International Finance and Macroeconomics

Members of the NBER's International Finance and Macroeconomics Program met in Cambridge on March 8-9. Research Associates Emmanuel Farhi of Harvard University and Brent Neiman of University of Chicago organized the meeting. These researchers' papers were presented and discussed:

Liliana Varela, University of Houston, and Juliana Salomao, University of Minnesota

Exchange Rate Exposure and Firm Dynamics

Varela and Salomao develop a firm-dynamics model with endogenous currency debt composition to study financing and investment decisions in developing economies. In their model, foreign currency borrowing arises from a trade-off between exposure to currency risk and growth. There is cross-sectional heterogeneity in these decisions in two dimensions. First, there is selection into foreign currency borrowing, as only productive firms employ it. Second, there is heterogeneity in firms' share of foreign currency loans, driven by their potential growth. The researchers econometrically assess the pattern of foreign currency borrowing using firm-level census data on Hungary, calibrate the model and quantify it's aggregate impact.

Dmitriy Sergeyev, Bocconi University, and Luigi Iovino, Bocconi University

Central Bank Balance Sheet Policies without Rational Expectations

Sergeyev and Iovino study the effects of central bank balance sheet policies--quantitative easing and foreign exchange interventions--in a model without rational expectations. The researchers use the "level-k thinking" belief formation and the associated reflective equilibrium that rationalize the idea that it is difficult to change expectations about economic outcomes even if it is easy to shift expectations about the policy. Sergeyev and Iovino emphasize two main results. First, under a iybroad set of conditions, central bank interventions are neutral in the rational expectations equilibrium, while they are effective in the reflective equilibrium. Second, the researchers derive testable predictions that can be used to differentiate this "bounded rationality channel" from the alternative "portfolio balance" and "signaling" channels of balance sheet policies.

Anil Ari, International Monetary Fund

Sovereign Risk and Bank Risk-Taking

Ari proposes a dynamic general equilibrium model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and slow recovery from crises. When banks' investment decisions are not contractible, depositors form expectations about bank risk-taking and demand a return on deposits according to their risk. This creates strategic complementarities and possibly multiple equilibria: in response to an increase in funding costs, banks may optimally choose to pursue risky portfolios that undermine their solvency prospects. In a bad equilibrium, high funding costs hinder the accumulation of bank net worth, leading to a persistent drop in investment and output. Ari brings the model to bear on the European sovereign debt crisis, in the course of which under-capitalized banks in default risky countries experienced an increase in funding costs and raised their holdings of domestic government debt. The model is quantified using Portuguese data and accounts for macroeconomic dynamics in Portugal in 2010-2016. Policy interventions face a trade-off between alleviating banks' funding conditions and strengthening risk-taking incentives. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.

Andrei A. Levchenko, University of Michigan and NBER, and Nitya Pandalai-Nayar, University of Texas at Austin

Technology and Non-Technology Shocks: Measurement and Implications for International Comovement

Levchenko and Pandalai-Nayar examine the role of both technology and non-technology shocks in international business cycle comovement. Using industry-level data on 30 countries and up to 28 years, they first provide estimates of utilization-adjusted TFP shocks, and an approach to infer nontechnology shocks. The researchers then set up a quantitative model calibrated to the observed international input-output and final goods trade, and use it to assess the contribution of both technology and non-technology shocks to international comovement. They show that unlike the traditional Solow residual, the utilization-adjusted TFP shocks are virtually uncorrelated across countries. Transmission of TFP shocks across countries also cannot generate noticeable comovement in GDP in their sample of countries. By contrast, non-technology shocks are highly correlated across countries, and the model simulation with only non-technology shocks generates substantial GDP correlations. Levchenko and Pandalai-Nayar conclude that in order to understand international comovement, it is essential to both model and measure non-TFP shocks.

Ryan Chahrour and Rosen Valchev, Boston College

International Medium of Exchange: Privilege and Duty

The United States enjoys an "exorbitant privilege" that allows it to borrow at lower interest rates than the rest of the world. Meanwhile, the dollar plays a special role in the international financial system as the main international medium of exchange. Chahrour and Valchev provide a new theory that links dollarization and exorbitant privilege through the need for an international medium of exchange. They consider a two-country world where international trade happens in decentralized matching markets, and must be collateralized by assets -- a.k.a. currencies -- issued by one of the two countries. Traders have an incentive to coordinate their currency choices and a single dominant currency arises in equilibrium. With a small heterogeneity in traders' information, the equilibrium currency choice is unique, given economic states. Nevertheless, due to feedback between the trading firms' currency choices and the households' portfolio decisions, the model has multiple steady states, where different currencies serve as the dominant international medium of exchange. The economy with the dominant currency enjoys lower interest rates and the ability to run current account deficits indefinitely. Currency regimes are stable as they are not subject to sunspots, but sufficiently large shocks or policy changes can lead to transitions from one steady state to another, with large welfare implications.

Emine Boz, International Monetary Fund; Gita Gopinath, Harvard University and NBER; and Mikkel Plagborg-Møller, Princeton University

Global Trade and the Dollar (NBER Working Paper No. 23988)

Boz, Gopinath, and Plagborg-Møller document that the U.S. dollar exchange rate drives global trade prices and volumes. Using a newly constructed data set of bilateral price and volume indices for more than 2,500 country pairs, they establish the following facts: 1) Bilateral non-commodities terms of trade are essentially uncorrelated with bilateral exchange rates. 2) The dollar exchange rate quantitatively dominates the bilateral exchange rate in price pass-through and trade elasticity regressions. 3) The strength of the U.S. dollar is a key predictor of rest-of-world aggregate trade volume and consumer/producer price inflation. A 1% U.S. dollar appreciation against all other currencies in the world predicts a 0.6% decline within a year in the volume of total trade between countries in the rest of the world, controlling for the global business cycle. 4) Using a novel Bayesian semiparametric hierarchical panel data model, the researchers estimate that the importing country's share of imports invoiced in dollars explains 15% of the variance of dollar pass-through/elasticity across country pairs. Their findings strongly support the dominant currency paradigm as opposed to the traditional Mundell-Fleming pricing paradigms. The researchers then employ a three country model to demonstrate the asymmetries in transmission of monetary policy shocks that arise in the U.S., versus in the rest of the world, in an environment of dollar pricing.

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