Trade Shocks and Macroeconomic Fluctuations in Africa *

Transcription

1 Trade Shocks and Macroeconomic Flucuaions in Africa * M. Ayhan Kose a and Raymond Riezman b Absrac: This paper examines he role of exernal shocks in explaining macroeconomic flucuaions in African counries. We consruc a quaniaive, sochasic, dynamic, muli-secor equilibrium model of a small open economy calibraed o represen a "ypical" African economy. In our framework, exernal shocks consis of rade shocks, modeled as flucuaions in he prices of expored primary commodiies, impored capial goods and inermediae inpus, and a financial shock, modeled as flucuaions in he world real ineres rae. We also sudy he role of domesic facors in generaing macroeconomic flucuaions as hese facors are capured by he changes in secoral produciviy. Our resuls indicae ha while rade shocks accoun for roughly 45% of economic flucuaions in aggregae oupu, financial shocks play only a minor role. Moreover, we find ha adverse rade shocks induce prolonged recessions since hey induce a significan decrease in aggregae invesmen. JEL Classificaion: F41, E31, E3, D58, F11. Key Words: Trade shocks, dynamic sochasic quaniaive rade model, African economies. * We would like o hank an anonymous referee whose suggesions significanly improved he paper. We are graeful o David Bevan, Simon Evene, Jan Gunning, David Richardson, Linda Tesar, and Kei-Mu Yi for heir helpful commens. We also benefied from he suggesions of Ahmed El-Sofy, Kamil Yilmaz, and seminar paricipans a he 1998 Fall Midwes Inernaional Economics Conference a he Universiy of Michigan and 1999 Easern Economic Associaion Conference in Boson. The usual disclaimer applies. a Graduae School of Inernaional Economics and Finance, Brandeis Universiy, Walham, MA 454, akose@brandeis.edu. b Deparmen of Economics, Universiy of Iowa, Iowa Ciy, IA 54, raymond-riezman@uiowa.edu.

2 1. Inroducion There is a large and expanding lieraure suggesing ha highly unsable domesic macroeconomic environmen is one of he primary reasons for he poor growh performance of African counries in he las hiry years. 1 The implicaion is ha o improve growh performance in Africa, we need o undersand why heir economies are so volaile. Tha is he objecive of his paper: using a dynamic, sochasic model we esablish a link beween exernal shocks and he highly volaile macroeconomic flucuaions in hese economies. We sudy he effecs of rade and financial shocks. Surprisingly, we find ha, despie he fac ha hese counries are ypically heavily indebed, rade shocks play a much more imporan role han financial shocks. In paricular, i urns ou ha rade shocks explain almos half of he volailiy in aggregae oupu. Inernaional rade can induce macroeconomic flucuaions in a small open economy by wo channels: one channel is hrough rade in goods and services, and he oher one is by rade in financial asses. In African economies, hese wo channels have disincively imporan roles in shaping domesic economic aciviy: firs, he volume of inernaional rade on average accouns for more han 7% of he aggregae oupu in hese counries. Moreover, a narrow range of primary commodiies consiues a significan fracion of heir expors, and heir main impor iems are inermediae inpus and capial goods. Their expor revenues are highly unsable due o recurren and sharp flucuaions in he prices of primary commodiies. Second, mos of he African counries are heavily indebed, and a significan fracion of heir expor revenues are used o mee heir deb service obligaions. These make African counries exremely vulnerable o sudden changes in he world ineres rae. A horough undersanding of he sources of macroeconomic flucuaions in African economies requires a good grasp of he impac of rade shocks, namely flucuaions in he prices of expored primary commodiies, impored capial goods, and inermediae inpus, and financial shocks, namely flucuaions in he world real ineres rae, on domesic economic aciviy. We address he following quesions o shed some ligh on hese issues: firs, do rade disurbances accoun for a significan fracion of macroeconomic flucuaions? Second, how are rade shocks ransmied and propagaed hrough hese economies? We begin by documening some of he major characerisics of indusrial srucure, composiion of inernaional rade, and dynamics of rade shocks o provide empirical evidence ha here is a srong link beween inernaional rade disurbances and domesic economic aciviy in African counries. We, hen, consruc a muli-secor, dynamic, sochasic small open economy model which reflecs he srucural characerisics of a represenaive African economy. There are wo secors in he model: primary goods and nonraded final goods secors. The economy expors 1 Collier and Gunning (1999) provide a deailed survey of he lieraure examining he reasons of he slow growh in Africa. Sachs and Warner (1996) and Rodrik (1998a) use a variey of growh regressions o sudy he deerminans of economic performance, and conclude ha macroeconomic sabiliy is an imporan facor for he long-run growh in Africa. Pindyck (1991), and Aizenman and Marion (1993) provide heoreical models where a volaile macroeconomic environmen has an adverse impac on growh. Ramey and Ramey (1995), using he daa of developing and developed economies, find ha counries wih highly volaile macroeconomic environmen have relaively lower growh. 1

3 primary goods, and impors all of is inermediae inpus and a significan fracion of is capial goods. The households in his economy can buy and sell one-period risk free bonds in he world financial markes. We also sudy he role of domesic facors in generaing macroeconomic flucuaions as hese facors are capured by he changes in secoral produciviy. We compare he properies of he macroeconomic flucuaions generaed by his model wih hose acually observed in African counries. We find ha ha he model successfully accouns for several imporan properies of macroeconomic flucuaions in African economies. We quaniaively evaluae he conribuion of inernaional rade shocks o domesic macroeconomic flucuaions. Our findings indicae ha rade shocks play an imporan role in driving economic aciviy in African counries: almos 45% of flucuaions in aggregae oupu is explained by rade shocks. Furher, rade shocks accoun for almos 87% of aggregae invesmen variaion and 8% of labor supply flucuaions. We also find ha world ineres rae flucuaions have only a minor impac on economic dynamics of African counries in our benchmark experimens. However, he imporance of hese shocks significanly increases as he raio of rade balance o aggregae oupu rises. Impulse response analysis demonsraes ha he propagaion of economic flucuaions generaed by he rade shocks is differen han ha caused by domesic produciviy shocks. In paricular, while posiive produciviy disurbances resul in shor lived expansions, adverse rade shocks cause prolonged recessions. Our paper conribues o he large lieraure examining he links beween economic aciviy and rade shocks in developing economies and is paricularly relaed o some recen papers sudying he sources of macroeconomic flucuaions in African counries. Deaon and Miller (1996) employ a vecor auoregression (VAR) model o examine he imporance of commodiy price shocks. Hoffmaiser, Roldos, and Wickham (1998) esimae a srucural VAR model, where idenifying resricions are derived from a long-run small open economy model, o sudy he role of erms of rade and world real ineres rae shocks. While he former sudy concludes ha price shocks play an imporan role in driving macroeconomic flucuaions in African economies, he laer one finds hese disurbances accoun for only a small fracion of he variaion in oupu. Mendoza (1995) examines he imporance of erms of rade shocks in a small open economy model calibraed for a ypical developing economy and finds ha hese shocks accoun for almos half of he aggregae oupu flucuaions. 3 This sudy exends he scope of his research program in several dimensions: firs, we sudy he sources of macroeconomic flucuaions in African counries in a fully specified, sochasic, Balassa (1978), Moran (1983), Feder (1983), and Basu and McLeod (199) examine he relaion beween expor insabiliy and economic growh. Bevan, Collier, and Gunning (1994) provide a compuable general equilibrium model of an open economy o examine he economic experiences of Kenya and Tanzania afer he major rade shock in Praschnik (1993) sudies he role of inpu price shocks in generaing business cycles in developing counries using a closed economy model. Kouparisas (1997a) invesigaes he ransmission of business cycles from developed Norhern counries o developing Souhern economies in a wo-counry model.

4 dynamic, open economy model reflecing he srucural characerisics of hese economies. 4 Since he model economy is dynamic, and involves endogenous labor-leisure choice, we are able o examine he link beween rade shocks and flucuaions in aggregae invesmen, foreign asse holdings, and labor markes. The model economy employs domesically produced capial goods, impored capial goods, and impored inermediae inpus in wo differen secors. This srucure of differeniaion in producive facors allows us o sudy he impac of differen ypes of rade shocks on differen secors of he economy. Moreover, hese feaures of he model help explain he links beween economic flucuaions in producive facors and aggregae oupu volailiy. Second, our sudy considers a broader definiion of rade shocks as i focuses on he price changes of he main expor and impor iems insead of erms of rade disurbances. This is moivaed by our empirical examinaion which reveals ha he erms of rade is no able o fully reflec highly volaile movemens in relaive prices of he main expor and impor iems of African counries. Third, while assessing he role of rade shocks, we invesigae he impac of world ineres rae flucuaions on domesic economic aciviy in African counries. The organizaion of he paper is as follows: in secion, we review he empirical regulariies of African daa. Following his, we presen he model. Model calibraion is described in secion 4. In secion 5, we firs assess he abiliy of he model in replicaing business cycle dynamics of a represenaive African counry. Then, we quaniaively evaluae he imporance of differen ypes of shocks in generaing macroeconomic flucuaions. The model dynamics are analyzed using impulse responses. Following his, he sensiiviy of he resuls o changes in he srucural parameers of he model is briefly invesigaed. We conclude wih a brief summary in secion 6.. Analysis of he daa.1. Srucural characerisics of he African economies We begin wih an examinaion of he decomposiion of aggregae oupu o provide a beer undersanding of he srucural characerisics of he African economies. Our analysis is based on he annual daa of weny-wo non-oil exporing African counries for he period. 5 We presen informaion abou he expendiure shares of aggregae oupu and indusrial srucure in Table 1a. The G7 average of each magniude is also provided for comparison purposes. The major difference beween hese wo groups is he role played by inernaional rade in domesic economic aciviy. In African (G7) counries, expors accoun for almos 31 ()% of oal GDP while 4 See Baxer (1995) for a survey on dynamic general equilibrium models of open economies. Kose (1999) examines he role of world price shocks in driving business cycles in developing economies and provides and exensive review of he relevan lieraure. 5 We examine he daa of non-oil exporing African counries. 18 of hese counries are Sub-Saharan African, 4 of hem are Arab Saes: Burundi, Cape Verde, Egyp, Gambia, Ghana, Guinea Buissea, Kenya, Liberia, Madagascar, Malawi, Mauriania, Mauriius, Morocco, Seychelles, Sierra Lione, Sudan, Swaziland, Tanzania, Tunisia, Zaire, Zambia, and Zimbabwe. Egyp, Seychelles, and Tunisia receive a significan fracion of heir expor revenues from oil. However, hese counries are no major oil exporers. When we considered a sample wihou hese counries and 3

5 impors consiue more han 4 (18)% of i. Srikingly, he volume of rade on average accouns for more han 71% of GDP in African counries while only 38% of oal GDP is aribuable o he rade volume in he G7 counries. As Table 1a indicaes, African counries have relaively large rade deficis: he average rade defici is around 1% of he GDP in he African economies in our sample. African economies indusrial srucures also make hem highly vulnerable o rade shocks: hey have relaively smaller indusry and service secors, and, consequenly, he share of agriculural secor is considerably larger in hese counries. To be more specific, agriculural goods on average accoun for 8 (4)% of oal GDP while indusrial producion consiues roughly 18 (3)% of oal domesic income in African (G7) counries. The share of agriculural secor in aggregae oupu in Africa ranges from a low of 9% in Seychelles o a high of 55% in Burundi. Table 1b describes he srucure of expors. As his able clearly illusraes, he African economies heavily depend on primary goods for heir expor revenues: he share of primary expors on average is 77% and ranges from 6% in Tanzania o 99% in Sudan. Ineresingly, he average share of capial good expors is less han % in oal expors. If hese counries expor a variey of primary goods, hen heir dependency on primary commodiies for heir expor revenues migh no be seen as an imporan problem, since flucuaions in he prices of differen ypes of primary commodiies can offse each oher, and resul in relaively sable expor earnings. In order o examine he exen of diversificaion of expors a a more disaggregaed level, we use wo differen crieria ha are presened in he las wo columns of Table 1b. Boh of hese measures sugges ha he African counries in our sample seem o be much more concenraed in heir expors han he G7 counries. Firs, we examine he number of commodiies expored by he African economies: hey expor on average 54 differen goods. This number is around 13 for he G7. Second, we use he Gini-Herschman coefficien o measure he concenraion of expors. A higher value of his coefficien indicaes a higher degree of expor concenraion. While he average coefficien of expor concenraion is more han 6 for he African counries, i is less han 1 for he G7. Table 1c provides informaion abou he decomposiion of impors. Two poins abou his able are noeworhy: firs, he main impor iems of hese counries are capial goods and inermediae inpus. While he impors of inermediae inpus accoun for almos half of he oal impors, he average share of capial good impors is approximaely 8%. Second, he share of agriculural goods is minor in oal impors. repeaed our calibraion exercise, we saw ha he resuls repored here were no affeced in any significan way. See Kose and Riezman (1999) for a deailed documenaion of he saisics repored here. 4

6 Movemens in he cos of servicing exernal deb also seem o be an imporan source of macroeconomic flucuaions in several African counries, paricularly highly indebed ones. 6 As Table indicaes, he average raio of exernal deb o GNP is around 89% and he deb service o expor raio, which is a widely used measure of deb burden, is around % for he African economies in our sample. Noably, he raio of shor-erm deb paymens o he expor revenues is on average 43%. We conclude his secion wih some broad observaions. A ypical African economy ges he bulk of is expor revenues from a narrow group of primary commodiies, impors mainly capial goods and inermediae inpus, faces persisen rade deficis, and has o allocae a significan fracion of is expor revenues o mee is shor erm deb obligaions. A model designed o examine he sources of macroeconomic flucuaions in African economies should reflec hese characerisics... Dynamics of Prices There has been a revival of ineres o undersand he dynamics of commodiy prices since a number of developing counries have faced a sharp downward rend in he prices of heir main expor iems over he las wo decades. 7 Since our ulimae objecive is o evaluae he effecs of rade shocks proxied by relaive price flucuaions on macroeconomic dynamics of he African economies, we briefly examine he cyclical feaures of price series and provide furher empirical evidence abou he relaion beween hese series and macroeconomic flucuaions in hese counries. Insead of analyzing he erms of rade dynamics only, we also examine a disaggregaed measure of he erms of rade and look a he dynamics of relaive prices of capial goods and inermediae inpus o primary goods. As we repored above, hese hree groups of commodiies consiue a significan fracion of he rade volume in African counries. Table 3 documens our findings. The relaive price of capial goods o primary goods, p k, is calculaed as he raio of he U.S. producer price index of capial equipmen o he expor price index of he domesic economy. The relaive price of inermediae goods, p v, is equal o he raio of he U.S. producer price index of inermediae maerials o he expor price index of he domesic economy. The erms of rade is calculaed as he raio of expor price index o impor price index of each counry. Ineresingly, he relaive prices are more volaile and more persisen han he erms of rade. The relaive prices of capial goods (inermediae inpus) o primary commodiies are 1.3 (1.11) imes more volaile han 6 Fosu (1996) finds ha he deb burden of Sub-Saharan African counries has a srong adverse impac on he growh performance of hese counries using regression esimaes. 7 Reinhar and Wickham (1994) find ha here has been a seady and considerable increase in he volailiy of commodiy prices since he early 197s. 5

7 he erms of rade. The persisence of he erms of rade is. while he persisence of relaive price of capial (inermediae) goods is.38 (.35). There are wo major reasons why relaive price series exhibi differen cyclical dynamics han he erms of rade. Firs, as we found in he previous secion, African counries heavily rely on a limied number of primary commodiies for heir expor earnings. Second, African counries expor and impor paerns are quie heerogeneous. These wo sugges ha i is hard o accuraely proxy he exen and duraion of flucuaions in he prices of main expor and impor iems of hese counries wih a single price index, like he erms of rade. In oher words, since he erms of rade is simply an aggregae price index, i is unable o fully reflec sharp peaks and deep roughs frequenly observed in he prices of major expor iems of developing counries (see Deaon and Laroque (199)) The Model Economy 3.1. Preferences The economy is inhabied by a large number of infiniely lived, idenical households. 9 represenaive household maximizes expeced lifeime uiliy given by The Ucl (,) = E{ = σ >, β > [ uc ( l, ) 1] β } 1 σ (1) where he parameer β denoes he subjecive discoun facor of he household and σ is he risk aversion parameer. c is consumpion of he non-raded final good and l represens leisure in period. Neiher expored nor impored goods are modeled as uiliy deriving goods in he model because of he following reasons: firs, he empirical evidence provided in he previous secion indicaes ha a significan fracion of expors comes from he primary goods secor in African counries. These expored primary goods are generally used as inpus in producing final goods, so 8 Kouparisas (1997b) provides exensive evidence ha he relaive prices are more volaile han he erms of rade. Alhough he is using a differen daa se, his resuls are very close o ours: he finds ha he relaive prices of non-fuel commodiies o manufacured goods is 1.37 imes more volaile han he erms of rade. He also shows ha he erms of rade can be wrien as a linear funcion of relaive prices. Bidarkoa and Crucini (1998) examine he commodiy price flucuaions and find ha commodiy prices are much more volaile han he erms of rade. 9 See Kose (1999) for deailed informaion abou he small open economy model presened here. 6

8 he conribuion of hese goods o uiliy is via final goods. Second, recen empirical sudies indicae ha consumer goods are only a small fracion of he oal impors of developing counries. 1 The insananeous uiliy funcion u has he form ν 1 σ uc (, l) = ( c ψ ( 1 l) ) ν > 1, ψ > () ν governs he ineremporal elasiciy of subsiuion in labor supply, ψ is a parameer used o se he seady sae level of labor hours. 3.. Technology The economy produces nonraded final goods and primary goods. Nonraded final goods f f f producion, y, uses labor, n, capial, k, and inermediae inpus, v : f f f f u u y = z ( n ) [ s( k ) + ( 1 s) v ] α ( 1 α )/ u < α, su, < 1 (3) z f represens he exogenous produciviy shock. α is he share of non-raded oupu earned by labor and s is he relaive weigh of capial. The elasiciy of subsiuion beween inermediae inpus and capial is governed by u. The CES formulaion allows us o analyze he impac of degree of subsiuabiliy beween domesic capial goods and foreign inermediae inpus on he dynamics of our model. The primary goods secor produces oupu by using labor, n p, capial, k p, and land, L p, which is assumed o be inelasically supplied. The producion funcion in he primary goods secor is given as p p p p p y = z ( n ) ( k ) ( L ) θ1 θ 1 θ1 θ < θ, θ < 1 1 (4) where z p is he echnology shock. θ 1 and θ are he labor and capial income shares respecively. Our modeling of primary goods producion is quie differen from earlier small open economy business cycle models: since producion of primary goods requires subsanial amoun of land inpu in African economies, we inroduce land ino he primary producion. This also reduces he variaion of he primary secor oupu by limiing he subsiuion effecs across differen facors. This, in urn, decreases volailiy of aggregae oupu, and helps he model o generae realisic volailiy properies. 1 See Ahearne (1997) and Henschel (199) for evidence suggesing ha he share of impored consumpion goods in aggregae consumpion is quie small in developing counries. 7

9 The producion srucure in his model also differs from hose in earlier models. For example, Mendoza (1995) consrucs a small open economy model where capial is perfecly subsiuable beween exporable and imporable goods producing secors, and domesically produced capial goods in he nonradable goods secor are inelasically supplied. Since he only endogenous facor in nonraded secor is labor, erms of rade disurbances have only an indirec effec on he dynamics of ha secor in his model. By conras, in our model, he supply of nonraded capial goods is endogenously deermined. Moreover, we do no allow he perfec subsiuabiliy of capial across wo secors, as capial is secor specific in our model. In paricular, we assume ha primary secor capial is impored and capial used in he nonraded goods secor is domesically produced. These feaures provide an environmen in which spillover effecs of he price shocks in he disribuion of impored inermediae inpus and capial goods across wo secors can be sudied. Furher, we are able o examine he impac of differen ypes of price shocks on differen ypes of facors of producion. Our approach is also empirically appealing because capial goods used in he primary goods secor are generally machinery and equipmen iems, and a significan fracion of capial goods used in he nonraded final goods secor are srucures. Capial accumulaion is modeled as Here δ is he rae of depreciaion, j j j i j k + 1 = ( 1 δ) k + φ j ( ) k j f p j =, (5) k j i is he amoun of invesmen in secor j, and φ j (.) represens he concave adjusmen cos funcion, wih φ j (.) >, φ j (.) >, and φ (.) <. Adjusmen coss prevens excessive volailiy of invesmen (see Baxer and Crucini (1993)). The resource consrain for he nonraded goods secor is given by f f c + i = y (6) The price of he primary good is numeraire in he resource consrain of he primary good secor which is k p v p p i + p v + nx = y (7) where nx represens he balance of rade. The household, who has a fixed ime endowmen normalized o one, faces he following labor-leisure allocaion consrain 11 f p l + n + n =1 (8) j 8

10 3.3. Financial Markes While each household has free access o world financial markes, hese markes are incomplee in he sense ha households can rade only a single financial asse, A, wih a rae of reurn, r, from period o +1. This marke srucure parly capures he fac ha a number of African counries mainain a variey of capial conrols. I also allows us o sudy he impac of he world ineres rae shocks on domesic economic flucuaions wih ease. The holdings of financial asses evolve according o he formula A + = nx + A ( + r ) (9) 1 1 The possibiliy of he household playing a Ponzi game is ruled ou by imposing he condiion: 1 lim E ( ( ) ) A = 1 + r In addiion o his, we assume ha β = 1/( 1+ r ), r is he seady sae level of ineres rae. I is known ha when he discoun rae is smaller (greaer) han he ineres rae, he represenaive household accumulaes (decumulaes) asses in a deerminisic version of he model. In oher words, here is no seady sae equilibrium in hose cases. If he wo are equal, he economy is a a seady sae equilibrium which is compaible wih any level of foreign asse holdings Exogenous shocks and Numerical Soluion Mehod There are five shocks in he model: wo shocks o he relaive prices of impored capial and inermediae goods, a world ineres rae shock, and wo secoral produciviy shocks. The vecor of k v f p exogenous shocks is represened by Z = [ln( p ), ln( p ), r, ln( z ), ln( z )]. The evoluion of Z follows a firs order Markov process and is given by ln Z = Π ln Z + ε (1) k v r f p The vecor of innovaions is denoed by ε = [ ε, ε, ε, ε, ε,] where ε ~ N(, Σ ). We solve he opimizaion problem of he represenaive household by maximizing he expeced lifeime uiliy, (1), subjec o he consrains (3)-(1). Since his problem canno be solved analyically, we find an approximae soluion using he log-linear approximaion mehod of King, Plosser and Rebelo (1988). 11 Our modeling of labor inpu also differs from Mendoza (1995), who assumes ha labor is inelasically supplied in he raded goods producing secors, as we assume ha endogenous labor inpu is mobile across he secors. 9

11 4. Model Calibraion 4.1. Preferences The risk aversion parameer, σ, is equal o.61 which is he GMM esimae from he panel sudy of a group of developing economies, some of which are African counries, by Osry and Reinhar (199). Prior empirical sudies show ha he value of he ineremporal elasiciy of subsiuion in labor supply, 1/(ν-1), is beween.3 and 3. (see Greenwood, Hercowiz and Huffman (1988)). We se he value of his parameer a.83 o produce reasonably volaile labor supply flucuaions. The value of ψ is seleced so ha he fracion of hours worked in he seady sae is consisen wih our assumpion abou he allocaion of labor hours beween he marke and non-marke aciviies. As he world real ineres rae measure, we use he LIBOR (he London Inerbank Offer Rae) deflaed by changes in he expor uni value index of developing counries. The average world real ineres rae, r, is found o be 3.5% annually. Since he ineres rae is equal he discoun rae a he deerminisic seady sae, he discoun facor, β, is equal o Technology The relaive weigh of capial, s, is se a.55. A he seady sae, he capial goods and inermediae inpus shares are equal o.3 and.3 respecively. These hree values ogeher imply ha he raio of inermediae inpus o oupu and he raio of invesmen goods o oupu are equal o 3% and 15% ha are approximaely equal o hose observed in developing economies. Following Praschnik (1993) we se he share of labor, θ 1, a.37. By using secoral daa and he firs order condiion for primary capial, we find ha he share of land, 1-θ 1 -θ, is equal o.45. We selec he rae of depreciaion a.1 ha is a widely used value in he business cycle lieraure. The labor share for he nonraded final goods secor, α, is se a.45 o be in line wih he earlier sudies in he lieraure (see Mendoza (1995)). We choose a value of.58 for he Allen elasiciy of subsiuion beween capial and inermediae goods. This value is consisen wih he esimaes provided by Bernd and Wood (1975). Following Baxer and Crucini (1993), we assume ha φ( i / k ) = φ( i / k ) = δ and f f p p φ ( i / k ) = φ ( i / k ) = 1 a he seady sae. The elasiciy of he marginal adjusmen cos f f p p funcion, η= ( φ / φ )/( i/ k ), for each ype of capial, is se so ha he volailiy of invesmen generaed by he model is equal o ha of he daa. Since we assume he equaliy of he ineres rae 1 Kim and Kose (1999) show ha a small open economy model wih an endogenous discoun facor produces business cycle dynamics ha are very similar o hose produced by a model wih a fixed discoun facor. Our formulaion is also similar o he one in Correia, Neves and Rebelo (1995). 1

12 o he discoun facor, he seady sae value of foreign asses is a free parameer, which is deermined by he rade balance o oupu raio. This raio is se a he average rade balance-oupu raio in our sample (-.96). Table 4b presens calibraed parameers of he model Exogenous shocks Produciviy Shocks We esimae he oal facor produciviy in he nonraded goods secor, z f, using he formula of he Solow residual in logarihms f f f log( z ) = log( y ) α log( n ) y f is he oal real value added of indusry and service oupu. n f is equal o he employmen index since daa on labor hours is unavailable for mos of he counries in our sample. The capial sock and inermediae inpu usage are excluded from he formula for he following reasons: firs, i is known ha flucuaions in he capial sock are no large in he shor-run. Second, he conemporaneous correlaion beween he capial sock and oupu is negligible. Third, he daa on inermediae inpu usage is no available. We fi an univariae AR(1) process o find he parameers of he produciviy shock for each counry and hen ake an average over he whole sample of hese parameers. These averages are assumed o be he relevan parameers for he represenaive African economy. By following he same seps and using he daa of agriculural value added, and employmen in manufacuring secor, we esimae he shock process for he primary secor oupu. Table 4a presens he resuling specificaions for exogenous processes Trade Shocks We deermine he parameers of he processes of rade shocks by using an univariae AR(1) processes. 13 We do no have any daa series or world price indices ha are specifically designed for capial goods and inermediae inpus. However, his daa is available a he counry level. We conjecure ha world prices of hose goods closely follow he prices of he same goods produced in he U.S. So, he U.S. producer price indices of capial equipmen and inermediae goods are used o represen he prices of impored capial and inermediae goods respecively. The price series of primary commodiies correspond o he expor uni values of each counry. This assumpion is easily jusified because a significan fracion of expors in African counries are primary commodiies. The relaive price of capial goods (inermediae inpus) o primary commodiies is he raio of he U.S. producer price index of capial equipmen (inermediae inpus) o he expor uni value index for each economy. In order o esimae he world real ineres rae, we use he six- 13 See Deaon and Miller (1996) for a similar AR(1) modeling of price series. 11

13 monh LIBOR (he London Inerbank Offer Rae) deflaed by changes in he expor uni value index of African counries. 14 We find he variance-covariance marix of innovaions by using he covariances beween he residual erms of esimaed processes for each counry. Then, we ake he average of hese marices over he sample. Table 4a presens he resuling specificaions for exogenous processes. 5. Resuls This secion sars wih an evaluaion of our model s abiliy in erms of capuring main regulariies associaed wih macroeconomic flucuaions in a ypical African economy. Then, we examine he imporance of differen ypes of shocks in generaing macroeconomic flucuaions by employing variance decomposiions. Nex, propagaion mechanisms of exogenous shocks in he model economy are analyzed using impulse responses. Following his, we provide a brief discussion abou he sensiiviy of our resuls o changes in he parameers of he model How successful is he model? While i is no our primary objecive o examine he abiliy of our model in erms of maching he main characerisics of macroeconomic flucuaions in African economies, we sill hink ha his is an useful exercise since our model economy is he firs one in is class designed o sudy economic dynamics of African counries. We presen some sylized feaures of macroeconomic flucuaions in hese counries along wih hose of he model economy in Table 5a. All properies of he daa refer o momens of Hodrick-Presco (HP(1)) filered variables (see Hodrick and Presco (1997)). We consider he wo main feaures of macroeconomic flucuaions: volailiy, measured by sandard deviaion, and comovemen, measured by correlaions. Columns, 3, and 4 reveal he following sylized feaures of business cycles in developing counries: firs, he volailiy of oupu in he primary goods secor is roughly wo imes larger han ha of aggregae oupu. Second, he volailiy of consumpion is wo imes greaer han ha of aggregae oupu since our consumpion series includes durable goods, and African economies do no have well funcioning financial markes ha can creae consumpion smoohing opporuniies. Third, while invesmen exhibis high cyclical volailiy, he rade balance is he mos volaile aggregae. Fourh, excep he rade balance, all macro aggregaes are procyclical. 15 We simulae our model wih he specificaion described in he previous secion. Each saisic we repor is he sample average of across 1 simulaions of he same lengh as he daa 14 The LIBOR is used as a benchmark ineres rae measure by inernaional organizaions and commercial banks when hey give loans o developing counries. See World Economic Oulook (1993, p. 83) for he use of his measure as a proxy for real cos of borrowing for developing economies. 1

14 (3 years). The simulaed daa is also derended wih he HP(1) filer. In erms of maching volailiy properies of macro aggregaes, he model is quie successful as columns 5, 6, and 7 show: qualiaively, i replicaes mos of he feaures of acual daa. Boh rade balance and invesmen are more volaile han aggregae oupu. The model also capures he volailiy ordering of oupus of producion secors: he primary secor oupu has he larges variabiliy, and aggregae oupu is he leas volaile series. From a quaniaive perspecive, he model is able o reproduce some of he sylized facs. For example, i is able o mimic volailiies of secoral oupus and aggregae oupu wih a small margin. The prediced sandard deviaion of he rade balance is slighly higher han he acual one. We se he relevan elasiciies of adjusmen coss so he model can exacly replicae he volailiy of invesmen. The volailiies of consumpion and employmen relaive o oupu are seemingly low in he model economy. This resul should no be inerpreed as a weakness of he model: firs, he only available daa on consumpion in African counries, which we have access o, includes boh nondurable and durable consumpion expendiures. Unlike he daa, our model does no ake ino accoun durabiliy. Hence, a direc comparison of he model generaed consumpion daa wih he acual one migh resul in an inaccurae assessmen of he model. I is known ha he volailiy of durable goods consumpion is wo o four imes higher han ha of non-durable consumpion. 16 Second, he labor supply variaion in he model is capured only along he inensive margin. Conversely, we have employmen daa which measures he labor supply flucuaions only along he exensive margin. Earlier empirical sudies indicae ha he volailiy of employmen is wo o hree imes higher han ha of labor hours. Ineresingly, he predicion of he model concerning employmen flucuaions is also consisen wih his empirical regulariy: he volailiy of labor hours in he model is approximaely wo imes smaller han he one of employmen series in he daa. We nex evaluae he performance of he model in replicaing comovemen properies of he daa. While quie closely maching he correlaion beween he primary secor oupu and aggregae oupu, he model overpredics he aggregae oupu-final secor oupu correlaion. The correlaions beween consumpion and oupu, and beween invesmen and oupu in he model are higher han hose in he daa. 17 The oupu-labor hours correlaion in he model is higher han he oupuemploymen correlaion in he daa. Our preference formulaion implies ha he marginal rae of 15 Kose and Riezman (1999) presen a deailed examinaion of he feaures of macroeconomic flucuaions in African counries. 16 Baxer (1996) provides an exensive discussion abou he durables vs. nondurables goods differeniaion and is macroeconomic implicaions. 17 I is possible o remedy near perfec procyclical behavior of consumpion by allowing he household o consume a variey of goods, such as exporable and imporable goods. 13

15 subsiuion beween consumpion and leisure depends only on labor supply inducing perfecly procyclical labor hours. One of he imporan feaures of he model economy is is abiliy o generae counercyclical behavior of he rade balance series. Ineresingly, compared wih he acual daa, here is a relaively high negaive correlaion beween he rade balance and aggregae oupu in he model. This resul migh be due o he coexisence of produciviy and rade shocks ha ogeher generae prolonged rade deficis in he model. We furher invesigae his possibiliy in secion 5.4. Our model is quie successful in maching some of he salien feaures of macroeconomic flucuaions in African economies. Several of our resuls have no been obained in earlier small open economy business cycle models. 18 For example, our model is able o reproduce he volailiy ordering of secoral oupus. I also capures he comovemen properies of secoral oupus. 5.. How imporan are he rade shocks? Our main objecive is o deermine he relaive conribuion of he rade shocks o macroeconomic flucuaions in African economies. We apply he variance decomposiion mehod, which is widely used in he vecor auoregression lieraure, on he soluion of he model o deermine he relaive imporance of shocks in explaining economic flucuaions. In oher words, we decompose he variances of macroeconomic variables ino fracions explained by exogenous shocks. 19 This mehod requires us o impose a cerain informaion ordering on he shocks because he relaive conribuion of each disurbance o macroeconomic flucuaions is sensiive o is place in he shock specificaion. Since our model represens a small open economy, here is a naural ordering of shocks. By consrucion, he small open economy does no have any conrol over he exernal shocks i faces in he world markes. This implies ha domesic shocks do no have any impac on he exernal shocks, i.e. he exernal shocks precede secoral produciviy shocks in our specificaion. The resuls of he variance decomposiions, which are obained by using he informaion ordering in (1), are repored in Table 6. We presen he fracion of variance due o rade shocks in 18 Our model does a much beer job in erms of maching some momens han he one in Mendoza (1995). For example, Mendoza's model generaes ha radables secor oupu is less volaile han nonradables secor oupu, and labor supply in he nonraded good secor is counercyclical. These resuls are no consisen wih he empirical evidence presened here. Moreover, his simulaions sugges ha he volailiy of oupu (invesmen) is almos hree (wo) imes less han ha in he daa, he volailiy of he rade balance is wo imes less han ha in he daa, and he correlaion beween invesmen and oupu is wo imes less han ha in he daa. 19 In a muli-shock model, measuring he conribuion of a single shock o business cycle flucuaions is difficul because he shocks are correlaed wih each oher. Mendoza (1995) employs he sandard variance-raio approach, which examines each shock in isolaion from he oher shocks. Some recen papers (see Ingram, Kocherlakoa, and Savin (1994) and Cochrane (1994)) argue ha he sandard approach can yield misleading inferences abou he relaive imporance of shocks. Our approach does no suffer from he problems of he sandard variance raio mehod. We also analyzed he sensiiviy of hese resuls o differen orderings of he shocks. This invesigaion indicaes differen informaion orderings do no cause significan changes in he resuls repored here. 14

16 he firs hree columns. Srikingly, a significan fracion of macroeconomic flucuaions is explained by rade shocks. They accoun for roughly 45% of he variaion in aggregae oupu. Our resuls indicae ha shocks o he relaive price of capial goods o primary goods play a more imporan role han shocks o he relaive price of inermediae inpus. While almos 5% of variabiliy in aggregae oupu is due o he changes in relaive prices of capial goods, less han % of he flucuaions is due o he disurbances o relaive prices of inermediae inpus. The domesic produciviy disurbances also play an imporan role in driving economic aciviy: roughly 55% of he oupu variaion is due o produciviy disurbances. Ineresingly, mos of he variaion explained by he produciviy shocks is due o he domesic produciviy movemens in he final goods secor. In our model, rade shocks have a direc impac on oupu flucuaions, since boh secors of he economy use impored goods as facors of producion. A significan fracion of he macroeconomic volailiy in he final goods producing secor, ha heavily relies on impored inermediae inpus and domesic capial goods, is explained by he rade shocks. Roughly 46% of he oupu variaion in he nonraded final goods producing secor is due o he rade shocks. Ineresingly, rade disurbances play a more imporan role in explaining consumpion flucuaions han hey do in oupu variaion: almos 8% of he variaion in consumpion is due o he rade shocks. Our resuls also show ha rade shocks have a large impac on macroeconomic flucuaions in facors of producion: more han 86% of he volailiy of aggregae invesmen is explained by rade disurbances. In paricular, shocks o he relaive prices of primary capial goods accoun for more han 98% of he variaion in primary invesmen. This resul can be explained by he fac ha all invesmen goods in he primary good producing secor are impored capial goods. More han 4% of he variaion in inermediae inpus is explained by he disurbances o he relaive prices of inermediae goods. Shocks o he prices of capial goods and inermediae inpus also play an imporan role in inducing flucuaions in he labor marke. Movemens in he relaive prices of capial goods (inermediae inpus) accoun for more han 4 (37)% of he variaion in he oal labor hours. Trade balance dynamics and foreign asse holdings are also heavily affeced by he price flucuaions in he world markes. This is an inuiively appealing resul as i esablishes he connecion beween highly volaile price shocks and rade balance dynamics: almos 74% of he flucuaions in he rade balance is accouned for by he rade shocks. Shocks o he relaive prices of capial goods explain more han 45% of he volailiy in he foreign asse holdings. 15

17 Deaon and Miller (1996) analyze he imporance of inernaional commodiy prices in driving economic flucuaions in African counries using vecor auoregression analysis. Their resuls sugges ha while a sudden 1% increase in commodiy prices resuls in a 6% increase in oupu, he price shocks mos heavily affec invesmen dynamics in African economies. Hoffmaiser, Roldos, and Wickham (1998) esimae a srucural VAR model, where idenifying resricions are derived from a long-run small open economy model. They consider erms of rade, world oupu, domesic supply, fiscal policy, and nominal policy shocks. Their resuls sugges ha erms of rade shocks play only a minor role in accouning for aggregae oupu flucuaions. Mendoza (1995) uses a similar model o he one presened here and finds ha erms of rade shocks explain roughly one half of he oupu volailiy in developing counries. Our resuls regarding he link beween rade shocks and price flucuaions are in line wih hose in Mendoza (1995) and Deaon and Miller (1996). However, hese sudies do no consider he imporance of price shocks in inducing business cycles in differen secors and facors of producion. One imporan conribuion of his sudy is ha i examines he impac of differen ypes of price shocks on cyclical flucuaions in differen secors and differen ypes of facors of producion. In paricular, our resuls show he subsanial role played by hese shocks in generaing economic flucuaions in raded and nonraded secors of he economy and all facors of producion. For example, Mendoza (1995) finds ha erms of rade shocks induce only negligible changes in nonraded oupu because capial is inelasically supplied in he nonraded secor in his model. Our findings sugges ha changes in he relaive prices direcly affec he dynamics in he nonraded good secor, because he nonraded secor employs impored inermediae inpus in my model. In paricular, we find ha roughly 46% of he oupu variaion in he nonraded final goods producing secor is due o he rade shocks. Our findings also emphasize he imporance of sudying he impac of he flucuaions in he prices of he major expor and impor goods. Ineresingly, we find ha world real ineres rae shocks do no play a significan role in driving domesic economic aciviy in our model. For example, hey accoun for less han 1% of he oupu volailiy. As expeced, hese shocks have a relaively more imporan role in driving he dynamics of asse holdings, bu heir influence is sill very small compared o he role of oher shocks: less han 6% of he variaion in foreign asse holdings is explained by ineres rae disurbances. We consider four possible reasons why world real ineres rae shocks play only a minor role in inducing macroeconomic flucuaions: firs, we sudy a highly sylized incomplee asse marke srucure in our model. A more complex asse marke consrucion, which includes borrowing consrains, migh lead o differen resuls. Second, our ineres rae daa suggess ha here are only 16

18 a few large ineres rae changes over he ime period we consider. 1 Capuring he effecs of hose large and shor-lived ineres rae flucuaions on economic aciviy migh require he use of differen echniques. Third, since our sample size is quie small, i migh be he case ha he persisence coefficien of he world real ineres rae shock we esimae is biased downwards. This, in urn, migh reduce he effec of hese shocks in generaing business cycles. 3 Fourh, and probably he mos imporan, i migh be he case ha since he raio of foreign ineres rae paymens o oupu is no sufficienly large in our benchmark calibraion, world real ineres rae shocks unable o generae srong enough income and subsiuion effecs o have a sizeable impac on economic flucuaions. In secion 6.3 we sudy he las wo possibiliies and show ha as he seady sae rade defici-oupu raio ges larger world real ineres rae shocks become more imporan in driving macroeconomic aciviy in African counries The dynamic effecs of shocks We sudy he dynamic effecs of rade and produciviy shocks by using impulse response analysis. This invesigaion provides informaion abou he differences beween he propagaion mechanisms of produciviy and rade disurbances. We analyze he impulse responses of model variables o a 1% emporary shock. The resuls, presened in Figures 1-, are ploed as percenage deviaions from he iniial seady sae. We presen he impulse responses of model variables o a emporary 1% increase in produciviy of boh secors in Figure 1. A sudden increase in produciviy resuls in an economywide boom: oupu increases in boh secors. This causes a rise in demand for impored capial goods, inermediae inpus and labor supply. Since he increase in expors (primary goods) is less han he rise in impors (he sum of he impored invesmen and inermediae goods), he economy has a subsanial rade defici. The represenaive household increases is consumpion. Qualiaively, he secoral produciviy shocks lead o more pronounced effecs in invesmen and rade balance compared o he hose in oupu and consumpion. Figure shows he ime pahs of model variables in response o a 1% emporary increase in he relaives price of capial goods and inermediae inpus. This ype of adverse price shock pushes he economy ino a recession. Invesmen in primary goods secor sharply drops; however his decrease does no lead o a significan decline in aggregae invesmen since he share of primary invesmen in he aggregae invesmen is relaively small. The household runs down is foreign asses as he rade balance improves. In oher words, he decrease in impors is larger han ha in 1 Kose and Riezman (1999) provide an exensive analysis of he ineres rae daa. See Blankenau, Kose, and Yi () for a mehodology, which allows backing ou world real ineres rae shocks in a small open economy model. They show ha ineres rae shocks, which are perfecly consisen wih he daa of major macroeconomic variables, can accoun for a significan fracion of oupu flucuaions. 17

19 expors. These impulse response plos clearly show he ypical propagaion mechanism of price shocks in several African counries which are ofen subjeced o adverse price flucuaions in heir expor markes: conracion in he expor secor, following a fall in he relaive price of expors, causes a subsanial decline in he impors of producive inpus. This hen decreases consumpion and invesmen Since labor supply in each secor is endogenously deermined in our model, we can analyze he movemen of labor across he wo secors. Our resuls sugges ha he magniudes of labor supply responses in he raded and non-raded secors of a ypical African economy, are comparable wih hose of he oher variables when he model is subjeced o domesic produciviy and inernaional rade shocks. For example, in response o a 1% emporary produciviy shock in he primary secor, here is a considerable increase in he labor supply in ha secor, a decrease of labor supply in he non-raded goods secor, and an increase in he aggregae labor supply. Correspondingly, primary secor oupu increases and he producion in non-raded final goods secor slighly decreases due o a shorage of producive inpus. 4 The overall effec of rade shocks in our model is he opposie of ha of domesic produciviy shocks since rade shocks ac like negaive produciviy shocks. While posiive produciviy shocks simulae he economy and resul in shor lived expansions, negaive rade disurbances have adverse implicaions: hey cause negaive income effecs which are accompanied by a fall in consumpion, and a conracion in demand for producive inpus. Furhermore, rade shocks lead o prolonged recessions by having a derimenal impac on aggregae invesmen: in response o a posiive produciviy shock, aggregae oupu reaches is seady sae level afer 15 periods, in oher words, he economic expansion generaed by he improvemen in domesic produciviy lass 15 periods. Afer receiving a negaive shock o he relaive price of inermediae inpus (capial goods), i akes 5 (35) periods o aain he seady sae level of aggregae oupu for he model economy Sensiiviy Analysis In his secion, we firs analyze he individual roles of produciviy and rade shocks in our model. In able 5b, he resuls of a simulaion when only produciviy shocks are presen are 3 We would like o hank he referee for suggesing his exercise. 4 These resuls are in line wih hose findings by van Wincoop (199) who argues ha wheher expor secor expands or conracs in response o an exogenous shock depends on he labor supply movemens beween ha secor and he oher secors of he economy in developing counries which face exremely volaile expor prices. Mendoza (1995) assumes ha labor is inelasically supplied in he raded secor and finds ha produciviy shocks induce only negligible changes in labor supply. Our resuls sugges ha when his assumpion is relaxed hese shocks can generae sizeable flucuaions in labor supply. 18