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This paper globally analyzes the bivariate relation between large current account imbalances and the real exchange rate over different degrees of nominal exchange rate variability. Employing both linear and nonlinear panel estimation procedures, we typically find an inverse long-run link between large imbalances and the real exchange rate at lower nominal exchange rate rigidity levels. This is in contrast to the often non-existent or positive comovement that materializes under lower nominal exchange rate variation. Our results thus suggest that greater nominal exchange rate adjustment can induce a stabilizing “current account”-“real exchange rate” relation. Meanwhile, current account adjustment speeds up with more flexible nominal exchange rates. Along the cross-section, the most salient findings are i) the striking positive relation between current account persistence and real exchange rate persistence based on country-specific estimates and ii) the inverse correlation between persistence in either the current account or real exchange rate and nominal exchange rate volatility.

Portugal is one of the most externally indebted economies in the eurozone. The deeply negative net international investment position (NIIP) suggests that large current account surpluses will be needed in the future to restore external sustainability. Despite significant interest in the scope for external adjustment within a monetary union, little is known about the magnitude or likelihood of the relative price change required to facilitate this adjustment. Drawing on a new probabilistic framework of external sustainability, this paper estimates the likelihood that a real effective depreciation is needed to lower Portugal’s net external liabilities to more prudent levels. Contrary to conventional thinking, we find that the NIIP is sustainable without real depreciation with fairly high probability, estimated between 32 and 43 percent. We highlight the predominance of financial account shocks over current account shocks in this assessment. To provide context to the assessment, we also apply the framework to Ireland. Despite a weaker NIIP than in Portugal, the probability that the external position is sustainable in Ireland is higher, estimated between 54 and 60 percent, predominantly reflecting forecasts of large and sustained trade surpluses.

Although currency adjustment is often proposed as a policy tool to reduce current account imbalances, there is no consensus regarding the macroeconomic effects. In this paper we study the macroeconomic aftermath of large exchange rate appreciations. Using a sample of 128 countries over the period 1960–2008, we identify 25 episodes of large nominal and real appreciations shocks. We use narrative identification of exogenous appreciation episodes and study the macroeconomic effects in a dummy-augmented panel autoregressive model. Our results indicate that exchange rate appreciations tend to have strong effects on current account balances. Within 3 years after the appreciation event, the current account balance on average deteriorates by three percentage points of GDP. This effect occurs through a reduction of savings without a meaningful reduction in investment. Real export growth slows down substantially, but the output costs are small and not statistically significant. All these effects appear somewhat more pronounced in developing countries.

This paper revisits the claim that flexible exchange rates facilitate external adjustment. While previous studies have used exchange rate regime as a proxy for exchange rate flexibility, in this study there is evidence of ARCH effects in exchange rate, and thus GARCH models are employed to estimate volatility. A dynamic panel data model is then specified, and the Arellano-Bond estimator and the Blundell-Bond estimator are employed to estimate the effect of exchange rate flexibility on the speed of adjustment of current account in a panel of 28 emerging and developing economies. There is robust evidence that flexible exchange rates indeed facilitate smoother adjustment of current account imbalances.

We provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus affecting both the level and volatility of exchange rates. Our theory of exchange rate determination in imperfect financial markets not only helps rationalize the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, it also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. Our framework is flexible; it accommodates a number of important modeling features within an imperfect financial market model, such as nontradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.

I model the equilibrium risk sharing between countries with varying financial development The most financially developed country takes greater risks because its financial intermediaries deal with funding problems better. In good times, the more financially developed country consumes more and runs a trade deficit financed by the higher financial income that it earns as compensation for taking greater risk. During global crises, it suffers heavier losses. Its currency emerges as the reserve currency because it appreciates during crises, thus providing a good hedge. I provide evidence that financial net worth plays a crucial role in understanding this asymmetric risk sharing.

This paper synthesizes recent advances in the theoretical and empirical literature on capital controls. We start by observing that international capital flows have both benefits and costs, but some of these are not internalized by individual actors and thus constitute externalities. The theoretical literature has identified pecuniary externalities and aggregate demand externalities that respectively contribute to financial instability and recessions. These externalities provide a natural rationale for countercyclical capital controls that lean against boom and bust cycles in international capital flows. The empirical literature has developed several measures of capital controls to capture different aspects of capital account openness. We evaluate the strengths and weaknesses of different measures and provide an overview of the empirical findings on the effectiveness of capital controls in addressing the externalities identified by the theory literature, that is, in reducing financial fragility and enhancing macroeconomic stability. We also discuss strategies to deal with the endogeneity of capital controls in such statistical exercises. We conclude by providing an overview of the historical and current debates on the role of capital controls in macroeconomic management and their relationship to the academic literature.

We investigate global factors associated with bank capital flows. We formulate a model of the international banking system where global banks interact with local banks. The solution highlights the bank leverage cycle as the determinant of the transmission of financial conditions across borders through banking sector capital flows. A distinctive prediction of the model is that local currency appreciation is associated with higher leverage of the banking sector, thereby providing a conceptual bridge between exchange rates and financial stability. In a panel study of 46 countries, we find support for the key predictions of our model.

This article explores the effect of news shocks in open economies using worldwide giant oil and gas discoveries as a directly observable measure of news shocks about future output—the delay between a discovery and production is on average four to six years. We first analyze the effects of a discovery in a two-sector small open economy model with a resource sector. We then estimate the effects of giant oil and gas discoveries on a large panel of countries. Our empirical estimates are consistent with the predictions of the model. After an oil or gas discovery, the current account and saving rate decline for the first five years and then rise sharply during the ensuing years. Investment rises robustly soon after the news arrives, whereas GDP does not increase until after five years. Employment rates fall slightly and remain low for a sustained period.

We study cross-country risk sharing as a second-best problem for members of a currency union using an open economy model with nominal rigidities and provide two key results. First, we show that if financial markets are incomplete, the value of gaining access to any given level of aggregate risk sharing is greater for countries that are members of a currency union. Second, we show that even if financial markets are complete, privately optimal risk sharing is constrained inefficient. A role emerges for government intervention in risk sharing both to guarantee its existence and to influence its operation. The constrained efficient risk-sharing arrangement can be implemented by contingent transfers within a fiscal union. We find that the benefits of such a fiscal union are larger, the more asymmetric the shocks affecting the members of the currency union, the more persistent these shocks, and the less open the member economies. Finally, we compare the performance of fiscal unions and of other macroeconomic stabilization instruments available in currency unions such as capital controls, government spending, fiscal deficits, and redistribution.