Dominant currency paradigm†

We propose a “dominant currency paradigm” with three key features: dominant currency pricing, pricing complementarities, and imported inputs in production. We test this paradigm using a new dataset of bilateral price and volume indices for more than 2,500 country pairs that covers 91 percent of world trade, as well as detailed firm-product-country data for Colombian exports and imports. In strong support of the paradigm we find that (i) noncommodities terms-of-trade are uncorrelated with exchange rates; (ii) the dollar exchange rate quantitatively dominates the bilateral exchange rate in price pass-through and trade elasticity regressions, and this effect is increasing in the share of imports invoiced in dollars; (iii) US import volumes are significantly less sensitive to bilateral exchange rates, compared to other countries’ imports; (iv) a 1 percent US dollar appreciation against all other currencies predicts a 0.6 percent decline within a year in the volume of total trade between countries in the rest of the world, controlling for the global business cycle. We characterize the transmission of, and spillovers from, monetary policy shocks in this environment

When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification

By exploiting basic common practice accounting and risk-management rules, we propose a simple analytical dynamical model to investigate the effects of microprudential changes on macroprudential outcomes. Specifically, we study the consequence of the introduction of a financial innovation that allows reducing the cost of portfolio diversification in a financial system populated by financial institutions having capital requirements in the form of Value at Risk (VaR) constraint and following standard mark-to-market and risk-management rules. We provide a full analytical quantification of the multivariate feedback effects between investment prices and bank behavior induced by portfolio rebalancing in presence of asset illiquidity and show how changes in the constraints of the bank portfolio optimization endogenously drive the dynamics of the balance sheet aggregate of financial institutions and, thereby, the availability of bank liquidity to the economic system and systemic risk. The model shows that when financial innovation reduces the cost of diversification below a given threshold, the strength (because of higher leverage) and coordination (because of similarity of bank portfolios) of feedback effects increase, triggering a transition from a stationary dynamics of price returns to a nonstationary one characterized by steep growths (bubbles) and plunges (bursts) of market prices

Capital flows to developing countries: The allocation puzzle

The textbook neoclassical growth model predicts that countries with faster productivity growth should invest more and attract more foreign capital. We show that the allocation of capital flows across developing countries is the opposite of this prediction: capital does notflowmore to countries that invest and grow more.We call this puzzle the "allocation puzzle". Using a wedge analysis, we find that the pattern of capital flows is driven by national saving: the allocation puzzle is a saving puzzle. Further disaggregation of capital flows reveals that the allocation puzzle is also related to the pattern of accumulation of international reserves. The solution to the "allocation puzzle", thus, lies at the nexus between growth, saving, and international reserve accumulation.We conclude with a discussion of some possible avenues for research. © The Author 2013. Published by Oxford University Press on behalf of The Review of Economic Studies Limited

Rents, technical change, and risk premia accounting for secular trends in interest rates, returns on capital, earning yields, and factor shares

The secular decline in safe interest rates since the early 1980s has been the subject of considerable attention. In this short paper, we argue that it is important to consider the evolution of safe real rates in conjunction with three other first-order macroeconomic stylized facts: the relative constancy of the real return to productive capital, the decline in the labor share, and the decline and subsequent stabilization of the earnings yield. Through the lens of a simple accounting framework, these four facts offer suggestive insights into the economic forces that might be at work

The safe assets shortage conundrum

A safe asset is a simple debt instrument that is expected to preserve its value during adverse systemic events. The supply of safe assets, private and public, has historically been concentrated in a small number of advanced economies, most prominently the United States. Over the last few decades, with minor cyclical interruptions, the supply of safe assets has not kept up with global demand. The reason is straightforward: the collective growth rate of the advanced economies that produce safe assets has been lower than the world's growth rate, which has been driven disproportionately by the high growth rate of high-saving emerging economies such as China. The signature of this growing shortage is a steady increase in the price of safe assets; equivalently, global safe interest rates must decline, as has been the case since the 1980s. The early literature, brought to light by Ben Bernanke's famous “savings glut” speech of 2005, focused on a general shortage of assets without isolating its safe asset component. The distinction, however, has become increasingly important over time, particularly in the aftermath of the subprime mortgage crisis and its sequels. We begin by describing the main facts and macroeconomic implications of safe asset shortages. Faced with such a structural conundrum, what are the likely short- to medium-term escape valves? We analyze four of them, each with its own macroeconomic and financial trade-offs

The International Monetary and Financial System

International currencies fulfill different roles in the world economy, with important synergies across those roles. We explore the implications of currency hegemony for the external balance sheet of the United States, the process of international adjustment, and the predictability of the US dollar exchange rate. We emphasize the importance of international monetary spillovers and of the exorbitant privilege, and we analyze the emergence of a new Triffin dilemma