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Journal ArticleDOI

Learning by Devaluating: A Supply-Side Effect of Competitive Devaluation

AbstractThis study shows that the learning by doing (LBD) effect has substantial, both quantitative and qualitative, consequences for the international transmission of monetary policy. LDB implies that a country can increase its productivity-increasing skill level, at the expense of the neighbor, by competitive devaluation engineered through low interest rates. If measured by the cumulative change in output after 12 quarters, LBD increases the harmful effect of competitive devaluation on foreign output by 85–125%, when compared to the case without it. If LBD is sufficiently strong and the cross-country substitutability is high (low), it reverses the effect of monetary policy on foreign (domestic) welfare into negative (positive). Moreover, a combination of a high cross-country substitutability and a sufficiently strong LDB effect implies that competitive devaluation increases both domestic output and welfare, at the expense of foreign output and welfare.

Topics: Devaluation (58%), Beggar thy neighbour (51%)

Summary (3 min read)

1 Introduction

  • During the recent global financial crisis, the U.S. Federal Reserve implemented expansionary monetary policy by lowering the short-term nominal interest rate to the zero-lower bound.
  • Porter (1990) argues that depreciations can be harmful, because an overvalued exchange rate can be better for productivity growth, by forcing higher productivity growth in the tradedgoods sector.
  • Moreover, they find that faster productivity growth is partly driven by the LBD effect.
  • They emphasise that the empirical labour economics literature has shown the following results:.
  • The LBD mechanism also has a qualitative implication for the welfare effects of monetary policy where the cross-country substitutability is low.

2 Model

  • I lay out a two-country open economy model.
  • Its innovation is the introduction of LBD into the production function, following the idea of Chang et al. (2002).
  • The world consists of two countries: home and foreign.
  • In the presentation of the model, I discuss only domestic equations, if the equations are symmetric across countries.

2.1.1 Preferences

  • The term is the elasticity of substitution between domestic and foreign goods, which is referred to as the cross-country substitutability.
  • These equations show that households allocate their total consumption between domestic and foreign goods, taking into account their relative prices and the cross-country substitutability.
  • All prices are expressed in local currency terms, although firms set their prices in the producer’s currency.
  • (5) The corresponding foreign indexes are defined in a similar way.
  • The purchasing power parity holds: *ttt PSP .

2.1.2 Budget Constraints

  • The foreign economy is identical to the domestic economy, with one notable exception: Foreign households can hold both domestic and foreign bonds; whereas domestic households can only hold domestic bond.
  • The use of the Taylor rule implies that the model must be stationary.
  • The log-linear version of UIP with a risk premium ( ) can be written as tttttt DSSEii ˆˆˆˆ) Equation (8) shows that the household has to pay a small cost if its bond holdings are not equal to their initial steady-state level (i.e., zero).
  • (12) Equations (9) and (10) are the Euler equations for optimal domestic and foreign consumption, respectively.

2.2 Monetary Policy

  • The central banks in both countries follow the log-linear Taylor rule with interest rate smoothing, as follows: titttt iyPi ,11321 ˆ)ˆ)(1(ˆ , (13) 6.
  • The empirical evidence supports the view that monetary policy shocks cause deviations from UIP (e.g., Faust and Roger, 2003; and Bluedorn and Bowdler, 2011).
  • The monetary policy rule shows that the inflation target is zero.
  • Therefore, the deviation of output from the initial steady state measures the output gap.
  • The central bank responds directly to the deviations of output from the initial level.

2.3.1 Skill Level, Demand and Profits

  • Chang et al. (2002) assume that the skill level of the household depends on hours worked in the past, and that the skill level raises the effective unit of labour supplied by the household.
  • The stock of the skill level evolves according to the following log-linear equation: )(ˆˆˆ 1 zxx ttt , (14) where 10 and 0 are parameters.
  • The firm minimises its costs, )(zw tt , subject to the production function (15).

2.3.2 Price Setting

  • (19) Under flexible prices, the price is simply a mark-up over the marginal cost.
  • Equations (16) and (19) demonstrate that an increase in the skill level is like a productivity shock that reduces the price of the domestic good.
  • Following Calvo (1983), I introduce nominal rigidities by assuming that each firm may reset its price with a probability of 1 in each period, independently of other firms and time passed since the last price adjustment.

2.4 Symmetric Equilibrium

  • Every firm that changes its price in any given period chooses the same price and output.
  • The price setting framework means that each period, a fraction of 1 of firms sets a new price, while the remaining firms keep their price unchanged.
  • (24) Equation (23) is the Calvo-weighted price index of domestic goods.
  • The model is log-linearized around a symmetric steady state, where initial net foreign assets are zero ( 00D ) and the initial skill level is normalized to one ( 00x ).
  • The consolidated budget constraint, in the case of a symmetric equilibrium, implies that )(00 zyC .

3 Choice of Parameter Values

  • The rationale for the choice of parameter values is as follows: Periods are defined as quarters, therefore =0.99.
  • Gopinath and Rigobon (2008) find that the trade weighted median price duration is 10.6 months for U.S. imports and 12.8 months for U.S. exports.
  • Chang et al. (2002) use a Bayesian approach and micro level data to estimate these parameters.
  • Therefore, a unit increase in the number of hours worked today increases the skill level in the next period by 0.11 units, and the depreciation rate of the skill level is 20%.9.

4.1 Method of Welfare Analysis

  • The method used for welfare analysis is as follows: I first analyse the change in period-byperiod utility.
  • Then, I calculate the discounted present value (PDV) of the change in utility.
  • The PDV value of the change in utility is calculated as 8.
  • On the other hand, Sutherland (2006) argues that typical estimates for the average elasticity across all traded goods are in the range of 5 to 6.

4.4 Sensitivity Analysis

  • The next step is to assess how responsive the international effects of monetary policy are to changes in parameter values, which govern the strength )( and duration )( of LBD.
  • These imply a stronger effect of employment on the skill level, and a faster depreciation rate of the skill level.
  • Table 5 shows the cumulative change in output.
  • On one hand, the improvement in the foreign terms of trade implies that foreign consumption increases despite a fall in output.
  • Table 7 shows the effects of the new parameterisation on output when cross-country substitutability is 1.5.

5 Conclusions

  • This paper analyses the consequences of LBD for the international transmission of monetary policy.
  • This mechanism implies that demand-driven business cycles affect the supply side of the economy.
  • LBD implies that this, in turn, leads to an increase in the U.S. skill level, which not only lowers the relative price of U.S. goods even further, but also increases the supply of U.S. goods.
  • If the elasticity of substitution between U.S. and foreign goods is low, LBD reverses to positive the effect of U.S. interest rate reductions on U.S. welfare.
  • The United States can increase not only its output, but also its welfare at the expense of the rest of the world.

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Citations
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Journal ArticleDOI
Abstract: We study the effects of learning by doing resulting from the production of a final good on economic growth in a region that is creative in the sense of Richard Florida. Firms in this region use creative and physical capital to produce output. We model learning by doing formally and our analysis of the working of this creative region leads to four results. First, we derive analytic expressions for the growth rates of physical capital and technology. Second, we draw phase diagrams and show that in the steady state, the preceding two growth rates must be equal. Third, we show that the economy of our creative region converges to a balanced growth path (BGP) in which the growth rates of physical capital, technology, and the output of the final good are identical. Finally, we investigate the impact that an increase in the savings rate has on the economic growth of our creative region in the long run.

15 citations


Cites background from "Learning by Devaluating: A Supply-S..."

  • ...The object of inquiry in a recent paper by Batabyal and Nijkamp (2010) is a two-sector 4 See Chou and Wong (2001), Goh and Wan (2005), Kutsoati and Zabojnik (2005), D’Albis et al. (2012) and Tervala (2013) for a more detailed corroboration of this claim....

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Abstract: Empirical studies support the hysteresis hypothesis that recessions have a permanent effect on the level of output. We analyze the implications of hysteresis for fiscal policy in a DSGE model. We assume a simple learning-by-doing mechanism where demand-driven changes in employment can affect the level of productivity permanently, leading to hysteresis in output. We show that the fiscal output multiplier is much larger in the presence of hysteresis and that the welfare multiplier of fiscal policy–the consumption equivalent change in welfare for one dollar change in public spending–is positive (negative) in the presence (absence) of hysteresis. The main benefit of accommodative fiscal policy in the presence of hysteresis is to diminish the damage of a recession to the long-term level of productivity and, thus, output.

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Cites background or methods from "Learning by Devaluating: A Supply-S..."

  • ...We assume, unlike Chang et al. (2002) and Tervala (2013), that fluctuations in employment can affect TFP quasi-permanently....

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  • ...As in Tervala (2013), the level of TFP evolves according to the following log-linear equation: ât(z) = φât−1(z) + µˆ̀t−1 (z) , (10) where 0 ≤ φ ≤ 1 and µ are parameters....

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  • ...To model endogenous changes in TFP, we add a simple learningby-doing mechanism into the production function, following the formulation of Tervala (2013), based on the idea of Chang et al. (2002)....

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  • ...Following this, Tervala (2013) assumes that the level of TFP accumulates over time according to past employment....

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Abstract: This article explores the implications of hysteresis for the welfare costs of recessions by extending the textbook New Keynesian model to include hysteresis. Hysteresis implies that recessions reduce the level of potential output. Famously Lucas (1987, 2003) argued that the welfare costs of business cycles are negligible without hysteresis. This article demonstrates that the welfare costs of recessions are huge (negligible) in the New Keynesian model with (without) hysteresis. The main finding is that an empirically observed degree of hysteresis increases the welfare costs of a recession by a factor of 121. The results are in contrast with Lucas (1987, 2003), who concluded that only changes in the long-term growth rate of consumption have a significant welfare effect. The welfare costs of recessions can be huge without a change in the long-term growth rate of consumption. Hysteresis therefore implies that stabilization policy should respond forcefully to recessions.

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References
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Book
01 Jan 1990
Abstract: The Need for a New Paradigm - PART I: FOUNDATIONS - The Competitive Advantage of Firms in Global Industries - Determinants of National Competitive Advantage - The Dynamics of National Advantage - PART II: INDUSTRIES - Four Studies in National Competitive Advantage - National Competitive Advantage in Services - PART III: NATIONS - Patterns of National Competitive Advantage: The Early Postwar Winners - Emerging Nations in the 1970s and 1980s - Shifting National Advantage - The Competitive Development of National Economies - PART IV: IMPLICATIONS - Company Strategy - Government Policy - National Agendas - Epilogue - Appendices - References

22,081 citations


"Learning by Devaluating: A Supply-S..." refers background in this paper

  • ...Porter (1990) argues that depreciations can be harmful, because an overvalued exchange rate can be better for productivity growth, by forcing higher productivity growth in the tradedgoods sector....

    [...]


Journal ArticleDOI
Abstract: We develop a model of staggered prices along the lines of Phelps (1978) and Taylor (1979, 1980), but utilizing an analytically more tractable price-setting technology. ‘Demands’ are derived from utility maximization assuming Sidrauski-Brock infinitely-lived families. We show that the nature of the equilibrium path can be found out on the basis of essentially graphical techniques. Furthermore, we demonstrate the usefulness of the model by analyzing the welfare implications of monetary and fiscal policy, and by showing that despite the price level being a predetermined variable, a policy of pegging the nominal interest rate will lead to the existence of a continuum of equilibria.

8,319 citations


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Abstract: This paper examines how recent econometric policy evaluation research on monetary policy rules can be applied in a practical policymaking environment. According to this research, good policy rules typically call for changes in the federal funds rate in response to changes in the price level or changes in real income. An objective of the paper is to preserve the concept of such a policy rule in a policy environment where it is practically impossible to follow mechanically any particular algebraic formula that describes the policy rule. The discussion centers around a hypothetical but representative policy rule much like that advocated in recent research. This rule closely approximates Federal Reserve policy during the past several years. Two case studies-German unification and the 1990 oil-price shock-that had a bearing on the operation of monetary policy in recent years are used to illustrate how such a policy rule might work in practice.

8,076 citations


Additional excerpts

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Journal ArticleDOI

2,288 citations


"Learning by Devaluating: A Supply-S..." refers background in this paper

  • ...Porter (1990) argues that depreciations can be harmful, because an overvalued exchange rate can be better for productivity growth, by forcing higher productivity growth in the tradedgoods sector....

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1,919 citations


"Learning by Devaluating: A Supply-S..." refers background in this paper

  • ...The authors show that the LBD mechanism improves the ability of real 1 The idea of learning by doing dates back at least to Arrow (1962) and Kaldor (1957)....

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This study shows that the learning by doing ( LBD ) effect has substantial, both quantitative and qualitative, consequences for the international transmission of monetary policy.