Academic journal article Journal of Money, Credit & Banking

Price Stability with Imperfect Financial Integration

Academic journal article Journal of Money, Credit & Banking

Price Stability with Imperfect Financial Integration

Article excerpt

THE LAST 15 years have recorded sizable and unprecedented current account deficits run by the United States accompanied by a gradual deterioration of the U.S. net international investment position that reached -22% of GDP in the year 2005 and has improved to -17% in 2007. Almost three-quarters of the world's surpluses are absorbed by the U.S. deficit. As documented by Lane and Milesi-Ferretti (2002), these developments have been paralleled by an increase in international financial diversification through instruments of different risk and liquidity characteristics. For the United States both assets and liabilities have increased up to 128% and 145% of GDP. These developments are usually welcomed for the gains that arise because of more integrated financial markets. Still, net negative positions in the international markets matter and global imbalances might have important negative macroeconomic consequences.

This paper studies whether the international monetary system can be affected by the presence of large asymmetries in the positions in international financial markets, i.e., the fact that some countries are large debtors while others are creditors. An important channel that will be explored is the interaction between international risk sharing and the stabilization role of monetary policy. In an important paper Obstfeld and Rogoff (2002) have shown that in a distorted economy with lack of full international risk-sharing self-oriented policies that achieve price stability in each country can replicate the cooperative outcome. The spillovers that monetary policymakers have on the risk-sharing margin are of second-order importance. This paper readdresses this issue in a two-country dynamic model that solves for the optimal cooperative monetary policy when countries have nonzero, but specular, positions in the international financial markets.

The understanding of whether there should be deviations from a policy of price stability at the international level goes parallel with the analysis of the costs of market incompleteness. The main finding is that the welfare costs of incomplete markets are increasing with the cross-country asymmetries in the initial net international positions and in particular they become nonnegligible when the persistence of the shocks increases. In the baseline scenario they are smaller than 0.20% of a permanent increase in steady-state consumption and they increase up to 1% with the persistence of the shocks. In these cases there are also important gains of deviating from a policy of price stability, above 0.2%.

Whereas optimal monetary policy requires a modest increase in the volatility of the producer-price inflation rates, the important adjustment should come through an increase in the volatility of real returns on assets traded. This is mostly reflected in an increase in the volatility of the nominal interest rates in both countries. Indeed, appropriate movements in the asset returns and so valuation effects can correct asymmetries in the business cycle synchronization improving risk sharing. Moreover, optimal monetary policy--in the calibrated example--requires more synchronization of the cross-country nominal interest rates when global imbalances increase. Instead, a policy of price stability commands a mildly positive correlation which is independent of the size of the global imbalances.

The welfare costs of incomplete markets and the optimal monetary policy regime are analyzed using a linear-quadratic solution method in a two-country model in which two bonds, issued in different currencies, are traded. Benigno and Woodford (2006) have shown that linear-quadratic solution methods are appropriate, as a first-order approximation of the optimal solution, for a general class of models. One important exception is the case in which the zero-order approximation is indeterminate, which turns out to be the relevant case for portfolio shares when portfolio choices are considered. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.