Comments and Discussion

Abstract

Comments and Discussion Ben S. Bernanke and Hélène Rey Ben S. Bernanke: Olivier Blanchard, Francesco Giavazzi, and Filipa Sa have produced a gem of a paper. They introduce a disarmingly simple model, which nevertheless provides a number of crucial insights about the joint dynamics of the current account and the exchange rate, in both the short and the long run. Their analysis will undoubtedly become a staple of graduate textbooks. The authors' model has two features that deserve special emphasis. First, following an older and unjustly neglected literature, the model dispenses with the usual interest rate parity condition in favor of the assumption that financial assets may be imperfect substitutes in investors' portfolios; that is, the model allows for the possibility that the demand for an asset may depend on features other than its rate of return, such as its liquidity or its usability as a component of international reserves. In focusing on imperfect asset substitutability and its implications, the authors identify an issue that has taken on great practical significance for policymakers in recent years. At least two contemporary policy debates turn in large part on the extent (or the existence) of imperfect asset substitutability. One is whether so-called nonstandard monetary policies—such as large purchases of government bonds or other assets by central banks—can stimulate the economy even when the policy interest rate has hit the zero lower bound. The other is whether sterilized foreign exchange interventions, like those recently undertaken on a massive scale by Japan and China, can persistently alter exchange rates and interest rates.1 The authors' analysis explores yet another important implication of imperfect substitutability: that, if assets denominated in different currencies are imperfect substitutes, then agents may rationally anticipate the sustained depreciation of a currency even in the absence [End Page 50] of cross-currency interest rate differentials. Thus, by invoking imperfect substitutability, the authors are able to show that expected dollar depreciation is not necessarily inconsistent with the currently low level of U.S. long-term nominal interest rates and the evident willingness of foreigners to hold large quantities of U.S. assets. The assumption that financial assets of varying characteristics are imperfectly substitutable in investor portfolios seems quite reasonable. (Almost as I write these words, an announcement by the U.S. Treasury that it is contemplating the reinstatement of the thirty-year bond seems to have triggered a jump in long-term bond yields, suggestive of a supply effect on returns.) However, both the theoretical and the empirical literatures on asset substitutability are exceedingly thin, which is a problem for assessing the quantitative implications of the authors' analysis. In particular, as they themselves note, in their model the speed of adjustment of the exchange rate and the current account depends importantly on the elasticities of foreign and domestic asset demands with respect to expected return differentials, numbers that are difficult to pin down with any confidence. Further complications arise if, as is plausibly the case, the degree of asset substitutability is not a constant but varies over time or across investors. For example, if private investors view assets denominated in different currencies as more substitutable than central banks do, which seems likely, then changes in the share of assets held by each type of investor will have implications for exchange rate dynamics. Finding satisfying microfoundations for the phenomenon of imperfect asset substitutability, and obtaining persuasive estimates of the degree of substitutability among various assets and for different types of investors, should be high on the profession's research agenda. The second feature of the authors' analysis worth special note is its attention to the long-run steady state. By integrating short-run and long-run analyses, the authors obtain some useful insights that a purely short-run approach does not deliver. Notably, they demonstrate that factors affecting the value of the dollar or the size of the U.S. current account deficit may have opposite effects in the short and in the long run. For example, an increased appetite for dollars on the part of foreign central banks is typically perceived by market participants as positive for the dollar in the short run, and the model supports...