We study a small open economy characterized by two empirically important frictions – incomplete ﬁnancial markets and an inability of the government to commit to policy. We characterize the best sustainable ﬁscal policy and show that it can amplify and prolong shocks to output. In particular, even when the government is completely benevolent, the government’s credibility not to expropriate capital endogenously varies with the state of the economy and may be “scarcest” during recessions. This increased threat of expropriation depresses investment, prolonging downturns. It is the incompleteness of ﬁnancial markets and lack of commitment that generate investment cycles even in an environment where ﬁrst best capital stock is constant.
In today’s times, the single most debated question in international policy circles is the fate of the U.S. dollar and the U.S current account. This book is a collection of essays on this debate. The papers were presented at a conference in Washington, D.C., on May 25, 2004, organized by the Institute for International Economics. The main questions that were asked at the time of the conference were the following: (1) How much further does the dollar need to depreciate? (2) Against which currencies does it need to depreciate? The general consensus among the authors is that there is a serious misalignment of key national currencies in the world. The main conclusion is that the dollar needs to decline by an additional 15 percent or so and most of this adjustment needs to take place against Asian currencies. This will require China to revalue its exchange rate against the dollar by around 20 percent.
World capital markets have experienced large scale sovereign defaults on a number of occasions. In this paper we develop a quantitative model of debt and default in a small open economy. We use this model to match four empirical regularities regarding emerging markets: defaults occur in equilibrium, interest rates are countercyclical, net exports are countercyclical, and interest rates and the current account are positively correlated. We highlight the role of the stochastic trend in emerging markets, in an otherwise standard model with endogenous default, to match these facts.
In this paper we use a quantitative model to explore the potential frictions that distinguish emerging market business cycles from developed small open economies. Following Aguiar and Gopinath (2007) we allow total factor productivity (TFP) to have a stationary and an integrated component. We also allow for shocks to the consumption and investment Euler Equations that operate through the interest rate. These “wedges” represent changes in the intertemporal marginal rate of transformation, which may be due to changes in observed interest rates, unobserved borrowing constraints, or other ﬁnancial frictions. We estimate the model using data from Mexico and Canada. We show that interest rate shocks orthogonal to domestic TFP fail to explain the behavior of emerging markets. We then allow for interest rates to respond to/co-vary with productivity shocks. We ﬁnd that emerging market business cycles appear to be driven by large shocks to trend income combined with relatively small transitory shocks that co-vary with the interest rate.