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Currently Assaf Razin is at the Tel Aviv University and Chi-Wa Yuen is at Hong Kong University. This work was conducted when they were visiting RES and FAD, respectively. The authors are grateful to Gian Maria Milesi-Ferretti for providing data on capital controls and to Eswar Prasad and Athanasios Vamvakidis for data on trade openness and financial sector depth. Mick Devereux (our discussant at an AEA session), Dale Henderson, Chris Erceg and workshop participants at the IMF, the Federal Reserve Board, and the Federal Reserve Bank of Boston provided useful comments.
To guarantee the existence of a long run (steady state) equilibrium for our system, the deterministic growth rates of output on both the supply and demand sides (gy) are assumed to be identical.
The parameter estimates for the United Kingdom also satisfy this condition. However, the estimates are not statistically insignificant, and therefore not considered here.
Another study in the new classical tradition was by Addison, Chappell and Castro (1986). Their empirical work incorporated some theoretical and econometric modifications to Lucas’s analysis that were suggested by Froyen and Waud (1980). The results using their estimates of the tradeoff parameter are quite similar to those for the other new classical studies, and are omitted in the interests of brevity.
Grilli and Milesi-Ferretti (1995, p. 525). Other papers that also interpret these restrictions as capital controls include Bartolini and Drazen (1995). Earlier studies tended to use alternate measures such as onshore-offshore interest rate differentials, the size of the black market exchange rate premium and deviations from covered interest rate parity.
Typically, these estimates are obtained from a regressing of the log-level of real GDP on nominal GDP growth.
It was noted by Lucas himself that his sample essentially provided “only two points,” the “highly volatile and expansive policies of Argentina and Paraguay, and the relatively smooth and moderately expansive policies of the remaining sixteen countries.” [Lucas (1973, p. 331).
See equation (5.1) on p. 41 of their paper.
Grilli and Milesi-Ferretti suggest a much longer list of potential measures of openness and public finance considerations than the two considered here. However, we found that the R-square of the “first-stage” regressions using alternate measures is generally in the range of 0.20, and the t-statistics on the instruments are between 1.2 and 2.0.
We are grateful to an anonymous referee for suggesting these tests.
We used trade (i.e exports+imports) as a share of GDP, imports as a share of GDP and the Sachs-Warner openness index as alternate measures of trade openness. Only the regressions using the Sachs-Warner index are reported in the Annex.
As is well-known, measures of CBI tend to have greater explanatory power for industrialized country inflation than for developing country inflation. Hence, we also tested whether CBI was an important determinant of the tradeoff for the OECD sample. The coefficient on CBI remained insignificant, while the coefficient on the capital controls index was negative and significant.
In other words, the country-fixed effects are (0,1) dummy variables that take on the value 1 for country I and 0 otherwise. Likewise, the year-fixed effects are (0,1) dummy variables that take on the value 1 for year t and 0 otherwise.