NBER Reporter: Spring 2000

International Finance and Macroeconomics

Members and guests of the NBER's Program on International Finance and Macroeconomics met in Cambridge on March 24. Charles M. Engel, NBER and University of Washington, and Andrew K. Rose, NBER and University of California, Berkeley, organized the program and chose the following papers for discussion:

Fernando Alvarez, NBER and University of Chicago; Andrew Atkeson and Patrick J. Kehoe, University of Minnesota, "Volatile Exchange Rates and the Forward Premium Anomaly: A Segmented Asset Market View"
Discussants: Bernard Dumas, NBER and INSEAD, and Urban J. Jermann, NBER and University of Pennsylvania

Giancarlo Corsetti and Stephen Morris, Yale University, and Hyun Song Shin, Oxford University, "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders"

Discussants: Andres Velasco, NBER and New York University, and Shang-Jin Wei, NBER and World Bank

Cedric Tille, Federal Reserve Bank of New York, "'Beggar-thy-Neighbor' or 'Beggar Thyself'? The Income Effect of Exchange Rate Fluctuations"
Discussants: Kenneth S. Rogoff, NBER and Harvard University, and Marianne Baxter, NBER and University of Virginia

Michael W. Klein, NBER and Tufts University, and Giovanni Olivei, Federal Reserve Bank of Boston,

"Capital Account Liberalization, Financial Depth, and Economic Growth" (NBER Working Paper No. 7384)
Discussants: Ross Levine, University of Minnesota, and Menzie D. Chinn, NBER and University of California, Santa Cruz

Andrew K. Rose, "One Money, One Market: Estimating the Effect of Common Currencies on Trade" (NBER Working Paper No. 7432)
Discussants: Jeffrey A. Frankel, NBER and Harvard University, and Richard Portes, NBER and University of California, Berkeley

Alvarez, Atkeson, and Kehoe analyze the effects of open market operations on interest rates and exchange rates in a model in which agents must pay a Baumol-Tobin style fixed cost to exchange bonds and money. Asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money only infrequently. Money injections fall disproportionately on the fraction of agents that are currently trading, and hence, they affect real interest rates and real exchange rates. The authors show that the model can generate the observed negative relation between expected inflation and real interest rates. With moderate amounts of segmentation, it generates persistent liquidity effects and volatile and persistent exchange rates.

Corsetti, Morris, and Shin build a model of currency crises in which a single large investor and a continuum of small investors, based on their private information about fundamentals, decide simultaneously whether to attack a currency. In the unique equilibrium of this trading game, the presence of the large investor makes all other traders more aggressive in their selling. Relative to the case of no large investors, small investors will attack the currency when fundamentals are stronger. Yet, the difference can be small or zero, depending on the relative precision of the private information held by the small and large investors.

Building on the work of Betts and Devereux (2000), Tille analyzes the impact of monetary shocks in an open economy. When exchange rate fluctuations are not entirely passed through to consumer prices, an exchange rate depreciation does not necessarily have a beggar-thy-neighbor effect, and in fact may have an opposite beggar-thyself effect. The direction of the welfare effect depends on who owns the firms that import goods and sell them to consumers, a dimension not explored in the earlier literature.

Klein and Olivei show that open capital accounts have a statistically significant and economically relevant effect on financial depth and economic growth in a cross-section of countries over the period 1986-95. However, these results are driven largely by the developed countries in the sample. The observed failure of capital account liberalization to promote financial deepening among developing countries suggests that opening up the capital account has important policy implications.

Rose uses a gravity model and a panel dataset that includes bilateral observations spanning the period from 1970-90 for 186 countries to assess the separate effects of exchange rate volatility and currency unions on international trade. He finds that currency unions have a large positive effect on international trade, and that exchange rate volatility has a small negative effect, even after controlling for a host of other features. These effects are statistically significant and imply that two countries that share the same currency trade three times as much as they would if they had different currencies. Thus, currency unions like the EMU may lead to a large increase in international trade, with all that entails.