model

Global Currency Substitution

Summary

Assumptions

  • Assume demand side currency substitution as opposed to supply side currency substitution which occurs under fixed exchange rates where central banks look to maintain fixed exchange rates.
  • Monetary currency substitution models contrast to global models in that the former interpret current balance surpluses (deficits) as an excess demand (supply) for foreign currency by domestic residents (where capital account and capital markets are ignored because there are no interest bearing assets in these models). The latter view the relevant money supply as the world money supply within the context of a highly developed and interdependent world capital market. The value of diverse money holdings relates then to the liquidity services money provides.
  • Motive for diversifying money holdings across currencies of denomination is 1. transactions based 2. speculative (incl. hedging)
  • 3 types of global currency substitution models are subdivided by the way they represent domestic residents' porfolios of assets. 

Theory/Model

  1. Two-stage portfolio allocation model
    • First stage - portfolio divided between money and bonds. 
    • Second stage - divide bonds between domestic and foreign and money between domestic and foreign.
    • Thus only need to consider the domestic/foreign allocation because bonds & money is already fixed.
    • Offers a restricted set of portfolio choices and currency substitution arises from switching different currencies in the liquid asset portfolio. This is independent of the non-liquid asset position.
    • Thus M=M_D+M_F & M*=M*_D+M*_F
    • Demand for each money K depends on price level P, level of income and both domestic and foreign rates of interest r & r*
    • Money market equilibrium conditions
      • M_D+M_F=PK_D(r, r*)Y+PK_F(r, r*)Y*
      • M*_D+M*_F = P*K*_D(r,r*)Y+P*K*_F(r, r*)Y*
      • where under Miles M_F=M*_F=0 i.e. focusing solely on domestic demand
    • Thus M_D/M*_D=PK_D(r, r*)Y/P*K*_D(r, r*)Y where assuming purchasing power parity the real income terms cancel to M_D/eM*_D=K_D(r, r*)/K*_D(r,r*)
    • This can be approximated by (after taking logarithms) log(M_D/eM*_D)=σlog(θ_1/θ_2)+σlog((1+r*)/(1+r)) where σ represents the degree of currency substitution where σ is positive such that the ratio of domestic to foreign currency balances held by domestic residents depends directly upon the foreign rate of interest and inversely on the domestic rate.
  2. Single-stage portfolio allocation
    • All four assets available.
    • Optimize return subject to a minimal level of risk in a single-decision process.
    • Fraction of real resources necessary for transactions (V) is inversely related to the level of money services S such that V=V(S)
    • Where level of money services S = S(M/P, M*/P*)
    • Consumer seeks to maximise utility from consumption subject to a wealth constraint and a savings/asset accumulation constraint such that:
      • S_1(M/P,M*/P*)/S_2(M/P, M*/P*)=(P/eP*)(r/(r*(1+ε)). 
      • Assuming constant electricity of substitution you can take logs to get log(M/eM*)=log(θ_1/θ_2)+σlog(P/(eP*)-σlog(r/(r*(1+ε))
  3. Portfolio balance model
    • All four assets available.
    • No constraints (except obviously total wealth= total asset stocks)

Predictions

  • Two-stage portfolio allocation model - σ is positive such that the ratio of domestic to foreign currency balances held by domestic residents depends directly upon the foreign rate of interest and inversely on the domestic rate.

Evidence

Evaluation

  • Also known as money services model.
  • An alternative specification of the Two-stage portfolio model M_F=M*_F=0 is the restriction that M*_D=0 i.e. domestic residents do not hold foreign money but foreign residents hold domestic money. Thus all currency substitution is undertaken by foreign residents. thus M_F/P=K_D(r, r*)Y*. One advantage of this specification is it includes Y* and that it doesn't require the assumption of purchasing power parity. Again like previous specification the interest rate captures the currency substitution.

Monetary Currency Substitution

Summary

Monetary policy is what determines the exchange rate through affecting demand and supply of domestic currency and in turn influencing flows of tradeables and corresponding flows of currency.

Assumptions

  • Assume demand side currency substitution as opposed to supply side currency substitution which occurs under fixed exchange rates where central banks look to maintain fixed exchange rates.
  • Monetary currency substitution models contrast to global models in that the former interpret current balance surpluses (deficits) as an excess demand (supply) for foreign currency by domestic residents (where capital account and capital markets are ignored because there are no interest bearing assets in these models). The latter view the relevant money supply as the world money supply within the context of a highly developed and interdependent world capital market. The value of diverse money holdings relates then to the liquidity services money provides.
  • Flow approach to currency substitution question and accumulation of foreign currency balances can only come about through a current account surplus
  • W=M/e+M* where domestic residents hold their wealth W measured in foreign currency in domestic currency priced in foreign currency at M/e and foreign currency M*.
  • Asset demands depend upon the level of wealth and inflation L=L(W, pi) and L*=L*(W, pi*)

Model/Theory

  • With money markets in equilibrium ratio of home money to foreign money is [M/eM*]=L/L*=l(W, ε) where epsilon = expected depreciation of the home currency
  • Currency substitution depends upon the monetary policy pursued by the domestic authorities. 

Predictions

  • Unanticipated rise in domestic monetary growth will lead to depreciation of the domestic currency. In turn stimulating foreign demand for domestic tradables leading to a current balance surplus financed by domestic residents accumulating foreign currency balances until the surplus is eliminated by appreciation in the real exchange rate.

Evidence

Evaluation

  • Weakness of this models is that they assume that capital inflow is solely in the form of money - no bonds are permitted in the analysis and thus the model is only applicable to economies with not well-developed financial and capital markets.

Dornbusch Model

Summary

The relative stickiness of prices and wages means that the exchange rate will overshoot in response to changes in monetary policy.

Assumptions

  • Like portfolio-balance models Dornbusch assumes, home and foreign goods are imperfect substitutes, that good markets adjust slowly relative to asset markets so that domestic prices and real output are fixed in the S-R, domestic money is only held in the home country, and the domestic country is small relative to world asset and goods marekts so that it faces a fixed foreign interest rate and price level. 
  • Key differing assumption: domestic and foreign interest-earning assets are perfect substitutes. I.e. i=i*+pi. Thus do not need equations for B & F because their earlier role was one of determining i & i* separately.
  • pi = theta(e-bar-e) i.e. partial adjustment to exchange rate toward an equilibrium level e-bar.
  • Also, wealth effects have no role in determining exchange rates so can focus on money market equilibrium for S-R exchange rate determination
  • Demand for money=M/P=Y^phi*exp^-(lamba*i) which in logarithms is m-p=phi*y-lambda*i where m, p & y are the logarithms of money, price and real income

Model/Theory

Key equation:

  • e=e-bar-1/(lambda*theta)*[p-m+phi*y-lambda*(i*)]
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For a given price level the exchange rate always adjusts instantaneously to clear the money market and thus always on the AA line. But long-run equilibrium requires being on the 45-degree line which has the exchange rate moving proportionally with the price level to maintain eP*/P in line with PPP (P* is assumed constant).

Predictions

In the S-R prices and wages are largely inflexible leaving only exchange rates to change in response to monetary policy. Thus the exchange rate will temporarily overshoot to Q before returning to R. 

Evidence

The model explains the surge in the US dollar from 1980 to 1984 well above its expected PPP value after the Fed tightened monetary policy unexpectedly in 1979-80 before falling again in 1985.

Evaluation

However if rigidities in nominal wages and prices are to blame then its not clear that deviations should persist for so long - Friedman argued they should only take 12-24 months. 

Portfolio Balance Models of Exchange Rates

Summary

In the short-run the exchange rate is governed by asset market conditions and determined (alongside the interest rate) by the interaction of asset demands and asset stocks.

Assumptions

  • Open economy
  • Four assets in the Branson Model - domestic money, foreign money, domestic securities, foreign securities. 
  • Neither money bears interest and the terms of money exchange is the exchange rate. Securities cannot be directly traded. 
  • No currency substitution allowed. 

Model/Theory

Have Market equilibrium when four conditions hold: 

  1. W=M+B+eF
  2. M=m(i,i*,pi)W
  3. B=b(i,i*,pi)W
  4. ef=f(i,i*,pi)W

Where W = domestic net wealth, M is domestic currency, B = domestic securities e = home price of foreign exchange, pi=expected depreciation of domestic currency

Given i* ,pi ,M , B and F determine e and i which can then be plotted for the MM, BB and FF markets

FF curve is flatter than the BB curve because domestic demand for domestic bonds is more responsive than domestic demand for foreign assets to change in the domestic interest rate. 

Predictions

2016-04-09 13.42.11.jpg

If the exchange rate determined on the asset markets is not consistent with the balance of trade and import/export flows then a current account balance will be matched with a corresponding capital account imbalance. 

E.g. if stock of foreign assets increases (perhaps because of trade surplus) there is an increase in wealth, but people will wish to balance their portfolios and thus the MM and BB curves shift down as people sell the foreign asset to buy domestically. 

  1. Exchange rate adjusts to long-run equilibrium determined by PPP as predicted by flow theory of exchange rates.
  2. In the short-run the exchange rate is governed by asset market conditions and is determined along with the rate of interest by asset models of exchange.
  3. Government policy affects asset stocks (money, bonds) and in turn affects the exchange rate and the interest rate and thus is an important channel for monetary (and fiscal policy) to be transmitted to the domestic economy.

Evidence

Short-run importancce of asset market conditions, the role of asset stocks in affecting exchange rates and the interest rate and the importance of expectations of future exchange rates seem indisputable. 

The long-role of PPP is the more controversial.

Evaluation

  • With era of floating exchange rates after 1971 economists had two main tools. Neither however was a good basis for explaining exchange rate movements. 
    1. Flow theory of exchange rates --> demand for foreign exchange to buy imports = supply of foreign exchange from the sale of exports
      • Only a small and rapidly shrinking part of foreign exchange transactions was around traded goods. 
      • Even if add capital inflows & outflows can't explain how large these flows are or how long they last.
    2. Purchasing power parity.
      • Only useful in the long-run
  • Expectations about exchange rates affect the exchange rate just like with any other asset class. 

Closed Economy Fixed Reserves (Floating Exchange)

Summary

Assumptions

  • With no intervention ΔR=0 thus ΔM=DCE
  • Four way equivalence theorem
    1. Purchasing power parity
      • In all three case the assumption is spot rate of excahnge at any date is underpinned by relative price levels in the two countries
    2. International Fisher Effect
      • Assumption of capital is mobile expected real rates of return should be equal

Model/Theory

Four way equivalence theorem

  1. Purchasing power parity -
    • explained by 
      1. aggregate price determination where you fix exchange rates to determine domestic money prices and fix reserves to predict exchange rate where equilibriums are both governed by PPP. where e=P/P*=(M/ky)/(M*/ky*)
      2.  Goods arbitrage but problems include 1. not all goods are traded 2. barriers to trade exist 3. not all commodities exhibit a high degree of substitutability. Further difficulty is why e rather than P adjusts.
      3. Demand for foreign exchange to buy imports (Z) = Supply from the resulting exports (X)
  2. International Fisher effect
    • Differences in nominal interest rates = differences in expected inflation.
  3. Interest rate parity
    • US exporter till receive £X at t=1
    • Could either do a forward foreign transaction f_0.X
    • Or borrow a loan, convert at spot and invest in US money market for X/(1+i_£).s_0(1+i_$)
    • These equate and simplify to the interest rate parity relationship.
  4. Expectations theory of exchange rates
    • Says that expected spot rate = unbiased predictor of the future spot rate. 
  5. Fisher open hypothesis

Predictions

Four way equivalence theorem

  1. Expected change in spot = Difference in expected inflation

Evidence

Only the covered interest rate parity holds all the time.

Evaluation

Two scenarios when a closed economy model is appropriate:

  1. Unified world economy employing a uniform currency or its close approximation fixed exchange rates pegs under the IMF from 1945 to 1971
  2. National currency to be linked to other currencies by a completely flexible exchange rates.

Four-way equivalence theorem - equilibrium but don't necessarily hold all the time. 

  • Purchasing power parity 
    • Problems include 1. not all goods are traded 2. barriers to trade exist 3. not all commodities exhibit a high degree of subsitutability 
    • Further difficulty is why e rather than P adjusts. 
  • Expectations
    • However, this assumes an absence of risk Thus the unbiased forward rate condition may not hold. 

Closed Economy Fixed Exchange Rates

Summary

A balance of payments deficit can only occur if the domestic monetary authority allows domestic credit to expand faster than demand for money holdings where domestic credit substitutes for international reserves in the backing of the money supply.

Assumptions

  • Balance of payments accounting identity (X-Z)+K = ΔR = ΔM-DCC
    • (X-Z) = current account, K = capital account, ΔR = change in the foreign reserves of the central bank, ΔM= new money (from abroad) and DCC= domestic credit creation
  • M' = P.L(y,i) and M=R+D
    • M' = money demand M= Money supply, D = domestic assets of the banking system (that contribute to money supply) R= foreign reserves of the central bank
  • Arguments of money demand need to be predictable or independent of the money supply so use a series of assumptions around purchasing power parity and interest rate parity
    • P=eP* and in growth rates P-dot=e-dot+P*-dot where P* is world prices 
    • Domestic and foreign securities are substitutes
    • Perfect capital mobility ensures that i=I*+pi where pi = expected depreciation of the domestic currency)
    • With exchange rates e constant (assumed = 1)
    • pi=0
    • y=y_0 (full unemployment

Model/Theory

  • In equilibrium R+D = P*.L(y_0, i*)

Predictions

  • Once the adjustment to world levels is complete and all the right-hand side variables are fixed it follows that if L(y_0, i*) is stable credit creation involving domestic assets (D) is offset by an equal and opposite decrease in reserves (R) until equilibrium is restored. 

Evidence

Evaluation

Two scenarios when a closed economy model is appropriate:

  1. Unified world economy employing a uniform currency or its close approximation fixed exchange rates pegs under the IMF from 1945 to 1971
  2. National currency to be linked to other currencies by a completely flexible exchange rates.

Monetarism

Summary

Monetarism gave a model for inflation where 'money does matter 1. for inflation in the long-run and 2 business cycle swings in the short-run'

Assumptions

  • Monetarism vs Keynesian is at its heart free market vs interventionist
  • Friedman's Restatement
    • M_t'=P_t*y_t/V & M_t'=M_t
    • where M_t' is the demand for money, M_t is the supply, P_t and y_t are constant so increases in the supply of money require an increase in P_t so that there is equilibrium in the money market.
  • Assets - wealth can be held in four different forms
    • Money
    • Bonds
    • Equities
    • Physical capital
    • Tastes
  • Demand function - given the following assumption we can derive the usual quantity theory of money.
    • Bond and equity yields are stable over time
    • Equity response to price level can be modelled sufficiently with capital response.
    • If return on bonds and return on equities are an adequate measure of total return
    • Homogeneity postulate the demand function can be assumed to be independent of nominal units.
    • Thus velocity is assumed to be a constant function but not a constant number - thus velocity varies systematically and predictably. 
  • Natural rate of unemployment
  • Rational expectations
  • Inflationary expectations -
    • IS curve depends upon the real rate of interest whilst the LM curve on the nominal rate of interest where i_t=r_t+expectedp_t - i.e. the Fisher effect 
    • M-dot_t=0, P-dot_t=0, i_t=r_t=5% equilibrium

Model/Theory

Four key aspects of monetarism

  1. Absence of a fundamental flaw in the price mechanism and a tendency to a long-run equilibrium position characterized by full employment of resources
  2. Quantity theory of money, in all its versions, rests on a distinction between the nominal quantity of money and real quantity of money
  3. Monetary changes exert an only transitory effect upon the real rate of interest. The interest rate is not the price of money but the price of credit. Although there is a short-term liquidity effect, interest rates will return to where they started
  4. Substantial changes in prices are almost always caused by changes in the nominal supply of money. Thus government deficits are expansionary primarily if they serve as a means of increasing the stock of money.

Key equations

  • S(y_t, r_t) = I(r_t)
  • L(y_t, r_t) = M_t/P_t
  • Two equations and three unknowns require a missing equation - typically solve by fixing y_t=y_0

Inflationary expectations model

  • Equilibrium is disturbed by a sustainable (and initially unanticipated) increase in the money stock of 10%, real initial interest rates are negative (liquidity effect) but then in response spending increase, driving up prices and expectations adjust and the new nominal interest rate is 15% 

Predictions

  • Change in monetary growth rate only feeds through to change in the rate of growth of nominal income 6/9 months later. With the change in output before prices. Prices only change another 9 to 15 months after that. 
  • Short-run (5-10 years) monetary changes affect primarily output and only in the long run affects prices. 
  • Fiscal policy is not important for inflation - it's how it's financed (e.g. printing money or tax payer consumption substitution).
  • Using the IS-LM model with the assumption of y_t=y_0 an increase in the money supply shifts the LM curve out lowering interest rates in the S-R only to have prices respond and have the LM curve return to its original level. Similarly changes in the interest rate to changes in money demand are also temporary (shifting the LM curve left temporarily).
  • The expectation of inflation shifts the IS curve outwards but not the LM curve which raises nominal interest rates - leaving real rate of interest and real income unchanged in equilibrium. However, inflation expectations does not lead to continuous price rises (i.e. inflation) only a one-off adjustment.
  • Re: inflation expectations Friedman suggested the liquidity effect might take 6 months and the income effect 12 months - so the whole process takes 18 months. Price expectations effect might take 10 to 20 years!
  • Monetarist superneutrality is the idea that variations in monetary growth find reflection predominately in inflation and only in the short-run in interest rates, output and unemployment etc.

Evidence

  • Usurped Keynesian orthodoxy only to itself eventually peter out. 
  • Inflationary expectations is why interest rates around the world are highest where monetary growth and prices increases are the highest. 

Evaluation

  • Monetarism's undoing is when under the influence of rational expectations monetary changes needed to distinguish unanticipated from anticipated. Ultimately real business cycle explanation of economic fluctuations supplanted monetarism.
  • Fisher and the quantity theorists treated 1/V as a constant, Keynes made the ratio depend upon the interest rate and state of expectations, Friedman recast Keynesian liquidity preference into a theory of choice amongst various assets based on known/anticipated returns. Downplaying role of imperfect info and the specific nature of the services provided by money.
  • Hyperinflation
    • Definition: generally and arbitrarily defined as price increases > 50%/month
    • 3 sources 1. depreciation of the foreign currency value of the currency 2. Upward adjustments in wages, for example, under trade union pressures 3. inflation may stem from a budget deficit and money creation.
    • 3 puzzles 1. Behaviour of velocity and apparent flight from money where price increases far outstrip money supply increases 2. Shortage of money (isn't inflation caused by too much money chasing too few goods?) 3. Why the money creation? 
    • Kagan used a demand for money function which includes expectations of future prices changes. This model explains puzzle
      • 1. making hyperflation endogenous to the model
      • 2. Two forces act on real balances from prices first adaptive inflation expectations and second in order to maintain constant real balances the public has to accumulate nominal money balances at a rate equal to the rate of inflation.
      • 3. Two answers first printing money is a convenient way to provide the government with real resources second the effectiveness of this method declined over time requiring larger issues
  • Inflation Tax 
    • Inflation is a tax on holding real balances and a revenue available for government expenditure. 
    • In the face of an inflation tax the demand for real money balances falls and so the government, in an effort to maintain same revenues, has to further increase the level of inflation tax.

Portfolio Theory

Summary

If interest rates fall below a critical level there will be widespread switch to money from bonds. Resulting in the liquidity trap problem.

Assumptions

Common features of modern portfolio analysis

  1. Multiple real/financial assets to allow choice between them.
  2. The possible assets differ in their risk (usually variance of the σ_returns) and return (expected yield) where the portfolio's  expected return is a weighted average of expected returns of each assets and variance of the portfolio is the weights^2 of the variances.
  3. Investors tend to hold mixed portfolios (unless have strong preference for liquidity/high returns etc.) to take advantage of diversification (esp. if have negatively correlated returns).
  4. Portfolio approach is a general eq approach where total financial wealth constrains choice and whether there are income and substitution effects between types of assets.
  5. Transaction costs introduce frictions to lower desire to substitute assets.
  6. Treatment of expectations is critical - generally it's assumed exp. are rational but with imperfect info.

Model/Theory

  1. Portfolio Approach to Keynes Transactions Demand

    • Q is why individuals do individuals hold purchasing power in non-interest bearing form? Answer is transaction costs to switching between assets.
    • Model optimise π_t=R_t-C_t
      • assumes no risk attached to holding bonds (it's a world of certainty)
      • where R_t = return = r_t(aveW_t-aveM_t)
      • C_t=brokerage costs=c_t(aveW_t/aveM_t)
      • subject to aveM_t where we find the optimal average money balances is aveM_t=(ct*aveW_t)^0.5/r_t
    • Marginal benefit is constant, marginal cost increases where they intersect is equilibrium money balances (p136)
    • Where a decrease in the interest rate lowers the marginal benefit of holding bonds, and increases the marginal benefit of holding money and thus the optimal average money balances rises.
  2. Portfolio Approach to Keynes' Precautionary Demand

    • Main assumption is risk-return correlation.
    • Lower interest rate leads to same variance but less returns, which would usually lead to higher proportion of average money balances (but depending upon indifference curves could lead to higher if for example wants to maintain the same target returns)
    • Higher risk leads to same expected returns but more variance (curve similarly rotates counter-clockwise).
    • Crucially if the majority of investors are risk-averse diversifiers then the model is precautionary in character.If investors are primarily risk-averse plungers (opposite of diversifiers) or risk-loving gamblers then the model has instability associated with the speculative motive.
  3. Portfolio Approach to Keynes' Speculative Demand

    • Herding behaviour and the critical threshold can lead to large instability.
    • In the model we assume certainty about future interest rates (and thus capital gain).
    • If interest rates are less than the critical rate losses on bonds will outweigh the interest income where the best outcome is all money with zeroreturns.
    • If interest rates are above the threshold the investor will hold all bonds and no money.
    • Interest rate policy under these conditions both 1. rise in r not past threshold 2. fall in r not past threshold will lead to no change in behaviour. 3. rise in r over threshold --> switch from money to bonds 4. fall in r over threshold --> switch from bonds to money.

Predictions

Evidence

Evaluation

  • Main criticism of Baumol-Tobin transactions model is that it is conducted in a world in which bold holding is not risky.
  • Main criticism of the speculative model is that it does not explain diversification.
  • Can integrate the three approaches to have the qualities we want, but regardless the effect of an expected capital loss on bonds when interest rates are below the critical rate is the dominant feature of the models. 
  • If you change the assets in the portfolios, for example, to currency and capital you find the minimum risk portfolio includes both assets in inverse proportion to their variances. The crucial difference being that money is no longer assumed to be riskless. 

IS-LM Model

Summary

Keynes could be thought of as a special theory of Hick's IS-LM model where S(Y), investment is relatively interest inelastic and liquidity preference rules interest rates.

Assumptions

Classicals 3 equations to determine unknowns Y, I & i

  1. M=kY - Y is income, M is demand for money
  2. I=K(i) where I is investment and K demand for capital
  3. I=S(i,Y) where S is savings

Keynes 3 equations: 

  1. M=L(i)
  2. I=K(i)
  3. I=S(Y)

Model/Theory

Hicks 3 equations:

  1. M=L(Y,i)
  2. I=K(Y,i)
  3. I=S(Y,i)

CC-curve = demand for investment

SS-curve = supply of savings

IS-curve = investment-savings eq. 

LM-curve = income-->interest rate curve.

Note: L-L is LM (for liquidity preference =money supply) and Y rather than I for income, Ix rather than I.

Predictions

  • Keynes view M--> i, Classical view M--> Y
  • Keynes view increase in inducement to invest or propensity to consumer will not raise rate of interest but only increase employment.

Evidence

Evaluation

  • Couldn't solve the liquidity preference vs loanable funds debate because IS-LM is an equilibrium model and the two theories are identical in equilibrium.
  • If L-M curve is vertical than you have Keynes
  • S-R bonds r < L-R bonds r in line with liquidity preference --> Theory of the term structure of interest rates + assumption of risk aversion --> positively sloped yield curve. However recently downward slope yield curves are not uncommon - where long-term rates are an average of the expected short-term rates over the same period (tho slightly biased because of liquidity preference)

Keynes' General Theory

Summary

Assumptions

3 characteristics of money

  1. High liquidity premium and low carrying costs
  2. Negligible or zero elasticity of production - i.e. higher demand --> higher production
  3. Negligible elasticity of substitution.

Total net-return of an asset can be divided into 3 elements where r_nt=r_mt+r_pt-r_at

  1. Pecuniary returns r_mt - interest/dividends
  2. Non-pecuniary service flow r_pt - liquidity premium of sorts
  3. Convenience costs r_at

Typical assets have r_mt>r_at and negligible r_pt. Money has r_pt>r_at and in the case of cash zero r_mt

Motives for holding money - three divisions of liquidity preference 

  1. Transactions motive
    • Saw-tooth diagram of money balances where the longer time periods between payments the higher the average money balances
  2. Precautionary motive
    • Like the transactions motive but for unexpected expenditures
  3. Speculative motive
    • Portfolio of risky but +ve rate of return bonds versus riskless but zero return money.
    • Future price of bonds are inversely related to the future interest rate. If the interest rate is expected to fall relative to present, the future price of bonds will be higher than current, there would be an excess demand for bonds and an excess supply of money. 
    • Thus demand for money depends upon expectations of the future rate of interest
    • Keynes assumed that market expectations were based on the assumption of reversion to 'normal' and thus if interest rates are higher than normal they can be expected to fall in the future. Lower future r--> higher future price of bonds --> excess demand for bonds , excess supply of money, less demand for money. 

Model/Theory

M=M1+M2 = L_1(Y)+L_2(r)

  • Where L's are two liquidity functions & transactions-precautionary (M1)  motive depends mainly on level of income and from the speculative motive (M2) we find that demand for money varies inversely with the rate of interest (and future expectations).

Liquidity preference theory

  • Unlike classical theory where rate of interest is a real eq between foregoing current consumption versus future return, Keynes asked how would individuals like to store their forgone consumption - money or bonds? Which depends upon liquidity preference - interest is a reward for parting with liquidity not consumption.

General Theory

  • Classical theory argues that saving --> investment (axiom of parallels) depends upon acceptance of the classical theory of the rate of interest.
  • Keynes argues investment --> savings. Where liquidity preference --> (determined in money market) rate of interest --> investment --> savings. Thus liquidity preference may keep interest rates too high for the full employment level of investment to be generated.

Predictions

  • Money --> unemployment because three characteristics incentivise the holding of money which means a reduction in labour effort required and real supply can (at least temporarily) exceed real demand.
  • In disequilibrium the loanable funds theory and liquidity preference theory differ, Ohler arguing the price of securities is determined by the demand & supply of securities, Keynes in D&S of money
  • Liquidity trap prevents interest rates falling much below zero because individuals will hold money instead because when interest rates are so low (and therefore expected to rise) that all preferences for holding money (and not bonds) align. Thus monetary policy becomes ineffective.

Evidence

Evaluation

  • Money isn't the only non-reproducible asset e.g. land, however Keynes argues it is unique in the fact that he doesn't have any substitutes.
  • Each individual speculator has a critical rate where they switch their entire portfolio from bonds to money or vice versa, it is only the diversity in opinions which smooths out this step function at an aggregate level.
  • Liquidity preference theory differs from loanable funds theory 1. money market eq interest rate rather than bond market. 2. liquidity is a stock of money balances theory whereas loanable funds is based on flows of funds. However it can be shown eq in one market implies eq in the other and that flows and stocks are equivalent.
  • Keynes was against cutting real wages arguing that workers react to nominal wages (sticky wages) and also depend upon the price level. 
  • Hick's IS-LM model synthesises classical and Keynesian views.

Arrow-Debreu

Summary

AS=AD for every commodity in the economy.......................

Assumptions

  • Part of the Walrasian heritage. 
  • Two basic principles
    1. Optimizing behaviour on the part of individual entities in the presence of prices taken as given.
    2. Setting of prices so that, given this individual behaviour, S=D in each market.
  • Three ways to include money:
    1. Overlapping generations - money is a device for accomplishing inter temporal reallocation of consumption - young people save, old people spend.
    2. Money in the utility function - lowest liquidity costs - particularly the question of whether money yields utility directly or indirectly through lower transaction costs.
    3. Cash-in-advance models - where cash is required to undertake transactions and this is a constraint rather than in the utility function.

Model/Theory

  • Firms maximise profits by choosing inputs and outputs subject to prices
  • Consumers maximise utility from consumption subject to a budget constraint which is consumption = endowment + profits
  • Equilibrium properties:
    1. Not unique as equations are homogenous (therefore can have multiples of the price level)
    2. Walras' Law defines the linear dependence among the n equations.
    3. Difference between temporary and full (Arrow-Debreu) equilibrium where all goods can be exchanged now via a set of futures markets and the implied future savings/investment decisions.

Predictions

Evidence

Evaluation

  • As Keynes said saving although the abstinence from current consumption offers no signals for future consumption and thus has a depressing effect on employment.
  • Problem with Arrow-Debreu system is there is no role for money. 
  • However, as a method for intertemporal transfers return-bearing assets are superior to money and argubably if an economy is of a finite duration then money will lose its ability to hold value. 
  • One problem with cash in advance is that it requires two constraints making it not obviously superior to a barter world (Clower dilemma). Though this is usually dealt with by 1. transaction costs & imperfect info 2. legal restrictions or social/institutional arrangements. 

Classical Theory of Money

Summary

Although markets can operate without money, money is a beneficial and efficient social institution. Although there are short-run effects to the real economy in the long-run money is neutral.

Assumptions

Walrasian System

  1. All trade takes place on specific market days where transactions are settled at the end of the trading period.
  2. Traders enter with goods either endowed or produced in the previous period. This is market supply.
  3. An auctioneer coordinates the market place, groping towards a set of relative prices that ensure all goods clear
  4. Prices are such that D=S in all goods and there is market equilibrium following which the market closes.

All goods are perishable except money which is a safe non-interest-bearing asset.

Quantity Theory of Money

  • US version = V is assumed to be constant where causality ran from money to prices P=f(M,V,1/T). And the Chicago (Fisher) School as a flow approach.

  • UK version where M=kPY, with causality from prices to money. Cambridge (Marshall) School as a stock approach.
  • M_s is assumed to be exogenous.

Thorton Model

  • Includes a loans market with banks and an interest rate which is a real variable determined by real forces of saving and investment

  • There is a natural rate of return that is the interest rate which the loans market readjusts to.

Model/Theory

  • Walras's Law proves that it is possible to find a set of relative prices that equilibriates all market simultaneously, and the market will not clear until the auctioneer does so. 

Monetary economy

  • By introducing an nth good - money which allows purchasing power to be held from one market day to the next by holding money, and thus allows individuals to defer purchase or if there is a loans market make purchases in advance.

  • If the monetary side of the economy is not in equilibrium, then by Walras' Law although there has to be general equilibrium there does not need to be equilibrium in the real economy. Σ(1-->n)p_i*D_i=Σ(1-->n)p_i*S_i
  • However, such conditions would be temporary as the value of the money demanded would be sufficient to cover the purchases of goods and the supply of money would be enough to cover the value of the demand for goods. p_n*D_n=Σ(1-->n-1)p_i*S_i and p_n*S_n=Σ(1-->n-1)p_i*D_i
  • Walras' Law says that when n-2 equations are in equilibrium the n-1th will also be in equilibrium.

Quantity Theory of Money

  • MV=PT where M=money supply, V= velocity of money, P= general price level, T = volume of transactions in the economy.

  • Transmission mechanism
    • Direct effect - M_d=kPY and M_s is vertical and everything is proportional
    • Indirect effect (using Thorton model) - Increase in M_s --> increase in deposits --> increase in supply of loans --> fall in price of loans (interest rate) below the natural rate --> increase in borrowing and higher demand for loans until back to natural rate & increase in demand for goods --> raising prices (inflation)

Predictions

Monetary economy

  • Homogeneity postulate: As all prices are relative, where p_n is the denominator of all the relative price terms, money is neutral only influencing prices in a one for one fashion.

Evidence

  • Dominant monetary theory from 1790-1936

Evaluation

  • Complications with the Quantity Theory of Money arise from 1. differences in opinion about how to define M, V, P and T. 2. differences in opinion about causality of the different varialbes. 
  • Even though neither Marshall or Fisher thought of velocity as constant (the former as a f(confidence, credit market conditions)
  • Two schools of thought around the indirect mechanism:
    • Currency School - if the bank interest rate is artificially low --> inflation. Rather than the BoE the foreign exchange markets should determine the value of the currency.
    • Banking School - argued that low interest rate kept the currency and credit be stable. 
  • Thorton's loan market can be modelled as the demand (I - investors) and supply  (S - savers) of bonds. where changes in the Money supply are matched by changes in the demand for bonds such that the real interest rate does not change in the long-run.

Patinkin's Critiques

  • Classical model flawed because the Walrasian market and the quantity theory are incompatible. He argued that in a Walrasian system the monetary and real sectors cannot be kept apart as money-holding and trading of good decisions are made simultaneously. Thus need to correct the classical system to include real money balances.
  • Patinkin argued that the two excess demand equations is
    1. Indeterminate in the absolute price level - excess demand functions depend only upon these relative prices and not on the absolute price level in the barter model.
    2. Overidentified in the number of equations and unknowns and is inconsistent in its treatment of the excess demand for money.
  • If you include the monetary economy Patinkin's invalidity hypothesis, excess demand for money does not depend upon on relative prices at all (just the absolute price level), excess demand for money from the real side is a function of just relative prices (and not the absolute price level)

Real Balance effect

  • Real balance effects is that M/pn gives utility and is included as part of a utility function.
  • This makes the excess demand equations no longer homogenous and therefore consistent with the monetary equations.
  • The work of Archibald and Lipsey shows that an increase in M_s and the wealth effect is offset by an increase in Pn restoring price stability and neutrality to the model and returning to original utility.
  • Evaluation - real money balances effect of tying down the price level could also be done by an interest rate. 

Interest bearing assets

  • Liviatin however showed that a permanent equilibrium is not a foregone conclusion by introducing interest-bearing securities (B/pn with a rate of return r every period) which means the endowment is no longer fixed and thus the long-term equilibrium points are no longer vertical (see p.86). 
  • Potentially S-R equiilbrium curve could be steeper than the L-R equilibrium curve and thus the system is unstable where deviations from equilibrium do not return to eq. Potentially there may not even be an initial equilibrium at all. 
  • However, we only observe the first case so it seems these are nothing more than theoretical possibilities.

Geography, Climate, Natural Resources & Growth

Summary

Assumptions

Types of Natural Resources

  1. Nonrenewable resources - Changes in level of resources 1. Discovery of new resources 2. Depletion of resources 3. Change in price making new sources viable 4. changes in technology
  2. Renewable resources ΔS_t=S_t+1-S_t=G_t-H_t where S_t is stock and G_t is growth and H_t is harvested

Model/Theory

Geography that matters:

  • Proximity to the ocean - affects openness
  • Economic spillover effects/clustering
  • Size of states & conduct of government 
    • Unification e.g. China means one large common market, less fighting, faster spread of ideas
    • Decentralization e.g. Europe 1. external competition (check on power) 2. f.o.p. (esp people) can move country. Europe has fragmented areas of fertile regions, India however is a counter-example.
  • Climate - latitude 
    • Agricultural productivity - relating to optimal temperate climate.
    • Diseases is more common in tropical regions.
    • People work harder in colder climates.
  • Natural resources
    • Resource curse
      1. Overconsumption (temporary booms) --> lower savings to maintain same level of consumption
      2. Dynamics of industrialization (shift away from manufacturing domestically - low transports costs and production abroad means there are less and less backward and forward linkages
      3. Politics - government spend the money on investment/infrastructure/education? - Often the presence of natural resources --> worst government policies

Global view - resource constrained?

  • Demand & Supply usual keeps scarcity of resources in check through higher prices but the environmental damage is largely an unpriced externality.
  • Renewable resources lead to a hill-shaped yield curve (p.488)
  • Lack of property rights can lead to inefficiently high overuse (tragedy of the commons) - biggest concerns are those that aren't owned by even governments - seas and air.
  • With I=R/yL where L = population, I = resource intensity R = resource consumption and thus R-hat=I-hat+y-hat+L-hat.
  • Can rework GDP accounts to include 'natural capital' and therefore account for the limited natural resources, were resource prices are adjusted to account for future externalities (q: are prices correlated with scarcity?)
  • Economics needs scarcity to be reflected in factor prices which it currently isn't.
  • Environmental Kuznets curve argue that initial development worsens the environment but in the long-run its better. Could potentially be gains from trade re: pollution
  • Global Warming - simple solution carbon tax.

Predictions

Evidence

  • There is a strong positive correlation between distance from the equator and gdp/capita, where although countries near the equator can be poor, countries far from the equator never are.
  • Positive correlation between natural capital and GDP/capita. Growth rates are negatively correlated with natural capital that makes up large proportion of the share of national wealth.
  • If oil reserves are estimated at 3.0 trillion barrels we have already used 39% and at that rate all the oil will be gone in 61 years. And if usage continues to grow at 1.6% a year (the average rate from 1983 to 2010) all the oil will be gone in 43 years

Evaluation

  • Geography/natural resources do not suffer from reverse causality.
  • Natural resources are not essential for economic growth and they may actually be a hinderance.
  • Resource constraints can be overcome by 1. substitution (SR this is hard, in the long run substitutes are found) and 2. technological progress

Culture & Growth

Summary

Assumptions

What determines culture?

  1. Religion
  2. Climate & Natural Resources
  3. Cultural homogeneity and social capital - homogeneity helps growth by social capital and stronger networks.
  4. Population density & social capability
  5. Government policy
  6. Income/capita & the economic environment
  7. Ethnic make-up
  8. Media/TV

Theory/Model

  • Ways culture matters: 
    1. Openness to new ideas
    2. Belief in the value of hard work
    3. Saving for the future
    4. Mutual trust - f(state, reputation).
      • Social capital - large social networks keep people accountable and higher trust feeds through to higher income/capita
    5. Social capability
      • peoples' experience of large-scale organisations
      • ability of residents to take advantage of market economics/specialization/trade
      • cause & effect over superstition or magic
      • life on earth > spiritual existence
  • Culture & Income/capita
    • Exogenous change in economic environment first leads to a shift B and then over time with a change in culture a shift to C.
    • This can lead to a positive multiplier effect.

 

Predictions

Evidence

  • Interestingly there is a negative relationship between belief in the value of hard work (versus leisure) and income/capita. However, it would be interesting to know if culture (with similar income/capita) is a good predictor of economic growth. Japanese in 1900 were deemed lazy and content. 
  • Studying immigrants to new countries found there was no correlation between the saving rate of an immigrant and the saving rate of the country they came from i.e. no relationship between culture and saving. Although immigrants are not a randomly selected group.
  • Law abidance has a cultural component (see p425 for parking tickets and culture).
  • Strong positive relationship between social capability and future economic growth (1960-2009)
  • A negative correlation between ethnic fractionalisation and gdp/capita, homogeneity is good - obviously may not be causal.
  • Strong relationship between population density in 1960 and growth rate in gdp/capita
  • Telenovas in Brazil were a significant contributor to the rapid reduction in Brazil's total fertility rate, from 5.8 children per woman in 1970 to 2.9 in 1991. 

Evaluation

  • Beware of observer bias - a country is successful therefore it must be because of its culture.
  • Cultural characteristics may be good at some times for growth and bad at other. 
  • How persistent are cultural traits? Do they last over multiple generations?

Government and Growth

Summary

Assumptions

Model/Theory

  • Government should solve market failures 1. public goods. 2. externalities 3. monopoly 4. coordination failure and 5. income distribution.
  • Government role: 
    1. Rule of Law
    2. Overall size of government
      • Tax distortions. Laffer curve.
    3. Practice of planning
      • Historically included state-owned enterprises, government-owned banks, marketing boards, trade restrictions.
  • Why do governments do things that are bad for growth?
    • Other goals e.g. reduction of pollution, equity-efficiency trade-off (redistribution).
    • Corruption & Kleptocracy --> 1. corrupt govs spend more (not to lowest bidder) 2. policies pursued purely as opportunities for bribery e.g. quotas 3. undermine rule of law
    • Self-preservation - economic growth can be destabilizing.
  • Is the causation bad government --> poverty? Or poverty to bad government?
    • Income --> gov 1. bad government not always an impediment to growth 2. quality of gov improves with growth 3. can pay civil servants high wages 4. larger pie to share 5. honest gov. is a luxury good only rich countries can afford
    • Gov --> Income 1. Evidence gov can affect economy 2. Colonialism led to bad govs but was not due to income  - weak institutions and poorly constructed national boundaries (concerning ethnic groups etc.)
  • Income inequality
    • Kuznet's hypothesis - as a country develops inequality would at first rise than fall. 
    • inequality --> higher growth
    • Causes - Distribution of economic characteristics and circumstance e.g. technological advances, increases in international trade, superstar dynamic
    • Effects of inequality 
      1. Physical capital accumulation - more saving if more rich people (better initially for growth)
      2. Human capital accumulation - more education if more equality (better in the long-run for growth)
      3. Productivity = technology & efficiency e.g. inequality --> redistribution via taxes --> inefficiency from distortions and tax avoidance; there may also be pressure for redistribution from crime political instability
    • Economic mobility e.g. intergenerational mobility --> 1. better use of human talent in society 2. less political pressure for redistribution. causes of mobility 1. education access 2. nature of institutions and government 3. nature of marriages

Predictions

Evidence

  • Strong relationship between rule of law and factors of production (p.358) and rule of law and productivity (p. 359)
  • Wagner's Law says that the size of government increases as countries become wealtheir because a more developed economy requires more complex regulation and because many public goods require spending that rises more than proportionally with income (p.360)
  • Robert Barro (p.377) found some democracy is good for growth but too much is bad.
  • Average income level rather than level of inequality is the key factor in determining an individual's income level.
  • No statistical relationship between inequality and instability, or inequality and higher levels of redistributive taxation.

Evaluation

  • Reasons against government intervention 1. government failure 2. can successful privatizse many public goods 3. can successful deregulate many monopolies 4. equity-efficiency trade-off wrong where most redistribution is life-cycle related rather than real redistribution - and potentially negative efficiency costs.
  • Swings in opinion in the 1920s with the success of the Soviet Union and the subsequent Great Depression economists were in favour of government intervention, since WW2 and the failure of Communist countries economists are more laissez-faire but once again since the 2008 recession the pendulum is potentially swinging back the other way as China faired better than say the USA.
  • Economic effects of government are sometimes a result of the fight for power rather than economic policy per se. E.g. Paul Collier has cited the multiple equilibria 'conflict trap' or a peaceful & prosperous country.

Free Capital Flow Model

Summary

Assumptions

  • Based on Solow Model
  • Economy is open to capital flows therefore use law of one price where rental rate is the same globally.
  • Small economy (compared to rest of the world) - i.e. no effect on global factor prices
  • Ignore human capital
  • r=MPK=αAk^(α-1)
  • r_w=r

Model/Theory

  • k=(αA/r_w)^1/(1-α) This implies that capital/labour ratio depend on world rental rate of capital - whereas in previous Solow model only domestic factors like the savings rate and growth rate of population mattered.
  • y=Ak^α=A^1/(1-α)*(α/r_w)^α/(1-α). This implies that saving rate is irrelevant for level of GDP/capita!

Predictions

  • For countries with high savings rates openness to capital flow will lower the level of GDP/worker as capital will flow abroad to countries where its MPK is higher (because the increase in capital stock would lower the MPK domestically). However GNP is still higher in both high and low saving countries when open vs closed.

Evidence

  • If free capital model holds savings and investment should be uncorrelated whereas in a closed model they are perfectly correlated. Having 1960-74 study found saving and investment are highly correlated therefore the assumption of free capital movement is inappropriate. Savings retention rate had fallen from 0.89 in 1970s to 0.60 between 1990-97.

Evaluation

  • Crucially a high savings rate may still make a country better off based on GNP/capita and owning overseas assets.
  • For a country with a low savings rate openness should raise GDP, at least much more rapidly than it could from domestic savings.
  • In general openness to free capital is not sufficient to be the primary channel of increasing GDP/capita - thus openness must improve productivity.

Technology: 2-Country Model

Summary

R&D spending in a country will have two effects 1. change the country's relative position in the world technology hierarchy, with transitory growth in both technology and income 2. increased R&D will lead to faster growth in technology for the world as a whole.

Assumptions

  • Technology is nonrival and frequently nonexcludable
  • One-country model key equations:
    1. γ_A=L_A/L (fraction of labour force in R&D)
    2. y=A(1-γ_A) from L_Y=(1-γ_A)L & Y=AL_Y
    3. A-hat=L_A/μ - where μ is price of the new invention.
    4. If γ_A is constant then γ-hat = A-hat i.e. technology
  • Two-country model key equations
    • wo-ways to develop technology 1. innovation 2. imitation, cost of latter (μ) is lower.
    • Assume technology leader has higher A, fraction of labour force in R&D (γ_A,1>γ_A,2) than technology follower but same size labour forces - collectively guaranteeing one is technology leader.
    • μ_i>μ_c - where cost of copying decreases with a larger gap in technology.

Model/Theory

One-country model

  • Increase in γ_A leads to long-run (permanent) increase in A-hat and y-hat but a temporary decrease in y

Two-country model

  • In the steady-state the countries grow at the same rate
  • μ_c=γ_A,2/γ_A,1*μ_i

Predictions

  • One-country model predicts that a country with a larger γ_A will have a larger growth rate. Also larger countries will have more R&D workers therefore larger A-hat.
  • Two-country model predicts that increase in γ_A,1 shift imitator curve up and shift steady-state to the left (smoother curve than one-country model) but crucially there is never convergence in the long-run.
  • Tacit knowledge means 1. much more difficult to transfer between countries than within a country because tacit knowledge is a general rather than specific 2. successful transfer of one technology can lead to large positive externality effects (e.g. taiwan/south korea)

Evidence

  • There is no evidence that larger countries (with larger numbers of researchers) growth faster.
  • Historically there has been a massive increase in the number of researchers but with tech progress being relatively stable.

Evaluation

  • Unlike Solow model increases in capital or savings, increases in γ_A lead to long-term (not temporary) increases in growth rate.
  • Technology leader is not necessarily better off (with a higher quality of living) because it also has to forgo a larger proportion of its workforce to research.
  • Now technological superiority is much more diffuse (unlike perhaps USA post-WW2 and UK in the early 19th century)
  • However technological transfer often doesn't happen for two reasons developing countries 1. choose not to use inappropriate technology (page 246 graph for capital-biased tech change) 2. are unable to use advanced tech (lack tacit knowledge)
  • Embodied technological progress is where new tech is fundamentally tied to capital investment (e.g. new machine). Can lead to leap-frogging where only those countries with the worst tech upgrade, but when they do they go to the best e.g. mobiles>land-lines
  • Assume that cost of technology is independent of level of technology however 1. -ve fishing out-effect of easy ideas 2. -ve time it takes to get to frontiers of knowledge 3. -v marginal value of additional researcher falls with larger numbers of researchers 4. +ve benefits of more areas to work on
  • In the long-run technological growth will probably decline because 1. limited number of new researchers from developing countries 2. fraction of labour force in research cannot grow 3. labour force will not grow. 
  • Tech growth could be zero in long-run if demand is for complements and therefore doesn't increase and f.o.p are shifted to other activities (manufacturing --> services), or if they substitutes it can lead to continued growth (improvements in services)

Productivity

Summary

Assumptions

  • Output=productivity x factors of production i.e. y=A x k^αh^(1-α)
  • Growth rate of output = growth rate of productivity + growth rate of factors of production.
  • Productivity = f(technology, cutting edge of technology, efficiency, open economy)
  • Technology - unlike capital - is nonrival which means easy transfer, but also means there are less incentives for creation because of a lack of excludability.
  • Efficiency = effectiveness with which factors of production and technology are combined to produce output - it's an umbrella concept for differences other than technology where A=TxE

Model/Theory

Productivity

  • Development accounting involves breaking down differences in income into a productivity part and a factor of production part: 
    • Ratio of productivity = Ratio of output / Ratio of factors of production
  • Growth accounting  A-hat = y-hat - αk-hat-(1-α)h-hat

Technology

  • Technology growth can overcome problems of diminishing returns
  • 75% of R&D is done by firms who are motivated by profits and the hope of  1. competitive adv (patents?) 2. size of the market 3. how long will adv last? 4. limited uncertainty

Efficiency

  • Break even point for technology gaps and efficiency is more than 100 years. Thus most of the difference is due to inefficiencies.
  • Featherbedding is when increases in price lead to unions forcing capitalists to pay higher wages/hire workers that are not needed.
  • Types of inefficiency - 1. unproductive activities (e.g. rent-seeking, theft), 2. idle resources 3. misallocation of factors among sectors (due to barriers to mobility &. wages not equal to marginal product - discrimination? 3. misallocation of factors among firms (e.g. government firms/monopoly) 4. technology blocking (not from patents etc.) - often violence related

Openness

  • Two times of international interaction 1. trade 2. flows of factors of production
  • Test for openness is law of one price (though there are transport costs)
  • Globalisation is due to 1. lower transport costs.2. transmission of information 3. more open trade policy (less tariffs, quotas, excessive standards, anti-dumping duties)
  • Openness is highly correlated with GDP/capita but does it cause?
    1. Compare growth rates in open and closed countries & find closed group is 1.5% vs open at 3.1%. Also, closed no relationship between GDP/capita and growth rate, open countries though offer strong evidence of convergence 
    2. Changes in openness affect growth rates? Increased openness e.g. South Korea lead to increased growth. Decreased openness lead to decreased growth.
    3. Used geography as randomly exogenous variable and found that when trade rose, income rose, and when trade fell income fell. 
  • Openness through factor accumulation or productivity? Not factor accumulation as capital flows aren't sufficient.
  • Productivity 1. Comparative Adv/Specialization 2. More able to import existing technologies/capital/business practices. 3. Larger markets (bigger incentives to invest) 4. Increases efficiency by reducing monopoly power/increased foreign competition 5.Economies of scale from increased output

Predictions

Evidence

  • We find large productivity differences between countries where India's productivity per worker is just 31% of USA's. 
  • We find that factors of production (47%) are roughly just as important as productivity (53%) and they tend to rise together. 
  • In US we find that productivity grew at 0.54% per year which makes up 40% (0.54%/1.34%) of the growth rate of output per worker. Across countries we find there is often negative productivity growth in poor poor countries. Across countries we find that 68% of the variation in growth rates is due to variation in productivity growth and 32% is because of factor accumulation. 
  • Alwyn Young found that Hong Kong's growth was primarily productivity, Singapore primarily capital accumulation (esp. human) which is unsustainable. 
  • Russian workers - even post communism are only 20% as productive as US workers - this is a difference in efficiency not technology.
  • Globalisation in two waves 1. peaking pre WWI with world exports at 8% of world GDP 2. now 24% in 2010. Between 1870 and 1925 100m changed countries ~ 10% of the world's population in 1870, much lower today.
  • 1990s study found non-tariff barriers roughly equal to tariff barriers. Though average tariff rates have fallen dramatically from 40% at the end of WW2 to 6% in 2000 and 2.8% among OECD countries.
  • In Japan only 27% of tech progress originated domestically, Canada 3%, US is the only country with a majority being domestic at 82%

Evaluation

  • Problems arise in inadequate measurements of factors of production, making the remainder (productivity) inaccurate.
  • Oftentimes economists overestimate the level of investment (particularly in developing countries) because corruption means much less money is going into companies than they think. 
  • Technological changes comes with creative destruction and potentially harmful side effects for society.
  • Patents have a number of problems incl. 1. inefficiency of monopoly 2. preventing other firms R&D (e.g. delays in patent applications to 3 years) 3. existence of patent trolls. Alternatives incl: 1. secrecy > patents. 2. open source movement
  • Opposition to openness comes from self-interested parties who are going to suffer from trade (though less than net national interest) e.g. a particular industry, or factor of production. Other weak arguments are: 
    • Exploitation - workers wouldn't take those jobs unless they didn't have better alternatives
    • Poor countries can't compete - it's exchange not competition.
    • Environmental exploitation.
    • Loss of national sovereignty
    • Ability to levy taxes (f.o.p. can just leave)
    • Costs of foreign capital 1. subject to international investors --> macro shocks 2. allow go into debt

Human Capital

Summary

Assumptions

  1. Human capital (like physical capital) has five key characteristics 1. it's productive, 2. it's produced (e.g. education) 3. human capital earns a return (but only for working) 4. depreciates
  2. Health and gdp/capita are both endogenous variables of each other.
  3. Human capital is 'installed' in owner whereas physical capital exists independently of owner.

Model/Theory

Human capital can be modelled as:

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  1. Health - people who couldn't work can work and those who could work before can work harder. Exogenous shifts in non-health related GDP/capita or non-GDP/capita related health  shift the curves.
  2. Education - Change Cobb-Douglas production function such that Y=AK^α(hL)^(1-α) where h is related to schooling. Where yss=h[A^(1/1-α)(γ/(n+𝛿))^(α/(1-α)) i.e. steady state income/capita is directly related to labour input per worker (h). Thus comparing countries, ceterus paribus, differences in y will be proportional to differences in h.

 

Predictions

Evidence

  1. Health - Improved nutrition estimated to have a 0.3% effect in UK compared to 1.13 total economic growth. 
  2. Education -  incl. opportunity cost investment in human capital is ~= investment in physical capital (about 12% of GDP in US). College premium (despite declining a bit in the 1970s) has shot up massively - two explanations 1. globalization made education a premium again 2. technological change is skill-biased. Regarding steady state analysis the variations in schooling explains some but not all of the variation in gdp/capita (see page 193).

Evaluation

  • Health - Health view vs Income view: former argues that health is the key problem and if that is solved income will rise, the latter that income is the key problem and if that is solved that health will rise.
  • Education - The reason Cobb-Douglas is better with α of 2/3 rather than 1/3 (which is the observed amount of physical capital) is that there is a return to human capital as well). Other factors that matter include quality of schooling - not just length.
  • Externalities - human capital has positive externalities that physical capital doesn't have - which made lead to an underinvestment on a purely private basis.

Demographic Transition

Summary

Assumptions

Model/Theory

Mortality transition (lower)

  1. Improvements in the standard of living esp. quantity and quality of food.
  2. Improvements in public health measures e.g. draining of mosquito-infected swamps and securing clean water.
  3. Role of medical treatments in curing diseases.

 

Fertility transition (lower)

  1. Improved contraception
  2. Cultural shift in favour of fertility control.
  3. Although total fertility is not that much higher than desired fertility
  4. Economic growth --> lower desired fertility because of  1. lower mortality 2. income & substitution effects (where price of children is higher) esp. opp cost of women not working 3. Resource flows between parents and children 4. Quality-quantity trade-offs.

Replacement rate of fertility is roughly 2.1 children per women would require both an increase in fertility in developed countries and a decrease in fertility in developing countries.

Predictions

  • Predict a generally declining world population growth rate stabilising at around 11 billion by about 2150.

Evidence

  • In developing world mortality rate has fallen faster than fertility thus populations are still growing.

Evaluation

  • Low Total Fertility Rate (TFR) may be due to a tempo effect where women are delaying the age at which they have children however this can only explain 0.25 to 0.4 of the reduction.
  • Demographic momentum is where the number of fertile women boosts population growth even if the rate of fertility stays the same.
  • Demographic structure particularly the percentage of the population of working age is significant for GDP/capita. E.g. In US fraction of working age population is forecast to fall from 0.6 to 0.54 which owould in a 20 year period have a -0.5% effect on GDP/capita.
  • Composition effect means that world GDP is declining as a larger proportion of the worlds population is from poor countries.