nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2019‒09‒23
ten papers chosen by
Martin Berka
University of Auckland

  1. Mussa Puzzle Redux By Oleg Itskhoki; Dmitry Mukhin
  2. World financial cycles By Yan Bai; Fabrizio Perri; Patrick Kehoe
  3. Exchange Rate and Interest Rate Disconnect: The Role of Capital Flows, Currency Risk and Default Risk By Sebnem Kalemli-Ozcan; Liliana Varela
  4. An estimated financial accelerator model for small-open African economies By Rasaki, Mutiu Gbade; Malikane, Christopher
  5. Foreign Currency Debt and the Exchange Rate Pass-Through By Salih Fendoglu; Mehmet Selman Colak; Yavuz Selim Hacihasanoglu
  6. Production Networks and the Propagation of Commodity Price Shocks By Shutao Cao; Wei Dong
  7. A disaster under-(re)insurance puzzle: Home bias in disaster risk-bearing By Hiro Ito; Robert N McCauley
  8. Oil prices, exchange rates, and interest rates By Lutz Kilian; Xiaoqing Zhou
  9. Estimates of Exchange Rate Pass-through with Product-level Data By Yusuf Emre Akgunduz; Emine Meltem Bastan; Ufuk Demiroglu; Semih Tumen
  10. What is the fiscal stress in Euro Area? Evidence from a joint monetary-fiscal structural model By Gerba, Eddie

  1. By: Oleg Itskhoki (Princeton University); Dmitry Mukhin (Yale University)
    Abstract: The Mussa (1986) puzzle - a sharp and simultaneous increase in the volatility of both nominal and real exchange rates after the end of the Bretton Woods System of pegged exchange rates in early 1970s - is commonly viewed as a central piece of evidence in favor of monetary non-neutrality. Indeed, a change in the monetary regime has caused a dramatic change in the equilibrium behavior of a real variable - the real exchange rate. The Mussa fact is further interpreted as direct evidence in favor of models with nominal rigidities in price setting (sticky prices). We show that this last conclusion is not supported by the data, as there was no simultaneous change in the properties of the other macro variables - neither nominal like inflation, nor real like consumption, output or net exports. We show that the extended set of Mussa facts equally falsifies both flexible-price RBC models and sticky-price New Keynesian models. We present a resolution to this broader puzzle based on a model of segmented financial market - a particular type of financial friction by which the bulk of the nominal exchange rate risk is held by a small group of financial intermediaries and not shared smoothly throughout the economy. We argue that rather than discriminating between models with sticky versus flexible prices, and monetary versus productivity shocks, the Mussa puzzle provides sharp evidence in favor of models with monetary non-neutrality arising due to financial market segmentation. Sticky prices are neither necessary, nor sufficient for the qualitative success of the model.
    Date: 2019
  2. By: Yan Bai (University of Rochester); Fabrizio Perri (Federal Reserve Bank of Minneapolis); Patrick Kehoe (Stanford University)
    Abstract: Data shows that, in the cross section of emerging countries, sovereign spreads are highly correlated, much more so than local economic conditions. However, in standard models of sovereign default the main drivers of sovereign spreads are local conditions. This paper proposes a mechanism that can explain, at the same time, the high correlation of spreads and the low correlation of local conditions. The model features a large developed economy, which lends to a large number of developing economies, using long run bonds that can be defaulted on. The key feature of the model is the presence of long run risk (as in Bansal and Yaron, 2005). We first show that the model can account for the dynamics of several real variables and of sovereign spreads in the cross section of developing economies. We then use the model for examining how much of the fluctuations in spreads in developing economies arise from the changes in long risk in the developed economy (the price of risk), v/s changes in long run risk in the developing economies themselves (the quantity of risk). We find that 2/3 of fluctuations in spreads are explained by the quantity of risk. Our conclusion is that world financial cycle is largely driven by a world-wide, low frequency long run risk component, rather than simply by fluctuations in the price of risk driven that shocks in developed countries that alter their willingness to lend.
    Date: 2019
  3. By: Sebnem Kalemli-Ozcan (University of Maryland); Liliana Varela (London School of Economics)
    Abstract: Using survey based measures of exchange rate expectations from a large set of advanced countries and emerging markets during 1996–2015, we document new facts on international arbitrage and exchange rate determination. We find that positive interest rate differentials imply expected depreciation as predicted by the no-arbitrage condition, however the expected depreciation is not enough to offset the interest rate differentials, leading to UIP deviations. To understand why there is not a full offset, we evaluate the response of each component of the UIP relation—that is the interest rate differential term and and exchange rate adjustment term—to changes in global risk and country fundamentals. This exercise reveals that, in short horizons (1-3 month), expected depreciation as a response to a given shock is large enough to offset most of the interest rate differentials, narrowing down the UIP deviations in general, and vanishing them in the advanced economies. In long horizons (12 month), this is not the case due to a combination of different factors in different countries. In advance countries, currency risk plays a key role, where in bad times (high global risk), currency depreciates more than the expectations, leading to larger deviations. In emerging markets, there is not enough movement in the exchange rate adjustment term. Capital outflows from emerging markets as a result of both higher global risk and worsening country fundamentals lead to larger interest rate differentials. Although there is an expected and actual depreciation as a result of such outflows, these are not enough to offset the interest rate differentials as the role played by the default risk is more important.
    Date: 2019
  4. By: Rasaki, Mutiu Gbade; Malikane, Christopher
    Abstract: The paper formulates and estimates an open economy monetary DSGE model to investigate the quantitative significance of the financial accelerator mechanism in business cycle fluctuations for African countries. We employ the Bayesian technique to evaluate the statistical importance of the financial accelerator channel in African countries. We compare the model with financial accelerator model to the model without financial accelerator. The estimation shows that financial accelerator channels are empirically important in African economies. The marginal likelihood results clearly favour the model with financial accelerator in African economies. Moreover, the results show that the financial accelerator channel dampens the expansionary effects of exchange rate depreciation in African economies. African countries should deepen their domestic debt markets to minimize their vulnerability to exchange rate shocks.
    Keywords: Financial accelerator, Bayesian technique, Marginal likelihood, Business cycle.
    JEL: C11 E32 F41
    Date: 2017–11–17
  5. By: Salih Fendoglu; Mehmet Selman Colak; Yavuz Selim Hacihasanoglu
    Abstract: We show that higher foreign currency indebtedness raises the degree of exchange rate pass-through to domestic producer prices. For identification, we use micro-level data from Turkey, an emerging market economy that has experienced large exchange rate movements over the last decade. Matching the Credit Register of Turkey with disaggregated manufacturing sector data on domestic prices and foreign currency revenues from international trade, we show that sectors with higher ex-ante net foreign-currency liabilities raise their prices significantly more following domestic currency depreciation. The results are stronger if foreign currency liabilities are short term.
    Keywords: Exchange rate pass-through, Producer prices, Foreign currency indebtedness, Emerging market economies
    JEL: E31 F31
    Date: 2019
  6. By: Shutao Cao (Bank of Canada); Wei Dong (Bank of Canada)
    Abstract: Commodity price fluctuations have macroeconomic implications not only through resource reallocation, currency value changes and monetary policy reaction, but also through production network linkages. In this paper, we study the propagation of commodity price shocks in a multiple-sector general equilibrium model for a small open economy that exports commodity. In the small open economy, a shock to commodity prices is both aggregate and sectoral. As an aggregate shock, commodity price movements lead to changes in the value of domestic currency, impacting the macro economy due to its size and triggering monetary policy responses. As a sectoral shock, changes in commodity price impact non-commodity sectors in two aspects: impacting demand for the upstream goods and impacting the cost of production in the downstream sectors. Calibrated to the Canadian data, our model suggests that, following a positive shock to commodity prices, production and exports in the commodity sector rises, while the net impact on the rest of the economy's production is negative. The aggregate gross domestic output increases primarily owing to growth in investment and improved trade balance. The export connection with the rest of the world in the open economy production network plays an important role in the process of adjusting to a commodity price shock, while the import connections do not matter nearly as much. We show that these propagation channels of shocks to commodity price explain a large fraction of drop in Canadian real GDP in 2015 following the sharp decline in commodity prices that started in late 2014.
    Date: 2019
  7. By: Hiro Ito; Robert N McCauley
    Abstract: The losses from the 2011 earthquakes in Japan remained in Japan, while reinsurance spread the losses from that year’s New Zealand earthquake to the rest of the world.This paper finds that the Japanese case is more typical: losses from natural disasters are shared internationally to a generally very limited extent. This finding of home bias in disaster risk-bearing poses a puzzle of international risk-sharing. We decompose international risk-sharing into the portion of losses insured and the portion ofinsurance that is internationally re-insured. We find that the failure of international risk-sharing begins at home with low participation in insurance. Regression analysis points to economic development and institutional/legal quality as important determinants of insurance participation. We propose a new method to measure international reinsurance payments with balance of payments data. This method identifies for the first time the cross-border flow of reinsurance payments to 88 economies that experienced insured disasters in the 1985–2017 period. Regression analysis of these data points to small size and de facto financial integration as positively related to the reinsurance share, as one might expect. However, we also find that more internationally wealthy economies reinsure less, suggesting that net foreign assets substitute for international sharing of disaster risk. For advanced economies, a lack of international risk-sharing is correlated with a lack of fiscal space. Thus, the governments under more pressure to provide ex post government insurance through the budget have less room to manoeuvre to do so. At high levels of public debt, a lack of ex ante insurance can turn disaster risk into financial risk.
    Keywords: international risk-sharing, earthquake insurance; reinsurance
    JEL: F32 G15 G22 Q54
    Date: 2019–08
  8. By: Lutz Kilian (University of Michigan); Xiaoqing Zhou (Bank of Canada)
    Abstract: There has been much interest in the relationship between the price of crude oil, the value of the U.S. dollar, and the U.S. interest rate since the 1980s. For example, the sustained surge in the real price of oil in the 2000s is often attributed to the declining real value of the U.S. dollar as well as low U.S. real interest rates, along with a surge in global real economic activity. Quantifying these effects one at a time is difficult not only because of the close relationship between the interest rate and the exchange rate, but also because demand and supply shocks in the oil market in turn may affect the real value of the dollar and real interest rates. We propose a novel identification strategy for disentangling the causal effects of oil demand and oil supply shocks from the effects of exogenous shocks to the U.S. real interest rate and exogenous shocks to the real value of the U.S. dollar. We empirically evaluate popular views about the role of exogenous real exchange rate shocks in driving the real price of oil, and we examine the extent to which shocks in the global oil market drive the U.S. real exchange rate and U.S. real interest rates. Our evidence for the first time provides direct empirical support for theoretical models of the link between oil prices, exchange rates, and interest rates.
    Date: 2019
  9. By: Yusuf Emre Akgunduz; Emine Meltem Bastan; Ufuk Demiroglu; Semih Tumen
    Abstract: We estimate the export and import pass-through rates using product-level data from Turkey. We find that the Turkish lira (TRY) exchange rate changes are mostly passed on to TRY prices of exports and imports–and therefore modestly to their prices in trading partners’ currencies. The rate of average pass-through to TRY-prices is 89% for imported goods and 82% for exported goods, with no apparent lags in the impact. Pass-through estimates by sector show variation and are relatively low for food and agricultural products. We argue that the highly-detailed productlevel data enable us to estimate the pass-through rates with better reliability and precision than we could by using only aggregated time-series data. We also introduce a pooled equation to estimate the difference between the export and import pass-through rates–a potentially useful statistic–in a way that allows statistical inference.
    Keywords: Exchange rate pass-through, Product-level estimates, Turkish export prices, Turkish import prices
    JEL: F14 F31 F41
    Date: 2019
  10. By: Gerba, Eddie
    Abstract: I examine the importance of fiscal policy in stabilizing the Euro Area economy and the degree of interaction with monetary policy. The results provide solid evidence of a common fiscal reaction in the monetary union despite the lack of a formal fiscal union. I identify area-wide shocks and find statistically significant (endogenous) responses of fiscal policies to shocks. I also find strong evidence for interactions between fiscal-and monetary policy. Said that, the nature of interactions depends very much on the shocks that hit the economy. At the same time, the way the two fiscal policies interact with monetary policy is also different and independent of each other. Furthermore, the spending multiplier is higher than the tax multiplier. Nonetheless, their relative efficacy has changed over time, with the spending (tax) multiplier falling (rising) since the onset of the Great Recession. To conclude, there are considerable differences in the nature of Euro Area monetary-fiscal interactions compared to the US. Not only are the impulse responses to different shocks significantly different, but also the fiscal multipliers vary a lot. Keynesian (or spending-oriented) fiscal policy is more effective in expanding output in the Euro Area while tax reductions are more effective in the US.
    Keywords: structural BVAR; sign restrictions; fiscal multipliers; fiscal and monetary transmission; debt channel
    JEL: F3 G3
    Date: 2018–11–09

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.