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The Centre for Growth and Business Cycle Research

Discussion papers 2005

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Haque, M.E., Kneller, R., (2005). 'Corruption Clubs: Endogenous Thresholds in Corruption and Development', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 67.

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The relationship between corruption and economic development is characterised by three stylised facts: (i) a strong negative correlation between corruption and development (ii) countries can remain trapped in high corruption-low development or low corruption-high development equilibria (iii) amongst intermediate levels of development corruption levels are more variable, some countries have high corruption and others low corruption. This paper argues that existing models are consistent with the first two only and demonstrates how these models might be extended to capture all three. The paper searches for the location of corruption clubs within the data and provides some explanation of their cause.

Angeles, L., (2005). 'Income Inequality and Colonialism', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 66.

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This paper proposes that Colonialism is a major explanation behind today’s differences in Income Inequality among countries. We argue that colonies that received an important number of European settlers were characterized by a concentration of economic and political power in the hands of these last ones. Moreover, European settlers later achieved independence from the metropolis and were able to prolong the status quo. Colonies where Europeans were much less present did not develop such strong inequality. The empirical evidence we provide strongly supports our thesis.

Angeles, L., (2005). 'Capital Account Openness and Bankruptcies', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 65.

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This paper presents a model where opening the capital account of an economy causes more bankruptcies to take place in the non tradables sector. Non tradable firms must forecast the future state of the economy when investing since the demand for their goods depends on this. In our model the interest rate is a powerful signal that non tradable firms use when the capital account is closed, but its informational content decreases once the capital account opens up and international (as well as domestic) shocks affect it.

Savva, C.S., Osborn, D.R., Gill, L., (2005). 'Spillovers and Correlations between US and Major European Stock Markets: The Role of the Euro', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 64.

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This paper investigates the transmission of price and volatility spillovers across the New York, London, Frankfurt and Paris stock markets under the framework of the multivariate EGARCH model. The model is extended to allow dynamic conditional correlations, with the correlations allowed to change with the introduction of the Euro. By using daily closing prices recorded at 16:00 London time (pseudo-closing prices) we find evidence that domestic stock returns and volatilities are influenced by the behaviour of foreign markets, with both volatilities and conditional correlations responding asymmetrically to news/innovations in other markets. The findings also indicate that the correlations of returns have increased for all markets since the launch of the Euro, with that between Frankfurt and Paris experiencing the largest increase.

Bratsiotis, G.J., (2005). 'Influential Price and Wage Setters, Monetary Policy and Real Effects', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 63.

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Using a general equilibrium model this paper shows that when large monopolistic firms or unions perceive even a small influence on aggregate nominal variables, price targeting results in a higher equilibrium output than monetary accommodation. This is because price targeting increases, whereas monetary accommodation decreases, (i) the price elasticity of demand, (ii) the labour elasticity of demand and (iii) the elasticity of the wage with respect to households’ total real income (ie wage, money transfers and profits). Within this framework, price targeting is shown to reduce the macroeconomic inefficiencies associated with monopolistic competition. The paper also shows that the standard approximation, that no single price or wage setter can affect nominal aggregates, is a good approximation provided, (a) at least a few hundreds of such large firms exist and more significantly (b) labour markets are decentralized or wage centralization is very low.

Agénor, P-R., (2005). 'Health and Infrastructure in Models of Endogenous Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 62.

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This paper studies the optimal allocation of government spending between infrastructure and health (which affects labour productivity as well as household utility) in an endogenous growth framework. A key feature of the model is that infrastructure affects not only the production of goods but also the supply of health services. The first part considers the case where health enters as a flow in production and utility, whereas the second focuses on a "stock" approach. Growth- and utility-maximizing rules for output taxation and the allocation of public spending are derived. It is shown, in particular, that the welfare-maximizing share of spending on health exceeds the growth-maximizing share.

Agénor, P-R., (2005). 'Schooling and Public Capital in a Model of Endogenous Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 61.

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This paper studies the allocation of public spending between education services and infrastructure investment in an endogenous growth model where public capital in infrastructure affects the process of human capital accumulation. The balanced growth path is derived and the dynamics associated with a budget-neutral reallocation of spending from education to infrastructure are studied through numerical simulations. The growth-maximizing tax rate is shown to depend only on the production technology (as in standard flow models of public expenditure), whereas the optimal share of infrastructure investment depends also on the "productiveness" of infrastructure (relative to education services) in the schooling technology.

Agénor, P-R., (2005). 'Infrastructure Investment and Maintenance Expenditure: Optimal Allocation Rules in a Growing Economy', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 60.

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This paper studies the allocation of public expenditure between infrastructure investment and maintenance in an endogenous growth framework. In the basic model maintenance affects both the durability and efficiency of public capital. The balanced growth path is derived and transitional dynamics associated with a revenue-neutral increase in spending on maintenance are analyzed. The growth-maximizing tax rate and share of infrastructure investment are then obtained. The model is then extended to account for the possibility that public spending on maintenance affects also the durability of private capital. Implications for optimal policies are also analyzed.

Agénor, P-R., (2005). 'Fiscal Policy and Endogenous Growth with Public Infrastructure', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 59.

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Optimal tax and spending allocation rules are derived in an endogenous growth model in which raw labour must be educated to become productive and infrastructure services affect the schooling technology. The optimal tax rate is found to depend only on the elasticities of output with respect to infrastructure services and educated labour. The optimal share of spending on infrastructure (relative to education) depends also on these elasticities, as well as the quality of schooling and the degree to which infrastructure services affect the production of educated labour. Congestion costs in education tend to raise the optimal share of spending on infrastructure.

Neanidis, K.C., (2005). 'Aid, Budgetary Policies, and the Macroeconomy: Growth, Inflation, and Welfare', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 58.

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This paper examines the macroeconomic effects of foreign aid transfers in a small open recipient economy. The focus, however, is not on the impact of foreign aid per se but rather on aid’s influence conditional upon the different budgetary financing policies under the discretion of the recipient government. We compare the effects of an aid transfer tied to investment in a public good from a pure aid transfer, under income-tax and/or inflation-tax financing of government expenditures. The effects of each form of aid under each type of public financing are examined with respect to the economic growth rate, the rate of inflation, and the percentage change in welfare of the recipient economy. The economy is analyzed numerically and specific policy recommendations are provided for individual recipient countries.

Bose, N., Holman, J.A., Neanidis, K.C., (2005). 'The Optimal Public Expenditure Financing Policy: Does the Level of Economic Development Matter?',Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 57.

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This paper explores how the optimal mode of public finance depends on the stage of economic development. The theoretical analysis is based on an overlapping generations growth model with an imperfect capital market. Random shocks create a demand for liquidity and establish a role for financial intermediaries. In this model, inflation matters because it affects the relative rates of return on assets in such a way that money becomes the preferred asset in the portfolio holdings of banks, causing a detrimental effect on economic growth. Such an effect is stronger (weaker) at lower (higher) levels of economic development due to the higher (lower) default risks associated with lending. Consequently, income taxation (seigniorage) is a relatively less distortionary way of financing public expenditure for low-income (high-income) countries. We provide empirical support for our model’s predictions using a panel of 21 OECD and 40 developing countries observed over the period 1972-1999.

Neanidis, K.C., Varvarigos, D., (2005). 'The Impact of Foreign Aid on Economic Growth: Volatility of Disbursements and Distribution of Receipts',Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 56.

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This paper is concerned with the effects of aid transfers and their degree of volatility on economic growth. We develop a theoretical framework that distinguishes the allocation of foreign aid between productive and non-productive uses. On the one hand, devoting aid inflows into productive public spending promotes growth while the related volatility has a damaging effect. On the other hand, the non-productive use of aid transfers has an adverse effect on growth while their volatility is growth-enhancing. The theoretical implications are supported by an empirical specification, formulated on similar grounds, for a panel of 74 aid-recipient countries over the time period from 1972 to 1998. The empirical results are found to be robust in a variety of sensitivity tests.

Blackburn, K., Sarmah, R., (2005). 'Corruption, Development and Demography', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 55.

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This paper presents an analysis of the joint, endogenous determination of bureaucratic corruption, economic development and demographic transition. The analysis is based on an overlapping generations model in which reproductive agents mature safely through two periods of life and face a probability of surviving for a third period. This survival probability depends on the provision of public goods and services which may be compromised by corrupt activities on the part of public officials. The dynamic general equilibrium of the economy is characterised by multiple development regimes, transition between which may or may not be feasible. In accordance with empirical evidence, the model predicts that low (high) levels of development are associated with high (low) levels of corruption and low (high) rates of life expectancy.

Blackburn, K., Forgues-Puccio, G.F., (2005). 'Financial Liberalisation, Bureaucratic Corruption and Economic Development ', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 54.

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We study the effect of international financial integration on economic development when the quality of governance may be compromised by corruption. Our analysis is based on a dynamic general equilibrium model of a small economy in which growth is driven by capital accumulation and public policy is administered by government appointed bureaucrats. Corruption may arise due to the opportunity for bureaucrats to embezzle public funds, an opportunity that is made more attractive by financial liberalisation which, at the same time, raises efficiency in capital production. Our main results may be summarised as follows: (1) corruption is always bad for economic development, but its effect is worse if the economy is open than if it is closed; (2) the incidence of corruption may, itself, be affected by both the development and openness of the economy; (3) financial liberalisation is good for development when governance is good, but may be bad for development when governance is bad; and (4) corruption and poverty may co-exist as permanent, rather than just transitory, fixtures of an economy.

Blackburn, K., Bose, N. and Haque M.E., (2005). 'Public Expenditures, Bureaucratic Corruption and Economic Development', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 53.

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This paper presents a dynamic general equilibrium analysis of public sector corruption and economic growth. In an economy with government intervention and capital accumulation, state-appointed bureaucrats are charged with the responsibility for procuring public goods which contribute to productive efficiency. Corruption arises because of an opportunity for bureaucrats to appropriate public funds by misinforming the government about the cost and quality of public goods provision. The incentive for each bureaucrat to do this depends on economy-wide outcomes which, in turn, depend on the behaviour of all bureaucrats. We establish the existence of multiple development regimes, together with the possibility of multiple, frequency-dependent equilibria. The predictions of our analysis accord strongly with recent empirical evidence on the causes and consequences of corruption in public office.

Agénor, P-R., (2005).'The Analytics of Segmented Labor Markets', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 52.

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This paper provides an analytical overview of models of segmented urban labour markets in developing countries. It begins by reviewing the characteristics of the labour market in these countries, including institutions and regulations that may lead to segmentation. The wage and employment effects of imperfect labour mobility between the formal and informal sectors are then illustrated with a simple graphical analysis. Formal models of urban wage formation are discussed next, and a two-sector shirking model with segmented urban labour markets is presented. The model is used to analyze the impact of an increase in the minimum wage on unskilled unemployment.

Kim, D.H. (2005)., 'Nonlinearity in the Term Structure', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 51.

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This paper investigates the nature of nonlinearities in the term structure using the flexible approach to nonlinear inference. The paper reports clear evidence of nonlinearity, in contrast to the affine term structure model and consistent with recent claims in the literature. We find that there is a threshold effect of volatility on the interest rate but this effect does not capture the entire nature of the nonlinearity. The quadratic term structure model recently proposed performs better for capturing the nonlinearity than the threshold model but the former model seems to miss some aspect of nonlinearity for short-term rates. However, our flexible nonlinear model which incorporates the threshold effect and the convexity of volatility into the quadratic model, generally performs well for all interest rates. The paper suggests that this model is a promising representation of nonlinearities and out-of-sample forecasts support the claim of nonlinearities.

Osborn, D.R, Perez, P.R, Sensier, M., (2005). 'Business Cycle Linkages for the G7 Countries: Does the US Lead the World?', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 50.

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This paper empirically models the relationship between quarterly business cycle movements in the US and the other G7 countries, including an analysis of the US with a European (E15) aggregate. By using a nonlinear smooth transition vector autoregressive framework, the possibility of asymmetric business cycle linkages is explored. Statistical testing almost always rejects linearity, with the nonlinearity in the VAR generally associated with lagged annual US growth. To represent different types of possible business cycle linkages, three nonlinear VAR models are estimated for each country with the US, where these represent common business cycle regimes, US-led (but not common) regimes and country-specific (or idiosyncratic) regimes. In general, high annual US growth is found to lead to a distinct business cycle regime in other G7 countries compared with average or low US growth. Tests indicate that quarterly US growth patterns are important for other countries primarily in the lower regime, with domestic autoregressive lags then sometimes insignificant.

Varvarigos, D. (2005)., 'Policy Variability in Models of Endogenous Growth with Productive Spending', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 49.

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Existing theoretical analyses have shown that if policy variables affect investment decisions in either physical or human capital then an increase in policy variability results in higher trend output growth as individuals respond to higher uncertainty with a precautionary increase in these types of investment. In this paper I present two models in which policy variability arises from randomness in the provision of productive spending. In the first model, public spending enters as an input in the production technology of the economy. In this case I find that the sign of the policy variability-growth relationship depends critically on the technological parameters of the production function. In the second model, public spending is an input on the education sector of the economy. In this case I find that policy variability is always growth retarding as individuals respond to increased uncertainty by actually reducing rather than increasing their investment in human capital.

Blackburn, K., Varvarigos, D., (2005). 'Growth, Uncertainty and Finance', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 48.

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We study the effects of uncertainty on long-run growth in two model economies, where households fund risky investment projects of entrepreneurs in the presence of financial market imperfections. Imperfections in the first model are due to asymmetric information which is resolved through costly state verification. In this case, some entrepreneurs may decide at the outset not to borrow and not to run projects. Imperfections in the second model are due to incomplete enforceability of loan contracts. In this case, all entrepreneurs are willing to borrow, but some of them may choose not to run projects, preferring to abscond with their loans, instead. We show that, in both cases, an increase in uncertainty increases the rate of interest on loans which increases the number of entrepreneurs who abstain from running projects. This reduces capital accumulation and growth. We also show that financial market frictions have similar effects, and that the effects of uncertainty disappear when these frictions are absent.

Agénor, P-R., (2005). 'Infrastructure, Public Education and Growth with Congestion Costs', Centre for Growth and Business Cycle Research Discussion Paper Series, The University of Manchester, No. 47.

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This paper studies the optimal allocation of public expenditure between infrastructure and education services in an endogenous growth framework. Raw labour must be educated to become productive. The balanced-growth path is derived and the transitional dynamics associated with an increase in the share of spending on infrastructure are characterized. The growth-maximizing share is shown to depend on the elasticities of output with respect to both infrastructure services and the supply of educated labour. If the supply of raw labour is increasing in wages, the growth-maximizing share of government spending on infrastructure depends negatively on the degree of congestion in schooling.