Federal Reserve Bank of St. Louis working papers are preliminary materials circulated to stimulate discussion and critial comment.
Reaction functions in a small open economy: What role for non-traded inflation?
I develop a structural general equilibrium model and estimate it for New Zealand using Bayesian techniques. The estimated model considers a monetary policy regime where the central bank targets overall inflation but is also concerned about output, exchange rate movements, and interest rate smoothing. Taking the posterior mean of the estimated parameters as representing the characteristics of the New Zealand economy, I compare the consequences that two alternative reaction functions have on the central bank''s loss, for different specifications of its preferences. I obtain conditions under which the monetary authority should respond directly to non-tradable inflation instead of overall inflation. In particular, if preferences are relatively biased towards inflation stabilization, responding directly to overall inflation results in better macroeconomic outcomes. If instead the central bank places relatively more weight on output stabilization, responding directly to non-traded inflation is a better strategy.
The Trade Comovement Puzzle and the Margins of International Trade
Countries that trade more with each other tend to have more correlated business cycles. Yet, traditional international business cycle models predict a much weaker link between trade and business cycle comovement. We propose that fluctuations in the number of varieties embedded in trade flows may drive the observed comovement by increasing the correlation among trading partners’ total factor productivity (TFP). Our hypothesis is that business cycles should be more correlated between countries that trade a wider variety of goods. We find empirical support for this hypothesis. After decomposing trade into its extensive and intensive margins, we find that the extensive margin explains most of the trade–TFP and trade–output comovement. This result is striking because the extensive margin accounts for only a fourth of the variability in total trade. We then develop a two-country model with heterogeneous firms, endogenous entry, and fixed export costs, in which TFP correlation increases with trade in varieties. A numerical exercise shows that our proposed mechanism increases business cycle synchronization compared with the levels predicted by traditional models.
Innovation, Diffusion, and Trade: Theory and Measurement
I develop a multicountry-model in which economic growth is driven mainly by domestic innovation and the adoption of foreign technologies embodied in traded intermediate goods. Fitting the model to data on innovation, output per capita, and trade in varieties for the period 1996-2007, I estimate the costs of both domestic innovation and adopting foreign innovations, and then decompose the sources of economic growth around the world. I find that the adoption channel has been especially important in developing countries, and accounts for about 65% of their “embodied” growth. Developed countries grow mainly through the domestic innovation channel, which explains 85% of their “embodied” growth. A counterfactual exercise shows that if all countries reached the same research productivity, then (i) the world’s steady-state growth rate would double, and (ii) developing countries would close the gap in terms of both growth rate and income per capita.
In this paper, we establish the importance of experience in international trade in reducing unmeasured trade costs and facilitating bilateral trade. We find a strong role for experience, measured in years of positive trade, for both aggregate and sectoral bilateral trade. In an augmented gravity framework, with a very comprehensive set of fixed-effects and trend variables, we find that a 1% increase in experience at the country-pair level increases bilateral exports by 0.417% and reduces trade costs by 0.105%. Non-parametric estimates imply that nine years of experience is equivalent to a country-pair joining a preferential trading area. We utilize multiple identification strategies, including difference-in-difference and instrumental variables. We show that experience matters more for country-pairs that are distant, non-contiguous, do not share a common language, lack colonial links, and legal ties to one another. Subsequently, we construct microfounded measures of trade costs and show how these decline with the accumulation of experience. Our results are consistent with experience reducing the bilateral unmeasured variable costs of trade and spillovers in experience across firms and industries.
Education Policies and Structural Transformation
This article studies the impact of education and fertility in structural transformation and growth. In the model there are three sectors, agriculture, which uses only low-skill labor, manufacturing, that uses high-skill labor only and services, that uses both. Parents choose optimally the number of children and their skill. Educational policy has two dimensions, it may or may not allow child labor and it subsidizes education expenditures. The model is calibrated to South Korea and Brazil, and is able to reproduce some key stylized facts observed between 1960 and 2005 in these economies, such as the low (high) productivity of services in Brazil (South Korea) which is shown to be a function of human capital and very important in explaining its stagnation (growth) after 1980. We also analyze how different government policies towards education and child labor implemented in these countries affected individuals’ decisions toward education and the growth trajectory of each economy.
Interjurisdictional competition and location decisions of firms
We examine the welfare properties of alternative regimes of interjurisdictional competition for heterogenous mobile firms. Firms differ not only in terms of the degree of mobility across jurisdictions but also in terms of productivity. Alternative taxation regimes represent restraints on the discretionary powers of taxation of local governments. We find that average welfare is higher under discretionary and more efficient taxation regimes (in the sense of minimizing deadweight losses from distortionary taxation) when firms are highly mobile. In this situation, further limiting competition by imposing a system of non-discretionary instruments can reduce average welfare by reducing the efficiency of the local governments at raising and allocating public funds. When firms face high moving costs, on the other hand, switching to a non-discretionary and less efficient taxation regime may increase welfare by preventing local governments from engaging in excessive redistribution of resources.
Can risk explain the profitability of technical trading in currency markets?
Academic studies show that technical trading rules would have earned substantial excess returns over long periods in foreign exchange markets. However, the approach to risk adjustment has typically been rather cursory. We examine the ability of a wide range of models: CAPM, quadratic CAPM, downside risk CAPM, Carhart’s 4-factor model, the C-CAPM, an extended C-CAPM with durable consumption, Lustig-Verdelhan (LV) carry-trade factor model, and models including macroeconomic factors, and foreign exchange volatility, skewness and liquidity, to explain these technical trading returns. No model plausibly accounts for much of the technical profitability. This failure implicitly supports non-risk based explanations such as adaptive markets.
Sovereign Default and Maturity Choice
This study develops a novel model of endogenous sovereign debt maturity choice that rationalizes various stylized facts about debt maturity and the yield spread curve: first, sovereign debt duration and maturity generally exceed one year, and co-move positively with the business cycle. Second, sovereign yield spread curves are usually non-linear and upward-sloped, and may become non-monotonic and inverted during a period of high credit market stress, such as a default episode. Finally, output volatility, sudden stops, impatience and risk aversion are key determinants of maturity, both in our model and in the data.
Unauthorized Immigration and Fiscal Competition
Reflecting upon recent enforcement policy activism of US states and countries within the EU towards unauthorized workers, we examine the overlap of centralized (federal) and decentralized (state or regional) enforcement of immigration policies in a spatial context. Among other results, we find that if interstate mobility is costless, internal enforcement is overprovided, and border enforcement and local goods are underprovided when regions take more responsibility in deciding policies. This leads to higher levels of unauthorized immigration under decentralization. Interregional migration costs moderate such over/underprovision. Moreover, income distributive motives in the host country may shape the design of immigration policies in specific ways. The basic model is extended in several ways. First, we study how the policies change when regions can exclude unauthorized immigrants from the consuming of regionally provided goods or services. Second, we assume that the potential number of unauthorized immigrants is endogenous. And finally, we examine the effect of considering an alternative spatial configuration that includes border and “interior" regions.
Capital Goods Trade and Economic Development
We argue that international trade in capital goods has quantitatively important effects on economic development through two channels: (i) capital formation and (ii) aggregate TFP. We embed a multi country, multi sector Ricardian model of trade into a neoclassical growth model. Barriers to trade result in a misallocation of factors both within and across countries. Our model matches several trade and development facts within a unified framework. It is consistent with the world distribution of capital goods production, cross-country differences in investment rate and price of final goods, and cross-country equalization of price of capital goods. The cross-country income differences decline by more than 50 percent when trade frictions are eliminated, with 80 percent of the change in each country’s income attributable to change in capital.
Determinants of Trade Margins: Insights Using State Export Data
We adapt the heterogeneous firm trade models of Helpman, Melitz, and Rubinstein (2008) and Lawless (2010) to analyze extensive and intensive trade margins using state-level exports to foreign nations. Our theoretical analysis provides definitive predictions for the effects of changes in fixed costs, variable costs, and foreign income on the extensive margin, while for the intensive margin the predictions regarding changes in fixed costs are definitive, but the effects of changes in variable costs and foreign income are not. The number of exporting firms of a state is used to measure the extensive margin, while the intensive margin is approximated by the average firm exports of a state. Various count-data models, such as the standard negative binomial and its hurdle extension, are used to address non-trading pairs and overdispersion in the extensive trade estimations, while a Heckman correction is examined to handle sample selection issues in the intensive margin estimations. As the theory predicts, we find more consistent and statistically significant effects of changes in cost-related variables on the extensive than on the intensive margin of trade. Unlike Lawless (2010), but consistent with a truncated Pareto distribution, empirical findings suggest that variable costs reduce average exports. A noteworthy finding is that U.S. foreign direct investment has a positive effect on both margins.
Risk Aversion at the Country Level
In this paper the authors estimate the coefficient of relative risk aversion for 75 countries using data on self-reports of personal well-being from the Gallup World Poll. Their analysis suggests that the coefficient of relative risk aversion varies closely around one, which corresponds to a logarithmic utility function. The authors conclude that their results support the use of the log utility function in numerical simulations.
Price Equalization, Trade Flows, and Barriers to Trade
In this paper we show that price equalization does not imply zero barriers to trade. There are many barrier combinations that deliver price equalization, but each combination implies a different volume of trade. We demonstrate this first theoretically in a simple two-country model and then quantitatively for the case of capital goods trade in a multi-country model. To be quantitatively consistent with the observed capital goods trade flows across countries, our model implies that trade barriers must be large, yet our model delivers capital goods prices that are similar across countries. The absence of barriers to trade in capital goods delivers price equalization in capital goods but cannot reproduce the observed trade flows.
Financing Growth through Foreign Aid and Private Foreign Loans: Nonlinearities and Complementarities
Compared to foreign grants, do concessional loans from foreign governments and/or unsubsidized loans from foreign private banks lead to faster growth in developing nations? The answer has implications for aid agencies (i) in allocating a given amount of resources between grants and concessional loans; and (ii) in encouraging financial market reforms. We examine the effects of ODA grants, concessional ODA loans, and private offshore bank loans on growth rates of 131 developing nations over 1996-2010 in a unified way. We find evidence of non-linearities in all three relationships, suggesting that at low (high) levels grants are better (worse) than loans (concessional or private).
The Quantitative Importance of Openness in Development
This paper deals with a classic development question: how can the process of economic development – transition from stagnation in a traditional technology to industrialization and prosperity with a modern technology – be accelerated? Lewis (1954) and Rostow (1956) argue that the pace of industrialization is limited by the rate of capital formation which in turn is limited by the savings rate of workers close to subsistence. We argue that access to capital goods in the world market can be quantitatively important in speeding up the transition. We develop a parsimonious open-economy model where traditional and modern technologies coexist (a dual economy in the sense of Lewis (1954)). We show that a decline in the world price of capital goods in an open economy increases the rate of capital formation and speeds up the pace of industrialization relative to a closed economy that lacks access to cheaper capital goods. In the long run, the investment rate in the open economy is twice as high as in the closed economy and the per capita income is 23 percent higher.
Which Continuous-time Model Is Most Appropriate For Exchange Rates?
This paper evaluates the most appropriate ways to model diffusion and jump features of high-frequency exchange rates in the presence of intraday periodicity in volatility. We show that periodic volatility distorts the size and power of conventional tests of Brownian motion, jumps and (in)finite activity. We propose a correction for periodicity that restores the properties of the test statistics. Empirically, the most plausible model for 1-minute exchange rate data features Brownian motion and both finite activity and infinite activity jumps. Test rejection rates vary over time, however, indicating time variation in the data generating process. We discuss the implications of results for market microstructure and currency option pricing.
This paper examines the relationship between trade and investment in technology adoption when firms face demand uncertainty. Our model predicts that, for a given overall market size, exporting to several countries reduces firms' demand uncertainty and, hence, raises incentives to invest in productivity improvements. The effects of diversification are heterogeneous across firms: An additional foreign market matters more for firms exporting to fewer destinations. We test the proposed theory using a large sample of Argentinean manufacturing exporters. The predictions of the model find strong support in the data.
Regionalization vs. Globalization
Both global and regional economic linkages have strengthened substantially over the past quarter century. We employ a dynamic factor model to analyze the implications of these linkages for the evolution of global and regional business cycles. Our model allows us to assess the roles played by the global, regional, and country-specific factors in explaining business cycles in a large sample of countries and regions over the period 1960–2010. We find that, since the mid-1980s, the importance of regional factors has increased markedly in explaining business cycles especially in regions that experienced a sharp growth in intra-regional trade and financial flows. By contrast, the relative importance of the global factor has declined over the same period. In short, the recent era of globalization has witnessed the emergence of regional business cycles.
Lobbying for a Common External Tariff from inside and out
We consider the interactions between domestic lobbying and cross-border lobbying in a Customs Union (CU) in determining the Common External Tariff (CET). There are two types of cross-border lobbying: (i) lobbying from member-nation firms to the governments of other CU countries, and (ii) lobbying by firms from outside to the CU nation governments. Within this context, we analyze the effect of regulations on foreign lobbying on the equilibrium lobbying levels, and on the CET. If lobbying levels are strategic complements, tightening of restrictions on lobbying from outside the CU unambiguously reduces all types of lobbying. If non-CU firms are relatively large, the CET will rise in response to tighter regulations.
Foreign Firms and the Diffusion of Knowledge
This paper constructs a model to examine the impact of foreign firms on a developing Country’s own accumulation of entrepreneurial knowledge. In the model, entrepreneurial skills are built up on the basis of productive ideas that diffuse internally (at the inside of firms) and externally (spillovers.) Openness to foreign firms enhances the aggregate exposure to ideas but also reduces the returns to investing in entrepreneurial skills. When externalities are present, openness can be welfare reducing. However, regardless of the relative importance of externalities, simple quantitative exercises suggest that the gains of openness are positive and can be large.
What Do We Know about the Relationship between Access to Finance and International Trade?
The recent financial crisis has focused attention on the relationship between access to finance and international trade, triggering a burgeoning segment of the literature evaluating this link empirically. We review the role of finance in international trade and the main theories connecting them. Moreover, we provide a structured road map to recent empirical studies while summarizing what we have learned to date about this relationship. We separately analyze studies that rely on aggregate, industry-level, and firm-level data, emphasizing the differences between those that analyze ordinary times and those that focus on banking and financial crises. We discuss the role of diverse measures of access to finance, financial health, and financial vulnerability along with the key challenges in estimating the relationship between trade and finance. We conclude that once the heterogeneity of methodologies and measures of access to and dependence on finance is accounted for, the empirical literature suggests an important role for finance in determining export participation at the extensive margin but weaker results for the intensive margin of trade. Moreover, while empirical studies tend to favor a causal relationship moving from finance to trade, there is some evidence suggesting causality moving in the opposite direction, which merits further investigation.
International Trade, Female Labor, and Entrepreneurship in MENA Countries
Middle Eastern and North African (MENA) countries stand out in international comparisons of de jure obstacles to female employment and entrepreneurship. These obstacles manifest themselves in low rates of female labor participation, entrepreneurship, and ownership. Recent research suggests a connection between international trade and female labor participation. In this article, the authors focus on the relationship between international trade and gender in the MENA countries. They first analyze female labor as a production factor and then focus on female entrepreneurship and firm ownership. The authors use country- and industry-level data to identify countries and industries characterized by a comparative advantage in female labor. They find evidence suggesting a strong link between a country’s specialization and its measures of female labor participation consistent with theories of brain-based technological bias and factor endowments trade theories. Using firm-level data, the authors then study whether trade empowers female entrepreneurs in country/industry pairs that exhibit comparative advantage. They conclude that the evidence supports the view that exposure to trade disproportionately affects firms in country/industry pairs with a comparative advantage in female labor—both in terms of female employment and female entrepreneurship and ownership—for the MENA countries and the period they study.
On the substitutability between foreign aid and international credit
We examine the effect of relaxing a binding borrowing constraint for a recipient country on theamount of foreign aid it receives. We do so by developing a two-country, two-period trade-theoretic model. The relaxation of the borrowing constraint reduces the flow of foreign aid, suggesting that the donor views developing nations\' access to international credit markets as a substitute for foreign aid.
International Channels of the Fed’s Unconventional Monetary Policy,
Previous research has established that the Federal Reserve’s large scale asset purchases (LSAPs) significantly influenced international bond yields. We use dynamic term structure models to uncover to what extent signaling and portfolio balance channels caused these declines. For the U.S. and Canada, the evidence supports the view that LSAPs had substantial signaling effects. For Australian and German yields, signaling effects were present but likely more moderate, and portfolio balance effects appear to have played a relatively larger role than in the U.S. and Canada. Portfolio balance effects were small for Japanese yields and signaling effects basically nonexistent. These findings about LSAP channels are consistent with predictions based on interest rate dynamics during normal times: Signaling effects tend to be large for countries with strong yield responses to conventional U.S. monetary policy surprises, and portfolio balance effects are consistent with the degree of substitutability across international bonds, as measured by the covariance between foreign and U.S. bond returns.
Price Equalization Does Not Imply Free Trade
In this paper we show that price equalization alone is not sufficient to establish that there are no barriers to international trade. There are many barrier combinations that deliver price equalization, but each combination implies a different volume of trade. Therefore, in order to make statements about trade barriers it is necessary to know the trade flows. We demonstrate this first theoretically in a simple two-country model. We then extend the result quantitatively to a multi-country model with two sectors. We show that for the case of capital goods trade, barriers have to be large in order to be consistent with the observed trade flows. Our model also implies that capital goods prices look similar across countries, an implication that is consistent with data. Zero barriers to trade in capital goods will deliver price equalization in capital goods, but cannot reproduce the observed trade flows in our model.
The Risk Premium and Long-run Global Imbalances
This study proposes that heterogeneous household portfolio choices within a country and across countries offer an explanation for global imbalances. We construct a stochastic growth multicountry model in which heterogeneous agents face the following restrictions on asset trade. First, the degree of US equity market participation is higher than that of the rest of the world. Second, a fraction of households in each country maintains a fixed share of equity in its portfolios. In our calibrated model, which matches the US net foreign asset position and the equity premium, the average US household loads up more aggregate risk than the average foreign household by investing in risky assets abroad and issuing risk-free assets. As a result, the US is compensated by a high risk premium and runs trade deficits even as a debtor country. The long-run average trade deficit in our model accounts for 50% of the observed US trade deficit.
Foreign Aid, Illegal Immigration, and Host Country Welfare
This paper analyzes the effect of foreign aid on illegal immigration and host country welfare using a general equilibrium model. We show that foreign aid may worsen the recipient nation’s terms of trade. Furthermore, it may also raise illegal immigration, if the terms of trade effect on immigration flows dominates the other effects identified in our analysis. Empirical analysis of the effect of foreign aid on illegal immigration to the United States broadly supports the predictions of our theoretical model. Foreign aid worsens the recipient’s terms of trade. While the terms of trade effect tends to reduce illegal immigration, countervailing effects are found to dominate. The paper contributes to the related literature by establishing that there are unintended consequences of foreign aid, and, while some of them are reminiscent of the classical transfer problem, others are new and arise due to endogenous illegal immigration flows.
Extensive and Intensive Trade Margins: A State-by-State View
This paper examines a topic of increasing interest, the potential determinants of extensive (i.e., number of firms) and intensive (i.e., average exports per firm) trade margins, using state-level trade to 190 countries. In addition to distance and country size, other factors affecting trade costs and export demand are explored. In state-by-state regressions, these other factors exhibit more consistent and statistically significant effects on the extensive than on the intensive trade margin. One noteworthy finding is that U.S. foreign direct investment has a positive effect on both margins. In regressions using all state-level data simultaneously, some factors affect both margins, but not necessarily in the same way. For example, the impact of the communications infrastructure in the importing country affects the extensive margin positively and the intensive margin negatively. Finally, reasons for differences across states, such as state size and trade missions, are identified.
What do happiness and health satisfaction data tell us about relative risk aversion?
In this paper we provide estimates of the coefficient of relative risk aversion using information on self-reports of subjective personal well-being from multiple datasets, including three cross-sectional surveys and two panel surveys, namely the Gallup World Poll, the European Social Survey, the World Values Survey, the British Household Panel Survey for the United Kingdom, and the General Social Survey for the United States. We additionally consider the implications of allowing for health-state dependence in the utility function on the estimates of risk aversion and examine how the marginal utility of income changes in poor health states. Our estimates of relative risk aversion with cross-section data vary closely around 1, which corresponds to logarithmic utility, while the estimates with panel data are slightly larger. We find that controlling for health dependence generally reduces these estimates. In contrast with other studies in the literature, our results also suggest that the marginal utility of income increases when satisfaction with health deteriorates, and this effect is robust across the various datasets analyzed.
The (Non-)Resiliency of Foreign Direct Investment in the United States
We study the contraction of foreign direct investment (FDI) flows in the United States during the recent financial crisis and show their unusual non-resiliency, which depends in part on the global nature of the economic recession, but also on the increases in the cost of financing FDI in the economies in which the flows originate. To formally study the effects of external financial conditions on FDI in the United States, we exploit the three dimensions of a panel of U.S. inward FDI flows organized by recipient U.S. industries, source countries, and years for the recorded flows. Changes in the cost of finance in the source countries have little or no effect on total inward flows (the sum of equity, debt, and reinvested earnings) over the 2006-2010 period. However, U.S. industries characterized by more financial vulnerability experience statistically significant variations in the debt and equity components of inward FDI flows in response to the changes in the cost of capital that occurred in the source countries during the crisis.
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