Innovations in Macroeconomics

Innovations in Macroeconomics

Paul J.J. Welfens

Innovations

in Macroeconomics

Third Edition

2123

Prof. Dr. Paul J.J. Welfens

EIIW – European Institute for International

Economic Relations

at the University of Wuppertal

Rainer-Gruenter-Str. 21

42119 Wuppertal

Germany

and

Sciences Po, Paris

27, Rue St. Guillaume

[email protected]

ISBN 978-3-642-11907-1 e-ISBN 978-3-642-11909-5

DOI 10.1007/978-3-642-11909-5

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Preface to the Third Edition

It is certainly unusual to have a book in its third edition within four years—I hope

that this testifies to the growing interest in innovation dynamics on the one hand

and on the other hand in finding better ways for macroeconomic modeling. I have

benefited from encouragement from David Audretsch and several other colleagues;

this particularly refers to the cooperation in a Jean Monnet Project where I have

enjoyed fruitful discussions with Cillian Ryan and Andrew Mullineux, University

of Birmingham. As regards the new chapter on the Transatlantic Financial Market

Crisis I am also indebted to discussions with Werner Roeger and Jürgen Kröger,

European Commission, Caroline Fohlin, Johns Hopkins University, Baltimore and

Walter Eubanks, Congressional Research Service, Washington DC; the author also

appreciates the debate at the Global Jean Monnet Conference/ECSA-World Confer￾ence 2008 “A Europe of Achievements in a Changing World”; Brussels, November

24-25, 2008. I am also grateful for technical support by Michael Agner, University of

Odense and Mevlud Islami as well as Jens Perret, EIIW/Schumpeter School of Busi￾ness and Economics at the University of Wuppertal. The new medium-term hybrid

macro model presented in the first edition seems to be particularly useful in under￾standing the effects of the international banking crisis: Output is determined—via

a modified version of Friedman’s permanent income consumption hypothesis—by

both short-term aggregate demand and by the anticipated long-run (steady state) in￾come as derived from the neoclassical growth model. I have also included a chapter

on financial innovations in this enlarged edition. The readers interested in a broader

analysis of the international banking crisis are invited to take a closer look at the book

Transatlantic Banking Crisis and Sovereign Debt Dynamics. Explaining a Modern

Disaster of the West is suggested, but the offered reflections only give a new starting

point in this field. The institutional innovations suggested here and presented at the

Congressional Research Service, the European Commission, the University of Eco￾nomics and Finance, St. Petersburg, and the Johns Hopkins University, Baltimore, in

2009 are part and parcel of innovative institutional reforms that seem to be necessary

in a world economy with potentially unstable globalization dynamics. Last but not

least, I am also grateful to the institutional network at the Schumpeter School of

Business and Economics at the University of Wuppertal.

v

vi Preface to the Third Edition

One of the final chapters look into a reformulation of the Marshall-Lerner con￾dition for a world with foreign direct investment and comes up—compared to the

standard approach—with rather different results for some parameter constellations.

As foreign direct investment continues to grow relative to GDP in many countries,

one should carefully consider the implications, namely that real depreciations of

currencies will often only contribute to a change in the current account position to

a limited extent; this is a point that has been emphasized time and again by Ronald

McKinnon (the specific points which I suggest are, however, somewhat different to

the well-known arguments of McKinnon). Moreover, new approaches to optimum

growth and for the link between trade, FDI and output are developed. Finally, the

role of a hybrid macroeconomic model for the understanding of banking crisis is

emphasized—and new insights into modified neoclassical growth models of closed

and open economies are considered (with due emphasis on innovation dynamics and

R&D employment as well as aspects of the CES-function).

Those who consider market economy and democracy as two crucial elements for

a decent life cannot avoid to frankly discuss the strange developments of financial

globalization and to push for consistent reforms. The responsibility for the analysis

is all mine.

December 2010 Prof. Dr. Paul J.J. Welfens

Wuppertal and Paris

Preface to the Second Edition

Within one year, this book has already been published in a second edition, testifying

to the broad interest in the important subjects covered. I have made some clarifica￾tions and also some corrections, while also adding a new chapter on Innovations and

the Economics of Exhaustible Resources, an important field with respect to the link

between modern Schumpeterian innovation analysis and macroeconomics. In Chap.

G, there are additional reflections on the ambiguity of the traditional approach of

optimum growth theory as well with key insights drawing on my Kondratieff Prize

Lecture in Moscow in 2007. I have also added some new ideas on the Macroeco￾nomics of Microeconomics which basically argues that there should be a double

consistency in Economics.

The basic perspective of this book is to emphasize the need to consider the innova￾tion phenomenon in a broader perspective; it is not only relevant for certain cyclical

dynamics but also—in a more traditional vein—for long term growth analysis as

well as sustainable economic development.

I have particularly benefited from my visiting Alfred Grosser professorship

2007/2008 at Sciences Po, Paris, and the interesting discussions with Antoine

Leblois, Paris, and the suggestions of Gerhard Huhn, Mevlud Islami and Jens Perret,

EIIW Wuppertal. Finally, I am grateful to discussions with my colleagues in the

Jean Monnet Project Financial Market Integration, Structural Change, Foreign Di￾rect Investment and Economic Growth in EU25. I am particularly grateful to Julius

Horvath at the Central European University, Budapest.

My greatest gratitude goes to my wonderful family who has supported my research

with so much patience over so many years.

December 2008 Prof. Dr. Paul J.J. Welfens

Wuppertal and Paris

vii

Preface to the First Edition

This book deals with the role of innovations in macroeconomics, and it presents

innovations in macroeconomic theory. Growth and structural change are key issues

here, but we also touch upon links between exchange rate dynamics and innovations.

The approaches and ideas presented are not integrated into a large comprehensive

model. Rather, we present analytical building blocks in selected fields of Schum￾peterian Macroeconomics, including new insights about trade, growth, exchange rate

dynamics, innovations and policy options.

An important starting point in Chap. A is a generalization of the Solow growth

model and a long term analysis of the link between process innovations and the

price level as well as the exchange rate, which is shown to critically depend on the

income elasticity of the demand for money. Moreover, we discuss the long term

Phillips curve in the context of a growth model and can thereby gain some new

insights. The theoretical reflections presented suggest the need for new empirical

work. We also consider the role of foreign direct investment flows. Chapter B is an

attempt to bridge the medium term analysis with the long run growth analysis. It is

argued that individuals will partly base consumption—and thus savings—on current

income and expected steady state income. While this approach is closely related

to the permanent income hypothesis, its specific implications are quite interesting.

Chapter C takes a closer look at some integration issues. Chapter D puts the focus

on both growth in open economies and the real exchange rate. The analysis in Chap.

E is again devoted to open economy topics, where we present a Mundell-Fleming￾Schumpeter model with product innovations. Chap. F focuses on the link between

stock market dynamics and the exchange rate, and the framework presented is new

and works rather satisfactorily from an empirical perspective. Chapter G starts with

the traditional optimum growth framework and then proceeds by looking at the topic

of endogenous growth (or quasi-endogenous growth). Chapter H involves trade,

structural change and growth in open economies, while Chap. I looks at the role of

innovations in a digital market economy. Chapter J puts the focus on EU innovation

policy and raises some critical questions about the EU economic policy. Finally,

Chap. K considers some aspects of monetary integration and growth including basic

policy implications. In a rather simple approach, we explain why the integration of

global financial markets has brought about a global fall of the interest rate along with

ix

x Preface to the First Edition

a higher stock market price index. Essentially, there is an interplay between Asian

capital inflows into the US and an increasing international bonds substitutability

concerning Dollar-denominated and Euro-denominated assets (the start of the Euro

has created a European bonds market which effectively offers better substitutes to the

Dollar bonds than was the case for the previous DM-$ comparison). We also look at

some other monetary issues. As regards the link between economic policy measures

and economic development, one should emphasize that policy makers rarely make

the crucial distinction between changes in the level of the growth path and the growth

rate itself. This distinction is quite important in the context of the basic and modified

neoclassical growth model.

Possibly the most important shift of analytical emphasis is the idea that one should

take a look at various modeling approaches whereby the choice of model depends

on the time horizon and the specific initial situation. From a policy perspective

medium term models could be quite useful, however there is no adequate model

which bridges the short run and the long run. One of the new ideas presented here

is to link the short term and long run aspects in a new medium term Keynes-Solow

model. In this approach, it is emphasized that both aggregate demand and aggregate

supply determine the dynamics of actual income. In a medium term perspective, this

approach can also be applied to hybrid growth modeling; in reality there is rarely a

case for which only the demand side or only the supply side is valid.

Some of the analytical elements presented are refinements or extensions of existing

approaches; other contributions aim at clarifying apparent inconsistencies in the

literature. An important aspect here is the inconsistency, implying for instance that

Poland or China export mainly capital goods to the USA and EU15, while reality is

characterized by trade flows of machinery and equipment in the opposite direction

between neoclassical growth theory and neoclassical (Heckscher-Ohlin-Samuelson)

trade theory. Economics is a scientific field in which competition among researchers

stimulates the specialization of scientists as well as the exploration of narrow islands.

Little research is devoted to building intellectual bridges between islands in order to

analyze the combined insights or to combine possible variants of models developed

on each island. A few bridges are presented here.

In market economies, innovation dynamics have played a crucial role since the

Industrial Revolution. Schumpeterian Economics has analyzed some of these devel￾opments on the basis of an evolutionary approach which is useful in many fields. At

the other end of the spectrum, there are innovation researchers who persue a rather

narrow focus on invention and novel products or on new process technologies in

certain sectors. This is unsatisfactory in the sense that innovation dynamics should

be combined with macroeconomic analysis, including growth analysis and models

of stabilization policy. The new growth theory has delivered some interesting re￾sults including aspects related to product differentiation and spillover effects. In a

different context, real business cycle models have shown that technological changes

are able to generate economic cycles in a quasi-Walrasian world with no frictions

in markets. However, the latter is a contradiction in itself since every innovation

automatically creates information asymmetries which, in turn, take us away from

competitive market clearing.

Preface to the First Edition xi

From an input perspective, one can measure innovation dynamics to some extent

using the ratio of expenditures on research and development (R&D) to Gross Do￾mestic Product or R&D expenditures per capita, from an output perspective through

the number of (international) patents or patent applications per capita. In the sec￾ond half of the twentieth century, the R&D-GDP ratio increased continuously in

OECD countries as did the number of patent applications per capita. At the start of

the twenty-first century the R&D-GDP ratio in the leading OECD country, Sweden,

reached 4%, in Japan 3%, and in the US and the EU15 it was close to 2.5%, up

from about 1% in the early 1960s. It is not only impressive to observe how strongly

R&D expenditures have increased, but one must also consider the R&D-GDP ratio in

comparison with the investment-GDP ratio, which is around 20% in leading OECD

countries. As much as investment in machinery and equipment is the basis for the

accumulation of a physical capital stock, the stream of R&D expenditures amounts

to the accumulation of an R&D stock, which obviously contributes to the output

of individual firms and the overall economy. Patent applications also increased in

OECD countries in the 1980s and 1990s. However, many innovations cannot easily

be patented; software is a difficult field in this respect.

Patenting behavior can also change considerably as market structures change.

With respect to this, the case of liberalization in European fixed-line telecommuni￾cations is interesting. Apparently, privatized former state-owned monopolies have

intensified patenting which is natural in an environment that has become more com￾petitive and more internationalized. (At the same time it seems that innovation

activities have shifted away from network operators to the equipment industry.)

Changes in patenting behavior make interpretation of growth in patent applications

rather difficult.

The results of innovation efforts are not simply patents, but what matters most are

two types of innovations:

• Process innovations which imply cutting costs and thus bringing about a higher

equilibrium output in markets; even modeling the simple case of endogenous

technological progress in the context of a macroeconomic production function

is not easy. Special problems occur if the industry has static or dynamic scale

economies, a field not analyzed much in this book.

• Product innovations increase the willingness to pay on the demand side. This

is a field of particular interest here, specifically in the case of open economies.

Schumpeterian competition—based on product innovations—in a two-country

model no longer allows for the assumption that the law of one price will hold.

As discussed in Industrial Economics literature, existing innovation-related literature

in economics is divided on the one hand into innovation analysis. On the other hand,

there is a niche in macroeconomic analysis, with some strands in the new growth

literature looking into process innovations including technology spillovers. This is

done, for example, in models by ROMER and LUCAS. GROSSMAN/HELPMAN

have emphasized the role of product differentiation and hence product innovation

broadly defined. However, those are rare efforts which indeed concern only part of

macroeconomic analysis. This book seeks to add some building blocks to the existing

xii Preface to the First Edition

literature, offering a particular focus on open economies in which the role of foreign

direct investment and network effects in telecommunications is emphasized.

Moreover, we are interested in integrating innovations into short-term financial

market analysis and medium-term models of the Mundell Fleming type. By doing

so, we wish to link product innovations with modified long-term growth modeling.

It must be emphasized, however, that we will not present comprehensive macroe￾conomic foundations for the innovations in our analysis. We present new ideas and

building blocks for more realistic macroeconomic modeling on issues such as real ex￾change rate dynamics, fiscal and monetary policies in economies with foreign direct

investment, and issues related to the use of telecommunications and the internet.

At the bottom line, it certainly is desirable to combine the analytical blocks devel￾oped here to a more comprehensive two-sector growth model for an open economy,

but this ambitious goal is beyond the scope of this book. Our more modest aim is

to suggest consistent improvement in Macroeconomics including approaches valid

for a situation with unemployment. (In this context, a theoretical basis for OKUN’s

Law is presented.) A key element in the approach presented is that the law of one

price is not assumed to hold strictly. This, however, is not really surprising for a

world economy in which many innovative firms in many countries contribute to im￾perfect competition in global markets. Moreover, in part of the analysis presented

here we look into convergence dynamics and product upgrading. At the same time,

we integrate unemployment into some of the models.

It would be a true surprise if this book is liked by very many, as the approaches

presented are to some degree unorthodox and also bridge Real Economics and Mon￾etary Economics, which in the standard literature are rather distinct fields. This book

should, however, have a lasting impact by encouraging economists and policymakers

to take a fresh look at important macroeconomic topics and issues.

I am quite grateful to have had the opportunity to present some of my ideas to

seminars at the IMF and the AICGS/the Johns Hopkins University in 2004 as well

as at the Research Committee on International Economics and Economic Policy

(Ausschuss für Außenwirtschaftstheorie und -politik) of the Verein für Socialpoli￾tik at the 2004 Paderborn meeting. Moreover, I would like to express my gratitude

for the excellent research support of Dora Borbély, Jens Perret and Andre Jungmit￾tag (EIIW at the University of Wuppertal) as well as Albrecht Kauffmann (EIIW

Center at the University of Potsdam). I am also grateful for discussions with many

colleagues during a conference at Chulalongkorn University in Bangkok in 2001 as

well as within the scope of the 2005 workshop “The EU and Asean Facing Economic

Globalization”, jointly organized by Jean Monnet Chairs at the University of Wup￾pertal and the University of Birmingham as well as the Center for European Studies,

Bangkok. With respect to stimulus of research, I would also like to mention the

intellectual support of my colleagues in the EU 5th framework project: “Changes

in Industrial Competitiveness as a Factor of Integration: Identifying Challenges

of the Enlarged Single European Market” (Contract No. HPSE-CT-2002-00148),

with special gratitude going to Anna Wziiatek-Kubiak (CASE, Warsaw) who offered

valuable criticism during the project meetings at CEPS, Brussels in November 2004

and November 2005. Finally, I am grateful to Jackson Janes from AICGS/The John

Preface to the First Edition xiii

Hopkins University who organized a seminar in Washington with SAIS in January

2006. My basic policy perception for continental Europa is that weak growth in the

Euro zone and in Germany in particular has reasons which can easily be identified.

The usual caveat holds here: I am solely responsible for the analysis. The editorial

support by Michael Agner, Stephanie Kullmann, and Christian Schröder is deeply

appreciated.

August 2006 Prof. Dr. Paul J.J. Welfens

Wuppertal and Washington