Publications
Capital Controls and Trade Policy (with Simon Lloyd) [Draft]
Journal of International Economics, Vol 151, 2024
How does the conduct of optimal cross-border financial policy change with prevailing trade agreements? We study the joint optimal determination of trade policy and capital- flow management in a two-country, two-good model with trade in goods and assets. While the cooperative optimal allocation is efficient, a country-planner can achieve higher domestic welfare by departing from free trade in addition to levying capital controls, absent retaliation from abroad. However, time variation in the optimal tariff induces households to over- or under-borrow through its effects on the path of the real exchange rate. As a result, optimal capital controls can be larger when used in conjunction with optimal tariffs in specific cases; and in others, the optimal trade tariff partly substitutes for the use of capital controls. Accounting for strategic retaliation, we show that committing to a free-trade agreement can reduce incentives to engage in costly capital-control wars for both countries.
Working Papers:
U.S. Risk and Treasury Convenience (with Giancarlo Corsetti, Simon Lloyd, and Daniel Ostry) [Draft]
We document that, over the past two decades, investors' assessment of U.S. risk has risen relative to other G.7 economies, driven by higher permanent risk, but this is not reflected in currency returns. We develop a two-country framework with trade in a rich maturity structure of bonds, which earn convenience yields, alongside risky assets and currencies.The theory establishes an equilibrium relationship between \textit{cross-border} convenience yields, relative country risk and carry-trade returns. Consistent with this, we identify a cointegrating relationship between relative permanent risk and cross-border convenience yields on long-maturity bonds. We conduct two counterfactual experiments and estimate that increases in relative permanent risk explain about 25\% and 30\%, of the decline in long-maturity convenience yields over the periods 2002-2006 and 2010-2014, respectively.
Incomplete Markets and Exchange Rates (with Sanjay Singh) [Draft]
We show that allowing for imperfect risk-sharing within countries can reconcile the cyclicality of exchange rates with respect to aggregate consumption, i.e. the Backus-Smith puzzle, as long as exchange rates are risky with respect to idiosyncratic states. Using a tractable two-country, consumption-based asset pricing model, in equilibrium, idiosyncratic risk must remain relatively high in the country experiencing higher consumption growth. Furthermore, we identify distinct roles for market incompleteness both within and across countries, to match key moments of exchange rates. Turning to household level data, we measure discount factor wedges which capture the effects of imperfect risk sharing and we find direct empirical support for the mechanism.
Exchange Rate Risk and Business Cycles (with Simon Lloyd) [Draft] R&R Journal of International Economics
We show that currencies with a steeper yield curve tend to depreciate at business-cycle horizons. We identify a tent-shaped relationship between the exchange-rate risk premium and the relative yield curve slope across horizons that peaks at 3 to 5 years. This empirical regularity is robust to a number of controls, including return differentials and bond liquidity yields. Within a no-arbitrage framework, we demonstrate that exchange-rate risk premia reflect investors’ changing valuations of returns over the business cycle. Risks driving exchange rates must therefore be transitory and cyclical, indicative of ‘business-cycle risk’. We calibrate a two-country, two-factor model for the term structure of interest rates to reflect business-cycle risk. We show that it can quantitatively reproduce the tent-shaped relationship we observe in the data, as well as variation in uncovered interest parity regression coefficients across horizons.
The Hegemon's Dilemma [Draft]
By keeping dollars scarce in international markets, the supplier of dollar debt– the hegemon –earns monopoly rents when borrowing. However a strong dollar depresses global demand for its exports and leads to losses on holdings of foreign assets. Using an open economy model with nominal rigidities and segmented financial markets, I show that transfer of monopoly rents from abroad gives rise to a policy dilemma because of private sector over-borrowing. Monetary and fiscal policy in the hegemon cannot support a constrained-efficient allocation, absent a corrective (macro-prudential) tax on borrowing. By increasing liquidity in international markets, dollar swap lines help stabilize the economy, but, unlike the macro-prudential tax, do so at the cost of eroding monopoly rents. Extending the model to allow for a measure of households not participating in financial markets unveils that the policy dilemma maps into distributional concerns. A scarce dollar leads to larger monopoly rents benefiting financially active households, but they over-borrow at the expense of inactive households, who suffer the full blunt of the aggregate demand externality.
A century of arbitrage and disaster risk pricing in the foreign exchange market (with Giancarlo Corsetti) [CEPR Working Paper]
The failure of uncovered interest parity (UIP) is a long-standing puzzle in international finance. But, following the Great Financial Crisis (GFC), the puzzle has changed and UIP cannot be rejected in the recent period. In this paper, we use a century-long time series for the GBP-USD exchange rate to show that the apparently puzzling switch in UIP coefficients since the GFC is not a new phenomenon following large global crises. First, by virtue of our long sample, we document that UIP switches at short horizons systematically occur around global disasters. However, UIP deviations remain small to almost negligible for long-horizon investment portfolios. Second, we argue that our century-long evidence is consistent with models featuring a time-varying probability of disasters. Specifying a model to account for the difference in UIP deviations in crises and normal times, as well as for a decreasing term structure of carry trade returns that on average characterize the data, we show that it can rationalise key empirical facts.
Book chapters and blogs:
The dollar and international capital flows in the COVID-19 crisis (with Giancarlo Corsetti) [VOX EU]
Emerging markeet currency risk around 'global disasters': Evidence from the Global Financial Crisis and the COVID-19 crisis (with Giancarlo Corsetti and Simon Lloyd) [COVID-19 in Developing Economies, CEPR ebook]
Other:
Country Solidarity and Self-Fulfilling Crises [ADEMU Working Paper (2018)]