KOBAYASHI Keiichiro: On the surface, business cycle fluctuations in developed economies look very different from those in developing economies. The fluctuations in developed markets are moderate, while production, consumption, and investment in developing markets are quite volatile. A recent paper suggests that this difference could be explained by a single theoretical framework.
Mark Aguiar and Gita Gopinath (2007), "Emerging Market Business Cycles: The Cycle Is the Trend," Journal of Political Economy 115(1): 69-102.
Aguiar-Gopinath (2007) states that business cycle fluctuations in emerging markets and developed markets (small economies) can be explained by differences in total factor productivity (TFP) shocks to the same type of neoclassical open economy models. According to their simulation, short-term fluctuations in emerging markets can be explained mostly by an exogenous change in the (trend) growth rate of TFP, if any, while short-term business cycle fluctuations in developed markets (developed small open economies) can be explained by an exogenous change in the level of TFP, if any.
Econo-kun: What lies behind the difference in features of TFP shocks? Why does the difference between being a developed market and an emerging market represent the difference between shocks to productivity trends and levels?
KOBAYASHI Keiichiro: The Aguiar-Gopinath paper does not clearly explain the reasons why this difference arises. It only states that market depth may be among the factors at play here.
To explain why changes in the growth rate of TFP differ between developing and developed economies, it is probably better to assume a model in which TFP is endogenously determined. This brings to mind the endogenous technological change model advocated by Paul Romer (1990). This model is also used to explain medium- and long-term business cycle fluctuations in developed markets such as the United States (Comin-Gertler, 2006). In the Romer or Comin-Gertler models, technologies increase through a process of exogenous probability, but it is the sector that conducts research and development (R&D) activities that make such technologies applicable to production. One of the points shown by Comin-Gertler (2006) is that since the sector that conducts R&D activities will slowly transform scientific knowledge into production technologies (according to shocks such as an exogenous change in the wage rate), medium-term business fluctuations will result.
It seems possible to use their models to construct a model that is able to explain the results of Aguiar-Gopinath's paper. One hypothesis is that the appearance of changes in productivity is different between (developed) economies where financial constraints do not affect R&D activities and (developing) economies where financial constraints do affect R&D activities.
Let us assume that an exogenous shock is a shock to the level of productivity whether it takes place in a developed or developing market. (In the case of Romer's model, let us assume a kind of shock in which the variety of intermediate goods increases or decreases, irrespective of R&D activities, since the level of productivity represents the number of varieties of intermediate goods in his model.) In developed economies, since there is no financial constraint, shocks to the level of productivity will only directly affect business cycle fluctuations. For developing economies, we will assume constraints on collateral such that input costs to R&D activities will be restricted by, for example, the value of land assets owned by companies that conduct R&D. If we assume that land is used for the production of final goods, a decrease (increase) in the level of production will lower (raise) the value of land. A fall (rise) in the land price will decelerate (accelerate) R&D activities by decreasing (increasing) the collateral value. As a result, the rate of productivity growth will fall (rise). In other words, even if we assume changes in the level of productivity alone as an exogenous shock, it will become likely that the growth rate of productivity will also change in those countries where financial constraints are severe. If this is the case, the economy will fluctuate significantly.
Econo-kun: I see. If we think that this is the difference between developed markets and emerging markets, could findings in the Aguiar-Gopinath paper could be explained by a single factor called "financial constraints?"
KOBAYASHI Keiichiro: On rare occasions, even developed economies experience violent fluctuations. It happened with the Great Depression in the 1930s and the recession in Japan in the 1990s. This mechanism could explain these phenomena. When financial constraints become quite severe for some reason, R&D activities that are not constrained in a normal business cycle will be financially restricted. It may therefore be reasonable to think that if the long-term trend of productivity weakens as a result of the above, phenomena such as a lengthy recession and the Great Depression will emerge. R&D activities are not limited merely to research and development in a literal sense. If we include other schemes for increasing the trend of productivity, an extremely broad range of activities could be covered. A model claiming that TFP changes endogenously could play a significant role as a business cycle model in the future.
* * *
KOBAYASHI Keiichiro: There is more to this topic. Mr. Kengo Nutahara (Research Fellow, Japan Society for the Promotion of Science), whom I collaborated with on this research, conducted a simulation to confirm my tentative theory. Although I expected that the financial constraints could explain the difference in business cycle fluctuations between developed economies and developing economies, the result was not as good as I had hoped. When making a calculation using a Romer-type model, we discovered that there was little difference in the reaction to exogenous shocks between economies where financial constraints (collateral constraints) are severe (model for developing economies) and economies where financial constraints are moderate (model for developed economies). Results of the simulation can be found here [PDF: 110KB]. Although the model we constructed this time did not yield a positive result, we may be able to attain the result that my tentative theory suggests if we devise other ways of constructing the model. I will continue to work on this hypothesis in my research.
