Are asset price guarantees useful for preventing Sudden Stops?: A quantitative investigation of the globalization hazard-moral hazard tradeoff

An implication of the globalization hazard hypothesis is that ‘Sudden Stops’ caused by global financial frictions could be prevented by offering foreign investors price guarantees on emerging markets assets. These guarantees create a tradeoff, however, because they weaken globalization hazard while creating international moral hazard. We study this tradeoff using a quantitative, equilibrium asset-pricing model. Without guarantees, margin calls and trading costs cause Sudden Stops driven by a Fisherian deflation. Price guarantees prevent this deflation by propping up foreign demand for assets. The effectiveness of price guarantees, their distortions on asset markets, and their welfare implications depend critically on whether the guarantees are contingent on debt levels and on the price elasticity of foreign demand for domestic assets.     

Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices

This paper shows that the quantitative predictions of an equilibrium asset-pricing model with financial frictions are consistent with key features of the Sudden Stop phenomenon. Foreign traders incur costs in trading assets with domestic agents, and a collateral constraint limits external debt to a fraction of the market value of domestic equity holdings. When this constraint does not bind, standard productivity shocks cause typical real-business-cycle effects. When it binds, the same shocks cause strikingly different effects depending on the leverage ratio and asset market liquidity. With high leverage and a liquid market, the shocks force “fire sales” of assets and Fisher's debt-deflation mechanism amplifies the responses of asset prices, consumption and the current account. Precautionary saving makes these Sudden Stops infrequent in the long run.     

The long or short of it: Determinants of foreign currency exposure in external balance sheets

A major focus of the recent literature on the determination of optimal portfolios in open-economy macroeconomic models has been on the role of currency movements in determining portfolio returns that may hedge various macroeconomic shocks. However, there is little empirical evidence on the foreign currency exposures that are embedded in international balance sheets. Using a new database, we provide stylized facts concerning the cross-country and time-series variation in aggregate foreign currency exposure and its various subcomponents. In panel estimation, we find that richer, more open economies take longer foreign-currency positions. In addition, we find that an increase in the propensity for a currency to depreciate during bad times is associated with a longer position in foreign currencies, providing a hedge against domestic output fluctuations. We view these new stylized facts as informative in their own right and also potentially useful to the burgeoning theoretical literature on the macroeconomics of international portfolios.     

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.     

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).     

International capital flows under dispersed private information

It is well established that private information is critical to our understanding of asset prices. In this paper we argue that it also affects international capital flows and use a simple two-country DSGE model to illustrate its impact. We show that private information (i) increases the volatility of both net and gross capital flows, (ii) leads to a high correlation between capital inflows and outflows, (iii) leads to a disconnect of capital flows from observed macro fundamentals and (iv) implies that capital flows contain information about the future macro fundamentals. We also show that dispersed information affects capital flows both through asset prices and directly, so that the impact on flows is not just the mirror image of the impact on prices.     

Valuation effects and the dynamics of net external assets

‘Valuation effects’ can imply that the traditional current account is an inaccurate measure of the change in the net foreign asset (NFA) position. This paper uses new developments in the analysis of portfolio choice in general equilibrium to investigate valuation effects in a two-country model. Broadly speaking, the valuation effects in the model correspond to those observed in the data. But there is a key distinction between ‘unanticipated’ and ‘anticipated’ valuation effects. Unanticipated effects can be large, dominating the movement in NFA, but anticipated effects arise only at higher orders of approximation and are small for reasonable parameterizations.     

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.     

Currency mismatches and monetary policy: A tale of two equilibria

We develop a model of a small economy whose residents choose whether to borrow in domestic or foreign currency. The central bank, in turn, chooses fixed or flexible exchange rates, taking the currency denomination of debts as given. We characterize the simultaneous determination of portfolios and exchange rate regime. Both floating and fixed rates can occur as equilibrium outcomes. “Fear of floating” may emerge endogenously and in association with a currency mismatch in assets and liabilities. If equilibria with both fixed rates and floating rates coexist, the latter is Pareto superior. Lessons for current “de-dollarization” proposals are discussed.     

Fluctuations in the foreign exchange market: How important are monetary policy shocks?

We study the effects of U.S. monetary policy shocks on the bilateral exchange rate between the U.S. and each of the G7 countries. We also estimate deviations from uncovered interest rate parity conditional on these shocks. The analysis is based on a structural vector autoregression in which monetary policy shocks are identified through the conditional heteroscedasticity of the structural disturbances. Unlike earlier work in this area, our empirical methodology avoids making arbitrary assumptions about the relevant policy indicator or transmission mechanism in order to achieve identification. At the same time, it allows us to assess the implications of imposing invalid identifying restrictions. Our results indicate that the nominal exchange rate exhibits delayed overshooting in response to a monetary expansion, depreciating for roughly ten months before starting to appreciate. The shock also leads to large and persistent departures from uncovered interest rate parity. Variance-decomposition results indicate that monetary policy shocks account for a non-trivial proportion of exchange rate fluctuations.     

The present-value model of the current account has been rejected: Round up the usual suspects

Tests of the present-value model (PVM) of the current account are frequently rejected by data. Standard explanations rely on the “usual suspects” of non-separable preferences, fiscal policy and world real interest rate shocks, external imperfect international capital mobility, and an internalized risk premium. We confirm these rejections on post-war Canadian data, then investigate their source by calibrating and simulating alternative versions of a small open economy, real business cycle model (RBC). Bayesian Monte Carlo experiments reveal that a “canonical” RBC model is close to the data, but far from the PVM predictions. Although each suspect matters in some way, none improve the fit to the data. However, the PVM restrictions are reproduced when the internalized risk premium is introduced into the canonical model. By adding the exogenous world real interest rate shock to this version of the model, it matches the data better and is moved closer to the PVM predictions. This suggests that there is an important common world component to current account fluctuations, which points to additional underlying macroeconomic factors that drive the current account.     

Habit formation and the present-value model of the current account: Yet another suspect

In a recent paper, Gruber (Gruber, J.W., 2004. A present value test of habits and the current account. Journal of Monetary Economics 51, 1495-1507) claims that habit formation in consumption plays an important role in current account fluctuations in selected developed countries, extending the present-value model of the current account (PVM) with consumption habits. In this paper, however, I show that the habit-forming PVM is observationally equivalent to the PVM augmented with persistent transitory consumption, which is induced by world real interest rate shocks. Based on a small open-economy real business cycle (SOE-RBC) model endowed with consumption habits as well as persistent world real interest rate shocks, this paper resolves the inherent identification problem of the habit-forming PVM by Bayesian methods to seek effects of habit formation on current account fluctuations in typical small open economies, Canada and the United Kingdom. Results reveal no clear evidence that habit formation plays a crucial role in current account fluctuations.     

Accounting for persistence and volatility of good-level real exchange rates: The role of sticky information

Volatile and persistent real exchange rates are observed not only in aggregate series but also in micro-price data at the retail level. Kehoe and Midrigan (2007) recently showed that, under a standard assumption on nominal price stickiness, empirical frequencies of micro price adjustment cannot replicate the time series properties of the Law of One Price (LOP) deviations. We extend their sticky price model by combining good-specific price adjustment with information stickiness in the sense of Mankiw and Reis (2002). Our framework allows for multiple cities within a country. Using a panel of U.S.-Canadian city pairs, we estimate a dynamic price adjustment process for 165 individual goods. Under a reasonable assumption on the money growth process, we show that the model matches the persistence of the LOP deviation for the median good and accounts for the majority of its volatility when information updates occur every 12 months.     

International trade in durable goods: Understanding volatility, cyclicality, and elasticities

Data for OECD countries document: 1. imports and exports are about three times as volatile as GDP; 2. imports and exports are pro-cyclical, and positively correlated with each other; 3. net exports are counter-cyclical. Standard models fail to replicate the behavior of imports and exports, though they can match net exports relatively well. Inspired by the fact that a large fraction of international trade is in durable goods, we propose a two-country two-sector model in which durable goods are traded across countries. Our model can match the business cycle statistics on the volatility and comovement of the imports and exports relatively well. The model is able to match many dimensions of the data, which suggests that trade in durable goods may be an important element in open-economy macro models.     

Temporal dimension and equilibrium exchange rate: A FEER/BEER comparison

This paper investigates the temporal links between two models of equilibrium exchange rate, namely the behavioral and the fundamental approaches. Our results show that, even though in the long-run they are closely related, important differences are observed for some countries and/or some periods. Contrary to previous contributions, we analyze the factors that explain this disconnection. We outline structural changes in matter of competitiveness, the dynamics of foreign assets and valuation effects as explanations. This novel evidence is important if the two approaches for assessing misalignments are used for policy decisions such as setting tariffs to cope with the “currency war”.     

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.     

On the international transmission of technology shocks

Using vector autoregressions on U.S. time series and an aggregate of industrialized countries, we find that technology shocks appreciate the terms of trade and lower the trade balance; they induce an ‘S’-shaped cross-correlation function for both variables (the S-curve). In calibrating a prototypical international business cycle model under complete and incomplete financial markets, we find two distinct sets of parameter values. While both model specifications deliver the S-curve, the underlying transmission mechanism of technology shocks is fundamentally different. Most importantly, only in the incomplete markets economy the terms of trade appreciate and thus amplify the relative wealth effects of technology shocks—as suggested by the evidence.     

The relevance or otherwise of the central bank's balance sheet

This paper explores the impacts on an economy of a central bank changing the size and composition of its balance sheet. One of the ways in which such asset purchases could influence prices and demand is via portfolio balance effects. We develop and calibrate a simple OLG model in which risk-averse households hold money and bonds to insure against risk. Central bank asset purchases have the potential to affect households' choices by changing the composition and return of their asset portfolios. We find that the effect is weak, and that its size depends on how fiscal policy is conducted.That is not to say that the big expansion of central bank balance sheets in recent years has been ineffective. Our finding is rather that the portfolio balance channel evaluated in an environment of normally functioning (though nonetheless incomplete) asset markets is weak. That is not inconsistent with the evidence that large-scale asset purchases by central banks since 2008 have had significant effects, because those purchases were made when financial markets were, to varying extents, dysfunctional. Nonetheless our results are relevant to those purchases because they may be unwound in an environment where financial markets are no longer dysfunctional.     

The real effects of financial integration

This paper shows how correlations in GDP fluctuations rise with financial integration. Finance serves to increase international correlations in both consumption and GDP fluctuations, which explains the persistent gap between the two in the data, a “quantity puzzle”. The positive association between financial integration and GDP correlation constitutes a puzzle, as theory suggests a negative relation if anything. Nevertheless, it prevails in the data even after the effects of finance on trade and specialization are accounted for.     

Stuck on gold: Real exchange rate volatility and the rise and fall of the gold standard, 1875-1939

Did the gold standard diminish macroeconomic volatility? Supporters thought so, critics thought not, and theory offers ambiguous messages. Hard regimes like the gold standard limit monetary shocks by tying policymakers' hands; but exchange-rate inflexibility compromises shock absorption in a world of real disturbances and nominal stickiness. A model shows how lack of flexibility affects the transmission of terms-of-trade shocks. Evidence from the late nineteenth and early twentieth century exposes a dramatic change. The classical gold standard did absorb shocks, but the interwar gold standard did not, supporting the view that the interwar gold standard was a poor regime choice.