China and South Africa (BRICS). Using modern econometric techniques, we show that a monetary policy contraction has a negative effect on output, suggesting that it can lean against unexpected macroeconomic shocks even when the financial markets are not well-developed in this group of countries. We also uncover the importance of commodity price shocks, which lead to a rise in inflation and demand an aggressive behaviour from central banks towards inflation stabilisation.