nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒04‒02
eight papers chosen by
Martin Berka
University of Auckland

  1. Exchange Rates, Interest Rates, and the Risk Premium By Charles Engel
  2. Capital Controls, Monetary Policy, and Balance Sheets in a Small Open Economy By Shigeto Kitano; Kenya Takaku
  3. ‘Buying and Selling of Money for Time’: Foreign Exchange and Interest Rates in Medieval Europe By Adrian R. Bell; Chris Brooks; Tony K. Moore
  4. Cross-Border Banking and Business Cycles in Asymmetric Currency Unions By Lena Dräger; Christian R. Proaño
  5. The macroeconomic effects of the sovereign debt crisis in the euro area By Stefano Neri; Tiziano Ropele
  6. The failure of the monetary model of exchange rate determination By Dinçer Afat; Marta Gómez-Puig; Simón Sosvilla-Rivero
  7. The Long and the Short of It: Sovereign Debt Crises and Debt Maturity By Raquel Fernández; Alberto Martín
  8. The Impossible Trinity: Where does India stand? By Sengupta, Rajeswari

  1. By: Charles Engel
    Abstract: The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms - indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands - one concerning short-run expected changes and the other concerning the level of the real exchange rate - have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. This paper documents the puzzle, and shows that existing models appear unable to account for both empirical findings. The features of a model that might reconcile the findings are discussed.
    JEL: F31 F41
    Date: 2015–03
  2. By: Shigeto Kitano (Research Institute for Economics & Business Administration (RIEB), Kobe University, Japan); Kenya Takaku (Faculty of Business, Aichi Shukutoku University)
    Abstract: We develop a small open economy, New Keynesian model that incorporates a financial accelerator in combination with liability dollarization. Applying a Ramsey-type analysis, we compare the welfare implications of an optimal monetary policy under flexible exchange rates and an optimal capital control policy under fixed exchange rates. In an economy without the financial accelerator, an optimal monetary policy under flexible exchange rates is superior to an optimal capital control policy under fixed exchange rates. In contrast, in an economy with the financial accelerator, an optimal capital control under fixed exchange rates yields higher welfare than an optimal monetary policy under flexible exchange rates.
    Keywords: Capital control, Monetary policy, Balance sheets, Ramsey policy, Exchange rate regimes, Small open economy, Nominal rigidities, New keynesian, DSGE, Welfare comparison, Incomplete markets, Financial accelerator, Financial frictions
    JEL: E44 E52 F32 F41
    Date: 2015–03
  3. By: Adrian R. Bell; Chris Brooks; Tony K. Moore
    Abstract: This paper argues that the relatively voluminous surviving records about foreign exchange (FX) rates in the Middle Ages can help to illuminate the much murkier question of medieval interest rates. We first explain how the medieval FX market operated and its links to the money market. Next, we set out the sources of our data on medieval exchange rates and the methodology for calculating implicit interest rates from the spreads between these exchange rates as quoted at seven different financial centres. Our results demonstrate that the FX rates did include an element of interest and that FX transactions could have been used to circumvent the usury prohibition. Further, these implicit interest rates are comparable to those charged on government debt and consumer credit. We also show that there were distinctive seasonal patterns in these interest rates at different financial centres related to their particular economic and trading patterns. Finally, our results provide further evidence of a long-term reduction in the risk-free rate of interest after c.1350.
    Keywords: in-sample uncertainty, out-of-sample uncertainty, real-time-vintage estimation
    JEL: F31 N13 N23
    Date: 2015–01
  4. By: Lena Dräger (Universität Hamburg (University of Hamburg)); Christian R. Proaño (The New School for Social Research)
    Abstract: Against the background of the recent housing boom and bust in countries such as Spain and Ireland, we investigate in this paper the macroeconomic consequences of cross-border banking in monetary unions such as the euro area. For this purpose, we incorporate in an otherwise standard two-region monetary union DSGE model a banking sector module along the lines of Gerali et al. (2010), accounting for borrowing constraints of entrepreneurs and an internal constraint on the bank’s leverage ratio. We illustrate in particular how different lending standards within the monetary union can translate into destabilizing spill-over effects between the regions, which can in turn result in a higher macroeconomic volatility. This mechanism is modelled by letting the loan-to-value (LTV) ratio that banks demand of entrepreneurs depend on either regional productivity shocks or on the productivity shock from one dominating region. Thereby, we demonstrate a channel through which the financial sector may have exacerbated the emergence of macroeconomic imbalances within the euro area. Additionally, we show the effects of a monetary policy rule augmented by the loan rate spread as in Cúrdia and Woodford (2010) in a two-country monetary union context.
    Keywords: Cross-border banking, euro area, monetary unions, DSGE
    JEL: F41 F34 E52
    Date: 2015–03
  5. By: Stefano Neri (Bank of Italy); Tiziano Ropele (Bank of Italy)
    Abstract: This paper uses a Factor Augmented Vector Autoregressive model to assess the macroeconomic impact of the euro-area sovereign debt crisis and the effectiveness of the European Central Bank's conventional monetary policy. First, our results show that in the countries most affected by the crisis, the tensions in sovereign debt markets made credit conditions significantly worse and weighed on economic activity and unemployment. The disruptive effects of the sovereign tensions propagated to the core economies of the euro area through the trade and confidence channels. Second, "modest" (in the sense of Leeper and Zha, 2003) counterfactual simulations suggest that the accommodative monetary policy stance of the ECB helped to moderate the negative effects of the sovereign debt tensions.
    Keywords: sovereign debt crisis, FAVAR models, Bayesian methods, monetary policy
    JEL: C32 E44 E52 F41
    Date: 2015–03
  6. By: Dinçer Afat (Department of Economic Theory - Universitat de Barcelona); Marta Gómez-Puig (Department of Economic Theory - Universitat de Barcelona); Simón Sosvilla-Rivero (Department of Quantitative Economics, Universidad Complutense de Madrid)
    Abstract: In this paper, we test three popular versions of the monetary model (flexible price, forward-looking and real interest differential models) for the OECD member countries by applying Johansen cointegration technique. Based on country-by-country analysis, we conclude that monetary models do not provide the expected results. We reveal several shortcomings of the models and examine the building blocks of the fundamental version. Although researchers always blame the deviations from purchasing power parity as the reason for the failure of the monetary model, our analysis indicates that invalidity of Keynesian money demand function is also responsible for unfavourable results.
    Keywords: exchange rate, flexible price monetary model, forward-looking monetary model, real interest differential model, money demand, purchasing power parity
    JEL: F31 F41
    Date: 2015–05
  7. By: Raquel Fernández; Alberto Martín
    Abstract: We present a simple model of sovereign debt crises in which a country chooses its optimal mix of short and long-term debt contracts subject to standard contracting frictions: the country cannot commit to repay its debts nor to a specific path of future debt issues, and contracts cannot be made state contingent nor renegotiated. We show that in order to satisfy incentive compatibility the country must issue short-term debt, which exposes it to roll-over crises and inefficient repayments. We examine two policies - restructuring and reprofiling - and show that both improve ex ante welfare if structured correctly. Key to the welfare results is the country's ability to choose its debt structure so as to neutralize any negative effect resulting from the redistribution of payments across creditors in times of crises.
    Keywords: sovereign debt, dilution, optimal maturity, restructuring, reprofiling, IMF
    JEL: F33 F34 F36 F41 G1
    Date: 2015–03
  8. By: Sengupta, Rajeswari
    Abstract: The Global Financial Crisis of 2008 and the heightened macroeconomic and financial volatility that followed the crisis raised important questions about the current international financial architecture as well as about individual countries’ external macroeconomic policies. Policy- makers dealing with the global crisis have been confronted with the ‘impossible trinity’ or the ‘Trilemma’, a potent paradigm of open economy macroeconomics asserting that a country may not target the exchange rate, conduct an independent monetary policy and have full financial integration, all at the same time. This issue is highly pertinent for India. A number of challenges have emanated from India’s greater integration with the global financial markets during the last two decades, one of which includes managing the policy tradeoffs under the Trilemma. In this chapter, I present a comprehensive overview of a few empirical studies that have explored the issue of Trilemma in the Indian context. Based on these studies I attempt to analyze how have Indian policy makers dealt with the various trade-offs while managing the Trilemma over the last two decades.
    Keywords: Impossible Trinity, Financial Integration, Currency Stabilization, International Reserves, Sterilized Intervention
    JEL: F3 F4
    Date: 2015–03–01

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