Investment-specific shocks and external balances in a small open economy model

Abstract.  We set up a standard small open economy business cycle model driven by government spending shocks, neutral productivity (TFP) shocks, and investment-specific shocks. The model is calibrated to quarterly Canadian data and its predicted moments and sample paths are compared with their Canadian counterparts. We find that the model captures the dynamics in investment and in the trade balance better than special cases of the model where either one of the productivity shocks is omitted. More specifically, the model matches the variance of the trade balance-output ratio, its correlation with output and its autocorrelation. It also matches the output-investment correlation.     

Convergence in West German Regional Unemployment Rates

Abstract. Differences in regional unemployment rates are often used to describe regional economic inequality. This paper asks whether changes in regional unemployment differences in West Germany are persistent over time. Understanding the persistency of regional unemployment differences helps us to assess how effective regional policy can be. While univariate tests suggest that changes in regional unemployment differences are persistent in West Germany, more powerful panel tests lend some support to the hypothesis that regional unemployment rates converge. However, these tests reveal a moderate speed of convergence at best. Because there is a structural break following the second oil crisis, we also use tests that allow for such a break. This provides evidence for both convergence and quick adjustment to an equilibrium distribution of regional unemployment rates that is, however, subject to a structural break.     

Income distribution, borrowing constraints and redistributive policies

This paper sheds light on the relationship between income inequality and redistributive policies and provides possible guidance in the specification of empirical tests of such a relationship. We model a two-period economy where capital markets are imperfect and agents vote over the level of taxation to finance redistributive policies that enhance future productivity. In this context, we show that the pivotal voter is not necessarily the agent (class) with median income. In particular, the poor, who are more likely to be liquidity constrained, may form a coalition with the rich and vote for low redistribution. The effects of an increase in income inequality on the level of redistribution turn out to depend on whether the increase in inequality is concentrated among the poor or the middle class. Empirical results from a panel of 22 OECD countries provide preliminary evidence consistent with our main theoretical implications.     

Revisiting the case for a populist central banker

It is known that discretionary policy may give rise to an inflationary bias if wages are negotiated in nominal terms. In a recent issue of this Review, Guzzo and Velasco argued that this bias can be eliminated, and welfare maximized, by the appointment of a central banker who does not care at all about inflation (a ‘populist’ central banker). A conceptual flaw of the latter result is identified here. It is shown that when wages are negotiated in nominal terms the result is true only in the special case of a single, all-encompassing, union. In the more general case of multiple unions, however, inflation increases linearly with their number and a populist central bank may turn out to decrease welfare.     

Inflation, investment and economic performance: The role of internal financing

This paper studies a link between inflation and economic activity that is built on two hypotheses. First, firms mitigate informational frictions in financial markets by accumulating retained earnings over a period of time. Second, firms allocate earnings among three competing uses - dividends, current investment, and the accumulation of internal funds - and inflation directly distorts this allocation decision as well as the real value of accumulated internal funds. The model predicts that the level of inflation - both unanticipated and expected inflation - as well as the variability of inflation distort firms’ internal financing decisions, increases frictions in financial markets, reduces the level and efficiency of investment, and reduces aggregate output. The marginal effects of inflation are increasing in the inflation rate.     

Collateral constraints and the amplification mechanism

Kiyotaki and Moore (J. Polit. Economy 105 (1997) 211) have offered a theory for how common shocks to credit-constrained firms are amplified through changes in collateral values and transmitted as fluctuations in output. I clarify and extend their model by showing that their collateral amplification mechanism is not robust to the introduction of markets that allow these firms to hedge against common shocks. A theory of incomplete hedging is proposed in which the supply of hedging available in the economy is constrained by the aggregate value of collateral. I illustrate how the constraint reinstates amplification effects and discuss empirical implications of this new mechanism.     

On some criteria for the formulation and testing of economic growth models

This paper presents a methodology for the formulation and testing of economic growth models. The model selected includes two production sectors with physical and human capital accumulation. These capital stocks are associated with spillover effects in the production of the physical good and in the accumulation of both factors.     

Cross-country differences in monetary policy execution and money market rates’ volatility

Volatility patterns in overnight interest rates display differences across industrial countries that existing models—designed to replicate the features of individual countries’ markets—cannot account for. This paper presents an equilibrium model of the overnight interbank market that matches cross-country differences in patterns in interest volatility by incorporating differences in how central banks manage liquidity in response to shocks. Our model is consistent with central banks’ practice of rationing access to marginal facilities when the objective of stabilizing short-term interest rates conflicts with another high-frequency objective, such as an exchange rate target.     

Growth effects of government expenditure and taxation in rich countries: A comment

Fölster and Henrekson (European Economic Review 45 (2001), 1501-1520) argue that “...the more the econometric problems that are addressed, the more robust the relationship between government size and economic growth appears”. But in failing to control for simultaneity and in ignoring issues of sample-selection bias, the regressions reported by Fölster/Henrekson are flawed. Using theoretically valid instruments, we find that the estimated partial correlation between size of the public sector and economic growth is statistically insignificant and highly unstable across specifications. Moreover, since instruments are weak, all hypothesis tests are unreliable. We conclude that cross-country growth regressions are unlikely to come up with a reliable answer to the question of the growth effects of government spending and taxation.     

Government guarantees and self-fulfilling speculative attacks

We develop a model in which government guarantees to banks’ foreign creditors are a root cause of self-fulfilling twin banking-currency crises. Absent guarantees, such crises are not possible. In the presence of guarantees banks borrow foreign currency, lend domestic currency and do not hedge the resulting exchange rate risk. With guarantees, banks will also renege on their foreign debts and declare bankruptcy when a devaluation occurs. We assume that the government is unable or unwilling to fully fund the resulting bailout via an explicit fiscal reform. These features of our model imply that government guarantees lead to self-fulfilling banking-currency crises.