International Finance and Macroeconomics

March 13, 2009
Roberto Chang and Kristin Forbes, Organizers

Sebnem Kalemli-Ozcan, University of Houston and NBER,and Bent Sorensen, University of Houston
Deep Financial Integration and Volatility (Joint with Vadym Volosovych)

Theoretical predictions regarding the effect of financial integration on output fluctuations are ambiguous. The empirical studies, using different sources of variation, find mixed results. Kalemli-Ozcan, Sorensen, and Volosovych argue that the key to understanding the relationship between international financial integration and volatility is to study the effect of foreign ownership on firm-level volatility and then to examine whether the firm-level patterns carry over to aggregate data. They investigate the relationship between financial integration, firm-level volatility, and aggregate output fluctuations. Using micro data from the AMADEUS database, they construct a measure of “deep" financial integration based on direct observations of foreign ownership at the firm level. They measure domestic financial development as the extent of firm-level cross-ownership within the same country. They find a significant positive effect of deep financial integration on the volatility of firms' outcomes. This effect survives aggregation (both by the authors and by Eurostat) and carries over to regional output, conditional on the extent of regulation. Although a high level of domestic cross-ownership is associated negatively with firm-level volatility, there is no robust effect of domestic financial development on regional output volatility. The authors further show that the level of volatility is lower in the countries that are highly regulated.

Charles Engel, University of Wisconsin and NBER
Currency Misalignments and Optimal Monetary Policy: A Reexamination

Engel examines optimal monetary policy in an open-economy two-country model with sticky prices. He shows that currency misalignments are inefficient and lower world welfare. He finds that optimal policy must target not only inflation and the output gap, but also the currency misalignment. However, the interest rate reaction function that supports this targeting rule involves only the CPI inflation rate. This result illustrates how examination of “instrument rules” may hide important trade-offs facing policymakers that are incorporated in “targeting rules.” The model is a modified version of Clarida, Gali, and Gertler (JME, 2002). The key change is that Engel allows pricing to market or local-currency pricing and considers the policy implications of currency misalignments. Besides highlighting the importance of the currency misalignment, this model also provides a rationale for targeting CPI inflation, rather than PPI inflation as in Clarida, Gali, and Gertler.

Menzie Chinn, University of Wisconsin and NBER, and Michael Moore, Queen’s University
Private Information and the Monetary Model of Exchange Rates: Evidence from a Novel Data Set

Chinn and Moore propose an exchange rate model that is a hybrid of the conventional specification with monetary fundamentals and the Evans-Lyons microstructure approach. It argues that the failure of the monetary model is principally attributable to private preference shocks that render the demand for money unstable. These shocks to liquidity preference are revealed through order flow. The authors estimate a model augmented with order flow variables, using a unique dataset: almost 100 monthly observations on inter-dealer order flow on dollar/euro and dollar/yen. The augmented macroeconomic, or “hybrid”, model exhibits out-of-sample forecasting improvement over the basic macroeconomic and random walk specifications.

Anrew Rose, UC Berkeley and NBER,and Mark Spiegel, Federal Reserve Bank of San Francisco
The Olympic Effect

Economists are skeptical about the economic benefits of hosting “mega-events" such as the Olympic Games or the World Cup, since such activities have considerable costs and seem to yield few tangible benefits. These doubts are rarely shared by policymakers and the population, who are typically quite enthusiastic about such spectacles. Rose and Spiegel reconcile these positions by examining the economic impact of hosting mega-events like the Olympics: they focus on trade. Using a variety of trade models, they show that hosting a mega-event like the Olympics has a positive impact on national exports. This effect is statistically robust, permanent, and large; trade is around 30 percent higher for countries that have hosted the Olympics. Interestingly, however, they also find that unsuccessful bids to host the Olympics have a similar positive impact on exports. They conclude that the Olympic effect on trade is attributable to the signal a country sends when bidding to host the games, rather than the act of actually holding a mega-event. They develop a political economy model that formalizes this idea, and derives the conditions under which a signal like this is used by countries wishing to liberalize.

Emine Boz, IMF, Christian Daude, OECD, and C. Bora Durdu, Federal Reserve Board
Emerging Market Business Cycles Revisited: Learning About the Trend

Using data from a large sample of countries, Boz, Daude, and Durdu show that emerging markets do not differ from developed countries in terms of the variance of permanent TFP shocks relative to transitory shocks. They do differ, however, in the degree of uncertainty that agents face when formulating expectations. Based on these observations, the authors build an equilibrium business cycle model in which the agents cannot perfectly distinguish between the permanent and transitory components of TFP shocks and must learn about those components using the Kalman filter. Calibrated to Mexico, the model predicts a higher variability of con- sumption relative to output and a strongly negative correlation between the trade balance and output, without the predominance of trend shocks. The estimated relative variance of trend shocks in this setup is similar to those estimated for Canada in which informational content of signals appears to be higher.

Yuriy Gorodnichenko, UC Berkeley and NBER, Enrique Mendoza, University of Maryland and NBER, and Linda Tezar, University of Michigan and NBER
The Finnish Great Depression: From Russia With Love

From 1991-3, Finland experienced the deepest economic downturn in an industrialized country since the 1930s. Gorodnichenko, Mendoza, and Tesar argue that the culprit behind this Great Depression was the collapse of Finnish trade with the Soviet Union, because it induced a costly restructuring of the manufacturing sector and a sudden, large increase in the cost of energy. The authors develop and calibrate a multi-sector dynamic general equilibrium model with labor market frictions, and show that the collapse of Soviet-Finnish trade can explain key features of Finland’s Great Depression. They also show that Finland’s Great Depression mirrors the macroeconomic dynamics of the transition economies of Eastern Europe. These economies experienced a similar trade collapse. However, as a western democracy with developed capital markets and institutions, Finland faced none of the large institutional adjustments that other transition economies experienced. Thus, by studying the Finnish experience the authors isolate the adjustment costs attributable solely to the collapse of Soviet trade.

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