Non-fundamental exchange rate volatility and welfare

We lay out an empirical and a theoretical model to analyze the effects of non-fundamental exchange rate volatility on economic activity and welfare. In the first part of the paper, the GARCH-SVARmodel is applied to measure empirically the effect of the conditional exogenous exchange rate volatility on the conditional mean of the endogenous variables in our open economy VAR. Our results for Canada, Germany and UK indicate that the effects of exchange rate uncertainty are small empirically. In the second part, we investigate the effect of non-fundamental exchange rate volatility in a stochastic open economy model. The second order approximation method of Sims [2003] is applied to the model equilibrium conditions. We show that in a model with habit persistence, even non-fundamental exchange rate volatility that generate only small variation in the unconditional mean of the variables might induce economically significant welfare changes. JEL Classification: C32, F31, F41Exchange rate volatility, GARCH-SVAR, Second-order

Assessing the impact of a change in the composition of public spending: a DSGE approach

Despite intense calls for safeguarding public investment in Europe, public investment expenditure, when measured in relation to GDP, has steadily fallen in the last three decades, evoking fears that economic activity may be correspondingly negatively affected. At the same time, however, public consumption in the EU-12 countries has trended up. In this paper, we provide a macroeconomic assessment of the observed change in the composition of public spending in the euro area in a medium-scale two-country dynamic stochastic general equilibrium (DSGE) model. First, we analyze the channels through which, both temporary and permanent public investment shocks generate larger fiscal multipliers than exogenous increases in public consumption. Furthermore, we quantify the negative impact of a change in fiscal stance, characterized by a permanent rise in public consumption and a permanent fall in public investment, keeping thereby the overall level of public spending constant. The key message of the paper is that calls for reversing the observed trend in the composition of public spending are well justifed. JEL Classification: F41, F42DSGE models, euro area, Public consumption, Public investment

Does Exchange Rate Risk Matter for Welfare?

second order solution, exchange rates

An Estimated Small Open Economy Model of the Financial Accelerator

This paper develops a small open economy model in which entrepreneurs partially finance investment using foreign currency-denominated debt subject to an external finance premium. We use Bayesian estimation techniques to evaluate the importance of balance sheet-related credit market frictions for emerging market countries by incorporating the financial accelerator mechanism. We obtain a sizable value for the external finance premium, which is tightly estimated away from zero. Our results support the inclusion of the financial accelerator in an otherwise standard model that-acting through balance sheets-magnifies the impact of shocks, thereby increasing real and financial volatility. Copyright 2006, International Monetary Fund

Does Exchange Rate Risk Matter for Welfare?

Volatility in exchange rates is a prominent feature of open economies, a fact which has motivated elaborate attempts in many countries at exchange rate management. This paper analyzes quantitatively the welfare effects of exchange rate risk in a general two-country environment. It finds that the effects of uncertainty tend to be small for the types of simplified cases considered in past literature. But it identifies other cases, not considered previously, in which these effects can be significantly larger. These include habit persistence, where agents are more sensitive to risk, and also incomplete asset market structures which allow for asymmetries between countries. The latter case suggests that countries which are hosts to an international reserve currency, such as the U.S. or members of the euro zone, may accrue

Assessing the impact of a change in the composition of public spending: a DSGE approach

Despite intense calls for safeguarding public investment in Europe, public investment expenditure, when measured in relation to GDP, has steadily fallen in the last three decades, evoking fears that economic activity may be correspondingly negatively affected. At the same time, however, public consumption in the EU-12 countries has trended up. In this paper, we provide a macroeconomic assessment of the observed change in the composition of public spending in the euro area in a medium-scale two-country dynamic stochastic general equilibrium (DSGE) model. First, we analyze the channels through which, both temporary and permanent public investment shocks generate larger fiscal multipliers than exogenous increases in public consumption. Furthermore, we quantify the negative impact of a change in fiscal stance, characterized by a permanent rise in public consumption and a permanent fall in public investment, keeping thereby the overall level of public spending constant. The key message of the paper is that calls for reversing the observed trend in the composition of public spending are well justifed

Non-fundamental exchange rate volatility and welfare

We lay out an empirical and a theoretical model to analyze the effects of non-fundamental exchange rate volatility on economic activity and welfare. In the first part of the paper, the GARCH-SVARmodel is applied to measure empirically the effect of the conditional exogenous exchange rate volatility on the conditional mean of the endogenous variables in our open economy VAR. Our results for Canada, Germany and UK indicate that the effects of exchange rate uncertainty are small empirically. In the second part, we investigate the effect of non-fundamental exchange rate volatility in a stochastic open economy model. The second order approximation method of Sims [2003] is applied to the model equilibrium conditions. We show that in a model with habit persistence, even non-fundamental exchange rate volatility that generate only small variation in the unconditional mean of the variables might induce economically significant welfare changes

Does Exchange Rate Variability Matter for Welfare? A Quantitative Investigation of Stabilization Policies

This paper evaluates quantitatively the potential welfare gains from monetary policy and fixed exchange rate rules in a two-country sticky-price model. The first finding is that the gains from stabilization tend to be small in the types of economic environments emphasized in recent theoretical literature. The analysis goes on to identify two types of economies in which the welfare implications of risk are larger: where agents exhibit habits, and where international asset markets exhibit asymmetry in the form of “original sin.” In the habits case, monetary policy aimed solely at inflation stabilization is optimal. But in the original sin case there are potentially large welfare gains from also eliminating exchange rate volatility.exchange rate risk, second order approximation

Does exchange rate variability matter for welfare? A quantitative investigation of stabilization policies

This paper evaluates quantitatively the potential welfare gains from monetary policy and fixed exchange rate rules in a two-country sticky-price model. The first finding is that the gains from stabilization tend to be small in the types of economic environments emphasized in recent theoretical literature. The analysis goes on to identify two types of economies in which the welfare implications of risk are larger: where agents exhibit habits, and where international asset markets exhibit asymmetry in the form of "original sin." In the habits case, monetary policy aimed solely at inflation stabilization is optimal. But in the original sin case there are potentially large welfare gains from also eliminating exchange rate volatility