1.

Assess the usefulness of econometric testing to the understanding of structural

differences between countries

Unless we can separate out key differences between systems/models the role of policy
becomes totally meaningless.

We tend to link economic models with economic outcomes

Is this link relevant?

 Yes, it is relevant as the type of economic model followed matters to distributional

mechanisms
 For example, socialist models encouraged savings for investment in industry (jam
today vs jam tomorrow)
 Other models encourage to contribute more directly, e.g. Singapore healthcare
provision- developed a reputation for combining market forces in the goods sector
with introducing some form of inductive social planning amongst its factor markets
 Under Central Provident Fund, average Singaporean contributes 20% of his income
toward future consumption

URB i = a + b . (GDP per capita) i + u i

 GDP per capita as a measure of economic development
 URB is proportion of a country’s population living in urban areas

Therefore, it is fundamental to measure model effects!!

There are various indicators but we mainly focus on patterns of urbanisation

WHY? Because there is plenty of empirical evidence to suggest that there is a positive
relationship between levels of urbanization and levels of development (i.e. more
urbanization=more development)

 Planned socialism focused on the requirement for urbanization to be controlled,

therefore urbanization may be important for the differences we see
 Gregory and Stuart (2014) established patterns of urbanisation>>economists have
been commenting for several years the positive relationship between different
measures of economic development and proportion of those in living large cities
 Focus on structural issues

e.g. was the Soviet union less urbanised than USA

 We can run regression using data from different countries (former socialist and
capitalist) and see what emerges. If we conclude that the data are indeed from
different populations then this proves the presence of structural dissimilarities.
 Three ways to do this: “Forecasting Approach”, “Dummy Variable Approach”,
“Chow-Test Approach”
Forecasting Approach

 use data from capitalist systems to estimate the parameters

 Forecast the URB for the former socialist countries in the same way (regression
analysis)- important to note that it is no longer helpful to classify economies as
socialist and capitalist etc, classify according to other measures such as number of
political parties, shape and nature of government, extent to whuch economy is
mixed, or other commonly set of observed variables
 Conclude as either UNDER URBANISED or OVER URBANISED or THE SAME
 RESULTS can be judged against data used for ESTIMATES and see if they are from the
SAME, or DIFFERENT POPULATIONS, thus determining STRUCTURAL PATTERNS
 Too much reliance on historical data making it nothing more than a summary of
historical data- sceptical particularly in age of rapid globalization, not concordant
 Variables accounted for symmetrically with other treating them ALL as RANDOM
VARIABLES

Dummy Variable Approach

URB i = a + b . (GDP per capita) i + c. DUM + u i

 Add dummy variable to original regression equation

 Run regression using COMBINED data from socialist and capitalist countries
 Values for the various parameters, especially dummies, reveal valuable
information on structural differences.
 Approach is useful when distinguishing features across the different economic
systems, or economic models can be identified quite clearly. When these
distinguishing features are fuzzy then the use of dummy variables become less
effective.

Chow Test Approach

 Estimate regression SEPARATELY using capitalist and socialist data sets

 End up with two, or more, sets of parametric values
 Use Chow to rest for structural differences (shocks) in the regression
 Series of data may contain structural shocks e.g. end of communism, stock market
crash, political outcomes, sudden change in policy

Problems with all 3 approaches

 Modelling the relationships (accounting for all factors etc)
 Misspecification errors
 Comparability of international data (soviet bloc didn’t disclose figures, same is
happening with North Korea, cant be assured to get accurate results)
 2. Discuss any two of the characteristics associated with determining the makeup of
the variety of economic models season

First, need to define what an economic model is.

Economic model is the set of arrangements used to allocate resources

Douglas North: Institutions are the rules of the game of a society, or more
fundamentally, are the humanly devised constraints that shape human interaction, in
consequence, they structure incentives in human exchange, whether political, social or
economic.

Philosophical difference on the rules of the game

Adam Smith- Classical Liberalism- strong tendencies towards voluntary and self-
enforcing rules that keep order in a society

Hobbes- no order without strong rules of the state that order human behavior- classic
conservatism

No rules in game- dictator controls rule, can lead to anarchy and periods of chaos

Principal Agent Issues

 Occurs when a principal delegates an action to another individual(agent), but due to
a lack of info, the principal has no idea how the agent will behave.
 Interests of principal diverge from that of agent (pursues own interests)
 Can cause MARKET FAILURE
- agent pursues own self interest rather than that of principal>>>business runs in an
inefficient way >>>> leads to ADVERSE SELECTION >>>poor choices based on
assymetric info
- causes MORAL HAZARD>>>individual takes excessive risk because cost is incurred
by someone else i.e. principal >>exploitation of info advantage, change behaviour
knowing principal will incur cost
-In a decentralized organization: decisions are made at low levels of
organization.
- Centralized organization: decisions are made at high levels.
 Decision Making levels reflect the organizations’ structure, how it generates and
utilizes info and how it allocates authority and responsibility making among the
levels of the organization.
 EX. In a corporation if the management team (agent) shares the shareholders’(
principals) goal of a higher stock price, there should be no conflict.
 Opportunistic behaviour: occurs when agents act contrary to the goals of the
principal.
Economic models are multidimensional, and cannot be defined in terms of a single
institution

FIVE characteristics

 Organization of decision-making arrangements-structure

 Decision Making levels reflect the organizations’ structure, how it generates and
utilizes info and how it allocates authority and responsibility making among the
levels of the organization (Decentralized and Centralized)
 Mechanism (rule) for the provision of information and coordination (market and
plan)
 Property rights: control and income
 Right to dispose of an asset
 Right to use an asset
 Right to use the product or service generated by the asset in question
 Consider whether or not the claims on assets are either public or private
 Mechanisms for setting goals and for inducing people to act
 Principal-Agent problem (market failure, adverse selection, moral hazard)
 Where do motivations come from? Should we induce agents’ incentive to
fulfil principal’s directives? What are the conditions for effectiveness?
 Agent needs to be in control of the outcome for which he is to be rewarded
 Principal needs to be able to verify that task has been executed properly
 Potential rewards must be meaningful
 Procedures for making public choices: the role of the government
 Dictatorship/totalitarian regimes
 Pure democracy- Does they even exist?
 Representative democracy-e.g. parliamentary system

3. “Capitalism has won but socialism offered more stability

 1991; idea that Western Liberalism had triumphed over socialism, leaving no room
for alternatives; ROOM FOR GLOBALIZATION, LESS CONFLICT (SUPPOSEDLY). As
Fukuyama prophesized in the end of history, the end of the cold war would be
greeted by universalization of Western Liberal Democracy as the final form of
human government>>>>capitalism essentially.
 The only remaining communist country China abandoned its communist economic
system in favor of globalization and market reforms, while keeping its monopoly of
the Chinese Communist party.
 If a state—even a Communist state—wished to enjoy the greatest prosperity
possible, it would have to embrace some measure of capitalism. Since wealth-
creation depends on the protection of private property, the “capitalist creep” would
invariably demand greater legal protection for individual rights.
 Fukuyama did not mean a real “end to history” necessarily but rather an end to
competing ideologies
 It can be said that capitalism has won the argument for the most efficient economic
system. Capitalism has brought unprecedented economic growth and development
that have adopted it. It has facilitated a substantial rise in living standards (and the
subsequent rise in the world’s middle class, and has overseen the fasted reduction in
in world poverty in history. Competition is an inherent notion in capitalism, whereby
firms are forced to provide as much added value to their products whilst still having
to accommodate for attractive prices in order to succeed. This spurs an incentive for
firms to operate to a level of efficiency that is unrivalled in comparison to all other
economic systems. By way of the market mechanism, the nature of capitalism makes
it the only system to not encroach upon economic freedoms, which is effect a
prerequisite for political freedom.
 Although it could be argued that capitalism is responsible for the inevitable
economic recessions, the great moderation has shown that developed countries can
manage these flaws-need for policy coordination
 History isn't over, and neither liberalism nor democracy is ascendant.
 But most disturbingly, the connection between capitalism, democracy, and
liberalism upon which Fukuyama’s argument depended has itself been broken.
 In the wake of the credit crunch and the global economic downturn, it has become
increasingly clear that prosperity is not, in fact, best served either by the pursuit of
laissez-faire economics.
 Indeed, quite the opposite. As Thomas Piketty argues in Capital in the Twenty-First
Century, free markets have not only enlarged the gap between rich and poor, but
have also reduced average incomes across the developed and developing worlds
 In the countries hardest hit by the recession—Greece and Hungary—voters have
REJECTED precisely that conception of liberalism that Fukuyama believed they would
embrace with open arms
 Across Europe, economic interventionism, nationalism, PROTECTIONISM have
exerted a greater attraction for those casting their democratic votes than the
causes of freedom, deregulation, and equality before the law.
 Liberal capitalist democracy hasn’t triumphed. Instead, the failures of capitalism
have turned democracy against liberalism. In turn, liberalism’s intellectual self-
identity has been left in tatters.

 2011, Fukuyama claims that “Western Liberal Democracy” may not necessarily be
the end; due to threat of “Political decay”; the collapse of democratic institutions in
the long run (Arab Spring, Greece, Spain, France, London riots). Second reason,
being “China”
 4. Assess the contribution of the discussion on monetary transmission mechanisms
to understanding the contribution of economic policy

Money and Monetary systems

Understanding monetised systems within the context of modern economies

They are a set of goals

 Understanding the role of money from a historical evolutionary standpoint

 Developing an understanding of the role of money and monetary institutions in
market-based economies from a policy perspective
 Theories of Exchange

So far we’ve emphasised the role of market-based economic activity above else; implies a
prominent role for the price system

There are different functions for money and different conditions under which it operates
without impediment functions include (unit of account, medium of exchange, store of value)
key conditions: accepted by all, etc one particular condition to take note of is the presence
of uncertainty

Role of Uncertainty

We discuss uncertainty fundamentally because certainty does not exist

 If certainty did exist, then credit would rule the world and there would be no need
for money whatsoever as trust would be what mattered
 In the absence of perfect certainty economic agents obtain information on matter
influencing production, exchange and consumption by using money; acquiring
information through other means is complex and costly

Monetary Transmission Mechanisms (MTMS)

The topic of monetary mechanisms grows naturally from discussions on money.

The monetary transmission mechanism is one of the most studied areas of monetary
economics for two reasons. First, understanding how monetary policy affects the economy
is imperative to evaluating what the stance of monetary policy is at a particular point in
time. Even if a central bank’s policy instrument, for example, the federal funds rate in the
United States, is low, monetary policy may well be restrictive because of effects that
monetary policy has had on other asset prices and quantities. Second, in order to decide on
how to set policy instruments, monetary policymakers must have an accurate assessment of
the timing and effect of their policies on the economy. To make this assessment, they need
to understand the mechanisms through which monetary policy impacts real economic
activity and inflation.

Monetary Transmission Mechanism represents the connection in the changes between

money supply or demand and the impact on the real economy>>>aggregate demand; goal
variables which include prices, output and employment.

In a closed economic system or one that does not contain a significant level of international
trade in goods/services and in capital flows>>> MTM links a change in price to the changes
in goal variables mentioned above

Core MTMs considered are portfolio balance and credit availability and the impact they
have on economic policy

What is a portfolio and how may it behave?

 Collection of assets of different yields, risks and maturities

 Composition of portfolio depends on money supply and goal variables (prices,
output and employment) all in relation to levels of wealth, credit availability and
expectations
 Changing asset characteristics (influenced by MTMs) result in portfolio changes-
extent of this change depends on the degree of substitutability and
complementarities between various assets
 MONEY is just ONE COMPONENT
 Identify appropriate content for a portfolio is dependent on ELASTICITY OF
SUBSTIUTION
 Portfolio has impact on aggregate expenditure function
 Generally speaking, adjustment to portfolios lead to increased expenditures and
through that it is possible to see the mechanism through which employment, prices
and output change.

THREE APPROACHES

KEYNESIAN- limited number of assets and open-market operations (OMOs) result in real
impact
JAMES TOBIN- increase in money supply/commercial banks take advantage of this (via more
loans made or buying of bonds)>>either way due to fluctuating interest rates and yields on
financial assets, the demand for real assets increases- variant of what Fed did in Janet Yellen
era and what was pursued by Shinzo Abe administration and BoJ.
MILTON FRIEDMAN- money has a low elasticity of substitution

1. changes in money supply or demand change the equilibrium interest rate

2. changes in equilibrium interest rate result in changes in desired investment
expenditure
3. changes in desired investment expenditure causes a shift in aggregate demand

e.g. increase in money supply>decrease in equilibrium interest rate>increase in desire for

investment expenditure>increase in aggregate expenditure>increase aggregate demand and
goal variables>increase in real GDP

4. How would you demonstrate that inflation is a purely monetary phenomenon? What
assumptions would you need?

Credit availability

 Credit Availability- except for the fact 9-10 years have seen crisis-hit financial
markets struggling to regain their composure, credit markets have in general worked
in more efficiently as compared to the constraints faced in the 1980s and early
1990s.
 Nowadays, with the influx of foreign banks and the general internationalization of
the loan markets we have much quicker adjustment periods for interest periods for
interest rates. But, as we have seen, this flexibility has also brought with it
tremendous uncertainties and provided some of the players with an opportunity to
participate in excessive levels of risky investments
 Prior to the 1980s, the major credit markets were considered to be quite imperfect
due to the existence of “administered pieces”. Basically, this meant that these rates
had little tendency to change at all. In transition, and other emerging economies, the
phenomenon of administer prices has lasted right up to recent times.

Few years ago there was price-interest rate stickiness; credit rationing behavior by
banks (after math of financial crisis)>>>loan market experienced considerable levels of
frustrated demand.

NEVERTHELESS BANK CREDIT IS ONLY ONE FORM OF CREDIT

RELATIONSHIP BETWEEN BANK CREDIT AND TOTAL CREDIT

NO RELATIONSHIP>> TOTAL CREDIT EXPANDS

COMPLEMENTARY RELATIONSHIP- TOTAL CREDIT EXPANDS
SUSBSTITUING RELATIONSHIP-AMBIGIOUS
THE LINK BETWEEN CREDIT ACTIVITY AND THE REAL ECONOMY WORKS
MAINLY THROUGH THE OPERATION OF THE AGGREGATE EXPENDITURE
FUNCTION IN THAT THE RISE OF THE MONEY SUPPLY MAY RAISE TOTAL
CREDIT AVAILABILITY; ONCE CREDIT EXPANDS THIS USEFULLY FEEDS THE
GOAL VARIABLES (PRICES, OUTPUT AND EMPLOYMENT)

Implications of money supply is change in price (inflation). Extreme version of this argument
is that inflation is a purely monetary phenomenon, that is to say that the main source for
inflationary pressure is the misplaced actions of the central bank.

QUANTITY THEORY OF MONEY (DEMAND-PULL //COST-PUSH)

M X V = P X Y (DO LOGS)

SUPPLY OF MONEY IN CIRCULATION X VELOCITY OF CIRCULATION OF

MONEY = INDEX OF AVERAGE PRICES X NUMBER OF TRANSACTIONS

the rate of growth of the money supply added to the rate of growth of the velocity of
circulation must tautologically equal the rate of growth of prices added to the rate of
growth of the number of transactions! Some economists assume that under certain
conditions (known as ‘Classical’ conditions), the rate of change of the velocity of
circulation is zero. Hence V*/V will tend toward ‘0’ the closer we get to these Classical
assumptions.

We can therefore write: M*/M = P*/P + Y*/Y

A second ‘Classical’ assumption is that the rate of growth of the number of transactions in an
economy, Y*/Y, tends toward a constant value. Let’s call this c.

So we can now say: M*/M = P*/P + c Or: P*/P = M*/M – c

Fischer equation- real interest rate=nominal interest rate,- inflation rate

Real interest rate falls as inflation rate increases unless nominal rates increase at same rate of
inflation

The term just above says: So long as we know the rate of growth of the number of
transactions in the economy (=> a proxy for the economy’s output?), then inflation (or P*/P)
may be explained as a purely monetary phenomenon QED (quod erat demonstrandum) !!!
This particular result is politically substantially ‘right of centre’ and hinges on the acceptance
of some fairly tough assumptions.
Another politically charged relationship is the one between inflation and fiscal policy. It can
be demonstrated that the former is explained fully by the latter!! This is how

Assume that government deficits may be financed entirely through the printing of money. As
such, the rate of growth of money tautologically equals the deficit.

So, we can write: M*/P => G – T … (A) Where, M*/P = rate of growth of real money supply
G = government spending T = government tax revenue Consider the following manipulations
to the above equation:

So the rate of growth in the money supply is nothing more than the velocity of circulation of
money multiplied by what we may refer to as the deficit expressed as a proportion of GDP.
But, a little earlier we had:

So, we can conclude that inflation is not only a ‘purely monetary phenomenon’ but also that
the rate of growth of the money supply can be linked to the fiscal position adopted by the
government!!!

Economic liberalization

Collective process

Reduce role of government (in microeconomic decision) , increase role of price system rather
than control

Increase integration in the world economy

EU 1993

NAFTA 1994

 Improve flows of FDI

 Promote the convertibility of the currency
 Trade reform >>>neutral trading regime

 Across Europe, economic interventionism, nationalism, PROTECTIONISM have
exerted a greater attraction for those casting their democratic votes than the
causes of freedom, deregulation, and equality before the law.
 Liberal capitalist democracy hasn’t triumphed. Instead, the failures of capitalism
have turned democracy against liberalism. In turn, liberalism’s intellectual self-
identity has been left in tatters.
Sources

Budet deficit cant only be financed by savings

Ineffective monetary policy
Substantial n=inflation