nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒09‒18
thirteen papers chosen by
Martin Berka
University of Auckland

  1. Costs of Adjustment and Exporter Behavior: Rationalizing the International Elasticity Puzzle By Yaniv Yedid-Levi; Stefanie Haller; Doireann Fitzgerald
  2. Domestic and multilateral effects of capital controls in emerging markets By Bijsterbosch, Martin; Falagiarda, Matteo; Pasricha, Gurnain; Aizenman, Joshua
  3. Does a Currency Union Need a Capital Market Union? By Thomas Philippon; Joseba Martinez
  4. The law of one price revisited: How do goods market frictions generate large and volatile price deviations? By Lee, Inkoo; Park, Sang Soo
  5. Capital inflows and euro area long-term interest rates By Carvalho, Daniel; Fidora, Michael
  6. Time-Consistent Fiscal Policy in a Debt Crisis By Morten Ravn; Neele Balke
  7. External debt and real exchange rates' adjustment in the euro area: New evidence from a nonlinear NATREX model By Cécile COUHARDE; Serge REY; Audrey SALLENAVE
  8. Unprecedented Changes in the Terms of Trade By Mariano Kulish; Daniel Rees
  9. Trend Fundamentals and Exchange Rate Dynamics By Daniel Kaufmann; Florian Huber
  10. Does the US Current Account Show a Symmetric Behavior over the Business Cycle? By Roberto Duncan
  11. Financial exposure to the euro area before and after the crisis: home bias and institutions at home By Floreani, Vincent Arthur; Habib, Maurizio Michael
  12. A Small Open Economy with the Balassa-Samuelson Effect By Robert Ambrisko
  13. The exchange rate, asymmetric shocks and asymmetric distributions By Demian, Calin-Vlad; di Mauro, Filippo

  1. By: Yaniv Yedid-Levi (The University of British Columbia); Stefanie Haller (University College Dublin); Doireann Fitzgerald (Federal Reserve Bank of Minneapolis)
    Abstract: Exports are not very responsive to real exchange rates, though they respond strongly to trade liberalizations, a fact sometimes referred to as the International Elasticity Puzzle. We show that two dimensions of costs of adjustment can rationalize this fact. We present a partial equilibrium model of the firm with both costly customer base accumulation and sticky prices. We calibrate the model to match steady state firm and export dynamics and steady state facts about price stickiness. We simulate the responses of these firms to real exchange rate and tariff processes estimated from data. The simulated responses match actual micro-level responses of exports to tariffs estimated using data for Ireland, and go close to matching actual responses to exchange rates.
    Date: 2015
  2. By: Bijsterbosch, Martin; Falagiarda, Matteo; Pasricha, Gurnain; Aizenman, Joshua
    Abstract: Using a novel dataset on changes in capital controls and currency-based prudential measures in 17 major emerging market economies (EMEs) over the period 2001-2011, this paper provides new evidence on domestic and multilateral (or spillover) effects of capital controls before and after the global financial crisis. Our results, based on panel VARs, suggest that capital control actions do not allow countries to avoid the trade-offs of the monetary policy trilemma. Where they have a desired impact on the trilemma variables – net capital inflows, monetary policy autonomy and the exchange rate – the size of that impact is generally small. While we find some evidence of effectiveness before the global financial crisis, the usefulness of these measures weakened in the post-crisis environment of abundant global liquidity and relatively strong economic growth in EMEs. Our results also show that capital control policies can have unintended consequences, as resident outflows offset the impact of capital control actions on gross inflows (or vice versa). These findings highlight the importance of the macroeconomic context and of the increasing role of resident flows in understanding the effectiveness of capital inflow management. Using panel near-VARs, we find significant spillovers of capital control actions in BRICS (Brazil, Russia, India, China and South Africa) to other EMEs during the 2000s. Spillover effects were more important in the aftermath of the global financial crisis than before the crisis, and arose from inflow tightening actions, rather than outflow easing measures. The channels through which these policies spilled over to other countries were exchange rates as well as capital flows (especially cross-border bank lending). Spillovers seem to be more prevalent in Latin America than in Asia, reflecting the greater role of cross-border banking and more open capital accounts in the former countries. These results are robust to various specifications of our models. JEL Classification: F32, F41, F42
    Keywords: Capital controls, capital flows, emerging market economies, monetary policy trilemma, policy spillovers
    Date: 2015–08
  3. By: Thomas Philippon (New York University); Joseba Martinez (New York University)
    Abstract: We study financial linkages and risk sharing in the context of the Eurozone crisis. We consider four types of currency unions: a currency union with (potentially) segmented markets; a banking union; a capital market union; and a currency union with complete financial markets. We then analyze how these economies respond to deleveraging shocks and to technology shocks. We find that a banking union is enough to deal with public and private deleveraging shocks, but a capital market union is necessary to approximate the complete market allocation when there are shocks that affect productivity or the terms of trade
    Date: 2015
  4. By: Lee, Inkoo; Park, Sang Soo
    Abstract: This paper analyzes the role of goods market frictions in accounting for the large and volatile deviations from the Law of One Price in a framework of flexible prices. We draw a distinction between goods market frictions that are required to consume tradable goods (e.g., distribution costs) and those that are necessary for international transactions (e.g., trade costs). We find that trade costs generate LOP deviations by introducing a no-arbitrage band, while distribution costs cause the price to deviate from the LOP by affecting the probability that trade will occur, given the band. We then conduct a Monte Carlo simulation to show that real exchange rate volatility is positively associated with trade costs, but negatively related to distribution costs. This effect depends on the interplay of trade costs and distribution costs, as they work in opposite directions when creating arbitrage opportunities.
    Keywords: Distribution costs, trade costs, law of one price, real exchange rate volatility
    JEL: F31 F37
    Date: 2015–09–01
  5. By: Carvalho, Daniel; Fidora, Michael
    Abstract: Capital flows into the euro area were particularly large in the mid-2000s and the share of foreign holdings of euro area securities increased substantially between the introduction of the euro and the outbreak of the global financial crisis. We show that the increase in foreign holdings of euro area bonds in this period is associated with a reduction of euro area long-term interest rates by about 1.55 percentage points, which is in line with previous studies that document a similar impact of foreign bond buying on US Treasury yields. These results are relevant both from a euro area and a global perspective, as they show that the phenomenon of lower long-term interest rates due to foreign bond buying is not exclusive to the United States and foreign inflows into euro area debt securities may have added to increased risk appetite and hunt-for-yield at the global level. JEL Classification: E43, E44, F21, F41, G15
    Keywords: capital flows, long-term interest rates ECB
    Date: 2015–06
  6. By: Morten Ravn (University College London); Neele Balke (University College London)
    Abstract: The financial crisis led to severe crises in much of Southern Europe that generated deep economic problems that still have not been resolved. Many of these economies (Greece, Italy, Spain and Portugal) witnessed not only large drops in aggregate activity but also rising levels of debt and falling debt prices which made financing of deficits very costly and triggered concerns about sovereign defaults. A large literature has considered environments in which large negative shocks can generate risk of default because sovereign governments lack commitment to debt. However, much of this literature either assumes that government has commitment to all other fiscal instruments or that these are exogenously determined. Therefore, it is unclear whether adjustments of other instruments - for example cuts in public spending or tax hikes - may not be preferable to default. Moreover, this literature typically does not allow for feedback from the fiscal instruments to the state of the economy beyond those triggered by punishment mechanisms in case of a sovereign default. Thus, these models are not useful for understanding richer questions regarding the adjustment of fiscal policy in crisis times. This paper takes a first step in addressing these issues. We study a small open economy model in which a benevolent government aims at maximizing social welfare but lacks commitment to all its fiscal instruments. The economy consists of a government, households, firms and foreign lenders. Households derive utility from consumption of private goods, leisure and from government provided public goods. They differ in their labor market status because of matching frictions. Some households work and earn labor income. The government imposes a payroll tax on these households. Other households are unemployed but choose search effort. Households cannot purchase unemployment insurance contracts but receive government financed unemployment transfers. Firms post vacancies to hire workers and there is free entry. There is an aggregate productivity shock and wages are determined by a non-cooperative Nash bargaining game between firms and households. The government chooses payroll taxes, unemployment benefits, government spending and may be able to smooth the budget by international borrowing and lending. International lenders are risk neutral and charge an interest rate which takes into account that governments may choose to default. If a government defaults it is excluded from international financial markets for a stochastic number of periods and it may suffer a loss of productivity whilst excluded from international lending. The government in this economy faces several trade-offs. It would like to insure households against unemployment risk and against wage risk which occurs due to productivity shocks. However, more generous unemployment insurance gives households less incentive to search for jobs and therefore produces higher unemployment and a smaller tax base. In order to smooth employed households against wage risk, the government would like to cut payroll taxes when productivity falls but this implies rising debt. The government also attempts to equalize the marginal utility of private and public consumption but cannot do so perfectly because of household heterogeneity. In this economy, falling productivity produces difficult choices since it puts a pressure on the government budget due to rising unemployment and a smaller tax base which produces an incentive for increasing government borrowing. However, rising debt levels may eventually impact on the price of debt because lenders perceive a risk of a sovereign default. For that reason, the government will eventually have to make a hard choice about whether to default on its debt which means it will have to balance its budget (and possibly suffer a drop in productivity), cut unemployment transfers which harms the unemployed, increase payroll taxes which harms the employed and produces higher unemployment, or cut government spending which lowers utility of households. We derive optimal fiscal policies in this environment by studying Markov perfect equilibria. The model is calibrated to emulate the conditions of a typical Southern European economy. We show that the time-consistent policies involve countercyclical payroll taxes, constant unemployment benefits, and mildly procyclical government spending in 'normal' times when the risk of default is negligible. In crisis times, the government is willing to further distort the economy by providing less insurance against unemployment, increasing payroll taxes and cutting public goods provision to limit rising debt. However, once a default becomes inevitable, the government partially lifts such austerity measures since it ceases to be concerned about honouring its outstanding debt.
    Date: 2015
  7. By: Cécile COUHARDE; Serge REY; Audrey SALLENAVE
    Abstract: In this paper we revisit medium- to long-run real exchange rate determination within the euro area, focusing on the role of external debt. Accordingly, we rely on the NATREX approach which provides an explicit framework of the external debt-real exchange rates nexus. In particular, given the indebtedness levels reached by the euro area economies, we investigate potential non-linearity in real exchange rates dynamics, according to the level of the external debt. Our results evidence that during the monetary union, gross and net external debt positions of the euro area countries have exerted pressures on real exchange rate dynamics within the area. Moreover, we find that, beyond a threshold reached by the external debt, euro area countries are found to be in a vulnerable position, leading to an unavoidable adjustment process. Nevertheless, the adjustment process, while effective, is found to be low and occurs slowly.
    Keywords: Euro area; External debt; NATREX approach; Panel Smooth Transition Regression models; Real exchange rates
    JEL: C23 F31 O47
    Date: 2015–09
  8. By: Mariano Kulish (School of Economics, University of New South Wales); Daniel Rees (Reserve Bank of Australia)
    Abstract: The ongoing development of Asia has led to unprecedented changes in the terms of trade of commodity-exporting economies. Using a small open economy model we estimate changes in the long-run level and variance of Australia's terms of trade and study the quantitative implications of these changes. We find that the long-run prices of commodities that Australia exports started to increase significantly in mid 2003 and that the volatility of shocks to commodity prices doubled soon after. The persistent increase in the level of commodity prices is smaller than single-equation estimates suggest, but our inferences rely on many observables that in general equilibrium also respond to shifts in the long-run level of the terms of trade.
    Keywords: Bayesian analysis; open economy macroeconomics; terms of trade
    JEL: C11 F41 Q33
    Date: 2015–08
  9. By: Daniel Kaufmann (KOF Swiss Economic Institute, ETH Zurich, Switzerland); Florian Huber (Oesterreichische Nationalbank, Vienna, Austria)
    Abstract: We estimate a multivariate unobserved components-stochastic volatility model to explain the dynamics of a panel of six exchange rates against the US Dollar. The empirical model is based on the assumption that both countries' monetary policy strategies may be well described by Taylor rules with a time-varying inflation target, a time-varying natural rate of unemployment, and interest rate smoothing. The estimates closely track major movements along with important time-series properties of the real and nominal exchange rates across all currencies considered. The model generally outperforms a simple benchmark model that does not account for changes in trend inflation and trend unemployment.
    Keywords: Exchange rate models, trend inflation, natural rate of unemployment, Taylor rule, unobserved components-stochastic volatility model
    JEL: F31 E52 F41 C5 E31
    Date: 2015–09
  10. By: Roberto Duncan (Ohio University)
    Abstract: Traditionally, the literature that attempts to explain the link between the current account and output finds a linear negative relationship (e.g., Backus et al., 1995). Using nonparametric regressions, we find a robust U-shaped relationship between the U.S. current account and the GDP cycle. When output is above (below) its trend the current account and detrended output are positively (negatively) correlated. We argue that this nonlinearity might be caused by persistent productivity shocks coupled with uncertainty shocks about future productivity.
    Keywords: U.S. current account, uncertainty shocks, business cycles, nonparametric regression
    JEL: E3 F3 F4
    Date: 2015–09
  11. By: Floreani, Vincent Arthur; Habib, Maurizio Michael
    Abstract: This paper investigates whether global investors are over or under exposed to- wards the euro area and the role of home bias and institutions at home in shaping this exposure. According to a simple benchmark from standard portfolio theory, euro area investors - in particular those from euro area low-rating economies - are overexposed to euro area securities. Instead, investors outside the EU are underexposed to euro area securities in their total portfolio, proportionally to their degree of home bias, but not in their foreign portfolio. Nevertheless, once we account for gravity factors, the largest foreign investors overweigh euro area securities, especially debt of euro area high rating economies. Crucially, this overexposure was resilient to the euro area crisis. Moreover, we show that institutions at home are important to explain exposure to euro area securities. In particular, the higher the standards of governance at home, the greater the exposure to the euro area debt. JEL Classification: E2, F3, G11, G15
    Keywords: Cross-border portfolio holdings, home bias, institutions, international finance gravity model
    Date: 2015–06
  12. By: Robert Ambrisko
    Abstract: The Balassa-Samuelson (B-S) effect implies that highly productive countries have higher inflation and appreciating real exchange rates because of larger productivity growth differentials between tradable and nontradable sectors relative to advanced economies. The B-S effect might pose a threat to converging European countries, which would like to adopt the Euro because of the limits imposed on inflation and nominal exchange rate movements by the Maastricht criteria. The main goal of this paper is to judge whether the B-S effect is a relevant issue for the Czech Republic to comply with selected Maastricht criteria before adopting the Euro. For this purpose, a two-sector DSGE model of a small open economy is built and estimated using Bayesian techniques. The simulations from the model suggest that the B-S effect is not an issue for the Czech Republic when meeting the inflation and nominal exchange rate criteria. The costs of early adoption of the Euro are not large in terms of additional inflation pressures, which materialize mainly after the adoption of the single currency. Also, nominal exchange rate appreciation, driven by the B-S effect, does not breach the limit imposed by the ERM II mechanism.
    Keywords: Balassa-Samuelson effect; DSGE; European Monetary Union; exchange rate regimes; Maastricht convergence criteria;
    JEL: E31 E52 F41
    Date: 2015–08
  13. By: Demian, Calin-Vlad; di Mauro, Filippo
    Abstract: The elasticity of exports to exchange rate fluctuations has been the subject of a large literature without a clear consensus emerging. Using a novel sector level dataset based on firm level information, we show that exchange rate elasticities double in size when the country and sector specific firm productivity distribution is taken into account in empirical estimates. In addition, exports appear to be sensitive to appreciation episodes, but rather unaffected by depreciations. Finally, only rather large changes in the exchange rate appear to matter. JEL Classification: F14, F41, F31
    Keywords: bilateral trade, exchange rate elasticity, productivity dispersion, TFP
    Date: 2015–06

This nep-opm issue is ©2015 by Martin Berka. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.