North-South Interdependence
Southern discomfort?

National economies are increasingly interdependent: this is true not only among industrial countries but also for the world economy as a whole. Many studies have analysed the consequences of interdependence for individual economies. More recently, economists have grouped countries into blocs in order to estimate econometric models of the world economy. This approach enables researchers to highlight important macroeconomic linkages such as the influence of developed countries' monetary and fiscal policies on world interest rates and on the economies of the LDCs, and the influence of commodity prices and LDCs' balance of payments and external indebtedness on the stability of the world financial system. These problems feature prominently in the CEPR/Brookings research programme on macroeconomic interactions in the world economy.

In two Discussion Papers, Research Fellow Michael Beenstock explores the channels of interdependence between the industrialized, developing and OPEC countries. In Discussion Paper No. 164, he explores how economic activity and inflation in the industrial economies as a whole are affected by shocks in world markets for output, capital and primary commodities. In Discussion Paper No. 165, he models the behaviour of the current and capital accounts of the balance of payments over the period 1963-83 for oil-importing LDCs as a whole.

In Discussion Paper No. 164, Beenstock estimates a model for the industrial countries as a whole, using annual data from 1950-83. This allows him to examine the relationship between economic activity in the industrialized countries and the price of raw materials. In particular, the model not only allows raw material prices to influence global activity, but also the converse. The introduction of a capital market allows him to explore current policy issues, such as the impact of fiscal policy and the factors which determine the level of world interest rates.

Aggregate supply in the model depends on real interest rates, commodity prices (including oil), and variables which raise the equilibrium real wage or lower labour productivity. The level of aggregate demand in the industrialized countries is assumed to depend on domestic fiscal and monetary conditions as well as external factors, such as the net demand for industrialized countries' output on the part of OPEC and the LDCs. In the capital market the rate of interest is assumed to adjust to equate the supply and demand for loanable funds. The supply of loanable funds is governed by individual savings behaviour and net OPEC lending, while demand depends on the level of economic activity and the desired capital stock of firms. Loanable funds are also demanded by the public sector to finance fiscal deficits and by LDCs to finance sovereign borrowing.

Raw materials are divided into oil and non-oil. Oil prices are exogenous in the model, while the demand for non-oil commodities is a flow demand for the use of raw materials in production which depends on the level of economic activity and on the relative price of non-oil commodities. There is also a stock demand for speculative inventories which depends on expected capital gains and the real rate of interest. Supply of non-oil commodities reflects their relative price and the relative price of oil. Beenstock completes the model by postulating equilibrium conditions in the markets for capital and non-oil commodities, while in the market for goods the equilibrium condition is replaced by a lagged adjustment process between output and prices.

Beenstock simulates the effects of bond- and money-financed fiscal expansions in the industrial countries. The simulations reveal that a one-period fiscal deficit which is entirely financed by the issue of bonds in the international capital market leads to a demand-side expansion for two years, but such a deficit is contractionary in the long run: it raises real interest rates, which in turn depresses aggregate supply. Beenstock's simulations also suggest that commodity prices rise when the dollar rises. Commodity markets appear to suffer from 'dollar illusion': prices do not appropriately reflect changes in the value of the dollar.

Interest rates fall in Beenstock's model as the ratio of money to public sector debt rises (i.e. as portfolios become more liquid). But interest rates also depend on the supply and demand for funds in the world capital market. As a result bond-financed fiscal deficits raise world interest rates, while OPEC surpluses invested in the international capital market have the opposite effect. In addition, LDC borrowing raises world interest rates in the model: it increases demand pressure in world capital markets and also increases the riskiness of world loan portfolios.

The balance of payments and external indebtedness of oil- importing developing countries have received much attention as a potential source of instability in the world economy. In Discussion Paper No. 165, Beenstock uses annual data for 1963-83 to estimate a model of the external sector of the oil-importing LDCs as a whole. The central feature of the model is its assumption that LDC exchange rates are not perfectly flexible and that as a result their imports are constrained by the availability of central bank reserves.

Beenstock simulates the model in order to verify that it captures the behaviour of LDCs adequately, but he also notes its policy implications. The simulations suggest that aid transfers and other capital inflows to LDCs tend to raise their nominal and real exchange rates and reduce competitiveness: exports fall and imports rise. The additional aid pushes the trade balance into deficit, through a 'crowding out' mechanism, and eventually the fall in reserves becomes so serious that the government has to restrict imports. These adverse effects occur because in the model the LDC exchange rate is not in general independent of aid flows. Beenstock concludes that such exchange rate effects should be taken into consideration when analysing the benefits and costs of aid (and capital) transfers.
While individual developing countries have operated fixed but adjustable exchange rates, Beenstock notes that the aggregate exchange rate between LDC and non-LDC currencies has been surprisingly flexible. The index of the real exchange rates of the oil-importing LDCs has been volatile, but has displayed no apparent trend. This indicates that the aggregate LDC real exchange rate has moved to offset differences in inflation rates between the LDCs and the industrial economies.


An Aggregate Model of Output, Inflation and Interest Rates for the Industrialised Economies

The Balance of Payments of Oil-Importing Developing Countries: An Aggregate Econometric Analysis
Michael Beenstock

Discussion Paper Nos. 164 and 165
March 1987 (IM)