Foreign Interest Rate Shocks Research Articles

Are All Types of Capital Flows Driven by the Same Factors? Evidence from Mexico

In this paper we analyze the impact and persistence of shocks to global (push) and domestic (pull) factors on each component of the financial account for the Mexican Balance of Payments at the highest degree of disaggregation, including investment by foreign residents in Mexican public and private sector securities, as well as investment by domestic residents in foreign securities. To this end, we estimate impulse response functions from vector autoregressive models for the period 1995-2015. We find that an increase in the foreign interest rate leads to lower portfolio investment, particularly in Mexican public sector securities. An increase in global risk generates lower portfolio investment, particularly in private sector securities. Foreign investors respond to a higher extent to foreign interest rate and liquidity shocks compared to domestic investors.

Bank Globalization and Monetary Policy Transmission in Small Open Economies

This paper investigates how the openness of banking sector influences the transmission channels of home and foreign monetary policy shocks in small open economies. For the analysis, I construct a small open economy DSGE model enriched with a globalized banking sector. I consider two forms of bank globalization: international bank capital finance and foreign loan account import. By comparing the effect of each type of bank globalization on monetary policy transmission, the analysis delivers the following results. First, bank globalization leads to a significant attenuation of domestic monetary policy transmission. This is because, in response to home monetary shocks, banks' global activities allow them to maintain bank rates and demands on deposit to some extent compared to those in financial autarky. On the other hand, opening of the banking sector intensifies the impact of foreign interest rate shocks on the local bank activities. In addition to the conventional channel of international monetary transmission through interest-parity condition, global bank operation opens a new channel which makes bank rates more responsive to foreign monetary shock.

Financial openness, the financial accelerator and sectoral dynamics

This paper studies the role of financial openness and the financial accelerator in the sectoral dynamics generated in a small open economy following capital inflow. The results show that where the financial accelerator exists, capital inflow in response to a foreign interest rate shock ultimately results in intersectoral resource transfer that is favorable to the nontradable sector under different monetary policies; the magnitude of the expansion in the nontradable sector being greater under a higher degree of financial openness. The study also finds that, in comparison to CPI inflation targeting, nontradable inflation targeting is better at mitigating resource transfers toward production of nontradables, and at reducing and stabilizing both nontradable inflation and CPI inflation. Furthermore, the findings suggest that the financial accelerator mechanism matters for the effectiveness of monetary policy in addressing dynamics pertinent to the Dutch disease phenomenon, such that CPI inflation targeting is only effective in such a scenario where the financial accelerator is non-existent, and that nontradable inflation targeting operates more effectively in the absence of the financial accelerator as well.

Macroeconomic shocks and fluctuations in African economies

We estimate a monetary DSGE model to examine the role of macroeconomic shocks in generating fluctuations in ten African countries. The model is estimated with the Bayesian technique using twelve macroeconomic variables. The findings indicate that both the internal and external shocks significantly influence output fluctuations in African economies. Over a four quarter horizon, internal shocks are dominant and over eight to sixteen quarter horizons, external shocks are dominant. Among the external shocks, external debt, exchange rate, foreign interest rate and commodity price shocks account for a large part of output variations in African economies. Money supply and productivity shocks are the most important internal shocks contributing to output fluctuations in African countries.

Optimal Monetary Policy and Capital Account Restrictions in a Small Open Economy

The recent financial crisis has led to large declines in world interest rates and surges of capital flows to emerging market economies. We examine the effectiveness and welfare implications of capital control policies in the face of such external shocks in a monetary DSGE model of a small open economy. We consider both optimal, time-varying restrictions on capital inflows and a simple capital account restriction, such as a constant tax on foreign debt holdings. We then compare the effectiveness of such capital account restrictions under alternative monetary regimes. We find that the optimal time-varying capital control policy is very effective in mitigating foreign interest rate shocks, but less effective for insulating the economy from export demand shocks; in the presence of export demand shocks, an exchange-rate stabilizing monetary policy regime can enhance macroeconomic stability and improve welfare. Under a simple and more practical capital control policy, a monetary policy regime that places larger weight on inflation fluctuations leads to additional gains in macroeconomic stability, although an exchange-rate stabilizing regime leads to even greater gains. Our findings suggest that, with either type of capital control policies, stabilizing the real exchange rate is a robust and effective monetary policy to help weather external shocks.

The transmission of foreign shocks to South Eastern European economies

This paper investigates the transmission of foreign shocks to economic activity and macroeconomic policies in three South Eastern European (SEE) economies: Croatia, Macedonia and Bulgaria. Specifically, we provide empirical evidence on the influence of several policy and non-policy shocks (euro-zone output gap, money market rate and inflation) on economic activity as well as monetary and fiscal policies in the three countries. The main motivation behind our empirical investigation is the fact that all of these economies are small open economies with rigid exchange rate regimes and different degree of integration within the European Union (EU). As for the methodological issues, we employ recursive vector autoregressions to identify the exogenous shocks in the euro-area. Generally, the estimated results imply that euro-zone economic activity has significant and relatively strong influence on these economies where foreign output shocks are transmitted relatively quickly. The results also suggest that the effects of foreign shocks are of larger magnitude in the countries that are more integrated with the EU. An additional finding is that positive foreign interest rate shocks trigger a contractionary response of domestic monetary policy notwithstanding the fact that domestic money market rates are not linked with euro-zone interest rates. Finally, euro-zone inflation is instantly transmitted to domestic inflation. We can explain these effects by several factors, such as: the fixed exchange rates, the relatively high trade integration of SEE economies within the euro-zone as well as the dependence of SEE banks on foreign financing.

Time to Produce and Emerging Market Crises

The inventory/cost ratio is a measure of the time to produce and distribute goods (time to produce) and, therefore, an important determinant of working capital demand. In the aftermath of emerging market crises, manufacturing industries with higher inventory/cost ratios experienced a larger drop in output, a drop which persisted multiple years into the recovery. This observation is shown to emerge following a persistent foreign interest rate shock in an environment where time to produce in different sectors matches inventory/cost ratios in the data. In such an environment, the interest rate shock is able to account for up to 25% of the deviation of output from its previous trend. In contrast, without time to produce, the interest rate shock generates a boom in the year of the crisis and cannot account for cross-sectoral differences. Likewise, it is impossible to generate cross-sectoral differences of the required magnitude in response to a productivity shock. These results underscore first the importance of working capital constraints as a transmission channel for financial shocks, and second, the importance of persistent interest rate shocks as a driving force of business cycles in emerging economies.

Foreign interest rate shocks and exchange rate regimes in East Asia

Using a theoretical dynamic stochastic general equilibrium model and an empirical panel vector autoregression, we assess the transmission of foreign real interest rate shocks on the volatility of various key macroeconomic variables in nine small open economies in East Asia taking into account the role of exchange rate regimes. Both the theoretical and empirical findings confirm the hypothesis that flexible exchange rate may work as a shock absorber when the economy is hit by foreign real interest rate shocks. The findings suggest a clear trade-off between the volatility of real exchange rate and real output to foreign interest rate shocks, both the US and G7 real interest rates, where the responses of real output are mitigated in countries that have more flexible exchange rate regime.

The transmission of international shocks to the UK. Estimates based on a time-varying factor augmented VAR

The aim of this paper is to gauge the importance of foreign demand, supply and interest rate shocks on the UK economy and assess how their role has changed over time. To that end we devise a time-varying factor augmented VAR model that captures the relationship between 17 industrialised countries and the UK and accounts for any temporal evolution in this relationship. The response of UK macroeconomic variables to a foreign interest rate shock is estimated to have changed significantly since the early 1990s. International demand shocks play an important role in driving World and UK real activity, especially during the recent recession.

Monetary policy in a dual currency environment

We develop a small open economy general equilibrium model with sticky prices and partial dollarization – a situation where both domestic and foreign currencies coexist. We derive a tractable representation of the model in terms of domestic inflation and the output gap in which a trade-off, which depends on the degree of dollarization, arises endogenously due to the presence of foreign interest rate shocks. We use this framework to show analytically how higher degrees of dollarization induce larger volatilities of the output gap and inflation, thus hampering a central bank’s effectiveness to stabilize the economy. Our impulse response functions show that the transmission of such shocks has a positive (negative) effect on inflation and negative (positive) effect on the output gap when money aggregates and consumption are complements (substitutes).

Exogenous Shocks and Exchange Rate Regimes

AbstractUsing a dynamic stochastic general equilibrium (DSGE) model with nominal price rigidity and imperfect competition, we examine the impact of terms‐of‐trade and foreign interest rate shocks on some key macroeconomic variables for a small open economy under different exchange rate regimes. Numerical solutions from the model are found consistent with empirical panel VAR results of 33 Asian economies for the period of 1980–2009. From both the theoretical model and empirical evidence, we find that (i) output responses to terms‐of‐trade and foreign interest rate shocks are smoother in floats, (ii) price responses to terms‐of‐trade shocks are smoother in floats than in pegs, while its responses to foreign interest shocks are more volatile in floats than in pegs, and (iii) the effects of terms‐of‐trade and foreign interest shocks are more prolonged under floats.

Fiscal deficits, banking crises and policy reversal in a semi-open economy

We study the effect of domestic policies and external shocks in a semi-open economy characterized by incomplete liberalization of the financial sector. We argue that in such transition economies stabilization programs can have a negative impact on the fiscal imbalances, offsetting to some extent the very achievement of the stabilization program. We develop a simple general equilibrium model which allows propagation of shocks in the presence of government guarantees and imperfect capital mobility. We also empirically test the impact of positive foreign interest shock on the Indian economy using a reduced form VAR approach. The econometric evidence, though broadly consistent with the main predictions of the model, suggests no significant impact of foreign interest rate shock on output and credit. We conclude that incomplete liberalization of the financial sector in transition economies has two effects. It reduces i) exposure to external financial shocks (like the current credit crisis) and ii) ability to deal with real sector shocks (which may arise from global recession in the medium term) due to endogenous policy reversals and presence of government guarantees.

Testing for Balance Sheet Effects in Emerging Markets: A Non‐Crisis Setting*

AbstractThe literature has established that emerging market economies are better insulated from large external shocks during a financial crisis when they adopt a flexible exchange rate regime. Looking at the strength of firms' balance sheets, this paper shows that the opposite holds true in non‐crisis periods. The reason is that balance sheets and thus spending decisions are less affected by external shocks under fixed regimes. This result is obtained through several theoretical and empirical methodologies that are useful for identifying balance sheet effects in a non‐crisis setting. Simulations reveal a larger (smaller) output response under flexible regimes when these effects are included (excluded). Although the transmission of foreign interest rate shocks to domestic interest rates is stronger under fixed regimes, it appears the limited effects on balance sheets generate a more muted output response.

The Varying Effect of Foreign Shocks in Central and Eastern Europe

This paper investigates the impact of international shocks – interest rate, commodity price and industrial production shocks – on key macroeconomic variables in ten Central and Eastern European (CEE) countries by using near-VAR models and monthly data from the early 1990s to 2009. In contrast to previous work, the empirical analysis takes explicit account of the possibility of (multiple) structural breaks in the underlying time series. We establish strong evidence of structural breaks, particularly along the years 2007 and 2008, suggesting the very relevant impact of the recent global crisis on CEE economies. Moreover, our results suggest that the way how countries react to world commodity price shocks is related to the underlying economic structure and the credibility of the monetary policy. We also find that some countries like Slovakia and Slovenia – already euro area members – react stronger to foreign industrial production shocks than other countries and that the responses to such shocks are strongly correlated for selected CEE countries. Nevertheless, our results also shed light on substantial differences in responses to foreign interest rate shocks that originate from the US or the euro area.

The effect of foreign shocks in Central and Eastern Europe

This paper investigates the impact of international shocks – interest rate, commodity price and industrial production shocks – on key macroeconomic variables in ten Central and Eastern European (CEE) countries by using near-VAR models and monthly data from the early 1990s to 2009. In contrast to previous work, the empirical analysis takes explicit account of the possibility of (multiple) structural breaks in the underlying time series. We establish strong evidence of structural breaks, particularly along the years 2007 and 2008, suggesting the very relevant impact of the recent global crisis on CEE economies. Moreover, our results suggest that the way how countries react to world commodity price shocks is related to the underlying economic structure and the credibility of the monetary policy. We also find that some countries like Slovakia and Slovenia – already euro area members – react stronger to foreign industrial production shocks than other countries and that the responses to such shocks are strongly correlated for selected CEE countries. Nevertheless, our results also shed light on substantial differences in responses to foreign interest rate shocks that originate from the US or the euro area.

The VARying Effect of Foreign Shocks in Central and Eastern Europe

This paper investigates the impact of international shocks ??? interest rate, commodity price and industrial production shocks ??? on key macroeconomic variables in ten Central and Eastern European (CEE) countries by using near-VAR models and monthly data from the early 1990s to 2009. In contrast to previous work, the empirical analysis takes explicit account of the possibility of (multiple) structural breaks in the underlying time series. We establish strong evidence of structural breaks, particularly along the years 2007 and 2008, suggesting the very relevant impact of the recent global crisis on CEE economies. Moreover, our results suggest that the way how countries react to world commodity price shocks is related to the underlying economic structure and the credibility of the monetary policy. We also find that some countries like Slovakia and Slovenia ??? already euro area members ??? react stronger to foreign industrial production shocks than other countries and that the responses to such shocks are strongly correlated for selected CEE countries. Nevertheless, our results also shed light on substantial differences in responses to foreign interest rate shocks that originate from the US or the euro area.

The Transmission of Foreign Interest Rate Shocks to a Small-Open Economy: The Role of External Debt and Financial Integration

This paper investigates the implications of external indebtedness and international financial integration on the effects of foreign interest rate shocks in a small-open economy. The empirical component of the analysis quantifies the effects of U.S. interest rate shocks on the Turkish economy. The theoretical component constructs a business cycle model that can successfully match the empirical impulse response functions. The model is estimated on quarterly Turkish data. It is found that the relationship between financial integration and macroeconomic volatility due to foreign interest rate shocks depends on the level of outstanding external debt. Financial integration mitigates the economy's responses to foreign rate shocks for higher levels of external debt and it magnifies the responses for lower levels of external debt.

Business Cycles in Small Developed Economies: The Role of Terms of Trade and Foreign Interest Rate Shocks

Empirical evidence for small developed economies finds that consumption is procyclical and as volatile as output, and real net exports are coutercyclical. Earlier studies have not been able to reproduce these regularities in a DSGE small open economy model when productivity shocks drive the business cycles and households have a normal intertemporal elasticity of substitution. Instead, these studies have reduced this elasticity to make consumption more procyclical and volatile and real net exports countercyclical. This paper shows that a standard model can reproduce these regularities, without lowering the intertemporal substitution, if the terms of trade and foreign interest rate are added as source of business cycle fluctuations. These shocks, compared to productivity shocks, make consumption and investment more volatile and procyclical relative to output, and make real net exports countercyclical.

Business Cycles in Small Developed Economies: The Role of Terms of Trade and Foreign Interest Rate Shocks

Empirical evidence for small developed economies finds that consumption is procyclical and as volatile as output, and real net exports are coutercyclical. Earlier studies have not been able to reproduce these regularities in a DSGE small open economy model when productivity shocks drive the business cycles and households have a normal intertemporal elasticity of substitution. Instead, these studies have reduced this elasticity to make consumption more procyclical and volatile and real net exports countercyclical. This paper shows that a standard model can reproduce these regularities, without lowering the intertemporal substitution, if the terms of trade and foreign interest rate are added as source of business cycle fluctuations. These shocks, compared to productivity shocks, make consumption and investment more volatile and procyclical relative to output, and make real net exports countercyclical.

Inflation targeting supported by managed exchange rate

We compare, on a welfare loss basis, possible inflation targeting regimes supported by different exchange rate rules. For model parametrization, we estimate a forward looking monetary policy rule for Trukey. When variable inflation targets are taken into consideration, as opposed to the fixed targets used in prior research that use data from developed countries, forward looking Taylor rules provide a reasonable description of Central Bank behaviour in Turkey. By applying a calibration based on estimated parameters, we compare the loss functions under flexible inflation targeting and strict inflation targeting while taking into consideration the supporting regimes, namely a flexible exchange rate and a managed floating exchange rate. We find that the welfare loss function caused by four simultaneous shocks, namely a foreign interest rate shock, a monetary policy shock, a foreign output shock and a domestic output shock, is minimized under the flexible inflation targeting regime supported by a managed floating exchange rate rule.