Monetary policy and noise traders: A welfare analysis

This paper studies the choice of monetary policy regime in a small open economy with noise traders in forex markets. We focus on two simple rules: fixed exchange rates and inflation targeting. We contrast the above two rules against optimal policy with commitment under productivity shocks. In general, the presence of noise traders increases the desirability of a fixed exchange rate regime. We also evaluate the welfare impact of Tobin taxes in this milieu. These taxes help unambiguously in the absence of productivity shocks; their welfare impact under productivity shocks depends on the monetary regime in place and trade elasticity between domestic and foreign goods.     

Productivity Shocks and Monetary Policy in a Two-Country Model

In this paper, we examine the effects of foreign productivity shocks on monetary policy in a symmetric open economy. Our two-country model incorporates the New Keynesian features of price stickiness and monopolistic competition based on the cost channel of Ravenna and Walsh (2006). In particular, in response to asymmetric productivity shocks, firms in one country achieve a more efficient level of production than those in another economy. Because the terms of trade are directly affected by changes in both economies’ output levels, international trade creates a transmission channel for inflation dynamics in which a deflationary spiral in foreign producer prices reduces domestic output. When there is a decline in economic activity, the monetary authority should react to this adverse situation by lowering the key interest rate. The impulse response function from the model shows that a productivity shock can cause a real depreciation of the exchange rate when economies are closely integrated through international trade.     

Optimal exchange rate policy for a small oil-exporting country: A dynamic general equilibrium perspective

This paper examines the choice of optimal exchange rate regime for an oil-exporting small open economy using a welfare-based model. The paper extends the standard New Keynesian Small Open Economy model to include three countries: a small oil-exporting country and two large foreign countries. The model also features three sectors: traded, non-traded, and primary-commodity (crude-oil). The sources of uncertainty are random monetary (demand), productivity (real), and real oil price (supply) shocks. Despite the absence of a non-oil traded sector in this primary-commodity economy, the welfare analysis suggests that flexible exchange rate regimes can reduce external shocks and consumption volatility given certain caveats about pricing-schemes. The analysis also suggests that a basket peg is more welfare-improving than a unilateral peg, as higher volatility of the anchor currency reduces consumer welfare.     

Flexible exchange rates as shock absorbers

In this paper we analyze empirically the effect of terms of trade shocks on economic performance under alternative exchange rate regimes. We are particularly interested in investigating whether terms of trade disturbances have a smaller effect on growth in countries with a flexible exchange rate arrangement. We also analyze whether negative and positive terms of trade shocks have asymmetric effects on growth, and whether the magnitude of these asymmetries depends on the exchange rate regime. We find evidence suggesting that terms of trade shocks get amplified in countries that have more rigid exchange rate regimes. We also find evidence of an asymmetric response to terms of trade shocks: the output response is larger for negative than for positive shocks. Finally, we find evidence supporting the view that, after controlling for other factors, countries with more flexible exchange rate regimes grow faster than countries with fixed exchange rates.     

Foreign Money Shocks and the Welfare Performance of Alternative Monetary Policy Regimes*

The welfare properties of monetary policy regimes for a country subject to foreign money shocks are examined in a two‐country sticky‐price model. Money targeting is found to be welfare superior to a fixed exchange rate when the expenditure switching effect of exchange rate changes is relatively weak, but a fixed rate is superior when the expenditure switching effect is strong. However, price targeting is superior to both these regimes for all values of the expenditure switching effect. A welfare‐maximising monetary rule yields lower output and exchange rate volatility than price targeting for a wide range of parameter values.     

Spillover effects of fiscal policy in a monetary union: Why do fiscal instruments matter?

Using a two‐country DSGE model, we analyse the spillover effects of fiscal policy in a monetary union. Based on a non‐Walrasian labour market with a labour force participation decision and involuntary unemployment and a detailed fiscal sector, we focus on the relative cross‐border effects of different kinds of fiscal shocks (government expenditure and tax shocks). Among the major lessons from this analysis, five general and striking results are worth highlighting : (1) spillover effects differ widely according to the fiscal instrument, (2) all fiscal instruments produce positive spillover effects on foreign GDP except a rise in government consumption, (3) the response of unemployment is not always negatively correlated with the response of output (4) the different fiscal shocks trigger different effects on foreign inflation and the term of trade, which implies heterogeneous interest‐rate and trade channels, and (5) a more accommodative monetary policy and a scenario of ‘fiscal dominance’ alter greatly the effects of fiscal policy shocks.     

Insulation properties of separating exchange markets

Insulation properties play an important role for countries in favour of separating rates for separating transactions. Such properties insulate the open economy from monetary and real shocks, of domestic and foreign origins. Through theoretical and numerical analyses, we find that in a unified flexible exchange rate system, portfolio holders' expectations drive the price adjustment, leading to expectations of exchange rate changes. In separating exchange markets, the financial rate reflects the instability of portfolio holders' expectations and capital flows; however, the real exchange rate and hence the macroeconomy is stable. Uncertainty of shocks ceases to affect the real sector of the economy.     

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility

This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. The traditional approach maintains that exchange-rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price response to exchange-rate changes—specifically, that there appears to be a large degree of local-currency pricing (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries.     

FINANCIAL MARKET INTEGRATION AND BUSINESS CYCLE VOLATILITY IN A MONETARY UNION

This paper uses a dynamic general equilibrium two‐country sticky‐price model to analyze the implications of financial market integration for the propagation of asymmetric productivity and government spending shocks in a monetary union. Financial market integration has a small effect on the propagation of these shocks if households can only trade in risk‐free bonds. However, financial market integration has a more substantial effect on the propagation of these shocks in a monetary union with a complete market for state‐contingent claims. This result indicates that it may be important to account for threshold effects in empirical analyses of the impact of financial market integration on business cycle volatility in a monetary union.     

The optimal choice of monetary policy instruments in a small open economy

Abstract.  This paper studies how the nature of shocks affects the optimal choice of monetary policy instruments in a small open economy. Three classic rules, fixed exchange rates, monetary targeting, and inflation targeting are studied and ranked by comparing with the optimal monetary policy under commitment. We find that the ranking of the simple rules can be mapped to the terms-of-trade variability that the rule allows relative to what a particular shock optimally calls for. It turns out that inflation targeting dominates the other two rules under productivity or velocity shocks, whereas monetary targeting is the best performer under fiscal shocks.     

Real exchange rates,asset prices and terms of trade: A theoretical analysis

This paper develops a continuous-time two-country dynamic equilibrium model, in which the real exchange rates, asset prices, and terms of trade are jointly determined in the presence of nontradable goods. The model determines the relation between the financial markets and real goods markets in the world economy and their responses to various shocks under the home bias assumption. A positive domestic supply shock induces a positive return on the domestic asset markets and a deterioration of terms of trade that improves the foreign output and boosts the foreign asset markets. Demand shocks act in the opposite way. This model also analyses the impact of change in the relative price of nontradable to tradable goods on the terms of trade and asset markets. A higher productivity growth in tradable goods than in nontradable goods leads to a higher relative price of nontradable to tradable goods, which appreciates the real exchange rate, deteriorates the terms of trade, and depresses the domestic and foreign asset markets. A lower relative price of nontradable goods depreciates the real exchange rate, improves the terms of trade, and lifts both the domestic and foreign asset markets.     

Openness and the case for flexible exchange rates

Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the [Corsetti Giancarlo, and Paolo Pesenti. 2001. Welfare and Macroeconomic Interdependence. Quarterly Journal of Economics 116 (2), 421–446.] model to allow for home bias in consumption—so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in home bias: with asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: in our specification each country produces an equal share of the world value added; the lower the import content of consumption, the higher the exchange rate volatility implied by optimal stabilization rules. In relatively closed economy, optimal monetary rules tend to converge, regardless of the nature of nominal rigidities in the exports market.     

Asymmetric responses of money demand to oil price shocks in Saudi Arabia: a non-linear ARDL approach

Saudi Arabia is an open oil-based economy with fixed exchange rates; therefore, it has limited monetary policy autonomy. Using non-linear autoregressive distributed lag approach, this article investigates the asymmetric effects of oil price shocks on the demand of money in Saudi Arabia over the period 1990:Q1–2014:Q4. The empirical results show evidence of positive long run but asymmetric effects of oil price shocks on the money demand. In particular, we find that the positive oil price shocks are more important than negative shocks. Therefore, two policy responses can be considered: either sustaining the fixed exchange rate regime and following an economic diversification policy or switching towards a flexible exchange rate regime to achieve price stability. In that case, the existence of a stable money demand function in Saudi Arabia is a necessary precondition for adopting a monetary policy strategy targeted to price stability using instruments like money targeting.     

Supply shocks and the interdependence of macroeconomic stability under flexible exchange rates

This paper analyzes the effects of a change in the monetary policy of a large economy on the macroeconomic stability of a small open economy with high dependence on imported intermediate goods. The analysis is carried out using the Taylor framework where the money supply rule is specified by the degree of monetary accommodation of price shocks. A supply shock to the large country is transmitted as both demand and supply shocks to the small country. A shift toward less monetary accommodation by the large country is shown to increase both price and output instability in the small country through the supply side linkage, while it may enhance price or output stability through the demand side linkage. Simulation results for Germany and Japan suggest that the supply side effect on price stability is important and that the effect on output stability depends crucially on the importance of trade in goods between the large country and the country in question.     

Balance-of-payments anti-crises

China and Switzerland have recently experienced foreign exchange reserve accumulation far in excess of what would be implied by the literature on optimal reserves. Using a dynamic general equilibrium model, we show that the credible expectation of an upper limit to how many reserves a country is willing to accumulate would lead to a balance-of-payments anti-crisis. This is characterized by an accelerated pre-crisis accumulation of foreign exchange reserves, followed by a collapse of the monetary target that is instantaneous under exchange rate targeting and gradual under price level targeting. We argue that Switzerland has recently experienced such an event.     

Analysis of shock transmissions to a small open emerging economy using a SVARMA model

Using a parsimonious structural vector autoregressive moving average (SVARMA) model, we analyse the transmission of foreign and domestic shocks to a small open emerging economy under different policy regimes. Narrower confidence bands around the SVARMA responses compared to the SVAR responses, advocate the suitability of this framework for analysing the propagation of economic shocks over time. Malaysia is an interesting small open economy that has experienced an ongoing process of economic transition and development. The Malaysian government imposed exchange rate and capital control measures following the 1997 Asian financial crisis. Historical decomposition and variance decomposition allow contrast of shocks propagating under different policy regimes. Malaysia is highly exposed to foreign shocks, particularly under the managed float exchange rate system. During the pegged exchange rate period, Malaysian monetary policymakers experienced some breathing space to focus on maintaining price and output stability. In the post-pegged period, Malaysia's exposure to foreign shocks increased and in recent times are largely driven by world commodity price and global activity shocks.     

Exchange Rate Volatility and Output Volatility: A Theoretical Approach*

This paper makes an attempt to determine the factors influencing exchange rate and exchange rate uncertainty, as well as output and output variability. In the context of a small open economy under flexible exchange rates regime it is found that the level both of exchange rate and output is affected by monetary and inflationary shocks, as well as shocks in government spending, output, and trade balance. Further, the uncertainty of exchange rate and output is associated positively with the uncertainty of all shocks while the contemporaneous occurrence of selected shocks imposes either a positive or negative impact on exchange rate and output volatility. Finally, it is shown that the effect of the determinants either of exchange rate volatility or output volatility is very sensitive to the parameter values.     

Asset prices, exchange rates and the current account

This paper analyses the role of asset prices in comparison to other factors, in particular exchange rates, as a driver of the US trade balance. It employs a Bayesian structural VAR model that requires imposing only a minimum of economically meaningful sign restrictions. We find that equity market shocks and housing price shocks have been major determinants of the US current account in the past, accounting for up to 30% of the movements of the US trade balance at a horizon of 20 quarters. By contrast, shocks to the real exchange rate have been less relevant, explaining about 9% and exerting a more temporary effect on the US trade balance. Our findings suggest that large exchange rate movements may not necessarily be the key element of an adjustment of today's large current account imbalances, and that in particular relative global asset price changes could be a potent source of adjustment.     

International finance in general equilibrium

Our purpose in this paper is to unify international trade and finance in a single general equilibrium model. Our model is rich enough to include multiple commodities (including traded and nontraded goods), heterogeneous consumers in each country, multiple time periods, multiple credit markets, and multiple currencies. Yet our model is simple enough to be effectively computable. We explicitly calculate the financial and real effects of changes in tariffs, productivity, and preferences, as well as the effects of monetary and fiscal policy.We maintain agent optimization, rational expectations, and market clearing (i.e. perfect competition with flexible prices) throughout. But because of the important role money plays, and because of the heterogeneity of markets and agents, we find that fiscal and monetary policy both have real effects. The effects of policy on real income, long-term interest rates, and exchange rates are qualitatively identical to those suggested in Mundell-Fleming (without the small country hypothesis), although our equilibrating mechanisms are different. However, because the Mundell-Fleming model ignores expectations and relative price changes, our model predicts different effects on the flow of capital, the balance of trade, and real exchange rates in some circumstances.     

Monetary Policy Rules for a Small Open Economy

In this paper, the optimal choice of a monetary target is investigated for a small open economy that is subject to foreign monetary policy shocks. In contrast to large parts of the literature, pegging the exchange rate is never the best policy choice for the small open economy in our model. Instead, monetary targeting and, depending on the parameter combination, producer price index targeting come closest to the optimal policy rule in terms of welfare. Generally, the welfare performance of the simple targeting rules under consideration hinge critically on the degree of pass-through in the home economy and in the rest of the world.