International Finance and Macroeconomics Program Meeting

October 14, 2011
Charles Engel, University of Wisconsin, and Linda Tesar, University of Michigan, Organizers

Adrien Verdelhan, MIT and NBER
The Share of Systematic Variation in Bilateral Exchange Rates

Verdelhan notes that changes in exchange rates are not random. Two factors account for 20-to-90 percent of the monthly exchange rate movements in developed countries. These two factors - a dollar and a carry factor - also explain a large share of daily and quarterly changes in exchange rates. Similar results emerge for developing countries with floating currencies. Moreover, the factor structure is persistent. As a result, if these two factors were known one period in advance, then mean-squared-errors would be a fraction of those obtained assuming that exchange rates are random walks. Across countries, the higher the share of systematic equity and bond risk, the higher the share of systematic currency risk. These results have direct implications for asset managers, motivate further work on exchange rates, and offer new insights into international economics and finance models.

Chadwick C. Curtis and Steven Lugauer, University of Notre Dame, and Nelson Mark, University of Notre Dame and NBER
Demographic Patterns and Household Saving in China

Curtis, Lugauer, and Mark study the effect that changing demographic patterns have had on the household saving rate in China. They undertake a quantitative investigation using an overlapping generations model where agents live for 85 years. Consumers begin to exercise decision making when they are 18. From ages 18 to 60, they work and raise children. Dependent children's utility enters into parent's utility, where parents choose the consumption level of the young until they leave the household. Working agents give a portion of their labor income to their retired parents and save for their own retirement, while the aged live on their accumulated assets and support from their children. Remaining assets are bequeathed to the living upon death. The authors parameterize the model and take future demographic changes, labor income, and interest rates as exogenously given from the data. They then run the model from 1963 to 2009 and find that it explains nearly all of the observed increase in the household saving rate.

Emmanuel Farhi and Gita Gopinath, Harvard University and NBER, and Oleg Itskhoki, Princeton University and NBER
Fiscal Devaluations

Farhi, Gopinath, and Itskhoki show that even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation in a standard New Keynesian open economy environment. They perform the analysis under alternative pricing assumptions -- producer or local currency pricing -- along with nominal wage stickiness; under alternative asset market structures; and for anticipated and unanticipated devaluations. There are two types of fiscal policies equivalent to an exchange rate devaluation: a uniform increase in import tariff and export subsidy, and an increase in value-added tax and a uniform reduction in payroll tax. When the devaluations are anticipated, these policies need to be supplemented with a reduction in consumption tax and an increase in income taxes. These policies have zero impact on fiscal revenues. In certain cases, equivalence also requires a partial default on foreign bond holders. The authors discuss the issues of implementation of these policies, in particular, under the circumstances of a currency union.

Marina Azzimonti, University of Texas at Austin; Eva deFrancisco, Towson University; and Vincenzo Quadrini, University of Southern California
Financial Globalization and the Raising of Public Debt

During the last three decades, the stock of government debt has increased in most developed countries. During the same period, international capital markets have been liberalized. Azzimonti, deFrancisco, and Quadrini develop a two-country political economy model with incomplete markets and endogenous government borrowing and show that countries choose higher levels of public debt when financial markets are internationally integrated. They also conduct an empirical analysis using OECD country data and find that the predictions of the theoretical model are consistent with the empirical results.

Julian di Giovanni, International Monetary Fund; Andrei Levchenko, University of Michigan and NBER; and Jing Zhang, University of Michigan
The Global Welfare Impact of China: Trade Integration and Technological Change

di Giovanni, Levchenko, and Zhang evaluate the global welfare impact of China's trade integration and technological change in a quantitative Ricardian-Heckscher-Ohlin model implemented on 75 countries. The model implies that the mean gain from trade with China is 0.13 percent, with a range from -0.27 to +0.80 percent. Countries in East Asia tend to gain the most, while many Textile-and-Apparel producing countries experience welfare losses. The authors then simulate two alternative productivity growth scenarios: a "balanced" one in which China's productivity grows at the same rate in each sector; and an "unbalanced" one in which China's comparative disadvantage sectors catch up disproportionately faster to the world productivity frontier. Contrary to a well known conjecture (Samuelson 2004), the average country in the world experiences an order of magnitude larger welfare gains when China's growth is unbalanced.

Logan Lewis, Federal Reserve Board of Governors
Exports versus Multinational Production under Nominal Uncertainty

Lewis examines how nominal uncertainty affects the choice firms face to serve a foreign market through exports or to produce abroad as a multinational. He develops a two-country, stochastic general equilibrium model in which firms make production and pricing decisions in advance, and considers its implications on the relative choice. For foreign firms, both exports and multinational production are priced in the destination currency, and this uncertainty has no effect on the relative choice. In the data, U.S. firms set nearly all of their export prices in dollars. Therefore, home firms price exports in their own currency in the model. Home exporters gain an advantage over home multinationals: during a foreign contraction, the foreign exchange rate appreciates, causing exported goods from the home country to be relatively cheaper. This pricing advantage affects exporters non-linearly through demand, which translates to convex profits. As foreign volatility rises, the model implies that the home country should serve the foreign country relatively more through exports. Lewis takes this implication to bilateral U.S. data, using inflation volatility as a proxy for nominal volatility. Using sectoral data on sales by majority-owned foreign affiliates matched with U.S. exports, he finds that higher inflation volatility is associated with a significantly lower ratio of multinational production to total foreign sales.

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