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Forward Guidance and the Exchange Rate
Jordi Galí
CREI, UPF, Barcelona GSE
May 2017
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 1 / 18
Introduction
ZLB ⇒ need for unconventional monetary policies
"Forward guidance"
Optimal policy under the ZLB: high effectiveness of forward guidance(Eggertson-Woodford,..)
The forward guidance puzzle (Del Negro et al., McKay et al.)
yt = Et{yt+1} −1σ
Et {it −Et{πt+1}}
⇒ yt = −1σ
∞∑k=0
Et {it+k − πt+1+k}
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 2 / 18
Present Paper
Forward guidance in the open economy
Role of the exchange rate in the transmission of forward guidance:
(i) theory: partial and general equilibrium(ii) empirical evidence
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 3 / 18
Forward Guidance and the Exchange Rate
Pricing of domestic and foreign bonds
1 = (1+ it)Et{Λt,t+1(Pt/Pt+1)}
1 = (1+ i∗t )Et{Λt,t+1(Et+1/Et)(Pt/Pt+1)}
Up to a first-order approximation:
it = i∗t +Et{∆et+1}
Letting qt ≡ p∗t + et − pt and rt ≡ it −Et{πt+1} :
qt = r∗t − rt +Et{qt+1}
⇒ qt =∞∑k=0
Et{r∗t+k − rt+k}+ limT→∞
Et{qt+T }
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 4 / 18
FG and the Exchange Rate: Partial Equilibrium
Assumption: small open economy, constant prices
Experiment: Announcement at time t
it+k = δ
for k = T ,T + 1, ...,T +D − 1
Real exchange rate response at t:
qt = −Dδ
⇒ invariance to implementation horizon (T )
Adjustment over time (fig.)
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 5 / 18
-4 -2 0 2 4 6 8 10 12
-1
-0.5
0
0.5
1
interest rate
exchange rate
Forward Guidance and the Exchange Rate: Partial Equilibrium
FG and the Exchange Rate: General Equilibrium
A small open economy NK model (Galí-Monacelli):
yt = (1− υ)ct + ϑqt
ct = Et{ct+1} −1σ(it −Et{πt+1})
ct =1σqt
πH ,t = βEt{πH ,t+1}+ κyt −ωqt
it = φππH ,t
πH ,t ≡ pH ,t − pH ,t−1 ; πt ≡ pt − pt−1qt ≡ et − pt ; pt = (1− υ)pH ,t + υet
⇒ qt = −(it −Et{πt+1}) +Et{qt+1}Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 6 / 18
FG and the Exchange Rate: General Equilibrium
Announcement at time t:
(i) it+k = 0 for k = 0, 1, ...,T − 1(ii) it+k = δ for k = T ,T + 1, ...,T +D − 1(iii) it+k = φππH ,t+k for k = T +D,T +D + 1, ...
Calibration
(i) preferences: β = 0.99, υ = 0.4, σ = 1, η = 2, ϕ = 5(ii) price stickiness: θ = 0.75
Dynamic responses: the role of the horizon
Dynamic responses: the role of duration
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 7 / 18
Forward Guidance in the Open Economy: The Role of the Horizon
0 2 4 6 8
real exchange rate
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domestic inflation
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output
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cpi inflation
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nominal interest rate
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1 T=1
T=2
T=4
Forward Guidance in the Open Economy: The Role of Duration
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real exchange rate
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FG and the Exchange Rate: Empirical Evidence
Decomposition (for any M > 0).
qt =∞∑k=0
Et{r∗t+k − rt+k}+ limT→∞
Et{qt+T }
= qSt (M) + qLt (M) + lim
T→∞Et{qt+T }
where
qSt (M) ≡M−1∑k=0
Et{r∗t+k − rt+k}
qLt (M) ≡∞∑k=M
Et{r∗t+k − rt+k}
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 8 / 18
FG and the Exchange Rate: Empirical Evidence
Yield on an M-period bond (expectations hypothesis):
rt(M) =JM
M−1∑k=0
Et{rt+k}
r∗t (M) =JM
M−1∑k=0
Et{r∗t+k}
⇒ qSt (M) =MJ[r∗t (M)− rt(M)]
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 9 / 18
FG and the Exchange Rate: Empirical Evidence
Assumption #1 :∞∑
k=MLEt{r∗t+k − rt+k} ' 0 for "large" ML:
qLt (M) 'ML−1
∑k=M
Et{r∗t+k − rt+k}
= qSt (ML)− qSt (M)
Assumption #2:
limT→∞
Et{qt+T } ' α0 + α1t + ...+ αqtq
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 10 / 18
FG and the Exchange Rate: Empirical Evidence
Data
- monthly, 2004:1-2016:12- euro-dollar real exchange rate- German and U.S. government bond yields with 2, 5, 10 and 30 yearmaturity- market-based inflation forecasts for 2, 5, 10 and 30 year horizons.
Estimated equation:
qt = α0 + α1t + α2t2 + γSqSt (M) + γLq
Lt (M) + εt
for M ∈ {24, 60, 120} and ML = 360Theoretical prediction:
H0 : γS = γL = 1
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 11 / 18
q fitted q
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016-30
-20
-10
0
10
20
30
qhat fitted qhat
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016-15
-10
-5
0
5
10
15
20
qhat fitted qhat S fitted qhat L
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016-15
-10
-5
0
5
10
15
20
Expected Real Interest Rate Differentials and the Real Exchange Rate (M=24)
FG and the Exchange Rate: Empirical Evidence
Data- monthly, 2004:1-2016:12- euro-dollar real exchange rate- German and U.S. government bond yields with 2, 5, 10 and 30 yearmaturity- market-based inflation forecasts for 2, 5, 10 and 30 year horizons.Estimated equation:
qt = α0 + α1t + α2t2 + γSqSt (M) + γLq
Lt (M) + εt
for M ∈ {24, 60, 120} and ML = 360Theoretical prediction:
H0 : γS = γL = 1
Robustness: First-difference specification
∆qt = α+ γS∆qSt (M) + γL∆qLt (M) + ξtJordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 12 / 18
Possible Explanations?
Proposed solutions for the closed economy FG puzzle
1 Finite lives (Del Negro et al.)2 Idiosyncratic labor income risk + borrowing constraints (McKay etal.)
3 Lack of common knowledge (Angeletos-Lian)4 "Behavioral discounting" (Gabaix)
⇒ yt = αEt{yt+1} −1σ(it −Et{πt+1})
(1) and (2) do not apply to exchange rate equation
(3) and (4) cannot account for overreaction to near-termexpectations
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 13 / 18
Possible Explanations?
Time-varying foreign exchange risk premium?
zt ≡ r∗t − rt +Et{∆qt+1}
qt =∞∑k=0
Et{r∗t+k − rt+k}+ ut
= qSt (M) + qLt (M) + ut
where ut ≡ −∞∑k=0
Et{zt+k}.
Independent evidence: cov(r∗t − rt , ut) > 0 (Engel 2016) ⇒ upwardbias of OLS estimates of γ in:
qt = γqSt (ML) + ut
qt − qSt (M) = γqLt (M) + utBut γ� 1 in the data!
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 18 / 18
Concluding comments
Effectiveness of forward guidance policies in open economies;exchange rate role.
Partial equilibrium: invariance to implementation horizon
General equilibrium: stronger effects the more distant theimplementation horizon
Empirical evidence: expectations of interest rate differentials in thenear (distant) future have much larger (smaller) effects thanpredicted by the theory
⇒ a forward guidance exchange rate puzzle?
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 14 / 18
FG and the Exchange Rate: General Equilibrium
Dynamic responses: the role of openness
πH ,t = βEt{πH ,t+1}+ κvyt
yt = Et{yt+1} −1
συ(it −Et{πH ,t+1})
qt = συ(1− υ)yt
where συ ≡ σ1+(ση−1)υ(2−υ)
and κv ≡ λ (συ + ϕ).
Benchmark case: ση = 1 ⇒ (πH ,t , yt) invariant to openness
Baseline calibration: ση > 1 ⇒ ∂συ∂υ < 0
⇒ constant prices: enhanced impact of forwardguidance
⇒ variable prices: ambiguous impactJordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 15 / 18
FG and the Exchange Rate: Empirical Evidence
Baseline real exchange equation
qt = qSt (M) + qLt (M) + lim
T→∞Et{qt+T }
First-Difference specification
∆qt = ∆qSt (M) + ∆qLt (M) + ξt
where ξt ≡ limT→∞(Et{qt+T } −Et−1{qt+T }).Estimated equation:
∆qt = α+ γS∆qSt (M) + γL∆qLt (M) + ξt
for M ∈ {24, 60, 120} and ML = 360Theoretical prediction:
H0 : γS = γL = 1
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 16 / 18
FG and the Exchange Rate: Empirical Evidence
First-Difference specification
∆qt = ∆qSt (M) + ∆qLt (M) + ξt
where ξt ≡ limT→∞(Et{qt+T } −Et−1{qt+T }).Estimated equation:
∆qt = α+ γS∆qSt (M) + γL∆qLt (M) + ξt
for M ∈ {24, 60, 120} and ML = 360Theoretical prediction:
H0 : γS = γL = 1
Potential endogeneity⇒ IV estimation using lags of ∆qt and qSt (M)
Jordi Galí (CREI, UPF, Barcelona GSE) Forward Guidance and the Exchange Rate May 2017 17 / 18
0 2 4 6 8
real exchange rate
-2
-1.5
-1
-0.5
0
0.5
0 2 4 6 8
domestic inflation
-20
-15
-10
-5
0
5
0 2 4 6 8
output
-6
-4
-2
0
0 2 4 6 8
nominal exchange rate
-10
-8
-6
-4
0 2 4 6 8
cpi inflation
-30
-20
-10
0
0 2 4 6 8
nominal interest rate
0
0.5
1 =0.2
=0.4
=0.6
Forward Guidance in the Open Economy: The Role of Openness