nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2021‒05‒24
nineteen papers chosen by
Martin Berka
University of Auckland

  1. Reserve Accumulation, Macroeconomic Stabilization, and Sovereign Risk By Javier Bianchi; César Sosa Padilla
  2. Exchange Rates and Prices: Evidence from the 2015 Swiss Franc Appreciation By Auer, Raphael; Burstein, Ariel Tomas; Lein, Sarah
  3. FX policy when financial markets are imperfect By Matteo Maggiori
  4. Barriers to Global Capital Allocation By Bruno Pellegrino; Enrico Spolaore; Romain Wacziarg
  5. Mr. Keynes Meets the Classics: Government Spending and the Real Exchange Rate By Benjamin Born; Francesco D’Ascanio; Gernot J. Müller; Johannes Pfeifer; Johannes Pfeiffer
  6. Central bank digital currency in an open economy By Ferrari, Massimo; Mehl, Arnaud; Stracca, Livio
  7. A Counterfactual Economic Analysis of Covid-19 Using a Threshold Augmented Multi-Country Model By Chudik, Alexander; Mehdi, Raissi; Mohaddes, Kamiar; Pesaran, M Hashem; Rebucci, Alessandro
  8. The empirical dimension of overborrowing By Damián Pierri; Gabriel Montes Rojas; Pablo Mira-Llambi
  9. The Global Factor Structure of Exchange Rates By Korsaye, Sofonias Alemu; Trojani, Fabio; Vedolin, Andrea
  10. Interest Rate Uncertainty and Sovereign Default Risk By Alok Johri; Shahed Khan; César Sosa-Padilla
  11. The Economics of Currency Risk By Hassan, Tarek Alexander; Zhang, Tony
  12. Globalization and Pandemics By Antràs, Pol; Redding, Stephen J.; Rossi-Hansberg, Esteban
  13. Dominant Currencies: How firms choose currency invoicing and why it matters By Amiti, Mary; Itskhoki, Oleg; Konings, Jozef
  14. Dominant currency dynamics: Evidence on dollar-invoicing from UK exporters By Crowley, Meredith A; Han, Lu; Son, Minkyu
  15. International Evidence on Shock-Dependent Exchange Rate Pass-Through By Forbes, Kristin; Hjortsoe, Ida; Nenova, Tsvetelina
  16. Capital account liberalisation in a large emerging economy: An Analysis of onshore-offshore arbitrage By Nidhi Aggarwal; Sanchit Arora; Rajeswari Sengupta
  17. Prospect Theory and Currency Returns: Empirical Evidence By Kozhan, Roman; Taylor, Mark P; Xu, Qi
  18. Exchange Rate Prediction with Machine Learning and a Smart Carry Trade Portfolio By Filippou, Ilias; Rapach, David; Taylor, Mark P; Zhou, Guofu
  19. Exchange Rate Shocks and Quality Adjustments By Goetz, Daniel; Rodnyansky, Alexander

  1. By: Javier Bianchi (Federal Reserve Bank of Minneapolis); César Sosa Padilla (University of Notre Dame/NBER)
    Abstract: In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. We propose a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we show that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. Reserves increase debt sustainability to such an extent that financing reserves with debt accumulation may not necessarily lead to increases in spreads. We also study simple and implementable rules for reserve accumulation. Our findings sug- gest that a simple linear rule linked to spreads can achieve significant welfare gains, while those rules currently used in policy studies of reserve adequacy can be counterproductive.
    Keywords: International reserves Sovereign default Macroeconomic stabilization Fixed exchange rates Inflation targeting
    JEL: F32 F34 F41
    Date: 2020–12
  2. By: Auer, Raphael; Burstein, Ariel Tomas; Lein, Sarah
    Abstract: We dissect the impact of a large and sudden exchange rate appreciation on Swiss border import prices, retail prices, and consumer expenditures on domestic and imported non-durable goods, following the removal of the EUR/CHF floor in January 2015. Cross-sectional variation in border price changes by currency of invoicing carries over to consumer prices and allocations, impacting retail prices of imports and competing domestic goods, as well as import expenditures. We provide measures of the sensitivity of retail import prices to border prices and the sensitivity of import shares to relative prices, which is higher when using retail prices than border prices.
    Keywords: exchange rate pass-through; Expenditure Switching; invoicing currency; large exchange rate shock; nominal rigidities; Optimal price-setting
    JEL: F12 F31 F41 L11
    Date: 2020–10
  3. By: Matteo Maggiori
    Abstract: In the last 15 years, central banks have purchased securities at unprecedented levels via quantitative easing and foreign exchange intervention. These policies have constituted the core response to crises such as the 2008–09 Great Financial Crisis, the 2011–12 European sovereign debt crisis and the ongoing Covid-19 pandemic. In many cases, policymakers have resorted to these policies as traditional monetary policy was constrained by the zero lower bound. In this paper, I review recent advances in open economy analysis with financial frictions. This type of analysis offers a different take on exchange rates compared with their traditional role as shock absorbers. When international financial intermediation is imperfect, the exchange rate is pinned down by imbalances in the demand and supply of assets in different currencies and, crucially, by the limited risk-bearing capacity of the financial intermediaries that absorb these imbalances. Exchange rates are distorted by financial forces and can be a source of shocks to the real economy rather than a re-equilibrating mechanism.
    JEL: E44 F31 F32 F41 G15
    Date: 2021–05
  4. By: Bruno Pellegrino; Enrico Spolaore; Romain Wacziarg
    Abstract: We quantify the impact of barriers to international investment, using a novel multi-country dynamic general equilibrium model with heterogeneous investors and imperfect capital mobility. Our model yields a gravity equation for bilateral foreign asset positions. We estimate this gravity equation using recently developed foreign investment data that have been restated to account for offshore investment and financing vehicles. We show that a parsimonious implementation of the model with four barriers (geographic distance, cultural distance, foreign investment taxation, and political risk) accounts for a large share of the observed variation in bilateral foreign investment positions. Our model predicts (out of sample) a significant home bias, higher rates of return on capital in emerging markets, as well as “upstream” capital flows. In our benchmark calibration, we estimate that the capital misallocation induced by these barriers reduces World GDP by 7%, compared to a situation without barriers. We also find that barriers to global capital allocation contribute significantly to cross-country inequality: the standard deviation of log capital per employee is 80% higher than it would be in a world without barriers to international investment, while the dispersion in output per employee is 42% higher.
    Keywords: capital allocation, capital flows, foreign investment, culture, geography, gravity, international macroeconomics, international finance, misallocation, open economy
    JEL: E22 E44 F20 F30 F40 G15 O40
    Date: 2021
  5. By: Benjamin Born; Francesco D’Ascanio; Gernot J. Müller; Johannes Pfeifer; Johannes Pfeiffer
    Abstract: In economies with fixed exchange rates, the adjustment to government spending shocks is asymmetric. A fiscal expansion appreciates the real exchange rate but does not stimulate output. A fiscal contraction does not alter the exchange rate, but lowers output. We develop these insights in a two-sector model of a small open economy with downward nominal wage rigidity. We establish new empirical evidence that supports he predictions of the model along several dimensions: not only does the exchange rate regime shape the fiscal transmission mechanism as predicted by the model – in doing so it also interacts with economic slack and inflation.
    Keywords: Downward nominal wage rigidity, government spending shocks, exchangerate peg, real exchange rate, nonlinear effects, asymmetric adjustment, depreciation bias
    JEL: E62 F41 F44
    Date: 2021
  6. By: Ferrari, Massimo; Mehl, Arnaud; Stracca, Livio
    Abstract: We examine the open-economy implications of the introduction of a central bank digital currency (CBDC). We add a CBDC to the menu of monetary assets available in a standard two-country DSGE model and consider a broad set of alternative technical features in CBDC design. We analyse the international transmission of standard monetary policy and technology shocks in the presence and absence of a CDBC and the implications for optimal monetary policy and welfare. The presence of a CBDC amplifies the international spillovers of shocks to a significant extent, thereby increasing international linkages. But the magnitude of these effects depends crucially on CBDC design and can be significantly dampened if the CBDC possesses specific technical features. We also show that domestic issuance of a CBDC increases asymmetries in the international monetary system by reducing monetary policy autonomy in foreign economies.
    Keywords: Central bank digital currency; DSGE model; international monetary system; open-economy; Optimal monetary policy
    JEL: E50 F30
    Date: 2020–10
  7. By: Chudik, Alexander; Mehdi, Raissi; Mohaddes, Kamiar; Pesaran, M Hashem; Rebucci, Alessandro
    Abstract: This paper develops a threshold-augmented dynamic multi-country model (TGVAR) to quantify the macroeconomic effects of Covid-19. We show that there exist threshold effects in the relationship between output growth and excess global volatility at individual country levels in a significant majority of advanced economies and in the case of several emerging markets. We then estimate a more general multi-country model augmented with these threshold effects as well as long term interest rates, oil prices, exchange rates and equity returns to perform counterfactual analyses. We distinguish common global factors from trade-related spillovers, and identify the Covid-19 shock using GDP growth forecast revisions of the IMF in 2020Q1. We account for sample uncertainty by bootstrapping the multi-country model estimated over four decades of quarterly observations. Our results show that the Covid-19 pandemic will lead to a significant fall in world output that is most likely long-lasting, with outcomes that are quite heterogenous across countries and regions. While the impact on China and other emerging Asian economies are estimated to be less severe, the United States, the United Kingdom, and several other advanced economies may experience deeper and longer-lasting effects. Non-Asian emerging markets stand out for their vulnerability. We show that no country is immune to the economic fallout of the pandemic because of global interconnections as evidenced by the case of Sweden. We also find that long-term interest rates could fall significantly below their recent lows in core advanced economies, but this does not seem to be the case in emerging markets.
    Keywords: COVID-19; Global Volatility; international business cycle; Threshold Effects; Threshold-augmented Global VAR (TGVAR)
    JEL: C32 E44 F44
    Date: 2020–09
  8. By: Damián Pierri (Universidad de Buenos Aires/UdeSA/CONICET); Gabriel Montes Rojas (Universidad de Buenos Aires/CONICET); Pablo Mira-Llambi (Universidad de Buenos Aires/CONICET)
    Abstract: Persistent current account deficits are common among low and middle income countries. We evaluate when this situation is danger- ous. We find a critical value for the yearly current account deficit just before the crisis sets o? and these findings give rise to an empirical measure of overborrowing: countries that have increased their exter- nal indebtedness by at least 26%-31% of the GDP in a time span of 3 to 5 years are more prone to be hit by a sudden stop. The typi- cal crisis produces a consumption drop of 4% of GDP and a current account reversal of 2.5-4.5% of GDP. We also contribute to the struc- tural characterization of sudden stops. Using a canonical model we are able to replicate these stylized facts. Moreover, we compute the corresponding ratio of net debt to GDP. This parameter is two or three times bigger than the benchmark value in the literature, a fact that improves the empirical performance of the model. From a policy perspective, our findings help to elaborate leading indicators to antic- ipate a sudden stop.
    Keywords: sudden stops Current account deficits Debt Crisis
    JEL: F32 F41
    Date: 2020–09
  9. By: Korsaye, Sofonias Alemu; Trojani, Fabio; Vedolin, Andrea
    Abstract: We provide a model-free framework to study the global factor structure of exchange rates. To this end, we propose a new methodology to estimate international stochastic discount factors (SDFs) that jointly price cross-sections of international assets, such as stocks, bonds, and currencies, in the presence of frictions. We theoretically establish a two-factor representation for the cross-section of international SDFs, consisting of one global and one local factor, which is independent of the currency denomination. We show that our two-factor specification prices a large cross-section of international asset returns, not just in- but also out-of-sample with R2s of up to 80%.
    Keywords: Capital Flows; factor models; Financial Frictions; incomplete markets; International Asset Pricing; Lasso; Market Segmentation; regularization; Stochastic discount factor
    JEL: F31 G15
    Date: 2020–10
  10. By: Alok Johri (McMaster University); Shahed Khan (University of Western Ontario); César Sosa-Padilla (University of Notre Dame/NBER)
    Abstract: International data suggests that fluctuations in the level and volatility of the world interest rate (as measured by the US treasury bill rate) are positively correlated with both the level and volatility of sovereign spreads in emerging economies. We incor- porate an estimated time-varying process for the world interest rate into a model of sovereign default calibrated to a panel of emerging economies. Time variation in the world interest rate interacts with default incentives in the model and leads to state con- tingent effects on borrowing and sovereign spreads which resemble those found in the data. The model delivers up to one-half of the positive comovement between the level and volatility of world interest rate and the level of sovereign spreads seen in emerg- ing economies. Moreover, the model also delivers significant positive co-movements between the volatility of the spread and the process for the world interest rate which is also consistent with the data. Our model provides one potential source for the observed bunching in default probabilities observed across nations, namely the world interest rate process. Our model generates a positive and significant correlation (0.51) between the spreads of two nations with uncorrelated income processes. This is close to the observed mean correlation in the data (0.61).
    Keywords: Sovereign Debt Sovereign Default Interest Rate Spread Time-varying Volatility Uncertainty Shocks
    JEL: F34 F41 E43 E32
    Date: 2020–12
  11. By: Hassan, Tarek Alexander; Zhang, Tony
    Abstract: This article reviews the literature on currency and country risk with a focus on its macroeconomic origins and implications. A growing body of evidence shows countries with safer currencies enjoy persistently lower interest rates and a lower required return to capital. As a result, they accumulate relatively more capital than countries with currencies international investors perceive as risky. Whereas earlier research focused mainly on the role of currency risk in generating violations of uncovered interest parity and other financial anomalies, more recent evidence points to important implications for the allocation of capital across countries, the efficacy of exchange rate stabilization policies, the sustainability of trade deficits, and the spillovers of shocks across international borders.
    Keywords: Capital Flows; carry trade; Country risk; currency risk; Forward premium puzzle; uncovered interest parity
    Date: 2020–09
  12. By: Antràs, Pol; Redding, Stephen J.; Rossi-Hansberg, Esteban
    Abstract: We develop a model of human interaction to analyze the relationship between globalization and pandemics. Our framework provides joint microfoundations for the gravity equation for international trade and the Susceptible-Infected-Recovered (SIR) model of disease dynamics. We show that there are cross-country epidemiological externalities, such that whether a global pandemic breaks out depends critically on the disease environment in the country with the highest rates of domestic infection. A deepening of global integration can either increase or decrease the range of parameters for which a pandemic occurs, and can generate multiple waves of infection when a single wave would otherwise occur in the closed economy. If agents do not internalize the threat of infection, larger deaths in a more unhealthy country raise its relative wage, thus generating a form of general equilibrium social distancing. Once agents internalize the threat of infection, the more unhealthy country typically experiences a reduction in its relative wage through individual-level social distancing. Incorporating these individual-level responses is central to generating large reductions in the ratio of trade to output and implies that the pandemic has substantial effects on aggregate welfare, through both deaths and reduced gains from trade.
    Keywords: Globalization; Gravity Equation; Pandemics; SIR model
    JEL: F15 F23 I10
    Date: 2020–09
  13. By: Amiti, Mary; Itskhoki, Oleg; Konings, Jozef
    Abstract: The currency of invoicing in international trade is central for the international transmission of shocks and macroeconomic policies. Using a new dataset on currency invoicing for Belgian firms, we analyze how firms make their currency choice, for both exports and imports, and the implications of this choice for exchange rate pass-through into prices and quantities. We derive our estimating equations from a theoretical framework that features variable markups, international input sourcing, and staggered price setting with endogenous currency choice, and also allowing for the dominant currency choice. Our structural specification provides a new test of the allocative consequences of nominal rigidities, by estimating the treatment effect of foreign-currency price stickiness on the dynamic response of prices and quantities to exchange rate changes, controlling for the endogeneity of the firm's currency choice. We show that flexible-price determinants of exchange rate pass-through are also the key firm characteristics that determine currency choice. In particular, small non-importing firms tend to price their exports in euros (producer currency) and exhibit close to complete exchange-rate pass-through into destination prices at all horizons. In contrast, large import-intensive firms tend to denominate their exports in foreign currencies, and especially in the US dollar, exhibiting a lower pass-through of the euro-destination exchange rate and a pronounced sensitivity to the dollar-destination exchangerate. Finally, the effects of foreign-currency price stickiness are still significant beyond the one-year horizon, but gradually dissipate in the long run, consistent with sticky price models of currency choice.
    Keywords: currency choice; exchange rate pass-through
    JEL: E31 F31 F41
    Date: 2020–10
  14. By: Crowley, Meredith A; Han, Lu; Son, Minkyu
    Abstract: How do the choices of individual firms contribute to the dominance of a currency in global trade? Using export transactions data from the UK over 2010-2016, we document strong evidence of two mechanisms that promote the use of a dominant currency: (1) prior experience: the probability that a firm invoices its exports to a new market in a dominant currency is increasing in the number of years the firm has used the dominant currency in its existing markets; (2) strategic complementarity: a firm is more likely to invoice its exports in the currency chosen by the majority of its competitors in a foreign destination market in order to stabilize its residual demand in that market.
    Keywords: Exchange rate; firm-level trade; invoicing currency; Vehicle currency
    JEL: F14 F31 F41
    Date: 2020–11
  15. By: Forbes, Kristin; Hjortsoe, Ida; Nenova, Tsvetelina
    Abstract: We analyse the economic conditions (the "shocks") behind currency movements and show how that analysis can help address a range of questions, focusing on exchange rate pass-through to prices. We build on a methodology previously developed for the United Kingdom and adapt this framework so that it can be applied to a diverse sample of countries using widely available data. The paper provides three examples of how this enriched methodology can be used to provide insights on pass-through and other questions. First, it shows that exchange rate movements caused by monetary policy shocks consistently correspond to significantly higher pass-through than those caused by demand shocks in a cross-section of countries, confirming earlier results for the UK. Second, it shows that the underlying shocks (especially monetary policy shocks) are particularly important for understanding the time-series dimension of pass-through, while the standard structural variables highlighted in previous literature are most important for the cross-section dimension. Finally, the paper explores how the methodology can be used to shed light on the effects of monetary policy and the debate on "currency wars": it shows that the role of monetary policy shocks in driving the exchange rate has increased moderately since the global financial crisis in advanced economies.
    Keywords: Currency wars; Exchange rate; inflation; monetary policy; Pass-Through; Price level
    JEL: E31 E37 E52 F47
    Date: 2020–09
  16. By: Nidhi Aggarwal (Indian Institute of Management, Udaipur); Sanchit Arora (Ernst and Young); Rajeswari Sengupta (Indira Gandhi Institute of Development Research)
    Abstract: In this paper, we decipher the openness of India's capital account by calculating the covered interest parity (CIP) deviations between the onshore-offshore rupee market. India is a country with an elaborate and comprehensive system of capital controls covering all kinds of international financial transactions. This has led to a thriving offshore rupee market of non-deliverable currency forward (NDF) contracts. We analyse more than 20 years (1999- 2020) of daily return differentials in the NDF market vis-a-vis the onshore spot market, estimate structural breaks in CIP deviations and connect these sub-periods to the patterns of changes in de-jure capital control actions announced by the Indian authorities. We also estimate no-arbitrage bands around the CIP using a Self-Exciting Threshold Autoregressive (SETAR) model. We find that on average over the duration of our sample period the capital controls broadly restrict capital outflows more than they restrict capital inflows. We also find that over time India has become more financially integrated with the rest of the world, though the process of capital account opening has not been a continuous and smooth one. This is reflected in large variations in CIP deviations across the period, and in recent times, smaller deviations and narrowing no-arbitrage bands that capture the transactions costs and the degree to which the capital controls are binding.
    Keywords: Capital account openness, Financial integration, Covered interest parity, Capital controls, Foreign exchange market
    JEL: G15 F30 F31 F32
    Date: 2021–04
  17. By: Kozhan, Roman; Taylor, Mark P; Xu, Qi
    Abstract: We empirically investigate the role of prospect theory in the foreign exchange market. Using the historical distribution of exchange rate changes, we construct a currency-level measure of prospect theory value and find that it negatively forecasts future currency excess returns. High prospect theory value currencies significantly underperform low prospect theory value currencies. The predictability is higher when arbitrage is limited and during periods of excess speculative demand of ir- rational traders. These findings are consistent with the hypothesis that investors mentally represent currencies by their historical distributions or charts and evaluate the distribution in the way described by prospect theory.
    Keywords: currency returns; foreign exchange; Limits to Arbitrage; prospect theory
    JEL: F31 G12 G15 G40
    Date: 2020–09
  18. By: Filippou, Ilias; Rapach, David; Taylor, Mark P; Zhou, Guofu
    Abstract: We establish the out-of-sample predictability of monthly exchange rate changes via machine learning techniques based on 70 predictors capturing country characteristics, global variables, and their interactions. To guard against overfi tting, we use the elastic net to estimate a high-dimensional panel predictive regression and find that the resulting forecast consistently outperforms the naive no-change benchmark, which has proven difficult to beat in the literature. The forecast also markedly improves the performance of a carry trade portfolio, especially during and after the global financial crisis. When we allow for more complex deep learning models, nonlinearities do not appear substantial in the data.
    Keywords: carry trade; deep neural network; Elastic Net; exchange rate predictability
    JEL: C45 F31 F37 G11 G12 G15
    Date: 2020–09
  19. By: Goetz, Daniel; Rodnyansky, Alexander
    Abstract: Do firms respond to cost shocks by reducing the quality of their products? Using microdata from a large Russian retailer that refreshes its product line twice-yearly, we document that higher quality products are more profitable than lower quality ones, but that the number of high quality products offered experiences a relative decrease after a large ruble devaluation in 2014. We show that rising firm costs-and not shrinking consumer incomes-explains the reallocation, and rationalize the data with a simple model that features consumer expenditure switching between high and low qualities. The reallocation to lower quality products reduces average pass-through by 15%.
    Keywords: crisis; Demand estimation; Devaluations; exchange rate pass-through; Quality
    JEL: E30 F14 F31 L11 L15 L16 L81 M11
    Date: 2020–09

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