Decomposing the Gains from Trade through the Standard Gravity Variables

Follow @yilmazkuday

 

Decomposing the Gains from Trade through the Standard Gravity Variables

One sentence summary: After controlling for proximity, FTAs contribute the most to the welfare gains from trade among other gravity variables following the Uruguay Round.

The corresponding paper by Hakan Yilmazkuday has been accepted for publication at International Economic Journal. Free access to first 50 copies is available here.

 

The corresponding working paper is available here.

 
Abstract
Using the implications of a trade model, this paper measures the gains from trade through the standard gravity variables. Theoretically, it is shown that such gains can be calculated by using the estimated coefficients of these variables in a gravity regression, together with the bilateral expenditure shares of countries investigated. Empirically, the results show that the total actual gains through all gravity variables in the world have increased from about 1% in 1950s to about 5% as of 2015 that can be decomposed as 3.5% through proximity and 1.5% through other gravity variables. Gains through free trade agreements (FTAs) have started dominating among these other variables starting from 1990s, following the Uruguay Round. Across countries, the total gains of OECD countries are about 1.5 times those of others, whereas the total gains of European countries are more than 10 times those of Pacific countries. Calculations based on the future potential gains from trade through policy-oriented gravity variables further suggest that there is room for an additional 0.8% or 0.4% of a welfare gain in the world through having free trade agreements or using common currencies, respectively.

Non-technical Summary
The gains from international trade has been investigated for decades. It has been shown in the literature that these gains can be measured by percentage changes in trade costs and the terms-of-trade, which can be summarized by using home expenditure shares of countries and the trade elasticity. Nevertheless, when welfare changes at the world level are considered, the terms-of-trade effects across countries effectively cancel out so that the welfare gains from trade calculations reduce to the knowledge of reductions in effective trade costs.

Based on this background, this paper proposes calculating the welfare gains from trade through reductions in effective trade costs measured by the standard gravity variables. Among these, gravity dummy variables such as proximity, common language or contiguity are mostly fixed as they represent either the geographical location or the historical characteristics of countries, whereas policy-oriented variables such as free trade agreements (FTAs) or common currencies are subject to changes over time through trade policies. Therefore, for policy evaluation, it is important to investigate the contribution of each gravity variable to the reduction in trade costs and thus to the welfare gains from trade.

This paper achieves such an investigation by decomposing the welfare gains from trade into those through each standard gravity variable. In particular, the following questions are asked:

• What are the gains from proximity?
• What are the gains from trading with countries through a free trade agreement?
• What are the gains from trading with countries using the same currency?
• What are the gains from trading with contiguous countries?
• What are the gains from trading with countries with a colonial relationship?
• What are the gains from trading with countries that speak the same language?

These questions are answered by using the implications of a trade model, where the actual welfare gains are calculated by comparing the current situation of countries with a hypothetical case in which none of the countries benefit from these gravity variables. Accordingly, welfare gains from trade through each gravity variable is theoretically shown to depend on the estimated coefficients of these variables in a typical gravity regression, together with the bilateral import shares, subject to the knowledge of the trade elasticity. The implications of the trade model is estimated by using a typical gravity regression to obtain the corresponding coefficients of the gravity (dummy) variables, and they are normalized by the trade elasticity, which is shown to be nothing more than a scale factor in this investigation while having a comparison across countries and across time. These coefficients are further combined with the bilateral imports data and the current value of gravity variables to obtain the actual welfare gains from trade through each gravity variable.

A similar strategy is used to investigate the potential gains from trade through the policy-oriented gravity variables. In particular, the following additional questions are asked:

• What are the potential gains from trading with countries through an FTA?
• What are the potential gains from trading with countries using the same currency?

These additional questions are again answered by using the implications of the trade model, where, this time, the potential welfare gains are calculated by comparing the current situation of countries with a hypothetical case in which they have FTAs or common currencies with all of their trade partners. This is achieved by combining the estimated coefficients of the gravity (dummy) variables (subject to their normalization by the trade elasticity) with the bilateral imports data and one minus the current value of gravity (dummy) variables (of FTAs or common currencies).

The empirical results based on a gravity regression covering the period 1948-2015 suggest that the actual gains from trade in the world through all gravity variables have increased over time from about 1% in 1950s to about 5% by the year of 2015. The latter (for 2015) ranges between 6% and 4% for OECD and non-OECD countries, 17% and 5% for landlocked and coastal countries, 11% and 1% for European and Pacific countries, and 3% and 8% for the United States and Germany, respectively.

When the actual gains are decomposed into their components, the total gains from proximity in the world have increased over time from about 1% in 1950s to about 4% by the year of 2015, whereas the total gains from other gravity variables have increased to about 2% during the same period. The latter (for 2015) ranges between 2% and 1% for OECD and non-OECD countries, 5% and 1% for landlocked and coastal countries, and 4% and 1% for South Asian and South American countries, respectively.

Among the gains through gravity variables other than proximity, the contribution of FTAs has started in late 1950s in the world, and they have dominated among these other variables starting from 1990s, following the Uruguay Round. The same domination has been experienced by OECD countries starting from late 1980s, whereas non-OECD countries, Japan or China had to wait until 2000s. In comparison, despite the increasing contribution of FTAs 2000s, the United States or India have not experienced such domination as of 2015, suggesting that there is potential room for further gains from trade through these policy-oriented variables.

Based on this suggestion, this paper has further calculated the potential gains from trade due to policy-oriented gravity variables that are calculated by comparing the current situation of countries with a hypothetical case in which countries have FTAs or common currencies with all of their trade partners. The corresponding results have shown that the world economy can gain about 0.8% more through FTAs and 0.4% more through common currencies as of 2015. The potential gains from FTAs are about 0.6% for Germany, and 0.9% for China and Japan, reflecting the fact that Germany is already gaining more from trade through FTAs compared to these countries. The potential gains from trade through using common currencies are the highest for Southeast Asian or landlocked countries, suggesting that they can compensate for certain geographical and historical restrictions through using common currencies with their trade partners.

Overall, the actual gains from trade through the standard gravity variables in the world are about 5%, whereas the potential gains from trade through the policy-oriented gravity variables are about 1%, suggesting that future FTAs and currency unions could easily boost the world welfare through the gains from trade. This investigation in this paper can easily be expanded by focusing on alternative gravity variables or the sectoral heterogeneity in estimated coefficients of gravity variables, which we leave for future research.

The corresponding paper by Hakan Yilmazkuday has been accepted for publication at International Economic Journal.

 

The corresponding working paper is available here.

Government Consumption, Government Debt and Economic Growth

Follow @yilmazkuday

 

Government Consumption, Government Debt and Economic Growth

One sentence summary: The negative effects of government consumption on growth are relatively higher than those of government debt.


The corresponding paper by Shahrzad Ghourchian and Hakan Yilmazkuday has been accepted for publication at Review of Development Economics.

The working paper version is available here.

 
Abstract
This paper compares the effects of government consumption and government debt on economic growth by using data from 83 countries, including both developed and developing markets, over the period between 1960 and 2014. Linear regressions reveal that the negative effects of government consumption are relatively higher than the negative effects of government debt. A nonlinear investigation further suggests that the restrictions on government expenditure to prevent negative growth are shown to be more important for countries with lower trade openness, lower inflation, or higher financial depth, whereas the restrictions on government debt are shown to be more important for countries with higher trade openness, lower inflation or higher financial depth.

Non-technical Summary
The Great Recession of 2007-2009 has resulted in many governments bailing out their financial institutions and even providing finance for the real sector using government resources. Combined with the necessity of an expansionary fiscal policy due to the restricted monetary policy at the zero lower bound, many governments around the world started having problems regarding their budgets, and they eventually employed austerity measures, potentially at the cost of their economic growth. Influential studies have ignited the debate based on such budget problems and their impact on growth from a policy perspective by showing a negative correlation between government debt and growth for countries with debt above 90% (of GDP) for the post--World War II era.

Within this picture, though, the effects of government consumption/expenditure on growth have not been investigated and compared enough with those of government debt. While the latter may be effective on growth through the reductions in public saving, the former may affect growth through factor accumulation or influences on technical progress such as public research and development, the reductions in company profits and private investment, or organized interest groups attempting to gain benefits for themselves in the form of legislation or transfers. Such a comparison between government consumption and government debt is also important from the policy perspective; e.g., according to, Carlo Cottarelli, former Director of the Fiscal Affairs Department, IMF:

"Government debt remains very high in many advanced economies, and fiscal adjustment to bring debt down over the medium term is essential. Nearly all advanced economies plan to reduce their deficits this year. But if growth slows more than expected, some may feel inclined to preserve their short-term plans through additional tightening, even if hurts growth more. My bottom line for them: unless you have to, you shouldn't."

where he also emphasizes the importance of country-specific fiscal policies due to the economic characteristics of the countries. Accordingly, the debate is not only about the government debt itself but also about the short- and medium-term adjustments of fiscal policies, which we can be measured by government consumption/expenditure and/or tax revenues.

Based on the discussion so far, in this paper, we compare the effects of government consumption versus government debt on growth by using data from 83 countries over the period between 1960 and 2014, including both developed and developing markets. In order to connect our results to the existing studies, we first consider linear regressions that are supported by statistical tests regarding the potential issue of endogeneity. Such a linear investigation results in government consumption having a bigger reducing impact on growth compared to the negative effects of government debt. When the significant effects are compared, one standard deviation of an increase in government consumption (% of GDP) results in about 0.52% of a reduction in growth, whereas one standard deviation of an increase in government debt (% of GDP) results in about 0.33% of a reduction in growth.

We further investigate this contradiction by considering nonlinear/threshold effects of government fiscal policies on growth. Such nonlinear analyses show that the effects of both government consumption and government debt on growth are highly affected by the economic characteristics of the countries investigated. It is implied that certain countries should pay more attention to their government expenditure, while certain others should pay more attention to their government debt, if they would like to prevent having negative economic growth.

In terms of policy suggestions, it is implied that restrictions on government expenditure, rather than government debt, are relatively more important for faster growth. Based on nonlinear analyses, the restrictions on government expenditure (to prevent negative growth) are shown to be more important for countries with lower trade openness, lower inflation, or higher financial depth, whereas the restrictions on government debt are shown to be more important for countries with higher trade openness, lower inflation or higher financial depth. Therefore, certain countries should pay more attention to their government expenditure, while certain others should pay more attention to their government debt, if they would like to prevent having negative economic growth.

Overall, this paper contributes to the literature by (i) comparing the effects of government expenditure versus government debt, (ii) using a rich data set with much more countries and time coverage compared to the existing studies, (iii) considering nonlinearities in the relationship between growth and government expenditure/debt that are essential in the determination of country-specific policies.

Inflation and Exchange Rate Pass-Through

Follow @yilmazkuday

 

Inflation and Exchange Rate Pass-Through

One sentence summary: Monetary policy shocks are responsible for higher exchange rate pass-through which can be reduced by more flexible exchange rate regimes or a credible commitment to an inflation target.


The corresponding paper by Jongrim Ha, Marc Stocker and Hakan Yilmazkuday is accepted for publication at Journal of International Money and Finance.

The World Bank working paper version is here.

 
Abstract
The degree to which domestic prices adjust to exchange rate movements is key to understanding inflation dynamics, and hence to guiding monetary policy. However, the exchange rate pass-through to inflation varies considerably across countries and over time. By estimating structural factor-augmented vector-autoregressive models for 55 countries, this paper brings to light two fundamental factors accounting for these variations: the nature of the shock triggering currency movements and country-specific characteristics. Regarding the former, monetary policy shocks are associated with higher exchange rate pass-through measures compared to other domestic shocks, while global shocks have widely different effects across countries. Regarding the latter, pass-through ratios tend to be lower in countries that combine flexible exchange rate regimes and credible inflation targets, where central bank independence can greatly facilitate the task of stabilizing inflation following large currency movements and allows fuller use of the exchange rate as a buffer against external shocks.

Non-technical Summary
Monetary authorities respond to currency movements to the extent that they impact consumer prices and thus inflation. This response not only requires information on the source of currency movements but also the persistence of the impact on inflation. Country characteristics may also play important roles within this picture, because, for example, the risk of policy missteps is particularly elevated in emerging market and developing economies (EMDEs), where large currency movements are more frequent and central banks have a greater propensity to respond to them. This highlights the importance of correctly assessing the exchange rate pass-through ratio (ERPTR), defined in this paper as the percentage increase in consumer prices associated with a 1 percent depreciation of the effective exchange rate following a specific shock after one year.

A rich literature has demonstrated that currency movements are only partially transmitted to domestic prices, with effects dissipating through the production chain. The pass-through to consumer prices goes through various channels, from direct effects through energy and other commodity prices, to indirect effects through import prices, wage formation, and profit markups. Even in the case of internationally traded goods, different forms of market segmentation and/or nominal rigidities may explain incomplete pass-through.

Many structural factors have been associated with a lower sensitivity of domestic prices to exchange rate movements, including the degree of competition among importing and exporting firms, the frequency of price adjustments, the composition of trade, the level of participation in global value chains, the share of trade invoiced in foreign currencies, and the use of currency hedging instruments. A credible monetary policy framework that supports well-anchored inflation expectations has also been viewed as an effective way to reduce the pass-through to consumer prices.

Beyond structural factors and country characteristics discussed so far, the nature of the macroeconomic shock that triggers an exchange rate movement also plays a key role in determining the size of the associated pass-through. This reflects the fact that shocks impacting the exchange rate concurrently affect activity, markups, productivity, and several other factors that influence price formation and inflation expectations. It is thus likely that the extent of estimated ERPTRs will vary widely depending on the shock that triggers them---a possibility that most empirical studies have not considered. For instance, if the ERPTR associated with monetary policy changes is higher than the one associated with other types of shocks, there is a risk that a central bank might underestimate the exchange rate channel of its actions and maintain an excessively tight (or loose) monetary policy stance relative to what is needed to stabilize inflation and output. This may lead to unnecessary fluctuations in activity and make the anchoring of inflation expectations more difficult to achieve over time.

Against this background, this paper contributes to a recent strand of the literature that emphasizes the importance of identifying underlying shocks to assess the transmission of exchange rate movements to inflation and, therefore, to formulate the correct monetary policy response. Three questions are asked. First, how have exchange rate movements impacted inflation over time? Second, how does the pass-through to inflation depend on the underlying shock triggering the exchange rate movement? Third, what country characteristics are associated with lower pass-throughs?

To answer these questions, this paper starts with examining the extent of the co-movement between inflation and exchange rates across 34 advanced economies and 138 EMDEs, including event studies of significant depreciation and appreciation episodes. It is shown that large depreciation episodes are associated, on average, with more significant increases in consumer price inflation in EMDEs than in advanced economies. Unconditional pass-throughs tend to increase with the size of the depreciation in both country groups. There is also evidence for broad-based decline in pass-through among EMDEs over time. Nevertheless, when the correlations between inflation and nominal effective exchange rate changes are considered, there is heterogeneity both across countries and over time, suggesting that different shocks as well as country-specific characteristics can shape the response of inflation to currency movements. The identification of these shocks, however, requires a formal investigation as we detail next.

The formal investigation is achieved by using a series of factor-augmented vector autoregression (FAVAR) models, where both global and domestic variables are used to identify the corresponding shocks. This is achieved by initially constructing the global series of inflation and output growth, where dynamic factor models are used. The constructed global series are combined with global oil price growth as well as domestic series of inflation, output growth, interest rate and nominal effective exchange rates in FAVAR estimations at the country level. Due to data availability, estimations are achieved for 55 countries, including 26 EMDEs. Shock-specific ERPTRs are estimated as the ratio between the one-year cumulative impulse response of consumer price inflation and the one-year cumulative impulse response of the exchange rate change, both following a specific shock.

The estimation results show that monetary policy shocks are associated with a higher exchange rate pass-through compared to other domestic shocks, while global shocks have widely different effects across countries. When a weighted average of shock-specific pass-through is computed for each country to facilitate comparison with the literature, EMDEs have a median (across countries) ERPTR of about 0.15 starting from 1970s, while this number has dropped to 0.08 after 1998. Although a similar drop is also observed for advanced countries over time, the corresponding ERPTRs are much lower, suggesting that EMDEs are the ones that have experienced significant pass-throughs.

Since country-specific ERPTRs are highly heterogenous, we further connect the empirical results to country-specific characteristics by paying particular attention to monetary policy frameworks, participation in GVCs, and foreign-currency invoicing. It is shown that pass-throughs are generally lower in countries with more flexible exchange rate regimes and a credible commitment to an inflation target. This, in turn, facilitates the central bank's task of stabilizing inflation and makes exchange rate movements a more effective buffer against external shocks. In contrast, domestic demand shocks are typically associated with negative and mostly insignificant pass-through ratios, due to the offsetting effects of growth and exchange rate channels (for example, weakening domestic demand giving rise to currency depreciation and declining inflation).

Inflation and Growth: The Role of Institutions

Follow @yilmazkuday

 

Inflation and Growth: The Role of Institutions

One sentence summary: The effects of inflation on growth are negative and significant in countries with stronger institutions, whereas they are positive and significant in countries with weaker institutions.

The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of Economics and Finance.

 

The working paper version is available here.

 
Abstract
This paper investigates the effects of inflation on per capita income growth for 36 developed and developing countries by using structural vector autoregression models that are robust to the consideration of endogeneity by construction. The results show evidence for heterogeneity of such effects across countries that are shown to be further connected to the strength of their institutions. While the effects of inflation on growth are negative and significant in countries with stronger institutions, they are positive and significant in countries with weaker institutions.

Non-technical Summary
Price stability is the main concern of monetary authorities, although benefits of economic growth are much larger than those of eliminating macroeconomic instability. Therefore, knowing the relationship between inflation and growth is essential to have an optimal balance between monetary and growth policies.

The theoretical literature provides mixed evidence on this subject, where the effects of inflation on growth can be positive, negative or insignificant. Empirical evidence mostly based on panel regressions is also mixed, where the effects of inflation can be negative or insignificant, based on countries investigated.

This paper contributes to this discussion by investigating the causal relationship between inflation and per capita income growth by using the implications of a structural vector autoregression (VAR) model, which is robust to the consideration of endogeneity by construction. The investigation is achieved for 36 countries over the period between 1970-2017, where control variables such as trade openness, financial development and government size have also been used. Since the estimations have been achieved for each country individually, the initial conditions of countries (e.g., initial human capital, initial development, initial institutions, etc.) are also controlled for (by estimated constant terms). The estimation results are further used to estimate the inflation elasticity of growth over time, which is defined as the cumulative response of growth divided by the cumulative response of inflation, both following an inflation shock.

The estimated inflation elasticity of growth measures are highly heterogeneous across countries, providing evidence for significantly positive, significantly negative or insignificant relationships between inflation and growth. Consistent with the mixed evidence suggested by the literature, it is implied that the effects of inflation on growth depend on the country investigated. 

To have an explanation for this heterogeneity across countries, in a secondary analysis, we investigate the relationship between country-specific measures of inflation elasticity of growth and country-specific strength of institutions. The corresponding results show that the effects of inflation on growth are negative and significant in countries with strong institutions, whereas they are positive and significant in countries with weak institutions.

 

 

Regarding the economic intuition behind our results, on one hand, the positive effects of inflation on growth are consistent with the idea that weak institutions can result in poorer access to direct capital; therefore, additional money (and thus higher inflation) can be used as substitute for capital in these countries. Such a positive effect, for example, can be achieved through borrowing of governments from their central banks in countries with weak institutions. On the other hand, the negative effects of inflation on growth are consistent with the idea that inflation can hurt growth due to political power of urban workers in countries with strong institutions, where governments can impose price controls to fight against inflation that would lead into shortages and thus lower growth. 

 

 

The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of Economics and Finance.

 

The working paper version is available here.

Protectionism, Competitiveness and Inequality: Cross-Country Evidence from Soccer

Follow @yilmazkuday

 

Protectionism, Competitiveness and Inequality: Cross-Country Evidence from Soccer

One sentence summary: Foreign direct investment increases international competitiveness of soccer clubs at the cost of their domestic equality.

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at International Economic Journal.

 

Working paper version is available here.

 
Abstract
Using club-level data on domestic-league and international points from 73 countries, this paper investigates the relationship between country-specific protectionist policies and soccer success. The main contribution is achieved by having a policy evaluation of country-specific regulations, where other domestic regulations, market value of clubs, or number of matches in domestic leagues are controlled for. The results show that restrictions on foreign direct investment reduce international competitiveness of clubs, whereas restrictions on international migration policies have no significant impact on it. Domestic inequality across clubs increases with international migration restrictions based on minimum number of home-grown players, while it goes down with restrictions on foreign direct investment or international migration restrictions based on maximum number of foreign players.

Non-technical Summary

Several countries have adopted economic policies to improve their national interests at the expense of international integration after the Great Recession of 2008. These so-called protectionist policies have resulted in restrictions on both foreign direct investment (FDI) and international migration, especially for certain sectors that are accepted as important.

Soccer is one of these sectors being subject to protectionism. Despite the well-known positive effects of human capital through transferring foreign talents, politicians such as Boris Johnson of England has promoted restrictive policies on international migration through blaming the unsuccessful results by the national team of England on the large number of foreign players "soaking up space on our top teams," whereas Silvio Berlusconi of Italy has revealed his preferences for the soccer club of Milan playing with all-Italian players. Similarly, both former chairman of the English Football Association, Greg Dyke, and English soccer coach Paul Scholes have spoken about their concerns regarding how foreign players could damage the national team of England as youngsters are unable to break through.

Besides these national-team concerns, club-level concerns are also significant for international migration policies. For example, when soccer clubs borrow heavily to attract foreign stars, they may become financially unstable; e.g., soccer clubs in Turkey had to have their mounting debts restructured by the country's banking association as their overall debt was more than $1.87 billion.

Protectionism on soccer has also been achieved through FDI restrictions, although FDI is an easy way for soccer clubs to obtain necessary financial resources to be more competitive. Potential reasons for FDI protectionism are soccer clubs or leagues no longer feeling local, or team owners not having any real connection with the city but only having a financial interest. For example, ProFans, a lobby group of Bundesliga supporters and ultras in Germany, has warned that "a storm would gather, nationwide" if foreign investors would be allowed to take over soccer clubs.

This paper investigates how these protectionist policies affect international competitiveness and domestic inequality of soccer clubs. This is achieved by using a cross-country data set from 73 countries at the top-tier soccer-club level. Three particular protectionist policies are investigated, namely FDI protectionism, restrictions on the maximum number of foreign players, and restrictions on the minimum number of home-grown players.

Rather than using data on the actual amount of FDI, actual number of foreign players or actual number of home-grown players, which are all subject to several club-level characteristics (and thus would lead into potential endogeneity in a typical investigation), we directly focus on a policy evaluation based on country-specific regulations. In particular, we utilize the cross-country regulation data published by Fédération Internationale de Football Association (FIFA), where information on country-specific regulations is provided for FDI and international-migration protectionism. We combine this cross-country regulation data with club-level success data (measured by club-level points) coming from both domestic soccer leagues and international competitions.

The investigation results in showing that having access to FDI corresponds to higher overall soccer success at the club level, whereas restrictions on international migration policies have no such significant impact. The results also show that domestic inequality across soccer clubs increases with international migration restrictions based on minimum number of home-grown players, while it goes down with restrictions on foreign direct investment or international migration restrictions based on maximum number of foreign players. The results are robust to the consideration of several control variables, including other domestic regulations or club-level characteristics such as their market value.

 

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at International Economic Journal.

 

Working paper version is available here.

The Impact of China’s Fiscal and Monetary Policy Responses to the Great Recession: An Analysis of Firm-Level Chinese Data

Follow @yilmazkuday

 

The Impact of China’s Fiscal and Monetary Policy Responses to the Great Recession: An Analysis of Firm-Level Chinese Data

One sentence summary: Employment and investment by larger Chinese firms have benefited more from bank loans following Chinese financial and fiscal policies during the Great Recession.

The corresponding paper by Jason Taylor, Wenjun Xue and Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance.
 
The working paper version is available here.

 
Abstract
This paper investigates the effects of Chinese financial and fiscal policies designed to counter the worldwide Great Recession of 2008. We examine how policies designed to increase bank credit and health (i.e., asset liquidity, capital adequacy ratio, profitability, and bad loan ratio) influenced firm-level output, employment and investment. We also explore the impact of China’s expansionary fiscal policy with regard to these firm-level variables. We find that the policy effects varied based on firm-level characteristics such as size, liability ratio, profitability, ownership and the industry in which the firm operates. With respect to the dynamic effects, our results suggest that Chinese financial and fiscal policies were generally effective in the short run, but their positive impacts ceased within two years.



Non-technical Summary
The economic crisis of 2008 began in the United States but soon affected almost all developed and developing countries worldwide. In response, the United States enacted fiscal stimulus via the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 (ARRA). Additionally, the Federal Reserve reduced the federal funds rate to near zero and engaged in several rounds of “quantitative easing” programs that sought to facilitate credit flows and reduce the cost of credit. The European Union likewise undertook large-scale fiscal stimulus via the European Economic Recovery Plan (EERP) and the European Central Bank also acted aggressively by cutting interest rates and insect liquidity into the economy. 

While global output was curtailed in the aftermath of the crisis, China’s economy continued to expand, albeit at a far slower rate than it had in the years prior to the crisis. Specifically, China’s reported GDP growth rate fell from around 15 percent in 2007 to around 9 percent in 2008. Its growth rate would almost certainly have declined much further had the nation not adopted aggressive countermeasures that were similar to those enacted in the United States and Europe. While the effects of countercyclical policies in Western nations have been widely analyzed, far less attention has been paid to the impact of such policies from the world’s largest emerging nation.  

China’s central bank (The People’s Bank of China) relaxed the credit constraints faced by commercial banks, most of whom are state owned, by reducing reserve requirements, cutting the prime lending rate, and relaxing credit limits. To be specific, during the last quarter of 2008, China’s central bank reduced reserve requirement ratios from 17.5% to 13.5% for small and medium-sized banks, and from 17.5% to 15.5% for large banks, and it reduced the prescribed one-year lending rate (commercial banks are typically allowed to set interest rates within a pre-specified range of the prescribed rate) from 7.47% to 5.31% (Cong et al., 2018). The credit limits faced by commercial banks were also eliminated in 2008. As a result of these actions, bank credit in China more than doubled from 4.7 trillion RMB (688 billion US dollars) in 2008 to 9.6 trillion in 2009, and it continued to grow in the years that followed. 

In addition to aggressive monetary policy, the Chinese government also launched a 4 trillion RMB (US$586 billion) fiscal stimulus in November of 2008—an amount more than 12 percent of China’s GDP. In comparison in the United States, the American Recovery and Reinvestment Act of 2009 allocated around $800 billion, which was around 5 percent of the size of its GDP. While the stimulus programs of Western nations were largely funded through federal government debt, nearly three quarters of China’s stimulus was funded by local governments. These governments secured loans via Local Government Financing Vehicles (LGFVs), which were state-owned enterprise, whereby the corresponding local government was the dominant shareholder. 

While there were differences in the nature of the policy responses of China and other major geopolitical areas such as the European Union and the United States, they were united in their attempts to stimulate aggregate demand via the credit channel. Still, the broader financial literature has shown that it is not just the quantity of credit, but also its quality (i.e. the efficiency of financial intermediation) that affects economic growth. In light of this literature, our focus is not just on the impact of quantitative monetary factors (money supply and quantity of credit), but we also focus heavily on the effects of qualitative factors affecting bank health (e.g., asset liquidity, capital adequacy ratio, profitability, and bad loan ratio). Given the nuances of the Chinese system highlighted above, it will be interesting to determine the extent that quantity and quality of credit affected China’s economic performance during the Great Recession and the subsequent recovery period.

In this paper, we employ firm-level data in an attempt to identify the effects of China’s fiscal and monetary responses to the crisis of 2008. Our work expands earlier studies by examining the determinants of firm-level output, employment, and investment  It is important to note that these three variables have significant dynamic interactions. Specifically, an increase in a firm’s employment and investment positively affects firm output. At the same time, an increase in firm output promotes the growth of employment and investment. Thus, we employ a panel vector autoregression (VAR) analysis which allows for these relationships. We find that key variables related to banking health such as asset liquidity, capital adequacy ratio, profitability, and bad loan ratio, as well as credit supply, are important determinants of a firm’s output, employment, and investment. We also find evidence for government spending positively affecting these three firm activities. Our results suggest that China’s fiscal and monetary response to the Great Recession helped mitigate the effects of the Great Recession and promoted faster economic recovery in the years that followed that event.  

Because we employ firm-level data, we also investigate which types of firms were most impacted by China’s financial and fiscal policies. We examine firm size, liability ratio, profitability, ownership, and industry, and we find that a healthy banking system and enhanced credit supply have positive and significantly stronger effects on larger firms and SEOs than they do on small and privately-owned firms. Regarding a firm’s liability ratios, a healthy banking system and a larger supply of credit have the most impact on the high- and medium-liability firms. Additionally, we find that expansionary monetary policy was most beneficial to those Chinese firms that had the highest profitability. With respect to fiscal policy, increases in government expenditures positively affected firm-level output, employment, and investment, regardless of the size, liability ratio, profitability, ownership and the industry to which firms belonged, although the magnitude of these effects varies based upon firm characteristics.

We also find that, consistent with China’s “top ten industry revitalization plan” of 2009, some industries benefited more than others from China’s policy response. Agriculture, utilities, manufacturing, transportation, and warehousing industries, which are heavily supported by bank credit in China, benefited the most. Additionally, our results suggest that the increased credit was funneled disproportionately to the real estate and construction industries, which contributed to overheating in the Chinese housing market. We also show that changes in net exports and the financial market performance of the United States differentially affected Chinese firms based on their characteristics. 

Our final step is to employ impulse-response functions to explore the dynamic interaction of firm-level output, employment, and investment and the dynamic effects of financial and fiscal policies between 2008 and 2014. Our results suggest that firm-level output, employment, and investment responded positively to the shocks created by financial and fiscal policies, however, these positive shocks end within two years.

Profit Margins in U.S. Domestic Airline Routes

Follow @yilmazkuday

 

Profit Margins in U.S. Domestic Airline Routes

One sentence summary: Profit margins in U.S. domestic airline routes have an average of about 13.3% across routes, with a range between 2.7% and 42.9%.

 

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Transport Policy.

The working paper version is available here.

 
Abstract

This paper estimates profit margins in the U.S. airline industry at the domestic route level. The dynamic estimation methodology used not only is robust to any simultaneity/endogeneity bias by construction but also results in profit margin estimates that are highly consistent with actual profit data from the U.S. airline industry. Estimated annual profit margins have an average of about 13.3%, with a range between 2.7% and 42.9% across routes. A cross-route analysis further suggests that annual profit margins increase with the market share of the largest airline serving the route, whereas they decrease with airfare. Important policy suggestions follow.

Non-technical Summary
One-way airfare between Seattle, WA and Yakima, WA is about $103, while it is about $402 between New York City, NY and Monterey, CA. Although these airfares might have been determined by several market conditions, which of these routes have higher profit margins? Answering this question is important not only for this particular route but also for any other one, because consumer welfare and thus optimal policy against excessive usage of market power by airlines highly depend on the answer. Airlines also manage their fleet and determine their investment plans to expand or shrink their facilities based on this critical information; moreover, even airplane designs are achieved based on these details.

This paper estimates profit margins for individual domestic routes within the U.S. by using quarterly data between 2000 and 2017. The estimation is achieved by using implications of the well-known Lerner markup rule in a structural vector autoregression (SVAR) model. This corresponds to estimating the inverse price elasticity of demand for each route in a dynamic framework as it represents the profit margin in the Lerner markup rule. The estimation of profit margins is achieved by using the textbook definition of the inverse price elasticity of demand, which is the percentage change in airfare divided by the percentage change in the number of passengers. Since profit maximization is achieved by choosing the number of passengers according to the Lerner markup rule, in the context of the SVAR model, profit margins are estimated as the cumulative response of airfares divided by the cumulative response of passenger numbers, both following a shock on the number of passengers after controlling for changes in airline costs. Such an approach not only is robust to any simultaneity/endogeneity bias by construction (due to allowing for changes in both airfare and passenger numbers, following a structural shock) but also results in continuous profit margin estimates.

Estimation results suggest that annual profit margins have an average of about 13.3% across routes, with a range between 2.7% and 42.9%. The average estimates (across routes) are highly similar to those implied by actual profit data obtained from the U.S. domestic airline industry, supporting our results. When variation across routes is further investigated, it is shown that annual profit margins can be explained by lower airfares, lower distance or higher airline market shares.

Going back to the question asked at the beginning of this paper, it turns out that the route between Seattle, WA and Yakima, WA with an average airfare of $103 has experienced annual profit margins of about 22.1%, while the route between New York City, NY and Monterey, CA with an average airfare of $402 has experienced annual profit margins of about 9.9%. Therefore, the higher airfare (with a distance of 2,596 miles) has experienced profit margins less than half of those experienced by the lower airfare (with a distance of only 103 miles), suggesting that consumer welfare has been higher with the higher airfare (or the longer distance). This result is not specific to this particular route; it has been shown by considering all routes that doubling airfare (distance) across routes results in about 1.4% (0.9%) lower annual profit margins.

Other market characteristics have also played important roles; e.g., doubling the market share of the largest airline results in about 3.1% higher annual profit margins. It is implied regarding consumer welfare that consumers benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher annual profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.

City characteristics have also shown to be important determinants of profit margins, where cities such as Albany, GA or Atlantic City, NJ are the cities with lowest profit margins, whereas cities such as Redding, CA or Panama City, FL are those with highest profit margins, on average across routes.

Regarding consumer welfare, it is implied that consumer benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher quarterly profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Transport Policy.

The working paper version is available here.

 

Oil Price Pass-Through into Consumer Prices: Evidence from U.S. Weekly Data

Follow @yilmazkuday

 

Oil Price Pass-Through into Consumer Prices: Evidence from U.S. Weekly Data

One sentence summary: Oil price pass-through into consumer prices is through gasoline prices in the short-run and through ex-gasoline consumer prices in the long-run.

 

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance.

The working paper version is available here.

 
Abstract

Using U.S. data from Monday of each week, this paper estimates oil price pass-through into consumer prices (PC) and oil price pass-through into gasoline retail prices (PG) in a continuous way. The results show that PC (PG) is about 0.5% (13%) after a week, 1.5% (37%) after three months, and 4.2% (50%) in the long run. The estimated PC is further decomposed into direct PC (representing oil price effects on consumer prices through gasoline retail prices) versus indirect PC (representing oil price effects on consumer prices through ex-gasoline prices), suggesting that long-run oil price effects on consumer prices are mostly through ex-gasoline consumer prices. Despite having distinct pass-through estimates, about three-fourths of weekly volatility in both gasoline retail and consumer prices are explained by oil price shocks in the long run.

Non-technical Summary
Optimal monetary policy depends on the accurate prediction of domestic inflation that requires consideration of international shocks in an open economy. Since oil is a basic raw material at many production levels and its price is determined in global markets, changes in oil prices constitute a big portion of such international shocks. Accordingly, policy makers are interested in measuring the effects of an oil price shock on inflation, which can be achieved by estimating the oil price pass through into consumer prices (henceforth PC).

Oil price shocks can affect consumer prices through direct and indirect channels. The direct channel (that we consider in this paper) works through gasoline retail prices, because gasoline is the form of oil that is consumed the most as a final product by consumers (about 4% of overall expenditure), and thus developments in gasoline prices are salient to consumers. The indirect channel works through prices of products other than gasoline (i.e., ex-gasoline prices) in the consumption basket, since oil is used in the production and/or transportation of almost all products. Within this picture, oil price pass-through into gasoline prices (henceforth PG) represents the direct channel, while oil price pass through into ex-gasoline prices (henceforth PE) represents the indirect channel, both subject to the corresponding expenditure weights in the consumption basket.

By taking into account these direct and indirect channels, this paper estimates PC and PG by using U.S. data from Monday of each week on oil, gasoline retail, and consumer prices, where the estimation is achieved by a structural vector autoregression (SVAR) model. Using data based on Monday of each week is important to capture the dynamics of the oil market, since taking averages within a month, quarter or year as in the literature may suppress valuable information on weekly dynamics. The estimation by SVAR is also essential to identify weekly oil price shocks that are independent of weekly gasoline or weekly consumer price shocks.

PC (PG) is measured as the cumulative impulse response of consumer (gasoline retail) prices divided by the cumulative impulse response of oil prices, both following an oil price shock. Such a strategy not only results in having oil price pass-through estimates in a continuous way but also makes them robust to any endogeneity problem, since the response of oil prices following an oil price shock is also taken into account. When the estimated measures of PC and PG are combined with the implications of an economic model introduced in the Appendix, measures of PE are also obtained. Finally, when pre-shock expenditure share of gasoline for consumers is considered, PC is decomposed into direct oil price pass-through into consumer prices (DPC) versus indirect oil price pass-through into consumer prices (IPC).

The results show that PC (PG) is about 0.5% (13%) after a week, 1.5% (37%) after three months, 3.3% (50%) after one year, and 4.2% (50%) in the long run. When continuous PC estimates are further decomposed into those through direct channels (DPC) versus indirect channels (IPC), the results show that DPC (IPC) is about 0.5% (0%) after a week, 1.5% (0.1%) after three months, 1.8% (1.5%) after one year, and 1.9% (2.3%) in the long run. Therefore, short-run effects of oil prices on consumer prices are through gasoline prices, while their long-run effects are more through ex-gasoline consumer prices.

It is implied that gasoline prices should have higher weights in the short run, whereas ex-gasoline prices should have higher weights in the long run while conducting optimal policy through forming forward-looking monetary policy reaction functions. When consumer income is fixed, PC can also be used as a measure of welfare loss following an oil price shock (e.g., see implications of an economic model in the Appendix). Accordingly, following an oil price shock, consumers lose welfare in the short run more due to the direct effects of oil price shocks on gasoline prices, while their welfare loss in the long run is more due to the indirect effects of oil price shocks on ex-gasoline consumer prices.

Despite having distinct pass-through estimates, about three-fourths of weekly volatility in both gasoline retail and consumer prices are explained by oil price shocks in the long run. Compared to earlier studies, the contribution of this paper can be listed as follows: (i) weekly consumer prices are used for the estimation of pass-through measures, (ii) oil price pass-through estimates are obtained in a continuous way, (iii) effects of oil prices on ex-gasoline prices (PE) are obtained by using the implications of an economic model, (iv) PC is decomposed into DPC and IPC, which results in important policy and welfare implications, and (v) estimation strategy is robust to the consideration of any endogeneity problem due to considering the response of oil prices to their own shocks.

 

 

The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Journal of International Money and Finance.

The working paper version is available here.

Understanding the International Elasticity Puzzle

Follow @yilmazkuday

Understanding the International Elasticity Puzzle

One sentence summary: The macro elasticity in international trade is a weighted average of the macro elasticity in international finance and the corresponding elasticity of substitution across products of foreign source countries.

The corresponding paper by Hakan Yilmazkuday has been published at Journal of Macroeconomics.

The working paper version is available here.

 
Abstract

International trade studies have higher macro elasticity measures compared to international finance studies, which has evoked mixed policy implications regarding the effects of a change in trade costs versus exchange rates on welfare measures. This so-called international elasticity puzzle is investigated in this paper by drawing attention to the alternative strategies that the two literatures use for the aggregation of foreign products in consumer utility functions. Using the implications of having a finite number of foreign countries in nested CES frameworks that are consistent with the two literatures, the discrepancy between the elasticity measures is explained by showing theoretically and confirming empirically that the macro elasticity in international trade is a weighted average of the macro elasticity in international finance and the corresponding elasticity of substitution across products of foreign source countries.

Non-technical Summary

International trade studies have higher macro elasticity measures compared to international finance studies. Since price movements due to policy changes are converted into welfare adjustments through these elasticities, this observation evokes mixed policy implications regarding the effects of trade costs in international trade versus the effects of exchange rates in international finance. Due to these mixed implications on welfare, this observation is called the international elasticity puzzle.

In the literature, international finance studies mostly have a macro elasticity value of about 1.5, while international trade studies mostly have a macro elasticity value of about 5. It is implied that if we directly employ these numbers in a policy analysis, say, in order to investigate the effects of a foreign price change due to tariffs or exchange rates, international trade studies imply quantity changes that are at least three times the international finance studies.

This paper attempts to understand the international elasticity puzzle by drawing attention to the alternative strategies the two literatures have for the aggregation of foreign products in consumer utility functions. In particular, while the majority of international finance models include a unique foreign country (in their two-country frameworks) in order to have an understanding of the macroeconomic developments in the home country, the majority of international trade models include multiple foreign countries in order to investigate the bilateral trade patterns of the home country. Since having alternative numbers of foreign countries is reflected as alternative macro elasticity measures between the two literatures in a nested constant elasticity of substitution (CES) framework, as shown in this paper, the international elasticity puzzle can be understood by paying attention to the alternative ways that foreign products are aggregated in the two literatures.

Regarding the details, when a finite number of goods and foreign countries is considered in nested CES frameworks that are consistent with both literatures, this paper finds alternative expressions for the price elasticity of demand as a function of the macro elasticity measures in the two literatures. In order to investigate the conditions under which the two literatures have the very same policy implications (e.g., regarding changes in trade costs versus exchange rates), this paper equalizes the price elasticity measures between the two literatures. This strategy results in an expression that connects the alternative macro elasticity measures in the two literatures, where good-level details are cancelled out during the equalization of the price elasticity measures. In particular, it is theoretically shown that the macro elasticity in international trade is a weighted average of the macro elasticity in international finance and the elasticity of substitution across products of different foreign source countries, where the weight is shown to depend on the number of foreign countries and home expenditure shares. Therefore, the alternative strategies in the two literatures for the aggregation of foreign products are reflected as alternative macro elasticity measures between the two literatures.

The implications of equalizing the price elasticity of demand measures between the two literatures are also tested empirically. Since this investigation requires data on both domestic and foreign trade, it cannot be achieved by using any international trade data set, where domestic trade data are not recorded. As an alternative, this paper uses the available trade data within the U.S. by considering interstate trade as foreign trade and intrastate trade as domestic trade. The results based on the estimation of macro elasticity measures in both literatures confirm the theoretical solution provided in this paper that the macro elasticity in international trade is a weighted average of the macro elasticity in international finance and the elasticity of substitution across products of different foreign sources. Therefore, the discrepancy between the macro elasticity measures in the two literatures can in fact be understood by paying attention to the alternative ways that foreign products are aggregated in the two literatures.

The corresponding paper by HakanYilmazkuday is available at Journal of Macroeconomics.

Redistributive Effects of Gasoline Prices

Follow @yilmazkuday

Redistributive Effects of Gasoline Prices

One sentence summary: There are significant redistributive effects of gasoline price changes among U.S. consumers, where the main determinant is shown to be the consumer income.

The corresponding paper by Demet Yilmazkuday and Hakan Yilmazkuday has been accepted for publication at Networks and Spatial Economics.

Free access to the published paper is available at https://rdcu.be/bfNqu 

The working paper version is available here.

Abstract

Consumers face significantly different gasoline prices across gas stations. Using gasoline price data obtained from 98,753 gas stations within the U.S., it is shown that such differences can be explained by a model utilizing the gasoline demand of consumers depending on their income and commuting distance/time, where the pricing strategies of both gas stations and refiners are taken into account. The corresponding welfare analysis shows that there are significant redistributive effects of gasoline price changes among consumers where the main determinant is shown to be the consumer income; e.g., welfare costs of an increase in gasoline prices are found to be higher for lower income consumers.

Non-technical Summary
Gasoline prices have significant effects on an economy, because higher energy prices can slow economic growth and affect individual welfare in many ways. As one example, gasoline prices have increased before any historical economic downturn in the U.S. As another example, consider the survey reported by Bankrate.com in May 2012, which depicts that, from the end of December 2011 through mid-April 2012, the price of regular gas rose from a national average of $3.30 per gallon to $3.94 (an increase about 19%), and, as a result, 59% of consumers cut back on nonessential spending on things such as vacations and dining out, only because of gasoline price changes. These macroeconomic examples provide an average picture of the gasoline price effects, but is the magnitude of these effects the same across consumers? The answer to this question is essential to understand the redistributive effects of gasoline prices, especially when gasoline prices differ across consumers.

Consider the following figure where each circle represents the location of a gas station. The colors of the circles represent the prices in U.S. dollars per gallon. Price intervals represent the intervals corresponding to the first, second, third, fourth and fifth 20th percentile of average of daily gasoline prices obtained from 98,753 gas stations between September 8th and September 14th, 2014. As is evident, while the gasoline prices are more expensive in the Northeast and the West (including Alaska and Hawaii), they are relatively cheaper in the Southeast.

To better understand the magnitude of gasoline price differences across consumers, consider a typical day (of September 14th, 2014) when the retail-level gasoline price difference between any two gas stations within the U.S. was as high as $2.28 per gallon of regular gas. If you think that this price dispersion was due to differences in state-taxes per gallon, which ranged between 42.75 cents (for New York) and 8 cents (for Georgia) in 2014, you are only partially right, because, for a typical day (of September 14th, 2014), the price difference between any two gas stations within any given state of the U.S. was as high as $1.68 (for the state of Massachusetts) followed by $0.99 (for the state of New York). Therefore, a detailed analysis is required to understand gasoline price dispersion at the gas-station level, which is the key to the investigation of the redistributive effects of gasoline price changes.

This paper achieves such an investigation by modeling the gasoline consumption of individuals and the pricing strategy of gas stations and refiners. The optimization in the model results in the gasoline demand of consumers depending on their income and commuting requirements as well as the price of gasoline. Gas stations take this demand into consideration while maximizing their profits, which results in a linear gasoline price expression due to having Leontief production functions. Refiners take into account the demand coming from gas stations to maximize their own profits. When the behavior of all agents in the model are combined, a final expression for gasoline prices is obtained at the gas station level, which depends on the income and commuting behavior of consumers as well as refiner-related costs.

Using data on gas-station level gasoline prices, zip-code level income and zip-code level commuting within the U.S., the implications of the model are estimated. The results show that most of the variation of gasoline prices (across gas stations) is explained by the proposed model. As a supplementary result, the average (across gas stations) markup per gallon is estimated about 16 cents, which is consistent with the surveys achieved by independent organizations.

After showing that the implications of the proposed model are consistent with gasoline price data, together with other supplementary data, we move to the welfare analysis to investigate the redistributive effects of gasoline price changes across consumers within the U.S.. The implications of the model combined with the results coming from the empirical investigation suggest that 1 percent of an increase in gasoline prices can lead to a reduction in consumer utility ranging between 0.08 percent and 2.76 percent (with an average of 0.82 percent) within the U.S.. Therefore, there are in fact significant redistributive effects of gasoline price changes. When the sources of these redistributive effects are further investigated, it is shown that consumer income is the main determinant; i.e., welfare costs related to a gasoline price increase are higher for lower-income consumers. It is implied that, in order to minimize the redistributive welfare effects of gasoline price changes, special policies should be conducted for lower-income consumers, especially when gasoline prices increase significantly.

Although gasoline prices can be affected by income, commuting distance/time, oil prices, and refiner costs according to the proposed model, they can also be affected by local or national taxes that have not been modeled here (nevertheless, they have been controlled for in the empirical investigation). Therefore, a change in any of these variables would change gasoline prices, and, thus, any policy conducted on such variables would result in redistributive welfare effects among consumers according to the analysis, above. Accordingly, one policy suggestion would be to provide gasoline tax cuts for neighborhoods with lower-income consumers. Providing tax reimbursements for lower-income consumers depending on their gasoline consumption and/or the gasoline (or oil) price changes over the preceding year can also be considered. Another one would be to promote/subsidize fuel-efficient cars for lower-income consumers that would effectively reduce the share of gasoline in their expenditure. Even though the formal investigation of such suggestions is out of the scope of this paper, future research can focus on the public policy implications of a more local analysis based on the insights of this study.

The working paper version is available here.

Unequal Exchange Rate Pass-Through across Income Groups

Follow @yilmazkuday

Unequal Exchange Rate Pass-Through across Income Groups

One sentence summary: There is evidence for redistributive effects of an exchange rate shock across income groups.

The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Macroeconomic Dynamics. 

The working paper version is available here.

Abstract

Exchange rate pass-through (ERPT) into prices and into income loss are shown to be enough to calculate ERPT into welfare loss by using implications of a simple model. These ERPT measures are estimated at the good level by using a unique micro-price data set from Turkey, and they are combined with income-group specific expenditure shares at the good level to obtain aggregate-level ERPT measures for alternative income groups. An exchange rate shock resulting in a real depreciation of 1% is shown to decrease welfare by about 0.80% for the average-income consumer, while this estimate ranges between 0.73% and 0.83% for consumers in the lowest and highest income quintiles, respectively, suggesting evidence for redistributive effects of an exchange rate shock. Using micro prices has further resulted in showing that traded, nondurable, flexible-price, or income-elastic goods contribute more to ERPT into welfare loss for the average-income consumer, suggesting important policy implications for filtering out the noise in the measurement of aggregate-level prices.

Non-technical Summary

Open economies are subject to international shocks that are mostly reflected as movements in their exchange rates. The effects of such movements, the so-called exchange rate pass-through (ERPT) measures, highly depend on the extent of expenditure switching between domestic and foreign goods, which may take time to observe due to price stickiness. Especially when exchange rate movements are not fully reflected in prices (i.e., incomplete ERPT into prices), there are significant welfare effects due to price setting in the currency of consumers versus producers that should be taken into account by policy makers. Therefore, it is not only important to understand ERPT into prices but also into quantities and thus welfare, both in the short and long-run. This paper follows such an approach by estimating ERPT into prices, income and welfare for alternative horizons.

Although there is a large body of literature investigating/estimating ERPT measures into prices, the existing evidence on ERPT is mostly at the aggregate level, suppressing disaggregated-level details such as income redistributive effects of exchange rate movements among consumers. Despite several studies in the literature that have proposed such income redistributive effects in their theoretical frameworks, to our knowledge, there is no corresponding empirical evidence. The lack of empirical evidence is mostly because aggregate-level prices (e.g., consumer price index) are published only for the average-income consumer, while the investigation of redistributive effects requires the knowledge of prices faced by alternative income groups. This paper proposes a solution to this problem by using a good-level investigation. In particular, with the knowledge of the set of goods consumed by each income group, we use the corresponding micro prices to estimate ERPT measures at the good level, which are further combined with the expenditure shares of goods for each income group to estimate the aggregate welfare effects.

Estimating ERPT measures at the good level (as in this paper) is also useful for avoiding any aggregation bias, since estimations at the aggregate level suppress several micro-level details. These include micro-level distortions such as price stickiness, tradability of goods, degree of competition reflected in markups, transportation costs in different sectors, or the quality of goods. These micro-level details not only are important to understand the economic intuition behind ERPT into good-level prices but also can be used to identify the goods/sectors responsible for the effects of exchange rate movements at the aggregate level. By using a good-level approach, this paper not only considers these micro-level details by construction but also achieves further decomposition analyses showing the contribution of each good category to ERPT measures for each income group.

Finding the goods/sectors that are responsible for ERPT measures has important monetary policy implications as well, because, understanding changes in micro prices can offer more relevant information about the nature of inflation in countries such as Turkey, where good-level prices change more frequently compared to other countries. In particular, to have a healthy measure of inflation that can be used for optimal policy making, the noise in aggregate-level prices should be filtered out by using measures such as the trend or core inflation, and using disaggregate-level price data to determine the responsible goods/sectors (as in this paper) is one way to do it as suggested by several studies in the literature. These measures are also useful to increase the effectiveness of communicating monetary policy actions in an environment of frequently changing prices.

Regarding the estimation methodology, several empirical studies in the literature have considered single-equation frameworks that result in endogeneity bias. Also considering our discussion on micro-level details above, it is implied that an empirical investigation based on a system of equations at the good level is necessary to avoid both aggregation and endogeneity biases in the estimation of ERPT measures. This paper achieves such an unbiased estimation of ERPT by using a structural VAR model at the good level, where ERPT ratios are considered for the measurement of ERPT. Specifically, ERPT into prices (income) is measured as the cumulative response of prices (income) divided by the cumulative response of exchange rates, both following an exchange rate shock. Such an approach followed at the good level effectively addresses concerns related to both aggregation and endogeneity biases. Micro-price data, good-level expenditure shares for alternative income groups, together with data on income and exchange rates, are used from Turkey over the monthly period between 2004m1-2018m12. Once ERPT into prices and income are estimated, by using the implications of a simple model introduced in this paper, ERPT into welfare is calculated as ERPT into income minus ERPT into prices.

The results for the average-income consumer suggest that an exchange rate shock resulting in a 1% depreciation of the currency increases the aggregate price index by about 0.45%, reduces income by about 0.34%, and reduces welfare by about 0.80%. When the same investigation is achieved across alternative income groups, the welfare loss ranges between 0.73% and 0.83% for consumers in the first and last income quintiles, respectively, suggesting redistributive effects of an exchange rate change among consumers.

The good-level investigation in this paper also allows for the decomposition of this aggregate-level result into the contribution of each good category to the welfare of alternative income groups. In particular, among good categories, those that are traded, nondurable, flexible-price, or income-elastic contribute more to ERPT into welfare for the average-income consumer, and the contribution of durable and income-elastic goods gets higher with consumer income.

Among sectors, "Food and Non-Alcoholic Beverages" followed by "Communications" and "Transport" contribute the most to ERPT into welfare for the average-income consumer, although this decomposition differs significantly across income groups. Specifically, ERPT into welfare is mostly through "Food and Non-Alcoholic Beverages" and "Housing, Water, Electricity, Gas and Other Fuels" for the lowest-income consumers, while it is mostly through "Transport" and "Communications" for the highest-income consumers. Due to their higher contribution to ERPT measures, it is implied that these sectors should be paid more attention while measuring the trend/core inflation and thus conducting policy.