nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2021‒05‒17
twenty papers chosen by
Martin Berka
University of Auckland

  1. The Story of the Real Exchange Rate By Itskhoki, Oleg
  2. How Does International Capital Flow? By Kumhof, Michael; Rungcharoenkitkul, Phurichai; Sokol, Andrej
  3. Why Does Capital Flow from Equal to Unequal Countries? By de Ferra, Sergio; Mitman, Kurt; Romei, Federica
  4. Uncertainty shocks in currency unions By Born, Benjamin; Müller, Gernot; Pfeifer, Johannes
  5. Global Portfolio Rebalancing and Exchange Rates By Camanho, Nelson; Hau, Harald; Rey, Hélène
  6. Optimal bailouts in banking and sovereign crises By Sewon Hur; César Sosa-Padilla; Zeynep Yom
  7. De-Globalisation? Global Value Chains in the Post-COVID-19 Age By Antràs, Pol
  8. Credit default swaps around the world By Bartram, Söhnke M; Conrad, Jennifer; Lee, Jongsub; Subrahmanyam, Marti G.
  9. The mercantile dilemma: formalisations and historical conclusions By Saccal, Alessandro
  10. Specialization, Market Access and Real Income By Bartelme, Dominick; Lan, Ting; Levchenko, Andrei A.
  11. Risk sharing in currency unions: The migration channel By Kohler, Wilhelm; Müller, Gernot J.; Wellmann, Susanne
  12. Relationship stickiness, international trade, and economic uncertainty By Martin, Julien; Mejean, Isabelle; Parenti, Mathieu
  13. Sovereign debt standstills By Juan Carlos Hatchondo; Leonardo Martínez; César Sosa-Padilla
  14. The Puzzling Change in the International Transmission of U.S. Macroeconomic Policy Shocks By Ilzetzki, Ethan
  15. Foreign Shocks as Granular Fluctuations By di Giovanni, Julian; Levchenko, Andrei A.; Mejean, Isabelle
  16. Do exchange rates absorb demand shocks at the ZLB? By Hoffmann, Mathias; Hürtgen, Patrick
  17. Foreign Direct Investment and Innovations: Transmission Dynamics of Persistent Demand and Technology Shocks in a Macro Model By Werner Roeger; Paul J.J. Welfens
  18. The random forest path of real exchange rate misalignments. The Argentinean case By Fernando Zarzosa Valdivia; Maximiliano Micheli
  19. The aggregate-demand doom loop: Precautionary motives and the welfare costs of sovereign risk By Francisco Roldán
  20. Is there consumer risk-pooling in the open economy? The evidence reconsidered By Minford, Patrick; Ou, Zhirong; Zhu, Zheyi

  1. By: Itskhoki, Oleg
    Abstract: The real exchange rate (RER) measures relative price levels across countries, capturing deviations from purchasing power parity (PPP). RER is a key variable in international macroeconomic models as it is central to equilibrium conditions in both goods and asset markets. It is also one of the most starkly-behaved variables empirically, tightly co-moving with the nominal exchange rate and virtually uncorrelated with most other macroeconomic variables, nominal or real. This survey lays out an equilibrium framework of RER determination, focusing separately on each building block and discussing corresponding empirical evidence. We emphasize home bias and incomplete pass-through into prices with expenditure switching and goods market clearing, imperfect international risk sharing, country budget constraint and monetary policy regime. We show that RER is inherently a general-equilibrium variable, which depends on the full model structure and policy regime, and therefore partial theories like PPP are insufficient to explain it. We also discuss issues of stationarity and predictability of exchange rates.
    Keywords: Backus-Smith puzzle; PPP puzzle; real exchange rate
    JEL: E30 F31 F41
    Date: 2020–12
  2. By: Kumhof, Michael; Rungcharoenkitkul, Phurichai; Sokol, Andrej
    Abstract: Understanding gross capital flows is increasingly viewed as crucial for both macroeconomic and financial stability policies, but theory is lagging behind many key policy debates. We fill this gap by developing a 2-country DSGE model that tracks domestic and cross-border gross positions between banks and households, with explicit settlement of all transactions through banks. We formalize the conceptual distinction between cross-border saving and financing, which often move in opposite directions in response to shocks. This matters for at least four policy debates. First, current accounts are poor indicators of financial vulnerability, because in a crisis creditors stop financing debt rather than current accounts, and because following a crisis current accounts are not the primary channel through which balance sheets adjust. Second, we re-interpret the global saving glut hypothesis by submitting that US households do not finance current account deficits with foreigners' physical saving, but with digital purchasing power, created by banks that are more likely to be domestic than foreign. Third, Triffin's current account dilemma is not in fact a dilemma, because the creation of additional US dollars requires dollar credit creation by domestic or foreign banks rather than US current account deficits. Finally, we show that the observed high correlation of gross capital inflows and outflows is overwhelmingly an automatic consequence of double entry bookkeeping, rather than the result of two separate and synchronized sets of economic decisions.
    Keywords: bank lending; current account; global saving glut; Gross capital flows; International Capital Flows; money creation; Sudden stops; Triffin's dilemma
    JEL: E44 E51 F41 F44
    Date: 2020–12
  3. By: de Ferra, Sergio; Mitman, Kurt; Romei, Federica
    Abstract: Capital flows from equal to unequal countries. We document this empirical regularity in a large sample of advanced economies. The capital flows are largely driven by private savings. We propose a theory that can rationalize these findings: more unequal countries endogenously develop deeper financial markets. Households in unequal counties, in turn, borrow more, driving the observed direction of capital flows.
    Keywords: Capital Flows; current account; inequality
    JEL: E21 F32 F41
    Date: 2021–01
  4. By: Born, Benjamin; Müller, Gernot; Pfeifer, Johannes
    Abstract: Uncertainty shocks cause economic activity to contract and more so, if monetary policy is constrained by an effective lower bound on interest rates. In this paper, we investigate whether countries within currency unions are also particularly prone to suffer from the adverse effects of heightened uncertainty because they lack monetary independence. First, we estimate a Bayesian VAR on quarterly time series for Spain. We find that country-specific uncertainty shocks impact economic activity adversely. Second, we calibrate a DSGE model of a small open economy and show that it is able to account for the evidence. Finally, we show that currency-union membership strongly reduces the effects of uncertainty shocks because it anchors long-run expectations of the price level and thus alleviates precautionary price setting in the face of increased uncertainty.
    Keywords: Euro Area; Euro crisis; Exchange Rate Regime; monetary policy; Uncertainty shocks
    JEL: E44 F41
    Date: 2020–12
  5. By: Camanho, Nelson; Hau, Harald; Rey, Hélène
    Abstract: We examine international equity allocations at the fund level and show how excess foreign returns influence portfolio rebalancing, capital flows and currencies. Our equilibrium model of incomplete FX risk trading where exchange rate risk partially segments international equity markets is consistent with the observed dynamics of equity returns, exchange rates, and fund-level capital flows. We document that rebalancing is more intense under higher FX volatility and Â?find heterogeneous rebalancing behavior across different fund characteristics. A granular instrumental variable (GIV) approach identiÂ?es a currency supply elasticity suggesting that an equity outflow shock of US$7.1 billion depreciates the dollar by 1 percent.
    Date: 2020–12
  6. By: Sewon Hur (Federal Reserve Bank of Dallas); César Sosa-Padilla (University of Notre Dame/NBER); Zeynep Yom (Villanova University)
    Abstract: We study optimal bailout policies in the presence of banking and sovereign crises. First, we use European data to document that asset guarantees are the most prevalent way in which sovereigns intervene during banking crises. Then, we build a model of sovereign borrowing with limited commitment, where domestic banks hold government debt and also provide credit to the private sector. Shocks to bank capital can trigger banking crises, with government sometimes finding it optimal to extend guarantees over bank assets. This leads to a trade-off: Larger bailouts relax domestic financial frictions and increase output, but also imply increasing government fiscal needs and possible heightened default risk (i.e., they create a ‘diabolic loop’). We find that the optimal bailouts exhibit clear properties. Other things equal, the fraction of banking losses that the bailouts would cover is: (i) decreasing in the level of government debt; (ii) increasing in aggregate productivity; and (iii) increasing in the severity of the bank- ing crisis. Even though bailouts mitigate the adverse effects of banking crises, we find that the economy is ex ante better off without bailouts: the ‘diabolic loop’ they create is too costly.
    Keywords: Bailouts Sovereign Defaults Banking Crises Conditional Transfers Sovereign-bank diabolic loop
    JEL: E32 E62 F34 F41 G01 G15 H63
    Date: 2021–04
  7. By: Antràs, Pol
    Abstract: This paper evaluates the extent to which the world economy has entered a phase of de-globalisation, and it offers some speculative thoughts on the future of global value chains in the post-COVID-19 age. Although the growth of international trade flows relative to that of GDP has slowed down since the Great Recession, this paper finds little systematic evidence indicating that the world economy has already entered an era of de-globalisation. Instead, the observed slowdown in globalisation is a natural sequel to the unsustainable increase in globalisation experienced in the late 1980s, 1990s and early 2000s. I offer a description of the mechanisms leading to that earlier expansionary phase, together with a discussion of why these forces might have run out of steam, and of the extent to which they may be reversible. I conclude that the main challenge for the future of globalisation is institutional and political in nature rather than technological, although new technologies might aggravate the trends in inequality that have created the current political backlash against globalisation. Zooming in on the COVID-19 global pandemic, I similarly conclude that the current health crisis may further darken the future of globalisation if it aggravates policy tensions across countries.
    Keywords: COVID-19; global value chains; globalisation; trade wars
    JEL: F1 F2 F3 F4 F5 F6
    Date: 2020–11
  8. By: Bartram, Söhnke M; Conrad, Jennifer; Lee, Jongsub; Subrahmanyam, Marti G.
    Abstract: We analyze the impact of the introduction of credit default swaps (CDS) on real decision making within the firm. Our structural model predicts that CDS introduction increases debt capacity more when uncertainty about the credit events that trigger CDS payment is lower. Using a sample of more than 56,000 firms across 51 countries, we find that CDS increase leverage more in legal and market environments where uncertainty regarding CDS obligations is reduced and when property rights are weaker. Our results highlight the importance of legal uncertainty surrounding the interpretation of the underlying trigger events of global credit derivatives.
    Keywords: CDS; credit default swaps; Creditor rights; Financing Policy; Investment policy; Ownership Concentration; Property rights
    JEL: F3 F4 G3
    Date: 2021–01
  9. By: Saccal, Alessandro
    Abstract: The following contributions are hereby worked: one mathematically formalises Mundell’s Impossible trio and Rodrik’s Globalisation paradox, supplying the latter with a taxonomy in terms of the current account; by means of Kaldor’s price endogeneity in output, one proves that external real money market disparity and trade generate external output mismatches and lead to autarky unless offset, using topology and dynamical systems; one characterises transfers and federalism and shows that all unitary states are federal polities and can merge into confederations; one demonstrates that the said external output mismatches can be only eluded via autarky or neutralisation, irrespective of federalism; one discerns artificial currency areas guaranteeing inter-regional external output equality and modern protectionism as two Nash equilibria, especially rationalising the nexus between the Gold standard, the Industrial revolution and the Great divergence therethrough.
    Keywords: autarky; federalism; inefficiency; trilemma.
    JEL: E12 F13 F22 F41 F43 F45 F52 F60 N10 O11 O40
    Date: 2019–07–27
  10. By: Bartelme, Dominick; Lan, Ting; Levchenko, Andrei A.
    Abstract: This paper estimates the impact of external demand shocks on real income. Our empirical strategy is based on a first order approximation to a wide class of small open economy models that feature sector-level gravity in trade flows. The framework allows us to measure foreign shocks and characterize their impact on income in terms of reduced-form elasticities. We use machine learning techniques to group 4-digit manufacturing sectors into a smaller number of clusters, and show that the cluster-level elasticities of income with respect to foreign shocks can be estimated using high-dimensional statistical techniques. We find clear evidence of heterogeneity in the income responses to different foreign shocks. Foreign demand shocks in complex intermediate and capital goods have large positive impacts on real income, whereas impacts in other sectors are negligible. The estimates imply that the pattern of sectoral specialization plays a quantitatively large role in how foreign shocks affect real income, while geographic position plays a smaller role. Finally, a calibrated multi-sector production and trade model can rationalize both the average and the heterogeneity in real income elasticities to foreign shocks under reasonable values of structural parameters.
    Keywords: Gravity; k-means clustering; real income; trade specialization
    JEL: F43 F62
    Date: 2020–12
  11. By: Kohler, Wilhelm; Müller, Gernot J.; Wellmann, Susanne
    Abstract: Country-specific business cycle fluctuations are potentially very costly for member states of currency unions because they lack monetary autonomy. The actual costs depend on the extent to which consumption is shielded from these fluctuations and thus on the extent of risk sharing across member states. The literature to date has focused on financial and credit markets as well as on transfer schemes as channels of risk sharing. In this paper, we show how the standard approach to quantify risk sharing can be extended to account for migration as an additional channel of cross-country risk sharing. In theory, migration should play a key role when it comes to insulating per capita consumption from aggregate fluctuations, and our estimates show that it does so indeed for US states, but not for the members of the Euro area (EA). Consistent with these results, we also present survey evidence which shows that migration rates are about 20 times higher in the US. Lastly, we find, in line with earlier work, that risk sharing is generally much more limited across EA members.
    Keywords: Risk sharing,Currency unions,Labour migration,Migration rates,Euro Area
    JEL: F41 F22 G15 J61
    Date: 2021
  12. By: Martin, Julien; Mejean, Isabelle; Parenti, Mathieu
    Abstract: This paper examines how the degree of stickiness in business relationships influences the real impact of aggregate uncertainty. We first develop a novel index of relationship stickiness (RS) for more than 5,000 HS6 products based on the duration of firm-to-firm trade. The RS measure is derived from a stylized search model in which a higher degree of stickiness implies a lower probability of switching and longer firm-to-firm trade relationships, conditional on match quality. Relationship stickiness shapes the dynamics of firm-to-firm relationships in response to uncertainty shocks. Uncertainty shocks induce a significant and larger decrease in the rate at which new firm-to-firm relationships are formed in high-RS product categories. The relationship between uncertainty and separation rates also varies along the distribution of RS indices, the probability of a trade relationship ending being significantly reduced in sticky-product markets in uncertain times. These results provide evidence that trade of sticky products is characterized by wait-and-see behaviors during uncertainty episodes.
    Keywords: firm-to-firm trade; relationship specificity; uncertainty
    JEL: D22 F14 F44
    Date: 2020–12
  13. By: Juan Carlos Hatchondo (University of Western Ontario); Leonardo Martínez (International Monetary Fund); César Sosa-Padilla (University of Notre Dame / NBER)
    Abstract: As a response to economic crises triggered by COVID-19, sovereign debt standstill proposals emphasize debt payment suspensions without haircuts on the face value of debt obligations. We quantify the effects of standstills using a standard default model. We find that a one-year standstill generates welfare gains for the sovereign equivalent to a permanent consumption increase of between 0.1% and 0.3%, depending on the initial shock. However, except when it avoids a default, the standstill also implies capital losses for creditors of between 9% and 27%, which is consistent with their reluctance to participate in these operations and indicates that this reluctance would persist even without a free-riding or holdout problem. Standstills also generate a form of "debt overhang" and thus the opportunity for a "voluntary debt exchange": complementing the standstill with haircuts could reduce creditors’ losses and simultaneously increase welfare gains. Our results cast doubts on the emphasis on standstills without haircuts.
    Keywords: Debt relief Standstill, Haircuts COVID-19 Default Debt Overhang Voluntary Debt Exchange
    JEL: F34 F41
    Date: 2021–04
  14. By: Ilzetzki, Ethan
    Abstract: We demonstrate a dramatic change over time in the international transmission of US monetary policy shocks. International spillovers from US interest rate policy have had a different nature since the 1990s than they did in post-Bretton Woods period. Our analysis is based on the a panel of 21 high income and emerging market economies. Prior to the 1990s, the US dollar appreciated, and ex-US industrial production declined, in response to increases in the US Federal Funds Rate, as predicted by textbook open economy models. The past decades have seen a shift, whereby increases in US interest rates depreciate the US dollar but stimulate the rest of the world economy. Results are robust to several identification methods. We sketch a simple theory of exchange rate determination in face of interest-elastic risk aversion that rationalizes these findings.
    Keywords: Exchange Rates; International Financial Intermediation; International spillovers; monetary
    Date: 2021–01
  15. By: di Giovanni, Julian; Levchenko, Andrei A.; Mejean, Isabelle
    Abstract: This paper uses a dataset covering the universe of French firm-level sales, imports, and exports over the period 1993-2007 and a quantitative multi-country model to study the international transmission of business cycle shocks at both the micro and the macro levels. The largest firms are both important enough to generate aggregate fluctuations (Gabaix, 2011), and most likely to be internationally connected. This implies that foreign shocks are transmitted to the domestic economy primarily through the largest firms. We first document a novel stylized fact: larger French firms are significantly more sensitive to foreign GDP growth. We then implement a quantitative framework calibrated to the full extent of observed heterogeneity in firm size, exporting, and importing. We simulate the propagation of foreign shocks to the French economy and report one micro and one macro finding. At the micro level heterogeneity across firms predominates: 40 to 85% of the impact of foreign fluctuations on French GDP is accounted for by the "foreign granular residual" -- the term capturing the fact that larger firms are more affected by the foreign shocks. At the macro level, firm heterogeneity dampens the impact of foreign shocks, with the GDP responses 10 to 20% larger in a representative firm model compared to the baseline model.
    Keywords: Aggregate fluctuations; granularity; input linkages; international trade; shock transmission
    JEL: E32 F15 F23 F44 F62 L14
    Date: 2020–11
  16. By: Hoffmann, Mathias; Hürtgen, Patrick
    Abstract: According to the two-country full information New Keynesian model with flexible exchange rates, the real exchange rate appreciates in response to an asymmetric negative demand shock at the zero lower bound (ZLB) and exacerbates the adverse macroeconomic effects. This finding requires inflation expectations to adjust counterfactually large. When modeling inflation expectations consistent with survey expectations using imperfect information, we find that exchange rates can absorb demand shocks at the ZLB. In sharp contrast to the full information model: (i) A negative demand shock concentrated in the home country causes a real exchange rate depreciation that partially absorbs the demand shock. (ii) A VAR with an identified demand shock via sign restrictions is consistent with a real exchange rate depreciation at the ZLB. (iii) When the ZLB is binding in the home country, it is optimal for the foreign policymaker to reduce rather than increase foreign interest rates. (iv) Forward guidance that reveals the true state of the economy exacerbates the negative output gap in the two countries.
    Keywords: monetary policy,inflation expectations,imperfect information,real exchange rates
    JEL: F33 E31 E32
    Date: 2021
  17. By: Werner Roeger (Europäisches Institut für Internationale Wirtschaftsbeziehungen (EIIW)); Paul J.J. Welfens (Europäisches Institut für Internationale Wirtschaftsbeziehungen (EIIW))
    Abstract: A deeper macroeconomic analysis of foreign direct investment (FDI), innovation and other key variables is needed to better understand technology shock effects, transmission dynamics and policy perspectives in open economies. FDI outward stock relative to the source country total capital stock was above 10 percent in nine OECD countries in 2017, including the UK and the US. This paper adds FDI to a standard model with a tradable and a non-tradable sector. Here, we define non-tradable in a broad sense. The non-tradable sector covers those firms which are located in the tradable sector but undertake FDI in order to overcome the costs associated with exports but it also includes firms in the service industry who offer services which are intrinsically non-tradable, but which can be offered internationally via subsidiaries. This relates to traditional services (e.g., in retail) but also to novel digital services. We study how opening up the non-tradable sector to international transactions (via FDI) affects the international transmission of technology shocks and of persistent demand shocks. We consider a wide range of technology shocks differentiated by product and process innovations and by sectoral origin. Product innovations in formerly non-tradable sectors widen the scope in which innovations in one country can be transmitted abroad. One major difference between FDI and trade is the location of production, which induces different international income flows and requires upfront investment in the case of FDI. We show that this has implications for both the current account and the exchange rate. Process innovation in the tradable sector leads to a fall in the terms of trade (ToT) and a real appreciation of the exchange rate, expressed as the ratio between domestic and foreign consumer prices. The opposite sign is due to the Balassa-Samuelson effect. This pattern changes with a total factor productivity (TFP) shock in the non-tradable sector. Now, the ToT increases and the real exchange rate depreciates (aside from a short run appreciation). In the case of product innovations, both ToT and the real exchange rate (RER) behave similarly in both cases. However, the composition of the Current Account (CA) varies. With a process innovation in the export sector, both the trade balance and the primary income balance turn negative while product innovations in the FDI sector make the primary balance positive while the trade balance stays negative. We are especially interested in seeing whether the impulse responses to permanent shocks can tell us something about the reasons for persistent external imbalances in countries like Germany and the United States. For the US we find that product innovations originating from US multinationals, at least qualitatively matches well the negative current account and trade balance and a positive primary income balance. The German/Eurozone CA surplus is less easy to explain by technological factors since in our model all technology shocks are associated with persistent CA deficits. Our model confirms what has been shown in previous studies that the German CA is strongly driven by savings. We add to this the observation that increased savings also shows up in an improved primary income balance, which can indeed be observed for Germany.
    Keywords: FDI, Product innovation, Process Innovation, Demand Shock, DSGE
    JEL: C6 E1 F21 O30 O31 O32
    Date: 2021–04
  18. By: Fernando Zarzosa Valdivia; Maximiliano Micheli
    Abstract: This research studies the dynamics of the misalignments of the purchasing power parity real exchange rate, which are based on equilibrium values measured by the Hodrick and Prescott and the Christiano-Fitzgerald filters. Following a theoretical model, the behaviour of real exchange rate misalignments is featured by Random Forest Models; which is a novelty on these regards. Real exchange rate misalignments, which are of short nature, are explained, in importance order, for their lagged values (up to the third order), the market turbulence index, the nominal exchange rates, the volatility VIX index, the interest rates, the seigniorage and the international reserves. En este trabajo evaluamos la dinámica de los desalíneos del tipo de cambio real, desde un punto de vista teórico y desde una visión práctica aplicando modelos de Bosques Aleatorios. Incorporamos como variables explicativas de dichos desalíneos al índice de turbulencia de mercado (o sus componentes, tipo de cambio nominal, reservas y tasas de interés), la cantidad de dinero, el índice de volatilidad VIX y los rezagos de los desalineos cambiarios. Contribuimos a la literatura tanto en la aplicación del modelo de bosques aleatorios como en la inclusión de variables explanatorias de los desalíneos del tipo de cambio real.
    Keywords: Real exchange rate, Hodrick and Prescott filter misalignment, Christiano-Fitzgerald misalignment, Random Forest, Market turbulence index, volatility VIX index
    JEL: C13 F31 F41
    Date: 2020–11
  19. By: Francisco Roldán (International Monetary Fund)
    Abstract: I examine the role of households' precautionary savings motive in amplifying and propagating changes in sovereign spreads. I study this mechanism in a model where the government of a small open economy borrows from foreigners but the debt is then partially held by heterogeneous domestic savers. In a calibration to Spain in the 2000s, default risk accounts for about half of the output contraction. More generally, sovereign risk exacerbates volatility in consumption over time and across agents, creating large and unequal welfare costs even if default does not materialize.
    Keywords: Sovereign risk default aggregate demand precautionary motives heterogeneous agents
    JEL: E21 F34 H63
    Date: 2021–04
  20. By: Minford, Patrick; Ou, Zhirong; Zhu, Zheyi
    Abstract: We revisit the evidence on consumer risk-pooling and uncovered interest parity. Widely used single equation tests are strongly biased against both. Using the full-model, Indirect Inference test, which is unbiased and has Goldilocks power by Monte Carlo experiments, we find that both the risk-pooling hypothesis and its weaker UIP version are generally accepted as part of a full world DSGE model. The fact that the risk-pooling hypothesis, with its implication of strong cross-border consumer linkage, has passed this test with generally the highest p-value, suggests that it deserves serious attention from policy-makers looking for a relevant model to discuss international monetary and other business cycle issues.
    Keywords: consumer risk-pooling; full-model test; indirect inference; Open economy; UIP
    JEL: C12 E12 F41
    Date: 2021–01

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