Internatinal

International Economics
Individual Assignment
Aaron Honour - 41276
09/08/2016
1

Contents
1 International Capital Markets and Financial Crisis 3
2 Economic Integration 4
2.1 EMU and GDP growth . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Economic Integration Theory . . . . . . . . . . . . . . . . . . 7
2.3 Evidence from Literature . . . . . . . . . . . . . . . . . . . . . 8
3 Inﬂation and Economic Openness 9
3.1 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
3.2 Diﬀerence in developing countries . . . . . . . . . . . . . . . 11
3.3 Factor control for robust analysis . . . . . . . . . . . . . . . . 12
4 References 15
2

1 International Capital Markets and Financial Cri-
sis
Capital markets are the part of the financial system which raises capital
funds by dealing in shares and bonds. This allows capital to flow across
international borders for a more efficient. Capital markets also mobilize
savings and increase economic growth and development.
Foreign Assets
Domestic Goods
Services
Foreign Goods
Services
Domestic Assets
Figure.1 International Capital Markets
There are two markets, the primary market where securities are sold for the
first time and a secondary market in which buying and selling of previously
issued securities is done. An international capital market involves trade
between domestic capital markets (figure 1)There are specific risks involved
in International capital markets such as:
- Exchange rate fluctuations: which causes bond purchasers to suffer
capital loss.
- Default: where a party refuses to pay its debt or is unable to.
Bonds are agreements offered by governments and corporations that
enable them to raise funds with the promise of a larger return at a later
date. Governments can finance spending through monetizing debt, this is
when the government issues shares and the central bank purchase them
with newly created money. This can allow the government to increase its
spending or pay off portions of its debt. As long as the government borrows
in the same currency it issues it can never become bankrupt.
When Greece joined the Euro in 2001 it lost the ability to finance its own
debt through monetizing, however it gained the benefits of a stable currency,
this lead to a fall in the 10-year Greek government bond from 20% to 3.5%
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in 2001 (Hardouvelis, 2011). The adoption of the Euro also lowered inflation
reducing the uncertainty caused by inflation distortion (Kouretas, 2010).
With both low inflation and nominal interest rates real GDP grew 3.9% per
year between 2001-2008. The Greek government did not take advantage
of the low inflation environment running a fiscal deficit of 6% a year and
increased the share of government spending to GDP (Antzoulatos, 2011).
When the financial crisis between 2007-2009 occurred unstable fiscal and
external imbalances were exposed in Greece.
Excessive government debt and a large current account deficit led to in-
creased bond interest rates due to the lack of competitiveness in the Greek
economy which indicated it would not be able to grow its way out of its debt
(Gibson et al, 2012). Greece was therefore no able to pay its loans which
lead to further refinancing and a reduced credit rating. Which lead to a loss
of liquidity due to lack of monetary policy control and therefore a larger
financial crisis.
2 Economic Integration
2.1 EMU and GDP growth
The European Monetary Union (EMU) was established in 1999 as part of the
the EU integration process. Liadze et al. (2008) found that between 1999 and
2007 EMU area growth has been weak relative to the US, UK, and Sweden
figure2 supports this data and shows that this pattern continued after the
2008. If the recession years 2008-09 are excluded there is a clear pattern of
slow growth in the EU area.
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1998200020022004200620082010201220142016
−6
−4
−2
0
2
4
6
Y ear
GDPGrowth(%)
Figure2. GDP Growth between 1999-2015
USA
UK
Sweden
EMU
Averages growth figures from the data in figure2 can be seen in table 1 which
shows the EMU has experienced between 0.6% and 1.1% less growth than
the countries used in the comparison by Liadze et al. (2008)
Table 1: Average GDP Growth by Country
Country ¯x Growth(%)
United States 2.091527412
United Kingdom 1.976918882
Sweden 2.396895765
Euro area 1.293725941
During the EMU’s active operation it experienced slower economic growth.
An extension of this comparison between the EMU countries is made through
the use of data before and after joining the EMU. This involves comparing
data from 1980-1998 with data from 1999-2015. A selection of countries
are used, based on geography and level of development in order to pro-
vide a world picture of the effect. This will help to establish if the EMU is
a contributor towards the cause of low GDP growth in the included countries.
5

1980 1985 1990 1995 2000 2005 2010 2015
−5
0
5
10
15
Y ear
GDPGrowth(%)
Figure3. GDP Growth between 1999-2015
EMU
Australia
Singapore
World
Figure3 shows that the EMU growth is on average lower than other coun-
tries however this trend is constant throughout the sample period. Table
2 shows the average growth from the period before and after the creation
of the EMU. The absolute difference between the two periods places the
EMU in roughly the middle with countries such as the USA Singapore and
Japan experiencing larger decreases in GDP growth while countries such as
Australia, UK and the world average experiencing a lower decrease in GDP
growth.
This suggests that while the EMU may have slowed growth the effect is
not as significant as often perceived.
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Table 2: My caption
Country 1980-1998 1999-2015 Difference
EMU 2.23 1.29 0.93
AUS 3.24 3.09 0.15
CAN 2.49 2.33 0.15
SGP 7.62 5.53 2.10
JPN 3.08 0.77 2.31
SWE 1.90 2.40 0.50
CHE 1.60 1.87 0.27
GBR 2.36 1.98 0.38
USA 3.11 2.09 1.02
WLD 2.84 2.90 0.06
CHN 10.01 9.43 0.58
2.2 Economic Integration Theory
Economic Integration is the policy of discriminatingly eliminating trade
barriers between countries. This process can be seen in Figure 4. At several
stages of economic integration there are benefits and challenges which will
be discussed.
Preferential Trading Area
Free Trade Agreement (FTA)
Customs Union
Common Market
Monetary Union
Fiscal Union
Political Integration
Figure4. Stages of Political Integration
FTA’s remove tariff barriers between participating countries allowing ben-
efits from competitive advantage, such as NAFTA where Mexico has the
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labour advantage and USA has the capital advantage. If the FTA is successful
participating countries may decide to create a customs union(CU) where
there is a common external tariff (Figure5).
The CU encourages further integration and trade dependence, however this
can lead to difficulties for certain countries, for example if a given country in
the CU was able to trade with low transport cost to a country outside the CU
the tariff will remove this advantage leading to a higher cost of production
and a higher price.
Figure5. FTA (left), Customs Union (right)
The common market (CM) is similar to a CU, however, further inte-
gration involves free movement of capital and labour. Enabling factors of
production to be efficiently allocated increasing competition and making it
monopoly formation difficult. Producers benefit from economies of scale
and consumers benefit from an increased selection of goods at a lower price.
Some sectors of national economies can fail due to increased international
competition. Countries may struggle to compete against more developed
and efficient peers, this can lead to unemployment and migration.
Monetary union with one currency and central bank removes exchange rate
fluctuations and uncertainty leading to a stable environment to increase
business confidence promoting trade with no transaction costs. However,
individuals cannot manage interest rates and money supply leading to no
government control of fiscal and monetary policy.
2.3 Evidence from Literature
Balassa (1961) outlined the five steps of the economic integration process as
(i)free exchange areas, (ii)customs union, (iii)common market, (iv)economic
union, (v)monetary union. Andrei (2012) described the contribution as a
decisive way to overcome the draw-back and decline of a multiplicity of
currency’s.
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Viner (1950) focused upon the creation of custom unions, he established that
they are susceptible to the effects of trade creation and trade perversion.
These stages have received much criticism due to the large amount of separa-
tion between them (Tosukalis, 2000). Andrei (2012) provides an alternative
suggestion based on two big stages the first called incipient integration (a
combination of (i) and (ii) of Balass’s model). The second called advance
integration which involves economic convergence and an optimum currency
area. These two large stages would enable the change to be protected from
the perversion mentioned by Viner (1950).
Overall Rodrik (1999) states that economic integration will always be lim-
ited even where there is an absence of tariffs, exchange-rate uncertainty and
linguistic or cultural differences. Due to the advanced industrial countries
exhibiting large amount of “home bias” which limits asset diversification.
While real interest rates are not driven to equality even in integrated finan-
cial markets. Obstfel (1998) uses the term “open-economy trilemma” to
describe the issues surrounding economic integration. Like with any im-
possible trinity model only two of the three variables can be chosen at once,
therefore until countries are willing to surrender mass politics or nation-
states complete integration cannot occur.
Figure6. Modified Impossible Trinity
3 Inflation and Economic Openness
The variable chosen to represent economic openness is the adjusted trade
intensity index (ATI) suggested by Frankel (2000) with modification to ac-
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count for PPP as suggested by Alcala and Ciccone (2004)
AT I = 1 − [(X + M)i/2RGDPi] ∗ 100
To determine the measure of CPI that should be used a correlation matrix
of CPI, GDP deflater and ATI was created.
Correlation coefficients, using the observations 1–175
5% critical value (two-tailed) = 0.1484 for n = 175
AdjustedTradeIn CPI GDPdeflator
1.0000 0.0999 −0.1041 AdjustedTradeIn
1.0000 0.6130 CPI
1.0000 GDPdeflator
This showed little variance in the correlation between CPI and GDP deflator
therefore both regressions were run and it was found that the ATI was most
significant when regressed with GDP this is likely due to their aggregate
nature.
OLS, using observations 1–175 (n = 173)
Dependent variable: GDP Deflator
Heteroskedasticity-robust standard errors, variant HC1
Coefficient Std. Error t-ratio p-value
const 7.15914 0.923253 7.7543 0.0000***
Adjusted Trade Intensity −0.0881765 0.0389359 −2.2647 0.0248**
Mean dependent var 6.665234 S.D. dependent var 10.09827
Sum squared resid 17349.83 S.E. of regression 10.07278
R2 0.010827 Adjusted R2 0.005042
F(1,171) 5.128685 P-value(F) 0.024789
Log-likelihood −644.0724 Akaike criterion 1292.145
Schwarz criterion 1298.451 Hannan–Quinn 1294.703
3.1 Correlation
The regression showed that as the GDP deflater increase by 1% the ATI fell
by 8.8% result was significant to the 5% level. Badinger (2009) found that
there is a negative relationship between inflation and openness (see also
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Muhammad and Batool (2006), Sachsida et al. (2006)).
Inflation undermines the confidence of domestic and foreign investors re-
garding the future, causes a reduction in total factor productivity and gen-
erates larger forecasting error by distorting prices (Hernando, 1999). An
increase in prices will lead to a decrease in international competitiveness,
which will be magnified by a reduction in investment reducing the accumula-
tion of capital required to benefit from increase productivity and economies
of scale.
When consumers feel uncertain regarding purchases they will be less in-
clined to take on the increased risk of trade with the country therefore
reducing the economies openness to trade. Braumann (2000) found that
increased inflation cause a decline in output, private consumption, in real
wages and a sharp decline in investment. All of these factor could greatly
impact the level of imports purchased and exports sold.
3.2 Difference in developing countries
GNI per capita will be used as a dummy to determine the differences between
developing and developed economy. GNI is used based on the world develop-
ment indicators suggested by the World Bank (2016) defining a developing
economies as any country which has a GNI per capita of less than $4,035.
The regression with dummy significantly changes, ATI decreases from -8%
to -20%. The dummy shows that developing countries GNI increases by 6.5
when the GDP deflater increases by one unit.
OLS, using observations 1–171
Dependent variable: GDP deflater
const 4.93782 0.682554 7.2343 0.0000***
AdjustedTradeIn −0.204078 0.0729415 −2.7978 0.0057***
GNI D 6.50285 2.08705 3.1158 0.0022***
R2 0.096881 Adjusted R2 0.086130
F(2,168) 4.977403 P-value(F) 0.007943
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A structuralist view of inflation describes a positive relationship between
inflation and growth. This argument is based on rigidities and in-elasticities
in the economic environment of the developing country which leads to a
build-up of inflationary pressure. These inflationary pressures arise when
industrial or developing sectors increase wages in order to attract people
from the subsistence sectors, this increase in wages results in a higher food
consumption level and population growth which push up the relative price
of food (Cardoso 1981).
Another cause of inflation in developing countries is the in-elasticity of de-
mand for traditional exports of the developing economy, the earnings from
such exports cannot rise fast enough to either finance the growing require-
ment of imports or to satisfy the demand for imports of intermediate goods
by producers of export-oriented and domestic goods. Therefore, import sub-
stitution is required and in combination with the low degree of comparative
advantage, the cost of production will be high creating inflationary pressures
(Omotunde, 1984). This theory thereby explains the increase in inflation
within a developing country and the different effect of inflation upon its
economy, due initial to the types of exports, natural resources, which are in
a typically un-fluctuating demand regardless of inflationary changes com-
pared to a service or industrial sectors in which sales change depending on
the levels of disposable income which are eroded by inflationary increases.
3.3 Factor control for robust analysis
There are many factors that can influence inflation level they will be dis-
cussed in order to establish how they can increase the robustness of the
model.
Unemployment: the theory of cost push inflation suggests that as unem-
ployment decreases wages will increase due to a reduction in the supply of
labour causing and inflationary rise (Alpanda et al, 2010).
Minimum Wage: creating a price floor can cause the supply and demand for
labour to be in disequilibrium
Exchange Rates and Natural resources: Abdul & Husain (2012) found the
inflation can be imported from other countries through international trade.
Interest Rates: Utami and Inaga (2009) found that there is a strong relation-
ship between interest rates and inflation this is based on monetary policy
where an increase in the interest rate increases the demand for money which
in turn increases the value of the currency and which requires an increased
supply of money in order to maintain equilibrium.
In order to discover an accurate measure of the relationship between the
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GDP deflater and ATI several control variable need to be included in order
to find a true relationship.
The control variables selected are a minimum wage dummy, unemployment
rate, log exchange rate, log natural resources as proportion of GDP and real
interest rate. logs of selected variables have been used in order to improve
interpretation, remove noise and increase the robustness of the model.
Dependent variable: GDPdeflator
const 4.64368 1.61353 2.8780 0.0049***
AdjustedTradeIn −0.119857 0.0534400 −2.2428 0.0270**
l Ex Rate 0.742931 0.275697 2.6947 0.0082***
MinimumWage 2.04037 1.17687 1.7337 0.0860*
GNI D 7.50246 2.13485 3.5143 0.0007 ***
Unemploy 0.0938021 0.0932762 1.0056 0.3169
Real Interest −0.879171 0.326378 −2.6937 0.0083***
R2 0.549992 Adjusted R2 0.523778
F(6,103) 3.506661 P-value(F) 0.003385
The results show that log exchange rates, developing dummy and real
interest rate all have significant impacts on the GDP deflater. This model
has an R2 of 0.54 which is significantly larger than the previous models
(0.01 and 0.09 respectively). An alternative model which includes the log
of natural resources as a percent of GDP provides an R2 of 0.58 which is
a slight improvement. When comparing the Akaike criterion the second
model is significantly better.
Dependent variable: GDP deflater
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const 2.13249 2.23242 0.9552 0.3418
AdjustedTradeIn −0.144266 0.0626038 −2.3044** 0.0233
l Ex Rate 0.823981 0.290348 2.8379 0.0055***
MinimumWage 1.42776 1.20399 1.1859 0.2385
GNI D 6.29294 2.43516 2.5842 0.0112**
l Unemploy 1.52512 0.920621 1.6566 0.1007*
Real Interest −0.839895 0.332014 −2.5297 0.0130**
l Nat ofGDP 0.885899 0.286960 3.0872 0.0026***
R2 0.583446 Adjusted R2 0.554287
F(7,100) 8.584729 P-value(F) 3.28e–08
The equation for this model with improved robustness is shown below
indicates that the when the GDP deflater increases by 1% ATI decreases by
14%. This is a more robust result which provides an accurate relationship
between GDP deflater and ATI while accounting for key control variables.
GDPdeflater = 2.13249
(2.2324)
− 0.144266
(0.062604)
AdjustedTradeIn + 0.823981
(0.29035)
l Ex Rate
+ 6.29294
(2.4352)
GNI D − 0.839895
(0.33201)
Real Interest + 0.885899
(0.28696)
l Nat ofGDP
T = 108 ¯R2
= 0.5543 F(7,100) = 8.5847 ˆσ = 7.8771
(standard errors in parentheses)
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4 References
Abdul, R. and Husain, F. (2010). Capital Inflows, Inflation and Exchange Rate Volatility:An
Investigation for Linear and Nonlinear Causal Linkages Pakistan Institute of Development
Economics Islamabad (PIDE) Working Papers; No. 63. Alcalá, F. and Ciccone, A. (2004).
Trade and Productivity. Quarterly Journal of Economics, 119, 613-46.
Alpanda, S., Kotze, K, and Woglom, G. (2010).The role of the exchange rate in model for the
South African economy.South African Journal of Economics. Vol. 78:2.
Andrei, C. (2012). The economic integration: concept and end of process. Theory of Applied
Economics, 19(10).
Antzoulatos, A. (2011). Greece in 2010: A tragedy without katharsis, Department of Bank-
ing and Financial Management, University of Piraeus.
Badinger, H. (2009). Globalization, the output–inflation tradeoff and inflation. European
Economic Review, 53(8), pp.888-907.
Balassa, B. (1961). The Theory of Economic Integration, London, Allew and Unwin.
Braumann, B. (2000). Real Effects of High In[U+FB02]ation. International Economic Policy
Review, 2, p.78.
Cardoso, A. Eliana, A. (1981) Food Supply and Inflation, Journal of Development Economics,
Vol. 8, pp. 269-84
Frankel, A. and Rose, K. (2000). Estimating the effect of currency unions on trade and
output (No. w7857). National Bureau of Economic Research.
Gibson, D. Hall, G and Tavlas, S. (2012) The Greek financial crisis: growing imbalances and
sovereign spreads, Journal of International Money and Finance.
Hardouvelis, A. (2011). The Greek crisis, its resolution and implications for the EU and
beyond, Joint Vienna Institute, mimeo.
Hernando, I. Andres, J. (1997). Does inflation harm economic growth? Evidence for the
OECD, NBER working paper, No.6062
Kouretas, G and Vlamis, P. (2010). The Greek crisis: causes and implications, Panoeconomi-
cus, 57, 391-404.
Liadze, I. Barrell, R. and Holland, D. (2008). The impact of EMU on growth in Europe (No.
314). National Institute of Economic and Social Research.
Muhammad, H. and Batool, I. (2006). Openness and Inflation: A case study of Pakistan.
MPRA Paper 10214.
Omotunde, E. G, Johnson. (1984). On Growth and Inflation in Developing Countries
(La croissance et l’inflation dans les pays en développement). Staff Papers (International
Monetary Fund), 31(4), 636-660.
Obstfeld M, 1998 International capital mobility over the long run, University of Chicago
press, Chicago.
Rodrik, D. (2000). How far will international economic integration go?. The Journal of
Economic Perspectives, 14(1), pp.177-186.
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Rodrik, D., (1999). The new global economy and developing countries: making openness
work (Vol. 24). Washington, DC: Overseas Development Council.
Sachsida, A. Cardoso, J. DeMendonc¸a, C. (2006). Inﬂation and Trade Openness Revised: An
Analysis Using Panel Data. Texto Para Discussion N 1148.
Tsoukalis, L. (2000). Noua Economie European˘a Revizuit˘a, Translated into Romanian by
”Open Society Institute”, CEU Press
Utami, R. and Inanga, L (2009). The Pecking Order Theory: Evidence from Manufacturing
Firms in Indonesia, Independent Business Review. 1 (1): 1-18.
Viner J, (1950) International economic studies, Economic review
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