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Essays on output and real exchange rate dynamics Khan, Hashmat Ullah

Abstract

There are two key observations in international macroeconomics which pertain to output and real exchange rate dynamics. First, fluctuations in national output around its long-run growth path are very persistent. Second, fluctuations in real exchange rates are very persistent. The sticky price framework offers an explanation for both phenomena. The first and second essay of this thesis take an empirical approach to test the predictions of this framework. In the first essay I test the prediction of the sticky price model for output dynamics using annual IFS data on 51 countries over the period 1950 -1996. The model predicts that price stickiness should be less important in high inflation countries and therefore output fluctuations less persistent. I find that, this inverse relationship is statistically insignificant in the international data. A similar result holds for OECD countries. In the empirical implementation I explicitly control for the within-country time variation in inflation by first characterizing the inflationary environment using the long-run movements in inflation (trend inflation), and secondly, by excluding episodes of hyperinflation. The analysis shows that when the within-country time variation in inflation is ignored, there is support for the prediction. For instance, the inverse relationship between persistence in deviations of output from its long-run growth path and average inflation is statistically significant in the full sample. However, the exclusion of a few episodes of hyperinflation renders this relationship statistically insignificant. In the second essay I investigate the prediction of the sticky price model for real exchange rate dynamics using annual IFS data on 49 countries over the period 1972-1996. The model predicts that deviations of real exchange rates from purchasing power parity should be less persistent, in high inflation countries. The empirical analysis reveals that the support for such an inverse relationship is extremely fragile. In particular, eliminating episodes of hyperinflation renders this relationship statistically insignificant. The lack of evidence in favour of the two predictions of the sticky price model is problematic since this model is extensively used as a microfoundation for understanding output and real exchange rate fluctuations. In the third essay I take a structural approach to qualitatively explore the role of slow diffusion of new products in propagating the effect of technology shocks on output. I present a multi-sector dynamic general equilibrium model in which the creation of new products requires real resources. These products are beneficial for the economy but only upon complete diffusion. However, this diffusion is not instantaneous. I find that relative to a model in which there is instantaneous diffusion of new products, the qualitative output dynamics are similar to what is observed in the U.S. data. This warrants further quantitative investigation.

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