Forecasting Local Inflation with Global Inflation: When Economic Theory Meets the Facts
(with Enrique Martínez-García)
This paper provides both theoretical insight as well as empirical evidence in support of the view that inflation is largely a
global phenomenon. First, we show that inflation across countries incorporates a significant common factor that can be approximated
with global inflation. Second, the contribution of global inflation to local inflation depends on the structural features of the
economy. Global inflation may arise from a common trend component, but it arises in the data at business cycle frequencies as well.
We show that in theory a role for global inflation in local inflation dynamics emerges over the business cycle even with country-specific
shocks (no common shocks), flexible exchange rates and complete international asset markets through cross-country trade spillovers.
Third, we identify a very robust "error correction mechanism" that brings local inflation rates back in line with global inflation
which explains the relative success of inflation forecasting models based on global inflation (e.g., Ciccarelli and Mojon (2010)).
Fourth, we argue that the solution to the workhorse New Open Economy Macro (NOEM) model of Martinez-Garcia and Wynne (2010) can be
approximated by a finite-order VAR and estimated using Bayesian techniques to forecast domestic inflation incorporating all relevant
linkages with the rest of the world. This NOEM-BVAR provides us with a tractable model of inflation determination that can be tested
empirically in forecasting. Finally, we use pseudo-out-of-sample forecasts to assess the NOEM- BVAR at different horizons (1 to 8
quarters ahead) across a selection of 17 OECD countries at quarterly frequency over the period 1980-2014. In general, we find that
the NOEM-BVAR model produces a lower root mean squared prediction error (RMSPE) than its competitors-which include most conventional
forecasting models based on domestic factors and also the recent models based on global inflation. In a number of cases, the gains
in smaller RMSPEs are statistically significant.
A Threshold Model of the US Current Account
(forthcoming in Economic Modelling, 2015) [pdf]
What drives US current account imbalances? Is there solid evidence that the behavior of the current account is different
during deficits and surpluses or that the size of the imbalance matters? Is there a threshold relationship between the US
current account and its main drivers? We estimate a threshold model to answer these questions using the instrumental
variable estimation proposed by Caner and Hansen (2004). Rather than concluding that the size or the sign of (previous)
external imbalances matters, we find that time is the most important threshold variable. One regime exists before and
another one exists after the third quarter of 1997, a period that coincides with the onset of the Asian financial crisis
and the Taxpayer Relief Act of 1997. Statistically significant determinants in the second regime are the fiscal surplus,
productivity, productivity volatility, oil prices, the real exchange rate, and the real interest rate. Productivity has
become a more important driver since 1997.
[Working paper version in Ideas]
[An Econbrowser Post]
Institutional Quality, the Cyclicality of Monetary Policy and Macroeconomic Volatility
(Journal of Macroeconomics, March 2014, 39: 113-155) [pdf]
In contrast to industrialized countries, emerging market economies
are characterized by pro- or a-cyclical monetary policies and high output volatility. This paper
argues that those facts can be related to a long-run feature of the economy -namely, its
institutional quality (IQL). The paper presents evidence that supports the link between an
index of IQL (law and order, government stability, investment profile, etc.), and (i) the
cyclicality of monetary policy, and (ii) the volatilities of output and the nominal interest rate.
In a DSGE model, foreign investors that choose a portfolio of direct investment and lending to
domestic agents, face a probability of partial confiscation which works as a proxy that captures
IQL. The economy is hit by external shocks to demand for home goods and productivity shocks while
its central bank seeks to stabilize inflation and output. In the long run, a lower IQL tends to
discourage external liabilities. If there is a positive external demand shock, we observe an
increase in output and real appreciation. The latter operates through two opposite channels.
First, it directly increases the opportunity cost of leisure generating incentives to expand
labor supply. Second, it reduces the real value of the debt denominated in foreign currency which
stimulates consumption but contracts the labor supply. If the IQL is low, the economy attracts
fewer loans for domestic consumers and shows a lower debt-to-consumption ratio in the steady state.
This implies that the reduction of the real value of the debt caused by the real appreciation is
smaller. Given this low wealth effect, the real appreciation leads to an expansion of the labor
supply. Wages drop and inflation diminishes. The central bank reacts by cutting its policy rate
to stabilize inflation and generates a negative comovement between output and the nominal interest
rate (pro-cyclical policy). As a corollary, negative correlations between policy rates and output
are not necessarily an indicator of destabilizing polices even in the presence of demand shocks.
[Working paper version in Ideas]
Do Good Institutions Promote Countercyclical Macroeconomic Policies?
(with César Calderón and Klaus Schmidt-Hebbel; conditionally accepted in OBES)
[Working paper version in Ideas]
The literature has argued that developing countries are unable to adopt counter-cyclical
monetary and fiscal policies due to financial imperfections and unfavorable political-economy
conditions. Using a world sample of 115 industrial and developing countries for 1984-2008,
we nd that the level of institutional quality plays a key role in countries' ability to implement
counter-cyclical macroeconomic policies. The results show that countries with strong
(weak) institutions adopt counter- (pro-) cyclical macroeconomic policies, re
ected in extended
monetary policy and scal policy rules. The threshold level of institutional quality
at which monetary and scal policies are a-cyclical is found to be similar.
Simple Models to Understand and Teach Business Cycle Macroeconomics for Emerging Market and Developing Economies
(December 2014, submitted) [pdf]
The canonical neoclassical model is insufficient to understand business cycle fluctuations in emerging market and developing economies
(EMDEs). We reformulate the models proposed by Aguiar and Gopinath (2007) and Neumeyer and Perri (2005) in simple settings that can
be used to do back-of-the-envelope analysis and teach business cycle macroeconomics for EMDEs at the undergraduate level. The simplified
models are employed for qualitatively explaining facts such as the countercyclicality of the trade balance and the real interest rate,
and the higher volatility of output, consumption, and real wages compared with those observed in advanced countries. Simple extensions
can be used to understand other empirical facts such as large capital outflows and output drops, small government spending multipliers,
the cyclical behavior of prices, and the negative association between currency depreciations and output.
Does the US Current Account Show a Symmetric Behavior over the Business Cycle?
(October 2014, submitted) [pdf]
Traditionally, the literature that attempts to explain the link between the current account
and output finds a linear negative relationship (e.g., Backus et al., 1995). Using
nonparametric regressions, we find a U-shaped relationship between the US current account
and the GDP cycle. That is, when output is above (below) its trend, the current
account and detrended output are positively (negatively) correlated. This finding is robust to
different measures of external imbalances and cyclical components, sample periods, type of
estimator, and econometric specifications. With the exceptions of Japan and the United Kingdom,
the U-curve is not observed in the rest of G7 countries. We argue that this nonlinearity might
be caused by non-variance-preserving productivity shocks or the presence of occasionally binding
Financial Liberalization, Low World Interest Rates, and Global Imbalances: A Note with a Simple Two-Country Model
(Applied Economics Letters, April 2014, 21(14): 1025-1029) [pdf]
We can understand the role of the liberalization of capital outflows on the global imbalances, the increasing share of
US equities in foreign investors' portfolio, and the decline in the world interest rate and the S&P dividend-price ratio,
facts observed during the last three decades, when taxes on international assets holdings are reduced in a simple
two-country model with costs of portfolio adjustment.