Solving General Equilibrium Models with Incomplete Markets and Many Assets

This paper presents a new numerical method for solving general equilibrium models with many assets. The method can be applied to models where there are heterogeneous agents, time-varying investment opportunity sets, and incomplete markets. It also can be used to study models where the equilibrium dynamics are non-stationary. We illustrate how the method is used by solving a one-- and two-sector versions of a two--country general equilibrium model with production. We check the accuracy of our method by comparing the numerical solution to the one-sector model against its known analytic properties. We then apply the method to the two-sector model where no analytic solution is available.

International Capital Flows, Returns and World Financial Integration

International capital flows have increased dramatically since the 1980s, with much of the increase being due to trade in equity and debt markets. Such developments are often attributed to the increased integration of world financial markets. We present a model that allows us to examine how greater integration in world financial markets affects the behavior of international capital flows and financial returns. Our model predicts that international capital flows are large (in absolute value) and very volatile during the early stages of financial integration when international asset trading is concentrated in bonds. As integration progresses and households gain access to world equity markets, the size and volatility of international bond flows fall dramatically but continue to exceed the size and volatility of international equity flows. This is the natural outcome of greater risk sharing facilitated by increased integration. We find that the equilibrium flows in bonds and stocks are larger than their empirical counterparts, and are largely driven by variations in equity risk premia. The paper also makes a methodological contribution to the literature on dynamic general equilibrium asset-pricing. We implement a new technique for solving a dynamic general equilibrium model with production, portfolio choice and incomplete markets.

Understanding Order Flow

This paper develops a model for understanding end-user order flow in the FX market. The model addresses several puzzling findings. First, the estimated price-impact of flow from different end-user segments is, dollar-for-dollar, quite different. Second, order flow from segments traditionally thought to be liquidity-motivated actually has power to forecast exchange rates. Third, about one third of order flow's power to forecast exchange rates one month ahead comes from flow's ability to forecast future flow, whereas the re-maining two-thirds applies to price components unrelated to future flow. We show that all of these features arise naturally from end?user heterogeneity, in a setting where order flow provides timely information to market-makers about the state of the macroeconomy.Exchange rates, forecasting, microstructure, order flow

Are Different-Currency Assets Imperfect Substitutes?

This paper provides a new test for whether different-currency assets are imperfect substitutes. The test exploits that under floating rates, changing public currency demand has no direct effect on monetary fundamentals, current or future. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per 1 billion dollar (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

Are Different-Currency Assets Imperfect Substitutes?

This paper provides a new test for whether different-currency assets are imperfect substitutes. Past work on imperfect substitutability in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on monetary fundamentals, current or future. This provides an opportunity to test for price effects from imperfect substitutability. We develop and estimate a micro portfolio balance model that has both Walrasian and microstructure features. Price effects from imperfect substitutability are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to intervention trades in the special case when they are indistinguishable from private trades (i.e., when interventions are sterilized, anonymous, and provide no monetary-policy signal).

Portfolio Balance, Price Impact, and Secret Intervention

This paper tests the portfolio-balance approach to exchange rate determination in a new way. Past work on portfolio balance in foreign exchange falls into two groups: (1) tests using measures of asset supply and (2) tests using measures of central-bank asset demand. We address the demand side, but we use a broad measure of public demand, rather than focusing on demand by central banks. Under floating rates, changing public demand has no direct effect on interest rates, current or future. This provides an opportunity to test for portfolio-balance effects on price. We develop and estimate a micro portfolio-balance model that has both Walrasian and microstructure features. Portfolio-balance effects are clearly present: the immediate price impact of public trades is 0.44 percent per $1 billion (of which, about 80 percent persists indefinitely). This estimate is applicable to central-bank trades as well, as long as they are sterilized, secret, and provide no monetary-policy signal. Intervention of this type is most effective when the flow of macroeconomic news is strong.

Exchange Rate Fundamentals and Order Flow

We address whether transaction flows in foreign exchange markets convey fundamental information. Our GE model includes fundamental information that first manifests at the micro level and is not symmetrically observed by all agents. This produces foreign exchange transactions that play a central role in information aggregation, providing testable links between transaction flows, exchange rates, and future fundamentals. We test these links using data on all end-user currency trades received at Citibank over 6.5 years, a sample sufficiently long to analyze real-time forecasts at the quarterly horizon. The predictions are borne out in four empirical findings that define this paper's main contribution: (1) transaction flows forecast future macro variables such as output growth, money growth, and inflation, (2) transaction flows forecast these macro variables significantly better than the exchange rate does, (3) transaction flows (proprietary) forecast future exchange rates, and (4) the forecasted part of fundamentals is better at explaining exchange rates than standard measured fundamentals.

Do Stationary Risk Premia Explain It All? Evidence from the Term Struct

Most studies of the expectations theory of the term structure reject the model. However, the significance of the rejections depend strongly upon the form of the test. In this paper, we use the pattern of rejection across maturities to back out the implied behavior of time-varying risk premia and/or market forecasts. We then use a new technique to test whether stationary risk premia alone can be responsible for these rejections. Surprisirj1y, this test is rejected for short maturities up to 6 months, suggesting that time-varying risk premia do not explain it all. We also describe hew this method can be used to test other asset pricing relationships.

Trends in Expected Returns in Currency and Bond Markets

Under conventional notions about rational expectations and market efficiency, expected returns differ from the actual expost returns by a forecast error that is uncorrelated with current information. In this paper, we describe how small departures from conventional notions of rational expectations and market efficiency can produce trends in excess returns. These trends are in addition to the trends typically found in the level of asset prices themselves. We report strong evidence for the presence of additional trends in excess foreign exchange and bond returns. We also estimate the additional trend component in excess returns on foreign exchange and find that it varied between -.8% and 1% for one month returns and between -6% and 8% for three month returns.

Do Expected Shifts in Inflation Policy Affect Real Rates?

This paper presents a new explanation for the negative correlation between ex post real interest rates and inflation found in earlier empirical studies. We begin by showing that there is a strong negative correlation between the permanent movements in ex post real interest rates and inflation. We argue that such a correlation can arise when people incorporate anticipated shifts in inflation policy into their expectations. Under these circumstances, a shift to lower (higher) inflation will lead to systematically higher (lower) ex post real rates. Using new time series techniques we are able to reject the hypothesis that nominal interest rates were unaffected by anticipated switches in inflation policy in the post-war era. To evaluate the impact of these switches, we then calculate the effects of inflationary expectations upon real rates using a Markov switching model of inflation. Inflation forecasts based upon the estimates of this rational model behave similarly to inflation forecasts from the Livingston survey. When ex ante real interest rates are identified with the Markov models of inflation, we find that ex ante real interest rate does not contain permanent shocks, nor is it related to permanent shocks in inflation.