International Finance and Macroeconomics

March 28, 2014
Gita Gopinath of Harvard University and Hélène Rey of London Business School, Organizers

Xavier Gabaix and Matteo Maggiori, New York University and NBER

International Liquidity and Exchange Rate Dynamics (NBER Working Paper 19854)

Gabaix and Maggiori provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers who bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus affecting both the level and volatility of exchange rates. The authors' theory of exchange rate determination in imperfect financial markets not only rationalizes the empirical disconnect between exchange rates and traditional macroeconomic fundamentals but also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. The authors derive conditions under which heterodox government financial policies, such as currency interventions and taxation of capital flows, can be welfare-improving. Their framework is flexible: it accommodates a number of important modeling features within an imperfect financial market model such as non-tradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.

Ralph Koijen, London Business School; Tobias Moskowitz, University of Chicago and NBER; Lasse Pedersen, Copenhagen Business School and NBER; and Evert Vrugt, VU University Amsterdam, PGO-IM

Carry (NBER Working Paper 19325)

Any security's expected return can be decomposed into its "carry" and its expected price appreciation, where carry is a model-free characteristic that can be observed in advance. While carry has been studied almost exclusively for currencies, Koijen, Moskowitz, Pedersen, and Vrugt find that carry predicts returns both in the cross-section and time series for a variety of different asset classes including global equities, global bonds, commodities, U.S. Treasuries, credit, and options. This predictability rejects a generalized version of the uncovered interest rate parity and expectations hypothesis in favor of models with varying risk premiums. The authors' global carry factor across markets delivers strong average returns and, while it is exposed to recession, liquidity, and volatility risks, its performance presents a challenge to asset pricing models.

Craig Burnside, Duke University and NBER, and Jeremy Graveline, University of Minnesota

Exchange Rate Determination, Risk Sharing and the Asset Market View (NBER Working Paper 18646)

Recent research in international asset pricing has argued that changes in real exchange rates can be understood using only asset market data and an equation that relates changes in the exchange rate to differences between representative agents' intertemporal marginal rates of substitution (IMRSs). Burnside and Graveline show that asset market data and this equation alone are not sufficient to understand how real exchange rates are determined, nor are they sufficient to economically interpret time-series variation in real exchange rates. Instead, they argue that it is necessary to make specific assumptions about preferences, goods market frictions, and asset markets. They also clarify the connection between agents' IMRSs and reduced-form stochastic discount factors (SDFs) that are identified using only asset market data. The authors show that reduced-form models of two SDFs that satisfy this equation have exactly the same economic content as an arbitrage-free statistical model of exchange rate dynamics.

Mark Aguiar, Princeton University and NBER, and Manuel Amador, University of Minnesota and NBER

Take the Short Route: How to Repay and Restructure Sovereign Debt with Multiple Maturities (NBER Working Paper 19717)

Aguiar and Amador address the question of whether and how a sovereign should reduce its external indebtedness when default is a significant possibility, with a particular focus on whether a sovereign should buy back or dilute existing long-term sovereign bonds. The main finding is that when reduction of debt is optimal, the sovereign should remain passive in the long-term bond market during the deleveraging process, retiring long-term bonds as they mature but never actively issuing or buying back these bonds. The only active margin is the short-term bond market, which involves partial rollover of such debt. Any active maturity management, as will typically be required to address rollover crisis risk, will be delayed until the end of the deleveraging process. The authors also show that there is a set of Pareto-improving debt restructurings in which maturities are shortened. However, these cannot be implemented by trading in competitive secondary markets.

Philippe Martin, Sciences Po, and Thomas Philippon, New York University and NBER

Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone

Economists disagree about the nature of the Eurozone crisis. Some see the crisis as driven by fiscal indiscipline, others by external imbalances and sudden stops, and still others by excessive private leverage. Motivated by the comparison of the Great Recessions in the United States and the Eurozone, Martin and Philippon analyze the role of private and public leverage and ask: What are the main drivers of the recession? To what extent can private and public leverage movements explain macroeconomic outcomes in the different Eurozone countries? What are the respective roles of sudden stops of foreign capital and fiscal policies? The authors find that from 2008 to 2012 the difference in fate across Eurozone countries is well explained by the dynamics of household leverage. The dynamics of the Eurozone are similar to those of the United States. In both currency areas, regions that experience the largest increases in household leverage during the credit boom of 2000-8 experience the largest declines in output and employment during the bust of 2008-10. However, after 2010 they find a distinct role for sudden stops and sovereign risk in the Eurozone, but not in the United States. To study these questions, the authors develop a model of open economies within a monetary union where macroeconomic dynamics are driven by private and public leverage decisions. They analyze how the model can explain the cross-sectional variance in employment, output, and consumption in the Eurozone countries.

Atish Ghosh, Mahvash Qureshi, and Charalambos Tsangarides, International Monetary Fund

Friedman Redux: External Adjustment and Exchange Rate Flexibility

Do flexible exchange rates faciliate external adjustment as argued by Milton Friedman? Recent studies find surprisingly little robust evidence that they do. Ghosh, Qureshi, and Tsangarides argue that this is because they use aggregate exchange rate regime classifications which often mask very heterogeneous bilateral relationships between countries. Constructing a novel dataset of bilateral exchange rate regimes that differentiates by the degree of exchange rate flexibility as well as by direct and indirect exchange rate relationships for a sample of 181 countries over 1980–2011, the authors find a significant and empirically robust relationship between exchange rate flexibility and the speed of external adjustment. Their results are supported by several natural experiments of exogenous changes in bilateral exchange rate regimes.

David Cook, HKUST, and Michael Devereux, University of British Columbia and NBER

Exchange Rate Flexibility under the Zero Lower Bound: the Need for Forward Guidance

Macroeconomic theory says that when a country is vulnerable to idiosyncratic macro shocks, it should have its own currency and a flexible exchange rate. But recently in many countries, interest rates have been pushed down close to the lower bound, limiting the ability of policymakers to accommodate shocks, even in countries with flexible exchange rates. Cook and Devereux argue that if the zero bound constraint is binding and policy lacks an effective "forward guidance" mechanism, a flexible exchange rate system may be inferior to a single currency area, even in the face of country-specific macro shocks. With monetary policy constrained by the zero bound, under flexible exchange rates, the exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries is constrained by the zero bound and other countries freely adjust their interest rates under an optimal targeting rule. In a zero lower bound environment, in order for a regime of multiple currencies to dominate a single currency, it is necessary to have effective forward guidance in monetary policy.

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