Financial markets under the global pandemic of COVID-19.

In this paper I argue that the current core of macroeconomics - by which I mainly mean the so-called dynamic stochastic general equilibrium approach - has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.

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Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome

Our goal in this project is to gain a better empirical understanding of the international financial implications of currency movements. To this end, we construct a database of international currency exposures for a large panel of countries over 19902004. We show that trade-weighted exchange rate indices are insufficient to understand the financial impact of currency movements. Further, we demonstrate that many developing countries hold short foreign-currency positions, leaving them open to negative valuation effects when the domestic currency depreciates. However, we also show that many of these countries have substantially reduced their foreign currency exposure over the last decade. Last, we show that our currency measure has high explanatory power for the valuation term in net foreign asset dynamics: exchange rate valuation shocks are sizable, not quickly reversed and may entail substantial wealth shocks.

/pdf/financial-exchange-rates-and-international-currency-k8x4onjt5z.pdf

Financial Exchange Rates and International Currency Exposures

In recent decades, research in economics and finance has largely focused on the rational actor model, in which economic agents process all available information perfectly. In contrast to an older perspective represented by Keynes and Pigou, the rational model rules out unjustified optimism or pessimism as an amplifying force for aggregate fluctuations. Consequently, the rational model struggles to explain some of the most prominent facts we observe in macroeconomics, such as large swings in asset prices, in other words “bubbles”, as well as credit cycles, investment cycles, and other mechanisms that contribute to the length and severity of economic contractions.

Relaxing the assumption of perfect rationality is a potential way of explaining aggregate volatility. Unfortunately, economists lack a consensus on how to do this. Economists often point out that psychological concepts like Keynesian “animal spirits” (Keynes, 1936) are vague and potentially even untestable (for instance, Fama, 1998). If a sample of macroeconomists were forced to write down a formal model of animal spirits, most wouldn’t know where to start and the rest would produce models that had little in common. In contrast, the rational actor model is conceptually elegant, disciplined, and parsimonious.

However, even the assumption of perfect rationality is not sufficient for modeling discipline. Creative assumptions about technology, preferences, information, and market frictions can offset the parsimony purchased with rational beliefs. If the methodological goal is modeling discipline, formal quasi-rational models with a small number of free parameters should also be serious contenders. The methodological litmus tests should be parsimony, portability, and explanatory power (Gabaix and Laibson, 2008 propose a list of seven properties of good models). Rational models are only one potential means to these ends.

In this paper, we make the case that quasi-rational models deserve greater attention. We begin by discussing a large body of empirical evidence which suggests that beliefs systematically deviate from perfect rationality. Much of the evidence implies that economic agents tend to form forecasts that are excessively influenced by recent changes – in other words, some form of “extrapolation bias.”

We then present a parsimonious quasi-rational model that we call natural expectations, which falls between rational expectations and (naive) intuitive expectations. Intuitive expectations are formed by running growth regressions with a limited number of right-hand-side variables. As we will see, this leads to excessively extrapolative beliefs in certain classes of environments.

Next, we show empirically that many U.S. macroeconomic time series have hump-shaped dynamics -- in other words, they exhibit momentum in the short run and (partial) mean reversion in the long run. Natural expectations turn out to be sophisticated enough to capture the short-run momentum but fail to fully reflect the more subtle long-run mean reversion. Hence, when the true dynamics are hump-shaped, natural expectations overstate the long-run persistence of economic shocks. In other words, agents with natural expectations turn out to form beliefs that don’t sufficiently account for the fact that good times (or bad times) won’t last forever.

Finally, we embed natural expectations in a simple dynamic macroeconomic model and compare the simulated properties of the model to the available empirical evidence. The model’s predictions match many patterns observed in macroeconomic and financial time series, such as high volatility of asset prices, predictable up-and-down cycles in equity returns, and a negative relationship between current consumption growth and future equity returns. We also discuss the model’s shortcomings, how these can be alleviated, and other potential directions for research in this area.

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Natural Expectations and Macroeconomic Fluctuations.

We study how credit supply shocks in the US, the euro area and Japan are transmitted to other economies. We use the recently-developed GVAR approach to model financial variables jointly with macroeconomic variables in 33 countries for the period 1983-2009. We experiment with inter-country links that distinguish bilateral trade, portfolio investment, foreign direct investment and banking exposures, as well as asset-side vs. liability-side financial channels. Capturing both bilateral trade and inward foreign direct investment or outward banking claim exposures in a GVAR fits the data better than using trade weights only. We use sign restrictions on the short-run impulse responses to financial shocks that have the effect of reducing credit supply to the private sector. We find that negative US credit supply shocks have stronger negative effects on domestic and foreign GDP, compared to credit supply shocks from the euro area and Japan. Domestic and foreign credit and equity markets respond clearly to the credit supply shocks. Exchange rate responses are consistent with a "flight to quality" to the US dollar. The UK, another international financial centre, is also responsive to the shocks. These results are robust to the exclusion of the 2007-09 crisis episode from the sample.

https://papers.ssrn.com/sol3/Delivery.cfm/DP8720.pdf?abstractid=1976061&mirid=1&type=2

How do Credit Supply Shocks Propagate Internationally? A GVAR Approach

This paper studies the effects of unconventional monetary policies in the major advanced economies. We first examine the cross-border financial market impact of central bank announcements of asset purchase programmes based on event studies. We find marked effects, as expansionary balance sheet policies influence the prices of a broad range of emerging market assets, raising equity prices, lowering government and corporate bond yields and compressing CDS spreads.We then study the economic impact of US quantitative easing on both emerging and advanced economies, based on an estimated global vector error-correcting macroeconomic (VECM) model, which takes into account trade and financial linkages. We focus on the effects of reductions in US term and corporate spreads, and in US market volatility. The estimated effects are sizeable and differ across economies. First, US QE measures which help to lower market volatility and reduce corporate spreads appear to have had far greater impact than lowering term spreads, as Blinder (2012) suggested. Second, such measures have prevented a prolonged recession and severe deflation in the advanced economies. Third, the impact on emerging economies has varied but is generally stronger than in the US and other advanced economies. US QE measures contributed to overheating in Brazil, China and other emerging economies in 2010 and 2011, but supported recovery in 2009 and 2012. The sign and size of QE effects differ across economies, implying that their costs and benefits are unevenly distributed.

Financial Crisis, Unconventional Monetary Policy and International Spillovers

We study the cross-border impact of quantitative easing (QE) in the major advanced economies, especially on emerging market economies. We first examine the cross-border financial market impact of central bank announcements of asset purchase programmes. We find marked QE announcement effects on global financial markets. Quantitative easing influenced prices of a broad range of emerging market assets, raising equity prices, lowering government and corporate bond yields and compressing CDS spreads. The evidence supports the view that QE programmes in advanced economies influenced market expectations about the strength of cross-border financial flows to emerging market economies and about accommodative monetary policy responses of emerging market central banks to concerns about these capital flows. In other words, the announcement of QE measures in one economy contributed to easier global liquidity conditions through the immediate re-pricing of assets in global financial markets. We then turn to the macroeconomic impact of US quantitative easing on emerging market and advanced economies using a global vector error-correcting model (VECM). In additional to the standard trade channels, this model takes account of financial linkages using the BIS locational bank lending statistics. The size of the estimated international spillover effects differed across regions. First, lower US treasury bond yields raised equity prices significantly in the advanced economies, but the expansionary impact on growth and inflation was only about half of that on the US economy. Second, there was little evidence that lower yields in the United States led to rapid credit growth in other advanced economies, at least in the immediate aftermath of the crisis. Third, the impact on emerging economies was in general stronger than that on the other advanced economies. In some economies such as Hong Kong and Brazil, the expansionary impact of US quantitative easing was significant and associated with rapid credit growth and strong capital inflow, currency appreciation and inflationary pressures.Full publication: Are Central Bank Balance Sheets in Asia Too Large?

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International Spillovers of Central Bank Balance Sheet Policies

Financial crisis, US unconventional monetary policy and international spillovers

We analyze the impact of monetary policy instruments on interbank lending rates and retail bank lending in China using an extended version of the model developed by Porter and Xu (2009). Unlike the central banks of advanced economies, the People’s Bank of China (PBoC) uses changes in the required reserve ratios and open market operations to influence liquidity in money markets and adjusts the regulated deposit and lending rates and loan targets to intervene in the retail deposit and lending market. These interventions prevent the interbank lending rate from signaling monetary policy stance and transmitting the effect of policy to the growth of bank loans. Since the global financial crisis, the PBoC’s monetary policy has gone through a full cycle. The combining effects of using different policy instruments simultaneously within a short period of time were quite effective in bringing the credit and money growth in line with its desired level. Most recently steps have been taken to speed up the interest rate liberalization. Effective July 2013, the PBoC removed the floors of the benchmark lending rates.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1920761_code849351.pdf?abstractid=1920761&mirid=1&type=2

The implementation of monetary policy in china: The interbank market and bank lending

We study the impact of the US quantitative easing (QE) on both the emerging and advanced economies, estimating a global vector error-correction model (GVECM) and conducting counterfactual analyses. We focus on the effects of reductions in the US term and corporate spreads. First, US QE measures reducing the US corporate spread appear to be more important than lowering the US term spread. Second, US QE measures might have prevented episodes of prolonged recession and deflation in the advanced economies. Third, the estimated effects on the emerging economies have been diverse but often larger than those recorded in the US and other advanced economies. The heterogeneous effects from US QE measures indicate unevenly distributed benefits and costs.

/pdf/financial-crisis-us-unconventional-monetary-policy-and-3ybuagbpu8.pdf

Qianying Chen

Papers

Financial Crisis, Unconventional Monetary Policy and International Spillovers

International Spillovers of Central Bank Balance Sheet Policies

Financial crisis, US unconventional monetary policy and international spillovers

The implementation of monetary policy in china: The interbank market and bank lending

Financial Crisis, US Unconventional Monetary Policy and International Spillovers