International Finance and Macroeconomics
October 28, 2016
Luca Fornaro, CREI, Universitat Pampeu Fabra and Barcelona GSE, and Federica Romei, Stockholm School of Economics
This paper studies optimal credit market interventions during a persistent global liquidity trap. Fornaro and Romei provide a tractable multi-country framework of an imperfectly financially integrated world, in which equilibrium interest rates are low and monetary policy is occasionally constrained by the zero lower bound. Idiosyncratic shocks generate capital flows and asymmetric liquidity traps across countries. Due to a domestic aggregate demand externality, it is optimal for governments to implement countercyclical macroprudential policies, taxing borrowing in good times, as a precaution against the risk of a future liquidity trap triggered by a negative shock. The key insight of the paper is that this policy is inefficient from a global perspective, because it depresses global rates and deepens the recession in the countries currently stuck in a liquidity trap. This international aggregate demand externality points toward the need for international coordination in the design of credit market interventions. Indeed, under the cooperative optimal credit policy, countries internalize the fact that a stronger demand for borrowing and consumption from countries at full employment sustains global rates, reducing the recession in liquidity trap economies.
Martin Eichenbaum and Sergio Rebelo, Northwestern University and NBER, and Benjamin Johannsen, Federal Reserve Board
This paper documents two facts about the behavior of floating exchange rates in countries where monetary policy follows a Taylor-type rule. First, the current real exchange rate is highly correlated with future changes in the nominal exchange rate at horizons greater than two years. This correlation is stronger the longer is the horizon. Second, for most countries, the real exchange rate is virtually uncorrelated with future inflation rates both in the short and in the long run. Eichenbaum, Johannsen, and Rebelo develop a class of models that can account for these observations. Their preferred model is also consistent with other key observations about the volatility and persistence of real exchange rates, as well as the fact that standard tests of uncovered interest rate parity reject that hypothesis.
Manuel Amador, University of Minnesota and NBER; Javier Bianchi, Federal Reserve Bank of Minneapolis and NBER; Luigi Bocola, Northwestern University and NBER; and Fabrizio Perri, Federal Reserve Bank of Minneapolis
This paper studies how the Central Bank of a small open economy achieves an exchange rate objective in an environment that features a zero lower bound (ZLB) constraint on nominal interest rates and limits to arbitrage in international capital markets. If the nominal interest rate that is consistent with interest parity is positive, the Central Bank can achieve its exchange rate objective while giving up its monetary independence, a well known result in international finance. However, if the nominal interest rate consistent with interest rate parity is negative, the pursuit of an exchange rate objective necessarily results in zero nominal interest rates, deviations from interest rate parity, capital inflows, and welfare costs associated with the accumulation of foreign reserves by the Central Bank. Amador, Bianchi, Bocola, and Perri characterize how these costs vary with the economic environment, and discuss situations in which these interventions are optimal from the point of view of a small open economy. They show that the recent breakdowns in covered interest rate parity documented in the literature are associated to large foreign exchange interventions carried out by Central Banks operating at the ZLB.
Vahid Gholampour, Bucknell University, and Eric van Wincoop, University of Virginia and NBER
With the advent of the internet and social media, Gholampour and van Wincoop now have real time opinions about future asset price changes by large numbers of people. This paper uses opinionated tweets about the Euro/dollar exchange rate to illustrate how information can be extracted from social media. The researchers develop a detailed lexicon used by FX traders to translate verbal tweets into opinions that are ranked positive, negative, and neutral. The methodologically novel aspect of their approach is the use of a model with a precise information structure to interpret the data from opinionated FX tweets. The parameters related to the information structure are quite precisely estimated and the model is able to match a wide variety of moments involving Twitter Sentiment and the exchange rate. Based on the estimated model the researchers are able to use daily Twitter Sentiment to predict exchange rates and compute Sharpe ratios for trading strategies. They are able to significantly outperform related results for interest differentials, which are the foundation of the large carry-trade industry.
Pierre-Olivier Gourinchas, University of California at Berkeley and NBER; Thomas Philippon, New York University and NBER; and Dimitri Vayanos, London School of Economics and NBER
Philippon, Gourinchas, and Vayanos provide an empirical and theoretical analysis of the Greek Crisis of 2010. The researchers first benchmark the crisis against all episodes of sudden stops, sovereign debt crises, and lending boom/busts in emerging and advanced economies since 1980. The decline in Greeces output, especially investment, is deeper and more persistent than in almost any crisis on record over that period. The researchers then propose a stylized macro-finance model to understand what happened. They find that a severe macroeconomic adjustment was inevitable given the size of the fiscal imbalance; yet a sizable share of the crisis was also the consequence of the sudden stop that started in late 2009. The researchers' model suggests that the size of the initial macro/financial imbalances can account for much of the depth of the crisis. When the researchers simulate an emerging market sudden stop with initial debt levels (government, private, and external) of an advanced economy, they obtain a Greek crisis. Finally, in recent years, the lack of recovery appears driven by elevated levels of non-performing loans and strong price rigidities in product markets.
Ricardo Caballero, MIT and NBER, and Alp Simsek, MIT and NBER
Gross capital flows are very large and highly cyclical. They are a central aspect of global liquidity creation and destruction. They also exhibit rich internal dynamics that shape fluctuations in domestic liquidity, such as the fickleness of foreign capital inflows and the retrenchment of domestic capital outflows during crises. In this paper Caballero and Simsek provide a model that builds on these observations to address some of the main questions and concerns in the capital flows literature. Within this model, the researchers find that for symmetric economies, the liquidity provision aspect of capital flows vastly outweighs their fickleness cost, so that taxing capital flows, which could prove useful for a country in isolation, backfires as a global equilibrium outcome. However, if the system is heterogeneous and includes economies with abundant (DM) and with limited (EM) natural domestic liquidity, there can be scenarios when global liquidity uncertainty is high and EM's reach for safety can destabilize DMs, as well as risk-on scenarios in which DM's reach for yield can destabilize EMs.