2011 - 2015 Working papers

ABSTRACT
We provide a set of stylised facts about Latvia's firms engaging in service exports, using detailed firm-level datasets for 2006–2013. We show that the fraction of firms involved in service exports is small, but the numbers of service exporters are on average bigger than of non-exporters and goods exporters. Service exporters also appear more productive than non-exporters and goods exporters, although this finding may be attributed mainly to innovative, knowledge-based sectors of the economy. We have also shown tentative evidence in favour of self-selection of productive firms in service exporting which warrants further investigation. The study suggests that it might be more difficult to enter the pool of service exporters than goods exporters, since the service market has historically been highly regulated in Latvia's major trading partners, and efforts necessary to become a service exporter are larger than those needed to become a goods exporter.
In a nutshell, the study enhances understanding of the relationship between trade behaviour and performance of service providers; likewise, it presents insight into how service and goods exporters compare. It complements the existing sparse set of empirical firm-level studies on service trade with evidence of a small open euro area economy.

Keywords: service trade, productivity, firm performance, micro data
JEL codes: D22, F10, F14

ABSTRACT
This paper evaluates misallocation of resources in Latvia during 2007–2013 using firm-level data. I found that allocation of resources worsened before 2010 and improved afterwards. Initially, misallocation of intermediate inputs was the major source of aggregate TFP losses, while the importance of capital misallocation increased after the financial crisis. Determinants of changes in allocation efficiency may include growing competition in domestic markets, tighter credit supply and legal issues. However, I show that fragmentation of production induces bias to the estimates of firm-specific distortions. Thus, in the absence of inter-firm trade data, the conclusions on misallocation should be treated with some caution.

Keywords: misallocation, TFP, productivity, firm-level data, Latvia
JEL codes: D24, L11, O11, O41, O47

ABSTRACT
This paper examines, in an estimated, full-fledged New Keynesian DSGE model with Nash wage bargaining, sticky wage and high value of leisure akin to Christiano, Trabandt and Walentin (2011), whether search-and-matching frictions in the labour market can explain aggregate labour market dynamics in Latvia. If vacancies are not observed, the model can, to a reasonable degree, generate realistic variance and dynamics of unemployment and the correlation between unemployment and (latent) vacancies, yet at the expense of too volatile vacancies. As a by-product, one quarter ahead forecasts of hours worked and GDP exhibit less excess volatility and, thus, are more precise compared to a model without search-and-matching frictions. However, if both unemployment and vacancies are observed and a shock to matching efficiency is allowed for, then cyclical behaviour of forecasted vacancies as well as correlation between unemployment and vacancies tend to counter the data (to the advantage of a better fit of vacancy volatility), and the smoothed matching efficiency is counter-intuitively counter-cyclical. Hence the model cannot fit the three statistics – variance of unemployment and vacancies, and correlation between the two, simultaneously.

Keywords:DSGE model, unemployment, small open economy, Bayesian estimation, currency union, forecasting
JEL codes: E0, E3, F0, F4, G0, G1

ABSTRACT
We employ EU-SILC micro data for Latvia to study how returns to education have changed during the economic crisis of 2008–2009 and afterwards. We found that returns to education increased significantly during the crisis and decreased slightly during the subsequent economic recovery. The counter-cyclical effect of education on wages was particularly strong for males; it was evident in majority of sectors and all age groups (except youth, for citizens of Latvia, resident non-citizens and other country citizens as well as in all regions of the country, particularly outside the capital city region. The share of career component (better access to higher paid occupations, sectors and positions) in the Mincer coefficient remained broadly constant over time. After the crisis, education became even more associated with a longer working week and higher chances to be employed. Furthermore, we show that returns to education in Latvia are generally higher in the capital city and its suburbs than outside the capital city region, for citizens of Latvia than for resident non-citizens and citizens of other countries, but lower for males and young people. Wage differential models reveal a relatively large wage premium for higher education and rather small for secondary education. In line with the previous findings for other countries, the estimates obtained with instrumental variable models significantly exceed the Mincer coefficient.

Keywords: returns to education, Mincer coefficient, wage differentials model, higher education wage premium, instrumental variables
JEL codes: I26, J31

ABSTRACT
In this paper we examine firm level survey data collected in the framework of the Eurosystem's Wage Dynamics Network (WDN) in Latvia. The survey explores labour cost adjustment strategies during 2008–2009 and 2010–2013 with the aim to uncover wage, employment, and price adjustment channels for different firm categories during crisis and post-crisis periods. The results show that more than half of firms were affected by a slump in demand and credit conditions during 2008–2009, with the effect being particularly strong on non-exporting firms. Unlike what the macroeconomic picture of average wage suggests, both flexible and permanent wages were adjusted strongly in response to the shock. One third of firms reduced employment or altered its structure strongly, with freeze of new hires and reduction of permanent employees used particularly often. The demand improved during 2010–2013 despite still tight credit conditions. Decrease in working hours, freeze of wages and new employment remained significant measures of labour cost adjustment during the latter period. Improvements in demand conditions transmitted into the increase in base wage, while bonuses were raised relatively less often.

Keywords: firm survey data, wage adjustment, labour force adjustment, price setting
JEL codes: J31, J38, J24, D22, C25

ABSTRACT
We develop and assess a suite of statistical models for forecasting Latvia's GDP. Various univariate and multivariate econometric techniques are employed to obtain short-term GDP projections and to assess the performance of the models. We also compile information contained in the GDP components and obtain short-term GDP projections from a disaggregate perspective. We propose a novel approach assessing GDP from the production side in real time, which is subject to changes in NACE classification. Forecast accuracy of all individual statistical models is assessed recursively by out-of-sample forecasting procedure. We conclude that factor-based forecasts tend to dominate in the suite. Encouraging results are also obtained using disaggregate models of factor and bridge models, which could be considered as good alternatives to aggregate ones. Furthermore, combinations of the forecasts of the statistical models allow obtaining robust and accurate forecasts which lead to a reduction of forecast errors.

Keywords: out-of-sample forecasting, real-time estimation, forecast combination, disaggregate approach
JEL codes: C32, C51, C53

Abstract
This study is devoted to examing marginal effects of traditional determinants of exports and imports with a focus on the role of price competitiveness in restoring external balances. It is a first attempt to compare marginal effects of various harmonised competitiveness indicators (HCIs) on both exports and imports of both goods and services across individual euro area countries. We find evidence that the HCIs based on broader cost and price measures have a larger marginal effect (with some exceptions) on exports of goods. Exports of services are sensitive to the HCIs in large euro area countries and Slovakia, where exports of services are also found to be more sensitive to competitiveness indicators based on broader price measures. Imports of goods and imports of services are quite insensitive to the changes in relative prices. Finally, in some cases the measures of the goodness of fit indicate that a large unexplained residual part is present, implying that other non-price related factors might play an important role in driving foreign trade.

Keywords: real exchange rate, exports, imports, price competitiveness, euro area
JEL classification: F14, F31, F41

Abstract
In this paper, we examine international transmission of the negative credit supply shock, which originated in the euro area and the US. We use the multi-country global vector autoregression (GVAR) approach with trade and bilateral banking exposures as weights, and identify five structural shocks via sign restrictions. Special focus of this research is on CESEE – a region that shares strong financial linkages with the euro area. Our main results are as follows. First, US-specific shocks account for a significant share in explaining the deviations from growth trends in output and total credit in both the euro area and the US; second, compared to a domestic aggregate demand shock, the economic downturn caused by the credit supply shock in the US and the euro area can bring more harm in the long run, yet the international spillover of the former is stronger; third, the transmission of euro area shocks to emerging Europe is faster and more pronounced compared to US shocks; fourth, there is strong heterogeneity in responses of emerging Europe to shocks in the euro area and the US.

Keywords: credit shock, global vector autoregressions, sign restrictions
JEL classification: C32, F44, E32, O54

Abstract
We propose a comprehensive analysis of a country's price and non-price competitiveness that accounts for changes in the value added content of trade by combining two datasets – highly disaggregated trade data from UN Comtrade and internationally integrated supply and use tables from the WIOD. When we focus attention on the traditional measure of gross exports of goods, the analysis shows that advanced economies lost non-price competitiveness relative to emerging economies over the period from 1995 to 2011. This picture changes when the fragmentation of production is considered. We find that the relative quality of production from the US, Canada, Germany and the UK, when tracing value added in exports, remained unchanged or even increased over this period. Likewise, the seemingly unchanged or improving relative quality of Brazil, Russia and India's export goods largely arose from outsourcing rather than from improvements in the quality of domestic production. However, gains in Chinese non-price competitiveness remain impressive even after accounting for global value chain integration.

Keywords: value added content of trade, fragmentation, non-price competitiveness, China, BRIC, G7
JEL classification: C43, F12, F15, L15, O47

Abstract
The paper proposes a theoretical framework for explaining gains and losses in export market shares by considering both price and non-price determinants. Starting from a demand-side model à la Armington (1969), we relax several restrictive assumptions to evaluate the contribution of unobservable changes in taste and quality, taking into account differences in elasticities of substitution across product markets. Using highly disaggregated trade data from UN Comtrade, our empirical analysis for the major world exporters (G7 and BRIC countries) reveals the dominant role of non-price factors in explaining the competitive gains of BRIC countries and concurrent decline in the G7 share of world exports.

Keywords: export market share decomposition, non-price competitiveness, real effective exchange rate
JEL classification: C43, F12, F14, L15

Abstract
This paper builds a dynamic stochastic general equilibrium (DSGE) model for Latvia that would be suitable for policy analysis and forecasting purposes at Latvijas Banka. For that purpose, the DSGE model with financial frictions of Christiano, Trabandt and Walentin (2011) is adapted to Latvia's data, estimated, and studied as to whether adding the financial frictions block to an otherwise identical (baseline) model is an improvement with respect to several dimensions. The main findings are: 1) adding of financial frictions block provides a more appealing interpretation for the drivers of economic activity and allows reinterpreting their role; 2) financial frictions played an important part in Latvia's 2008 recession; 3) the financial frictions model beats both the baseline model and the random walk model in forecasting CPI inflation and GDP, and performs roughly the same as a Bayesian structural vector autoregression.

Keywords: DSGE model, financial frictions, small open economy, Bayesian estimation, currency union
JEL classification: E0, E3, F0, F4, G0, G1

Program codes for Buss 2/2014 (7z archive)

Abstract
This study presents an approach based on a perturbation technique to construct global solutions to dynamic stochastic general equilibrium models (DSGE). The main idea is to expand a solution in a series of powers of a small parameter scaling the uncertainty in the economy around a solution to the deterministic model, i.e. the model where the volatility of the shocks vanishes. If a deterministic path is global in state variables, then so are the constructed solutions to the stochastic model, whereas these solutions are local in the scaling parameter. Under the assumption that a deterministic path is already known the higher order terms in the expansion are obtained recursively by solving linear rational expectations models with time-varying parameters. The present work proposes a method which rests on backward recursion for solving this type of models.

Keywords: DSGE, perturbation method, rational expectations models with time-varying parameters, asset pricing model
JEL classification: C61, C62, C63, D50, D58

ABSTRACT
This paper presents a method to construct a sequence of approximate policy functions of increasing accuracy on non-local domains. The method is based upon the notion of stable manifold originated from dynamical systems theory. The approximate policy functions are constructed employing the contraction mapping theorem and the fact that solutions to rational expectations models converge to a steady state. The approach allows us to derive the accuracy of the approximations and their domain of definition. The method is applied to the neoclassical growth model and compared with the perturbation method. Just the second approximation of the proposed approach yields very high accuracy of the approximate solution on a global domain. In contrast to the Taylor series expansions, the solutions of the method inherit globally the properties of the true solution such as monotonicity and concavity.

Keywords: dynamic equilibrium, rational expectations, non-linear perfect foresight models, stable manifold, perturbation method, extended path, neoclassical growth model
JEL codes: C62, C63, D9, D58

ABSTRACT
This research gives an overview of labour market internal and occupational mobility in Latvia comparing periods before, during and after the crisis. It uses both the labour flow analysis and the survival analysis to evaluate labour mobility and to determine factors influencing it. The analysis is based on labour force survey (LFS) longitudinal data for 2005–2011.The paper investigates possible asymmetric responses of the labour market during the extreme period of economic boom and bust, provides detailed information on the aspects of labour market mobility (e.g. changes in the types of labour contract, sector and region of work) and factors determining changes in the status of economic activity (employed or unemployed). We also propose a new way for calculating labour market flows to provide information on quarterly changes.

Keywords: labour flows, labour force survey, labour mobility, occupational mobility, unemployment
JEL codes: J23, J61, J62, J64

ABSTRACT
This paper evaluates the inflation effect of recent VAT rate changes in Latvia by using CPI micro data. Our findings suggest that the pass-through of the tax rate to consumer prices is strong in case of upward tax adjustments, especially when there are no demand restrictions, while the pass-through is weaker for tax reductions. The frequency of price changes peaks at the moment of VAT adjustment, which, however, is partially compensated by lower average size of price revisions. The level of pass-through exhibits a high degree of heterogeneity with higher pass-through for goods, especially food, and lower for services.

Keywords: VAT, inflation, sample selection model, CPI micro data, Latvia
JEL codes: C24, D40, E31, H20

ABSTRACT
The paper studies regularised direct filter approach as a tool for high-dimensional filtering and real-time signal extraction. It is shown that the regularised filter is able to process high-dimensional data sets by controlling for effective degrees of freedom and that it is computationally fast. The paper illustrates the features of the filter by tracking the medium-to-long-run component in GDP growth for the euro area, including replication of Eurocoin-type behavior as well as producing more timely indicators. A further robustness check is performed on a less homogeneous dataset for Latvia. The resulting real-time indicators are found to track economic activity in a timely and robust manner. The regularised direct filter approach can thus be considered a promising tool for both concurrent estimation and forecasting using high-dimensional datasets and a decent alternative to the dynamic factor methodology.

Keywords: high-dimensional filtering, real-time estimation, coincident indicator, leading indicator, parameter shrinkage, business cycles, dynamic factor model
JEL codes: C13, C32, E32, E37

ABSTRACT
The evolution of total factor productivity (TFP) is a key determinant of long-run economic growth of a country. In this paper we analyse the contributions from technological change at the industry level to an economy's aggregate growth performance. Our derivation of total TFP growth entails three major improvements over the traditional Solow residual approach. First, we allow for non-constant returns to scale as well as changes in the utilisation of input factors in our estimation of industry TFP growth. Second, we use a novel approach to aggregate TFP from industry level to macro level, which incorporates both direct and indirect effects through intermediate linkages within an economy. Third, we take account of open economy characteristics by assigning an explicit role to terms-of-trade shocks. Our calculations for the sample of 10 Eastern European EU Member States over the time period from 1995 to 2009 are based on the newly available World Input-Output Database (WIOD).

Keywords: total factor productivity, terms of trade, utilisation, input-output table, Central, Eastern and Southeastern Europe
JEL codes: C23, D24, E23, O47

ABSTRACT
The aim of this study is to estimate the equilibrium REER of Latvia, which was done by using different methodologies, including IMF CGER approach, and the NATREX and SVAR models. The IMF methodology implies the application of three different methods: the macroeconomic balance method, the external sustainability method and the reduced-form equilibrium real exchange rate method. The results of all approaches used in this study indicate that the real exchange rate of Latvia, after appreciation during the boom years and subsequent adjustment afterwards, remained close to its equilibrium level at the end of the sample period, i.e. at end-2010.

Keywords: equilibrium realexchange rate, BEER, macroeconomic balance, external sustainability, NATREX, SVAR, Latvia
JEL codes: F31, F32, O24

ABSTRACT
The paper evaluates competitiveness of Latvia's exporters from various aspects by using detailed trade data from Comtrade. Competitiveness represented by the market share of Latvia's products in world trade was on the rising trend, growing almost two times between 1999 and 2010. Such a dynamic improvement was mainly accounted for by intensive margin, as Latvia's exporters increased their presence on traditional markets. Moreover, the contribution of extensive margin was also positive due to geographical expansion. The analysis of non-price competitiveness signals that although Latvia's export unit values were increasing faster than those of its main rivals, relative quality and taste for Latvia's products were rising even faster, and, overall, competitiveness of Latvia's exporters improved.

Keywords: exports, extensive margin, intensive margin, non-price competitiveness, Latvia
JEL codes: C43, F12, F14, L15

ABSTRACT
The paper proposes a new real-time unrevised indicator tracking medium-to-long-term component in the quarterly growth of the euro area GDP. The new indicator is based on recently developed real-time filtration methodology, the multivariate direct filter approach, applied to selected business and consumer survey and share price data. The new indicator is found to have led another established indicator, the Eurocoin, by about three months since mid-2009 and be about coincident with but smoother than the PMI. In addition to the euro area aggregate indicator, the paper presents prototypical indicators for four biggest EU economies – Germany, France, the UK and Italy. Overall, the described filter approach appears to be able to provide somewhat better results in tracking business cycle developments than other widely used approaches.

Keywords: real-time signal extraction, coincident indicator, multivariate direct filter approach
JEL codes: C13, C32, E32, E37

ABSTRACT
We propose an export price indicator adjusted for non-price factors as a measure of a country's competitiveness. Based on the approach by Broda and Weinstein (2006) who adjust price developments for changes in varieties of imported products, we relax their assumption of unchanged quality over time and apply this index to export prices of the ten CESEE EU Member States which acceded in 2004 and 2007. The index is calculated using data from Comext at the highly disaggregated eight-digit CN product level. Our analysis spans the time period from 1999 to 2010, thus including the recent global recession in 2009. The results show that all CESEE10 countries experienced loss in price competitiveness, although much smaller than is usually suggested by the traditional CPI-based or ULC-based real effective exchange rate measures. Although relative export prices (unit values) increased stronger in CESEE10 countries as compared with their competitors, the average quality of their goods increased even more, thus fully compensating for the rise in prices. These improvements in non-price competitiveness were pronounced in all CESEE10 countries.

Keywords: non-price competitiveness, quality, relative export price
JEL codes: C43, F12, F14, L15

ABSTRACT
The severe repercussions of the latest financial crisis highlighted the crucial role of the financial sector in the propagation of economic and financial shocks. In this paper we analyse the role of financial market frictions in business cycle fluctuations and in the transmission of monetary policy in a small open economy pursuing fixed exchange rate strategy. To this end, we develop and estimate a DSGE model for Latvia with financially constrained households and firms, embedding monopolistically competitive banking sector facing capital constraints. This general equilibrium framework is useful to study the potential of macro-prudential tools and their interaction with other macroeconomic and monetary policy instruments. Our findings suggest that the banking sector mutes the response of bank retail rates to an increase in the foreign policy rate and thus attenuates the drop in real aggregates. A permanent bank capital contraction subdues output, consumption, investment, domestic lending and foreign borrowing in the long run. Under a temporary shock to bank capital, asset prices and housing investment are first to recover, for loans it takes several years, while output, consumption and capital investment rebound at a slower pace. In the long run, a tighter capital requirement leads to higher output, capital investment and domestic lending while reducing household deposits and foreign liabilities of banks.

Keywords: DSGE models, Bayesian estimation, banks, financial frictions, macro-financial linkages, small open economy
JEL codes: C11, C32, E43, E44, F41, R21

ABSTRACT
We evaluate implications of inflation targeting versus fixed exchange rate regime for the UK, Sweden, Poland, the Czech Republic, Estonia, Latvia and Lithuania, i.e. seven EU non-euro area countries. To this end, we estimate a small open economy DSGE model and simulate a model under estimated structural parameters and different sets of policy parameters. The results obtained are compared in terms of inflation, output gap and interest rate volatility. For inflation targeting countries, a policy switch to fixed exchange rate would entail 3–6 times higher inflation volatility. In the Baltic economies, a policy change to inflation targeting with fully flexible exchange rate would amplify inflation volatility 2–4 times, whereas the existing price stabilisation and exchange rate fluctuations within the ERM II bands would entail 3–6 times more volatile inflation. Policy simulations thus show evidence that in all the countries the existing monetary rule guarantees more stable inflation and output than under alternative regimes.

Keywords: DSGE, small open economy, fixed exchange rate, inflation targeting, Bayesian estimation
JEL codes: C11, C3, C51, D58, E58, F41

ABSTRACT
This paper discovers the driving forces behind firms' decisions to adjust prices by using various panel logit models, which explain the probability of observing price change by a broad set of exogenous variables. The results of the models show that the consumer price formation in Latvia is a combination of both state-dependent and time-dependent behaviour. On the one hand, frequency of price changes depends on inflation, demand conditions, and the size of last price changes. On the other hand, we observe some elements of time-dependent price setting, e.g. price truncation and strong seasonal pattern. We also find several important differences in the price setting behaviour for cases of price increases and decreases. The fact that frequency of price changes in Latvia depends on inflation as well as demand and supply conditions could be seen as a prerequisite for faster price adjustment process in the event of distortions in the economy. In the case of economic imbalances, state-dependent price formation changes flexibility of prices and ensures a faster adjustment process towards equilibrium.

Keywords: price setting behaviour, Latvia's consumer prices, frequency of price change, sales, time-dependent pricing, state-dependent pricing, panel logit model
JEL codes: C23, D40, E31