Università degli studi di Roma Tor Vergata

Dottorato di ricerca in Banca e Finanza

Regional Economic Outlook: Dealing with shocks

Evidence from old EU members and Serbia
By
Abdelmoneim youssef
PhD student in Banking and finance

May 2010
ABSTRACT.

This study aims to determine the causes of the destabilization of three old
member countries in EU and Serbia in recent years, causing the floating
currencies. Using a structural VAR, we analyze the impact of a restrictive
monetary policy of the United States, a decline in confidence in financial
markets and rising world prices of agricultural products in sectors real,
financial and monetary these countries. The vulnerability of economies to
shocks reveals the lack of sustainability of exchange rate regimes in place
during this period. In addition, although the countries' reactions to each type
of shock are close, differences remain because of the heterogeneity of
macroeconomic and financial structures of countries.

Introduction
Multiple shocks are coming slow economic activity in Europe. The high level of
commodity prices has taken its toll on real incomes and consumption, and pushed
inflation to its highest level since a decade. The strong euro and weaker demand
from trading partners have weighed on exports. Finally, the extraordinary
tensions plaguing the financial markets exert a negative effect on advanced
countries and are testing the resilience of emerging markets.

The activity will remain sluggish in the short term in most advanced
countries, while consumption and asset prices will fall after reaching record
levels and that financial institution limit the credit to reduce leverage. In
most emerging countries, projections suggest a marked slowdown in
economic growth. It is likely that the adjustment of the financial system is
laborious and requires some time, therefore we expected a modest recovery
in activity, but only towards the end of 2009. The escalating tensions in the
financial sector and the negative interaction between environmental and
financial condition of the economic activity in general are the main factors
that may cause substantial downward revision of forecasts. In principle,
higher oil prices and food should not cause a flare lasting inflation. However,
there is concern that, given its size and scope, the current rise in wage
demands rise, causing the widespread price pressures. The risk that snaps a
wage-price spiral is particularly acute in emerging countries where the
effects of overheating have already been felt. In advanced countries, the
slowdown in activity as reported by the projections and the recent ebbing of
the course of several major commodities are expected to generate a steady
decline in inflation. Stabilizing the financial situation in priority.

Stabilizing the financial situation is the priority. To achieve this , action

prevails worldwide, including the provision of liquidity if necessary and clean
up balance sheet by the recognition of losses and capital replenishment.
European leaders must undertake to consult and to take coordinated action
to alleviate the financial stress. The financial turmoil has clearly
demonstrated that, given the importance of transnational financial
institutions, the European Union must make financial stability a shared
responsibility and a duty to prevent serious risk of being wiped out the gains
from integration European Financial.

Controlling inflation remains a concern of government, but it is likely that

efforts will also focus increasingly on ways to fuel the recovery. In most
advanced economies, headline inflation, according to projections, return to
levels below central bank objectives because of very bleak outlook for
economic activity. In these circumstances and given the fact that the
situation could deteriorate further because of financial turmoil, it is now
possible to loosen monetary policy. At the same time, the automatic fiscal
stabilizers should support activity, but to preserve the long-term
sustainability of public finances, it must meet the deficit ceiling imposed by
the fiscal rules. Exceptions may be considered, if necessary, when public
resources are needed to directly alleviate financial stresses. In many
emerging countries, it may be necessary to further tighten macroeconomic
policies to counter inflationary pressures and external vulnerabilities. Finally,
plans should be put in place to deal with the risks of financial instability and
a sharp slowdown in growth.
Advanced economies are better placed than their counterparts to overcome
emerging indirect effects of soaring commodity prices in terms of inflation
(Chapter 2). Although vestiges of indexation remain in some countries, more
flexible labor market, established the credibility of monetary policy and the
outlook bleak for activity should limit the impact of soaring prices of
Commodities on the underlying inflation. The risk that the price pressures
spill over into a wider range of goods is more pronounced in emerging
countries, where food and energy represent a significant portion of consumer
spending. In some of these countries, higher commodity prices add to
pressure on prices resulting from the overheating of the economy. Moreover,
inflation may be more difficult to control in emerging markets using a regime
of fixed exchange rates or where the credibility of monetary policy is not yet
well established.
The response to make to the rising prices of commodities depends on the
origin of the pressures on prices, the credibility of policymakers and the
degree of labor market flexibility. Given that aspects related to global
demand have played an important role during the period leading to soaring
prices, it could be said to tighten more than usual monetary policy,
especially in some emerging and in countries where the labor market is
relatively more rigid. Experience shows that policy makers should resist the
temptation to seek to maintain high growth rates from soaring prices of raw
materials. It is best to focus on fiscal and structural policies on removing
bottlenecks that impede the productive apparatus and the establishment of
appropriate incentives for producers and consumers.

As forcefully remind the current financial turmoil, financial systems following

the cycles that they cannot escape which have important implications but
differentiated real activity in the country (Chapter 3). The development of
national systems of finance and real estate companies, which strengthen the
role of financial assets as collateral for borrowing and can give a procyclical
effect of bank loans. In this way the financial sector has the capacity to
amplify business cycle fluctuations and the effects of monetary shocks and
as forcefully remind the current financial turmoil, financial systems following
the cycles that they can not escape, which have important implications but
differentiated real activity in the country (Chapter 3). The development of
national systems of finance and real estate companies, which strengthen the
role of financial assets as collateral for borrowing and can give a procyclical
effect of bank loans. In this way the financial sector has the capacity to
amplify business cycle fluctuations and the effects of monetary shocks and
changes in asset prices on real activity. The cross-border ownership of assets
only strengthens this mechanism. This analysis shows that emerging
markets are probably more vulnerable than developed countries during the
current downturn in the credit cycle, even if there are great disparities
between countries in this regard.

What can policy makers do to mitigate the adverse macroeconomic volatility

that accompany the dynamic evolution of asset prices? Opinions still differ
about this, but the introduction of a countercyclical element in prudential
regulation could substantially reduce the volatility of investment, especially
in the countries included in the financial plan that apply more restrictive
borrowing limits . In this respect, financial integration remains essential to
facilitate a smooth adjustment based on growth. At the same time, he agrees
that oversight bodies are able to control transnational linkages increasingly
complex to ensure adequate coordination of fiscal policies across Europe,
particularly in the euro area.

With international capital, the flow of labor across borders of new Member
States of the European Union has been a pillar of the convergence process in
these countries (Chapter 4).Since the beginning of the transition, these labor
movements have significantly intensified and become more diverse and
flexible. The mobility of the workforce has clear advantages: it speeds up the
convergence process, improves the ratio between capital and labor
throughout the economy, supports aggregate demand through remittances
from migrant workers and can contribute to improving local skills where
migrant workers are returning home to rejoin the national labor market.

Contrary to what some observers believe, not by restricting the mobility of

the workforce that can counteract the overheating of the economy, it is
much better to improve the global mobilization of workforce. Far from being
a cause of overheating, the mobility of labor is more often a moderating
role. Indeed, wage increases granted during periods of economic expansion
were deter workers from seeking employment abroad, however, attract
immigrants, two factors that reduce wage pressures interiors. However, the
emigration of the workforce faster wage growth which is normally
accompanied the process of income convergence. If the labor market is rigid,
this increase may have inflationary effects, we must now fight to preserve
competitiveness. In addition, the flow of labor input and output differ in age
and skills, which can create imbalances between supply and quality demand
on the labor market. It is therefore essential to improve the mobilization and
utilization of manpower to enable sustainable growth and ensure a balanced
distribution of resources within countries.

Methodology
Let the vector autoregressive representation (VAR q) model in reduced form:
Where q is the number of delays, Yt is the vector of observable variables of
dimension n × 1, where n is the number of variables of the model and is
white noise. In order to obtain the response functions to shocks and the
variance decompositions of forecast error, it is necessary to write this
process as infinite moving average structural. To this end, an intermediate
step is to "invert" the VAR model by canonical Wold theorem to get the
canonical form VAR moving average:

With C (0) = In, and the vector of innovations and canonical.

Hence the shape of the moving average structural VAR:

Where P is a transition matrix invertible n × n to be estimated in order to

identify the structural shocks. The constraints of short-term result in the
nullity of the coefficients of the matrix P. The matrix represents Θj response
functions to shocks εt elements ΔYt. It is assumed that the various structural
shocks are not correlated and have a variance unitaire2:

Ω is the matrix of variances and covariance of the canonical innovations, we

have:

The lack of response in the long term a number of variables to shocks ΔYt ε
results in the invalidity of the multiplier corresponding long-term dynamics.
The choice of variables

We work with three countries and their oldest associate members of

European Union and Serbia:

Italy, France, Serbia, UK, the period 1991M1, 2004M3, in monthly. The
objective is to study the effects of international shocks in the real sector,
financial and monetary each country, and the interactions between the
different spheres of the economy. Five variables domestic and three external
shocks were selected. In our model, each economic variable is described by
the vector of endogenous variables:

Where ext is the variable extreme, there is production,

RERT the real exchange rate, the asset share of foreign
assets held by the central bank, m the money supply
M2 and ninrte the nominal interest rate equal to the
money market rates short term. The order of variables
is chosen to facilitate the implementation constraints of
short and long term. These are the variables traditionally
used in the literature on structural VAR since the objective is to take into
account both the actual size of the economy and monetary policy both in
terms of supply and application. The first two and last two domestic variables
of our model refer to the literature on the impact of monetary shocks on
business cycles more recently highlighted the importance of real exchange
rate as a transmission mechanism shocks. The breakdown between supply
shocks and demand, monetary and real uses the same logic as Gali (1992),
Clarida and Gali (1994) and Sims and Zha (1999). Furthermore, the role of
international fluctuations has been emphasized in particular by Cushman and
Zha (1997), Kim and Roubini (2000), Canova (2003)

Consequently, the vector of structural shocks associated to each variable

takes the following form:
Represent respectively the external shock, the real domestic supply shock,
the shock
real domestic demand, domestic financial shocks, the domestic money
demand shock, the domestic money supply shock.

The selected external perturbations are a positive shock in interest rates in

the United States .taking into account the interest rate of short-term money
in the country, the prices of agricultural products, and changes composite
stock index of country emerging proposed by Standard and Poor's (EMEI).

The volatility of this indicator has been calculated from a GARCH model
which gives the variance of the index from which the standard deviation can
be deducted.
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