Discussion Papers

Real Exchange Rate Dynamics: The Role of Elastic Labor Supply

A.K.M. Mahbub Morshed et al. — Thu, 24 Feb 2011 13:39:21 PST

Empirical evidence suggests that the flexibility of labor supply is closely related to the dynamic adjustment of the real exchange rate. This paper investigates this relationship in a two-sector dependent economy model. While, the long-run equilibrium real exchange rate is independent of the elasticity of labor supply, our analysis confirms that the nature of the labor supply can be a crucially important determinant of its short-run dynamics. The extent to which this is so depends to some degree on the source of the underlying structural change that is driving the dynamics of the real exchange rate. Numerical simulations confirm that this mechanism may help explain the larger shortrun volatility and more rapid convergence typically associated with developing countries having less flexible labor markets.

Managing Innovation in Vertical Relationships

Chifeng Dai et al. — Thu, 24 Feb 2011 13:39:20 PST

We study the structure of an optimal management for innovative activities. The top management of a buyer hires a supplier for production. The production efficiency can be enhanced by investing in R&D before production. The buyer chooses between using its own subunit for the R&D, or outsourcing the task to the supplier (integration of R&D and production). Our analysis reveals that (i ) when the R&D cost is small, the buyer prefers in- house R&D, (ii ) when the R&D cost is intermediate, the buyer prefers outsourcing R&D, and (iii ) when the R&D cost is large, the buyer prefers in-house or outsourcing R&D, depending on the parameter. Within the regime in which R&D outsourcing prevails, the optimal production levels may have "partial bunching" for successful yet less favorable R&D results, depending on the R&D cost. Thus, motivating R&D may require that less favorable R&D results be overly and equally appreciated, unless the R&D is a failure.

Economic integration in Latin America

Hem C. Basnet et al. — Thu, 24 Feb 2011 13:39:19 PST

This study investigates the feasibility of economic integration in Latin America by considering the seven largest economies in the region i.e. Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. We hypothesize that if the seven largest economies in the region are integrated then the smaller economies will follow the suit. Towards this goal we analyze the long-term and short-term relationship among key macro variables—real GDP, intra-regional trade, private investment and consumption in these seven countries. We observe that all variables in these countries are driven by more than one common trends and these variables also share common cycles. The common trend-common cycle decomposition of real GDP, private investment and consumption reveal that the economic fluctuations in these countries follow a similar pattern in terms of duration, intensity and timing both in the long and the short run. Since these countries demonstrate a high degree of co-movement among key macro variables these seven largest countries in Latin America can lead the path of integration process in the region and reap the benefits of economic integration.

Do Good Institutions Lower the Benefit of Democratization?

Andreas Assiotis et al. — Thu, 24 Feb 2011 13:39:18 PST

Recent studies have reported positive associations between democratization and economic growth. They have also explored how these associations could differ across regions. However, might the effects of democratization upon growth also depend upon other factors such as institutions promoting law and order (or the lack thereof)? Using a panel specification, we employ a democratization-law and order interactive term to examine if the effects of democratization upon economic growth depend upon these other institutions. We find that the coefficient on the interaction term is negative. The positive effects of democratization diminish in countries where other institutions are strong. In fact, we find that democratization could even lower growth where the rule of law already prevails.

Do the Effects of Corruption upon Growth Differ across Political Regimes?

Andreas Assiotis et al. — Thu, 24 Feb 2011 13:39:16 PST

Many studies find that corruption lowers economic growth. However, most of these studies do not consider whether the effects of corruption upon growth differ across countries. This paper investigates whether the association between corruption and economic growth differs between democracies and authoritarian regimes. Consider illegal corruption and legal lobbying, both forms of rent seeking, as imperfect substitutes. Suppose lobbying is easier to do in democracies. Then, lowering corruption in authoritarian regimes could have greater growth benefits because of the lower substitutability between corruption and lobbying in these countries. Using cross-country, annual data from 1984 to 2007, we regress economic growth on: the inverse of the level of corruption, the degree of democracy, and an interaction term combining the two. We find that coefficients are positive on the first two variables. However, the coefficient on the interactive term is negative, suggesting that the benefits upon growth of controlling corruption are actually greater in authoritarian regimes.

Piecemeal Reform of Domestic Indirect Taxes toward Uniformity in the Presence of Pollution: with and without a Revenue Constraint

Michael S. Michael et al. — Thu, 24 Feb 2011 13:39:15 PST

The literature on indirect tax reforms in pollution-ridden economies is quite limited. This paper, using a general model of a perfectly-competitive small open economy with both production and consumption generated pollution, considers the welfare implications of tax reforms that take the structure of consumption and production taxes toward uniformity. Specifically, both in the presence and absence of a binding government revenue constraint, we derive sufficient conditions for welfare improvement in the case where we implement (i) reforms in either production or consumption taxes, and (ii) reforms in both consumption and production taxes.

Loan Portfolio and Performance of Bank Holding Companies in the US: 2006-2008

Mahelet Fikru — Mon, 21 Jun 2010 12:25:31 PDT

The paper examines loan portfolio of bank holding companies in the US during the years 2006-2008 to identify any significant differences in bank lending before and during the financial crisis. The results of the study suggest that for the largest banks there was no significant change in loan portfolio throughout 2006-8. However, for small banks, the share of real estate loans slightly increased in 2008 where as the share of consumer loans declined suggesting some possible substitution of consumer loans by real estate loans. The study also examines the relationship between loan types and overall performance of bank holding companies in order to identify any significant difference in the effect of loan on bank profitability between the years 2006, 2007 and 2008. The empirical evidence suggests that higher aggregate loans were consistently associated with lower bank performance throughout 2006-08 where as evidence for the varying effect of loan portfolio on performance throughout 2006-08 is limited.

Picking a Present Value Estimate of Future Earnings: The Role of Simulation

Scott Gilbert — Mon, 21 Jun 2010 12:25:30 PDT

In a classic paper, Dulaney (1987) proposes a historical simulation- based method for evaluating measures of the present value of future earnings. This method compares a given ex ante estimate of present value with an ex post simulated value, in each time period. A key issue is the interpretation of what it means to have a good fit, when matching historical simulated present values. With best fit defined in standard statistical terms, I find that the total offset approach - whereby projected growth in wages is assumed equal to the projected interest rate - works best in the examples considered here and in Dulaney (1987). This finding violates convention as most forensic economists implicitly allow a gap between projected wage growth and the interest rate, when estimating present value. It does, however, jibe with the absence of a statistically significant long-run gap between U.S. annual wage growth and the interest rate.

Tax Competition with Asymmetric Market Structures: The Role of Policy Instruments

Qian Hao et al. — Mon, 21 Jun 2010 12:25:29 PDT

IWe analyze the location choice of a multinational corporation (MNC) between two host countries with dierent market structures, i.e., the number of competing domestic rms in them. We consider the eects of import tari and lump-sum subsidy instruments on the MNC's choice. Our ndings include: (i) when the domestic rms export, with lump-sum subsidy, the country with fewer rms always gets the MNC. In contrast, with taris, the country with more rms gets the MNC if they are suffciently ineffcient, (ii) when the domestic rms do not export, the country with more domestic rms may get the MNC when the domestic rms are suffciently ineffcient with either of the two instruments, and (iii) with either instrument, the MNC location decision may crucially depend on which instrument is used to attract the MNC.

Cross-Border Lobbying in Preferential Trading Agreements: Implications for External Taris

Subhayu Bandyopadhyay et al. — Mon, 21 Jun 2010 12:25:29 PDT

This paper examines the eect of cross-border lobbying on domestic lobbying and on external taris in both Customs Union (CU) and Free Trade Area (FTA). We do so by developing a two-stage game which endogenizes the tari formation function in a political economic model of the directly unproductive rent-seeking activities type. We nd that cross-border lobbying unambiguously increases both domestic lobbying and the equilibrium common external taris in a CU. The same result also holds for FTA provided taris for the member governments are strategic complements. We also develop a specic oligopolistic model of FTA and show that taris are indeed strategic complements in such a model.

Optimal Contracting with Unknown Risk Preference

Chifeng Dai — Mon, 21 Jun 2010 12:25:28 PDT

In environments of uncertainty risk sharing is often an important element of economic contracts. We consider a setting where a buyer and a risk-averse supplier contract for the production of some good under cost uncertainty. At the time of contracting, both parties have incomplete information on cost of production. However, after contracting and before production, the supplier can privately discover the realization of cost. We study the supply contract that optimally balances risk sharing and information revelation when the supplier is privately informed of its risk preference. We find that all types of supplier could produce either below or above the efficient supply schedule depending on the buyer’s risk preference. Moreover, "inflexible rules" rather than "discretion" arise for some range of cost realizations as a solution to the conflict between risk sharing and information revelation.

Blood Diamond: International Policy Options for Conflict Resolution

Sajal Lahiri — Mon, 21 Jun 2010 12:24:06 PDT

We construct a trade-theoretic model of two open economies which are in conflict with each other. War efforts - which involve the use of soldiers and military hardware - are determined endogenously. The purpose of war is the capture of land containing a natural resource like diamond, but the costs are that lives are lost and production sacrificed. The capture of mining land helps to reinforce the war by using profits from the sale of the natural resource to purchase arms. We examine the effect of a number of policy instruments available to the international community (such as foreign aid, a tax on arms exports and on the export of the natural resource from the war areas) on war efforts. We identify the role of the 'protective' nature of arms, and of income effects of the policy instruments, on the results.

Will Trade Sanctions Reduce Child Labour? The Role of Credit Markets: an Empirical Test

Malokele Nanivazo — Mon, 21 Jun 2010 12:24:06 PDT

In this study we investigate the relationship between trade sanctions and child labor based on a theoretical model created by Jafarey and Lahiri (2002). In their study, Jafarey and Lahiri (henceforth JL) created a two goods and two periods model in which they examined the relationship between trade sanctions and child labor in the context of three scenarios, namely whether parents had access to an international credit market, or to a domestic credit market, or have borrowing constraints. This study investigates the first two scenarios. Using panel data of 141 countries over a period of 40 years, my results seem to confirm results found in JL. Nevertheless, my data suffers of an endogeneity problem which I overcame by using the method of two stages least squares estimation. Moreover, the two stages least squares method of estimation enabled me to look at both the direct and indirect effects of the relationship between trade sanctions and child labor.

Public Support for Private Efforts at Assimilation by Immigrants: the Role of Credit Constraints

Sajal Lahiri — Mon, 21 Jun 2010 12:24:05 PDT

We examine the effect of borrowing constraint facing new immigrants on the process of their assimilation in the new society. We shall do so in a two-period model. In period one, immigrants invest, with some costs to them, in trying to assimilate. The probability of success in this endeavor depends on the amount invested and also on the level of the provision of a 'public' good paid for by lump-sum taxation of 'natives'. Those who succeed enjoy a higher level of productivity and therefore wages in period 2. The level of investment is endogenously determined. Assimilation also affect remittances by immigrants. Given this framework, we examine the effect of public support on the degree of assimilation and income repatriation. We do so under two scenarios regarding the credit market facing new immigrants. In the first, they can borrow as much as they want in period 1 at an exogenously given interest rate. In the second scenarios, there is a binding borrowing constraint. We compare the equilibrium under the two scenarios.

Undervaluation, Institutions, and Development

Guangjun Qu et al. — Mon, 21 Jun 2010 12:24:04 PDT

Rodrik (2008) claims that weak institutions hurt the development of the tradable sector more than that of the nontradable sector and that undervaluation can foster growth by diminishing the distortion created by weak institutions between the two sectors. Using the International Country Risk Guide (ICRG) dataset on four components of institutional quality, we consider the effects of investment profile, law and order, corruption, and bureaucratic quality upon the relative development of the tradable sector to the nontradable sector, which is measured by the ratio of industry value added to services valued added. On the basis of comparison of the two sectors, the panel evidence of 131 countries indicates that none of the four components mentioned above is positively associated with the relative development of the tradable sector to the nontradable sector. That is, the tradable sector does not suffer disproportionately (compared to the nontradable sector) from institutional weaknesses. Our results cast skepticism upon one of Rodrik’s explanations on the growth-promoting effects of real undervaluation because the existence of such a distortion is not supported empirically.

Does Wealth Imply Secularization and Longevity?

Zsolt Becsi — Thu, 09 Jul 2009 09:36:56 PDT

We develop a simple life cycle model with endogenous longevity where religious firms influence religious beliefs using donations as an input. The model suggests that either wealth and economic development or competition by religious firms can explain cross-country variation in religious beliefs, but to explain cross-country variation in religious beliefs, longevity, and consumption both development and competition are required. Our results depend on the wealth and substitution effects that accompany economic development and religious market competition.

International Joint Venture under Asymmetric Information: Technology vis-à-vis Information Advantage

Chifeng Dai et al. — Thu, 09 Jul 2009 09:34:21 PDT

We study the relationship between a multinational corporation (MNC) and a domestic firm under demand uncertainty. The MNC possesses a superior production technology, but the domestic firm is better at predicting market demand. We examine how the MNC’s preference for, and the ownership structure of, a joint venture depend on the credit market, demand uncertainty, the domestic firm’s ability to gather demand information, the MNC’s technology advantage, and the efficiency of technology transfer. We also consider a dynamic setting with technology spillover and show that whether technology spillover hinders or facilitates joint venture depends on the nature of the credit market.

Violence and Capital

Zsolt Becsi — Thu, 09 Jul 2009 09:34:21 PDT

We introduce a survival contest with lethal violence into a simple overlapping generations model with production and characterize how such violence interacts with capital along the equilibrium path. We find that shocks to economic fundamentals can have a variety of effects on the steady state levels of capital and violence, thus, explaining observed variation in development-violence outcomes. We also show that violence and capital are always negatively related along the adjustment path to steady state.

Foreign Aid as Prize: Incentives for a Pro-Poor Policy

Tejashree Sayanak et al. — Thu, 09 Jul 2009 09:34:20 PDT

We develop a theoretical model of foreign aid to analyze a method of disbursement of aid which induces the recipient government to follow a more pro-poor policy than it otherwise would do. In our two-period model, aid is given in the second period and the volume of it depends on the level of wellbeing of the target group in the first period. We find that this way of designing aid does increase the welfare of the poor. We also consider the situations where the donor and the recipient governments act simultaneously as well as sequentially, and find that by moving first in a sequential game, the donor country can, under certain conditions, increase the welfare of the poor and its own compared to the case of simultaneous moves.

Profit Share and Partner Choice in International Joint Ventures

Litao Zhong et al. — Thu, 09 Jul 2009 09:34:19 PDT

This paper suggests a new approach to the determination of profit allocation between the partners in joint ventures. We also examine the issue of partnership choice. The foreign firm would be willing to give more than half of profits to its partner, and it would like to choose the more efficient firm. However, the host government, under certain situation, may persuade the foreign firm, by a suitable lump-sum transfer, to form partnership with the less efficient firm.