nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒02‒28
sixteen papers chosen by
Martin Berka
University of Auckland

  1. A Tale of Two Countries: Sovereign Default, Exchange Rate, and Trade By Gu, Grace Weishi
  2. Income inequality and Germany’s current account surplus By Patrick Grüning ; Thomas Theobald ; Till van Treeck
  3. The International Transmission of Credit Bubbles: Theory and Policy By Jaume Ventura ; Alberto Martin
  4. International Coordination of Central Bank Policy By Charles Engel
  5. The Maturity and Payment Schedule of Sovereign Debt By Yan Bai ; Seon Tae Kim ; Gabriel P. Mihalache
  6. International Interest Rates and Housing Markets By Luis Franjo
  7. Pegging the exchange rate to gain monetary policy credibility By Davis, J. Scott ; Fujiwara, Ippei
  8. Structural Change and the Dynamics of Real Exchange Rate By Xiaodong Zhu ; Juanyi Xu ; Yong Wang
  9. Structural Break, Nonlinearity, and Asymmetry: A re-examination of PPP proposition By Omay, Tolga ; Hasanov, Mubariz ; Emirmahmutoglu, Furkan
  10. Learning to open up: Capital account liberalizations in the post-Bretton Woods era By Bicaba, Zorobabel T. ; Coricelli, Fabrizio
  11. Sovereign Default, Debt Restructuring, and Recovery Rates: Was the Argentinean “Haircut” Excessive? By Sebastian Edwards
  12. "Twin deficits" in Greece in search of causality. By Michaelis Nikiforos ; Laura Carvalho ; Christian Schoder
  13. Natural Resources, Decentralization, and Risk Sharing: Can Resource Booms Unify Nations? By Ohad Raveh ; Fidel Perez-Sebastian
  14. Optimal capital requirements over the business and financial cycles By Malherbe, Frédéric
  15. Trilemma Challenges for the People's Republic of China By Kawai, Masahiro ; Liu, Li-Gang
  16. Yield curve and monetary policy expectations in small open economies By Doh, Taeyoung ; Park, Woong Yong ; Bong, Kwan Soo

  1. By: Gu, Grace Weishi
    Abstract: This paper explores the impacts of sovereign defaults on trade and income through a real exchange rate channel, in a DSGE model of two risk-averse open economies, with production. In the model, once the borrower country defaults due to an adverse productivity shock, foreign firms reduce their imports of intermediate goods from the defaulting country, whose income consequently declines. This causes the defaulting country to adjust its consumption portfolio of domestic goods and imports according to its home bias preference, triggers a collapse in its real exchange rate, and leads to a further endogenous plummet in national income. This paper makes three main contributions. First, along business cycles, the model generates countercyclical trade balances, procyclical trade flows, and countercyclical bond spreads with a data-consistent average. Second, following a sovereign default, the model endogenously delivers sharp real exchange rate deterioration, output drops, trade balance improvements, and bilateral trade flow declines. This paper thus also studies a real exchange rate channel, through which default risks and occurrences, income, and trade interact with each other. Lastly, this model predicts lasting welfare gains for the creditor country through the real exchange rate channel, but relatively short-lived welfare losses for the borrower country and the world during and after a sovereign default.
    Keywords: sovereign default, real exchange rate, trade, DSGE
    JEL: E44 F31 F34 F41
    Date: 2015–02–23
  2. By: Patrick Grüning ; Thomas Theobald ; Till van Treeck
    Abstract: Germany entered the euro with a current account deficit but over the entire past decade has run large and persistent current account surpluses. Besides joining the common currency, the increase of Germany’s current account since the late 1990s has been accompanied by strong shifts in the personal and, in particular, the functional income distribution. In this paper, we argue that income inequality should always be analyzed with respect to both the personal and the functional distribution of income. We present a dynamic stochastic general equilibrium (DSGE) model in which a current account surplus arises as an endogenous result of a decrease in the share of household income in national income. On the one hand, this result complements existing literature where current account deficits result from rising personal income inequality. On the other hand, we find that current account imbalances will be more pronounced when accompanied by changes in the financial system. Accordingly, if we link Germany’s accession to the European monetary union to lower exchange rate costs for German bank lending, the current account surplus becomes larger.
    Keywords: income inequality, functional income distribution, household debt, financial system, current account
    JEL: D31 E17 F32
    Date: 2015
  3. By: Jaume Ventura ; Alberto Martin
    Abstract: We live in a new world economy characterized by financial globalization and historically low interest rates. This environment is conducive to countries experiencing credit bubbles that have large macroeconomic effects at home and are quickly propagated abroad. In previous work, we built on the theory of rational bubbles to develop a framework to think about the origins and domestic effects of these credit bubbles. This paper extends that framework to two-country setting and studies the channels through which credit bubbles are transmitted across countries. We find that there are two main channels that work through the interest rate and the terms of trade. The former constitutes a negative spillover, while the latter constitutes a negative spillover in the short run but a positive one in the long run. We study both cooperative and noncooperative policies in this world. The interest-rate and terms-of-trade spillovers produce policy externalities that make the noncooperative outcome suboptimal.
    JEL: E32 E44 O40
    Date: 2015–02
  4. By: Charles Engel
    Abstract: This paper surveys the current state of the literature on international monetary policy coordination. It relates recent policy discussions to the lessons from the literature. It proposes several avenues for future research.
    JEL: F41 F42
    Date: 2015–02
  5. By: Yan Bai ; Seon Tae Kim ; Gabriel P. Mihalache
    Abstract: This paper studies the maturity and stream of payments of sovereign debt. Using Bloomberg bond data for eleven emerging economies, we document that countries react to crises by issuing debt with shortened maturity but back-load payment schedules. To account for this pattern, we develop a sovereign default model with an endogenous choice of debt maturity and payment schedule. During recessions, the country prefers its payments to be more back-loaded—delaying relatively larger payments—to smooth consumption. However, such a back-loaded schedule is expensive given that later payments carry higher default risk. To reduce borrowing costs, the country optimally shortens maturity. When calibrated to the Brazilian data, the model can rationalize the observed patterns of maturity and payment schedule, as an optimal trade-off between consumption smoothing and endogenous borrowing cost.
    JEL: E62 F34
    Date: 2015–01
  6. By: Luis Franjo (Chair of International Finance, Ecole Polytechnique Federale de Lausanne (EPFL), Switzerland )
    Abstract: Current account deficits and housing prices showed a strong positive correlation throughout the mid-90s to 2007. This paper studies the effect of a decrease in the international interest rate and in the downpayment requirement to buy a house during that period on the joint behavior of the current account and housing prices. To this end, I build a small open economy model with life-cycle heterogeneous agents and two goods: tradable (non-housing) and non-tradable (housing). I calibrate the model to replicate selected aggregate statistics of the U.S. economy and compute the transition after the decrease in the interest rate and in the downpayment. The model is able to match some relevant facts: the boom and the bust (after 2007) in the housing market, where the bust, as the data show, occurs without a reversal in the interest rate; the increase in the homeownership rate; the simultaneous boom - and bust - in non-housing consumption; and the coexistence of borrowing from abroad with a current account deficit throughout the transition.
    Keywords: Current account, housing prices, debt, non-housing consumption, home-ownership, collateralized borrowing constraints.
    JEL: E21 F41 G11
    Date: 2015–02
  7. By: Davis, J. Scott (Federal Reserve Bank of Dallas ); Fujiwara, Ippei (Keio University )
    Abstract: Central banks that lack credibility often tie their exchange rate to that of a more credible partner in order to “import” credibility. We show in a small open economy model that a central bank that displays “limited credibility” can deliver significant improvements to a social welfare function that contains no role for exchange rate stabilization by maximizing an objective function that places weight on exchange rate stabilization, and thus the central bank with limited credibility will peg their currency to that of a more credible partner. As the central bank’s credibility improves it will place less weight on exchange rate stabilization in its objective function and thus loosen the peg. When the central bank is perfectly credible its objective function and the social welfare function are identical; it places no weight on exchange rate stabilization and allows the currency to freely float. Empirical results using a panel of both developed and developing countries show that as central banks become more independent they tend to allow more currency flexibility.
    JEL: E30 E50 F40
    Date: 2015–01–01
  8. By: Xiaodong Zhu (University of Toronto ); Juanyi Xu (Hong Kong Univ of Science and Technology ); Yong Wang (Hong Kong University of Science and Tech )
    Abstract: In this paper, we first examine empirically the Balassa-Samuelson effect in the presence of structural change. Using cross-country data on per capita income, price level and employment shares by sector, we find that a country’s tradable sector’s share of employment is a more significant predictor of the country’s price level than its per capita income, suggesting that the widely used empirical Balassa-Samuelson model is often mis-specified and biased in the face of structural change. We then re-examine the theoretical relationship between price level and per capita income in a model with structural change and show that the positive relationship between price level and per capita income predicted by the standard model is not a robust result in a multi-sector world. In contrast, the relationship between a country’s price level and the tradable sector’s share of employment is much more robust. Finally, we extend our theoretical analysis into a dynamic trade model with unbalanced trade to quantitatively examine how structural changes and policy distortions may have influenced the dynamics of the China-US real exchange rate. We show that much of the slow increase in the value of the Chinese currency over the last decade can be accounted for by the significant expansion of the tradable sector in China.
    Date: 2014
  9. By: Omay, Tolga ; Hasanov, Mubariz ; Emirmahmutoglu, Furkan
    Abstract: In this study, we propose a new unit root test procedure that allows for both gradual structural break and asymmetric nonlinear adjustment towards the equilibrium level. Small-sample properties of the new test are examined through Monte-Carlo simulations. The simulation results suggest that the new test has satisfactory size and power properties. We then apply this new test along with other unit root tests to examine stationarity properties of real exchange rate series of the sample countries. Our test rejects the null of unit root in more cases when compared to alternative tests. Overall, we find that the PPP proposition holds in majority of the European countries examined in this paper.
    Keywords: Smooth Structural Break; Nonlinear Unit Root test; PPP
    JEL: C12 C22 F41
    Date: 2014–09–03
  10. By: Bicaba, Zorobabel T. ; Coricelli, Fabrizio
    Abstract: The Great Recession has shattered the consensus on the benefits of capital account liberalization. Capital account controls have been introduced in several countries and have even been supported by the International Monetary Fund. In this paper we investigate whether capital account policies in the post-Bretton Woods era can be explained as a process driven by learning by policymakers, who update their beliefs on the basis of their own experience and of the policies adopted by other countries. We emphasize the impact of financial crises on the learning process. The learning model developed in the paper explains more than 90% of the variability of capital account policies. We find that over time beliefs about the growth effects have changed slowly and not smoothly from negative to positive. However, at the outset of the Great Recession beliefs on the positive growth dividends from capital account liberalization were still affected by a significant degree of uncertainty, which suggests that reversals in external liberalizations in the aftermath of the Great Recession are consistent with rational learning by policymakers. Finally, in evaluating the potential benefits and costs of capital controls in a given set of countries, contagion effects through changing beliefs of other countries should be taken into account.
    Keywords: beliefs; capital account liberalization; learning; strategic experimentation
    JEL: C79 D8 E61 F42 G15 G18
    Date: 2015–02
  11. By: Sebastian Edwards
    Abstract: I use data on 180 sovereign defaults to analyze what determines the recovery rate after a debt restructuring process. Why do creditors recover, in some cases, more than 90%, while in other cases they recover less than 10%? I find support for the Grossman and Van Huyk model of “excusable defaults”: countries that experience more severe negative shocks tend to have higher “haircuts” than countries that face less severe shocks. I discuss in detail debt restructuring episodes in Argentina, Chile, Uruguay and Greece. The results suggest that the haircut imposed by Argentina in its 2005 restructuring (75%) was “excessively high.” The other episodes’ haircuts are consistent with the model.
    JEL: F34 F41 G15
    Date: 2015–02
  12. By: Michaelis Nikiforos ; Laura Carvalho ; Christian Schoder
    Abstract: The paper discusses the trajectories of the Greek public deficit andsovereign debt between 1980 and 2010 and its connection to thepolitical and economic environment of the same period. We payspecial attention to the causality between the public and the externaldeficit in the period after 1995, the post-Maastricht treaty period.We argue that, due to the European monetary unification processand the adoption of the common currency, causality ran fromthe external deficit to the public deficit. This hypothesis is testedeconometrically using both Granger Causality and Cointegrationanalyses. We find empirical support for this hypothesis.
    Keywords: Greece, crisis, public debt, twin deficits, imbalances
    JEL: E62 F21 F34 F41
    Date: 2014
  13. By: Ohad Raveh ; Fidel Perez-Sebastian
    Abstract: Previous studies imply that a positive regional fiscal shock, such as a resource boom, strengthens the desire for separation.  In this paper we present a new and opposite perspective.  We construct a model of endogenous fiscal decentralization that builds on two key notions: a trade-off between risk sharing and heterogeneity, and a positive assocation between resource booms and risk.  The model shows that a resource windfall causes the nation to centralize as a mechanism to share risk.  In addition, we provide cross country empirical evidence for the main hypotheses.  Specifically, we find that resource booms: (i) decrease the level of fiscal decetralization, primarily through the risk sharing channel, and (ii) have no effect on political decentralization.
    Keywords: Natural resources, decentralization, risk sharing
    Date: 2014–07–30
  14. By: Malherbe, Frédéric
    Abstract: I propose a simple theory of intertwined business and financial cycles, where financial regulation both optimally responds to and influences the cycles. In this model, banks do not internalize the effect of their credit expansion on other banks’ expected bankruptcy costs, which leads to excessive aggregate lending. In response, the regulator sets a capital requirement to trade off expected output against financial stability. The capital requirement that ensures investment efficiency depends on the state of the economy and, because of a general equilibrium effect, its stringency increases with aggregate banking capital. A regulation that fails to take this effect into account would exacerbate economic fluctuations and result in excessive aggregate lending during a boom. It would also allow for an excessive build-up of risk in the financial sector, which implies that, at the peak of a boom, even a small adverse shock could trigger a banking sector collapse, followed by an excessively severe credit crunch.
    Keywords: Basel 3; capital requirement; costly default; counter-cyclical buffers; financial cycles; financial regulation
    JEL: E44 G01 G21 G28
    Date: 2015–02
  15. By: Kawai, Masahiro (Asian Development Bank Institute ); Liu, Li-Gang (Asian Development Bank Institute )
    Abstract: This paper first reviews recent developments in exchange rate regimes, capital account liberalization, interest rate liberalization, and monetary policymaking in the People's Republic of China (PRC). It then observes that the PRC's monetary policy autonomy may have been reduced with falling capital control effectiveness and a rigid exchange regime that is still tightly managed against the United States (US) dollar. This hypothesis is investigated empirically using both the Taylor rule and the McCallum-like rule to test whether the PRC's money market interest rate and/or quantity of money supply are being increasingly influenced by the US interest rate or reserve accumulation. The paper concludes that there is considerable evidence suggesting diminishing monetary policy autonomy in the PRC. To regain policy autonomy, the monetary authority needs to substantially increase exchange rate flexibility of the renminbi as long as it continues to pursue capital account opening.
    Keywords: trilemma challenges; exchange rate regimes; monetary policy autonomy; peoples republic of china; taylor rule; mccallum rule
    JEL: E52 E58
    Date: 2015–02–16
  16. By: Doh, Taeyoung (Federal Reserve Bank of Kansas City ); Park, Woong Yong ; Bong, Kwan Soo
    Abstract: This paper estimates a New Keynesian dynamic stochastic general equilibrium (DSGE) model in small open economies using the yield curve data as well as standard macro data. The DSGE model is estimated on the data of three inflation-targeting small open economies (Australia, Canada, and New Zealand) using Bayesian methods. We find that the long-end of the yield curve is highly correlated with the current and future short-term interest rates determined by domestic central banks. Yield curve data are particularly informative about the future stance of monetary policy in Australia and Canada in that the correlation between the model-implied monetary policy expectations and the ex-post realized policy interest rates increases when the yield curve data are used in estimation. Unlike the estimation results solely based on the macro data that imply the cental bank’s relatively strong focus on inflation stabilization, our results using yield curve information suggest that even inflation-targeting central banks have a significant concern for output stabilization. We also document that persistent domestic shocks, not foreign disturbances, drive the average level of the yield curve in these three countries
    Keywords: dynamic general equilibrium model; small open economy model; yield curve; monetary policy expectations
    Date: 2014–11–01

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