(WP 2007-01) Openness, Income-Tax Progressivity, and Inflation

This paper considers a model of an open economy in which the degree of income-tax progressivity influences the interaction among openness, central bank independence, and the inflation rate. Our model suggests that an increase in the progressivity of the tax system induces a smaller response in real output to a change in the price level. This implies that increased income-tax progressivity reduces the equilibrium inflation rate and that the effect of increased income-tax progressivity on inflation is smaller when the central bank places a higher weight on inflation or when there is greater openness. Examination of cross-country inflation data provides empirical support for these key predictions

Essays on International Capital Flows

This dissertation consists of three essays on international capital flows. The first chapter documents the accumulation of foreign exchange reserves and the simultaneous increase in the foreign direct investment (FDI) for emerging market economies. The second chapter discusses the performance of FDI firms and domestic firms in creating jobs using firm-level data from Orbis. The third chapter studies the proper exchange rate and monetary policy when emerging market economies denominate their external debt in foreign currencies. In Chapter 1, I study why emerging market economies hold high levels of foreign exchange reserves. I argue that foreign exchange reserves help emerging markets attract foreign direct investment. This incentive can play an important role when analyzing central banks' reserve accumulation. I study the interaction between foreign exchange reserves and foreign direct investment to explain the level of reserves using a small open economy model. The model puts the domestic entities and international investors in the same picture. The optimal level of the reserve-to-GDP ratio generated by the model is close to the level observed in East Asian economies. Additionally, the model generates positive co-movement between technology growth and the current account. This feature suggests that high technology growth corresponds to net capital outflow, because of the outflow of foreign exchange reserves in attracting the inflow of foreign direct investment, thus providing a rationale to the `allocation puzzle' in cross-economy comparisons. The model also generates positive co-movement between foreign exchange reserves and foreign debt, thus relating to the puzzle of why economies borrow and save simultaneously. In Chapter 2, joint work with Sakai Ando, we study whether FDI firms hire more employees than domestic firms for each dollar of assets. Using the Orbis database and its ownership structure information, we show that, in most economies, domestic firms tend to hire more employees per asset than FDI firms. The result remains robust across individual industries in the case study of the United Kingdom. The analysis shows that an ownership change itself (from domestic to foreign or vice versa) does not have an immediate impact on the employment per asset. This result suggests that different patterns of job creation seem to come from technological differences rather than from different ownership structures. In Chapter 3, I investigate how the devaluation of domestic currency imposes a contractionary effect on small open economies who have a significant amount of debt denominated in foreign currencies. Economists and policymakers express concern about the "Original Sin" situation in which most of the economies in the world cannot use their domestic currencies to borrow abroad. A devaluation will increase the foreign currency-denominated debt measured in the domestic currency, which will lead to contractions in the domestic economy. However, previous literature on currency denomination and exchange rate policy predicted limited or no contractionary effect of devaluation. In this paper, I present a new model to capture this contractionary devaluation effect with non-financial firms having foreign currency-denominated liabilities and domestic currency-denominated assets. When firms borrow from abroad and keep part of the asset in domestic cash or cash equivalents, the contractionary devaluation effect is exacerbated. The model can be used to discuss the performance of the economy in interest under exchange rate shocks and interest rate shocks. Future directions for empirically assessing the model and current literature are suggested. This assessment will thus provide policy guidance for economies with different levels of debt, especially foreign currency-denominated debt

Foreign direct investment in a macroeconomic framework : finance, efficiency, incentives, and distortions

Does foreign direct investment (FDI) increase domestic investment, or does it provide additional foreign exchange for a pre-existing current account deficit, or some linear combination of the two? The author investigates this question for a group of five Pacific Basin countries and a control group of 11 other developing countries. For the sample of all 16 developing countries, the author finds that FDI does not provide additional balance of payments financing for a pre-existing current account deficit. In the control group of 11 developing countries, FDI is associated with reduced domestic investment - implying that FDI to those countries is simply a close substitute for other capital inflows. For the five Pacific Basin market economies, however, FDI raises domestic investment by the full extent of the FDI inflow. The author finds that FDI has a significantly negative impact on national saving in the sample of all 16 developing countries. For the control group, this negative effect is similar in magnitude to FDI's negative effect on domestic investment - implying a zero effect on the current account. But FDI's negative effect on national saving in the five Pacific Basin developing market economies implies that FDI could have more of a negative effect on the current account than through increased domestic investment alone. The author also investigates the impact of FDI on economic growth in these 16 countries, taking into account distortions in the economies. He estimates reduced-form current account equations, and presents an analytical framework for estimating FDI's effect on economic growth in the presence of incentive-disincentive packages and other economic distortions. He illustrates his framework using indicators of foreign trade and financial distortions. His main conclusion: the effect of FDI differs markedly from one group of countries to another. FDI has a negative effect on economic growth in the control group. It has the same positive effect on growth as domestically financed investment does in the Pacific Basin countries. The main cause for the different effect is the low level of distortion in the Pacific Basin countries.Environmental Economics&Policies,Economic Theory&Research,Foreign Direct Investment,International Terrorism&Counterterrorism,Macroeconomic Management

Infrastructure investment in network industries: The role of incentive regulation and regulatory independence

This paper finds that coherent regulatory policies can boost investment in network industries of OECD economies. Rate-of-return regulation is generally thought to result in overinvestment, while incentive regulation is believed to entail underinvestment. Yet, previous empirical work has generally found that the introduction of incentive regulation has not systematically changed investment in network industries. According to the theoretical literature, regulatory uncertainty exposes both types of regimes to the danger of underinvestment. However, regulatory uncertainty is arguably higher under rate-of-return regulation because investment decisions (what can be included in the rate base) are usually evaluated in a discretionary manner, while firms operating under incentive regulation are less affected by this behaviour. In addition, incentive regulation encourages investment in cost-reducing technologies. Using Bayesian model averaging techniques, this paper shows that incentive regulation implemented jointly with an independent sector regulator (indicating lower regulatory uncertainty) has a strong positive impact on investment in network industries. In addition, lower barriers to entry are also found to encourage sectoral investment. These results support the importance of implementing policies in a coherent framework.http://deepblue.lib.umich.edu/bitstream/2027.42/64379/1/wp956.pd

Missing Market in Labor Quality: The Role of Quality Markets in Transition

This paper characterizes a key feature of the classic socialist economy and state-owned enterprise, namely that of missing markets in labor quality. Under the socialist regime in which students and workers were assigned to work units, the rights of managers to monitor and reward workers were limited. The exchange of labor services was based more on measures of quantity rather than quality. Workers who performed functions broadly consistent with that of their assigned occupations for the duration of the designated workweek received the standard wage. With the reassignment of property rights, this situation has changed. Students and workers have resumed control over the accumulation of their human capital the trade of skill and effort. Managers have acquired greater authority to monitor labor - to discriminate in setting wages and bonuses and to hire and fire - as well as stronger incentives to use this authority to raise efficiency and profits. The result is an emerging market in labor quality.A 1995 cross section of enterprise data spanning 10 ownership types is used to test the hypothesis of an emerging labor quality market. The results show that certain non-state forms of ownership, in which the rights of managers to monitor and reward skill and effort are presumed to be relatively well developed, encourage labor quality, most notably training, which raises productivity. The relative inability of state enterprises to monitor and reward high quality labor is likely to create an adverse selection problem in which the most skilled and motivated workers exit from the state sector, so as to cause a "hollowing" of skilled workers and weakened enterprise performance. The theoretical contribution of this paper is to generalize Coase's analysis of the critical role of property rights in creating resource markets to the creation and exchange of quality in all goods. Analytically, the conditions for a missing market in labor quality are equivalent to those for a missing market in pollution abatement and water quality. The analysis underscores the importance of property rights in creating the conditions for the accumulation and efficient exchange of human capital.http://deepblue.lib.umich.edu/bitstream/2027.42/39645/3/wp260.pd

Openness and optimal monetary policy

We show that the composition of imports has important implications for the optimal volatility of the exchange rate. Using input-output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. We build a business cycle model of a small open economy to discuss how the problem of the optimizing policy-maker changes endogenously as the composition of imports and of final demand is altered. Contrary to models where steady state trade openness is entirely characterized by home bias, we find that trade openness is a very poor proxy of the welfare impact of alternative monetary policies. Finally, we quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports, using parameter values that are estimated from OECD input-output tables data. We find that the main determinant of the losses is the share of non-traded goods in final demand. JEL Classification: E52, E31, F02, F41Exchange Rate Regimes, international trade, Non-tradable Goods, Optimal Policy

ADB–OECD Study on Enhancing Financial Accessibility for SMEs: Lessons from Recent Crises

During the era of global financial uncertainty, stable access to appropriate funding sources has been much harder for small and medium-sized enterprises (SMEs). The global financial crisis impacted SMEs and entrepreneurs disproportionately, exacerbating their traditional financing constraints. The financial conditions of many SMEs were weakened by the drop in demand for goods and services and the credit tightening. The sovereign debt crisis that hit several European countries contributed to further deterioration in bank lending activities, which negatively affected private sector development. The global regulatory response to financial crises, such as the Basel Capital Accord, while designed to reduce systemic risks may also constrain bank lending to SMEs. In particular, Basel III requires banks to have tighter risk management as well as greater capital and liquidity. Resulting asset preference and deleveraging of banks, particularly European banks with significant presence in Asia, could limit the availability of funding for SMEs in Asia and the Pacific. Lessons from the recent financial crises have motivated many countries to consider SME access to finance beyond conventional bank credit and to diversify their national financial system. Improving SME access to finance is a policy priority at the country and global level. Poor access to finance is a critical inhibiting factor to the survival and growth potential of SMEs. Financial inclusion is thus key to the development of the SME sector, which is a driver of job creation and social cohesion and takes a pivotal role in scaling up national economies. The Asian Development Bank (ADB) and the Organisation for Economic Co-operation and Development (OECD) have recognized that it is crucial to develop a comprehensive range of policy options on SME finance, including innovative financing models. With this in mind, sharing Asian and OECD experiences on SME financing would result in insightful discussions on improving SME access to finance at a time of global financial uncertainty. Based on intensive discussions in two workshops organized by ADB in Manila on 6–7 March 2013 and by OECD in Paris on 21 October 2013, the two organizations together compiled this study report on enhancing financial accessibility for SMEs, especially focusing on lessons from the past and recent crises in Asia and OECD countries. The report takes a comparative look at ADB and OECD experiences, and aims to identify promising policy solutions for creating an SME base that is resilient to crisis, from a viewpoint of access to finance, and which can help drive growth and development

Openness, Income-Tax Progressivity, and Inflation

This paper considers a model of an open economy in which the degree of income-tax progressivity influences the interaction among openness, central bank independence, and the inflation rate. Our model suggests that an increase in the progressivity of the tax system induces a smaller response in real output to a change in the price level. This implies that increased income-tax progressivity reduces the equilibrium inflation rate and that the effect of increased income-tax progressivity on inflation is smaller when the central bank places a higher weight on inflation or when there is greater openness. Examination of cross-country inflation data provides empirical support for these key predictions

Circuit theory of finance and the role of incentives in financial sector reform

The author analyzes the financial system's role in economic growth and stability, addressing several core policy issues associated with financial sector reform in emerging economies. He studies finance's role in the context of a circuit model, with interacting rational, forward-looking, heterogeneous agents. He shows finance to essentially complement the price system in coordinating decentralized intertemporal resource allocation choices made by agents operating with limited information and incomplete trust. He discusses the links between finance and incentives for efficiency and stability in the context of the circuit model. He also identifies incentives and incentive-compatible institutions for reform strategies for financial sectors in emerging economies. Among his conclusions: 1) Circuit theory features important methodological advantages to analyze the role of finance, and to assess structural weaknesses of financial systems under different institutional settings and in different stages of economic development. 2) Incentives for prudence and honesty can protect the stability of the circuit by directing private sector forces unleashed by liberalization. In particular: a) Financial institutions should be encouraged to invest in reputational capital. b) Governments should complement the creation of franchise value by strengthening supervision and by adopting a regulatory regime based on rules designed to align the private incentives of market players with the social goal of financial stability. c) Safety nets to reduce systemic risk should minimize the moral hazard from stakeholders by limiting risk protection and by making the cost of protection sensitive to the risk taken. d) Governments should encourage self-policing in the financial sector. e) Where information and trust are scarce, there is a potential market for them, and governments can greatly improve incentives for optimal provision of information. f) Governments should strengthen the complementarity between the formal and the informal financial sectors. Emphasizing incentives is not to deny the importance of good rules, capable regulators andsupervisors, and strong enforcement measures. It is to suggest that the returns on investments to set up rules, institutions, and enforcement mechanisms can be greater if market players have an incentive to align their own objectives with the social goal of financial stability.Banks&Banking Reform,Economic Theory&Research,Payment Systems&Infrastructure,Environmental Economics&Policies,Financial Intermediation,Economic Theory&Research,Environmental Economics&Policies,Banks&Banking Reform,Financial Intermediation,International Terrorism&Counterterrorism

Institutional determinants of investment in transition economies

Investment has been found to be a significant determinant of growth. This paper analyses the effects of institutions and transition progress on investment rates of transition economies since the collapse of the Socialist Bloc. Political institution is measured by the Freedom House’s Political Rights and Civil Liberties indexes; economic institution is proxied by the Index of Economic Freedom compiled by the Heritage Foundation; and transition progress is documented by the European Bank for Reconstruction and Development’s transition index. Panel data estimation techniques are applied and the results show that institutions and transition progress have expected and significant effect on investment rates of transition economies. However, it is the progress in all aspects of economic freedom that matters; just some individual economic freedom measures are significant marginally. Besides, as conditioning variables, growth, saving and financial development (liquid liabilities as % of GDP) are also found to have significant and positive effect on investment in transition economies. This paper highlights the indirect effect of institutions on economic growth via investment