Nontradable sector reform and external rebalancing in monetary union: A model-based analysis

The paper uses the QUEST III model to analyse the question of whether nontradable (service) sector reform would reduce external imbalances in monetary union, notably from the side of surplus countries. It considers an open economy with a positive net foreign asset (net creditor) position and shows that tradable and nontradable sector reforms, understood as reforms that shift the supply curve in the respective sector outward, tend to have similar external balance effects. Namely, supply-side reforms improve the price competitiveness of domestic output and tend to increase the trade and current account balance on impact. In the longer term, competitiveness gains are compensated by additional imports associated with domestic income growth. Starting from a non-zero NFA position, the denominator effect does also contribute significantly to changes in external accounts relative to GDP. The results are robust across modifications of the model.     

The unbearable tightness of being in a monetary union: Fiscal restrictions and regional stability

We study how constrained fiscal policy can affect macroeconomic stability and welfare in a two-region model of a monetary union with sticky prices and distortionary taxation. Both government spending and taxes can be used to stabilize regional variables; however, the best welfare outcome is obtained under some tax variability and constant regional inflations. We use a variety of rules to characterize constrained fiscal policy and find that strict fiscal rules coupled with a monetary policy that targets union-wide inflation result in regional inflation stability and the welfare costs of such rules are not as unbearable as one would expect. Fiscal authorities can enhance welfare by targeting the regional output gap, while targeting regional inflation is less successful since inflation stability is guaranteed by the central bank.     

Monetary union: A welfare based approach

This article attempts to shed light on the consequences of the transition to EMU for individual welfare following specific shocks. To this end, we develop a two country intertemporal general equilibrium model that extends the Obstfeld and Rogoff (Journal of Political Economy 103 (3) (1995) 624) specification to nominal rigidities through price adjustment costs and pricing-to-market behavior.We show that, when facing a positive asymmetric permanent shock to either technology or government expenditures occurring in one country, implementing a monetary union is beneficial to the households living in this economy. Conversely, it is detrimental to foreigners. Further, a sensitivity analysis shows that if the gains/losses to implementing monetary union are qualitatively robust when facing changes in the degree of nominal rigidities and the elasticity of substitution between foreign and domestic goods, they are quite sensitive to the degree of pricing-to-market in the economy.     

The prospects of a monetary union in East Asia

This paper assesses the empirical desirability of the East Asian economies to form a monetary union. The Structural Vector Autoregression (VAR) method is employed to assess the nature of macroeconomic disturbances among the East Asian countries, as a preliminary guide in identifying potential candidates for forming an Optimum Currency Area (OCA). In comparison with European countries, East Asia has less symmetric underlying structural shocks but the speed of adjustment to shocks is much faster. The empirical results suggest that there exists a scope among some small sub-regions, comprising mainly of ASEAN countries, for potential monetary integration. The finding of an increased symmetry of shocks among countries after the Asian Financial crisis indicates that the regional policy-coordinating effort after the crisis has put the region on the right track if monetary union is a desired goal.     

Stabilization mechanisms in a monetary union

The stability of a monetary union entails the establishment of mechanisms that allow the member countries to smooth their paths of consumption after negative shocks in their income. A centralized fiscal institution could help countries through a mechanism of taxes and transfers. In this paper we study the stabilizing effects of different mechanisms of compensation in a two-country general equilibrium model subject to asymmetric technology shocks. In particular, we have focused on an optimal system of taxes and transfers as opposed to a discretionary transfer mechanism, finding that the optimal transfer consists in an intertemporal distribution to the economy that experiences the negative shock instead of a current high transfer as in the non-optimal mechanism. Lastly, we have assessed the degree of stabilization related to the mechanisms in question, showing that the optimal mechanism can match the degree of stabilization the empirical literature attributes to the case of the United States.     

International transmission of environmental policy: A New Keynesian perspective

In this paper we examine the international transmission of environmental policy using a New Keynesian model of the global economy. We first consider the case in which the quality of the environment affects utility, but not productivity. This allows us to look at the trade-off between environmental quality and output. We then consider the case in which the quality of the environment increases productivity but does not affect utility. Our main results show that in both cases a unilateral implementation of a more stringent environmental policy by the domestic country raises foreign welfare under a benchmark parameterization. Our modeling strategy allows an analysis of how nominal rigidities interact with the implementation of environmental reforms, by allowing the domestic country to shift, through exchange rate depreciation, parts of the costs of more stringent environmental policies to the foreign one.     

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.     

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.     

Fiscal restrictions and monetary union: Rationales,repercussions, reforms

We offer a critique of the fiscal preconditions for participation in Stage III of EMU and the Excessive Deficit Procedure of the Maastricht Treaty. We show that the high output costs associated with meeting the fiscal preconditions in Stage II and the incompatibility of the reference values for fiscal policy with other convergence criteria make it unlikely that a mechanical interpretation of those conditions will govern admission to Stage III. Knowledge of this fact will deter governments from undertaking major fiscal adjustments in the first place. Hence, the fiscal criteria of the treaty will not function as an efficient filter for distinguishing countries that are and are not prepared to live with the fiscal consequences of EMU.In Stage III, the function of the Excessive Deficit Procedure is to buttress the European Central Bank's protection from demands for a central bank bailout in the event of a debt crisis in a participating state. We show that other aspects of EU fiscal structure, namely the retention by member states of the bulk of their own revenue-raising capacity, should suffice to restrain the demand for a central bank bailout and the pressure on the ECB to supply it. Until political union follows monetary union, leading to the centralization of fiscal functions and revenu-raising capacity in the EU itself, the Excessive Deficit Procedure will be redundant. If there remains any reason to doubt the credibility of the no-bailout rule, then the best way to buttress it is directly, by further insulating the ECB from pressure to extend a bailout.If it is felt that policy in EU member states is biased toward excessive deficits, then the appropriate place to address this problem is at the national level. A limited approach would involve steps to insure that negotiations over the budget occur in the context of a firm general constraint on the overall level of spending. A more far-reaching reform would involve the creation of National Debt Boards to offset the prevailing bias.     

European monetary union, adjustment, and exchange rate variability

This paper uses a three-country, three-good, factor-specific model of trade with wage rigidities to investigate how European Monetary Union is likely to affect exchange rate variability. Focusing on international macroeconomic adjustment under both exogenous and optimizing monetary policies, it shows that the relative variability (against external currencies) of the euro and a basket of predecessor currencies depends on the relative sizes and specialization patterns of countries and the relative importance of different shocks. Monetary union is likely to decrease (increase) aggregate European exchange rate variability for shocks to industries in which large (small) euro area countries specialize.     

Potential economic reforms in North Korea: a dynamic general equilibrium model

We use a dynamic general equilibrium model to examine hypothetical market reforms in North Korea. We model partial reform, in which producers choose capital allocations across sectors, with the government still fixing total capital. We also consider two full market reform scenarios. In one, public infrastructure investment remains unchanged, while, in the other, it increases substantially. In all scenarios, we assume a closed economy and a constant military size. Our simulations show little hope for the North Korean economy without boosting infrastructure. Although all of the reforms raise consumption, only significant increases in infrastructure investment bring positive economic growth.     

Equity home bias,incomplete financial markets,and nominal rigidities

Abstract This paper analyzes optimal portfolio decisions in a monetary open‐economy framework. It is found that market completeness and the specific form of nominal rigidities, namely, nominal price vs. nominal wage rigidities, matter for justifying the observed structure of equity holdings. When markets are complete, sticky prices generate a negative correlation between the non‐diversifiable labour income and the profit of domestic firms with respect to the productivity shocks, which explains why households invest little abroad. In contrast, when markets are incomplete, rigidities in goods prices result in a counterfactual ‘super home bias’, because domestic equities provide a good hedge against not only the labour income risk but also the relative price risk. Wage rigidities, however, have the opposite effect. Therefore, nominal rigidities in both goods prices and wage rates are needed to address the empirical composition of gross equity positions under incomplete markets.     

Nonlinear dynamics in exchange rate deviations from the monetary fundamentals: An empirical study

This paper reexamines empirical performance of the monetary exchange rate model with nonlinear dynamics of exchange rate deviation from the monetary fundamentals. First, we apply unit root test of Park and Shintani (2005) to post-Bretton Woods exchange rate data and able to reject the null of unit root deviation from monetary fundamentals against alternative hypothesis of nonlinear stationary process for deutschemark, pound, and Swiss franc. Our empirical results find that exchange rates show high degree of mean-reversion with larger deviation and long periods of overvaluation and undervaluation of dollar. We also find empirical evidence of predictability of the monetary fundamentals at longer horizons.     

Liquidity risk, economic development, and the effects of monetary policy

Empirical evidence indicates that monetary policy is not super-neutral in many countries. In particular, in high inflation economies, inflation is negatively related to economic activity. By comparison, inflation may be positively correlated with output in low inflation countries. We present a neoclassical growth model with money in which the incidence of liquidity risk is inversely related to aggregate capital formation. Interestingly, there may be multiple monetary steady-states where the effects of monetary policy vary. In poor economies, the financial system is highly distorted and higher rates of money growth are associated with less capital formation. In contrast, in advanced economies, a Tobin effect is observed. Since inflation exacerbates distortions from a coordination failure in the low-capital steady-state, individuals become much more exposed to liquidity risk. Consequently, optimal monetary policy depends on the level of development.     

Policy analysis in real time using IMF's monetary model

We investigate to what extent estimated relationships of the IMF's monetary model and their policy implications are sample dependent. We observe that estimates of the model's key parameters and model-based measures of macroeconomic disequilibria are highly dependent on the data vintage employed. Changes in parameter estimates solely due to data revisions are found to be much smaller than those owing to parameter instability, possibly reflecting model misspecification. Moreover, instability in parameter estimates contributes to more uncertainty in assessments of macroeconomic disequilibria than data revisions. Analyses based on a version of the model in difference form are also found to be quite sensitive to the data vintage employed, although to a lesser extent than those based on the standard version of the model with variables in levels.     

Fiscal inertia, donor credibility, and the monetary management of aid surges

Donors cannot pre-commit to support scaled-up public spending programs on a continuing basis, nor can governments credibly commit to curtail expenditure rapidly in the event that aid revenues contract. An aid boom may therefore be accompanied by a credibility problem. When this is the case, the absorb-and-spend strategy recommended by the IMF leads to capital flight, higher inflation, and large current account surpluses inclusive of aid. The right policy package combines a critical minimum degree of fiscal restraint with reverse sterilization.     

Exchange rate movements and monetary policy in Brazil: Econometric and simulation evidence

The literature on monetary economy has aroused growing interest in macroeconomics. Due to computational advancements, models have become increasingly more complex and accurate, allowing for an in-depth analysis of the relationships between real economic variables and nominal variables. Therefore, using a dynamic stochastic general equilibrium (DSGE) model, based on Gali and Monacelli (2005), we propose and estimate a model for the Brazilian economy by employing Bayesian methods so as to assess whether the Central Bank of Brazil takes exchange rate fluctuations into account in the conduct of monetary policy. The most striking result of the present study is that the Central Bank of Brazil does not directly change the interest rate path due to exchange rate movements. A simulation exercise is also used. Our conclusion is that the economy quickly accommodates shocks induced separately on the exchange rate, on the terms of trade, interest rate, and global inflation.     

Globalization, the output-inflation tradeoff and inflation

This paper provides comprehensive evidence on the relation between inflation and globalization, defined here as trade and financial openness, using a large cross-section of 91 countries over the period 1985-2004. We establish two main empirical regularities: both higher trade and financial openness (i) reduce central banks’ inflation bias, yielding lower average inflation and (ii) are associated with a larger output-inflation tradeoff. This evidence is at odds with the standard Barro-Gordon framework, which would require globalization to have a negative effect on the output-inflation tradeoff to yield lower equilibrium inflation, but it is consistent with a recent strand of new Keynesian models emphasizing the role of imperfect competition and nominal rigidities. Our findings also support the relevance of the time-inconsistency hypothesis, which underlies the theoretical models predicting a relation between globalization and inflation. For the OECD subsample, however, we do not find an effect of openness on inflation (the output-inflation tradeoff), suggesting that these countries have created an institutional framework for central banks that eliminates distortions due to the time-inconsistency problem.     

International portfolio reallocation: Diversification benefits and European monetary union

We investigate the determinants of bilateral international equity and bond portfolio reallocation across a large cross-section of countries spanning over two sample periods: 1997-2001 and 1997-2005. We find that the strongest drivers are the marginal diversification benefits arising from the pure asset component and the initial degree of underweight. This evidence suggests that global portfolio reallocations over the asset boom and bust period were determined by optimal diversification considerations. We also find that due to economic and monetary union (EMU) the weight assigned by euro area investors to investment in euro area countries increased significantly in equity and fixed income portfolios, with a trade diverting effect against the British bond market.     

Sovereign credit ratings in the European Union: A model-based fiscal analysis

We present a model-based measure of sovereign credit ratings derived solely from the fiscal position of a country: a forecast of its future debt liabilities, and its potential to use fiscal policy to repay these. We use this measure to calculate credit ratings for 14 European countries over the period 1995–2012. This measure identifies a European sovereign debt crisis almost two years before the official ratings of the credit rating agencies.