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The Centre for Growth and Business Cycle Research

Discussion papers 2006

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Bratsiotis, G.J., Peng, B., (2006). 'Social Interaction and Effort in a Success-at-Work Augmented Utility Model', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 86.

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This paper examines how success-at-work, interpreted by both subjective and relative criteria, can motivate individuals to enhance their effort and utility. We employ a general specification utility function and show that the final effect of technological growth on individuals’ effort and utility depends, respectively, on the assumptions we make about their nature with regard to their effort strategies (ie conformists, deviants or neutrals) and to their utility preferences (ie altruistic or envious). We show that these effects are determined largely by individuals’ personal success-consciousness at-work, as well as their competition strategies towards relative success and status.

Bataa, E., Kim, D.H., Osborn, D.R., (2006). 'New Evidence on the Expectations Theory for UK Term Structure', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 85.

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This paper extends the empirical evidence on the Expectations Theory (ET) in the UK term structure using recent developments in the testing methodology and looking at multiple conventional maturity pairs across the term structure spectrum. Although different tests yield different conclusions about the validity of the ET in some cases, there are maturity pairs and time periods for which all tests seem to agree. All testing methods are surprisingly positive about the ET at the longest end and when the ET is rejected it occurs only at the short end of the maturity spectrum irrespective of the method used. Moreover, none of the tests have rejected the theory in the first sub-sample which ends before the introduction of inflation targeting in 1992.

Bataa, E., Kim, D.H., Osborn, D.R., (2006). 'Does Spread Really Predict the Short Rate? Explaining Empirical Anomalies in the Expectations Theory',Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 84.

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Empirical studies often find that the spread between longer and shorter rates does not have predictive power for future longer rates, violating the Expectations Theory (ET). Although the predictive power of the spread for future shorter rates is largely in accordance with the ET, especially when the forecast period is long, researchers often find this holds to varying degrees across samples (country-wise or time-wise). We show this pattern may be due to the powers of all tests depending on interest rates’ maturities and their persistency in small samples. This paper also compares the powers of tests of the ET against the under/overreaction and the time varying term premium alternatives across various maturity combinations, levels of persistency and sample sizes. Tests perform best and are comparable to each other at the shortest end of the term structure, but deteriorate as the distance between maturities of longer and shorter rates increase. However, this deterioration is of varying degrees for different tests and its speed diminishes as we depart from the shortest end. In general Lagrange multiplier and distance metric tests emerge as being the most powerful and least sensitive to interest rate maturities and their persistency.

Agénor, P-R., (2006). 'A Theory of Infrastructure-led Development', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 83.

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This paper proposes a theory of long-run development based on public infrastructure as the main engine of growth. The government, in addition to investing in infrastructure, spends on health services, which in turn raise labour productivity and lower the rate of time preference. Infrastructure affects the production of both commodities and health services. As a result of network effects, the degree of efficiency of infrastructure is nonlinearly related to the stock of public capital itself. This in turn may cause multiplicity of equilibrium growth paths. Provided that governance is adequate enough to ensure a sufficient degree of efficiency of public investment outlays, an increase in the share of spending on infrastructure (financed by a cut in unproductive expenditure or foreign grants) may facilitate the shift from a low growth equilibrium, characterized by low productivity and low savings, to a high growth steady state.

Blackburn, K., Sarmah, R ., (2006). 'Red Tape, Corruption and Finance', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 82.

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We study the effects of red tape and corruption in a model of occupational choice, entry regulation and imperfect capital markets. Red tape is the set of rules and regulations that private agents are obliged to comply with in order to engage in entrepreneurial activity. Corruption is the payment of bribes to public officials for the purpose of circumventing red tape. Capital market imperfections are the asymmetries of information between borrowers and lenders about the returns to entrepreneurship. We show that both red tape and corruption deter entrepreneurial activity, but that only corruption affects financial market outcomes, including the probability of bankruptcy and the costs of verifying bankruptcy claims. The existence of corruption compounds the effects of both aggregate uncertainty and capital market frictions, each of which compounds the effects of corruption. We examine the interactions between red tape and corruption when both are endogenous to the bureaucratic process

Berardi, M., (2006). 'Monetary policy with heterogeneous and misspecified expectations', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 81.

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In recent literature on monetary policy and learning, it has been suggested that private sector’s expectations should play a role in the policy rule implemented by the central bank, as they could improve the ability of the policymaker to stabilize the economy. Private sector’s expectations, in these studies, are often taken to be homogeneous and rational, at least in the limit of a learning process. In this paper, instead, we consider the case in which private agents are heterogeneous in their expectations formation mechanisms and hold heterogeneous expectations in equilibrium. We investigates the impact of this heterogeneity in expectations on central bank’s policy implementation and on the ensuing economic outcomes.

Angeles,L., Neanidis,K.C., (2006). 'Aid Effectiveness: The Role of the Local Elite', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 80.

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We study the importance of the local elite as a determinant of the effectiveness of foreign aid in developing countries. An "extractive" elite will misuse aid flows, an issue that is probably as old as foreign aid itself. We proxy for the existence of an "extractive" elite by using an historically determined variable: the percentage of European settlers in colonial times. Our econometric results clearly show the importance of this factor and its robustness to a wide set of alternative aid-growth relationships advanced in the literature.

Zhang, C., Osborn, D.R., Kim, D.H., (2006). 'Observed Inflation Forecasts and the New Keynesian Phillips Curve', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 79.

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Estimating the micro-founded New Keynesian Phillips Curve using rational inflation expectation proxies has often found that the output gap is not a valid measure of inflation pressure. This paper investigates the empirical success of the NKPC in explaining US inflation, using observed measures of inflation expectations and taking account of serial correlation in the stylized NKPC. Contrary to recent results indicating no role for the GDP gap, we find it to be a statistically significant driving variable for inflation while labour income share is generally insignificant. The paper also develops an extended model in which serial correlation is absent and the output gap remains a valid inflation driving force. In most of our estimations, however, lagged inflation dominates the role of inflation expectations, casting doubt on the extent to which price setting is forward-looking over the period 1968 to 2005. From an econometric perspective, the paper uses GMM estimation to account for endogeneity while also addressing concerns raised in recent studies about weak instrumental variables used in estimating NKPC models.

Zhang, C., Osborn, D.R., Kim, D.H., (2006). 'The New Keynesian Phillips Curve: from Sticky Inflation to Sticky Prices', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 78.

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The New Keynesian Phillips Curve (NKPC) model of inflation dynamics based on forward-looking expectations is of great theoretical significance in monetary policy analysis. Empirical studies, however, often find that inflation inertia, rather than inflation expectations, dominate the dynamics of the short-run aggregate supply curve. This paper examines this inconsistency by investigating multiple structural changes in the NKPC for the US over 1968-2005. Both inflation expectations survey data and a rational expectations approximation are used to capture expectations. We find that forward-looking behaviour plays a smaller role during the high and volatile inflation regime to 1981 than in the subsequent period of moderate inflation, providing support for the empirical coherence of sticky prices models over the last two decades. A further break in the intercept of the NKPC is identified around 2001 and this may be associated with monetary policy in the recent period.

Savva, C.S.,Osborn, D.R., Gill, L., (2006). 'Periodic Dynamic Conditional Correlations between Stock Markets in Europe and the US', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 77.

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This study extends the dynamic conditional correlation model to allow day-specific correlations of shocks across international stock markets. The properties of the resulting periodic dynamic conditional correlation (PDCC) model are examined, with the model then applied to study the intra-week interactions between six developed European stock markets and the US over the period 1993 - 2005. We find very strong evidence of periodic effects in the conditional correlations of the shocks. The highest correlations are generally observed on Thursdays, with these Thursday correlations in some cases being twice those on Monday or Tuesday. Prior to estimating the PDCC model, periodic mean and volatility effects are removed using a PAR model for returns combined with a periodic EGARCH specification for the variance equation. Strong periodic mean effects are found for returns in the French, Italian and Spanish stock markets, whereas such effects are present in volatility for all stock markets except Italy.

Agénor, P-R., Montiel, P.J., (2006). 'Credit Market Imperfections and the Monetary Transmission Mechanism Part I: Fixed Exchange Rates', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 76.

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This paper develops a simple static model with credit market imperfections and flexible prices for monetary policy analysis in a fixed-exchange rate economy. Lending rates are set as a premium over the cost of borrowing from the central bank. The premium itself depends on firms' net worth. In the basic framework, banks' funding sources are perfect substitutes and the provision of liquidity by the central bank is perfectly elastic at the prevailing refinance rate. The model is used to perform a variety of experiments, such as changes in the refinance and reserve requirement rates, central bank auctions, shifts in the premium and contract enforcement costs, and changes in public spending and world interest rates. The analysis is then extended to examine credit targeting and sterilization policies.

Attfield, C.L.F. , Temple, R.R.W., (2006). 'Balanced growth and the great ratios: new evidence for the US and UK', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 75.

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Standard macroeconomic models suggest that the ‘great ratios’ of consumption to output and investment to output should be stable functions of structural parameters. We examine whether the ratios are stationary for the US and UK, allowing for structural breaks that could reflect timevarying parameters. We find stronger evidence for stationarity than previous work. We then use the long-run restrictions associated with the stationarity of the great ratios to extract measures of trend output from the joint behaviour of consumption, investment and output. This approach is attractive because it uses information from several series without requiring restrictive assumptions.

Blackburn, K. , Varvarigos, D., (2006). 'Human Capital Accumulation in a Stochastic Environment: Some New Results on the Relationship Between Growth and Volatility', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 74.

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We study the relationship between growth and volatility in a simple analytical model, where human capital accumulation depends on both deliberate and non-deliberate learning, and where stochastic fluctuations arise from both preference and technology shocks. We derive a number of new results which challenge some of the results in the existing literature. First, we show that the optimal allocations of time to working and learning are both pro-cyclical. Second, we identify a preference parameter (other than the coefficient of relative risk aversion) that is potentially crucial for governing the effect of volatility on growth. Third, we demonstrate how the correlation between growth and volatility can be either positive or negative under each type of learning. Fourth, we also reveal how the sign of the correlation may be different for the two types of shock. Our results may be seen as providing further explanation for the lack of robust evidence on the relationship.

Agénor, P-R., Yilmaz, D., (2006). 'The Tyranny of Rules: Fiscal Discipline, Productive Spending, and Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 73.

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The performance of alternative fiscal rules is examined in an endogenous growth model with public capital and debt. In addition to investing in infrastructure, the government spends on maintenance and health. Infrastructure affects the production of both commodities and health services. The performance of a balanced budget rule, as well as standard and modified (including and excluding productive spending) golden rules and primary surplus rules are compared numerically. Under a range of plausible parameter configurations and spending shares, and as long as the debt-related risk premium is not too elastic, a primary surplus rule that excludes productive spending is shown to perform better than alternative rules in response to a variety of shocks. As a practical policy implication, we propose the definition of a transparent Core Productive Expenditure Program.

Bataa, E., Kim, D.H., Osborn, D.R.,(2006). 'A Further Examination of the Expectations Hypothesis for the Term Structure', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 72.

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We extend the vector autoregression (VAR) based expectations hypothesis tests of term structure using recent developments in bootstrap literature. Firstly, we use wild bootstrap to allow for conditional heteroskedasticity in the VAR residuals without imposing any parameterization on this heteroskedasticity. Secondly, we endogenize the model selection procedure in the bootstrap replications to reflect true uncertainty. Finally, a stationarity correction is introduced which is designed to prevent finite sample bias adjusted VAR parameters from becoming explosive. When the new methodology is applied to extensive US zero coupon term structure data ranging from 1 month to 10 years, we find less rejections for the theory in a subsample of Jan 1982-Dec 2003 than in Jan 1952-Dec 1978, and when it is rejected it occurs at only the very short and long ends of the maturity spectrum, in contrast to the U shape pattern observed in some of the previous literature.

Neanidis, K.C., Savva, C.S.,(2006). 'The Effects of Uncertainty on Currency Substitution and Inflation: Evidence from Emerging Economies', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 71.

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This paper examines the effects of inflation and currency substitution volatility on the average rates of inflation and currency substitution for twelve emerging market economies. Using a bivariate GARCH-in-Mean model, which accommodates for asymmetric and spillover effects of inflation and currency substitution innovations on their volatilities, we find that for the majority of the countries in the sample the variability of inflation exerts a positive influence on both the average rates of inflation and currency substitution. Similarly, higher uncertainty in currency substitution displays enhancing effects on inflation and currency substitution. These results indicate an alternative avenue that stresses the importance of currency substitution for the conduct of monetary policy in terms of price stability, and provide an additional explanation to the phenomenon of dollarization hysteresis.

Jahjah, S., Montiel, P.,(2006). 'Devaluation, Debt, and Default in Emerging Economies', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 70.

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Motivated by the experiences of Mexico and Argentina, we explore a model intended to capture the interactions among exchange rate policy, fiscal policy, and default on foreign currency-denominated debt. Our objective is to examine how exchange rate policy affects the supply of short-term debt facing the government. We show that under a conventional soft peg, it can be optimal for the government to choose a level of the exchange rate that may result in partial or complete debt default, as in the Mexican case. Paradoxically, default may also be an equilibrium outcome under a hard peg, as in the case of Argentina, precisely because devaluation is not an option. Multiple equilibria may exist under a soft peg, with one equilibrium featuring a high domestic interest rate, an overvalued exchange rate, a low level of output, and a high default probability. Under a hard peg, however, there is a unique equilibrium.

Agénor, P-R., Neanidis, K.C.,(2006). 'The Allocation of Public Expenditure and Economic Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 69.

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This paper studies the optimal allocation of government spending between health, education, and infrastructure in an endogenous growth framework. In the model, infrastructure affects not only the production of goods but also the supply of health and education services. The production of health (education) services depends also on the stock of educated labour (health spending). Transitional dynamics associated with budget-neutral shifts in the composition of expenditure are analysed, and growth- and welfare-maximizing allocation rules are derived and compared. The discussion highlights the key role played by the parameters that characterize the health and education technologies.

Agénor, P-R. (2006). 'External Shocks and the Urban Poor', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 68.

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This paper examines the effect of external shocks on urban poverty in a two-household (rich and poor) intertemporal optimizing model of an open economy with segmented labour markets. Skilled and unskilled labour are used in the formal sector, whereas only unskilled labour is used in the informal economy. Using the minimum wage in the formal sector as the poverty line, various poverty indicators are defined and computed. The analysis shows that the extent to which an increase in the world risk-free interest rate affects the incidence and depth of poverty depends crucially on the wedge between consumption and product wages in the formal economy.