Institutional quality, the cyclicality of monetary policy and macroeconomic volatility

Abstract

In contrast to industrialized countries, emerging market economies are characterized by proor acyclical monetary policies and high output volatility. This paper argues that those facts can be related to a long-run feature of the economy -namely, its institutional quality (IQL). The paper presents evidence that supports the link between an index of IQL (law and order, government stability, investment profile, etc.), and (i) the cyclicality of monetary policy, and (ii) the volatilities of output and the nominal interest rate. In a DSGE model, foreign investors that choose a portfolio of direct investment and lending to domestic agents, face a probability of partial confiscation which works as a proxy that captures IQL. The economy is hit by external shocks to demand for home goods and productivity shocks while its central bank seeks to stabilize inflation and output. In the long run, a lower IQL tends to discourage external liabilities. If there is a positive external demand shock, we observe an increase in output and real appreciation. The latter operates through two opposite channels. First, it directly increases the opportunity cost of leisure generating incentives to expand labor supply. Second, it reduces the real value of the debt denominated in foreign currency which stimulates consumption but contracts the labor supply. If the IQL is low, the economy attracts fewer loans for domestic consumers and shows a lower debt-to-consumption ratio in the steady state. This implies that the reduction of the real value of the debt caused by the real appreciation is smaller. Given this low wealth effect, the real appreciation leads to an expansion of the labor supply. Wages drop and inflation diminishes. The central bank reacts by cutting its policy rate to stabilize inflation and generates a negative comovement between output and the nominal interest rate (procyclical policy). As a corollary, negative correlations between policy rates and output are not necessarily an indicator of destabilizing polices even in the presence of demand shocks.

Impact of foreign direct investment, trade openness and economic institutions on growth in emerging countries: The case of Vietnam

“…Institutional quality contributes to the reduction of the asymmetric information problem, transactional costs and risks. Hence, institutional quality positively affects the market and resources allocation (Acemoglu and Robinson, 2008, Duncan, 2014, Stefan et al, 2014, Jones and Romer, 2010, Góes and Matheson, 2015. Institutions are also important for improving the relations between human capital, physical factors and economic growth (Jones and Romer, 2010).…”

Local governance, private investment and economic growth: The case of Vietnamese provinces

“…The institutions are defined as game rules in a society (North, 1990a), which can set constraints on human behavior (North, 1981;Acemoglu & Robinson, 2008). Institutional theory emphasizes that institution as fundamental determinants of long-run growth, which explains the residual differences in economic growth between countries based on differences in human capital, physical capital, technological progress, and other economic factors (Acemoglu & Robinson, 2008;Branch, 2014;Busse & Hefeker, 2007;Duncan, 2014). Institutional quality reduces asymmetric information problems, transaction cost, and risk, while it increases market efficiency and asset allocations, and protects property rights (Williamson, 1981;Cohen et al, 1983;Ho & Michaely, 1988).…”

Macroeconomic Policies and Business Cycle: The Role of Institutions in Selected SAARC Countries

“…Countries, where institutions are strong, conduct contractionary policies in boom and expansionary policies in recession while countries with poor level of institutions contract the policies in recession and expand in boom [Acemoglu, Johnson, Robinson, and Thaicharoen (2003); Calderon and Schmidt-Hebbel (2008)]. Countries with weak institutions show the strong negative relation between output and interest rate while countries with strong institutions have positive link between output and interest rate [Duncan (2012)]. That's why developing countries are pursuing tight monetary policy in recession and loose policy in boom, although little empirical literature is available on this issue [Lane (2003)].…”

“…Regarding monetary policy, a negative relation is observed between nominal interest rate and GDP gap, which shows that the monetary authorities adopt pro-cyclical stance due to presence of weak institutions [Duncan (2012)]. No one has yet studied the impact of institution on macroeconomic policies in selected SAARC countries.…”

“…We use monetary policy rule defined by Taylor (1993a) and modified by and fiscal policy rule defined by Braun (2001) for this analysis. To show the impact of institutions on business cycle, we introduce the interaction term between output gap and institution quality by following the studies of Kaminsky, Reinhart, and Vegh, (2004); Ilzetzki and Vegh (2007) and Duncan (2012).…”