nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2019‒04‒22
eleven papers chosen by
Martin Berka
University of Auckland

  1. Monetary policy spillovers, capital controls and exchange rate flexibility, and the financial channel of exchange rates By Georgiadis, Georgios; Zhu, Feng
  2. Do monetary unions dream of structural reforms? By Loewald, Christopher; Wörgötter, Andreas
  3. Ties That Bind: Estimating the Natural Rate of Interest for Small Open Economies By Grossman, Valerie; Martinez-Garcia, Enrique; Wynne, Mark A.; Zhang, Ren
  4. Labor mobility in a monetary union By Hauser, Daniela; Seneca, Martin
  5. America First? A US-centric view of global capital flows By McQuade, Peter; Schmitz, Martin
  6. Does Inflation Targeting Always Matter for the ERPT? A robust approach By Antonia Lopez Villavicencio; Marc Pourroy
  7. Capital Controls as Macro-prudential Policy in a Large Open Economy By Davis, J. Scott; Devereux, Michael B.
  8. Does the Number of Countries in an International Business Cycle Model Matter? By Myunghyun Kim
  9. Labor Mobility in a Monetary Union By Daniela Hauser; Martin Seneca
  10. Global financial cycles since 1880 By Potjagailo, Galina; Wolters, Maik H.
  11. The Global Macroeconomics of a Trade War: The EAGLE model on the US-China trade conflict By Wilko Bolt; Kostas Mavromatis; Sweder van Wijnbergen

  1. By: Georgiadis, Georgios; Zhu, Feng
    Abstract: We assess the empirical validity of the trilemma (or impossible trinity) in the 2000s for a large sample of advanced and emerging economies. To do so, we estimate Taylor-rule type monetary policy reaction functions, relating the local policy rate to real-time forecasts of domestic fundamentals, global variables, as well as the base-country policy rate. In the regressions, we explore variations in the sensitivity of local to base-country policy rates across different degrees of exchange rate flexibility and capital controls. We find that the data are in general consistent with the predictions from the trilemma: Both exchange rate flexibility and capital controls reduce the sensitivity of local to base-country policy rates. However, we also find evidence that is consistent with the notion that the financial channel of exchange rates highlighted in recent work reduces the extent to which local policymakers decide to exploit the monetary autonomy in principle granted by flexible exchange rates in specific circumstances: The sensitivity of local to base-country policy rates for an economy with a flexible exchange rate is stronger when it exhibits negative foreign-currency exposures which stem from portfolio debt and bank liabilities on its external balance sheet and when base-country monetary policy is tightened. The intuition underlying this finding is that it may be optimal for local monetary policy to mimic the tightening of base-country monetary policy and thereby mute exchange rate variation because a depreciation of the local currency would raise the cost of servicing and rolling over foreign-currency debt and bank loans, possibly up to a point at which financial stability is put at risk. JEL Classification: F42, E52, C50
    Keywords: financial globalisation, monetary policy autonomy, spillovers, trilemma
    Date: 2019–04
  2. By: Loewald, Christopher; Wörgötter, Andreas
    Abstract: When the principal decisions for the European Monetary Union (EMU) were made it was acknowledged that it would not be an optimal currency area (OCA). Potential trouble was assumed away as asymmetric shocks were expected to fade, while rising productivity enhanced the resilience of EMU member economies. We argue however that for less export-focused member countries the loss of the exchange rate mechanism has become an especially debilitating constraint limiting recovery from recessions. The common monetary policy helps to absorb some financial shocks but cannot address structural issues in financial, product or labour markets. Fiscal policy too is constrained. It has little positive short-run impact on competitiveness and works as a shock absorber only if fiscal balances are sustainable. Without nominal exchange rate adjustments, only internal devaluation corrects an overvalued real exchange rate, either through wage restraint or productivity increases. Co-ordinated sets of prioritised structural policies could push the real exchange rate in the right direction and generate cross-border synergies, reducing short run costs. For example, Germany should lower its value added tax (VAT) to provide room for more imports, while Italy and other deficit economies could strengthen work incentives to reduce labour shortages in the export sector.
    Date: 2019
  3. By: Grossman, Valerie (Federal Reserve Bank of Dallas); Martinez-Garcia, Enrique (Federal Reserve Bank of Dallas); Wynne, Mark A. (Federal Reserve Bank of Dallas); Zhang, Ren (Bowling Green State University)
    Abstract: This paper estimates the natural interest rate for six small open economies (Australia, Canada, South Korea, Sweden, Switzerland and the U.K.) with a structural New Keynesian model using Bayesian techniques. Our empirical analysis establishes the following four novel findings: First, we show that the open-economy framework provides a better fit of the data than its closed-economy counterpart for the six countries we investigate. Second, we also show that, in all six countries, a monetary policy rule in which the domestic real policy rate tracks the Wicksellian domestic short-term natural rate fits the data better than an otherwise standard Taylor (1993) rule. Third, we show that over the past 35 years, the natural interest rates in all six countries have shifted downwards and strongly comoved with each other. Fourth, our findings illustrate that foreign output shocks (spillovers from the rest of the world) are a major contributor to the dynamics of the natural rate in these six small open economies, and that natural rates comove strongly with estimated U.S. natural rates.
    Keywords: Small Open-Economy Model; Monetary Policy; Natural Rate; Bayesian Estimation
    JEL: C11 C13 E43 E58 F41
    Date: 2019–03–31
  4. By: Hauser, Daniela (Bank of Canada); Seneca, Martin (Bank of England)
    Abstract: We study macroeconomic dynamics and optimal monetary policy in an economy with cyclical labor flows across two distinct regions sharing trade links and a common monetary framework. In our New Keynesian DSGE model with search and matching frictions, migration flows are driven by fluctuations in the relative labor market performance across the monetary union. The optimizing monetary policymaker shows greater flexibility in inflation targeting when labor is mobile by leaning somewhat against deviations of migration flows from efficient benchmarks. But strict inflation targeting remains close to optimal. For a given monetary policy, labor mobility facilitates macroeconomic adjustments by reducing efficiency gaps in regional labor markets. Internal migration therefore reduces the welfare costs of following simple suboptimal monetary policy rules in a monetary union.
    Keywords: Labor mobility; monetary policy; monetary union; business cycles
    JEL: E32 E52
    Date: 2019–04–12
  5. By: McQuade, Peter (Central Bank of Ireland); Schmitz, Martin (European Central Bank)
    Abstract: Both academic researchers and policymakers posit a unique role for the US in the international financial system. This paper investigates the characteristics and determinants of US cross-border financial flows and examines how these contrast with those of the rest of the world. We analyse the relative importance of US, country-specific, and global variables as determinants of aggregate and bilateral US financial flows and as determinants of country-level cross-border financial flows excluding those directly involving the US. Our results indicate that variation in US variables – notably the VIX and US dollar exchange rate – has a quantitatively important influence on global financial flows, but mostly via US cross-border flows. Global and national risk indicators perform better in explaining “rest of the world” flows. Moreover, we find that the correlation between US and rest of the world flows peaks in periods of elevated uncertainty. We interpret our findings as evidence for the existence of a global financial cycle, only some of which is driven by policies and events in the US.
    Keywords: International capital flows, US financial system, VIX, US dollar exchange rate, monetary policy spillovers
    JEL: F15 F21 F36 F42 G15
    Date: 2019–03
  6. By: Antonia Lopez Villavicencio (GATE Lyon Saint-Étienne - Groupe d'analyse et de théorie économique - ENS Lyon - École normale supérieure - Lyon - UL2 - Université Lumière - Lyon 2 - UCBL - Université Claude Bernard Lyon 1 - Université de Lyon - UJM - Université Jean Monnet [Saint-Étienne] - Université de Lyon - CNRS - Centre National de la Recherche Scientifique); Marc Pourroy (CRIEF - Centre de Recherche sur l'Intégration Economique et Financière - Université de Poitiers)
    Abstract: This paper estimates the effects of different forms of inflation targeting (IT) in the exchange rate pass-through (ERPT). To this end, we first estimate the ERPT for a large sample of countries using state-space models. We then consider the adoption of an inflation targeting framework by a country as a treatment to find suitable counterfactuals to the actual targeters. By controlling for self-selection bias and endogeneity of the monetary policy regime, we confirm that the ERPT tends to be lower for countries adopting explicit IT. However, we uncover that older regimes, adopting a range or point with tolerance band and keeping inflation close to the target, outperform other IT regimes. We also show that IT is effective even with a relatively high inflation target or low central bank independence.
    Keywords: state-space model,propensity score matching,exchange rate pass-through,inflation targeting
    Date: 2019–03–28
  7. By: Davis, J. Scott (Federal Reserve Bank of Dallas); Devereux, Michael B. (University of British Columbia)
    Abstract: The literature on optimal capital controls for macro-prudential policy has focused on capital controls in a small open economy. This ignores the spillover effects to the rest of the world. This paper re-examines the case for capital controls in a large open economy, where domestic financial constraints may bind following a large negative shock. There is a tension between the desire to tax inflows to manipulate the terms of trade and tax outflows for macro-prudential purposes. Non-cooperative capital controls are ineffective as macro-prudential policy. Cooperative policy will ignore terms-of-trade manipulation and thus cooperative capital controls yield more effective macro-prudential policy.
    Keywords: Capital controls; large open economy; terms-of-trade; macroprudential; crisis management
    JEL: F40
    Date: 2019–03–27
  8. By: Myunghyun Kim (Economic Research Institute, Bank of Korea)
    Abstract: Until the 1990s, standard models with two large open economies (i.e. the U.S. and Europe) provided plausible representations of the world economy. However, with the emergence of many countries such as China since then, this approach no longer seems reasonable. In line with this change to the global economic environment, there also have been changes in cross-country correlations: the output correlation between the U.S. and Europe has risen, and their consumption correlation has slightly fallen. Accordingly, this paper adds many countries to a standard model to show that doing so can capture the transition in the cross-country correlations. By analytical investigation, I first show that as the number of countries in a simple model increases, the output correlation rises and the consumption correlation falls. A quantitative analysis with a more general model also shows that when the model has more countries, it yields a higher output correlation and a smaller consumption correlation.
    Keywords: International business cycles, Number of countries, n-country model, Output correlation, Consumption correlation
    JEL: F40 F41 F44
    Date: 2019–04–15
  9. By: Daniela Hauser; Martin Seneca
    Abstract: The optimal currency literature has stressed the importance of labor mobility as a precondition for the success of monetary unions. But only a few studies formally link labor mobility to macroeconomic adjustment and policy. In this paper, we study macroeconomic dynamics and optimal monetary policy in an economy with cyclical labor flows across two distinct regions that share trade links and a common monetary framework. In our New Keynesian dynamic, stochastic, general-equilibrium model calibrated to the United States, migration flows are driven by fluctuations in the relative labor market performance across the monetary union. While labor mobility can be an additional channel for cross-regional spillovers as well as a regional shock absorber, we find that a mobile labor force closes the efficiency gaps in the labor market and thus lessens the trade-off between inflation and labor market stabilization. As migration flows are generally inefficient, however, regionspecific disturbances introduce additional trade-offs with regional labor market conditions. Putting some weight on stabilizing fluctuations in the labor market enhances welfare when monetary policy follows a simple rule.
    Keywords: Business fluctuations and cycles; Economic models; Labour markets; Monetary policy framework; Regional economic developments
    JEL: E32 E52 F4
    Date: 2019
  10. By: Potjagailo, Galina; Wolters, Maik H.
    Abstract: The authors analyze cyclical co-movement in credit, house prices, equity prices, and long-term interest rates across 17 advanced economies. Using a time-varying multi-level dynamic factor model and more than 130 years of data, they analyze the dynamics of co-movement and compare recent developments to earlier episodes such as the early era of financial globalization from 1880 to 1913 and the Great Depression. They find that joint global dynamics across various financial quantities and prices as well as variable-specific global co-movements are important to explain fluctuations in the data. From a historical perspective, global co-movement in financial variables is not a new phenomenon. For equity prices, however, global cycles play currently a historically unprecedented role, explaining more than half of the fluctuations in the data. Global cycles in credit and housing have become much more pronounced and longer, but their importance in explaining dynamics has only increased for some economies including the US, the UK and Nordic European countries. Regarding GDP, the authors also find an increasing role for a global business cycle.
    Keywords: financial cycles,financial crisis,global co-movement,dynamic factor models,time-varying parameters,macro-finance
    JEL: C32 C38 E44 F44 G15 N10 N20
    Date: 2019
  11. By: Wilko Bolt (The Nederlandsche Bank, Vrije Universiteit); Kostas Mavromatis (The Nederlandsche Bank, University of Amsterdam); Sweder van Wijnbergen (The Nederlandsche Bank, University of Amsterdam)
    Abstract: We study the global macroeconomic effects of tariffs using a multiregional, general equilibrium model, EAGLE, that we extend by introducing US tariffs against Chinese imports into the US, and subsequently Chinese tariffs against US imports into China, consistent with recent trade policies by the US and the Chinese governments. We abstract from tariffs on goods exported from the euro area, focusing on a US-China trade war. A unilateral tariff from the US against China dampens US exports in line with the Lerner Symmetry theorem but global output contracts. Global output contracts even further after China retaliates. The euro area benefits from this trade war. These European trade diversion benefits are caused by cheaper imports from China and improved competitiveness in the US. As price stickiness in the export sector in each region increases, the negative effects of tariffs in the US and China are mitigated, but the positive effects in the euro area are then also dampened.
    Keywords: Trade Policy, Exchange Rates, Trade Diversion, Local Currency Pricing
    JEL: E32 F30 H22

This nep-opm issue is ©2019 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.