Jeffrey A. Frankel

Currency crashes in emerging markets: an empirical treatment

We use a panel of annual data for over 100 developing countries from 1971 through 1992 to characterize currency crashes. We define a currency crash as a large change of the nominal exchange rate that is also a substantial increase in the rate of change of nominal depreciation. We examine the composition of the debt as well as its level, and a variety of other macroeconomic factors, external and foreign. Crashes tend to occur when: output growth is low; the growth of domestic credit is high; and the level of foreign interest rates are high. A low ratio of FDI to debt is consistently associated with a high likelihood of a crash.

An Estimate of the Effect of Common Currencies on Trade and Income

Gravity-based cross-sectional evidence indicates that currency unions and currency boards stimulate trade; cross-sectional evidence indicates that trade stimulates income. This paper estimates the effect that common-currency regimes have, via trade, on income per capita. We use economic and geographic data for over 200 countries to quantify the implications of common currencies for trade and income, pursuing a two-stage approach. Our estimates at the first stage suggest that belonging to a currency union more than triples trade with the other members of the zone. Moreover, there is no evidence of trade-diversion. Thus currency unions raise overall trade. Currency boards have similar effects. Our estimates at the second stage suggest that every one percent increase in trade (relative to GDP) raises income per capita by at least one third of a percent over twenty years. We combine the two estimates to quantify the effect of common currencies on output. Our results support the hypothesis that the beneficial effects of such regimes on economic performance come through the promotion of trade, rather than through a commitment to non-inflationary monetary policy, or other macroeconomic influences.

A Panel Project on Purchasing Power Parity: Mean Reversion within and between Countries

Previous time-series studies have shown evidence of mean-reversion in real exchange rates. Deviations from purchasing power parity (PPP) appear to have half-lives of approximately four years. However, the long samples required for statistical significance are unavailable for most currencies, and are potentially inappropriate because of regime changes. In this study, we re-examine deviations from PPP using a panel of 150 countries and 45 annual post WWII observations. Our panel shows strong evidence of mean-reversion that is similar to that from long time-series. PPP deviations are eroded at a rate of approximately 15 percent annually, i.e.,

Trading blocs and the Americas: The natural, the unnatural, and the super-natural

Abstract Is world trade becoming more regionalized, as a result of preferential arrangements such as NAFTA, the Andean Pact and MERCOSUR? If so, is this deviation from the principle of MFN (non-discriminatory trade policies) good or bad? This paper attempts to answer both questions. Using the gravity model to examine bilateral trade patterns throughout the world, we find evidence of trading blocs in the Western Hemisphere and elsewhere, as in earlier work. Intra-regional trade is greater than could be explained by natural determinants: the proximity of a pair of countries, their sizes and GNP/capitas, and whether they share a common border or a common language. Within the Western Hemisphere, MERCOSUR and the Andean Pact countries appear to function as significantly independent trading areas, but NAFTA much less so (as of 1990). The intra-regional trade bias within MERCOSUR increased the most rapidly during the 1980s. In East Asia, on the other hand, increased intra-regional trade can be explained entirely by the rapid growth of the economies. We then turn from the econometrics to an analysis of economic welfare. Krugman has supplied an argument against a world of three trading blocs (that they would be protectionist), in a model that assumes no transport costs. He has supplied another argument in favor of trading blocs, provided the blocs are drawn along ‘natural’ geographic lines, in a model that assumes prohibitively high transportation costs between continents. In this paper we attempt to resolve the Krugman vs. Krugman debate. We complete the model of the welfare implications of trading blocs for the realistic case where inter-continental transport costs are neither so high as to be prohibitive nor zero. We consider three applications of the model. 1. Continental Free Trade Areas (FTAs). We show that it is not only Krugmans ‘unnatural’ FTAs that can leave everyone worse off than under MFN, but that under conditions of relatively low inter-continental transport costs, FTAs that are formed along natural continental lines can do so as well. We call such welfare-reducing blocs super-natural . 2. Partial regionalization. We find that partial liberalization within a regional Preferential Trading Arrangement (PTA) is better than 100 percent liberalization. In the super-natural zone the regional trading arrangement, in contrast to the Article 24 provision of the GATT, reduces welfare. It occurs for combinations of low inter-continental transport costs and high intra-bloc preferences, i.e., when the regionalization of trade policy exceeds what is justified by natural factors. 3. The formation of several sub-regional PTAs on each continent. We find that multiple FTAs on each continent could lower welfare, but that multiple PTAs, with partial internal liberalization, would raise welfare. We conclude the paper with an attempt to extract estimates of transportation costs from the statistics. Estimates suggest that trading blocs on the order of the EC are in fact super-natural.

Forward Discount Bias: Is it an Exchange Risk Premium?

A common finding is that the forward discount is a biased predictor of future exchange rate changes. We use survey data on exchange rate expectations to decompose the bias into portions attributable to the risk premium and expectational errors. None of the bias in our sample reflects the risk premium. We also reject the claim that the risk premium is more variable than expected depreciation. Investors would do better if they reduced fractionally the magnitude of expected depreciation. This is the same result that many authors have found with forward market data, but now it cannot be attributed to risk.

Empirical research on nominal exchange rates

Publisher Summary This chapter presents a critical survey and an interpretation of recent exchange rate research. It focuses on empirical results for exchange rates among major industrialized countries. The expectations of future exchange rate changes are a key determinant of asset demands, and therefore of the current exchange rate. The expectations variable is relatively straightforward in the conventional monetary models; in theoretical terms , it is determined by the rational expectations assumption, while in empirical terms, it is typically measured by the forward discount or interest differential. The standard empirical implementation of rational expectations methodology infers ex ante expectations of investors from ex post changes in the exchange rate. Unexpected changes in monetary policy frequently cause movements in the exchange rate in the direction hypothesized by the sticky-price monetary model. The chapter presents a survey of the work on exchange rate determination in floating rate regimes. It considers evidence across exchange rate regimes and examines the issue of speculative bubbles. It also reviews some relatively new directions in exchange rate research that focus on the micro-structure of foreign exchange markets.

Is EMU more justifiable ex post than ex ante

Abstract Yes. A countrys suitability for EMU entry depends on the intensity of trade with EMU members, and the extent to which its business cycles are correlated with those of other members. But both international trade patterns and international business cycle correlations are endogenous. Theoretically, economic integration has an ambiguous effect on the degree to which business cycles are correlated across countries. Empirically though, countries with closer trade links tend to have more tightly correlated business cycles. It follows that countries are more likely to satisfy the criteria for entry into a currency union after taking steps toward economic integration than before.

MONETARY AND PORTFOLIO-BALANCE MODELS OF EXCHANGE RATE DETERMINATION

Abstract “Monetary and Portfolio-Balance Models of Exchange Rate Determination” was a survey of empirical models of the 1970s, published in Economic Interdependence and Flexible Exchange Rates , edited by J. Bhandari (M.I.T. Press: Cambridge), in 1983. It is here supplemented with a brief epilogue to update the literature to 1987, including some skeptical observations on recent claims that “random walk” results constitute evidence in favor of an “equilibrium” model of the exchange rate.

Expectations and Commodity Price Dynamics: The Overshooting Model

Monetary policy has important effects on agricultural commodity prices because, though they are flexible, other goods prices are sticky. This paper formalizes the argument by applying the Dornbusch overshooting model. A decline in the nominal money supply is a decline in the real money supply in the short run. It raises the real interest rate, which depresses real commodity prices. They overshoot their new equilibrium in order to generate an expectation of future appreciation sufficient to offset the higher interest rate. These real effects (which vanish in the long run) also result from a decline in the money growth rate.

Why interest rates react to money announcements: An explanation from the foreign exchange market☆

Abstract When the Fed announces a money supply greater than had been expected, interest rates rise. Why? One explanation is that the market raises its estimate of the future rates of money growth and inflation, and bids up nominal interest rates. We offer contrary evidence: on such days the dollar appreciates, not depreciates. An alternative explanation is that the market perceives the change in the money stock as a transitory fluctuation that the Fed will reverse in the future. The anticipated future tightening raises todays real interest rate, causes a capital inflow, and appreciates the dollar, the result in fact observed.