nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒10‒25
sixteen papers chosen by
Martin Berka
University of Auckland

  1. Credit Constraints and Growth in a Global Economy By Nicolas Coeurdacier; Stéphane Guibaud; Keyu Jin
  2. The Distributional Consequences of Exchange Rate Devaluations By Andrei Levchenko; Javier Cravino
  3. Fiscal Policy in Debt Constrained Economies By Amador, Manuel; Aguiar, Mark
  4. Exchange Rate Pass-Through, Currency of Invoicing and Market Share By Michael Devereux; Wei Dong; Ben Tomlin
  5. Shock Transmission Through International Banks: Canada By James Chapman; H. Evren Damar
  6. The international transmission of credit bubbles: theory and policy By Jaume Ventura; Alberto Martin
  7. Oil currencies in the face of oil shocks: What can be learned from time-varying specifications? By Jean-Pierre Allegret; Cécile Couharde; Valérie Mignon; Tovonony Razafindrabe
  8. International Evidence on the Role of Monetary Policy in the Uncovered Interest Rate Parity Puzzle By Alfred V Guender
  9. The cyclicality of (bilateral) capital inflows and outflows By Davis, J. Scott
  10. Sovereign Debt, Risk Sharing, and Austerity Programs By Kjetil Storesletten; Fabrizio Zilibotti; Andreas Mueller
  11. Capital flows and the current account: Taking financing (more) seriously By Claudio Borio; Piti Disyatat
  12. Breaking free of the triple coincidence in international finance By Stefan Avdjiev; Robert Neil McCauley; Hyun Song Shin
  13. Domestic and Multilateral Effects of Capital Controls in Emerging Markets By Gurnain Pasricha; Matteo Falagiarda; Martin Bijsterbosch; Joshua Aizenman
  14. Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results By Richard T. Froyen; Alfred V Guender
  15. Liquidity Risk and Time-Varying Correlation Between Equity and Currency Returns By Jung, Kuk Mo
  16. Exchange Rate Pass-Through to Consumer Prices: Theory and Recent Evidence By Laurence Savoie-Chabot; Mikael Khan

  1. By: Nicolas Coeurdacier (Département d'économie); Stéphane Guibaud (Département d'économie); Keyu Jin (London School of Economics and Political Science (LSE))
    Abstract: We show that in an open-economy OLG model, the interaction between growth differentials and household credit constraints—more severe in fast-growing countries—can explain three prominent global trends: a divergence in private saving rates between advanced and emerging economies, large net capital outflows from the latter, and a sustained decline in the world interest rate. Micro-level evidence on the evolution of age-saving profiles in the US and China corroborates our mechanism. Quantitatively, our model explains about a third of the divergence in aggregate saving rates, and a significant portion of the variations in age-saving profiles across countries and over time.
    Keywords: Global Economu; Economical Growth; Credit Constraints
    JEL: E21 E22 F21 F32 F41 O16 P24
    Date: 2015–09
  2. By: Andrei Levchenko (University of Michigan); Javier Cravino (University of Michigan)
    Abstract: We study the differential impact of large exchange rate devaluations on the cost of living at different points on the income distribution. Across product categories, the poor have relatively high expenditure shares in tradeables. Within tradeable product categories, the poor consume lower-priced varieties that contain relatively less domestic value added. A devaluation raises the relative price of tradeables, and within product categories raises the relative price of cheaper varieties. Both effects imply that the devaluation hurts the low-income households more than the high-income ones. We quantify these effects following the 1994 Mexican peso devaluation and show that the distributional consequences can be large. Following the devaluation, the cost of the consumption basket of those in the bottom decile of the income distribution rose between 1/3 and 1/2 times more than the cost of the consumption basket for the top income decile. We supplement the detailed results for Mexico using cross-country evidence.
    Date: 2015
  3. By: Amador, Manuel (Federal Reserve Bank of Minneapolis); Aguiar, Mark (Princeton University)
    Abstract: We study optimal fiscal policy in a small open economy (SOE) with sovereign and private default risk and limited commitment to tax plans. The SOE's government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the economy is subject to sovereign debt constraints and the domestic households are impatient relative to the international interest rate. The front loading of tax distortions allows the economy to build a large (aggregate) debt position in the presence of limited commitment. We show that a similar result holds in a closed economy with imperfect inter-generational altruism, providing a link with the closed-economy literature that has explored disagreement between the government and its citizens regarding inter-temporal tradeoffs.
    Keywords: Fiscal policy; Sovereign debt; Limited commitment
    JEL: E62 F32 F34
    Date: 2015–10–16
  4. By: Michael Devereux; Wei Dong; Ben Tomlin
    Abstract: This paper investigates the impact of market structure on the joint determination of exchange rate pass-through and currency of invoicing in international trade. A novel feature of the study is the focus on market share of firms on both sides of the market—that is, exporting firms and importing firms. A model of monopolistic competition with heterogeneous firms has the following set of predictions: a) exchange rate pass-through should be non-monotonic and U-shaped in the market share of exporting firms, but monotonically declining in the market share of importers; b) exchange rate pass-through should be lower, the higher is local currency invoicing of imports; and c) producer currency invoicing should be related non-monotonically and U-shaped to exporter market share, and monotonically declining in importing firms’ market share. We test these predictions using a new and large micro data set covering the universe of Canadian imports over a six-year period. The data strongly support all three predictions.
    Keywords: Exchange rates, Inflation and prices, Market structure and pricing
    JEL: F3 F4
    Date: 2015
  5. By: James Chapman; H. Evren Damar
    Abstract: In this paper, we investigate how liquidity conditions in Canada may affect domestic and/or foreign lending of globally active banks and whether this transmission is influenced by individual bank characteristics. We find that Canadian banks expanded their foreign lending during the recent financial crisis, often through acquisitions of foreign banks. We also find evidence that internal capital markets play a role in the lending activities of globally active Canadian banks during times of heightened liquidity risk.
    Keywords: Financial institutions; Financial stability
    JEL: E44 F36 G21 G32
    Date: 2015
  6. By: Jaume Ventura (CREI); Alberto Martin (CREI, UPF and Barcelona GSE)
    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.
    Date: 2015
  7. By: Jean-Pierre Allegret; Cécile Couharde; Valérie Mignon; Tovonony Razafindrabe
    Abstract: While the oil currency property is clearly established from a theoretical viewpoint, its existence is less clear-cut in the empirical literature. We investigate the reasons for this apparent puzzle by studying the time-varying nature of the relationship between real effective exchange rates of five oil exporters and the real oil price in the aftermath of the oil price shocks of the last two decades. Accordingly, we rely on a time-varying parameter VAR specification which allows the responses of real exchange rates to different oil price shocks to evolve over time. We find that the reason of the mixed results obtained in the empirical literature is that oil currencies follow different hybrid models in the sense that oil countries’ real exchange rates may be driven by one or several sources of oil price shocks that furthermore can vary over time. In addition to structural changes affecting oil countries, structural changes arising from the oil market itself through the various, time-varying sources of oil price shocks are found to be crucial.
    Keywords: oil currencies;oil shocks;Time-Varying Parameter VAR model
    JEL: C32 F31 Q43
    Date: 2015–10
  8. By: Alfred V Guender (University of Canterbury)
    Abstract: CPI inflation targeting necessitates a flexible exchange rate regime. This paper embeds an endogenous target rule into a simple open economy macro model to explain the UIP puzzle. The model predicts that the change in the exchange rate is inversely related to the lagged interest rate differential. Openness and aversion to inflation variability determine the strength of this linkage. Foreign inflation and the foreign interest rate also affect exchange rate changes. This hypothesis is tested on data from three small open economies, Canada, Norway, and Switzerland, all of which target CPI inflation and maintain extensive trade and finance links with a larger neighboring country. Supportive evidence is strongest for Switzerland during a clean float period before the outbreak of the Global Financial Crisis.
    Keywords: Uncovered Interest Rate Parity (UIP) Puzzle, Target Rule, Optimal Monetary Policy, Openness, Aversion to Inflation Variability
    JEL: E4 E5 F3
    Date: 2015–08–01
  9. By: Davis, J. Scott (Federal Reserve Bank of Dallas)
    Abstract: Recent research has shown that gross capital inflows and outflows are positively correlated and highly procyclical. This poses a puzzle since most theory predicts that capital inflows and outflows should be negatively correlated, and while capital inflows should be procyclical, capital outflows should be countercyclical. This previous work has examined the behavior of aggregate capital inflows and outflows (capital flows between a country and the rest of the world). This paper shows that bilateral capital inflows and outflows (flows between a pair of countries) are also positively correlated and strongly procyclical. This empirical finding poses a new puzzle. The data suggests that any model that can explain capital flows at the bilateral level needs to rely on market incompleteness and non-diversification. In addition, the data suggests that this positive correlation and procyclicality is largely the feature of crisis episodes. After controlling for crisis episodes, we find that bilateral capital flows move positively with GDP in the country receiving the capital and co-move negatively in the country sending the capital.
    JEL: F3 F4 G0 G1
    Date: 2015–08–01
  10. By: Kjetil Storesletten (University of Oslo); Fabrizio Zilibotti (University of Zurich); Andreas Mueller (University of Oslo)
    Abstract: We construct a dynamic model of sovereign debt related to Arellano (2008), where the economy's aggregate income and the cost of default is stochastic, and the outstanding debt is periodically renegotiated in equilibrium as in Bulow and Rogoff (1989). Like in Krugman (1989), in a recession the sovereign can provide effort to increase the probability of recovery, however part of the gains of good performance will go to the creditors, causing moral hazard. We characterize analytically the equilibrium in terms of the price of the non state-contingent sovereign debt, the probability of renegotiation and the consumption and reform effort dynamics. We find that during a recession, in the decentralized equilibrium, the government's limited commitment to repay the sovereign debt induces excessive consumption volatility in comparison to the constrained optimal allocation. Moreover, the government underprovides reform effort, thus the expected duration of the recession is too long compared to the first-best as well as the second-best allocation. This inefficiencies leave potential for external intervention. To this end, we study a small open economy in a persistent recession with an endogenous probability of recovery (let's say Greece), and evaluate the effect of several assistance programs run by an international authority (e.g., the IMF, ECB, or the EU) that can provide a guarantee for the repayment of the sovereign debt conditional on repeated compliance, and possibly fiscal austerity and reform effort. We find that successful assistance programs require reform effort control, and allow the debtor to renegotiate terms whenever conditions favor leaving the program. The welfare losses caused by ill-designed assistance programs can be substantial.
    Date: 2015
  11. By: Claudio Borio; Piti Disyatat
    Abstract: This paper questions the appropriateness of popular analytical frameworks that focus on current accounts or net capital flows as a basis for assessing the pattern of cross-border capital flows, the degree of financial integration and the vulnerability of countries to financial crises. In the process, it revisits the Lucas paradox, the Feldstein-Horioka puzzle and the notion of sudden stops. It argues that, in a world of huge and free capital flows, the centrality of current accounts in international finance, and hence in academic and policy debates, should be reconsidered.
    Keywords: capital flows, current account, global imbalances, financial integration, credit, finance, money
    Date: 2015–10
  12. By: Stefan Avdjiev; Robert Neil McCauley; Hyun Song Shin
    Abstract: The traditional approach to international finance is to view capital flows as the financial counterpart to savings and investment decisions, assuming further that the GDP boundary defines both the decision-making unit and the currency area. This "triple coincidence" of GDP area, decision-making unit and currency area is an elegant simplification but misleads when financial flows are important in their own right. First, the neglect of gross flows, when only net flows are considered, can lead to misdiagnoses of financial vulnerability. Second, inattention to the effects of international currencies may lead to erroneous conclusions on exchange rate adjustment. Third, sectoral differences between corporate and official sector positions can distort welfare conclusions on the consequences of currency depreciation, as macroeconomic risks may be underestimated. This paper illustrates the pitfalls of the triple coincidence through a series of examples from the global financial system in recent years and examines alternative analytical frameworks based on balance sheets as the unit of analysis.
    Keywords: capital flows, global liquidity, international currencies
    Date: 2015–10
  13. By: Gurnain Pasricha; Matteo Falagiarda; Martin Bijsterbosch; Joshua Aizenman
    Abstract: Using a novel data set on capital control actions in 17 emerging-market economies (EMEs) over the period 2001–11, we provide new evidence on domestic and multilateral (or spillover) effects of capital controls. Our results, based on panel vector autoregressions, suggest that capital control actions had limited impact on the variables of the monetary policy trilemma, as a result of offsetting resident flows and ample investment opportunities in EMEs. 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. Tightening of capital inflow restrictions in Brazil, Russia, India, China and South Africa (the BRICS) generated significant spillovers via bank lending and exchange rates, particularly in the post-2008 environment of abundant global liquidity. Spillovers seem to be strongest among the BRICS and in Latin America. These results are robust to various specifications of our models.
    Keywords: Econometric and statistical methods, Financial system regulation and policies, International financial markets, International topics, Monetary policy framework
    JEL: F32 G15 F41 F42
    Date: 2015
  14. By: Richard T. Froyen; Alfred V Guender (University of Canterbury)
    Abstract: Under optimal policy from a timeless perspective, a central bank targeting an inflation measure which is adjusted for changes in the real exchange rate (REX inflation) has the ability to stabilize the output gap and inflation against demand disturbances in an open economy. This distinct advantage is lost if a central bank follows a Taylor-type rule. The bank has an incentive to add the real exchange rate to the Taylor rule because it duplicates the performance of the optimal policy for portfolio shocks. The Taylor-type rule becomes a Monetary Conditions Index (MCI) that outperforms Taylor-type rules which accord no weight at all or a higher weight to the real exchange rate. In the current environment of concern about sudden increases in U.S. interest rates, the properly designed MCI would have a considerable advantage.
    Keywords: REX Inflation, Optimal Policy, Taylor-Type Rules, MCI, Openness, Portfolio Shocks
    JEL: E3 E5 F5
    Date: 2015–06–19
  15. By: Jung, Kuk Mo
    Abstract: Using data on twenty major OECD countries over time, this paper documents a new evidence on real equity and real currency prices: higher real returns in the home equity market relative to foreign counterparts are generally associated with real home currency depreciation at a monthly frequency, but this negative correlation breaks down or even reverses during times of relatively higher aggregate economic uncertainty or volatility. This paper also proposes one plausible explanation for this time-varying correlation structure. The suggested model is based on a long-run risks type model, combined with time-varying liquidity risks in stock markets. With recursive preference for the early resolution of uncertainty and a negative link between the level of short-run economic growth and equity market liquidity volatility, the model demonstrates that severe short-run economic uncertainty overturns the otherwise negative link between the real currency and real relative equity returns.
    Keywords: foreign exchange rates, long run risks models, liquidity risks
    JEL: E43 F31 G12 G15
    Date: 2015–10
  16. By: Laurence Savoie-Chabot; Mikael Khan
    Abstract: In an open economy such as Canada’s, exchange rate movements can have a material impact on consumer prices. This is particularly important in the current context, with the significant depreciation of the Canadian dollar vis-a-vis the U.S. dollar since late 2012. This paper provides a broad overview of the various mechanisms by which exchange rate movements pass through to consumer prices and discusses the implications of exchange rate pass-through (ERPT) for the conduct of monetary policy. It then describes some of the tools used at the Bank of Canada to help quantify ERPT. We conclude by taking a closer look at the current situation in Canada, presenting a range of evidence that suggests ERPT has played an important role in recent inflation dynamics.
    Keywords: Exchange rates, Inflation and prices
    JEL: E31 E52 F31
    Date: 2015

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