Exchange Rate Disconnect in General Equilibrium

May 21, 2017

By Oleg Itskhoki and Dmitry Mukhin

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major puzzles associated with nominal and real exchange rates. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus- Smith puzzle, and the UIP puzzle. The model has two main building blocks — the driving force (or the exogenous shock process) and the transmission mechanism — both crucial for the quantitative success of the model. The transmission mechanism — which relies on strategic complementarities in price setting, weak substitutability between domestic and foreign goods, and home bias in consumption — is tightly disciplined by the micro-level empirical estimates in the recent international macroeconomics literature. The driving force is an exogenous small but persistent shock to international asset demand, which we prove is the only type of shock that can generate the exchange rate disconnect properties. We then show that a model with this financial shock alone is quantitatively consistent with the moments describing the dynamic comovement between exchange rates and macro variables. Nominal rigidities improve on the margin the quantitative performance of the model, but are not necessary for exchange rate disconnect, as the driving force does not rely on the monetary shocks. We extend the analysis to multiple shocks and an explicit model of the financial sector to address the additional Mussa puzzle and Engel’s risk premium puzzle.

After all those years, we still do not have a good model of exchange rates. This paper advances an idea I had not seen before, international asset demand shocks, that I had not seen before. Results look really promising. We’ll see whether this will stick to the wall.


House Prices, Geographical Mobility, and Unemployment

May 17, 2017

By Marcus Mølbak Ingholt

Geographical mobility correlates positively with house prices and negatively with unemployment over the U.S. business cycle. I present a DSGE model in which declining house prices and tight credit conditions impede the mobility of indebted workers. This reduces the workers’ cross-area competition for jobs, causing wages and unemployment to rise. A Bayesian estimation shows that this channel more than quadruples the response of unemployment to adverse housing market shocks. The estimation also shows that adverse housing market shocks caused the decline in mobility during the Great Recession. Absent this decline, the unemployment rate would have been 0.5 p.p. lower.

I have always been apprehensive about the policy recommendation to favor owner occupied housing. Think of the admittedly extreme example of Flint, Michigan, where workers lost their jobs when the factories closed and lost their assets as local house prices fell. It became impossible for them to move as they cannot afford housing elsewhere. This paper shows that this issue is no to be neglected in an aggregate way either, as it generates serious geographic miss-allocations of labor.

May 2017 calls for papers

May 15, 2017

Time for a round of calls for papers. Note that the QM&RBC Agenda tries to be current with those.

  • Workshop of the Australasian Macroeconomics Society, Canberra, 17-19 August 2017.

  • Workshop on Time-Varying Uncertainty in Macro, St. Andrews, 2-3 September 2017.

  • Canadian Macro Study Group, Ottawa, 10-11 November 2017.

  • Information heterogeneity, housing dynamics and the business cycle

    May 10, 2017

    By Zi-Yi Guo

    Empirical evidence shows that house prices are highly volatile and closely correlated with the business cycle, and the fact is at odds with the evidence that rental prices are relatively stable and almost uncorrelated with the business cycle. To explain the fact, we introduce information heterogeneity into a standard dynamic stochastic general equilibrium (DSGE) model with financial frictions. Agents are endowed with heterogeneous shocks, and rationally extract information from market activities. Since agents are confused by changes in average private signals about future fundamentals, the model generates an amplified effect of technology shocks on house prices, which accounts for the disconnect between house prices and the discounted sum of future rents. In addition, the model provides insights for the lead-lag relationship between residential and nonresidential investment over the business cycle. The solution method developed in this paper can be applied in other DSGE models with heterogeneous information.

    Interesting paper. While the emphasis is on the price volatility result, I find the implications for the leads-lags of residential and non-residential investment more exciting. This has been a tough nut to crack for a long time.

    Commodity price risk management and fiscal policy in a sovereign default model

    May 2, 2017

    By Bernabe Lopez-Martin ; Julio Leal ; Andre Martinez Fritscher

    Commodity prices are an important driver of fiscal policy and the business cycle in many developing and emerging market economies. We analyze a dynamic stochastic small-open-economy model of sovereign default, featuring endogenous fiscal policy and stochastic commodity revenues. The model accounts for a positive correlation of commodity revenues with government expenditures and a negative correlation with tax rates. We quantitatively document the extent to which the utilization of different financial hedging instruments by the government contributes to lowering the volatility of different macroeconomic variables and their correlation with commodity revenues. An event analysis illustrates how financial hedging instruments moderate fiscal adjustment in response to significant falls in the price of commodities. We evaluate the conditional and unconditional welfare gains for the representative household, generated by financial derivatives and commodity-indexed bonds.

    This is a really big deal for little diversified economies, and in particular those depending on few commodities. The question is then obviously whether they would be granted such contracts given that they are often on shaky financial grounds admittedly often because of their lack of diversification.