nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2017‒01‒22
twelve papers chosen by
Martin Berka
University of Auckland

  1. Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union By Corsetti, Giancarlo; Dedola, Luca; Jarociński, Marek; Maćkowiak, Bartosz; Schmidt, Sebastian
  2. Synopsis of the Euro Area Financial Crisis By Matthieu Darracq Paries; Pascal Jacquinot; Niki Papadopoulou
  3. Debt overhang and the macroeconmics of carry trade By Sweder J.G. van Wijnbergen; Egle Jakucionyte
  4. Chinese Foreign Exchange Reserves, Policy Choices and the U.S. Economy By Neely, Christopher J.
  5. Parsing Financial Frictions Underlying Bank Lending Fragmentation during the Euro Area Crisis By Matthieu Darracq Paries; Pascal Jacquinot; Niki Papadopoulou
  6. Quantitative Easing by the Fed and International Capital Flows By Sameer Khatiwada
  7. Real Exchange Rates, Current Accounts and Competitiveness Issues in the Euro Area By Rajmund Mirdala
  8. Eurozone Debt Crisis and Bond Yields Convergence: Evidence from the New EU Countries By Minoas Koukouritakis
  9. Foreign capital inflow and its welfare implications in a developing country context By Mukherjee, Rudrarup
  10. Determinants of sub-sovereign bond yield spreads: the role of fiscal fundamentals and federal bailout expectations By Beck, Roland; Ferrucci, Gianluigi; Hantzsche, Arno; Rau-Goehring, Matthias
  11. Fiscal policy coordination in currency unions at the effective lower bound By Hettig, Thomas; Müller, Gernot
  12. Fiscal Discipline and Exchange Rates; Does Politics Matter? By João Tovar Jalles; Carlos Mulas-Granados; José Tavares

  1. By: Corsetti, Giancarlo; Dedola, Luca; Jarociński, Marek; Maćkowiak, Bartosz; Schmidt, Sebastian
    Abstract: The euro area has been experiencing a prolonged period of weak economic activity and very low inflation. This paper reviews models of business cycle stabilization with an eye to formulating lessons for policy in the euro area. According to standard models, after a large recessionary shock accommodative monetary and fiscal policy together may be necessary to stabilize economic activity and inflation. The paper describes practical ways for the euro area to be able to implement an effective monetary-fiscal policy mix. JEL Classification: E31, E62, E63
    Keywords: eurobond, government bonds, joint analysis of fiscal and monetary policy, lower bound on nominal interest rates, self-fulfilling sovereign default
    Date: 2016–12
  2. By: Matthieu Darracq Paries (European Central Bank); Pascal Jacquinot (European Central Bank); Niki Papadopoulou (Central Bank of Cyprus)
    Abstract: The paper is putting forward a structural narrative for the euro area financial crisis and its asymmetric consequences through the monetary union. We conjecture three originating factors to the euro area financial fragmentation and discuss the role of specific financial frictions in transmitting and amplifying them: (i) the macroeconomic spillovers of sovereign market tensions through risky banks, (ii) the adverse real-financial feedback loop from rising corporate default to weak banks and credit supply constraints, (iii) bank deleveraging process at times of unprecedented regulatory overhaul. We develop global DSGE model featuring a sovereign-bank nexus, a granular set of relevant financial frictions. The model is calibrated for 6 regions in order to reflect the financial heterogeneity across the largest countries of the euro area. The counterfactual scenarios show that the interplay between sovereign, bank and corporate solvency risks generated sizeable procyclicality in some jurisdictions of the euro area during the crisis and severely impaired the transmission of the single monetary policy.
    Keywords: DSGE models, banking, nancial regulation, cross-country spillovers, bank lending rates
    JEL: E4 E5 F4
    Date: 2016–12
  3. By: Sweder J.G. van Wijnbergen (University of Amsterdam, The Netherlands); Egle Jakucionyte (University of Amsterdam, The Netherlands)
    Abstract: The depreciation of the Hungarian forint in 2009 left Hungarian borrowers with a skyrocketing value of foreign currency debt. The resulting losses worsened debt overhang in to debt-ridden firms and eroded bank capital. Therefore, although Hungarian banks had partially isolated their balance sheets from exchange rate risk by extending FX-denominated loans, the ensuing debt overhang in borrowing firms exposed the banks to elevated credit risk. Firms, households and banks had run up the open FX-positions hoping to profit from low foreign rates in the run-up to Euro adoption. This example of carry trade in emerging Europe motivates our analysis of currency mismatch losses in different sectors in the economy, and the macroconsequences of reallocating losses from the corporate to the banking sector ex post. We develop a small open economy New Keynesian DSGE model that accounts for the implications of domestic currency depreciation for corporate debt overhang and incorporates an active banking sector with financial frictions. The model, calibrated to the Hungarian economy, shows that, in periods of unanticipated depreciation, allocating currency mismatch losses to the banking sector generates a milder recession than if currency mismatch is placed at credit constrained firms. The government can intervene to reduce aggregate losses even further by recapitalizing banks and thus mitigating the effects of currency mismatch losses on credit supply.
    Keywords: Debt overhang, foreign currency debt, leveraged banks, small open economy, Hungary
    JEL: E44 F41 P2
    Date: 2017–01–13
  4. By: Neely, Christopher J. (Federal Reserve Bank of St. Louis)
    Abstract: China is both a major trading partner of the United States and the largest official holder of U.S. assets in the world. The value of Chinese foreign exchange reserves peaked at just over $4 trillion in June 2014, but has since declined to $3.19 trillion as of August 2016. This very large decline is in foreign exchange reserves is unprecedented and some analysts have speculated that continued sales of these (mostly U.S.) assets might significantly impact the U.S. and global economies. This article explains the reasons for this large decline in official assets, what China’s policy choices are, and how these choices could affect the U.S. economy.
    Keywords: Monetary policy; central banks and their policies; foreign exchange; current account
    JEL: E52 E58 F31 F32
    Date: 2017–01–09
  5. By: Matthieu Darracq Paries (European Central Bank); Pascal Jacquinot (European Central Bank); Niki Papadopoulou (Central Bank of Cyprus)
    Abstract: The euro area experience during the financial crisis highlighted the importance of financial and sovereign risk factors in macroeconomic propagation, as well as the constraints that bank lending fragmentation would pose for monetary policy conduct in a currency union. Focusing specifically on the credit intermediation process, we claim that sources of impairments in the monetary policy transmission mechanism can arise from five distinct segments, related both to the demand and the supply of credit, namely: (i) deposit spread, (ii) market-funding cost spread, (iii) bank capital charges, (iv) compensation for expected losses and (v) competitive wedge. These intermediation wedges constitute specific types of financial frictions which may independently be the epicenter of financial disturbances. Against this background we design a DSGE model spanning the relevant "financial wedges" at play during the crisis, together with its cross-country heterogeneity within the euro area, focusing on Germany, France, Italy, Spain, and rest-of-euro area. Our main results are the following. First, we show that the cross-country heterogeneity of micro-structure of financial frictions are relevant to explain the divergence in lending rates. Second, sovereign risk, bank risk and corporate risk have been the most relevant channels to explain the financial heterogeneity observed during the banking crisis (bank capital shock). Third, the corporate risk channel has been the main source of impairment of the monetary policy transmission across euro area countries. Fourth, a 10 pp increase in the annual debt-to-GDP ratio triggers a surge in sovereign yields by than 300 bps and 200 bps for Italy and Spain respectively. Fifth, cross-border financial linkages are more important for Italy and Germany and affect for both countries the transmission of bank capital shocks.
    Keywords: DSGE models, banking, financial regulation, cross-country spillovers, bank lending rates
    JEL: E4 E5 F4
    Date: 2016–12
  6. By: Sameer Khatiwada (IHEID, Graduate Institute of International and Development Studies, Geneva and ILO Regional Office Bangkok)
    Abstract: By employing a novel dataset on international capital flows, this paper examines the impact of Fed’s quantitative easing (QE) policies on flows to emerging markets economies (EMEs) and the EU countries. Episodes of QE are examined separately, with the last episode divided between pre- and post-tapering. We find evidence that QE was associated with an increase in capital inflow, while tapering was associated with a period of retrenchment. The magnitude of the impact varied by different episodes of QE and the types of assets (bonds or equities). Our results show that the EU countries behaved differently than the EMEs. We also find support for the importance of “pull factors” and individual country characteristics for capital inflows. However, the paper shows that episodes of QE accounted for most of the variation in capital inflows during 2008-2014. G20 statements during the episodes of QE show that countries are increasingly cognizant of their inability to control flows and have thus called for better monetary policy coordination to avoid excessive volatility and negative spillovers.
    Keywords: Quantitative Easing (QE), spillovers, capital flows, emerging market economies (EMEs)
    JEL: E44 E52 E58 F32 F41 F42
    Date: 2017–01
  7. By: Rajmund Mirdala
    Abstract: The lack of nominal exchange rate flexibility in the monetary union induced the growing divergence of trade performance among the member countries. Intra-Eurozone current account imbalances among countries with different income levels per capita fuel discussions on competitiveness channels under common currency. Asynchronous current account trends between North and South of the Euro Area were accompanied by significant appreciations of real exchange rate in the periphery economies originating in the strong shifts in consumer prices and unit labor costs in these countries relative to the countries of the Euro Area core. The issue is whether the real exchange rate is a significant driver of persisting current account imbalances in the Euro Area considering than, according to some authors, differences in domestic demand are more important than is often realized. In the paper we analyze main aspects of current account adjustments in the Euro Area member countries. From estimated VAR model we calculate impulse-response function of the current account to the real exchange rate (REER calculated on CPI and ULC base) and domestic demand shocks and variance decomposition to examine the relative importance of both shocks. Our results indicate that while the prices and costs related determinants of external competitiveness affected imports more significantly than exports, demand drivers shaped current account balances mainly during the crisis period.
    Keywords: current account, real exchange rate, economic crisis, vector autoregression, impulse-response function, variance decomposition
    JEL: C32 F32 F41
    Date: 2016–12
  8. By: Minoas Koukouritakis
    Abstract: Long-term bond yields’ convergence between each new EU country and the Eurozone is examined in the present paper, in the framework of the current debt crisis in the Eurozone. As the German dominance was established during the crisis, convergence implies that the long-term bond yield of each new EU country must converge to that of Germany. As shown in this paper, under the conditions of uncovered interest rate parity (UIP) and ex-ante relative purchasing power parity (PPP) long-term bond yield spreads are equal to expected inflation differentials. Thus, evidence of yields’ convergence between a new EU country and Germany can be interpreted as monetary policy convergence of this country to Germany. However, lack of yields’ convergence does not necessarily imply monetary policy divergence with Germany. There is the possibility that a new EU country has achieved monetary policy convergence to Germany, but its yields to diverge with those of Germany. The reason is that the recent debt crisis in the Eurozone might increase the sovereign default risk of this country and thus, led to large and persistent risk premium. Of course, such information has practical implications regarding the evaluation of each new EU country in order to join the Eurozone.1 Hence, a proper evaluation of bond yield linkages or, in other words, monetary policy convergence should take the above arguments into account, especially in the period of the debt crisis. Otherwise, invalid conclusions may be drawn. The empirical literature on interest rate convergence within the EU is extensive, and convergence has been linked to the concepts of unit roots and cointegration in most studies. Among others, Karfakis and Moschos (1990) investigated interest rate linkages between Germany and each of Belgium, France, Ireland, Italy and the Netherlands. Using short rates from the late 1970s to the late 1980s, they found no evidence of long-run interest rates convergence. Evidence against the German leadership hypothesis within the European Monetary System (EMS) for the same period, was also found by Katsimbris and Miller (1993). By including the USA to their sample, they showed that both the US and the German rates have important causal influences on the interest rates of the EMS members. Hafer and Kutan (1994) examined long-run co-movements of short rates and money supplies in a group of five EMS countries from the late 1970s to the early 1990s, and found evidence that implies partial monetary policy convergence. Similar evidence was provided by Kirchgässner and Wolters (1995), who used money market rates from mid-1970s to mid-1990s, and showed that Germany has a strong long-run influence within the EMS. Haug et al. (2000) tried to determine which of the twelve original EU countries would form a successful monetary union based on the nominal convergence criteria of the Treaty on European Union (TEU). Using data from 1979 to 1995, they found that the formation of a successful monetary union would require significant adjustments in fiscal and monetary policies by several of these countries. Camarero et al. (2002) investigated convergence of long-term interest rate differentials for the EU countries in relation to the TEU criterion, using 10-year bond yields from 1980 to mid-1990s. Departing from the literature, they adopted the definitions of long-run convergence of per capital output and catching-up convergence (Bernard and Durlauf, 1995, 1996),2 and accounted for structural breaks in the data using the one-break unit root test of Perron (1997). They showed that six countries satisfied the criterion of long-run convergence, seven countries satisfied the conditions of catching-up convergence, and only Italy did not converge in either sense. Holtemöller (2005) studied the degree of monetary integration to the Eurozone for Greece and the Central and Eastern European EU countries, based on interest rate spreads and ex-post deviations from the UIP. Using interbank rates from mid-1990s to the early 2000s, his evidence implied high degree of monetary integration for Estonia and Lithuania, medium degree of monetary integration for Greece and Slovakia, and low degree of monetary integration for the Czech Republic, Hungary, Latvia, Poland and Slovenia. Jenkins and Madzharova (2008) investigated real interest rate convergence for the original EU countries, using 10-year bond yields from the late 1990s to mid-2000s. Their evidence implied failure of the real interest rate parity, mainly due to inflation rate differences. Gabrisch and Orlowski (2010) departed from cointegration analysis and applied GARCH methodology in order to investigate interest rate convergence for the Czech Republic, Hungary, Poland, Slovakia and Slovenia in relation to the Eurozone yields. They focused on 10-year bond yields from the early to the late 2000s and found evidence of stronger convergence for the Czech Republic, Slovenia, and Poland, in which the macroeconomic fundamentals are solid and the financial markets are stable, and weaker convergence for Hungary and Slovakia. Frömmel and Kruse (2015) studied interest rate convergence by implementing a changing persistence model for Belgium, France, Italy and The Netherlands in relation to Germany as the reference country. Using 3-month treasury bill rates from the early 1980s to the late 2000s, they found evidence of very different convergence periods for the sample countries, and showed that fiscal and monetary policy coordination were the main factors that led to interest rate convergence. Several limitations of the existing studies can be pointed out, which may have affected the reported results. Firstly, most of the aforementioned studies, with the exception of Camarero et al. (2002), did not account for structural shifts in the data. Secondly, the existing studies have not distinguished in a systematic way between stochastic and deterministic trends in the structure of interest rates. This is an important issue because evidence of cointegration between, for example, two interest rates implies the presence of a single common stochastic trend that ties them in the long run. On the other hand, deterministic trends depend on the underlying process that generates the stochastic variables under study. Thus, for two interest rates it is not enough to cointegrate with cointegrating vector (1.-1); it is also required that they are cotrended, so that the deterministic trends cancel out in the differential of the two series. Thirdly, in most of the existing studies, interest rate convergence has been examined without an explicit formal definition of convergence or a data generation process (DGP) for the interest rates. The above omissions make the interpretation of the empirical results less transparent and informative. The present study attempts to deal with these considerations. Firstly, consistent with the Eurozone’s nominal convergence criteria, this study focuses on nominal 10-year bond yields’ convergence between each new EU country and Germany, in the framework of an explicit DGP for bond yields and a new definition of convergence that allows for a constant non-negative deviation in each pair of bond yields. The inclusion of these elements leads to explicit testable cointegration and cotrending restrictions that makes the interpretation of the econometric results more informative and meaningful. Furthermore, under the UIP and PPP conditions, deviations from yields’ parity are equal to expected inflation differentials. Such deviations can be eliminated in the long run, if monetary authorities (or market forces) in each new EU country contribute in establishing common deterministic and stochastic trends with Germany, regarding the long-term yields or expected inflation rates. This case can be interpreted as strong convergence with Germany, which more than satisfies the TEU criterion for yields’ convergence. On the other hand, if the UIP and PPP conditions do not hold due to time-varying stationary risk premia, different tax rates (Mark, 1985) or transactions costs (Goodwin and Grennes, 1994) across countries, yields convergence can be defined broader as weak convergence, in which yields converge to a non-negative constant. If this constant is less than 2%, the TEU criterion is also satisfied. Hence, the empirical results are interpreted in terms of strong or weak monetary policy convergence between each new EU country and Germany. Secondly, I employ the cointegration test developed by Lütkepohl, Saikkonen and Trenkler in several papers noted below, in order to capture possible structural shifts in the data. The omission of such shifts in the data when they actually exist can distort substantially standard inference procedures for cointegration. In this analysis, such shifts cannot be omitted as the current debt crisis in the Eurozone has probably altered the deterministic components of the new EU countries’ yields. In addition, as the deterministic components of yields are assumed to be independent of the stochastic components, the Gonzalo and Granger (1995) methodology for estimating and testing for the common stochastic trend in each pair of yields has been implemented.
    Keywords: debt crisis, yields convergence, structural shifts, cointegration, common trends, cotrending
    JEL: E43 F15 F42
    Date: 2016–09–22
  9. By: Mukherjee, Rudrarup
    Abstract: In a small open developing country context, the author considers a three-sector general equilibrium framework and tries to find out the effects of foreign capital inflow on welfare of the country. Comparative-static results show that foreign capital inflow widens the skilled-unskilled wage gap under some reasonable conditions, although it causes an expansion of the foreign enclave and the agricultural sector and contraction of the domestic manufacturing sector. Taking sector specific foreign capital, the author finds that foreign direct investment is beneficial in a small open economy in the absence of tariffs.
    Keywords: foreign capital,small open economy,welfare,tariff,economic development
    JEL: D50 D60 F4 F63 O11
    Date: 2017
  10. By: Beck, Roland; Ferrucci, Gianluigi; Hantzsche, Arno; Rau-Goehring, Matthias
    Abstract: This paper investigates to what extent yield spreads on bonds issued by sub-sovereign entities within federations are driven by bailout expectations and investors’ risk appetite, as opposed to fundamental values related to default risk. The question is analysed both across and within federations using a novel dataset for sub-sovereign governments that includes Australian states, Canadian provinces, Swiss cantons, German Länder, US states, Spanish communities, and Indian states. The paper finds that, regardless of the prevailing set-up of the federal system, sub-sovereign debt levels relative to GDP and global risk aversion are important drivers of sub-sovereign spreads. Moreover, within federations, the market’s expectation of a federal bailout of the sub-sovereign entity and the capacity of the federal government to provide support to the weaker members of the federation affect the extent to which fundamental factors are priced into spreads. In particular, the paper shows that the positive link between debt and risk premia tends to break down when sub-sovereign government debt rises above certain thresholds. This could reflect the market’s expectation of a federal bailout as fundamentals deteriorate. Additionally, larger sub-sovereign entities tend to pay higher premia as fundamentals worsen which could be linked to the limited capacity of the federal government to provide support as the size of the expected bailout increases. A pattern of rising risk premia as fundamentals worsen is also found for sub-sovereign entities when the central government faces borrowing constraints. JEL Classification: E62, G12, H7
    Keywords: fiscal federalism, government debt, sovereign bond spreads, sub-national governments
    Date: 2016–12
  11. By: Hettig, Thomas; Müller, Gernot
    Abstract: According to the pre-crises consensus there are separate domains for monetary and fiscal stabilization in a currency union. While the common monetary policy takes care of union-wide fluctuations, fiscal policies should be tailored to meet country-specific conditions. This separation is no longer optimal, however, if monetary policy is constrained by an effective lower bound on interest rates. Specifically, we show that in this case there are benefits from coordinating fiscal policies across countries. By coordinating on a common fiscal stance, policy makers are able to stabilize union-wide activity and inflation while avoiding detrimental movements of a country's terms of trade.
    Keywords: coordination; Currency union; effective lower bound; EMU; Fiscal policy; optimal policy; terms-of-trade externality
    JEL: E61 E62 F41
    Date: 2017–01
  12. By: João Tovar Jalles; Carlos Mulas-Granados; José Tavares
    Abstract: We look at the effect of exchange rate regimes on fiscal discipline, taking into account the effect of underlying political conditions. We present a model where strong politics (defined as policymakers facing longer political horizon and higher cohesion) are associated with better fiscal performance, but fixed exchange rates may revert this result and lead to less fiscal discipline. We confirm these hypotheses through regression analysis performed on a panel sample covering 79 countries from 1975 to 2012. Our empirical results also show that the positive effect of strong politics on fiscal discipline is not enough to counter the negative impact of being at/moving to fixed exchange rates. Finally, we use the synthetic control method to illustrate how the transition from flexible to fully fixed exchange rate under the Euro impacted negatively fiscal discipline in European countries. Our results are robust to a number of important sensitivity checks, including different estimators, alternative proxies for fiscal discipline, and sub-sample analysis.
    Keywords: Fiscal policy;Exchange rate regimes;Flexible exchange rates;Fixed exchange rates;Political economy;Fiscal discipline; Deficit; Political Economy; Exchange Rates
    Date: 2016–11–17

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