The Transmission of International Shocks: A Factor-Augmented VAR Approach

The empirical literature on the transmission of international shocks is based on small -scale VARs. In this paper, we use a large panel of data for 17 industrialized countries to investigate the international transmission mechanism, and revisit the anomalies that arise in the empirical literature. We propose a factor augmented VAR (FAVAR) that extends the model in Bernanke, Boivin, and Eliasz (2005) to the open economy. The main results can be summarized as follows. First, the dynamic effects on the UK economy of an unanticipated fall of short-term interest rates in the rest of the world are: real house price inflation, investment, GDP and consumption growth peak after 1 year, wages peak after 2 years, and CPI and GDP deflator inflation peak during the third year. Second, a positive international supply shock makes the distribution of the components of the UK consumption deflator negatively skewed. Third, in response to a domestic monetary shock, we find little evidence of the exchange rate and liquidity puzzles and little evidence of the forward discount and price anomalies.     

Inflation Differentials between Spain and the EMU: A DSGE Perspective

This paper estimates a dynamic stochastic general equilibrium model of a currency union with nominal rigidities to explain the sources of inflation differentials between the Economic Monetary Union (EMU) and one of its member countries, Spain. The paper finds that productivity shocks account for 85% of the variability of the inflation differential. Demand shocks explain a large fraction of output growth volatility but not variability in inflation differentials. In addition, the estimated model finds evidence that inflation dynamics are different across countries in the nontradable sector only. Finally, the Balassa–Samuelson effect does not appear to be an important driver of the inflation differential during the EMU period.     

The International Dimension of Inflation: Evidence from Disaggregated Consumer Price Data

We estimate the contribution of international common factors to the dynamics of price inflation rates of a cross-section of 948 CPI products in four OECD countries: United States, Germany, France, and United Kingdom. We find two main results. First, on average, and at least in the sample 1991–2004, one international common factor explains between 15% and 30% of the variance of consumer prices (depending on the transformation applied to the data). Given the high level of disaggregation of our panel, this estimate is best viewed as a lower bound for the contribution of international factors to inflation dynamics. Second, we find a strongly positive and statistically significant relationship between exposure of consumer inflation to international shocks and trade openness at the sectoral level. The latter result holds regardless of whether the original data are expressed in local as opposed to common currency.     

Debt, taxes, and international equilibrium

This paper employs an extended Miller model to analyze capital structure decisions of individual firms in a two-country setting. Miller equilibria are generally not consistent with an international equilibrium if the tax subsidy of debt differs across countries. The most obvious reason for differential tax subsidies is differences between national corporate tax rates. We also identify differential tax subsidies of debt if inflation rates differ across countries. For both cases we examine the adjustment process from national equilibria to an international equilibrium without and with barriers to international investment. We derive the relationship between the equilibrium yields on debt and equity in the two countries and discuss the Fisher hypothesis that real returns do not depend upon inflation in a two-country Miller world.     

Does inflation targeting really make a difference? Evaluating the treatment effect of inflation targeting in seven industrial countries

We evaluate the treatment effect of inflation targeting in seven industrial countries that adopted this policy in the 1990s. To address the self-selection problem of policy adoption, we make use of a variety of propensity score matching methods recently developed in the treatment effect literature. Our results show that inflation targeting has no significant effects on either inflation or inflation variability in these seven countries. Further evidence from long-term nominal interest rates and income velocity of money also supports the window-dressing view of inflation targeting.     

Understanding the Backus–Smith puzzle: It's the (nominal) exchange rate,stupid

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3–4), 297–316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to ‘rule of thumb’ consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.     

Inflation dynamics: A cross-country investigation

We document that “persistent and lagged” inflation (with respect to output) is a world-wide phenomenon in that these short-run inflation dynamics are highly synchronized across countries. In particular, the average cross-country correlation of inflation is significantly and systematically stronger than that of output, while the cross-country correlation of money growth is essentially zero. We investigate whether standard monetary models driven by monetary shocks are consistent with the empirical facts. We find that neither the new Keynesian sticky-price model nor the sticky-information model can fully explain the data. An independent contribution of the paper is to provide a simple solution technique for solving general equilibrium models with sticky information.     

International evidence on bond risk premia

This paper revisits the study of time-varying excess bond returns in international bond markets. Using newly available yield curve data from 10 different countries with independent monetary policy, I test the robustness of Cochrane and Piazzesi (2005). For most countries in my sample, I find more modest predictive power for forward rates than originally found by Cochrane and Piazzesi (2005) for the US. Their single-factor model captures well the predictability in international data, and this factor also tends to have a tent-shape in most countries of my sample. CP factors are more idiosyncratic across countries than yields or forward rates. Finally, I show that the recent financial crisis has significantly affected the predictability of excess bond returns.     

Explaining international stock correlations with CPI fluctuations and market volatility

This paper investigates the dynamic correlations among six international stock market indices and their relationship to inflation fluctuation and market volatility. The current research uses a newly developed time series model, the Double Smooth Transition Conditional Correlation with Conditional Auto Regressive Range (DSTCC-CARR) model. Findings reveal that international stock correlations are significantly time-varying and the evolution among them is related to cyclical fluctuations of inflation rates and stock volatility. The higher/lower correlations emerge between countries when both countries experience a contractionary/expansionary phase or higher/lower volatilities.     

Escaping Volatile Inflation

Why has inflation been so stable in developed economies since the early 1990s? In this paper, we answer that the United States and other countries may have escaped from a volatile inflation equilibrium. Our argument builds on the story proposed by Tom Sargent in The Conquest of American Inflation, where the fall in inflation in the 1980s was attributed to changing government beliefs. To explain the escape in inflation volatility, we unwind one of Sargent's simplifications and allow the government to react to some of the shocks in the economy. In this case, when government beliefs turned against the Phillips curve in the 1980s they not only led to an escape from high inflation, but also stopped government using changes in inflation to offset shocks. Inflation and inflation volatility therefore escaped in tandem. Our analysis also sheds some light on why the escape in inflation occurred at the time it did.     

Interest rate co-movements, global factors and the long end of the term spread

The decoupling of US short and long interest rates has been a distinctive feature of the 2000s. We employ recent advances in panel econometrics to document this disconnect for industrial countries and link it to a global latent factor in long term rates. We investigate whether international forces, such as global inflation, global output, or the global savings glut may be behind this global latent factor. The savings glut is the most likely contender, suggesting that reserve accumulation and a search for yield from emerging markets has lowered long rates internationally, driving a wedge between domestic short and long rates.     

Globalization, Macroeconomic Performance, and Monetary Policy

The paper argues that many of the exaggerated claims that globalization has been an important factor in lowering inflation in recent years just do not hold up. Globalization does, however, have the potential to be stabilizing for individual economies and has been a key factor in promoting economic growth. The paper then examines four questions about the impact of globalization on the monetary transmission mechanism and arrives at the following answers: (i) Has globalization led to a decline in the sensitivity of inflation to domestic output gaps and thus to domestic monetary policy? No. (ii) Are foreign output gaps playing a more prominent role in the domestic inflation process, so that domestic monetary policy has more difficulty stabilizing inflation? No. (iii) Can domestic monetary policy still control domestic interest rates and so stabilize both inflation and output? Yes. (iv) Are there other ways, besides possible influences on inflation and interest rates, in which globalization may have affected the transmission mechanism of monetary policy? Yes.     

Modelling sovereign credit spreads with international macro-factors: The case of Brazil 1998–2009

This paper develops a macro-finance model of the Brazilian economy and its sovereign debt markets that allows for domestic and international macroeconomic influences as well as swings in investor confidence. It finds significant evidence of common trends in the US and Brazilian economies and bond markets as well as spillover effects from US inflation and business cycles to the Brazilian economy. The US Fed Funds rate influences Brazilian sovereign spreads, as do Brazilian inflation and policy rates. The Brazilian confidence factor dominates the behavior of the spreads during periods of crisis and we find that it also has a powerful effect on the level and volatility of macroeconomic variables. These results suggest that the macro-finance approach could throw light upon the behavior of other economies that are troubled by sovereign risk.     

Inflation risk and international asset returns

We show that inflation risk is priced in international asset returns. We analyze inflation risk in a framework that encompasses the International Capital Asset Pricing Model (ICAPM) of Adler and Dumas (1983). In contrast to the extant empirical literature on the ICAPM, we relax the assumption that inflation rates are constant. We estimate and test a conditional version of the model for the G5 countries (France, Germany, Japan, the UK, and the US) over the period 1975–1998 and find evidence of statistically and economically significant prices of inflation risk (in addition to priced nominal exchange rate risk). Our results imply a rejection of the restrictions imposed by the ICAPM. In an extension of our analysis to 2003, we show that even after the termination of nominal exchange rate fluctuations in the euro area in 1999, differences in inflation rates across countries entail non-trivial real exchange rate risk premia.     

Domestic variance and international comovement bonds tests of interest rates

This article demonstrates that long rates exhibit both domestic excess variance and international excess comovement compared to fundamental yields derived from short rates under the rational expectations theory of term structure. The results are consistent for all countries sampled: the US, UK, Canada, Germany, and Japan. Probing deeper, long rates are found to “overreact” to domestic expected future inflation and/or short real rates both of which are the underlying components of the short nominal rate according to the Fisher hypothesis. Since inflation rates as well as short real rates are highly correlated between countries, the excess volatility in long rates translates into excess covariance (“co-overreact”) internationally.     

International transmission of inflation among G-7 countries: A data-determined VAR analysis

We investigate the international transmission of inflation among G-7 countries using data-determined vector autoregression analysis, as advocated by Swanson and Granger [Swanson, N., Granger, C., 1997. Impulse response functions based on a causal approach to residual orthogonalization in vector autoregressions. Journal of the American Statistical Association 92, 357–367]. Over the period 1973–2003, we find that unexpected changes in US inflation have large effects on inflation in other countries, although they are not always the dominant international factor. Similarly, shocks to some other countries also have a statistically and economically significant influence on US inflation. Moreover, our evidence indicates that US inflation has become less vulnerable to foreign shocks since the early 1990s, mainly because of the diminished influence from Germany and France.     

Purchasing power,interest rate parities and the modified Fisher effect in presence of tax agreements

This paper shows that in a world with different rates of inflation and taxation, in the presence of an international tax agreement, the simultaneous coexistence of the purchasing power parity mechanism, the interest rate parity mechanism, and the revised Fisher effect is impossible. The analysis reveals a possible inherent instability of interest rates and exchange rates generated by inflation. This instability is greater the larger the tax rate differentials among countries.     

The Impact of Macroeconomic and Financial Variables on Market Risk: Evidence from International Equity Returns

Using a GARCH approach, we estimate a time–varying two–factor international asset pricing model for the weekly equity index returns of 16 OECD countries. We find significant time–variation in the exposure (beta) of country equity index returns to the world market index and in the risk–adjusted excess returns (alpha). We then explain these world market betas and alphas using a number of country–specific macroeconomic and financial variables with a panel approach. We find that several variables including imports, exports, inflation, market capitalisation, dividend yields and price–to–book ratios significantly affect a country's exposure to world market risk. Similar conclusions are obtained by using lagged explanatory variables, and thus these variables may be useful as predictors of world market risks. Several variables also significantly impact the risk–adjusted excess returns over this time period. Our results are robust to a number of alternative specifications. We further discuss some economic hypotheses that may explain these relationships.     

Testing Commitment Models of Monetary Policy: Evidence from OECD Economies

Inflation in many Organisation for Economic Co-operation and Development (OECD) countries was low in the 1960s, rose for a time before peaking in the 1970s or early 1980s, and then fell back to initial levels. This paper shows that a simple time inconsistency model of monetary policy does not explain OECD inflation outcomes, except in the United States. The hypothesis that time inconsistency mattered only in earlier decades fits the data no better than the baseline model. We find some, albeit limited support for a model in which inflation spills over from the United States into other countries as a result of exchange rate targeting.     

Time-Varying Expected Returns in International Bond Markets

This article examines the predictable variation in long-maturity government bond returns in six countries. A small set of global instruments can forecast 4 to 12 percent of monthly variation in excess bond returns. The predictable variation is statistically and economically significant. Moreover, expected excess bond returns are highly correlated across countries. A model with one global risk factor and constant conditional betas can explain international bond return predictability if the risk factor is proxied by the world excess bond return, but not if it is proxied by the world excess stock return.