nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2021‒07‒26
eight papers chosen by
Martin Berka
University of Auckland

  1. Foreign Exchange Intervention, Capital Flows, and Liability Dollarization By Paul Castillo; Juan Pablo Medina
  2. U.S. Monetary Policy Spillovers to Emerging Markets: Both Shocks and Vulnerabilities Matter By Shaghil Ahmed; Ozge Akinci; Albert Queraltó
  3. Reputation and Partial Default By Manuel Amador; Christopher Phelan
  4. Fundamentals vs. policies: can the US dollar’s dominance in global trade be dented? By Georgios Georgiadis; Helena Le Mezo; Arnaud Mehl; Cedric Tille
  5. The eurozone: what is to be done? By Minford, Patrick; Ou, Zhirong; Wickens, Michael; Zhu, Zheyi
  6. Oligopoly Banking, Risky Investment, and Monetary Policy By Altermatt, Lukas; Wang, Zijian
  7. Incentive compatible relationship between the ERM II and close cooperation in the Banking Union: the cases of Bulgaria and Croatia By María J. Nieto; Dalvinder Singh
  8. The Anatomy of Sentiment-Driven Fluctuations By Sushant Acharya; Jess Benhabib; Zhen Huo

  1. By: Paul Castillo (Central Bank of Peru); Juan Pablo Medina (Universidad Adolfo Ibanez, Chile)
    Abstract: This paper investigates the relevance of foreign exchange intervention in dealing with the global financial cycle in emerging economies. We show in a VAR analysis that a shock to global capital flows has a sizable effect on economic activity, and this effect is amplified in emerging economies with liability dollarization. However, countries that systematically rely on sterilized foreign exchange intervention display lower output and real exchange rate volatility in response to global capital flows shocks. We then develop a small open economy model with liability dollarization and balance sheets effects calibrated to an emerging economy. The model is consistent with the empirical evidence. Model simulations show that liability dollarization amplifies the effects of the global financial cycle and that foreign exchange intervention can reduce macroeconomic volatility and improve welfare. These results point to the importance of foreign exchange reserves in insulating emerging economies from shocks to global capital flows.
    Keywords: Foreign Exchange Intervention; Global Financial Cycle; Liability Dollarization; Balance Sheet Effects; Emerging Economies
    JEL: E58 F31 F41
    Date: 2021–06–25
  2. By: Shaghil Ahmed; Ozge Akinci; Albert Queraltó
    Abstract: Using a macroeconomic model, we explore how sources of shocks and vulnerabilities matter for the transmission of U.S. monetary changes to emerging market economies (EMEs). We utilize a calibrated two-country New Keynesian model with financial frictions, partly-dollarized balance sheets, and imperfectly anchored inflation expectations. Contrary to other recent studies that also emphasize the sources of shocks, our approach allows the quantification of effects on real macroeconomic variables as well, in addition to financial spillovers. Moreover, we model the most relevant vulnerabilities structurally. We show that higher U.S. interest rates arising from stronger U.S. aggregate demand generate modestly positive spillovers to economic activity in EMEs with stronger fundamentals, but can be adverse for vulnerable EMEs. In contrast, U.S. monetary tightenings driven by a more-hawkish policy stance cause a substantial slowdown in activity in all EMEs. Our model also captures the challenging policy tradeos that EME central banks face. We show that these tradeoffs are more favorable when inflation expectations are well anchored.
    Keywords: Financial frictions; U.S. monetary policy spillovers; Adaptive expectations
    JEL: E32 E44 F41
    Date: 2021–07–15
  3. By: Manuel Amador; Christopher Phelan
    Abstract: This paper presents a continuous-time reputation model of sovereign debt allowing for both varying levels of partial default and full default. In it, a government can be a non-strategic commitment type, or a strategic opportunistic type, and a government's reputation is its equilibrium Bayesian posterior of being the commitment type. Our equilibrium has that for bond levels reachable by both types without defaulting, bigger partial defaults (or bigger haircuts for bond holders) imply higher interest rates for subsequent bond issuances, as in the data.
    JEL: F34 F41
    Date: 2021–07
  4. By: Georgios Georgiadis (European Central Bank); Helena Le Mezo (European Central Bank); Arnaud Mehl (European Central Bank & CEPR); Cedric Tille (Geneva Graduate Institute & CEPR)
    Abstract: The US dollar plays a dominant role in the invoicing of international trade, albeit not an exclusive one as more than half of global trade is invoiced in other currencies. Of particular interest are the euro, with a large role, and the renminbi, with a rising role. These two currencies are well suited to contrast the roles of economic fundamentals and policies, as European policy makers have taken a neutral stance in contrast to the promotion of the international role of the renminbi by the Chinese authorities. We assess the drivers of invoicing using the most recent and comprehensive data set for 115 countries over 1999-2019. We find that standard mechanisms that foster use of a large economy’s currency predicted by theory—i.e. strategic complementarities in price setting and integration in cross-border value chains—underpin use of the dollar and the euro for trade with the United States and the euro area. These mechanisms also support the role of the dollar, but not the euro, in trade between non-US and non-euro area countries, making the dollar the globally dominant invoicing currency. Fundamentals and policies have played a contrasted role for the use of the renminbi. We find that China’s integration into global trade has further strengthened the dominant status of the dollar at the expense of the euro. At the same time, the establishment of currency swap lines by the People’s Bank of China has been associated with increases in renminbi invoicing, with an adverse effect on dollar use that is larger than for the euro.
    Keywords: International trade invoicing, dominant currency paradigm, markets vs. policies
    JEL: F14 F31 F44
    Date: 2021–07–06
  5. By: Minford, Patrick (Cardiff Business School); Ou, Zhirong (Cardiff Business School); Wickens, Michael (Cardiff Business School); Zhu, Zheyi (Cardiff Business School)
    Abstract: We construct a macro DSGE model of the eurozone and its two main regions, the North and the South, with the aim of matching the macro facts of these economies by indirect inference and using the resulting empirically-based model to assess possible new policy regimes. The model we have found to fit the facts suggests that substantial gains in macro stability and consumer welfare are possible if the fiscal authority in each region is given the freedom to respond to its own economic situation. Further gains could come with the restoration of monetary independence to the two regions, in effect creating a second 'southern euro' bloc.
    Keywords: eurozone; macro stability; fiscal policy; monetary independence
    JEL: E32 E52 E62 F41
    Date: 2021–06
  6. By: Altermatt, Lukas; Wang, Zijian
    Abstract: Oligopolistic competition in the banking sector and risk in the real economy are important characteristics of developed economies, but have so far mostly been abstracted from in monetary economics. We build a dynamic general equilibrium model of monetary policy transmission that incorporates both of these features and document that including them leads to important insights in our understanding of the transmission mechanism. Various equilibrium cases can occur, and policies have differing effects in these cases. We calibrate the model to the U.S. economy in 2016-2019 in order to study how changes in the degree of banking competition or the policy rate would have affected equilibrium outcomes. We find that doubling banking competition would have increased welfare by 1.02\%, but at the cost of increasing the probability of bank default from 0.02\% to 0.44\%. We further find that the policy rate was set optimally to minimize the probability of bank default, but that a decrease in the policy rate by 1pp would have increased welfare by 0.40\%. We also show that bank profits are increasing in the policy rate, in particular when interest rates are low. Thus, a 1pp reduction in the policy rate would have reduced profits per bank by 35.5\% in our calibrated economy. Finally, we document that monetary policy pass-through is incomplete under imperfect competition in the banking sector, as a change in the policy rate by 1pp leads to a change of only 0.92pp in the loan rate, while pass-through to the deposit rate is nearly complete for rate increases, but almost zero for rate reductions due to the zero-lower bound.
    Keywords: Oligopoly competition, Risky investment, Monetary policy, Financial intermediation
    Date: 2021–07–13
  7. By: María J. Nieto (Banco de España); Dalvinder Singh (University of Warwick)
    Abstract: The goal of expanding participation in the European Banking Union was to allow the “outs” to enter into close cooperation, but it did not include the simultaneous joining of the Exchange Rate Mechanism (ERM II). Focusing on the cases of Bulgaria and Croatia, this paper attempts to respond to various questions. What is the rationale behind the double requirement of having simultaneously to apply to become a member of the ERM II and to prepare to become a member of the Banking Union via the rule-based “close-cooperation” coordination mechanism between the EU non-euro-area national competent authorities (NCAs) and the European Central Bank (ECB)? Does the integration of close-cooperation countries’ banking systems with the euro-area banking systems support the decision to join the ERM II and “opting in” to the Single Supervisory Mechanism (SSM)? What are the advantages of preparing to become a full member of the euro area and the SSM? It is evident from the research undertaken in this paper that there are clear benefits of close cooperation for these member states whose domestic currencies are already linked to the euro, in view of the dominant position eurozone banks have in their respective domestic markets. It is more difficult for a national central bank or NCA to exercise discretion in implementing ECB decisions once it is committed to the path leading to full European Monetary Union (EMU) membership. Hence the commitment to join the EMU minimises the authority risk for the ECB as well as for the Single Resolution Board, as safeguards become non-significant and termination is not an issue. The uncertainty about the functioning and durability of the close-cooperation arrangement is largely removed.
    Keywords: Banking Union, close cooperation, ERM II
    JEL: E02 E44 F15 G15 G21 H12 K23
    Date: 2021–07
  8. By: Sushant Acharya; Jess Benhabib; Zhen Huo
    Abstract: We show that sentiments—self-fulfilling changes in beliefs that are orthogonal to fundamentals—can drive persistent aggregate fluctuations under rational expectations in a beauty contest game. Such fluctuations can occur even in the absence of exogenous aggregate fundamental shocks. Moreover, sentiments alter the volatility and persistence of aggregate outcomes in response to fundamental shocks. We provide (i) necessary conditions under which sentiments can affect aggregate outcomes in equilibrium and (ii) conditions under which sentiments drive persistent fluctuations and when they only affect aggregate outcomes contemporaneously. We also show that sentiment equilibria are stable under least-squares learning while the fundamental equilibrium is not.
    Keywords: Business fluctuations and cycles; Economic models
    JEL: E20 E32 F44
    Date: 2021–07

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