Chapter 3
Behavioral Functions
© Pierre-Richard Agénor and Peter J. Montiel
1
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Consumption and Saving.
Private Investment.
The Demand for Money.
Aggregate Supply Functions.
2
Consumption and Saving




Consumption Smoothing.
Length of Planning Horizon and Liquidity Constraints.
Effects of Interest Rate Changes on Savings.
Public and Private Consumption.
4
Importance of consumption:
 Private consumption represents the largest component
of aggregate demand.
 Domestic investment in developing countries is
generally financed by domestic saving, and private
consumption is an important determinant of it.
 Since current account deficit is equal to domestic
investment minus domestic saving, private consumption
behavior is central to the external adjustment process.
Standard model of household consumption:
 Representative household devises a consumption plan
by maximizing utility over its lifetime, subject to an
intertemporal budget constraint.
5

With additively separable utility and no uncertainty, the
household maximizes lifetime utility:
T
V=
u(ct)

t
t = 0 (1+)
(1)
u(·): concave period utility function;
c: real consumption;
: constant rate of time preferences.
6

Assuming constant real interest rate r, V is maximized
T
by choosing a path of consumption {c} t = 0 subject to
T

t=0
u(ct)
(1+r )t
T
 a0 + 
t=0
yt
(1+r )t
(2)
a0: household’s initial wealth;
y: disposable factor income.
7

First-order condition for an optimum is given by the
Euler equation:
1+
u(ct+1) =
1+r




u(ct),
t = 1,…,T - 1. (3)
(3): allocation of consumption across periods must be
such that an extra unit of consumption makes the same
contribution to lifetime utility no matter to period.
Consumption path that solves the household's
optimizing problem
 satisfies Equation (3),
 (2) holds as an equality.
(3) determines the rate of growth of consumption.
8
(2) determines the initial level of consumption.
Implications:
 Households will tend to smooth consumption, so
consumption will not be tied to current income.
 Effect of changes in income on current consumption
depends on
 when such changes take place;
 how long they are expected to last.
 No prediction about the effects of changes in r on
consumption:
 Substitution effect tends to depress current
consumption.
 Income effect tends to increase it.
 Net effect on consumption of a change in r depends
on the relative strength of these two effects.
9
Application of this theory in developing countries
raises four issues:
 Whether households can effectively smooth
consumption which depends on access to unconstrained
borrowing and lending.
 Effective length of planning horizons.
 Empirical determination of the effects of r changes on
consumption.
 Effects of fiscal policy on private consumption.
10
Why is household consumption behavior different in
developing countries? (Gersovitz (1988) and Deaton
(1989)):
1) Households tend to have different demographic
structures:
 Individual household tends to be larger;
 More generations live together, sharing resources.
Implications:
 If resources are shared among the several generations
within the household, there is no need for “hump'' saving
to finance retirement.
 With pooled resources, the household provides
insurance for individuals against risk.
11

Developing-country households provide a closer
approximation to the “dynastic” household of Barro
(1974).
2) Household incomes in the developing world are more
uncertain.
 Reasons:
 share of agricultural incomes;
 macroeconomic instability arising from both external
shocks and domestic macroeconomic policy shocks.
 Since this uncertainty cannot be diversified away by risk
pooling within the household, precautionary saving is
more important in developing countries.
12
3) Many households in developing countries operate at
near-subsistence income levels.
 This strengthens the motive for consumption smoothing.
4) Developing-country households' need to cope with the
implications of financial repression.
 Thus, consumption smoothing may be restricted to
transfer resources across time by
 inability to borrow against future earnings
 very low real returns on current saving.
13
Consumption Smoothing
Evidence on consumption smoothing in developing
countries:
 This evidence comes from tests of the permanent
income hypothesis (PIH).
 These tests effectively consist of estimating regression:
c = a0 + a1yp + a2(y–yp) + u,
c: real per-capita consumption,
yp: real per-capita permanent income,
y: current per-capita real income,
u: disturbance term.
14







Results indicate that income decomposition matters.
That is propensity to consume out of yp exceeds
propensity to consume out of y.
These results are consistent with the consumptionsmoothing hypothesis.
But elasticity of c with respect to yp is not found to be
unity, nor is the propensity to consume out of y found to
be zero.
Thus, the strict form of the PIH is not often supported by
the data in developing nations.
Second type of evidence emerges from cross-country
studies of saving behavior.
If “hump” saving over the life cycle is important,
countries experiencing rapid growth in per-capita
15
incomes should exhibit high saving rates.






Evidence suggests that consumption smoothing over
the life cycle may be important.
Third type of evidence has to do with responses to
income shocks.
Changes in the terms of trade have been large in many
developing countries.
Bevan et al. (1993): effects of the 1976-1979 coffee
boom on farmers in Kenya.
Increase in coffee prices was passed on to small
growers, who thus experienced a windfall in income.
This windfall was understood to be temporary and
saved (consumption smoothing).
16
Length of Planning Horizon
and Liquidity Constraints



Evidence suggests that planning horizons extend
beyond a single period and some households are able
to move resources intertemporally.
This evidence is consistent with Deaton's suggestion
that the “dynastic family” construct is more relevant in
the developing world.
Measured incidence of liquidity constraints is
substantially greater in developing countries.
17
Corbo and Schmidt-Hebbel (1991):
 Variables measuring liquidity constraints are added
significantly to aggregate consumption equations.
 This result suggests two groups of consumers:
 those who smooth consumption over time;
 those whose consumption is limited by current
resources.
Haque and Montiel (1989):
 Point estimates of the share of total consumption
accounted for by households that simply spend their
current incomes.
 For fourteen of their sixteen countries the estimated
share exceeded 20%.
 These are larger than the typical estimate of 0.1 for the
18
United States.
Effects of Interest Rate
Changes on Savings
Some authors have found evidence of positive interest
rate effects on saving in developing countries, but
estimated effects are small.
Fry (1996):
 Sample of fourteen Asian developing countries over the
period 1961-1983.
 1% increase in the real deposit rate increased the
saving rate by about 0.1%.
 Giovaninni (1985) and Schmidt-Hebbel et al. (1992)
have failed to detect a statistically significant positive
interest rate effect.

19





Standard Lucas critique and data related problems
make the results difficult to interpret.
Alternative: estimate the intertemporal elasticity of
substitution directly.
If utility function exhibits constant relative risk aversion,
(3) will relate the rate of growth of consumption to the
difference between the r and , with a factor of
proportionality equal to the intertemporal elasticity of
substitution.
Estimation of the Euler equation can thus yield an
estimate of the intertemporal elasticity of substitution.
This approach estimates a “deep” parameter directly
and relies on consumption data.
20
Giovaninni (1985) finds statistically significant
intertemporal elasticity of substitution (averaging about
0.5) in only 5 out of 15 cases.
Rossi (1988):
 Allows for liquidity constraints and direct substitutability
between private and public consumption.
 He found larger estimates of the intertemporal elasticity
of substitution.
 But these were too small to say that changes in real
interest rates affect consumption.
Ogaki, Ostry and Reinhart (1996):
 Estimate effects of real interest rates on saving.
 Intertemporal elasticity of substitution varies with the
level of wealth.

21




They find that sensitivity of saving to the interest rates
rises with the level of income.
In low-income countries, estimates of the intertemporal
elasticity of substitution are low.
Range of estimated values for the intertemporal
elasticity of substitution is large: from 0.05 to 0.6.
Even the highest estimates remain small, so effect of
changes in interest rates on saving is weak.
22
Public and Private
Consumption



Could public consumption be a direct substitute for
private consumption in developing countries?
McDonald (1983) finds results consistent with this view.
Karras (1994) suggests that private and public
consumption expenditure are complementary rather
than substitutes.
23
Private Investment


Specification Issues.
Determinants of Private Investment: The Evidence.
25
Why investment is important?
 It determines the rate of accumulation of physical capital
and is thus an important factor in the growth of
productive capacity.
 Because it is a forward-looking activity with irreversible
aspects, it is a volatile component of aggregate
demand.
26
Specification Issues





Empirical investment functions for industrial countries
have relied on either a “stock” or a “flow” approach.
Under the stock approach:
Price of installed capital is pk.
Given a discount rate  and rate of depreciation , the
rental price of capital is  = ( + )pk.
Flow profit function:
(k) = py[k, n(w/p, k)] – wn(w/p, k),
p: price of output;
w: nominal wage;
n(·): level of employment.
27

Optimal capital stock k* satisfies
(k*) = .

Given an initial capital stock k0, net investment
represents a gradual adjustment of the actual to the
desired capital stock.

Gross investment is derived by adding to this an amount
of replacement investment that is proportional to the
initial capital stock.
Under flow model:

Convex function h(I): total cost of achieving the level of
gross investment I.
28

If the firm's objective is to maximize the present value
V(k) of its profits (k) net of the costs of investment ph(I),
then at each period rate of I must satisfy
h(I*) = q/p,
q = dV(k)/dk : marginal value of installed capital at the
current period;
q/p: marginal value of “Tobin's q” (ratio of the value of
installed capital to its replacement cost).
29
Determinants of investment in stock version:
 expected future values of aggregate demand;
 user cost of capital;
 wage rate;
 initial capital stock.
 Determinants of investment in flow version:
 marginal value of Tobin's q;
 parameters of the adjustment-cost function.
Modification of standard industrial-country investment
theory is required in developing country analysis:
 Investment functions are heavily dependent on
institutional environment in financial system; but equity
markets are absent and prevalence of financial
repression is prevalent in the developing world.
30



Imported capital goods are important in the developing
world; so foreign exchange rationing, and cost of foreign
exchange may be important determinants of private
investment behavior.
Role of imported intermediate goods are important; so
specification of relative factor prices in empirical
investment functions cannot be restricted to the wage
rate and user cost of capital:
 Domestic-currency price and availability of such
goods must be also taken into consideration.
 Servén (1990b): long-run effect of a real devaluation
on private capital formation is ambiguous.
 It depends on the effect of the real depreciation on
the import content of capital goods.
31


Existence of a debt overhang in many countries:
possibility that confiscatory future taxation will be used
to finance future debt service may need to be reflected
in the specification of private investment behavior.
Large role of the public capital stock suggests the need
to incorporate complementarity-substitutability
relationships between public and private capital into
private investment decisions:
 Public sector investment crowds out private
investment expenditure if it uses scarce physical and
financial resources that would otherwise be available
to the private sector.
 Public investment to maintain or expand
infrastructure and provision of public goods are
complementary to private investment.
32

Macroeconomic instability and resulting uncertainty may
have a large influence on private investment:
 There will be a tendency to delay irreversible
investment in the face of uncertainty.
 Delay involves trading off the returns from investing
now against the gains from being able to make a more
informed decision in the future.
 Servén (1996): interactions between instability,
irreversibility, and uncertainty played a significant role
in the poor investment performance of sub-Saharan
Africa.
33
Determinants of Private
Investment: The Evidence
Rama (1993):
 Thirty-one studies conducted over the period 1972-1992.
Problems:
 All of them are vulnerable to the Lucas critique.
 Moreover, many of them employ ad hoc investment
functions.
 Treatment of expectations is often rudimentary.
 In several cases the dependent variable is total, rather
than private, investment.
 Data are typically annual, and the available time series
are often very short.
34
Estimating techniques do not always handle simultaneity
problems.
Conclusions of the evidence:
 Aggregate demand plays an important role driving
private investment (consistent with “flexible accelerator”
specification).
 Relative factor prices enter the stock version of the
theoretical investment function; but little information is
available on effects of financial variables on private
capital formation through user cost of capital in
developing countries.
 Credit variables have a statistically significant coefficient
with the expected sign.

35



Indicators of foreign exchange availability tended to
behave as expected.
Seven out of eleven studies found a positive role for the
public capital stock.
 When a distinction is made between infrastructural
and other types of public investment, more significant
results are obtained (Blejer and Khan (1984)).
 Results are consistent with the hypothesis that
infrastructural investment is complementary to
private investment,
increases in other types of government investment
crowd out the private sector.
Indicators of macroeconomic instability of various types
have significant negative effects on private investment.
36




Rodrik (1991): uncertainty on the part of economic
agents regarding the government's future intentions
affects investment behavior.
Larraín and Vergara (1993): real exchange-rate
variability has an adverse effect on private capital
formation.
Cardoso (1993) and Bleaney and Greenaway (1993a):
fluctuations in the terms of trade affect private
investment.
Fitzgerald et al. (1994), Greene and Villanueva (1991),
Oshikoya (1994), and Schmidt-Hebbel and Muller (1992):
significant negative effect of the debt output ratio on
investment.
37

Cohen (1993): stock of debt itself does not have a
significant influence on investment, but that debt service
may have crowded out investment.
38
The Demand for Money


Conventional Money Demand Models.
Currency Substitution and the Demand for Money.
 Domestic- and Foreign-Currency Deposits.
 Currency Substituton: The Evidence.
40
Conventional Money
Demand Models
Conventional models of money demand in developing
countries include
 real income as a scale variable;
 rate of inflation as an opportunity cost variable.
Reasons for why domestic interest rates are excluded.
 Alternative financial assets are assumed not to be
available.
 Government regulations imply that such rates display
little variation over time.

41



Early studies that introduced nominal interest rates in
money demand functions met with little success.
Some recent studies have found a significant effect of
interest rates on money demand in developing nations
where financial markets have
 reached a relatively high degree of diversification;
 began to operate with relative freedom from
government intervention and regulations.
Statistically significant effects of interest rate variables on
the demand for real money balances.
 Arrau et al. (1995), José Rossi (1989) for Brazil;
 Reinhart and Végh (1995) for Argentina, Chile, and
Uruguay.
42





Foreign interest rate can be relevant opportunity cost of
holding domestic monetary assets.
 Hoffman and Tahiri (1994) for Morocco;
 Calvo and Mendoza (1996) for Mexico.
Limitation: ignore interest rate in informal credit markets
as a relevant opportunity cost of holding cash.
This neglect may explain why early studies using official
interest rates were not very successful.
Van Wijnbergen (1982): informal-market interest rate had
a significant effect on the demand for time deposits in
Korea.
Problem: lack of adequate time series information on
informal interest rates in most countries.
43


Exclude interest rates and assume a partial adjustment
mechanism of actual to desired levels.
Conventional money demand function:
lnm = a0 + a1 ln y -
a
a2+k
+ (1-) lnm-1 + u, (8)
m: real money balances;
y: real income;
a
+k: expected inflation rate for k periods ahead;
u: disturbance term;
0 <  < 1 : speed of adjustment.
44
Estimation of (8) raises econometric issues related to
simultaneity, the choice of proxy variables for
expectations, and so on.
Two-step estimation approach:
 Estimate the long-run determinants of the demand for
money using cointegration techniques.
 “General-to-specific” approach is used to specify the
short-run dynamics of money demand.
 Asilis et al. (1993) for Bolivia, Domowitz and Elbadawi
(1987) for Sudan, and Ahumada (1992) for Argentina.

45


Advantages of this approach:
 provides richer specification of the short-run
dynamics;
 better predictions of the short-run behavior of real
money holdings.
Problems:
 Long-run parameter estimates do not vary significantly
from those derived by less sophisticated techniques.
 Excessively long lags in estimated money demand
equations.
46
Currency Substitution
and the Demand for Money
Currency substitution: foreign currency substitutes for
domestic money as a store of value, unit of account, and
medium of exchange.
 This has become a pervasive phenomenon in many
developing countries.
What does the degree of currency substitution depend
on?
 Assets denominated in domestic currency cannot
provide an efficient hedge over time in countries where
 inflation is high;

47
opportunities for portfolio diversification are limited;
 ceilings on domestic interest rates are present.
Degree of currency substitution is higher when there are




low transactions costs of switching from domesticcurrency assets to foreign-currency assets;

uncertainty about social and political developments;

fear of expropriation of assets denominated in
domestic currency;

potential need to leave the country.
Existence of informal markets facilitates transactions in
foreign exchange may reinforce the substitution between
domestic- and foreign-currency assets.
48
Domestic- and Foreign-Currency Deposits

Figure 3.1: evolution of foreign-currency-dominated
deposits in Egypt and Indonesia.

Short- and long-run consequences of an increase in the
holdings of foreign currency (Agénor and Khan, 1996).
Short run effects:

Rise in foreign-currency deposits held abroad is
equivalent to a capital outflow.

This can have destabilizing effects on

domestic interest rates;

exchange rate;

international reserves.
49
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51

Outflow may create a shortage of liquidity in the
domestic banking system.

This puts upward pressure on domestic interest rates.

Outflow depreciates the domestic currency under a
floating exchange-rate regime.

If the government is committed to defending a particular
exchange rate, it would deplete its reserves.

Residents increase transfers abroad by foreseeing
devaluation and higher inflation or the imposition of
exchange controls when a country faces

possibility of a balance-of-payments crisis;

immediate corrective policy action is not taken.
52

Consequently, funds are shifted abroad, accelerating the
erosion of official reserves and precipitating the crisis.
Long run effects:

They are seen if the resources are permanently lost by
the home country.

Reduction in available resources to finance domestic
investment leads


in the short run to a reduction in activity;

in the long run to a decline in the rate of capital
formation, thus in the country's growth rate.
Reduction in government's ability to tax all the income
earned by its residents.
53

Thus, there is an increased need to

borrow from abroad;

domestic monetary financing (higher long-run inflation
rate).
54
Currency Substitution: The Evidence


To capture the effect of currency substitution, researchers
introduce

interest rate differential between domestic and foreign
interest rates, or if it is not available;

expected rate of depreciation of the exchange rate.
Expected rate of exchange-rate depreciation is proxied by

actual rate of depreciation of the exchange rate;

deviations from purchasing power parity, with foreign
prices valued at the parallel market rate (Blejer, 1978);
55


Ramírez-Rojas (1985):

differential between the domestic and foreign
inflation rates for Argentina and Mexico;

3-month future price of the U.S. dollar in pesos for
Mexico;

differential between the domestic interest rate paid
on deposits denominated in domestic currency for
Uruguay;

domestic interest rate paid on foreign-currency
deposits for Uruguay;
rate of depreciation of the black market rate
augmented with the foreign inflation rate Phylaktis and
Taylor (1993).
56

Evidence supports the existence of significant currency
substitution effects in many developing countries.

Some studies use data on domestic foreign-currency
deposits.
57

Regression equation takes the form:
ln (M/EF) = a0 - a1a + …
(9)
+ (1-) ln (M/EF)-1+u,
M and F: domestic and foreign currency holdings;
E: exchange rate;
a: expected rate of depreciation;
u: disturbance term;
0 <  <1: speed of adjustment.

(9) relates the currency ratio

inversely to expected rate of depreciation;

to lagged values of the currency ratio.
58

Inclusion of the inflation rate as an additional regressor
is avoided due to the high degree of collinearity between
inflation and the rate of depreciation.

Domestic-foreign interest rate differential is sometimes
included in the studies of the countries for which data on
domestic market-determined rates are available.

Calvo and Végh (1996): (9) tests existence of a
dollarization phenomenon rather than currency
substitution.

Reason: it does not capture the role of foreign-currency
holdings as a medium of exchange.
59

In some studies, data on foreign currency deposits held
domestically are supplemented by available information
on monetary assets held overseas.

Savastano (1992) uses data on foreign-currency
deposits both at home and abroad in the United States
in his study of currency substitution in Latin America.

In their study of dollarization in Argentina, Kamin and
Ericsson (1993) use an estimate of the stock of dollars
circulating in that country.
60
Agénor and Khan (1996):
 Data on deposits held abroad by residents of developing
countries and estimate a dynamic, forward-looking
model of currency substitution.



Model is developed in two steps.
 Desired composition of currency holdings is derived
from an optimizing model of household behavior.
 Actual currency holdings are then determined in a
multiperiod, costs-of-adjustment framework.
Complete solution of the model leads to an empirical
specification that incorporates both backward- and
forward-looking elements.
Important feature: it does not require information on the
domestic interest rate.
61

Empirical evidence:

foreign interest rate

expected rate of depreciation of the parallel market
exchange rate
are important in the choice between domestic money
balances and overseas foreign-currency deposits.
62
Aggregate Supply Functions



Cross-Regime Tests.
Within-Regime Tests.
An Assessment of the Evidence.
64





Controversy:
 “New classical” macroeconomics, featuring the Lucas
“surprise” supply function, versus
 Keynesian “sticky wage” formulations as empirical
approximations to short-run supply behavior.
Degree of stickiness of wages and prices depends on
institutional structure of labor markets.
Taylor (1980): staggered, overlapping multiperiod wage
contracts cause sticky nominal wages.
Corden (1989): less-organized labor markets in
developing countries make Keynesian nominal wage
stickiness less likely to be observed.
It may be more feasible to characterize labor markets in
developing countries as auction markets.
65






Then the Lucas “surprise” short-run aggregate supply
function may be relevant for developing countries.
This function postulates a positive relation between
output and unexpected movements in prices.
In the Lucas model, workers cannot infer the aggregate
price level based on contemporaneously available
information.
Policy ineffectiveness proposition in new classical
macroeconomics requires the use of rational
expectations on the part of economic agents.
Relevance of this mechanism for the formation of
expectations has been questioned for developing
countries.
Reason: scarcity of information.
66
Relevance for developing countries of the policy
neutrality proposition associated with new classical
macroeconomics and the Lucas supply function.
 Tests of the neutrality proposition for developing
countries have taken two forms.
 Cross-regime tests: empirical plausibility of the “surprise”
supply function itself using cross-sectional evidence,
following the approach of Lucas (1973).
 Within-regime tests: power of anticipated aggregate
demand policy to affect the deviation of actual real
output from its capacity level, following Barro (1978).
 They use time series data for individual countries.
67
Cross-Regime Tests



If agents know
 true distribution of relative prices,
 average price level,
 their own selling price
when formulating supply decisions, they face an
inference problem.
Reason: their supply choice depends on the
unobservable relative price of what they sell.
Optimal forecast of the aggregate price level: weighted
average of the price they observe and the mean of the
aggregate price level distribution.
68



The more variable the nominal demand in the economy,
the more agents will interpret an observed increase in
their own selling prices as a change in the aggregate
price level rather than in relative prices.
Thus, the smaller will be their supply response.
“Surprise” supply function:
~
y = y + (p–pa) + (L)y-1,
(10)
~
y: actual output;
y: “normal” output;
p: actual price level;
pa: expected price level;
 : decreasing function of the variance of aggregate
demand.
69




In more unstable aggregate demand regimes, the shortrun aggregate supply function will be steeper in the
price-output space.
Lucas (1973): small size of  in Argentina and Paraguay
provided his only two volatile observations.
Williams and Baumann (1986) use nonparametric
methods and found significantly different from zero
correlation.
Ram (1984) used extended country group and
supported the predictions of Lucas's model.
70
Jung (1985):
 Refined Lucas's test by noting that the slope of the
aggregate supply curve in Lucas's model depends on
 variance of nominal income, but also
 variance of relative prices,
 responsiveness of supply to unanticipated changes in
relative prices.
 Thus, tests tests need to examine the partial correlation
between nominal income variance and the slope of the
supply curve.
 He found a negative partial correlation.
 This result is consistent with Lucas's formulation, but the
relationship was statistically weaker for developing.
71


Limitation: these tests do not discriminate among
competing hypotheses.
To obtain more definitive results, it is necessary to use a
test that can discriminate between these competing
models of short-run supply behavior.
72
Within-Regime Tests



This empirical testing of the Lucas supply function
satisfies this criterion.
This test estimates the reduced-form output equation
emerging from a model that incorporates the function as
its description of short-run supply behavior (Barro, 1978).
Adding to the supply function (10) an aggregate demand
function:
y = (m-p) + Z,
 > 0,
(11)
m: logarithm of the nominal money supply;
Z: vector of other variables that affect aggregate
demand.
73

This yields a reduced-form equation for y:
~
y = y + a1(m-ma) + a2 (Z-Za) + a3(L)y-1, (12)





ma and Za: expected values of m and Z.
(12): only unanticipated changes in m and Z can cause y
to deviate from its full-capacity level.
This is in contrast to the “sticky wage” Keynesian
formulation.
Policy ineffectiveness proposition follows from (12).
Reason: systematic aggregate demand policy would be
foreseen by economic agents who know the rule.
Thus, it would be incapable of generating unanticipated
changes in m or Z.
74




Test of the model against the Keynesian alternative
involves
 estimating (12)
 determining whether anticipated changes in m and Z
add explanatory power to the regression (12) after the
unanticipated components have been included.
Because these tests require the specification of
anticipated changes in m and Z, the rule governing the
behavior of these variables must be estimated jointly with
(12).
Because m is a policy variable, and if policy variables are
included in Z, these rules imply stable policy regimes.
These tests are therefore within-regime tests of the
“surprise” supply function.
75
Tests represent joint tests of the “surprise” supply
function and the assumed expectations mechanism.
 Barro (1979a): link between money growth and output in
Mexico, but no strong links in either Brazil or Colombia.
Hanson (1980):
 Statistically significant small effects of unanticipated
money growth on output in Brazil, Chile, Colombia,
Mexico, and Peru.
 Different processes explained money growth in different
countries.
 Not test for the importance of the anticipated
unanticipated distinction.

76
Edwards (1983):
 Takes into account the role of fiscal deficits in causing
money growth.
 Significant effects of money growth (anticipated or not) in
only three of nine Latin American countries.
Canarella and Pollard (1989):
 Significant effect of unanticipated money growth on real
output, and negative effect on the price level.
 Significant negative relationship between unanticipated
money growth and its predictability.
Sheehey (1986):
 More comprehensive set of predictors for monetary
policy.
77
His results were not supportive of the Lucas supply
function.
 Weak negative association between the variance of
unanticipated money growth and the effect of
unanticipated money on output.
 This raises questions about the strength of the crossregime evidence.
Choudhary and Parai (1991):
 Estimated reduced-form output equations including
contemporaneous and lagged terms in both
unanticipated and anticipated money.
 Tested exclusion restrictions on the anticipated money
terms.
 Found anticipated money had effect.

78
Chopra (1985):
 Estimated a reduced-form price level equation using
aggregate demand as the policy variable.
 Keynesian formulation: this equation would
 contain lagged prices,
 impose equal coefficients on anticipated and
unanticipated aggregate demand components.
 Lucas formulation excludes lagged prices and require a
unitary coefficient on anticipated movements in
aggregate demand.
 Restrictions imposed by the Lucas formulation were
consistent with the estimated parameters in 3 out of 13
cases.
 In 6 cases these restrictions were rejected in favor of the
79
Keynesian alternative.
An Assessment of the Evidence
Although the cross-regime tests support the Lucas
supply function in developing countries, such tests do not
necessarily discriminate against a Keynesian alternative.
 Within-regime tests have not always been applied in that
way.
 Where they have applied, the Keynesian alternative is
not easily rejected in developing countries.
Evidence is weak for two reasons:
 Geographic coverage of this research has been quite
limited, focused on Latin America.
 Existing within-regime tests use simple “representative”
industrial-country macroeconomic models.

80




If the relevant developing-country model is different, then
the reduced-form output equation will be misspecified.
Example: if capital mobility is high,
 anticipated or unanticipated money should not enter a
reduced-form output regression in a “new classical”
model,
 but fiscal policy and foreign interest rates should.
Failure of several of the studies may reflect high capital
mobility not failure of “surprise” supply function.
Conclusion: Keynesian features could be defended if
models were generalized to yield reduced-form output
equations nesting both classical and Keynesian
hypotheses.
81
Appendix
Uncertainty, Irreversibility,
and Investment:
A Simple Example





Effects of uncertainty and irreversibility on investment.
Risk-neutral firm must decide whether to invest in an
irreversible project at the purchase cost pK in period t =
0.
If investment takes place at the beginning of period t = 0,
it will yield a known return of R0 at the end of the period,
and then an uncertain return R in every future period.
Given the information available at t = 0, expected value
of the future return is E0R.
Net present value of anticipated return stream of cash
flows associated with the project is

R0
+
V0  -pK +
(1+r)
r: discount rate.
[
1
(1+r)
]
2
(1+r)-iE0 R,
i=0
83

Rearranging this:
R0 + E0R/r
V0  -pK +
(1+r)

Applying a conventional net present value criterion would
suggest that the firm should invest as long as V0 > 0:
E0R - rpK
R0 - rpK +
> 0,
r


(A2)
rpK: user cost of capital.
If investment were fully reversible, then the future would
not matter.
Then optimal decision rule: invest today as long as
R0 - rpK > 0.
84
Irreversibility requires taking into account the difference
between expected return and user cost of capital as well.
 Although (A2) can hold in an ex ante sense, ex post it
may not.
 Reason: there is a nonzero probability that in a future
period R-rpK < 0.
 Thus, firm may be “locked in” an unprofitable venture.
 Therefore, it has incentives to delay investment in order
to learn more about the factors affecting future return.
How does uncertainty affect (A2)?
 Consider the case that firm knows for sure that
uncertainty will vanish in t = 1 and that the project's
returns for t > 1 will remain constant.
 Firm decides not to invest at all today and to invest next
period if and only if the realized return exceeds rpK. 85


In that case, net present value of the anticipated stream
of cash flows will be given by
V1  Pr(R > rpK)
{

-pK
+
(1+r)
[
1
(1+r)
2 
]
}
(1+r)-iE0(R | R >
i=0 rpK)
Pr(R > rpK): probability that the project's return exceeds
the cost of capital;
E0(R | R > rpK): expected value of R, conditional on the
project's return exceeding the cost of capital.
Comparing the above strategy with the previous case
can be done by calculating
86

Comparing the above strategy with the previous case
can be done by calculating
1
V1 - V0 =
(1+r)
{
E0(rpK - R | R  rpK)
Pr(R > rpK)
r
- (R0-rpK)

}
Firm is better off investing today if V1 - V0 < 0, a condition
can be written as
E0(rpK - R | R  rpK)
(R0 - rpK) > Pr(R  rpK)
r
(A3)
87




This equation compares cost of waiting (R0 - rpK), with
value of waiting (R  rpK).
Expected present value of the mistake is measured by
the right-hand side of (A3):
 mistake is made with probability Pr (R  rpK);
 its expected per-period size, given today's information,
is E0(rpK - R | R  rpK);
 because it accrues every period into the indefinite
future, it has to be multiplied by 1/r to transform it to
present value terms.
It pays to invest immediately only if cost of waiting
outweighs value of waiting.
Implication of (A3): possibility that in the future R may
exceed rpK has no effect on the investment threshold and
88
thus no effect on the decision to invest today.


Reason for this asymmetry: option to wait has no value in
states in which investing would have indeed been the
right decision.
This option value of waiting is given by
 = max(V1 - V0, 0).

Another implication: increase in the spread of the
distribution of future returns that raises the likelihood of
“bad” outcomes will
 raise the critical threshold that the marginal
productivity of capital must reach;
 thus tend to depress investment.
89