Safe Asset Scarcity and Aggregate Demand Caballero, Ricardo J.; Farhi, Emmanuel; Gourinchas, Pierre-Olivier
The American economic review,
05/2016, Volume:
106, Issue:
5
Journal Article
Peer reviewed
Open access
We explore the consequences of safe asset scarcity on aggregate demand in a stylized IS-LM/Mundell Fleming style environment. Acute safe asset scarcity forces the economy into a “safety trap” ...recession. In the open economy, safe asset scarcity spreads from one country to the other via capital flows, equalizing interest rates. Acute global safe asset scarcity forces the economy into a global safety trap. The exchange rate becomes indeterminate but plays a crucial role in both the distribution and the magnitude of output adjustment across countries. Policies that increase the net supply of safe assets somewhere are output enhancing everywhere.
•Joint term structure models can fit yields from multiple countries.•We show that it is not necessary to estimate such models to forecast yields.•Information about foreign yields is already reflected ...in today’s domestic yields.
While the open-economy macroeconomics literature amply demonstrates the importance of allowing for trade and financial linkages between countries, the finance literature on the term structure of interest rates has largely adopted a “closed-economy” setting in which yields in one country depend only on their own lagged values. This paper examines whether it is in fact necessary to jointly model yields in multiple countries, as proposed by a handful of recent studies. We show that there is little convincing evidence that would point to such a need. The reason is that bond yields are forward-looking variables: any relevant information about foreign countries is likely to be already reflected in today’s domestic yield curve.
The new-Keynesian, Taylor rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed induces ever-larger inflation, unless ...inflation jumps to one particular value on each date. However, economics does not rule out explosive inflation, so inflation remains indeterminate. Attempts to fix this problem assume that the government will choose to blow up the economy if alternative equilibria emerge, by following policies we usually consider impossible. The Taylor rule is not identified without unrealistic assumptions. Thus, Taylor rule regressions do not show that the Fed moved from “passive” to “active” policy in 1980.
We study the validity of uncovered interest-rate parity by constructing ultra-long time series that span two centuries. The forward-premium regressions yield positive slope estimates over the whole ...sample. The estimates become negative only when the sample is dominated by the period of 1980s. We also find that large interest-rate differentials have significantly stronger forecasting powers for currency movements than small interest-rate differentials. Furthermore, when we regress domestic currency returns on foreign bonds against returns on domestic bonds as an alternative test of the parity condition, the null hypotheses of zero intercept and unit slope cannot be rejected in most cases. These results are consistent with a world in which expectations formation is highly imperfect and characterized on the one hand by slow adjustment of expectations to actual regime changes and on the other by anticipations for extended periods of regime changes or other big events that never materialize. An historical account of expected and realized regime changes adds credence to this explanation and illustrates how uncovered interest-rate parity holds over the very long haul but nevertheless can be deviated from over long periods of time due to ex post-expectation errors.
The missing risk premium in exchange rates Dahlquist, Magnus; Pénasse, Julien
Journal of financial economics,
February 2022, 2022-02-00, 20220201, 2022-02-01, Volume:
143, Issue:
2
Journal Article
Peer reviewed
Open access
We use a present-value model of the real exchange rate to impose structure on the currency risk premium. We allow the currency risk premium to depend on both the interest rate differential and a ...latent component: the missing risk premium. Consistent with the data, our present-value model implies that the real exchange rate should predict currency returns. We find that the missing risk premium, not the interest rate differential, explains most of the variation in the real exchange rate. Moreover, our model sheds light on puzzling relations between the interest rate differential, the real exchange rate, and the currency risk premium.
We study the effects of FOMC announcements of federal funds target rate decisions on individual stock returns, volatilities and correlations at the intraday level. For all three characteristics we ...find that the stock market responds differently to positive and negative target rate surprises. First, the average response to positive surprises (that is, bad news for stocks) is larger. Second, in case of bad news the mere occurrence of a surprise matters most, whereas for good news its magnitude is more important. These new insights are possible due to the use of high-frequency intraday data.
•We provide a new exchange rate uncertainty index.•We show that UIRP is more likely to hold at times when uncertainty is not exceptionally high.•On the other hand, UIRP breaks down during periods of ...high uncertainty.•The finding is robust to using a variety of uncertainty measures.
It is well-known that uncovered interest rate parity does not hold empirically, especially at short horizons. But is it really so? We conjecture that uncovered interest rate parity is more likely to hold in low uncertainty environments, relative to high uncertainty ones, since arbitrage opportunity gains become more uncertain in a highly unpredictable environment, thus blurring the relationship between exchange rates and interest rate differentials. In this paper, we first provide a new exchange rate uncertainty index, that measures how unpredictable exchange rates are relative to their historical past. Then we use the new measure of uncertainty to provide empirical evidence that uncovered interest rate parity does hold in five industrialized countries vis-a’-vis the US dollar at times when uncertainty is not exceptionally high, and breaks down during periods of high uncertainty.
This paper explores the frequency dynamics of volatility spillovers among crude oil and international stock markets using implied volatility indices. I find evidence of volatility spillovers driven ...mainly by short-term spillovers. Moreover, low interest rate is the primary driver of volatility spillovers, whose roles mainly stem from its impact on short-term spillovers. The impact of interest rate on long-term spillovers is significantly positive, but relatively limited. The findings highlight that although the low interest rate offers a anticipation of the stability of financial system in the long run, it can be a source of global system risk, especially in the short run.
•Volatility spillover is driven mainly by short-term spillovers.•Low interest rate is the primary driver of volatility spillovers•Its role mainly stems from the impact on short-term spillovers.•Its role in long-term spillovers is positive, but limited.
•We build a quantitative DSGE model to simultaneously study the three principal tools of unconventional monetary policy - quantitative easing, forward guidance, and negative interest ...rates.•Endogenous quantitative easing via a feedback rule can largely mitigate the costs of a binding zero lower bound.•We discuss implications of large central bank balances for quantitative tightening and the efficacy of negative interest rate policy.
We develop a structural DSGE model to systematically study the principal tools of unconventional monetary policy – quantitative easing (QE), forward guidance, and negative interest rate policy (NIRP) – as well as the interactions between them. To generate the same output response, the requisite NIRP and forward guidance interventions are twice as large as a conventional policy shock, which seems implausible in practice. In contrast, QE via an endogenous feedback rule can alleviate the constraints on conventional policy posed by the zero lower bound. Quantitatively, QE1-QE3 can account for two thirds of the observed decline in the “shadow” Federal Funds rate. In spite of its usefulness, QE does not come without cost. A large balance sheet has consequences for different normalization plans, the efficacy of NIRP, and the effective lower bound on the policy rate.
This paper investigates the effects of various monetary policy instruments in China with the structural vector autoregression model. Empirical results are as follows. The effects of benchmark lending ...rate and short‐term interest rate shocks are larger than those of reserve requirement ratio shocks. Nonpolicy shocks exert substantial effects on intermediate targets under a quantity‐based policy framework. The size and effects of short‐term interest rate shocks in recent years are large. Short‐term interest rate shocks have strong effects on property prices. These results suggest that the new interest rate‐based policy framework is more effective than the previous quantity‐based policy framework.
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