Capital Flows, Currency Wars and Monetary Policy

A conference on Capital Flows, Currency Wars and Monetary Policy took place Cambridge on April 5-6. Research Associates Emmanuel Farhi of Harvard University and Sebnem Kalemli-Ozcan of University of Maryland organized the meeting. These researchers' papers were presented and discussed:

Silvia Miranda-Agrippino, Bank of England, and Hélène Rey, London Business School and NBER

US Monetary Policy and the Global Financial Cycle (NBER Working Paper No. 21722)

Miranda-Agrippino and Rey analyze the workings of the "Global Financial Cycle." They study the effects of monetary policy of the United States, the center country of the international monetary system, on the joint dynamics of the domestic business cycle and international financial variables such as global credit growth, cross-border credit flows, global banks leverage and risky asset prices. One global factor, driven in part by U.S. monetary policy, explains an important share of the variance of returns of risky assets around the world. The researchers find evidence of large financial spillovers from the hegemon to the rest of the world.

Ricardo J. Caballero and Alp Simsek, MIT and NBER

A Model of Fickle Capital Flows and Retrenchment (NBER Working Paper No. 22751)

Caballero and Simsek develop a model of gross capital flows that addresses the tension between their fickleness during foreign crises and retrenchment during local crises. In a symmetric environment with domestic crises, capital flows mitigate fire sales since fickle inflows exit the crisis location at weak prices whereas past outflows provide liquidity at higher valuations. However, due to the public good aspect of flows' liquidity services, local policymakers with financial stability concerns may restrict flows. Greater scarcity of safe assets and lower correlation between crises increase gross flows. With asymmetric locations, the model features reach-for-safety and reach-for-yield flows that can be destabilizing.

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

Foreign Reserve Management

Amador, Bianchi, Bocola, and Perri presents a theory of how a central bank should manage its portfolio of foreign reserves, in situations when it cannot use the conventional tools of monetary policy. They show that reserve management allows the central bank to alter the risk-adjusted returns on domestic securities and, by doing so, it can achieve conventional monetary policy objectives. Manipulating prices and returns of securities comes at cost, as when the central bank does so, the domestic economy experiences arbitrage losses to foreign arbitrageurs. For a relatively closed economy these losses are minor and it is optimal for the central bank to engage in active portfolio management. For a relatively open economy, the central bank minimizes arbitrage losses and it does so by following a passive portfolio management. The theory provides foundations to study what kind of assets should central banks buy, what are the basic principles that should be pursued and what are the relevant trade-offs involved.

Ozge Akinci, Federal Reserve Bank of New York, and Albert Queralto Olive, Federal Reserve Board

Balance Sheets, Exchange Rates, and International Monetary Spillovers

Akinci and Queralto use a two-country New-Keynesian model with balance-sheet constraints on banks to investigate the extent of international spillovers of U.S. monetary policy. Home banks borrow from domestic households in domestic currency, as well as from residents of the foreign economy (the U.S.) in dollars. The researchers assume agency frictions are more severe for foreign debt than for domestic deposits. As a consequence, a deterioration in domestic banks' balance sheets induces a rise in the home currency's risk premium and an exchange rate depreciation. They use the model to investigate how domestic monetary transmission and international monetary spillovers are affected by the extent of banks' liability dollarization, and whether the latter makes it desirable for domestic policy to target the nominal exchange rate.

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

Currency Manipulation (NBER Working Paper No. 22790)

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.

Emine Boz, International Monetary Fund; Gita Gopinath, Harvard University and NBER; and Mikkel Plagborg-Møller, Princeton University

Global Trade and the Dollar (NBER Working Paper No. 23988)

Boz, Gopinath, and Plagborg-Møller document that the U.S. dollar exchange rate drives global trade prices and volumes. Using a newly constructed data set of bilateral price and volume indices for more than 2,500 country pairs, they establish the following facts: 1) Bilateral non-commodities terms of trade are essentially uncorrelated with bilateral exchange rates. 2) The dollar exchange rate quantitatively dominates the bilateral exchange rate in price pass-through and trade elasticity regressions. 3) A 1% U.S. dollar appreciation against all other currencies in the world predicts a 0.6% decline within a year in the volume of total trade between countries in the rest of the world, controlling for the global business cycle. 4) Using a novel Bayesian semiparametric hierarchical panel data model, the researchers estimate that the importing country's share of imports invoiced in dollars explains 15% of the variance of dollar pass-through/elasticity across country pairs. Their findings strongly support the dominant currency paradigm as opposed to the traditional Mundell-Fleming pricing paradigms. We then employ a three country model with dollar pricing to demonstrate the asymmetries between the transmission of monetary policy shocks that arise in the U.S. and the rest of the world.

Olivier Jeanne, Johns Hopkins University and NBER

Currency Wars, Trade Wars and Global Demand

Jeanne presents a tractable model of a global economy in which countries attempt to boost their employment and welfare by depreciating their currencies and making their goods more competitive -- a "currency war" -- or by imposing a tariff on imports -- a "trade war." Because of downward rigidity in nominal wages the global economy may be in a liquidity trap with less than full employment. In such a situation a trade war further depresses global demand and leads to large welfare losses (amounting to about 10 percent of potential GDP under Jeanne's benchmark calibration). By contrast, currency war in which countries depreciate their currencies by raising their inflation targets restores full employment and leads to large welfare gains. The uncoordinated use of capital controls leads to symmetry breaking, with a fraction of countries competitively devaluing their currency and lending their surpluses to deficit countries at a low interest rate.

Toni Ahnert and Christian Friedrich, Bank of Canada; Kristin Forbes, MIT and NBER; and Dennis Reinhardt, Bank of England

Macroprudential FX Regulations: Shifting the Snowbanks of FX Vulnerability

Can macroprudential foreign exchange (FX) regulations on banks reduce the financial and macroeconomic vulnerabilities created by borrowing in foreign currency? To evaluate the effectiveness and unintended consequences of macroprudential FX regulation, Ahnert, Forbes, Friedrich, and Reinhardt develop a parsimonious model of bank and market lending in domestic and foreign currency and derive four predictions. They confirm these predictions using a rich dataset of macroprudential FX regulations. These empirical tests show that FX regulations: (1) are effective in terms of reducing borrowing in foreign currency by banks, (2) have the unintended consequence of simultaneously causing firms to increase FX debt issuance, (3) reduce the sensitivity of banks to exchange rate movements, but (4) may not significantly reduce the sensitivity of corporates or the broader financial market to exchange rate movements. As a result, FX regulations on banks appear to be successful in mitigating the vulnerability of banks to exchange rates movements and the global financial cycle, but may have the side effect of "shifting the snowbanks" of a portion of this vulnerability to other sectors.

Agnes Benassy-Quere and Pauline Wibaux, Paris School of Economics, and Matthieu Bussiere, Banque de France

Trade and Currency Weapons

The debate on currency wars has re-emerged in the wake of the exceptionally accommodative monetary policies carried out after the 2008 global financial crisis. Using product level data for 110 countries over the 1989-2013 period, Benassy-Quere, Bussiere, and Wibaux estimate trade elasticities to exchange rates and tariffs within the same empirical specification, using a gravity approach. They find that the impact of a 10 percent depreciation of the exporter country's currency is "equivalent" to a cut in the power of the tariff in the destination country in the order of 2.4 to 3.4%. The researchers then study the policy implications of these results based on a stylized macroeconomic model where the government aims at internal and external balance. They find that monetary and trade policies are imperfect substitutes and that the former is more effective in stabilizing output, except when the internal transmission channel of monetary policy is muted (at the zero-lower bound). One implication is that, in normal times, a country will more likely react to a trade aggression through monetary easing than through a tariff increase.

Stefan Avdjiev and Catherine Koch, Bank for International Settlements, and Hyun Song Shin, Bank for International Settlements and NBER

Exchange Rates and the Transmission of Global Liquidity

Exchange rate fluctuations influence economies not only through a net exports channel, but also through a financial amplification channel. While the trade-weighted effective exchange rate is key for the net exports channel, financial amplification rests on risk-taking and leverage associated with shifts in the bilateral exchange rate against international funding currencies. Avdjiev, Koch, and Shin examine the impact of fluctuations in the U.S. dollar, the euro and the yen on cross-border bank lending. While the US dollar remains the preeminent global funding currency, the yen also exhibits many similar characteristics. Meanwhile, the euro has recently also emerged as an international funding currency.

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