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PhD in Economics and Finance – XXII Cycle
Theoretical aspects and empirical evidence of
the impact of military expenditure on the
advanced capitalist economies
DISSERTATION PROPOSAL
Marco Lorusso
Advisor: Prof. Luca Pieroni
December 31, 2007
Contents
1. Introduction
1.1. Military spending and economic performance
3
3
2. The effects of defence expenditure, and the monetary policy,
in the case of the open economy
7
2.1. Objectives
7
2.2. Theoretical model
7
2.3. Data requirements
7
3. Further evidences of the impact of military spending on the
economy. A comparative analysis between USA and UK.
10
3.1. Introduction
10
3.2. The theoretical framework
12
3.3. The econometric model
15
4. The defence economics problem
20
4.1. Objectives
20
4.2. Theoretical model
20
4.3. Data requirements
20
2
1. INTRODUCTION
1.1. Military spending and economic performance
Since the end of the World War II, in the developed world, the economic theory has
been applied to defence related issue. During the Cold War, research was focused on the
superpower arms races, alliances and nuclear weapons. The end of the Cold War
resulted in analysis into disarmament, the challenges of conversion and the availability
of a peace dividend. Since the end of the Cold War, the world remains a dangerous
place with regional and ethnic conflicts, threats from international terrorism, and
weapon of mass destruction. In line with these themes, a debate has been developed on
the following question: does military spending provide economic stimulation through
higher demand and technological innovations, or does military spending retard
economic performance because it draws resources from more productive activities?
Broadly speaking, there are two sets of view. On one hand, a version of hypothesis
focuses on the costs of defence expenditure, especially its adverse impact on economic
performance. On this view the adverse effects might arise from three reasons. First,
defence may divert resources away from public and private sector investment which
may be more favourable than defence spending. Second, adverse balance of payments
impacts through imports of arms and resources are diverted away from the export
sector. Finally, defence, particularly defence Research and Development (R&D), might
divert resources from private sector R&D activities affecting both technologies and
spin-offs. The resources diverted embrace both physical and human capital (Hartley,
2005).
On the other hand a different point of view concerns the benefits of military spending
that are the following. First, in periods of high unemployment, countries might
experience stimulative effects from defence spending, in fact defence spending adds to
aggregate demand in the economy. Second, defence provides technology benefits and
spin-offs, where spin-offs applied to the civil sector can promote the economy. Third,
defence spending might promote growth if some of the expenditure is used to provide
social infrastructure. Fourth, defence spending develops and supports human capital, in
fact a nation’s armed forces are provided with nutrition, education, training and
3
discipline, with some of these benefits spilling over into the civil sector labour force.
Finally, defence spending provides protection to a nation’s citizens where internal and
external security promotes market exchange (Hartley, 2005).
In the light of these different points of view, several approaches have been developed.
The neoclassical approach to military expenditure is based upon the notion of a state,
reflecting some form of social democratic consensus, recognising some well-defined
national interest, and threatened by some real or apparent potential enemy. Given the
external potential enemy it is necessary to deter aggression and it is done by developing
a particular level of capability. High military spending is here the result of changes in
technology, rising costs and arms races (Dunne, 1990).
On the contrary, the Marxist approach starts from the premise that military expenditure
has a necessary, though contradictory, role in maintenance of the capitalist system. In
this view military expenditure imposes a substantial burden. Among the advanced
capitalist nations high military spending is associated with much lower investment,
lower growth and higher rates of unemployment (Smith, 1977).
An alternative view treats the military budget as a source of aggregate demand for
goods and services and, therefore, a source of economic stimulation. This approach has
come to known as “Military Keynesianism”, after John Maynard Keynes, who argued
that in extreme situations the government should spend on anything as a means of
stimulating aggregate demand (Gold, 2005). A rise or a fall in military spending is
likely to bring about consequential changes in the long run equilibrium path of the
macro economy as distinct from short run dynamics (Atesoglu, 2002).
For our interest, the relevance of this debate is devoted to macroeconomic policy. Thus,
the question, here, is to analyze if government defence expenditure, as a component of
public expenditure, affects significantly economic performance, accounting for the
potential role in explaining fiscal policy fluctuations. We focus on two main aspects of
policy. The first is its short run conduct: we would like to know how governments
should act in the face of the various disturbances that impinge on the economy. In most
developed countries today, short run stabilization is done mainly by monetary rather
than fiscal policy. Though, many traditional prescriptions for monetary policy focus on
4
the money stock rules, central banks, especially in advanced countries, have only rarely
given the behaviour of the money stock more than a minor role in policy (Romer, 2006).
The measures of the money stock that the central bank can control tightly, such as high
powered money, are not closely linked to the aggregate demand. And the measures of
the money stock that are often closely linked with aggregate demand are difficult for the
central bank to control. Further, in many countries the relationship between all measures
of the money stock and aggregate demand has broken down in recent decades,
weakening the case for money stock rules even more (Romer, 2000). Thus, central
banks for the most part conduct policy not by trying to achieve some target growth rate
for the money stock, but by adjusting the short term interest rate in response to various
disturbances. This basic fact about policy, together the disadvantages of money stock
rules, has led researchers to focus on rules for how the interest rate should be adjusted.
In contrast to money stock rules, interest rate rules cannot be passive. For example, if
the central bank keeps the nominal interest rate constant, and a disturbance to aggregate
demand occurs, this pushes output above its natural rate causing inflation to rise. With
the nominal interest rate fixed, this reduces the real interest rate, which raises output
further, which causes inflation to rise even faster (Friedman, 1968).
The second central aspect of policy is its long run performance. Monetary policy often
causes high rates of inflation over extended periods, and fiscal policy often causes
persistent high budgets deficit. On one hand, though popular view intensely dislike
inflation economists have difficulty in identifying a substantial cost of inflation. For
example, in periods when inflation is moderately high in industrialized countries, it is
often cited in opinion polls as the most important problem facing the countries and it
appears to have an important effect on the outcome of political elections. On the other
hand many industrialized countries have run persistently large budget deficits in recent
decades and face long term budgetary challenges. These large and persistent budget
deficits have generated considerable concern. There is a widespread perception that they
reduce growth, and that they could lead to a crisis of some type if they go on too long or
became to large (Romer, 2006).
In this light, defence budgets can be viewed as showing the outcome of the political
bargaining between various interest groups. In fact, defence budgets show how
5
expenditure is allocated between equipment, personnel, infrastructure and other inputs
required to produce the output of defence, the so called Defence Industrial Base (DIB).
The concept of the DIB has been defined in various ways. First, the DIB comprises the
wide range of firms which supply the defence department and the armed forces with the
equipment which they require (Taylor and Hayward, 1989). Second, the DIB consists of
those industrial assets which provide key elements of military power and national
security: such assets demand special attention by government (Taylor and Hayward,
1989). Third, the DIB embraces industrial sectors that unequivocally manufacture
military goods (e.g. artillery, missiles, submarines) as well as sector which produces
civil goods. Designation as a defence industry depends upon the destination of the bulk
of the industry’s output: should most of it be earmarked for defence markets, the
industry is qualified as a defence industry (Todd, 1988). Fourth, the DIB refers to those
sectors of a country’s economy that can be called upon generate goods, services and
technology for the ultimate consumption by the state’s armed forces. A DIB has to fulfil
two requirements: it must provide the normal peacetime material requirements of the
country’s military, and it must be rapidly expansible to meet the increased demands of
the wartime or emergency situation (Haglund, 1989). Finally, the DIB comprises prime
contractors, subcontractors and part suppliers operating publicly and or privately owned
facilities supplying air, land and sea systems (Gansler, 1989).
Thus, defence budgets can be presented in a variety of ways, depending on such factors
as the needs of the Ministry of Defence or Defence Department, government, public
accountability, secrecy and constitutional requirements. This approach concerns on the
supply side of the market for defence equipment. In an era of expensive equipment,
rising weapon costs and increasingly constrained budgets, nation cannot avoid
questioning the efficiency and the competitiveness of their defence industries (Hartley,
1995).
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2. THE EFFECTS OF DEFENCE EXPENDITURE, AND THE MONETARY
POLICY, IN THE CASE OF THE OPEN ECONOMY
2.1. Objectives
The goal of this section is to build up a model that explains how changes in defence
spending impact the overall economy. That is, it is important to verify the role of
monetary sector and policy compared to defence spending in determining the path of the
macro economy. One important aspect of this framework is to consider open economy
mechanisms.
Following the approach of Taylor (2000), the key assumption of this approach is that
the central bank follows a real interest rate rule; that is, it acts to make the real interest
rate behave in a certain way as a function of macroeconomic variables such as inflation
and output. This assumption is vastly better description of how central banks behave
than the assumption that they follow a money supply rule. Central banks in almost all
industrialized countries focus on the interest rate on loans between banks in their short
run policymaking. Thus, it is better to model the open economy in a way that allows the
domestic interest rate to differ from the world interest rate, that allows the central bank
to follow an interest rate rule (Romer, 2000).
2.2. Theoretical model
A macro-based framework is used to derive a dynamic model.
2.3. Data requirements
The data of macroeconomic variables are taken from the International Financial Statistic
(IFS), reports yearly redacted by the International Monetary Found, while the data of
government defence expenditure from the Stockholm International Peace Research
Institute (SIPRI).
7
References
Bernanke, B. S., Mihov, I. (1997). What Does the Bundesbank Target? European
Economic Review; 41, 1025–1053.
Campbell, Y., Gregory, N. M. (1989). Consumption, Income, and Interest Rates:
Reinterpreting the Time Series Evidence. NBER Macroeconomics Annual; 4, 185–216.
Clarida, R., Gali, J., Gertler, M. (1999). The Science of Monetary Policy: A New
Keynesian Perspective. Journal of Economic Literature; 37 (4), 1661-1707.
Clarida, R., Gertler, M. (1997). How the Bundesbank Conducts Monetary Policy.
Reducing Inflation: Motivation and Strategy. Romer, C. D., Romer, D. H. eds. Chicago:
University of Chicago Press, 363–406.
Fuhrer, J. C., Madigan, B. F. (1997). Monetary Policy When Interest Rate are Bounded
at Zero. Review of Economics and Statistics; 79, 573-585.
Goodfriend, M., King, R. (1997). The New Neoclassical Synthesis and the Role of
Monetary Policy. Macroeconomics Annual Cambridge. Bernanke, B., Rotemberg, J.
eds. Cambridge: MIT Press; 231-282.
Goodfriend, M. S. (1993). Interest Rate Policy and the Inflation Scare Problem: 1979–
1992. Federal Reserve Bank of Richmond Economic Quarterly; 79, 1–24.
Gordon, R. J. (1990). What Is New-Keynesian Economics? Journal of Economic
Literature; 28, 1115–1171.
Hall, R. E., Taylor J. B. (1997). Macroeconomics. Fifth edition. New York: W. W.
Norton.
Laubach, T., Posen, A. S. (1997). Disciplined Discretion: Monetary Targeting in
Germany and Switzerland. Essays in International Finance. No. 206.
Romer, D. (2000). Keynesian Macroeconomics without the LM curve. Journal of
Economic Perspective; 14(2), 149-169.
Rotemberg, J., Woodford, M. (1997). An Optimization Based Econometric Framework
for the Evaluation of Monetary Policy. NBER Macroeconomics Annual; Bernanke B.,
Rotemberg, J. eds. Cambridge Massachusetts: MIT Press; 297-346.
Svensson, L. E. O. (2000). Open Economy Inflation Targeting. Journal of International
Economics; 50(1), 155-183.
Taylor, J. B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester
Conference Series on Public Policy; 39, 195–214.
Taylor, J. B. (1997). A core of Practical Macroeconomics. American Economic Review;
87(2), 233–235.
Taylor, J. B. (1998). Economics. Second edition. Boston: Houghton Mifflin.
Taylor, J. B. (1999). Monetary Policy Rules. eds. Chicago: University of Chicago
Press.
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Taylor, J. B., Woodford, M. (1999). Handbook of Macroeconomics. eds. Amsterdam:
North Holland.
Von Hagen, J. (1995). Inflation and Monetary Targeting in Germany. Inflation Targets.
Leiderman, L., Svensson, L. E. O., eds. London: Centre for Economic Policy Research,
107–121.
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3. FURTHER EVIDENCES OF THE IMPACT OF MILITARY SPENDING ON
THE ECONOMY. A COMPARATIVE ANALYSIS BETWEEN USA AND UK.
3.1. Introduction
One of the dominant approaches to macroeconomic research in the past several decades
based the policy predictions on the IS-LM model. In this framework the debates
between Keynesian and monetarists concerning the effectiveness of monetary and fiscal
policy played a central role in the analysis of short-run fluctuations (Romer, 2000). One
assumption largely criticized of this aggregate macroeconomic model involved in the
monetary policy behaviour of the central bank concentrated on the aims targeting the
money supply. Empirical policy researches have shown that central banks mainly use
the tool of the interest rate to characterize the monetary policy with respect to determine
the money supply. This approach developed by Taylor (2000) and Romer (2000) has,
therefore, driven to replace the traditional money market curve with a more coherent
monetary policy (MP) framework of the activity of central banks.
Although such a framework is useful for understanding how the monetary policy affects
the economy, through the closed relationship between inflation-real interest rate, it is illequipped to investigate how the fiscal policy shocks impact on aggregate output through
the composition of the government expenditure. The latter focus is motivated by our
interest in understanding how the society might best avoid the distortions created by the
presence of misallocation in the government expenditure. In this paper we provide some
empirical evidence of the effects of the composition of the fiscal policy on the aggregate
output when the categories of defence and civilian expenditure are explicitly
distinguished within government sector. Firstly, we assess the model by identifying
fiscal policy shocks as motivating forces for the nonstationarity of output. Indeed,
equilibrium of the IS-MP framework implies that, if the shock of government
expenditure components, namely defence and civilian spending, are unobservable
shocks I(1), these forcing variables will determine a long run equilibrium along with
output and real interest rate. This theoretical implication of one cointegrating vector in
the model will be tested by aggregate data. Secondly, we are interested to document
10
and to discuss the effects of a particular kind of government expenditure – the defence
expenditure - on the long run output since the empirical evidence does not provide a
clear picture if defence spending stimulate through higher demand and innovations the
economy or retard economic performance by the crowding out effects (Gold, 2005).
Thus, this paper reviews the debate in line with the work of developed by Atesoglu
(2002), by updating the sample of data in the US and by comparing the estimated results
with that obtained for the UK economy.
Theoretically, the well-known hypothesis of Keynesian approach, that treats the military
budget as a source of aggregate demand for goods and services, suggests that positive
government expenditure should induce economic stimulation by means of an income
multiplier effect. Though, this positive effect on output is more important the farther the
economy is from full employment, its importance depends also on the time length
considered. The “utilisation effect” may have relatively large relevance in the short run,
but it may have much less pronounced output effects in a longer span (Smith, 2000).
Another highly discussed effect from the demand side point of view is the opportunity
cost of defence spending in terms of other government expenditures, i.e. the crowding
out effect. The most obvious cost of military spending is the reduction of resources
available for investment which turns to be a drag for the economic take-off. Roughly
speaking, when defence spending is financed with cuts in other public expenditure, the
crowding out is a direct cost of the defence sector, such that the resource constraints
they face may substantially hinder the Keynesian multiplier effect.
Focusing our attention in the empirical analysis, it is known that the robustness of the
aforementioned long run model can be better obtained by working with quarterly
frequency data. While for the US, National Income and Product Accounts (NIPA)
produces quarterly data for the categories of government defence ad civilian
expenditure, we have an issue with the classification of government expenditure in the
UK, because quarterly observations are available for the series of total public
consumption only, while disaggregated information on the composition of public
spending are available on annual basis. Thus, we provide to reconstruct quarterly data
on defence and non-defence public expenditure of the UK by disaggregating the relative
annual series in line with the Chow and Lin’s procedures (1971).
11
In summary, this paper theoretically justifies and empirically tests two hypotheses: (i)
the effects of defence expenditure on output depend on the long run equilibrium model
that also includes the variables of policy monetary and civilian expenditure; (ii) defence
expenditure, as a component of public expenditure, positively and significantly impact
on the long run output. In both countries, the identification of a cointegrating vector
shows the coherence with the Keynesian model. However, by assessing the estimated
parameters of the models, we find that the relationship between defence expenditure and
output is strongly sample-dependent with a fall of the elasticity values in more recent
years. This implies that a better understanding of the pattern between government
defence expenditure and output is an important prerequisite to strengthen policy
recommendations.
3.2. The theoretical framework
In this section, an IS-MP model that identifies the policy fiscal shocks by using the
defence and civilian expenditure components of the public budget sector will be
formulated. To organize the discussion, a stripped-down baseline model is exposited as
a version of one described in Atesoglu (2002), to characterize a number of broad
principles that underlie optimal policy management. We then consider the fiscal policy
implications adding various real world complications to test how the prediction from
theory is linked with policy-making in practice. Specifically, it will serve as a basis for
the empirical work to assess the impact of the government defence expenditure on
economic stimulation.
Because we are interested in characterizing fiscal policy rules in terms of composition
of the government budget, the model we use evolve as in Romer (2000) and Taylor
(2000) and it is derived by assuming that the real interest rate is predetermined by the
central bank1. The main change of the monetary policy rule is that it replaces the
assumption to target the money supply with respect a simple interest rate rule, as
supported by the central banks behaviour in the developed countries (Taylor, 1993).
1
In the complete version of the new macroeconomic model, R is explained by additional equations.
12
On the other hand, to evaluate the importance of this assumption may depend on its
applications. For example, it might be reasonable to ignore that the real interest rate may
depend on aggregate output, when applied to the effects of government expenditure of
civilian and defence categories, if the aim is to examine their effects on aggregate
output rather than to assess the new Keynesian model2.
Below, we formally document the theoretical framework and we discuss the assumption
of the model. Let R jt denote the measure of type-j interest rate chosen as leading target
indicator from the Central Bank in period t to drive the monetary policy3. Then, the
aggregate output, the amount of the final good and services produced in the economy, is
denoted as Yt . Since the aggregate income is Yt  W (rjt ) , the mathematical formulation
of the IS equilibrium equation requires that:
Yt   Rt  t
[1]
where  t is a stochastic term that includes shocks of fiscal policy or the net export
variable. The right-hand side of IS equation describes the known inverse relationship
between the (real) rate of interest targeted by the central bank choices and aggregate
output. The stochastic term of Equation [1] plays a central role in the following analysis
since we will concentrate our estimations on the effects of government defence
expenditure. Hence, it is worth thinking of the intuitive meaning behind it. If this
specific component of fiscal policy increase, the shock on the IS curve generates a
positive shift on output and a new equilibrium in the output-real interest rate space is
produced. Let M and G denote defence and civilian components of total government
expenditure, respectively, that we will identify as fiscal policy shocks in the Keynesian
model.
Let us now turn to the real interest rate. This variable is assumed dependent only on
inflation such as the behaviour rule generates a monetary policy (MP). For sake of


simplicity, we assume that: rt   , where  is the inflation rate assumed predetermined
(known) from the central bank. A number of implications emerge from this baseline
2
It is worth noting that the straightforward assumption that the central bank is able to follow a real
interest rate rule makes the model Keynesian.
3
See Atesoglu (2007) for a discussion on the choice rule of the interest rate target.
13
case in which monetary policy is firmly based. The optimal policy embeds inflation
targeting in the sense that it calls for instantaneous adjustment to the optimal inflation
rate. The implication (and simplification) of our model focused on evaluating fiscal
policy shocks is that the central bank adjust the nominal short rate one-for-one with
perfect foresight of (expected future) inflation. That is, it should instantaneously adjust
the nominal interest rate such that it does not alter the real interest rate (and aggregate
demand).
To sum up, since the central bank’s choice of the real interest rate is strictly
predetermined by inflation, the real interest rate rule can be approximated by a
horizontal line in output-real interest rate space such that the IS curve, that includes
government defence and civilian expenditure and real interest rate, then determines
aggregate output.
Rather than work through the details of the derivation, we instead directly introduce the
key aggregate relationships by the reduced form of the model. For convenience, the
framework abstracts from public expenditure was financed. This abstraction does not
affect any qualitative conclusions as we discuss. Formally, the model specification is as
follow:
Yt   0*   2* M t   3*Gt   4* Rt   t
[2]
where the  t term of the Equation [2] contains net export shocks.  *  ( 0* ,  2* ,  3* ,  4* )
represents the vector of parameters to be estimated.
Though the model is quite simple, it nonetheless contains the main ingredients of
descriptively richer frameworks that are used for policy analysis. Within the model, as
in practice, the instruments of fiscal policy based on the composition of the government
expenditure account for the short term fluctuations. However, we remark that the policy
design problem is to characterize how the composition of government expenditure may
affect the long run relationship, namely the equilibrium relationship. For this reason, in
next Section, a dynamic reduced form model will enable to test the presence of a long
run effects of the Keynesian stimulus on the economy.
14
3.3. The econometric model
Given equation [2], we discuss its specification as a cointegrated system. It firstly
considers the vector autoregressive (VAR) formulation and then describes the
corresponding vector error correction (VECM) representation. This model will be then
applied in Section 4 for testing the impact of defence spending on the output for the US
and UK.
Formally, we consider an extended VAR(p) specification for mx1 vector of variables:
p
X t   0  1T  h Dth   Ai X t i   t
t  1,........, T
[3]
i 1
0,
with i  (0,1........) and Dth  
1,
th
th
where 0 is mx1 constant term, 1 is mx1 coefficient vector related to the
deterministic trend, Dth is a dx1 vector containing deterministic variables (shift
dummies) and h the corresponding mxd matrix of parameters. Ai is a mxm matrix of
unknown parameters, while  t is a Gaussian white noise process with covariance matrix
 and p the lag order of the VAR. Equation [3] can be rewritten in a VECM form as:
p 1
p 1
i 1
j 1
X t   0  X t*1   i X t i    j Dt  j   t
p
p
i 1
j i 1
[4]
where   ( Ai  I p ) , i    A j and  j   j  with j  1..... p  1 . The matrix
of parameters  (m x m  2) describes the long-run relationship of the VECM among
the variables in the vector X t*1  [ X t 1 ; Dt ; T ]' . A necessary condition is that the
polynomial characteristics associated with the VAR can determine the stability of the
system.  i refer to the short-run dynamics of the system X t 1 , while Dt  j
characterises the persistence of a shock of the variables included in the cointegration
space by means of the vector of shift dummy variables.
15
Under general conditions, the VECM equation [4] is I(1) and cointegrated and can be
written as4:
p 1
p 1
i 1
j 1
X t   0   * X t*1   i X t i    i Dt  j   t
[5]
where  *  [ ' , , ] ,    ' 1 and    ' . In the equation [5]  is a mxr
matrix,  * is (m  2) xr matrix and r (0  r  m) is the cointegration rank of the system.
The VECM equation [5] is the extended model of this article. The residual rx1 vector
u t   * X t* in equation [5] is trend-stationary and, under suitable unitary identifying
'
normalization, it can be interpreted as a vector of deviations of observable variables
from the long run equilibrium relationships.
With respect to the theoretical discussion in Section 2, we have assumed that the
cointegrating rank is given by r  1 . The long run equilibrium levels are predicted by
equation [5] by identifying the block decomposition of the matrix X t  ( X 1't , X 2t ) ' ,
where X 1t  (Yt ) and X 2t  ( M t , Gt , Rt ) is the 3x1 vector containing real defence and
civilian spending and real interest rate. The deviation of estimated from observable
output can be therefore obtained as:
 X 1t 1 
X 
*
'
ut 1   * X t 1   I1 , 2 ,  ,    2t 1   X 1t 1  2' X 2t 1   Dt  T
 Dt 


T

[6]
It is possible that some institutional decisions regarding monetary or fiscal policies can
modify the structure of long run patterns of time series. The exclusion of a determinist
trend component as well as shift dummy variables from the econometric analysis may
be a cause of possible misspecifications of the model and of the inconsistency in the
estimation results. Thus, in order to empirically test the best dynamic specification that
rationalize the data, nested models are obtained setting   0 , in which is excluded the
4
The set of the conditions because Equation [5] is I(1) and cointegrated are: i) the roots of the
characteristic polynomial are outside the unit circle; ii)  t   ' where  and  ' are matrices of full rank
r ' , 0  r  m ; iii) the matrix obtained by multiplying the orthogonal complement of the matrix and the
parameter matrix of long run is non-singular (Johansen, 1995).
16
presence of a linear deterministic trend in equation [6], or setting   0 where a model
without shift dummy is specified, or a long run specification that both restricts the
hypothesis tests.
From the conditions to derive the equation [6] follows that a cointegrated system is
obtained by a reduced rank of the  matrix. In a parsimonious long run dynamic
model, inference on the number of cointegration relationships can be carried out by
testing the hypothesis:
H (r )  rank ( )  r against the alternative H (m)  rank ( )  m
[7]
for r  0,1,.....m  1. By maximizing the log-likelihood of the equation [5] both under
the null and alternative hypotheses, we derive the likelihood ratio or trace statistics that
has non standard distribution. For the models that include the presence of changes of the
constant term or the presence of a linear deterministic trend, the quantiles of the trace
statistics are tabulated by simulation in Johansen (1995), while for the specifications
that contain shift dummy the tabulated quantiles are derived by (Johansen et al., 2001).
17
References
Abbad, A., Quillis, E. (2005). Software to perform temporal disaggregation of economic
time series, Eurostat, Working Paper and Studies.
Atesoglu, H.S. (2007). Monetary Policy Rules and US Monetary Policy. Journal of Post
Keynesian Economics; Forthcoming.
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4. THE DEFENCE ECONOMICS PROBLEM
4.1. Objectives
Following the end of the Cold War, defence budgets have been either constant or falling
in real terms, and these limited budgets are faced with rising input costs of both capital
and labour. Equipment costs have been rising at some 10% per annum in real terms
which means a long run reduction in the numbers of weapons acquired for the Armed
Forces. Similarly, with an all volunteer force, the costs of military personnel have to rise
faster than wage increases in the civil sector. This wage differential is required to attract
and retain military personnel by compensating them for the net disadvantages of
military life. This combination of constant or falling defence budgets and rising input
costs means that governments cannot avoid the need for difficult choices in a world of
uncertainty, where the future is unknown and no one can predict accurately the future
(Hartley, 2006).
Thus, there is the challenge of achieving “top level” efficiency in defence provision.
The goal of this chapter is to analyse this challenge. Economic theory solves this
challenge as a standard optimization problem involving the maximization of a social
welfare function subject to resource or budget constraints, where welfare is dependent
on civil goods and security, with security provided by defence. Operationalising this
apparently simple optimization rule is much more difficult. Individual preferences for
defence are subject to its public good characteristics and free riding problems arise.
4.2. Theoretical model
Methodology: optimization problem.
4.3. Data requirements
The data of defence industries are taken from North Atlantic Treaty Organization
(NATO), and from Stockholm International Peace Research Institute (SIPRI). The data
of the civilian category of government expenditure are taken from Organization for
Economic Cooperation and Development (OECD).
20
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