The main objective of this £5 million programme is to promote and support world-class theoretical, empirical and policy-oriented research focusing on the interrelationship between finance and the world economy under the following two related areas:

Rationale/Profile for the Programme:

Given the recent world events, the subject matter provides an opportune moment for a broadly based yet focused programme of research on Finance and World Economy, to address a number of key issues faced by academics, policy makers and practioners.

The questions or topics, set out above, have been formulated following an extensive consultation exercise with senior academics and policy makers both in the UK and overseas. They should, therefore, provide a very useful framework for researchers, and help them to propose projects based on ideas that are likely to be 'winners' in terms of high quality academic research and policy relevance.

Scientific, Practical and Policy Context:

The context in which the research will be carried out is one in which the transition economies and developing countries are challenged both by their own needs for appropriate policy and the knock-on implications of the policies adopted in the developed world. Many of these countries are additionally handicapped by an inadequately developed institutional infrastructure that prevents them from benefiting fully from increased integration of financial markets. For example, inadequate enforcement of contracts, protection of (physical and intellectual) property rights, and corruption are widely recognised as substantial obstacles to investments, FDI, trade, financial developements in political economy, which highlight the influence of interest groups.

Financial instability has had enormous consequences on the world economy, affecting even relatively successful economies, and a major adjunct of attacking world poverty under the UN vision for 2015 has to be achieving a more stable financial environment. Financial crises in East Asia, Russia and more recently Argentina, have rekindled the debate on the choice of an exchange rate regime and the desirability of free capital flows. They have also raised important questions concerning the policies of the IMF in resolving financial crises, and, more broadly its governance and accountability. There are also related questions regarding the transmission mechanisms of financial instability across borders and the influence of psychological factors. Episodes of financial instability have also served to highlight the link between poverty and poorly designed policies, as well as the political economy aspects of financial crises. Demographic developments, such as the rise of Aids in Africa are likely to become increasingly important in the design of appropriate policies, providing additional challenges for policy makers. Some of the epidemiological projections regarding Aids, for example, are quite worrying. Yet, there is very little, if any analysis, of these new challenges and their implications for policies.

In contrast, the developed world is characterised by downward spiralling financial markets, widespread low inflation, with monetary policy based on inflation targeting and floating exchange rates. There are also concerns about private savings in these countries (too little in some countries, too much in others) as well as over investment and public debt.

The dominant framework for monetary policy in the developed world, and increasingly also in emerging countries, is one in which independent commitees of experts or independent central banks set interest rates. It seems for the moment that the question of how to conduct monetary policy has been 'solved'. But how long will this regime last? On past experience, one would not expect any monetary policy regime - however seemingly stable - to last long. In theoretical terms the current (Kydland-Prescott-Lucas) paradigm, on which this policy framework is based, does not recognise financial market imperfections or incompleteness, and ignores the importance of stock market volatility and the existence of distortionary fiscal policy. Thus, many of the theoretical solutions break down under plausible scenarios, for example when there are asset price bubbles, multiple equilibria or bounded rationality. In practical terms, one danger associated with low inflation is Japanese-style persistent depression following over investment and deflation of asset values. An interesting feature of Japan and other countries is the prolonged failure of policymakers to tackle these problems effectively, which may indicate the relevance of political economy considerations, such as active interest groups and political pressures to maintain the status quo.

A further feature of low inflation is the question of whether it is associated with more wage and price rigidity, which may indicate the existence of a long-run inflation/employment trade-off. A related development concerns public debt and its interation with changing demographics - ageing populations and changing patterns of work and leisure - and their wider socio-economic effects.

The appropriate (re-)design of the international financial architecture, together with appropriate ,echanisms for crisis avoidance and resolution remains a high priority for policy makers. Progress has been quite slow in this area and there still remain many issues to be worked through before such a mechanism is likely to come into being.

Last but by no means least, the broader context in which the research will be carried out is one in which global security issues are of paramount importance, following on from the events of 9/11 in the U.S. and subsequent developments in Asia and the Middle East. These vents have exposed a new and so far little understood source of vulnerability for the world economy, which a programme of research on 'finance and world economy' cannot ignore. The social and political aspects of these events, as well as their causes and effects together with the role played by finance, need to be better understood by researchers and policy makers alike. This undoubtedly dictates innovative inter-disciplinary approaches and international perspectives.

Research needs / implications (data, methods etc):

In the absence of a suitable established model of financial markets and their interrelationship with the world economy, research methods will include developing theoretical approaches as well as empirical testing of data, new models and ideas. Empirical methods to address the research questions and topics will include time series studies using long-run historical data, mostly available for developed economies, and cross section or, perhaps more profitably panel data, which exploit both cross-country and time-series variation using state of the art computational, econometric and statistical techniques.

There is also scope for greater diversity in the data and models that can be used to examine institutional, political economy, and psychological or geographical factors. Scope for new theoretical and analytical interdisciplinary work also provides ample opportunities for methodological advances across the different social science disciplines and to provide a greater evidence base for policy making. Besides the empirical testing of theories, some research questions would also lend themselves to financial and economic experiments, across countries and cultures, thereby moving the field of experimental economics more into the grounds of finance and psychology and thus widening the scopes for comparison. For example, it would be worthwhile using experiments to test whether rational choice and efficient markets receive more support in experiments conducted in Anglo-Saxon countries, than in transition economies, with their post-communist legacy, or in Muslim countries. Similarly, the Programme would bring anthropological insights into advancing our understanding of apparently intractable economic problems such as the failure of repeated fiscal and monetary interventions in Japan.

Data resources to support the programme are also available through the Economic and Social Data Service (ESDS) International via the following web link: