Vol. 9, No. 2

Roger E. A. Farmer:
A theory of business cycles (pp. 91–109)


This paper constructs a complete dynamic general equilibrium model of a macroeconomy that is similar in many respects to the IS/LM model that dominated the thinking of most macroeconomists for a generation. Unlike the IS/LM model all markets are modeled as in equilibrium at all points in time. Since the model is set in an overlapping generations structure in which there is incomplete participation in insurance markets, we are able to model business fluctuations that are driven by the self-fulfilling beliefs of investors. These fluctuations are Pareto inefficient since agents are risk averse and would prefer a non-stochastic allocation to an allocation that fluctuates. Our model is in contrast to the real business cycle approach that also uses a general equilibrium model but in which all fluctuations are Pareto efficient. Since the framework of our model is a complete intertemporal maximizing model we are able to explain why there may be a role for government in stabilizing business fluctuations.

(JEL: E32, D51)

Amartya Lahiri and Hinh T. Dinh:
External debt and creditworthiness: theory with evidence (pp. 110–125)


The existence of international lending raises the issue of credit worthiness of sovereign debtors. From a lender perspective, it is important to have some prior warnings about potential debt repudiation. We analyze how the fiscal evolution of a country might contain information about its creditworthiness. In a two good, small open economy theoretical framework, we find that budget deficits and current account developments hold critical information regarding structural imbalances and creditworthiness. The model is also able to account for a number of features which often characterize countries with chronic debt problems including the phenomenon of capital flight and the usefulness of debt relief for stabilizing explosive debt situations. Estimation of a model of debt arrears with cross country data provides general support to the theoretical structure. A major finding of the paper is that it is the efficiency of investment and not the level of investment that is important for creditworthiness purposes. In general, wefind that exports, imports, income inequality, inflation and the efficiency of investment are able to explain about three-fourths ofthe cross-country variation in debt servicing performance. We find that the results are robust to both different specifications as well as alternative measures of country risk such as credit ratings assigned by international creditors.

(JEL: F3, F4)

Friedrich L. Sell:
On the theoretical determination of optimal currency areas in the framework of club theory
(pp. 126–143)


The paper provides an analytical approach to determine ex ante the optimal size (number of participants) and the optimal monetary conditions (inflation rate) of a monetary union. In the first part, the case of homogenous members is presented from the »total economy point of view» put forward by club theory. In the second part, the case of heterogenous members is explained on the background of the prospective European Monetary Union. Here also the »individual member point of view» and stability problems are discussed.

(JEL: F31, F36, F41, F42)

Timo Koivumäki:
Permanent income hypothesis and variability of consumption (pp. 144–154)


This paper investigates the variability of Finnish consumption with a purpose to determine whether traditional permanent income hypothesis is consistent with Finnish consumption data, or is consumption excessively smooth as suggested in recent empirical studies. A spectral density based measure is used to determine the variability ratios for nondurables consumption and durables expenditures. Results show strong excess smoothness in durables expenditures, and slight excess smoothness in nondurables consumption. The issue of excess smoothness is also approached using cross spectral analysis. The role of features such as liquidity constraints, uncertainty and irreversibility of durables stock in causing excess smoothness is discussed.

(JEL: D12, C4)

Finnish Economic Papers 2/1996