Macroeconomics with Segmented Financial Markets
Paper Session
Sunday, Jan. 3, 2021 12:15 PM - 2:15 PM (EST)
- Chair: Oleg Itskhoki, University of California-Los Angeles
A Quantity-Driven Theory of Term Premiums and Exchange Rates
Abstract
We develop a model in which risk-averse, specialized bond investors must be paid to absorb shocks to the supply and demand for long-term bonds in two currencies. Since long-term bonds and foreign exchange are both exposed to unexpected movements in short-term interest rates, our model naturally links the predictability of long-term bond returns to the predictability of foreign exchange returns. Specifically, a shift in the net supply oflong-term bonds in one currency influences bond term premiums in both currencies as well as the foreign exchange rate between the two currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and bond term premiums as well as the finding that central banks quantitative easing policies impact not only local-currency long-term yields, but also foreign exchange rates. We also show that this quantity-driven approach provides a unified account explaining both why foreign exchange tends to outperform when the foreign interest rates exceed domestic rates and why long-term bonds tend to outperform when the yield curve is steep.
A Preferred-Habitat Model of Term Premia and Currency Risk
Abstract
We propose an integrated preferred-habitat model of term premia and exchange rates, building on Vayanos and Vila (2019). Our model generates deviations from UIP and also a decreasing term structure of currency risk premia. Using our framework we explore the transmission of monetary policy to domestic and currency markets, as well as the spillovers to the foreign term premia; the effect of non-conventional monetary policy on the domestic and foreign economies; and the effect of shifts in the ‘specialness’ of one country’s bonds or currency.Mussa Puzzle Redux
Abstract
The Mussa (1986) puzzle – a sharp and simultaneous increase in the volatility of both nominal and real exchange rates after the end of the Bretton Woods System of pegged exchange rates in early 1970s – is commonly viewed as a central piece of evidence in favor of monetary non-neutrality. Indeed, a change in the monetary regime has caused a dramatic change in the equilibrium behavior of a real variable – the real exchange rate. The Mussa fact is further interpreted as direct evidence in favor of models with nominal rigidities in price setting (sticky prices). We show that this last conclusion is not supported by the data, as there was no simultaneous change in the properties of the other macro variables – neither nominal like inflation, nor real like consumption, output or net exports. We show that the extended set of Mussa facts equally falsifies both conventional flexible-price RBC models and sticky-price New Keynesian models. We present a resolution to this broader puzzle based on a model of segmented financial market – a particular type of financial friction by which the bulk of the nominal exchange rate risk is held by a small group of financial intermediaries and not shared smoothly throughout the economy. We argue that rather than discriminating between models with sticky versus flexible prices, or monetary versus productivity shocks, the Mussa puzzle provides sharp evidence in favor of models with monetary non-neutrality arising due to financial market segmentation. Sticky prices are neither necessary, nor sufficient for the qualitative success of the model, yet can improve its quantitative fit of the data.JEL Classifications
- F3 - International Finance
- E4 - Money and Interest Rates