WORKING PAPER SERIES DOES FISCAL POLICY MATTER FOR THE TRADE ACCOUNT? A PANEL COINTEGRATION STUDY NO 620 / MAY 2006

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1 WORKING PAPER SERIES NO 620 / MAY 2006 DOES FISCAL POLICY MATTER FOR THE TRADE ACCOUNT? A PANEL COINTEGRATION STUDY by Kaja Funke and Chrisiane Nickel

2 WORKING PAPER SERIES NO 620 / MAY 2006 DOES FISCAL POLICY MATTER FOR THE TRADE ACCOUNT? A PANEL COINTEGRATION STUDY 1 by Kaja Funke 2 and Chrisiane Nickel 3 In 2006 all publicaions will feaure a moif aken from he 5 banknoe. This paper can be downloaded wihou charge from hp:// or from he Social Science Research Nework elecronic library a hp://ssrn.com/absrac_id= The auhors would like o hank Jürgen von Hagen, Robero Peroi, Philipp Roher, Georg Sadmann, Jean-Pierre Vidal, paricipans a an seminar and an anonymous referee for helpful discussions and commens. Any remaining errors are he responsibiliy of he auhors. The opinions expressed in his paper are hose of he auhors and do no necessarily reflec hose of he European Cenral Bank (), he Inernaional Moneary Fund (IMF) or IMF policy. 2 Inernaional Moneary Fund, h Sree, N.W., Washingon, D. C , USA; kfunke@imf.org 3 European Cenral Bank, Kaisersrasse 29, Frankfur am Main, Germany; chrisiane.nickel@ecb.in

3 European Cenral Bank, 2006 Address Kaisersrasse Frankfur am Main, Germany Posal address Posfach Frankfur am Main, Germany Telephone Inerne hp:// Fax Telex ecb d All righs reserved. Any reproducion, publicaion and reprin in he form of a differen publicaion, wheher prined or produced elecronically, in whole or in par, is permied only wih he explici wrien auhorisaion of he or he auhor(s). The views expressed in his paper do no necessarily reflec hose of he European Cenral Bank. The saemen of purpose for he Working Paper Series is available from he websie, hp:// ISSN (prin) ISSN (online)

4 CONTENTS Absrac 4 Non-echnical summary 5 1 Inroducion 7 2 The governmen secor and he rade accoun 8 3 The model specificaion Sandard formulaions of he rade accoun Impor equaions and expendiure componens Specificaion of he empirical model 13 4 Empirical analysis and resuls Panel uni roo es Panel coinegraion es Esimaion of rade volume equaions 18 5 Summary and conclusion 23 Appendix 1: Daa descripion and sources 25 Appendix 2: Single ime series esimaions of rade elasiciies for he G7 counries 26 References 27 European Cenral Bank Working Paper Series 30 3

5 Absrac This paper analyses he empirical relaionship beween fiscal policy and he rade accoun. Research prior o his paper did no consider ha he componens of privae and public demand in he impor demand equaion exhibi differen elasiciies. Using pooled mean group esimaion for annual panel daa of he G7 counries for he years 1970 hrough 2002, we provide empirical evidence ha he composiion of overall demand i.e. he disribuion among public demand, privae demand and expor demand has an impac on he magniude of he rade accoun defici. Key words: Fiscal policy, rade accoun, rade elasiciies, panel coinegraion JEL: F32, E62, F41 4

6 Non-echnical summary Lile is known abou he effecs ha a lasing change in governmen expendiures has on a counry s exernal balance. There seems o be a consensus ha lower expendiures and he concomian improvemen in he fiscal balance lead o an improvemen in he curren accoun. Empirical research so far, however, has led o ambiguous resuls: Some empirical sudies find ha higher budge deficis lead o higher curren accoun deficis; ohers prove he opposie or show no significan impac a all. A flaw of earlier research could be ha reduced-form equaions are esimaed, wherein differen effecs migh counerac each oher wihou showing he underlying causaliies. The laer can only be revealed in a srucural model. Furhermore, earlier sudies suffer from he fac ha economeric echniques ha allow sudying long-run equilibrium relaionships beween ime series daa were no ye developed. This paper akes a fresh look a he empirical relaionship beween fiscal policy and he rade accoun by analysing he relaionship beween governmen expendiures and impors. Because rade accoun deficis are ofen a he hear of curren accoun problems, a srucural model of he rade accoun is an imporan sep when modelling he impac of fiscal policies on he exernal balance. Wihin he rade accoun, we concenrae on impors because impor demand is deermined by domesic demand facors, while expors depend on exernal demand facors. To pin down he effecs of fiscal policy we esimae goods and service impor equaions on he basis of disaggregae demand variables. This implies ha in conras o he convenional form of rade equaions, which ake oal demand as an explanaory variable we allow for all componens of demand, i.e., privae consumpion, privae secor invesmen, governmen expendiure, and expors, o exhibi differen elasiciies. Our empirical analysis is based on annual panel daa of he G7 counries for he years 1970 hrough We deermine he coinegraion relaionship by a pooled mean group esimaion. This echnique allows he inerceps, shor-run coefficiens and error variances o differ freely across counries, while he long-run coefficiens are consrained o be he same for all cross secions. We are herefore able o accoun for cross counry differences wihou losing he general message abou he long-run relaionships beween impor volumes and he differen demand componens. We find ha an increase in governmen expendiures by 1 percen leads o an increase in goods impors by abou 0.4 percen and o an increase in service impors by almos 0.5 5

7 percen. This implies ha, ceeris paribus, an increase in governmen expendiure would also lead o a deerioraion of he rade accoun. However, he ceeris paribus assumpion in our conex migh lead o wrong policy conclusions if an increase (decrease) in governmen expendiure were o crowd ou (crowd in) he privae demand componens. If his crowdingin/ou effec were o prevail, an increase in governmen expendiures could bring abou he opposie resul. The ambiguiy of our resuls is in line wih he findings of he lieraure; and, agains his background, his paper provides an addiional explanaion for he commonly found ambiguous effec of governmen expendiures on impor demand. We show ha he ambiguiy is, in par, he oucome of he composiional effec ha an increase in governmen expendiures has on aggregae demand. The naure of his effec is no revealed when using a reduced-form equaion. We find ha higher governmen expendiures, ceeris paribus, lead o higher impors simply because he governmen consumes more from abroad in line wih he impor conen of governmen consumpion. However, when considering he composiional effec ha fiscal policy measures have on overall demand depending on he reacion of privae demand he opposie conclusion can also be derived. Furher research could deermine he overall impac, i.e. he direc impac of a change in expendiure and he indirec impac hrough he reacion of privae demand, ha a change in governmen expendiure could have on he rade accoun of a paricular counry. For his purpose, a counry-specific analysis of he link beween fiscal policy measures and privae demand would be appropriae. 6

8 1 Inroducion Lile is known abou he effecs ha a lasing change in governmen expendiures has on a counry s exernal balance. There seems o be a consensus ha lower expendiures and he concomian improvemen in he fiscal balance lead o an improvemen in he curren accoun. Empirical research so far, however, has led o ambiguous resuls: 4 Some empirical sudies find ha higher budge deficis lead o higher curren accoun deficis; ohers prove he opposie or show no significan impac a all. A flaw of he models applied in his field of research seems o be ha hey esimae reduced-form equaions, wherein differen effecs migh counerac each oher wihou showing he underlying causaliies. The laer can only be revealed in a srucural model. Furhermore, earlier sudies suffer from he fac ha economeric echniques ha allow sudying long-run equilibrium relaionships beween ime series daa were no ye developed. This paper akes a fresh look a he empirical relaionship beween fiscal policy and he rade accoun by analysing he relaionship beween governmen expendiures and impors. Because rade accoun deficis are ofen a he hear of curren accoun problems, a srucural model of he rade accoun is an imporan sep when modelling he impac of fiscal policies on he exernal balance. Wihin he rade accoun, we concenrae on impors because impor demand is deermined by domesic demand facors, while expors depend on exernal demand facors. To pin down he effecs of fiscal policy, we esimae goods and service impor equaions on he basis of disaggregae demand variables. This implies ha in conras o he convenional form of rade equaions, which ake oal demand as an explanaory variable we allow for all componens of demand, i.e., privae consumpion, privae secor invesmen, governmen expendiure, and expors, o exhibi differen elasiciies. For rade equaions, he differen elasiciies of he aggregae demand componens are essenial because he impor conen of governmen consumpion is generally lower han he impor conen of oher demand componens. Earlier sudies ook ino accoun only he effec of differen impor conens of consumpion, invesmen, and expors, bu hey do no discriminae beween privae and public demand. The empirical analysis is based on annual panel daa of he G7 counries for he years 1970 hrough We deermine he coinegraion relaionship by a pooled mean group 4 For a lieraure review, see Bussière, Frazscher and Müller (2005) or Cavallo (2005). 7

9 esimaion. This echnique allows he inerceps, shor-run coefficiens and error variances o differ freely across counries, while he long-run coefficiens are consrained o be he same for all cross secions. We are herefore able o accoun for cross counry differences wihou losing he general message abou he long-run relaionships beween impor volumes and he differen demand componens. Based on his echnique, we find ha a change in governmen expendiure has a significan posiive impac on boh goods and service impors. This implies ha an increase in governmen expendiure would ceeris paribus also lead o a deerioraion of he rade accoun. However, we also show ha he ceeris paribus assumpion in our conex migh lead o wrong policy conclusions if an increase (decrease) in governmen expendiure was o crowd ou (crowd in) he privae demand componens. If his crowding in/ou-effec was only srong enough an increase in governmen expendiures could bring abou he opposie resul. The paper is srucured as follows. Secion 2 presens some sylized facs on governmen expendiure and impors in our daa sample. Secion 3 explains he model and he esimaion echnique. Secion 4 presens he empirical analysis and he resuls. Secion 5 concludes. 2 The governmen secor and he rade accoun Noable differences exis wih respec o he impor conen of privae consumpion, governmen expendiure, invesmen and expors, respecively. Table 1 repors he impor conen of he differen demand componens for he UK in 2001 and for Germany, France, he UK and Ialy in 1980, respecively. Despie some cross-counry variaion of he general level of impor conens, i becomes obvious ha compared o he oher demand componens governmen expendiure reveals he lowes impor conen across counries. Table 1: Toal impor conen of demand componens Germany France Ialy Unied Kingdom Unied Kingdom * Aggregae expendiure Privae consumpion Governmen expendiure Gross invesmen Expors Source: Giovannei (1989), * Bank of England (2002). 8

10 Because of he differen impor conens of he demand componens one can assume ha he smaller he size of he governmen secor measured as governmen expendiures in percen of GDP he higher he impor-o-gdp raio. When he size of he governmen decreases he governmen secor uses less resources of he privae secor and he composiion of aggregae demand changes in favour of he privae secor. Because he governmen secor has a smaller impor conen han he privae secor, his shif in he composiion of aggregae demand has a posiive impac on impor demand. If he governmen secor shrinks and he privae secor increases, given he relaively low impor conen of governmen expendiure in comparison o privae consumpion, he demand for impors should increase. To ge an idea wheher his proposiion sill holds when looking a G7 counries for recen years, we ploed governmen expendiure-o-gdp raios agains he impor-o-gdp raios for annual daa from (see Figure 1). The wo panels show our findings for AMECO daa and he general governmen (lef panel) as well as for he IFS daa and he cenral governmen (righ panel). Figure 1: Impor raio and governmen expendiure raio for G7 counries ( ) a General governmen Cenral governmen Impors of goods and services as % of GDP 45% 40% 35% 30% 25% 20% 15% 10% CAN EU counries - DEU, FRA, ITA, and UK USA JAP y = -0.56x (-7.67) (14.69) y = -0.90x (-5.63) (7.91) y = -1.04x (-5.75) (9.64) y = 0.17x (1.65) (0.67) Impors of goods and services as % of GDP 45% 40% 35% 30% 25% 20% 15% 10% 5% CAN EU counries - DEU, FRA, ITA, and UK USA JAP y = -1.34x (-4.57) (7.31) y = -0.86x (-3.27) (8.01) y = 0.42x (2.78) (1.01) y = -1.83x (-3.94) (7.44) 5% 10% 20% 30% 40% 50% 60% 70% Toal general governmen expendiure excluding ineres as % of GDP 0% 10% 12% 14% 16% 18% 20% 22% 24% 26% Toal cenral governmen expendiure excluding ineres as % of GDP Source: Inernaional Financial Saisics, IMF (2005), AMECO, (2005), own calculaions. a The lef panel uses he AMECO daa base and refers o general governmen. The righ panel shows he IFS daa, which was used in our calculaions and refers o cenral governmen expendiure. T-saisics are given in brackes below he coefficiens. Figure 1 illusraes ha an increase in he public expendiure raio goes hand in hand wih a decrease of he impor raio in all counries bu Japan. Wih he excepion of Japan, he - saisics show ha all coefficiens are significan a he 1% level. The differen behaviour of Japan could be relaed o he excepional, decade-long sagnaion of he economy. Figure 1 9

11 also reveals ha by and large he negaive relaion beween governmen expendiures and impors holds regardless of he degree of openness. The negaive relaionship beween general governmen expendiure and impors also exiss for oher counries ouside he G7. As Table 2 shows, hough he correlaion coefficiens differ across counries, he behavioural relaionship seems o be relaively similar. 5 Again, mos of he correlaion coefficiens are significan a he 1%-level. This could be aken as an indicaion ha i migh no be oo far feched o apply conclusions drawn from G7 counries o oher counries where daa problems preven a more elaborae analysis such as he one conduced in his paper. Table 2: Correlaions of governmen expendiure raio and impor o GDP raio ( ) Counries Correlaion Counries Correlaion G7 Counries EFTA Counries Canada -0.88*** Swizerland 0.06 Germany -0.57*** Norway 0.43* France New EU Member Saes Unied Kingdom -0.59*** Cyprus -0.98*** Ialy -0.94*** Czech Republic Japan 0.42* Esonia Unied Saes -0.84*** Hungary -0.73*** Oher EU Counries Lihuania -0.47** Ausria -0.81*** Lavia 0.17 Belgium -0.89*** Mala -0.68*** Denmark -0.89*** Poland -0.41* Finland -0.40* Slovakia -0.62*** Ireland -0.91*** Slovenia -0.43* Luxembourg -0.76*** Porugal -0.44* Neherlands -0.91*** Sweden -0.96*** Source: Auhors own calculaions. Noes: *** indicaes a 1% significance level, ** indicaes a 5% significance level, * indicaes a 10% significance level. 5 Daa is aken from he AMECO daa base. For some counries, i.e., Canada, Germany, Sweden, Swizerland and he CEECs, he full daa range is no available and correlaions are calculaed by applying he reduced daa series. For Cyprus, Hungary, Mala and Slovenia only seven daa poins are available. The correlaions, herefore, only provide an indicaion for he relaion of he variables and mus be inerpreed cauiously. 10

12 Despie hese relaively robus resuls, he correlaions do no reveal he poenial impac of a change in governmen expendiure on impors. For a policymaker i is imporan o know how a change in governmen expendiure affecs impors, he curren accoun and hus he exernal balance. We assess hese effecs in he following empirical analysis. 3 The model specificaion 3.1 Sandard formulaions of he rade accoun Our analysis concenraes on he impac of fiscal policy on he rade accoun because rade accoun deficis are ofen a he hear of curren accoun problems. 6 For all counries in he sample he rade accoun is quaniaively he mos imporan of he hree pars of he curren accoun, hough is share has been declining somewha in recen years. We base our analysis on an exension of he radiional model of he rade accoun. The basic rade model consiss of an impor and an expor equaion which relae impor (M) and expor (X) volumes o domesic (Y) and foreign (Y*) real income and relaive prices (RP). 7 Equaions 1 and 2 show he expor and impor equaions as given in he lieraure in heir general and heir log form: γ γ * 1 2 * Expors: X = γ 0Y RPX in logs x = γ 0 + γ 1y + γ 2rpx (1) δ δ 1 2 Impors: M = δ 0Y RPM in logs m = δ 0 + δ1y + δ rpm 2. (2) RPX and RPM are he relaive prices, γ 1 and δ 1 represen he income elasiciies and γ 2 and δ 2 he price elasiciies of expors and impors, respecively. Domesic real income (Y) is equivalen o real GDP, which equals he sum of he demand componens, i.e., privae consumpion, public spending, privae invesmen and ne expors. Foreign real income (Y*) represens he oal income of he res of he world and can no easily be decomposed ino demand componens. Relaing impor volumes o oal real income implicily assumes ha he impor conen and he impor elasiciy are he same for all demand componens. 6 Recen lieraure also poins ou a reversed causaliy beween he curren accoun and fiscal policy. In his respec Baker (2004) finds ha increased foreign indebedness may conribue o an erosion of he ax base. We do, however, focus on he impac ha fiscal policy has on he curren accoun hrough he demand side. 11

13 3.2 Impor equaions and expendiure componens Earlier research showed ha impor demand is no only deermined by he level of income and final expendiure bu also by he composiion of expendiure and he impor conen of he differen componens. Abbo and Seddighi (1996), Giovannei (1989) and Mohammad and Tang (2000), for example, esimae impor equaions by aking disaggregaed demand/expendiure componens ino accoun. They divide oal demand ino consumpive expendiure, invesmen expendiure and expors. The resuls show ha he elasiciies of he differen demand componens differ significanly. 8 To our knowledge, so far he exising lieraure assumed ha a leas privae consumpion and governmen expendiure reveal common elasiciies. Hence, he impac of fiscal policy measures on impor demand has no been aken ino accoun by he lieraure. Our model, however, allows us o gauge he impac of a change in public spending on impors because we disaggregae domesic real income ino is demand componens and separaely consider privae consumpion and governmen expendiure. The exended impor equaion disinguishes beween privae consumpion (C), privae invesmen (I), governmen expendiure (G) and expors (X): M = 0C I G X RPM in logs m 0 + 1c + i g x = rpm. (3) Equaion (3), hus, permis divergen impor elasiciies for privae consumpion and governmen expendiure 9 because he impor conen of governmen expendiure is generally lower han ha of privae consumpion (see Secion 2). The major pars of governmen expendiures are public wages and social expendiures, which have a low or marginal impor 7 Recen research in his field has been publisher by Hooper e al. (2000) and Marquez (2002). For a more general discussion of he radiional rade model see Goldsein and Khan (1985). 8 Abbo and Seddighi (1996) apply a likelihood raio es o see wheher he long-run elasiciies esimaed by a Johansen procedure could be resriced o be he same for all demand componens. They had o rejec he resricion. 9 A more deailed analysis could consider public consumpion and public invesmen demand separaely. These wo componens of public expendiure can be expeced o reveal major differences in erms of impor conen. Due o limiaions in he availabiliy of consisen daa for he empirical analysis disaggregaing public expendiure was no possible. 12

14 conen. 10 Equaion (3) shows ha he impac of fiscal policy on he rade accoun depends on he direc effec of governmen expendiure on impors bu also on he indirec effecs ha fiscal policy measures migh have on he oher demand componens, i.e., privae consumpion and privae secor invesmen. 3.3 Specificaion of he empirical model Our rade volume equaions are an exension of he expor and impor equaions 1 and 2 ha are separaed ino rade volume equaions for goods (equaions 4 and 6) and services (equaion 5 and 7). Firs, he following four convenional rade volume equaions are esimaed in heir log form: 11 Goods expors: * xg γ 0 + γ 1yg + γ 2 = rpxg, (4) Service expors: * xs θ 0 + θ1ys + θ2 = rps, (5) Goods impors: mg δ 0 + δ1y + δ 2 = rpmg, (6) Service impors: ms ψ 0 + ψ1y + ψ 2 = rps, (7) Then impor volume equaions for goods (equaion 6) and services (equaion 7) are exended along he lines described in he previous secion: Exended form of goods impors: mg 0 + 1c + i g x = rpmg, (8) Exended form of service impors: ms ϑ 0 + ϑ1c + ϑ i g x 2 + ϑ3 + ϑ4 + ϑ5 = rps. (9) The esimaion considers annual daa for he G7 counries from hrough A full descripion of he variables is given in Appendix Daa from he OECD 1990 inpu-oupu able for Germany reveals ha abou 50% of governmen expendiure is spen on inpus from producers of governmen services which in urn have human labour as here only inpu. Wihou having a horough look a he componens of governmen consumpion i seems reasonable o conclude ha a major porion of governmen demand is saisfied by domesic oupu. 11 In conras o Driver and Wren-Lewis (1998), a ime rend is no included. This, however, does no change he esimaion resuls. In a firs sep, Driver and Wren-Lewis also esimaed he elasiciies wihou considering he ime rend and in a second sep esimaed he ime rend while applying he coefficiens as derived in he firs sep (Driver and Wren-Lewis (1998), p. 119). 12 Due o missing daa poins, equaions (5), (7) and (9) are esimaed using daa from 1977 hrough

15 For he convenional rade equaions 4 o 7, domesic income or demand (y) are expeced o have a posiive impac on impor volumes (ms) or (mg). Likewise, expor volumes (xg) or (xm) are expeced o increase wih foreign income (yg*) or (ys*). 13 As discussed by Marquez (2002), economic heory posulaes he income elasiciy o be equal o one provided i is assumed o be consan. However, various empirical sudies show ha he esimaed coefficien deviaes from one bu remains close o one. 14 In he presen analysis income elasiciies are herefore also expeced o be close o one across all sample counries. Likewise, i is assumed ha he sum of he demand elasiciies (i.e. for consumpion, invesmen, governmen expendiure and expors) should also be equal or close o one in he exended rade equaions (8) and (9). Since demand decreases as prices increase, he coefficiens of relaive prices are expeced o be negaive in all six equaions. 4 Empirical analysis and resuls When esimaing he rade volume equaions he analysis follows he approach by Driver and Wren-Lewis (1998). Panel uni roo ess are applied o es for saionariy of he ime series. Almos all variables are inegraed of order one. Because of his resul panel coinegraion echniques are applied o a panel of G7 counries o esimae he elasiciies of he expor and impor volume equaions in he convenional form as well as in he exended form in he case of impor volumes. Furhermore, he Johansen procedure is applied o each counry individually o verify wheher he common coefficiens derived from he panel analysis appropriaely reflec he individual counry daa. 15 The deails of he esimaions as well as he resuls are presened in he following subsecions. 13 The world demand for goods expors (yg*) is proxied by world merchandise rade, which only includes goods rade. Similar daa is no available for services. Hence, he world demand for service impors (ys*) is proxied by world real GDP. 14 See, for example, Cline (1989), Caporale and Chui (1999), Hooper e al. (2000) and Marquez (2002). 15 Comparing he counry-by-counry esimaion wih he resuls of he panel coinegraion only provides an eyeball es for he adequacy of he common coefficien from he pooled esimaion. The analysis is refined by a pooled mean group esimaor and a mean group esimaor which allow a quaniaive assessmen of he relevance of he common coefficien for he individual counries by applying a Hausman es. 14

16 4.1 Panel uni roo es Muliple mehods for uni roo ess as well as coinegraion analyses have been developed for panel daa in he recen pas. These panel uni roo ess are mosly based on esimaing some version of a sandard dynamic model for a panel, such as y i = ρ yi 1 + δ 0 + δ1 + ηi + ν + εi (10) and esing wheher he coefficien ρ is equal o one. The subscrip i = (1, 2,..., N) disinguishes he N counries included in he panel. Examples for such ess are Levin, Lin and Chu (2002) and Breiung (2000). Oher procedures, for example, Im, Pesaran and Shin (2003), are based on averages of he individual uni roo es saisics. They recommend, for example, o apply he Dickey-Fuller (DF) and he augmened Dickey-Fuller (ADF) ess o he individual ime series and o calculae one common es saisic from he individual -ess. By deermining heir es saisics based on he full informaion conained in he daa panel he echniques proposed by Levin, Lin and Chu (2002) (LLC) and Breiung (2000) bes offers he mos suiable asympoic properies in he case of medium size panels, i.e., an equivalen exension of he cross secion and he ime series dimension. We herefore apply boh mehods o es he relevan ime series for saionariy. LLC and Breiung es he null hypohesis ha each individual ime series in he panel is inegraed versus he alernaive hypohesis ha all individual ime series are saionary. Boh ess are based on he following pooled ADF equaion y i pi = δ y + θ y + α + α + ε i 1 i i L 0i 1i i, L= 1 where a common δ = ρ - 1 is assumed. The null of H 0 : δ = 0 under he assumpion ha δ i = δ for all i is esed agains he alernaive hypohesis, H a : δ < 0 for δ i = δ for all i. The ess allow for counry specific inerceps (α 0i ) and he rend coefficiens (α 1i ). However, while he LLC is based on a echnique which removes auocorrelaion as well as he deerminisic componens, i.e., individual inercep and individual rend, when making he relevan sandardisaions he es saisic proposed by Breiung is calculaed by removing he auoregressive componen bu no he deerminisic porion of he ADF equaion. The resuls of he LLC and he Breiung ess are given in Table 3. 15

17 Table 3: Resuls of he Levin/Lin uni roo ess LLC Breiung H 0 : δ = 0 H 0 : δ = 0 Criical probabiliy Criical probabiliy Relaive price of expored goods rpxg Relaive price of impored goods rpmg Relaive price of services rps Expor goods xg Expor services xs Impor goods mg Impor services ms World rade volume yg* World real GDP ys* Real GDP y Privae consumpion c Governmen consumpion g Privae invesmen i Expor x Source: Auhors own calculaions. Noe: The ADF specificaion akes individual inerceps bu no rend erm ino accoun. According o he Breiung es saisic he null of nonsaionariy can no be rejeced for all daa series bu he relaive price for expored goods. The resuls generaed by he LLC are somewha weaker. Alernaive es procedures e.g. he uni roo es by Im, Pesaran and Shin (2003) confirm ha all bu he rpxg series possess a uni roo and hus suppor he oucome of he Breiung es. Coinegraion echniques are, herefore, he appropriae ool o esimae he rade volume equaions. 4.2 Panel coinegraion es The available echniques for panel coinegraion ess are Engle/Granger-like residual based ess. Similar o single ime series, hese approaches es he residuals from he esimaion for saionariy. If he esimaed residuals are saionary a linear combinaion of he ime series included in he esimaion exiss so ha he resuling ime series is a saionary process. The ime series are hus coinegraed. As in he case of single ime series, his form of coinegraion es does no allow o es for he number of coinegraing relaionships among he variables. In cases where more han one coinegraion relaionship exiss and/or no all variables are par of he coinegraion space, hese ess only show ha some combinaion of he included variables reveals saionary residuals. This means ha some of he variables bu 16

18 no necessarily all of hem are coinegraed. Therefore, he race and he maximum eigenvalue saisics suggesed by Johansen (1988) are applied on a counry by counry basis for all G7 counries. Since hese ess reveal in almos all cases of he rade volume equaions ha all relevan variables are par of a single coinegraion equaion, i is reasonable o apply he available residual based panel coinegraion ess. 16 For he following esimaions, residual based panel coinegraion ess as suggesed by Pedroni (1999) and Kao (1999) are employed. Boh assume homogenous slope coefficiens across counries. This is in line wih he purpose of our analysis, namely deriving a general relaionship beween governmen expendiure and impor volumes. Pedroni as well as Kao apply he null hypohesis of no coinegraion. Kao (1999) ess he residuals ) ε i of he OLS panel esimaion by applying DF- (equaion 11) and ADF- (equaion 12) like ess. ) ) ε + ν i = ρεi 1 i (11) ) ) ) ε ϕ ε + ν p i = ρεi 1 + j= 1 j i j ip (12) The null hypohesis of no coinegraion i.e. H 0 : ρ = 1 is esed agains he alernaive hypohesis of saionary residuals i.e. H a : ρ < 1. Pedroni (1995) sugges a Phillips-Perron-ype es, which implies less sric assumpions wih respec o he disribuion of he error erms han he DF and ADF ess do. The resuls of he coinegraion ess are given in Table 4. They show ha he null hypohesis of no coinegraion can be rejeced a convenional significance levels in all cases. These resuls combined wih he oucome of he Johansen procedure indicae ha he variables included in he differen rade volume equaions are coinegraed and ha one coinegraion relaionship exiss. 16 The resuls of he Johansen-Tess can be requesed from he auhor. The fac ha he relaive price does no appear as separae coinegraion relaionship migh indicae ha he ime series is in fac no saionary. This suppors he decision o apply coinegraion analysis despie he panel uni roo es does no suppor he null of a uni roo for hese variables. 17

19 Table 4: Panel coinegraion ess Kao (1999) 1 Goods expors DF-roh (0.0162) DF (0.0777) DF-rho* DF-* Kao (1999) 2 (0.0248) ADF (0.0628) Service expors (0.0002) (0.0110) (0.038) (0.0197) Goods impors (0.1643) (0.2689) (0.0659) (0.1247) Service impors (0.0039) (0.0375) (0.0102) (0.0191) Exended goods impors (0.0002) (0.0145) (0.0046) (0.0086) Exended service impors (0.0003) (0.0001) (0.0008) Pedroni (1995) 3 PC PC Source: Auhors own calculaions. Noes: p-values are given in parenheses. 1 The DF es saisics given above are analogous o he parameric Dickey-Fuller es for nonsaionary ime series. The DF-rho and DF- saisics assume sric exogeneiy of he regressors wih respec o errors and no auocorrelaion. DF-rho* and DF-* saisics are based upon endogenous regressors. Noe ha hese ess depend on consisen esimaes of he long-run variance-covariance marix o correc for nuisance parameers once he limiing disribuion has been found. 2 The ADF es is analogous o he parameric Augmened Dickey-Fuller es for nonsaionary ime series. 3 PC1 and PC2 are he non-parameric Phillips-Perron ess. 4.3 Esimaion of rade volume equaions Trade elasiciies are esimaed by applying he pooled mean group (PMG) esimaor proposed by Pesaran e al. (1999). The long-run relaionships are esimaed in a pooled as well as in a counry-by-counry seing. The cross-counry average of he coefficiens from he laer is he mean group (MG) esimaor. A Hausman es allows assessing wheher slope homogeneiy exiss among cross secions and hereby reveals wheher he PMG esimaor provides a consisen and efficien esimaion for he coefficiens across all counries. 18

20 The esimaion is based on he following re-parameerizaion of he sandard auoregressive disribued lag (ARDL) model y i i p 1 p 1 ' * *' i, 1 + βi xi + λij yi, j + δ ij xi, j + µ i + γ i ε i, j= 1 j= 0 = φ y + where y i and x i are a vecor of observaions on he dependen variable, i.e., rade volume, and a vecor of explanaory variables, i.e, relaive price and income, for counry i, respecively. µ i represens he counry specific fixed effec, γ i is he individual ime rend coefficien and ε i sands for he counry specific error erm. The long-run relaionship beween y i and x i is given by y i ' ( β i / φi ) xi + ηi =, ' where ( β i / φ ) is he long-run coefficien, i.e., he respecive elasiciy, η i is he error erm i and all oher variables are defined as given above. To address he problem of cross secional correlaion, demeaned daa 17 are used in he case of all impor equaions. In he case of expor equaions a ime rend is considered insead. This is due o he fac ha world income is common for all cross secions and can no be demeaned. Table 5 shows he esimaion resuls. The counry sample included in he esimaion is adjused where necessary o include only hose counries for which he daa allows o deermine a long-run relaionship. 18 The p-values of he join Hausman es 19 reveal ha for he counries included in he esimaions he null of slop homogeneiy can no be rejeced. 17 Demeaned daa is consruced by subracing he cross-secional average of a respecive variable from each T 1 daa poin of he respecive cross secion: yi = T = y 1 i, 18 The fac ha no reasonable coinegraion relaionship can be esablished for example for France in he case of service expor migh be a counry-specific problem ha, for example, forced Driver and Wren-Lewis (1998) o assign values for he elasiciies in such cases. Our analysis does no inend o deermine counry-specific elasiciies bu general resuls and he number of cross secions is large enough so ha he exclusion of one or wo counries from he pars of he analysis does no harm he general proposiions drawn from he esimaion resuls. 19 The join Hausman es assesses he null hypohesis of slop homogeneiy agains he alernaive hypohesis of heerogeneous slope coefficiens across counries 19

21 Table 5: Coinegraion esimaion of convenional rade volume equaions 20 Goods expor (equaion (4)) Price elasiciy ** Service expors (equaion (5)) Goods impors (equaion (6)) Service impors (equaion (7)) PMGE 1)2) PMGE 1)2)3) PMGE 4) PMGE 2)4) (-8.647) Income elasiciy 0.906** (36.395) ** (-3.500) 1.018** (3.572) ** (-3.076) 1.953** (9.896) ** ( ) 1.316** (56.190) Join Hausman es Source: Auhors own calculaions. Noes: -saisics are provided in parenheses. * and ** denoe saisical significance a a 5% and 1% level respecively. -saisic are given in parenheses. 1) Esimaion equaion includes ime rend. 2) Japan is excluded from he esimaion. 3) France is excluded from he esimaion. 4) The esimaion is based on demeaned daa. Comparing he resuls of he esimaion above wih hose generaed by Hooper e al. (2000) and Driver and Wren-Lewis (1998) shows ha he esimaed coefficiens are in he range of hose received from single ime series analysis. Hooper e al. (2000) esimae long-run rade elasiciies for he G7 counries. Their resuls reflec he fac ha income elasiciies usually deviae from uniy and ha price elasiciies vary significanly among counries. Driver and Wren-Lewis (1998) use he Johansen approach and vecor error correcion esimaes in order o deermine he rade volume elasiciies for he G7 counries on a counry by counry basis. Their resuls also reflec he fac ha he esimaes for income elasiciies for he G7 counries deviae from uniy. This can be inferred from heir explanaions and from he fac ha almos all coefficiens ha he auhors finally use for oher esimaions were generaed hrough consrained esimaions or even imposed wihou aking he original esimaion oupu ino accoun. The resuls of he sudies of Hooper e al. and Driver and Wren-Lewis are given in Appendix 2 in Table A1 and Table A2, respecively. In he nex sep, he exended form of he impor volume equaions (equaion 8 and 9) are esimaed o analyze he effecs of governmen expendiure on foreign rade. The resuls of he PMG esimaion are summarized in Table 6. As in he convenional rade equaions, he relaive price variable is significan and has he expeced sign. All demand variables (bu privae secor invesmen in he service impor 20 The dependen variable is he log of he respecive rade volume. 20

22 equaion) are significan. They show a posiive effec on goods and service impors. The magniude of he elasiciies differs among he demand componens. This confirms ha he composiion of demand maers for he impor equaion and ha using a single aggregae demand variable migh disor he resul. In he case of services, privae invesmen does no have a significan impac on impor volumes and governmen expendiure reveals he smalles elasiciy among he remaining demand componens. One migh argue ha hese resuls migh be flawed because of mulicollineariy, in paricular, beween governmen spending and privae consumpion. The pracical consequence of mulicollineariy could be ha confidence inervals end o be much wider, leading o he accepance of he null hypohesis more readily. Hence, he -raios migh be inerpreed as saisically insignifican even hough in realiy hey are significan. Because he -saisics in Table 6 show ha all variables (excep for privae secor invesmens in he service impor equaion) are significan, from a saisical poin of view mulicollineariy is no a concern. Table 6: Coinegraion esimaion of exended impor volume equaions 21 Price elasiciy Privae consumpion (ln C) Governmen expendiure (ln G) Privae secor invesmens (ln I) Expors (ln X) Goods impors (equaion 8) Service impors (equaion 9) PMGE 2) 3) 4) 2) 4) 5) PMGE ** (-5.015) 1.102** (3.481) 0.392* (1.762) 0.427** (5.152) 0.435** (4.156) ** (-6.747) 1.433** (1.916) 0.491** (2.485) (0.076) 0.503** (1.972) Join Hausman es Source: Own esimaions. * and ** denoe saisical significance a a 5% and 1% level respecively. -saisic are given in parenheses. 1) Esimaion equaion includes a ime rend. 2) Japan is excluded from he esimaion. 3) France is excluded from he esimaion. 4) The esimaion is based on demeaned daa. 5) The coefficiens of privae consumpion and privae secor invesmen are no resriced o be homogenous across counries. 21 The dependen variable is he log of he respecive rade volume. 21

23 Our empirical resuls show ha an increase in governmen expendiures has a posiive impac on oal impor demand. A lasing increase in governmen expendiure of one percen will lead o an increase of demand for goods and service impors of 0.4 and 0.5 percen, respecively. An increase in public spending will, hus, ceeris paribus lead o a deerioraion of he rade accoun simply because he governmen consumes more from abroad in line wih is impor conen. Because of he relaive weigh of he rade accoun in he curren accoun he curren accoun would improve if governmen expendiure were reduced. However, our resuls need o be inerpreed wih cauion because he ceeris-paribus inerpreaion of he coefficiens is problemaic in our conex as an increase (decrease) in governmen expendiure is likely o crowd ou (crowd in) he privae demand componens. Oher empirical sudies have shown ha an increase in governmen expendiure migh crowd ou privae secor invesmen while privae consumpion is likely o increase as public expendiure rises. 22 If an increase in governmen expendiure crowds ou privae invesmen bu posiively impacs privae consumpion, he impac on impor volumes becomes less predicable. If public expendiure and privae consumpion replace privae invesmen due o he combinaion of a high elasiciy of privae consumpion and he low elasiciy of public expendiure he decline in impor demand due o he slowdown in privae invesmen migh or migh no be compensaed by he surge in impor demand caused by he increase in public expendiure and privae consumpion. The overall effec of such a demand shif on goods impors depends on he relaive size of he change in public expendiure and privae consumpion. In he case of service impors he effecs are more predicable. According o our resuls he increase in governmen expendiure and he relaed rise in privae consumpion cause an increase in service impors while he decrease in privae invesmen does no impac he service accoun. An increase in governmen expendiure would hus lead o a deerioraion of he service accoun. Because he goods accoun is more sizeable han he service accoun, 23 i can be expeced ha he effec coming from he goods accoun overrides he effec semming from he service accoun. If his is he case, he overall impac of an increase in governmen expendiure of he rade accoun depends on he reacion of privae consumpion and privae invesmen on he expansion of he governmen secor. 22 See, for example, Karras (1994) and Blanchard and Peroi (2002). 23 In he case of he G-7 counries, service impors are less han one hird of he size of goods impors. 22

24 Overall he resuls of our esimaion provide insighs regarding he direc effec of a change in governmen expendiure on impor demand bu is indirec effecs are less clear. Governmen expendiure reveals a posiive elasiciy wih respec o goods impors and service impors. An increase in governmen expendiure, ceeris paribus, causes an increase in impor volumes. However, he indirec effecs of fiscal policy measures caused by he reacion of privae consumpion and privae invesmen o a change in public expendiure are less clear-cu. Since he empirical lieraure does no provide unanimous evidence regarding he impac ha fiscal policy measures have on privae demand, 24 he inerpreaion of our resuls depends on he ineracion beween he public and he privae secor. 5 Summary and conclusion This paper analyzes he empirical relaionship beween fiscal policy and he rade accoun. I shows ha fiscal policy maers for he rade accoun and sheds ligh on how fiscal policy affecs he rade accoun. Research prior o his paper did no ake ino accoun he fac ha he componens of privae and public demand in he impor equaion exhibi differen elasiciies. Using pooled mean group esimaion for annual panel daa of he G7 counries for he years 1970 hrough 2002, we find ha an increase in governmen expendiures has a significan posiive impac on boh goods and service impors. An increase in governmen expendiures by 1 percen leads o an increase in goods impors by abou 0.4 percen and o an increase in service impors by almos 0.5 percen. This implies ha, ceeris paribus, an increase in governmen expendiure would also lead o a deerioraion of he rade accoun. However, he ceeris paribus assumpion in our conex migh lead o wrong policy conclusions if an increase (decrease) in governmen expendiure was o crowd ou (crowd in) he privae demand componens. If his crowding-in/ou effec was only srong enough an increase in governmen expendiures could bring abou he opposie resul. 24 Considering he impac of governmen expendiure on consumpion and invesmen separaely, Blanchard and Peroi (2002) reveal ha fiscal expansion has a posiive impac on consumpion and a negaive impac on invesmen. Faás and Mihov (2001), however, find ha consumpion increases as a response o a posiive expendiure shock while invesmen is no affeced significanly. Karras (1994) finds evidence ha privae consumpion and governmen spending are complemenary: privae consumpion decreases as governmen expendiures are cu. 23

25 The ambiguiy of our resuls is in line wih he findings of he lieraure; 25 and agains his background, his paper provides an addiional explanaion for he commonly found ambiguous effec of governmen expendiures on impor demand. We showed ha hey are, in par, he oucome of he composiional effec ha an increase in governmen expendiures has on aggregae demand. The naure of his effec would no have been revealed when using a reduced-form equaion. We saw ha higher governmen expendiures, ceeris paribus, lead o higher impors simply because he governmen consumes more from abroad in line wih he impor conen of governmen consumpion. However, when considering he composiional effec ha fiscal policy measures have on overall demand depending on he reacion of privae demand he opposie conclusion can also be derived. This sudy reveals ha a difference beween he rade elasiciies of privae and public demand exiss. Furher research could deermine he overall impac, i.e. he direc impac of a change in expendiure and he indirec impac hrough he reacion of privae demand, ha a change in governmen expendiure could have on he rade accoun of a paricular counry. For his purpose, a counry-specific analysis of he link beween fiscal policy measures and privae demand would be appropriae. 25 For example Erceg, Guerrieri and Gus (2005), Lane and Peroi (1998) or Baxer (1995) who analyse he impac of fiscal policies on he rade accoun find divergen effecs. Analysing he relaion beween fiscal defici and curren accoun defici, sudies by Berenheim (1988), Bussière, Müller and Frazscher (2004), Normandin (1999), Piersani (2000), Enders and Lee (1990), Dewald and Ulan (1990) as well as Kim and Roubini (2004) reveal conradicing resuls. Some of he sudies find a posiive, some a negaive and some find no significan relaion beween he wo deficis a all. 24

26 Appendix 1: Daa descripion and sources All esimaions are carried ou wih annual daa for he G7 counries (Japan, he Unied Saes, Canada, he Unied Kingdom, France, Ialy and Germany). Daa series are aken from he IMF s inernaional financial saisic (IFS), he OECD s main economic indicaors (MEI) daa bases and he IMF s Direcion of Trade Saisics (DOTS). Daa for he esimaion of rade equaions For his par of he analysis daa series for he G7 counries and world aggregaes or OECD daa for world variables covering he period from 1970 hrough 2002 are considered. The rade equaions (equaions 4 o 9) include he following variables: 26 Variable Explanaion Daa source and ransformaion XG Goods expor volumes Expor volumes (IFS line 72) are urned from an index ino consan price series using he 1995 average for merchandise expors in US$ (IFS line 78aa) convered ino domesic currency using he 1995 average for he exchange rae (r). The series are hen urned ino a volume series by deflaing by PC. XS Service expor volumes Service credis in US$ (IFS line 78ad) are convered ino domesic currency using he acual exchange rae (r). The series are hen urned ino a volume series by deflaing by PC. MG Domesic goods impor volumes The impor volume FOB series (IFS line 73) is urned from an index ino a consan price series using 1995 average by muliplicaion wih merchandise expors in US$ (IFS line 78ab) and is convered ino domesic currency using he 1995 average for he US$ exchange rae (r). MS YG* YS* Domesic service impor volumes World income relevan for goods expor demand (equivalen o world rade volume) World income relevan for service expor demand (equivalen o world real GDP) Service debis in US$ (IFS line 78ae) are convered ino domesic currency using he acual US$ exchange rae (r) and ino a volume series by deflaing by PCW afer convering PCW ino domesic currency erms using EFEX. OECD. YG* as world rade volume is proxied by oal world expors in US$ a curren prices (IFS line 70), deflaed using WPXG. OECD. Toal OECD GDP a consan marke prices in US$. Y Domesic real GDP IFS line 99b and deflaed by PY. C real privae consumpion IFS line 96f and deflaed by CP I Real privae secor IFS line 93i plus IFS line 93e and deflaed by PY. invesmen G real governmen IFS line 91f and deflaed by PY. expendiure X real expors IFS line 90c and deflaed by PY. PC domesic consumer price IFS line 64 index in domesic currency PCW world consumer price MEI of he OECD index PXG domesic expor prices Expor prices index (IFS line 76) are used in he case of Japan, UK and he US. PD as he domesic prices index in domesic currency is given by wholesale prices (IFS line 63). WPXG world expor prices in US$ uni value of world expors in US$ (IFS line 74). For Canada, France, Germany and Ialy his is an expor uni value index (IFS line 74). 26 The upper case abbreviaions for he variables correspond o he lower case equivalens in he equaions as given in he ex. However he upper case sands for absolue values while he equaions are given in logs. 25

27 Variable Explanaion Daa source and ransformaion PY domesic GDP deflaor IFS line 99bi r nominal US$ exchange IFS line rf rae EFEX nominal effecive exchange rae RPXG RMPG RPS relaive price for goods expors relaive price for goods impors relaive price for service expors and service impors Calculaed from he exchange raes (r) and he bilaeral rade weighs (expors plus impors (lines 70 and 71 of he direcion of rade saisics)) of he G7 counries and heir 39 larges rading parners (including he G7 counries hemselves). (WPXG*r)/PXG. (WPXG*r)/PD PCW/ (PC*EFEX) Appendix 2: Single ime series esimaions of rade elasiciies for he G7 counries Table A1: Long-run income and price elasiciies esimaed by Hooper e al. (2000) Income elasiciies Price elasiciies Expor Impor Expor Impor Canada 1.1* 1.4* -0.9* -0.9* France 1.5* 1.6* * Germany 1.4* 1.5* * Ialy 1.6* 1.4* -0.9* -0.4* Japan 1.1* 0.9* -1.0* -0.3* Unied Kingdom 1.1* 2.2* -1.6* -0.6 Unied Saes 0.8* 1.8* -1.5* -0.3* Source: Hooper e al. (2000), p. 8. * Saisically significan a a 5% level. Table A2: Income and price elasiciies esimaed by Driver and Wren-Lewis (1998) Income elasiciies Price elasiciies Expor Impor Expor Impor Canada France Germany Ialy Japan Unied Kingdom Unied Saes Source: Driver and Wren-Lewis (1998), pp. 41, indicaes ha he coefficien comes from a consrained ECM or a consrained Johansen esimaion. ++ indicaes ha he coefficien was imposed by he auhors. 26