Exchange risk and asset returns: A theoretical and empirical study of an open economy asset pricing model

This study develops a consumption-based asset pricing model in which domestic consumers can buy goods from domestic and foreign markets but can only invest in domestic markets. In this model, the exchange rate influences asset prices through the marginal utility of consumption and increases the risks investors face. We find that our model can successfully price the 25 Fama–French portfolios and industry portfolios in the Chinese market, and the exchange rate is an important pricing factor in the unconditional linear model. We also find that the exchange risk is time-varying and countercyclical, which can help to explain the countercyclicality in equity premium.     

The determinants of exit in an open economy

In this paper the determinants of exit are investigated for the manufacturing sector of the United States economy, which has been subjected to growing international influences. The analysis uses United States cross-sectional data. The results of the exit equation suggest that low profitability, declining industry growth, and displacement of incumbents by entrants foster exit. International influences are also seen to have an impact on U.S. manufacturing exit. Specifically, imports into an industry have a small effect on exit and protection has little influence in stemming exit.I would like to thank John Mayo, Don Clark, Ron Shrieves, Robert Feinberg, Joseph Shaanan and an anonymous referee for their comments on earlier drafts of this paper. The views in this paper do not necessarily reflect those of the Commission. The usual caveat applies.     

The dynamics of fiscal policy in an open economy

This paper extends the work of Blinder and Solow, analyzing the dynamics of fiscal policy, to a small open economy having a fixed exchange rate. The model is developed under the assumption that domestic and foreign bonds are imperfect substitutes. The stationary properties of this system are discussed and it is shown how, in general, equilibrium requires both the government budget to be balanced and the balance of payments on current account to be in equilibrium. The stability of the system is analyzed under two extreme assumptions: zero capital mobility and perfect capital mobility. A significant result of the analysis is to show how the appropriate choice of the policy parameters, describing the mode of deficit financing and sterilization policies, is of central importance to the stability of the model.     

Inflation,R&D and growth in an open economy

This study explores the long-run effects of inflation in a two-country Schumpeterian growth model with cash-in-advance constraints on consumption and R&D investment. We find that increasing domestic inflation reduces domestic R&D investment and the growth rate of domestic technology. Given that economic growth in a country depends on both domestic and foreign technologies, increasing foreign inflation also affects the domestic economy. When each government conducts its monetary policy unilaterally to maximize the welfare of domestic households, the Nash-equilibrium inflation rates are generally higher than the optimal inflation rates chosen by cooperative governments who maximize the welfare of both domestic and foreign households. Under the CIA constraint on R&D (consumption), a larger market power of firms amplifies (mitigates) this inflationary bias. We use cross-country panel data to estimate the effects of inflation on R&D and also calibrate the two-country model to data in the Euro Area and the US to quantify the welfare effects of decreasing the inflation rates from the Nash equilibrium to the optimal level.     

Bayesian estimation of an open economy DSGE model with incomplete pass-through

In this paper, we develop a dynamic stochastic general equilibrium (DSGE) model for an open economy, and estimate it on Euro area data using Bayesian estimation techniques. The model incorporates several open economy features, as well as a number of nominal and real frictions that have proven to be important for the empirical fit of closed economy models. The paper offers: i) a theoretical development of the standard DSGE model into an open economy setting, ii) Bayesian estimation of the model, including assessments of the relative importance of various shocks and frictions for explaining the dynamic development of an open economy, and iii) an evaluation of the model's empirical properties using standard validation methods.     

National welfare in an open economy in the presence of foreign-owned factors of production

In the presence of foreign-owned factors of production in the economy, the effect of trade policy changes on national welfare needs to take into account the possible redistributive effect between foreign-owned and domestic factors. Therefore, an otherwise welfare-improving trade liberalization may paradoxically worsen national welfare. This paper analyzes this important, new area of trade theory and establishes the condition under which this paradox of immiserizing trade liberalization arises. The analysis is also applicable to analyzing the effects of external tariff variation in customs unions, with full internal factor mobility, on member countries' welfare.     

The yield curve in a small open economy

Long-term nominal interest rates in a number of inflation-targeting small open economies have tended to be strongly correlated with those of the United States. This observation has recently led support to the view that, in these economies, the long-end of the yield curve has decoupled from its short-end and naturally to a concern that monetary policy may have lost some of its autonomy. We set up and estimate a two-country small open economy model in which the expectations hypothesis and uncovered interest rate parity hold to study the co-movement of long-term nominal interest rates of different currencies. We show that differences in the persistence of domestic and foreign disturbances, a hypothesis for which we find support in recent data, can explain the observed pattern of correlations. These correlations are not evidence of weaker monetary policy.     

The yield curve in a small open economy

Long-term nominal interest rates in a number of inflation-targeting small open economies have tended to be strongly correlated with those of the United States. This observation has recently led support to the view that, in these economies, the long-end of the yield curve has decoupled from its short-end and naturally to a concern that monetary policy may have lost some of its autonomy. We set up and estimate a two-country small open economy model in which the expectations hypothesis and uncovered interest rate parity hold to study the co-movement of long-term nominal interest rates of different currencies. We show that differences in the persistence of domestic and foreign disturbances, a hypothesis for which we find support in recent data, can explain the observed pattern of correlations. These correlations are not evidence of weaker monetary policy.     

Price mechanism and endogenous productivity in an open economy stock‐flow consistent model

This paper combines a Stock‐Flow Consistent open economy two‐country model with the Verdoorn‐Kaldor law, which posits a positive relationship between the rate of growth of output and productivity growth. The model shows the role of endogenous productivity as a shock magnifier and underlines the limits of the mechanisms of adjustment that rely exclusively on the “buffer” provided by flexible exchange rates. It also provides arguments in support of fiscal policy both in the context of flexible exchange rates and fixed exchange rates. Finally, it challenges the sustainability of austerity measures aimed to achieve external balance.     

Time consistency of monetary policy in the open economy

This paper shows that in an open economy time-consistency problems are created not only by nominal government debt, but also by nominal private debt to foreigners. Given any external nominal debt, inflation redistributes wealth between domestic residents and foreigners. A government that cares about the welfare of its residents will be tempted to inflate whenever it or its residents have issued nominal debt to foreigners. An analysis of the U.S. net investment position shows that these international considerations have become increasingly relevant for the United States, because the recent external deficits have largely been financed in nominal terms.     

Monetary policy and welfare in a small open economy

This paper analyzes optimal monetary policy in a small open economy featuring monopolistic competition and nominal rigidities. It shows that the utility-based loss function for this economy can be written as a quadratic expression of domestic inflation, output gap and real exchange rate. The presence of an internal monopolistic distortion and a terms of trade externality drives optimal policy away from domestic inflation targeting and affects the optimal level of exchange rate volatility. When domestic and foreign goods are close substitutes for each other, the optimal policy rule implies lower real exchange rate volatility than a domestic inflation targeting regime. The reverse is true when the elasticity of substitution between goods is low.     

Context in international business: Entrepreneurial internationalization from a distant small open economy

Context matters in International Business, but to what extent does it influence the content of knowledge? This study offers a systematic literature review on the internationalization of New Zealand firms. A geographically isolated small open economy (SMOPEC) with audacious trade aspirations, a strong domestic institutional environment, favorable attitude toward trade, and entrepreneurial small-to-medium size enterprises (SMEs), New Zealand provides an enlightening context to study internationalization. Using a sample of 95 studies, the review identifies antecedents, stimuli, capabilities, strategy, process and outcomes underpinning internationalizing New Zealand firms (INZFs). Context matters but not in the manner anticipated. On one hand research on the internationalization of New Zealand firms is largely congruent with extant knowledge, on the other the New Zealand context shapes uniquely, how and what scholars choose to research.     

Optimal borrowing constraints and growth in a small open economy

Chinese high growth has been accompanied by government restrictions on international borrowing (capital controls). In this paper, we ask: are such restrictions a useful policy tool to facilitate growth? We provide a theory of borrowing constraints on households as a tool to correct a learning-by-doing externality. Borrowing constraints operate as a policy tool through two channels: (i) increasing labor supply and (ii) reallocating labor towards traded goods. We find that welfare gains are closest to that of the First-Best Planner allocation when the externality is not too large. We compute the sequence of optimal constraints along the growth path and show how the use of this policy tool contributes to repressed wages, current account balance, and slow real exchange rate appreciation.     

Optimal borrowing constraints and growth in a small open economy

Chinese high growth has been accompanied by government restrictions on international borrowing (capital controls). In this paper, we ask: are such restrictions a useful policy tool to facilitate growth? We provide a theory of borrowing constraints on households as a tool to correct a learning-by-doing externality. Borrowing constraints operate as a policy tool through two channels: (i) increasing labor supply and (ii) reallocating labor towards traded goods. We find that welfare gains are closest to that of the First-Best Planner allocation when the externality is not too large. We compute the sequence of optimal constraints along the growth path and show how the use of this policy tool contributes to repressed wages, current account balance, and slow real exchange rate appreciation.     

Expectations,monetary policy rules,and macroeconomic stability: Analysis of an open economy with flexible exchange rates

This paper makes use of a dynamic model of an open economy with flexible exchange rates to examine the dynamic characteristics of the system for different specifications of monetary authority behavior. The model contains dynamic adjustment equations for both output and prices. Two policy rules are examined: (a) maintaining a constant nominal money supply growth, and (b) maintaining a constant nominal interest rate. With the former the system is found to be self-equilibrating. The latter, however, could easily give rise to self-perpetuating disequilibrium situations. In both cases expectations play a crucial role in the adjustment process.     

Public inputs and land taxes in a small open economy

In this paper we examine the issues of gains from trade and the welfare effects of trade policies in the presence of public inputs. Based on the formulation of Negishi (Journal of Public Economics 2 (1973), 231–40), we assume that public inputs are financed by a land tax scheme. We show that the welfare effects of trade policies and the desirability of trade depend crucially on the rules of public input provision reflecting different conjectures of the government.