nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2016‒02‒04
fourteen papers chosen by
Martin Berka
University of Auckland

  1. Country Portfolios, Collateral Constraints and Optimal Monetary Policy By Ozge Senay; Alan Sutherland
  2. Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets By Ozge Senay; Alan Sutherland
  3. The effects of a stronger dollar on U.S. prices By Diez, Federico J.; Gopinath, Gita
  4. Secular Drivers of the Global Real Interest Rate By Lukasz Rachel; Thomas Smith
  5. Risk sharing in a world economy with uncertainty shocks By Kollmann, Robert
  6. Liquidity traps, capital flows By ACHARYA, Suchant; BENGUI, Julien
  7. Monetary policy and exchange rate dynamics By Stavrakeva, Vania; Tang, Jenny
  8. Business cycles in the eastern Caribbean economies: the role of fiscal policy and interest rates By Carneiro,Francisco Galrao; Hnatkovska,Viktoria
  9. On the individual optimality of economic integration By CASTRO, Rui; KOUMTINGUÉ, Nelnan
  10. Quantitative assessment of the role of incomplete asset markets on the dynamics of the real exchange rate By Martinez-Garcia, Enrique
  11. Sources of Real Exchange Rate Fluctuations in New EU Member Countries By Rajmund Mirdala
  12. The Sovereign-Bank Diabolic Loop and ESBies By Marcus K. Brunnermeier; Luis Garicano; Philip R. Lane; Marco Pagano; Ricardo Reis; Tano Santos; David Thesmar; Stijn Van Nieuwerburgh; Dimitri Vayanos
  13. What can Big Data tell us about the passthrough of big exchange rate changes? By Lewis, John
  14. Optimal monetary and fiscal policy at the zero lower bound in a small open economy By Bhattarai, Saroj; Egorov, Konstantin

  1. By: Ozge Senay (University of St. Andrews); Alan Sutherland (University of St Andrews and CEPR)
    Abstract: Recent literature shows that, when international financial trade is absent, optimal policy deviates significantly from strict inflation targeting, but when there is trade in equities and bonds, optimal policy is close to strict inflation targeting. A separate line of literature shows that collateral constraints can imply that cross-border portfolio holdings act as a shock transmission mechanism which significantly undermines risk sharing. This raises an important question: does asset trade in the presence of collateral constraints imply a greater role for monetary policy as a risk sharing device? This paper finds that the combination of asset trade with collateral constraints does imply a potentially large welfare gain from optimal policy (relative to inflation targeting). However, the welfare gain of optimal policy is even larger when there is no international asset trade (but collateral constraints bind within each country). In other words, the risk sharing role of asset trade tends to reduce the welfare gains from policy optimisation even when collateral constraints act as a shock transmission mechanism. This is true even when there are large and persistent collateral constraint shocks.
    Keywords: Optimal monetary policy, Financial market structure, Country Portfolios, Collateral constraints
    JEL: E52 E58 F41
    Date: 2016–01–29
  2. By: Ozge Senay (University of St. Andrews); Alan Sutherland (University of St Andrews and CEPR)
    Abstract: Recent literature on monetary policy in open economies shows that, when international financial trade is restricted to a single non-contingent bond, there are significant internal and external trade-offs that prevent optimal policy from simultaneously closing all welfare gaps. This implies an optimal policy which deviates from inflation targeting in order to offset real exchange rate misalignments. These simple models are, however, not good representations of modern financial markets. This paper therefore develops a more general and realistic two-country model of incomplete markets, where, in the presence of a wide range of stochastic shocks, there is international trade in nominal bonds denominated in the currencies of the two countries and equity claims on profit streams in the two countries. The analysis shows that, as in the recent literature, optimal policy deviates from inflation targeting in order to offset exchange rate misalignments, but the welfare benefits of optimal policy relative to inflation targeting are quantitatively smaller than found in simpler models of financial incompleteness. It is nevertheless found that optimal policy implies quantitatively significant stabilisation of the real exchange rate gap and trade balance gap compared to inflation targeting.
    Keywords: Optimal monetary policy, Financial market structure, Country Portfolios
    JEL: E52 E58 F41
    Date: 2016–01–27
  3. By: Diez, Federico J. (Federal Reserve Bank of Boston); Gopinath, Gita (Harvard University)
    Abstract: Since 2014:Q3, the U.S. dollar has experienced the third-fastest appreciation in over 30 years, with its nominal exchange and real exchange rate rising 15 percent against almost all foreign currencies (as measured by the Major Currencies Dollar Index). This sudden and rapid gain has engendered concerns about how a stronger dollar will affect U.S. export and import prices and ultimately, consumer prices and inflation in the United States. This paper assembles a rich database, spanning the period from 1985:Q1 through 2014:Q4, that combines several measures of prices and exchange rates in order to examine the likely outlook for U.S. import and export prices and consumer prices in the short run (one quarter) and over a 24-month period.
    Keywords: exchange rates; pass-through; inflation
    JEL: E31 F31 F41
    Date: 2015–12–01
  4. By: Lukasz Rachel (Department of Economics, London School of Economics (LSE); Centre for Macroeconomics (CFM); Bank of England); Thomas Smith (Bank of England)
    Abstract: Long-term real interest rates across the world have fallen by about 450 basis points over the past 30 years. The co-movement in rates across both advanced and emerging economies suggests a common driver: the global neutral real rate may have fallen. In this paper we attempt to identify which secular trends could have driven such a fall. Although there is huge uncertainty, under plausible assumptions we think we can account for around 400 basis points of the 450 basis points fall. Our quantitative analysis highlights slowing global growth as one force that may have pushed down on real rates recently, but shifts in saving and investment preferences appear more important in explaining the long-term decline. We think the global saving schedule has shifted out in recent decades due to demographic forces, higher inequality and to a lesser extent the glut of precautionary saving by emerging markets. Meanwhile, desired levels of investment have fallen as a result of the falling relative price of capital, lower public investment, and due to an increase in the spread between risk-free and actual interest rates. Moreover, most of these forces look set to persist and some may even build further. This suggests that the global neutral rate may remain low and perhaps settle at (or slightly below) 1% in the medium to long run. If true, this will have widespread implications for policymakers — not least in how to manage the business cycle if monetary policy is frequently constrained by the zero lower bound.
    Keywords: Equilibrium interest rate, long-term yields, globalsaving and investment, global trend
    JEL: E02 E10 E20 E40 E50 E60 F00 F41 F42 F47 J11 O30 O40
    Date: 2015–12
  5. By: Kollmann, Robert (European Centre for Advanced Research in Economics and Statistics (ECARES))
    Abstract: This paper analyzes the effects of output volatility shocks and of risk appetite shocks on the dynamics of consumption, trade flows and the real exchange rate, in a two-country world with recursive preferences and complete financial markets. When the risk aversion coefficient exceeds the inverse of the intertemporal substitution elasticity, then an exogenous rise in a country’s output volatility triggers a wealth transfer to that country, in equilibrium; this raises its consumption, lowers its trade balance and appreciates its real exchange rate. The effects of risk appetite shocks resemble those of volatility shocks. In a recursive preferences-complete markets framework, volatility and risk appetite shocks account for a noticeable share of the fluctuations of net exports, net foreign assets and the real exchange rate. These shocks help to explain the high empirical volatility of the real exchange rate and the disconnect between relative consumption growth and the real exchange rate.
    JEL: F31 F32 F36 F41 F43
    Date: 2015–11–01
  6. By: ACHARYA, Suchant; BENGUI, Julien
    Abstract: This paper explores the role of capital flows and exchange rate dynamics in shaping the global economy's adjustment in a liquidity trap. Using a multi-country model with nominal rigidities, we shed light on the global adjustment since the Great Recession, a period where many advanced economies were pushed to the zero bound on interest rates. We establish three main results: (i) When the North hits the zero bound, downstream capital flows alleviate the recession by reallocating demand to the South and switching expenditure toward North goods. (ii) A free capital flow regime falls short of supporting efficient demand and expenditure reallocations and induces too little downstream (upstream) flows during (after) the liquidity trap. (iii) When it comes to capital flow management, individual countries' incentives to manage their terms of trade conflict with aggregate demand stabilization and global efficiency. This underscores the importance of international policy coordination in liquidity trap episodes.
    Keywords: Capital flows; International spillovers; Liquidity traps; Uncovered interest parity; Capital flow management; Policy coordination; Optimal monetary policy
    JEL: E52 F32 F42 F44
    Date: 2015
  7. By: Stavrakeva, Vania (London Business School); Tang, Jenny (Federal Reserve Bank of Boston)
    Abstract: Financial markets regard exchange rate movements as conveying information about future expected policy rates. This paper explores the empirical link between conventional and unconventional monetary policy surprises and exchange rate fluctuations at a quarterly frequency. It examines these links using the currencies of ten developed economies calculated against four base currencies: the U.S. dollar, the British pound, the Deutschmark/euro, and the Japanese yen. Two periods are studied: 1990:Q1–2008:Q4, when the U.S. dollar hit the zero lower bound (ZLB) in December 2008, and the ZLB period between 2009:Q1 and 2015:Q1. The authors decompose exchange rate movements using a standard no-arbitrage asset pricing equation and two alternate interest rate forecasting models—a standard Taylor rule and a yield factor model. This decomposition reveals how contemporaneous unanticipated monetary policy surprises and changes in the expected future paths of policy are linked to exchange rate changes directly through relative interest rates as well as indirectly through expected excess returns and expected long-run exchange rate levels. The authors also use this decomposition to measure the fractions of the estimated effects of conventional and unconventional monetary policy surprises on exchange rate changes that are due to each component of the exchange rate change.
    JEL: E43 F31 G12 G15
    Date: 2015–10–29
  8. By: Carneiro,Francisco Galrao; Hnatkovska,Viktoria
    Abstract: This paper analyzes the business cycle characteristics of the economies of the Organization of Eastern Caribbean States using a model of a small open economy subject to interest rate and fiscal expenditure shocks and financial frictions. The paper shows that macroeconomic aggregates in this region are quite volatile, with consumption exhibiting higher volatility than gross domestic product. The analysis also finds that in these economies real interest rates are highly volatile and strongly countercyclical with gross domestic product and other macroeconomic aggregates. Similarly, fiscal expenditures show significant volatility, but are pro-cyclical with gross domestic product. The results suggest two major directions for designing policies to help reduce the volatility experienced by the Organization of Eastern Caribbean States economies. First, Organization of Eastern Caribbean States countries should seek a greater openness to international financial markets, which could help them smooth out the effects of fundamental shocks, such as shocks to technology and terms of trade, and shocks associated with natural hazards. However, this removal of international financial barriers needs to be accompanied by improvements in domestic financial conditions, as this would reduce the vulnerability of these economies to country risk premium shocks. Second, the Organization of Eastern Caribbean States region should try harder to move toward a countercyclical fiscal policy stance, as this could help to stabilize the domestic risk premium and cushion the negative effects of interest rate shocks on economic activity, hence reducing volatility.
    Keywords: Debt Markets,Economic Conditions and Volatility,Economic Theory&Research,Access to Finance,Emerging Markets
    Date: 2016–01–27
  9. By: CASTRO, Rui; KOUMTINGUÉ, Nelnan
    Abstract: Which countries find it optimal to form an economic union? We emphasize the risk-sharing benefits of economic integration. Consider an endowment world economy model, where international financial markets are incomplete and contracts not enforceable. A union solves both frictions among member countries. We uncover conditions on initial incomes and net foreign assets of potential union members such that forming a union is welfare-improving over standing alone in the world economy. Consistently with evidence on economic integration, unions in our model occur (i) relatively infrequently, and (ii) emerge more likely among homogeneous countries, and (iii) rich countries.
    Keywords: Incomplete markets; Endogenous borrowing constraints; Risk sharing; Economic integration
    JEL: F15 F34 F36 F41
    Date: 2015
  10. By: Martinez-Garcia, Enrique (Federal Reserve Bank of Dallas)
    Abstract: I develop a two-country New Keynesian model with capital accumulation and incomplete international asset markets that provides novel insights on the effect that imperfect international risk-sharing has on international business cycles and RER dynamics. I find that business cycles appear similar whether international asset markets are complete or not when driven by a combination of non-persistent monetary shocks and persistent productivity (TFP) shocks. In turn, international asset market incompleteness has sizeable effects if (persistent) investment-specific technology (IST) shocks are a main driver of business cycles. I also show that the model with incomplete international asset markets can approximate the RER volatility and persistence observed in the data, for instance, if IST shocks are near-unit-root. Hence, I conclude that the nature of shocks, the extent of financial integration across countries and the existing limitations on asset trading are central to understand the dynamics of the real exchange rate and the endogenous international transmission over the business cycles.
    JEL: F31 F37 F41
    Date: 2016–01–01
  11. By: Rajmund Mirdala
    Abstract: Fixed versus flexible exchange rate dilemma has become a subject of rigorous academic discussions for decades. Advantages of exchange rates flexibility contrasted benefits of exchange rate stability though a phenomenon known as the fear of floating favoured exchange rate variability and its positive effects on economies. Relative diversity in the exchange rate regimes in EU11 countries motivated many authors to investigate the sources of their real exchange rate volatility provided that even fixed exchange rates may fluctuate via adjustments in prices and wages. However, fixed exchange rate perspective associated with Eurozone membership may induce changed patterns in the real exchange rate determination in countries that benefit from nominal exchange rate flexibility prior to euro adoption. In the paper we analyse sources of real exchange rates fluctuations in EU11 countries. SVAR methodology and impulse-response functions will be employed to examine the responsiveness of real exchange rates to the underlying structural shocks by employing SVAR methodology. Our results indicate an increased responsiveness of real exchange rates in EMU non-member countries to demand and supply shocks, particularly due to the effects of the crisis period. At the same time, real exchange rates in EMU member countries became more responsive to nominal shocks.
    Keywords: real exhange rates, exogenous shocks, economic crisis, structural vector auto regression, impulse-response function
    JEL: C32 E52
    Date: 2015–12
  12. By: Marcus K. Brunnermeier (Princeton University); Luis Garicano (London School of Economics); Philip R. Lane (Trinity College Dublin); Marco Pagano (University of Naples Federico II and EIEF); Ricardo Reis (Columbia University); Tano Santos (Columbia Business School); David Thesmar (HEC Paris); Stijn Van Nieuwerburgh (New York University Stern Business School); Dimitri Vayanos (London School of Economics)
    Abstract: We propose a simple model of the sovereign-bank diabolic loop, and establish four results. First, the diabolic loop can be avoided by restricting banks domestic sovereign exposures relative to their equity. Second, equity requirements can be lowered if banks only hold senior domestic sovereign debt. Third, such requirements shrink even further if banks only hold the senior tranche of an internationally diversified sovereign portfolio known as ESBies in the euro-area context. Finally, ESBies generate more safe assets than domestic debt tranching alone; and, insofar as the diabolic loop is defused, the junior tranche generated by the securitization is itself risk-free.
    Date: 2016
  13. By: Lewis, John (Bank of England)
    Abstract: Using a large data set of import volumes and values for goods imports from around 50 trading partners, and 3,000 goods type, this paper finds that the micro level, passthrough is non-linear in the exchange rate. The passthrough of larger bilateral exchange rate movements (ie more than 5%) is around four times larger than that of smaller changes. However, regressions on aggregate data indicate that passthrough at the macro level is close to full. The resolution to this apparent puzzle lies in the fact that larger bilateral movements account for the vast majority of variation in the exchange rate index, and hence the non-linearity at the micro level largely disappears at the macro level.
    Keywords: Exchange rate passthrough; Big Data; non-linearity
    JEL: E31 F14 F41
    Date: 2016–01–08
  14. By: Bhattarai, Saroj (University of Texas at Austin); Egorov, Konstantin (Pennsylvania State University)
    Abstract: We investigate open economy dimensions of optimal monetary and fiscal policy at the zero lower bound (ZLB) in a small open economy model. At positive interest rates, the trade elasticity has negligible effects on optimal policy. In contrast, at the ZLB, the trade elasticity plays a key role in optimal policy prescriptions. The way in which the trade elasticity shapes policy depends on the government's ability to commit. Under discretion, the increase in government spending at the ZLB depends critically on the trade elasticity. Under commitment, the difference between future and current policies, both for domestic inflation and government spending, is smaller when the trade elasticity is higher.
    JEL: E31 E52 E58 E61 E62 E63 F41
    Date: 2016–01–01

This nep-opm issue is ©2016 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.