nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2020‒02‒10
thirteen papers chosen by
Martin Berka
University of Auckland

  1. Commodity Currencies and Causality: Some High-Frequency Evidence By Ahmed, Rashad
  2. Rational bubbles in non-linear business cycle models: Closed and open economies By Robert Kollmann
  3. Monetary Policy and Sovereign Risk in Emerging Economies (NK-Default) By Cristina Arellano; Yan Bai; Gabriel P. Mihalache
  4. EQCHANGE Annual Assessment 2019 By Carl Grekou
  5. Non-linear exchange rate pass-through to euro area inflation: A local projection approach By Roberta Colavecchio; Ieva Rubene
  6. When is a Current Account Deficit Bad? By Devadas,Sharmila; Loayza,Norman V.
  7. Investor Experiences and International Capital Flows By Ulrike Malmendier; Demian Pouzo; Victoria Vanasco
  8. Stability of a Small Open Economy under Nonlinear Income Taxation By Chen, Been-Lon; Hu, Yunfang; Mino, Kazuo
  9. The cost of holding foreign exchange reserves By Eduardo Levy Yeyati; Juan Francisco Gómez
  10. The Behavioral Economics of Currency Unions: Economic Integration and Monetary Policy By Akvile Bertasiute; Domenico Massaro; Matthias Weber
  11. Coalition-Proof Risk Sharing Under Frictions By Harold L. Cole; Dirk Krueger; George J. Mailath; Yena Park
  12. Exchange Rates and Political Uncertainty: The Brexit Case By P. Manasse; G. Moramarco; G. Trigilia
  13. Winners and losers from Sovereign debt inflows: evidence from the stock market By Fernando Broner; Alberto Martin; Lorenzo Pandolfi; Tomas Williams

  1. By: Ahmed, Rashad
    Abstract: I investigate the link between economic fundamentals and exchange rate adjustment to commodity price fluctuations. I overcome the traditional issue of simultaneity by exploiting the September 14, 2019 drone attack on two Saudi Arabian refineries as a natural experiment. This unanticipated event caused the largest 1-day global crude oil price shock in over a decade. Using high-frequency exchange rate data for 30 countries, I link the cross-section of currency movements around the event to country-specific economic and financial fundamentals. Crude export and import intensities were associated with appreciation (depreciation). Additionally, countries with higher policy interest rates and weaker financial positions experienced greater currency depreciation while safe haven currencies appreciated, consistent with 'risk-off' sentiment triggering carry trades to unwind. I also find that across currencies, estimated (pre-event) crude oil and VIX betas are tightly associated with oil-related and financial fundamentals, respectively. Therefore, exchange rate adjustment around the drone attack can also be explained by currency risk factors.
    Keywords: Commodity,currency risk, carry trade, exchange rates, oil price, terms of trade
    JEL: E44 F3 F31 Q43
    Date: 2019–10–10
  2. By: Robert Kollmann
    Abstract: This paper studies rational bubbles in non-linear dynamic general equilibrium models of the macroeconomy. The term ‘Rational bubble’ refers to multiple equilibria due to the absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an OLG population structure. If a TVC is imposed, the macro models considered here have a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about future investment. In contrast to explosive rational bubbles in linearized models (Blanchard (1979)), the rational bubbles in non-linear models here are bounded. Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of business cycles. I construct bubbles (in non-linear models) that feature recurrent boombust cycles characterized by persistent investment and output expansions which are followed by abrupt contractions in real activity. Both closed and open economies are analyzed. In a non-linear two-country model with integrated financial markets, bubbles must be perfectly correlated across countries. Global bubbles may, thus, help to explain the synchronization of international business cycles.
    Keywords: Rational bubbles, boom-bust cycles, business cycles in closed and open economies, non-linear DSGE models, Long-Plosser model, Dellas model
    JEL: E1 E3 F3 F4 C6
    Date: 2020–02
  3. By: Cristina Arellano; Yan Bai; Gabriel P. Mihalache
    Abstract: This paper develops a New Keynesian model with sovereign default risk (NK-Default). We focus on the interaction between monetary policy, conducted according to an interest rate rule that targets inflation, and external defaultable debt issued by the government. Monetary policy and default risk interact since both affect domestic consumption, production, and inflation. We find that default risk amplifies monetary frictions and generates a tension for monetary policy, which increases the volatility of inflation and nominal rates. These monetary frictions in turn discipline sovereign borrowing, slowing down debt accumulation and lowering sovereign spreads. Our framework replicates the positive comovements of spreads with nominal domestic rates and inflation, a salient feature of emerging markets data, and can rationalize the experience of Brazil during the 2015 downturn, with high inflation, nominal rates, and spreads.
    JEL: E52 F34 F41
    Date: 2020–01
  4. By: Carl Grekou
    Abstract: This publication, accompanying the 2019’s update of EQCHANGE, aims at providing an overview of exchange rate misalignments for 2018. In a nutshell, 2018 has been characterized by relatively minor movements in exchange rate misalignments except few EMEs that registered important downward movements owing from the exchange rate depreciations. This is especially the case of Turkey, and to a lesser extent, Brazil, India, Indonesia and Russia. In contrast, most of the major currencies registered a slight appreciation vis-à-vis the US dollar that generally translated in upward movements in currency misalignments. The euro area is again featured two opposite situations with Finland Germany, Ireland and the Netherlands displaying noticeable undervaluations.
    Keywords: EQCHANGE;Exchange Rates;Currency Misalignments;Imbalances
    JEL: E3 E4 E5 E6 F3
    Date: 2019–12
  5. By: Roberta Colavecchio; Ieva Rubene
    Abstract: How long does it take for exchange rate changes to pass through into inflation? Does it make a difference whether the exchange rate depreciates or appreciates? Do relatively large exchange rate changes entail more exchange rate pass-through? In this paper, we examine possible non-linearities in the transmission of exchange rate movements to import and consumer prices in all 19 euro area countries as well as the euro area as a whole from 1997 to 2019Q1. We extend a standard single-equation linear framework with additional interaction terms to account for possible non-linearities and apply local projections to obtain state-dependent impulse response functions. We find that (i) euro area consumer and import prices respond significantly to exchange rate movements after one year, responding more when the exchange rate change is relatively large; and (ii) euro appreciations and depreciations affect the level of euro area exchange rate pass-through in a symmetric fashion; (iii) for euro area countries results differ for import and consumer prices and across countries.
    Keywords: Exchange Rate Pass-Through; Inflation; Local Projections; Non-Linearities
    JEL: E31 F41
    Date: 2019–12
  6. By: Devadas,Sharmila; Loayza,Norman V.
    Abstract: A current account deficit is sustainable when its underlying drivers support a smooth correction in the future. It is unsustainable when symptomatic of macroeconomic imbalances that would eventually trigger disruptive adjustments. Although a current account deficit in itself is neither good nor bad, it is likely to be unsustainable and lead to harmful consequences when it is persistently large, fuels consumption rather than investment, occurs alongside excessive domestic credit growth, follows an overvalued exchange rate, or accompanies unrestrained fiscal deficits. Even though a current account deficit is often paralleled by deteriorating net foreign assets, it may not be as informative about immediate-term financial vulnerabilities as the size, maturity, and currency composition of gross financial stocks.
    Keywords: International Trade and Trade Rules,Macroeconomic Management,Demographics
    Date: 2018–10–01
  7. By: Ulrike Malmendier; Demian Pouzo; Victoria Vanasco
    Abstract: We propose a novel explanation for classic international macro puzzles regarding capital flows and portfolio investment, which builds on modern macro-finance models of experience-based belief formation. Individual experiences of past macroeconomic outcomes have been shown to exert a long-lasting influence on beliefs about future realizations, and to explain domestic stock-market investment. We argue that experience effects can explain the tendency of investors to hold an over proportional fraction of their equity wealth in domestic stocks (home bias), to invest in domestic equity markets in periods of domestic crises (retrenchment), and to withdraw capital from foreign equity markets in periods of foreign crises (fickleness). Experience-based learning generates additional implications regarding the strength of these puzzles in times of higher or lower economic activity and depending on the demographic composition of market participants. We test and confirm these predictions in the data.
    Date: 2020–01
  8. By: Chen, Been-Lon; Hu, Yunfang; Mino, Kazuo
    Abstract: The stabilization effect of nonlinear income taxation is addressed in the standard model of small open economy. It is shown that if income taxation schedule is progressive, the small open economy tends hold saddle-point stability. On the other hand, if taxation on the interest income is regressive, then the small open economy may exhibit sunspot-driven fluctuations or it displays a diverging behavior.
    Keywords: Taxation Rule, Stability, Equilibrium Indeterminacy, Small Open Economy
    JEL: E62 F41
    Date: 2019–05–15
  9. By: Eduardo Levy Yeyati; Juan Francisco Gómez
    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 effect s 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
  10. By: Akvile Bertasiute; Domenico Massaro; Matthias Weber
    Abstract: We analyze different behavioral models of expectation formation in a multicountry New Keynesian currency union model. Our analyses yield the following robust results. First, economic integration is of crucial importance for the stability of the economic dynamics in a currency union. Second, when the economic dynamics are unstable, more activist monetary policy does not lead to stable economic dynamics. These findings have natural counterparts in the rational expectations version of the model: there, economic integration is crucial for the determinacy of the equilibrium and when the equilibrium is indeterminate, more activist monetary policy does not lead to a determinate equilibrium. In an application to euro area data, we find that the behavioral macroeconomic model outperforms its rational counterpart in terms of prediction performance.
    Keywords: Behavioral Macroeconomics, Monetary Unions, Determinacy of Equilibria, Reinforcement Learning
    JEL: F45 E52 D84
    Date: 2019–11
  11. By: Harold L. Cole; Dirk Krueger; George J. Mailath; Yena Park
    Abstract: We analyze efficient risk-sharing arrangements when coalitions may deviate. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any deviating coalition rely on a belief in future cooperation, and we treat the contracting conditions of original and deviating coalitions symmetrically. We show that better belief coordination (higher social capital) tightens incentive constraints since it facilitates both the formation of the original as well as a deviating coalition. As a consequence, the payoff of successfully formed coalitions might be declining in the degree of belief coordination and equilibrium allocations might feature resource burning or utility burning.
    JEL: E20
    Date: 2020–01
  12. By: P. Manasse; G. Moramarco; G. Trigilia
    Abstract: This paper studies the impact of political risk on exchange rates. We focus on the Brexit Referendum as it provides a natural experiment where both exchange rate expectations and a time-varying political risk factor can be measured directly. We build a simple portfolio model which predicts that an increase in the Leave probability triggers a depreciation of the British Pound, both on account of exchange rate expectations and of political risk. We estimate the model for multilateral and bilateral British Pound exchange rates. The results confirm the model’s main implications. When we extend the analysis to a portfolio model of multiple currencies, we find that the cross-currencies restrictions implied by the theory are not rejected by our system estimation. Moreover, the joint estimates of the multi-currency model in the presence of time-varying political risk premium are in many cases consistent with the Uncovered Interest Parity.
    JEL: F31 F41 G11 G15
    Date: 2020–02
  13. By: Fernando Broner; Alberto Martin; Lorenzo Pandolfi; Tomas Williams
    Abstract: This paper analyzes the effects on firms of sovereign debt inflows in emerging countries. To deal with the endogeneity between capital inflows and economic activity, we focus on capital inflows driven by countries’ inclusions into well-known local currency sovereign debt market indexes. These events convey little information about the future economic prospects of countries but induce large capital flows from institutional investors tracking the indexes. We show that inclusion-driven flows significantly reduce government bond yields and appreciate the domestic currency. In turn, these flows have heterogenous impact on firms’ stock market returns. Government related firms, financial firms and firms with larger financial constraints experience positive abnormal returns following the announcement of these events. Instead, companies operating in export-intensive sectors have negative abnormal returns. Our findings shed novel light on the channels through which capital inflows to sovereign debt markets affect firms in the economy.
    Keywords: Sovereign debt; capital inflows; exchange rate; government bond yields; external financial dependence
    JEL: F31 F32 F36 G15 G23
    Date: 2019–12

This nep-opm issue is ©2020 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.