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Revision & links to debates in
positive and normative international
macro
MSc International macro
Birmingham, Autumn 2015
Tony Yates
Plan
• Quick revision of basic themes of lectures.
• Look back and see WHY these things were on
the course.
• Establish links with debates in
– ‘positive’ international macro [how the world
works] NB the OR ‘puzzles’ of international macro
– ‘Normative’ [what would be a better world and
how can policy help?]
L1: THE DORNBUSCH-MUNDELFLEMMING MODEL
L1: The Dornbusch, Mundell Fleming
model
• Model with perfect foresight, rational
expectations, 1 period sticky prices, long run
money neutrality, short run non-neutrality.
• Motivated by nominal exchange rate volatility at
the end of Bretton Woods.
• Nominal exchange rates overshoot their long run
destinations, where e moves proportionately
with m and p.
• This causes large REAL exchange rate fluctuations.
DMF model: proof of overshooting by
contradiction
• Informal proof by contradiction of the
overshooting result.
• Assume falsely that e moves proportionately
with p and m.
• Deduce that msupply goes up > mdemand
• …requiring an interest rate rise, and expected
depreciation to compensate.
• Which violates constancy of the exchange rate
over the future that we assumed.
DMF: links with ongoing policy and
econ controversies
• Cause and consequence of nominal and real
exchange rate volatility
• Optimal exchange rate regime.
• Methodological debates about how to do
macro: microfounded or not? Rational
expectations or not?
DMF: links to today
• Causes and consequences of real exchange
rate volatility:
– Eg Eurozone crisis.
– Huge rise in real exchange rate [measured by
nominal wages] between core and periphery….
Pre-crisis looked like real
exchange rate [eg measured by
nominal wages] convergence…
But post crisis, prob a bubble,
painful correction afterwards as
nominal wages often viewed as
downwardly rigid.
See, SGU ‘Case for temporary
inflation….’ JEP, on reading list.
DMF: links to today
• What is the optimal exchange rate regime?
• History of EZ creation and crisis reflects
debates about this.
• A focal point for DMF, which was written post
Bretton Woods, and worried about XS nominal
ER and real ER volatility.
Exchange rate regimes
Source: Rose
(2011)
Exchange rate regimes
Source: Rose
(2011)
XR Regime switchers
Source: Rose
(2011)
DMF: links to debate about optimal
exchange rate regimes.
• RE and speculative attacks on managed, fixed
exchange rate regimes.
• Optimal Currency Area Theory:
– Need either similarity of shocks
– Or flexible prices, free movement of goods/labour
– Or fiscal transfers to compensate for lack of
monetary policy flexibility
Source: The Economist, 2011
• Eurozone Stability and Growth Pact involved
tight restrictions on domestic fiscal policy….
[though often breached]
• No provision for significant cyclical fiscal
transfers across countries.
• Failed to anticipate huge real exchange rate
changes that would be needed, v painful
without fiscal stimulus, price/wage flexibility.
DMF: links to debates about macro
methodology
• ‘Old fashioned’ non-micro-founded model
• DMF written at time microfounded models in
infancy; Lucas, Kydland, Prescott beginning a
revolution.
• ‘Lucas Critique’ paper of 1976.
• Sims critique of 1980: ‘incredible identification’
• Debate won by pre-crisis period, but now reopened with apparent neglect of finance in DSGE
models.
L2 TESTING THE DMF MODEL USING
LONG RUN VAR RESTRICTIONS
L2 Testing the DMF model using long
run restrictions
• Long run restrictions emerged out of a problem
of identification.
• Money stock changes were not exogenous, but
themselves the product of central banks using
instrument in response to, and to stabilise the
macro economy.
• VAR identification problem; v-covariance matrix
estimated consistently, but has too few
independent elements, because of symmetry, to
pin down the elements of the structural model.
L2/ctd…
• We realised that IF we were prepared to write
the LR impact matrix as a lower triangular
cholesky factor [and therefore restrict some
long run impacts=0]….
• We could get an expression for this cholesky
factor in terms of things we know from
reduced form VAR.
• Restrictions; open economy versions of long
run money neutrality.
L2/ctd….
• Potential links to today’s debates
– Use of VARS as a critique of ‘Cowles Commission
models
– Use of long run restrictions generally
– Pervasive identification problem
– Substantive q of causes of real exchange rate
movements…
Sims and Cowles Commission models
• Cowles Commission was research institute
focused on large scale non-microfounded,
simultaneous eq macro models.
• Dominated macro policy work in academia until
mid 1970s, and survived in central banks, finance
ministries, and consultancies.
• Sims: no evidence for the exclusion restrictions
that made up these equations.
• VARs more ‘credible’ as more agnostic, less
reliance on bogus identifying restrictions.
VARs and LR restrictions
• Came under fire for biases in small samples.
Debate between Chari, Kehoe, McGratten and
Christiano, Eichenbaum, Evans.
• Proliferation of other identification methods.
Short run/recursive, sign restrictions,
heteroskedasticity, external instruments.
• Other uses: measuring core inflation,
identifying technology shocks.
Pervasive identification problem [in
macro]
• UK/US: measuring the impact of fiscal policy,
the ‘multiplier’.
• ‘Neo Fisherian’ arguments about whether low
inflation is caused by current low interest
rates, or boosted by them.
Causes of real exchange rate
movements
• As we already noted:
– Were non-traded/labour price increases in EZ
periphery ‘convergence’ or a bubble driven by
excessive, under-priced borrowing?
• Another recent example: Kirsten Forbes paper
wondering about the impact of rise in £ and
concluding that this was related to its cause.
L3 EGGERTSON-KRUGMAN’S MODEL OF
DEBT-DELEVERAGING IN A 2 COUNTRY
MODEL
EK: the story
• Impatient borrowers, patient lenders.
• Financial crisis causes the debt limit to contract.
• Borrowers consumption drops as they repair
balance sheets.
• Drives down real rates, perhaps even negative.
• Which might mean deflation.
• Which could aggravate the problem with nominal
debt.
Links to contemporary events
• The paper is transparently linked to the crisis; it’s
a model of why the real equilibrium rate is so low
and won’t rise until balance sheets repaired.
• Related to debates about how to stop ‘debt limit’
from falling. Stop borrowing in the first place?
Or prudential regulation to prevent sudden
stops?
• Contrasts with ‘secular stagnation’ as an account
of low equilibrium real rates.
• SS implies low real rates persist even after
balance sheets repair.
Other causes of low real rates
• Rates are low because
– Productivity growth lower [less income to bring
forward, so demand for borrowing lower] ‘secular
stagnation’
– Investment goods cheaper [so need to borrow less
to finance firms
– Demographic bulge of those saving for retirement
[increased supply of savings drives down real
rates]… tho this coming to an end.
– Supply of safe savings assets has fallen.
Cheaper investment goods lowers size
of funds required to finance
production
Middle aged savings glut
Source: Bean (2015) [MMF]
Cross-country evidence of middle-aged
effect on savings
Source: Bean (2015) [MMF]
Source: Bean (2015) [MMF]
L4 INTERTEMPORAL APPROACH TO
THE CURRENT ACCOUNT
SOE microfounded model
• Infinite period, representative agent, small
open economy, random, exogenous
endowment.
• Stationary endowment; in good times,
consumer saves some, and current account
improves.
• Non-stationary endowment; in good times,
consumer borrows from the future to share in
the benefits of the higher level tomorrow.
SOE model: link to debates about
performance of microfounded models
• Model part of scrutinising the microfounded
approach.
• 3 basic types: closed economy; 2 country; SOE
model
• Debates brought together in the 6 puzzles of
international macro paper by Obstfeld and
Rogoff.
SOE model: capital flows and capital
controls
• Related literature focuses on optimality of free
or regulated capital flows in emerging and
Western economies.
• Pre-crisis orthodoxy = liberalise everything.
• Post-crisis: capital flows may be helpful if
prudential standards can be strained, or
expectations that fuel borrowing are
unfounded.
Macro effects of sudden stops
Source: Mendoza,
(2010) ‘Sudden
stops…’
Inflows before a sudden stop
Source: Calvo and Reinhardt
(2000)
The stop in a sudden stop
Source: Calvo and Reinhardt
(2000)
Clearing up the mess from a sudden
stop
Source: Calvo and Reinhardt
(2000)
Capital inflow controls
Source:
Fernandez et al
(2015), IMF.
Capital outflow controls
Source:
Fernandez et al
(2015), IMF.
L5 TIME SERIES TESTS OF THE
INTERTEMPORAL APPROACH TO THE
CURRENT ACCOUNT
• Covered most recently, so not worth revising!
• Paper shd be seen as part of wider effort to
test models, and improve them.
• Wider literature focuses on appropriate
frictions in otherwise perfect microfounded
models; appropriate model of expectations.
• Policy conclusions often rest on sorting these
things out. Eg whether business cycles should
be smoothed or not.
• Purpose for putting L5 on the course:
– You can see the SOE model in action
– Brings together two main tools of modern macro,
namely, microfounded theory, and VARs
L7 DEVIATIONS FROM PPP AND
LOOP EXPLORED AND EXPLAINED
Lecture in brief
• Unspecified multi-good price index to
diagnose source of real exchange rate
deviations as wedge between ratio of traded
to non traded goods prices.
• Balassa-Samuelson model:
– Labour mobile between sectors, not countries.
– Traded goods productivity rise drives up nontraded wages and prices.
Links: EZ crisis causes and
consequences
• We already covered this….
• Periphery in EZ; very large rises in real
exchange rate.
• Before crisis, looked like convergence as
technology advanecd.
• After crisis, looks like boom created by
unwarranted capital inflow.
• Subsequent correction in real exchange rate
very painful.
Links: global income convergence or
not?
Recent convergence?
Source: Rodrick (2013)
Longer run, lack of convergence
Source: Rodrick (2013)
Convergence within manufacturing
Source: Rodrick (2013)
Convergence at aggregate and
disaggregated levels…
3 different inequality concepts
Source: Milanovic (2013)
Global inequality falls
Source: Milanovic (2013)
Source: Milanovic (2013)
Income and institutional quality
Source: IMF (2003)
Economic performance and
institutional quality
Source: IMF (2003)
Income and institutions
Source: IMF (2003)
Rule of law improvements
L6 UIP/CIP IN A 2 STATE
MICROFOUNDED SOE MODEL
UIP Lecture in brief
• Microfounded small open economy model.
• 2 period, 2 states, good and bad.
• Consumer decides how much to save, and
how much savings to insure by buying the
foreign exchange in advance, and how much
not to insure.
• Derive CIP, UIP.
UIP Lecture in brief/ctd
• For CIP to imply UIP required F=E(S)
• But this generally wasn’t possible because of
risk, and in particular covarianve between
exchange rates and the stochastic discount
factor [ratio of m utility today compared to
tomorrow].
Link from UIP to OR puzzles
•
•
•
•
Home equity bias puzzle
Feldstein Horioka puzzle
Consumption correlations puzzle
These puzzles refute the basic framework of
agents engaging in perfect goods and asset
markets and achieving perfect risk
sharing/insurance…
• Which is also implicit in UIP/CIP.
Feldstein-Horioka puzzle
• Saving should flow round the globe to where
investment opportunities are best.
• And should be unrelated to domestic
investment.
• But Feldstein-Horioka regressions reveal high
correlation between domestic savings and
investment.
Feldstein-Horioka regressions
Source: Obstfeld and Rogoff (2000)
2 Home bias in trade
NB : consumers should be indifferent between traded goods
produced by their own country and those produced elsewhere.
Home bias in portfolios
• Model predicts should be indifferent between
geographic nature of investments. Risk and
return is all that matters.
• Controversies over measurement.
• Basic idea is that share in home equities
should equal share in global market
capitalisation.
Simple home bias calculations
Source: Sercu
and Vanpee
(2009)
Home equity bias, ctd…
Consumption correlations puzzle
• Arises out of ‘incomplete risk sharing’.
• Perfect international macro model involves
agents insuring against idiosyncratic shocks to
domestic output
• …and consumption rising and falling with
aggregate shocks only…
• …meaning consumption perfectly correlated
across countries, output not.
Consumption correlations
Source: Obstfeld and Rogoff (2000)
Output [net] correlations
Source: Obstfeld and Rogoff (2000)
L8 SOVEREIGN DEBT AND DEFAULT
Sov default lecture in brief 1
• Many sovereign defaults. Which are very
costly in terms of trade, access to future
finance, domestic recession, etc.
• With commitment: perfect insurance optimal.
Implies a state-contingent sovereign debt, not
a simple IOU like we normally see?
• No-commitment; no insurance. No positive
payment to lender credible; only 0 balances
lenders books in expectation, therefore.
Sov default lecture in brief 2
• Sanctions can generate some of benefits of
commitment.
• Partial insurance for endowment draws that
are worse than the sanctions level.
Links to modern concerns and
developments
• International rules for workouts and holdouts.
• Ukranian default.
• EZ crisis defaults – Ireland, Portugal, Greece,
Cyprus.
Concluding points
• Have a look at all the sources in the revisions
section of the reading list.
• Sample end of year exam questions by end
March, posted on teaching homepage.
• MCQ exam Tues Jan 12th [provisional]. 2
hours, 40 questions.
• Advice on PhD? Come and see me. Look at
self-study PhD course materials on my
homepage.