IFDP 1998-632
The Implications of Risk Management Information Systems for the Organization of Financial Firms


Financial dealer firms have invested heavily in recent years to develop information systems for risk measurement. I take it as given that technological progress is likely to continue at a rapid pace, making it less expensive for financial firms to assemble risk information. I look beyond questions of risk measurement methodology to investigate the implications of risk management information systems. By examining several theoretical models of the firm in the presence of asymmetric information, I explore how a financial firm’s capital budgeting, incentive compensation, capital structure, and risk management activities are likely to change as it becomes less costly to assemble risk information. I also explore the likely effects of the falling cost of assembling risk information on a financial firm’s organizational structure. Two common themes emerge: centralization within the firm and increased disclosure of risk information outside the firm are both likely to increase.

Keywords: Asymmetric information, value at risk, capital budgeting, incentive compensation, capital structure, organizational structure.

IFDP 1998-631
Idiosyncratic Tastes in a Two-Country Optimizing Model: Implications of a Standard Presumption

Francis E. Warnock


International spillovers and exchange rate dynamics are examined in a two-country dynamic optimizing model that allows for idiosyncratic tastes across countries. Specifically, there is a home-good bias in consumption patterns: at given relative prices the ratio of home goods consumed to foreign goods consumed is higher in the home country. The setup nests Obstfeld and Rogoff (1995), who assume identical tastes. Allowing for idiosyncratic tastes produces results that differ from Obstfeld and Rogoff’s: expansionary monetary policy increases home utility by more, the positive spillovers of a fiscal expansion are reduced, and both short-run and long-run deviations from consumption-based purchasing power parity are possible. The model’s predictions are broadly consistent with those from the Frenkel, Razin and Yuen (1996) version of the two-country Mundell-Fleming model and with observed behavior of real and nominal exchange rates.

Keywords: Home bias, monetary policy, fiscal policy, purchasing power parity

IFDP 1998-630
A Model of Crises in Emerging Markets

Michael P. Dooley


This paper presents a "first generation" model of speculative attacks on emerging markets. Credit-constrained governments accumulate liquid assets in order to self-insure against shocks to national consumption. Governments also insure poorly regulated domestic financial markets. Given this policy regime, a variety of internal and external shocks generate capital inflows followed by anticipated speculative attacks. The model suggests that a common shock generated capital inflows to emerging markets in Asia and Latin America after 1989. Country-specific factors determined the timing of speculative attacks. Economic reform programs may also have generated capital inflow/crisis sequences.

Keywords: Speculative attack, policy conflict

IFDP 1998-629
Currency and Banking Crisis: The Early Warnings of Distress

Graciela L. Kaminsky


The abruptness and virulence of the 1997 Asian crises have led many to claim that these crises are of a new breed and thus they were unforecastable. This paper examines 102 financial crises in 20 countries and concludes that the Asian crises are not of a new variety. Overall, the 1997 Asian crises, as well as previous crises in other regions, occur when the economies are in distress, making the degree of fragility of the economy a useful indicator of future crises. Based on this idea, the paper proposes different composite leading indicators of crises, which are evaluated in terms of accuracy both in-sample and out-of-sample.

Keywords: Banking and currency crises, early warnings, predicting crises

IFDP 1998-628
Inflation and the Great Ratios: Long-Term Evidence from the U.S.


Using more than 100 years of data from the United States, we find that the long-run effects of inflation on consumption, investment, and output are positive. Thus, models generating long-term negative effects of inflation on output and consumption (including endogenous growth and RBC models with money) seem to be at odds with data from the moderate inflation rate environment we consider. Also, great ratios like the consumption and investment rates are not independent of inflation, which we interpret in terms of the Fisher effect. However, in the full sample, the variability of the stochastic inflation trend is small relative to the variability of the productivity and fiscal trends, so inflation accounts for little of the movements in real variables. By comparison, we find in the post-WWII sub-period that although significant "permanent" shocks to inflation are a more regular feature of the data, the long-run real effects of an inflation shock of a given size are much smaller.

Keywords: Investment, Tobin Effect, Fisher Effect

IFDP 1998-627
Tradeoffs between Inflation and Output-Gap Variances in an Optimizing-Agent Model

Christopher J. Erceg, Dale W. Henderson, and Andrew T. Levin


We demonstrate the existence of a monetary policy tradeoff between price-inflation variability and output-gap variability in an optimizing-agent model with staggered nominal wage and price contracts. This variance tradeoff is absent only in the special case in which prices are sticky and wages are perfectly flexible. When the model is calibrated to exhibit an empirically reasonable degree of nominal wage inertia, strict inflation targeting induces substantial output-gap volatility.

Keywords: Monetary policy frontier, inflation targeting, sticky wages, sticky prices, staggered contracts, determinacy

IFDP 1998-626
A Framework for Economic Forecasting

Neil R. Ericsson and Jaime Marquez


This paper proposes a tripartite framework of design, evaluation, and post-evaluation analysis for generating and interpreting economic forecasts. This framework's value is illustrated by re-examining mean square forecast errors from dynamic models and nonlinearity biases from empirical forecasts of U.S. external trade. Previous studies have examined properties such as nonlinearity bias and the possible nonmonotonicity and nonexistence of mean square forecast errors in isolation from other aspects of the forecasting process, resulting in inefficient forecasting techniques and seemingly puzzling phenomena. The framework developed reveals how each such property follows from systematically integrating all aspects of the forecasting process.

Full paper (3130 KB Postscript)

Keywords: Forecasts, mean square forecast error, Monte Carlo, nonlinearity bias, trade balance.

IFDP 1998-625
Are Technology Improvements Contractionary?

Susanto Basu, John G. Fernald, and Miles Kimball


Yes. We construct a measure of aggregate technology change, controlling for imperfect competition, varying utilization of capital and labor, and aggregation effects. On impact, when technology improves, input use falls sharply, and output may fall slightly. With a lag of several years, inputs return to normal and output rises strongly. These results are inconsistent with frictionless dynamic general equilibrium models, which generally predict that technology improvements are expansionary, with inputs and (especially) output rising immediately. However, the results are consistent with plausible sticky-price models, which predict the results we find: When technology improves, input use generally falls in the short run, and output itself may also fall.

Full paper (2423 KB Postscript)

Keywords: Productivity, business cycles, sticky-price models

IFDP 1998-624
"Big Bang" Deregulation and Japanese Corporate Governance: A Survey of the Issues


The "Big Bang" deregulation of Japanese financial markets focuses on financial modernization. I argue that financial modernization is of secondary importance for improving the performance of the Japanese economy. A key long-term issue facing Japan is to maintain its high level of per capita income in the face of an aging population and slower productivity growth. To achieve this, it is important to increase the return earned on Japan’s large stock of wealth. I argue the low return on wealth reflects characteristics of the Japanese corporate governance system. The proper focus of the Big Bang should be on measures to strengthen corporate governance.

I identify three characteristics of the Japanese corporate governance system that lead Japanese managers to produce low returns for shareholders. First, insider stakeholders dominate corporate governance. Second, institutional investors are weak. Third, there is no market for corporate control. For each characteristic, I describe potential changes which would strengthen Japanese corporate governance. For each potential corporate governance change, I review empirical evidence on its effectiveness, its current status in Japan, and how it is addressed, if at all, in the Big Bang. I conclude that the progress of the Big Bang reforms to corporate governance has been limited.

Keywords: Executive compensation, stock options, independent directors, share buybacks, institutional investors, market for corporate control, minority shareholders

IFDP 1998-623
Relative Price Volatility: What Role Does the Border Play

Charles M. Engel and John H. Rogers


We reexamine the effect of the U.S.-Canadian border on integration of markets. The paper updates work from our earlier paper, Engel and Rogers (1996). We consider alternative measures of deviations from the law of one price. We pay special attention to the effect of the U.S.-Canada free trade agreement on market integration. Our conclusions are unchanged: markets in the U.S. and Canada are more segmented than can be explained by the physical distance between the two locations. Formal trade barriers do not appear to explain much of that segmentation.

Keywords: Exchange rates, segmentation, trade barriers

IFDP 1998-622
Two Equivalence Theorems for Government Finance

Dahai Yu


This paper studies the effects of a path change in government debt composition and aggregate transfers on allocations and prices. It is shown that the effects are zero under some agent-specific transfer scheme even when markets are incomplete. If markets are complete, then the effects are zero under any transfer scheme that leaves each agent's lifetime resource unchanged if and only if agents are always collectively compensated for next period's return change. The infinite-horizon framework used has an arbitrary number of assets with arbitrary returns and an arbitrary mixture of finitely and infinitely lived agents.

Full paper (711 KB Postscript)

Keywords: Debt composition, Ricardian equivalence, general equilibrium

IFDP 1998-621
Rational Bubbles under Diverse Information

Dahai Yu


This paper uses a set of post-extraction information trees to generally model diverse information and agent specific state price processes to define present and fundamental values. It shows that there can be no negative or finite bubbles and that, if agents are impatient and the aggregate endowment has a finite present value under some state price process of some agent, then there can be no bubble under this state price process for any asset with positive supply.

Full paper (723 KB Postscript)

Keywords: Bubbles, asset pricing, information

IFDP 1998-620
What Determines Public Support for Affirmative Action?

Murat F. Iyigun and Andrew T. Levin


We present a model of public higher education finance in which demand for educational services can exceed supply because of indivisibilities in educational investment. In such situations, a screening mechanism--which may be imperfect because of direct or indirect discrimination--is required for allocation. We show how changes in the education premium affect political support for affirmative action policies. When the education premium is relatively low, the matching efficiency gains provided by affirmative action policies are relatively high compared to the opportunity cost of not acquiring education, and the majority supports broader affirmative action. In contrast, when the education premium is high, the opportunity cost of not acquiring education is high relative to the matching efficiency gains provided by affirmative action policies, and the majority's support for affirmative action is weaker. With endogenous wages, the negative relationship between the returns to education and affirmative action is reinforced.

Keywords: Public education, education premium, screening

IFDP 1998-619
Puzzles in the Chinese Stock Market

John G. Fernald and John H. Rogers


Many companies on China’s stock markets have separate, restricted classes of shares for domestic residents and foreigners. Other than who can own them, these shares are identical, but foreigners pay only about one-quarter the price paid by domestic residents. We show that plausible differences--about 4 percentage-points--in expected rates of return by foreign and domestic investors can account for the generally higher level and volatility of prices for domestic shares relative to foreign shares. We attribute low Chinese expected returns to the limited alternative investments available in China. We then explore the extent to which various company characteristics can explain cross-company differences in the relative price paid by foreigners. For example, foreigners pay a lower relative price for companies with a higher proportion owned by the state--reflecting, surprisingly, a higher absolute price paid by both foreigners and domestic residents. Several puzzles remain. For example, we are unable to explain why Chinese investors in Shanghai paid lower prices in 1994 and 1995 for companies with their foreign listings in Hong Kong rather than Shanghai.

Full paper (611 KB Postscript)

Keywords: Emerging markets, segmented stock market, China

IFDP 1998-618

Simeon Djankov and Caroline L. Freund


We study the effects of trade barriers and the persistence of past linkages on trade flows in the former Soviet Union (FSU). Estimating gravity equations on 1987-1996 trade among and between nine Russian regions and fourteen FSU republics, we find that Russian regions traded 60 percent more with each other than with republics in the reform period (1994-96). In contrast, they did not trade significantly more with each other than with republics in the pre-reform period (1987-90). Estimating a richer model, we find that trade barriers are primarily responsible for the current domestic bias. However, the existing infrastructure stock has significantly limited the recent reorientation in trade. Finally, we find evidence of anticipatory adjustment during the transition to independence.

Keywords: Infrastructure, trade, adjustment costs

IFDP 1998-617
The Business Cycles of Currency Speculation: A Revision of The Mundellian Framework

Enrique G. Mendoza and Martin Uribe


In his seminal 1960 study on the dynamics of alternative exchange rate regimes, Robert Mundell proposed a theory of balance-of-payments crises in which speculators base their actions on the observed holdings of central bank foreign reserves. We examine the quantitative implications of this view from the perspective of an equilibrium business cycle model in which rational expectations of a devaluation are conditioned on foreign reserves. The model explains some of the empirical regularities of the business cycle associated with temporary fixed-exchange-rate regimes. In turn, these cyclical dynamics validate the agents' expectations by producing devaluation probabilities that resemble those estimated from the data. The model thus aims to explain both the real effects and the collapse of exchange-rate-based stabilizations in a unified framework.

Keywords: Currency crises, balance-of-payments crises, real business cycles

IFDP 1998-616
Exogeneity, Cointegration, and Economic Policy Analysis

Neil R. Ericsson, David F. Hendry, and Grayham E. Mizon


This overview examines conditions for reliable economic policy analysis based on econometric models, focusing on the econometric concepts of exogeneity, cointegration, causality, and invariance. Weak, strong, and super exogeneity are discussed in general; and these concepts are then applied to the use of econometric models in policy analysis when the variables are cointegrated. Implications follow for model constancy, the Lucas critique, equation inversion, and impulse response analysis. A small money-demand model for the United Kingdom illustrates the main analytical points. This paper then summarizes the other articles in this special section of the Journal of Business and Economic Statistics on "Exogeneity, Cointegration, and Economic Policy Analysis."

Full paper (2207 KB Postscript)

Keywords: Causality, equation inversion, impulse response analysis, invariance, Lucas critique, money demand

IFDP 1998-615
Equilibrium Liquidity Premia

Dahai Yu


This paper studies in a general framework the relative prices of perpetuities with identical dividends and different bid-ask spreads. It establishes four sets of conditions under which the liquidity premium is always positive (i.e., an asset with smaller spread always commands a higher price). To show that the liquidity premium is not necessarily positive, the paper presents two examples of general equilibrium in which the liquidity premium is sometimes negative. The paper also establishes four sets of conditions under which the price-spread relation is convex and uses results on asset price bubbles to establish liquidity premium bounds.

Full paper (770 KB Postscript)

Keywords: Liquidity premium, bid-ask spread, general equilibrium

IFDP 1998-614
Multilateralism and the Endogenous Formation of PTAs

Caroline L. Freund


This paper examines the interaction between preferential trade agreements (PTAs) and multilateral tariff reduction in a model of imperfect competition. A growing literature finds that the formation of PTAs alters the incentives for and the sustainability of multilateral tariff reduction. We show that the causation is not one-sided -- multilateral tariff reduction also affects the formation of PTAs. Specifically, tariff reduction enhances the incentives to form a PTA and increases the likelihood that it is self-enforcing. Thus, each round of multilateral tariff reduction should lead to a new wave of PTAs. This may help to explain the current trend towards regionalism.

Original version (PDF)

Keywords: Trade, regionalism, imperfect competition

IFDP 1998-613
Macroeconomic Implications of Competitive College Admissions

Murat F. Iyigun and Andrew T. Levin


We present a public higher education model in which there exist indivisibilities in educational investment. Consequently, when demand for educational services exceed supply, a screening mechanism, which may potentially be imperfect, is required to choose the student body. We demonstrate how distortions or biases in screening--caused by parental factors--interact with the distribution of income to help explain the considerable differences across countries in the share of resources devoted to public higher education. Moderate degrees of admission bias lower the share of resources devoted to public education whereas higher levels of bias may have positive effects on public education supply. Thus, while lower screening biases lead to a better allocation of a given amount of spending on education, they do not necessarily lead to more political support for public education, and thereby to higher aggregate human capital and output. When wage rates are endogenous, the effects of screening biases on public higher education supply can be positive even for smaller biases. Moreover, higher inequality will lead to a lower share of resources devoted to public higher education when biases are relatively moderate.

Keywords: Public education, income distribution, screening

IFDP 1998-612
Monetary Shocks and Real Exchange Rates


Many explanations of the stylized facts concerning real exchange rate movements focus on monetary shocks, but it is often found empirically that monetary shocks are unimportant. I provide evidence that is contrary to this empirical finding. Using over 100 years of data, I estimate the contribution of various shocks to explaining variation in the real pound-dollar exchange rate. Monetary shocks consist of both monetary base and money multiplier shocks; real shocks include fiscal, productivity, and preference shocks. Estimates of several alternative VAR specifications provide a range for the contribution of the various shocks: from 19 to 60 percent in the short-run for monetary shocks and 4 to 26 percent for fiscal and productivity shocks combined. My modeling strategy and results are compared directly to related work. The results lend empirical support to the convention in recent quantitative general equilibrium modeling of focusing on monetary shocks.

Keywords: Vector autoregressions

IFDP 1998-611
Some Multi-Country Evidence on the Effects of Real Exchange Rates on Output

Steven B. Kamin and Marc Klau


The simultaneous occurrence of devaluation and recession in Mexico in 1995, as well as in the East Asian economies more recently, appears to contradict the conventional view that devaluations are expansionary. Moreover, a sizeable theoretical and empirical literature also argues that, contrary to the predictions of textbook analysis, exchange rate devaluations may be contractionary rather than expansionary. However, prior statistical analyses of the effects of exchange rate devaluation on output have been subject to several limitations: (i) they have failed to distinguish adequately between short and long-run effects; (ii) they have not controlled for the full range of external shocks; and (iii) they have not considered whether the effects of devaluation might differ between different regions of the world. The purpose of this paper is to estimate the impact of devaluation on output for 27 countries while attempting to address these limitations in previous empirical analyses. We find no evidence that devaluations are contractionary in the long run. Additionally, controlling for sources of spurious correlation and reverse causality appears to mute the measured contractionary effect of devaluation in the short run, although this effect remains even after these controls are introduced. Finally, while the literature on contractionary devaluation has focused primarily on developing countries, we found no evidence that this effect is stronger in developing countries than in industrialised countries.

Full paper (507 KB Postscript)

Keywords: Contractionary devaluation

IFDP 1998-610
The Robustness of Identified VAR Conclusions about Money

Jon Faust


This paper presents a new way to assess robustness of claims from identified VAR work. All possible identifications are checked for the one that is worst for the claim, subject to the restriction that the VAR produce reasonable impulse responses to shocks. The statistic on which the claim is based need not be identified; thus, one can assess claims in large models using minimal restrictions. The technique reveals only weak support for the claim that monetary policy shocks contribute a small portion of the forecast error variance of postwar U.S. output in standard 6-variable and 13-variable models.

Keywords: Identification, VAR, monetary policy

IFDP 1998-609
Trade Elasticities for G-7 Countries

Peter Hooper, Karen Johnson, and Jaime Marquez


This paper reports the results of a project to estimate and test the stability properties of conventional equations relating real imports and exports of goods and services for the G-7 countries to their incomes and relative prices. We begin by estimating cointegration vectors and the error-correction formulations. We then test the stability of these equations using Chow and Kalman-Filter tests. The evidence suggests three findings. First, conventional trade equations and elasticities are stable enough, in most cases, to perform adequately in forecasting and policy simulations. Equations for German trade, as well as equations for French and Italian exports, are an exception. Second, income elasticities of U.S. trade have not been shifting in a direction that will tend to ease the trend toward deterioration in the U.S. trade position. The income-elasticity gap for Japan found in earlier studies was not confirmed in this analysis. Finally, the price channel is weak, if not wholly ineffective, in the case of continental European countries.

Keywords: Exports, imports, cointegration, error-correction modeling

IFDP 1998-608
El Niño and World Primary Commodity Prices: Warm Water or Hot Air?

Allan D. Brunner


This paper examines the historical effects of El Niño on world prices and economic activity. Although the primary focus is on world real non-oil primary commodity prices, the effects on G-7 consumer price inflation and GDP growth are also considered. This paper has several distinct advantages over previous studies. First, several econometric models are estimated using fairly broad measures of prices and economic activity. Second, the models include continuous measures of El Niño intensity (sea surface temperature and sea-level air pressure anomalies in the Pacific Ocean) rather than dummy variable measures. Finally, confidence intervals are constructed for all estimated effects of El Niño on world prices and economic activity.

The analysis indicates that El Niño has economically-important and statistically-significant effects on world real commodity prices. A one-standard-deviation surprise in El Niño, for example, raises real commodity price inflation about 3-1/2 to 4 percentage points. Moreover, El Niño appears to account for over 20 percent of commodity price inflation movements over the past several years. El Niño also has some explanatory power for world consumer price inflation and world economic activity, accounting for about 10 to 15 percent of movements in those variables.

Keywords: El Niño, commodity prices, business cycle fluctuations

IFDP 1998-607
U.S. Monetary Policy and Econometric Modeling: Tales from the FOMC Transcripts 1984-1991

Hali J. Edison and Jaime Marquez


This paper uses the transcripts from the FOMC meetings to characterize the interactions between policymakers and macro models in the formulation of U.S. monetary policy. We develop a taxonomy of these interactions and present two case studies. The first case focuses on the debate on the choice of monetary target and the second case focuses on the 1990/1991 recession. The analysis reveals that U.S. monetary policy relies on models for information. Models give estimates of both the outlook and the response of the economy to policy changes. Models also evolve to recognize the changing context in which policymakers operate--exchange rate flexibility, financial deregulation, and international trade agreements.

Keywords: FOMC, econometric modelling, monetary policy, United States

IFDP 1998-606
Asset Bubbles, Domino Effects and 'Lifeboats': Elements of the East Asian Crisis

Hali J. Edison, Pongsak Luangaram, and Marcus Miller


Credit market imperfections have been blamed for the depth and persistence of the Great Depression in the USA. Could similar mechanisms have played a role in ending the East Asian miracle? After a brief account of the nature of the recent crises, we use a model of highly levered credit-constrained firms due to Kiyotaki and Moore (1997) to explore this question. As applied to land-holding property companies, it predicts greatly amplified responses to financial shocks--like the ending of the land price bubble or the fall of the exchange rate. The initial fall in asset values is followed by the ‘knock-on’ effects of the scramble for liquidity as companies sell land to satisfy their collateral requirements--causing land prices to fall further. This could lead to financial collapse where--like falling dominoes--prudent firms are brought down by imprudent firms.

Key to avoiding collapse is the nature of financial stabilisation policy; in a crisis, temporary financing can prevent illiquidity becoming insolvency and launching ‘lifeboats’ can do the same. But the vulnerability of financial systems like those in East Asia to short-term foreign currency exposure suggests that preventive measures are also required.

Full paper (1094 KB Postscript)

Keywords: Credit market imperfections, asset price bubbles, financial crisis, illiquidity and insolvency

IFDP 1998-605
Transparency and Credibility: Monetary Policy with Unobservable Goals

Jon Faust and Lars E.O. Svensson


We define and study transparency, credibility, and reputation in a model where the central bank's characteristics are unobservable to the private sector and are inferred from the policy outcome. A low-credibility bank optimally conducts a more inflationary policy than a high-credibility bank, in the sense that it induces higher inflation, but a less expansionary policy in the sense that it induces lower inflation and employment than expected. Increased transparency makes the bank's reputation and credibility more sensitive to its actions. This has a moderating influence on the bank's policy. Full transparency of the central bank's intentions is generally socially beneficial, but frequently not in the interest of the bank. Somewhat paradoxically, direct observability of idiosyncratic central bank goals removes the moderating incentive on the bank and leads to the worst equilibrium.

Keywords: Credibility, transparency, monetary policy, dynamic game

IFDP 1998-604
Was China the First Domino? Assessing Links between China and the Rest of Emerging Asia

John G. Fernald, Hali J. Edison, and Prakash Loungani


We assess links between China and the rest of emerging Asia. Some commentators have argued that China’s apparent devaluation in 1994 may have contributed to the Asian financial crisis. We argue that the devaluation was not economically important: The more-relevant exchange rate was a floating rate that was not devalued, and high Chinese inflation has led to a very sharp real appreciation of the currency. Although in principle, export competition with China could nevertheless have placed pressure on other Asian exporters, we argue that the striking feature of the data is the common movement between export growth from China and from other developing Asian economies. To the extent there is evidence of export competition, it is the period from about 1989 to 1993: China’s exchange rate depreciated sharply, Chinese export growth exceeded export growth of other Asian economies, and the composition of Asian exports (measured by export shares of various goods to the United States and other industrial economies) changed substantially. Finally, we speculate on the effects of the Asian crisis on China’s prospects. China’s economic growth is likely to slow because of increased trade competition as a result of the devaluation of other Asian currencies, and because of reduced capital inflows. In addition, these reduced inflows are likely to reduce job creation in the non-state sector, and hence make enterprise restructuring more difficult in China.

Keywords: Asian financial crisis, trade linkages, devaluation, currency crises, contagion

IFDP 1998-603
A Multi-Country Comparison of the Linkages Between Inflation and Exchange Rate Competitiveness


This paper describes research comparing the response of inflation to changes in exchange rate competitiveness in various regions of the world. The paper first presents evidence that an empirical relationship between the rate of inflation and the level of the real exchange rate, which was documented for Mexico in previous research by the author, holds for a large set of other countries as well. This result may pose a dilemma for policy-makers, since it implies that it may not be possible to achieve low inflation and a high export competitiveness simultaneously. The paper then demonstrates that the responsiveness of inflation to the real exchange rate has been much higher in Latin America than in Asian or industrialised countries. This difference in inflationary responsiveness is not fully explained either by the prior history of inflation or by the extent of openness to foreign trade. It is possible that the lower responsiveness of inflation to the real exchange rate in Asia than in Latin America is what has allowed the Asian countries to remain more consistently focused on maintaining competitiveness and export growth.

Full paper (970 KB Postscript)

Keywords: Prices, real exchange rates

IFDP 1998-602
Regionalism and Permanent Diversion

Caroline L. Freund


We compare free trade reached through expanding regional trading blocks to free trade accomplished by multilateral negotiation. With sunk costs, the outcomes are different. Trade in an imperfectly competitive good flows disproportionately more between the original members of a regional agreement even after free trade is reached. They secure a higher welfare level from regionalism than from free trade achieved multilaterally; non-members, however, reach a lower welfare level. A surprising result is that world welfare during free trade is greater when it is achieved by the regional path. We conclude with some empirical evidence from the European Union that is consistent with the model.

Keywords: Imperfect competition, sunk costs, preferential trade agreements

IFDP 1998-601
The Choice of a Monetary Policy Reaction Function in a Simple Optimizing Model

Dale W. Henderson and Jinill Kim


Monetary policy reaction functions are compared in a simple optimizing model with one-period nominal stickiness, i.i.d. shocks, and no capital accumulation. The interest rate is the instrument and is either kept constant, "interest rate targeting" for short, or used in targeting one of the following: money, the price level, output, nominal income (output), money growth, inflation, and the sum of inflation and output. There are three varieties of one-period nominal stickiness---wage stickiness, wage and price stickiness, and price stickiness---and three kinds of shocks---money demand shocks, goods demand shocks, and productivity shocks. A given type of targeting is "better" than some other type for a given variable and kind of shock if it results in smaller deviations of the variable from its target value. Some familiar results regarding the ranking of types of targeting are confirmed in the optimizing model, and some new results are obtained. It is not surprising that rankings may depend both on the type of shock and on which variable is the target variable. However, it may be somewhat surprising that, given that wages are sticky, rankings depend on whether prices are sticky, but that given that prices are sticky rankings do not depend on whether wages are sticky.

Keywords: Inflation targeting, price level targeting, nominal stickiness

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Last Update: February 12, 2021