International Finance and Macroeconomics

Members of the NBER's on International Finance and Macroeconomics Program met in Cambridge on October 26. Research Associates Guido Lorenzoni of Northwestern University and Vivian Yue of Emory University organized the meeting. These researchers' papers were presented and discussed:

Andres Drenik, Columbia University; Rishabh Kirpalani, Pennsylvania State University; and Diego Perez, New York University

Currency Choice in Contracts

Drenik, Kirpalani, and Perez study the general equilibrium of an economy with credit chains in which agents choose the currency in which to denominate contracts, and the government chooses the inflation rate. Denominating contracts in local currency helps mitigate fundamental risk, while denominating in a foreign currency minimizes risks due to the government's choice of monetary policy. In the aggregate, the equilibrium currency denomination calls for a coordination of currencies in bilateral contracts within a chain to avoid costly default due to currency mismatch. This implies that the incentives to denominate contracts in a foreign currency might persist even after government risk has been significantly reduced. The researchers' model can help explain the observed hysteresis of dollarization that occurred in several Latin American countries. The researchers show that the socially optimal allocation would call for even more dollarization than is privately optimal in order to constrain the government's choices ex-post. They also study the role of the credit network structure in determining whether the equilibrium currency choices matter and if so whether they are unique or not.

George A. Alessandria, University of Rochester and NBER, and Carter B. Mix, University of Rochester

The Global Trade Slowdown: Trade and Growth, Cause and Effect

Alessandria and Mix study the trade and growth slowdown since the Great Recession in a dynamic quantitative two-country model in which trade responds gradually to changes in trade costs and trade policy changes are gradual. They capture the growth and trade factors driving the economy with movements in productivity, investment efficiency, and trade costs. The model offers insights into how trade policy affects the economy and how productivity and investment efficiency can affect trade. The researchers use Bayesian estimation to match the time series on trade integration and business cycles since 1980. They find that the trade slowdown since 2012 primarily reflects the completed transition to past reforms as well as a rise in current and future barriers. Absence these changes in trade barriers, growth factors should have led to a substantial increase in trade since 2012. The rise in current and future barriers though have temporarily boosted growth but make the researchers pessimistic about future trade flows.

Anusha Chari, University of North Carolina at Chapel Hill and NBER; Ryan Leary, University of North Carolina at Chapel Hill; and Toan Phan, Federal Reserve Bank of Richmond

The Transmission of (sub)Sovereign Default Risk: Evidence from Puerto Rico

Puerto Rico's unique characteristics as a U.S. territory allow Chari, Leary, and Phan to examine the real effects of (sub) sovereign default risk. They conjecture that an increase in the sovereign default risk increases austerity risk, and the real economy contracts. The evidence suggests that in times of increasing default risk, industries with higher exposure to government demand experience significantly sharper declines in employment growth. In addition, fiscal austerity drives reduced output growth via a local fiscal multiplier effect. The researchers also find evidence for a bank-lending channel where increased default risk leads to significant declines in employment in external finance dependent industries, and credit from non-Puerto Rican banks does not substitute for the reduced supply of local credit from Puerto Rican banks.

Pablo Sebastian Fanelli, Princeton University, CEMFI

Monetary Policy, Capital Controls, and International Portfolios

In the past two decades, there has been a large increase in cross-border holdings of financial assets, making currency movements important sources of capital gains and losses. In this context, monetary policy can enhance risk-sharing across countries by influencing exchange rates. Furthermore, the strength of this channel depends on the portfolio the country holds, giving rise to a potential rationale for capital controls. To shed light on these issues, Fanelli studies an open economy model with nominal rigidities, incomplete markets, and assets denominated in home and foreign currency. Fanelli develops an approximation method that allows him to characterize the optimal policy explicitly. Fanelli shows that optimal monetary policy is a weighted average of an inflation target and an insurance target and characterize the optimal weight sharply. Perhaps surprisingly, as insurance considerations become more important, home-currency positions become larger, and the excess-return volatility of home-currency assets actually decreases, rather than increases as one would expect with fixed ad hoc portfolios. In addition, Fanelli finds that private portfolio decisions in small open economies are approximately efficient so that differential capital controls on foreign- vs. home-currency assets are not called for by the approximate solution. In a baseline calibration, the welfare gains from the optimal policy are 1.5 times larger than those from inflation-targeting.

Pierre-Olivier Gourinchas, University of California, Berkeley and NBER; Philippe Martin, Sciences Po; and Todd E. Messer, University of California, Berkeley

The Economics of Sovereign Debt, Bailouts and the Eurozone Crisis

Gourinchas and Martin build a model that analyzes how fiscal transfers and monetary policy are optimally deployed in a monetary union at times of crisis. Because of collateral damage, transfers in a monetary union cannot be ruled out ex-post in order to avoid a costly default. This generates risk shifting with an incentive to overborrow by fiscally fragile countries. However, a more credible no bailout commitment that reduces this incentive, may not be optimal in order to avoid immediate insolvency. Ex-post transfers are such that creditor countries get the whole surplus of avoiding a default and of debt monetization: assistance to a country that is close to default does not improve its fate. Expected debt monetization may reduce the yield because it lowers transfers required to avoid default. When transfers are not possible, the central bank of the monetary union is pushed into inefficient debt monetization.

Graciela L. Kaminsky, George Washington University and NBER

The Center and the Periphery: Two Hundred Years of International Borrowing Cycles (NBER Working Paper No. 23975)

A common belief in both academic and policy circles is that capital flows to the emerging periphery are excessive and ending in crises. One of the most frequently mentioned culprits is the cycles of monetary easing and tightening in the financial centers. Also, many focus on the role of crises in the financial center, pointing to excess international borrowing predating crises in the financial center and global retrenchment in capital flows in its aftermath. Kaminsky re-examines these views using a newly-constructed database on capital flows spanning two hundred years. Extending the study of capital flows to the first episode of financial globalization has two major advantages: During this episode, monetary policy in the financial center is constrained by the adherence to the Gold Standard, thus providing a benchmark for capital flow cycles in the absence of an active role of central banks in the financial centers. Second, panics in the financial center are rare disasters that need to be examined in a longer historical episode. Kaminsky finds that boombust capital flow cycles in the periphery are milder in the second episode of financial globalization when the financial center follows a cyclical monetary policy. Also, cyclical monetary policy in the financial center is far more pronounced in times of crises in the financial center, cutting short capital flow bonanzas in the periphery and injecting liquidity in the aftermath of the crisis.

Cristina Arellano, Federal Reserve Bank of Minneapolis and NBER; Yan Bai, University of Rochester and NBER; and Gabriel P. Mihalache, Stony Brook University

Inflation Targeting with Sovereign Default Risk (slides)

Arellano, Bai, and Mihalache analyze the interplay of monetary policy with sovereign debt and risk, motivated by the adoption of inflation targeting by emerging markets since the early 2000s. They build a framework that integrates a workhorse small open economy New Keynesian monetary environment within a canonical sovereign default model. The researchers show that this framework replicates the positive co-movements of sovereign interest rate spreads with domestic nominal rates and inflation, a salient feature of emerging markets data. The framework rationalizes the experience of Brazil during the 2015 downturn, which featured high inflation, high nominal rates, and high sovereign spreads. The counterfactual experiment suggests that by raising the domestic rate the Brazilian central bank not only reduced inflation but also alleviated the debt crisis. Finally, the researchers caution that implementing inflation targeting in economies subject to default risk will call for a more volatile domestic policy rate, in response to higher underlying volatility in consumption and inflation.

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