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The Centre for Growth and Business Cycle Research

Discussion papers 2012

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Haque, M.E., (2012). 'Unproductive Education in a Model of Corruption and Growth', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 178.

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This paper presents a dynamic general equilibrium analysis of education, public sector corruption and economic growth. In an economy with government intervention along with physical and human capital accumulation, state-appointed bureaucrats are responsible for procuring public goods, which contribute to productive efficiency. Corruption arises because of an opportunity for bureaucrats to embezzle public funds. Education has two opposing effects, a positive productivity enhancing effect and a negative corruption efficiency of bureaucrats. If the latter dominates the former, the incentive for bureaucrats to acquire education rises. The net effect may result in an insignificant (or even negative) effect of human capital on growth. Our results are straightforward. First, corruption and development are determined jointly in a relationship that is two-way causal: bureaucratic malfeasance both influences and is influenced by economic activity and human capital accumulation. Second, this two-way causality gives rise to threshold effects and multiple development regimes with very different equilibrium properties: in low stages of development there is a unique equilibrium with high corruption where higher human capital cannot get the economy out of poverty trap, in high stages of development there is a unique equilibrium with low corruption where human capital can exert its influence, and in intermediate stages of development there are both types of equilibrium. Third, transition between regimes may or may not be feasible and it is possible for a development trap to occur.

Berardi, M., Galimberti, J.K., (2012). 'On the plausibility of adaptive learning in macroeconomics: A puzzling conflict in the choice of the representative algorithm', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 177.

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The literature on bounded rationality and learning in macroeconomics has often used recursive algorithms such as least squares and stochastic gradient to depict the evolution of agents' beliefs over time. In this work, we try to assess the plausibility of such practice from an empirical perspective, by comparing forecasts obtained from these algorithms with survey data. In particular, we show that the relative performance of the two algorithms in terms of forecast errors depends on the variable being forecasted, and we argue that rational agents would therefore use different algorithms when forecasting different variables. By using survey data, then, we show that agents instead always behave as least squares learners, irrespective of the variable being forecasted. We thus conclude that such findings point to a puzzling conflict between rational and actual behaviour when it comes to expectations formation.

Antunes, A., Cavalcanti , T., Villamil , A., (2012). The Effects of Credit Subsidies on Development', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 176.

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Under credit market imperfections, the marginal productivity of capital will not necessarily be equalized, resulting in misallocation and lower output. Preferential interest rate policies are often used to remedy the problem. This paper constructs a general equilibrium model with heterogeneous agents, imperfect enforcement and costly intermediation. Occupational choice and firm size are determined endogenously by an agent's type (ability and net wealth) and credit market frictions. The credit program subsidizes the interest rate on loans and requires a fixed application cost, which might be null, in the form of bureaucracy and regulations. First, we find that the interest credit subsidy policy has no significant effect on output, but it can have negative effects on wages and government finances. The program is largely a transfer from households to a small group of entrepreneurs with minor aggregate effects. We include a transition analysis. Second, we provide quantitative estimates of the effects of reducing the frictions directly. When comparing differences in U.S. output per capita in baseline and simulations with counterfactually high frictions such as those observed in Brazil, intermediation costs and enforcement

Berardi, M., Galimberti, J.K., (2012). 'On the initialization of adaptive learning algorithms: A review of methods and a new smoothing-based routine',Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 175.

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We provide a critical review on the methods previously adopted into the literature of learning and expectations in macroeconomics in order to initialize its underlying learning algorithms either for simulation or empirical purposes. We find that none of these methods is able to pass the sieve of both criteria of coherence to the algorithm long run behavior and of feasibility within the data availability restrictions for macroeconomics. We then propose a smoothing-based initialization routine, and show through simulations that our method meets both those criteria in exchange for a higher computational cost. A simple empirical application is also presented to demonstrate the relevance of initialization for beginning-of-sample inferences.

Bolodea, O., Hall, A.R ., (2012). 'Estimation and Inference in Unstable Nonlinear Least Squares Models', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 174.  

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There is compelling evidence that many macroeconomic and financial variables are not generated by linear models. This evidence is based on testing linearity against either smooth nonlinearity or piece-wise linearity, but there is no framework that encompasses both. This paper provides an econometric framework that allows for both breaks and smooth nonlinearity in-between breaks. We estimate the unknown break-dates simultaneously with other parameters via nonlinear least-squares. Using new central limit results for nonlinear processes, we provide inference methods on break-dates and parameter estimates and several instability tests. We illustrate our methods via simulated and empirical smooth transition models with breaks.

Hall, A.R ., Osborn, D., Sakkas, N.D., (2012). 'Inference on Structural Breaks using Information Criteria', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 173.

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This paper investigates the usefulness of information criteria for inference on the number of structural breaks in a standard linear regression model. In particular, we propose a modified penalty function for such criteria based on theoretical arguments, which implies each break is equivalent to estimation of three individual regression coefficients. A Monte Carlo analysis compares information criteria to sequential testing, with the modified BIC and HQIC criteria performing well overall, for DGPs both without and with breaks. The methods are also used to examine changes in Euro area monetary policy between 1971 and 2007.

Agénor, P-R., Bratsiotis, G. J., Pfajfar, D., (2012). 'Credit Frictions, Collateral and the Cyclical Behaviour of the Finance Premium', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 172.  (Forthcoming in: Macroeconomic Dynamics).

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This paper examines the behaviour of the finance premium following technology and monetary shocks in a Dynamic Stochastic General Equilibrium (DSGE) model where borrowers use a fraction of their production (output) as collateral. We show that this simple framework is capable of producing a countercyclical finance premium, while matching the macro dynamics of well-documented stylized facts. A key feature is the endogenous derivation of the default probability from break even conditions, that results in the loan rate being set as a countercyclical finance premium over the cost of borrowing from the central bank. The latter is shown to provide an accelerator effect through which shocks can amplify the loan spread and the dynamic response of macro variables.

Kishor, N.K., Neanidis, K.C., (2012). 'What is Driving Financial Dollarization in Transition Economies? A Dynamic Factor Analysis', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 171.

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This paper investigates the usefulness of information criteria for inference on the number of structural breaks in a standard linear regression model. In particular, we propose a modified penalty function for such criteria based on theoretical arguments, which implies each break is equivalent to estimation of three individual regression coefficients. A Monte Carlo analysis compares information criteria to sequential testing, with the modified BIC and HQIC criteria performing well overall, for DGPs both without and with breaks. The methods are also used to examine changes in Euro area monetary policy between 1971 and 2007.

Berardi, M., Galimberti, J.K., (2012). 'A note on exact correspondences between adaptive learning algorithms and the Kalman filter', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 170.

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Digressing into the origins of the two main algorithms considered in the literature of adaptive learning, namely Least Squares (LS) and Stochastic Gradient (SG), we found a connection between their non-recursive forms and their interpretation within a state-space unifying framework. Based on such connection, we extend the correspondence between the LS and the Kalman filter recursions to a formulation with time-varying gains of the former, and also present a similar correspondence for the case of the SG. Our correspondences hold exactly, in a computational implementation sense, and we discuss how they relate to previous approximate correspondences found in the literature.

Agénor, P-R., (2012). 'A Computable OLG Model for Gender and Growth Policy Analysis', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 169.

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This paper develops a computable Overlapping Generations (OLG) model for gender and growth policy analysis. The model accounts for human and physical capital accumulation (both public and private), intra- and inter-generational health persistence, fertility choices, and women's time allocation between market work, child rearing, and home production. Bargaining between spouses and gender bias, in the form of discrimination in the work place and mothers' time allocation between daughters and sons, are also accounted for. The model is calibrated for a low-income country and various experiments are conducted, including improved access to infrastructure, an increase in subsidies to child care, and a reduction in gender bias. By focusing on steady-state effects, based on an explicit analytical characterization of the long-run equilibrium, the model provides a practical tool that may help to integrate more systematically interactions between structural policies, gender, and growth.

Berardi, M., (2012). 'Endogenous time-varying risk aversion and asset returns', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 168.

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Stylized facts about statistical properties for short horizon returns in financial markets have been identified in the literature, but a common cause for their manifestation has yet to be found. We show that a simple asset pricing model with representative agent and rational expectations is able to generate time series of returns that replicate such stylized facts if the risk aversion coefficient is allowed to change endogenously over time in response to unexpected excess returns. The same model, under constant risk aversion, would instead generate returns that are essentially Gaussian. We conclude that an endogenous time-varying risk aversion represents a very parsimonious way to make the model match real data on key statistical properties, and therefore deserves careful consideration from economists and practitioners alike.

Masino, S., (2012). ''Macro-institutional Instability and the Incentive to Innovate'', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 167.

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This paper investigates the channels through which macroeconomic and institutional instability prevents or hinders innovative investment undertakings financed by the domestic private sector. The analysis is based on a sample of 44 countries representing all levels of development and considers a number of instability dimensions. The results suggest a negative impact of real, monetary and political instability on the aggregate level of national R&D financed by the business sector. Thus, they highlight the desirability of stable macro-institutional environments in preventing avoidance or abandonment of private innovation undertakings.

Agénor, P-R., Alper, K., Pereira da Silva, L., (2012). 'Sudden Floods, Macroprudential Regulation and Stability in an Open Economy', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 166.

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We develop a dynamic stochastic model of a middle-income, small open economy with a two-level banking intermediation structure, a risk-sensitive regulatory capital regime, and imperfect capital mobility. Firms borrow from a domestic bank and the bank borrows on world capital markets, in both cases subject to an endogenous premium. A sudden flood in capital flows generates an expansion in credit and activity, and asset price pressures. Countercyclical regulation, in the form of a Basel III-type rule based on real credit gaps, is effective at promoting macroeconomic stability (defined in terms of the volatility of a weighted average of inflation and the output gap) and financial stability (defined in terms of the volatility of a composite index of the nominal exchange rate and house prices). However, because the gain in terms of reduced volatility may exhibit diminishing returns, a countercyclical regulatory rule may need to be supplemented by other, more targeted, macroprudential instruments.

Agénor, P-R., Yilmaz, D., (2012). 'Simple Dynamics of Public Debt with Productive Public Goods', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 165.

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This paper analyzes the dynamics of public debt in a simple two-period overlapping generations model of endogenous growth with productive public goods. Alternative fiscal rules are defined, with particular attention devoted to the golden rule. Conditions under which multiple equilibria may emerge under that rule are characterized. The analysis is then extended to consider the case of an endogenous risk premium, a generalized golden rule, and network externalities. If network effects are sufficiently strong, an increase in public investment may shift the economy from a low-growth equilibrium to a steady state characterized by both higher public debt ratios and higher output growth. This shift may enhance welfare as well. These results illustrate the importance of preserving the allocation of resources to specific types of public investment, even in a context of fiscal retrenchment.

Miller, S.M., Neanidis, K.C., (2012). 'Demographic Transition and Economic Welfare: The Role of Humanitarian Aid', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 164.

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This paper considers the effects of humanitarian aid on economic welfare through a demographic transition channel. 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. Health status in adulthood exhibits "state dependence", as it depends on health in childhood. In this framework, we examine the effects of changes in inkind and monetary humanitarian aid on economic welfare. We conclude that if parents strongly value children, giving monetary aid produces more children and yields higher welfare. This positive welfare effect dominates an indirect negative welfare effect due to a lower growth rate. But, if parents value the quality of their children (health status), they achieve greater utility by inkind aid, which also lowers fertility and augments economic growth.

Neanidis, K.C., Papadopoulou, V., (2012). 'Crime, Fertility, and Economic Growth: Theory and Evidence', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 163.

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This paper studies the link between crime and fertility and the way by which they jointly impact on economic growth. In a three-period overlapping generations model, where health status in adulthood depends on health in childhood, adult agents allocate their time to work, leisure, child rearing and criminal activities. An autonomous increase in the probability offenders face in escaping apprehension, increases both crime and fertility non-monotonically, giving rise to an ambiguous effect on growth. A cross-country empirical examination, based on data that span four decades, supports the non-linear effects on both crime and fertility. At the same time, it reveals a negative effect on output growth.

Haque, M.E., Keller, R., (2012). 'Why Public Investment fails to raise economic growth in some countries?: The role of corruption', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 162.

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In an endogenous growth model, the government officials are given the task of procuring public goods that are used as productive inputs in the production. Due to the information asymmetry between the government and the bureaucracy, the bureaucrats can falsely report of high quality-high cost procurement, while providing low quality-low cost product. This affects the productivity of the economy and hence reduces growth. Our analysis can show that corruption not only reduces the quality of public services that are necessary for production, but also inflates the public spending beyond the efficient level. In this way, we can explain why public investment fails to raise growth in the countries where corruption is endemic. We test our results empirically by improving the methodology on previous research on this topic by explicitly recognizing the role of simultaneity between public investment, corruption and growth and the possible biases arising from omission of correlated variables from the single reduced form equation based analysis. We use three-stage least squares method in a panel set up for a system of four equations on growth, public investment, corruption and private investment. Our primary results are twofold. First, corruption increases public investment. Second, corruption reduces the returns to public investment and makes it ineffective in raising economic growth.

Zilberman, R., (2012). 'Supply Shocks and the Cyclical Behaviour of Bank Lending Rates under the Basel Accords', Centre for Growth and Business Cycle Research Discussion Paper Series, University of Manchester, No. 161.

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This paper examines the cyclical effects of bank capital requirements in a simple macro model with credit market frictions. A bank capital channel is introduced through a monitoring incentive effect of bank capital buffers on the repayment probability and hence the loan rate. We also identify a collateral channel, which mitigates moral hazard behaviour by firms, and therefore raises their repayment probability. Basel I and Basel II regulatory regimes are then defined, with a distinction made between the Standardized and Foundation Internal Ratings Based (IRB) approaches of Basel II. We analyze the role of the bank capital and collateral channels in the transmission of supply shocks, and show that depending on the strength of these channels, the loan rate can either amplify or mitigate the effects of the shock. Finally, the relative impact of the two channels also determines which of the regulatory regimes is most procyclical.