A present value test of habits and the current account

Forecasts derived from standard intertemporal current account (ICA) models generally fail to match the volatility of actual current accounts. This paper offers a solution to the “excess volatility” problem of standard ICA models by incorporating consumption habits into the standard model. The model, as developed in the paper, shows that significant habit formation implies increased current account volatility, as sluggishness is introduced into the consumption adjustment process that follows income shocks. A theory-consistent measure of the degree of habit formation is estimated using GMM. The estimated habit parameter is found to be statistically significant in six of eight quarterly samples.     

Designing targeting rules for international monetary policy cooperation

This study analyzes a two-country dynamic general equilibrium model with nominal rigidities, monopolistic competition and producer currency pricing. A quadratic approximation to the utility of the consumers is derived and assumed as the policy objective function of the policymakers.It is shown that only under special conditions there are no gains from cooperation and moreover that the paths of the exchange rate and prices in the constrained-efficient solution depend on the kind of disturbance that affects the economy. Despite this result, simple targeting rules that involve only targets for the growth of output and for both domestic GDP and CPI inflation rates can replicate the cooperative allocation.     

Business cycles with staggered prices and international trade in intermediate inputs

International trade in intermediate inputs and, increasingly, in goods produced at multiple stages of processing has been widely studied in the real trade literature. We assess the role of this feature of modern world trade in accounting for some stylized facts about international business cycles. Our model with staggered prices and trade in intermediates across four stages of processing does well in explaining the observed international correlations in aggregate quantities, and it performs much better than a single-stage model with no trade in intermediates. The model in itself does not provide a full account of the cyclical behavior of the real exchange rate, but, compared to the single-stage model, it moves in the right direction.     

Finance and international business cycles

Business cycles are more correlated among countries that have similar financial structures. We first document this empirical regularity using OECD data, and then build a two-country DSGE model with financial frictions that replicates it. Alternative monetary policy regimes and parameter values are explored. Output co-movements increase when the countries involved are linked by a credible exchange rate peg and when they open up to trade; they decrease when their financial openness increases. The model also accounts for a number of stylized facts of international business cycles, such as the positive international correlation of output, investment and employment.     

The role of household and business credit in banking crises

Private credit expansions are an important predictor of subsequent banking crises. We revisit that result with a new dataset from developed and developing countries that decomposes private credit into household credit and enterprise credit. We argue that household credit growth raises debt levels without much effect on long-term income. Rapid household credit expansions generate vulnerabilities that can precipitate a banking crisis. Enterprise credit expansions can have the same effects but it is tempered by the associated increase in income. Our estimates show that household credit expansions have been a statistically and economically significant predictor of banking crises. Enterprise credit expansions are also associated with banking crises but their effect is weaker and less robust.     

Revisiting the consumption-real exchange rate anomaly in a model with non-traded goods

This paper shows that the assumption used in many two-country business cycle models that all non-traded goods are nondurable consumption goods magnifies the severity of the consumption-real exchange rate anomaly, which is the discrepancy between the high correlation between relative consumption and the real exchange rate predicted by most models and the low correlation observed empirically. This assumption hampers the ability to generate wealth effects necessary for the economies to deviate away from full risk-sharing. Using an alternative setup in which non-traded goods can also be investment goods improves the ability of the model to generate wealth effects, and therefore to overcome the anomaly.     

Multinational banking and the international transmission of financial shocks: Evidence from foreign bank subsidiaries

Using bank-level data on 368 foreign subsidiaries of 68 multinational banks in 47 emerging economies during 1994–2008, we present consistent evidence that internal capital markets in multinational banking contribute to the transmission of financial shocks from parent banks to foreign subsidiaries. We find that internal capital markets transmit favorable and adverse shocks by affecting subsidiaries’ reliance on their own internal funds for lending. We also find that the transmission of financial shocks varies across types of shocks; is strongest among subsidiaries in Central and Eastern Europe, followed by Asia and Latin America; is global rather than regional; and becomes more conspicuous in recent years. We also explore various conditions under which the international transmission of financial shocks via internal capital markets in multinational banking is stronger, including the subsidiaries’ reliance on funds from their parent bank, the subsidiaries’ entry mode, and the capital account openness and banking market structure in host countries.     

International financial integration and national price levels: The role of the exchange rate regime

This paper proposes a new perspective on systematic deviations from purchasing power parity. Panel evidence for OECD countries shows that international financial integration increases the national price level under managed exchange rate regimes and lowers the price level under floating exchange rates. An open economy sticky-price model reproduces these findings by relating them to the possibility of insurance against consumption losses in internationally integrated financial markets. The utilization of insurance is reflected by relative price adjustments which manifest themselves in changes of the national price level. The direction of relative price adjustments, however, depends on the extent to which insurance is used under different exchange rate regimes: under a peg, financial integration raises the national price level; under a float, however, financial integration lowers the national price level.     

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.     

Trade, production sharing, and the international transmission of business cycles

Countries that are more engaged in production sharing exhibit higher bilateral manufacturing output correlations. We use data on trade flows between US multinationals and their affiliates as well as trade between the United States and Mexican maquiladoras to measure production-sharing trade and its link with the business cycle. We then develop a quantitative model of international business cycles that generates a positive link between the extent of vertically integrated production-sharing trade and internationally synchronized business cycles. A key assumption in the model is a relatively low elasticity of substitution between home and foreign inputs in the production of the vertically integrated good.     

An open-economy macro-finance model of international interdependence: The OECD,US and the UK

This paper develops a multi-country macro-finance model to study international economic and financial linkages. This approach models the economy and financial markets jointly using both types of data to throw light on such issues. The world economy is modelled using data for the US and aggregate OECD economies as well as the US Treasury bond market using latent variables to represent a common inflation trend and a US real interest rate factor. We find strong evidence of global effects on both the US and UK, calling into question the standard closed economy macro-finance specification. These economic linkages also help to explain the co-movement of yields in the US and UK Treasury bond markets.     

Time Patience and Specialization Patterns in the Presence of Asset Trade

Specialization patterns in an open-economy two-sector growth model with endogenous capital accumulation are examined in the presence of free international lending and borrowing. Without free international lending and borrowing it is known that, whereas the less (time-)patient country decumulates real capital, the more patient country accumulates real capital and eventually specializes in a capital-intensive industry. However, free trade of international financial assets causes a dramatic change in long-run specialization patterns. In this case the less patient country may well specialize in the capital-intensive industry and the more patient country in the labor-intensive industry.     

Dynamic risksharing in the United States and Europe

We use a panel VAR model to improve upon the existing methodologies to analyze interregional risksharing and consumption smoothing channels. First, we endogenize the output process within a more general multi-equation framework, capturing the dynamic feedback between output and various smoothing channels. Second, in line with dynamic general equilibrium open economy models of risksharing, we exploit impulse response functions to trace the role of each smoothing channel over time, in the presence of different structural shocks (temporary vs. permanent and output vs. smoothing channels). In the application to the US and OECD countries, we find different dynamic properties of different smoothing channels. We compare our results with the predictions of standard risksharing and consumption theories, and tackle some of the puzzles in the literature, such as the “international risksharing puzzle” and the “consumption-output correlation puzzle.” We are also able to address such policy issues as whether fiscal stabilizers have been substitutes or complements for financial market diversification activities and whether further financial market integration is likely to provide countries with more shock-absorption tools. A key result is the strong substitutability between capital and credit smoothing in the US, and between fiscal and credit smoothing in the OECD.     

The effect of a common currency on the volatility of the extensive margin of trade

This paper studies the effects of the European monetary unification on the volatility of the extensive margin of trade. First, we highlight empirical novel facts about the effects of monetary unification. We build country-level measures of the extensive margin of intra-EMU exports and describe how their volatilities evolved over time. We show that the adoption of a common currency has been associated with an increase of the volatility of the extensive margin of exports for most countries, and a decrease in the volatility of the extensive margin of exports for Germany. Second, we address this question theoretically and build a two-country version of the model of Ghironi and Melitz (2005) with endogenous entry, heterogenous firms, endogenous tradability, endogenous labor supply and sticky prices. We compare the volatility of the extensive margin of trade under fixed exchange rates and in a monetary union. Monetary unification does imply an increase in the volatility of the extensive margin of trade for pre-EMU followers (such as France or the Netherlands) and a decrease in the volatility of the extensive margin of trade for the leader (Germany). This pattern is qualitatively consistent with the data but arises only if monetary policy responds moderately to output.     

International business cycles: What are the facts?

Modern business cycle theory involves developing models that explain stylized facts. For this strategy to be successful, these facts should be well established. In this paper, we focus on the stylized facts of international business cycles. We use the generalized method of moments and quarterly data from twenty industrialized countries to estimate and test hypotheses concerning pairwise cross-country correlations of macroeconomic aggregates. A remarkable common feature emerges: these correlations are mostly positive, not very high and of a similar order of magnitude. The most important discrepancy with the theory is the low cross-country correlation of consumption.     

Behind the scenes of abandoning a fixed exchange rate regime

This paper explores the process of abandoning a fixed exchange rate regime during sudden stops in a small open economy. The Bank of Korea’s exchange rate policy reports during the East Asian crisis suggest that its fixed exchange rate regime was forced to collapse due to the depletion of usable foreign reserves, which resulted from the credit policy of the Korean central bank to support domestic banks in need of foreign currency liquidity. To capture the Korean crisis experience, I build a quantitative small open economy model in which, in response to the country risk premium shock, the foreign-currency credit policy of a central bank under fixed regime leads to the exhaustion of international reserves and consequent exchange rate regime shift. This model does well at replicating the observed contraction in Korean aggregate variables.     

The Composition of Government Spending and the Real Exchange Rate

We show that the composition of government spending influences the long-run behavior of the real exchange rate. We develop a two-sector small open-economy model in which an increase in government consumption is associated with real appreciation, while an increase in government investment may generate real depreciation. Our empirical work confirms that government consumption and government investment have differential effects on the real exchange rate and the relative price of nontradables.     

Business cycles in emerging economies: the role of interest rates

We find that in a sample of emerging economies business cycles are more volatile than in developed ones, real interest rates are countercyclical and lead the cycle, consumption is more volatile than output and net exports are strongly countercyclical. We present a model of a small open economy, where the real interest rate is decomposed in an international rate and a country risk component. Country risk is affected by fundamental shocks but, through the presence of working capital, also amplifies the effects of those shocks. The model generates business cycles consistent with Argentine data. Eliminating country risk lowers Argentine output volatility by 27% while stabilizing international rates lowers it by less than 3%.     

Do the ECB and the fed really need to cooperate? Optimal monetary policy in a two-country world

A two-country model with monopolistic competition and price stickiness is employed to investigate the implications for macroeconomic stability and the welfare properties of three international policy arrangements: (a) cooperative, (b) non-cooperative and (c) monetary union. I characterize the conditions under which there is scope for policy cooperation and quantify the costs of non-cooperation and monetary union. The non-cooperative equilibrium may be suboptimal because of terms of trade spillover effects, while monetary union may be suboptimal because of the sluggishness of relative prices. Both the costs of policy competition and of a monetary union are sensitive to the values assumed for the intertemporal and international demand elasticity and the degree of openness of the economy. Independently of the calibration scenario adopted, the ECB has little to gain by coordinating with the Fed.     

Interest rate smoothing and financial stability

Central banks smooth fluctuations in interest rates based on a belief that this policy promotes financial stability. This belief is based on a presumption that the direct effect of less interest rate volatility on a bank's likelihood of insolvency is the predominant effect of this policy. The main point of this paper is that these policies also give rise to indirect effects that lower financial stability. These indirect effects occur because the policy itself alters bank behavior. In effect, if the central bank provides (liquidity) insurance (at zero premia), it may introduce a classic moral hazard problem that encourages risk taking by banks. As a result, to maintain a given degree of financial stability, a bank regulator may, in fact, need to impose a higher prudential capital requirement when an interest rate smoothing policy is in place. The paper concludes that the link between interest rate smoothing policy and financial stability may be more complicated than is generally recognized.