Creator: Backus, David, Kehoe, Patrick J., and Kydland, Finn E. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 498 Keyword: Harberger-Laursen-Metzler effect, Net exports , Balance of trade, Terms of trade, J curve, and Marshall-Lerner condition Subject (JEL): F41 - Open Economy Macroeconomics, F11 - Neoclassical Models of Trade, and F30 - International Finance: General
Creator: Cole, Harold Linh, 1957-, Leung, Ron, and Ohanian, Lee E. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 356 Abstract:
This paper presents a dynamic, stochastic general equilibrium study of the causes of the international Great Depression. We use a fully articulated model to assess the relative contributions of deflation/monetary shocks, which are the most commonly cited shocks for the Depression, and productivity shocks. We find that productivity is the dominant shock, accounting for about 2/3 of the Depression, with the monetary shock accounting for about 1/3. The main reason deflation doesn’t account for more of the Depression is because there is no systematic relationship between deflation and output during this period. Our finding that a persistent productivity shock is the key factor stands in contrast to the conventional view that a continuing sequence of unexpected deflation shocks was the major cause of the Depression. We also explore what factors might be causing the productivity shocks. We find some evidence that they are largely related to industrial activity, rather than agricultural activity, and that they are correlated with real exchange rates and non-deflationary shocks to the financial sector.
Keyword: Monetary Shocks, Deflation, Productivity Shocks, and Great Depression Subject (JEL): E30 - Prices, Business Fluctuations, and Cycles: General (includes Measurement and Data) and F40 - Macroeconomic Aspects of International Trade and Finance: General
Creator: Parente, Stephen L. and Prescott, Edward C. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 333 Abstract:
This essay develops a theory of the evolution of international income levels. In particular, it augments the Hansen-Prescott theory of economic development with the Parente-Prescott theory of relative efficiencies and shows that the unified theory accounts for the evolution of international income levels over the last millennium. The essence of this unified theory is that a country starts to experience sustained increases in its living standard when production efficiency reaches a critical point. Countries reach this critical level of efficiency at different dates not because they have access to different stocks of knowledge, but rather because they differ in the amount of society-imposed constraints on the technology choices of their citizenry.
Keyword: Catch-up, Trading clubs, Capital share, Transition to modern economic growth, and Aggregate economic efficiency Subject (JEL): O11 - Macroeconomic Analyses of Economic Development, E00 - Macroeconomics and Monetary Economics: General, F40 - Macroeconomic Aspects of International Trade and Finance: General, and O19 - International Linkages to Development; Role of International Organizations
Creator: Alvarez, Fernando, 1964-, Atkeson, Andrew, and Kehoe, Patrick J. Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 371 Abstract:
Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation.
Keyword: Pricing Kernel, Segmented Markets, Asset Pricing-Puzzle, Time-Varying Conditional Variances, Fama Puzzle, and Forward Premium Anomaly Subject (JEL): F30 - International Finance: General, F31 - Foreign Exchange, E43 - Interest Rates: Determination, Term Structure, and Effects, G12 - Asset Pricing; Trading Volume; Bond Interest Rates, G15 - International Financial Markets, and F41 - Open Economy Macroeconomics
Creator: Alvarez, Fernando, 1964-, Atkeson, Andrew, and Kehoe, Patrick J. Series: Working paper (Federal Reserve Bank of Minneapolis. Research Department) Number: 627 Abstract:
Time-varying risk is the primary force driving nominal interest rate differentials on currency-denominated bonds. This finding is an immediate implication of the fact that exchange rates are roughly random walks. We show that a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation—can produce key features of actual interest rates and exchange rates. The endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, the benefit of asset market participation varies, and that changes the fraction of agents participating. These effects lead the risk premium to vary systematically with the level of inflation. Our model produces variation in the risk premium even though the fundamental shocks have constant conditional variances.
Keyword: Forward premium anomaly, Pricing kernel, Asset pricing-puzzle, Time-varying conditional variances, Segmented markets, and Fama puzzle Subject (JEL): E43 - Interest Rates: Determination, Term Structure, and Effects, F30 - International Finance: General, G15 - International Financial Markets, G12 - Asset Pricing; Trading Volume; Bond Interest Rates, F31 - Foreign Exchange, and F41 - Open Economy Macroeconomics
Creator: Ray, Debraj. and Streufert, Peter A. Series: Models of economic growth and development Abstract:
We incorporate the consumption-ability relationship of static "efficiency wage" models into a dynamic general equilibrium model. We show that for many aggregate land stocks, there is a continuum of unemployment rates which could persist indefinitely as part of a stationary equilibrium. For many of these aggregate land stocks, both unemployment and full employment are distrinct possibilities. Broadly speaking, more unemployment corresponds to more undernourishment and more inequality in land distribution. Thus our results suggest that the market mechanism is less efficacious than land reform in reducing unemployment and undernourishment.
Subject (JEL): J41 - Particular labor markets - Labor contracts, F41 - Macroeconomic aspects of international trade and finance - Open economy macroeconomics, and O42 - Economic growth and aggregate productivity - Monetary growth models
Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 525 Abstract:
This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government's inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.
Keyword: Sovereign default, Tax reforms, and Debt crisis Subject (JEL): F30 - International Finance: General
Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 495 Abstract:
This paper studies an optimal renegotiation protocol designed by a benevolent planner when two countries renegotiate with the same lender. The solution calls for recoveries that induce each country to default or repay, trading off the deadweight costs and the redistribution benefits of default independently of the other country. This outcome contrasts with a decentralized bargaining solution where default in one country increases the likelihood of default in the second country because recoveries are lower when both countries renegotiate. The paper suggests that policies geared at designing renegotiation processes that treat countries in isolation can prevent contagion of debt crises.
Keyword: Sovereign default, Contagion, and Renegotiation policy Subject (JEL): F30 - International Finance: General and G01 - Financial Crises
Creator: Arellano, Cristina and Bai, Yan Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 491 Abstract:
We develop a multicountry model in which default in one country triggers default in other countries. Countries are linked to one another by borrowing from and renegotiating with common lenders. Countries default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. Defaulting is also attractive in response to foreign defaults because the cost of rolling over the debt is higher when other countries default. Such forces are quantitatively important for generating a positive correlation of spreads and joint incidence of default. The model can rationalize some of the recent economic events in Europe as well as the historical patterns of defaults, renegotiations, and recoveries across countries.
Keyword: Sovereign default, Contagion, Renegotiation, European debt crisis, and Self-fulfilling crisis Subject (JEL): F30 - International Finance: General and G01 - Financial Crises
Creator: Arellano, Cristina, Bai, Yan, and Lizarazo, Sandra Series: Staff report (Federal Reserve Bank of Minneapolis. Research Department) Number: 559 Abstract:
We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).
Keyword: Sovereign default, Bond spreads, Renegotiation, and European debt crisis Subject (JEL): F30 - International Finance: General and G01 - Financial Crises