nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2019‒10‒14
twenty papers chosen by
Martin Berka
University of Auckland

  1. Global Dimensions of US Monetary Policy By Maurice Obstfeld
  2. Trade Flows and Exchange Rates: Importers, Exporters and Products By Michael B. Devereux; Wei Dong; Ben Tomlin
  3. Foreign exchange inflows, the trade balance and real effective exchange rates By Michael Bleaney; Mo Tian
  4. Net foreign assets and current account balances By Michael Bleaney; Mo Tian
  5. A New Keynesian DSGE model for Low Income Economies with Foreign Exchange Constraints By Bertha C. Bangara
  6. Boom Goes the Price: Giant Resource Discoveries and Real Exchange Rate Appreciation By Radek Stefanski
  7. International Spillovers of U.S. Monetary Policy By Demir, Ishak
  8. The Political Economy of a Diverse Monetary Union By Perotti, Enrico C; Soons, Oscar
  9. The Cost of Holding Foreign Exchange Reserves By Eduardo Levy Yeyati
  10. Putting Global Governance in its Place By Dani Rodrik
  11. The Aggregate and Distributional Effects of Financial Globalization: Evidence from Macro and Sectoral Data By Furceri, Davide; Loungani, Prakash; Ostry, Jonathan D.
  12. The Brexit Vote, Productivity Growth and Macroeconomic Adjustments in the United Kingdom By Broadbent, Ben; DiPace, Federico; Drechsel, Thomas; Harrison, Richard; Tenreyro, Silvana
  13. Business Cycles and Currency Returns By Colacito, Ric; Riddiough, Steven; Sarno, Lucio
  14. The role of the rand as a shock absorber By Luchelle Soobyah; Daan Steenkamp
  15. Riders on the Storm By Jordá, Óscar; Taylor, Alan M.
  16. Monetary Policy Autonomy and International Monetary Spillovers By Demir, Ishak
  17. Structural Asymmetries and Financial Imbalances By Ivan Jaccard
  18. Monetary policy for commodity booms and busts By Drechsel, Thomas; McLeay, Michael; Tenreyro, Silvana
  19. Fiscal Policy and Adjustment in a Foreign Exchange Constrained Economy: Evidence from Malawi By Bertha C. Bangara; Amos C. Peters
  20. Monetary policy in a model with commodity and financial market By Vo Phuong Mai Le; Ruthira Naraidoo

  1. By: Maurice Obstfeld (Peterson Institute for International Economics)
    Abstract: This paper is a partial exploration of mechanisms through which global factors influence the tradeoffs that US monetary policy faces. It considers three main channels. The first is the determination of domestic inflation in a context where international prices and global competition play a role, alongside domestic slack and inflation expectations. The second channel is the determination of asset returns (including the natural real safe rate of interest, r*) and financial conditions, given integration with global financial markets. The third channel, which is particular to the United States, is the potential spillback onto the US economy from the disproportionate impact of US monetary policy on the outside world. In themselves, global factors need not undermine a central bank's ability to control the price level over the long term--after all, it is the monopoly issuer of the numeraire in which domestic prices are measured. Over shorter horizons, however, global factors do change the tradeoff between price-level control and other goals such as low unemployment and financial stability, thereby affecting the policy cost of attaining a given price path.
    Keywords: Monetary policy, natural rate of interest, Phillips curve, current account, capital flows, policy spillbacks
    JEL: E52 F32 F41
    Date: 2019–10
  2. By: Michael B. 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.
    JEL: F1 F4
    Date: 2019–09
  3. By: Michael Bleaney; Mo Tian
    Abstract: There has long been a concern that large net inflows of property income or income transfers (such as aid and remittances) pull up the real exchange rate and thus divert resources away from the tradables sector (the so-called Dutch disease effect), although the empirical evidence is somewhat mixed. Using annual data for a large sample of countries back to 1971, it is shown here that the long-run effect of an improvement in the non-trade elements of the current account balance is real exchange rate appreciation and a deterioration of the trade balance.
    Keywords: current account, exchange rates, trade balance
    Date: 2019
  4. By: Michael Bleaney; Mo Tian
    Abstract: Theory predicts a negative long-run equilibrium relationship between net foreign assets and net exports (the trade balance plus net transfers). In a large sample of countries back to 1971, the data are found to be consistent with this provided that the short-run dynamics are allowed to vary across countries. By contrast, the correlation between net foreign assets and net exports in a given year tends to be positive in most years. The correlation between net foreign assets and the current account balance shows a similar pattern: negative in time series but positive in cross-section. Shocks to relative prices and cycles in international lending prevent the world from settling on an equilibrium for any length of time.
    Keywords: current account, exchange rates, net foreign assets, net exports
    Date: 2019
  5. By: Bertha C. Bangara
    Abstract: The existing literature is clear that low income economies tend to suffer from foreign exchange shortages exacerbated by their exports. Most importantly, the concentration of their exports renders these countries susceptible to international price fluctuations. This frequently affects the level of foreign exchange, causing excess demand for foreign exchange leading to foreign exchange shortages. Using a four-sector New Keynesian dynamic stochastic general equilibrium (DSGE) model with foreign exchange constraints faced by importing rms, we calibrate the model to Malawian economy to investigate the implications of foreign exchange constraints on key macroeconomic variables in low income import dependent economies. We demonstrate that imports are a vital part of the production process for LIEs and determine the response and direction of output and consumption. Second, the degree of the foreign exchange constraint determines the degree of variability of the shock, but, does not change the direction of the shock. Third, increasing imports in an effort to increase productivity reduces output and consumption and induces a depreciation of the exchange rate. Fourth, the model illustrates that the domestic contractionary monetary policy produces the conventional results on output, consumption and other variables.
    Keywords: Low income economies, Foreign Exchange Constraints, DSGE, Malawi
    JEL: E32 F31 F35 O55
    Date: 2019–09
  6. By: Radek Stefanski (University of St Andrews)
    Abstract: We estimate the effect of giant oil and gas discoveries on bilateral real exchange rates. The size and plausibly exogenous timing of such discoveries make them ideal for identifying the effects of a resource boom on prices. We find that a giant discovery with the value of 10% of a country's GDP appreciates the real exchange rate by 1.5% within 10 years following the discovery. Importantly, a significant part of the appreciation occurs before production starts and the appreciation is driven by the non-traded component of the real exchange rate. Moreover, we show that labor reallocates from the traded goods sector to the non-traded goods sector leading to changes in labor productivity in the respective sectors. Our findings provide direct evidence on the channels central to the theories of the Dutch disease and the Balassa-Samuelson effect.
    Date: 2019
  7. By: Demir, Ishak
    Abstract: We estimate a structural dynamic factor model on large panel quarterly data to analyse the spillovers of U.S. monetary policy to the advanced economies and emerging and frontier market economies. The estimated model suggests that monetary contraction in U.S. leads to a significant decrease in real GDP with typical inverted hump-shape almost for all countries. It reduces permanently aggregate price level, increases interest rate and leads appreciation of U.S. dollar. However, contagion of U.S. monetary policy to the individual countries shows heterogeneity. For instance, its impact is larger in developing countries. We also find that global financial crisis has amplified the impact of U.S monetary policy on the rest of world in particular on developing countries. Lastly, the empirical results suggest that the cross-country heterogeneity in responses may be consequence of difference in country-specific characteristics such as exchange rate regimes, currency of price settings of firms, central bank independence and geographical distance from Unites States.
    Keywords: cross-country heterogeneity,country-specific characteristic,international monetary spillovers,structural factor model,monetary policy
    JEL: C38 E43 E52 E58 F42 G12
    Date: 2019
  8. By: Perotti, Enrico C; Soons, Oscar
    Abstract: We analyze the political economy of monetary unification among countries with different quality of institutions. Countries with stronger institutions have lower public spending and better investment incentives, even under a stronger currency. Governments under weaker institutions spend more so must occasionally devalue. In a MU market prices and flows adjust quickly but institutional differences persist, so a diverse monetary union (DMU) has many redistributive effects. The government in the weaker country expand spending and investment may be reduced by the fiscal and common exchange rate effect. Strong country production benefits from the weaker currency but needs to offer fiscal support in a fiscal crisis, a transfer legitimized by its ex ante devaluation gain. Some governments may join a DMU even if it depresses productive capacity to expand public spending. Even in a DMU beneficial for all countries, workers and firms in weaker countries and savers in stronger countries may lose.
    Keywords: institutional quality; institutions; Monetary Unions; political economy
    Date: 2019–09
  9. By: Eduardo Levy Yeyati
    Abstract: Recent studies that have emphasized the costs of accumulating reserves for self-insurance purposes have overlooked two potentially important side-effects. First, the impact of the resulting lower spreads on the service costs of the stock of sovereign debt, which could substantially reduce the marginal cost of holding reserves. Second, when reserve accumulation reflects countercyclical LAW central bank interventions, the actual cost of reserves should be measured as the sum of valuation effects due to exchange rate changes and the local-to-foreign currency exchange rate differential (the inverse of a carry trade profit and loss total return flow), which yields a cost that is typically smaller than the one arising from traditional estimates based on the sovereign credit risk spreads. We document those effects empirically to illustrate that the cost of holding reserves may have been considerably smaller than usually assumed in both the academic literature and the policy debate.
    Keywords: international reserves, exchange rate policy, capital flows, financial crisis
    JEL: E42 E52 F33 F41
    Date: 2019–05
  10. By: Dani Rodrik (Center for International Development at Harvard University)
    Abstract: In a world economy that is highly integrated, most policies produce effects across the border. This is often believed to be an argument for greater global governance, but the logic requires scrutiny. There remains strong revealed demand for policy and institutional diversity among nations, rooted in differences in historical, cultural, or development trajectories. The canonical case for global governance is based on two set of circumstances. The first occurs when there is global public good (GPG) and the second under “beggar-thy-neighbor” (BTN) policies. However, the world economy is not a global commons, and virtually no economic policy has the nature of a global public good (or bad). And while there are some important BTN policies, much of our current discussions deal with policies that are not true BTNs. The policy failures that exist arise not from weaknesses of global governance, but from distortions of domestic governance. As a general rule, these domestic failures cannot be fixed through international agreements or multilateral cooperation. The paper closes by discussing an alternative model of global governance called “democracy-enhancing global governance.”
    Keywords: Global Governance
    JEL: F50
    Date: 2019–08
  11. By: Furceri, Davide; Loungani, Prakash; Ostry, Jonathan D.
    Abstract: We take a fresh look at the aggregate and distributional effects of policies to liberalize international capital flows-financial globalization. Both country- and industry-level results suggest that such policies have led on average to limited output gains while contributing to significant increases in inequality. The country-level results are based on 228 capital account liberalization episodes spanning 149 advanced and developing economies from 1970 to the present. Difference-in-difference estimation using industry-level data for 23 advanced economies suggests that liberalization episodes reduce the share of labor income, particularly for industries with higher external financial dependence, higher natural propensity to use layoffs to adjust to idiosyncratic shocks, and higher elasticity of substitution between capital and labor.
    Keywords: Capital account openness; Globalization; inequality
    JEL: F13 G32 O11
    Date: 2019–09
  12. By: Broadbent, Ben; DiPace, Federico; Drechsel, Thomas; Harrison, Richard; Tenreyro, Silvana
    Abstract: The UK economy has experienced significant macroeconomic adjustments following the 2016 referendum on its withdrawal from the European Union. This paper develops and estimates a small open economy model with tradable and non-tradable sectors to characterize these adjustments. We demonstrate that many of the effects of the referendum result can be conceptualized as news about a future slowdown in productivity growth in the tradable sector. Simulations show that the responses of the model economy to such news are consistent with key patterns in UK data. While overall economic growth slows, an immediate permanent fall in the relative price of non-tradable output (the real exchange rate) induces a temporary "sweet spot" for tradable producers before the slowdown in the tradable sector productivity associated with Brexit occurs. Resources are reallocated towards the tradable sector, tradable output growth rises and net exports increase. These developments reverse after the productivity decline in the tradable sector materializes. The negative news about tradable sector productivity also lead to a decline in domestic interest rates relative to world interest rates and to a reduction in investment growth, while employment remains relatively stable. As a by-product of our Brexit simulations, we provide a quantitative analysis of the UK business cycle.
    Keywords: Brexit; Exchange Rate Adjustment; growth; productivity; Tradable Sector; Trade; UK Economy
    JEL: E13 E32 F17 F47 O16
    Date: 2019–09
  13. By: Colacito, Ric; Riddiough, Steven; Sarno, Lucio
    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.
    Keywords: business cycles; currency risk premium; Exchange Rates; Long-run risk
    JEL: F31 G12 G15
    Date: 2019–09
  14. By: Luchelle Soobyah; Daan Steenkamp
    Abstract: This paper investigates the impact of rand shocks on industry output and various other South African macroeconomic variables. We use a factor augmented model, which has the key advantage of providing a rich narrative about the disaggregated impacts of exchange rate shocks. We show that the currency tends to react to changes in the relative fundamentals of the economy, such as those captured by commodity export prices, and that the independent impact on the economy of exchange rate changes that are unrelated to fundamentals is estimated to be small. The results suggest that the exchange rate tends to act as a shock absorber to the shocks that hit the economy: a large proportion of the variation in the rand can be explained by other shocks, while rand shocks themselves explain a relatively small proportion of South Africa’s macroeconomic volatility. That said, the role that the exchange rate plays as a shock absorber appears to be weaker in South Africa than for other commodity exporters like Australia and New Zealand.
    Keywords: FAVAR, exchange rate shocks
    JEL: C38 F31 F41
    Date: 2019–07
  15. By: Jordá, Óscar; Taylor, Alan M.
    Abstract: Interest rates in major advanced economies have drifted down and in greater unison over the past few decades. A country's rate of interest can be thought of as reflecting movements in the global neutral rate of interest, the domestic neutral rate, and the stance of monetary policy. Only the latter is controlled by the central bank. Estimates from a state space New Keynesian model show that central bank policy explains less than half of the variation in interest rates. The rest of the time, the central bank is catching up to trends dictated by productivity growth, demography, and other factors outside of its control.
    Keywords: Kalman filter; monetary policy stance; neutral rate of interest; state-space model
    JEL: E43 E44 E52 E58 F36 N10
    Date: 2019–09
  16. By: Demir, Ishak
    Abstract: While Federal Reserve continues to normalize its monetary policy on the back of a strengthening U.S. economy, the possibility of mimicking U.S. policy actions and so the debate of monetary autonomy has been particularly heated in the most of developing countries, even in advanced economies. We analyse the role played by country-specific characteristics in domestic monetary policy autonomy to set short-term interest rates in the face of spillovers from of U.S. monetary policy as global external shocks. First, we extricate the non-systematic (non-autonomous) component of domestic interest rates which is related to business cycle synchronisation across countries. Then we employ an interacted panel VAR model, which allows impulse response functions to vary by country characteristics for a broad sample of countries. We find strong empirical evidence for the role of exchange rate flexibility, capital account openness in line with trilemma, but also a significant role for other country characteristics, such as dollarisation in the financial system, the presence of a global bank, use of macroprudential policies, and the credibility of fiscal and monetary policy.
    Keywords: monetary policy autonomy,global financial cycle,international spillovers,trilemma,country-specific characteristics,cross-country difference,dilemma
    JEL: C38 E43 E52 E58 F42 G12
    Date: 2019
  17. By: Ivan Jaccard (European Central Bank)
    Abstract: Many southern European economies experience large capital inflows during periods of expansion that are followed by abrupt reversals when a recession hits. This paper studies the dynamics of capital flows between the North and South of Europe in a two-country DSGE model with incomplete international asset markets. Over the business cycle, the direction of capital flows between the two regions can be explained in a model in which common shocks have asymmetric effects on debtor and creditor economies. This mechanism explains why aggregate consumption is more volatile in the South than in the North and generates a higher welfare cost of business cycle fluctuations in the region that experiences procyclical net capital inflows. We also study the adjustment to asymmetric financial shocks.
    Date: 2019
  18. By: Drechsel, Thomas; McLeay, Michael; Tenreyro, Silvana
    Abstract: Macroeconomic volatility in commodity-exporting economies is closely tied to fluctuations in international commodity prices. Commodity booms improve exporters' terms of trade and loosen their borrowing conditions, while busts lead to the reverse. This paper studies optimal monetary policy for commodity exporters in a small open economy framework that includes a key role for financial conditions. We incorporate the interaction between the commodity and financial cycles via a working capital constraint for commodity producers, which loosens as commodity prices increase. A rise in global commodity prices causes an inefficient reallocation towards the commodity sector, which expands and increases its demand for inputs. The real exchange-rate appreciates, but because domestic fims do not internalize that the appreciation reduces the scale of the reallocation, they do not raise prices enough. An inefficient boom takes place, with inflation rising and output increasing relative to its welfare-maximizing level. Returning inflation to target is not sufficient to close the output gap, leaving the policymaker facing a stabilization tradeoff. The optimal policy lets the exchange rate appreciate and raises interest rates, with a larger rate rise required the greater the loosening in borrowing conditions. The paper compares alternative policy rules and discusses a key practical challenge for emerging and developing economies: how to transition to a stable path from initial conditions of high and persistent inflation.
    Keywords: Commodity financialization; commodity prices; Exchange Rates; monetary policy; small open economy
    JEL: E31 E52 E58 F41 Q02 Q30
    Date: 2019–09
  19. By: Bertha C. Bangara; Amos C. Peters
    Abstract: Most of the recent literature analysing the adjustments of macroeconomic variables to fiscal policy shocks rely on the inclusion of non-Ricardian households to generate a positive response of consumption to an increase in government spending. This paper examines the dynamic effects of government financing behaviour in a foreign exchange constrained low income economy on key macroeconomic aggregates such as output, consumption, wages and labour supply. Using a dynamic stochastic general equilibrium (DSGE) model with Ricardian households calibrated to Malawian data, we find that consumption, wages and labour supply increase with increased government expenditure. This is contrary to popular arguments that government expenditure is inversely associated with the private consumption of intertemporal optimizing households in DSGE models. We argue that the positive response of consumption to increased government expenditure arises from the inclusion of aid in the government budget since government expenditure in low income economies may rise with increases in aid inflows for a given level of taxes. We also show that a positive shock to aid relaxes the foreign exchange constraint and improves the economy although it induces an appreciation of the real exchange rate.
    Keywords: fiscal policy, Foreign Exchange Constraint, DSGE, Malawi
    JEL: E32 F31 F35 H32
    Date: 2019–04
  20. By: Vo Phuong Mai Le; Ruthira Naraidoo
    Abstract: This paper builds a small open economy model for a net commodity exporter to consider financial frictions and monetary policies in order to investigate the main determinants of business cycles. Since we make a distinction to the access of financial markets between the commodity and non-commodity sectors, we notice that as usual, a commodity price shock benefits the competitiveness of the economy and its borrowing terms. We outline a novel effect in this paper which we dub the financial market effect following a positive commodity price shock that decreases the credit premium and hence exacerbate the commodity price boom. However the negative sectoral downturn affects entrepreneur credit together with disinflationary pressures of a real exchange rate appreciation. This opens the role for stabilization policies which we analyze comparing three types of monetary regimes. Estimating the model on South Africa, a major commodity exporting economy with inflation targeting regime, we .find as conventional wisdom suggests that a hypothetical Taylor rule targeting the price-level allows for adjustment in inflation expectations that can dampen disinflationary pressures. Furthermore, due to smoother change in nominal rate of interest, there is lesser variability in financial markets.
    Keywords: Business cycles, Small open economy, Commodity prices, financial frictions, Monetary policy, Price-level targeting, South Africa economy
    JEL: E32 E44 E58 F41 F44 O16
    Date: 2019–05

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