The Hidden Structural Features of the Fiscal Rule: A European Saga

This paper addresses the question of the reform of the Stability and Growth Pact (SGP). More and more authors and policymakers are bringing to light the negative impacts of the European deficit rule on the countries and their ability to respond asymmetric economic shocks, and some are asking for a redefinition of the pact. If the focus of the SGP is only fiscal, and two of the biggest countries in Europe have failed to abide by the pact since its implementation, it seems clear that the SGP needs at least a re-examination. Yet, on the contrary, if we introduce into the analytical framework the SGPs impacts on the European Unions structural policies, the conclusions are far different. Abolishing the SGP could hinder the presently up-to-date convergence prospective. This paper proposes a theoretical analysis of the SGP that emphasizes a new feature of the SGP: a strong incentive to structural reforms.The author would like to thank the participants of the International Atlantic Economic Conference in Quebec City (Oct. 16–19, 2003) for their helpful comments, Kenneth Donahue, and two anonymous referees. The usual caveat applies.     

Interest Rate Volatility Prior to Monetary Union under Alternative Pre-Switch Regimes

Abstract. The volatility of interest rates is relevant for many financial applications. Under realistic assumptions the term structure of interest rate differentials provides an important predictor of the term structure of interest rates. This paper derives the term structure of differentials in a situation in which two open economies plan to enter a monetary union in the future. Two systems of floating exchange rates prior to the union are considered, namely a free-float and a managed-float regime. The volatility processes of arbitrary-term differentials under the respective pre-switch arrangements are compared. The paper elaborates the singularity of extremely short-term (i.e. instantaneous) interest rates under extensive leaning-against-the-wind interventions and discusses policy issues.     

International transmission of business cycles: Evidence from dynamic correlations

We exploit dynamic correlations to estimate determinants of output comovement between OECD countries. Trade intensity, financial integration, and specialization patterns have significantly different effects on comovements at different frequencies. This sheds more light on previous results based on statistical filters.     

Introduction: macroeconomic implications of capital flows in a global economy

The papers in this volume address issues raised by the wave of financial crises that hit emerging markets since the mid 1990s. Several of the papers examine the role that different credit market frictions may have played in triggering the crises, or in determining the effects of policies aimed at containing them. Other papers ask more general questions about the implications of international financial integration for business cycles, risk sharing, and sovereign lending.     

Dollarization and financial integration

How does a country's exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government responds to shocks by adjusting monetary policy and foreign borrowing. Sovereign borrowing is subject to endogenous limits, which ensure repayment when the default punishment corresponds to financial autarky. Dollarizing implies renouncing monetary policy, but can make access to international debt markets more valuable, thereby loosening borrowing constraints. This mechanism linking dollarization to financial integration is consistent with observed declines in spreads on foreign-currency debt in countries adopting the dollar or the euro.     

External factors in emerging market recoveries: An empirical investigation

We estimate conditional duration models to analyse recovery processes in emerging market economies. Our reduced form specification is parsimonious, as we focus on exogenous factors, such as the effect of growth in the US, EU, and Japan on the prospects for recovery in emerging market economies experiencing recessions. The model confirms the importance of external factors in recovery processes. However, the short-run effect of Japanese growth on recovery prospects is unconventional: weak economic conditions in Japan turn out to facilitate recoveries.     

Monetary policy in a financial crisis

What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite effects? We answer these questions in a general class of open economy models, where a financial crisis is modelled as a time when collateral constraints are suddenly binding. We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment. When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfare-increasing economic expansion.     

Money Market Uncertainty and Retail Interest Rate Fluctuations: A Cross-Country Comparison

Abstract. This paper analyzes empirically the relationship between money market uncertainty and unexpected deviations in retail interest rates in a sample of ten OECD countries. We find that, with the exception of the United States, money market uncertainty has only a modest impact on the conditional volatility of retail interest rates. Even for the United States, we find that the effects of money market uncertainty are spread out over time. Our results also indicate that money market uncertainty tends to be passed on to retail rates to a lesser extent in countries where banking relationships play a substantial role.     

Monetary integration and inflation preferences: A real options analysis

We use a two-country model where policymakers minimize Barro-Gordon-type loss functions over inflation, and inflation preferences follow geometric Brownian motions, to characterize and solve the optimal stopping problem describing a given country's decision of whether or not to pursue monetary integration with the other one, and derive the conditions under which monetary integration can, or will never, be an equilibrium outcome in our economy. We then carry out comparative statics analysis on the bounds characterizing these conditions and on the range of relative inflation preference parameters that support monetary integration in equilibrium, and illustrate with numerical examples.     

Currency crisis transmission through international trade

The Eurozone recent crisis has shown how balance of payments problems in less developed European Monetary Union (EMU) member countries can affect EMU trading partners, spreading the crisis to a larger group of countries. This paper introduces a three-country dynamic general equilibrium model to analyze whether and how terms of trade effects can generate a spillover effect or a currency crisis transmission between countries. Specifically, using a two period model, it incorporates world market clearing conditions for tradables into a new theoretic model, analyzes net capital flow movements between countries, and establishes cross-border macroeconomic linkages. This paper shows how a currency crisis can transmit through the real (trade) sector channel of the economy.     

Exchange Rate Unification Under Non-Credibility: The Haïtian Economy

This paper builds on three strands of literature—Early Warning Systems (EWS), parallel exchange rates, and collapsing exchange rate regimes—by addressing the issue of credibility in the context of unification of the exchange rate in the Haïtian economy. It takes the view that when policymakers are perceived as non-credible, economic agents resort to observation of the economy's performance to assess the imminence of reforms. They then readjust their own behavior, particularly in the area of asset holdings. This paper models the adjustment process using the EWS ratios. Data supports the idea that credibility of the reform mounts over time reaching 85 percent on the eve of the reform.Winston-Salem State University—U.S.A. I would like to thank Mina Baliamoune and an anonymous referee of this journal for helpful comments and suggestions. All remaining errors are my responsibility.     

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.     

A new interpretation of known facts: The case of two-way causality between trading and volatility

Efficient price setting implies that news create volatility since traders flock to the market in order to re-optimise their portfolios. In due course of the price finding process volatility should decline once the asset price approaches its new, efficient level. In this note I present evidence that the reverse mechanism plays as well. Traders genuinely increase volatility challenging the presumption that more traders help to identify the efficient price more quickly.     

Monetary union or currency competition? Currency arrangements for monetary stability in East and West

Recent events in the European Monetary System on the one hand and monetary disintegration in the former Soviet Union on the other hand have revived interest in the question of how to design and choose a monetary regime for both parts of Europe that ensures monetary stability. The objective of monetary stability can be achieved either by complete monetary union or by currency competition. Building on Hayek's ideas, I argue that both regimes are viable solutions depending on the circumstances. The paper first focuses on the misperceived benefits of flexible exchange rates, making the case for monetary union in Western Europe. However, monetary union is no alternative for Eastern Europe and the former Soviet Union. Instead currency competition could be used to retain the benefits of flexible exchange rates and to foster monetary stability at the same time.     

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.