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on International Finance |
| By: | Adrien Verdelhan (Department of Economics, Boston University) |
| Abstract: | This paper presents a fully rational general equilibrium model that produces a time- varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more risk-averse than her foreign counterpart. Times of high risk- aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor. |
| Keywords: | Exchange rate, Time-varying risk premium, Habits |
| JEL: | F31 G12 G15 |
| Date: | 2005–08 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-031&r=ifn |
| By: | Christopher Gust; Nathan Sheets |
| Abstract: | Recent papers have found evidence of a decline in exchange rate pass-through to import prices in the United States and in a number of other industrial countries as well. This paper examines the implications of a decline in pass-through for the prospective adjustment of global external imbalances. We find that a decline in pass-through to trade prices may mute the responsiveness of the nominal trade balance to shifts in the exchange rate, but that a decline in pass-through does not shut down nominal adjustment completely. We also find that the channels of adjustment vary with pass-through. When pass-through is high, nominal adjustment is driven by moves in trade quantities. When pass-through is low, nominal adjustment mainly reflects shifts in the terms of trade (i.e., export prices relative to import prices). Our work employs a forward-looking, optimizing model in which firms set their prices with an eye toward maintaining their competitiveness against other producers; this feature of the model generates a variable desired markup and, hence, exchange rate pass-through that is less than complete. |
| Keywords: | Foreign exchange rates ; Balance of trade |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgif:850&r=ifn |
| By: | Michele Cavallo; Cedric Tille |
| Abstract: | A narrowing of the U.S. current account deficit through exchange rate movements is likely to entail a substantial depreciation of the dollar, as stressed in research by Obstfeld and Rogoff. We assess how the adjustment is affected by the high degree of financial integration in the world economy. A growing body of research emphasizes the increasing leverage in international financial positions, with industrialized economies holding substantial and growing financial claims on each other. Exchange rate movements then lead to valuation effects as the currency composition of a country's assets and liabilities are not matched. In particular, a dollar depreciation generates valuation gains for the United States by boosting the dollar value of much of its foreign-currency-denominated assets. We consider an adjustment scenario in which the U.S. net external debt is held constant. The key finding is that as the current account moves into balance, the pace of adjustment is smooth. Intuitively, the valuation gains from the depreciation of the dollar allow the United States to finance ongoing, albeit shrinking, current account deficits. We find that the smooth pattern of adjustment is robust to alternative scenarios, although the ultimate movements in exchange rates will vary under different conditions. |
| Keywords: | International finance ; Foreign exchange ; Dollar, American |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:237&r=ifn |
| By: | Joshua Aizenman; Reuven Glick |
| Abstract: | This paper studies the empirical and theoretical association between the duration of a pegged exchange rate and the cost experienced upon exiting the regime. We confirm empirically that exits from pegged exchange rate regimes during the past two decades have often been accompanied by crises, the cost of which increases with the duration of the peg before the crisis. We explain these observations in a framework in which the exchange rate peg is used as a commitment mechanism to achieve inflation stability, but multiple equilibria are possible. We show that there are ex ante large gains from choosing a more conservative not only in order to mitigate the inflation bias from the well-known time inconsistency problem, but also to steer the economy away from the high inflation equilibria. These gains, however, come at a cost in the form of the monetary authority's lesser responsiveness to output shocks. In these circumstances, using a pegged exchange rate as an anti-inflation commitment device can create a "trap" whereby the regime initially confers gains in anti-inflation credibility, but ultimately results in an exit occasioned by a big enough adverse real shock that creates large welfare losses to the economy. We also show that the more conservative is the regime in place and the larger is the cost of regime change, the longer will be the average spell of the fixed exchange rate regime, and the greater the output contraction at the time of a regime change. |
| Keywords: | Foreign exchange rates ; Monetary policy |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedfwp:2006-07&r=ifn |
| By: | Willem THORBECKE |
| Abstract: | East Asia is characterized by intricate production and distribution networks. Higher skilled workers in Japan, South Korea, and Taiwan produce sophisticated technology-intensive intermediate goods and capital goods and ship them to China and ASEAN for assembly by lower skilled workers and reshipment throughout the world. These networks have promoted economic efficiency and functioned as an engine of growth. They have also been accompanied by large trade imbalances with the U.S. that could cause Asian currencies to appreciate against the dollar. This in turn would alter relative exchange rates in Asia, given the variety of exchange rate regimes in the region. This paper investigates how such exchange rate changes would affect trade within Asia and between Asia and the U.S. The results indicate that exchange rate changes can cause significant declines in exports of intermediate and capital goods from developed Asia to developing Asia. This evidence implies that exchange rate appreciations in developed Asia relative to developing Asia would disrupt the complimentary relationship that exists between these countries in the trade of sophisticated technology-intensive goods. The results also indicate that exchange rate elasticities for trade between Asia and the U.S. are not large enough to lend confidence that a depreciation of the dollar would improve the U.S. trade balance with Asia. This evidence implies that policymakers in the U.S. should not expect too much from an appreciation of Asian currencies and should focus instead on shortfalls of saving relative to investment if they are concerned about their trade imbalances. |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:eti:dpaper:06009&r=ifn |
| By: | Hanno Lustig; Adrien Verdelhan (Department of Economics, Boston University) |
| Abstract: | Investors earn positive excess returns on high interest rate foreign discount bonds, because these currencies appreciate on average. Lustig and Verdelhan (2005) show that investing in high interest rate foreign discount bonds exposes them to more aggregate consumption risk, while low interest rate foreign bonds provide a hedge. This paper provides a simple model that replicates these facts. Investing in foreign currency is like betting on the di®erence between your own intertemporal; marginal rate of substitution (IMRS) and your neighbor's IMRS. These bets are very risky if your neighbor's IMRS is not correlated with yours, but they provide a hedge when his IMRS is highly correlated and more volatile. If the foreign neighbors that face low interest rates also have more volatile and correlated IMRS, that accounts for the spread in excess returns in the data. |
| Keywords: | Exchange Rates, Currency Risk. |
| Date: | 2005–10 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-038&r=ifn |
| By: | Adrien Verdelhan (Department of Economics, Boston University); Hanno Lustig (UCLA/ NBER) |
| Abstract: | Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate di®erential and why high interest rate currencies do not depreciate as much as the interest rate di®erential. We sort foreign currency returns into portfolios based on foreign interest rates, and we test the Euler equation of a domestic investor who invests in these currency portfolios. We ¯nd that domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies do not under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk. |
| Keywords: | Exchange Rates, Asset Pricing. |
| Date: | 2005–06 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-019&r=ifn |
| By: | Isabel Faeth |
| Abstract: | In this paper the determinants of FDI inflows in Australia, the second largest net importer of FDI in the developed world, are analysed using quarterly aggregate data for Q3/1985 to Q2/2002. FDI inflows are explained using market size, factor costs, transport costs and protection, risk factors, policy variables and other factors, i.e. variables based on a number of different theoretical models. It was found that Australian FDI is driven by longer term considerations and its determinants could not be fully explained by any single theoretical model. Exchange rate appreciation discouraged FDI in the medium-term, but had a positive longer term effect, indicating that FDI is encouraged by a sound economic environment. There was, however, no evidence that lower corporate tax rates increased FDI inflows. |
| Keywords: | FDI; Time Series Analysis |
| JEL: | F21 C22 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:mlb:wpaper:946&r=ifn |