Innovations in Macroeconomics

Economic globalization means the combined growth of trade and foreign direct investment (FDI) on a worldwide scale. FDI grew particularly in the 1980s and 1990s, when the role of multinational companies started to grow strongly for various reasons:

In macroeconomics, there are two contrasting views to the role of the savings rate. In a short-term Keynesian perspective, a rise in the savings rate s reduces the equilibrium income. However, the long run neoclassical growth model suggests that a rise in the savings rate raises equilibrium real income. Short term macroeconomic analysis is rarely linked to long term dynamics and this can be misleading for policymakers. Moreover, it leaves policymakers, who would like to know under which conditions a rise in the savings ratio shows up in a contractionary or an expansionary impact, confused. The following analysis – for a non-inflationary world - is straightforward and first recalls the simple long run neoclassical growth model (SOLOW, 1956) and the short run Keynesian macro model before we merge both approaches within a new medium-term model. We present the multipliers for monetary policy, fiscal policy and supply side policy (rise in the savings rate s). Section 2 presents the model and the final section gives some policy conclusions. Several conclusions reached are in marked contrast to the standard Keynesian model and also go beyond the monetarist debate.

The world economy consists of many poor countries and a few dozen relatively rich countries. Per capita income differentials across countries were fairly large at the beginning of the 21^st century. Asian countries did relatively well in catching-up with leading OECD countries in the 1970s and 1980s. As respect to the 1990s, several transforming countries from Eastern Europe have also achieved relatively high per capita income ratios, and there is some optimism that EU accession countries could catch up relatively quickly with EU-15. BEN-DAVID (1996) has empirically shown that economic integration has contributed to economic convergence, SACHS/WARNER (1995) have presented evidence on the positive links between trade liberalization and economic growth. LEVINE/RENELT (1992) have also found that economic openness is closely related to growth. MANKIW/ROMER/WEIL (1992) have emphasized the role of human capital for growth and economic convergence; however, below we do not look into the human capital issues — but capital K could be adequately defined to include human capital and thus we include some such aspects, at least implicitly. Various alternative approaches to growth modelling in open economies and the issue of international real convergence have been discussed in the literature (OBSTFELD/ROGOFF, 1996), but no convincing general approach has emerged.

Much of the convergence optimism in the context of EU eastern enlargement is related to the Heckscher-Ohlin-Samuelson (HOS) theorem which shows for the case of identical linear-homogeneous production functions in a 2country-2goods- 2factor model that moving from autarchy to free trade will bring about relative price equalization that will go along with relative factor price equalization. The ratio of real wage w to the real interest rate r in the home country will become equal to the foreign relative factor price ratio w*/r*.

While there are many trade modelling variations in modern Economics –partly taking into account economic integration – (eg BRETSCHGER, 2002; SLAUGHTER, 1997), there is no doubt that many economists would emphasize convergence optimism in the context of the HOS model. This holds despite the fact that DEARDORFF (1986) has shown that small deviations in the underlying modelling assumptions can undermine the convergence results of the HOS approach – there could be convergence of relative prices while relative factor prices are diverging.

As regards economic transition countries as well as EU accession countries, one can observe that they have recorded a long term real appreciation vis-à-vis the Euro and other currencies. Long term appreciation does not exclude considerable short term real exchange rate dynamics where stages of temporary nominal and real currency depreciation can be an element of a long term real appreciation process. One thus has to ask which role volatility — including potential overshooting — plays on the one hand. On the other hand, the focus is on the impact of the real exchange rate trend on economic development.

From a theoretical perspective, the real exchange rate affects trade, structural change and economic growth in an interdependent way. In the medium term the real exchange rate will affect the trade volume, the product mix of exports and imports plus the current account position. Moreover, the structure of output will be affected; this will partly be linked to sectoral productivity growth. In the medium term and in the long run, there will be direct and indirect effects on national income and per capita income. Those changes will in turn affect structural change and trade. In an open economy, the picture would be incomplete if one did not consider the effects of exchange rate dynamics on capital inflows as well as the stock market. To the extent that there is an increase of capital inflows and in particular foreign direct investment inflows, there will be effects on the production potential and productivity growth (see Fig. below). From a policy perspective one must ask whether and which impulses are coming from regional integration and economic globalization. Moreover, the question arises as to which EU policy impulses are relevant and which national policy measures could be adopted to spur growth and a stable economic development.

Economic opening up has been a natural element of systemic transformation in the former Soviet Union and the smaller post socialist countries of Eastern Europe. Anticipating EU eastern enlargement, eastern European transition countries have reoriented the regional focus of trade towards the EU-15 countries. The change in regional orientation coincided with changes in the structure of output and trade. As regards structural change of exports, several countries underwent rapid structural change and achieved gradually improved RCAs (revealed comparative advantage) in non-labor intensive sectors (BORBÉLY, 2004).

After high inflation rates and a massive transformational recession in the early transition stage – reflecting obsolescence of part of the capital stock and adjustment costs in the course of restructuring – in the first transition stage, most transition countries have achieved considerable economic growth. Countries with relatively low per capita income, a well educated labor force and a functioning banking system should indeed be able to record considerable economic growth if stable and efficient institutions, competitive pressure and opening up are combined in a sustained manner. It is not easy for transition countries with a young democracy to come up with the right combination of constitutional foundations and efficiency enhancing political learning, in particular since governments eager to generate quick improvement in some fields might favour short-term political action over long term growth strategies.

The banking business in the late 20^th century has undergone profound changes. A first aspect is that the speed of adjustment in financial markets has increased in the course of digitization, computer expansion and the internet revolution, at the same time bringing down heavily prices of transactions in financial markets and thus contributing to the internationalization of financial markets and banking. A second key aspect is economic globalization with the result that for many financial products there exists a global market in which only a few large banks compete. A third element is that prudential supervision has started to emphasize risk-based equity requirements – indeed, Basel II rules will bring about broader spreads across different classes of loan risk. A fourth element is the increasing role of investment banking and the role of international mergers & acquisitions which accounted for roughly 3/5 of foreign direct investment in the 1990s. This in turn reinforces the role of stock markets on whose dynamics our analysis will focus. Moreover, in the presence of imperfect capital markets there is a renewed interest in the development of the real exchange rate since it will affect foreign direct investment: FROOT/STEIN (1991) have emphasized that a real depreciation of the currency of the host country implies that equity capital of foreign bidders – expressed in terms of the currency of the host country - is increased so that a successful leveraged international M&A will become more likely; FDI inflows will increase. Defining the real exchange rate of country I (home country) as q = P/eP* or q* = eP*/P where e is the nominal exchange rate and P the price level (*denotes foreign variables) it is clear that both nominal exchange rate dynamics and changes in the sticky price level at home and abroad will affect the real exchange rate. Our analytical focus will be partly on short term stock market dynamics in open economies which we define as having trade and foreign direct investment inflows. We will present a new short term model which models the interaction of money market, stock market and foreign exchange rate. Moreover, a medium term model based on the capital asset pricing model will be presented and finally we will plug the stock market into a modified growth model. Indeed, we will emphasize the role of stock markets for short-term and long term dynamics.

In all industrialized countries, achieving sustained economic growth in the sense of a long run increase of output or output per capita is a crucial goal. From a neoclassical perspective, the basic growth models of SOLOW (1970) emphasize the role of the production function - and the respective input factors capital and labor — and the savings rate, respectively. Growth is modeled as a steady state equilibrium phenomenon which is characterized by accumulation dynamics for capital and certain parameters of the utility function (DIXIT, 1976). Modern growth theory to some extent has added emphasis on the role of human capital formation (LUCAS, 1979), but the mechanics of the basic neoclassical growth model can be retained if one interprets capital as human capital or skilled labor.

As regards structural change in Eastern Europe, it is clear that one should expect considerable structural change in the initial transition stage and possibly also once high foreign direct investment inflows occur. This occurred early on in Hungary, and the Slovak Republic, but only with a considerable delay in Poland. The various subsequent indicators show different intensities of structural change, and the intensity of change is not equal across the various indices. On theoretical grounds (see appendix) one should focus mainly on the Lilien index and the modified Lilien index. As the feature of those two indicators consider the sectors’ relative weights, and also meet other standard requirements. As we can see in the subsequent table, the various indicators which summarize the intensity of structural change in the period from 1993 to 2001/02, the statistics point to rather strong structural change in several accession countries. Ideally, workers move out of sectors with low productivity growth towards sectors with high productivity growth, the latter often being found in sectors with high foreign direct investment inflows (FDI). FDI and investment of domestic firms will increase capital intensity and this, along with improved technology, will raise productivity. A positive gap between the growth rate of the wage rate and sectoral productivity growth will reinforce sectoral profit rates which in turn should stimulate sectoral FDI inflows. To the extent that economic catching-up and modernization is associated with high cumulated FDI inflows, one should expect that a considerable part of trade is shaped by FDI. Intra-company trade accounts for roughly 1/3 of trade in OECD countries.

Starting in the 1980s, a new wave of economic globalization has brought about a relative increase of foreign direct investment and hence a rising role of multinational companies (MNCs). MNCs are crucial for the diffusion of new knowledge, and those firms are also key actors in research and development. With China and a new Russia – plus the smaller former socialist CMEA countries of Eastern Europe – opening up to the world economy, new players have entered global markets and competition has intensified. The end of the Cold War has intensified the global innovation race for civilian products as the share of military R&D expenditures in the US, France and the UK has fallen to close or less than 50%.

There is a long-term upward trend in the ratio of expenditures on research and development (R&D) to national income. While the ratio of R&D to GDP was close to 1% in OECD countries in the 1960s, it reached about 2% in the 1980s and is moving towards 3% at the beginning of the 21st century. Technological competition has increased since expenditures on research and development have grown relative to GDP. While process innovations have reduced production costs, product innovations stand for novel goods for which consumers (or investors) show a higher willingness to pay than for standard products. Product innovations also tend to raise profitability of firms and hence stimulate investment. While innovations in industry are often reflected in patents, innovations in services are more difficult to protect through intellectual property rights. A special case is software which enjoys copyright protection and more recently patent protection in the US. Technological competition also increased in the 1990s and the early 21st Century, because global diffusion of new knowledge accelerated due to the expansion of the internet.

Economic globalization has accelerated the innovation race among leading OECD countries as foreign direct investment in Newly Industrializing Countries (NICs) plus China and India have created a new international divison of labor. Indeed, globalization went along with a more intensive innovation race (JUNGMITTAG/ MEYER-KRAHMER/REGER, 1999). Moreover, in the 1990s increased R&Dexpenditures in China and many NICs as well as Russia have reinforced the ability of economic and technological catching-up. There is a certain minimum R&D expenditure requirement — relative to GDP — if countries are to be able to effectively adopt foreign technologies. Both innovation and fast diffusion can contribute critically to international innovativeness. Improving the international competitiveness of the overall EU-15 has been an explicit goal of the EU Lisbon summit of 2000. This summit has proclaimed the goal to make the EU the most competitive economy by 2010; exploitation of the digital information society is to play a crucial role in this respect as the Heads of State and Government of European Union endorsed the idea of a European Research Area (ERA) and declared the creation of a European knowledge-based society a crucial element of the political strategy.

With the expansion of digital networks and the internet, respectively, there are also new global channels for technology diffusion on the one hand, on the other hand modern digital networking also facilitates cooperation among researchers and engineers which enhances the effectiveness of the innovation process in leading OECD countries; this also applies to the EU-15 which has emphasized building a European Information Society early on.

Economic globalization progressed considerably in the 1990s with the opening-up of post-socialist eastern European countries for trade and capital flows as well as with the completion of the single EU market. Part of the single EU15 market introduced in 1993 was the liberalization of services including financial services. With EU eastern enlargement in 2004, there were steps towards an EU25 single market. However, free movement of labour was postponed for most EU15 countries until 2011 (at the latest). In ASEAN countries, financial integration resumed after the 1997/98 crisis, and a broader integration strategy was envisaged. Both the EU and ASEAN are facing economic globalization in the sense that there is a long run increase in the trade of financial services, in foreign direct investment in the banking and insurance sector and a growing influence from global international organizations such as the IMF and the Bank of International Settlements.

Financial markets are important for economic development for many reasons, including the financing of capital accumulation, innovation and human capital formation. In his survey, TSURU (2000) points to several channels through which financial markets can affect growth. Competitive financial markets contribute to

In the wake of the two oil price shocks of the 1970s — each bringing with it a quadrupling of the oil price — the Economics of exhaustible resources became an important research field (e.g. STIGLITZ, 1974; DASGUPTA/HEAL, 1979; SINN, 1981). Oil and gas are particular examples of non-renewable resources, and they are politically sensitive since the main deposits are concentrated regionally, in the case of oil in politically rather sensitive Arab countries as well as Iran and Russia. In addition major oil producers have formed the OPEC which became a powerful cartel in the 1970s when it controlled about 60% of the world market for oil. As transportation costs for oil are very small, the oil price is a true world market price since equilibrium is determined by world oil supply and global oil demand. There is considerable short-term oil price volatility in the short run und there have been major shifts in oil prices over the medium term. Changes in market structure will affect the optimum rate of depletion of resources (KHALATBARI, 1977).

The oil and gas sector has a long history of high Schumpeterian dynamics, where analysis by ENOS (1962) suggests there is a time lag of about 11 years between invention and innovation. By implication, R&D promotion in this industry will go along with considerable time lags with respect to innovation – this is also a challenge for policy makers, who would have to apply a relatively long time horizon. As regards R&D Promotion, FURTADO (1997) found that differences in the degree of appropriability between upstream and downstream of the oil industry had a great impact on effect of R&D promotion. There are regional case studies on the dynamics of innovation in the oil and gas industry – concerning Stavanger and Aberdeen (HATAKENTA/WESTNES/GJELSVIK/LESTER, 2006) – which show that different approaches to R&D Promotion can have similar effects. It is also noteworthy that the energy sector has been a leading early user of information technology (WALKER, 1986).