Imperfect Asset Substitutability Research Articles

A Stochastic Blanchard Model with a State-of-Market Dependent Reaction Coefficient

We reformulate and extend the Blanchard model of output dynamics, the stock market and interest rates that studies Keynesian IS-LM analysis from the perspective of a richer array of financial assets, namely equities and long-term bonds. Investment demand now depends on Tobin’s average q in the place of the real rate of interest and as a result share price dynamics feed back into the real sector. Our main contribution is to extend the model to allow imperfect asset substitutability, imperfect forecasts of capital gains in the place of Blanchard’s limit case of perfect substitutes and myopic perfect foresight, and the assumption of a state-of-the-market dependent speed of reaction to expected asset return differentials. These elements introduce an underlying nonlinear dynamic feedback mechanism between the real and financial sectors. Furthermore we introduce some stochastic elements into the model and use numerical simulations to study the interaction of the nonlinear and stochastic elements. We focus in particular on the propensity of the model to generate stock market booms and crashes when the underlying deterministic model is locally unstable.

More on monetary policy in a small open economy A credit view

When the representative bank's backward-bending loan supply curve peaks at the profit-maximizing loan rate, credit rationing could exist as an equilibrium phenomenon and the equilibrium interest rate in the loan market is subject to upward rigidity. With the loan-market setting as micro-foundation for investment, this paper further develops a macro model of a small open economy under the regime of fixed exchange rates with perfect capital mobility in the bond market and imperfect asset substitutability between bonds and loans. In spite of whether there exists credit rationing, a change in money supply shifts the IS as well as LM curves; the credit-driven adjustment in transaction demand for money lessens the disequilibrium pressure on the money and foreign exchange markets so that the offset coefficient of open market operation is less than one. The stronger the credit channel is, the more legacy of monetary policy it can preserve as desired. In particular, monetary autonomy tends to be less impaired under the credit-rationing regime than under the market-clearing regime.

Nonfundamental FX trading and excess volatility in credible target zones Theory and empirical evidence

This paper presents a target zone model with imperfect asset substitutability in which exchange rates are driven both by expectations regarding the credible defense of the currency band and foreign exchange traders' stop-loss trading strategies. The model generates excess volatility and nonuniqueness in the density function of the exchange rate. These results obtain independently of whether the stop-loss strategies are known to the market. In an empirical section, the authors find support for the existence of excess volatility for selected countries of the European monetary system (EMS) during the stable EMS period.

Optimal sterilization policies in interdependent economies

In this paper, a two-country leader-follower model with imperfect asset substitution is used to derive the optimal sterilization coefficients for two-country flexible and fixed exchange rate regimes. It is found that, in general, incomplete sterilization is optimal. However, both the origin and the type of macroeconomic shocks the economies experience are important in determining the appropriate degree of sterilization. We also find that sterilization policies have spill-over effects (strategic complements) in both cases. Thus, in a competitive policy-making environment, greater sterilization by one country leads to greater sterilization by the other country. Further, the impact of increasing capital market integration is examined in particular. We show that greater integration compounds this problem, leading to full sterilization as the optimal outcome under perfect capital mobility.

Monetary Independence under Bretton Woods: Perspectives from a Stochastic, Maximizing Model

Research based on the Kouri-Porter (1974) model of international capital flows suggests that the central banks of nonreserve countries enjoyed considerable monetary independence during the Bretton Woods era. This paper is a theoretical and empirical reassessment of this conclusion. Using a stochastic, maximizing model, it is shown that the existence of imperfect asset substitutability does not guarantee monetary control. At the empirical level, the estimated offset coefficients for four industrialized countries are consistent with zero monetary independence.

Real Exchange Rate Targeting under Imperfect Asset Substitutability

This paper presents a model of an economy that uses nominal exchange rate policy to keep the real exchange rate constant at a certain target level, under an assumption of imperfect asset substitutability. The paper discusses the determinants of inflation under such a policy and examines the effects of exogenous and policy-induced shocks on inflation, the external accounts, and the fiscal accounts. The shocks considered include changes in the real exchange rate target, changes in fiscal policy, changes in foreign interest rates, and open market sales of public sector domestic bonds.

Real Exchange Rate Targeting Under Imperfect Asset Substitutability

This paper presents a model of an economy that uses nominal exchange rate policy to keep the real exchange rate constant at a certain target level, under imperfect asset substitutability. The paper discusses the determinants of inflation under such a policy, and examines the consequences of exogenous and policy-induced shocks on inflation, the external accounts, and the fiscal accounts. The shocks considered include changes in the real exchange rate target, changes in fiscal policy, changes in foreign interest rates, and open market sales of public sector domestic bonds.

Real Exchange Rate Targeting Under Imperfect Asset Substitutability

This paper presents a model of an economy that uses nominal exchange rate policy to keep the real exchange rate constant at a certain target level, under imperfect asset substitutability. The paper discusses the determinants of inflation under such a policy, and examines the consequences of exogenous and policy-induced shocks on inflation, the external accounts, and the fiscal accounts. The shocks considered include changes in the real exchange rate target, changes in fiscal policy, changes in foreign interest rates, and open market sales of public sector domestic bonds.

Speculative Attacks and Models of Balance of Payments Crises

Recent developments in the theoretical and empirical analysis of balance of payments crises are reviewed. A simple analytical model highlighting the process leading to such crises is first developed. The basic framework is then extended to deal with a variety of issues, including alternative postcollapse regimes, uncertainty, real sector effects, external borrowing and capital controls, imperfect asset substitutability, sticky prices, and endogenous policy switches. Empirical evidence on the collapse of exchange rate regimes is also examined, and the major implications of the analysis for macroeconomic policy are discussed.

Speculative Attacks and Models of Balance of Payments Crises

This paper reviews recent developments in the theoretical and empirical analysis of balance-of-payments crises. A simple analytical model highlighting the process leading to such crises is first developed. The basic framework is then extended to deal with a variety of issues, such as: alternative post-collapse regimes, uncertainty, real sector effects, external borrowing and capital controls, imperfect asset substitutability, sticky prices, and endogenous policy switches. Empirical evidence on the collapse of exchange rate regimes is also examined, and the major implications of the analysis for macroeconomic policy are discussed.

Speculative Attacks and Models of Balance of Payments Crises

This paper reviews recent developments in the theoretical and empirical analysis of balance-of-payments crises. A simple analytical model highlighting the process leading to such crises is first developed. The basic framework is then extended to deal with a variety of issues, such as: alternative post-collapse regimes, uncertainty, real sector effects, external borrowing and capital controls, imperfect asset substitutability, sticky prices, and endogenous policy switches. Empirical evidence on the collapse of exchange rate regimes is also examined, and the major implications of the analysis for macroeconomic policy discussed.

Imperfect asset substitution in a two-country model

The paper reports results obtained from the simulation of a two-country model in which the real and financial sectors are integrated under an assumption of rational expectations and steady state inflationary equilibria. The government of each country issues a single financial asset (‘currency’) which is held by the government of the other country and by the private residents of both countries. The model is simulated under a variety of shocks and the effects of higher currency substitution (measured in different ways) are explored. The results show that, depending on the shock hitting the system and the way in which the degree of currency substitution is measured, higher levels of currency substitution may reduce instead of increasing the degree of exchange rate overshooting and may even convert overshooting into undershooting. The paper lays a basis for various extensions which will be reported in subsequent papers.

Speculative Attacks and Models of Balance-of-Payments Crises

This paper reviews recent developments in the theoretical and empirical analysis of balance-of-payments crises. A simple analytical model highlighting the process leading to such crises is first developed. The basic framework is then extended to deal with a variety of issues, such as: alternative post-collapse regimes, uncertainty, real sector effects, external borrowing and capital controls, imperfect asset substitutability, sticky prices, and endogenous policy switches. Empirical evidence on the collapse of exchange rate regimes is also examined, and the major implications of the analysis for macroeconomic policy discussed.

The J-Curve and Short-Run Exchange-Rate Dynamics

Levin (1983) has argued that the J-Curve' conjunctions with imperfect asset substitutability and rational expectations necessarily results in overshooting of the exchange rate in response to a real disturbance. We argue here that Levin has excluded three important considerations from his analysis: (i) the response of income and the interest rate to trade balance variations, (ii) the effect of exchange rate changes on the domestic price level, and (iii) the ‘valuation effect’ of exchange rate changes on domestic holdings of the foreign asset. We demonstrate that consideration (i) cannot, and considerations (ii) abd (iii) can, produce exchange rate undershooting, and we also explore the effect of various parameter configurations on the overall trajectory of the exchange rate. [431]

Exchange-rate dynamics in a model with imperfect capital mobility and asset substitutability

This paper analyses the dynamic properties of the exchange rate and the balance of payments in a model which allows for imperfect capital mobility as well as imperfect asset substitutability. We show that a monetary expansion leads to a short-run overshooting of the exchange rate depending upon the relationship between the degrees of capital mobility and asset substitutability.

Interest Rate Policy with Expectations of Devaluation

The problem of recurrent devaluations in the Nordic countries is dealt with using a simple rational expec tations model. Given imperfect international asset substitutability a nd sufficient foreign exchange reserves, a small open economy can use interest rate policies geared to competitiveness to put an end to re current devaluations. If this policy is known and credible, no intere st rate adjustments are called for, except shortly before and during the expected devaluation phase. In contrast, a completely unanticipat ed interest rate policy requires that the rate of interest be raised continuously as the expected devaluation date is approached. Copyright 1988 by The editors of the Scandinavian Journal of Economics.

CURRENT ACCOUNT MOVEMENTS, WEALTH EFFECTS AND THE DETERMINATION OF THE REAL EXCHANGE RATE

The literature on small open-economy macroeconomic models has concentrated on nominal shoc ks to a model with sluggish goods markets and a forward-looking excha nge market. This paper considers generalizations of these models to c ases of significant wealth effects of external trade imbalance and im perfect asset substitut-ability in the market for foreign exchange. I t shows that a number of standard results, due initially to R. A. Mun dell and J. M. Fleming, are modified significantly in these cases. Fu rthermore, it shows that real, as well as nominal, shocks can explain the high variability of the real exchange rate. Copyright 1987 by Blackwell Publishers Ltd and The Victoria University of Manchester

Monetary policy, exchange rate dynamics and the labour market

This paper analyzes exchange-rate dynamics in a model that integrates slowly-adjusting prices with wealth accumulation dynamics under imperfect asset substitutability. The aim is to examine the overshooting hypothesis and the nature of the dynamic path following a change in monetary policy. The model incorporates sluggish adjustment of trade flows to relative prices, and the interaction of wealth accumulation with the government budget constraint, and assumes rational expectations in the assets markets and adaptive expectations in the labor market. It shows that the nature of the exchange-rate dynamic path depends on the speed of adjustment of the labor market. Copyright 1989 by Royal Economic Society.

Exchange rate overshooting, the trade balance, and rational expectations

This paper presents a model of exchange-rate determination characterized by imperfect asset substitutability between domestic and foreign bonds, sticky goods-market prices, and rational expectations. The model is used to analyze the response of the exchange rate to a step change in relative money supplies. The assumption of imperfect asset substitutability permits introduction into the analysis of trade flows which respond to relative price changes. These flows create non-monotonic exchange-rate adjustments to long-run equilibrium. These non-monotonic adjustments are consistent with rationality, and may lead to short-run undershooting or overshooting.

Imperfect asset substitutability and monetary policy under fixed exchange rates

This paper presents a long-run model of the open economy in a world of fixed exchange rates and imperfect substitutability between bonds denominated in different currencies. The model explicitly accounts for the wealth flow accompanying current-account imbalance and for the flow of interest payments associated with international lending. Both the dynamic and steady-state implications of the model are quite different from those of models that specify the capital account as a continuing flow responding to the level of interest rates. In particular, we find that when there exists outside government debt, open-market policy is not in general neutral in the long run. We also find conditions under which the central bank is able to hold the domestic price level constant in the face of an inflationary disturbance from abroad without exhausting, in the long run, its stock of domestic assets.