Openness and Imperfect Pass-Through: Implications for the Monetary Policy

This paper analyzes the positive and normative implications of the degree of openness of a small economy for the transmission mechanism of monetary shocks. First, we show empirical evidence on the direct relationship between openness and the degree of exchange rate pass-through. Then, we develop a general equilibrium model where countries do not fully specialize according to their comparative advantages. With this framework we show that incomplete specialization makes the pass-through from exchange rate to import prices imperfect. The less open is the country --the less specialized- the lower is the pass-through from exchange rate to import prices. Despite the fact that the pass-through is incomplete and the expenditure switching effect is diminished, the flexible price allocation can still be reached with an inward-oriented monetary policy.

Can Fluctuations in the Consumption-Wealth Ratio Help to Predict Exchange Rates?

It is well documented that macroeconomic fundamentals are little help in predicting changes in the nominal exchange rates compared to the predictions made by a simple random walk. Letta and Ludvigson (2001) find that fluctuations in the common long-term trend in consumption, asset wealth, and labor income (herby, consumption-wealth ratio)is a strong predictor of the excess returns. In this paper, we study the role of the consumption-wealth ratio in predicting the change in the nominal exchange rate of a large set of countries. We find evidence that fluctuations in the consumption-wealth ratio help to predict in-sample all the currencies. in terms of out-of-sample forecasts, our results suggest that the consumption-wealth ratio may play a significant role predicting the Canadian dollar at all horizons and at short-intermediate horizons for some currencies.Exchange Rates, Consumption-Wealth Ratio, PRedictability

The Consumption-Real Exchange Rate Anomaly: Non-Traded Goods, Incomplete Markets and Distribution Services

The real exchange rate is volatile and tends to move in opposite direction with respect to relative consumption across countries. Chari, Kehoe and McGrattan (CKM, 2002) refer to the inability of models to replicate the last stylized fact as the consumption-real exchange rate anomaly. In this paper we show that an international RBC model similar to the one proposed by CKM but extended by considering nontraded goods and an incomplete asset market structure can solve this anomaly. Non tradable goods amplify wealth effects that arise from the incomplete assets market structure generating a negative comovement between the real exchange rate and relative consumption. The model performs reasonable well with other business cycle moments and, by adding distribution services in terms of nontraded goods, it generates a real exchange rate as volatile as in the data. Results are robust to the addition of nominal price rigidities and -in contrast with CKM- there is no need of monetary shocks to account for the real exchange rate dynamics.

Is The FX Derivatives Market Effective and Efficient in Reducing Currency Risk?

In a typical tactical asset allocation set up a manager receives compensation for his excess of return given a tracking error target. Critics of this framework cite its lack of control over the total portfolio risk. Current approaches recommend what we call a mixed allocation, derived from concerns about relative and absolute return and risk. This work provides an analytical framework for mixed tactical asset allocation, based on the premise that after the investor sets a tracking error target, a fundamental trade off remains unsolved: the one between excess of return and total risk. The article derives a separation theorem for tactical allocation, wherein the portfolio is a linear combination of an alpha portfolio providing excess returns and a beta portfolio providing overall risk hedge. The author shows how the formal expression summarizes all previous works. Moreover, it also includes the simplest Black-Litterman allocation.

Net Foreign Assets And Imperfect Financial Integration: An Empirical Approach

Empirical evidence against both risk-sharing across countries and the uncovered interest rate parity (UIP) condition has been extensively documented. This paper investigates the empirical implications of imperfectly integrated financial markets resulting from these two issues. Under this asset market structure both the risk-sharing condition and the UIP are affected by the Net Foreign Assets Position(NFA) of the country. First, we find strong evidence for OECD countries that the NFA contributes to explaining the lack of risk-sharing across countries. Similarly, in terms of the UIP, the NFA is able to capture a time-varying risk-premium for a small group of countries over short-term horizons.

Net foreign assets and imperfect pass-through: the consumption real exchange rate anomaly

An unresolved issue in international macroeconomics is the apparent lack of risk-sharing across countries, which contradicts the prediction of models based on the assumption of complete markets. We assess the importance of financial frictions in this issue by constructing an incomplete market model with stationary net foreign assets (NFA) and imperfect pass-through (IPT). In this paper, there is a cost of bond holdings that allows us to incorporate the dynamics of NFA into the risk-sharing condition. On theoretical grounds, our results suggest that the dynamics of NFA may account for the lack of risk-sharing across countries. In addition, the IPT mechanism, by closing the current account channel, does not help to explain this feature of the data. On empirical grounds, we test the risk-sharing condition derived in the paper, and we find that growth factors of consumption and real exchange rates behave in a manner that may be consistent with a significant role for the net foreign asset position.Risk ; International finance

External Imbalances, Valuation Adjustments and Real Exchange Rate: Evidence of Predictability in an Emerging Economy

We evaluate the ability of a measure of external imbalances that combines the trade and the financial channels to forecast the real effective exchange rate for Chile. By making use of a quarterly database of external assets and liabilities for the period 1983 to 2005, and employing a recently developed test of out-of-sample predictive ability, we show that this measure is able to predict the real exchange rate at horizons of up to 2 years. Out-of-sample evidence of predictability tends to get stronger as the size of the window used to estimate the parameters increases. This is probably because of the greater relative importance of the external balance in the dynamics of the exchange rate in the last few years, or because of the increasing precision of parameter estimates with the sample size. When we break down our measure of external imbalances into its three components: exports to imports ratio, exports to assets ratio and assets to liabilities ratio, we find that out-of-sample predictability is mainly driven by the last two ratios.

Comercio Intraindustrial en Chile.

This paper presents the evolution of Chilean intra-industry trade (IIT) from 1985 to 1996, and estimates it’s degree of horizontal and vertical differentiation. Additionally, using measures of intra-industry trade we estimate the participation of low adjustment cost trade in the growth of total trade. Finally, we estimate the effects of bilateral trade agreements on IIT for the sample of countries considered. The results allow us to conclude that IIT has increased until the early 90s, and has sustained a participation of approximately 20% during the present decade. The highest levels of IIT have been achieved with geographical neighbours. This seems to support the policy followed by the government, since liberalisation programs have been primarily oriented to neighbouring countries. Chilean IIT can be characterised as vertical, which means that IIT with the rest of the world is mainly of manufactures of different qualities that are classified as the same. After correcting IIT to measure the participation of non-disruptive IIT, we can observe that 82% of the growth of trade has been inter-industrial, and that it has generated more adjustment costs than the remaining 18% that was intra-industrial.

High Frequency Dynamics of the Exchange Rate in Chile

We estimate a reduced form model for the daily dynamics of the nominal spot exchange rate in Chile. The model does reasonably well in explaining the long and short run dynamics for the peso-dollar exchange rate for the period 2001-2006. In addition, we extend the model to evaluate the effects of the foreign investment of pension funds, foreign exchange rate interventions by the Central Bank and other events whose effects on the exchange rate have policy implications. We find –in line with previous work conducted at the Central Bank - that the impact of Central Bank actions on the FX market seemed to be better channeled through public announcements. Moreover, we find that changes in the pension funds limits on foreign assets had significant, but small and transitory effects on the spot peso-dollar exchange rate.

Stocks, Flows and Valuation Effects of Foreign Assets and Liabilities: Do They Matter?

Large holdings of foreign assets and liabilities, along with increasing relevance of valuation effects—capital gains or losses—have characterized global financial integration. In this paper, we assess empirically the implications of stocks, flows and valuation adjustments in external crises (current-account reversals, sudden stops and currency crises), sovereign credit ratings and the longrun real exchange rates (RER), in both industrial and developing economies. We find support for the view that foreign assets and liabilities are rather distinctive external holdings with different implications in the occurrence of external crisis. Valuation adjustments have an impact on crises, although quantitatively not very large. Portfolio liabilities (particularly equity) increase the probability of current-account reversals and currency crises, while the likelihood of sudden stops increases with the stock of foreign direct investment (FDI) assets. In the case of sovereign credit ratings, we find a noteworthy effect of the stock and flows of FDI liabilities on improving sovereign ratings. Finally, as for the RER, gross assets and liabilities appear equally important, but components of external holdings have considerably different effects. While the cumulative current account is associated with real depreciation, the valuation effect is strongly linked with real currency appreciations in developing economies.