Industrial research and development and real exchange rate depreciation in a small open economy

• Published date: 01 September 2020
• Author: Saleh S. Tabrizy
• DOI: http://doi.org/10.1111/twec.12924
• Date: 01 September 2020

2490

|

wileyonlinelibrary.com/journal/twec World Econ. 2020;43:2490–2523.

© 2020 John Wiley & Sons Ltd

Received: 20 April 2019

|

Revised: 20 December 2019

|

Accepted: 6 January 2020

DOI: 10.1111/twec.12924

ORIGINAL ARTICLE

Industrial research and development and real

exchange rate depreciation in a small open economy

Saleh S.Tabrizy

College of Arts and Sciences, Department of Economics, The University of Oklahoma, Norman, Oklahoma

KEYWORDS

exchange rate, export intensity, R&D

1

|

INTRODUCTION

A growing body of international economics literature is concerned with questions that are primarily

raised in the economics of innovation. Identifying the open economy determinants of investments in

research and developments (henceforth, R&D) is among those questions. In this research, I focus on

how industrial R&D expenditures in a small open economy respond to changes in relative national

prices, as measured by industry-specific effective real exchange rates (henceforth, IERER).

Firms’ current and future profits provide the channels for the interaction between R&D and ex-

change rates. For a given industry, R&D expenditures depend on the investments in R&D equipment

and the utilisation cost of that equipment (e.g., the wage bill for scientists, engineers or designers).

Over time, these expenditures are expected to affect the innovative capabilities and, hence, the future

profitability of the industry. In return, improvements in profit provide more resources that may be al-

located to R&D activities. Considering this interdependence, changes in relative national prices may

affect R&D expenditures through, at least, three channels. First, part of the inputs that are used for in-

novative activities may be imported. There may also exist a complementarity between other imported

inputs and R&D activities (Bøler, Moxnes, & Ulltveit-Moe, 2015). Lastly, current and future profits

that provide resources for innovative activities depend partially on export revenue. For a given indus-

try, the ultimate effect of these offsetting forces may depend on the importance of exporting activities,

the reliance on imported inputs and the relative magnitude of pass-through elasticities.

In this study, I employ industry-level observations from a panel of manufacturing industries in

the Republic of Korea. The data set in use includes information about the IERERs and industry-level

I am grateful to Rebecca Neumann for her supervision. I am also grateful to an anonymous referee, Kundan Kishor, Suyong

Song, Mohsen Bahmani-Oskooee, Avik Chakrabarti, Niloy Bose and Ariel Weinberger for their advice. Further, I would like

to thank seminar participants at University of Wisconsin–Milwaukee, the University of Oklahoma, Midwest Economics

Association Conference (2014), Southern Economic Association Conference (2014) and Eastern Economic Association

Conference (2016) for helpful comments. Also, the regression analyses of this paper are done using two estimation

procedures, one of which is written by David Roodman, and the other one is written by Giovanni S.F. Bruno. I have had free

access to these estimation procedures. For this, I am grateful to the authors. I remain responsible for any shortcomings and

errors.

|

2491

TABRIZY

R&D expenditures, as well as industry-level value added, exports and imports. It offers variations

across 22 manufacturing industries over a 15-year window: from 2001 to 2015. During this period,

R&D expenditures increased significantly in Korea. In 2001, the gross domestic R&D expenditures in

Korea was 2.34% of its GDP, just slightly above the figure for all OECD countries (2.16%). By 2015,

the gross domestic R&D expenditures in Korea reached 4.22% of its GDP, while the same figure for

all OECD countries remained almost steady (2.34%). In fact, no other OECD country experienced

such consistent growth in R&D activities during this time window (OECD, 2019).

I employ a dynamic model to examine the effects of lagged changes in IERER on contemporane-

ous changes in industry-level R&D. I control for lagged changes in industry-level R&D expenditures,

contemporaneous and lagged changes in other important covariates and time-invariant unobserved in-

dustry-specific characteristics. Considering the cross-section and time series dimensions of the above

panel, I make use of the corrected least square with dummy variables estimation procedure (Bruno,

2005a; Bun & Kiviet, 2003; Kiviet, 1995) to estimate the parameters of interest. Compared with con-

ventional estimation procedures, Judson and Owen (1999), Bruno (2005b) and Buddelmeyer, Jensen,

Oguzoglu, and Webster (2008) suggest that the above procedure provides better estimation for key

parameters in dynamic panel models with relatively small cross-section and time series dimensions.

The results reveal that among industries with medium levels of export intensity a lagged deprecia-

tion in IERER (i.e. increase in price competitiveness) leads to a decline in contemporaneous indus-

try-level R&D expenditures. Among industries with very low or very high export intensities, however,

I find no significant effects from lagged depreciation. This pattern may be the result of two factors.

First, compared with industries on the tails, industries that are at the middle of export intensity distri-

bution are likely to have relatively low pass-through elasticities (Garetto, 2016). Second, despite their

differences in exports intensity, evidence from input–output tables suggest that the reliance of Korean

industries with medium levels of export intensity on imported intermediate inputs is similar to the

reliance of other industries on those inputs. Given the complementarity between international sourc-

ing and R&D activities (Bøler et al., 2015), an increase in the relative price of imported inputs as a

result of real depreciation may adversely affect R&D investments.1 The reliance on imported inputs

being similar among all industries, this adverse effect may in particular be significant among indus-

tries that have relatively low pass-through elasticities, which include industries that are at the middle

of the export intensity distribution. This finding improves our understanding of how industrial R&D

expenditures may react to changes in relative national prices in a small open economy.

Previous empirical findings are summarised in Section 2. The data in use are fully described in

Section 3. The empirical analyses are discussed in Section 4. Section 5 concludes.

2

|

BACKGROUND

This study contributes to a growing body of empirical research on the linkages between innovation

and selected open economy variables. While others examine the effects of greater access to foreign

markets (Baldwin & Gu, 2004; Bustos, 2011; Damijan, Kostevc, & Polanec, 2010; Lileeva & Trefler,

2010) or import competition (Autor, Dorn, Hanson, Pisano, & Shu, 2017; Bloom, Draca, & Van

Reenen, 2016; Scherer & Huh, 1992; Teshima, 2009), this paper explores the effect of changes in rela-

tive national prices. Within this line of literature, the existing empirical studies are of two types. Some

of them examine the effect of exchange rate uncertainty or volatility on R&D expenditures. Others

1 Chen (2017) offers a detailed description of how this complementarity may govern the relationship between exchange rate

and R&D expenditures.

2492

|

TABRIZY

examine the direction of changes in R&D expenditures following exchange rate swings. Empirical

evidence showing an adverse effect of exchange rate uncertainty or volatility on R&D expenditures

seem to be conclusive (Becker & Hall, 2009; Ito & Haneda, 2017; Mahagaonkar, Schweickert, &

Chavali, 2009). However, evidence on the direction of changes in R&D expenditures in response to

TABLE 1 Summary of previous empirical findings

Author(s) and

publication year Data

Main estimation

method(s) Main findings

Zietz and Fayissa

(1994)

Panel of 360

manufacturing firms

from 1975 to 1987 in

the US

Ordinary least square,

fixed effect, and random

effect

Increase in R&D expenditures

in response to exchange rate

appreciation among firms in R&D-

intensive industries

Funk (2003) Panel of 269

manufacturing firms

from 1979 to 1994 in

the US

Pooled mean group Increase in R&D expenditures

in response to exchange rate

depreciation among exporting firms

Also, decline in R&D expenditures

in response to exchange rate

appreciation among purely domestic

firms

Becker and Pain

(2008)

Panel of 11

manufacturing

industries from 1993 to

2000 in the UK

Ordinary least square and

dynamic panel data

Decline in R&D expenditures

in response to exchange rate

depreciation among manufacturing

industries

Chen (2017) Panel of 49 developed

and developing

countries from 1996 to

2011

Fixed effect and dynamic

panel data

Decline in aggregate R&D

expenditures per capita in response

to exchange rate depreciation among

developed countries

Kaiser et al.

(2017)

Panel of about 700

manufacturing firms

from 1996 to 2015 in

Switzerland

Fixed effect poisson

estimation

Increase in R&D expenditures

in response to exchange rate

appreciation for firms that have

access to considerable financial

means and small R&D-intensive

firms that that are not internationally

exposed

Also, decline in R&D expenditures

in response to exchange rate

appreciation for firms with average

net international exposures, firms

with low financial means, and

large R&D-intensive firms that are

internationally exposed

Alfaro et al.

(2018)

Panel of about 495,000

firms from 2001 to

2010 in 76 emerging

economies and 23

industrialised countries

Fixed effect Increase in R&D expenditures

in response to exchange rate

depreciation among firms in export-

oriented emerging economies in Asia

Also, decline in R&D expenditures

in response to exchange rate

depreciation among firms in

emerging economies in Latin

America and Eastern Europe