Openness and optimal monetary policy

We show that the composition of international trade has important implications for the optimal volatility of the exchange rate, above and beyond the size of trade flows. Using an analytically tractable small open economy model, we characterize the impact of the trade composition on the policy trade-off and on the role played by the exchange rate in correcting for price misalignments. Contrary to models where openness can be summarized by the degree of home bias, we find that openness can be a poor proxy of the welfare impact of alternative monetary policies. Using input–output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. The estimates are used in a richer small-open-economy DSGE model to quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports. We find that the main determinant of the losses is the share of non-traded goods in final demand.     

Currency depreciations, financial transfers, and firm heterogeneity

The present paper investigates five episodes of currency collapse from the perspective of non-financial firms operating in Argentina, Brazil and Mexico. We focus on two aspects: wealth and income transfers from borrowing firms to lenders and firm heterogeneity. At the firm level, we find that the currency collapses are preceded and associated with sharply rising financial transfers from firms to lenders. The debt and income structure is central in explaining the asymmetric firm dynamics. Most affected are firms with high levels of unhedged foreign-currency debt. At the country level, Argentina, Brazil, and Mexico display three contrasting examples. Argentina has a large currency mismatch, Brazil balances the currency denomination of debt and income (natural hedge), and Mexico occupies an intermediate position.     

Long-duration bonds and sovereign defaults

This paper extends the baseline framework used in recent quantitative studies of sovereign default by assuming that the government can borrow using long-duration bonds. This contrasts with previous studies, which assume the government can borrow using bonds that mature after one quarter. We show that, when we assume that the government issues bonds with a duration similar to the average duration of sovereign bonds in emerging economies, the model generates an interest rate that is substantially higher and more volatile than the one obtained assuming one-quarter bonds. This narrows the gap between the predictions of the model and the data, which indicates that the introduction of long-duration bonds may be a useful tool for future research about emerging economies. Our analysis is also relevant for the study of other credit markets.     

International transmission of transitory and persistent monetary shocks under imperfect information

We analyze the transmission of monetary shocks in a new open-economy macroeconomics model with one-period nominal contracts and imperfect information. Shocks may have transitory and persistent components that can be disentangled only through the accumulation of information over time. As a consequence, the responses to shocks are significantly altered compared with the case of full information. There are persistent effects on international relative prices, and delayed exchange-rate overshooting is possible following a persistent shock. In some cases, there are (ex post) excess returns as a positive interest rate spread is accompanied by an appreciating currency (or vice versa). Lastly, it is demonstrated that staggering reinforces persistence.     

Relative price volatility under Sudden Stops: The relevance of balance sheet effects

Sudden Stops are associated with increased volatility in relative prices. We introduce a model based on information acquisition to rationalize this increased volatility. An empirical analysis of the conditional variance of the wholesale price to consumer price ratio using panel ARCH techniques confirms the relevance of Sudden Stops and potential balance sheet effects as key determinants of relative price volatility, where balance sheet effects are captured by the interaction of a proxy for potential changes in the real exchange rate (linked to the degree of external leverage of the absorption of tradable goods) and a measure of domestic liability dollarization.     

News and sovereign default risk in small open economies

This paper builds a unified model of sovereign debt, default risk, and news shocks. News shocks improve the quantitative performance of the sovereign default model in a number of empirically-relevant dimensions. First, with news shocks, not all defaults occur during downturns. Second, the news shocks help account for key differences between developing and more developed economies: as the precision of news improves, the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt in line with more developed economies. Third, the model captures the hump-shaped relationship between default rates and the precision of news obtained from the data. Finally, the news shocks have a nonmonotonic effect on welfare.     

The need for international policy coordination: what's old, what's new, what's yet to come?

The first generation of policy coordination models was introduced some 25 years ago; it provided a rationale for policy coordination, but the gains from coordination were generally thought to be small. Now, a new generation of policy coordination models is emerging, incorporating monopolistic competition and nominal inertia. Here, we examine macroeconomic interdependence and the scope for policy coordination in a tractable second generation model with two countries and multiple sectors. Initial calibration of the model suggests that second generation models may have more scope for policy coordination than did the first.     

Private capital flows, capital controls, and default risk

What has been the effect of the shift in emerging market capital flows toward private sector borrowers? Are emerging market capital flows more efficient? If not, can controls on capital flows improve welfare? This paper shows that the answers depend on the form of default risk. When private loans are enforceable, but there is the risk that the government will default on behalf of all residents, private lending is inefficient and capital controls are potentially Pareto-improving. However, when private agents may individually default, capital flow subsidies are potentially Pareto-improving.     

Business cycles and monetary regimes in emerging economies: A role for a monopolistic banking sector

This study shows that the presence of imperfect competition in the banking system propagates external shocks and amplifies the business cycle. Strategic limit pricing, aimed at protecting retail niches from potential competitors, generates countercyclical bank markups. Markup increments during recessions directly increase borrowing costs for firms and indirectly damage the financial position of firms' balance-sheets, increasing the risk perception of lenders. I use Bayesian techniques and data from Argentina to show that the inclusion of monopolistic banking improves the fit of the New Keynesian small open economy model.     

Monetary policy and exchange rate overshooting: Dornbusch was right after all

Dornbusch's exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has been viewed by some researchers as a “stylized fact” to be reckoned with in policy modelling. However, many of these studies, in particular those using vector autoregressive (VARs) approaches, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restrictions on them. In contrast, we achieve identification by imposing a long-run neutrality restriction on the real exchange rate, thereby allowing for contemporaneous interaction between the interest rate and the exchange rate. In a study of four open economies, we find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate, which appreciates on impact. The maximum effect occurs within 1-2 quarters, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with uncovered interest parity (UIP).     

Expectations and exchange rate dynamics: A state-dependent pricing approach

This paper presents a two-country DSGE model with state-dependent pricing as in Dotsey et al. [Dotsey, M., King, R.G., and Wolman, A.L., 1999. State-dependent pricing and the general equilibrium dynamics of money and output. Quarterly Journal of Economics 114, 655-690] and variable demand elasticity as in Kimball [Kimball, M.S., 1995. The quantitative analytics of the basis neomonetarist model. Journal of Money, Credit, and Banking 27, 1241-1277]. Following a domestic monetary expansion, the model predicts: (i) positive hump-shaped responses of domestic output and consumption, (ii) positive spillover effects on foreign output and consumption, (iii) a high international output correlation relative to consumption correlation, (iv) a delayed increase in domestic and foreign inflation, (v) a delayed nominal exchange rate overshooting, (vi) a deterioration in the terms of trade, and (vii) a J-curve in the trade balance. The model matches the impulse responses from an identified VAR more closely than an otherwise identical model with time-dependent pricing.     

Currency substitution,money growth rules,and the interdependence of monetary policy

This paper examines the interdependence of national monetary policies under flexible exchange rates when national currencies are seen as substitutes for one another. It is shown that the efficacy of a constant monetary growth rule as a means of controlling a country's price level depends on the policies of foreign central banks. These results are in contrast to those found under flexible exchange rates and no currency substitution. The role of monetary growth rules in a world of currency substitution is discussed.     

Composition and growth effects of the current account: A synthesized portfolio view

This paper analyzes a useful accounting framework that breaks down the current account to two components: a composition effect and a growth effect. We show that past empirical evidence, which strongly supports the growth effect as the main driver of current account dynamics, is misconceived. The remarkable empirical success of the growth effect is driven by the dominance of the cross-sectional variation, which, under conditions met by the data, is generated by an accounting approximation. In contrast to previous findings that the portfolio share of net foreign assets to total assets is constant in a country, both our theoretical and empirical results support a highly persistent process or a unit-root process, with some countries displaying a trend. Finally, we reestablish the composition effect as the quantitatively dominant driving force of current account dynamics in the past data.     

European monetary policy: Institutional design and policy experience

The following article examines design issues relevant to European monetary policy: central bank independence, and the accountability and transparency of monetary policy strategy. An empirical approach is then applied which allows a comparison between the ECB and other central banks. It also enables an investigation of whether the ECB simply follows the US Federal Reserve Bank, as is sometimes claimed.     

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.     

Varying monetary policy regimes: A vector autoregressive investigation

Recently, two stylized facts about the behavior of the U.S. economy have emerged: first, macroeconomic aggregates appear to be less volatile post-1984 than in the preceding 2 decades; second, monetary policy appears more responsive to inflationary pressures – and thereby more “stabilizing” – during the Volcker/Greenspan chairmanships relative to earlier regimes. Does a causal relationship exist between these two observations? In particular, has “better” policy by the Federal Reserve Board contributed significantly to the lessened volatility of the U.S. economy? This paper uses a structural vector autoregressive (VAR) specification to address these questions, examining the advantages and limitations of such an approach. In contrast with much of the existing research on these topics, I find that most of the quantitatively significant changes in volatility are attributed to breaks in the non-policy portion of the structural VAR, and not to the identified policy equation.     

A new perspective on “the new rule”of the current account

In an influential series of contributions, Kraay and Ventura (2000, 2003) offer a “new rule” for the current account: in response to a temporary income shock, the change in the current account is equal to the change in saving times the ratio of net foreign assets to wealth. We analyze the impact of a temporary income shock on the current account in the context of a two-country dynamic general equilibrium model of portfolio choice and show that the new rule does not hold. We also show that the cross-section evidence reported by Kraay and Ventura in favor of the new rule is a feature implied by the steady state of the model that is conceptually distinct from the new rule. We argue that the new rule could only hold in a model with one-way capital flows (only inflows or outflows, but not both), a feature that is strongly counterfactual.     

A theory of the currency denomination of international trade

The currency denomination of international trade has significant macroeconomic and policy implications. In this paper we solve for the optimal invoicing choice by integrating this microeconomic decision at the level of the firm into a general equilibrium open economy model. Strategic interactions between firms play a critical role. We find that the less competition firms face in foreign markets, as reflected in market share and product differentiation, the more likely they will price in their own currency. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.     

The monetary model strikes back: Evidence from the world

We revisit the dramatic failure of monetary models in explaining exchange rate movements. Using the information content from 98 countries, we find strong evidence for cointegration between nominal exchange rates and monetary fundamentals. We also find fundamentals-based models very successful in beating a random walk in out-of-sample prediction.