Cross-country co-movement in long-term interest rates: a DSGE approach

July 24, 2015

By Michael Chin, Thomai Filippeli and Konstantinos Theodoridis

Long-term interest rates in a number of small open inflation-targeting economies co-move more strongly with US long-term rates than with short-term rates in those economies. We augment a standard small open economy model with imperfectly substitutable government bonds and time-varying term premia, that captures this phenomenon. The estimated model fits a range of US and UK data remarkably well, and produces term premium estimates that are comparable to estimates from the affine term structure model literature. We find that the strong co-movement between US and UK long-term interest rates arises primarily via correlated policy rate expectations, rather than through correlated term premia. This is due to policymakers in both economies responding to foreign productivity and discount factor shocks that cause persistent changes in inflation. We also overcome the common failure of similar models to account for the large influence of foreign disturbances on domestic economies found empirically, where in our model around 40% of the variation in UK GDP can be explained by shocks originating in the US economy.

Interesting approach to see whether financial intermediation can have an impact on business cycles. I wonder whether the fact that the correlation of long-term interest rates has increased (I think so, right?) has more to do with globalization of markets or monetary policy correlation, or this correlation may even be a result of globalization. This paper opens interesting questions.

Fertility, Longevity and International Capital Flows

July 23, 2015

By Zsófia Bárány, Nicolas Coeurdacier and Stéphane Guibaud

The neoclassical growth model predicts large capital flows towards fast-growing emerging countries. We show that incorporating fertility and longevity into a lifecycle model of savings changes the standard predictions when countries differ in their ability to borrow inter-temporally and across generations through social security. In this environment, global aging triggers capital flows from emerging to developed countries, and countries’ current account positions respond to growth adjusted by current and expected demographic composition. Data on international capital flows are broadly supportive of the theory. The fact that fast-growing emerging countries are also aging faster, while having less developed credit markets and pension systems, explains why they are more likely to export capital. Our quantitative multi-country overlapping generations model explains a significant fraction of the patterns of capital flows, across time and across developed and emerging countries.

The paper importantly highlights why demographics are important even when considering international capital flows. This could also explain the savings glut in developed economies and thus why the natural real interest rate may be lower now.

Unpleasant debt dynamics: Can fiscal consolidations raise debt ratios?

July 20, 2015

By Gabriela Castro, Ricardo Felix, Paulo Julio and Jose Maria

Using PESSOA, a medium-scale DSGE model for a small euro-area economy, we evaluate how fiscal adjustments impact short- and medium-term debt dynamics and output for alternative policy options, and budgetary and economic conditions. Fiscal adjustments may increase the public debt-to-GDP ratio in the short run, even for consolidations carried out in normal times in economies characterized by moderate indebtedness levels. Financial turmoils and hikes in the nationwide risk premia, coupled with high indebtedness levels and stiff fiscal measures, boost the output costs of fiscal consolidations and severely affect their effectiveness in bringing the public debt-to-GDP ratio down in the short term. In the medium run credible fiscal adjustments entail a decline in the public debt ratio, though at potentially very large output losses when carried out under unfavorable budgetary and economic conditions.

Again a new paper that is very relevant to current policy making. And who is saying academic economists are out of touch with current events?

Labor market reforms and current account imbalances: Beggar-thy-neighbor policies in a currency union?

July 17, 2015

By Timo Baas and Ansgar Belke

Member countries of the European Monetary Union (EMU) initiated wideranging labor market reforms in the last decade. This process is ongoing as countries that are faced with serious labor market imbalances perceive reforms as the fastest way to restore competitiveness within a currency union. This fosters fears among observers about a beggar-thy-neighbor policy that leaves non-reforming countries with a loss in competitiveness and an increase in foreign debt. Using a two-country, two-sector search and matching DSGE model, we analyze the impact of labor market reforms on the transmission of macroeconomic shocks in both, non-reforming and reforming countries. By analyzing the impact of reforms on foreign debt, we contribute to the debate on whether labor market reforms increase or reduce current account imbalances.

A timely paper. That is all I need to say.

Monetary and macroprudential policy with foreign currency loans

July 14, 2015

By Michał Brzoza-Brzezina, Marcin Kolasa and Krzysztof Makarski

In a number of countries a substantial proportion of mortgage loans is denominated in foreign currency. In this paper we demonstrate how their presence affects economic policy and agents’ welfare. To this end we construct a small open economy model with housing loans denominated in domestic or foreign currency. The model is calibrated for Poland – a typical small open economy with a large share of foreign currency loans (FCL). We show that FCLs negatively affect the transmission of monetary policy. In contrast, their impact on the effectiveness of macroprudential policy is much weaker but positive. We also demonstrate that FCLs increase welfare when domestic interest rate shocks prevail and decrease it when risk premium (exchange rate) shocks dominate. Under a realistic calibration of the stochastic environment FCLs are welfare reducing. Finally, we show that regulatory policies that correct the share of FCLs may cause a short term slowdown

The model is calibrated to Poland for a good reason: a third of all mortgages are denominated in Swiss Francs, which amounts to 8% of GDP. So when the Swiss Franc appreciated by 23% within a day, this must be leaving some marks in the Polish economy. And the possibility of such shocks is important for policy, as this paper nicely shows. However, I do not think that Polish borrowers we aware of such exchange rate risks when they opted for low interest Swiss Franc mortgages.

[And sorry for the long hiatus. I will be catching up over the next days]

Dynamic equilibrium with rare events and heterogeneous Epstein-Zin investors

June 8, 2015

By Georgy Chabakauri

We consider a general equilibrium Lucas (1978) economy with one consumption good and two heterogeneous Epstein-Zin investors. The output is subject to rare large drops or, more generally, can have non-lognormal distribution with higher cumulants. The heterogeneity in preferences generates excess stock return volatilities, procyclical price-dividend ratios and interest rates, and countercyclical market prices of risk when the elasticity of intertemporal substitution (EIS) is greater than one. Moreover, the latter results cannot be jointly replicated in a model where investors have EIS ≤ 1 or CRRA preferences. We propose new approach for deriving equilibrium, and extend the analysis to the case of heterogeneous beliefs about probabilities of rare events.

The Lucas tree is still capable of new and important insights, and rare disasters also have a lot of potential in explaining behavior even when they do not happen. The Great Recession has revived this literature that got forgotten. Markets, however, seem not to have forgotten that such events are possible.

An Over-the-Counter Approach to the FOREX Market

May 27, 2015

By Athanasios Geromichalos and Kuk Mo Jung

The FOREX market is an over-the-counter market (in fact, the largest in the world) characterized by bilateral trade, intermediation, and significant bid-ask spreads. The existing international macroeconomics literature has failed to account for these stylized facts largely due to the fact that it models the FOREX as a standard Walrasian market, therefore overlooking some important institutional details of this market. In this paper, we build on recent developments in monetary theory and finance to construct a dynamic general equilibrium model of intermediation in the FOREX market. A key concept in our approach is that immediate trade between ultimate buyers and sellers of foreign currencies is obstructed by search frictions (e.g., due to geographic dispersion). We use our framework to compute standard measures of FOREX market liquidity, such as bid-ask spreads and trade volume, and to study how these measures are affected both by macroeconomic fundamentals and the FOREX market microstructure. We also show that the FOREX market microstructure critically affects the volume of international trade and, consequently, welfare. Hence, our paper highlights that modeling the FOREX as a frictionless Walrasian market is not without loss of generality.

The foreign exchange market is modelled in an incredibly naive way, incredible given the size of the market. And despite its size, there are sizable frictions and many missing bilateral markets. This paper is an important step n the direction of modelling the microfoundations of this market to better understand how issues in intermediation can have macroeconomic, even global, implications.


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