Capital Flows, Capital Controls, and Exchange Rate Policy: {Joint with Michael B. Devereux,  Download pdf file }

Many emerging market economies use alternative forms of capital controls. Often the use of capital controls is related to the defense of the exchange rate. This paper examines the welfare case for capital controls, and the interaction between capital controls and the the interaction between capital controls and the exchange rate. Our results suggest a very conditional yes to this question, but only when there are capital outflows. Surprisingly, there is also a similar case for capital controls in the face of capital inflows if the economy is on a freely floating exchange rate. But there are always better policies, which if available will eliminate the case for capital controls. As a corollary, our results suggest an optimal exchange rate stance for an economy experiencing capital flows, a country receiving capital inflows should follow a fixed exchange rate, while a country experiencing capital outflows should allow the exchange rate to float.

Did International Debt Sink Asia’s Financial System? (with Timothy K. Chue  Download pdf file  )

Abstract:  Before the currency crisis of 1997-1998, East Asian financial intermediaries borrowed heavily in international markets. During the crisis, the intermediaries’ stock market value declined sharply, and a sizable fraction of the institutions were closed or nationalized. We find that 1) the stocks of intermediaries with large international debt exposure performed poorly during the crisis; 2) more short-term international debt outstanding was associated with a higher probability of bankruptcy; 3) among those intermediaries that survived, more long-term international debt was associated with a lower equity return; and 4) higher international debt, especially short-term international debt, was associated with a more severe contraction in the assets and liabilities of the intermediaries. It indicates that both the sudden withdrawal of funds by international creditors and the foreign currency nature of international debt damage the financial system, and exacerbate the decline in the financing of investment.
 

Robust Control and the Small Open Economy  (Revision Download pdf file  )

This paper examines the properties of business cycles in a small open economy in which consumers choose plans that are robust to potential model mis-specification. Faced with a range of potential correct specifications of the distribution of future shocks, households choose plans that are optimal under the worst case specification. Linear approximations to these robust plans are solved for using robust control methods. The robust plans has a number of important effects on the equilibrium response of the small open economy to business cycle shocks. First, the equilibrium is stationary. In a standard linear quadratic model of an open economy facing an exogenous interest rates, consumption will follow a random walk. Second, consumption plans robust to model mis-specification allow for greater response of consumption to temporary income shocks. In a model calibrated to match the features of the economy of Great Britain, the greater volatility of consumption leads to a counter-cyclical trade balance matching the data.
 

Emerging Market Exchange-Rate Exposure  (with Timothy K. Chue    Download pdf file )

We estimate the exposure of emerging-market companies to fluctuations in their domestic exchange rates. We use an instrumental-variable approach that identifies the total exposure of a company to exchange-rate movements, yet abstracts from the influence of confounding macroeconomic shocks. We find the impact of depreciations on emerging-market stock returns is overwhelmingly negative. Since we estimate the exchange-rate exposure of firms from different countries with a common set of instruments, we can make coherent comparisons of their determinants across markets. We find a firm’s foreign-currency debt outstanding is an important determinant of its exchange-rate exposure.
 

Stock Market Liquidity and the Macroeconomy: Evidence from Japan  (Joint with Woon Gyu Choi  Download pdf file ) In a liquid financial market, investors are able to sell large blocks of assets without substantially changing the price. We document a steep drop in the liquidity of the Japanese stock market in the post-bubble period and a steep rise in liquidity risk. We find that, during Japan’s deflationary period, firms with more liquid balance sheets were less exposed to stock market liquidity risk, while slowly growing firms were highly exposed to liquidity shocks. Also, aggregate liquidity had macroeconomic effects on aggregate demand through its effect on money demand.
 
 

Published or Accepted for Publication

External Currency Pricing and the East Asian Crisis Joint with Michael B. Devereux,}
(Forthcoming Journal of International Economics)
This paper provides a quantitative investigation of the East Asian crisis of 1997-99.  The two essential features of the crisis that we focus on are a) the crisis was a regional phenomenon; the depth and severity of the crisis was exacerbated by a large decline in regional demand, and b) the practice of setting export goods prices in dollars (which we document empirically) led to a powerful internal propagation effect of the crisis within the region, contributing greatly to the decline in regional trade flows.  We construct a model with these two features, and show that it can do a reasonable job of accounting for the response of the main macroeconomic aggregates in Korea, Malaysia, and Thailand during the crisis.
 
 

Liability Dollarization and the Bank Channel {with Woon Gyu Choi)
(Forthcoming Journal of International Economics)
Banks in developing economies often face a mismatch in the currency denomination of their liabilities (foreign currency denominated debt incurred from foreign lenders) and assets (domestic currency loans to domestic borrowers). We study the effect of this mismatch on business cycles and monetary policy in a sticky price, dynamic general equilibrium model of a dependent economy. We show\ that a fixed exchange rate rule that stabilizes the balance sheets of banks will also stabilize production and offer higher welfare to agents in a developing economy than would an inflation targeting interest rate rule. This result differs sharply from standard macroeconomic intuition which suggests that inflation targeting ameliorates the destabilizing effects of sticky prices.
 

Experience and Growth
(Forthcoming Economics Letters)

This paper jointly estimates the social returns to physical and human capital with aggregate production functions using cross-country, first differenced panel data at frequencies of 10 years. Following cross-sectional wage regressions, the average experience of the workforce is added to average education as a proxy for the workforce. Growth in average experience is significantly associated with productivity growth. Controlling for experience increases the level and significance of returns to education. After controlling for the endogeneity of physical capital, this paper finds that social returns to physical and human capital are close to private returns estimated using factor payments.

Monetary Policy in Emerging Markets: Devaluation and Foriegn Debt Appreciation
(Forthcoming Journal of Monetary Economics)
A monetary expansion can lead to a contraction in output in economies in which firms' debts are denominated in foreign currency even when nominal goods prices are sticky. A nominal expansion that causes an exchange rate depreciaion will increase the domestic currency cost of servicing foreign currency debt. Simultaneously sticky goods prices will prevent a rise in the nominal value of a firms sales and, thus, the nominal value of a firm's assets. The result is a negative shock to firms balance sheets. I assume borrowing costs depend on the state of firms balance sheets due to asymetric information about financial project. A devaluation can thus lead to a high cost of capital and low investment demand and a subsequent contraction in output. I calibrate a small, new open macroceonomic model to study the quantitave strength of this channel and show conditions under which a monetary expansion leads to an output contraction.

Accounting for the East Asian Crisis: A Quantitative Model of Capital Outflows in Small Open Economies {Joint with Michael B. Devereux,  Download pdf file }

This paper conducts a quantitative investigation of the East Asian crisis, within a calibrated dynamic general equilibrium model.  The central question addressed by the paper is this; to what extent can the crisis can be accounted for by the measured shocks to country risk-premia?  The model is calibrated to match three East Asian economies: Thailand, Korea, and Malaysia. Using published data on country-risk premium, we find that a single interest rate shock of the size observed can explain a large share of the real sectoral outcomes in those countries, especially in Korea and Thailand. The model has more difficulty explaining the large exchange rate devaluations that occurred in those economies.
 
 

Real Propagation of Monetary Shocks: Dynamic Complementarities and Capital Utilization
(accepted for publication by Macroeconomic Dynamics)
This paper studies the dynamic propagation of a liquidity shock (see Fuerst 1992 or Christiano 1991) through two real propagation channels:  dynamic complementarities (see Cooper and Johri 1997) and time varying capital utilization (see Burnside and Eichenbaum 1996). The findings for an economy with intertemporal externalities are:  i) an otherwise transient liquidity shock will have real effects on output for several years; ii) time varying capital utilization strongly augments this propagation; iii) the real effects of monetary shocks last longer when external productivity depreciates faster; and iv) nominal prices respond more sluggishly to a change in the money supply when there is a strong real propagation channel.

The Liquidity Effect and Money Demand
(accepted for publication by Journal of Monetary Economics)
I suggest a ``liquidity effect'' model in which financial intermediation costs are determined by aggregate economic activity. An expansionary monetary shock leads to a persistent contraction in the loan-deposit rate spread, a persistent liquidity effect, and a persistent real expansion. A feature of this expansion is that nominal prices respond sluggishly to monetary shocks as an equilibrium outcome.
 

Time to Enter and Business Cycles ( accepted for publication at the Journal of Economic Dynamics & Control)
This paper examines a model in which market entry forms a business cycle propagation mechanism. During expansionary periods, new firms enter previously monopolized markets creating efficiency gains that amplify the effect of technology and fiscal policy shocks on employment. Market entry is delayed creating a dynamic pattern to output growth closer to that observed in the US economy than the standard RBC model.

Counter-cyclical Markups and the Open Economy: A Transmission Mechanism for International Business Cycles  ( accepted for publication at the Journal of International Economics)
In this paper, I describe a model open market economy in which business formation acts as an international transmission mechanism for business cycle shocks. When fixed costs are the only barriers to market entry, a technology shock in a large open economy can lead to additional business formation in a parallel large open economy. This expansion in the number of firms increases the intensity of competition at the industry level (thus, counter-cyclical markups). These demand spillovers expand employment, production, and investment in the economies not directly affected by the shock. In a calibrated version of the model, the two model economies display a high degree of business cycle comovement, a feature of empirical data.

World War II and Convergence (Forthcoming, Review of Economics and Statistics February 2002)
Proxies that measure the effect of the Second World War on a country's capital stock are used as instruments for estimating the standard cross-country growth regressions. The war's destruction should offer a natural experiment which allows us to examine the speed of convergence. The estimate convergence rates are about 4-6% per annum, substantially larger than conventional wisdom.

Capital Controls in Malaysia: Effectiveness and Side Effects(Forthcoming, Inaugaral Issue, Asian Economics Papers  )

In 1998 and 1999, following the financial crisis, Malaysia imposed a set of constraints and taxes on the movement of capital out of the country. Using a quantitative equilibrium model, we attempt to construct estimates of the effects of these controls on Malaysia's recovery from the East Asian crisis. The analysis is constructed around a model of a dependent economy with taxation on capital movements. We focus on the aftermath of a financial panic (the East Asian crisis) in which effective international interest rates rise. Capital taxation implicitly ameliorates the brunt of such a rise in the interest rate, and substantially limits its real effects. This amelioration is shown to be especially significant under fixed exchange rates, a policy used by the Malaysian government to complement the capital controls.

Liability Dollarization and the Bank Channel {with Woon Gyu Choi)
(Forthcoming Journal of International Economics)
Banks in developing economies often face a mismatch in the currency denomination of their liabilities (foreign currency denominated debt incurred from foreign lenders) and assets (domestic currency loans to domestic borrowers). We study the effect of this mismatch on business cycles and monetary policy in a sticky price, dynamic general equilibrium model of a dependent economy. We show\ that a fixed exchange rate rule that stabilizes the balance sheets of banks will also stabilize production and offer higher welfare to agents in a developing economy than would an inflation targeting interest rate rule. This result differs sharply from standard macroeconomic intuition which suggests that inflation targeting ameliorates the destabilizing effects of sticky prices.

(In Stasis)

The Demographics of Demand: Instruments for Production Function Estimation
( download .pdf file )
In this paper, I estimate a representative production function using instrumental variable methods. The instruments are demographic variables which reflect the age structure of the US population. These variables should affect sectoral demand and factor availability. I suggest that due to the low frequency and high predictability of demographic changes, the instruments are useful in illuminating the effects of exogenous changes in capital equipment. I find evidence that strongly favor constant returns to scale in U.S. manufacturing.

Credit Markets and Export Dynamics  (Download pdf file )
In this paper, I quantitatively examine the effect of credit market imperfections on the dynamics of exports following a monetary expansion. During a monetary expansion, the finance costs of export firms due to an increase in default risk. This produces a delayed response of exports to a persistent money shock. Keywords:Credit Markets, Current Account, Dynamics, Sticky Prices JEL Classification:{F4} Macroeconomic Aspects of International Trade and Finance

Macroeconomic Effects of Interational Financial Panics
 (joint with Mick Devereux,  Download .pdf file here )
This paper explores the macroeconomic effects of capital market panics in a small open economy. The model is motivated by the sudden and dramatic capital outflows from East Asian economies in 1997-1998, which led to sharp exchange rate depreciations, followed by a collapse in the real economy, and a large reversal in the position of the current account. Our interpretation of this event follows the literature on `financial fragility', which points to the problems of the maturity mismatch between short term borrowing and long-term investment projects giving rise to the risk of capital market panics. We go beyond this literature, however, in attempting to provide a complete macro model to explain how a capital market panic can precipitate a large fall in the real exchange rate, and a collapse in the real economy and a shift from deficit to surplus in the current account.
 

Education and Growth: Instrumental Variables Estimates {Download the latest version here}
{ Original Version Download pdf file    }
Estimating the marginal effect of additional education on output growth faces a fundamental problem. Data on education levels are poorly measured at high frequency in many countries. Use of high frequency data to estimate parameters of an aggregate production function will lead to biased results. Averaging across time is no solution. Education levels are likely to be endogenously determined at low frequencies leading to biased results. Exogenous instrumental variables can potentially solve either problem. Using cross-country panel data, I estimate a representative production function using instrumenttal variable methods. The instruments are demographic variables which reflect the age structure of the population. The age profile is relevant for education growth because new, more highly educated workers enter the labor force at a particular age range and older workers leave at that range. The estimates of the marginal effect of human and physical capital on productivity are close to estimates derived from income shares: a 1% increase in the capital stock leads to a 1/3 of 1% in output and a 1 year increase in average education levels leads to a 10% in output.