Asset price dynamics,inflation and sectoral composition of output: a dependent economy model

This article develops a dependent economy model that focuses on the interactions between inflation and asset price dynamics under a flexible exchange rate and rational expectation. We assume that money wage adjusts instantaneously to clear the labour market. The asset prices are represented by the Tobin’s q and exchange rate. Using this framework, we will examine implications of monetary policy, fiscal policy, tariff liberalization and exogenous capital flows for inflation and asset prices, which in turn determine the allocation of labour and the sectoral composition of output. The effects of different exogenous and policy-induced shocks critically depend on the difference in the speeds of adjustment in commodity price and asset prices and multiple cross effects generated by changes in these prices.     

Asset Prices,News Shocks,and the Trade Balance

We analyze the relationship between asset prices and the trade balance estimating a Bayesian VAR for a broad set of 38 industrialized and emerging market countries. To derive model‐based identifying restrictions, we model asset price shocks as news shocks about future productivity in a two‐country dynamic stochastic general equilibrium model. Such shocks are found to exert sizable effects on the trade balance. Moreover, the effects are highly heterogeneous across countries. For instance, following a news shock that implies on impact a 10% increase in domestic equity prices relative to the rest of the world, the U.S. trade balance will worsen by up to 1.0 percentage points, but much less so for most other economies. We find that this heterogeneity appears to be linked to the financial market depth and equity home bias of countries. Moreover, the channels via wealth effects and via the real exchange rate are important for understanding the heterogeneity in the transmission.     

Capital inflows and asset prices: Evidence from emerging Asia

The withdrawal of foreign capital from emerging countries at the height of the recent financial crisis and its quick return sparked a debate about the impact of capital flow surges on asset markets. This paper addresses the response of property prices to an inflow of foreign capital. For that purpose we estimate a panel VAR on a set of Asian emerging market economies, for which the waves of inflows were particularly pronounced, and identify capital inflow shocks based on sign restrictions. Our results suggest that capital inflow shocks have a significant effect on the appreciation of house prices and equity prices. Capital inflow shocks account for – roughly – twice the portion of overall house price changes they explain in OECD countries. We also address cross-country differences in the house price responses to shocks, which are most likely due to differences in the monetary policy response to capital inflows.     

Stabilizing non-fundamental asset price movements under discretion and limited information

Inflation, output and interest rate stabilization are all potential central bank objectives. We explore whether monetary policy should respond to asset price fluctuations when they are driven by irrational expectational shocks to the future returns to capital. In our model, an optimistic shock to future returns generates both an increase in equity prices and physical investment. The increased investment is inefficient and, thus, a central bank optimally responds to this expectations shocks. This induces a trade-off between stabilizing nominal prices and non-fundamental asset price movements. We compare the optimal policy under different assumptions: full versus limited information and commitment versus discretion. If the central bank has limited information about whether an asset price movement has a fundamental or non-fundamental origin, then the central bank responds less aggressively to the non-fundamental exuberance shocks than under full information. Without commitment, a central bank responds more aggressively to non-fundamental exuberance shocks.     

Drivers of Exchange Rate Dynamics in Selected CIS Countries: Evidence from a Factor-Augmented Vector Autoregressive (FAVAR) Analysis

We investigate the likely sources of exchange rate dynamics in selected member countries of the Commonwealth of Independent States (CIS; Russia, Kazakhstan, Ukraine, Kyrgyzstan, Azerbaijan, and Moldova) over the past decade (1999-2010). Evidence is based on country VARs augmented by a regional common-factor structure (FAVAR model). The models include nominal exchange rates, the common factor of exchange rates in the CIS countries, and international drivers such as global trade, share prices, and oil price. Global, regional, and idiosyncratic shocks are identified in a standard Cholesky fashion. Their relevance for exchange rates is explored by a decomposition of the variance of forecast errors. The impact of global shocks on the development of exchange rates has increased, particularly if financial shocks are considered. Because of the recent global financial crisis, regional shocks have become more important at the expense of global shocks.     

Exchange Rates and the Conversion of Currency‐Specific Risk Premia

How do the risk factors that drive asset prices influence exchange rates? Are the parameters of asset price processes relevant for specifying exchange rate processes? Most international asset pricing models focus on the analysis of asset returns given exchange rate processes. Little work has been done on the analysis of exchange rates dependent on asset returns. This paper uses an international stochastic discount factor (SDF) framework to analyse the interplay between asset prices and exchange rates. So far, this approach has only been implemented in international term structure models. We find that exchange rates serve to convert currency‐specific discount factors and currency‐specific prices of risk – a result linked to the international arbitrage pricing theory (IAPT). Our empirical investigation of exchange rates and stock markets of four countries presents evidence for the conversion of currency‐specific risk premia by exchange rates.     

Exchange Rate Pass-Through in a Competitive Model of Pricing-to-Market

This paper extends the Mussa and Rosen (1978) model of quality pricing under perfect competition. Exporters sell goods of different qualities to consumers who have heterogeneous preferences for quality. Production is subject to decreasing returns to scale and, therefore, supply and the toughness of competition react to cost changes brought about by exchange rate fluctuations. First, we predict that exchange rate shocks are imperfectly passed through into prices. Second, prices of low-quality goods are more sensitive to exchange rate shocks than prices of high-quality goods. Third, in response to an exchange rate appreciation, the composition of exports shifts toward higher quality and more expensive goods. We test these predictions using highly disaggregated price and quantity U.S. import data and find only weak empirical evidence in support of our theory.     

Oil price shocks and their transmission mechanism in an oil-exporting economy: A VAR analysis informed by a DSGE model

This paper examines the macroeconomic effects of oil price shocks and the oil shock transmission mechanism in an oil-exporting country, Canada. We use a structural VAR with sign restrictions that comes from a two-country dynamic stochastic general equilibrium (DSGE) model to jointly identify oil price, domestic supply and U.S. and domestic monetary policy shocks. This identification strategy not only controls for reverse causality from the Canadian and U.S. macroeconomic conditions to the real oil prices, but more importantly, it also allows for contemporaneous interactions between the Canadian and U.S. variables. We find that oil shocks have a stimulative effect on Canadian aggregate demand, appreciate the Canadian dollar, improve the terms of trade and reduce real wages. Foreign disturbances, including innovations in oil prices and the U.S. interest rate, have a significant influence on Canadian economic activities. Our counterfactual analysis indicates that the reaction of the U.S. interest rate as an indirect transmission channel for oil price shocks plays a moderate role in explaining the real exchange rate and inflation, but has negligible impacts on the Canadian output and interest rate.     

General equilibrium pricing with multiple dividend streams and regime switching

In this paper, we investigate a regime switching Lucas economy in continuous time, with multiple dividend streams and labour income. We determine the asset prices in equilibrium in the economy with regime switching, and derive a system of partial differential equations for the asset prices and the short interest rate. The solutions for the endogenous short interest rate, the bond price and the yield of the bond are obtained. We also consider applications of the equilibrium model and show that the model implies a rich framework for the term structure of interest rates. We demonstrate how the regime switching economy helps to improve the model-implied annual excess rate of return. This assists in explaining the famous equity premium puzzle.     

A fundamental theory of exchange rates and direct currency trades

In this paper we construct a two-country search model to determine the nominal exchange rate between two fiat monies. Our model allows agents to use any currency to trade for goods in all countries. However, search frictions restrict agents’ opportunities for instantaneous arbitrage, and hence make the nominal exchange rate determinate. The nominal exchange rate depends on the two countries’ economic fundamentals, including the stocks and growth rates of the two monies. Direct exchanges between currencies are essential and they imply a nominal exchange rate that is different from the relative price between the two currencies in the goods markets. There are persistent violations of the law of one price and purchasing power parity in equilibrium, despite the fact that prices are perfectly flexible and all goods are tradeable between countries. Nominal and real exchange rates can move together in the steady state in response to money growth shocks.     

Analysis of DJIA,S&P 500, S&P 400, NASDAQ 100 and Russell 2000 ETFs and their influence on price discovery

This study examines the temporal behavior of price discovery in the spot, ETF and futures markets of the DJIA, S&P 500, S&P 400, NASDAQ 100 and Russell 2000. We document an increasing trend in the price discovery metrics of exchange traded funds for all indexes but the DJIA. Contrary to past studies, our findings show that the spot market rather than the futures market leads the price discovery. The arbitrage process that links exchange traded funds to spot prices, and not the futures prices might explain the results. This daily arbitrage that ensures exchange traded funds prices equal net asset values appear to promote spot market price discovery especially with the popularity of exchange traded funds in more recent years. We additionally document that the temporal behavior of the exchange traded funds price discovery metric affects differently price discovery in the spot and futures markets across indexes.     

Monetary policy for inattentive economies

We offer a contribution to the analysis of optimal monetary policy. We begin with a critical assessment of the existing literature, arguing that most work is based on implausible models of inflation-output dynamics. We then suggest that this problem may be solved with some recent behavioral models, which assume that price setters are slow to incorporate macroeconomic information into the prices they set. A specific such model is developed and used to derive optimal policy. In response to shocks to productivity and aggregate demand, optimal policy is price level targeting. Base drift in the price level, which is implicit in the inflation targeting regimes currently used in many central banks, is not desirable in this model. When shocks to desired markups are added, optimal policy is flexible targeting of the price level. That is, the central bank should allow the price level to deviate from its target for a while in response to these supply shocks, but it should eventually return the price level to its target path. Optimal policy can also be described as an elastic price standard: the central bank allows the price level to deviate from its target when output is expected to deviate from its natural rate.     

Exchange Rate Pass-Through in an Emerging Market: The Case of the Czech Republic

We examine exchange rate pass-through, or how domestic prices respond to exchange rate shocks, in the Czech Republic from 1998 to 2013 by employing vector autoregression models. Using the aggregate consumer price index and its subcomponents, we find that the peak response occurs between nine and thirteen months after the exchange rate shock. The average pass-through at the monetary policy horizon is approximately 20 percent at the aggregate level. Regarding the subcomponents, the degree of pass-through is greatest for food prices.     

Real exchange rate fluctuations, endogenous tradability and exchange rate regimes

The real exchange rate is driven by fluctuations of the relative price of traded goods and the relative price of nontraded to traded goods. This study explains the variance decomposition of the real exchange rate using a stochastic dynamic general equilibrium model of comparative advantage with money. Given interest rate shocks, exchange rate stability reduces the covariance between the two relative prices and raises the contribution of the relative price of nontraded to traded goods. Productivity shocks do not alter the covariance across exchange rate regimes and let the relative price of traded goods drive the real exchange rate.     

The Impact of House Prices on Consumer Credit: Evidence from an Internet Bank

This paper shows that house price fluctuations can have a significant impact on credit availability. Data from Prosper.com, a peer‐to‐peer lending site that matches borrowers and lenders to provide unsecured consumer loans, indicate that homeowners in states with declining house prices experience higher interest rates, greater credit rationing, and faster delinquency. We find especially large effects for subprime borrowers whose balance sheets are likely most exposed to asset price declines. This evidence suggests that asset price fluctuations can play an important role in determining credit conditions and are thus a potentially significant mechanism for propagating macroeconomic shocks.     

The Credibility of Hong Kong's Link from the Perspective of Modern Financial Theory

Hong Kong's linked exchange rate system (LERS) has been in operation since 1983, during which time many other fixed exchange rate systems have succumbed to shocks and/or speculative attacks. This paper investigates how market participants assessed changes made to the LERS by using the tools of modern finance to extract information from financial asset prices about market expectations. These changes have been characterized as making the system less discretionary over time. We find that decreasing the discretionary element of the LERS led to an increase in credibility of the arrangement.     

Fundamentals and bubbles in asset prices: Evidence from U.S. and Japanese asset prices

This paper investigates the existence and extent of non-fundamental bubbles in both U.S. and Japanese asset prices by employing a flexible empirical method which allows us to decompose asset prices into fundamental and non-fundamental bubble components. This study finds that a substantial fraction of U.S. and Japanese asset prices is accounted for by non-fundamental bubble components and that these asset prices overreact to non-fundamental bubble shocks. In addition, allowing for time-varying interest rates as another fundamental factor does not change any qualitative results about the role of non-fundamental bubble components. This suggests that the present value model fails to explain volatile asset price behavior even with time-varying interest rates. This paper was initially written when I was visiting Keio University in Japan. I benefited from several discussions with Mike Dothan, Pat Hess, and Steve LeRoy in my department, Takashi Kaneko, Yukitami Tsuji and Naoyuki Yoshino at Keio University, and Yong-Seok Park at the International University of Japan. Special thanks are due to the anonymous referee and the editor of this journal, who provided many useful and insightful comments that helped to improve the paper. This research was in part supported by a grant from the International Program Development.     

Financial globalization, financial crises and contagion

Two observations suggest that financial globalization played an important role in the recent financial crisis. First, more than half of the rise in net borrowing of the U.S. non-financial sectors since the mid-1980s has been financed by foreign lending. Second, the collapse of the U.S. housing and mortgage-backed-securities markets had worldwide effects on financial institutions and asset markets. Using an open-economy model where financial intermediaries play a central role, we show that financial integration leads to a sharp rise in net credit in the most financially developed country and to large asset price spillovers of country-specific shocks to bank capital. The impacts of these shocks on asset prices are amplified by bank capital requirements based on mark-to-market.     

违约与杠杆周期——一个带有救助的金融加速器模型

我国为应对2008年国际金融危机的冲击采取了一系列经济刺激政策,在发挥“稳增长”作用的同时,也在一定程度上导致我国企业部门杠杆水平快速上升,但与此同时,不良贷款率并没有随企业部门杠杆的上升而显著增加。为了解释企业部门违约与杠杆的周期特征,本文在金融加速器模型(Bernanke et al.,1999)基础上,引入政府对企业部门的违约救助机制,建立DSGE模型进行讨论。进一步地,本文还通过一个不合意的去杠杆政策试验表明,忽略资产价格稳定(或者说金融稳定)前提下的去杠杆政策,反而会使企业部门的杠杆和违约率同时上升到一个较高水平。最后,引入一个盯住预期资产价格的动态救助规则能够发挥稳定经济的作用,并提高社会福利水平。     

The run-up to the global financial crisis: A longer historical view of financial liberalization,capital inflows,and asset bubbles

Using forecast error and sensitivity analyses with a vector error correction model for the US economy, we find that the specific exogenous shocks that contributed to the run-up to the global financial crisis of 2007–2009 vary across the three time periods (1980–1988; 1989–1997; and 1998–2006) that are known for distinctive historical events. Deregulation in the 1980s and capital inflows in the early and mid-1990s triggered by the collapse of the European exchange rate mechanism contributed significantly to changes in real house prices. However, capital inflows after the Asian financial crises in 1997 were driven in large part by rising asset prices. Thus, there were interesting changes in the nature of exogenous shocks and directions of causality through the three sub-periods. These results are robust even after controlling for the exogenous global factors partly determining short-run changes in capital flows, asset prices, and per capita real GDP. We conclude that all of the short run changes in response to financial deregulation starting in the 1980s, surges in capital inflows in the early 1990s, and people's expectation of ever-rising asset prices in the late 1990s and early 2000s culminated in the crisis of 2007–2009.