Nancy Peregrim Marion

Volatility and Investment: Interpreting Evidence from Developing Countries

The authors uncover a significant negative correlation between various volatility measures and private investment in developing countries, even when adding the standard control variables. No such correlation is uncovered when the investment measure is the sum of private and public investment spending. Indeed, public investment spending is positively correlated with some measures of volatility. These findings suggest that the detrimental impact of volatility on investment may be easier to detect using disaggregated data. The authors provide several possible interpretations for their findings. Nonlinearities in preferences or budget constraints can cause volatility to have first-order negative effects on private investment. Copyright 1999 by The London School of Economics and Political Science

International Reserve Holdings with Sovereign Risk and Costly Tax Collection

We derive a precautionary demand for international reserves in the presence of sovereign risk and show that political-economy considerations modify the optimal level of reserve holdings. A greater chance of opportunistic behavior by future policy makers and political corruption reduce the demand for international reserves and increase external borrowing. We provide evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-to-reserves ratio is a symptom of opportunistic behavior, a policy recommendation to increase international reserve holdings may be welfare-reducing.

Explaining the duration of exchange-rate pegs

This paper is a theoretical and empirical investigation into the duration of exchange-rate pegs. The theoretical model considers a policy-maker who must trade off the economic costs of real exchange- rate misalignment against the political cost of realignment. The optimal time to spend on a peg is derived and factors that influence peg duration are identified. The predictions of the model are tested using logit analysis with a data set of exchange-rate pegs for sixteen Latin American countries and Jamaica during the 1957-1991 period. We find that the real exchange rate is a significant determinant of the likelihood of a devaluation. Structural variables, such as the openness of the economy and its geographical trade concentration, also significantly affect the likelihood of a devaluation. Finally, political events that change the political cost of realignment, such as regular and irregular executive transfers, are empirically important determinants of the likelihood of a devaluation.

Macroeconomic uncertainty and private investment

Abstract This paper provides empirical support for a link between macroeconomic uncertainty and private investment in developing countries. Cross-section regressions with constructed measures of uncertainty confirm that for developing countries uncertainty is negatively correlated with private investment.

Insulation Properties of a Two-Tier Exchange Market in a Portfolio Balance Model

When countries peg their currencies to those of their major trading partners, they expose themselves to interest-sensitive and speculative capital flows that can undermine their ability both to maintain their exchange rate and to pursue an independent monetary policy. Some countries, notably France, Italy and the Belgo-Luxembourg Economic Union (BLEU), experimented with two-tier exchange rates in the early 1970s in the hopes of insulating their economies from the effects of international capital flows while at the same time protecting foreign trade from exchange rate fluctuations. France and Italy soon abandoned the experiment, but the BLEU continues to maintain separate exchange markets, with separate exchange rates, for current and capital account transactions. The commercial exchange rate, which relates to the market for current account transactions, is generally pegged by the authorities; the financial exchange rate, determined in the market for capital account transactions, is usually free to fluctuate. 1 This paper investigates how well a two-tier exchange market insulates a small open economy from foreign disturbances, taking into account recent developments in the theory of exchange rate determination. Work by Branson (1977), Dornbusch (1976), and Kouri (1976) suggests that the short-run equilibrium value of the exchange rate is determined, along with interest rates, by demand and supply in the markets for financial assets. This asset market-or portfolio balance-approach to exchange rate determination is particularly well suited to a study of the two-tier exchange market. One can view the financial exchange rate as a relative asset price. It is among the variables that equilibrate asset markets, and it is determined in the short run in those asset markets. Previous theoretical work on the two-tier exchange market has generally been within the Mundellian framework; the financial exchange rate has been treated as equating a flow demand and supply of foreign exchange. The asset market approach has the advantage of carefully distinguishing between stocks and flows. In particular, it treats demands for assets as stock demands that are realized instantaneously so that actual holdings of assets always reflect the desired composition of the portfolio. Disturbances to portfolio equilibrium create immediate stock adjustments as portfolios are rebalanced, causing instantaneous changes in endogenous market-clearing variables. In addition, disturbances alter the rate of accumulation (the flow) of financial assets over time. Portfolio balance models of two-tier exchange rates can be found in Dornbusch (1976) and Decaluwe and Steinherr (1976), but they differ from the one presented here. Dornbusch partitioned the exchange market so that interest income, a current account transaction, was channelled through the financial market. That segmentation yields a different expected rate of return on foreign

Nontraded goods, oil price increases and the current account

Abstract An intertemporal maximizing model is used to examine the current-account response to oil price increases. The analysis shows that the introduction of a nontraded goods sector influences the current-account response. Whether the current account worsens or improves depends crucially on relative production technologies in the traded and nontraded goods sectors.

International Risk Sharing During the Globalization Era

Though theory suggests financial globalization should improve international risk sharing, empirical support has been limited. We develop a simple welfare-based measure that captures how far countries are from the ideal of perfect risk sharing. We then take it to data and find international risk sharing has, indeed, improved during globalization. Improved risk sharing comes mostly from the convergence in rates of consumption growth among countries rather than from synchronization of consumption at the business cycle frequency. Our finding explains why many existing measures fail to detect improved risk sharing-they focus only on risk sharing at the business cycle frequency.

Exchange-rate regimes in transition: Italy 1974*

In order to explain the behavior of the lira during the operation of the Italian two-tier exchange market in 1973–74, we develop a model of exchange-rate regimes in transition. On the assumption that the market will set exchange rates so as to eliminate speculative profits at the time of transition, the model indicates that expectations of a transition, combined with uncertainty about the nature of the post-transition regime, can cause a jump in exchange rates at the moment of transition as well as volatile exchange-rate movements prior to the transition. The model suggests that the perceived temporariness of an exchange-rate regime should be treated as a market fundamental.

The size and timing of devaluations in capital-controlled economies

Abstract In this paper, we consider a policymaker in a stochastic environment who pegs the nominal exchange rate and adjusts the peg periodically so as to minimize the flow cost of real exchange-rate misalignment and the fixed cost of peg readjustment. Characterizing the real exchange rate as regulated Brownian motion permits the policymakers problem to be solved for the optimal size and timing of devaluations. Using cross-sectional data on 80 peg episodes from seventeen Latin American countries over the 1957–1990 period, we find empirical support for the models main predictions.

Policy Implications of "Second-Generation" Crisis Models

After the speculative attacks on government-controlled exchange rates in Europe and in Mexico, economists began to develop models of currency crises with multiple solutions. In these models, a currency crisis occurs when the economy jumps suddenly from one solution to another. This paper examines one of the new models, as presented by Obstfeld (1994), and finds that raising the cost of devaluation may make a crisis more likely. Consequently, slow convergence to a monetary union, which increases the cost to the government of reneging on an exchange rate peg, may be counterproductive. This conclusion is exactly the opposite of that obtained from earlier models.