Most undergraduate economics students are familiar with the concept of spillover effects, i.e. when activity in one sector affects the activity or participants in another sector. For example, homeowners with property on a river are adversely affected when the factory up-river dumps its waste into the water. Professor Kent, a macroeconomist, is researching the spillover effects that occur internationally. How can a shock in one country’s business cycle affect another’s?
To answer this question, Kent has compiled a list of 35 countries with a wide variety of characteristics, including those of both middle- and upper-income. Low-income countries are not included because data does not exist for the measurements Kent focuses on (including cross-border asset holdings and Portfolio equity) in these countries. Each country is paired with the 34 others in the sample in order to determine possible spillover effects. This grid shows all of the pairs in the sample. The yellower a pair’s box, the higher the likelihood of spillover effects.
Most of the action occurs between trading partners. For example, many French firms and households hold a lot of equity in German industries. A shock that begins in the German economy may spill over to France through that channel. Kent is not only looking at how financial holdings can link nations together, but also trading links, including the importing and exporting of several types of goods (such as goods for consumption and goods for production, i.e. inputs). Japanese firms import a lot of steel from South Korea. If South Korea experiences a shock, Japanese firms may suddenly find that the price of their inputs have increased, the effects of which may reverberate through the entire economy.
The latter is an example of an upstream shock. A downstream shock occurs in a country when one of their important export markets (a country they ship things to) experiences a shock, and demand for their product decreases. So far, Kent has found that the importing of goods for intermediate goods and consumption are more highly associated with these spillovers. It is important to note that this is not just considering correlation, but dynamic response and forecast– in other words, if there were a shock in South Korea tomorrow, we could predict the size and duration of its spillover in Japan given that South Korea is one of Japan’s important input markets.
Kent has also found that financial links between countries tend to be associated with spillovers that happen very quickly, rather than the prolonged ones that occur when there are shocks to trading links. We see the effects of these prolonged spillovers playing out over a longer period of time, with adjustments in trade and the economy as a whole. Thus, finance does not appear to be important when considering these long, slow effects.
So, broadly, Kent is studying how countries move together in the world economy. Specifically, he is looking to understand the forecasts of economies in partner countries following a shock, rather than the shock’s immediate impact. How do spillovers carry through into future quarters of the business cycle?
“Policymakers might want to know how holding certain kinds of foreign or linked assets may increase or decrease the risk of experiencing a spillover shock from another country. We wouldn’t want to stop countries from holding each other’s’ assets, since shutting down trade would lead to welfare losses, but it may help us learn how to react when spillovers occur,” said Kent.
Written by Lauren Hurley