Macroeconomics, Financial Linkages and the Regions: Research Themes

New Classical and the New Open Economy Macroeconomic

A significant growth area in both closed and open economy macroeconomics is to develop models which have well-articulated frictions. In the open economy context, this research programme has become known as the New Open Economy Macroeconomics.

The models are being used to assess important policy issues, such as the effectiveness of the Stability and Growth Pact in facilitating the ECB’s fight against inflation, the nature of spillovers between the Euro-area and the United States, the importance of learning in obtaining determinate model solutions.

Scotland is fortunate to have a number of leading economists who make significant contributions to this literature Jacques Mélitz and Anton Muscatelli (Heriot Watt); Campbell Leith, Ronald MacDonald, Jim Malley, and Gabriel Talmain (Glasgow); Kaushik Mitra, Charles Nolan, Alan Sutherland, Christoph Thoenissen (St Andrews).

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Financial Markets, Growth and Development

Our understanding of the interaction between financial institutions (broadly speaking, banks and securities markets) and a country’s long-run growth performance remains rudimentary. Whilst statistical analyses show that across countries well-developed financial institutions correlate with a better growth record, our understanding of how and why these institutions develop within a particular country remains far from complete.

We need to dig deeper into history. For example it is illuminating to look at the emergence of financial and capital markets in the 18th and early 19th centuries: were financial crises exacerbated? How did equity capital impact on growth? There is, of course, much work on post-war growth, asking questions such as: How do monetary and fiscal policies affect growth? Which exchange rate regime is most conducive to growth? What is the mechanism through which financial crises and contagion inhibit growth?

A very exciting new development has been to incorporate modern political science into our thinking on economic growth. Again, Scotland has considerable strength in these areas, through the work of Kaushik Mitra, Charles Nolan and Gary Shea (St Andrews), Ronald MacDonald, Jim Malley and Joe Byrne (Glasgow), David Cobham and Anton Muscatelli (Heriot Watt), and Hassan Molana (Dundee).

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Asset Pricing and Finance Constraints

Over the long-run financial market depth may go hand-in-hand with a strong growth performance, but the notion that financial markets may exacerbate shorter-term fluctuations in output has long been a concern to policy-makers. We now understand that asset prices, and the fact that asset prices may be misaligned, have an important effect on the real economy.

In particular, the exchange rate is a key relative price that can deviate from its natural value for long periods of time, and this can have important implications for trade, investment and overall macroeconomic activity. Understanding higher frequency – i.e. day to day – exchange rate movements, and appreciating the importance of market microstructure, are vital topics of research. Other asset prices matter too, such as equity and house prices. Economists have found that small temporary shocks can cause shifts in wealth that give rise to large and persistent effects.

The policy implications of these findings remain under investigation: for example monetary policy may not be very effective if it reacts systematically to asset prices. There is an important link between this and the ‘Financial Contracting and Money’ theme in the Behaviour Incentives and Contracts programme. Key researchers in this area working in Scotland include, Alexander Kovalenkov and Ronald MacDonald, (Glasgow); Charles Nolan (St Andrews); Andrew Snell, John Moore and Richard Holt (Edinburgh), Hassan Molana (Dundee), David Cobham and Anton Muscatelli (Heriot-Watt).

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Policy Co-ordination and Fiscal Federalism

The design of both monetary and fiscal policies over the business cycle, and at longer-run frequencies, remains a central topic for macroeconomists, and many Scottish-based researchers are successfully contributing to our understanding of these issues. Of particular interest are the coordination issues that lie at the heart of the joint formulation of monetary and fiscal policies, since in the UK and many other countries these policies are in the hands of separate policymakers.

The debate is given an additional twist when one considers the impact of fiscal federalism, where elements of fiscal policy-making are delegated to sub-national policymakers. This may correct for some distortions at the expense of others. The increasing globalisation of financial, product and factor markets may reduce the effectiveness of national and regional policies. There is a need for policy coordination across countries and regions.

Julia Darby, Peter McGregor, Kim Swales and Ian Wooton (Strathclyde); Campbell Leith, Ronald MacDonald (Glasgow); Alan Sutherland, Christoph Thoenissen and Charles Nolan (St Andrews); Geoff Whittam and Mike Danson (Paisley); Jonathan Thomas (Edinburgh) and David Cobham, Jacques Mélitz and Anton Muscatelli (Heriot Watt) are among those working on these central topics.

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Regions and Globalization

The common threads linking international and regional economics are particularly clear when thinking of trade, investment and the location of production. Here the impact of tax regimes, language and legal differences, labour market restrictions, financial regulation, geography and agglomeration, on firms’ choices are explored both theoretically and empirically. The interdependence between regional and national economies becomes increasingly important as production becomes more fragmented with the intensification of globalization of manufacturing and service production. Research engages the twin issues of the outsourcing of production by national enterprises and the competition to attract from abroad, determining the optimal policy responses for regional and national governments.

Research is also engaging with the critical issues of: the sources of changing regional imbalances (within the EU as well as the UK); the determinants of regional growth, enterprise and productivity (for example, using micro plant and firm level data; the implications of financial development for entrepreneurship and growth at the regional level); the regional impacts of national policies (exploring, inter alia, the differential regional sensitivity to interest rate policies); regeneration and economic development (and the role of policies in this process); the economics of multilevel governance, and the vertical and horizontal linkages across regional and national levels of government. As an example of the latter the impact of the UK government’s recent radical programme of devolution and decentralization has been explored theoretically and through CGE simulation.

As one example of potential synergies we consider the two main elements of the economics of multilevel governance theme in more detail. The first element has a theoretical focus and concerns the issues of incentives, organisations and institutions within policy making in a spatial development context. The second concerns empirical work assessing the efficiency of devolved and delegated institutions. There is a vast, mainly American, literature that approaches these issues from a broad principal-agent, “political economy” perspective, making the scope for joint research with the Behaviour, Incentives & Contracts programme clear. Further, regional and national policy efficacy depends critically on the character and extent of labour mobility and the nature of the wage determination processes, while empirical analysis in this field utilises common micro-econometric tools, highlighting the important linkages which exist with the Work and Well-being programme.

A further example, of considerable concern currently in Scotland is the Government Audit Department (GAD)’s projection of a significant population decline in Scotland, and the attendant contraction in the working population and its associated ageing. The basis and ramifications of the GAD projections are currently being explored and the Fresh Talent Initiative evaluated. There is obvious scope for synergies with the research in the Work and Well-being programme on the impact of ageing (on the labour market and health care), and the potential for additional research council funding is substantial. Research exploring energy and environmental issues and their inter-linkages with regional and national economic development has also recently attracted substantial support from research councils, and this again offers exciting synergies with research in Work and Well-being.

Our understanding of these matters has clear relevance to Scotland and the other regions of the UK. There is considerable research strength already in place: Richard Harris, Ronald MacDonald and Anton Muscatelli (Glasgow), David Bell and Nick Hanley (Stirling) Brian Ashcroft, Gary Koop, Peter McGregor, Kim Swales, Lise Tole, Ian Wooton, and Robert Wright (Strathclyde), Felix Fitzroy (St Andrews), John Dewhurst and Catia Montagna (Dundee) and Mike Danson (Paisley). This grouping of researchers, in combination with the recently established Centre for Public Policy for Regions (CPPR) provides a very strong foundation on which to build.