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on International Finance |
| By: | Adrien Verdelhan (Department of Economics, Boston University); |
| Abstract: | This paper presents a fully rational general equilibrium model that produces a time-varying exchange rate risk premium and solves the uncovered interest rate parity puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences similar to Campbell & Cochrane (1999) and they incur proportional and quadratic international trade costs. The domestic investor receives a positive exchange rate risk premium when she is effectively more risk-averse than her foreign counterpart. Times of high risk-aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. |
| Keywords: | Exchange rate, Time-varying risk premium, Habits. |
| JEL: | F31 G12 G15 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2006-042&r=ifn |
| By: | Vitale, Paolo |
| Abstract: | We offer a critical review of recent developments in the study of foreign exchange intervention. In particular, we discuss some unresolved issues, such as the secrecy puzzle, the relevance of the signalling and portfolio-balance effect hypotheses, the identification of the impact of foreign exchange intervention on currency values. We suggest that: i) the unresolved nature of these issues is partly due to the absence of a market microstructure perspective in most of the existing analysis of foreign exchange intervention; and ii) that recent promising advances in this strand of research have not fully exploited the potential of such perspective. |
| Keywords: | exchange rate dynamics; foreign exchange micro structure; official intervention |
| JEL: | D82 G14 G15 |
| Date: | 2006–06 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5729&r=ifn |
| By: | Artis, Michael J |
| Abstract: | The paper presents the text of a lecture given at the Bank of England in December 2005 as the first in a series of lectures in memory of John Flemming. It provides a personal view of what the profession has learnt about currency unions as a result of the establishment and operation of the European Monetary Union. It argues that the salience of business cycle concurrence as a criterion for participation is probably less than used to be understood and for some countries borders on irrelevance. In any case the effects of union upon business cycle concurrence are themselves not obvious. It also appears that, after a period in which very large estimates of the trade effect of currency unions were widespread, more modest estimates are in order. The most unlooked-for effect is probably that which has occurred in the financial markets; country premia within the EMU are very small, offering a means for insurance against asymmetric shocks. Finally, the lessons of another, local, experiment in currency union is examined. But the useful lessons from this experiment (Ecco L’Euro) are found to be limited. |
| Keywords: | currency union; EMU; optimal currency area theory |
| JEL: | E0 E4 F1 |
| Date: | 2006–05 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5677&r=ifn |
| By: | Alexandre B. Cunha (IBMEC Business School - Rio de Janeiro) |
| Abstract: | In this paper we extend the Modigliani-Miller Theorem to the composition of the public debt. We show that in a deterministic model the structure of a government's assets and liabilities is undetermined. Hence, a floating exchange rate regime can implement any attainable competitive equilibrium. Concerning stochastic economies, if the government issues nominal bonds of several maturities, then the same result may hold. Thus, a conceivable link between the choice of an exchange rate regime and economic outcomes may be due to factors often not considered in standard macroeconomic models. |
| Keywords: | Modigliani-Miller Theorem, exchange rate regime, indeterminacy |
| JEL: | E42 E58 F31 F41 G32 |
| Date: | 2006–10–24 |
| URL: | http://d.repec.org/n?u=RePEc:ibr:dpaper:2006-03&r=ifn |
| By: | Rose, Andrew K |
| Abstract: | A stable international monetary system has emerged since the early 1990s. A large number of industrial and a growing number of developing countries now have domestic inflation targets administered by independent and transparent central banks. These countries place few restrictions on capital mobility and allow their exchange rates to float. The domestic focus of monetary policy in these countries does not have any obvious international cost. Inflation targeters have lower exchange rate volatility and less frequent “sudden stops” of capital flows than similar countries that do not target inflation. Inflation targeting countries also do not have current accounts or international reserves that look different from other countries. This system was not planned and does not rely on international coordination. There is no role for a center country, the IMF, or gold. It is durable; in contrast to other monetary regimes, no country has yet abandoned an inflation-targeting regime in crisis. Succinctly, it is the diametric opposite of the post-war system; Bretton Woods, reversed. |
| Keywords: | capital; controls; durable; exchange; finance; fixed; inflation; rate; regime |
| JEL: | F02 F10 F34 |
| Date: | 2006–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5854&r=ifn |
| By: | Hanno Lustig (UCLA/NBER); Adrien Verdelhan (Department of Economics, Boston University) |
| Abstract: | Aggregate consumption growth risk explains why low interest rate curren- cies do not appreciate as much as the interest rate di®erential and why high interest rate currencies do not depreciate as much as the interest rate di®er- ential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreci- ate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk. |
| JEL: | F31 G12 |
| Date: | 2006–02 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2006-040&r=ifn |
| By: | Gersbach, Hans; Schmutzler, Armin |
| Abstract: | We analyze a two-country model of Foreign Direct Investment (FDI). Two firms, each of which is originally situated in only one of the two countries, first decide whether to build a plant in the foreign country. Then, they decide whether to relocate R&D activities. Finally, they engage in product-market competition. Our main points are: first, FDI liberalization causes a relocation of R&D activities if intrafirm communication is sufficiently well developed, external spillovers are substantial, competition is not too strong and foreign markets are not too small. Second, such a relocation of R&D activities will usually nevertheless increase domestic welfare since it only occurs if intrafirm communication is well developed and therefore knowledge generated and obtained abroad flows back to the domestic country. Third, the potential of R&D offshoring makes FDI itself more likely. Fourth, when countries are asymmetric, the small-country firm is more likely to offshore its R&D activities into the large country than conversely. |
| Keywords: | foreign direct investment; R&D; research relocation; spillovers |
| JEL: | F23 O30 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5766&r=ifn |
| By: | Marin, Dalia; Schnitzer, Monika |
| Abstract: | In this paper we analyze the conditions under which a foreign direct investment (FDI) involves a net capital flow across countries. Frequently, foreign direct investment is financed in the host country without an international capital movement. We develop a model in which the optimal choice of financing an international investment trades off the relative costs and benefits associated with the allocation and effectiveness of control rights resulting from the financing decision. We find that the financing choice is driven by managerial incentive problems and that FDI involves an international capital flow when these problems are not too large. Our results are consistent with data from a survey on German and Austrian investments in Eastern Europe. |
| Keywords: | firm specific capital costs; internal capital markets; international capital flows; multinational firms |
| JEL: | D23 F21 F23 G32 L20 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5755&r=ifn |
| By: | Devereux, Michael B; Saito, Makoto |
| Abstract: | Recent global imbalances and large gross external financial movements have raised interest in modeling the relationship between international financial market structure and capital flows. This paper constructs a model in which the composition of national portfolios is an essential element in facilitating international capital flows. Each country chooses an optimal portfolio in face of real and nominal risk. Current account deficits are financed by net capital flows which reflect differential movements in the holdings of gross external assets and liabilities. A country experiencing a current account deficit will be accumulating both gross external liabilities and gross external assets. Net capital flows generate movements in risk premiums such that the rate of return on a debtor country's gross liabilities is lower than the return on its gross assets. This ensures stability of the world wealth distribution. An attractive feature of the model is that portfolio shares, returns, and the wealth distribution can be characterized analytically. A calibrated version of the model can match quite well the observed measures of gross and net external assets and liabilities for the US economy. |
| Keywords: | current account; international capital flows; portfolio |
| JEL: | F32 F34 F41 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5746&r=ifn |
| By: | Obstfeld, Maurice |
| Abstract: | In the face of huge balance of payments surpluses and internal inflationary pressures, China has been in a classic conflict between internal and external balance under its dollar currency peg. Over the longer term, China’s large, modernizing, and diverse economy will need exchange rate flexibility and, eventually, convertibility with open capital markets. A feasible and attractive exit strategy from the essentially fixed RMB exchange rate would be a two-stage approach, consistent with the steps already taken since July 2005, but going beyond them. First, establish a limited trading band for the RMB relative to a basket of major trading partner currencies. Set the band so that it allows some initial revaluation of the RMB against the dollar, manage the basket rate within the band if necessary, and widen the band over time as domestic foreign exchange markets develop. Second, put on hold ad hoc measures of financial account liberalization. They will be less helpful for relieving exchange rate pressures once the RMB/basket rate is allowed to move flexibly within a band, and they are best postponed until domestic foreign exchange markets develop further, the exchange rate is fully flexible, and the domestic financial system has been strengthened and placed on a market-oriented basis. |
| Keywords: | China balance of payments; China currency; fixed exchange rate exit strategy; renminbi |
| JEL: | F32 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5771&r=ifn |
| By: | Alexei Deviatov (New Economic School); Igor Dodonov (New Economic School) |
| Abstract: | Empirical analysis of exchange rates has produced puzzles that conventional models of exchange rates cannot explain. Here we deal with four puzzles regarding both real and nominal exchange rates, which are robust and inconsistent with standard theory. These puzzles are that both real and nominal exchange rates: i) are disconnected from fundamentals, ii) are much more volatile than fundamentals, iii) show little di?erence in behavior, and iv) fail to satisfy conservation of volatility. We develop a two-country, two-currency version of the random matching model to study exchange rates. We show that search and legal restrictions can produce exchange-rate dynamics consistent with these four puzzles. |
| Keywords: | exchange-rate puzzles, exchange-rate volatility, bargaining, search |
| JEL: | F31 C78 |
| Date: | 2006–06 |
| URL: | http://d.repec.org/n?u=RePEc:cfr:cefirw:w0079&r=ifn |
| By: | Devereux, Michael B; Engel, Charles M |
| Abstract: | Both empirical evidence and theoretical discussion have long emphasized the impact of `news' on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods when nominal goods prices are sticky. In this paper we argue that these two roles may conflict with one another. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. Friedman's (1953) case for unfettered flexible exchange rates is overturned when exchange rates are asset prices. We outline a series of models in which an optimal policy eliminates the effects of news on exchange rates. |
| Keywords: | exchange rate; expectations; monetary policy |
| JEL: | F3 F31 F33 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5743&r=ifn |
| By: | Kirill Sosunov (Higher School of Economics); Oleg Zamulin (New Economic School) |
| Abstract: | The paper investigates the ability of monetary authorities to keep the real exchange rate undervalued over the long run by implementing a policy of accumulating foreign exchange reserves. We consider a model of a three-sector, small, open economy, where the central bank continuously purchases foreign currency reserves and compare the results to Russian and Chinese economies in recent years. Both countries appear to pursue reserve accumulation policies. We find a clear trade-o between the steady state levels of the real exchange rate and inflation. After calibration, the model predicts an 8.5% real undervaluation of the Russian currency and a 13.7% undervaluation of the Chinese currency. Predicted inflation is found to match observed levels. |
| Keywords: | Real exchange rate targeting, foreign exchange reserves, Dutch disease |
| JEL: | E52 F4 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:cfr:cefirw:w0082&r=ifn |
| By: | Papaioannou, Elias; Portes, Richard; Siourounis, Gregorios |
| Abstract: | Foreign exchange reserve accumulation has risen dramatically in recent years. The introduction of the euro, greater liquidity in other major currencies, and the rising current account deficits and external debt of the United States have increased the pressure on central banks to diversify away from the US dollar. A major portfolio shift would significantly affect exchange rates and the status of the dollar as the dominant international currency. We develop a dynamic mean-variance optimization framework with portfolio rebalancing costs to estimate optimal portfolio weights among the main international currencies. Making various assumptions on expected currency returns and the variance-covariance structure, we assess how the euro has changed this allocation. We then perform simulations for the optimal currency allocations of four large emerging market countries (Brazil, Russia, India and China), adding constraints that reflect a central bank’s desire to hold a sizable portion of its portfolio in the currencies of its peg, its foreign debt and its international trade. Our main results are: (i) The optimizer can match the large share of the US dollar in reserves, when the dollar is the reference (risk-free) currency. (ii) The optimum portfolios show a much lower weight for the euro than is observed. This suggests that the euro may already enjoy an enhanced role as an international reserve currency ('punching above its weight'). (iii) Growth in issuance of euro-denominated securities, a rise in euro zone trade with key emerging markets, and increased use of the euro as a currency peg, would all work towards raising the optimal euro shares, with the last factor being quantitatively the most important. |
| Keywords: | currency optimizer; euro; foreign reserves; international currencies |
| JEL: | F02 F30 G11 G15 |
| Date: | 2006–07 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5734&r=ifn |
| By: | Corsetti, Giancarlo; Dedola, Luca; Leduc, Sylvain |
| Abstract: | This paper investigates the international transmission of productivity shocks in a sample of five G7 countries. For each country, using long-run restrictions, we identify shocks that increase permanently domestic labour productivity in manufacturing (our measure of tradables) relative to an aggregate of other industrial countries including the rest of the G7. We find that, consistent with standard theory, these shocks raise relative consumption, deteriorate net exports, and raise the relative price of nontradables -- in full accord with the Harrod-Balassa-Samuelson hypothesis. Moreover, the deterioration of the external account is fairly persistent, especially for the US. The response of the real exchange rate and (our proxy for) the terms of trade differs across countries: while both relative prices depreciate in Italy and the UK (smaller and more open economies), they appreciate in the US and Japan (the largest and least open economies in our sample); results are however inconclusive for Germany. These findings question a common view in the literature, that a country's terms of trade fall when its output grows, thus providing a mechanism to contain differences in national wealth when productivity levels do not converge. They enhance our understanding of important episodes such as the strong real appreciation of the dollar as the US productivity growth accelerated in the second half of the 1990s. They also provide an empirical contribution to the current debate on the adjustment of the US current account position. Contrary to widespread presumptions, productivity growth in the US tradable sector does not necessarily improve the US trade deficit, nor deteriorate the US terms of trade, at least in the short and medium run. |
| Keywords: | international transmission mechanism; long-run restrictions; net exports; real exchange rates; terms of trade; US current account; VAR |
| JEL: | F32 F41 F42 |
| Date: | 2006–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5853&r=ifn |
| By: | Adao, Bernardino; Correia, Maria Isabel Horta; Teles, Pedro |
| Abstract: | This paper assesses the relevance of the exchange rate regime for stabilization policy. This regime question cannot be dealt with independently of other institutions, in particular how fiscal policy is designed. We show that once fiscal policy is taken into account, 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 and regardless of the incompleteness of international financial markets. The only relevant condition is labour mobility. The immobility of labour across countries is a necessary condition for our results. |
| Keywords: | fiscal and monetary policy; fixed exchange rates; labour mobility; monetary union; nominal rigidities; stabilization policy |
| JEL: | E31 E63 F20 F33 F41 F42 |
| Date: | 2006–08 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5797&r=ifn |
| By: | Paz Rico Belda (Universitat de València) |
| Abstract: | This paper investigates whether threshold effects exist in the relationship between dollar-euro real exchange rate and real interest differential, over the period January 1984 to December 2004. We specify a three-regime threshold model and the results provide evidence that there is no threshold effect in the short term, but the nonlinear behaviour of real exchange rate implies threshold effect in the long term. On the other hand, the nonlinearity into the behaviour of real exchange rates can be modelled by a Band-TAR which implies a symmetric response to the real interest differential outside the bank. Finally, into the threshold band the behaviour of real exchange rate is near to follow a random walk, so monetary shocks are more persistence than outside this region. En este trabajo se analiza si existe efecto umbral en la relación entre el tipo de cambio real dólar-euro y el diferencial de intereses reales, durante el periodo comprendido entre enero de 1984 y diciembre de 2004. Para ello se específica un modelo threshold de tres regímenes y los resultado evidencian que no existe efecto umbral corto plazo pero si a largo plazo. El comportamiento no lineal del tipo de cambio real conlleva en el largo plazo una respuesta al diferencial de intereses reales que es diferente fuera que dentro de la banda umbral. Asimismo, el comportamiento del tipo de cambio real sigue un proceso Band-TAR, de tal forma que reacciona igual por arriba que por debajo de la banda al diferencial de intereses reales. Finalmente, dentro de la banda umbral el tipo de cambio real muestra un comportamiento cercano a presentar raíz unitaria, por lo que los shocks monetarios generan desviaciones de su nivel de equilibrio más persistentes que fuera de la banda. |
| Keywords: | banda umbral, tipo de cambio real, diferencial de intereses reales, paridad de poder adquisitivo, no linealidad Threshold, real exchange rates, real interest differentials, purchasing power parity, nonlinearity. |
| JEL: | F30 F47 C53 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:ivi:wpasec:2006-13&r=ifn |
| By: | Kose, Ayhan; Prasad, Eswar; Rogoff, Kenneth; Wei, Shang-Jin |
| Abstract: | The literature on the benefits and costs of financial globalization for developing countries has exploded in recent years, but along many disparate channels with a variety of apparently conflicting results. We attempt to provide a unified conceptual framework for organizing this vast and growing literature. This framework allows us to provide a fresh synthetic perspective on the macroeconomic effects of financial globalization, both in terms of growth and volatility. Overall, our critical reading of the recent empirical literature is that it lends some qualified support to the view that developing countries can benefit from financial globalization, but with many nuances. On the other hand, there is little systematic evidence to support widely-cited claims that financial globalization by itself leads to deeper and more costly developing country growth crises. |
| Keywords: | capital account liberalization; developing countries; financial crises; financial integration; growth and volatility |
| JEL: | F02 F21 F36 F4 |
| Date: | 2006–09 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:5842&r=ifn |