Essays on net foreign assets and exchange rates

Field: Economics, Econometrics and Finance (Social Sciences)

As the world becomes more integrated in terms of both trade and finance, there is an enormous number of questions that academics and policymakers are eager to find the answers to. In this thesis, we focus on the issues related to net foreign assets and exchange rates. First, we conduct an empirical analysis to investigate the impacts of net foreign asset accumulation on macroeconomic variables. Second, we examine the out-of-sample predictability in emerging economies using Taylor rule fundamentals. Lastly, we simulate an alternative exchange rate policy in a small open economy to study the change in the stablizing effect on the economy. The results are summarized below. Chapter 1 analyses the co-movements of net foreign asset accumulation, consumption, real exchange rate, and real interest rate in a cross section of countries. Our sample covers both industrial and developing economies, spanning 1981-2010 period. We find that the accumulation of net foreign assets is associated with increasing consumption and real exchange rate appreciation. In a cross section of countries, when a country increases its net foreign assets to GDP ratio by a one-standard deviation, consumption to GDP increases by .02% per year and real exchange rate appreciates by 2% per year. Consumption to GDP responds more positively to net foreign asset accumulation in G7 countries, +0.1 to +0.2% per year, while the response is smaller and negative in developing countries reporting a -0.02% per year. The real exchange rate appreciation, however, is about +3% per year in developing countries and only about +0.2% per year in OECD countries. Chapter 2 investigates the out-of-sample predictability of exchange rate using Taylor rule fundamentals. Conventional empirical models of exchange rate determination based on open-economy macroeconomic theory fail to yield convincing evidence of out-of-sample exchange rate predictability. A recent strand in the empirical literature uses Taylor rules to model exchange rate determination. We use the empirical methodologies used by Molodtsova and Papell (2009) to investigate the out-of-sample predictability of exchange rate using Taylor rule fundamentals in 13 developing countries with inflation targeting monetary policy regimes. We find some evidence of out-of-sample exchange rate predictability using the Taylor rules for Brazil, Czech Republic, Philippines, Thailand and South Africa but not for Chile, Israel, Korea and Peru.In Chapter 3, we estimate a dynamic stochastic general equilibrium (DSGE) model of a small open economy to assess an alternative exchange rate rule that is augmented by a wage inflation term. Imported inflation is an important concern in highly trade-dependent economies. Managed floating exchange rate regime helps in stabilizing prices of imports but it is not targeted to stabilize wages. From the DSGE model we estimate, we find that (i) the additional target in exchange rate policy is effective in reducing the volatilies of most macroeconomic variables, (ii) the trade-off is that inflation volatility will be reduced at the expense of higher GDP gap volatility, (iii) more flexible wage policy combined with wage inflation targeting exchange rate rule could stabilize prices better.