Trade and Unemployment,What Do the Data Say,Gabriel Felbermayr. University of Stuttgart Hohenheim,Julien Prat,University of Vienna. New York University and IZA,Hans J rg Schmerer,University of T bingen and. University of Stuttgart Hohenheim,Discussion Paper No 4184. P O Box 7240,53072 Bonn,Phone 49 228 3894 0,Fax 49 228 3894 180. E mail iza iza org, Any opinions expressed here are those of the author s and not those of IZA Research published in. this series may include views on policy but the institute itself takes no institutional policy positions. The Institute for the Study of Labor IZA in Bonn is a local and virtual international research center. and a place of communication between science politics and business IZA is an independent nonprofit. organization supported by Deutsche Post Foundation The center is associated with the University of. Bonn and offers a stimulating research environment through its international network workshops and. conferences data service project support research visits and doctoral program IZA engages in i. original and internationally competitive research in all fields of labor economics ii development of. policy concepts and iii dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character A revised version may be. available directly from the author,IZA Discussion Paper No 4184. Trade and Unemployment What Do the Data Say, This paper documents a robust empirical regularity in the long run higher trade openness is. causally associated to a lower structural rate of unemployment We establish this fact using. i panel data from 20 OECD countries ii cross sectional data on a larger set of countries. The time structure of the panel data allows us to deal with endogeneity concerns whereas. cross sectional data make it possible to instrument openness by its geographical component. In both setups we carefully purge the data from business cycle effects include a host of. institutional and geographical variables and control for within country trade Our main finding. is robust to various definitions of unemployment rates and openness measures The. preferred specification suggests that a 10 percent increase in total trade openness reduces. unemployment by about one percentage point Moreover we show that openness affects. unemployment mainly through its effect on TFP and that labor market institutions do not. appear to condition the effect of openness,JEL Classification F16 E24 J6. Keywords international trade real openness unemployment GMM models IV estimation. Corresponding author,Gabriel Felbermayr,University of Stuttgart Hohenheim. Economics Department,70593 Stuttgart,E mail gabriel felbermayr uni hohenheim de. We are very grateful to Luca De Benedictis Peter Egger Benjamin Jung Wilhelm Kohler Devashish. Mitra Christopher Pissarides Richard Upward as well as participants at the CESifo Munich T bingen. workshop and workshops at the Universities of Aarhus G ttingen Leicester and Nottingham. 1 Introduction, Does exposure to international trade create or destroy jobs In the short run trade lib. eralization increases job turnover as workers are reallocated from shrinking to expanding. 1 Empirical evidence suggests that those adjustments temporarily raise frictional. unemployment on the aggregate level as documented by Tre er 2004 for the case of. NAFTA On the other hand the long run e ect of trade liberalization on the equilibrium. rate of unemployment is less clear, A burgeoning literature introduces labor market imperfections into workhorse mod. els of international trade Most papers conclude that trade openness matters for the. equilibrium rate of unemployment however the sign of the relationship di ers across pa. pers Blanchard 2006 talks about an overabundance of theories of wage setting and. unemployment Interacted with di erent explanations for international trade compara. tive advantage versus product di erentiation models the number of possible theoretical. frameworks is large Brecher 1974 and Davis 1998 incorporate minimum wages into. Heckscher Ohlin models and nd that trade liberalization can exacerbate unemployment. Davidson and Matusz 1988 1999 introduce frictional unemployment in models of com. parative advantage and nd that the sign of the relationship depends on a comparison of. capital labor endowments across countries Egger and Kreickemeier 2009 introduce fair. wages into a model with increasing returns to scale and nd that trade liberalization in. creases unemployment Felbermayr Prat and Schmerer 2008 introduce search frictions. into a similar trade model and nd that unemployment is likely to be decreasing in the. degree of openness Helpman and Itshoki 2008 also use the search matching approach. but combine comparative advantage motives and increasing returns to scale They nd. that globalization can increase unemployment, The state of the theoretical literature therefore suggests to turn towards an empirical. assessment As stated by Davidson and Matusz 2004 whether trade a ects the level of. equilibrium unemployment is primarily an empirical issue Yet there is very little em. pirical work on the aggregate employment e ects of trade policies This paper attempts. to shed some light on this question Rather than testing a speci c theoretical model it. See Bernard Redding and Schott 2007 for a recent paper. Paul Krugman 1993 famously argues that the level of employment is a macroeconomic issue. depending in the short run on aggregate demand and depending in the long run on the natural rate of. unemployment with microeconomic policies like tari s having little net e ect However theoretical con. siderations as well as empirical evidence suggest that at least some microeconomic policies such as product. market regulation do a ect the structural rate of unemployment see Blanchard and Giavazzi 2003 for. the theoretical argument and Bassanini and Duval 2006 for a survey of the empirics. The theoretical literature is large and quickly growing our short summary cannot be but a very. incomprehensive list of papers, presents the results of a thorough quest for the causal relationship between the rate of. unemployment and openness in cross sections of countries There are two important chal. lenges on the way First published data on unemployment rates are notoriously unreliable. with measurement bias systematically related to determinants of unemployment More. over good data on labor market regulation is available only for a few countries Second. the incentive for politicians to erect trade barriers as a response to unemployment shocks. may introduce a negative spurious correlation between unemployment and openness If the. timing of trade liberalization and labor market reform coincide domestic demand shocks. will concurrently reduce unemployment and increase imports. We tackle the data quality problem by focusing on two di erent samples We start. with a high quality data set of 20 rich OECD countries provided by Bassanini and Duval. 2009 Great e orts have been made at the OECD to construct unemployment rates and. indicators of various labor market institutions with meaningful time and cross sectional. variance In a second step we use a lower quality cross section of countries for which. we average yearly unemployment rates from various data sets such as provided by the. World Bank the International Labor Organization the International Monetary Fund or. the CIA and draw on labor market variables provided by Botero et al 2004 To avoid. endogeneity problems we do our best to purge the data from business cycle e ects and we. use a comprehensive set of variables to control for labor market institutions To address. simultaneity bias in the OECD panel we use various GMM based techniques and exploit. the time dimension of the data to construct instruments In the cross section we use the. geographical component of trade openness as an instrument. Across di erent econometric models di erent speci cations and di erent data sources. we are able to esh out an important and robust result the structural rate of unem. ployment is a non increasing function of openness to trade In the largest share of our. regressions higher trade openness actually decreases unemployment In some exercises. it is irrelevant but never turns out to be positively correlated with unemployment We. nd the following additional results i There is no evidence that the e ect of openness. on unemployment is biased upwards due to endogeneity Quite to the contrary we nd. that OLS yields a negative bias which signals that attenuation bias due to non systematic. measurement error in the openness measure which biases results to zero dwarves the en. dogeneity bias ii Controlling for endogeneity is nevertheless crucial when comparing the. e ects of import openness with that of export openness OLS type models overestimate in. absolute values the e ect of import openness but underestimate that of export openness. This is an interesting result that is fully in line with intuition policy makers may react. to adverse labor market shocks by restricting imports and by promoting exports Hence. the correlation between the shock and the openness is negative for imports and positive. for exports leading to a positive bias in the rst instant and a negative one in the sec. ond iii It is important to adjust the openness measures for di erences in the relative. prices of non traded goods as suggested by Alcal and Ciccone 2004 in the context of. cross country growth regressions In particular the unadjusted openness measure tends to. exaggerate the e ect of openness on unemployment,4 iv We investigate potential chan. nels through which openness may a ect the rate of unemployment The strongest one is. through total factor productivity TFP Openness increases TFP as is well known in the. growth literature In turn TFP has a strong negative e ect on the rate of unemployment. For other channels the capital labor ratio the degree of labor market distortions or the. amount of product market competition we do not obtain clear cut results over samples. and speci cations v We do not nd that the e ect of openness is strongly and robustly. conditioned by the capital labor ratio or the extent of labor or product market regulation. Related literature Apart from the theoretical literature discussed above our exercise. is closely related to two important strands of empirical research First labor economists. have long estimated cross country unemployment regressions usually based on panel data. for a restricted sample of rich OECD countries Following Blanchard and Wolfers 2000. seminal paper the literature is mainly concerned with the explanatory power of labor. market institutions and macroeconomic shocks Nickell et al 2005 provide a recent. example of this approach whereas Bassanini and Duval 2009 present a comprehensive. survey The terms international trade openness or globalization do not appear in their. comprehensive 130 pages study Hence it appears to us that the role of international trade. in cross country regressions has not yet been thoroughly addressed. 5 To connect our results, with previous research we closely follow the received methodology since we use similar. data econometric techniques and speci cations To the best of our knowledge this paper. is the rst to systematically assess the role of trade openness for unemployment within. the context of standard cross country unemployment regressions for OECD countries. Surprisingly enough the in uence of trade turns out to be much more robust than that of. many labor market institutions, We also incorporate insights from the large empirical literature about the e ect of. Note that this issue is of much less concern in our panel analysis where we can e ectively control for. the time invariant component of cross country variation in relative prices. Scarpetta 1996 uses an index measuring the pervasiveness of trade restrictions to proxy the intensity. of competition One also should add that many papers interact terms of trade shocks with labor market. variables However they do not use the level of openness as an independent covariate Boulhol 2008. interacts trade openness with labor market institutions but does not address the endogeneity problem. The report of the European Economic Advisory Group at CESifo 2008 also includes some cross. country regressions of unemployment rates on openness but does not attempt to sort out correlation from. trade openness on per capita income Frankel and Romer 1999 have proposed an instru. mentation strategy based on geography which is as a matter of fact applicable only in. cross sections The consensus is that the positive e ect of openness on per capita income is. not robust to seemingly unrelated geographical controls such as the distance to equator. Their paper has triggered a debate on the relative importance of trade institutions and. the common underlying exogenous driver geography Prolonging this line of investigation. a recent paper by Dutt et al 2009 test speci c implications of the Davidson and Matusz. 1999 model using cross country regressions and a geography based instrument Although. their sample data sources and methodology are di erent their results are qualitatively in. line with ours Interestingly our own IV estimates much inspired by the approach of. Alcal and Cicone 2004 suggest a negative relationship between openness and unem. ployment that is robust to inclusion of variables such as distance to equator or general. institutional controls, Structure of the paper In section 2 we provide a brief rst glance at the data We. identify our two key concerns about data quality and endogeneity bias This motivates. section 3 where we sketch the empirical strategy for our di erent data sets Section 4. contains our core results on the trade unemployment relation We provide evidence for a. high quality OECD panel with relatively narrow country coverage a larger cross section of. countries and a short panel with a greater number of countries We contrast import and. export openness and compare the real measure proposed by Alcal and Ciccone 2004 to. the traditional one used e g in Frankel and Romer 1999 Section 5 presents additional. results on the channels through which openness a ects labor markets and on interactions. between labor market institutions the capital labor ratio and trade It also discusses. a large number of robustness checks with the details relegated to a supplement paper. Finally section 6 concludes,2 A descriptive look at the data. As a rst step this section discusses the data that we use in our empirical exercise unem. ployment rates and di erent measures of openness to international trade It also provides. a rst heuristic look at the unemployment openness relationship A detailed discussion of. the data is contained in the Appendix,See for example Rodriguez and Rodrik 2000. The supplement paper do les and our data are available at. http sites google com site gfelberm,2 1 Data sources and variables. 2 1 1 Unemployment rates, International institutions such as the OECD the World Bank or the International Labor. Organization ILO provide harmonized unemployment rates that are calculated following. the same conventions Across di erent international institutions these rules can di er For. example the rates published by the OECD or the World Bank rely on national administra. tive sources while the ILO data is based on labour market surveys The former strategy. presupposes the cooperation of national statistical agencies the latter is probably better. suited to developing countries Country coverage is always an issue While the World Bank. has 185 members in the year 2000 it reports unemployment rates only for 93 of them The. ILO data exhibits an ever lower degree of country coverage 86 countries. However in all cases the accuracy of the published rates depends on the quality of the. data delivered by the institutions member states Data quality is only a minor issue for the. 20 rich OECD countries but appears to be highly problematic for the rest of the world. The correlation between unemployment rates from these di erent data sets is strikingly low. within the group of low income low openness countries which suggests that data quality. systematically depends on country characteristics Such non random measurement error in. our dependent variable the rate of unemployment however will tend to bias the absolute. value of the estimated e ect of openness upwards, Unfortunately there is very little that one can do about data quality problems except. running as many robustness checks as possible or working with the small panel of OECD. countries for which data quality is satisfactory,10 Hence in a rst step we focus on. 20 high quality OECD countries for which systematic measurement bias in the rate of. unemployment is unlikely but where the analysis may su er from non random sample. selection This choice strongly limits the cross sectional scope of our analysis and makes. it necessary to use panel data and rely on time variance for estimation In addition we. perform purely cross sectional regressions with larger country samples and also experiment. with a short panel for this larger sample To verify the robustness of our results we use. di erent data sources for the dependent variable unemployment rate. In its statistical factbook the CIA publishes yearly estimates of unemployment rates for a larger. sample of countries as of 2000 there is data for 160 countries The CIA makes use of all publicly. available information plus the insider information of its employees How exactly the CIA experts obtain. these estimates is not made explicit In the non OECD sample average CIA estimates are substantially. larger than the information provided by o cial sources in the OECD sample there is no such gap. More details on countries included is provided in the Appendix. 2 1 2 Openness measures, The summary measure of trade openness nearly always used in empirical work is nominal. imports plus exports relative to nominal GDP usually referred to as trade openness and. denoted by T For recent examples see Coe and Helpman 1995 Frankel and Romer s. 1999 Ades and Glaeser 1999 Alesina Spolaore and Wacziarg 2000 Dinopoulos and. Thompson 2000 or Alcal and Ciccone 2004 The openness measure has the advantage. that it re ects the actual exposure of an economy to international trade and is easily. measurable Trade policy itself is often hard to observe in particular because of the. declining importance of tari s or quotas and the increasing use of informal trade barriers. Also membership in regional trade agreements or the WTO does not necessarily provide. information about the actual openness of an economy see Rose 2005. There are some obvious alternatives to the standard de nition of T that may be relevant. in the openness unemployment debate First since imports and exports need not coincide. and rising imports may have a di erent e ect on unemployment than increasing exports. one could rede ne T as nominal imports or exports over nominal GDP Second Alcal and. Ciccone 2004 argue that the Balassa Samuelson e ect distorts nominal price openness. measures since countries with low labor productivity and hence a high price of traded. relative to non traded goods have arti cially high degrees of openness They propose to. use real openness de ned as imports plus exports in exchange rate US relative to GDP. in purchasing power parity US PPP GDP This eliminates cross country di erences in. the relative price of non traded services from the summary measure of trade They show. how the real openness measure can be computed using data provided in the Penn World. Tables PWT The measure of real openness may be particularly relevant to the extent. that the e ect of trade openness on aggregate unemployment works through total factor. productivity We use real total trade openness constructed according to Alcal and Ciccone. 2004 as our benchmark measure Even if accounting for the Balassa Samuelson e ect is. not a big issue for countries in our OECD sample the problem becomes more severe in. our large cross sectional regressions Comparing real and current price openness measures. reveals that the e ect is smaller for real openness but coe cients are more stable across. di erent models and setups, As with unemployment rates the openness measures may be noisy proxies for the. actual degree of exposure to international trade However it is less obvious that measure. ment error should be systematically related to any determinant of the unemployment rate. In our robustness checks we also work with constant price openness measures which x all prices at. some base year Moreover data provided by the World Bank allows to focus on merchandize trade only. This allows to see whether trade in services has a di erent e ect on unemployment compared to trade in. Random measurement error would bias estimated towards zero making it harder for us. to nd signi cant e ects The real challenge therefore lies in the potential endogeneity of. openness to adverse labor market shocks,2 1 3 Labor market institutions. The OECD has collected data on a wide array of institutional variables that can be expected. to a ect the equilibrium rate of unemployment Bassanini and Duval 2009 discuss the. data in detail These measures include the degree of union density or of union coverage. the extent of employment protection legislation or of active labor market policies e ective. average tax rates on wages the average replacement rate of unemployment insurance the. degree of corporatism and many more The data also includes a measure of product market. regulation which re ects entry barriers These variables are available for 20 rich OECD. countries and for most of them we have time series ranging from 1980 2003. The data for the wider cross section of countries is more problematic By far the most. careful data collection has been undertaken by Botero et al 2004 They provide a. data set containing data on various aspects of labor market regulations for 85 countries. Observations range from 1990 2000 and were averaged over the whole period In our. study we focus on measures related to the generosity of unemployment bene ts the extent. of employment protection EPL and the importance of minimum wages Additionally. to those labor market regulations Botero et al also collected data on the size of the. informal economy Reported unemployment rates and the degree of openness may both. be systematically related to the size of the shadow economy so that omitting this variable. could easily bias the e ect of trade This is a particularly important issue in the large. cross section where we cannot control for unobserved heterogeneity and where we have a. large number of developing countries, The Botero et al data does not contain a time dimension Therefore when running. panel regressions for the large country sample we need to rely on data from the Fraser. Freedom of the world data base where we have variables on unemployment bene ts labor. market institutions and product market regulations The former variable is an index that. collects information on many dimensions of labor market institutions the latter quanti es. the extent of price controls, 12 Observations for 116 countries are available in ve year. intervals beginning in 1975 and ranging until 2005. In the original Fraser data higher values indicate more freedom and thus less regulation To avoid. confusion when comparing with the OECD or the Botero et al data we rescale the Fraser variables by the. 2 2 A rst glance at the openness unemployment nexus. 2 2 1 Time variance in the OECD sample, The solid line in Figure 1 plots the unweighted average unemployment rate of 20 rich OECD. countries see the Appendix for a list of countries Starting from a low level at about 2. percentage points in 1970 the unemployment rate increased over time to reach a peak of. 10 percent in the mid nineties but fell back to about 6 percent in 2003 Not surprisingly. the unemployment rate exhibits substantial cyclical variation Measured on the right. vertical axis of Figure 1 the unweighted average share of trade in total GDP measured. as real openness also displays a clear upward trend it increased from about 25 percent in. 1970 to about 40 percent in the early years of the new millennium The trade share also. displays cyclical variation albeit at a smaller degree Hence in the OECD sample average. unemployment rates and the average real openness appear positively correlated over time. OECD panel,OECD panel,Wage distortion mean,Unemployment mean. Total trade openness mean,Unemployment mean,1970 1975 1980 1985 1990 1995 2000. 1970 1975 1980 1985 1990 1995 2000,Year Unemployment mean Wage distortion mean. Unemployment mean Total trade openness mean,Figure 2 Unemployment and wage dis. Figure 1 Unemployment and openness, So far the empirical labor market literature has usually not accounted for any measure. of trade openness Nickell et al 2005 show that the evolution of labor market institutions. has substantial explanatory power for unemployment rates In particular tax rates and. replacement rates perform well other institutional variables do not yield robust results. This is not entirely surprising since the theoretical predictions relating to employment pro. tection legislation or union coverage are usually ambiguous Costain and Reiter 2008 use. a theoretical model to argue that tax and replacement rates should have similar qualitative. and quantitative e ects in a search and matching model of unemployment They propose. to add them The obtained index consists of the sum of the average wage tax burden and. social bene ts foregone when a worker switches from unemployment into a job It therefore. measures the total scal burden imposed on the worker see also Saez 2002 Immervoll et. al 2007 and is sometimes referred to as the participation tax Figure 2 shows that the. average wedge and average unemployment are also positively correlated over time Hence. the prima facie evidence suggests that it is important to control for both variables in any. meaningful cross country unemployment regression that draws on time variance. Figures 1 and 2 present sample averages over time and fully disregard heterogeneity. across countries In a next step we correlate rst di erences of the real openness measure. against rst di erences in the unemployment rate Di erencing should eliminate country. speci c e ects unrelated to openness that may drive the correlation in Figure 1 Figure 3. shows the scatter plot and ts a univariate linear regression The slope of the line is esti. mated at 0 04 with a t value of 5 69 This preliminary evidence points towards a negative. e ect of trade openness on the rate of unemployment A one standard deviation increase. about 10 percentage points of openness is associated to a decrease in the rate of unem. ployment of about 0 4 percentage points Interestingly our more elaborate multivariate. instrumental variable analysis below suggests results of very similar magnitude. Full OECD 20 sample 1970 2000,Change in unemployment rate. IRL GBRFIN,NLD DNK NLD,ESP ESP ESP,NZLUSACAN DNK,PRTESP FIN ESP. DNK BEL IRLGER,ESP ESP NORESP,FIN NZL BEL,NZLESPFRA PRT. FINUSA ESP,FRA GBR AUS,AUS CAN USAAUS,ESP ITA NOR,JPN USA ITA. NLD GER BEL,FRAAUS AUT,BEL IRLSWENLD,CHE AUT AUT,SWE NORIRL NLD. FIN CHE JPN,DNKJPN FIN DNK,CHE NOR NOR AUT,FIN DNK NOR. CHECHE BEL,DNKSWE FIN,NORIRL JPN,ITAAUTSAUS,GBR GBR NOR IRL IRL NOR BEL. GERGBR ITA,SWE AUS AUS,DNK FINGBR,AUSGBR NLD IRL FIN BEL. FINNLD DNK,DNK NZL FINFRA,SWE FINIRL NLD,NZL PRTFIN. ITA FRA IRL,FIN ESP SWE,BEL NZL DNK,IRLBELESP PRT,NLD IRL IRL. 20 0 20 40,Change in openness, Unemployment and trade openness rst di erences OECD sample. 2 2 2 Cross sectional variance in the large sample. Figure 4 sets the average level of unemployment WDI estimates against the average level. of openness real current price for the largest cross section of countries for which we have. In the picture the unemployment rate leads the measure of wage distortion over time Costain and. Reiter 2008 discuss the endogeneity issues suggested by this fact but conclude that they are unlikely to. pose any serious problems, data Averages are based on the period from 1990 2006 but there may be substantial. spans of missing values within that period, The linear regression line tted to the scatter plot has a slope of about 0 044 with. a t value of 2 20, 14 Hence also in the large cross section of countries the unconditional. regression of openness on the rate of unemployment yields a negative correlation Because. the variance of the openness measure is much larger in the large cross section than in the. narrow OECD sample the point estimate implies that a one standard deviation increase. of openness is associated to a decrease in the rate of unemployment by about 1 percentage. 62 countries 1990 2007,Unemployment rate,COL LVA HRV. KAZ ITAFRA FIN,TUR HUNGER BEL,ROU NZLGBR SVN SWE,PAK USA DNK. CHN MEXKOR MYS CHE SGP,0 50 100 150, Figure 4 Unemployment and trade openness averaged levels large cross section. 2 3 Implications and challenges, The above gures are suggestive However they cannot establish a causal relationship. There are several reasons why the correlations in gures 3 and 4 may be spurious First. while we have used yearly data there may be business cycle e ects any positive shock on. domestic spending is likely to increase domestic as well as import demand This lowers. unemployment and increases openness Second in periods of reform countries may simul. taneously liberalize their product and labor markets leading to a simultaneous increase in. openness and employment Third politicians may react to shocks in the unemployment. rate by imposing protectionist measures More precisely they may resort to policy mea. sures that discourage imports and encourage exports since the overt use of tari s quotas. The nding of a negative slope is robust to the exclusion of HKG Hong Kong and SGP Singapore. statistical t is improved by taking logs of both variables. or subsidies is strongly restricted by international agreements governments may use non. tari measures which are di cult to control for directly In the case that import restricting. policies dominate the rise in unemployment would be associated with a reduction in open. We deal with the rst problem the business cycle e ect in the following way In the. OECD sample we take 5 year averages to smooth out business cycle variation Moreover. in all regressions we include a measure of the output gap based on HP ltering methods. and provided by Bassanini and Duval 2009 In the larger cross section we take averages. over the entire available period 1990 2006 We also include the output gap. The second issue relates to an omitted variables bias In the OECD sample we can. draw on high quality data provided by Bassanini and Duval 2009 For the wider sample. we use the variables provided by Botero et al 2004 See the Appendix for a detailed. description of all our data, The third and most interesting problem is a classical simultaneity problem We can only. address it by instrumenting the openness measures In the case of the OECD panel we can. exploit the time variance of the data and use lagged di erences and levels as instruments. In the case of the wider cross section we draw on the instrument proposed by Frankel and. Romer 1999 and used i a by Alcal and Ciccone 2004 We have opposite expectations. concerning the sign of the endogeneity bias for import openness and export openness This. provides us with a natural external check of our instrumentation strategy. 3 Empirical strategy, We have to adapt our econometric strategy to the nature of the available data For the. OECD sample where we can draw on meaningful time variance we build on the rich. tradition of empirical labor market studies surveyed in Bassanini and Duval 2009 and. use panel methods For the wider sample we use the cross sectional approach which. has been widely employed in the growth openness literature While time variance in the. larger cross section is somewhat problematic we still check our results by running panel. regressions as well,3 1 OECD sample GMM panel regressions. We extend Nickell et al 2005 and estimate variants of a dynamic model. ui t s ui t s Ti t LMIi t PMRi t GAPi t i t i t, where S is the number of lags of the endogenous variables All variables are ve year aver. ages The vectors LMIi t and PMRi t collect variables measuring labor market institutions. and product market regulation respectively GAPi t is the output gap. 15 is a vector of, country speci c e ects t denotes time e ects and i t is an error term We are primarily. interested in the estimate of and expect that the e ects of LMI and PMR conform with. the evidence surveyed in Bassanini and Duval 2009 This evidence is mixed Baker et. al 2004 show that those panel data estimations lack robustness and that clear results. on the role of most labor market institutions hardly exist There is however an emerg. ing consensus that replacement rates and the tax wedge have a robust and theoretically. sensible e ect see Costain and Reiter 2008, The preferred equation estimated by Nickell et al 2005 is similar to 1 but does. not include openness They use generalized least squares techniques on this equation. and are not particularly worried by the potential endogeneity of labor or product market. institutions Many of the speci cations surveyed in Bassanini and Duval 2009 constrain. s 0 and estimate static xed e ects models Some papers use the log of ui t as the. dependent variable Nickell 1997 Costain and Reiter 2008 but there does not seem any. consensus as to which speci cation is preferred In our baseline speci cations we use ui t. in levels but provide robustness checks for the logarithmic case. We address the potential endogeneity of openness and of the lagged dependent vari. able by instrumenting with the respective lagged values. 16 In the rst di erenced general, method of moments di GMM approach by Arellano and Bond 1991 all variables are. di erenced and endogenous variables are instrumented by their lags in di erences The. more general approach proposed by Blundell and Bond 1998 adds level equations to the. di erenced ones This leads to a system of two di erent sets of moment conditions dif. ferences and levels Blundell and Bond use Monte Carlo simulations to show that the. sys GMM approach is more e cient since a larger number of moment conditions is avail. able All techniques discussed above allow to control for potential endogeneity even when. there is no obvious instrument waiting on the wing Nevertheless those GMM approaches. must be treated cautiously since small degrees of model speci cation error may induce. large e ects on results and lagged variables might be weak instruments There are how. ever a number of tests that can be used to check whether the conditions of the approach. are ful lled For both GMM methods two requirements must hold i the instruments. For the OECD output gap is measured as derivation of actual output from potential output Basanini. and Duval 2009 For the large cross section we use a proxy constructed as di erence between actual. GDP and trend GDP The latter is obtained by HP ltering the data where the smoothing parameter is. set to 400, Additionally we treat the wage distortion index sum of average replacement rate and tax wedge as.
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