International Finance and Macroeconomics

November 9, 2012
Charles Engel, University of Wisconsin, and Linda Tesar, University of Michigan, Organizers

Anton Korinek, University of Maryland and NBER

Capital Controls and Currency Wars

Policy measures that affect international capital flows have led to considerable controversy in international policy circles. Korinek analyzes the welfare effects of such measures in a general equilibrium model of the world economy. Capital controls or reserve accumulation in one country leads to significant international spillover effects via lower world interest rates and greater flows to other countries. If controls are designed to offset domestic externalities, then the resulting equilibrium is nonetheless Pareto efficient -- that is, a global planner would impose the same measure and there is no role for global coordination. Korinek illustrates this for several examples of externalities, including financial stability externalities and capital controls that act as second-best devices to correct a domestic distortion. On the other hand, if policymakers face an imperfect set of instruments, for exmaple targeting problems or costly enforcement, then multilateral coordination is desirable in order to mitigate the inefficiencies arising from such imperfections.

Gazi Kara, University of North Carolina at Chapel Hill

Systemic Risk, International Regulation, and the Limits of Coordination

Kara examines the incentives of national regulators to coordinate regulatory policies in the presence of systemic risk in global financial markets. In a two-country and three-period model, correlated asset fire sales by banks generate systemic risk across national financial markets. In this framework, relaxing regulatory standards in one country increases both the cost and the severity of crises for both countries. In the absence of coordination, independent regulators choose inefficiently low regulatory standards, and systemic banking crises can occur in equilibrium. A central regulator internalizes the systemic risk and improves the welfare of cooperating countries. Also, common central regulation will voluntarily emerge only between sufficiently similar countries.

Logan Lewis, Federal Reserve Board of Governors

Menu Costs, Trade Flows, and Exchange Rate Volatility

In the short run, U.S. imports and exports respond little to exchange rate changes. Pricing behavior has been thought to explain this response: if local prices do not respond to exchange rates, then neither will trade flows. Sticky prices and strategic complementarities in price setting generate sluggish responses, and both are necessary to match newly available international micro price data. Lewis tests models capable of replicating price data against trade flows and finds that even with significant short-run frictions, the models imply a trade response to exchange rates that is stronger than what is found in the data. Moreover, using significant cross-sector heterogeneity, the comparative statics implied by the model find little or no support in the data. These results suggest that while complementarity in price setting and sticky prices can explain pricing patterns, some other short-run friction is needed to match actual trade flows. Furthermore, the muted response found for sectors with high long-run substitutability implies that simply assuming low elasticities may be inappropriate. Finally, there is evidence of an asymmetric response to exchange rate changes.

Mary Amiti, Federal Reserve Bank of New York; Oleg Itskhoki, Princeton University and NBER; and Jozef Konings, Katholieke Universiteit

Importers, Exporters, and Exchange Rate Disconnect

Large exporters are simultaneously large importers. Amiti, Itskhoki, and Konings show that this pattern is key to understanding low aggregate exchange rate pass-through as well as the variation in pass-through across exporters. First, they develop a theoretical framework that combines variable markups caused by strategic complementarities with endogenous choice to import intermediate inputs. The model predicts that firms with high import shares and high market shares have low exchange rate pass-through. Second, they test and quantify the theoretical mechanisms using Belgian firm-product-level data with information on exports by destination and imports by source country. They confirm that import intensity and market share are the prime determinants of pass-through in the cross-section of firms. A small exporter with no imported inputs has a nearly complete pass-through of over 90 percent, while a firm at the 95-th percentile of both import intensity and market share distributions has a pass-through of 56 percent, with the two mechanisms playing roughly equal roles. The largest exporters are simultaneously high-market-share and high-import-intensity firms, which helps to explain the low aggregate pass-through and exchange rate disconnect observed in the data.

Christopher Erceg and Jesper Linde, Federal Reserve Board

Fiscal Consolidation in a Currency Union: Spending Cuts vs. Tax Hikes

Erceg and Linde uses a two country DSGE model to examine the effects of tax-based versus expenditure-based fiscal consolidation in a currency union. They find three key results. First, given limited scope for monetary accommodation, tax-based consolidation tends to have smaller adverse effects on output than expenditure-based consolidation in the near-term, though it is more costly in the longer-run. Second, a large expenditure based consolidation may be counterproductive in the near-term if the zero lower bound is binding, reflecting the fact that output losses rise at the margin. Third, a "mixed strategy" that combines a sharp but temporary rise in taxes with gradual spending cuts may be desirable in minimizing the output costs of fiscal consolidation.

Matteo Cacciatore, HEC Montreal; Giuseppe Fiori, North Carolina State University; and Fabio Ghironi, Boston College and NBER

Market Deregulation and Optimal Monetary Policy in a Monetary Union

The global crisis that began in 2008 reheated the debate on market deregulation as a tool to improve economic performance. Cacciatore, Fiori, and Ghironi address the consequences of increased flexibility in goods and labor markets for the conduct of monetary policy in a monetary union. They model a two-country monetary union with endogenous product creation, labor market frictions, and price and wage rigidities. They allow regulation in goods and labor markets to differ across countries. They first characterize optimal monetary policy when regulation is high and show that the Ramsey allocation requires significant departures from price stability, both in the long run and over the business cycle. Welfare gains from the Ramsey-optimal plicy are sizeable. Second, they show that the adjustment to market reform requires expansionary policy to reduce transition costs. Third, deregulation reduces static and dynamic inefficiencies, making price stability more desirable. International coordination of reforms is beneficial as it eliminates policy tradeoffs generated by asymmetric deregulation.