Welfare Costs of Urban Traffic through Retail Prices

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Welfare Costs of Urban Traffic through Retail Prices

One sentence summary: Reducing the time spent in urban traffic by 1 minute would result in a welfare gain of about 1.3% for the average city.

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

 

The working paper version is available here.

 
Abstract
This paper investigates the welfare costs of urban traffic by considering its implications on good-level prices. Using price data for 40 products from 70 cities (covering 47 countries) for multiple years, the estimation results suggest that the elasticity of good-level prices with respect to the time spent in urban traffic is about 0.5. This elasticity is further connected to the welfare of individuals by using the implications of a simple model. The corresponding investigation shows that reducing the time spent in urban traffic by one minute results in a welfare gain of about 1.3% for the average city, with a range between 0.8% and 2.3% across cities.

Non-technical
The amount of time spent in urban traffic changes significantly across cities. While one-way transportation takes only about 23 minutes in Thessaloniki, Greece, it takes about 64 minutes in Mumbai, India. These differences are important to have an economic comparison across cities, because besides the well-known opportunity costs of time and energy costs that can be considered as direct costs, there are also indirect (off-the-road) costs of urban traffic. For example, based on interviews with managers at distribution centers in the United Kingdom, it has been shown that urban traffic can increase warehousing costs by about 20%. On top of this, it has been shown that unreliability of delivery due to urban traffic has added about another 8% to 11% to the costs of traffic congestion in Netherlands. Similarly, the majority of the companies in Ireland has experienced traffic problems (and thus cost increases) according to the literature.

Against this background, this paper attempts to measure the welfare costs of urban traffic through its effects on good-level retail prices. The main idea is that retail costs can be affected by traffic congestion as in the studies introduced above, and these effects are further reflected in the welfare of individuals through their purchasing power. Accordingly, using the implications of a simple economic model, first, we investigate the effects of urban traffic (measured in minutes for one-way transportation) on good-level prices. The results based on price data from 40 products coming from 70 cities (from 47 countries) show that good-level prices are affected positively and significantly by urban traffic. Regarding the magnitude of this effect, the elasticity of good-level prices with respect to the time spent in urban traffic is estimated about 0.5.

 

The effects of urban traffic on good-level prices are further connected to the welfare of individuals by using the implications of the economic model introduced. In particular, it is shown that changes in individual welfare depend on changes in urban traffic, subject to the elasticity (of good-level prices with respect to the time spent in urban traffic) estimated. Within this picture, we consider two hypothetical changes in urban traffic. To measure the overall welfare costs of urban traffic, the first hypothetical change corresponds to the removal of the overall effects of urban traffic from good-level prices. Although this exercise may not be convenient to have a policy investigation that could only partially reduce the effects of urban traffic, it provides useful information on the overall welfare costs of urban traffic. To have a more convenient policy investigation, a second hypothetical change is defined as reducing the time spent in urban traffic by one minute.

 

The results for the first hypothetical change (based on the price data introduced above) suggest that removing the overall effects of urban traffic on prices would increase welfare by about 1.8 times the current welfare in the average city, with a range between 1.6 times (for Thessaloniki, Greece) and 2.1 times (for Mumbai, India). Hence, there are significant overall effects of urban traffic on consumer welfare through retail prices. 

 

The results for the second hypothetical change show that reducing the time spent in urban traffic by one minute would result in a welfare gain of about 1.3% for the average city, with range between 0.8% (for Mumbai, India) and 2.3% (for Thessaloniki, Greece) across cities.

The corresponding paper by Hakan Yilmazkuday is available as a working paper here.

Welfare Costs of Bilateral Currency Crises: The Role of International Trade

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Welfare Costs of Bilateral Currency Crises: The Role of International Trade

One sentence summary: A single currency crisis can result in welfare reductions through international trade corresponding up to 41% of the costs of autarky.

 

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

Free access to the read-only version is available here.

 

The working paper version is available here.

 
Abstract
This paper shows that bilateral currency crises reduce bilateral trade up to 50% after controlling for the depreciation rate. Using a trade model, these reductions are connected to the welfare costs of currency crises. The results show that a single currency crisis can result in welfare reductions through changes in international trade corresponding to more than 10% (and up to 41%) of the costs of autarky for 23 different currency crisis episodes between 1960 and 2014. These welfare costs are also shown to be greater than the welfare gains from having free trade agreements and using common currencies for 25 different currency crisis episodes.

Non-technical Summary
The negative effects of having a currency crisis at the country level are well known. These country-level currency crises are mostly identified by using the depreciation of the nominal exchange rate of a country with respect to a vehicle currency such as the U.S. dollar. However, international trade patterns are determined over bilateral exchange rates, since both exporters and importers solve their optimization problems based on their home currencies due to their costs and/or income being subject to these currencies. Therefore, the negative effects of currency crises on international trade can be at the bilateral level, especially when bilateral currency transactions are interrupted due to a crisis.

This paper investigates the possibility that bilateral currency crises (defined over bilateral nominal exchange rates) can affect bilateral imports. This is achieved by using the implications of a trade model, where bilateral currency crises are accepted as additional trade costs due to potential increases in transaction costs. Accordingly, bilateral imports are shown to depend on bilateral currency crises after controlling for the depreciation rate of the importer country's currency with respect to the exporter country's currency. This implication is tested empirically by using bilateral trade data from 66 countries covering the annual period between 1960-2014. The empirical results suggest that having a bilateral currency crisis can reduce international trade up to 50%, depending on the severity of the crisis.

These negative effects of bilateral currency crises are further connected to the corresponding welfare costs by using the implications of the trade model. It is shown that these welfare costs can be measured as the weighted average of the negative effects of bilateral currency crises on international trade, where weights are bilateral import shares. The corresponding empirical results suggest that the welfare costs of a single bilateral currency crisis are up to 2.5% (for Costa Rica in 1982). In order to put these welfare costs into context, they are further compared to the costs of autarky and the welfare gains from having free trade agreements and common currencies. The results show that the welfare costs of a single bilateral currency crisis correspond to more than 10% of the costs of autarky for 23 different episodes, up to 41% (for Angola in 1991). These costs are also shown to be more than the welfare gains from having free trade agreements and common currencies (at the time of the crisis) for 25 different episodes.

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

Free access to the read-only version is available here.

 

The working paper version is available here.

Gains from Trade: Does Sectoral Heterogeneity Matter?

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Gains from Trade: Does Sectoral Heterogeneity Matter?

One sentence summary: Sectoral heterogeneity does not always lead to an increase in the gains from trade, which is consistent with the theory.

The corresponding paper by Rahul Giri, Kei-Mu Yi and Hakan Yilmazkuday has been accepted for publication at Journal of International Economics.

 

The NBER working paper version is available here.

 
Abstract 
This paper assesses the quantitative importance of including sectoral heterogeneity in computing the gains from trade. Our theoretical framework has sectoral heterogeneity along five dimensions, including the elasticity of trade to trade costs. We estimate the sectoral trade elasticity with the simulated method of moments estimator and micro price data. Our estimates range from 2.97 to 8.94. Our benchmark model is calibrated to 21 OECD countries and 20 sectors. We remove one or two sources of sectoral heterogeneity at a time and compare the gains from trade to the benchmark model. We also compare an aggregate model with a single elasticity to the benchmark model. Our main result from these counterfactual exercises is that sectoral heterogeneity does not always lead to an increase in the gains from trade, which is consistent with the theory.

Non-technical Summary
Estimating the gains from international trade is one of the oldest and most important issues in economics. In recent years, owing to the development of easily accessible sectoral, bilateral trade and output data, as well as input-output tables, on the one hand, and tractable multi-sector, multi-country general equilibrium trade models on the other hand, there has been a surge in research quantifying the gains from trade. In many of these studies, there is a presumption that increased sectoral heterogeneity leads to higher gains from trade. This presumption is natural; in a simple multi-sector model in which the only source of heterogeneity across sectors is the initial sectoral trade shares, the multi-sector setting will always yield greater gains from trade, owing to Jensen's inequality, than the aggregate version of this model (with the same parameters).

 

However, there are many sources of sectoral heterogeneity in a typical multi-sector trade model. Trade elasticities, value-added shares of gross output, input-output linkages, and final demand shares, in addition to initial trade shares (driven by fundamental productivity and trade costs) can all vary across sectors. The gains from trade are a non-linear function of these parameters and variables; ultimately, whether sectoral heterogeneity yields greater gains depends on whether, for example, sectors with high initial trade shares are also sectors with low value-added shares of gross output. The goal of this paper is to quantitatively evaluate how sectoral heterogeneity affects the gains from trade in a systematic, comprehensive, and structurally consistent way.

We employ a model that embodies these forms of sectoral heterogeneity. Our calibrated model has 20 sectors and 21 countries, and we estimate and calibrate the parameters to match key features of the sectoral production, trade, expenditure and micro-price data. One of the main contributions of our paper is that we estimate the elasticity of trade with respect to trade costs for each of 19 traded sectors using the simulated method of moments (SMM). This methodology builds on the method-of-moments estimation methodology with micro price-level data, by correcting the bias from a small sample of price observations. To our knowledge, this is the first application of the SMM estimator to estimate the trade elasticity at the sector level. We use the Eurostat surveys of retail prices, which covers 12 OECD countries and 19 three-digit ISIC traded good sectors for 1990.

Our sectoral trade elasticity estimates range from 2.97 to 8.94; the median is 4.38. We also estimate the sectoral trade elasticities with the original method-of-moments method and the minimum, maximum, and median elasticities are 4.26, 35.55, and 10.29. So, our SMM estimates are clearly lower, as earlier studies have shown in their papers incorporating a one-sector framework. In addition, the “bias” is larger the smaller the sample size. For example, ISIC 352, Other chemicals, has a sample size of 4, while ISIC 311, Food products, has a sample size of 343. Our SMM estimates are similar across these two industries, 3.75 and 3.57, respectively, but the method-of-moments estimates are 11.93 and 4.28, respectively. These estimates are used in our calibrated model.

We calibrate the other parameters to match their data counterparts and/or to be consistent with sectoral outputs and trade flows. With our calibrated model, we compute the gains from trade by comparing the welfare in our benchmark equilibrium relative to welfare in a counterfactual autarky equilibrium. Our benchmark calibrated model delivers gains from trade ranging from 0.40 percent in Japan to 8.33 percent in Ireland. The median gain in going from autarky to the calibrated equilibrium is 3.96 percent (Mexico). We also decompose the gains into the trade effect and sectoral linkage effect and find that the former is considerably larger than the latter. 

We then conduct two sets of counterfactual exercises to assess the role of sectoral heterogeneity. We focus on five sources of heterogeneity in the gains from trade equation: sectoral trade elasticities, value-added gross output ratios, final demand shares, input-output linkages, and initial trade shares. In the first set of exercises, which we think of as “inspect the mechanism” exercises, we eliminate one or two sources of sectoral heterogeneity at a time. For each source of sectoral heterogeneity, we substitute a parameter (or variable) that is common across all sectors. For example, we replace the estimated sectoral trade elasticities with a single elasticity common to all sectors. We compute the gains from trade and compare these gains to those from the benchmark model.

When we eliminate one source of heterogeneity at a time, we find that in all cases the gains from trade are little or moderately changed relative to the benchmark model. That is, when we replace our estimated sectoral trade elasticities with the median estimate (4.38), the sectoral value-added shares with the average value-added share, the sectoral final demand share with the average final demand share, the sectoral intermediate use requirements with an average intermediate use requirements, or the initial sectoral trade shares with a common average initial share, the median gains from trade are within 10 or 20 percent of the benchmark gains. Our results for removing two sources of heterogeneity are similar, as for the most part, the difference in the gains from removing two sources of heterogeneity (relative to the benchmark model) is a sum of each difference in gain from removing one source of heterogeneity. In one final exercise, we remove all heterogeneity associated with intermediate goods and sectoral linkages by considering a value-added only model. We find, as other research has shown, that the gains from a value-added only model are less than one half that of the benchmark model. Overall, we find that most sources of sectoral heterogeneity lead to slight or moderate additional gains from trade, and some sources lead to less.

 

 

In the second set of exercises, we compare the welfare gains in our benchmark model to our aggregate model. The aggregate model has just one tradable sector; all heterogeneity across tradable sectors is eliminated. We also estimate the aggregate trade elasticity with the SMM methodology; we obtain a value of 2.37. Owing in part to this low estimate, we find that the gains from trade in the aggregate model are moderately (about one-third) larger than in the benchmark model. That is, when we compare our benchmark model with its estimated sectoral trade elasticities and sectoral heterogeneity on several other dimensions to our aggregate model with its estimated aggregate trade elasticity and no sectoral heterogeneity across tradable sectors, it is the aggregate model with greater gains from trade. Further investigation shows that the low estimated aggregate elasticity plays a key role. It is important to reiterate that both sets of elasticities are estimated in a model-consistent way.

To understand better all of our results, we conduct a Monte Carlo-type exercise in which we simulate prices and trade shares from our calibrated benchmark model. We then aggregate across sectors, and ask: “suppose this data were generated from an aggregate model. What would be the implied aggregate trade elasticity?” We find that the estimated aggregate elasticity from this exercise is about 2.65, which is only slightly larger than our actual estimated aggregate elasticity. In other words, our benchmark model generates data that would be consistent with a low aggregate elasticity in an aggregate model.

Overall, we conclude from our “inspect the mechanism” counterfactual, our benchmark vs. aggregate model counterfactuals, and our Monte Carlo exercise that increased sectoral heterogeneity does not necessarily imply larger gains from trade. This should not be a surprise, because it is just as the theory implies. The formula for the gains from trade shows clearly that whether sectoral heterogeneity per se leads to greater gains depends on two sets of interactions. One is the interaction of the sectoral trade elasticity, initial trade share, final demand share, and value-added share of gross output. The second is the input-output linkages along with the relative prices of inputs. Our results also show that overall, the interactions “cancel” to a large degree. A second conclusion is that model-consistent elasticity estimates should be used no matter the level of aggregation.

The main difference between our results and the previous research is that we use model- consistent trade elasticity estimates of both our benchmark model and our aggregate model. By contrast, much of the previous research uses an average of the sectoral elasticities as a stand-in for the aggregate elasticity. As our work, and previous research, have shown, an appropriate estimated aggregate elasticity is likely to be less than an average of sectoral elasticities. With a lower elasticity, all else equal, there will be greater gains from trade.

The corresponding paper by Rahul Giri, Kei-Mu Yi and Hakan Yilmazkuday has been accepted for publication at Journal of International Economics.

 

The NBER working paper version is available here.

Welfare Implications of Solving the Distance Puzzle: Global Evidence from the Last Two Centuries

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Welfare Implications of Solving the Distance Puzzle: Global Evidence from the Last Two Centuries

One sentence summary: The distance puzzle corresponds to about 81% of a cumulative welfare loss in the world, whereas solving it corresponds to about 58% of a welfare gain.

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

 

The working paper version is available here.

 
Abstract

This paper theoretically shows that changes in the distance elasticity of trade can be connected to welfare changes that depend on bilateral distance measures and expenditure shares of countries. Empirical results based on international and domestic trade data from the last two centuries show that the negative effects of distance on trade have increased over time when zero trade observations are ignored in inconsistent OLS estimations, confirming the distance puzzle in the literature. The corresponding welfare implications suggest that the world economy has experienced a cumulative welfare loss (about 81%) due to this puzzle in the last two centuries. When the puzzle is solved by considering zero trade observations in PPML estimations, the tables turn such that there are significant welfare gains from trade (about 58%) during the same period due to the decreasing negative effects of distance on trade over time. Welfare gains from further reductions in the negative effects of distance are investigated as well, suggesting significant potential gains from trade in the future.

 
Non-technical Summary
The negative effects of distance on trade are shown to increase over time in standard gravity regressions, which is against the expectations due to decreasing costs of transportation and communication. The so-called "distance puzzle" has been investigated extensively in the literature, where several explanations have been offered, including information barriers, augmented trade barriers, the role of nontradables, marginal costs of transportation, the composition of trade, zero-trade observations, trading propensities of entrants, domestic versus international integration of markets or nonhomothetic preferences. Nevertheless, none of the studies in the literature have investigated the welfare implications of the distance puzzle before and after it is solved.

This paper focuses on the welfare implications of the distance puzzle by considering the implications of a standard trade model. Theoretically, it is shown that changes in the distance elasticity of trade can be connected to the changes in the welfare gains from trade by using bilateral distance measures and bilateral expenditure shares across countries. When trade implications of this model are estimated in a log-linear Ordinary Least Squares (OLS) regression (where zero-trade observations are ignored by construction), the distance puzzle is confirmed, and it is shown that the world economy has a cumulative welfare loss (about 81%) due to this puzzle in the last two centuries. When zero-trade observations are included in a Pseudo-Poisson Maximum Likelihood (PPML) regression, the distance puzzle is solved, and it shown that the world economy has a cumulative welfare gains from trade (about 58%) due to reductions in the negative effects of distance on trade over time. Whereas 47% of these welfare gains are through international trade, 11% of them are through domestic trade.

The implications of the model have also been used to measure the potential future gains from trade. This has been achieved by considering a hypothetical case in which the effects of distance have been set to zero, both within and across countries. The corresponding results have shown that the potential future gains from domestic trade are about 79%, whereas those from international trade are about 197%, suggesting that there is much more to be done to reduce the negative effects of distance on trade.

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

 

The working paper version is available here.

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).