nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2018‒09‒03
fourteen papers chosen by
Martin Berka
University of Auckland

  1. Fundamentals News, Global Liquidity and Macroprudential Policy* By Enrique G. Mendoza; Javier Bianchi; Chenxin Liu
  2. Financial Openness, Bank Capital Flows, and the Effectiveness of Macroprudential Policies By Hao Jin; Chen Xiong
  3. Debt, Defaults and Dogma: politics and the dynamics of sovereign debt markets By Johnny Cotoc; Alok Johri; Cesar Sosa-Padilla
  4. Structural Change and Aggregate Employment Fluctuations in China and the US By Wen Yao; Xiaodong Zhu
  5. International Spillovers of Monetary Policy : Conventional Policy vs. Quantitative Easing By Stephanie E. Curcuru; Steven B. Kamin; Canlin Li; Marius del Giudice Rodriguez
  6. Self-Fulfilling Debt Dilution: Maturity and Multiplicity in Debt Models By Mark A. Aguiar; Manuel Amador
  7. How International Reserves Reduce the Probability of Debt Crises By Juan Hernandez
  8. The Macroeconomic Effect of Trade Policy By Christopher Erceg; Andrea Prestipino; Andrea Raffo
  9. The Phillips Curve: Price Levels or Real Exchange Rates? By Francois Geerolf
  10. External debts and real exchange rates in developing countries: evidence from Chad. By Kouladoum, Jean-Claude
  11. Oil, Equities, and the Zero Lower Bound By Deepa Dhume Datta; Benjamin K. Johannsen; Hannah Kwon; Robert J. Vigfusson
  12. The quanto theory of exchange rates By Kremens, Lukas; Martin, Ian
  13. Currency Choices in Contracts By Andres Drenik; Diego Perez; Rishabh Kirpalani
  14. International Medium of Exchange: Privilege and Duty By Ryan Chahrour; Rosen Valchev

  1. By: Enrique G. Mendoza (Department of Economics, University of Pennsylvania); Javier Bianchi (Federal Reserve Bank of Minneapolis); Chenxin Liu (Department of Economics, UW-Madison)
    Abstract: We study optimal macroprudential policy in a model in which unconventional shocks, in the form of news about future fundamentals and regime changes in world interest rates, interact with collateral constraints in driving the dynamics of financial crises. These shocks strengthen incentives to borrow in good times (i.e. when \good news" about future fundamentals coincide with a low-world-interest-rate regime), thereby increasing vulnerability to crises and enlarging the pecuniary externality due to the collateral constraints. Quantitatively, an optimal schedule of macroprudential debt taxes can lower the frequency and magnitude of financial crises, but the policy is complex because it features significant variation across interest-rate regimes and news realizations.
    Keywords: Financial crises, macroprudential policy, systemic risk, global liquidity, news shocks
    JEL: D62 E32 E44 F32 F41
    Date: 2016–12–05
  2. By: Hao Jin (Xiamen University); Chen Xiong (Xiamen University)
    Abstract: We study the effectiveness of macroprudential policies in mitigating credit growth in open economies. Empirically we find that macroprudential policies contain domestic credit growth but are less effective in financially more integrated economies due to greater cross-border bank borrowing. We develop a small open economy DSGE model with cross-border bank financing to interpret the empirical findings and quantitatively evaluate the macroeconomic and welfare implications of macroprudential policies. Consistent with the empirical evidence, our model shows that banks contract credits and increase the fraction of foreign financing in response to macroprudential policy tightening. This liability composition shift significantly under-mines the stabilizing effect and welfare gains of macroprudential policies, so they become less effective in financially more open economies. Our results also suggest it is desirable to implement more restrictive macroprudential regulations when capital moves more freely.
    Keywords: Intermediary; Financial Frictions; Financial Openness; Macroprudential Policy
    Date: 2018–08
  3. By: Johnny Cotoc; Alok Johri; Cesar Sosa-Padilla
    Abstract: Using data from 40 nations, we obtain new stylized facts regarding the impact of polit- ical leanings of the ruling government on sovereign debt yields and fiscal policy. Left- wing governments' yields are 166 basis points higher and 23% more volatile than yields of right-wing governments. Moreover, left-wing governments face more counter-cyclical yields. Left-wing governments have higher levels of government spending and right-wing governments collect lower tax revenue as a percent of GDP. A calibrated sovereign de- fault model with elections and two politically heterogeneous policy makers who differ in the marginal impact of their fiscal choices on their re-election probabilities delivers the above-mentioned facts.
    Keywords: Sovereign default, Interest rate spread, Political turnover, Left-wing, Right-wing, Cyclicality of fiscal policy.
    JEL: F34 F41 E62
    Date: 2018–08
  4. By: Wen Yao (Tsinghua University); Xiaodong Zhu (University of Toronto)
    Abstract: One salient feature of business cycles in developed countries is that the aggregate employment is highly procyclical. In China, however, the correlation of the cyclical components of aggregate employment and output is close to zero. In this paper, we document three new stylized facts: (1) the business cycle properties of employment at sector level (agriculture and non-agriculture) in China are very similar to those in the US; (2) employments in the agricultural and non-agricultural sectors are negatively correlated in both China and the US; and (3) for both economies, the agriculture’s share of employment is negatively correlated with the real GDP per work in both sectors. These facts suggest that difference in sector composition could be an important reason for the difference in aggregate employment fluctuations between the two economies. We then construct a simple two-sector growth model with productivity shocks and non-homothetic preferences and show that the model can simultaneously account for the secular trend in labor reallocation away from agriculture and employment fluctuations at sector level and in the aggregate for both China and the US.
    Date: 2018
  5. By: Stephanie E. Curcuru; Steven B. Kamin; Canlin Li; Marius del Giudice Rodriguez
    Abstract: This paper evaluates the popular view that quantitative easing exerts greater international spillovers than conventional monetary policies. We employ a novel approach to compare the international spillovers of conventional and balance sheet policies undertaken by the Federal Reserve. In principle, conventional monetary policy affects bond yields and financial conditions by affecting the expected path of short rates, while balance-sheet policy is believed act through the term premium. To distinguish the effects of these two types of policies we use a term structure model to decompose longer-term bond yields into expected short-term interest rates and term premiums. We then examine the relative effects of changes in these two components of yields on changes in exchange rates and foreign bond yields. We find that the dollar is more sensitive to expected short-term interest rates than to term premia; moreover, the rise in the sensitivity of the dollar to monetary policy announcements since the GFC owes more to an increased sensitivity of the dollar to expected interest rates than to term premiums. We also find that changes in short rates and term premiums have similar effects on foreign yields. All told, our findings contradict the popular view that quantitative easing exerts greater international spillovers than conventional monetary policies.
    Keywords: Monetary policy ; International spillovers ; Term premium
    JEL: E5 F3
    Date: 2018–08–21
  6. By: Mark A. Aguiar; Manuel Amador
    Abstract: We establish that creditor beliefs regarding future borrowing can be self-fulfilling, leading to multiple equilibria with markedly different debt accumulation patterns. We characterize such indeterminacy in the Eaton-Gersovitz sovereign debt model augmented with long maturity bonds. Two necessary conditions for the multiplicity are: (i) the government is more impatient than foreign creditors, and (ii) there are deadweight losses from default; both are realistic and standard assumptions in the quantitative literature. The multiplicity is dynamic and stems from the self-fulfilling beliefs of how future creditors will price bonds; long maturity bonds are therefore a crucial component of the multiplicity. We introduce a third party with deep pockets to discuss the policy implications of this source of multiplicity and identify the potentially perverse consequences of traditional “lender of last resort” policies.
    JEL: F3 F34
    Date: 2018–06
  7. By: Juan Hernandez (Inter-American Development Bank)
    Abstract: Many emerging economies maintain significant positions in both external sovereign debt and foreign reserves, paying spreads of over 250 basis points on average. Arguments advanced in empirical work and policy discussions suggest that governments may do this because international reserves play a role in reducing the likelihood of sovereign debt crises, improving a country’s access to debt markets. This paper proposes a model that justifies that argument. The government makes optimal choices of debt and reserves in an environment in which self-fulfilling rollover crises a-là Cole-Kehoe and external default a-là Eaton-Gersovitz coexist. This allows for both fundamental and market-sentiment-driven debt crises. Self-fulfilling crises arise because of a lender’s coordination problem when multiple equilibria are feasible. Conditional on the country’s Net Foreign Asset position, additional reserves make the sovereign more willing to service its debt even when no new borrowing is possible, which enlarges the set of states in which repayment is the dominant strategy and, hence, reduces the set of states that admit a self-fulfilling crisis. From an ex-ante perspective, reserves reduce the probability of crises in the future which lowers current sovereign spreads. Quantitatively the model can explain 50% of Mexico’s international reserves holdings, while accounting for key cyclical facts.
    Date: 2018
  8. By: Christopher Erceg (Federal Reserve Board); Andrea Prestipino (Federal Reserve Board); Andrea Raffo (Federal Reserve Board)
    Abstract: We study the short-run macroeconomic e¤ects of trade policies that are equivalent in a frictionless economy, namely a uniform increase in import tari¤s and export subsidies (IX), an increase in value-added taxes accompanied by a payroll tax reduction (VP), and a border adjustment of corporate pro t taxes (BAT). Using a dynamic New Keynesian open-economy framework, we rst argue that IX tends to boost output and ination even under exible exchange rates, a result in sharp contrast with the conventional view of neutrality of these policies. We then provide (quite restrictive) conditions for exact neutrality of IX policies, whereby the real exchange rate appreciates enough to fully o¤set their competitive enhancing effects. Finally, we show that the equivalence among IX, VP,and BAT policies depends critically on assumptions about tax pass through. Under full pass through of taxes, IX and BAT are equivalent but VP is not. With su¢ cient price rigidities, VP is contractionary rather than expansionary.
    Date: 2018
  9. By: Francois Geerolf (University of California, Los Angeles)
    Abstract: This paper argues that the Phillips Curve is driven by a correlation between real exchange rates and economic activity, which implies a correlation between inflation and economic activity in fixed exchange rate regimes. According to this interpretation, the Phillips Curve is a correlation between relative prices and economic activity, and does not result from a monetary phenomenon. Three new facts are put forward to support that hypothesis. First, the original Phillips relation is valid in fixed exchange rate regimes, including across regions of the same country, and becomes flatter as the exchange rate regime moves continuously from fixed to floating. Second, when nominal or real exchange rates are used in place of inflation, the Phillips relation is restored in floating exchange rate regimes. Third, identified aggregate demand shocks (such as tax cuts) drive a positive relation between real exchange rates and economic activity in the reduced form. A textbook international finance model is developed to help rationalize these findings. This hypothesis implies that the US Phillips Curve broke down in the 1970s following the collapse of the Bretton Woods system.
    Date: 2018
  10. By: Kouladoum, Jean-Claude
    Abstract: The objective of this work is to analyze the effect to external debts on the real exchange rate rate in Chad from 1975 to 2014. The generalized method of moment is used. Findings show that external debts positively and significantly affect the real exchange rate at 5% significant level. Moreover, debt servicing affects negatively and significantly real exchange rate. The main recommandation goes to Chadian government, it should adopt a budgetary policy, in such a way to reorient its debt towards economic sectors that is able to boost economic growth and reinforce that the strategies contribute re-equilibrate industrial activities.
    Keywords: External debts, real exchange rate, debt servicing, econmic growth.
    JEL: F3 F31
    Date: 2018–08–12
  11. By: Deepa Dhume Datta; Benjamin K. Johannsen; Hannah Kwon; Robert J. Vigfusson
    Abstract: From late 2008 to 2017, oil and equity returns were more positively correlated than in other periods. In addition, we show that both oil and equity returns became more responsive to macroeconomic news. We provide empirical evidence and theoretical justification that these changes resulted from nominal interest rates being constrained by the zero lower bound (ZLB). Although the ZLB alters the economic environment in theory, supportive empirical evidence has been lacking. Our paper provides clear evidence of the ZLB altering the economic environment, with implications for the effectiveness of fiscal and monetary policy.
    Keywords: Equities ; Macroeconomic surprises ; New-keynesian model ; Oil ; Zero lower bound
    JEL: F31 F41 E30 E01 C81
    Date: 2018–08–17
  12. By: Kremens, Lukas; Martin, Ian
    Abstract: We present a new identity that relates expected exchange rate appreciation to a risk-neutral covariance term, and use it to motivate a currency forecasting variable based on the prices of quanto index contracts. We show via panel regressions that the quanto forecast variable is an economically and statistically significant predictor of currency appreciation and of excess returns on currency trades. Out of sample, the quanto variable outperforms predictions based on uncovered interest parity, on purchasing power parity, and on a random walk as a forecaster of differential (dollar-neutral) currency appreciation.
    JEL: F31 F37 F47 G12 G15
    Date: 2018–08–11
  13. By: Andres Drenik (Columbia University); Diego Perez (New York University); Rishabh Kirpalani (The Pennsylvania State University)
    Abstract: We study the optimal currency choice in contracts in an economy with credit chains and endogenous government-policy risk. Denominating contracts in local currency helps mitigate real exchange rate risk while denominating in a foreign currency (dollar) minimizes risks due to government policy, for example inflation. In the aggregate, the equilibrium currency denomination calls for a coordination of currencies in bilateral contracts within a chain to avoid costly default due to currency mismatch. This implies that the incentives to denominate in a foreign currency might persist even after government/political risk has been significantly reduced. Our model can help explain the observed hysteresis of dollarization that occurred in several Latin American countries. We also show that the socially optimal allocation would call for even more dollarization than is privately optimal in order to constrain the government’s choices ex-post.
    Date: 2018
  14. By: Ryan Chahrour (Boston College); Rosen Valchev (Boston College)
    Abstract: The United States enjoys an “exorbitant privilege” that allows it to borrow at especially low interest rates. Meanwhile, the dollarization of world trade appears to shield the U.S. from international disturbances. We provide a new theory that links dollarization and exorbitant privilege through the need for an international medium of exchange. We consider a two-country world where international trade happens in decentralized matching markets, and must be collateralized by safe assets — a.k.a. currencies — issued by one of the two countries. Traders have an incentive to coordinate their currency choices and a single dominant currency arises in equilibrium. With small heterogeneity in traders’ information, the model delivers a unique mapping from economic conditions to the dominant currency. Nevertheless, the model delivers a dynamic multiplicity: in steady-state either currency can serve as the international medium of exchange. The economy with the dominant currency enjoys lower interest rates and the ability to run current account deficits indefinitely. Currency regimes are stable, but sufficiently large shocks or policy changes can lead to transitions, with large welfare implications.
    Date: 2018

This nep-opm issue is ©2018 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.