Expectations and optimal monetary policy: A stability problem revisited

A landmark result in the optimal monetary policy design literature is that fundamental-based interest rate rules invariably lead to rational expectations equilibria (REE) that are not stable under adaptive learning. In this paper, we make a novel information assumption that private agents cannot observe aggregate fundamental shocks, and use simple linear forecasting rules for learning. We find that with fundamental-based rules, there exist limited information equilibria that are stable under learning. Moreover, there are multiple equilibria. Learning can be used as a selection tool to identify a unique equilibrium.     

Impact of Central Bank Intervention during Periods of Speculative Pressure: Evidence from the European Monetary System

Abstract. This paper studies the effects of Banco de España and Banque de France interventions during the 1992–93 European Monetary System crises. In particular, a Markov Switching model is estimated where interventions influence the probabilities of transition between a calm and a turbulent regime. Furthermore, we analyze the impact of intervention on the expected rate of realignment. On balance, the results are consistent with the view that publicly known interventions but not secret interventions increased both the probability of switching to the turbulent regime as well as the expected realignment rate.     

CROSS‐HEDGING OF EXCHANGE RATE RISKS: A NOTE*

This note studies the optimal production and hedging decisions of a competitive international firm that exports to two foreign countries. The firm faces multiple sources of exchange rate uncertainty. Cross‐hedging is plausible in that one of the two foreign countries has a currency forward market. We show that the firm's optimal forward position is an over‐hedge, a full‐hedge or an under‐hedge, depending on whether the two random exchange rates are strongly positively correlated, uncorrelated or negatively correlated, respectively.     

Operational risk as a function of the state of the economy

This paper examines the frequency and severity of the operational losses incurred by U.S. firms during the period 1990-2007, as reported by Fitch Risk. The losses are examined in relation to the state of the U.S. economy as represented by the unemployment rate, which is the macroeconomic variable that is most intuitively appealing in terms of association with the incidence of operational losses. The results of structural time series modelling reveal that while total severity and average severity are positively related to the unemployment rate, the frequency of losses is not.     

Some international evidence on the Lucas Supply Function

We provide empirical evidence on the Lucas Supply Function based on actual inflation surprises for 19 industrial economies. Our results show that the inflation surprise positively correlates with the output gap and that this relationship is negatively related to inflation variability.     

A note on the POUM effect with heterogeneous social mobility

We study the determinants of the (steady-state) POUM effect in a model where the individuals evaluate their expected future income using both their current income and observable characteristics such as education, race or gender.     

Inflation,nominal portfolios,and wealth redistribution in Canada

Abstract This paper quantifies the redistributional effects of inflation in Canada that arise through the revaluation of nominal assets and liabilities. We find that the effects are non‐trivial even for low inflation episodes. The main winners are young, middle‐class households with mortgage debt. The government receives a windfall gain from its long‐term debt. The old, the rich or the middle‐aged, middle‐class lose, largely owing to their holdings of bonds and non‐indexed defined benefit pension assets. Finally, our Canada‐U.S. comparison reveals that the extent of redistributions can be quite different even between countries of similar economic and legal environments.     

Spillover Dynamics of Central Bank Interventions

Abstract. Central banks frequently intervene in foreign exchange markets to reduce volatility or to correct misalignments. Such operations may be successful if they drive away destabilizing speculators. However, the speculators do not simply vanish but may reappear on other foreign exchange markets. Using a model in which traders are able to switch between foreign exchange markets, we demonstrate that while a central bank indeed has several means at hand to stabilize a specific market, the variability of the other markets depends on how the interventions are implemented.     

Exchange rate puzzles: A tale of switching attractors

The rational expectations efficient market model of the exchange rate has failed empirically. In this paper, we develop a model of the exchange rate in which agents use simple forecasting rules. Based on an ex post evaluation of the relative profitability of these rules they decide whether to switch or not. In addition, transactions costs in the goods market are introduced. We show that this simple model creates great complexity in the market which is characterised by the fact that the exchange rate is disconnected from its fundamental most of the time. Finally we show that this model mimicks most of the empirical puzzles uncovered in the literature.     

Do forecasters of major exchange rates herd?

This paper uses forecast data from 1995 through 2014 to examine, whether the market consensus of exchange rate forecasts has an effect on the forecasts of individual experts. Such an effect could take the form of herding or anti-herding. We use a very comprehensive data set to study experts' forecasts of three of the most important exchange rates. The results indicate that anti-herding vis-à-vis the consensus of forecasts occurs more often than herding. We also show how the increase in the forecasting horizon and financial crises affect the intensity of anti-herding behavior. Moreover, we report that the (anti-)herding behavior does not affect the forcasting performnce.     

On the potential for observational equivalence in experiments on risky choice when a power value function is assumed

We demonstrate theoretically and illustrate the implications of assuming power utility when the true function is of the expo-power form. Empirical results can appear to be consistent with cumulative prospect theory when they are in fact generated from a Markowitz model.     

The purchasing power parity of Southeast Asian currencies: A time-varying coefficient approach

The economies of Southeast Asia have undergone several structural changes, including the Asian currency crisis, during the post-Bretton Woods era. We use a time-varying coefficient cointegration model to test for purchasing power parity (PPP) of Southeast Asian currencies and to track changes in purchasing power relationships over time. The main empirical findings are as follows. First, the stability of the relationship between exchange rates and price differentials is strongly rejected. Second, a major structural change occurs at the outbreak of the Asian currency crisis in 1997. Third, when the cointegration vector is allowed to vary with time, we find evidence of a cointegration relationship for four countries in terms of the US dollar and for four countries in terms of the Japanese yen. Therefore, it seems unlikely that Southeast Asian currencies form a “yen bloc.”     

Riding the wave: Monetary responses to aid surges in low-income countries

We focus on the management of highly persistent shocks to aid flows in the presence of currency substitution by the domestic private sector. Such shocks have beneficent long-run effects, but when currency substitution is high they can produce dramatic macroeconomic management problems in the short run. What is the appropriate mix of money and exchange rate targeting in such cases, and the role of temporary sterilization? We analyze these and related issues in an intertemporal optimizing model that allows a portion of aid to be devoted to reducing the government's seigniorage requirement. Our results show that a managed float, with little or no sterilization of increases in the monetary base, supports the smooth absorption of the increased aid without incurring higher inflation, higher real interest rates or overshooting of the real exchange rate.     

Technology and outsourcing: An explanation to the rising wage gap

The recent phenomenon of widening skilled–unskilled wage gap in both North and South has been either explained by a technological change or by increasing trade or globalization. The paper provides a new explanation and emphasizes that it is neither technology nor trade alone but both that have contributed to the widening wage inequality. It argues, using a two-country occupational choice model, that any technological improvement in North results in a rise in the skilled–unskilled wage gap in North via an increase in the productivity of skilled labor followed by a rise in the same in South via trade or the outsourcing activities of the northern firms. The extent of outsourcing or the number of northern firms that outsource jobs to South is endogenously determined in the model. The paper also analyzes some major economic impacts of such a technological upgradation in North on the southern economy.     

Inflation targeting and real exchange rates: A bias correction approach

This paper examines whether inflation targeting (IT) influences purchasing power parity (PPP) by a bias correction approach under cross-sectional dependence. The recursive mean adjustment (RMA) method proposed by So and Shin (1999) and Shin and So (2001) is employed to correct a downward bias in half-life estimates of real exchange rates. More importantly, the empirical results show that IT lowers variability of real exchange rates and plays an important role in providing favorable evidence for long-run PPP.     

Do elites benefit from democracy and foreign aid in developing countries?

A popular argument for the absence of any beneficial effects of foreign aid is that it is skimmed by political elites in recipient countries. However, studies also suggest that aid may be more effective in relatively democratic developing countries. By exploring data on income quintiles derived from the World Income Inequality Database for 88 developing countries, a set of results indicate that foreign aid and democracy in conjunction are associated with a higher share of income held by the upper quintile. It thus appears that foreign aid, contrary to popular beliefs, leads to a more skewed income distribution in democratic developing countries while the effects are negligible in autocratic countries. The paper closes with a discussion of potential mechanisms generating this perverse effect.     

On the duality between prior beliefs and trading demands

In an abstract model with asymmetric information, we show that there is a duality relationship between the prior beliefs and trading demands of bets for any given individual. Then we aggregate all the agents to obtain a second duality relationship between common prior beliefs and trading possibilities. We easily derive from these relationships the no trade theorem and its converse. General efficiency results can be obtained. Moreover, our framework is sufficiently general to cover special cases proved previously (for example, Econometrica 62 (1994) 1327; Discussion Paper 83, Center for Rationality and Interactive Decision Theory, The Hebrew University of Jerusalem, 1995; J. Econom. Theory 91 (2000) 127; Games Econom. Behav. 24 (1998) 172. Yet, our arguments are both simple and intuitive.     

The behaviour of relative prices in the European Union: A sectoral analysis

Using multivariate unit root test methods, this paper investigates the Purchasing Power Parity (PPP) hypothesis at the sectoral level across six European countries over the last 17 years. Evidence of mean reversion towards PPP is found for the relative prices of some sectors and countries. Mean reversion in relative prices is explained by cross-country and cross-sectoral characteristics such as the distance between countries, nominal exchange rate volatility, differences in GDP per capita, non-tariff barriers, research and development, advertising, industrial concentration and tradeability of the products.     

On the relevance of exchange rate regimes for stabilization policy

This paper assesses the relevance of the exchange rate regime for stabilization policy. Using both fiscal and monetary policy, we conclude that the exchange rate regime is irrelevant. This is the case independently of the severity of price rigidities, independently of asymmetries across countries in shocks and transmission mechanisms. The only relevant conditions are on the mobility of labor and financial assets. The results can be summarized with the claim that every currency area is an optimal currency area. However, with labor mobility or tradable state-contingent assets, additional policy instruments would be required to establish the irrelevance result.     

Exchange rate volatility and international trade: A general-equilibrium analysis

We analyze the relation between exchange-rate volatility and the volume of international trade, in a general-equilibrium stochastic-endowment economy with imperfect international commodity markets, and treating both variables as endogenous. Even in the simplest model, the sign of the relation depends on the source for the change in volatility. For instance, more volatility of the endowments and higher costs to international trade both boost exchange risk (and lower welfare); but the first increases the expected volume of trade, while the second decreases trade. Note that even the (inter-equilibria) relation between trade and welfare is ambiguous.