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External Cyclicality in the Face of Aggregate Demand Shocks:Pros

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External Cyclicality in the Face of Aggregate Demand Shocks:Pros VOL. 4, NO. 5, December 2015 ISSN 2307-2466 International Journal of Economics, Finance and Management ©2011-2015. All rights reserved. http://www.ejournalofscience.org External Cyclicality in the Face of Aggregate Demand Shocks: Pros and Cons across Developed and Developing Countries Magda Kandil Central Bank of the United Arab Emirates (CBUAE), Abu Dhabi, United Arab Emirates ABSTRACT Using data for a sample of advanced and developing countries, the paper studies variation in the effects of aggregate demand shocks on the external sector and underlying components and distinguishes between the effects of expansionary and contractionary shocks. The aim is to study the determinants and implications of cyclicality across representative countries in each group. The composite evidence points to high degree of cyclicality in many countries. Based on time- series correlations, there is a stronger cyclical co-movement between the trade and current account balances across advanced countries, compared to developing countries. Further, fluctuations in the financial balance are dependent on developments in exports in many developing countries. The determinants of external vulnerability vary with macroeconomic indicators. The evidence points to higher vulnerability of the external balance with respect to higher trend inflation across developing countries. In addition, constraints on capacity in developing countries could risk external stability as trend growth increases across countries. Government spending is an important determinant of external stability in developing countries, reflecting the adverse implications of higher government spending and a widening fiscal deficit on debt sustainability and external financial flows. Further, private consumption is a key driver of aggregate uncertainty and cyclical fluctuations in the external balances across developing countries. Keywords: Cyclicality, demand shocks, financing, crowding out, supply constraints, developing and advanced countries. 1. INTRODUCTION Macroeconomic policies could further help Cyclical downturns could have adverse effects external competitiveness if targeting higher growth and on the trade and financial balances of the balance of less inflation. payments. External balances are determined by exports and imports, which primarily determine the trade and The data under investigation are for a sample of current account balances. Further, the financial external 29 advanced countries and 19 developing countries balance is primarily determined by FDI and portfolio between 1963 and 2013. Estimation coefficients will flows. It is expected that trade and external balances vary measure the effects of fluctuations in aggregate demand with the business cycle. During booms, exports and on export growth, import growth, the trade balance, the imports may increase. The net effect on the trade and current account balance, FDI flows, portfolio flows and current account balances will depend on the relative the financial balance. The evidence will inform policy elasticity of exports and imports to the business cycle. makers on how to capitalize on external openness to stimulate the economy and ensure the best results for Further, it is likely that financial inflows increase economic performance and external stability, without in response to improved economic conditions. unduly exacerbating macroeconomic imbalances and subsequent adverse effects on the economy. Demand elasticities or constraints on the supply side may differentiate the expansionary and The composite evidence points to high degree of contractionary effects of shocks to aggregate demand. cyclicality in the underlying components of external balances in many countries. The correlation between the Further, macroeconomic policies could trade and current account balances is stronger across exacerbate (pro-cyclical) or mitigate (counter-cyclical) the advanced countries, compared to developing countries. In effects of aggregate demand shocks on the macro addition to the trade balance, other components of the economy. The aim of this research is to study variation in current account balance are equally important to external the effects of aggregate demand shocks on the external stability in many developing countries. Fluctuations in the balances and major underlying components and financial balance are dependent on developments in distinguish between the effects of expansionary and exports in many developing countries, signifying the need contractionary shocks. Higher inflation is likely to for external financing. The determinants of cyclicality in undermine competitiveness and the prospect of improved external stability also provide sharp contrasts across the external balances during an economic boom. In contrast, two country groups. The evidence points to higher spending on investment contributes to capacity building vulnerability of the external balance with respect to higher and eases constraints on the supply side. Hence, trend inflation across developing countries. In addition, investment spending stimulates real output with little constraints on capacity in developing countries could risk inflationary effects. Through this channel, the external external stability as trend growth increases across balances are likely to improve during economic booms. countries. Government spending is an important determinant of external stability in developing countries, reflecting the adverse implications of higher government spending and a widening fiscal deficit on debt 171 VOL. 4, NO. 5, December 2015 ISSN 2307-2466 International Journal of Economics, Finance and Management ©2011-2015. All rights reserved. http://www.ejournalofscience.org sustainability and external financial flows. Further, private 2.1 Demand-Side Asymmetry consumption is a key driver of aggregate uncertainty and The size of the aggregate demand shift may be cyclical fluctuations in the external balances across different with respect to the specific underlying developing countries. expansionary and contractionary shocks. The remainder of the paper is organized as Two factors determine the size of aggregate follows. Section II provides theoretical background. demand shifts with respect to the underlying shocks. First, binding liquidity constraints may differentiate the effects Section III describes the empirical methodology. of demand shocks on financial markets. Access to credit is Section IV discusses the implications of the time-series necessary to finance higher spending. Given the limited evidence. supply of available loanable funds above maximum capacity, an increase in spending raises the interest rate. Section V analyzes co-movements in the cyclical responses of macro variables to aggregate demand shocks An increase in the cost of borrowing counters across the groups of developing and advanced countries. demand expansion in the face of a stimulus policy. 1 Constraints on capacity in the labor and product markets Section VI analyzes determinants of cyclicality increase crowding out and the probability of asymmetry in in the external balances and underlying components demand shifts in the face of equal underlying across the two country groups. Section VII offers a expansionary and contractionary shocks. summary and conclusion 2.2 Supply-Side Asymmetry 2. THE ASYMMETRIC EFFECTS OF Conditions on the supply side in the labor and/or AGGREGATE DEMAND SHOCKS product markets may differentiate the slope of the The empirical investigation will separate shocks aggregate supply curve in the face of expansionary and to aggregate demand into positive and negative contractionary demand shifts. New Keynesian theoretical components to study possible asymmetric effects on the models have focused on market imperfections towards an macro-economy over the business cycle. This section explanation of a kinked-supply curve. The source of outlines the theoretical arguments regarding the asymmetry has varied between sticky-wage and sticky- determinants of asymmetry in the face of variation in price explanations of business cycles. aggregate demand. Sticky-wage models have traced sources of Asymmetric cyclical fluctuations may be a cyclical fluctuations to conditions in the labor market function of conditions on the demand and/or supply-side (see, e.g., Gray (1978)). Implicit or explicit labor of the economy (Kandil, 1995, 1996, 1998, and 1999; contracts may offer an explanation of sticky wages. Given Karras, 1996a, b; Apergis et al., 2005). To illustrate, nominal wage rigidity, an unanticipated increase in price, consider the following reduced-form equation: in response to a positive demand shock decreases the real wage and increases the output supplied in the short-run. Conditions in the labor market may differentiate, however, upward and downward nominal wage flexibility (1) in the face of expansionary and contractionary demand D(.) is the first-difference operator. The log of exports is denoted by x where denotes the log value of imports. Aggregate demand shocks comprise distributed 1 The unfolding debt crisis in Europe provides a clear lags of positive and negative shocks, posd and t j illustration of how the increase in government spending d financed by higher cost of borrowing results in a negd . The difference between and t j pvj ballooning deficit that demands ever increasing risk d premium. The end result is unsustainable public finances measures asymmetry in each variable’s response to that undermine the effectiveness of government spending nvj to stimulate growth and crowd
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