nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2015‒11‒01
sixteen papers chosen by
Martin Berka
University of Auckland

  1. Dynamics of Exchange Rates and Capital Flows By Matteo Maggiori; Xavier Gabaix
  2. Are Capital Inflows Expansionary or Contractionary? Theory, Policy Implications, and Some Evidence By Blanchard, Olivier; Chamon, Marcos; Ghosh, Atish; Ostry, Jonathan D
  3. The Permanent Effects of Fiscal Consolidations By Fatás, Antonio; Summers, Lawrence
  4. The Pitfalls of External Dependence: Greece, 1829-2015 By Reinhart, Carmen M.; Trebesch, Christoph
  5. Government spending and the exchange rate By Giorgio Di Giorgio; Salvatore Nisticò; Guido Traficante
  6. Investment Hangover and the Great Recession By Andrei Shleifer; Alp Simsek; Matthew Rognlie
  7. Global Imbalances and Currency Wars at the ZLB By Emmanuel Farhi; Ricardo J. Caballero; Pierre-Olivier Gourinchas
  8. Global Economic Divergence and Portfolio Capital Flows to Emerging Markets By Zeyyad Mandalinci; Haroon Mumtaz
  9. Capital Controls as an Instrument of Monetary Policy By Ignacio Presno; Scott Davis
  10. "The Macroeconomics of a Financial Dutch Disease" By Alberto Botta
  11. Notes on the Underground: Monetary Policy in Resource-Rich Economies By Andrea Ferrero; Martin Seneca
  12. Asymmetric credit growth and current account imbalances in the euro area By Unger, Robert
  13. Credit, Asset Prices and Business Cycles at the Global Level By Stephane Dees
  14. Relative Prices and Sectoral Productivity By Diego Restuccia; Margarida Duarte
  15. Capital Unemployment, Financial Shocks, and Investment Slumps By Pablo Ottonello
  16. Foreign exchange predictability during the financial crisis: implications for carry trade profitability By Anatolyev, Stanislav; Gospodinov, Nikolay; Jamali, Ibrahim; Liu, Xiaochun

  1. By: Matteo Maggiori (Harvard University); Xavier Gabaix (Stern School of Business)
    Abstract: We explore the quantitative implications of a framework where exchange rates are directly affected by financiers' risk bearing capacity and capital flows. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of exchange rates. We calibrate the model show that it can account for the variability and correlation not only of financial variables, such as the exchange rate and capital flows, but also real variables, such as exports imports and consumption. The model can account for the "excess volatility" of the exchange rate, Backus and Smith puzzle, the failure of UIP, and the exchange rate disconnect. We also consider how policy interventions (especially interventions in the FX market) can mitigate the excess volatility and increase welfare.
    Date: 2015
  2. By: Blanchard, Olivier; Chamon, Marcos; Ghosh, Atish; Ostry, Jonathan D
    Abstract: The workhorse open-economy macro model suggests that capital inflows are contractionary because they appreciate the currency and reduce net exports. Emerging market policy makers however believe that inflows lead to credit booms and rising output, and the evidence appears to go their way. To reconcile theory and reality, we extend the set of assets included in the Mundell-Fleming model to include both bonds and non-bonds. At a given policy rate, inflows may decrease the rate on non-bonds, reducing the cost of financial intermediation, potentially offsetting the contractionary impact of appreciation. We explore the implications theoretically and empirically, and find support for the key predictions in the data.
    Keywords: capital controls; capital inflows; foreign exchange intervention
    JEL: F21 F23
    Date: 2015–10
  3. By: Fatás, Antonio; Summers, Lawrence
    Abstract: The global financial crisis has permanently lowered the path of GDP in all advanced economies. At the same time, and in response to rising government debt levels, many of these countries have been engaging in fiscal consolidations that have had a negative impact on growth rates. We empirically explore the connections between these two facts by extending to longer horizons the methodology of Blanchard and Leigh (2013) regarding fiscal policy multipliers. Using data seven years after the beginning of the crisis as well as estimates on potential output our analysis suggests that attempts to reduce debt via fiscal consolidations have very likely resulted in a higher debt to GDP ratio through their negative impact on output. Our results provide support for the possibility of self-defeating fiscal consolidations in depressed economies as developed by DeLong and Summers (2012).
    Keywords: austerity; fiscal policy; Great Recession; hysteresis; persistence
    JEL: E32 E62 O40
    Date: 2015–10
  4. By: Reinhart, Carmen M.; Trebesch, Christoph
    Abstract: Two centuries of Greek debt crises highlight the pitfalls of relying on external financing. Since its independence in 1829, the Greek government has defaulted four times on its external creditors – with striking historical parallels. Each crisis is preceded by a period of heavy borrowing from foreign private creditors. As repayment difficulties arise, foreign governments step in, help to repay the private creditors, and demand budget cuts and adjustment programs as a condition for the official bailout loans. Political interference from abroad mounts and a prolonged episode of debt overhang and financial autarky follows. We conclude that these cycles of external debt and dependence are a perennial theme of Greek history, as well as in other countries that have been “addicted” to foreign savings.
    Keywords: Bailouts; Crisis Resolution; External Debt; Sovereign Default
    JEL: E6 F3 H6 N0
    Date: 2015–10
  5. By: Giorgio Di Giorgio (LUISS Guido Carli, Department of Economics and Finance, Rome (Italy)); Salvatore Nisticò (Dipartimento di Scienze Sociali ed Economiche, Sapienza University of Rome); Guido Traficante (European University of Rome)
    Abstract: Contrary to widespread empirical evidence, standard NOEM models imply that the real exchange rate appreciates following an increase in public spending. This paper uses a two-country \perpetual youth" DSGE model with productive government purchases to show to what extent the real exchange rate can instead depreciate after a positive spending shock, thus reconciling the theoretical model with the empirical evidence. In particular, the model is able to imply a depreciation both on impact and in the transition, displaying the hump-shaped response documented by most empirical studies. The transmission mechanism of fiscal shocks works through an increase in domestic private sector productivity and, in turn, lower real marginal costs at Home.
    Keywords: Exchange Rate, Fiscal Shocks, Endogenous Monetary and Fiscal Policy.
    JEL: E52 E62 F41 F42
    Date: 2015–10
  6. By: Andrei Shleifer (Harvard University); Alp Simsek (Massachusetts Institute of Technology); Matthew Rognlie (Massachusetts Institute of Technology)
    Abstract: We present a model of investment hangover motivated by the Great Recession. In our model, overbuilding of residential capital requires a reallocation of productive resources to nonresidential sectors, which is facilitated by a reduction in the real interest rate. If the interest rate is bounded from below due to nominal rigidities, then the economy enters a liquidity trap with limited reallocation and low output. The drop in output also reduces nonresidential investment through a mechanism similar to the acceleration principle of investment. The burst in nonresidential investment is followed by an even greater boom due to low interest rates during the liquidity trap. The boom in nonresidential investment induces a partial and asymmetric recovery in which the residential sector is left behind, consistent with the broad trends of the Great Recession.
    Date: 2015
  7. By: Emmanuel Farhi; Ricardo J. Caballero; Pierre-Olivier Gourinchas
    Abstract: This paper explores the consequences of extremely low equilibrium real interest rates in a world with integrated but heterogenous capital markets, and nominal rigidities. In this context, we establish five main results: (i) Economies experiencing liquidity traps pull others into a similar situation by running current account surpluses; (ii) Reserve currencies have a tendency to bear a disproportionate share of the global liquidity trap--a phenomenon we dub the \reserve currency paradox;" (iii) Beggar-thy-neighbor exchange rate devaluations stimulate the domestic domestic economy at the expense of other economies; (iv) While more price and wage exibility exacerbates the risk of adeflationary global liquidity trap, it is the more rigid economies that bear the brunt of the recession; (v) (Safe) Public debt issuances and increases in government spending anywhere are expansionary everywhere, and more so when there is some degree of price or wage exibility. We use our model to shed light on the evolution of global imbalances,interest rates, and exchange rates since the beginning of the global financial crisis.
    Date: 2015–01
  8. By: Zeyyad Mandalinci (Queen Mary University of London); Haroon Mumtaz (Queen Mary University of London)
    Abstract: This paper studies the role of global and regional variations in economic activity and policy in developed world in driving portfolio capital flows (PCF) to emerging markets (EMs) in a Factor Augmented Vector Autoregressive (FAVAR) framework. Results suggest that PCFs to EMs depend mainly on economic activity at the global level and monetary policy in America, positively on the former and negatively on the latter. In contrast, economic activity and policy shocks in Europe and Asia contribute significantly less to variations in PCFs to EMs. Hence, PCFs are driven by not only common shocks across all developed countries, but also variations in specific regions. This implies that economic divergence in the developed world can have significant effects on EMs via PCFs.
    Keywords: Portfolio capital flows; Bayesian analysis, Factor model, VAR, Emerging markets
    JEL: C11 C32 E30 E52 E58 F32
    Date: 2015–10
  9. By: Ignacio Presno (Universidad de Montevideo); Scott Davis (Federal Reserve Bank of Dallas)
    Abstract: Large swings in capital flows into and out of emerging markets can potentially lead to excessive volatility in asset prices and credit supply. In order to lessen the impact of capital flows on financial instability, a number of researchers and policy makers have recently proposed the use of capital controls. This paper considers the benefit of adding capital controls as a potential instrument of monetary policy in a small open economy. In a DSGE framework, we find that when domestic agents are subject to collateral constraints and the value of collateral is subject to fluctuations driven by foreign capital inflows and outflows, the adoption of temporary capital controls can lead to a significant welfare improvement. The benefits of capital controls are present even when monetary policy is determined optimally, implying that there may be a role for capital controls to exist side-by-side with conventional monetary tools as an instrument of monetary policy.
    Date: 2015
  10. By: Alberto Botta
    Abstract: We describe the medium-run macroeconomic effects and long-run development consequences of a financial Dutch disease that may take place in a small developing country with abundant natural resources. The first move is in financial markets. An initial surge in foreign direct investment targeting natural resources sets in motion a perverse cycle between exchange rate appreciation and mounting short- and medium-term capital flows. Such a spiral easily leads to exchange rate volatility, capital reversals, and sharp macroeconomic instability. In the long run, macroeconomic instability and overdependence on natural resource exports dampen the development of nontraditional tradable goods sectors and curtail labor productivity dynamics. We advise the introduction of constraints to short- and medium-term capital flows to tame exchange rate/capital flows boom-and-bust cycles. We support the implementation of a developmentalist monetary policy targeting competitive nominal and real exchange rates in order to encourage product and export diversification.
    Keywords: Financial Dutch Disease; Exchange Rate Volatility; Macroeconomic Instability; Developmentalist Monetary Policy
    JEL: F32 O14 O24
    Date: 2015–10
  11. By: Andrea Ferrero; Martin Seneca
    Abstract: How should monetary policy respond to a commodity price shock in a resource-rich economy? As in the baseline New Keynesian model, the central bank of a small oil-exporting economy faces a tradeoff, between the stabilization of domestic infl ation and an appropriately defined output gap. But in our framework the output gap depends on oil technology, and the weight on output gap stabilization is increasing in the importance of the oil sector. Given substantial spillovers to the rest of the economy, optimal policy calls for a reduction of the interest rate following a drop in the oil price. In contrast, a central bank with a mandate to stabilize consumer price infl ation would raise interest rates to limit the infl ationary impact of an exchange rate depreciation.
    Keywords: small open economy, oil export, monetary policy
    JEL: E52 E58 J11
    Date: 2015
  12. By: Unger, Robert
    Abstract: The euro area crisis is often linked to the emergence of current account imbalances. As most of the deficit countries experienced pronounced credit booms at the same time that these imbalances were building up, this paper investigates the link between domestic credit developments and the current account balance, distinguishing between a credit pull and a credit push factor. The pull factor captures flows of bank loans to the domestic non-financial private sector. An increase in these flows is expected to lead to higher domestic demand and a deterioration of the current account. The push factor measures flows of claims of domestic banks on debtors in other euro-area countries, and an increase is expected to lead to higher external demand and an improvement in the current account. Using a panel error correction specification, the estimation results confirm that the pull factor is a significant determinant of the current account, whereas the results for the push factor are less clear-cut. The paper also shows that variations in the flows of bank loans to the non-financial private sector (i.e. the pull factor) - together with changes in competitiveness - constituted the most important factor driving the build-up of current account imbalances in the deficit countries. Accordingly, impeding an increase in private sector indebtedness seems to be a promising way to dampen the formation of unsustainable current account imbalances.
    Keywords: banks,credit growth,current account imbalances,euro area
    JEL: E5 F32
    Date: 2015
  13. By: Stephane Dees
    Abstract: This paper assesses the role of financial variables in real economic fluctuations, in view of analysing the link between financial cycles and business cycles at the global level. A Global VAR modelling approach, which has been proved suitable for modelling country or regional linkages, is used to first assess the contribution of credit and asset price variables to real economic activity in a number of countries and regions. The GVAR model is based on 38 countries estimated over 1987-2013. An analysis on a sample excluding the post-financial crisis period is also provided to check whether financial variables have gained importance in explaining business cycle fluctuations over the recent past. In a second step, an attempt to identify broader financial shocks through sign restrictions is given in order to illustrate how financial and business cycles could be related. Overall, the paper shows that the importance of credit and asset price variables in explaining real economic fluctuations is relatively large, but has not significantly increased since the global financial crisis. The international transmission of financial shocks on business cycle fluctuations also tends to be large and persistent.
    Keywords: transmission of shocks; financial cycle; business cycle; GVAR model
    JEL: E32 E37 E44 E51 F47
    Date: 2015–10
  14. By: Diego Restuccia (University of Toronto); Margarida Duarte (University of Toronto)
    Abstract: The relative price of services rises with development. A standard interpretation of this fact is that cross-country productivity differences are larger in manufacturing than in services. The service sector comprises heterogeneous categories. We document that the behavior of relative prices is markedly different across two broad classifications of services: traditional services, such as health and education, feature a rising relative price with development and non-traditional services, such as communication and transportation, feature a falling relative price with income. Using a standard model of structural transformation with an input-output structure, we find that cross-country productivity differences are much larger in non-traditional services (a factor of 106.5-fold between rich and poor countries) than in manufacturing (24.5-fold). Moreover, this relative productivity difference is reduced by more than half when abstracting from intermediate inputs. Development requires an emphasis on solving the productivity problem in non-traditional services in poor countries.
    Date: 2015
  15. By: Pablo Ottonello (Columbia university)
    Abstract: Recoveries from financial crises are characterized by low investment rates and declines in capital stocks. This paper constructs an equilibrium framework in which financial shocks have a persistent effect on aggregate investment. The key assumption is that physical capital is traded in a decentralized market with search frictions, generating 'capital unemployment.' After a negative financial shock, the share of unemployed capital is high, and the economy dedicates more resources to absorbing existing unemployed capital into production, and less to accumulating new capital. An estimation of the model for the U.S. economy using Bayesian techniques shows that the model can generate the investment persistence and half of the output persistence observed in the Great Recession. Investment search frictions also lead to a different interpretation of the sources of business-cycle fluctuations, with a larger role for financial shocks, which account for 33% of output fluctuations. Extending the model to allow for heterogeneity in match productivity, the framework also provides a mechanism for procyclical capital reallocation, as observed in the data.
    Date: 2015
  16. By: Anatolyev, Stanislav (New Economic School); Gospodinov, Nikolay (Federal Reserve Bank of Atlanta); Jamali, Ibrahim (American University of Beirut); Liu, Xiaochun (University of Central Arkansas)
    Abstract: In this paper, we study the effectiveness of carry trade strategies during and after the financial crisis using a flexible approach to modeling currency returns. We decompose the currency returns into multiplicative sign and absolute return components, which exhibit much greater predictability than raw returns. We allow the two components to respond to currency-specific risk factors and use the joint conditional distribution of these components to obtain forecasts of future carry trade returns. Our results suggest that the decomposition model produces higher forecast and directional accuracy than any of the competing models. We show that the forecasting gains translate into economically and statistically significant (risk-adjusted) profitability when trading individual currencies or forming currency portfolios based on the predicted returns from the decomposition model.
    Keywords: exchange rate forecasting; carry trade; positions of traders; return decomposition; copula; joint predictive distribution
    JEL: C32 C53 F31 F37 G15
    Date: 2015–08–01

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