International Finance and Macroeconomics

March 31, 2017
Laura Alfaro of Harvard Business School and Emmanuel Farhi Harvard University, Organizers

Markus K. Brunnermeier and Wei Xiong, Princeton University and NBER, and Michael Sockin, the University of Texas at Austin

China's Model of Managing the Financial System

China's economic model involves active government intervention in financial markets. It relaxes/tightens market regulations and even directs asset trading with the objective to maintain market stability. Brunnermeier, Sockin, and Xiong develop a theoretical framework that anchors government intervention on a mission to prevent market breakdown and the explosion of volatility caused by the reluctance of short-term investors to trade against noise traders when the risk of trading against them is sufficiently large. In the presence of realistic information frictions about unobservable asset fundamentals, the researchers' framework shows that the government can alter market dynamics by making noise in its intervention program an additional factor driving asset prices, and can divert investor attention toward acquiring information about this noise rather than fundamentals. Through this latter channel, the widely-adopted objective of government intervention to reduce asset price volatility may exacerbate, rather than improve, the information efficiency of asset prices.

George A. Alessandria, the University of Rochester and NBER, and Horag Choi, Monash University

Trade Integration and the Trade Balance in China

Alessandria, Choi, and Lu study the large rise in Chinese gross and net trade flows, summarized by its large positive net foreign asset position, in a dynamic stochastic general equilibrium model of China and the Rest of the World with endogenous trade participation, pricing-to-market, aggregate fluctuations, and incomplete financial markets. The model features an endogenous time-varying trade elasticity from producer-level investments in export market access. The researchers estimate the changes in technology, trade costs, and preferences accounting for the changes in China's gross and net trade flows, export participation, real GDP, and real exchange rate. They find that changes in trade barriers to be an important driver of the Chinese trade balance and the accumulation of foreign assets. They also find that the stagnation in trade growth since 2011 primarily reflects the completed transition to past trade reforms rather than to the increase in trade barriers or the reversal in the expected pace of future integration.

Ethan Ilzetzki, London School of Economics, and Carmen M. Reinhart and Kenneth S. Rogoff, Harvard University and NBER

Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold? (NBER Working Paper No. 23134)

This paper provides a comprehensive history of anchor or reference currencies, exchange rate arrangements, and a new measure of foreign exchange restrictions for 194 countries and territories over 1946-2016. Ilzetzki, Reinhart, and Rogoff find that the often-cited post-Bretton Woods transition from fixed to flexible arrangements is overstated; regimes with limited flexibility remain in the majority. Their central finding is that the U.S. dollar scores (by a wide margin) as the world's dominant anchor currency and, by some metrics, its use is far wider today than 70 years ago. In contrast, the global role of the euro appears to have stalled in recent years. While the incidence of capital account restrictions has been trending lower for decades, an important wave toward capital market integration dates as recently as the mid-1990s. The researchers suggest that record accumulation of reserves post 2002 has much to do with many countries' desire to stabilize exchange rates in an environment of markedly greater capital mobility. Indeed, the continuing desire to manage exchange rates despite increased capital mobility post-2003 may be a key factor underpinning the modern-day Triffin dilemma that some have recently pointed to.

Tarek Alexander Hassan, the University of Chicago and NBER; Thomas Mertens, Federal Reserve Bank of San Francisco; and Tony Zhang, the University of Chicago

Currency Manipulation

Hassan, Mertens, and Zhang propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country's currency to appreciate in bad times, lower its risk premium in international markets and, as a result, lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country ("currency stabilization"), the researchers find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country.

Anusha Chari, the University of North Carolina at Chapel Hill and NBER, and Karlye Maris Stedman and Christian Lundblad, the University of North Carolina at Chapel Hill

Taper Tantrums: QE, its Aftermath and Emerging Market Capital Flows

This paper examines the implications of unconventional monetary policy (UMP) and its continued unwinding for emerging market capital flows and asset prices with an emphasis on quantifying the magnitude of these effects. Chari, Stedman, and Lundblad combine U.S. Treasury data on emerging market flows and prices with Fed Funds Futures data to estimate the surprise component of Fed announcements. Results from a commonly employed affine term structure model indicate that monetary policy shocks represent, in small part, revisions in market participants' expectations about the path of short term interest rates and, even more significantly, changes in their required risk compensation. The importance of revisions in risk compensation is true despite the fact that these shocks are extracted from relatively short-maturity futures contracts. While this interpretation characterizes the conventional (pre-crisis) period, the risk compensation effects are even more pronounced in the later unconventional monetary policy period. Controlling for a range of pull and push factors, panel regression results then suggest that the global impact of alternative monetary surprise measures varies significantly across the pre-crisis, Quantitative Easing (QE) and policy "tapering" periods. In particular, the effect of monetary policy shocks on global asset values is larger than that for physical capital flows. Relative to debt, emerging market equity positions and valuations are more sensitive to monetary policy shocks during the QE and normalization periods. There is an order-of-magnitude difference between the QE and the tapering periods for the effects of monetary policy on all types of emerging-market portfolio flows. Finally, the primary advantage of extracting the monetary surprise magnitude is that the researchers can directly estimate a dollar amount in terms of U.S. investor position and flow changes to emerging markets. The quantification exercise suggests that the impact of U.S. monetary policy on emerging market capital flows depends critically on the size, sign and dispersion of the policy surprises.

Alessandro Dovis, the University of Pennsylvania and NBER, and Rishabh Kirpalani, Pennsylvania State University and New York University

Fiscal Rules, Bailouts, and Reputation in Federal Governments

Expectations of bailouts by central governments incentivize over-borrowing by local governments. In this paper, Dovis and Kirpalani ask if fiscal rules can correct these incentives to over-borrow when central governments cannot commit and if they will arise in equilibrium. The researchers address these questions in a reputation model in which the central government can either be a commitment or a no-commitment type and local governments learn about this type over time. Their first main result is that if the reputation of the central government is low enough, then fiscal rules can be welfare reducing as they can lead to even more debt accumulation relative to the case with no rules. This is because the costs of enforcing the punishment associated with the fiscal rule worsens the payoffs of preserving reputation and incentivizes the no-commitment type to reveal its type earlier relative to an environment without rules. This early resolution of uncertainty makes over-borrowing more attractive for the local governments. Despite being welfare reducing, binding fiscal rules will arise in the equilibrium of a signaling game due to the incentives of the commitment type to reveal its type. The model can be used to shed light on the numerous examples throughout history where tight fiscal rules were instituted but were not enforced ex-post, such as the Stability and Growth Pact.

Andrei Levchenko, the University of Michigan and NBER, and Nitya Pandalai-Nayar, the University of Michigan

TFP, News, and "Sentiments:" The International Transmission of Business Cycles (NBER Working Paper No. 21010)

Levchenko and Pandalai-Nayar propose a novel identification scheme for a non-technology business cycle shock, that they label "sentiment." This is a shock orthogonal to identified surprise and news TFP shocks that maximizes the short-run forecast error variance of an expectational variable, alternatively a GDP forecast or a consumer confidence index. The researchers then estimate the international transmission of three identified shocks — surprise TFP, news of future TFP, and "sentiment" — from the U.S. to Canada. The U.S. sentiment shock produces a business cycle in the U.S., with output, hours, and consumption rising following a positive shock, and accounts for the bulk of U.S. short-run business cycle fluctuations. The sentiment shock also has a significant impact on Canadian macro aggregates. In the short run, it is more important than either the surprise or the news TFP shocks in generating business cycle comovement between the U.S. and Canada, accounting for over 40% of the forecast error variance of Canadian GDP and over one-third of Canadian hours, imports, and exports. The news shock is responsible for some comovement at 5-10 years, and surprise TFP innovations do not generate synchronization. The researchers provide a simple theoretical framework to illustrate how U.S. sentiment shocks can transmit to Canada.

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