nep-ifn New Economics Papers
on International Finance
Issue of 2007‒02‒24
eleven papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. Purchasing Power Parity: The Irish Experience Re-visited By Derek Bond; Michael J. Harrison; Edward J. O'Brien
  2. Hitting and Hoping? Meeting the Exchange Rate and Inflation Criteria During a Period of Nominal Convergence By John Lewis
  3. Testing the Equilibrium Exchange Rate Model - Updated By Guilherme, Moura; Sergio, Da Silva
  4. Random Walk Expectations and the Forward Discount Puzzle By Bacchetta, Philippe; van Wincoop, Eric
  5. Currency Areas and International Assistance By Tim Worrall; Pierre M. Picard
  6. Solving Endogeneity in Assessing the Efficacy of Foreign Exchange Market Interventions By Seok Gil Park
  7. On Current Account Surpluses and the Correction of Global Imbalances By Sebastian Edwards
  8. "Fixed and Flexible Exchange Rates and Currency Sovereignty" By C. Sardoni; L. Randall Wray
  9. The Returns to Currency Speculation in Emerging Markets By Craig Burnside; Martin Eichenbaum; Sergio Rebelo
  10. "Global Imbalances, Bretton Woods II, and Euroland's Role in All This" By Joerg Bibow
  11. Transmitting shocks to the economy: The contribution of interest and exchange rates and the credit channel By Edda Claus; ris Claus

  1. By: Derek Bond (University of Ulster); Michael J. Harrison (Department of Economics, Trinity College); Edward J. O'Brien (European Central Bank)
    Abstract: This paper looks at issues surrounding the testing of purchasing power parity using Irish data. Potential difficulties in placing the analysis in an I(1)/I(0) framework are highlighted. Recent tests for fractional integration and nonlinearity are discussed and used to investigate the behaviour of the Irish exchange rate against the United Kingdom and Germany. Little evidence of fractionality is found but there is strong evidence of nonlinearity from a variety of tests. Importantly, when the nonlinearity is modelled using a random field regression, the data conform well to purchasing power parity theory, in contrast to the findings of previous Irish studies, whose results were very mixed.
    JEL: C22 F31 F41
    Date: 2006–11
  2. By: John Lewis
    Abstract: This paper analyses the problem faced by CEECs wishing to join the Euro who must hit both an inflation and exchange rate criterion during a period of nominal convergence. This process requires either an inflation differential, an appreciating nominal exchange rate, or a combination of the two, which makes it difficult to simultaneously satisfy the exchange rate and inflation criteria. The authorities can use their monetary policy to hit one criterion, but must essentially just "hope" to satisfy the other one. The paper quantifies the likely size and speed of these convergence effects, their impact on inflation and exchange rates, and their consequences for the simultaneous compliance with both criteria under an inflation targeting setup and under a fixed exchange rate regime. The key result is that under an inflation targeting regime, the nominal appreciation implied by convergence is not big enough to threaten a breach of the exchange rate criterion, but for countries with fixed exchange rates, inflation is likely to exceed the reference value. This result is robust to plausible changes in the assumed convergence scenario.
    Keywords: Central and Eastern Europe; Nominal Convergence; Euro Adoption
    JEL: E52 E61 E31
    Date: 2007–01
  3. By: Guilherme, Moura; Sergio, Da Silva
    Abstract: We find favorable evidence for the textbook equilibrium exchange rate model of Stockman (1987) using Blanchard and Quah’s (1989) decomposition. Real shocks are shown to account for more than 90 percent of movements in the real exchange rate between Brazil and the US, and for more than half of nominal exchange rate changes. Impulse response functions also suggest that real shocks alter these countries’relative prices.
    Keywords: Equilibrium Exchange Rate Model; Blanchard and Quah’s Decomposition
    JEL: F41 F31 F47 F37
    Date: 2006
  4. By: Bacchetta, Philippe; van Wincoop, Eric
    Abstract: Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk while at the same time exchange rate changes are predictable by interest rate differentials. In this paper we investigate whether these two features of the data may in fact be related. In particular, we ask whether the predictability of exchange rates by interest differentials naturally results when participants in the FX market adopt random walk expectations. We find that random walk expectations can explain the forward premium puzzle, but only if FX portfolio positions are revised infrequently. In contrast, with frequent portfolio adjustment and random walk expectations, we find that high interest rate currencies depreciate much more than what UIP would predict.
    Keywords: excess return; incomplete information; predictability
    JEL: E4 F3 G1
    Date: 2007–02
  5. By: Tim Worrall (Department of Economics Keele University); Pierre M. Picard (University of Manchester, School of Social Sciences, Department of Economics)
    Abstract: This paper considers a simple stochastic model of international trade with three countries. Two of the tree countries are in an economic union. Comparisons are made between equilibrium welfare for these two countries under fixed and flexible exchange rate regimes. Within the model it is shown that flexible exchange rate regimes generate greater welfare. However, we then consider comparisons of welfare when the two countries also engage in some international assistance in order to share risk. Such risk-sharing is limited by enforcement constraints of cross border assistance. It is shown that taking into account limited commitment risk-sharing fixed exchange rates or currency areas can dominate flexible exchange rate regimes reversing the previous result.
    Keywords: Monetary Union; Currency Areas; Fiscal Federalism; Limited Commitment; Mutual Insurance
    JEL: F12 F15 F31 F33
    Date: 2007–01
  6. By: Seok Gil Park (Indiana University)
    Abstract: Sterilized foreign exchange market interventions have been suspected of being inefficient by many empirical studies, but they are plagued by endogeneity problems. To solve the problems, this paper identifies a system that depicts interactions between the interventions and the foreign exchange rate. The model shows that the interventions are effective when the interventions alter the market participants' conditional expectations of the rate without decreasing the conditional variances. This paper estimates Markov-switching type policy reaction functions by conditional MLE, and market demand/supply curves by IV estimation with generated regressors. The empirical results verify that the interventions of the Bank of Korea from 2001 to 2002 were indeed effective.
    Keywords: Sterilized intervention, Endogeneity, Markov-switching policy function
    JEL: F31 E58 G15
    Date: 2007–02
  7. By: Sebastian Edwards
    Abstract: In this paper I analyze the nature of external adjustments in current account surplus countries. I ask whether a realignment of world growth rates -- with Japan and Europe growing faster, and the U.S. growing more slowly -- is likely to solve the current situation of global imbalances. The main findings may be summarized as follows: (a) There is an important asymmetry between current account deficits and surpluses. (b) Large surpluses exhibit little persistence through time. (c) Large and abrupt reductions in surpluses are a rare phenomenon. (d) A decline in GDP growth, relative to long term trend, of 1 percentage point results in an improvement in the current account balance -- higher surplus or lower deficit -- of one quarter of a percentage point of GDP. Taken together, these results indicate that a realignment of global growth -- with Japan and the Euro Zone growing faster, and the U.S. moderating its growth -- would only make a modest contribution towards the resolution of global imbalances. This means that, even if there is a realignment of global growth, the world is likely to need significant exchange rate movements. This analysis also suggests that a reduction in China's (very) large surplus will be needed if global imbalances are to be resolved.
    JEL: F02 F31 F32
    Date: 2007–02
  8. By: C. Sardoni; L. Randall Wray
    Abstract: This paper provides an analysis of KeynesÕs original ÒBancorÓ proposal as well as more recent proposals for fixed exchange rates. We argue that these schemes fail to pay due attention to the importance of capital movements in todayÕs economy, and that they implicitly adopt an unsatisfactory notion of money as a mere medium of exchange. We develop an alternative approach to money based on the notion of currency sovereignty. As currency sovereignty implies the ability of a country to implement monetary and fiscal policies independently, we argue that it is necessarily contingent on a countryÕs adoption of floating exchange rates. As illustrations of the problems created for domestic policy by the adoption of fixed exchange rates, we briefly look at the recent Argentinean and European experiences. We take these as telling examples of the high costs of giving up sovereignty (Argentina and the European countries of the EMU) and the benefits of regaining it (Argentina). A regime of more flexible exchange rates would have likely produced a more viable and dynamic European economic system, one in which each individual country could have adopted and implemented a mix of fiscal and monetary policies more suitable to its specific economic, social, and political context. Alternatively, the euro area will have to create a fiscal authority on par with that of the U.S. Treasury, which means surrendering national authority to a central governmentÑan unlikely possibility in todayÕs political climate. We conclude by pointing out some of the advantages of floating exchange rates, but also stress that such a regime should not be regarded as a sort of panacea. It is a necessary condition if a country is to retain its sovereignty and the power to implement autonomous economic policies, but it is not a sufficient condition for guaranteeing that such policies actually be aimed at providing higher levels of employment and welfare.
    Date: 2007–01
  9. By: Craig Burnside; Martin Eichenbaum; Sergio Rebelo
    Abstract: The carry trade strategy involves selling forward currencies that are at a forward premium and buying forward currencies that are at a forward discount. We compare the payoffs to the carry trade applied to two different portfolios. The first portfolio consists exclusively of developed country currencies. The second portfolio includes the currencies of both developed countries and emerging markets. Our main empirical findings are as follows. First, including emerging market currencies in our portfolio substantially increases the Sharpe ratio associated with the carry trade. Second, bid-ask spreads are two to four times larger in emerging markets than in developed countries. Third and most dramatically, the payoffs to the carry trade for both portfolios are uncorrelated with returns to the U.S. stock market.
    JEL: F3 F41
    Date: 2007–02
  10. By: Joerg Bibow
    Abstract: Approaching the issue of mounting global imbalances from the perspective of the ÒBretton Woods II hypothesis,Ó this paper argues that the popular preoccupation with ChinaÕs supposed export-led development strategy is misplaced. It also suggests, similar to JapanÕs depression, subdued growth in Euroland for most of the time since the Maastricht Treaty has been of first-order importance in these developments. Germany is identified as being at the heart of the European trouble. Globally, there is an ongoing clash between two approches to macroeconomic policy making: a highly dogmatic German approach, and a very pragmatic Anglo-Saxon one. The low levels of interest at which global demand imbalances have been smoothed out financially reflect deficient global demand in an environment of vast supply-side opportunities. After contributing greatly to the build-up of imbalances, Euroland is unlikely to play any constructive part in their unwinding. Hampered by an exchange-rate policy vacuum, a small-country mindset, and soaring intra-area imbalances, Euroland is also illpositioned to cope with fading external growth stimuli.
    Date: 2006–12
  11. By: Edda Claus; ris Claus
    Abstract: Understanding the transmission channels of shocks is critical for successful policy response. This paper develops a dynamic general equilibrium model to assess the relative importance of the interest rate, the exchange rate and the credit channels in transmitting shocks in an open economy. The relative contribution of each channel is determined by comparing the impulse responses when the relevant channel is suppressed with the impulse responses when all three channels are operating. The results suggest that all three channels contribute to business cycle fluctuations and the transmission of shocks to the economy. But the magnitude of the impact of the interest rate channel crucially depends on the inflation process and the structure of the economy.
    Keywords: Transmission channels, open economy, general equilibrium model
    Date: 2007–02–19

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