nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2016‒05‒08
fifteen papers chosen by
Martin Berka
University of Auckland

  1. Secular Stagnation in the Open Economy By Gauti B. Eggertsson; Neil R. Mehrotra; Lawrence H. Summers
  2. Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets By Senay, Ozge; Sutherland, Alan
  3. International Business Cycles and Risk Sharing with Uncertainty Shocks and Recursive Preferences By Robert Kollmann
  4. The ‘Real’ Explanation of the PPP Puzzle By Nicholas Ford; Charles Yuji Horioka
  5. The banking sector and the Swiss financial account during the financial and European debt crises By Raphael Anton Auer; Cédric Tille
  6. Sovereign Defaults, External Debt, and Real Exchange Rate Dynamics By Tamon Asonuma
  7. EAGLE-FLI. A macroeconomic model of banking and financial interdependence in the euro area By Nikola Bokan; Andrea Gerali; Sandra Gomes; Pascal Jacquinot; Massimiliano Pisani
  8. Exchange rate pass-through in emerging countries: Do the inflation environment, monetary policy regime and institutional quality matter? By Antonia Lopez-Villavicencio; Valérie Mignon
  9. Empirical Investigation of Purchasing Power Parity for Turkey: Evidence from Recent Nonlinear Unit Root Tests By Dilem Yıldırım
  10. What to Aim for? The Choice of an Inflation Objective When Openness Matters By Richard T. Froyen; Alfred V Guender
  11. A macroprudential stable funding requirement and monetary policy in a small open economy By Punnoose Jacob; Anella Munro
  12. Does the Yuan’s Overseas Expansion Increase the Currency Exposure of Chinese Financial Firms? By Cuestas, Juan Carlos; Huang, Ying; Tang, Bo
  13. The Real Exchange Rate in Open-Economy Taylor Rules: A Re-Assessment By Richard T. Froyen; Alfred V Guender
  14. A European Disease? Non-tradable inflation and real interest rate divergence By Sophie Piton
  15. Exchange Rate Pass-Through in the Euro Area By Rajmund Mirdala

  1. By: Gauti B. Eggertsson; Neil R. Mehrotra; Lawrence H. Summers
    Abstract: Conditions of secular stagnation - low interest rates, below target inflation, and sluggish output growth – now characterize much of the global economy. We consider a simple two-country textbook model to examine how capital markets transmit secular stagnation and to study policy externalities across countries. We find capital flows transmit recessions in a world with low interest rates and that policies that trigger current account surpluses are beggar-thy-neighbor. Monetary expansion cannot eliminate a secular stagnation and may have beggar-thy-neighbor effects, while sufficiently large fiscal interventions can eliminate a secular stagnation and carry positive externalities.
    JEL: E31 E52 F3 F44
    Date: 2016–04
  2. By: Senay, Ozge; Sutherland, Alan
    Abstract: Recent literature on monetary policy shows that, when international financial trade is restricted to a single non-contingent bond, there are significant trade-offs that prevent optimal policy from simultaneously closing all internal and external welfare gaps. Optimal policy therefore 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 develops a more realistic two-country model of incomplete markets, where 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 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: Country portfolios; Financial market structure; Optimal monetary policy
    JEL: E52 E58 F41
    Date: 2016–03
  3. By: Robert Kollmann
    Abstract: This paper analyzes the effects of output volatility shocks on the dynamics of consumption, trade flows and the real exchange rate, in a two-country, two-good world with consumption home bias, 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, to compensate for the greater riskiness of the country’s output stream. This risk sharing transfer raises the country’s consumption, lowers its trade balance and appreciates its real exchange rate. In the recursive preferences framework here, volatility shocks account for a non-negligible 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 and the real exchange rate.
    Keywords: international business cycles; international risk sharing; external balance; exchange rate; volatility; consumption-real exchange rate anomaly
    JEL: F31 F32 F36 F41 F43
    Date: 2016–03
  4. By: Nicholas Ford; Charles Yuji Horioka
    Abstract: This article shows that global financial markets cannot, by themselves, achieve net transfers of financial capital and real interest rate equalisation across countries and that the integration of both global financial markets and global goods markets is needed to achieve net transfers of capital and real interest rate equalisation across countries. Thus, frictions (barriers to mobility) in one or both of these markets can impede the net transfer of capital between countries, produce the Feldstein and Horioka (1980) finding of high saving-investment correlations, and prevent real interest rates from being equalised across countries. Moreover, frictions in global goods markets can explain why real exchange rates deviate from PPP (purchasing power parity) for extended periods of time and can therefore also explain the PPP puzzle. Thus, we are able to resolve 2 of Obstfeld and Rogoff’s (2000) “6 major puzzles in macroeconomics” with essentially the same explanation.
    Date: 2016–04
  5. By: Raphael Anton Auer; Cédric Tille
    Abstract: The US financial crisis and the later eurozone crisis have substantially impacted capital flows into and out of financial centers like Switzerland. We focus on the pattern of capital flows involving the Swiss banking industry. We first rely on balance-of-payment statistics and show that net banking inflows rose during the acute phases of the crises, albeit with a contrasting pattern. In the wake of the collapse of Lehman Brothers, net inflows were driven by a substantial retrenchment into the domestic market by Swiss banks. By contrast, net inflows from mid-2011 to mid-2012 were driven by large flows into Switzerland by foreign banks. We then use more detailed data from Swiss banking statistics which allow us to differentiate the situation across different banks and currencies. We show that, during the US financial crisis, the bank flows cycle was driven strongly by exposures in US dollars, and to a large extent by Swiss-owned banks. During the eurozone crisis, by contrast, the flight to the Swiss franc and move away from the euro was also driven by banks that are located in Switzerland, yet are foreign-owned. In addition, while the demand for the Swiss franc was driven by both foreign and domestic customers from mid-2011 to early 2013, domestic demand took a prominent role thereafter.
    Keywords: capital flows, safe haven, Switzerland, financial globalization, international banking.
    JEL: E51 G15 G21 F21 F32 F36 F65
    Date: 2016
  6. By: Tamon Asonuma
    Abstract: Emerging countries experience real exchange rate depreciations around defaults. In this paper, we examine this observed pattern empirically and through the lens of a dynamic stochastic general equilibrium model. The theoretical model explicitly incorporates bond issuances in local and foreign currencies, and endogenous determination of real exchange rate and default risk. Our quantitative analysis replicates the link between real exchange rate depreciation and default probability around defaults and moments of the real exchange rate that match the data. Prior to default, interactions of real exchange rate depreciation, originated from a sequence of low tradable goods shocks with the sovereign’s large share of foreign currency debt, trigger defaults. In post-default periods, the resulting output costs and loss of market access due to default lead to further real exchange rate depreciation.
    Keywords: Sovereign debt defaults;Real exchange rates;Exchange rate depreciation;Argentina;Debt burden;Debt service payments;External debt;Econometric models;Sovereign Defaults, External Debt, Real Exchange Rate, Currency Composition of Debt, Bond Spreads, exchange, default, exchange rate, defaults, International Lending and Debt Problems, Asset Pricing, All Countries,
    Date: 2016–02–25
  7. By: Nikola Bokan (European Central Bank); Andrea Gerali (Bank of Italy); Sandra Gomes (Bank of Portugal); Pascal Jacquinot (European Central Bank); Massimiliano Pisani (Bank of Italy)
    Abstract: We incorporate financial linkages in EAGLE, a New Keynesian multi-country dynamic general equilibrium model of the euro area (EA) by including financial frictions and country-specific banking sectors. In this new version, termed EAGLE-FLI (Euro Area and GLobal Economy with Financial LInkages), banks collect deposits from domestic households and cross-country interbank market and raise capital to finance loans issued to domestic households and firms. In order to borrow from local (regional) banks, households use domestic real estate whereas firmsuse both domestic real estate and physical capital as a collateral. These features – together with the full characterization of trade balance and real exchange rate dynamics and with a rich array of financial shocks – allow to properly assess domestic and cross-country macroeconomic effects of financial shocks. Our results support the views that (1) the business cycles in the EA can be driven not only by real shocks, but also by financial shocks, (2) the financial sector could amplify the transmission of (real) shocks, and (3) the financial/banking shocks and the banking sectors can be sources of business cycle asymmetries and spillovers across countries in a monetary union.
    Keywords: Banks, DSGE models, econometric models, financial frictions, open-economy macroeconomics, policy analysis
    JEL: E51 E32 E44 F45 F47
    Date: 2016–04
  8. By: Antonia Lopez-Villavicencio; Valérie Mignon
    Abstract: In this paper, we estimate the exchange rate pass-through (ERPT) to consumer prices and assess its dynamics for a sample of 15 emerging countries over the 1994-2015 period. To this end, we augment the traditional bivariate relationship between the nominal effective exchange rate and inflation by accounting for the inflation environment, monetary policy regime, as well as domestic institutional factors. We show that both the level and volatility of inflation matter in the sense that declining ERPT is evidenced with more stable and anti-inflationary environment. Monetary policy also plays a key role since adopting an inflation target-especially de jure-leads to a significant reduction in ERPT for most countries. Adopting exchange rate targeting regime matters as well, contributing to a diminishing ERPT. Finally, we find evidence that transparency of monetary policy decisions clearly reduces ERPT, while this is not the case for central bank independence.
    Keywords: exchange rate pass-through; inflation; emerging countries; monetary policy.
    JEL: E31 E52 F31
    Date: 2016
  9. By: Dilem Yıldırım (Department of Economics, METU)
    Abstract: This study explores the empirical validity of the purchasing power parity (PPP) hypothesis between Turkey and its four major trading partners, the European Union, Russia, China and the US. Accounting for the possible nonlinear nature of real exchange rates, mainly due to the existence of transaction costs, we employ a battery of recently developed nonlinear unit root tests. Empirical results reveal that nonlinear unit root tests deliver stronger evidence in favor of the PPP hypothesis when compared to the conventional unit root tests only if nonlinearities in real exchange rates are correctly specified.
    Keywords: Purchasing Power Parity, Real Exchange Rate, Nonlinearity, Smooth Transition
    JEL: C22 C61 F31 F41
    Date: 2016–04
  10. By: Richard T. Froyen; Alfred V Guender (University of Canterbury)
    Abstract: Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange- rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting delivers price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. CPI inflation targeting also does a better job of stabilizing the real exchange rate and interest rate which is an advantage from the standpoint of financial stability. REX inflation targeting does well in achieving output stability and has an advantage if demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes.
    Keywords: CPI, Domestic, REX Inflation Targeting, Openness, Inflation-Output Trade-off
    JEL: E3 E5 F3
    Date: 2016–03–08
  11. By: Punnoose Jacob; Anella Munro
    Abstract: The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of long-term wholesale funding and deposits to fund their assets. A similar regulation has been in place in New Zealand since 2010. This paper introduces the stable funding requirement (SFR) into a DSGE model featuring a banking sector with richly-specified liabilities, and estimates the model for New Zealand. We then evaluate the implications of an SFR for monetary policy trade-offs. Altering the steadystate SFR does not materially affect the transmission of most structural shocks to the real economy and hence has little effect on the optimised monetary policy rules. However, a higher steady-state SFR level amplifies the effects of bank funding shocks, adding to macroeconomic volatility and worsening monetary policy trade-offs conditional on these shocks. We find that this volatility can be moderated if optimal monetary or prudential policy responds to credit growth.
    Keywords: DSGE models, prudential policy, monetary policy, small open economy, sticky interest rates, banks, wholesale funding
    JEL: E31 E32 E44 F41
    Date: 2016–05
  12. By: Cuestas, Juan Carlos; Huang, Ying; Tang, Bo
    Abstract: This study investigates both the symmetric and asymmetric exchange rate exposures of Chinese financial firms in the context of an accelerated pace of RMB internationalisation. We find that an increasing number of Chinese financial firms are exposed to negative symmetric effects from the change in the trade weighted effective exchange rate. The evidence concerning asymmetries shows that after 2009 negative exchange rate shocks have a stronger effect on exposures than positive shocks. Changes in the bilateral exchange rate also have a significant impact on firm returns, given the importance of the USD in the effective exchange rate. Further, the empirical analysis reveals that exchange rate exposures are associated with firm level characteristics including total assets, earnings per share, net cash flows, investment incomes, total liabilities and firm size. Finally, we suggest that domestic and foreign stakeholders need to pay close attention to the movement of the Yuan’s exchange rate before it becomes completely convertible.
    Keywords: exchange rate exposure, RMB internationalisation, Chinese financial firms.
    JEL: C58 F3 F31 G1 G15
    Date: 2016–04–18
  13. By: Richard T. Froyen; Alfred V Guender (University of Canterbury)
    Abstract: This paper re-examines the merits of including an exchange rate response in Taylor-type interest rate rules for small open economies. Taylor (2001) and Taylor and Williams (2011) express what has been the conventional view: inclusion of the real exchange rate will either add little or might negatively affect the rule’s performance. We argue that developments in the theory of optimal monetary policy for open economies taken together with increased instability in world financial markets warrant a re-examination of the issue. Examining three flexible inflation targeting strategies, we find that a small weight on real exchange rate stability in the loss function is sufficient to improve the performance of Taylor-type rules relative to optimal policy. Gains are substantial for domestic and REX inflation targets because a small weight on real exchange rate fluctuations inhibits the aggressive use of the policy instrument under optimal policy. As real exchange rate stability is a built-in feature of a CPI inflation objective, the gains under a CPI inflation target are considerably lower. A central bank that values real exchange rate stability and follows a Taylor-type rule should respond to the real exchange rate. Doing so reduces relative losses irrespective of the specification of the inflation objective. Only a complete disregard for exchange rate stability bears out the view that there is no substantive role for the real exchange rate in Taylor-type rules.
    Keywords: CPI, Domestic, REX Inflation Targeting, Taylor-Type Rules, Timeless Perspective, Real Exchange Rate
    JEL: E3 E5 F3
    Date: 2016–02–20
  14. By: Sophie Piton
    Abstract: This paper studies the contribution of real interest rate divergence to the dynamics of the relative price of non-tradables within Europe. Based on a model by De Gregorio et al. (1994), it shows that the real interest rate fall in the Euro Area (EA) periphery following the single currency's inception induced an increase in the relative price of non-tradable goods. Using a new dataset, it documents the dynamics of the tradable and the non-tradable sectors over 1995-2013 and the expansion of the non-tradable sector in the periphery before the euro crisis. It then carries out an econometric estimation for 11 EA countries over 1995-2013 and quantifies the contribution of the pure Balassa-Samuelson effect and the impact of the interest rate on non-tradable relative prices. Diverging evolution in the interest rate impacted greatly the evolution of non-tradable relative prices within the euro area over the period. In Greece, the fall in the real interest rate over 1995-2008 could explain almost half of the non-tradable price increase relative to the EA average, while in Germany the increase in the real interest rate might have contributed up to 7% of the decrease of the non-tradable price relative to the average of the EA.
    Keywords: Non-tradable prices;Balassa-Samuelson effect;Real interest rate
    JEL: F41 F45 E43
    Date: 2016–04
  15. By: Rajmund Mirdala
    Abstract: Time-varying exchange rate pass-through effects to domestic prices under fixed euro exchange rate perspective represent one of the most challenging implications of the common currency. The problem is even more crucial when examining crisis related redistributive effects associated with relative price changes. The degree of the exchange rate pass-through to domestic prices reveals its role as the external price shocks absorber especially in the situation when the leading path of exchange rates is less vulnerable to the changes in the foreign prices. Adjustments in domestic prices followed by exchange rate shifts induced by sudden external price shocks are associated with changes in the relative competitiveness among member countries of the currency area. In the paper we examine exchange rate pass-through to domestic prices in the Euro Area member countries to examine crucial implications of the nominal exchange rate rigidity. Our results indicate that absorption capabilities of nominal effective exchange rates clearly differ in individual countries. As a result, an increased exposure of domestic prices to the external price shocks in some countries represents a substantial trade-off of the nominal exchange rate stability.
    Keywords: exchange rate pass-through, inflation, Euro Area, VAR, impulse-response function
    JEL: C32 E31 F41
    Date: 2016–04

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