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Article

Charles Ka Yui Leung and Cho Yiu Joe Ng

This article summarizes research on the macroeconomic aspects of the housing market. In terms of the macroeconomic stylized facts, this article demonstrates that with respect to business cycle frequency, there was a general decrease in the association between macroeconomic variables (MV), such as the real GDP and inflation rate, and housing market variables (HMV), such as the housing price and the vacancy rate, following the global financial crisis (GFC). However, there are macro-finance variables, such as different interest rate spreads, that exhibited a strong association with the HMV following the GFC. For the medium-term business cycle frequency, some but not all patterns prevail. These “new stylized facts” suggest that a reconsideration and refinement of existing “macro-housing” theories would be appropriate. This article also provides a review of the corresponding academic literature, which may enhance our understanding of the evolving macro-housing–finance linkage.

Article

While it is a long-standing idea in international macroeconomic theory that flexible nominal exchange rates have the potential to facilitate adjustment in international relative prices, a monetary union necessarily forgoes this mechanism for facilitating macroeconomic adjustment among its regions. Twenty years of experience in the eurozone monetary union, including the eurozone crisis, have spurred new macroeconomic research on the costs of giving up nominal exchange rates as a tool of adjustment, and the possibility of alternative policies to promote macroeconomic adjustment. Empirical evidence paints a mixed picture regarding the usefulness of nominal exchange rate flexibility: In many historical settings, flexible nominal exchanges rates tend to create more relative price distortions than they have helped resolve; yet, in some contexts exchange rate devaluations can serve as a useful correction to severe relative price misalignments. Theoretical advances in studying open economy models either support the usefulness of exchange rate movements or find them irrelevant, depending on the specific characteristics of the model economy, including the particular specification of nominal rigidities, international openness in goods markets, and international financial integration. Yet in models that embody certain key aspects of the countries suffering the brunt of the eurozone crisis, such as over-borrowing and persistently high wages, it is found that nominal devaluation can be useful to prevent the type of excessive rise in unemployment observed. This theoretical research also raises alternative polices and mechanisms to substitute for nominal exchange rate adjustment. These policies include the standard fiscal tools of optimal currency area theory but also extend to a broader set of tools including import tariffs, export subsidies, and prudential taxes on capital flows. Certain combinations of these policies, labeled a “fiscal devaluation,” have been found in theory to replicate the effects of a currency devaluation in the context of a monetary union such as the eurozone. These theoretical developments are helpful for understanding the history of experiences in the eurozone, such as the eurozone crisis. They are also helpful for thinking about options for preventing such crises in the future.

Article

Chao Gu, Han Han, and Randall Wright

This article provides an introduction to New Monetarist Economics. This branch of macro and monetary theory emphasizes imperfect commitment, information problems, and sometimes spatial (endogenously) separation as key frictions in the economy to derive endogenously institutions like monetary exchange or financial intermediation. We present three generations of models in development of New Monetarism. The first model studies an environment in which agents meet bilaterally and lack commitment, which allows money to be valued endogenously as means of payment. In this setup both goods and money are indivisible to keep things tractable. Second-generation models relax the assumption of indivisible goods and use bargaining theory (or related mechanisms) to endogenize prices. Variations of these models are applied to financial asset markets and intermediation. Assets and goods are both divisible in third-generation models, which makes them better suited to policy analysis and empirical work. This framework can also be used to help understand financial markets and liquidity.

Article

Many nonlinear time series models have been around for a long time and have originated outside of time series econometrics. The stochastic models popular univariate, dynamic single-equation, and vector autoregressive are presented and their properties considered. Deterministic nonlinear models are not reviewed. The use of nonlinear vector autoregressive models in macroeconometrics seems to be increasing, and because this may be viewed as a rather recent development, they receive somewhat more attention than their univariate counterparts. Vector threshold autoregressive, smooth transition autoregressive, Markov-switching, and random coefficient autoregressive models are covered along with nonlinear generalizations of vector autoregressive models with cointegrated variables. Two nonlinear panel models, although they cannot be argued to be typically macroeconometric models, have, however, been frequently applied to macroeconomic data as well. The use of all these models in macroeconomics is highlighted with applications in which model selection, an often difficult issue in nonlinear models, has received due attention. Given the large amount of nonlinear time series models, no unique best method of choosing between them seems to be available.

Article

Stuti Khemani

“Reform” in the economics literature refers to changes in government policies or institutional rules because status-quo policies and institutions are not working well to achieve the goals of economic wellbeing and development. Further, reform refers to alternative policies and institutions that are available which would most likely perform better than the status quo. The main question examined in the “political economy of reform” literature has been why reforms are not undertaken when they are needed for the good of society. The succinct answer from the first generation of research is that conflict of interest between organized socio-political groups is responsible for some groups being able to stall reforms to extract greater private rents from status-quo policies. The next generation of research is tackling more fundamental and enduring questions: Why does conflict of interest persist? How are some interest groups able to exert influence against reforms if there are indeed large gains to be had for society? What institutions are needed to overcome the problem of credible commitment so that interest groups can be compensated or persuaded to support reforms? Game theory—or the analysis of strategic interactions among individuals and groups—is being used more extensively, going beyond the first generation of research which focused on the interaction between “winners” and “losers” from reforms. Widespread expectations, or norms, in society at large, not just within organized interest groups, about how others are behaving in the political sphere of making demands upon government; and, beliefs about the role of public policies, or preferences for public goods, shape these strategic interactions and hence reform outcomes. Examining where these norms and preferences for public goods come from, and how they evolve, are key to understanding why conflict of interest persists and how reformers can commit to finding common ground for socially beneficial reforms. Political markets and institutions, through which the leaders who wield power over public policy are selected and sanctioned, shape norms and preferences for public goods. Leaders who want to pursue reforms need to use the evidence in favor of reforms to build broad-based support in political markets. Contrary to the first generation view of reforms by stealth, the next generation of research suggests that public communication in political markets is needed to develop a shared understanding of policies for the public good. Concomitantly, the areas of reform have circled from market liberalization, which dominated the 20th century, back to strengthening governments to address problems of market failure and public goods in the 21st century. Reforms involve anti-corruption and public sector management in developing countries; improving health, education, and social protection to address persistent inequality in developed countries; and regulation to preserve competition and to price externalities (such as pollution and environmental depletion) in markets around the world. Understanding the functioning of politics is more important than ever before in determining whether governments are able to pursue reforms for public goods or fall prey to corruption and populism.

Article

The idea that prices and exchange rates adjust so as to equalize the common-currency price of identical bundles of goods—purchasing power parity (PPP)—is a topic of central importance in international finance. If PPP holds continuously, then nominal exchange rate changes do not influence trade flows. If PPP does not hold in the short run, but does in the long run, then monetary factors can affect the real exchange rate only temporarily. Substantial evidence has accumulated—with the advent of new statistical tests, alternative data sets, and longer spans of data—that purchasing power parity does not typically hold in the short run. One reason why PPP doesn’t hold in the short run might be due to sticky prices, in combination with other factors, such as trade barriers. The evidence is mixed for the longer run. Variations in the real exchange rate in the longer run can also be driven by shocks to demand, arising from changes in government spending, the terms of trade, as well as wealth and debt stocks. At time horizon of decades, trend movements in the real exchange rate—that is, systematically trending deviations in PPP—could be due to the presence of nontraded goods, combined with real factors such as differentials in productivity growth. The well-known positive association between the price level and income levels—also known as the “Penn Effect”—is consistent with this channel. Whether PPP holds then depends on the time period, the time horizon, and the currencies examined.

Article

The Hou–Xue–Zhang q-factor model says that the expected return of an asset in excess of the risk-free rate is described by its sensitivities to the market factor, a size factor, an investment factor, and a return on equity (ROE) factor. Empirically, the q-factor model shows strong explanatory power and largely summarizes the cross-section of average stock returns. Most important, it fully subsumes the Fama–French 6-factor model in head-to-head spanning tests. The q-factor model is an empirical implementation of the investment-based capital asset pricing model (the Investment CAPM). The basic philosophy is to price risky assets from the perspective of their suppliers (firms), as opposed to their buyers (investors). Mathematically, the investment CAPM is a restatement of the net present value (NPV) rule in corporate finance. Intuitively, high investment relative to low expected profitability must imply low costs of capital, and low investment relative to high expected profitability must imply high costs of capital. In a multiperiod framework, if investment is high next period, the present value of cash flows from next period onward must be high. Consisting mostly of this next period present value, the benefits to investment this period must also be high. As such, high investment next period relative to current investment (high expected investment growth) must imply high costs of capital (to keep current investment low). As a disruptive innovation, the investment CAPM has broad-ranging implications for academic finance and asset management practice. First, the consumption CAPM, of which the classic Sharpe–Lintner CAPM is a special case, is conceptually incomplete. The crux is that it blindly focuses on the demand of risky assets, while abstracting from the supply altogether. Alas, anomalies are primarily relations between firm characteristics and expected returns. By focusing on the supply, the investment CAPM is the missing piece of equilibrium asset pricing. Second, the investment CAPM retains efficient markets, with cross-sectionally varying expected returns, depending on firms’ investment, profitability, and expected growth. As such, capital markets follow standard economic principles, in sharp contrast to the teachings of behavioral finance. Finally, the investment CAPM validates Graham and Dodd’s security analysis on equilibrium grounds, within efficient markets.

Article

Stock-flow matching is a simple and elegant framework of dynamic trade in differentiated goods. Flows of entering traders match and exchange with the stocks of previously unsuccessful traders on the other side of the market. A buyer or seller who enters a market for a single, indivisible good such as a job or a home does not experience impediments to trade. All traders are fully informed about the available trading options; however, each of the available options in the stock on the other side of the market may or may not be suitable. If fortunate, this entering trader immediately finds a viable option in the stock of available opportunities and trade occurs straightaway. If unfortunate, none of the available opportunities suit the entrant. This buyer or seller now joins the stocks of unfulfilled traders who must wait for a new, suitable partner to enter. Three striking empirical regularities emerge from this microstructure. First, as the stock of buyers does not match with the stock of sellers, but with the flow of new sellers, the flow of new entrants becomes an important explanatory variable for aggregate trading rates. Second, the traders’ exit rates from the market are initially high, but if they fail to match quickly the exit rates become substantially slower. Third, these exit rates depend on different variables at different phases of an agent’s stay in the market. The probability that a new buyer will trade successfully depends only on the stock of sellers in the market. In contrast, the exit rate of an old buyer depends positively on the flow of new sellers, negatively on the stock of old buyers, and is independent of the stock of sellers. These three empirical relationships not only differ from those found in the familiar search literature but also conform to empirical evidence observed from unemployment outflows. Moreover, adopting the stock-flow approach enriches our understanding of output dynamics, employment flows, and aggregate economic performance. These trading mechanics generate endogenous price dispersion and price dynamics—prices depend on whether the buyer or the seller is the recent entrant, and on how many viable traders were waiting for the entrant, which varies over time. The stock-flow structure has provided insights about housing, temporary employment, and taxicab markets.

Article

Structural vector autoregressions (SVARs) represent a prominent class of time series models used for macroeconomic analysis. The model consists of a set of multivariate linear autoregressive equations characterizing the joint dynamics of economic variables. The residuals of these equations are combinations of the underlying structural economic shocks, assumed to be orthogonal to each other. Using a minimal set of restrictions, these relations can be estimated—the so-called shock identification—and the variables can be expressed as linear functions of current and past structural shocks. The coefficients of these equations, called impulse response functions, represent the dynamic response of model variables to shocks. Several ways of identifying structural shocks have been proposed in the literature: short-run restrictions, long-run restrictions, and sign restrictions, to mention a few. SVAR models have been extensively employed to study the transmission mechanisms of macroeconomic shocks and test economic theories. Special attention has been paid to monetary and fiscal policy shocks as well as other nonpolicy shocks like technology and financial shocks. In recent years, many advances have been made both in terms of theory and empirical strategies. Several works have contributed to extend the standard model in order to incorporate new features like large information sets, nonlinearities, and time-varying coefficients. New strategies to identify structural shocks have been designed, and new methods to do inference have been introduced.