nep-opm New Economics Papers
on Open Economy Macroeconomics
Issue of 2023‒09‒11
ten papers chosen by
Martin Berka, Massey University

  1. Optimal policy under dollar pricing By Egorov, Konstantin; Mukhin, Dmitry
  2. A Behavioral New Keynesian Model of a Small Open Economy Under Limited Foresight By Seunghoon Na; Yinxi Xie
  3. Integrated Monetary and Financial Policies for Small Open Economies By Mr. Suman S Basu; Ms. Emine Boz; Ms. Gita Gopinath; Mr. Francisco Roch; Ms. Filiz D Unsal
  4. Real exchange rate and international reserves in the era of financial integration By Sy-Hoa Ho; Luu Duc Toan Huynh; Jamel Saadaoui; Gazi Uddin; Joshua Azienman
  5. The Geography of Capital Allocation in the Euro Area By Beck, Roland; Coppola, Antonio; Lewis, Angus; Maggiori, Matteo; Schmitz, Martin; Schreger, Jesse
  6. Climate Defaults and Financial Adaptation By Toan Phan; Felipe Schwartzman
  7. Accessing U.S. Dollar Swap Lines: Macroeconomic Implications for a Small Open Economy By Dominguez, Begona; Gomis-Porqueras, Pedro
  8. The Dominant Currency Financing Channel of External Adjustment By Camila Casas; Sergii Meleshchuk; Mr. Yannick Timmer
  9. Sovereign Debt and Credit Default Swaps By Gaston Chaumont; Grey Gordon; Bruno Sultanum; Elliot Tobin
  10. A HANK² Model of Monetary Unions By Christian Bayer; Alexander Kriwoluzky; Gernot J. Müller; Fabian Seyrich

  1. By: Egorov, Konstantin; Mukhin, Dmitry
    Abstract: Empirical evidence shows that most international prices are sticky in dollars. This paper studies the policy implications of this fact in the context of an open economy model with general preferences, technologies, asset markets, nominal rigidities, and a rich set of shocks. We show that although monetary policy is less efficient and cannot implement the flexible-price allocation, inflation targeting and a floating exchange rate remain robustly optimal in non-US economies. The capital controls cannot unilaterally improve the allocation and are useful only when coordinated across countries. International cooperation benefits other economies, but is not in the self-interest of the United States.
    JEL: E31 E52 F14 F31 F41
    Date: 2023–07–01
  2. By: Seunghoon Na; Yinxi Xie
    Abstract: This paper investigates exchange rate dynamics in open economies by incorporating bounded rationality. We develop a small open-economy New Keynesian model with an incomplete asset market, wherein decision-makers possess limited foresight and can plan for only a finite distance into the future. The equilibrium dynamics depend on the degree of foresight and the decision-makers’ belief-updating behaviors that approximate continuation values at the end of their planning horizons. This limited foresight leads to persistent, non-monotonic forecast errors in the real exchange rate across time horizons and distinguishes between short- and long-term expectations. This framework hence provides a micro-foundation for understanding time-horizon variability in uncovered interest parity puzzles.
    Keywords: Exchange rates; Monetary policy transmission; International topics; Business fluctuations and cycles
    JEL: E43 E70 F31 F41
    Date: 2023–08
  3. By: Mr. Suman S Basu; Ms. Emine Boz; Ms. Gita Gopinath; Mr. Francisco Roch; Ms. Filiz D Unsal
    Abstract: We develop a tractable small-open-economy framework to characterize the constrained efficient use of the policy rate, foreign exchange (FX) intervention, capital controls, and domestic macroprudential measures. The model features dominant currency pricing, shallow FX markets, and occasionally-binding external and domestic borrowing constraints. We characterize the conditions for the “traditional prescription”—relying on the policy rate and exchange rate flexibility—to be sufficient, even if externalities persist. The conditions are satisfied for world interest rate shocks if FX markets are deep. By contrast, we show that to manage non-fundamental inflow surges and taper tantrums related to local currency debt, capital inflow taxes and FX intervention should be used instead of the policy rate and exchange rate flexibility. In the realistic case where countries face both shallow FX markets and external borrowing constraints, we establish that some kinds of FX mismatch regulations may reduce the external debt limit friction but worsen FX market depth. Finally, we show that capital controls and domestic macroprudential measures cease to be perfect substitutes if there is a risk that the domestic borrowing constraint binds as a result of the transmission of the global financial cycle.
    Keywords: integrated policy framework; monetary policy; capital controls; foreign exchange intervention; macroprudential policies
    Date: 2023–08–04
  4. By: Sy-Hoa Ho (VNU University of Economics and Business); Luu Duc Toan Huynh (University of Strasbourg and University of Lorraine); Jamel Saadaoui (University of Strasbourg and University of Lorraine); Gazi Uddin (Linköping University); Joshua Azienman (University of Southern California)
    Abstract: The great financial crisis has brought increased attention to the consequences of international reserves holdings. In an era of high financial integration, we investigate the relationship between the real exchange rate and international reserves using nonlinear regressions and panel threshold regressions over 110 countries from 2001 to 2020. We capture the buffer effect of international reserves, which is more pronounced in Europe and Central Asia, above a threshold of 17%. Unlike previous literature, our study shows how financial institution development plays an essential role in explaining the buffer effect of international reserves. Countries with low-developed financial institutions may use the international reserves as a shield to deal with the negative consequences of terms-of-trade shocks on the real exchange rate. We also found that the buffer effect is stronger in countries with intermediate levels of financial openness.
    Date: 2023–08–11
  5. By: Beck, Roland (European Central Bank); Coppola, Antonio (Stanford U); Lewis, Angus (Stanford U); Maggiori, Matteo (Stanford U); Schmitz, Martin (European Central Bank); Schreger, Jesse (Columbia U)
    Abstract: We reassess the pattern of Euro Area financial integration adjusting for the role of “on- shore offshore financial centers†(OOFCs) within the Euro Area. While the Euro Area records large levels of international investment both within and outside of the currency union, much of these flows are intermediated via the OOFCs of Luxembourg, Ireland, and the Netherlands. These countries have dual roles as both hubs of investment fund intermediation and centers of securities issuance by foreign firms. We look through both roles and restate the pattern of Euro Area investment positions by linking fund sector investments to the underlying holders and securities issuance to the ultimate parent firms. Our new estimates of Euro Area investment allow us to document a number of stylized facts. First, the Euro Area’s estimated gross external position is smaller than in official data. Second, the Euro Area is more biased towards euro-denominated assets and away from US dollar and other foreign currency assets than in official data. Third, the Euro Area is less financially integrated than it appears. Fourth, European financial integration occurs disproportionately through securities issued in OOFCs rather than via domestic capital markets. Fifth, there is a North-South bias in Euro Area financial integration whereby Northern European countries are relatively underweight securities issued by Southern European countries.
    JEL: F3 F4 G2 G3
    Date: 2023–05
  6. By: Toan Phan; Felipe Schwartzman
    Abstract: We analyze the relationship between climate-related disasters and sovereign debt crises using a model with capital accumulation, sovereign default, and disaster risk. We find that disaster risk and default risk together lead to slow post-disaster recovery and heightened borrowing costs. Calibrating the model to Mexico, we find that the increase in cyclone risk due to climate change leads to a welfare loss equivalent to a permanent 1% consumption drop. However, financial adaptation via catastrophe bonds and disaster insurance can reduce these losses by about 25%. Our study highlights the importance of financial frictions in analyzing climate change impacts.
    Keywords: climate change; disasters; sovereign default; emerging markets; growth
    JEL: Q54 F41 F44 H63 H87
    Date: 2023–03
  7. By: Dominguez, Begona; Gomis-Porqueras, Pedro
    Abstract: This paper proposes a framework to examine the macroeconomic impact of having U.S. dollar swap arrangements, where domestic and foreign currencies are valued and where agents also have access to domestic short and long-term bonds that have differential pledgeability. Within this environment, we investigate how U.S. dollar swap lines affect inflation and debt dynamics in the small open economy when domestic quantitative easing and standard interest rate management policies are also enacted. We show different combinations of U.S. dollar swap lines, and domestic quantitative easing as well as interest rate management policies can deliver the same steady state. We also find that such policies imply different short-run dynamics. Moreover, we find that traditional stabilization policies are not operative when agents do not consume the first best. When calibrated to Australia during the pandemic and under some conditions, we find that a more favorable swap line (agents in the small open economy can obtain U.S. dollar cheaper than in the forex market) would have allowed to cut back on long-term bond purchases from 35% to 24% of GDP. We also show that swaps and quantitative easing dampen the fiscal eigenvalue, changing the speed of adjustment towards the long run equilibria. Moreover, we find that the region of indeterminacy is enlarged when more liquid quantitative easing policies and more favorable swaps are pursued. Finally, we show that swap lines have a differential impact on domestic and foreign consumption.
    Keywords: swaps, quantitative easing, repos, interest rate management
    JEL: E4 E40 E44 F4 F42
    Date: 2023–08
  8. By: Camila Casas; Sergii Meleshchuk; Mr. Yannick Timmer
    Abstract: We provide evidence of a new channel through which exchange rates affect trade. Using a novel identification strategy that exploits firms’ maturity structure of foreign currency debt around a large depreciation in Colombia, we show that firms experiencing a stronger debt revaluation of dominant currency debt due to a home currency depreciation compress imports relatively more while exports are unaffected. Dominant currency financing does not lead to an import compression for firms that export, hold foreign currency assets, or are active in the foreign exchange derivatives markets, as they are all hedged against a revaluation of their debt. These findings can be rationalized through the prism of a model with costly state verification and foreign currency borrowing. Quantitatively, the dominant currency financing channel explains a significant part of the external adjustment process in addition to the expenditure switching channel. Pricing exports in the dominant currency, instead of the producer’s currency, mutes the effect of dominant currency financing on trade flows.
    Keywords: Imports; Exports; Foreign Currency Exposure; Capital Structure; Exchange Rates; Debt Revaluation; Hedging
    Date: 2023–08–11
  9. By: Gaston Chaumont; Grey Gordon; Bruno Sultanum; Elliot Tobin
    Abstract: ow do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.
    Keywords: sovereign debt; CDS; Directed search; Over-the-counter
    JEL: F34 G12
    Date: 2023–03–14
  10. By: Christian Bayer; Alexander Kriwoluzky; Gernot J. Müller; Fabian Seyrich
    Abstract: How does a monetary union alter the impact of business cycle shocks at the household level? We develop a Heterogeneous Agent New Keynesian model of two countries (HANK2) and show in closed form that a monetary union shifts the adjustment to a shock horizontally—across countries—within the brackets of the union-wide wealth distribution rather than vertically—that is, across the brackets of the union-wide wealth distribution. Calibrating the model to the euro area reveals that a monetary union alters the impact of shocks most strongly in the tails of the wealth distribution but leaves the middle class almost unaffected.
    Keywords: HANK2, OCA theory, Two-country model, monetary union, spillovers, monetary policy, heterogeneity, inequality, households
    JEL: F45 E52 D31
    Date: 2023–08

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