nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2022‒07‒18
eight papers chosen by
Martin Berka
Massey University

  1. Exchange rate disconnect in general equilibrium By Itskhoki, Oleg; Mukhin, Dmitry
  2. Numerical Fiscal Rules for Economic Unions: the Role of Sovereign Spreads By Juan Carlos Hatchondo; Leonardo Martinez; Francisco Roch
  3. The Currency Channel of the Global Bank Leverage Cycle By Justine Pedrono
  4. Robust Optimal Macroprudential Policy By Federico Bennett; Giselle Montamat; Francisco Roch
  5. Who Holds Sovereign Debt and Why It Matters By Xiang Fang; Bryan Hardy; Karen K. Lewis
  6. On Wars, Sanctions and Sovereign Default By Javier Bianchi; Cesar Sosa-Padilla
  7. The Path to Kina Convertibility: An Analysis of Papua New Guinea’s Foreign Exchange Market By Davies, Martin; Schröder, Marcel
  8. European Stabilization Policy After the Covid-19 Pandemic: More Flexible Integration or More Federalism? By Andersson, Fredrik N. G.; Jonung, Lars

  1. By: Itskhoki, Oleg; Mukhin, Dmitry
    Abstract: We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comove-ment with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.
    JEL: F3 G3 J1
    Date: 2021–08–01
  2. By: Juan Carlos Hatchondo (Western University); Leonardo Martinez (IMF); Francisco Roch (IMF)
    Abstract: We study gains from introducing a common numerical fiscal rule in a “Union” of model economies facing sovereign default risk. We show that among economies in the Union, there is significant disagreement about the common debt limit the Union should implement: the limit preferred by some economies can generate welfare losses in other economies. In contrast, a common sovereign spread limit results in higher welfare across economies in the Union.
    Keywords: Fiscal Rules, Sovereign Spread, Spread Limit, Debt Dilution, Debt Intolerance
    JEL: F34 F41
    Date: 2022–06
  3. By: Justine Pedrono
    Abstract: The amplitude of leverage procyclicality is heterogeneous across banks and across countries. This paper introduces international diversification of bank balance sheet as a factor of this observed heterogeneity, with a special emphasis on currency diversification. Based on a new theoretical framework, it shows that the impact of international diversification on leverage procyclicality depends on the relative performance of economies, the global business cycle and the exchange rate regime. By altering the distribution of global bank portfolio, international diversification adds a currency channel to the risk channel of the global leverage cycle. Using granular data on banks located in France, the paper shows that the pre-crisis international diversification of banks increased leverage procyclicality during the 2008-2009 crisis. Focusing on the currency channel, namely the valuation effect of currency diversification, results show that it had a negative effect on leverage procyclicality during this period, hence decreasing procyclicality. The currency channel contributed to offset part of the increased risk due to the crisis and the risk channel. These findings draw attention to the specific role of balance sheet currency diversification in financial stability risk.
    Keywords: Bank, Financial Cycles, Leverage, Internationalization, International Portfolio, Currency
    JEL: E32 F34 F36 F44 G15 G20
    Date: 2022
  4. By: Federico Bennett (Duke University); Giselle Montamat (Uber); Francisco Roch (IMF)
    Abstract: We consider how fear of model misspecification on the part of the planner and/or the households affects welfare gains from optimal macroprudential taxes in an economy with occasionally binding collateral constraints as in Bianchi (2011). In this setup, the decentralized equilibrium may differ from the social planner’s equilibrium both because of the pecuniary externalities associated with the collateral constraint and because of the paternalistic imposition of the planner’s beliefs when designing policy. When robust agents have doubts about the model, they create endogenous worst-case beliefs by assigning a high probability to low-utility events. The ratio of worst-case beliefs of the planner over the household’s captures the degree of paternalism. We show that this novel channel could render the directions of welfare gains from a policy intervention ambiguous. However, our quantitative results suggest that doubts about the model need to be large in order to make a “laissez-faire regime” better than an intervention regime.
    Keywords: Robust Control, Model Uncertainty, Optimal Taxation, Sudden Stops, Financial Crises
    JEL: D62 E32 E44 E62 F32 F41 G01 H21
    Date: 2022–05
  5. By: Xiang Fang; Bryan Hardy; Karen K. Lewis
    Abstract: This paper studies the impact of investor composition on the sovereign debt market and the implied funding costs to borrowers. We construct an aggregate data set of sovereign debt holdings by foreign and domestic bank, non-bank private, and official investors for 95 countries over twenty years. We find that private non-bank investors absorb most of the increase in sovereign debt supply. We further find that foreign non-bank investor demand is most responsive to the yield for emerging market (EM) debt, while yield elasticity for all investors is much lower for advanced economy debt. We show that EM sovereigns are highly vulnerable to losing their foreign non-bank investors.
    JEL: F34 F41 G11 G15
    Date: 2022–05
  6. By: Javier Bianchi (Federal Reserve Bank of Minneapolis); Cesar Sosa-Padilla (University of Notre Dame)
    Abstract: This paper explores the role of restrictions on the use of international reserves as economic sanctions. We develop a simple model of the strategic game between a sanctioning (creditor) country and a sanctioned (debtor) country. We show how the sanctioning country should impose restrictions optimally, internalizing the geopolitical benefits and the financial costs of a potential default from the sanctioned country.
    Date: 2022–06
  7. By: Davies, Martin (Washington and Lee University); Schröder, Marcel (Asian Development Bank)
    Abstract: Papua New Guinea (PNG) has faced a foreign exchange (forex) shortage since 2015. To protect reserves, the Bank of PNG has resorted to forex rationing that led to a large backlog of orders and import compression. This paper surveys the structure of PNG’s forex market and analyzes recent market conditions. We argue that the various policy proposals being discussed currently in PNG are inadequate to restore currency convertibility. For this, a real exchange rate depreciation is required instead. We develop a forex market model that features a backlog of unmet orders, which suggests that a frontloaded depreciation is preferred to an often-favored gradual adjustment. Empirical results indicate that the government’s large budget deficits have contributed to the forex shortage, which highlight the need for greater fiscal restraint. In the longer term, we argue for more exchange rate flexibility and forex allocation through competitive auction.
    Keywords: foreign exchange shortage; foreign exchange rationing; currency convertibility; Papua New Guinea
    JEL: F31 O23 Q32
    Date: 2022–06–03
  8. By: Andersson, Fredrik N. G. (Department of Economics, Lund University); Jonung, Lars (Department of Economics, Lund University)
    Abstract: Crises are a major driving force behind cooperation in the European Union. This holds also for monetary and fiscal policy. During severe crises, cooperation has been enlarged and intensified. The recent covid-19 pandemic is a clear example of this pattern. The pandemic has had huge impact on the conduct of stabilization policies in the EU. Public debt has grown rapidly in many EU member states. The ECB has carried out a highly expansionary monetary policy. In this paper, we discuss the implications for the EU of a move towards increased fiscal federalism following the pandemic. First, the role of crises as a driver of political change is analysed. Next, we examine in greater detail, the effect of crises on the design of stabilisation policies in the EU since the introduction of the euro, the common currency. Finally, we discuss the significance of the recent pandemic-induced steps towards increased federalism for the EU. We raise the question as to whether this is a desirable path for the future of European cooperation.
    Keywords: Monetary policy; fiscal policy; fiscal rules; stabilization policy; European Union; ECB; crises
    JEL: E60 F42 H60
    Date: 2022–06–21

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