¿La volatilidad de la demanda reduce el crecimiento y eleva la inflacion? Evidencia de paises caribenos.
| Autor | Kandil, Magda |
| Cargo | Report |
Does Demand Volatility Lower Growth and Raise Inflation? Evidence from the Caribbean.
Introduction
In general, Caribbean countries have been largely successful in bringing annual inflation down to single digits in recent years. Nonetheless, their growth rates have been disappointing despite fiscal stimulus. Previous research (see, e.g., Sahay, 2006) suggests that in the absence of higher growth, the fiscal position may not be sustainable over time.
Caribbean countries are small open economies that are highly dependent on tourism receipts. This unique feature exposes their economies to excessive demand variability from external shocks. The ability of these economies to absorb demand variability has implications for economic performance. Furthermore, as policy makers attempt to smooth the outcome of demand variability on economic performance, structural impediments may impose a serious challenge to their efforts.
To shed some light on structural rigidities governing the relation between demand variability and economic performance, this paper traces the nature of cyclical fluctuations on the macro-economy across a sample of fifteen Caribbean countries. Demand-side fluctuations could arise from domestic factors or policies, including monetary or fiscal policies, or external factors, such as those affecting flows of remittances and/or other determinants of the external position. Asymmetry in the response of real growth and price inflation to demand shocks over the business cycle will determine the net effect of demand variability on economic performance over time.
The analysis indicates that the majority of the Caribbean countries are characterized by a kinked supply curve; i.e., one that is flat when output is below potential and steep when it is above. This implies that during demand expansions, inflation accelerates while the real output response is moderate. On the other hand, during demand contractions, a flatter supply curve implies a bigger drop in real output growth with only a small deceleration in inflation.
These results point to two important policy implications: l) the need to address structural rigidities that create the kink in the supply curve, and 2) the dangers of procyclical policies that accentuate demand shocks and exacerbate the associate upward bias on inflation and downward bias on real growth.
The outline of the paper is as follows. Section r provides an overview of macroeconomic developments in the fifteen Caribbean countries, focusing on output growth and inflation. Section II provides a theoretical background for the kinked-slope of the supply curve. Section III presents the empirical models and results. Section IV analyzes the time-series results. Section v presents the conclusion and policy implications.
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An Overview of Macroeconomic Developments in Caribbean Countries
The analysis of the paper concerns cyclicality in real growth and price inflation across Caribbean countries. This section summarizes major indicators characterizing real growth and price inflation across countries. Table 1 presents average real GDP growth for each of the countries under investigation over the sample period 1975-2005. (1) The lowest average real growth is in Haiti (0.64%) and the highest average real growth is in Belize (5.4%). The volatility of real growth is generally high across Caribbean countries, as measured by the standard deviation. The lowest volatility is in St. Kitts and Nevis, 2.5 per cent, and the highest in Suriname, 5.9 per cent. As noted by Cashin (2006), output in Caribbean countries is, on average, about 1.6 times as variable as output in the United States. (2)
In Table 1, the rate of inflation, using the GDP deflator, ranges from a low 2.8 per cent in Belize, to a high 25.9 per cent in Suriname over the period 1975-2005. The highest inflation variability is in Suriname, 39 per cent, and the lowest in The Bahamas, 2.8 per cent.
Across countries, where inflation was high, real growth tended to be low, providing some evidence for supply-side constraints. On average, the correlation coefficient between real growth and price inflation is negative (-0.57) and statistically significant across countries. The paper turns to the analysis of fluctuations contributing to variation in real growth and price inflation over time.
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Theoretical Background
Assume aggregate demand intersects with the aggregate supply curve at a level of output [y.sup.*] that corresponds to full capacity utilization. Aggregate demand may be subject to random shocks that generate fluctuations around the steady state equilibrium output over time. Assume these shocks follow a symmetric distribution, i.e., shocks have zero mean and constant variance. Demand variability determines the size of demand shifts over the business cycle. The allocation of demand shocks between real growth and price inflation is dependent on the shape of the supply curve. Along a linear supply curve with a constant slope, the effects of demand shifts, positive and negative, cancel out, implying demand variability does not determine trend real output growth or price inflation over time. However, this is not the case when the supply curve has a kink (see figure 1).
[FIGURE 1 OMITTED]
Theoretical explanations of a kinked-shape supply curve have emphasized the role of institutional and structural rigidities in the labor and product markets. In a framework in which nominal wage negotiations follow contractual agreements, the magnitude and speed of wage adjustments (degree of wage indexation) may be different during expansions and contractions. During boom periods, cost of living adjustments may be specified to guarantee workers upward adjustment of wages, to keep up with inflation. In contrast, employers may resist adjusting wages in the downward direction during recessions. (3)
Alternatively, the asymmetric flexibility of nominal wages may be an endogenous response to uncertainty impinging on the economic system. Models of the variety of Gray (1978) have emphasized the dependency of the degree of indexation on the variability of stochastic disturbances. Higher demand variability may increase uncertainty and, therefore, the probability of realizing positive and negative demand shocks. Agents may form asymmetric behavior to hedge against uncertainty. Agents are more inclined to hedge against the risk of higher inflation, demanding a stipulation of cost of living adjustments to protect their real wages. In contrast, cost of living adjustments are usually not stipulated in anticipation of a slow down in demand and, therefore, price deflation. Similarly, agents in economies with a history of high trend inflation are likely to have larger incentives for upward wage flexibility, compared to downward flexibility.
An alternative explanation of supply-side asymmetry is based on the frequency and speed of adjusting product prices. This framework emphasizes the cost of adjusting prices "menu costs" in determining producers' decisions. Menu costs comprise the cost and effort involved in changing prices (see, e.g., Ball and Mankiw, 1994). When trend inflation is high, the presence of menu cost implies an upward bias on inflation. High trend inflation increases producers' incentives to raise prices above the current equilibrium, in anticipation of the need for continuous upward adjustment. An expansionary demand shock, coupled with high trend inflation, creates a large gap between desired and actual relative prices. During a recession, producers may resist paying the menu cost to adjust prices downward, as they expect trend inflation to decrease their relative prices in par with their competitors. As a result, positive shocks are more likely to induce a larger upward price adjustment, compared to downward adjustment in the face of negative shocks.
Along a kinked supply curve (see figure 1), demand variability induces a trade-off between real output growth and price inflation. Assuming a steeper supply curve in the face of positive demand shocks, demand variability will have a net average positive contribution to price (inflation) and a net average negative contribution to output (contraction) over time. Accordingly, demand variability increases the trend of price inflation and decreases the trend of real output growth, on average, over time.
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Econometric Investigation
The investigation will study asymmetry in Caribbean business cycles over the period 1975-2005. Business cycles are fluctuations that develop randomly around the trend component of economic variables. The trend is the domain of real growth, which progresses over time in line with underlying fundamentals that determine production potential. The latter grows over time in line with growth in the economy's endowed resources of labor, capital and technological advances. Consequently, the trend component follows a non-stationary stochastic trend. In contrast, cyclical fluctuations generate transitory deviations around the stochastic trend and, therefore, are the domain of short-term stationary shocks.
It is worth noting a few factors that differentiate the analysis of this paper from similar studies analyzing business cycles in Caribbean countries. Cashin (2006) uses a statistical business-cycle filter to eliminate the trend component from the random cyclical component, following the suggestions of Baxter and King (1999). Similar to Cashin's, the approach of this paper relies on a filtering technique to extract the cycle (stationary component) from the trend (non-stationary component) of the dependent variables under investigation: real GDP and the GDP deflator. However, in contrast to Cashin's work, this paper develops an empirical model to model the cycle, differentiating between the effects of supply and demand shocks, and modeling asymmetry in short-term adjustments to expansionary and contractionary shocks.
The empirical model identifies the size and significance of cyclical responses...
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