Open Economy Context Research Articles

Utilizing Financial Market Information in Forecasting Real Growth, Inflation and Real Exchange Rate

Based on an extension of the Gordon (1962) growth model we propose a simple approach to forecasting real growth, inflation and real exchange rate. The extension is rooted in introducing the Fisher (1930) and Euler equations, and in the open economy context, also the purchasing power parity (PPP) and the uncovered interest rate parity (UIP) relations to the analysis. Based on these equilibrium conditions as the final form we suggest a forecasting system of three simple equations, all based on current financial market information in the form of dividend yields and short-term interest rate. Our empirical results based on standard time series analytical tools indicate that the role of simple financial market information both in the forms of dividend yields and nominal interest rate is highly important for forecasting out-of-sample the time-varying underlying trends in the macroeconomic data for the U.K., Euro-zone and Japan, and treating the U.S. as the world market. Our results strongly stress the importance of including some measure of stock market performance in macroeconomic forecasting systems, especially during turbulent time periods in the financial market and macro economy.

The Narrow Money Demand Behaviour in Indonesia, 1970– 2005

This paper specifies a simple partial adjustment model of narrow money demand for Indonesia in an open economy context and estimates it with annual data for the period 1970-2005. Empirical results suggest that real income, inflation (a proxy for expected inflation), and the return on foreign financial assets are the major determinants of narrow money demand in this country. The deposit rate of interest (a proxy for the interest rate on alternative domestic financial assets) is statistically insignificant. The CUSUM and CUSUMSQ of residuals' tests suggest that the narrow money demand function remained stable during the sample period of study. Having selected an empirically parsimonious model, both the recursive and rolling regression techniques are applied to investigate the possibility of structural change in the regression coefficients possibly due to financial reforms and innovations since the early 1990s. Empirical results suggest that since the late 1990s the long-run income elasticity of the demand for narrow money has remained relatively stable around a value not different from one while the narrow money demand elasticities with respect to the rates of inflation and the return on foreign financial assets have declined markedly. The paper interprets the overall empirical results in a historical context and draws implications on the strategy of monetary policy in Indonesia.

Taxa de juros e prêmio de risco: investigando a hipótese Bresser-Nakano para a economia brasileira, 1995-2005

A proposta Bresser-Nakano deflagrou uma forte discussão sobre a política de juros no Brasil, suscitando uma série de críticas e contribuições para o seu aperfeiçoamento. Seu argumento central baseia-se na suposição de que o sentido da causalidade vai da taxa de juros para o prêmio de risco, e não o contrário. Com isso, a autoridade monetária, ao reduzi-la, promove um círculo virtuoso na economia, reduzindo o prêmio de risco e, através da taxa de câmbio, a própria inflação. Essa hipótese, no entanto, continua controversa e carece de estudos empíricos visando à sua verificação. O objetivo principal deste trabalho é investigar a sua validade para a economia brasileira nos últimos 10 anos de política monetária. Aplicando testes de causalidade de Granger, os resultados encontrados apóiam a hipótese Bresser-Nakano.

Redealing the Cards: How the Presence of an Eco-Industry Modifies the Political Economy of Environmental Policies

An incumbent government maximizes its chances of being reelected. Its objective function encompasses both social welfare and political contributions. Its only instrument is a pollution tax. In an open-economy context, we introduce an eco-industry in addition to lobbies of polluting firms and environmentalists. Not only does the eco-industry lobby add a new political contribution toward a higher environmental tax, it also modifies the incentives of the usual lobbies. When the foreign environmental policy is constant, environmentalists can be in favor of a decrease in the local tax in order to reduce foreign pollution. It could also be in the interest of a vertical industrial pressure group to lobby toward more stringent environmental policy. In general, the impact of lobbying activities on the politically optimal tax is ambiguous as pressure groups push in different directions.

Firm Heterogeneity, Exporting and Foreign Direct Investment

A rapidly expanding literature on firm heterogeneity and firm level globalisation strategies has developed over the last decade. There are new insights on why some firms export and others do not, why some firms fail to survive in export markets and some choose to produce overseas rather than export. This article provides a synthesis and evaluation of this literature. It reviews both new theories of firms in an open economy context and the extensive microeconometric evidence base, which has now developed. It highlights the implications of this evidence base for policy and includes an assessment of how the research agenda may evolve.

Sequential Cross-border Mergers in Models of Oligopoly

Anti-competitive mergers may be held up when outside firms respond pro-competitively. I examine the profitability of cross-border mergers by embedding a class of oligopoly models—where mergers are anti-competitive and actions are strategic substitutes—in a sequential merger game, cast in a two-country setting. I find that cross-border mergers: (i) are held up only when ‘international differences’ are minimal; (ii) happen in clusters, not in isolation; and (iii) can be interdependent. I illustrate with two standard oligopolies. The ‘bumpiness’ of the world suggests that the hold-up problem is less pervasive in an open-economy context.

Firm Heterogeneity, Exporting and Foreign Direct Investment: A Survey

A new literature on firm heterogeneity and firm level globalisation strategies has developed rapidly over the last decade. New insights on why some firms export and others do not, why some firms fail to survive in export markets and why some choose to produce overseas rather than export have been generated. This paper provides a survey and evaluation of this literature. It reviews both new theories of the firm in an open economy context and the extensive microeconometric evidence base which has now developed. As well as highlighting the implications of this evidence base for policy, the evaluation also includes an assessment of how the research agenda may evolve in the future.

AN OPEN-ECONOMY NEW KEYNESIAN PHILLIPS CURVE: EVIDENCE FROM HONG KONG

Abstract. This paper extends the new hybrid Keynesian Phillips Curve (NKPC) to the open-economy context. We hypothesize that pricing decisions depend on both labour costs and intermediate imported input prices. The results for Hong Kong are consistent with the theory if import prices are given substantial weight in measuring marginal cost, rejecting the labour costs model. We find that forward-looking behaviour is dominant, and that price stickiness is smaller in Hong Kong than in the USA. The results are sensitive to the choice of instruments, and a model using the output gap instead of marginal cost as the forcing variable also performs well.

Tight credit policy versus currency depreciation: Simulations from a trade and inflation model of India

Using a small macroeconometric model that examines the determinants of India's trade and inflation, this paper addresses the effects of a reform policy package similar to those implemented in 1991. Policy simulations using dynamic simulation method compare the responses to devaluation with the responses to tight credit policy. It is shown that the trade balance effects of tight credit policy are more enduring than that of devaluation, conditional on inflation being modelled in an open economy context. The simulations demonstrate that the devaluation actually worsens trade balance and hence devaluation cannot be an option in response to a negative trade shock, whereas the reduction in domestic credit reflecting demand contraction can produce a desirable improvement in the trade balance.

Scale Externalities of the G7 Countries

Scale effects in per capita production are an outcome of many theoretical economic models like second generation growth models, models of the new trade theory or the new economic geography. The prediction is that larger economies should have a higher per capita production than smaller economies. However, in an open economy context the scale of the economy is less important because countries can participate in the scale of other countries through trade. This paper develops an open economy growth model of the second generation type which shows the relevance of the scale of the trading partners in technology goods for per capita production. This model is empirically tested using a cross section of 88 countries for the year 2000. The scale of these economies is measured by a weighted sum of scales of the G7 countries, since these are the countries spending most on R&D and are thus the main origin of technology. The results show that there is a significant effect of this scale variable on per capita production.

A dynamic macroeconometric model for short-run stabilization in India

A small macroeconometric model examining the determinants of India's trade and inflation is developed to address the effects of a reform policy package similar to those implemented in 1991. This is different from the previous studies in two important respects. First, inflation has been modelled in an open economy context, and second, the non-stationarity of the data into the model and estimation procedures has been explicitly incorporated, suggesting that the stationarity assumption in earlier studies may be a source of misspecification. The model in this paper has been estimated using data from 1950 to 1995 employing fully modified Phillips–Hansen method of estimation to obtain the cointegrating relations and the short-run dynamic model. Policy simulations using dynamic simulation method compare the responses to devaluation with the responses to tight credit policy. It is shown that the trade balance effects of tight credit policy are more enduring than that of devaluation. The simulations demonstrate that the devaluation actually worsens trade balance and hence devaluation cannot be an option in response to a negative trade shock, whereas the reduction in domestic credit reflecting demand contraction produces a desirable improvement in the trade balance.

A Theory of the Currency Denomination of International Trade

Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modeling. The "New Open Economy Macroeconomics" literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant macroeconomic and policy implications. In this paper we solve for the optimal invoicing choice by integrating this microeconomic decision at the firm level into a general equilibrium open economy model. Strategic interactions between firms play a critical role in the analysis. We find that the less competition firms face in foreign markets, as reflected in market share and product differentiation, the more likely they will price in their own currency. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.

Inflation Targeting in South Africa: A Var Analysis

The first part of the paper analyses CPI inflation targeting in an open economy context. Inflation targeting makes the exchange rate less flexible in response to foreign shocks and thus lessens the automatic stabilisation provided by flexible exchange rates. The second part uses VAR techniques to study the relative frequencies of different kinds of shocks impinging on the South African, New Zealand and Canadian economies. The results suggest that South Africa is not a good candidate for an inflation target relative to the other two countries because of the relative importance of foreign shocks and of the weak linkage between monetary policy and inflation.

Comparative Economic Organization—Within and Between Countries

This paper explores the implications of going beyond transaction cost theory's implicit focus on domestic investors to include multinational actors. As developed herein, the discriminating alignment between the level of hazards (contractual and/or political) and the mode of governance carries over. In the open-economy context, such an alignment reflects the hazards that arise from the nature of the transaction and those that arise from the nature of the political and regulatory environment.

Production of Commodities by Means of Commodities and the Open Economy

The small open economy assumption cannot protect marginalist theory from the Sraffian critique. But a member of Sraffian ideas are not readily applicable in the open economy context.

How Constraining is Capital Mobility? The Partisan Hypothesis in an Open Economy

A growing literature argues that international financial integration has eliminated the possibility for distinct partisan macroeconomic strategies. I test this hypothesis by reformulating the partisan hypothesis in an open-economy context and conducting pooled timeseries analysis of budget balances, real interest rates, and capital controls for fourteen OECD countries between 1970 and 1994. The analysis provides little evidence that financial integration has eliminated distinct partisan macroeconomic policies. Under fixed exchange rates leftist governments run larger deficits than rightist governments and use capital controls to reduce interest rate premia. Under floating exchange rates leftist governments pursue looser monetary policies than rightist governments. While partisan distinctions do weaken in the 1990s in countries with fixed exchange rates, this is attributed to the recession of the early 1990s and to important institutional changes in the European Union. International financial integration, therefore, does not prevent governments from pursuing distinct partisan macroeconomic policies.

Econometric tests of alternative scale variables in money demand in open economies: International evidence from selected OECD countries

The choice of the scale variable in the money demand function is important because of its striking implications on the magnitude and direction of the domestic monetary and fiscal policy effects and effectiveness of international policy coordination. In this study several tests are applied to the money demand functions of Japan, Germany, Canada, France, and Italy in an open economy context to determine the appropriate scale variable for each country. Both narrow and broad definitions of money are used. Income, disposable income, consumption, private spending, and domestic absorption are investigated as contenders for the scale variable. The findings indicate that the scale variable is country-specific, rather than universal, and it is sensitive to the definition of money.

Public Investment: Optimal Provision of Hicksian Public Inputs

A considerable portion of government spending is devoted to commodities that are not public goods but that directly affect production possibilities. Examples include public infrastructure like roads and dams; educational facilities and research projects in basic science; and some forms of information. Such commodities are public inputs. In a small open economy context, the focus of this paper is on those that are Hicksian in nature. An interesting decomposition of the beneficial impact of a Hicksian public input is developed. Then first-best and second-best optimality conditions for public inputs that are comparable to those for collective consumption goods are derived.

Monetary policy under flexible exchange rates: When is expansion contractionary?

This paper studies whether the observed instability in the effects of monetary policy could be due to the way in which the behavior functions have been specified in an open economy context. Accordingly, special emphasis is on the specification of the behavior functions to correspond to their foundations in closedeconomy macrotheory. The demand for real money balances, in terms of the expenditure basket of goods, is specified as a function of income in terms of the same basket. Imports are specified as a function of expenditures, being functionally part of expenditures. The supply of labor is specified as a function of the expenditure price. It is shown that the exchange rate overshoots but output declines, to eventually rise above its original level in response to monetary expansion in the real wage model. In the money wage model, output and the exchange rate overshoot their steady-state levels if the expansion eventually leads to an increase in nominal wealth. If it leads to a decrease, both variables undershoot. However, if interest payments on foreign securities are not small relative to the trade balance, many of the effects are reversed. Thus the overshooting result is far from robust even in a standard model with an exogenous money supply.

Absorptive capacity: On the creation and acquisition of technology in development

Recent studies on technological transformation in developing countries emphasize that successful industrialization requires both technological information and a good understanding of its implementation. In an open economy context it is shown that the sustained gains in growth derived from a move towards an open trade regime evaporate as soon as one gives up the arguably inadequate notion of ‘technology’ as being all-inclusive. In this paper, technology is only implementable as the labor force has built up the corresponding skills. Trade liberalization disseminates new technologies and goods to the domestic economy, and has beneficial effects on the level of final output and consumption. But sustained growth gains are only forthcoming if in addition to the arrival of new technologies also skills are accumulated at a higher rate than before the regime change. I argue that this explains part of the variation in the long-run growth effects of trade liberalization in newly industrializing countries.