This book contains the proceedings of a conference held in honor of Robert P. Flood Jr. Contributors to the conference were invited to address many of the topics that Robert Flood has explored including regime switching, speculative attacks, bubbles, stock market voloatility, macro models with nominal rigidities, dual exchange rates, target zones, and rules versus discretion in monetary policy. The results, contained in this volume, include five papers on topics in international finance.
International Finance and Financial Crises
Essays in Honor of Robert P. Flood, Jr.
Peter Isard, Assaf Razin and Andrew K. Rose
Partly reprinted from International Tax and Public Finance, Volume 6, No. 4 (1999)
KLUWER ACADEMIC PUBLISHERS
Boston / Dordrecht / London
INTERNATIONAL MONETARY FUND
Washington, D. C.
Distributors for North, Central and South America:
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photo–copying, recording, or otherwise, without the prior written permission of the publisher, Kluwer Academic Publishers, 101 Philip Drive, Assinippi Park, Norwell, Massachusetts 02061
Printed on acid-free paper.
Printed in the United States of America
to Bob’s parents, Robert and Nancy Flood, and to Of air Razin
Contributors and Conference Participants
A Tribute to Robert P. Flood, Jr.
1. Some Parallels Between Currency and Banking Crises
Nancy P. Marion
Carmen M. Reinhart
Donald J. Mathieson
2. Balance Sheets, the Transfer Problem, and Financial Crises
3. Financial Crises: What Have We Learned from Theory and Experience?
Summary of Panel Remarks
Michael P. Dooley
Jacob A. Frenkel
4. On the Foreign Exchange Risk Premium in Sticky-Price General Equilibrium Models
James M. Boughton
Richard A. Meese
5. An Information-Based Model of Foreign Direct Investment: The Gains from Trade Revisited
Assaf Razin, Efraim Sadka, and Chi-Wa Yuen
6. An International Dynamic Asset Pricing Model
Robert J. Hodrick, David Tat-Chee Ng, and Paul Sengmueller
Paul D. Kaplan
7. Role of the Minimal State Variable Criterion in Rational Expectations Models
Bennett T. McCallum
8. Exact Utilities under Alternative Monetary Policy Rules in a Simple Macro Model with Optimizing Agents
Dale W. Henderson and Jinill Kim
Simple Monetary Policy Rules Under Model Uncertainty
Peter Isard, Douglas Laxton, and Ann-Charlotte Eliasson
Jo Anna Gray
Lars E. O. Svensson
Bennett T. McCallum
Appendix. Robert P. Flood, Jr. - Bibliography
This book contains the proceedings of a conference held in honor of Robert P. Flood, Jr.
The “Floodfest” took place at the International Monetary Fund in Washington, DC on the occasion of Bob’s fiftieth birthday in January 1999. The idea arose some two years earlier in a conversation between Peter Garber (Bob’s longtime co-author) and Assaf Razin (an old friend and colleague). The sad origin of the event was the untimely and tragic death of Assaf’s son Ofair from complications arising from Multiple Sclerosis, the same disease that continues to affect Flood. Razin and Garber quickly asked Andy Rose (another collaborator and friend of Bob’s) to join the organizing team. The Research Department of the International Monetary Fund, under the leadership of Michael Mussa, then generously offered to provide both financial and logistic support for the conference, including the organizing talents of Peter Isard (yet another friend and co-author of Bob’s) and his administrative assistant, Norma Alvarado.
A number of Bob’s many friends and colleagues over the years were asked to consider contributing to the academic festivities. The request met with a gratifying response, as this book amply shows. Indeed, to accommodate the long list of people who wished to honor Bob, the program provided scope for a round table discussion on policy matters, two discussants for most of the papers, session chairs, and opportunities to participate from the audience.
Bob has written on a variety of subjects over the years, including regime switching, speculative attacks, bubbles, stock market volatility, macro models with nominal rigidities, dual exchange rates, and target zones. Most of these topics are represented in this volume, the “Floodschrift” counterpart of the “Floodfest” conference. The volume begins with Stanley Fischer’s tribute to Flood’s scholarly contributions and also contains Bob’s vitae as an appendix.
The enthusiasm of the profession to honor Bob’s achievements is one of the many signs of the affection and esteem with which we regard him. To many of us, Bob has offered much more than just academic scholarship and new ways of tackling economic problems. He has been an intellectual mentor, who has inspired us to think about economics in a whimsical way. He has encouraged us to think long and hard about both theory and empirics, trying to confront mathematical conjectures with the messy facts—and vice versa! And he has invited us into his home to meet his delightful family—his wife, Petrice (Pete), and children, Greg and Kate—inspiring us by the way he has confronted his disease without surrendering his enjoyment in life and work.
Bob Flood received his B.A. from Wake Forest College, which he attended on a golf scholarship. Spurning the lure of professional sports—or having understood the theory of comparative advantage—he turned to more intellectual pursuits, enrolling in the Ph.D. program at the University of Rochester. At Rochester he met the young Mike Mussa and the young Rudi Dornbusch and, impressed and inspired by them, chose to specialize in international monetary economics.
Under Mike Mussa’s supervision, Bob wrote a thesis entitled “Essays on Real and Monetary Aspects of Various Exchange Rate Systems.” His Ph.D. was awarded in 1977, the same year that he published his first journal article (“Growth and the Balance of Payments,” then a popular topic) in the Canadian Journal of Economics. In the fall of 1976, Bob joined the Department of Economics at the University of Virginia, where he was mentored by Ben McCallum. He left in 1980 to spend two and a half years visiting Dale Henderson’s group in the International Finance Division at the Federal Reserve Board. After a brief return to Virginia, he moved in 1983 to Northwestern to join Bob Hodrick. And then in 1987, he was persuaded by Jacob Frenkel to join the Fund’s Research Department—and the Fund has been benefiting ever since.
Bob has been a prolific scholar during the twenty-two years since his doctorate. He has published almost sixty papers, as well as a book and a number of comments and reviews. He remains an active scholar, and continues to be a lively contributor to the profession’s neverending debate on exchange rate regimes, as well as on speculative bubbles and currency crises. He has played an important role as mentor to some of the younger members of the IMF research community—and given his acceptance of the editorship of IMF Staff Papers, we very much hope and expect that role will grow substantially in the future.
At Virginia, Bob began an extensive collaboration with Peter Garber, which resulted in seminal contributions to the analysis of “process switching.” Technically, this literature analyses how macroeconomic behavior is affected by the prospect and/or realization of changes in policy regimes that are triggered when the operation of an initial regime induces relevant endogenous variables to move beyond certain thresholds and thus trigger a shift into another regime. The best known example is a switch in exchange rate regimes from fixed to floating. Flood and Garber’s famous 1984 Journal of International Economics paper on collapsing exchange rate regimes formalized a model of speculative attacks in a linear setup. The model’s clarity and simplicity both made it a hit from the start, and explain why it remains one of most highly cited JIE papers of all times. As a result, Bob is known as one of the founding fathers of the modern literature on currency crises. But the methodology is sufficiently general that it can be applied to a number of other examples, including the stabilization of hyper-inflations and currency reforms. This research program has proven invaluable in allowing the use of the same analytical and empirical framework to model economic behavior in a system that may exhibit either normal or crisis periods.
Bob is also well-known as one of the founders of the work on bubbles in markets with rational expectations. He and Garber developed the first empirical tests for price level bubbles. At Northwestern, he teamed up with Bob Hodrick to extend the work to asset price bubbles, allowing foreign exchange and stock markets to be dissected with much the same tools.
Much of Bob’s other work is in international finance. He developed a well-known model of dual exchange rates, which led to collaboration with Nancy Marion on a number of papers addressing two-tier markets, speculative attacks, and related issues. Since joining the Fund, Bob has continued to focus on a variety of issues relating to exchange rate behavior and the macroeconomics of different exchange rate regimes. With Andy Rose he provided definitive empirical evidence against existing smooth-pasting models of exchange rate target zones and against standard macroeconomic models of exchange rate regimes; he has written with Peter Isard on rules versus discretion in monetary policy, introducing the concept of “escape clauses;” and the list of papers and co-authors stretches on.
Bob remains very active in generating frontline research that appears in the top journals. The academic community is looking forward, with particular interest, to his long-awaited paper with Garber on the economics of time zones!
Bob’s students and colleagues have often remarked on the great enthusiasm he brings to discussions of economic issues and the exceptional generosity he displays in explaining concepts and providing helpful advice to others. His talents as an expositor are legendary. His outstanding abilities as a teacher have made him a regular lecturer at IMF Institute courses.
It came as great news that Bob would be willing to accept the editorship of IMF Staff Papers. He is just the man to revive the journal and help regenerate excitement about research at the Fund. An important part of his new role is to upgrade the caliber of feedback that Fund staff members receive on the research papers they submit for publication.
Bob is an excellent researcher and superb colleague, and we are very lucky to have him at the Fund. But beyond that, every one of us admires the extraordinary courage he has shown in dealing with his long battle with multiple sclerosis. He has remained productive and cheerful in the face of adversity as he continues to charge ahead, extending his scholarly contributions, and now taking on a major new challenge.
Bob: almost every one of your co-authors is here today; so are many of your teachers, and your colleagues. They are here to salute you, honor you, look forward to your future contributions, and to tell you how much you mean to all of us, and how much the example of your courage means to so many.
Thank you for all you have done—and Happy Birthday!
Editted version of luncheon remarks. I am grateful to Andrew Rose and Peter Isard for their assistance.
Bob Flood has made important contributions to many areas of economic analysis, including regime switching, speculative attacks, bubbles, stock market volatility, macro models with nominal rigidities, dual exchange rates, target zones, and rules versus discretion in monetary policy. Contributors to the Floodfest were invited to address any of the topics that Bob has explored, or others of their choosing. The results, contained in this volume, include five papers on topics in international finance. Two of these papers, as well as the panel discussion, focus on speculative attacks and financial crises. The other three take new directions in exploring topics on which exisiting models leave much to be desired. Thus, most of the eight papers in this volume fit the title: International Finance and Financial Crises.
In Chapter 1, Nancy Marion reviews both the literature on the causes of speculative attacks on fixed exchange rates and the separate literature on the determinants of bank runs. Both types of crises involve attacks on asset price-fixing schemes. Marion draws a number of parallels between the two areas of analysis and examines some of the new insights that are emerging from a more integrated approach in the aftermath of the Asian financial crisis. Carmen Reinhart and Donald Mathieson provide comments.
The paper by Paul Krugman, in Chapter 2, argues that we badly need a “third-generation” crisis model to make sense of recent events and to help warn of crises to come. He is skeptical about whether either moral-hazard or Diamond-Dybvig types of bank-run stories really get at the essential nature of what went wrong in Asia, and he sketches a candidate for third-generation crisis modeling. Krugman’s model emphasizes the role of companies’ balance sheets in determining their ability to invest, and the role of capital flows in affecting the real exchange rate. Comments are provided by Peter Garber and Olivier Jeanne.
The Floodfest included a panel to solicit the views of some of the leading experts on “Financial Crises: What Have We Learned from Theory and Experience?” Chapter 3 summarizes the oral presentations of four of the panelists: Michael Dooley, Rudiger Dornbusch, David Folkerts-Landau, and Michael Mussa. It also includes written remarks by the fifth panelist, Jacob Frenkel.
The centerpiece of Chapter 4 is a paper in which Charles Engel derives expressions for the foreign exchange risk premium in four different specifications of sticky-price general equilibrium models. The models are distinguished by two basic types of pricing assumptions: pricing in the producer’s currency and pricing to market (i.e., in the consumer’s currency). Further model differentiation comes from two alternative assumptions about money demand: cash in advance, and real balances in the utility function. Among the interesting results, Engel finds that a pricing-to-market model with cash in advance is capable of explaining much larger risk premiums than the other three model variants. James Boughton and Richard Meese comment.
In Chapter 5, Assaf Razin, Efraim Sadka, and Chi-Wa Yuen provide an information-based model of foreign direct investment (FDI) that revisits the gains from trade. Their model emphasizes a feature of FDI that distinguishes it from other types of capital flows. In particular, FDI is viewed as an exercise in control and management, rather than merely buying an ownership share in the domestic firm, and the problem of channeling domestic saving into productive investment is analyzed in the presence of asymmetric information between the managing owners of firms and other portfolio stakeholders. Razin, Sadka, and Yuen emphasize that, in the absence of a well-developed domestic credit market, FDI can raise welfare through its double role of providing a vehicle to revive the domestic equity market and supplementing domestic saving with foreign saving; but in the presence of a well-developed credit market and asymmetric information, FDI can generate welfare losses. The paper is followed with comments by Joshua Aizenman.
In Chapter 6, Robert Hodrick, David Ng, and Paul Sengmueller extend John Campbell’s asset-pricing model to investigate international equity returns. They also utilize and evaluate recent evidence on the predictability of stock returns. They find some evidence for the role of hedging demands in explaining stock returns and compare the predictions of the dynamic model to those from the static capital asset pricing model. Both models fail in their predictions of average returns on portfolios of high book-to-market stocks across countries. Comments are provided by Louis Scott and Paul Kaplan.
The next two chapters contain the three conference papers that do not address topics in international finance. Bennett McCallum’s contribution, in Chapter 7, focuses on the fact that many dynamic models with rational expectations feature a multiplicity of paths that satisfy all of the conditions for intertemporal equilibrium. McCallum addresses several alternative criteria that have been proposed for selecting among the multiplicity of solution paths, makes the case for the minimum-state-variable (MSV) criterion, and demonstrates how unique MSV solutions can be defined and calculated in a very wide class of linear rational expectations models. Edwin Burmeister provides comments.
Chapter 8 includes two papers on monetary policy rules. Dale Henderson and Jinill Kim develop an optimizing-agent model of a closed economy that is sufficiently simple to allow exact utility calculations. The set-up includes one-period nominal contracts for wages, with prices either flexible or also governed by one-period contracts, as well as shocks that are unknown when contracts are signed. Alternative monetary policy rules for stabilizing the economy (including fully optimal rules and “naive” and “sophisticated” simple rules) are evaluated and compared, under each type of price-level behavior, using the utility function of the representative agent. In the second paper, Peter Isard, Douglas Laxton, and Ann–Charlotte Eliasson use stochastic simulations and stability analysis to compare how different monetary policy rules perform in a moderately nonlinear model in which policymakers tend to make serially-correlated errors in estimating a time-varying NAIRU. They find that rules that work well in linear models but implicitly embody backward-looking measures of real interest rates (such as conventional Taylor rules) or substantial interest rate smoothing perform very poorly in their model. This is presented as a challenge to the general practice of evaluating policy rules on the basis of their performances in linear models. The chapter also includes comments by Jo Anna Gray, Lars Svensson, and Bennett McCallum.
“Gold Monetization and Gold Discipline,”Journal of Political EconomyFebruary, 1984 (with P. Garber), reprinted as Chapter 10 inR.Aliber (ed.), The Reconstruction of International Monetary Arrangements. MacMillan, 1987.
“Gold Monetization and Gold Discipline,”Journal of Political EconomyFebruary, 1984 (with P. Garber), reprinted as Chapter 10 inR.Aliber (ed.), The Reconstruction of International Monetary Arrangements. MacMillan, 1987.)| false
“Macroeconomic Policy, Speculative Attacks and Balance of Payments Crisis,” (revised version of previous paper) inF.Van Der Ploeg (ed.), The Handbook of International Macroeconomics, Basil Blackwell, 1994 (with R. Agenor).
“Macroeconomic Policy, Speculative Attacks and Balance of Payments Crisis,” (revised version of previous paper) in F.Van Der Ploeg (ed.), The Handbook of International Macroeconomics, Basil Blackwell, 1994 (with R. Agenor).)| false
“The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates: Further Results,” inM.Miller and P.Krugman (eds.), Exchange Rate Targets and Currency BandsCambridge University Press, 1992.
“The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates: Further Results,” inM.Miller and P.Krugman (eds.), Exchange Rate Targets and Currency BandsCambridge University Press, 1992.)| false
“An Evaluation of Recent Evidence on Stock Market Bubbles” inR.Flood and P.Garber,Speculative Bubbles, Speculative Attacks and Policy Switching. MIT Press, 1994 (with R. Hodrick and P. Kaplan).
“An Evaluation of Recent Evidence on Stock Market Bubbles” inR.Flood and P.Garber,Speculative Bubbles, Speculative Attacks and Policy Switching. MIT Press, 1994 (with R. Hodrick and P. Kaplan).)| false
“Exchange Rate Economics: What’s Wrong with the Conventional Approach?,” inJ.Frankel,G.Galli and A.Giovannini,eds., The Micro structure of Foreign Exchange MarketsNBER, University of Chicago Press1996 (with M. Taylor).
“Exchange Rate Economics: What’s Wrong with the Conventional Approach?,” inJ.Frankel,G.Galli and A.Giovannini,eds., The Micro structure of Foreign Exchange MarketsNBER, University of Chicago Press1996 (with M. Taylor).)| false
“Mexican Foreign Exchange Market Crises From the Perspective of the Speculative Attack Literature,” inInternational Capital Markets: Developments, Prospects and Policy Issues, International Monetary Fund, August1995 (with C. Kramer).
“Mexican Foreign Exchange Market Crises From the Perspective of the Speculative Attack Literature,” inInternational Capital Markets: Developments, Prospects and Policy Issues, International Monetary Fund, August1995 (with C. Kramer).)| false
“Bubbles, Noise and the Trading Process in Speculative Markets,” inInternational Capital Markets: Developments, Prospects and Policy IssuesInternational Monetary Fund, August1995 (with T. Ito and C. Kramer).
“Bubbles, Noise and the Trading Process in Speculative Markets,” inInternational Capital Markets: Developments, Prospects and Policy IssuesInternational Monetary Fund, August1995 (with T. Ito and C. Kramer).)| false
“Stochastic Process Switching and Inflation: A Comment on Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation: Some Further Results” inJ.Frenkel,ed., Exchange Rates and International Macroeconomics, University of Chicago Press, 1984.
“Stochastic Process Switching and Inflation: A Comment on Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation: Some Further Results” inJ.Frenkel,ed., Exchange Rates and International Macroeconomics, University of Chicago Press, 1984.)| false
Comment onW. McKibbin and J.Sachs,“Coordination of Monetary and Fiscal Policies in Industrial Economics,” inJ.Frenkel,ed., University of Chicago Press, International Aspects of Fiscal Policy, 1988.
Comment onW. McKibbin and J.Sachs,“Coordination of Monetary and Fiscal Policies in Industrial Economics,” inJ.Frenkel,ed., University of Chicago Press, International Aspects of Fiscal Policy, 1988.)| false