Limited asset market participation and the consumption-real exchange rate anomaly

Under efficient consumption risk sharing, as assumed in standard international business cycle models, a country's aggregate consumption rises relative to foreign consumption, when the country's real exchange rate depreciates. Yet, empirically, relative consumption and the real exchange rate are essentially uncorrelated. I show that this "consumption-real exchange rate anomaly" can be explained by a simple model in which a subset of households trade in complete financial markets, while the remaining households lead hand-to-mouth (HTM) lives. HTM behavior also generates greater volatility of the real exchange rate and of net exports, which likewise brings the model closer to the data.International economic integration ; Economic forecasting ; Financial markets ; Foreign exchange rates ; Consumption (Economics)

Rational Bubbles in Non-Linear Business Cycle Models: Closed and Open Economies

This paper studies rational bubbles in non-linear dynamic general equilibrium models of the macroeconomy. The term ‘Rational bubble’ refers to multiple equilibria due to the absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an OLG population structure. If a TVC is imposed, the macro models considered here have a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about future investment. In contrast to explosive rational bubbles in linearized models (Blanchard (1979)), the rational bubbles in non-linear models here are bounded. Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of business cycles. I construct bubbles (in non-linear models) that feature recurrent boom-bust cycles characterized by persistent investment and output expansions which are followed by abrupt contractions in real activity. Both closed and open economies are analyzed. In a non-linear two-country model with integrated financial markets, bubbles must be perfectly correlated across countries. Global bubbles may, thus, help to explain the synchronization of international business cycles

International Portfolios with Supply, Demand and Redistributive Shocks

This paper explains three key stylized facts observed in industrialized countries: 1) portfolio holdings are biased towards local equity; 2) international portfolios are long in foreign currency assets and short in domestic currency; 3) the depreciation of a country's exchange rate is associated with a net external capital gain, i.e. with a positive wealth transfer from the rest of the world. We present a two-country, two-good model with trade in stocks and bonds, and three types of disturbances: shocks to endowments, to the relative demand for home vs. foreign goods, and to the distribution of income between labor and capital. With these shocks, optimal international portfolios are shown to be consistent with the stylized facts.

Rational Bubbles in Non-Linear Business Cycle Models: Closed and Open Economies

This paper studies rational bubbles in non-linear dynamic general equilibrium models of the macroeconomy. The term ‘Rational bubble’ refers to multiple equilibria due to the absence of a transversality condition (TVC) for capital. The lack of TVC can be due to an OLG population structure. If a TVC is imposed, the macro models considered here have a unique solution. Bubbles reflect self-fulfilling fluctuations in agents’ expectations about future investment. In contrast to explosive rational bubbles in linearized models (Blanchard (1979)), the rational bubbles in non-linear models here are bounded. Bounded rational bubbles provide a novel perspective on the drivers and mechanisms of business cycles. I construct bubbles (in non-linear models) that feature recurrent boom-bust cycles characterized by persistent investment and output expansions which are followed by abrupt contractions in real activity. Both closed and open economies are analyzed. In a non-linear two-country model with integrated financial markets, bubbles must be perfectly correlated across countries. Global bubbles may, thus, help to explain the synchronization of international business cycles

International portfolios, capital accumulation and foreign assets dynamics

Despite the liberalization of capital flows among OECD countries, equity home bias remains sizable. We depart from the two familiar explanations of equity home bias: transaction costs that impede international diversification, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversified portfolios. We show that the interaction of the following ingredients generates a realistic equity home bias: capital accumulation, shocks to the efficiency of physical investment, as well as international trade in stocks and bonds. In our model, domestic stocks are used to hedge fluctuations in local wage income. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods. In contrast to related models, the low level of international diversification does not depend on strongly countercyclical terms of trade. The model also reproduces the cyclical dynamics of foreign asset positions and of international capital flows.International finance ; Financial markets ; Capital movements

Global banking and international business cycles

This paper incorporates a global bank into a two-country business-cycle model. The bank collects deposits from households and makes loans to entrepreneurs, in both countries. It has to finance a fraction of loans using equity. We investigate how such a bank capital requirement affects the international transmission of productivity and loan default shocks. Three findings emerge. First, the bank's capital requirement has little effect on the international transmission of productivity shocks. Second, the contribution of loan default shocks to business cycle fluctuations is negligible under normal economic conditions. Third, an exceptionally large loan loss originating in one country induces a sizeable and simultaneous decline in economic activity in both countries. This is particularly noteworthy, as the 2007–09 global financial crisis was characterized by large credit losses in the US and a simultaneous sharp output reduction in the U.S. and the euro Area. Our results thus suggest that global banks may have played an important role in the international transmission of the crisis.Equity ; Bank capital ; Productivity ; Default (Finance) ; Loans

International portfolios, capital accumulation and foreign assets dynamics

Despite the liberalisation of capital flows among OECD countries, equity home bias remains sizable. We depart from the two familiar explanation of equity home bias: transaction costs that impede international diversification, and terms of trade responses to supply shocks that provide risk sharing, so that there is little incentive to hold diversified portfolios. We show that the interaction of the following ingredients generates a realistic equity home bias: capital accumulation, shocks to the efficiency of physical investment, as well as international trade in stocks and bonds. In our model, domestic stocks are used to hedge fluctuation in local wage income. Terms of trade risk is hedged using bonds denominated in local goods and in foreign goods. In contrast to related models, the low level of international diversification does not depend on strongly countercyclical terms of trade. The model also reproduces the cyclical dynamics of foreign asset positions and of international capital flows. --capital accumulation,international equity and bond portfolios,capital flows,current account,valuation effects,terms of trade

Liquidity Traps in a World Economy

This paper studies a New Keynesian model of a two-country world with a zero lower bound (ZLB) constraint for nominal interest rates. A floating exchange rate regime is assumed. The presence of the ZLB generates multiple equilibria. The two countries can experience recurrent liquidity traps induced by the self-fulfilling expectation that future inflation will be low. These “expectations-driven” liquidity traps can be synchronized or unsynchronized across countries. In an expectations-driven liquidity trap, the domestic and international transmission of persistent shocks to productivity and government purchases differs markedly from shock transmission in a “fundamentals-driven” liquidity trap

A Tractable Overlapping Generations Structure for Quantitative DSGE Models

This paper develops a novel tractable overlapping generations (OLG) structure that is suitable for use in rich quantitative dynamic stochastic general equilibrium (DSGE) models. The OLG structure assumes that newborn agents receive a wealth transfer such that that their equilibrium consumption represents a time-invariant share of aggregate consumption. Under efficient risk sharing across contemporaneous cohorts, this implies that aggregate consumption obeys a (quasi-)Euler equation that is isomorphic to the Euler equation of an infinitely-lived representative agent. As a result, DSGE models, with the proposed OLG structure, can be solved as conveniently as standard DSGE models with infinitely-lived representative agents. The great tractability of the OLG structure here constitutes an important advantage over conventional OLG models, especially when agents are long-lived. While highly tractable, the present OLG structure maintains key predictions of standard OLG models, namely the possibility of low (even negative) real interest rates and of equilibrium indeterminacy

"Why Can't the Long-Term Unemployed Find Jobs? A Possible Explanation and Dynamic Implications", MSc thesis, London School of Economics, 1986 (MSc Econometrics and Mathematical Economics).

MSc thesis, London School of Economics, 1986 (MSc Econometrics and Mathematical Economics). Advisor: Prof. John Moore. It is a feature of most labour markets that firms are unable to determine the precise characteristics (skills) of unemployed workers without incurring considerable costs. Firms which want to hire workers are thus induced to "exploit" any signal which can inform them about the likelihood that particular unemployed workers meet their skill requirements before incurring these costs. Workers who meet the requirements of a high proportion of firms are likely to be the first to leave unemployment: the duration of unemployment spells is thus an "informative signal" which firms can use when evaluating job applicants. In section 2 of this essay, we show that this may lead firms to disregard job applications made by workers whose unemployment spell exceeds a "cut-off" duration. In section 3 we show that the existence of such a "cut-off" duration affects the dynamic characteristics of the economy: it leads to an asymmetry in its adjustment to positive as opposed to negative productivity shocks; furthermore increases in the amplitude of these shocks (holding constant their mean and their frequency) influence the average employment level (we identify a condition under which an increase in the amplitude of productivity shocks raises average employment); increases in their frequency (holding constant their amplitude and their mean) reduce the amplitude of the fluctuation of employment ("inertia"). Employment exhibits serial correlation: a one-time productivity shock leads to an adjustment path which extends over several periods. The model developed in this essay is an equilibrium model (the wage rate is fully flexible). The serial correlation result is obtained even in the absence of misperception, i.e. even for perfectly anticipated shocks and although there are no costs of adjustment