Abstract
The four essays included in this dissertation are in the field of open economy Macroeconomics. Essays I, II and IV deal with a work-horse model in this field – a two-sector small open economy growth model with traded and nontraded goods. Writing down such a model requires an assumption about the role of traded and nontraded goods in domestic consumption and investments. While several empirical studies have looked at the consumption side, a systematic examination of the role of traded and nontraded goods in investments is missing. Essay I aims to fill this gap. Drawing on extensive empirical evidence, we show that aggregate investment expenditure shares on traded and nontraded goods are very similar in rich and poor countries. Furthermore, the two expenditure shares have remained close to constant over time, with the average nontraded expenditure share varying between 0.54-0.60 over the 1960-2002 period. Combined with the fact that the relative price of nontraded goods correlates positively with income and exhibits large differences across space and time, our findings suggest that investment can be modeled using the Cobb-Douglas aggregator. The results of this essay offer a new restriction for the two-sector growth model, which can alter the conclusions drawn from the model. To demonstrate this, we apply the new restriction to a study by Hsieh and Klenow (2003), which argues that differences in relative productivity between traded and nontraded sectors, i.e., the Balassa-Samuelson effect, is the main cause of higher PPP-adjusted investment rates in rich countries. With the restriction imposed on the model, no more than 25 percent of the differences in PPP-adjusted investment rates between rich and poor counties can be attributed to the Balassa-Samuelson effect. In Essays II and IV the same two-sector growth model is put to the test using the recent economic developments in countries of Eastern and Central Europe. Essay II investigates whether the two-sector growth model can explain the magnitudes and the timing of the trade flows in the Baltic countries. The model is calibrated for each of the three countries, which we simulate as small closed economies that suddenly open up to international trade and capital flows. The results show that the model can account for the observed magnitudes of the trade deficits in the 1995-2001 period. Introducing a real interest rate risk premium in the model increases its explanatory power. According to the model, trade balances will turn positive in the Baltic states around 2010. Essay IV starts by summarizing empirical regularities for the key aggregate real sector variables in the eight countries that joined the EU in May 2004. It is shown that, following the reforms in the early 1990s, real sector developments in all eight countries exhibit remarkable similarities. Interestingly, this is the case despite the fact that different reform policies were pursued in several dimensions (e.g., privatization, nominal exchange rate). Next, we show that a calibrated two-sector small open economy growth model can account for most of the real sector adjustments in early post-reform years. Empirical studies have found rapid traded sector productivity growth in Central and Eastern European countries over the last decade. When traded sector productivity growth is added to the model, it captures the development in all key real sector variables during the post-reform period. Finally, Essay III contributes to the study of financial crises in emerging markets. In contrast to the other essays, this paper develops a highly stylized theoretical model that allows us to study analytically government response to financial crises. In particular, Essay III develops a framework for analyzing optimal government bailout policy in a dynamic stochastic general equilibrium model where financial crises are exogenous. Important elements of the model are that private borrowers internalize only part of the social cost of foreign borrowing in the emerging market and that the private sector is illiquid in the event of a crisis. The distinguishing feature of our paper is that it addresses the optimal bailout policy in an environment where there are both costs and benefits of bailouts, and where bailout guarantees potentially distort investment decisions in the private sector. We show that it is always optimal to commit to a bailout policy that only partially protects investment against inefficient liquidation, both in a centralized economy and a market economy. Due to overinvestment in the market economy, the government's optimal level of bailout guarantees is lower than in the social optimum. Further, we show that, in contrast to a social planner, the government in the market economy should optimally bail out a smaller fraction of private investments when the probability of a crisis is higher.