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The Centre for Growth and Business Cycle Research

Discussion papers 2010

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Anderson, H.M., Dungey, M., Osborn, D.R., Vahid, F., (2010). Financial Integration and the Construction of Historical Financial Data for the Euro Area', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 152.

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Time series analysis for the Euro Area requires the availability of sufficiently long historical data series, but the appropriate construction methodology has received little attention. The benchmark dataset, developed by the European Central Bank for use in its Area Wide Model (AWM), is based on fixed-weight aggregation across countries with historically distinct monetary policies and financial markets of varying international importance. This paper proposes a new methodology for producing back-dated financial series for the Euro Area, that is based on the time-varying distance of periphery countries from core countries with respect to monetary integration. Historical decompositions of the residuals of vector autoregressive models of the Euro Area economy are then used to explore and compare the monetary policy implications of using the new methodology versus the use of AWM fixed weight series.

Becker, R., Clements, A., O'Neill, R., (2010). 'A Kernel Technique for Forecasting the Variance-Covariance Matrix', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 151.

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In this paper we propose a novel methodology for forecasting variance convariance matrices (VCM) using kernel estimates. While the popular Riskmetrics methodology can be seen as a special case of our methodology, the generalisation is significant as it allows the researcher to use a number of variables to determine the kernel weights of past VCM. The complexity of the methodology scales with the number of explanatory variables used and not with the size of the VCM. This, as well as the automatic positive definiteness of the VCM forecasts are major improvements on currently available forecasting methods. An empirical analysis establishes the usefulness of our proposed methodology.

Middleditch, P., (2010). 'A New Keynesian Model with Heterogeneous Price Setting', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 150.

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The Calvo contract pricing mechanism has become the most widely accepted microfoundation to the NK Phillips curve but unfortunately predicts that all firms in the economy face the same probability of price change. To better explain the stylized fact this paper relaxes the homogeneous firm assumption in the Calvo contract, to provide a macroeconomic explanation more consistent with recently available microeconomic evidence that suggests firms face differing probabilities of price change. A simple New Keynesian dynamic stochastic general equilibrium (DSGE) model with nominal rigidities and habit in consumption for the US is estimated using Bayesian techniques and finds evidence of a flexible price sector of around 6% and a sticky price sector of between 55% and 70% depending on model specification.

Becker, R., Clements, A., O'Neill, R., (2010). 'A Cholesky-MIDAS model for predicting stock portfolio volatility', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 149.

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This paper presents a simple forecasting technique for variance covariance matrices. It relies significantly on the contribution of Chiriac and Voev (2010) who propose to forecast elements of the Cholesky decomposition which recombine to form a positive definite forecast for the variance covariance matrix. The method proposed here combines this methodology with advances made in the MIDAS literature to produce a forecasting methodology that is flexible, scales easily with the size of the portfolio and produces superior forecasts in simulation experiments and an empirical application.

Berardi, M., (2010). 'Heterogeneous learning dynamics and speed of convergence', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 148.

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In a simple, forward looking linear stochastic model we investigate the impact of heterogeneity in expectations formation on the speed of convergence of the learning process of agents towards equilibrium. We find that even when heterogeneity does not affect learnability in term of its asymptotic outcome, it can still have an important impact on the learnability of an equilibrium in terms of the speed of convergence of learning dynamics.

Berardi, M., Duffy, J., (2010). 'Real-Time, Adaptive Learning via Parameterized Expectations', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 147.

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We explore real time, adaptive nonlinear learning dynamics in stochastic macroeconomic systems. Rather than linearizing nonlinear Euler equations where expectations play a role around a steady state, we instead approximate the nonlinear expected values using the method of parameterized expectations. Further we suppose that these approximated expectations are updated in real time as new data become available. We explore whether this method of real-time parameterized expectations learning provides a plausible alternative to real-time adaptive learning dynamics under linearized versions of the same nonlinear system.

Neanidis, K.C., Savva, C.S., (2010). 'Nominal Uncertainty and Inflation: The Role of European Union Membership', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 146.

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Using a GARCH model we provide evidence that higher inflation uncertainty leads to higher inflation in the new European Union (EU) member states and candidate countries only prior to EU accession. During EU accession and entry inflation uncertainty has no effect on mean inflation. This result supports the consideration of policy regime shifts in assessing the nominal uncertainty-average inflation relationship.

Neanidis, K.C., Savva, C.S., (2010). 'Macroeconomic Uncertainty, Inflation and Growth: Regime-Dependent Effects in the G7', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 145.

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We analyse the causal effects of real and nominal macroeconomic uncertainty on inflation and output growth and examine whether these effects vary with the level of inflation and location on the business cycle. Employing a bivariate Smooth Transition VAR GARCH-M model for the G7 countries during the period 1957- 2009, we find strong nonlinearities in these effects. First, uncertainty regarding the output growth rate is related with a higher average growth rate mostly in the low-growth regime, supporting the theory of “creative destruction”. Second, higher inflation uncertainty induces lower growth rates, increasingly so at the high-inflation regime. Third, real and nominal uncertainties have mixed effects on average inflation. Nevertheless, there is a trend in favour of the Cukierman- Meltzer hypothesis in the high-inflation regime. Our results can be viewed as offering an explanation for the often mixed and ambiguous findings in the literature.

Angeles, L., Neanidis, K.C.,(2010). 'Colonialism, Elite Formation and Corruption ', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 144.

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This paper argues that corruption in developing countries has deep historical roots which go all the way back to their colonial experience. We substantiate our thesis with empirical evidence showing how the degree of European settlement during colonial times is a powerful explanatory factor of present-day corruption. The rationale behind the use of this variable is a link between the degree of European settlement and the power of the local elite. Interestingly, our mechanism is different from the prevailing view in the literature on institutions and growth, where the degree of European settlement has only positive effects. We argue that European settlement leads to higher level of corruption for all countries where Europeans remained a minority in the population, i.e., for all developing countries.

Neanidis, K.C.,(2010). 'Financial Dollarization and European Union Membership ', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 143.

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We analyse the effect of European Union (EU) membership on financial dollarization for the Central and Eastern European countries. Using a unique monthly dataset that spans about two decades, we find that both the accession process toward EU membership and EU entry have a direct impact on deposit and loan dollarization. EU membership reduces deposit dollarization while it increases loan dollarization. The negative effect on deposit dollarization captures the increased confidence of the private sector in the domestic currency as they consider the EU admission process to reflect their government’s commitment in promoting policies of long-run currency stability. The positive impact on credit dollarization is the outcome of a greater convergence of exchange rates to the euro and the subsequent anticipation for a lower currency risk, which diminishes the cost of foreign currency borrowing.

Antunes, A., Cavalcanti, T., Villamil, A., (2010). 'Intermediation Costs and Welfare', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 142.

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This paper studies quantitatively how intermediation costs affect household consumption loans and welfare. Agents face uninsurable idiosyncratic shocks to labour productivity in a production economy with costly financial intermediation and a natural borrowing limit. Reducing intermediation costs leads to two effects: First, for a given interest rate, borrowing costs decrease, which improves the ability of agents to smooth consumption overtime. Second, the demand for loans increases, which increases the interest rate. The aggregate welfare gain of reducing intermediation costs from 3.927 percent (US level) to 1 percent is about 1.14 percent of equivalent consumption in the baseline economy for an endogenous interest rate and and 1.90 for an exogenous interest rate. The gains are distributed unevenly: households at the bottom wealth decile improve welfare by 3.96 and 5.86 percent of equivalent consumption, while those at the top decile have a welfare gain of 0.35 and 0.2 percent, when the interest rate is determined endogenously and exogenously, respectively.

Becker, R., Osborn, D.R., Yildirim, D., (2010). 'A threshold cointegration analysis of interest rate pass-through to UK mortgage rates', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 141.

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This paper empirically analyses the interest rate transmission mechanism in the United Kingdom by exploring the pass-through of the official rate to the money market rate and of the market rate to the mortgage rate. Potential asymmetries, due to financial market conditions and monetary policy, lead to the use of a nonlinear threshold error-correction model, with hypothesis tests based on non-standard bootstrap procedures that take into account the discrete nature of changes in the official rate. The empirical results indicate the presence of substantial asymmetries in both steps of the process, with these asymmetries depending on past changes in the money market rate and whether these are motivated by official rate changes. Generalized impulse response function analysis shows that adjustments differ with regard to the sign and magnitude of interest rate changes in a way that is consistent with conditions in the interbank and mortgage markets over the recent period.

Neanidis, K.C., Ghosh, S., (2010). 'Corruption, Fiscal Policy, and Growth: A Unified Approach', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 140.

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In this paper, we study the effects of bureaucratic corruption on fiscal policy and the subsequent impact on economic growth. Here corruption takes three forms: (i) it reduces the tax revenue raised from households, (ii) it inflates the volume of government spending, and (iii) it reduces the productivity of ‘effective’ government expenditure. The analysis distinguishes between the case where fiscal choices are determined exogenously to ensure a balanced budget and the case where the government optimally sets its policy instruments. Our policy experiments reveal that for both cases, corruption affects fiscal policy and growth in similar ways, in particular, through higher income tax and inflation rates, and a lower level of government spending. The findings from our unified framework could rationalise the diverse empirical evidence on the impact of corruption on economic growth in the literature.

Neanidis, K.C.,(2010). 'Humanitarian Aid, Fertility, and Economic Growth ', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 139.

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This paper examines the effect of humanitarian aid on the rates of fertility and economic growth in recipient countries. We develop a two-period overlapping generations model where reproductive agents face a non-zero probability of death in childhood. As adults, agents allocate their time to work, leisure, and child rearing activities of surviving children. Health status in adulthood exhibits "state dependence" as it depends on health in childhood. Humanitarian aid influences the probability of survival to adulthood, health in childhood, and the time adults allocate to child rearing, giving rise to an ambiguous effect on both the rates of fertility and growth. An empirical examination for the period 1973-2007 suggests that humanitarian aid has on average a zero effect on both the fertility rate and the rate of per capita output growth. The findings are robust to a wide number of sensitivity considerations.

Blackburn, K., Bose, N., Capasso, S.,(2010). 'Tax Evasion, the Underground Economy and Financial Development ', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 138.

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We study the relationship between the underground economy and financial development in a model of tax evasion and bank intermediation. Agents with heterogenous skills seek loans in order to undertake risky investment projects. Asymmetric information between borrowers and lenders implies a menu of loan contracts that induce self-selection in a separating equilibrium. Faced with these contracts, agents choose how much of their income to declare by trading off their incentives to offer collateral against their disincentives to comply with tax obligations. The key implication of the analysis is that the marginal net benefit of income disclosure increases with the level of financial development. Thus, in accordance with empirical observation, we establish the result that the lower is the stage of such development, the higher is the incidence of tax evasion and the greater is the size of the underground economy.

Blackburn, K.,Wang, Y., (2010). 'Growth and Development Under Alternative Corruption Regimes', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 137.

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Empirical observation suggests that not all countries of the world have suffered as a result of widespread corruption. Whilst many countries have undoubtedly been damaged considerably, others appear to have coped well - in some cases, very well - with the problem. The analysis that follows seeks to provide an explanation for this puzzle. It does so by differentiating alternative types of corruption regime according to the way that corruption is practised. Specifically, we distinguish between organised and disorganised, collusive and non collusive corruption. This gives four possible scenarios, the implications of which are compared and contrasted to provide a ranking of regimes in terms of their impact on growth. We find that the least (most) damaging regime is one in which corruption is both organised and collusive (disorganised and non-collusive), as broadly characterises the situation in China and its fast-growing neighbours (many African countries).

Artis, M., Sensier, M., (2010). 'Tracking Unemployment in the North West Through Recession and Forecasting Recovery', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 136.

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This paper applies a business cycle dating algorithm to monthly North West county and local authority district claimant count data to assess turning points in the economic cycle of sub-regions. We date the transition of all districts of the North West into recession beginning in June 2007. By utilising manufacturing and service sector survey information in a logistic regression model we forecast the continuation of the recession for North West region’s employment cycle in the first quarter of 2010. A longer term forecast with the Land Registry’s house price index predicts a transition to an expansion phase in the fourth quarter of 2010.

Agénor, P-R., Neanidis, K.C., (2010). 'Innovation, Public Capital, and Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 135.

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This paper studies interactions between innovation, public capital, and human capital in an OLG model of endogenous growth. Public capital affects growth through productivity, the diffusion rate of new technologies, innovation capacity, and human capital accumulation. Panel data regressions show that higher innovation performance promotes growth directly, whereas public capital (through quantity and quality effects) has both direct and indirect effects on growth by promoting human capital accumulation and raising innovation capacity. The direct growth effect operates in a nonlinear fashion, in line with "critical mass" models of infrastructure. Elasticity estimates derived from simultaneous equation techniques show that the general equilibrium effects of public capital on steady-state output per capita (which account for indirect effects though human capital and innovation) are significantly higher than those derived from single equation methods.

Boldea, O., Hall, A., Han, S.,(2010). 'Asymptotic distribution theory for break point estimators in models estimated via 2SLS', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 134.

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In this paper, we present a limiting distribution theory for the break point estimator in a linear regression model with multiple structural breaks obtained by minimizing a Two Stage Least Squares (2SLS) objective function. Our analysis covers both the case in which the reduced form for the endogenous regressors is stable and the case in which it is unstable with multiple structural breaks. For stable reduced forms, we present a limiting distribution theory under two different scenarios: in the case where the parameter change is of fixed magnitude, it is shown that the resulting distribution depends on the distribution of the data and is not of much practical use for inference; in the case where the magnitude of the parameter change shrinks with the sample size, it is shown that the resulting distribution can be used to construct approximate large sample confidence intervals for the break points. For unstable reduced forms, we consider the case where the magnitudes of the parameter changes in both the equation of interest and the reduced forms shrink with the sample size at potentially different rates and not necessarily the same locations in the sample. The resulting limiting distribution theory can be used to construct approximate large sample confidence intervals for the break points. The finite sample performance of these intervals are analysed in a small simulation study and the intervals are illustrated via an application to the New Keynesian Phillips curve.