This paper reviews selected post–Global Financial Crisis theoretical and empirical contributions on capital controls and identifies three theoretical motives for the use of capital controls: pecuniary externalities in models of financial crises, aggregate demand externalities in New Keynesian models of the business cycle, and terms of trade manipulation in open-economy models with pricing power. Pecuniary and demand externalities offer the most compelling case for the adoption of capital controls, but macroprudential policy can also address the same distortions. So capital controls generally are not the only instrument that can do the job. If evaluated through the lenses of the new theories, the empirical evidence reviewed suggests that capital controls can have the intended effects, even though the extant literature is inconclusive as to whether the effects documented amount to a net gain or loss in welfare terms. Terms of trade manipulation also provides a clear-cut theoretical case for the use of capital controls, but this motive is less compelling because of the spillover and coordination issues inherent in the use of control on capital flows for this purpose. Perhaps not surprisingly, only a handful of countries have used capital controls in a countercyclical manner, while many adopted macroprudential policies. This suggests that capital control policy might entail additional costs other than increased financing costs, such as signaling the bad quality of future policies, leakages, and spillovers.
Alessandro Rebucci and Chang Ma
The development of a simple framework with optimizing agents and nominal rigidities is the point of departure for the analysis of three questions about fiscal and monetary policies in an open economy. The first question concerns the optimal monetary policy targets in a world with trade and financial links. In the baseline model, the optimal cooperative monetary policy is fully inward-looking and seeks to stabilize a combination of domestic inflation and output gap. The equivalence with the closed economy case, however, ends if countries do not cooperate, if firms price goods in the currency of the market of destination, and if international financial markets are incomplete. In these cases, external variables that capture international misalignments relative to the first best become relevant policy targets. The second question is about the empirical evidence on the international transmission of government spending shocks. In response to a positive innovation, the real exchange rate depreciates and the trade balance deteriorates. Standard open economy models struggle to match this evidence. Non-standard consumption preferences and a detailed fiscal adjustment process constitute two ways to address the puzzle. The third question deals with the trade-offs associated with an active use of fiscal policy for stabilization purposes in a currency union. The optimal policy assignment mandates the monetary authority to stabilize union-wide aggregates and the national fiscal authorities to respond to country-specific shocks. Permanent changes of government debt allow to smooth the distortionary effects of volatile taxes. Clear and credible fiscal rules may be able to strike the appropriate balance between stabilization objectives and moral hazard issues.
The geography of economic activity refers to the distribution of population, production, and consumption of goods and services in geographic space. The geography of growth and development refers to the local growth and decline of economic activity and the overall distribution of these local changes within and across countries. The pattern of growth in space can vary substantially across regions, countries, and industries. Ultimately, these patterns can help explain the role that spatial frictions (like transport and migration costs) can play in the overall development of the world economy. The interaction of agglomeration and congestion forces determines the density of economic activity in particular locations. Agglomeration forces refer to forces that bring together agents and firms by conveying benefits from locating close to each other, or for locating in a particular area. Examples include local technology and institutions, natural resources and local amenities, infrastructure, as well as knowledge spillovers. Congestion forces refer to the disadvantages of locating close to each other. They include traffic, high land prices, as well as crime and other urban dis-amenities. The balance of these forces is mediated by the ability of individuals, firms, good and services, as well as ideas and technology, to move across space: namely, migration, relocation, transport, commuting and communication costs. These spatial frictions together with the varying strength of congestion and agglomeration forces determines the distribution of economic activity. Changes in these forces and frictions—some purposefully made by agents given the economic environment they face and some exogenous—determine the geography of growth and development. The main evolution of the forces that influence the geography of growth and development have been changes in transport technology, the diffusion of general-purpose technologies, and the structural transformation of economies from agriculture, to manufacturing, to service-oriented economies. There are many challenges in modeling and quantifying these forces and their effects. Nevertheless, doing so is essential to evaluate the impact of a variety of phenomena, from climate change to the effects of globalization and advances in information technology.
Sushant Acharya and Paolo Pesenti
Global policy spillovers can be defined as the effect of policy changes in one country on economic outcomes in other countries. The literature has mainly focused on monetary policy interdependencies and has identified three channels through which policy spillovers can materialize. The first is the expenditure-shifting channel—a monetary expansion in one country depreciates its currency, making its goods cheaper relative to those in other countries and shifting global demand toward domestic tradable goods. The second is the expenditure-changing channel—expansionary monetary policy in one country raises both domestic and foreign expenditure. The third is the financial spillovers channel—expansionary monetary policy in one country eases financial conditions in other economies. The literature generally finds that the net transmission effect is positive but small. However, estimated spillovers vary widely across countries and over time. In the aftermath of the Great Recession, the policy debate has devoted special attention to the possibility that the magnitude and sign of international spillovers might have changed in an environment of low interest rates worldwide, as the expenditure-shifting channel becomes more relevant when the effective lower bound reduces the effectiveness of conventional monetary policies.
Home bias in international macroeconomics refers to the fact that investors around the world tend to allocate majority of their portfolios into domestic assets, despite the potential benefits to be had from international diversification. This phenomenon has been occurring across countries, over time, and across equity or bond portfolios. The bias towards domestic assets tends to be larger in developing countries relative to developed economies, with Europe characterized by the lowest equity home bias, while Central and South America—by the highest equity home bias. In addition, despite the secular decline in the level of equity home bias over time in all countries and regions, home bias still remains a robust feature of the data. Whether home bias is a puzzle depends on the portfolio allocation that one uses as a theoretical benchmark. For instance, home bias in equity portfolio is a puzzle when assessed through the lens of a simple international capital asset pricing model (CAPM) with homogeneous investors. This model predicts that investors should hold world market portfolios, namely a portfolio with the share of domestic asset equal to the share of those assets in the world market portfolio. For instance, since the share of US equity in the world capitalization in 2016 was 56%, then US investors should allocate 56% of their equity portfolio into local assets, while investing the remaining 44% into foreign equities. Instead, foreign equity comprised just 23% of US equity portfolio in 2016, hence the equity home bias. Alternative portfolio benchmark comes from the theories that emphasize costs for trading assets in international financial markets. These include transaction and information costs, differential tax treatments, and more broadly, differences in institutional environments. This research, however, has so far been unable to reach a consensus on the explanatory power of such costs. Yet another theory argues that equity home bias can arise due to the hedging properties of local equity. In particular, local equity can provide insurance from real exchange rate risk and non-tradable income risk (such as labor income risk), and thus a preference towards home equities is not a puzzle, but rather an optimal response to such risks. These theories, main advances and results in the macroeconomic literature on home bias are discussed in this article. It starts by presenting some empirical facts on the extent and dynamics of equity home bias in developed and developing countries. It is then shown how home bias can arise as an equilibrium outcome of the hedging demand in the model with real exchange rate and non-tradable labor income risk. Since solving models with portfolio choice is challenging, the recent advances in solving such models are also outlined in this article. Integrating the portfolio dynamics into models that can generate realistic asset price and exchange rate dynamics remains a fruitful avenue for future research. A discussion of additional open questions in this research agenda and suggestions for further readings are also provided.
The links of international reserves, exchange rates, and monetary policy can be understood through the lens of a modern incarnation of the “impossible trinity” (aka the “trilemma”), based on Mundell and Fleming’s hypothesis that a country may simultaneously choose any two, but not all, of the following three policy goals: monetary independence, exchange rate stability, and financial integration. The original economic trilemma was framed in the 1960s, during the Bretton Woods regime, as a binary choice of two out of the possible three policy goals. However, in the 1990s and 2000s, emerging markets and developing countries found that deeper financial integration comes with growing exposure to financial instability and the increased risk of “sudden stop” of capital inflows and capital flight crises. These crises have been characterized by exchange rate instability triggered by countries’ balance sheet exposure to external hard currency debt—exposures that have propagated banking instabilities and crises. Such events have frequently morphed into deep internal and external debt crises, ending with bailouts of systemic banks and powerful macro players. The resultant domestic debt overhang led to fiscal dominance and a reduction of the scope of monetary policy. With varying lags, these crises induced economic and political changes, in which a growing share of emerging markets and developing countries converged to “in-between” regimes in the trilemma middle range—that is, managed exchange rate flexibility, controlled financial integration, and limited but viable monetary autonomy. Emerging research has validated a modern version of the trilemma: that is, countries face a continuous trilemma trade-off in which a higher trilemma policy goal is “traded off” with a drop in the weighted average of the other two trilemma policy goals. The concerns associated with exposure to financial instability have been addressed by varying configurations of managing public buffers (international reserves, sovereign wealth funds), as well as growing application of macro-prudential measures aimed at inducing systemic players to internalize the impact of their balance sheet exposure on a country’s financial stability. Consequently, the original trilemma has morphed into a quadrilemma, wherein financial stability has been added to the trilemma’s original policy goals. Size does matter, and there is no way for smaller countries to insulate themselves fully from exposure to global cycles and shocks. Yet successful navigation of the open-economy quadrilemma helps in reducing the transmission of external shock to the domestic economy, as well as the costs of domestic shocks. These observations explain the relative resilience of emerging markets—especially in countries with more mature institutions—as they have been buffered by deeper precautionary management of reserves, and greater fiscal and monetary space. We close the discussion noting that the global financial crisis, and the subsequent Eurozone crisis, have shown that no country is immune from exposure to financial instability and from the modern quadrilemma. However, countries with mature institutions, deeper fiscal capabilities, and more fiscal space may substitute the reliance on costly precautionary buffers with bilateral swap lines coordinated among their central banks. While the benefits of such arrangements are clear, they may hinge on the presence and credibility of their fiscal backstop mechanisms, and on curbing the resultant moral hazard. Time will test this credibility, and the degree to which risk-pooling arrangements can be extended to cover the growing share of emerging markets and developing countries.
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.
Menzie D. Chinn
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.