nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2019‒10‒07
24 papers chosen by
Martin Berka
University of Auckland

  1. Optimal Monetary Policy under Dollar Pricing By Konstantin Egorov; Dmitry Mukhin
  2. Trade Flows and Exchange Rates: Importers, Exporters and Products By Michael Devereux; Wei Dong; Ben Tomlin
  3. Towards resolving the Purchasing Power Parity (PPP) ‘puzzle’ in Newly Industrialized Countries (NIC’s) By David de Villiers; Andrew Phiri
  4. Price Dispersion and the Border Effect By Ryan Chahrour; Luminita Stevens
  5. Business Cycles and Currency Returns By Riccardo Colacito; Steven J. Riddiough; Lucio Sarno
  6. Determinants of real exchange rate movements in 15 emerging market economies By Thomas Goda; Jan Priewe
  7. Emerging markets, household heterogeneity, and exchange rate policy By Gabriela Cugat
  8. Global Trends in Interest Rates By Marco Del Negro; Andrea Tambalotti; Domenico Giannone; Marc Giannoni
  9. Using online data for international wage comparisons By Alberto Cavallo; Andres Drenik; Javier Cravino
  10. Trinity Strikes Back: Monetary Independence and Inflation in the Caribbean By Serhan Cevik; Tianle Zhu
  11. Balance Sheets, Exchange Rates, and International Monetary Spillovers By Albert Queralto
  12. International Shadow Banking and Macroprudential Policy By Christopher Johnson
  13. Financial Development and Trade Liberalization By David Kohn; Fernando Leibovici; Michal Szkup
  14. The Macroeconomics of the Greek Depression By Gabriel Chodorow-Reich; Loukas Karabarbounis; Rohan Kekre
  15. China’s Impact on Global Financial Markets By Isha Agarwal; Grace Weishi Gu; Eswar S. Prasad
  16. U.S. Monetary Policy and International Risk Spillovers By Ṣebnem Kalemli-Özcan
  17. Productivity and innovation at the industry level: What role for integration in global value chains? By Peter Gal; William Witheridge
  18. Currency Hedging for International Real Estate Portfolios By Halil Memis; Steffen Sebastian
  19. On the Relationship between Trade Openness and Government Size By Mohammad Farhad; Michael Jetter
  20. A Macroprudential Theory of Foreign Reserve Accumulation By Fernando Arce; Julien Bengui; Javier Bianchi
  21. Nominal Exchange Rate Volatility, Default Risk and Reserve Accumulation By Siqiang Yang
  22. Exchange Rates Co-movement and International Trade By Aleksandra Babii
  23. Fiscal Stimulus under Sovereign Risk By Javier Bianchi; Pablo Ottonello; Ignacio Presno
  24. Sudden Stops and Reserve Accumulation in the Presence of International Liquidity Risk By Flora Lutz; Leopold Zessner-Spitzenberg

  1. By: Konstantin Egorov (New Economic School); Dmitry Mukhin (Yale University)
    Abstract: The recent empirical evidence shows that most international prices are sticky in dollars. This paper studies the optimal non-cooperative monetary policy and the welfare implications of dollar pricing in a context of an open economy model with nominal rigidities. We establish the following results: 1) as in a closed economy, the optimal policy in both the U.S. and other economies stabilizes prices of local producers; 2) this policy generates asymmetric spillovers between countries such that the U.S. has a free floating exchange rate and an independent monetary policy, while other countries partially peg their exchange rates to the dollar giving rise to a “global monetary cycle”; 3) capital controls cannot insulate countries from U.S. spillovers; 4) the optimal cooperative policy is hard to implement because of the conflict of interest between countries; 5) there are potential gains from dollar pricing for the U.S., while other countries can benefit from forming a currency union such as the Eurozone.
    Date: 2019
  2. By: Michael Devereux; Wei Dong; Ben Tomlin
    Abstract: Using highly disaggregated transaction-level trade data, we document the importance of new firm level trade partner relationships and the addition of new products to existing relationships in driving long-run import flows. Moreover, we find that these margins are sensitive to movements in the exchange rate. We rationalize these findings in a model of international trade with endogenous matching between heterogenous importers and exporters. Simulations of the model highlight a new channel through which exchange rate movements can affect trade—through the short-run formation of new trade relationships and the range of products traded within relationships—which can impact long-run flows.
    Keywords: Exchange rates; Firm dynamics; International topics
    JEL: F1 F4
    Date: 2019–10
  3. By: David de Villiers (Department of Economics, Nelson Mandela University); Andrew Phiri (Department of Economics, Nelson Mandela University)
    Abstract: The Purchasing Power Parity (PPP) hypothesis represents one of the oldest existing economic doctrines and is plagued with empirical inconsistencies collectively labelled as ‘puzzles’. Our study resolves these ‘puzzles’ for 14 Newly Industrialized Countries (NIC) whose developmental strategies are impinged on the stability of real exchange rates which, in turn, validates the PPP hypothesis. We test for the stationarity of real exchange rates (RER’s) by applying an exponential smooth transition autoregressive unit root test augmented with a fractional frequency flexible Fourier form component (ESTAR-FFFFF) to capture heterogeneous smooth transition asymmetries and approximate unknown structural breaks in the time series. We find the RER’s in all 14 NIC’s are mean-reverting over monthly period of 1970:1-2018:12 which confirms the PPP hypothesis for these economies in the presence of exchange-rate regime shifts, oil and food shocks, financial crisis and other forms of asymmetries and structural breaks. Length: 29 pages
    Keywords: Purchasing power parity (PPP); fractional frequency flexible Fourier form (FFFFF) unit root tests; asymmetries; structural breaks; Emerging economies; New Industrialized Countries (NIC).
    JEL: C12 C13 C22 C24 C58 F31
    Date: 2019–09
  4. By: Ryan Chahrour (Boston College); Luminita Stevens (University of Maryland)
    Abstract: We find that observed cross-country price differences primarily reflect regional market segmentation occurring within countries. Using a model of price setting subject to costly search, we show that identification of national versus regional segmentation requires augmenting price data with regional trade flow data. Calibrating the model to data from U.S. and Canadian regions, we estimate substantial regional trade frictions: U.S. producers are three times more likely to sell to retailers in their own region than in the “away” region of the United States, and only slightly less likely to sell to a region in Canada, controlling for market size differences. Canadian producers have an even stronger home bias: they are seven times more likely to sell in their own region than in the “away” region in Canada, and 11 times more likely to sell in their own region than in a U.S. region. Models that do not explicitly account for regional home bias can misstate the severity of segmentation at the national border.
    Date: 2019
  5. By: Riccardo Colacito; Steven J. Riddiough; Lucio Sarno
    Abstract: We find a strong link between currency excess returns and the relative strength of the business cycle. Buying currencies of strong economies and selling currencies of weak economies generates high returns both in the cross section and time series of countries. These returns stem primarily from spot exchange rate predictability, are uncorrelated with common currency investment strategies, and cannot be understood using traditional currency risk factors in either unconditional or conditional asset pricing tests. We also show that a business cycle factor implied by our results is priced in a broad currency cross section.
    JEL: F31 G12 G15
    Date: 2019–09
  6. By: Thomas Goda; Jan Priewe
    Keywords: Real Exchange Rate; Foreign Exchange Rate Policy, Commodity Prices, CapitalInflows, Global Risk
    JEL: F31 F41 O11 O57 P52
    Date: 2019–10–01
  7. By: Gabriela Cugat (Northwestern University)
    Abstract: I argue that household heterogeneity plays a key role in the transmission of aggregate shocks in emerging market economies. Using Mexico's 1995 crisis as a case study, I first document empirically that working in the tradable versus non-tradable sector is a crucial determinant of the income and consumption losses of different types of households. Specifically, households in the non-tradable sector suffered much larger income and consumption losses regardless of other household characteristics. To account for the effect of this observation on macroeconomic dynamics, I construct a New Keynesian small open economy model with household heterogeneity along two dimensions: uninsurable sector-specific income and limited financial-market participation. I find that the propagation of shocks in this economy is affected by both dimensions of heterogeneity, with uninsurable sector-specific income playing a quantitatively larger role. In terms of policy, a managed exchange rate policy is more costly overall when households are heterogeneous; however, households in the non-tradable sector benefit from it.
    Date: 2019
  8. By: Marco Del Negro (Federal Reserve Bank of New York); Andrea Tambalotti (Federal Reserve Bank of New York); Domenico Giannone (Federal Reserve Bank of New York); Marc Giannoni (Federal Reserve Bank of Dallas)
    Abstract: The trend in the world real interest rate for safe and liquid assets fluctuated close to 2 percent for more than a century, but has dropped significantly over the past three decades. This decline has been common among advanced economies, as trends in real interest rates across countries have converged over this period. It was driven by an increase in the convenience yield for safety and liquidity and by lower global economic growth.
    Date: 2019
  9. By: Alberto Cavallo (Harvard); Andres Drenik (Columbia University); Javier Cravino (University of Michigan)
    Abstract: We use a novel dataset from a large freelance website to document international wage differences for performing tasks that can be delivered online. We show large wage disparities across freelancers from different countries working on narrowly defined occupations. These wage differentials across countries cannot be explained by differences in observable worker characteristics. Instead, real exchange rate levels account for about 70 percent of the cross-country-variation in average wages, and the elasticity of relative wages with respect to the real exchange rate is about 0.4. The magnitudes of these findings are pervasive across different country groups and types of jobs.
    Date: 2019
  10. By: Serhan Cevik; Tianle Zhu
    Abstract: Monetary independence is at the core of the macroeconomic policy trilemma stating that an independent monetary policy, a fixed exchange rate and free movement of capital cannot exist at the same time. This study examines the relationship between monetary autonomy and inflation dynamics in a panel of Caribbean countries over the period 1980–2017. The empirical results show that monetary independence is a significant factor in determining inflation, even after controlling for macroeconomic developments. In other words, greater monetary policy independence, measured as a country’s ability to conduct its own monetary policy for domestic purposes independent of external monetary influences, leads to lower consumer price inflation. This relationship—robust to alternative specifications and estimation methodologies—has clear policy implications, especially for countries that maintain pegged exchange rates relative to the U.S. dollar with a critical bearing on monetary autonomy.
    Date: 2019–09–20
  11. By: Albert Queralto (Federal Reserve Board)
    Abstract: We use a two-country New Keynesian model with balance sheet constraints to investigate the magnitude of international spillovers of U.S. monetary policy. Home borrowers obtain funds from domestic households in domestic currency, as well as from residents of the foreign economy (the U.S.) in dollars. In our economy, foreign lenders differ from domestic lenders in their ability to recover resources from defaulting borrowers' assets, leading to more severe financial constraints for foreign debt than for domestic borrowing. As a consequence, a deterioration in borrowers' balance sheets induces a rise in the home currency's premium and an exchange rate depreciation. We use the model to investigate how spillovers are affected by the degree of currency mismatches in balance sheets, and whether the latter make it desirable for policy to target the exchange rate. We find that the magnitude of spillovers is significantly enhanced by the degree of currency mismatches. Our findings also suggest that using monetary policy to stabilize the exchange rate is not necessarily more desirable with greater balance sheet mismatches and may actually exacerbate short-run exchange rate volatility.
    Date: 2019
  12. By: Christopher Johnson (UC Davis)
    Abstract: The Great Recession featured a global collapse in real and financial economic activity that was highly synchronized across countries. Two unique precursors to the crisis were the rise in the shadow banking sector and increased securitization. I develop a model that is the first to explain the extent to which these factors contributed to the international transmission of the crisis that mostly originated in the United States. Using a two-country model with commercial and shadow banking sectors, I show that a country-specific financial shock leads to a simultaneous decline in real and financial aggregates in both countries. My model is the first to include both shadow and commercial banking in an open-economy framework. While commercial banks transfer funds from borrowers to lenders, shadow banks securitize loans and sell them to intermediaries internationally as asset-backed securities. Transmission occurs through a balance sheet channel, which is stronger when intermediaries hold more securities from abroad. I also consider the implications of capital controls on the transmission of a financial crisis. In general, I find that capital controls can reduce transmission.
    Date: 2019
  13. By: David Kohn (Pontificia Universidad Católica de Chile); Fernando Leibovici (Federal Reserve Bank of St. Louis); Michal Szkup (University of British Columbia)
    Abstract: We investigate the extent to which frictions in financial markets affect the gains from trade liberalization. We study a small open economy populated with entrepreneurs heterogeneous in productivity and net worth who can trade internationally and are subject to financing constraints. We calibrate the model to match key features of Colombian plant-level data and use it to quantify the role of credit frictions in shaping the economy's response to trade liberalization. We find that frictions in financial markets slow down the response of capital and output in the aftermath of trade liberalization; in contrast, the dynamics of exports adjustment are largely independent of financial development. We document evidence consistent with these findings for the Colombian trade liberalization in the early 1990s.
    Date: 2019
  14. By: Gabriel Chodorow-Reich (Harvard University); Loukas Karabarbounis (University of Minnesota); Rohan Kekre (University of Chicago)
    Abstract: The Greek economy has experienced three distinct phases in the past 20 years: a boom from 1999 to 2007, a crash from 2007 to 2012, and a flattening from 2012 to 2017. We explore these dynamics using a quantitative model of a two-sector small open economy with nominal frictions, collateral constraints, and endogenous utilization. We first evaluate the roles of shocks to productivity, financial conditions, fiscal policy, external demand, and disaster risk in contributing to the cycle. We then ask whether counterfactual policies such as an unexpected devaluation or an alternative mix of fiscal adjustments could have facilitated the recovery.
    Date: 2019
  15. By: Isha Agarwal; Grace Weishi Gu; Eswar S. Prasad
    Abstract: We analyze shifts in the structure of China’s capital outflows over the past decade. The composition of gross outflows has shifted from accumulation of foreign exchange reserves by the central bank to nonofficial outflows. Unlocking the enormous pool of domestic savings could have a significant impact on global financial markets as China continues to open up its capital account and as domestic investors look abroad for returns and diversification. We analyze in detail the allocation patterns of Chinese institutional investors (IIs), which constitute the main channel for foreign portfolio investment outflows. We find that, relative to benchmarks based on market capitalization, Chinese IIs underweight developed countries and high-tech sectors in their international portfolio allocations but overinvest in high-tech stocks in developed countries. To further examine Chinese IIs’ joint decisions on destination country-sector pairs, we construct continuous measures of revealed relative comparative advantage and disadvantage in a sector for a country based on trade patterns. We find that, in their foreign portfolio allocations, Chinese IIs overweight sectors in which China has a comparative disadvantage. Moreover, Chinese IIs concentrate such investments in countries that have higher relative comparative advantage in those sectors. Diversification and information advantages related to foreign imports to China seem to influence patterns of foreign portfolio allocations, while yield-seeking and learning motives do not.
    JEL: F2 F3 F4
    Date: 2019–09
  16. By: Ṣebnem Kalemli-Özcan
    Abstract: I show that monetary policy divergence vis-a-vis the U.S. has larger spillover effects in emerging markets than advanced economies. The monetary policy of the U.S. affects domestic credit costs in other countries through its effect on global investors’ risk perceptions. Capital flows in and out of emerging market economies are particularly sensitive to fluctuations in such risk perceptions and have a direct effect on local credit spreads. Domestic monetary policy is ineffective in mitigating this effect as the pass-through of policy rate changes into short-term interest rates is imperfect. This disconnect between short rates and monetary policy rates is explained by changes in risk perceptions. A key policy implication of my findings is that emerging markets’ monetary policy actions designed to limit exchange rate volatility can be counterproductive.
    JEL: E0 F0
    Date: 2019–09
  17. By: Peter Gal; William Witheridge
    Abstract: Productivity growth has declined in most advanced economies in the past two decades and there are signs that the pace of global value chain (GVC) integration has slowed in the post-crisis period. This paper explores the role of GVCs - international trade in intermediate inputs - for multi-factor productivity growth using a range of cross-country industry-level data sources. We find that greater participation in GVCs is associated with faster domestic productivity growth at the industry level. We estimate that if GVCs had continued to grow at their pre-crisis trend, productivity growth would have been around 1 percentage point faster over the subsequent five years in both manufacturing and services. We also find that the productivity-enhancing direction of trade differs between sectors. For manufacturing sectors, greater use of intermediate inputs from foreign sources (backward participation) is linked with faster productivity growth, reflecting the beneficial effects of having access to better quality or cheaper inputs. For services sectors, it is more the sales of intermediates (forward participation) that is associated with productivity gains, in line with the traditional role of services in foreign trade as providing inputs to other activities. Looking by partner country, GVC participation with higher productivity countries is particularly productivity enhancing. We also find that GVC integration spurs greater domestic innovation activity.
    Keywords: global value chains, innovation, productivity
    JEL: F14 D24 O30
    Date: 2019–10–04
  18. By: Halil Memis; Steffen Sebastian
    Abstract: The aim of this thesis is to examine the role of real estate investments in the global financial system. The comprehensive investment spectrum conditional on currency-unhedged and fully hedged portfolios is conducted on 23 individual assets from the perspective of three major economies -- the euro, pound sterling, and the U.S. dollar. The approach used in the analysis provides a high information content as it distinguishes between the sources of diversification benefits in a statistically significant way. The econometric analysis shows that internationally diversifying a portfolio is superior to a domestic investment. The strongest evidence thereof is found in global bonds during bear markets, while diversification properties for international stocks are detected in bull markets. Global real estate investments are in fact powerful diversifiers as long as exchange rate risk is fully hedged. Overall, the findings confirm that global investing with hedged positions are valuable investments from the perspective of diversification.
    Keywords: asset allocation; Diversification; Foreign exchange rates; Spanning test; Step-down procedure
    JEL: R3
    Date: 2019–01–01
  19. By: Mohammad Farhad; Michael Jetter
    Abstract: Does trade openness systematically imply bigger governments, as proposed by Rodrik (1998)? This paper presents a novel and more refined explanation for when and why international trade may enlarge the public sector. We propose that trade openness is associated with bigger governments if (i) the price volatility of a country’s export basket is substantial and (ii) the country is democratic. The first condition satisfies the prior that open trade barriers indeed introduce uncertainty and external risk – something that is not necessarily the case for all trade. The second condition ensures that the people’s desire for greater economic security can be realized through government spending. Empirical evidence for 143 countries (accounting for approximately 96 percent of world population) from 2000-2016 is consistent with this hypothesis. Exploring areas of public spending, we find intuitive patterns: Consistent with the compensation hypothesis, government spending on economic affairs and housing increases significantly with trade openness, whereas public spending on education, health care, and the military are not immediately concerned. As with our general result, this is only the case in democracies that are subject to high price volatility on the global market.
    Keywords: economic globalization, trade openness, government size, export price volatility, democracy
    JEL: F14 F41 H10
    Date: 2019
  20. By: Fernando Arce; Julien Bengui; Javier Bianchi
    Abstract: This paper proposes a theory of foreign reserves as macroprudential policy. We study an open-economy model of financial crises in which pecuniary externalities lead to overborrowing, and show that by accumulating international reserves, the government can achieve the constrained-efficient allocation. The optimal reserve accumulation policy leans against the wind and significantly reduces the exposure to financial crises. The theory is consistent with the joint dynamics of private and official capital flows, both over time and in the cross-section, and can quantitatively account for the recent upward trend in international reserves.
    Keywords: Balance of payments and components; Financial stability; Financial system regulation and policies; Foreign reserves management; International financial markets
    JEL: D52 D62 F34
    Date: 2019–10
  21. By: Siqiang Yang (University of Pittsburgh)
    Abstract: The paper investigates how nominal exchange rate volatility affects a sovereign’s default risk and its incentive to accumulate reserves. The model considers an environment where the sovereign faces a currency mismatch problem and is subject to volatile exchange rate fluctuations. This implies that when the exchange rate depreciates, the debt burden in terms of domestic currency increases, leading to higher default risk and borrowing costs. To insure against this risk, the sovereign optimally accumulates reserves to (i) smooth consumption when borrowing becomes costly, (ii) to hedge against the depreciation of the exchange rate, and (iii) to reduce the volatility of the exchange rate. The model is then calibrated using data from Mexico (1991-2015). The model can replicate the positive association between nominal exchange rate volatility and sovereign default risk. It can also generate more than half of the reserve holdings in Mexico. Moreover, all three channels of reserve accumulation are shown to be quantitatively important.
    Date: 2019
  22. By: Aleksandra Babii (Toulouse School of Economics)
    Abstract: Nominal exchange rates strongly co-move. However, little is known about the economic source of common variation. This paper examines how international trade links nominal exchange rates. First, I document that two countries that trade more intensively with each other have more correlated exchange rates against the U.S dollar. Second, I develop a general equilibrium multi-country model, where a shock to a single country propagates to the exchange rates of its trading partners and serves as a source of common variation. In the baseline three-country model, I show that the sign and the strength of correlation between exchange rates depend on the elasticities of trade balances of countries with respect to both exchange rates. As a result, the model’s prediction about the relationship between bilateral trade intensity and exchange rates correlation depends on the currency in which international prices are set. Lastly, an augmented model is calibrated to twelve countries to quantitatively assess the importance of trade linkages. I find that trade linkages alone, with uncorrelated shocks across countries, account for 50% of the empirical trade-exchange-rates-correlation slope coefficient.
    Date: 2019
  23. By: Javier Bianchi; Pablo Ottonello; Ignacio Presno
    Abstract: The excess procyclicality of fiscal policy is commonly viewed as a central malaise in emerging economies. We document that procyclicality is more pervasive in countries with higher sovereign risk and provide a model of optimal fiscal policy with nominal rigidities and endogenous sovereign default that can account for this empirical pattern. Financing a fiscal stimulus is costly for risky countries and can render countercyclical policies undesirable, even in the presence of large Keynesian stabilization gains. We also show that imposing austerity can backfire by exacerbating the exposure to default, but a well-designed “fiscal forward guidance” can help reduce the excess procyclicality.
    JEL: E62 F34 F41 F44 H50
    Date: 2019–09
  24. By: Flora Lutz; Leopold Zessner-Spitzenberg
    Abstract: We propose a small open economy model where agents borrow internationally and invest in liquid foreign assets to insure against liquidity shocks, which tem-porarily shut out the economy of short-term credit markets. Due to the presence of a pecuniary externality individual agents borrow too much and hold too little liquid assets relative to a social planner. This ine?ciency rationalizes macropru-dential policy interventions in the form of reserve accumulation at the central bank coupled with a tax on foreign borrowing. Unless combined with other measures, a tax on foreign borrowing is detrimental to welfare; it reduces agents’ incentives to invest in liquid assets and thereby increases ?nancial instability. Our model can quantitatively match the simultaneous depreciation of the exchange rate and con-tractions in output, gross trade ?ows, foreign liabilities and liquid reserves during Sudden Stop episodes.
    JEL: D62 E44 F32 F34 F41
    Date: 2019–09

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