Financial Globalization and Emerging Market Portfolios

Although emerging market Asian economies have experienced high growth without crises for close to a decade, many commentators find the large buildup of foreign exchange reserves among these economies both puzzling and evidence of incipient global imbalances. This paper reviews some of the experiences of Asian countries over the last decade. We focus on the degree to which Asian economies have experienced financial globalization, meaning that their gross external asset and liability positions have grown significantly. In particular, while Asian economies have become significant gross creditors in bonds and other fixed income assets, their liability position in equity and foreign direct investment assets has also grown significantly. We show that a simple dynamic general equilibrium model of portfolio choice in an emerging market economy can account for this trend remarkably well.Asia; Financial globalization; Foreign direct investment; Foreign exchange rate reserves

Financial Globalization and Emerging Market Portfolios

Although emerging market Asian economies have experienced high growth without crises for close to a decade, many commentators find the large buildup of foreign exchange reserves among these economies both puzzling and evidence of incipient global imbalances. This paper reviews some of the experience of Asian countries over the last decade. We focus on the degree to which Asian economies have experienced financial globalization, meaning that their gross external asset and liability positions have grown significantly. In particular, while Asian economies have become significant gross creditors in bonds and other fixed income assets, their liability position in equity and FDI assets has also grown significantly. We show that a simple dynamic general equilibrium model of portfolio choice in an emerging market economy can account for this trend remarkably well.Asia, Financial Globalization, FDI, Foreign Exchange Rate Reserves

Fiscal deficits, debt, and monetary policy in a liquidity trap

The macroeconomic response to the economic crisis has revived old debates about the usefulness of monetary and fiscal policy in fighting recessions. Without the ability to further lower interest rates, policy authorities in many countries have turned to expansionary fiscal policies. Recent literature argues that government spending may be very effective in such environments. But a critical element of the stimulus packages in all countries was the use of deficit financing and tax reductions. This paper explores the role of government debt and deficits in an economy constrained by the zero bound on nominal interest rates. Given that the liquidity trap is generated by a large increase in the desire to save on the part of the private sector, the wealth effects of government deficits can provide a critical macroeconomic response to this. Government spending financed by deficits may be far more expansionary than that financed by tax increases in such an environment. In a liquidity trap, tax cuts may be much more effective than during normal times. Finally, monetary policies aimed at directly increasing monetary aggregates may be effective, even if interest rates are unchanged.Fiscal policy ; Recessions ; Deficit financing ; Debts, Public ; Government spending policy ; Monetary policy ; Taxation ; Liquidity (Economics)

A Simple Dynamic General Equilibrium Analysis of the Trade-off Between Fixed and Floating Exchange Rates

This paper provides a complete analytical characterization of the positive and normative effects of alternative exchange rate regimes in a simple two-country sticky-price dynamic general equilibrium model with money, technology, and government spending shocks. A central question addressed is whether fixing the exchange rate prevents macroeconomic adjustment in relative prices from occurring, in face of shocks. In the model, the exchange rate regime has implications for both the volatility and mean of macroeconomic aggregates. But the effects of the exchange rate regime depend upon both the stance of monetary policy and the way in which the exchange rate is pegged. With a passive monetary policy, a cooperative pegged exchange rate regime has no implications for macroeconomic volatility, relative to a floating regime, but implies a higher mean level of employment, capital stock, and real GDP. When monetary policy is determined optimally however, a fixed exchange rate regime leads to higher employment volatility and a lower mean level of employment and real GDP. Therefore, whether fixing the exchange rate involves a welfare cost depends critically upon the flexibility of monetary policy in responding to macroeconomic shocks.

The Optimal Choice of Exchange-Rate Regime: Price-Setting Rules and Internationalized Production

We investigate the choice of exchange-rate regime fixed or floating in a dynamic, intertemporal general equilibrium framework. Our framework extends Devereux and Engel (1998) by investigating the implications of internationalized production. We examine the role of price-setting -- whether prices are set in the currency of producers or the currency of consumers in determining the optimality of exchange-rate regimes in an environment of uncertainty created by monetary shocks. We find that when prices are set in producers' currencies, floating exchange rates are preferred when the country is large enough, or not too risk averse. On the other hand, floating exchange rates are always preferred when prices are set in consumers' currencies because floating exchange rates allow domestic consumption to be insulated from foreign monetary shocks. The gains from floating exchange rates are greater when there is internationalized production in this case.

Endogenous Currency of Price Setting in a Dynamic Open Economy Model

Many papers in the recent literature in open economy macroeconomics make different assumptions about the currency in which firms set their export prices when nominal prices must be pre-set. But to date, all of these studies take the currency of price setting as exogenous. This paper sets up a simple two-country general equilibrium model in which exporting firms can choose the currency in which they set prices for sales to foreign markets. We make two alternative assumptions about the structure of international financial markets: one where there are complete markets for hedging consumption risk internationally, and the other without risk-sharing possibilities. Our results are quite sharp: exporters will generally wish to set prices in the currency of the country that has the most stable monetary policy. When monetary stability is similar among countries, there is an equilibrium where firms from all countries set their price in the currency of the buyer (local currency pricing). But except for a special case where money variances are exactly identical across countries, there is no equilibrium where all firms set export prices in their own currencies (producer currency pricing).

Country Portfolio Dynamics

This paper presents a general approximation method for characterizing timevarying equilibrium portfolios in a two-country dynamic general equilibrium model. The method can be easily adapted to most dynamic general equilibrium models, it applies to environments in which markets are complete or incomplete, and it can be used for models of any dimension. Moreover, the approximation provides simple, easily interpretable closed form solutions for the dynamics of equilibrium portfolios.Country portfolios, solution methods.

Financial globalization and monetary policy

Recent data show substantial increases in the size of gross external asset and liability positions. The implications of these developments for optimal conduct of monetary policy are analyzed in a standard open economy model which is augmented to allow for endogenous portfolio choice. The model shows that monetary policy takes on new importance due to its impact on nominal asset returns. Nevertheless, the case for price stability as an optimal monetary rule remains. In fact, it is reinforced. Even without nominal price rigidities, price stability is optimal because it enhances the risk sharing properties of nominal bonds. --Portfolio Choice,International Risk Sharing,Exchange Rate

Sharing the burden: monetary and fiscal responses to a world liquidity trap

With integrated trade and financial markets, a collapse in aggregate demand in a large country can cause "natural real interest rates" to fall below zero in all countries, giving rise to a global "liquidity trap." This paper explores the optimal policy response to this type of shock, when governments cooperate on both fiscal and monetary policy. Adjusting to a large negative demand shock requires raising world aggregate demand, as well as redirecting demand towards the source (home) country. ; The key feature of demand shocks in a liquidity trap is that relative prices respond perversely. A negative shock causes an appreciation of the home terms of trade, exacerbating the slump in the home country. At the zero bound, the home country cannot counter this shock. Because of this, it may be optimal for the foreign policymaker to raise interest rates. ; Strikingly, the foreign country may choose to have a positive policy interest rate, even though its natural real interest rate is below zero. A combination of relatively tight monetary policy in the foreign country combined with substantial fiscal expansion in the home country achieves the desired mix in terms of the level and composition of world expenditure. Thus, in response to conditions generating a global liquidity trap, there is a critical mutual interaction between monetary and fiscal policy.Monetary policy ; Fiscal policy ; Interest rates