Globalization and Monetary Policy Institute
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The Globalization and Monetary Policy Institute Working Papers
2008 | 2007
2008
No. 22
The Taylor Rule and Forecast Intervals for Exchange Rates
Jian Wang and
Jason J. Wu
Astract: This paper attacks the Meese-Rogoff (exchange rate disconnect) puzzle from a different
perspective: out-of-sample interval forecasting. Most studies in the literature focus on point
forecasts. In this paper, we apply Robust Semi-parametric (RS) interval forecasting to a
group of Taylor rule models. Forecast intervals for twelve OECD exchange rates are
generated and modified tests of Giacomini and White (2006) are conducted to compare the
performance of Taylor rule models and the random walk. Our contribution is twofold. First,
we find that in general, Taylor rule models generate tighter forecast intervals than the
random walk, given that their intervals cover out-of-sample exchange rate realizations
equally well. This result is more pronounced at longer horizons. Our results suggest a
connection between exchange rates and economic fundamentals: economic variables contain
information useful in forecasting the distributions of exchange rates. The benchmark Taylor
rule model is also found to perform better than the monetary and PPP models. Second, the
inference framework proposed in this paper for forecast-interval evaluation, can be applied
in a broader context, such as inflation forecasting, not just to the models and interval
forecasting methods used in this paper.
No. 21
Vertical Specialization and International Business Cycle Synchronization
Costas Arkolakis and Ananth Ramanarayanan
Astract: We explore the impact of vertical specialization—trade in goods across multiple stages of production—on the relationship between trade and international business cycle synchronization. We develop a model in which the degree of vertical specialization is endogenously determined by comparative advantage across heterogeneous goods and varies with trade barriers between countries. We show analytically that fluctuations in measured productivity in our model are not linked across countries through trade, despite the greater transmission of technology shocks implied by higher degrees of vertical specialization. In numerical simulations, we find this transmission is insufficient in generating substantial dependence of business cycle synchronization on trade intensity.
No. 20
An International Perspective on Oil Price Shocks
and U.S. Economic Activity
Nathan S. Balke, Stephen P. A. Brown and Mine K. Yücel
Astract: The effect of oil price shocks on U.S. economic activity seems to have changed since the mid-1990s. A variety of explanations have been offered for the seeming change—including better luck, the reduced energy intensity of the U.S. economy, a more flexible economy, more experience with oil price shocks and better monetary policy. These explanations point to a weakening of the relationship between oil prices shocks and economic activity rather than the fundamentally different response that may be evident since the mid-1990s. Using a dynamic stochastic general equilibrium model of world economic activity, we employ Bayesian methods to assess how economic activity responds to oil price shocks arising from supply shocks and demand shocks originating in the United States or elsewhere in the world. We find that both oil supply and oil demand shocks have contributed significantly to oil price fluctuations and that U.S. output fluctuations are derived largely from domestic shocks.
No. 19
Default and the Maturity Structure in Sovereign Bonds
Cristina Arellano, Ananth Ramanarayanan
Astract: This paper studies the maturity composition and the term structure of interest rate spreads
of government debt in emerging markets. We document that in Argentina, Brazil, Mexico,
and Russia, when interest rate spreads rise, debt maturity shortens and the spread on short-term
bonds is higher than on long-term bonds. To account for this pattern, we build a
dynamic model of international borrowing with endogenous default and multiple maturities
of debt. Short-term debt can deliver higher immediate consumption than long-term debt;
large longterm loans are not available because the borrower cannot commit to save in the
near future towards repayment in the far future. However, issuing long-term debt can insure
against the need to roll-over short-term debt at high interest rate spreads. The trade-off
between these two benefits is quantitatively important for understanding the maturity
composition in emerging markets. When calibrated to data from Brazil, the model matches
the dynamics in the maturity of debt issuances and its comovement with the level of spreads
across maturities.
No. 18
Some Preliminary Evidence on the Globalization-Inflation Nexus
Sophie Guilloux, Enisse Kharroubi
Astract:The aim of this paper is to evaluate the impact of globalization, if any, on inflation and the
inflation process. We estimate standard Phillips curve equations on a panel of OECD
countries over the last 25 years. While recent papers have concluded that globalization has
had no significant impact, this paper highlights that trying to capture globalization effects
through simple measures of import prices and/or imports to GDP ratios can be misleading.
To do so, we try to extend the analysis following two different avenues. We first separate
between commodity and non-commodity imports and show that the impact on inflation of
commodity import price inflation is qualitatively different from the impact of noncommodity
import price inflation, the former depending on the volume of commodity
imports while the latter being independent of the volume of non-commodity imports. This
first piece of evidence highlights the role of contestability and the insufficiency of trade
volume statistics to properly describe the impact of globalization. This leads us to adopt a
more systematic approach to capture the contents and not only the volume of trade.
Focusing on the role of intra-industry trade, we provide preliminary evidence that this
variable can account (i) for the low pass-through of import price to consumer price and (ii)
for the flattening of the Phillips curve, i.e. the lower sensitivity of inflation to changes in
output gap. We hence conclude that different facets of globalization, especially changes in
the nature of goods traded, can be an important channel through which globalization affects
the inflation process.
No. 17
The Real Exchange Rate in Sticky Price Models: Does Investment Matter?
Enrique Martinez-Garcia and Jens Søndergaard
Astract: This paper re-examines the ability of sticky-price models to generate volatile and persistent
real exchange rates. We use a DSGE framework with pricing-to-market akin to those in
Chari, et al. (2002) and Steinsson (2008) to illustrate the link between real exchange rate
dynamics and what the model assumes about physical capital. We show that adding capital
accumulation to the model facilitates consumption smoothing and significantly impedes the
model's ability to generate volatile real exchange rates. Our analysis, therefore, caveats the
results in Steinsson (2008) who shows how real shocks in a sticky-price model without
capital can replicate the observed real exchange rate dynamics. Finally, we find that the CKM
(2002) persistence anomaly remains robust to several alternative capital specifications
including set-ups with variable capital utilization and investment adjustment costs (see, e.g.,
Christiano, et al., 2005). In summary, the PPP puzzle is still very much alive and well.
No. 16
Technical Note on 'The Real Exchange Rate in Sticky Price Models: Does Investment Matter?'
Enrique Martinez-Garcia and Jens Søndergaard
Astract: This technical note is developed as a mathematical companion to the paper "The Real
Exchange Rate in Sticky Price Models: Does Investment Matter?" (Institute working paper no.
17). It contains three basic calculations. First, we derive the equilibrium conditions of the
model. Second, we compute the zero-inflation, zero-trade balance (deterministic) steady
state. Third, we describe the log-linearization of the equilibrium conditions around the
deterministic steady state. Simultaneously, we explain the system of equations that
constitutes the basis for the paper to broaden its scope. Commentary is provided whenever
necessary to complement the model description and to place into context the assumptions
embedded in our DSGE framework.
No. 15
Variety, Globalization, and Social Efficiency
W. Michael Cox and Roy J. Ruffin
Astract: This paper puts recent work on the benefits of variety into the context of a more complete quantitative analysis of the Dixit-Stiglitz-Krugman model of monopolistic competition. We show how the gains from globalization are reflected in the increase in variety and the exploitation of economies of scale, and that the social efficiency question is quantitatively insignificant. These results follow from examining a Bertrand-Nash equilibrium that allows for a finite number of varieties to affect the elasticity of demand facing each firm. We develop a precise expression for per capita real income with any number of sectors where globalization increases productivity through economies of scale.
No. 14
The Effect of Trade with Low-Income Countries on U.S. Industry
Raphael Auer and Andreas M. Fischer
Abstract: When labor-abundant nations grow, their exports increase more in labor-intensive sectors than in
capital-intensive sectors. We utilize this sectoral difference in how exports are affected by growth
to identify the causal effect of trade with low-income countries (LICs) on U.S. industry. Our
framework relates differences in sectoral inflation rates to differences in comparative advantageinduced
import growth rates and abstracts from aggregate fluctuations and sector specific trends.
In a panel covering 325 manufacturing industries from 1997 to 2006, we find that LIC exports are
associated with strong downward pressure on U.S. producer prices and a large effect on
productivity. When LIC exporters capture 1% U.S. market share, producer prices decrease by
3.1%, which is nearly fully accounted by a 2.4% increase in productivity and a 0.4% decrease in
markups. We also document that while LICs on average find it easier to penetrate sectors with
elastic demand, the price and productivity response to import competition is much stronger in
industries with inelastic demand. Overall, between 1997 and 2006, the effect of LIC trade on
manufacturing PPI inflation was around two percentage points per year, far too large to be
neglected in macroeconomic analysis.
No. 13
Globalisation, Domestic Inflation and Global Output Gaps: Evidence from the Euro Area
Alessandro Calza
Abstract: This paper tests whether the proposition that globalisation has led to greater sensitivity of
domestic inflation to the global output gap (the "global output gap hypothesis") holds for the euro
area. The empirical analysis uses quarterly data over the period 1979–2003. Measures of the
global output gap using two different weighting schemes (based on PPPs and trade data) are
considered. We find little evidence that global capacity constraints have either explanatory or
predictive power for domestic consumer price inflation in the euro area. Based on these findings,
the prescription that central banks should specifically react to developments in global output gaps
does not seem to be justified for the euro area.
No. 12
Financial Globalization, Governance, and the Evolution of the Home Bias
Bong-Chan Kho, René M. Stulz, and Francis E. Warnock
Abstract: Standard portfolio theories of the home bias are disconnected from corporate finance theories of
insider ownership. We merge the two into what we call the optimal ownership theory of the home
bias. The theory has the following components. In countries with poor governance, it is optimal
for insiders to own large stakes in corporations and for large shareholders to monitor insiders.
Foreign portfolio investors will exhibit a large home bias against such countries because their
investment is limited by the shares held by insiders (the "direct effect" of poor governance) and
domestic monitoring shareholders ("the indirect effect"). Foreigners can also enter as foreign
direct investors; if they are from countries with good governance, they have a comparative
advantage as insider monitors in countries with poor governance, so that the relative importance
of foreign direct investment in total foreign equity investment is negatively related to the quality
of governance. Using two datasets, we find strong evidence that the theory can help explain the evolution of the home bias. Using country-level U.S. data, we find that on average the home bias
of U.S. investors towards the 46 countries with the largest equity markets did not fall over the
past decade, but it decreased the most towards countries in which the ownership by corporate
insiders decreased, and the importance of foreign direct investment fell in countries in which
ownership by corporate insiders fell. Using firm-level data for Korea, we find evidence of the
additional indirect effect of poor governance on portfolio equity investment by foreign investors.
No. 11
Globalization and Monetary Policy: An Introduction
Enrique Martinez-Garcia
Abstract: Greater openness has become an almost universal feature of modern, developed economies. This paper develops a workhorse international model, and explores the role of standard monetary policy rules applied to an open economy. For this purpose, I build a two-country DSGE model with monopolistic competition, sticky prices, and pricing-to-market. I also derive the steady state and a log-linear approximation of the equilibrium conditions. The paper provides a lengthy explanation of the steps required to derive this benchmark model, and a discussion of: (a) how to account for certain well-known anomalies in the international literature, and (b) how to start "thinking" about monetary policy in this environment.
No. 10
Vehicle Currency
Michael B. Devereux and Shouyong Shi
Abstract: While in principle, international payments could be carried out using any currency or set of
currencies, in practice, the US dollar is predominant in international trade and financial
flows. The dollar acts as a "vehicle currency" in the sense that agents in nondollar economies
will generally engage in currency trade indirectly using the US dollar rather than using direct
bilateral trade among their own currencies. Indirect trade is desirable when there are
transactions costs of exchange. This paper constructs a dynamic general equilibrium model
of a vehicle currency. We explore the nature of the efficiency gains arising from a vehicle
currency, and show how this depends on the total number of currencies in existence, the size
of the vehicle currency economy, and the monetary policy followed by the vehicle currency's
government. We find that there can be very large welfare gains to a vehicle currency in a
system of many independent currencies. But these gains are asymmetry weighted towards the
residents of the vehicle currency country. The survival of a vehicle currency places natural
limits on the monetary policy of the vehicle country.
No. 9
Country Portfolios in Open Economy Macro Models
Michael B. Devereux and Alan Sutherland
Abstract: This paper develops a simple approximation method for computing equilibrium portfolios in
dynamic general equilibrium open economy macro models. The method is widely applicable,
simple to implement, and gives analytical solutions for equilibrium portfolio positions in any
combination or types of asset. It can be used in models with any number of assets, whether
markets are complete or incomplete, and can be applied to stochastic dynamic general
equilibrium models of any dimension, so long as the model is amenable to a solution using
standard approximation methods. We first illustrate the approach using a simple two-asset
endowment economy model, and then show how the results extend to the case of any
number of assets and general economic structure.
No. 8
How Should Central Banks Define Price Stability?
Mark A. Wynne
Abstract: It is now generally accepted that the primary objective of central banks should be the maintenance of price stability. This paper considers the question of how central banks should define price stability. I address three specific questions. First, should central banks target broad or narrow measures of inflation? Second, should central banks target headline or core measure of inflation? And third, should central banks define price stability as prevailing at some positive measured rate of inflation?
No. 7
Accounting for Persistence and Volatility of Good-level Real Exchange Rates: The Role of Sticky Information
Mario J. Crucini, Mototsugu Shintani and Takayuki Tsuruga
Abstract: Volatile and persistent real exchange rates are observed not only in aggregate series but also
on the individual good level data. Kehoe and Midrigan (2007) recently showed that, under a
standard assumption on nominal price stickiness, empirical frequencies of micro price
adjustment cannot replicate the time-series properties of the law-of-one-price deviations. We
extend their sticky price model by combining good specific price adjustment with
information stickiness in the sense of Mankiw and Reis (2002). Under a reasonable
assumption on the money growth process, we show that the model fully explains both
persistence and volatility of the good-level real exchange rates. Furthermore, our framework
allows for multiple cities within a country. Using a panel of U.S.-Canadian city pairs, we
estimate a dynamic price adjustment process for each 165 individual goods. The empirical
result suggests that the dispersion of average time of information update across goods is
comparable to that of average time of price adjustment.
No. 6
Driving Forces of the Canadian Economy: An Accounting Exercise
Simona E. Cociuba and Alexander Ueberfeldt
Abstract: This paper analyzes the Canadian economy for the post-1960 period. It uses an accounting
procedure developed in Chari, Kehoe, and McGrattan (2006). The procedure identifies
accounting factors that help align the predictions of the neoclassical growth model with
macroeconomic variables observed in the data. The paper finds that total factor productivity
and the consumption-leisure trade-off—the productivity and labor factors—are key to
understanding the changes in output, labor supply and labor productivity observed in the
Canadian economy. The paper performs a decomposition of the labor factor for Canada and
the United States. It finds that the decline in the gender wage gap is a major driving force of
the decrease in the labor market distortions. Moreover, the milder reduction in the labor
market distortions observed in Canada, compared to the US, is due to a relative increase in
effective labor taxes in Canada.
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