Essays on exchange rates, capital flows and growth

Siourounis, G (2005) Essays on exchange rates, capital flows and growth. Doctoral thesis, University of London: London Business School.

Abstract

My thesis comprises of two parts. The first part consists of two chapters. The first chapter titled "A Model of Real Exchange Rates and Real Consumption Spending with Time Varying Discount Factors" generalizes a "no-arbitrage" or "real business cycle" equilibrium model by allowing for different time varying impatience parameters across countries and provides empirical evidence for this model vis-ä-vis a restricted one, where impatience parameters are constant. My contribution is to show, based on a generalization of the equilibrium model of exchange rates, that the test equation linking exchange rates to fundamentals should allow for heterogeneity in time preferences across countries and across time, as well as noise-that is the model should not be tested as an exact relation. The second chapter titled "Capital Flows and Exchange Rates" investigates the empirical relationship between capital flows and nominal exchange rates for five major countries. Recent international finance theory suggests that currencies are influenced by capital flows as much as by current account balances and log-term interest rates. Using Vector Auto Regressions (VAR's) I document the following: Incorporating net cross-border equity flows into linear exchange rate models can improve their in-sample performance. Using net cross-border bond flows, however, has no such effect; (ii) An equity-augmented linear model supports exchange rate predictability and outperforms a random walk in several cases. The second part of my thesis consists also of two chapters (co-authored with Elias Papaioannou, LBS). In the third chapter titled "Democratization and Growth" we revisit the relationship between democracy and growth. Addressing several drawbacks of previous studies yields new evidence: (i) A permanent democratization results in a positive and significant increase of real per capita GDP growth of approximately one percent. (ii) A J-shaped dynamic pattern emerges, with output costs around the transition, but significantly positive growth gains after democracy's stabilization. The empirical evidence thus validates Hayek's (1960) insight that "the merits of democracy will only come in the long-run". The fourth chapter titled "What Drives Democracy? " is directly linked to the previous one since it aims to explore further the endogenous formation of democratization. We examine countries that enter our sample as non-democratic to identify the systematic factors that led certain countries to abandon autocracy permanently. This approach stands in contrast to the limited empirical studies that pool all countries to quantify the correlates of long-run democracy. We document that: (i) In contrast to recent studies that challenge the income-freedom link, a permanent democratization is more likely to occur in wealthy (but not oil-abundant) countries. ii) In line with the liberal hypothesis (Friedman, 1962), economic and political liberalizations appear to be re-enforcing. (iii) Democratic transitions are more likely to occur after an economic crisis. (iv) Beyond economic factors, religion and fractionalization are key determinants of political systems.