nep-opm New Economics Papers
on Open MacroEconomics
Issue of 2011‒03‒19
seven papers chosen by
Martin Berka
Massey University, Albany

  1. The Capital Inflow “Problem” Revisited By Reinhart, Carmen; Reinhart, Vincent
  2. Capital inflows and exchange rate in LDCs: The Dutch disease problem revisited By Mouhamadou Sy; Hamidreza Tabarraei
  3. Price dispersion in Europe: Does the business cycle matter? By Marco Hoeberichts; Ad Stokman
  4. Income insurance and the determinants of income insurance via foreign asset revenues and foreign liability payments By Balli, Faruk; Basher, Syed Abul; Ozer-Balli, Hatice
  5. The Dynamics between Real Exchange Rate Movements and Trends in Trade Performance: The Case of Ethiopia By Melesse, Wondemhunegn Ezezew
  6. Real indeterminacy and the timing of money in open economies By Stephen McKnight
  7. Carry Trades and Global Foreign Exchange Volatility By Menkhoff, Lukas; Sarno, Lucio; Schmeling, Maik

  1. By: Reinhart, Carmen; Reinhart, Vincent
    Abstract: Capital inflows can be a mixed blessing, especially in economies with thin domestic financial markets and when driven by investors with a short-term focus. Many levers of policy can be applied to resist the effects of the inflows. One that has been widely relied upon has been currency intervention. Key to that appears to be keeping their bilateral exchange rate stable vis-à-vis the U.S. dollar. But this requires them to resist currency appreciation and accumulate dollar reserves when the anchor country is mired in financial problems and keeps monetary policy accommodative in an unprecedented manner. The willingness of emerging market economies to limit exchange rate fluctuations will be tested as monetary policy in advanced economies remains geared toward domestic considerations. Meanwhile, some advanced economies will be looking to finance large deficits and to roll over large debts. In that environment, prior reticence toward capital controls and other restrictions on finance may well lift. For emerging markets, this insulates them from monetary policy in advanced economies that may be inappropriate for domestic circumstances. For advanced economies, this limits the competition for the debt they dearly have to sell. In such a world, the policy tools we discussed will be increasingly relied upon.
    Keywords: capital flows; reserves; exchange rates;capital controls
    JEL: F40 F30
    Date: 2011–02
  2. By: Mouhamadou Sy (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole des Ponts ParisTech - Ecole Normale Supérieure de Paris - ENS Paris - INRA, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris); Hamidreza Tabarraei (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole des Ponts ParisTech - Ecole Normale Supérieure de Paris - ENS Paris - INRA, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)
    Abstract: In this paper, the link between capital inflows and real exchange rate movements in LDCs is revisited theoretically and empirically. On the theoretical side we present a simple model to show that the real exchange rate depends mainly on "real fundamentals" such as terms of trade or productivity differentials. Empirically, we take into account the heterogeneity of the sample, the dynamics of the RER and the non stationary nature of the data. Capital inflows can be oil revenues, foreign aid, remittances or FDI. We show that real fundamentals are the main driving forces of real exchange rate movements in LDCs and not capital inflows. The Balassa-Samuelson effect by itself accounts for 57% of the RER variations while capital inflows account only for 19% of RER variations. The Dutch Disease theory is not rejected but its effect on RER movements in LDCs is weak.
    Keywords: Dutch disease ; capital inflows ; real exchange rate ; dynamic and heterogeneous panel
    Date: 2010–04
  3. By: Marco Hoeberichts; Ad Stokman
    Abstract: We analyze the effect of the business cycle on price dispersion in Europe . Five decades of price level dispersion data for Europe enable us to distinguish short-term influences from long-term influences like market integration. We find that at the business cycle frequency, price dispersion across EMU member countries over the 1960 - 2009 period is significantly lower during economic downturns. This confirms on a macroeconomic level the evidence from micro and survey studies that markets become more competitive with falling demand, reducing deviations from the Law of One Price. Our model replicates most of the major drops in price level dispersion during severe economic recessions of the early 1970s, 1980s and 1990s, as well as the small change during the recent financial crisis.
    Keywords: economic integration; price level convergence; Law of One Price; EMU; business cycle
    JEL: E31 E50 F15 F41
    Date: 2011–03
  4. By: Balli, Faruk; Basher, Syed Abul; Ozer-Balli, Hatice
    Abstract: We document that the net factor income smoothing channel in OECD countries is primarily driven by net financial asset income, while the other two sub-components (net compensation of employees, net taxes on imports) turn out to be ineffective. Once factor income inflows are distinguished from outflows, empirical evidence suggests a non-significant effect of inflows in terms of income smoothing as opposed to a positive and significant role of factor income outflows (18 percent for the EMU and 16 percent for the EU). Factor income outflows also appear robust with respect to positive output shocks, while neither factor income inflows nor factor income outflows provide insurance against negative output shocks. In terms of the determinants of income smoothing, results indicate that an increase in foreign equity and debt liabilities positively affect the extent of smoothing via factor income outflows. Whereas, contrary to the current literature, an increase in foreign assets holding does not have a positive impact on smoothing via factor income inflows. The tendency of European investors' in allocating a sizeable portion of their assets within the Euro zone is shown to undermine income smoothing.
    Keywords: Factor income flows; Consumption smoothing; Income smoothing; International portfolio diversification.
    JEL: F36
    Date: 2011–02–13
  5. By: Melesse, Wondemhunegn Ezezew
    Abstract: Ethiopia’s exchange rate policies have been a bone of contention for concerned economic analysts and commentators alike. This study takes a new look at the record to explore the impact of exchange rate liberalization reforms on export growth in Ethiopia. I employ generalized method of moments estimators (GMM) techniques on time series data for the period 1981-2009. The study does not support the widely held view that exchange rate reforms induce export growth. But world income was found to positively impact Ethiopia’s export receipts over time.
    Keywords: Real Exchange Rate; Devaluation; Export Performance
    JEL: F00 B22 C22 A10
    Date: 2011–03–04
  6. By: Stephen McKnight (El Colegio de México)
    Abstract: Should central banks target producer price inflation or consumer price inflation in the setting of monetary policy? Previous studies suggest that in order to avoid real indeterminacy and self-fulfilling fluctuations, the interest rate rule for open economies should react to producer price inflation. However, as this paper shows, the preference towards a particular inflation index crucially depends upon the timing assumption on money employed in the determinacy analysis. This timing assumption importantly determines the transactions-facilitating services of money. It is shown that the conclusions of the existing literature, that advocate targeting producer price inflation, is a by-product of adopting end-of-period timing, i.e. what matters for transactions purposes is the money one leaves the goods market with. However, we find that the conditions for equilibrium determinacy change significantly once cash-in-advance timing is adopted, i.e. what matters for current transactions is the money one enters the goods market with. Thus in stark contrast to previous studies, we show that under cash-in-advance timing, targeting consumer price inflation is preferable to targeting producer price inflation in preventing self-fulfilling expectations.
    Keywords: real indeterminacy, open economy monetary models, trade openness, interest rate rules
    JEL: E32 E43 E53 E58 F41
    Date: 2011–03
  7. By: Menkhoff, Lukas; Sarno, Lucio; Schmeling, Maik
    Abstract: We investigate the relation between global foreign exchange (FX) volatility risk and the cross-section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high-interest rate currencies, so-called 'carry trades'. We find that high interest rate currencies are negatively related to innovations in global FX volatility and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Our proxy for global FX volatility risk captures more than 90% of the cross-sectional excess returns in five carry trade portfolios. In turn, these results provide evidence that there is an economically meaningful risk-return relation in the FX market. Further analysis shows that liquidity risk also matters for expected FX returns, but to a lesser degree than volatility risk. Finally, exposure to our volatility risk proxy also performs well for pricing returns of other cross sections in foreign exchange, U.S. equity, and corporate bond markets.
    Keywords: carry trade; forward premium puzzle; liquidity; volatility
    JEL: F31 G12 G15
    Date: 2011–03

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