International Seminar on Macroeconomics

June 12-13, 2009
Jeffrey Frankel and Francesco Giavazzi, ISOM Chairs
Lucrezia Reichlin and Kenneth West, Program Organizers

Dennis Quinn, Georgetown University; and Hans-Joachim Voth, MIT,
Free Flows, Limited Diversification: Openness and the Fall and Rise of Stock Market Correlations, 1890-2001

Using a new dataset on capital account openness, Quinn and Voth investigate why equity return correlations changed over the last century. Based on a new, long-run dataset on capital account regulations in a group of 16 countries over the period 1890-2001, they show that correlations increase as financial markets are liberalized. These findings are robust to controlling for both the Forbes-Rigobon bias and global averages in equity return correlations. They test the robustness of their conclusions and show that greater synchronization of fundamentals is not the main cause of increasing correlations. These results imply that the home bias puzzle may be smaller than traditionally claimed.

Marc Flandreau, Graduate Institute Geneva; Juan Flores, University of Geneva; Norbert Gaillard, Sciences Po.; and Sebastian Nieto, OECD,
The Default Puzzle: Underwriters and Sovereign Bond Markets 1815-2007

Flandreau, Flores, Gaillard, and Nieto provide a comparison of salient organizational features of primary markets for foreign government debt over the very long run. They focus on output, quality control, information provision, competition, pricing, charging and signaling. They find that the markets' set up experienced a radical transformation in the recent period and they interpret this as resulting from the rise of liability insurance provided by rating agencies. Underwriters have given up their former role as gatekeepers of liquidity and certification agencies to become aggressive competitors in a new speculative grade market.

Romain Ranciere, International Monetary Fund; and Aaron Tornell, UC, Los Angeles,
Systemic Risk-Taking and the US Financial Crisis

The recent macroeconomic experience of the United States resembles the boom-bust cycles of emerging markets more than the tame postwar U.S. business cycles. Ranciere and Tornell present a model in which a feedback loop between credit and prices generates the boom and the bust and accounts for several stylized facts that characterize the U.S. experience. They then use this framework to analyze the dynamics of external imbalances and to evaluate post-crisis stabilization policy.

Domenico Giannone, European Central Bank; and Michele Lenza, European Central Bank,
The Feldstein-Horioka Fact

Giannone and Lenza show that general equilibrium effects can partly rationalize the high correlation between saving and investment rates observed in OECD countries. They find that once controlling for general equilibrium effects, the saving-retention coeffcient remains high in the 197os but decreases considerably after the 1980s, consistent with the increased capital mobility in OECD countries.

Philippe Bacchetta, University of Lausanne; and Eric van Wincoop, University of Virginia and NBER,
Can Parameter Instability Explain the Meese-Rogoff Puzzle?

The empirical literature on nominal exchange rates shows that the current exchange rate is often a better predictor of future exchange rates than a linear combination of macroeconomic fundamentals. This result is behind the famous Meese-Rogoff puzzle. Bacchetta and van Wincoop evaluate whether parameter instability can account for this puzzle. They consider a theoretical reduced-form relationship between the exchange rate and fundamentals in which parameters are either constant or time varying. They calibrate the model to data for exchange rates and fundamentals and conduct the same Meese-Rogoff exercise with data generated by their model. Their main finding is that the impact of time-varying parameters on the prediction performance is either very small or goes in the wrong direction. To help interpret the findings, they derive theoretical results on the impact of time-varying parameters on the out-of-sample forecasting performance of the model. They conclude that it is not time-varying parameters, but rather small sample estimation bias, that explains the Meese-Rogoff puzzle.

Kathryn M.E. Dominguez, University of Michigan and NBER,
International Reserves and Underdeveloped Capital Markets

International reserve accumulation by developing countries is just one example of the puzzling behavior of international capital flows. Capital should flow to where its return is highest, which ought to be where capital is scare. Yet recent data suggest the opposite - net capital flows from developing countries to industrialized countries. Dominguez examines the role of financial market development in the accumulation of international reserves. In countries with underdeveloped capital markets, the government's accumulation of reserves may substitute for what would otherwise be private sector capital outflows. Effectively, these governments are acting as financial intermediaries, channeling domestic savings away from local uses and into international capital markets, thereby offsetting the effects of domestic financial constraints that lead to excessive private sector exposure to potential capital shortfalls.

Lukasz A. Drozd, University of Minnesota; and Jaromir Nosal, Columbia University,
The Nontradable Goods’ Real Exchage Rate Puzzle

Drozd and Nosal study the decomposition of the real exchange rate into tradable and nontradable components, in the spirit of Engel (1999). Empirically, using an extended decomposition, they find that the contribution of the relative price of nontradable goods to local nontradable output to the overall real exchange rate movements is at best modest. Theoretically, they argue that this finding is a puzzle for the standard models in which the law of one price holds, and fluctuations of the real exchange rate for tradable goods are fully accounted for by the relative price movements of the differentiated home and foreign tradable goods. Specifically, they find that, in the best case scenario, the standard model overshoots the contribution of non-tradable goods to the overall real exchange rate fluctuations by a factor of two.

Luca Ricci, IMF
Assessing External Equilibrium in Low Income Countries

Christiansen and co-authors empirically investigate the external performance of low income countries, as measured by the real exchange rate, the current account, and the net foreign assets. Their paper focuses on indicators that are specific to low income countries, such as the quality of policies and institutions, the special financing access, and the role of shocks. They also offer a metric for linking the external indicators via a calibration of trade elasticities.

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