Capital Accumulation, Asset Price Dynamics and the Macroeconomy

AuthorMoumita Basu,Ranjanendra Narayan Nag
Published date01 August 2018
Date01 August 2018
Subject MatterArticles
Capital Accumulation,
Asset Price Dynamics
and the Macroeconomy:
A Dependent
Economy Model
Moumita Basu1
Ranjanendra Narayan Nag2
This article develops a dependent economy model of determination of employ-
ment and asset prices that integrates the roles of relative prices, expectations
and dynamics of capital accumulation. In this model, money wage is rigid which
leads to persistence of unemployment. Labour and capital are used as factors
of production in the traded sector while the non-traded sector uses labour and
imported intermediate inputs. The article examines macroeconomic implications
of selective economic reforms for asset price dynamics, growth and employ-
ment. The discussion of comparative static exercises shows that not only the
effects of different policies are ambiguous but also the short-run and the long-
run effects are qualitatively different. For example, tariff liberalization causes the
short-run expansions of both traded and non-traded sectors but overtime it
may depress the capital stock leading to contraction of both the sectors and an
increase in unemployment. The broad message of this article is that the design
of macroeconomic policy should not be purely based on considerations of the
short-run effects of policy changes.
JEL: E22, F13, F41
Tobin’s q, dependent economy, capital accumulation, employment
Foreign Trade Review
53(3) 127–155
©2018 Indian Institute of
Foreign Trade
SAGE Publications
DOI: 10.1177/0015732517734753
1 Assistant Professor, Department of Economics, Bidhannagar College, Salt Lake, Kolkata, West Bengal,
2 Associate Professor, Department of Economics, St. Xavier’s Autonomous College, 30, Mother
Teresa Sarani, Kolkata, West Bengal, India.
Corresponding author:
Moumita Basu, 7/2A, Biswas Nursery Lane, Kolkata 700085, India.
128 Foreign Trade Review 53(3)
In an international economy, an aggregative framework is inappropriate for ana-
lysing the full economy-wide impact of policy-induced shocks and structural
changes since international trading activities affect different sectors of the econ-
omy to varying degree. Some sectors are specialized in the production of export-
able while other sectors, notably construction and service industries, operate more
or less independent of international environment. The asset prices in conjunction
with macroeconomic policies and external shocks can significantly influence
resource allocation and level of employment of an open economy. The differential
impacts of policy-induced shocks and external shocks on the various sectors
through the adjustment of asset as well as commodity prices are a central issue in
studying macroeconomic development of an emerging market economy. To study
such developments is objective of this article.
Contemporary macroeconomic models of the dependent economy, by and
large, ignore the interaction between stock market, sectoral composition of out-
put, employment and dynamics of capital accumulation. For example, Murphy
(1992) developed a two-sector open economy model to study the adjustment of
investment, saving and the current account to a deterioration in the terms of trade
and he found that a temporary deterioration in the terms of trade is always associ-
ated with current account deficit and capital accumulation in the long run, although
the current account and investment may rise or fall in the short run. Turnovsky
and Sen (1995) emphasized the role of sectoral capital intensities in determining
real exchange rate dynamics by considering a small open economy model with
traded and non-traded sectors and accumulating capital. Morshed and Turnovsky
(2004) developed a two-sector model in which intersectoral capital movements
involve adjustment costs, which have important consequences for the dynamics
of capital accumulation and particularly for real exchange rate dynamics. Farhat
(2010) constructed a model with non-traded final goods and traded inputs by
incorporating capital into the production of final goods and he found that shocks
to final goods production are important in replicating the empirical regularities of
imports, exports, the real exchange rate and their relationship to GDP. Cardi and
Restout (2011) used a two-sector neoclassical open economy model with traded
and non-traded goods to investigate both the aggregate and the sectoral effects of
temporary fiscal shocks and they have found that both sectoral capital intensities
and labour supply elasticity play an important role in determining the change in
investment and in the current account. In contrast to the existing literature, our
model examines the fluctuations in the stock market in response to variety of
shocks and also explains how the behaviour of stock market affects capital accu-
mulation, sectoral composition of output and unemployment in a dependent econ-
omy framework.
The purpose of this article is to investigate how different policy-induced
shocks affect the asset prices, capital stock and level of employment in terms of a
dependent economy model that can apply to a large class of emerging market
economies. In this model, there are two sectors: traded and non-traded. Differing
from Turnovsky and Sen (1995), Morshed and Turnovsky (2004) and Farhat

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