The cyclicality of (bilateral) capital inflows and outflows
Recent research has shown that gross capital inflows and outflows are positively correlated and highly procyclical. This poses a puzzle since most theory predicts that capital inflows and outflows should be negatively correlated, and while capital inflows should be procyclical, capital outflows should be countercyclical. This previous work has examined the behavior of aggregate capital inflows and outflows (capital flows between a country and the rest of the world). This paper shows that bilateral capital inflows and outflows (flows between a pair of countries) are also positively correlated and strongly procyclical. This empirical finding poses a new puzzle. The data suggests that any model that can explain capital flows at the bilateral level needs to rely on market incompleteness and non-diversification. In addition, the data suggests that this positive correlation and procyclicality is largely the feature of crisis episodes. After controlling for crisis episodes, we find that bilateral capital flows move positively with GDP in the country receiving the capital and co-move negatively in the country sending the capital.
AUTHORS: Davis, J. Scott
The effect of commodity price shocks on underlying inflation: the role of central bank credibility
This paper seeks to document and explain the effect of a commodity price shock on underlying core inflation, and how that effect changes both across time and across countries. Impulse responses derived from a structural VAR model show that across many countries there was a break in the response of core inflation to a commodity price shock. In an earlier period, a shock to commodity prices would lead to a large and significant increase in core inflation, but in later periods, the effect was insignificant. ; To explain this, we construct a large-scale DSGE model with both headline and core inflation, and most significantly, a mechanism whereby fluctuations in inflation caused by purely transitory shocks can become incorporated into long-term inflation expectations. Inflation has a trend and a cyclical component. Private agents cannot distinguish between the two, so a cyclical fluctuation in inflation may be confused for a shift in the trend component. Bayesian estimation reveals that there was a change between the earlier and the later periods in the parameter that governs the anchoring of expectations. Impulse responses derived from simulations of the model show that this change in the effect of commodity prices on core inflation is driven by the change in the anchoring of inflation expectations.
AUTHORS: Davis, J. Scott
Globalization and the Increasing Correlation between Capital Inflows and Outflows
The correlation between capital inflows and outflows has increased substantially over time in a sample of 128 advanced and developing countries. We provide evidence that this is a result of an increase in financial globalization (stock of external assets and liabilities). This dominates the effect of an increase in trade globalization (exports plus imports), which reduces the correlation between capital inflows and outflows. In the context of a two-country model with 14 shocks we show that the theoretical impact of financial and trade globalization on the correlation between capital inflows and outflows is consistent with the data.
AUTHORS: Van Wincoop, Eric; Davis, J. Scott
Distribution capital and the short- and long-run import demand elasticity
International business-cycle models assume that home and foreign goods are poor substitutes. International trade models assume they are close substitutes. This paper constructs a model where this discrepancy is due to frictions in distribution. Imports need to be combined with a local non-traded input, distribution capital, which is slow to adjust. As a result, imported and domestic goods appear as poor substitutes in the short run. In the long run this non-traded input can be reallocated, and quantities can shift following a change in relative prices. Thus the observed substitutability between home and foreign goods gets larger as time passes.
AUTHORS: Crucini, Mario J.; Davis, J. Scott
Central bank communications: a case study
Over the past twenty five years, central bank communications have undergone a major revolution. Central banks that previously shrouded themselves in mystery now embrace social media to get their message out to the widest audience. The Federal Reserve System has not always been at the forefront of these changes, but the volume of information about monetary policy that the Federal Open Market Committee (FOMC) now releases dwarfs what it was releasing a quarter century ago. In this paper we focus on just one channel of FOMC communications, the post-meeting statement. We document how it has evolved over time, and in particular the extent to which it has become more detailed, but also more difficult to understand. We then use a VAR with daily financial market data to estimate a daily time series of U.S. monetary policy shocks. We show how these shocks on Fed statement release days have gotten larger as the statement has gotten longer and more detailed, and we show that the length and complexity of the statement has a direct effect on the size of the monetary policy shock following a Fed decision.
AUTHORS: Wynne, Mark A.; Davis, J. Scott
Foreign Exchange Reserves as a Tool for Capital Account Management
Many recent theoretical papers have argued that countries can insulate themselves from volatile world capital flows by using a variable tax on foreign capital as an instrument of monetary policy. But at the same time many empirical papers have argued that only rarely do we observe these cyclical capital taxes used in practice. In this paper we construct a small open economy model where the central bank can engage in sterilized foreign exchange intervention. When private agents can freely buy and sell foreign bonds, sterilized foreign exchange intervention has no effect. But we analytically prove that when private agents cannot freely buy and sell foreign bonds, that is, under acyclical capital controls, optimal sterilized foreign exchange intervention is equivalent to an optimally chosen tax on foreign capital. Numerical simulations of the model show that a variable capital tax is a reasonable approximation for sterilized foreign exchange intervention under the levels of capital controls observed in many emerging markets.
AUTHORS: Wang, Jiao; Huang, Kevin X. D.; Fujiwara, Ippei; Davis, J. Scott
Credit booms, banking crises, and the current account
What is the marginal effect of an increase in the private sector debt-to-GDP ratio on the probability of a banking crisis? This paper shows that the marginal effect of rising debt levels depends on an economy's external position. When the current account is in surplus or in balance, the marginal effect of an increase in debt is rather small; a 10 percentage point increase in the private sector debt-to-GDP ratio increases the probability of a crisis by about 1 to 2 percentage points. However, when the economy is running a sizable current account deficit, implying that any increase in the debt ratio is financed through foreign borrowing, this marginal effect can be large. When a country has a current account deficit of 10% of GDP (which is similar to the value in the Eurozone periphery on the eve of the recent crisis) a 10 percentage point increase in the private sector debt ratio leads to a 10 percentage point increase in the probability of a crisis.
AUTHORS: Davis, J. Scott; Mack, Adrienne; Vandenabeele, Anne; Phoa, Wesley
The asymmetric effects of deflation on consumption spending: evidence from the Great Depression
Does expected deflation lead to a fall in consumption spending? Using data for U.S. grocery store sales and department store sales from 1919 to 1939, this paper shows that expected price changes have asymmetric effects on consumption spending. Department store sales (durable consumption) react negatively to the expectation of falling prices, but grocery store sales (non-durable consumption) do not react to expected price changes.
AUTHORS: Davis, J. Scott
Pegging the exchange rate to gain monetary policy credibility
Central banks that lack credibility often tie their exchange rate to that of a more credible partner in order to ?import? credibility. We show in a small open economy model that a central bank that displays ?limited credibility? can deliver significant improvements to a social welfare function that contains no role for exchange rate stabilization by maximizing an objective function that places weight on exchange rate stabilization, and thus the central bank with limited credibility will peg their currency to that of a more credible partner. As the central bank?s credibility improves it will place less weight on exchange rate stabilization in its objective function and thus loosen the peg. When the central bank is perfectly credible its objective function and the social welfare function are identical; it places no weight on exchange rate stabilization and allows the currency to freely float. Empirical results using a panel of both developed and developing countries show that as central banks become more independent they tend to allow more currency flexibility.
AUTHORS: Davis, J. Scott; Fujiwara, Ippei
Global Drivers of Gross and Net Capital Flows
While prior to the global financial crisis, the empirical international capital flow literature has focused on net capital flows (the current account), since the crisis there has been an increased focus on gross flows. In this paper we jointly analyze global drivers of gross flows (outflows plus inflows) and net flows (outflows minus inflows) by estimating a latent factor model. We find evidence of two global factors, which we call the GFC (global financial cycle) factor and a commodity price factor as they closely track respectively the Miranda-Agrippino and Rey asset price factor and an average of oil and gas prices. These factors together account for half the variance of gross flows in advanced countries and forty percent of the variance of gross flows in emerging markets. But remarkably, they also account for forty percent of the variance of net capital flows in both groups of countries. We also analyze the heterogeneity across countries in the impact of the two factors. One of the key findings is that the impact of the GFC factor on both gross and net capital flows is stronger in countries that have larger net debt liabilities. Other asset classes (FDI and portfolio equity) do not significantly impact the exposure to the GFC factor.
AUTHORS: Valente, Giorgio; Van Wincoop, Eric; Davis, J. Scott