Essays in International Finance and Macroeconomics

Abstract

This dissertation is formed of three chapters, each addressing a pressing issue in modern macroeconomics. The first two chapters explore current topics in international finance and macroeconomics, while the final chapter contributes to recent policy debates. The first chapter, which is written in collaboration with Simon Lloyd and Daniel Ostry, employs novel econometric techniques to tackle a classical issue in international finance, namely the link between capital flows and exchange rates. A major obstacle to resolving this has been the difficulty identifying plausibly exogenous variation in cross-border flows since capital flows evolve simultaneously with current and future macroeconomic prospects, and their relationship with exchange rates can be confounded by other factors, such as global risk sentiment. We resolve this impasse by using bank-level data on the external assets and liabilities of UK-resident intermediaries to construct novel Granular Instrumental Variables (GIVs) that identify exogenous shocks to cross-border US dollar positions. Our GIVs reflect the unique positions taken by large banks vis-à-vis average banks. We use these instruments to ask: What are the causal effects of international banking flows on the US dollar? How do exchange-rate changes causally influence the supply and demand for US dollars? And what role does banks’ time-varying risk-bearing capacity play for these links? Our dataset is sufficiently representative and granular to answer these questions in a robust and general manner. In line with the predictions of a new granular international banking model, we show empirically that cross-border flows have a significant and persistent causal impact on exchange rates. A 1% increase in UK-based global banks’ net external US dollar-debt position appreciates the dollar by 2% against sterling. While we estimate that the supply of dollars from abroad is price-elastic, our results suggest that UK-resident global banks’ demand for dollars is price-inelastic. Furthermore, we show that the causal effect of banking flows on exchange rates is state-dependent, with effects twice as large when banks’ capital ratios are one standard deviation below average. Our findings showcase the importance of banks’ risk-bearing capacity for exchange-rate dynamics and, therefore, for insulating their domestic economies from global financial shocks. The second chapter, which is written in collaboration with Caterina Mendicino and Luigi Falasconi, incorporates realistic financial linkages into an otherwise standard two-country DSGE model to quantitatively explore various aspects of cross-country financial contagion and macroprudential regulation. The transmission of heightened distress in the banking sector has typically been analysed in the literature through the lens of closed economy models. In contrast, we emphasise the role of cross-border bank lending in the domestic and international transmission of shocks originating in the banking sector. In particular, we build a quantitative macro-banking open economy model that includes cross-border bank-to-bank lending, endogenous bank default, and shocks to the volatility of domestic and foreign bank asset returns, referred to as ’bank risk shocks’. We use this framework to ask the following questions: How do banking sector shocks transmit across borders through cross-border lending? And what role does bank capital regulation play in their international propagation? Our findings reveal that increased distress in the banking sector of the lender country leads to a global recession characterised by synchronised financial cycles. Conversely, increased bank distress in the borrower country results in a domestic recession but asymmetric financial cycles. These results have interesting policy implications. Higher capital requirements in the lender country increase the resilience of banks in that country to financial shocks, thereby reducing the negative spillovers to the borrower country. On the other hand, higher capital requirements in the borrower country mitigate the domestic effects of such shocks without, however, having significant effects on the lender country. This suggests that, from a global perspective, tighter bank capital regulation in the lender country could be more beneficial than stricter bank regulation in the borrower country. The third chapter delves into issues which became salient during the policy debates of recent years. It focuses on short-time work (STW) programmes, which subsidise reductions in work hours during economic downturns. While STW payments have become a prominent policy instrument amidst recent crises, little is known about their economic desirability. In this chapter, I build a dynamic general equilibrium model with labour search-and-matching to provide a new perspective on the effectiveness of such programmes. The model features firm heterogeneity, occasionally binding cash-flow constraints, and both intensive (work hours) and extensive (job creation and destruction) margins of adjustment. STW policies prove to be effective during liquidity crises in which firms’ binding constraints lead to inefficiently high unemployment and underutilisation of the intensive margin. I present closed-form solutions for the optimal time-varying STW subsidy that achieves the constrained efficient allocation. This optimal policy consists of a countercyclical eligibility criterion and subsidy rate. Furthermore, I show that STW policies can yield significant welfare benefits by preventing mass layoffs during crises. At the same time, I warn that, if implemented too generously, STW subsidies can lead to moral hazard, reducing both economic activity and overall welfare.