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Topic 1: What's different about applied development

Kasper Brandt
4. september 2015

4. september
• Rise of New Classical Macroeconomics:
○ Philips curve: relationship between inflation and unemployment. In 1970's we
experienced rising inflation with the same high unemployment rate (Stagflation).
○ Lucas critique. Models need to have a microfoundation. Optimizing behaviour of
○ What emerged: Macro based on micro.
• New Keynesian Revival (1980s):
○ Incorporated rigidities (example: only a share of firms can update their prices)
• Example (Slide 13):
○ Main goal of policy: Reduce macroeconomic volatility.
○ Assumptions: Perfectly competitive firms. Only one good. No capital is flowing in or out.
The market for capital, labor and commercial bank loans are competititve.
○ This is a typical paper from 2007. Kinda outragous assumptions.
• Crisis in macroeconomics and critique of the 'New' Neoclassical Synthesis:
○ Krugman: Let's stop deriving models from 1. principles of economics, and start deriving
models from empirical facts.
○ Representative agent implies homogenous beliefs which rules out coordination
problems. However, in the real world different views on the economy leads to
coordination failures.
○ Robert Solow and Sidney Winter are strong opponents to the DSGE models and the
assumptions of representative agent and rationality.
○ DSGE models will not be found anywhere but in Academia and Central Banks. The
private sector uses much simpler methods. If DSGE models are so good, why don't the
private sector use them and make better prediction and more money?
• How do developing countries differ from developed countries (structural differences)?
○ Statistics more difficult to obtain.
○ Politics and corruption.
○ More exposed to severe exogenous shocks.
○ Market failures.
○ Self-sustaining households.

9. September
• Applied Economics = applying an established core of theory to specific applications using
empirical methods.
○ What theory? --> new neoclassical synthesis. However, increased theoretical critique of
these models and empirical failure (lack of use in "real world").
• Definition of developing countries.
○ Classifications: World Bank income groups (ADP, Atlas method), UNDP HDI (Education,
income, health).
○ Operational classifications: Much more about vulnerability. A country may ask for
assistance from IMF if it cannot meet its international net payments on affordable
terms. Developing countries are in general more vulnerable (volatile income, trade
balance, etc) than developed countries.
 Solow residual is for developing countries dominated by a stochastic trend process
(unit root process).
Adv. Dev. Econ. Applied Macro Page 1

(unit root process).
○ Stylized facts. Developing countries are much more volatile and vulnerable to shocks.
○ Structure. Long tradition of seeing developing countries as being 'dualistic'. Does not
have to be a two sector or two market economy. It can also be three or more. Ex.:
traditional rural, informal urban, and formal urban.
• Styles of economic reasoning
○ Deductive: Theory --> Hypothesis --> test (Theoretical method). Very academic and
not popular in policy analysis. Therefore not used a lot by for example IMF.
○ Inductive: Data --> Infer patterns --> models (Statistical method). Ex: RCTs and natural
experiments. RCTs are not possible in macroeconomics, but natural experiments are
possible. Drawbacks: i) hard to find evidence of something if you don't know what to
look for or ask the right questions, ii) different statistical models give rise to different
results, iii) External validity.
○ Abductive (iterative): given evidence E and candidata explanations H()1, ... , H(n) of E, if
H(i) explains E better than any of the other hypotheses, infer that H(i) is closer to the
truth than any of the other hypotheses. The "Ten Commandments for Economists" by
Danny Rodrik.
• Compulsory assignment:
○ Starts with a question or statement
○ Elaboration drawing on evidence or literature
• Questions:
○ The applicability of new neo-classical synthesis macroeconomic models to developing
countries is limited.
○ When working with policy challenges in developing countries, an abductive approach
to research is appropriate.
 Reasons why this is true or proof of contradiction.
 de Long, B. (2011). ‘Economics in crisis’. "We need fewer efficient-markets
theorists and more people who work on microstructure, limits to arbitrage, and
cognitive biases." That is, we need practitioners. This statement is in favour of the
inductive or abductive reasoning. Remember to say that this blog focuses on the
crisis of economics after the financial crisis, though he does say that various
economists have emphasized the possibility of a new major crisis. The crisis arises
in the fact that economics departments are not (according to the author)
reorienting themselves. They continue to appreciate theorists too much.
 Use the three circles from the slides.
 Colander (2013). "Koen carefully points out that, while there is a connection
between engineering and science, engineering is not applied science; rather,
science should be seen as applied engineering. By that he means that science is the
application of the engineering methodology ‘Use the best available engineering
heuristics to solve problems’ to a particular problem". Thereby, Koen argues that
the abductive approach relates to engineering methodology. Since Koen argues in
favour of the engineering approach, then he must appreciate the abductive
approach the most.
○ Important insights can be gained from the use of dualistic macroeconomics models in
developing countries.
 Use new new-classical synthesis models to show that dualistic models give rise to
important insights not gained in the new neo-classical synthesis.
○ Should applied macroeconomists in developing countries orient themselves as
engineers rather than detached scientists?
 De Long, B. (2011). May also we relevant for this question. Economics in crisis
leads to economists having to reorient themselves as practitioners rather than
theorists that have structural solutions. In contrast to Colander (2013).
 De Long, B. (2015). Science is good if it is detached. However, "some economists
have a tendency to claim that what is true about certain types of theories is true
Adv. Dev. Econ. Applied Macro Page 2

□ Scholars should see themselves as engineers who solve real-world problems instead of detached theorists whose goal is to provide better understanding of the economy for the sake of the understanding. See the paper for these changes. it is highly successful in recruiting students and in being respected by the public.  Colander (2013). Applied science sees scientific knowledge at its core. the more likely the methods will differ." □ If a situation is perfectly understood then the engineering and scienrific approach is asymptotically the same. Adv. and then it is problematic to apply theories that have been developed for the sake of understanding. Historical knowledge. This larger core opens up the analysis to a wider range of acceptable models than does applied science. techniques. homogenous agents. the economics profession is not in crisis – far from it. and economic judgment. If the primary goal of macroeconomists were to provide policy advice then the methodology used is very problematic. Thereby. It excludes all non-scientific knowledge. First. intuitive knowledge and guestimates are all allowed as foundations for engineering models. research incentives would change to a more engineering/problem-solving approach.have a tendency to claim that what is true about certain types of theories is true for all theories and thus applicable to the real world". and rational expectations." □ Implementation could be through university funding. □ "The difference between thinking about applied economics as applied science and as engineering can be seen by considering what is at the core of the model used. These are for example price taking behaviour. Contrary to what some heterodox economists claim. The engineering core includes all applied science but can include non-scientific knowledge in the core as well as established scientific knowledge. It wouldn't be a problem if objective for macroeconomists was to understand theories for the sake of understanding. However." □ No economics crisis. And it is in agreement with what Colander says about non-scientific knowledge also being important (economic judgment). Some of the funding is for applied research while another share of the funding is for purely scientific purposes. and more uncertain. "The main conclusions are as follows. Dev. Applied Macro Page 3 . the situation. Macroeconomists forgot to point this out and that the primary goal usually just is to understand the theory for the sake of model building. Econ. "But Koen emphasizes that engineers deal with ‘poorly understood and uncertain’ situations. no single model or framework is universally applicable—policy formulation relies on a variety of models." This is in agreement with what de Long is saying about what is true for one theory may not be true for another.  IMF (2004). society expect macroeconomists to help with real-world problems. "Implementing an engineering methodology instead of a scientific methodology would lead to five changes in how applied economics is done. and the less understood.

○ Selection bias problem. Dev. Capital controls have been used extensively in the past.g. September • What do we mean by macroeconomic policy: Policy domain Elements / tools Institution Monetary policy Money supply. The effect from the number of loans to macroeconomic distortions. debt-to-GDP aim) Easterly (2005): What did structural adjustment adjust? • Position: Loans from the World Bank and IMF conditioned on structural adjustment have not worked (no positive effects on policies or growth) properly. • Other macroeconomic instruments are monetary policy and fiscal policy (e.Topic 2: How has macroeconomic policy evolved in developing countries? Kasper Brandt 14. Dynamically adjusted financial regulation. getting the prices right (inflation stabilization). Macroprudential tools more used after the Crisis. Addressed by using Heckman-type selection techniques and IV estimation. september 2015 21:54 Rethinking macroeconomic policy: Introduction • Macroprudential policies. MTEF Central government Exchange rate policy (can't be used seperately from monetary policy) International reserves/Debt obligations Central bank or government if central bank is not independent Monetary policy is the most important/used macroeconomic policy since our main objective is to stabilize inflation. trade liberalization. but it has not been used in a dynamic way.g. while maintaining their growth and developmental momentum. deposit interest rate Central bank Macro-prudential policy Financial sector regulation (like liquidity rules). But due to country-specific heterogeneity it might be the case that some countries need more loans than other countries or that the loans do not work in every country. ○ Rationale from the structural adjustment loans (SALs) was to maintain growth and to facilitate balance of payments adjustment. . Fiscal policy Annual budget --> Allocation of spending and taxation. Applied Macro Page 4 . Econ. to strengthen their balance of payments. • Oil shocks Adv. then we would expect a negative relationship between the number of loans and macroeconomic distortions. Financial sector regulation is rather new and we have not seen the long-term implications of this tool." ○ SALs are e. fiscal adjustment. If we believe that loans are like a pill or drug. More specific the objective was to "reduce their current account deficit to more manageable proportions by supporting programs of adjustment . 16. . and in general a movement towards free markets. ○ Objective: Measure the performance of SALs. Financial Risk Capital controls Council in Developed Countries.

Short-term macroeconomics: ○ Control inflation ○ Guarentee essential imports ○ Balance of payments correction • Structural adjustment (mainly World Bank). ○ See table by Rodrik on slide 27. This led to the Washington Consensus of SALs. Maybe some countries benefit less from these programmes than other countries. • Crisis following the Washington Consensus --> questioning the consensus: ○ Mexico Crisis. September • Pre-Washington Consensus view was primarely neoclassical synthesis (new neoclassical synthesis emerging). • Why is it so difficult to evaluate whether IMF/WB programmes have been successful? ○ No counterfactual ○ Selection bias ○ Country heterogeneity is difficult to deal with. 23. ○ When the second oil crisis hit many developing countries couldn't pay off their debt and in order to stabilize balance of payment (BoP) they asked IMF and World Bank for help. ○ Basically: Market works. ○ Between 1973 and 1977 developing countries struggled a lot with repayments of debt. Led to reinforcing optimism and essentially they had to devalue the peso remarkably. Econ. • Post-Washington Consensus ○ The Washington Consensus + focus on institutions + country-specificity + more. ○ Open-up to the rest of the world through trade and capital account liberalization. ○ Liberalize domestic product and factor markets through privatization and deregulation. Applied Macro Page 5 . Mexico adopted all the recommendations by IMF and World Bank. • Post-Washington Consensus had the same view as the Washington Consensus. Dev. Being in a macroeconomic crisis today might influence the probability of still being in a macroeconomic crisis tomorrow. ○ Lost decades of growth in Africa (1980s and 1990s) ○ Success in India and China show that there are other paths to growth than the Washington Consensus. but we need to wrap inside a nice framework of good institutions. market works. ○ Multiple outcomes (what should be measure when we want to evaluate the performance of the programmes. Adv.• Oil shocks ○ Oil shock of 1973 led to huge current account deficits which led to a slowdown of investments and growth. Long-term macroeconomics: ○ Sustainable public finances ○ BoP sustainability ○ Static efficiency (factor reallocation) ○ Dynamic efficiency (institutions) • Washington Consensus (1980s/1990s): ○ Pursue macroeconomic stability by controlling inflation and reducing fiscal deficits. Due to the focus on institutions a larger role for government emerged. but also focused on institutions. ○ Confounding factors (national and global) ○ Sample size (usually a maximum of 70 developing countries) ○ Dynamics. • Washington Consensus was markets works and sound money (fiscal and monetary policy). Role for government was very limited. • Superficial evidence on stabilization and structural adjustment loans. • Stabilization (mainly IMF). That is. ○ East Asian financial crisis of 1997.

g. Difficult to replicate the paper. then nothing will happen. the effect on implemening good policies). we might even find a negative effect from the loans due to this selection problem. But. E. fiscal laws. They can vary depending on the specific context. Applied Macro Page 6 . the countries that gets better form the loans will stop receiving loans. Not only "how much am I gonna spend this year". • Sum up: ○ Absence of Evidence (Not evidence of absence). In addtion. Difficult and not many countries have solved this issue. ○ Selection problem. ○ Institutional independence. ○ Rule-based behaviour (e. Loosen X and development will we can observe all imf loans to a specific countries. The countries engaging in these loans are not randomly chosen. budget reporting). ○ Selection problems. Dynamic effects ignored (being distorted today is correlated with being distorted yesterday). etc. X.• Superficial evidence on stabilization and structural adjustment loans. because he does not make clear definitions of his data (e. ○ Transparent and timely reporting of data/decisions. current account dificit should not be more than 3% of GDP. the budget needs to be availavle by a certain date. Dev. • Government budget rules (fiscal rules): e. As long as these institutional arrangements pursue the universal principles we should be fine.g.g. ○ Multi-year horizon over policy and plans. ○ Mechanisms for policy monitoring and coordination. The believe of what X is has changed during time. Econ. • At imf. The important thing is to have an institutional framework which pursue these universal principles. • Easterly (2005) conclusion: "No relationship between cummulative adjustment loans and macro distortions". "Absence of Evidence" is not the same as "Evidence of Absence".g. • Rodrik (2005) ○ Universal principles which in general works.g.g. ○ Usually the relationship between programmes and outcomes (e. E. That is. • How do we identify good institutional designs (not comprehensive list): ○ Clear and distinct institutional mandates over different domains of macroeconomic policy. it might be better to focus on the relationship between programmes and policies (e. ○ Institutional arrangements need not be universal. where do the 30 IMF loans to Argentina come from?). Common fallacy is that underdevelopment is due to one constraint. It is countries with fundamental macroeconomic problems. ○ Probably wouldn't get published today. • Questions: Adv. but different ways of implementing these principles.g. but if a country does not have an institutional framework for doing so. • Data sources at slide 49. but also a draft plan for future years. ○ Over-simplification. Failure to account for country heterogeneity. where to build roads. growth) is in focus. Therefore. how to achieve growth. how many schools to build. liberalizing trade and other objectives might be good. while countries not recovering will continue receiving loans. ○ But.

(This would be a minimum for an answer). Not one golden path as has been suggested by WB/IMF. There can be cases where these fiscal rules and central bank independence are limiting flexibility and disimprove stability because they limit policy.g. Easterly)? Overall they find little evidence of any macroeconomic effects from WB/IMF programmes. independent central bank or fiscal rules). Question from Sam (V1 and V2 are the same): ○ V1: Good macroeconomic governance (policy-making institutions) is critical for the achievement of macroeconomic stability.  There is a paper on the reading list relating to this question. inflation and balance of payments) in developing countries. heterogeneity.both underlying principles (sound money.  You could argue that China followed the underlying principles. Important distinction between underlying principles and specific policy content. E. non distortionary policies) and specific policy content (widespread deregulation. Applied Macro Page 7 . Rodrik (2005): ○ Policy recommendations of Washington Consensus (WC) are not necessary to achieve sustained economic growth.  What does research tell us (e.  First of all. privatization. ○ V2: Fiscal rules and Central Bank independence can be critical for achievement of macroeconomic policy. Dev.• Questions: Easterly (2005): ○ There is little evidence to suggest that WB/IMF programmes (SALs) have contributed to growth and macroeconomic stability (like public debt.  Distinction between institutions and policy-making institutions (institutions with capacity or/and legally bounded to follow underlying principles. Look at Rodrik (2005) for more flexible considerations on the WC.  Opposite cases. □ Absence of evidence. □ Econometric problems like selection bias. etc. Not necessary for macroeconomic stability. not evidence of absence. Econ.  Evidence.  Examples of improving macro governance. but differed in their specific policy content. measurement error.  Go further and ask why this is the case. what are the policy recommendations of WC . □ Bad advice.g. reverse causality. Adv. financial liberalization).

Avoiding crisis. but several years before the peak. variance = variance of consumption. but the integrated income between the counterfactual GDP and reality (volume between actual GDP curve and counterfactual GDP curve). september 2015 21:52 30. while fiscal policy is closer linked to distribution. the Africans receiving the land (political allies) had no experience in farming and no interest in farming. Like the position notes. it is ok also to be critical saying that under certain circumstances the standpoint taken is not true or less true. ○ The utility function can be either CRRA (constant risk aversion) or logarithmic. In real life they are definetely not stochastic . October • Zimbabwe. But. 2. ○ Gains at margin from stabilization vs. because the years before the shock experienced higher growth than the counterfactual stabilizing outcomes. if you avoid crisis by stabilizing more then more stabilization might still have severe positive effects. Applied Macro Page 8 . • It might be that the counterfactual should not start at the peak. So the effect from stabilizing more mainly comes from the lower probability of crisis. ==> interest rate is equal to the inverse of the money demand function ( i = Adv. September Exam relevant: Start by taking a standpoint.they have persistance and will not necessarily return to the trend or at least not very fast.Topic 3: What priorities should macroeconomic policymakers focus on? Kasper Brandt 27. But. • The interesting part is not only how much GDP declines. • At least four potential sub-goals: ○ Stabilization. ○ ==> Real money as a share of GDP (M/(P*Y)) is equal to the f(i). ○ c(t)_bar = certain income ○ c(t) = c(t)_bar * e(-(sigma^2)/2) * epsilon(t) ○ We want to find a situation where utility of certain income is equal to utility of actual income times a risk premium (lambda). • Real money (M/P) is equal to GDP times the money demand function of the interest rate.  ==> lambda is approximately the same as variance / 2. When you get to a reasonbly stabilized business cycle then the gains from stabilization are low. • Welfare costs of consumption volatility. But. ○ Lucas' point = Too much emphasis have been put on fighting volatility in the business cycle. Dev. ○ A problematic assumption is that expected shocks are stochastic. Could argue that the focus has been on stabilization. Econ. ○ Allocation ○ Distribution ○ Accumulation • Monetary policy and macro-prudential policy is closely linked to stabilization. ○ Using the ln-function we get that:  ln(1 + lambda) = variance / 2 . Around 2000 Mugabe made a reform redistributing land from the white to the African. and then argue for your case.

Argument: Cost of increases in inflation is a fair price for the change in relative prices which will lead to lower unemployment. ○ We would expect convergence so that the productivity of sectors became more and more alike. while internal shocks are within your reach of something you can change.that inflation reductions do not lead to large gains when being in a moderate/reasonable inflation situation. ○ Differences in productivity between sectors have widened. • Blog by Michael Power: "Devaluation and inflation". • Vollrath (2009). Economically. ○ South Africa has a surplus labour force.g. Applied Macro Page 9 . So how much economic activity should we sacrifice to keep inflation down. ○ They find that their time series are not stationary. Econ. ○ Concern in the population is that devaluation will lead to inflation and increase the prices of oil and other necesssities. moving people from agriculture to manufacture). ○ The author argues against this concern. There are large gains from being intermediate stable compared to unstable. What we see is that people usually value employment more than low inflation. ○ Stabilization as a precondition for growth. Inflation targetting is probably more effective when inflation is due to internal shocks. ○ Inflation targetting might be ineffective when there are foreign (external) price shocks and a country needs to restructure its factors of production.  Wage inflation.○ ==> interest rate is equal to the inverse of the money demand function ( i = f^-1(M/(P*Y)) = g(M/(P*Y)) ) • South Africa paper on measuring welfare costs from inflation (Gupta & Uwilingiye (2008). ○ Different forms of inflation:  Cost push inflation.g.  Inflation targetting less effective: External shock --> higher intermediate prices --> higher domestic prices --> inflation  Inflation targetting more effective: Internal shock --> wage increases --> inflation Adv. so they check for cointegration. But. There might be a technical trade-off. the opposite has occured. However. This is in accordance with the key point from the lecture . October • Four main critiques of price stability focus: ○ Economic vs. Inflation of 10% leads to a deadweight loss of approximately 1% of GDP. oil. the gains from reallocation of resources are large. Less severe wage inflation if the labour force is unemployed. there are not large gains from being stable compared to intermediate stable. 9. A failed structural transformation story. If a lot of imports are intermediates in domestic production and therefore prices will rise. • Priorities in practice: ○ Stability as the primary mandate of monetary and fiscal policy (macroeconomic policies). E. Devaluation shifts relative prices in the economy (relative price of import versus domestically produced goods). we have the usual Phillips curve saying there is a trade-off between inflation and unemployment. ○ According to his results. but does this trade-off transfer into social preferences. Dev. ○ Gains from moving people to specific sectors (e. The reason is that if the external shocks are permanent then you need to restructure factors. ○ When you're in a situation with moderate levels of inflation the gains from reducing inflation is rather small in a welfare context. If you have a market with low level of unemployment then wage inflation will rise. • Jones & Tarp (2015). Social trade-offs between employment and inflation.

Another is debt followed by these huge investment rates. so the government should put some emphasis on these distortions. □ Explicit and implicit interventions in financial markets. Inflation targetting more effective: Internal shock --> wage increases --> inflation • Pham & Riedel (2013): Inflation Growth Scenario Rising Rising "Phillips Curve" Rising Falling Incredible policy environment Falling Rising Credible policy reform ○ According to the authors we should be in the third row. ○ Lucas paper which points to the need of structural change. and not only price inflation) and the objective from price stability. but we probably are in the second row. • Questions: Lucas (2003): ○ Do long-run structural policies have a larger impact on consumption possibilities than short-run stabilization policies? ○ Can cyclical output variability be completely offset by stabilization policies? Should macroeconomics policymakers in developing countries focus only on price stability? ○ Answer should distinguish between what kind of price stability (remember there is also wage inflation.  Monetary policy easing (standard response). • Wong. In most developing countries we would be lucky to see investment rates of 20%. Applied Macro Page 10 . There are trade-offs. The Fiscal Stimulus Programme and Public Governance Issues in China. One trade-off is the housing bubble they experience in China. ○ The paper gives a good overview on what the Chinese government did in response to the financial crisis. not all developing countries should follow this strategy. (2013). Currently.  More than 60% investment rate in 2009. Dev. ○ Vietnam paper. ○ South African blog which points to reallocation of factors. Price stability as avoiding crisis versus price stability as maintaining inflation below some X% of GDP. Financed through central government and bank financing. ○ It's not the central bank's mandate to restructure the labour market or SOEs. ○ However. we don't know the magnitude of the debt. If not (Vietname case) Adv. At least temporarily. and the case of South Africa where the author argues that structural changes are also necessary. ○ Draw on the case of China as an example where they do not only focus on inflation targetting. In that sense. What structural features of developing countries should be taken into account in the design of growth and stabilization policies? ○ Vollrath paper. □ Local investment companies (quasi public. Do have a stable Pihillips Curve? If yes. A lot of public investment is through these local investment companies. ○ The primary objective for the Chinese government is to maintain a high growth rate in order to maintain high employment rate. Econ. □ Administrative measures. because they are allowed to earn profits).  Stimulus package of around 20% of GDP. then we can fine tune. C. we could experience falling inflation and increases in growth.

○ Do have a stable Pihillips Curve? If yes. If not (Vietname case) then we need structural changes. then we can fine tune. Applied Macro Page 11 . Dev. Adv. Econ.

Q = E(ij) * P(j) / P(i) = real exchange rate. All approaches should be similar and publishing GDP statistics should preferably use all three methods as a robustness check. Y = r*K + w*L. ○ Real interest rates. real. In order to have a composite measure we calculate the effective exchange rate. ○ Laspeyres consumer price index. capital). • GDP. ○ Interest rates: nominal. 2) capital income (financial interest. or maybe central databases in advanced countries)? Adv. October • Morgenstern (1963): Argue that economic statistics should only be published together with an estimate of their error. Surveys/censuses (household budget survey. "which nominal interest rate?". dollar. L(p) * P(q) = V ==> P(q) = V / L(p) • Each contry has many bilateral exchange rates. because there are various interest rates. rental income). But it is difficult to calculate these. Total values of sales in the economy minus intermediates. 4) Own income (grey economy). "s(0)" is the weighting factor. effective. Especially difficult in developing countries. Y = C + I + G + (X . E(ij) = nominal exchange rate. we calculate a trade-weighted average. If we have a Laspeyres prices index and expenditure shares then we can obtain a Paasche quantity index. ○ Real effective exchange rate. It can be Arithmethic average and Geometric average. "what should be considered part of production (how about the grey economy)?".M) ○ Incomes (labour. • Pick one of the following macroeconomic aggregates: ○ Real GDP index.Topic 4: What are we measuring? Kasper Brandt 21. E. etc. real. ○ Exchange rates: nominal. What do we need? 1) wage incomes. Three approaches: ○ Value-added (output . Denmark has bilateral exchange rate with the euro. agricultural survey) are the only way in which we can measure incomes when administrative data are missing. It is simply just a weighted mean of price ratios. informal business survey. • The most applied index number is probably the Laspeyres index. These are complicated measures to calculate. ○ Final expenditures. oktober 2015 08:16 21.inputs). Applied Macro Page 12 . ○ Price and volume indexes. W(i) / P(i) = what can be bought in country i. Dev. Main questions when we want to calculate these measures: 1) What do you need (which statistics)? 2) Where do you get it from (surveys. • The real exchange rate tries to capture the differences in purchase power. 3) Corporation profits. W(i) / ( E(ij) * P(j) ) = what can be bought in country j. svenske kroner.g. Typically. Econ. different ways to measure exchange rates and prices. "which prices to use?". • We need practical definitions for: ○ GDP: value of total domestic production. In the Paasche index "s(t)" is the weighting factor.

and these have high uncertainty.  Surveys. which is problematic. in Mozambique CPI is calculated with data from a few large cities. On the slides we compare real effective exchange rate for US and South Africa using various deflators. because you are only measuring what was measured in the old base year. household appliances. quarterly) statistics are measured. Dev. Simply ask an agent in a region: "How has your crops been doing this year . "beer group".g. revisions take place and the statistics get more accurate. Use supermarket websites and their prices on food.  Is official inflation "wrong"? ○ How do the authors answer?  Web-scraped prices for various countries (other Latin American countries). etc. how much?". October • When calculating the real effective exchange rate we need to choose a deflator. but now the challenge is to put weight on the products. balance of payments. They have the prices. Usually preliminary (e. October • Sources of uncertainty ○ Temporary uncertainty. These old base years leads to new products.g. cpi) are delayed and not reported as fast as in developed countries. beverages. E. but also which nominal interest rate to use. services and technologies being overseen. National accounts base year. and NOT data from a representative sample. How significant are these sources of uncertaincy. Geometric mean of each group. Applied Macro Page 13 . We can get an estimate of this uncertainty in different ways. Econ. Informal sector is higher in Sub-Saharan Africa and Latin America. • Case studies (Argentina): ○ What is the research question?  Can online inflation data match offline inflation measures? (since 2007 there has been discussion on wether the offical inflation statistic is correct).g.good. You cannot get the same for dollar in Denmark as in Mozambique. public statistics (government accounts. ○ Persistent uncertainty. Later. and then use growth rate within two benchmark years based on surveys. ○ Base years are pretty bad for LDC. Nigeria and Ghana were adjusting GDP upwards by around 89% and 60% respectively. we use PPP. In the old base year you naturally didn't measure products invented after the base year.  Data from extension agents.). • Often GDP estimates are downward biased due to old base years. The older the benchmark year is the higher is the probability that you will miss new products and services.CPI is heavily weighted towards non-tradables. ○ Permanent uncertainty. "bread group". For developed countries base years are usually within the last fice years. It may take many years for the statistics to be correct or "very accurate".advanced countries)? 28. Even regular data is usually poor in LDcs. But later years will not measure these (now invented) products. Therefore. ○ Spatial uncertainty. • Relevance.  Agricultural censuses. Adv.  Construct an online price index. • In measuring real interest rate we have the same problem with deflators. ○ Especially in Africa we see huge impacts of revisions.  Rainfall. They take a product and put it into a group (e.  Base year --> prices (fixed)  Benchmark year --> comprehensice set of national accounts estimates for ONE benchmark year. But which one should we choose? . 30. bad. "milk group". Also.

If they DO fabricate the statistics then other people can go in an to the same calculations and find different results.  Are key research papers robust to use of different versions of PWT? They take key papers that use a specific version of the PWT. real interest rate. but fails to replicate the revision of the service sector using the standard approach. To see if there is systematic differences explained by certain factors. "milk group". transparency. In Argentina there is systematic differences in LEVEL of prices.: ○ What is the research question?  Are PWT versions different?  What is driving the differences? If they are random and not systematic then it might not be that big of a problem. Thereby. Give us more". etc.  Price deflator in service sector is moving around a lot. ○ What do we learn about measurement challenges?  There are political incentives to manipulate with official statistics. Or countries may undervalue growth rate in order to say: "We are very poor and we need more aid". the political incentives will be diminished.  Real wages has a political dimension. Geometric mean of each group.  Most "extra" growth from service. Arithmetic weighted of each group price. ○ How do the author answers?  To answer the first research question they simply look at descriptive statistics. Dev. (growth of GDP as dependent variable). In China the incentive was to live up to the target of 8 percentage real growth rate. "bread group".  For the second research question they regress the differences between version 6. • Case studies (China): ○ What is the research question?  Is revision on Chinas GDP reliable? Level of nominal GDP increased for 2004 (which was the most recent year the considered).  Decline in construction growth. Conclusion is that they manipulated the price deflator to generate political acceptable or "desirable" real growth rates. In other countries they may overvalue the growth rate in order to say: "Look.).1 on some variables and see if they can explain the differences. and they do the same calculations with a new version of PWT. secondary production and construction. Might move both ways. He keeps the original deviations around the trend.  What happened in 1998? ○ How do the author answers?  He applies standard retropolation methods (trend-deviation interpolation approach). Applied Macro Page 14 .  Robustness check says the same. • Penn World Table (PWT) paper by Johnson et al. Higher inflation than officially estimated. ○ What do we learn about measurement challenges?  Knock-one effects. If you miscalculate inflation then it will have an immediate effect on real wages.  He is able to replicate the results for the primary production. He compares his results from the standard technique to what the revision reports. Do the average growth rate for countries change when looking at different versions of PWT. Econ.2 and".  Online measure ==> inflation higher than officially estimated. aid is working here. ○ What are the main findings?  Online and offline measures match in other Latin American countries. This leads to the relevance of an independent statistical agency. but the trend changes. etc. ○ What are the main findings?  GDP growth is higher for every year except for 1998. What are the main findings? Adv. Or.

and if so. ○ What are the priorities for improving the quality of macroeconomic statistics in developing countries?  Pretty much the same as the above question (question 4). and should we care?  International prices = PPP. Also. labour force surveys.  We can bring in the China and Argentina studies as examples of why independence and transparency is important.  Systematic relationship with the distance to the base year (larger distance leads to higher differences). Econ. household budget surveys.  Discuss what can be done to bring these uncertainty sources down.g. ○ What do we learn about measurement challenges? • Questions: ○ What drives large differences in estimates of GDP at international prices.  Do countries neglect statistical capacity because they have other priorities? Production of good quality statistics costs money. are some sources more important than others? Can we directly observe key macroeconomic variables? Does revisions (i. Papers on developing countries and countries with bad data seem to be much less robust than papers on developed countries. Dev. rebasing. rebasing. That is. PWT report GDP in PPP. It looks at how key articles change results when using different versions of PWT.e. E.g. There are challenges of collecting international prices.  Johnson et al. frequency matters a lot.  Pretty much the same as the above question (question 2). ○ Statistical agencies should focus on creating statistical capacity via independence and transparancy.  They find that some papers are robust while others are not. ○ ○ ○ ○ Is there only one optimal way in which real GDP can be constructed? Is uncertainty important. papers looking at annual changes in growth rates will suffer more from using different versions of PWT than papers using changes over a long run. This relates to the "should we care" part. decreasing uncertainty) alter macroeconomic research? Adv. Why do these national accounts change? e. ○ What can be done to reduce the scope for bias/manipulation of key statistics such as poverty estimator?  Look at the four different sources of uncertainty and explain their impact on potential bias on key macroeconomic variables (diagnosis).○ What are the main findings?  They find large differences in growth rates between versions.  Changes in underlying national accounts. (2013) is the key study. ○ The IMF should promote quality and quantity of statistics. Applied Macro Page 15 . We want our statistics to be timely and precise.

because the process is mean-reverting (returns to the trend). November • DF test has null hypothesis of a unit root. • We distinguish between unit root and non-unit root processes by using the Dickey-Fuller type tests. • Cuestas & Garratt (2011): ○ What is the main research question?  Is there a unit root in real GDP? ○ What methods do the authors use?  They use multiple tests for various countries. (2014): Adv. This is because the past matters more when the stochastic trend is strong. ○ (4) = Non-stationary with deterministic trend (trend-stationary). Dev. ○ (3) = Random walk with drift. • Level shift may be caused by war or conflict (negative level shock) or by opening up for trade and ressource finding (positive level shock). • Ying et al.  Non-linearity in two ways □ ESTAR process. ○ If the shock is permanent then we will do a lot to avoid these negative shocks. oktober 2015 08:14 3. Applied Macro Page 16 . The same goes with level shifts. • Very important when forecasting to know whether we have a deterministic trend or a stochastic trend. ○ (2) = Random walk.Topic 5: What kind of a process is GDP? Kasper Brandt 30. The examples from class with simulated data show that we can easily reject both the DF test and the KPSS test when the real process is nonlinear and we only do linear unit root tests. • Examples of stationarity and non-stationarity processes: ○ Basicly we do not know exactly what kind of process.  Evidence that GDP may be stationary around some non-linear deterministic trend (of unknown form). Econ. 11. ○ Main findings. but we can test and get an idea of the process. • To what extent are shocks permanent or temporary? ○ Policy implications. November • What kind of process? ○ Stationary? ○ Trend-stationary? ○ Difference stationary? (stochastic trend/unit root process/random walk). ○ (1) = Stationary with break. ○ If the shock is only temporary then we do not need to do anything. ○ If we assume presence of stochastic trend then the economy will be less able to recover from a negative shock. while KPSS test has no unit root at the null hypothesis. Exponential smooth transition autoregressive process □ Polynomial de-trending.

○ Main findings. ○ Noise. • It is always possible to include a polynomial of a specific order to make a time series be trend stationary. It could be price spikes or short term recessions. Europe). • Retrospectively identifying business cycles is important because fiscal policy is dependent on which state we are in. reforms)  To "take care" of the structural breaks they use Fourier transforms. It will not give us the linear trend that is actually going on. November • Questions ○ How convincing is the claim that GDP is stationary around a deterministic trend?  Important to show the empirics. In the majority of cases we accept the null hypothesis (in 7 cases we reject the null hypothesis). But. Econ. Dev. often a function of time.  Conclusion is in contrast with the Cuestas & Garratt paper which found that for most countries we could reject the null hypothesis. Usually 1600 is chosen. inflation react to fiscal policy in certain states. A popular one is the Hodrick-Prescott filter (HP filter). (2014): ○ What is the main research question?  Is real GDP stationary in Africa? ○ What methods do the authors use?  They are worried about weak DF tests and structural breaks (e. Higher values of the smoothing parameter (in HP) will take us closer to the linear trend and lower values of the smoothing parameter will take us closer to the raw data. Applied Macro Page 17 . ○ Transitory effects ---> possibly with short-term memory. E.g.  Where are the data from? The figures on the GDP processes seem totally unrealistic.  They take sinus and cosinus to smooth out the structural breaks (see equation (1) in the paper). 18. • Moving average is the most normal detrending tool.• Ying et al. November • What determine e. "Sophisticated non-linear approximation". • African countries have faced many more structural breaks than other regions (e. However. GDP: ○ Deterministic trend ---> predictable. But to find out how inflation reacts in certain states we first need to identify the states (business cycles). the question is if this polynomial is a meaningful trend. but it has a permanent level effect on GDP.g. "The decomposition can pick out the structural breaks)".g. • Why is it important to retrospectively identify growth cycles (periods of elevated/depressed growth)? It is important because we don't want to make the same mistakes over again.g. • Characterizing the data generating process behind GDP (deterministic or stochastic or both) is important because it has different policy implications whether we have a deterministic trend or a stochastic trend. Drawback with HP filter: If we have a linear deterministic trend with a lot of noise then the HP filter moves with the noise although we have a linear trend.  Unit root test which takes into account the Fourier transform with sinus and cosinus terms. That is why we changed the question from "how Adv. This indicates that the GDP processes in Africa are more stochastic. linear trend. 13. Does not make much sense to have a deterministic trend following a polynomial of order 5.  Null hypothesis: There is a unit root. there exist much more sophisticated tools. and we can see how e. ○ Stochastic trend ---> unpredictable (random).g.

 Again we have to look at the distinction between deterministic versus stochastic trend. 2) evidence from the papers we have looked at. Dev. ○ Can we separate structural breaks in growth from volatility?  The same procedure as the first question: meaning/definition of structural breaks. That is why we changed the question from "how can we determine whether GDP contains a stochastic versus deterministic trend". evidence from the paper related to structural breaks.  This question will be put into the first question.  Satisfy the first bullit in learning objectives ("To understand the theoretical and empiral differences between stochastic and deterministic trends in macroeconomic time series.  To do: 1) meaning/definition of stationarity. ○ What are the challenges of forecasting GDP levels over the long-run and what does this mean for policy?  If there is some component of GDP where there is a deterministic trend then we have a chance of doing a reasonable approximation of future GDP (good forecast). If Sam does not merge the two questions together then you can still use structural breaks as a subject or a paragraph in the first question.  Important to find a reasonable non-linear trend.  Also relates to Frankel (2011). Often we cannot reject because of low power). Important to show the empirics. unit root. 3) how convincing? Linear trend is not convincing. Econ. Maybe structural breaks should be included.  Severe volatility makes it more difficult to do a good forecast. and how convincing are the results from that paper. stochastic trend. but the function is arbitrary and a high degree polynomial is nonsense for a true process. Adv. Applied Macro Page 18 .  Of course it has large policy implications.  Relates a lot to our papers where they test for unit roots in the GDP processes. Look at the power of the methods (depends on the null. deterministic trend. Non-linear is more convincing. since public investments are dependent on how many resources that are available.  If there is no trend then we have no chance of doing a good forecast.

These analysis may reveal that these similar countries face the same or larger problems. That is. Many of the cells will be empty because there is no linkage between two specific sectors.especially access to (or cost of) capital inflows. December • New-style crisis ○ Faster-paced financial or balance sheet mismatch. A crisis in one country may signal that other countries similar to the crisis country face the same problems. ○ Real contagion. December • National accounting identities page 24 out of 72 ○ A = aggregate absorption ○ GNDI can be understood as total income available in the economy. ○ "Stylized balance sheet". where each column represent a sector. ○ Every column is expenses (outflows from a sector).Topic 6: Monitoring economic structure and stability Kasper Brandt 18. It does not equal to zero here. Commercial banking sector has a maturity mismatch in assets and liabilities in this hypothetical example. november 2015 09:09 18. ○ Current account deficit is equal to changes in assets minus changes in reserves. 2. Crisis via external financing channels . So real contagion can happen if your trading partners (both importers and exporters) experience a crisis. Applied Macro Page 19 . When Thai baht depreciated they ceteris paribus become more competitive than Indonesia (that is when there is a crisis in a net exporter country). ○ Informational contagion. Dev. they need to apply for long-term financing. Then IMF will demand structural changes which takes time to negotiate upon. • Old-style crisis ○ Main symptom: persistent weakening of current account balance. then they will buy less from Indonesia (that is when there is a crisis in a nat importer country).g. and every row is revenues (inflows to a sector) • Indonesia's balance of payments ○ Current Account + Capital Account + Financial Account should equal zero. Adv. At least focus is directed towards the similar countries and analysis of the similar countries is carried out. ○ Financial contagion. E. There are a broad and narrow type of contagion (don't know what the difference is). 4. ○ Often these crisis are associated with less developed countries. 2) mismatch in maturity of assets and liabilities ○ We need to think about if macroeconomic policies generate these mismatches. we need foreign savings to finance our own consumption or investments. which takes longer time to obtain. Econ. Distinguish between direct and indirect financial linkages. If Thailand buys a lot from Indonesia and Thailand is hit by a crisis. because they do not have access to short-term financing. ○ What to look for: 1) mismatch in currency denomination of assets and liabilities. They borrow short-term and invest longterm. Instead. November • The "Table 1: Generic macroeconomic (Social) Accounting Matrix [SAM]" handed out in class. ○ This is a small example of a SAM containing households and enterprises. In this example we would be worried about a potential depreciation. because they have separated "Reserves". Transmission through trade linkages. It could potentially contain hundreds of rows and columns. • Contagion ○ Transmission of economic and/or financial crisis across border. getting a loan from IMF.

 Comment/reflect on robustness. the new-style crisis. evaluate which indicators are the best at predicting a crisis. Maybe there is different degrees of crisis. Dev. Applied Macro Page 20 . 1) Difficulty of defining a crisis.  Practical? 1) reliable. ○ A sustainable current account position is not sufficient to avoid an economic crisis. In general. we need to define what constitutes a crisis.reveal that these similar countries face the same or larger problems. 2) availability (how easy to get the data and what is the most reason data).  Third. 9. Adv. Econ. 2) Changing nature of crises (balance sheet mismatches?) What might have been good indicators in the beginning is not necessarily good indicators anymore. • Early warning methods ○ Signals (leading indicators)  First. ○ Regression-based prediction ○ Market-based sentiment (not discussed here). and how practical are they for use in real time in developing countries.  Second. contaigion). choose a set pf ptential crisis indicators and associated thresholds. December • Questions ○ What are the most robust early warning indicators of economic crises.  Empirical results (describing the results in the literature).  Talk about other triggers of economic crisis (balance sheet mismatch crisis.

○ Soft Peg: Many different kinds of soft pegs. Another paper says it has never been "floating". but noone does this anymore). December • A currency board = every note and penny (M1) has to be backed by foreign currency. See slide for an overview of IMF classifications. Therefore. Relates to "interest rate pass through" (IRPT). while a third paper says it has been shifting between being "floating" and "fixed".  Fixed exchange rate. 2) Jamaica paper. • Exam practice.  The financial markets need to be very deep. ○ Institutional credibility. • The IMF classification is de facto. December • Gold Standard and interwar years: Exchange rate system was backed by gold. commodities (gold.  How does this affect choice of regime? Evidence (data or empirical results). • Most small developing countries prefer to fix their exchange rate. If the CB is not the largest player. partially backed by gold. 11. rule for rate of growth of money aggregates (used in many developing countries. IMF document that explains the different anchors: "Annual report on exchange arrangements and exchange restrictions 2015". Examples: Inflation target. but subjective. M1).nominal policy variables that serve to anchor monetary policy. • Potential empirical indicators of FX (foreign exchange rate) regime ○ Nominal FX volatility. Think of it like a dollar standard (like the gold standard). But all other currencies were fixed to the dollar. • Distinguish between "hard pegs" and "short pegs". What determines the choice of exchange rate regime? ○ Practical efficacy. • What is it that maintain the value of the currency? Which nominal anchor? ○ Nominal anchors are intermediate targets . ○ More on slides ○ IMF classify Canada as floating since 1970. december 2015 08:53 9.Topic 7: Choosing the MERP regime Kasper Brandt 9. Sam is generally unsure how they distinguish between "floating" and "free floating". then they will have difficulty in influencing the price. more examples on slides. we have "floating" and "free floating" exchange rates. Other countries do not have the same credibility Adv. In Sam's view the difference is that for "floating" they will sometimes intervene. • Bretton Woords System: Only the US dollar was backed by gold. Econ. Dev. but for "free floating" the central bank will never intervene in international monetary markets. That is. very big markets decreases the likelihood of having a fixed exchange rate. Case of Zimbabwe: "Borrow others credibility"). Not even the central bank has the authority to change the exchange rate. fixed exchange rate (anchor your currency to another currency. • Floating Exchanges Rates: Not backed by anything. Applied Macro Page 21 . 3) China. ○ Hard Peg: Very strong commitment to the fixed exchange rate. Denmark. ○ In addition.  Examples: 1) Breakdown of M1: interest rates in advanced countries.

Adv.  "Exchange rate pass through" (ERPT). ○ Shocks.  Trade/investment (higher nominal and real exchange rates volatility tends to dampen trade investments). using examples. However. because the new exchange rate will very fast lead to higher prices.g. In addition. Dev.  Example: Brazil is a good example at the moment. evidence…. Evidence. we can use the four above-mentioned considerations. evidence. if you have previously obtained external loan of 50 million in foreign currency and devalue your own currency by 40%. High rate ==> less incentive to devalue. Especially difficult for small countries to obtain loans from other countries. Argument 1. Therefore. Denmark. Argument 2. what are the principal trade-offs between alternative MERP frameworks in developing countries?  Are there genuine trade-offs? Describe main trade-offs. Fixed exchange rate. then you have to repay 70 million.  Dollarization (currency board). However. US dollar or Euro) and are there costs in doing so?  Relates to the above four considerations. "Borrw other countries' credibility". • Questions ○ What might lead a country to adopt another currency (e. it is preferable when you have larger shocks than the country where the currency has been pegged.  A currency board is seen as more credible than a peg. Refers to the magnitude and speed by which changes in the exchange rate are reflected in domestic prices. ○ Explain. since the other countries have no interest in the small country's currency. Other countries do not have the same credibility as Denmark. Zimbabwe stopped hyper inflation with dollarization. Four arguments and evidence for each argument.  If you have large domestic shocks then it is more profitable to peg the exchange rate to another currency.  Again.  Original Sin (inability to issue external debt in own currency). in some cases (Argentina) the currency board will not work either. Applied Macro Page 22 . fixing the exchange rate exposes you to international shocks (or just the shocks in the country you have pegged your exchange rate to). Econ. ==> incentive for stabilization of currency. ○ Benefits/motives of foreign exchange stabilization.

Econ. ○ Knowledge of relevant empirical results. Applied Macro Page 23 . Quality. ○ Ability to explain fundamental concepts/ideas. Etc. Reason 1. ○ First argument. 1) Empirital results. Approximately 3 pages per question. • Conclusion. challenges with data availability or reliability of data. Dev. and studies from the curriculum. Do not copy the exam question or statement. Critically assess the evidence. december 2015 08:35 • • • • • Don't write less than or more than demanded. Reason 2. Structure is essential . Maybe add some reflections if not done so before. Include list of references. • Don't ignore important arguments or relevant counter-arguments. E. then evidence. Ask yourself: is there something missing? • Remember to refer back to the desired learning objectives. Show all the abilities below. Adv. reflect on policy recommendations/issues/challenges. ○ Evaluate the quality or strength of existing arguments/evidence. Repeat main argument/viewpoint. not quantity. Evidence. 2) Reflection on robustness. ○ Where it is relevant.use headings! ○ E. Evidence. Case studies. 3) Practicality.g.g.Exam Kasper Brandt 9. ○ Bring in ideas from relevant empirical studies (from different papers). • Demonstrate understanding of curriculum.