nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2014‒08‒25
eleven papers chosen by
Martin Berka
University of Auckland

  1. Asset Price Bubbles and Monetary Policy in a Small Open Economy By Martha López
  2. Demystifying Dutch disease By Kojo, Naoko C.
  3. The Swiss franc's honeymoon By Rahel Studer-Suter; Alexandra Janssen
  4. Firms’ Heterogeneity and Incomplete Pass-Through By STEFANIA GARETTO
  5. The rise in home currency issuance By Hale, Galina; Jones, Peter; Spiegel, Mark M.
  6. Reserve Requirement Policy over the Business Cycle By Pablo Federico; Carlos A. Vegh; Guillermo Vuletin
  7. A Threshold Vector Autoregression Model of Exchange Rate Pass-Through in Mexico By Abdul Aleem; Amine Lahiani
  8. The Effects of Globalization on Macroeconomic Dynamics in a Trade-Dependent Economy: the Case of Korea By Fabio Milani; Sung Ho Park
  9. Determinants of the real impact of banking crises: A review and new evidence By Philip Wilms; Job Swank; Jakob de Haan
  10. Debt Dilution and Sovereign Default Risk By Juan Carlos Hatchondo; Leonardo Martinez; Cesar Sosa-Padilla
  11. Cross-Country Interactions, the Great Moderation and the Role of Output Volatility in Growth By Steven Trypsteen

  1. By: Martha López
    Abstract: In this paper we expanded the closed economy model by Bernanke and Gertler (1999) in order to account for the macroeconomic effects of an asset price bubble in the context of a small open economy model. During the nineties emerging market economies opened their financial accounts to foreign investment but it generated growing macroeconomic imbalances in these economies. Our goal in this paper is twofold: first we want to analyze if the conclusions of Bernanke and Gertler (1999) remain in the case of a small open economy. And second, we want to compare the results in terms of macroeconomic volatility of the model for a closed economy versus the model for a small open economy. Our results show that the conclusion about the fact that the Central Bank should not react to asset prices remains as in the case of a closed economy model, and that small open economies are more vulnerable to asset prices bubbles due to capital inflows and the exchange rate mechanism of the monetary policy. Therefore in small open economies the business cycle is deeper. Finally, in the face of a boom followed by a bust in an asset price bubble, macroeconomic volatility would be dampened if the monetary authority focus only on inflation.
    Keywords: Exogenous bubble, monetary policy, macroeconomic volatility, DSGE model.
    JEL: E32 R40 E47 E52
    Date: 2014–08–08
  2. By: Kojo, Naoko C.
    Abstract: This paper examines the theory of Dutch disease and its implications for practical policy questions. Dutch disease is a term that is well-known to economists and development practitioners. But it is also a concept that is often conflated with"resource curse"and misinterpreted as a"disease"that necessarily causes adverse impacts on the economy. The paper points out that many of the seemingly well-established arguments in this field are not necessarily grounded in theory or empirical evidence. Great care is needed in diagnosing Dutch disease and formulating policy prescriptions based on the theoretical framework, given the restrictive assumptions that may not be fully applicable and the limited relevance to today’s inextricably intertwined trade flows. Countries facing large inflows of foreign currency should focus on safeguarding the domestic economy from the volatility of international commodity and capital markets, and building robust institutions to reduce adjustment costs and boost broader competitiveness. A policy package needs to be comprehensive, covering macroeconomic and structural policy measures, and should be calibrated to target country specific concerns. Policies may need to be adjusted continuously in view of the evolving dynamics of the global and domestic economic environment.
    Keywords: Currencies and Exchange Rates,Economic Theory&Research,Debt Markets,Emerging Markets,Environmental Economics&Policies
    Date: 2014–07–01
  3. By: Rahel Studer-Suter; Alexandra Janssen
    Abstract: To counter the sharp appreciation of the Swiss franc that set in in the wake of the European sovereign debt crisis, on September 6, 2011, the Swiss National Bank announced to enforce a minimum EUR/CHF exchange rate of CHF 1.20. We find that the simple, though elegant model for the exchange rate within a target zone proposed by Krugman (1991) describes the behavior of the Swiss franc since the inception of this lower bound. Being a prime example of a safe haven currency, the Swiss franc systematically appreciates when global market conditions tighten. But as Krugman's model predicts, the sensitivity of the Swiss franc exchange rate to state variables that indicate such risky times declines as it approaches its lower bound. In particular, the Swiss franc is well described as an S-shaped function of the option prices implied probability for EUR/CHF exchange rate realizations below the lower bound. This state variable not only indicates times of increased global risk, but also quantifies appreciation pressure on the Swiss currency at the lower bound. We conclude that the Swiss franc lower bound helps stabilizing the value of the Swiss currency.
    Keywords: Exchange rate target zone, safe haven currency, volatility smile
    JEL: E52 E58 F31 G01
    Date: 2014–08
  4. By: STEFANIA GARETTO (Department of Economics, Boston University)
    Abstract: A large body of empirical work documents that prices of traded goods change by a smaller proportion than real exchange rates between the trading countries (incomplete pass-through). The wedge between exchange rates and relative prices also varies a cross countries (pricing-to-market). I present a model of trade and international price-setting with heterogeneous firms, where firms’ strategic behavior implies that: 1) firm-level pass-through is incomplete and a U-shaped function of firm market share; 2) exchange rate fluctuations affect both the prices of traded goods and the prices of goods sold domestically; and 3) firm-level pass-through varies across destination countries. Estimates from a panel data set of cars prices support the predictions of the model.
    Keywords: Heterogeneous firms, incomplete pass-through, pricing to market
    JEL: F12 F31 L13
    Date: 2014–03
  5. By: Hale, Galina (Federal Reserve Bank of San Francisco); Jones, Peter (University of California, Berkeley); Spiegel, Mark M. (Federal Reserve Bank of San Francisco)
    Abstract: Using a large sample of private international bond issues, we document a substantial decline in the share of international bonds denominated in major reserve currencies over the last two decades, and an increase in bonds denominated in issuers’ home currencies. These secular trends appear to have accelerated notably after the global financial crisis. Observed increases in home currency foreign bond issuance was larger in countries with stable inflation and lower government debt, and in emerging markets that adopted explicit inflation targeting policies. We then present a model that demonstrates how the global financial crisis could have a persistent impact on home currency bond issuance. Firms that issue for the first time in their home currencies during disruptive episodes, such as the crisis, find their relative costs of issuance in home currencies remain lower after conditions return to normal, due to the increased depth of the home currency market. Empirically, we show that countries with more stable inflation and lower government debt were more likely to benefit from the opportunity to switch to home currency foreign bond issuance presented by the crisis.
    Keywords: bond; original sin; inflation targeting; debt; crisis; currency
    JEL: E52 F34 F36
    Date: 2014–07
  6. By: Pablo Federico (BlackRock (; Carlos A. Vegh (Johns Hopkins University and NBER (E-mail:; Guillermo Vuletin (The Brookings Institution (
    Abstract: Based on a novel quarterly dataset for 52 countries for the period 1970-2011, we analyze the use and cyclical properties of reserve requirements (RR) as a macroeconomic stabilization tool and whether RR policy substitutes or complements monetary policy. We find that (i) around two thirds of developing countries have used RR policy as a macroeconomic stabilization tool compared to just one third of industrial countries (and no industrial country since 2004); (ii) most developing countries that rely on RR use them countercyclically; and (iii) in many developing countries, monetary policy is procyclical and hence RR policy has substituted monetary policy as a countercyclical tool. We interpret the latter finding as reflecting the need of many emerging markets to raise interest rates in bad times to defend the currency and not raise or lower the interest rate in good times to prevent further currency appreciation. Under these circumstances, RR policy provides a second instrument that substitutes for monetary policy. Evidence from expanded Taylor rules (i.e., Taylor rules that include a nominal exchange rate target) supports these mechanisms.
    Keywords: macroprudential, reserve requirement, monetary policy, exchange rate, business cycle
    JEL: E32 E50 F31 F41
    Date: 2014–08
  7. By: Abdul Aleem (Department of Mathematics and Statistics [Canada] - Dalhousie University, CEPN - Centre d'Economie Université Paris Nord - UFR de Sciences Economiques Paris XIII); Amine Lahiani (ESC Rennes School of Business - ESC Rennes School of Business, LEO - Laboratoire d'économie d'Orleans - CNRS : UMR7322 - Université d'Orléans)
    Abstract: Considering nonlinearities in the exchange rate pass-through to domesticprices, this paper estimates exchange rate pass-through in Mexico. We examine responses of domestic prices to a positive one unit exchange rate shock by estimating a threshold vector autoregression (TVAR) model. A monthly rate of inflation of 0.79% acts as a threshold. The exchange rate pass-through to domestic prices is statistically significant above the threshold level of the inflation rate and statistically insignificant below it.
    Keywords: Exchange rate pass-through ; Prices ; Threshold vector autoregression
    Date: 2014
  8. By: Fabio Milani (Department of Economics, University of California-Irvine); Sung Ho Park (Economic Research Institute, Bank of Korea)
    Abstract: This paper studies the implications of globalization for the dynamics of macroeconomic variables over the business cycle for a small open trade-dependent economy, such as South Korea. We study the impact of globalization through the lens of a structural model. Globalization is modeled as a time-varying degree of openness in the economy. We estimate the model allowing for non-fully rational expectations, learning by economic agents, and incomplete international financial markets. The empirical results show that globalization led to important changes in the macroeconomic environment. Domestic variables have become much more sensitive toward global measures over the 1991-2012 sample. In particular, domestic output and inflation are significantly affected by global output. Fluctuations in Korean output, inflation, and interest rates, which were driven for the most part by domestic shocks in the early 1990s are, by the end of the sample, due in large part (roughly 70%) to global shocks (and shocks that are open-economy in nature).
    Keywords: Globalization; Inflation dynamics; Global slack hypothesis; Inflation expectations; Openness; Small open eonomy DSGE model; Korea
    JEL: E31 E32 E50 E52 E58 F41
    Date: 2013–12
  9. By: Philip Wilms; Job Swank; Jakob de Haan
    Abstract: We examine which variables are robust in explaining cross-country differences in the real impact of systemic banking crises. Based on a meta-analysis, we identify 21 variables frequently used as determinants of the severity of crises. Employing nine proxies for crisis severity, we find that large current account imbalances are the most robust determinant of the real impact of banking crises. Countries with a high GDP per capita have more prolonged downfalls after the occurrence of a banking crisis. Exchange rate developments and pre-crisis GDP growth are related to the peak-to-trough impact of a banking crisis.
    Keywords: banking crises; real impact of crises; duration of crises
    JEL: F3 G01 G18
    Date: 2014–08
  10. By: Juan Carlos Hatchondo; Leonardo Martinez; Cesar Sosa-Padilla
    Abstract: In this study, we measure the effects of debt dilution on sovereign default risk and consider debt covenants that could mitigate these effects. First, we calibrate a baseline model of defaultable debt (in which debt can be diluted) with endogenous debt duration, using data from Spain. Secondly, we present a model in which sovereign bonds contain a covenant that eliminates debt dilution. We quantify the effects of dilution by comparing the simulations of the model with and without this covenant. We find that dilution accounts for 79 percent of the default risk in the baseline economy. Without dilution, the optimal duration of sovereign debt increases by almost two years. Consumption volatility also increases, but eliminating dilution still produces substantial welfare gains. Introducing debt covenants that could be easier to implement in practice has similar effects. A covenant that penalizes the government for bond prices below a threshold is more effective in reducing the default frequency. A covenant that penalizes the government for debt levels above a threshold is more effective in reducing consumption volatility. These covenants could be useful for enforcing fiscal rules.
    Keywords: sovereign default, debt dilution, debt covenant, long-term debt, endogenous borrowing constraints
    JEL: F34 F41
    Date: 2014–07
  11. By: Steven Trypsteen
    Abstract: This paper investigates the effect of output volatility and the great moderation on growth in a model that simultaneously accounts for cross-country interactions, structural breaks and heterogeneous effects. This is done by augmenting the univariate GARCH-M model of growth for each G7 country with cross-country weighted averages of growth and shift dummies. I find that volatility affects growth positively, that there is a great moderation in five of the G7 countries and that the great moderation has a negative effect on growth in all G7 countries. A simulation exercise shows that cross-country interactions are important in estimating the volatility effect.
    Keywords: Cross-country interactions, Volatility, Growth, GARCH-M, The great moderation
    Date: 2014

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