NBER Reporter: Fall 2001

International Finance and Macroeconomics

Members and guests of the NBER's Program on International Finance and Macroeconomics met in Cambridge on October 26. Charles M. Engel, NBER and University of Wisconsin, and Linda Tesar, NBER and University of Michigan, organized this program:

Daron Acemoglu and Jaume Ventura, NBER and MIT, "The World Income Distribution" (NBER Working Paper No. 8083)

Discussants: Pierre-Olivier Gourinchas, NBER and Princeton University, and Ricardo Hausmann, Harvard University

Sergio Rebelo, NBER and Northwestern University, and Carlos A. Végh, NBER and University of California, Los Angeles, "When is it Optimal to Abandon a Fixed Exchange Rate?"

Discussant: Robert Flood, International Monetary Fund, and Michael W. Klein, NBER and Tufts University

Torben G. Andersen, NBER and Northwestern University; Tim Bollerslev, NBER and Duke University; Francis X. Diebold, NBER and University of Pennsylvania; and Clara Vega, University of Pennsylvania, "Micro-Effects of Macro Announcements: Real Time Price Discovery in Foreign Exchange"

Discussants: Kathryn M. Dominguez, NBER and University of Michigan, and Nelson Mark, NBER and Ohio State University

Michael W. Brandt, NBER and University of Pennsylvania; John H. Cochrane, NBER and University of Chicago;

and Pedro Santa-Clara, University of California, Los Angeles, "International Risk Sharing is Better Than You Think (or Exchange Rates are Much Too Smooth)" (NBER Working Paper No. 8404)

Discussants: Helene Rey, NBER and Princeton University, and Roberto Rigobon, NBER and MIT

Rui Albuquerque, University of Rochester, "The Composition of International Capital Flows: Risk Sharing through FDI"

Discussant: Robert E. Lipsey, NBER and City University of New York, and Jonathan Eaton, NBER and Boston University

Acemoglu and Ventura show that, even in the absence of diminishing returns in production and technological spillovers, international trade leads to a stable world income distribution. This is because specialization and trade introduce de facto diminishing returns: countries that accumulate capital faster than average experience declining export prices, depressing the rate of return to capital and discouraging further accumulation. The dispersion of the world income distribution is determined by the forces that shape the strength of the terms-of-trade effects: the degree of openness to international trade and the extent of specialization. Finally, the authors show that countries accumulating capital faster experience a worsening in their terms of trade. The estimates imply that, all else equal, a single percentage point faster growth is associated with approximately a 0.7 percentage point decline in the terms of trade.

Rebelo and Végh discuss the optimal time to abandon a fixed exchange rate regime in response to an increase in government spending that renders the peg unsustainable. They consider two variants of an optimization-based first-generation speculative attack model. In the first variant there are fiscal costs of abandoning fixed exchange rates. These costs may represent the bailout of the banking sector, loss of tax revenues, difficulties in refinancing public debt, and so on. The second variant incorporates fiscal reform that makes the peg sustainable and that arrives according to a Poisson process while the exchange rate is fixed. In both cases, for moderate government expenditure shocks it is optimal to abandon the peg when international reserves hit a pre-specified lower bound. When the government expenditure shock is large, it is optimal to abandon the peg as soon as the shock materializes. Surprisingly, immediate abandonment of the peg is also optimal when the fiscal costs of abandoning the peg are large.

Using a new dataset consisting of six years of real-time exchange rate quotations, macroeconomic expectations, and macroeconomic realizations (announcements), Andersen, Bollerslev, Diebold, and Vega characterize the conditional means of U.S. dollar spot exchange rates for Germany, England, Japan, Switzerland, and the Euro. In particular, they show that announcement surprises (that is, divergences between expectations and realizations, or "news") produce conditional mean jumps; hence high-frequency exchange rate dynamics are linked to fundamentals. The details of the linkage are intriguing and include announcement timing, size, and sign effects. The sign effect refers to the fact that the market reacts to news in an asymmetric fashion: bad news has greater impact than good news, which the authors relate to recent theoretical work on information processing and price discovery.

Exchange rates depreciate by the difference between the domestic and foreign growth in marginal utility. Exchange rates vary a lot, as much as 10 percent per year. However, equity premiums imply that marginal utility growth varies much more, by at least 50 percent per year. This means that marginal utility growth must be highly correlated across countries: international risksharing is better than you think. Conversely, if risk really is not shared internationally, then exchange rates should vary more than they do: exchange rates are much too smooth. Brandt, Cochrane, and Santa-Clara calculate an index of international risksharing that formalizes this intuition in the context of both complete and incomplete capital markets. Their results suggest that risksharing is indeed very high across several pairs of countries.

Evidence on international capital flows suggests that foreign direct investment (FDI) is less volatile than other financial flows. To explain this finding, Albuquerque models international capital flows under the assumptions of imperfect enforcement of contracts and inalienability of FDI. Imperfect enforcement of contracts leads to endogenous financing constraints and the pricing of default risk. Inalienability implies that it is not as advantageous to expropriate FDI relative to other flows. These features combine to give a risksharing advantage of FDI over other capital flows. This risksharing advantage translates into a lower default premium on FDI and a smaller response to changes in a country's financing constraint. The model produces the new implication that financially constrained countries borrow relatively more through FDI. Using several creditworthiness and country risk ratings to measure financial constraints, the author presents supporting evidence of the model.


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