ECONOMICS IN THEORY AND PRACTICE: AN ECLECTIC APPROACH

Advanced Studies in Theoretical and Applied Econometrics Volume 17

Managing Editors: J.P. Ancot, Netherlands Economic Institute, Rotterdam, The Netherlands A.J. Hughes Hallet, University of Strathclyde, Glasgow, Scotland

Editorial Board: F.G. Adams, University of Pennsylvania, Philadelphia, U.S.A. P. Balestra, University of Geneva, Switzerland M.G. Dagenais, University of Montreal, Canada D. Kendrick, University of Texas, Austin, U.S.A. J.H.P. Paelinck, Netherlands Economic Institute, Rotterdam, The Netherlands R.S. Pindyck, Sloane School of Management, M.I. T, U.S.A. H. Theil, University of Florida, Gainesville, U.S.A. W. Welte, University of Lodz, Poland

For a list of volumes in this series see final page.

Economics in Theory and Practice: An Eclectic Approach

Essays in Honor of F. G. Adams

edited by

Lawrence R. Klein Department of Economics, University of Pennsylvania, U.S.A

and

Jaime Marquez Division of International Finance, Federal Reserve Board, U.S.A

KLUWER ACADEMIC PUBLISHERS DORDRECHT / BOSTON / LONDON

Library of Congress Cataloging in Publication Data

Economics in theory and practice an ecletic approach I edlted by Lawrence Klein, ~aime Marquez.

p. cm. -- (Advanced studies in theoretlcal and applied econometrlcs ; 17)

"Essays in honour of F.G. Adams." 1. Econometric models. 2. Economics. 3. Adams, F. G. I. Adams,

F. Gerard (Francis Gerard), 1929- II. Klein, Lawrence Robert. III. Marquez, ~alme R. IV. Series Advances studles ln theoretica~ and applled econometrics; v. 17. HB141.E256 1989 330--dc20 89-15588

ISBN-13: 978-94-010-6693-8 001: 10.1007/978-94-009-0463-7

e-ISBN-13: 978-94-009-0463-7

Published by Kluwer Academic Publishers, P.O. Box 17, 3300 AA Dordrecht, The Netherlands.

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TABLE OF CONTENTS

Preface

L.R. f{[ein and J. Marquez

P ART I: FRONTIERS IN FORECASTING AND ECONOMETRIC

MODELLING

vii

1. Combinations of High and Low Frequency Data in Macroeconometric 3

l\Iodels

L.R. Klein and E. Sojo

2. Stochastic Simulation, Prediction and Validation of Nonlinear Models 17

R. S. Mariano and B. W. Brown

3. An Integrated Exhaustible Resource Model of Copper Market Dynamics 37

We. Labys

PART II: TRADE, DEBT, AND DEVELOPMENT

11. The Impact of Commodity Price Instability: Experiments with a 59

General Equilibrium Model for Indonesia

J.R. Behrman and J.D. Lewis

5. Commodity Price Contractions, Debt and Economic Growth

in Developing Countries: The Venezuelan Case

P.A. Palma

G. Income and Price Elasticities of Foreign Trade Flows:

Econometric Estimation and Analysis of the US Trade Deficit

J. Marquez

lOl

129

VI

PART III: INDUSTRIAL ORGANISATION AND GOVERNMENT POLICY

7. Previous Cartel Experience: Any Lessons for OPEC?

J. M. Griffin

8. The Implications for Future Contingency Planning of the

1979 Gasoline Shortage

L.E. Grayson and R.M. Morris

179

207

9. International Trade, Investment, and American Cities and Regions 227

N. J. Glickman

Index 249

PREFACE

Lawrence Klein, University of Pennsylvania

Jaime Marquez, Federal Reserve BoarrI*

All examination of the economics literature over the last twenty years reveals a

marked tendency towards polarisation. On the one hand, there has been a

propensity to develop theoretical models which have little connection with either

empirical verification or problems requiring immediate attention. On the other

iland, empirical analyses are generally typified by testing for its own sake, with

limited examination of the implications of the results. As a result, the number of

papers confronting theory with facts towards the solution of economic problems

has been on the decline for years.

To fill this growing gap in the literature, we have invited a number of

authors to write papers using both theoretical and empirical techniques to

address current issues of interest to the profession at large: the US trade deficit

and the global implications of policies that attempt to reduce it, the international

ramifications of the debt crisis, the international oil market and its implications

for the US oil industry, and the development of new econometric techniques. In

addressing these issues, each author has approached the subject matter from an

eclectic standpoint - that is, avoiding strict adherence to a given doctrine.

These essays are grouped in three sections according to issue they address. In

section I we include papers dealing with the development of new techniques for

forecasting, model evaluation, and econometric modelling. Section II contains

three papers examining the international debt crisis and its relation with

international trade. Finally, section III is devoted to studying the issue of

industrial organisation and its relation to changes in both the regulatory

environment and the international oil market.

vii

viii

I. FRONTIERS IN FORECASTING AND ECONOMETRIC MODELLING

For an econometric model to be useful in decision making, it must be accurate. In

this regard, much has been written about the forecasting records of both time

series models and structural models. However, until recently, the approaches

available forced practitioners to choose one type of model or the other. Lawrence

J({ein and Eduardo Sojo develop a single forecasting model that integrates time

series modelling with structural modelling. As they show, the chief advantage of

this integration is the reduction in the risk associated with forecasting. This task

is accomplished by combining forecasts from models that rely on data with

different frequencies. For example, the forecasts of a structural quarterly model

can be combined with the forecasts of a supplementary time series model that

relies on monthly information.

Several advantages arise from their approach to forecasting. First, it is

possible to exploit the most recent information, which is generally available ill

high frequencies. Second, it is possible to integrate time series and structural

modelling, with the former being more accurate in the short run and the latter

being more accurate in the long run. Finally, the paper by Klein and Sojo is of

interest to policymakers, who often have access to a low frequency model and the

high frequency data.

A particular forecast is not very useful if there is no information about its

standard error. With this error, it is possible to evaluate the relative risk of the

forecast, which is particularly important for making economic decisions.

However, the complexity of existing econometric models precludes the

computation of such standard errors in all but the simplest of models. Roberto

Ma1'iano and Bryan Brown develop a methodology to compute forecast standard

errors for large scale models in a computationally simple way. They accomplish

this task by examining the large sample properties of alternative forecasting

procedures for the class of dynamic nonlinear models. Because the vast majority

of econometrically estimated models fall into this class, their analysis has

immediate applicability to private and public institutions for which economic

forecasts are an integral part of the decision making process. Mariano and Brown

recognise that the historical residuals of an econometric model can be treated as

estimates of the original disturbances. These estimated residuals form the basis to

generate stochastic dynamic simulations that would enable researchers to

compute the standard errors associated with both model forecasts and model

multipliers.

IX

Finally, the econometric estimation of parameters of interest requires

variation in the data. There are circumstances, however, in which model

predictions would be improved by incorporating relations which, by their own

nature, do not tend to produce data with the needed variability. An important

issue is, then, whether it is possible to combine models using different

methodologies for parameter estimation, and if so, what interpretation can be

given to the model results.

Walter Labys studies these questions in the context of the world copper

market. Specifically, he uses II engineering II parameter estimates along with

econometric parameter estimates in a single model. The former are used to gauge

technical relations which ultimately determine productive capacity and thus, long

run supply. However, it is not possible to obtain data on long-run relations, and

even if it were, the data would not exhibit enough variation to permit

('conometric estimation of the associated parameters.

By integrating two strands of commodity market modelling, Labys is able to

['oeus on the transition from a short-run disequilibrium to a long-run

equilibrium. Short-run disequilibrium is modelled in a standard commodity

(econometric) model (e.g., the work of Adams, Behrman, and Labys) which is

well suited for explaining supply side considerations, such as capacity formation.

The model is validated and in this process, Labys is able to identify the effects of

both supply and demand factors on fluctuations in copper prices.

II. TRADE, DEBT, AND DEVELOPMENT

One of the oldest questions in economics is whether international trade is

conducive to development. Although theoretical arguments lead one to believe

that it does, it has been argued that international trade has increased the

exposure of developing countries to price fluctuations which in turn have

hampered their development process.

To address this question, Je1'e Behrman, Jeffrey Lewis, and Sherif Lotfi use a

Computable General Equilibrium model to examine the extent to which

fluctuations in commodity prices have affected the development process of

Indonesia. As it stands, the existing literature, much of which has been written

by Behrman himself, focuses on the macroeconomic consequences of lower

commodity prices. However, as the paper argues, the question is not whether

lower export prices affect adversely growth prospects, but whether a greater

variability in these prices is responsible for lower growth rates. Furthermore, very

x

little attention has been given to the microeconomic implications of greater price

variability. Microeconomic considerations are important because they explain the

degree to which the supply of both labour and goods are affected by

unpredictable price paths. Finally, the effects of price increases have received less

attention than the effects of price decreases. This asymmetry in price effects

interacts with policy responses from both domestic and international institutions

potentially obscuring the ultimate effect.

A more recent, and related issue is the degree to which many debtor

countries are able to support both a sustained growth path and service their debt

obligations. Pedro Palma studies the policy responses of debtor countries to

commodity price changes, an issue of interest given that most debtor countries

are currently engaged in debt rescheduling agreements the viability of which are

also dependent on commodity prices. A second important issue addressed by

Palma is the effect of alternative debt rescheduling agreements on the

macroeconomy. Knowledge of these macro effects is of interest because it helps to

determine the rescheduling package a country should adopt and the policy

responses that would be required to support a given rescheduling plan if

commodity prices change.

To address these questions, Palma relies on dynamic simulations of a

medium size econometric model for the Venezuelan economy. Venezuela is an

ideal case for addressing these questions because of the recent volatility in oil

prices, the heavy reliance on oil exports as a source of export revenues, and the

existence of a debt rescheduling agreement with banks. Thus fluctuations in oil

prices affect not only Venezuela's growth prospects but also the country's ability

to service its external obligations. The result of this analysis, besides being

relevant to policy making in other debtor nations (e.g., Mexico), might shed light

on questions regarding the difference between liquidity and solvency as well as

the conduct of stabilisation policy in developing countries.

Jaime Marquez studies the design of policy responses to address international

trade imbalances and the associated consequences for international trade flows.

To address these issues, Marquez develops a trade model explaining bilateral

trade flows in an eight region world economy (Canada, Germany, Japan, the

United Kingdom, the United States, Other OECD, non-OPEC developing

countries, and OPEC). A key feature of this model is that international trade

imbalances add up to zero. The analysis estimates income and price elasticities

for bilateral import equations, tests for the properties of the error term, for

xi

parameter constancy, and for the choice of dynamic specification.

The paper also re-€xamines the structural asymmetries in elasticities noted

by Houthakker and Magee and tests whether the Marshall-Lerner condition

holds. The reliability of the model as a whole is assessed with residual based

stochastic simulations. The paper finds that changes in relative prices account for

the bulk of the deterioration of the US trade account, that reliance on either

foreign or domestic growth to eliminate the US external imbalances entails

significant changes in real income, and that the speed with which US net exports

respond to exchange rate changes is sensitive to minor changes in own-price

elasticities.

III. INDUSTRIAL ORGANISATION AND GOVERNMENT POLICY

Conventional economic theory predicts that cartels are short lived forms of

organisations. Chiselling and cheating among the members of the cartel

ultimately result in its elimination as a viable organisation. Yet, a closer

examination of the historical record suggests that the predictions of economic

theory are at variance with the actual experience of numerous cartels. Is this

discrepancy bet ween theory and practice real? If so, what factors call ccount for

it?

To address these questions, James Griffin develops a model to explain the

determinants of a cartel's success. Specifically, Griffin explains the Lerner index

for a given cartel as a function of the Herfindahl index, the market share of the

cartel, and the cartel's organisation structure. To estimate the relative

importance of these determinants, Griffin relies on least squares as applied to a

sample of international commodity cartels that have been active since 1900. The

paper uses the statistical findings to draw implications for the future of OPEC, a

cartel that (up to now) has defied a conventional characterisation of its

behaviour.

A second important question in the area of industrial organisation is the

degree to which existing government regulations affect an industry's flexibility to

respond to changes in its external environment. Leslie Grayson and Robert

Morris examine this question by focusing on how the disruption in the oil market

in 1979 interacted with the existing regulatory system to affect the distribution of

gasoline in the United States. In particular, they examine the monthly

distributional patterns of gasoline across states in which the Iranian oil

disruption led to shortages.

Xll

Knowledge of these interactions is important for several reasons. First, by

comparing the 1979 crisis to the experience of the 1974 oil shock, it is possible to

estimate the extent to which the regulatory system affected the flexibility of the

price allocation system to respond to supply shocks. Second, it is clear that the

behaviour of oil companies, as reflected in their adjustment of oil inventories,

affects the distribution of gasoline. As a result, there might be a conflict between

private and social interests, an issue that Grayson and Morris address.

Economic changes generally involve shifts in the location of economic

activities and the form of their organisations - the fall of the industrial

Northeast, the rise of the Sunbelt. Specifically, firms' ability to shift

internationally both the location of production and investment decisions, as well

as the change in the structure of production away from manufacturing and

towards services, has had a number of implications for regional unemployment

levels and thus for the development of macroeconomic policies. To examine these

implications, Norman Glickman studies the degree to which regional changes in

US economic activities have been influenced by international considerations (e.g.

exchange rates and oil prices) and by domestic considerations (e.g. productivity

and demographics). An understanding of the determinants of these regional shifts

is relevant to addressing policy questions at the local level (city and state), which

have been largely neglected by mainstream economics.

* The views expressed in this book are solely the responsibility of the authors and should not be interpreted as reflecting those of the Board of Governors of the Federal Reserve System or other members of its staff.