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Exchange Rates, Capital Controls and the Hegemon's Dilemma



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Marin, Emile 


In this thesis, I study the interplay between exchange rate dynamics and capital flows in the international macroeconomy, and I consider the optimal policy response for economies that are large in goods and financial markets. I focus on features characterising the modern International Monetary System: the predictability and excess volatility of exchange rates, large and volatile capital and trade flows, and the search for safe (particularly dollar) assets by foreign investors. Chapter 1 provides a brief introduction of the topics studied and methodologies used, high- lighting why the questions I tackle are relevant. Chapter 2, which is co-authored with Simon Lloyd and is entitled Exchange Rate Risk and Business Cycles, presents an empirical study of exchange rate dynamics and, using a simple asset-pricing framework, it links them to business cycle risk and cross-country liquidity yields. We show that currencies with a steeper yield curve depreciate at business-cycle horizons. We identify a tent-shaped relationship between exchange- rate risk premia (ERRP) and the relative yield curve slope across horizons that peaks at 3-5 years and is robust to a number of controls, including liquidity yields. Within the asset-pricing framework, ERRP reflect investors’ changing return valuations over the business cycle. We then calibrate a two-country, two- factor model of interest rates, where exchange rates are driven by business-cycle —transitory and cyclical—risk. The model quantitatively reproduces the tent- shaped relationship, as well as variation in uncovered interest parity coefficients across horizons. In chapter 3 entitled Capital Controls and Free Trade Agreements, also co-authored with Simon Lloyd, we study the joint optimal determination of trade tariffs and capital controls in a two- country, two-good model with trade in both goods and assets. Policy is driven by the incentive to manipulate the terms of trade both across goods and over time. When tariffs are ruled out by a free-trade agreement (FTA), capital controls are chosen to trade-off the two margins. Absent a FTA, the planner achieves weakly higher welfare by additionally employing tariffs on goods. However, time-varying tariffs have second-best effects on the cost of borrowing, so the size of optimal capital controls depends on trade policy. Specifically, in response to fluctuations in the endowment of goods consumed with home bias, capital controls are larger when the optimal tariff is in place. In contrast, faced with fluctuations in the endowment of the second good, the optimal time-varying tariff partly substitutes for the use of capital controls, so capital controls are smaller. Our results extend to a Nash equilibrium where countries engage in both capital-control and trade wars. Chapter 4, entitled The Hegemon’s Dilemma, is single-authored. I show that by keeping dollars scarce in international markets, the U.S. –the hegemon– earns monopoly rents when borrowing in dollar debt and investing in foreign-currency assets. However, in equilibrium, these rents result in a strong dollar, which depresses global demand for its exports and leads to losses on existing holdings of foreign assets, and give rise to private sector over-borrowing. Using an open economy model with nominal rigidities and segmented financial markets, I show that, because of over-borrowing, monetary policy alone cannot achieve the constrained efficient allocation. Absent a corrective macro-prudential tax on capital inflows, the hegemon faces inefficiently volatile output and prices, and lower monopoly rents. By increasing liquidity in international markets, dollar swap lines extended by the central bank improve stabilisation, but, unlike macro-prudential taxes, do so at the cost of eroding monopoly rents for the hegemon. In contrast, dollar swaps improve outcomes for foreign investors. Dollar shortages can also have distributional consequences for the hegemon. A scarce dollar leads to larger monopoly rents which benefit financially-active households, but they over-borrow at the expense of inactive households, who suffer the full brunt of aggregate demand externalities.





Corsetti, Giancarlo


Exchange Rates, Capital Controls, Monetary Policy, International Monetary System


Doctor of Philosophy (PhD)

Awarding Institution

University of Cambridge