nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒10‒04
ten papers chosen by
Martin Berka
University of Auckland

  1. International Risk Sharing and Portfolio Choice with Non-separable Preferences By Hande Kucuk; Alan Sutherland
  2. Real Exchange Rates and Sectoral Productivity in the Eurozone By Berka, M; Devereux, MB; Engel, C
  3. Uncertainty and International Capital Flows By Michael Siemer; Adrien Verdelhan; Francois Gourio
  4. Back to gold: Sterling in 1925 By Gerlach, Stefan; Kugler, Peter
  5. External Shocks, Banks and Monetary Policy in an Open Economy: Loss Function Approach By Yasin Mimir; Enes Sunel
  6. The Role of International Reserves in Sovereign Debt Restructuring under Fiscal Adjustment By Tavares, Tiago
  7. Labor Market Distortions under Sovereign Default Crises By Tavares, Tiago
  8. Portfolio Flows in a two-country RBC model with financial intermediaries By Kavli, Haakon; Viegi, Nicola
  9. Risk Sharing and Growth in Small-Open Economies By Raouf Boucekkine; Giorgio Fabbri; Patrick A. Pintus
  10. What drives the labour wedge? A comparison between CEE countries and the Euro Area By Ma³gorzata Skibiñska

  1. By: Hande Kucuk; Alan Sutherland
    Abstract: This paper aims to account for the Backus-Smith puzzle in a generally calibrated two-country DSGE model with endogenous portfolio choice in international bonds and equities. There are multiple shocks, including shocks to TFP, labour supply, investment, government spending and monetary policy. Hence, there are more risks than can be spanned by international trade in equities and bonds, i.e. markets are incomplete. The utility function in the benchmark model is non-separable in consumption and leisure and there is external habit formation in consumption. We compare the benchmark model with models that differ according to preference/habit specification and financial market structure. We find that the benchmark model with non-separable preferences across consumption and leisure, habit formation and incomplete financial markets implies almost zero correlation between relative consumption and the real exchange rate while generating bond and equity portfolios that are broadly in line with the data. What is more, the cross-country correlation of consumption is lower than the cross-country correlation of output in our benchmark model, which has proved to be a difficult fact to match in IRBC models. Non-separable preferences are found to be crucial to generating these results but financial market structure plays only a minor role.
    Keywords: Portfolio choice, International risk sharing, Consumption-real exchange rate anomaly, Backus-Smith puzzle, Non separable preferences, Incomplete markets
    JEL: F31 F41
    Date: 2015
  2. By: Berka, M; Devereux, MB; Engel, C
    Abstract: We investigate the link between real exchange rates and sectoral total factor productivity measures for countries in the Eurozone. We show that real exchange rate variation, both in cross-country and time series, closely accords withan amended Balassa-Samuelson interpretation, incorporating shocks both to sectoral productivity and a labor market wedge. We construct a sticky price dynamic general equilibrium model to generate a cross-section and time series of real exchange rates that can be directly compared to the data. Under the assumption of a common currency, estimates from simulated regressions are very similar to the empirical estimates for the Eurozone. Our findings contrast with previous studies that have found little relationship between productivity levels and the real exchange rate among high-income countries, but those studies have included country pairs which have a floating nominal exchange rate.
    Date: 2015
  3. By: Michael Siemer (Board of Governors of the Federal Reserve System); Adrien Verdelhan (MIT Sloan); Francois Gourio (FRB Chicago)
    Abstract: In a large panel of 26 emerging countries over the last 40 years, aggregate stock market return volatilities, our measure of uncertainty, forecast capital flows. When the stock market return volatility increases, capital inflows decrease and capital outflows increase. We propose a simple decomposition of each country's market return volatility into two components: countries differ by their exposure to systematic volatility, measured by their uncertainty betas, and by their country-specific volatility. Capital inflows respond to both systematic and country-specific shocks to volatility, and they respond more in high uncertainty beta countries. These results are all statistically significant. A simple portfolio choice model illustrates the impact of uncertainty on gross capital flows: in the model, foreigners are exposed to expropriation risk. When the probability of expropriation increases, foreigners sell the domestic assets to the domestic investors, leading to a counter-cyclical home bias.
    Date: 2015
  4. By: Gerlach, Stefan; Kugler, Peter
    Abstract: Expectations of Sterling returning to Gold have been disregarded in empirical work on the US dollar - Sterling exchange rate in the early 1920s. We incorporate such considerations in a PPP model of the exchange rate, letting the probability of a return to gold follow a logistic function. We draw several conclusions: (i) the PPP model works well from spring 1919 to spring 1925; (ii) wholesale prices outperform consumer prices; (iii) allowing for a return to gold leads to a higher speed of adjustment of the exchange rate to PPP; (iv) interest rate differentials and the relative monetary base are crucial determinants of the expected return to gold; (v) the probability of a return to Gold peaked at about 72% in late 1924 and but fell to about 60% in early 1925; and (vi) our preferred model does not support the Keynes' view that Sterling was overvalued after the return to gold.
    Keywords: Gold Standard,Sterling,exchange rate,PPP,expectations
    JEL: E5 F31 N1
    Date: 2015
  5. By: Yasin Mimir; Enes Sunel
    Abstract: We systematically document that the 2007-09 financial crisis exposed emerging market economies (EMEs) to an adverse feedback loop of capital outflows, depreciating exchange rates, deteriorating balance sheets, rising credit spreads and falling real economic activity. Using a medium-scale New Keynesian DSGE model of a small open economy augmented with a banking sector that has access to both domestic and foreign funds, we explore the quantitative performances of alternative augmented IT rules in terms of macroeconomic and financial stabilization. In response to external financial shocks, credit-augmented IT rules are found to outperform output and exchange rate augmented rules in achieving policy mandates that target financial and external stability. A countercyclical reserve requirement policy that positively responds to the noncore liabilities share is found effective especially in coordination with monetary policy in reducing the procyclicality of the financial system.
    Keywords: External shocks, Banks, Foreign debt, Reserve requirements
    JEL: E44 G21 G28
    Date: 2015
  6. By: Tavares, Tiago
    Abstract: Highly indebted developing economies commonly also hold large external reserves. This behavior seems puzzling given that governments in these countries borrow with an interest rate penalty to compensate lenders for default risk. Reducing debt to the same extent as reserves would maintain net liabilities constant while decreasing interest payments. However, holding reserves can have insurance benefits in a financial crisis. To rationalize the levels of international reserves and external debt observed in the data, a standard dynamic model of equilibrium default is extended to include distortionary taxation and debt restructuring. This paper shows that fiscal adjustments induced by sovereign default can generate large demand for reserves if taxation is distortionary. At the same time, a non-negligible position in reserves modifies the debt restructuring negotiations upon default. A calibrated version of the model produces recovery rate schedules that are increasing with reserves, as seen in the data, being also able to replicate large positions of reserves and debt to GDP. Finally, I study how both mechanisms play a key quantitative role to generate such result, in fact, not including them, produces a counterfactual demand for reserves that is close to zero.
    Keywords: Sovereign default, international reserves, distortionary taxation, external debt, sudden stops, debt renegotiation
    JEL: E62 F32 F34 F41
    Date: 2015–04–01
  7. By: Tavares, Tiago
    Abstract: Risk of sovereign debt default has frequently affected emerging market and developed economies. Such financial crisis are often accompanied with severe declines of employment that are hard to justify using a standard dynamic stochastic model. In this paper, I document that a labor wedge deteriorates substantially around swift reversals of current accounts or default episodes. I propose and evaluate two different explanations for these movements by linking the wedges to changes in labor taxes and in the cost of working capital. With these two features included, a dynamic model of equilibrium default is able to replicate the behavior of the labor wedge observed in the data around financial crisis. In the model, higher interest rates are propagated into larger costs of hiring labor through the presence of working capital. As an economy is hit with a stream of bad productivity shocks, the incentives to default become stronger, thus increasing the cost of debt. This reduces firm demand for labor and generates a labor wedge. A similar effect is obtained with a counter-cyclical tax rate policy. The model is used to shed light on the recent events of the Euro Area debt crisis and in particular of the Greek default event.
    Keywords: Sovereign default, labor markets, distortionary taxation, external debt, debt renegotiation, labor wedge
    JEL: E62 F32 F34 F41
    Date: 2015–05–01
  8. By: Kavli, Haakon; Viegi, Nicola
    Abstract: The paper presents a two-country real business cycle model with a financial sector that intermediates portfolio flows. It is changes in demand for financial assets from foreign investors relative to domestic investors that gives rise to portfolio flows. The simulations show that portfolio flows to emerging markets respond negatively to global risk in line with findings from the empirical literature. The transmission channel that links portfolio flows to credit in emerging markets is the financial intermediary's demand for deposit liabilities (demand for savings). One can avoid the transmission by absorbing the shock before it affects the intermediary's demand for savings. The results show that financial shocks (eg: risk) can be absorbed by optimal changes in the supply of risk free assets. Real shocks (eg: income) can be absorbed by keeping the supply of financial assets fixed and instead allowing the prices to adjust to demand. Macroprudential regulation that limits the total risk exposure of the financial sector increases the volatility of portfolio flows, but reduces the volatility of consumption and labour and therefore increases welfare. Volatility in the composition of the balance sheet (portfolio flows), does not necessarily increase volatility in the aggregate size of the balance sheet (savings). The model uses a risk-constraint on bank balance sheets as a tool to ensure less-than-perfect elasticity of demand for financial assets. The elasticity of demand is important because it determines the size and direction of portfolio flows.
    Keywords: International capital flows, portfolio flows, financial intermediaries, macroprudential policies, DSGE Open Economy
    JEL: F3 F4 F41 F44
    Date: 2015–03
  9. By: Raouf Boucekkine (Aix-Marseille University (Aix-Marseille School of Economics), CNRS and EHESS); Giorgio Fabbri (Aix-Marseille University (Aix-Marseille School of Economics), CNRS and EHESS); Patrick A. Pintus (Aix-Marseille Université (Aix-Marseille School of Economics), CNRS & EHESS)
    Abstract: In this paper, we revisit the question of how domestic and foreign risks affect growth through the lens of an AK small-open economy model with risky borrowing/lending and global diversification. Wealth is allocated between domestic and foreign assets and the optimal allocation depends on both the difference in deterministic returns and the relative magnitude and correlation of domestic and foreign risks. Depending on parameters, the small-open economy may choose to either borrow from abroad, despite the fact that this is risky, or lend. In contrast to standard N-country models, whether growth is faster or slower (and whether growth is more or less volatile) compared to autarky is not entirely driven by relative risk aversion but also depends on the return and risk characteristics of domestic and foreign assets. We also show that growth volatility and mean growth have typically nonmonotonic relationships with the the levels and correlation of domestic and foreign risks. We argue that these results are in line with, and lay down some theoretical foundations for explaining the conflicting empirical results regarding the impact of international financial integration on growth and in particular threshold effects.
    Keywords: International Financial Integration, endogenous growth, small open economy, domestic and foreign risks
    JEL: F34 F43 O40
    Date: 2015–09–17
  10. By: Ma³gorzata Skibiñska
    Abstract: We use a structural macroeconomic model with search and matching frictions on the labour market to analyse the di?erences in the business cycle ?uctuations of the labour wedge between two CEE countries and the Euro Area. Our results indicate that the observed higher volatility of this wedge in the CEE region re?ects mainly di?erent characteristics of stochastic disturbances rather than country-speci?c features of the labour market. We also ?nd signi?cant di?erences in the sources of labour wedge ?uctuations across the considered economies. While the labour wedge dynamics in Poland is to large extent explained by shocks originating in the labour market, most of its variations in the Czech Republic and in the Eurozone are attributable to changes in households’ preferences. Overall, our results suggest that labour market frictions in Poland are relatively more severe and generate ?uctuations that are more harmful for social welfare.
    Keywords: labour wedge, search and matching frictions, business cycle, CEE countries
    JEL: E32 J64
    Date: 2015–09

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