Domestic Supply Shocks Research Articles

Sources of fluctuations in output: Evidence from small, open economies of Asia

This paper considers a set of five Asian economies that differ in their degree of outward orientedness, and examines the role of oil price shocks, non‐oil world supply shocks, exports and domestic supply shocks in causing fluctuations in domestic output. Results from a vector autoregressive model indicate that exports and non‐oil world supply shocks are more important for the ‘outward‐oriented’ economies of Singapore, South Korea and Malaysia, when compared with the moderately ‘inward‐oriented’ economy of the Philippines and the strongly ‘inward‐oriented’ economy of India. However, exports and non‐oil world supply shocks each account for no more than a fifth of the variation in output in Singapore, South Korea and Malaysia. There is no long‐term equilibrium relationship (cointegration) between exports and output. This supports the view that exports were not the single driving force behind the economic growth of these high‐performing countries. A substantial portion of variation in domestic output is explained by domestic supply shocks. Adverse effects of oil price shocks are found in the case of the oil‐importing countries of South Korea and India.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

Sources of fluctuations in Australian imports

Dynamic interactions among the real exchange rate, income and imports are modelled for Australia. Evidence of one cointegrating relationship is found among these series and base structural inferences on long-run identifying restrictions of the type proposed for vector-error correction models by King, Plosser, Stock and Watson (1991). Under the identifying restriction that a domestic supply shock has no effect on the real exchange rate in the long run, this shock explains most of the forecast-error variance of imports at all horizons except for one quarter. At this horizon, the domestic demand shock is most important. The foreign supply shock becomes more important as the forecast horizon increases and explains almost half of the forecast-error variance of imports in the long run.

Sources of macroeconomic fluctuations in small open economies

This paper examines the sources of economic fluctuations in seven OECD small open economies. We measure the relative contribution of external shocks and country-specific aggregate demand and supply disturbances (internal shocks) in explaining short-term movements of output, inflation and the trade balance. We find: (i) output fluctuations are primarily explained by domestic supply shocks, (ii) trade balance movements are explained mostly by domestic absorption shocks, and (iii) spillover effects of external shocks on the domestic economy are primarily on nominal, rather than real, variables. We conclude that, while domestic absorption policies like fiscal restraint may improve the trade balance, they cannot stabilize output.

Money, Output, and Real Business Cycles in a Small Open Economy

This paper examines some key propositions of real business cycle theory using a small open-economy framework and a structural vector autoregressive methodology. Identification is achieved by long-run restrictions. The main results from the Canadian economy are that domestic supply shocks are important in explaining short-run fluctuations in output, while real interest rate and terms-of-trade changes are not; an important source of the money-output correlation is output shocks affecting inside money in the short run; and the presence of a causal influence of high-powered money or demand deposits on output is not strongly supported by the data. This paper examines some key propositions of real business cycle theory using a small open-economy framework and a structural VAR methodology. Identification is achieved by long-run restrictions. The main results from the Canadian economy are (i) domestic supply shocks are important in explaining short-run fluctuations in output, while real interest rate and terms of trade changes are not; (ii) an important source of the money-output correlation is output shocks affecting inside money in the short run; and (iii) the presence of a causal influence of high-powered money or demand deposits on output is not strongly supported by the data.

Indexation and Inflationary Inertia: Brazil 1964–1985

Some governments facing high rates of inflation have adopted wage and exchange rate indexation in an attempt to offset the costs to workers and exporters. But indexation based on past values of inflation is considered to be a powerful source of current and future inflation that undermines fiscal and monetary stringency designed to reduce inflation. Brazil indexed wages and the exchange rate for more than twenty years. The authors derive a transfer function and estimate time-varying parameters to allow for the changes in indexing policy over the period. The authors find that the increased frequency of wage and exchange rate adjustment amplified the effect of past inflation and made it less sensitive to monetary and fiscal policies and more vulnerable to domestic agricultural supply shocks. Indexing did not eliminate the effectiveness of monetary policy, however, which retained a significant effect throughout the indexation period.

External shocks and growth prospects: The case of Brazil, 1973–1989

This is a study of the factors underlying the current account deficits experienced by Brazil since the mid-1970s. It also explores the country’s economic prospects through 1989, with the help of a simple macro-simulations model. The current account deficit is identically equal to the excess of domestic spending over national income. Provided that net external financing is available, this excess may increase for a number of reasons. Prominent among them is an expansion of real domestic spending, associated with increases either of real consumption expenditures or of real domestic capital formation. Even if domestic absorption is invariant, the external deficit may worsen because of inadequate domestic pricing policies. These may make it impossible for local firms to compete with cheaper foreign products, thus forcing a contraction of national income and employment. A temporary reduction of GNP below its potential value may also be caused by domestic supply shocks of a climatic or other nature. However, other factors can also cause a deterioration of the current account. In this context, this study investigates the factors underlying the evolution of the external accounts of Brazil since the mid-1970s following an approach suggested in the Dell Report and elaborated by Balassa.’ The reasons for a deterioration of the current account are divided into three groups: external shocks, burden of accumulated debt, and domestic policy actions. The first group comprises terms of trade, international interest rates, and world recession. The second includes the accumulated effect of past shocks and domestic policy actions. Finally, the third group encompasses the variables supposedly under the control of local policy-makers: domestic absorption and the economy’s tradability.

STABILIZATION POLICIES IN DEVELOPING COUNTRIES

The article focuses on the design of stabilization measures to correct excessive balance of payments deficits and moderate the rate of inflation. It distinguishes three sources of balance of payments difficulties—excessively expansionary aggregate demand policies; domestic supply shocks stemming, for example, from increases in real wages in excess of productivity growth; and external terms of trade shocks. It also analyzes the effects of devaluations. The second part of the article discusses policies aimed at reducing the rate of inflation and summarizes the theoretical literature on the dynamics and the transitional costs of adjustment to lower rates of inflation in closed economies. Evidence on the adjustment costs of disinflationary policies is reviewed, and the discussion is extended to some recent analysis of adjustment in open economies.