Decomposing the Gains from Trade through the Standard Gravity Variables

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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

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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

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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

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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

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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.