Exogenous Interest Rate Research Articles

Are exchange rates absorbers of global oil shocks? A generalized structural analysis

This paper studies the impact of global oil market shocks on the level, volatility, and correlation dynamics of real effective exchange rates over time. We find that the USD and the EURO act as shock absorbers, as shocks to the global oil market explain substantial proportions of the volatility and correlation dynamics of each exchange rate – compared to the small or even negligible contributions of exogenous interest rate and effective exchange rate shocks. Further we find an interesting “puzzle” that the Euro Area unexpectedly behaves as if it were an oil exporting country - the EURO appreciates in response to a flow demand shock that increases oil price. Our findings are garnered from a generalized time-varying SVAR model with stochastic volatility that allows for correlated disturbances between observation and transition equations and among transition equations themselves. This approach of enriching dynamics between the first and second moments of endogenous variables is particularly suitable for capturing the transmission of structural level oil shocks to the volatility of exchange rates and their correlation with the global oil market.

Household debt, knowledge capital accumulation, and macrodynamic performance

Motivated to some extent by the empirical significance of student loans in the U.S., this paper incorporates knowledge capital formation by working households financed through debt to a demand-led dynamic model of physical and knowledge capital utilization and output growth. Average labor productivity varies positively with the average knowledge capital across the labor force. A rise in labor productivity resulting from knowledge capital accumulation is fully passed on to the real wage so that the wage share remains constant. In the unique long-run equilibrium, which is stable, an exogenous rise in the wage share raises the rates of physical capital utilization and output growth but has an ambiguous effect on the rate of employment (which also measures the rate of knowledge capital utilization). The long-run equilibrium also features the following interrelated results: the output growth rate is greater than the exogenous interest rate; the debt ratio (working households’ debt as a ratio of either the physical or the knowledge capital, or the output) is independent of the interest rate; and the allocation of a higher (lower) proportion of wage income to debt repayment (consumption) raises instead of lowers the debt ratio, which we dub the paradox of debt repayment.

Heterogeneity in sectoral price and quantity responses to shocks to monetary policy

This paper investigates the sectoral price and quantity responses to an exogenous interest rate shock in the United States. It has two main findings. First, an interest rate shock causes strong relative price effects in a non-negligible number of sectors whose price responses to the shock differ broadly from those of the aggregate. More importantly, such effects are present even four years after the shock. Second, sectoral differences in the frequency of price changes are only weakly associated with the sectoral price and quantity responses. We show that a multi-sector model equipped with a working-capital channel, sticky wages, and sectoral heterogeneity in the frequency of price changes and the structure of production costs can explain these two findings.

Pegging the interest rate on bank reserves: A resolution of New Keynesian puzzles and paradoxes

Introducing bank reserves (or money) into the basic New Keynesian (NK) model offers a resolution of NK puzzles and paradoxes. The resulting models deliver local-equilibrium determinacy under an exogenous interest rate on reserves and an exogenous nominal stock of reserves, even for an arbitrarily small monetary friction. This leads to a resolution of the forward-guidance puzzle, the fiscal-multiplier puzzle, and the paradox of flexibility. As the monetary friction becomes vanishingly small, the models converge to the basic NK model and serve to select a particular equilibrium of that model - which also offers a resolution of the paradox of toil.

Quarter-of-a-Century of Dividend Pricing

Investments in short-term dividend assets outperform investments in the market according to Binsbergen, Brandt, and Koijen (2012), but contrary to predictions of several asset pricing models. To examine these findings, we double the sample to 24 years. We also advocate an interest rate-invariant approach to estimate prices of dividend assets by combining put-call pairs. This approach avoids the bias in returns induced by exogenous interest rates. In our results, the term structure of dividend returns is flat throughout maturities and varies over the business cycle more than once thought. Moments of the dividend assets are in line with the index.

The Theory and Countermeasure of Deflation

The Theory and Countermeasure of Deflation

Trends and Cycles in Small Open Economies: Making the Case for a General Equilibrium Approach

Economic research into the causes of business cycles in small open economies is almost always undertaken using a partial equilibrium model. This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices. We demonstrate the failure of the second assumption by contrasting general and partial equilibrium approaches to the study of a cross-section of small open economies. In doing so, we provide a method for modelling small open economies in general equilibrium that is no more technically demanding than the small open economy approach while preserving much of the value of the general equilibrium approach.

Trends and cycles in small open economies: making the case for a general equilibrium approach

Economic research into the causes of business cycles in small open economies is almost always undertaken using a partial equilibrium model. This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices. We demonstrate the failure of the second assumption by contrasting general and partial equilibrium approaches to the study of a cross-section of small open economies. In doing so, we provide a method for modeling small open economies in general equilibrium that is no more technically demanding than the small open economy approach while preserving much of the value of the general equilibrium approach.

Working Capital in a Closed Economy Real Business Cycle Model

One challenge in real business cycle (RBC) models is their performance in matching non-targeted data moments. In small open economy environment, exogenous interest rate has been widely used to bring additional volatility through the working capital. The role of working capital channel in a simple closed economy has not been explicitly investigated though. This paper explores the impacts of working capital on the business cycle statistics in a closed economy RBC framework. I illustrate that working capital on both inputs decreases the volatilities of consumption and output, whereas its impact on relative volatilities and first order autocorrelations is ambiguous. Working capital drives the correlation between consumption and output to a reasonable range. Moreover, when the working capital is only on one of the inputs, business cycle implications are more complicated. I also show that level of working capital is crucial for the degree of procyclicality of interest rate. The asymmetric effects of this channel on the business cycle moments suggest that it can be used in order to improve the performance of closed economy RBC models.

Trends and Cycles in Small Open Economies: Making The Case For A General Equilibrium Approach

Economic research into the causes of business cycles in small open economies is almost always undertaken using a partial equilibrium model. This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices. We demonstrate the failure of the second assumption by contrasting general and partial equilibrium approaches to the study of a cross-section of small open economies. In doing so, we provide a method for modeling small open economies in general equilibrium that is no more technically demanding than the small open economy approach while preserving much of the value of the general equilibrium approach.

Second-order accelerator of investment: The case of discrete time

This paper presents a discrete time version of Hillinger’s (1992,2005) second order accelerator model that investigates the dynamic behavior of capital, for pedagogical purposes. Such a version is put forward as a means of improving student acquaintance with the analysis of investment cycles -defined as quasi-periodic cyclic movements of capital- and with the convergence towards the steady-state when capital is subjected to trigonometric oscillations. In addition, we extend the analysis, introducing the exogenous interest rate on loans in the behavioral equation of investors. It is inferred that the introduction of this credit term results in a lower equilibrium level of capital.

Exogenous tax changes and interest rates: testing for Ricardian equivalence using an efficient markets model

This article tests the Ricardian theory (i.e., Barro 1974) using Mishkin’s (1981, 1982) efficient markets model of interest rates. Employing Romer and Romer’s (2010) measure exogenous tax changes, I am able to test whether the U.S. bond market reacts in a Keynesian or Ricardian manner to exogenous tax policy changes. This helps avoid the endogeneity problems associated with measuring the interest rate effects of deficits and provides a cleaner test of the pure Ricardian thought experiment. I find a significant negative relationship between tax changes and interest rates which is inconsistent with the Ricardian model and support the Keynesian crowding out framework.

Mundell–Fleming without the LM curve: the exogenous interest rate in an open economy

In this paper we evaluate critically the popular Mundell–Fleming model from the heterodox standpoint of the exogenous interest-rate approach. We criticize the assumptions of exogenous money supply, ‘perfect’ international capital markets and inelastic exchange-rate expectations. We show that in a more realistic framework none of the main results of the Mundell–Fleming model on the relative effectiveness of fiscal and monetary policies is valid, either in floating and fixed exchange-rate regimes. We conclude that, within certain very asymmetric bounds, the Central Bank has the power to determine the domestic interest rate exogenously even in open economy with free capital mobility and that there is no automatic market mechanism to ensure the automatic adjustment of the interest rate and exchange rate to sustainable levels.

Untapped fossil fuel and the green paradox: a classroom calibration of the optimal carbon tax

A classroom model of global warming, fossil fuel depletion and the optimal carbon tax is formulated and calibrated. It features iso-elastic fossil fuel demand, stock-dependent fossil fuel extraction costs, an exogenous interest rate and no decay of the atmospheric stock of carbon. The optimal carbon tax reduces emissions from burning fossil fuel, both in the short and medium run. Furthermore, it brings forward the date that renewables take over from fossil fuel and encourages the market to keep more fossil fuel locked up. A renewables subsidy induces faster fossil fuel extraction and thus accelerates global warming during the fossil fuel phase, but brings forward the carbon-free era, locks up more fossil fuel reserves and thus ultimately curbs cumulative carbon emissions and global warming. For relatively large subsidies social welfare is more likely to fall as the economic costs rises more than proportionally with the size of the subsidy. Our calibration suggests that such subsidies are not a good second-best alternative for the carbon tax. Of course, such subsidies are required if markets fail to internalize learning-by-doing externalities in renewable production.

When are Interest Rates Exogenous?

Paper for a conference in honor of Basil Moore: Complexity, Endogenous Money, and Exogenous Interest Rates, January 7-11, 2004, Stellenbosch, South Africa. Perhaps the most important of Basil Moore's contributions to economic theory is the recognition that the money supply should be treated as an endogenous variable while the interest rate should be taken to be exogenous. The first proposition has been accepted by virtually all Post Keynesians, while the second was more problematic and briefly resulted in rival horizontal and structuralist approaches. This paper explores several issues surrounding interest rate exogeneity: first, what we mean by the term exogeneity; second, which interest rate(s) is(are) directly administered by policy; third, whether interest rate exogeneity is in some sense natural or whether it follows from particular institutional arrangements, and whether it applies over all stages of the business cycle; and, finally, implications arising from adoption of an exogenous interest rate for Keynes's liquidity preference theory and Minsky's financial instability hypothesis.

Trends and Cycles in Small Open Economies: Making the Case for a General Equilibrium Approach

Economic research into the causes of business cycles in small open economies is almost always undertaken using a partial equilibrium model. This approach is characterized by two key assumptions. The first is that the world interest rate is unaffected by economic developments in the small open economy, an exogeneity assumption. The second assumption is that this exogenous interest rate combined with domestic productivity is sufficient to describe equilibrium choices. We demonstrate the failure of the second assumption by contrasting general and partial equilibrium approaches to the study of a cross-section of small open economies. In doing so, we provide a method for modeling small open economies in general equilibrium that is no more technically demanding than the small open economy approach while preserving much of the value of the general equilibrium approach.

A General Equilibrium Model of Sovereign Default and Business Cycles

Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments. This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Fixed- and Variable-Rate Mortgages, Business Cycles, and Monetary Policy

The aim of this paper is twofold. First, I study how the proportion of fixed and variable-rate mortgages in an economy can affect the way shocks are propagated. Second, I analyze optimal implementable simple monetary policy rules and the welfare implications of this proportion. I develop and solve a New Keynesian dynamic stochastic general equilibrium model that features a housing market and a group of constrained individuals who need housing collateral to obtain loans. A given proportion of constrained households borrows at a variable rate, while the rest borrows at a fixed rate. The model predicts that in an economy with mostly variable-rate mortgages, an exogenous interest rate shock has larger effects on borrowers than in a fixed-rate economy. Aggregate effects are also larger for the variable-rate economy. For plausible parametrizations, differences are muted by wealth effects on labor supply and by the presence of savers. More persistent shocks, such as inflation target and technology shocks, cause larger aggregate differences. From a normative perspective I find that, in the presence of collateral constraints, the optimal Taylor rule is less aggressive against inflation than in the standard sticky-price model. Furthermore, for given monetary policy, a high proportion of fixed-rate mortgages is welfare enhancing.

A General Equilibrium Model of Sovereign Default and Business Cycles

Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments.

A General Equilibrium Model of Sovereign Default and Business Cycles

Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments.