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International Monetary Fund

This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.

International Monetary Fund

Canadian housing prices are higher than levels consistent with current fundamentals in some provinces. The empirical estimates suggest that a 10 percent decline in housing prices would lead to a 1¼ percent decline in private consumption. The high level of household leverage and housing prices could prove to be a source of vulnerability. The rebound in debt and housing prices after the crisis largely reflects the resilience of the financial system and the stronger economic recovery in Canada, as well as historically low interest rates.

ALESSANDRO PENATI and MICHAEL DOOLEY

The integration of financial markets among industrial countries in the 1970s and 1980s is often cited as indirect evidence that changes in net foreign asset positions of countries (which are the sum of net private and official capital flows over a given period) have become more sensitive to differential rates of return on investment in physical capital across countries. An increase in the sensitivity of net capital flows would imply that national savings have been increasingly allocated among countries through current account imbalances in a manner that more nearly equalizes rates of return. Increased sensitivity would also imply that foreign savings have played an important role in the capital accumulation process of the industrial world.1

Mr. Bart Turtelboom
This paper analyzes exchange rate behavior in a model where consumers trade goods to diversify shocks to their income. A model with traded and nontraded goods is simulated in a multilateral context based upon historical output correlations for the period 1970–92. Simulation results indicate that the observed volatility of multilateral real exchange rates for the United States, Germany and Japan is not inconsistent with exchange rate volatility implied by consumption-smoothing behavior.
Ms. Susana Garcia Cervero, J. Humberto Lopez, Mr. Enrique Alberola Ila, and Mr. Angel J. Ubide
This paper presents a methodology for calculating bilateral equilibrium exchange rates for a panel of currencies in a way that guarantees global consistency. The methodology has three parts: a theoretical model that encompasses the balance of payments and the Balassa-Samuelson approaches to real exchange rate determination; an unobserved components decomposition in a cointegration framework that identifies a time-varying equilibrium real exchange rate; and an algebraic transformation that extracts bilateral equilibrium nominal rates. The results uncover that, by the start of Stage III of the European Economic and Monetary Union (EMU), the euro was significantly undervalued against the dollar and the pound, but overvalued against the yen. The paper also shows that the four major EMU currencies locked their parities with the euro at a rate close to equilibrium.
Ding Ding, Mr. Werner Schule, and Ms. Yan M Sun
This paper studies the dynamics of net foreign liabilities across a number of countries. Our historical analysis suggests that an orderly reduction in a country’s net foreign liabilities has mostly occurred when there was significant improvement in gross public savings through deliberate fiscal consolidation measures. Simulations of a dynamic general equilibrium model calibrated for New Zealand indicates that sustained government deficit reduction could improve the country’s net foreign assets by about half of the accumulated public savings. However, given New Zealand’s relatively strong fiscal positions and previous work noting structurally low household savings, an orderly improvement in New Zealand’s external position in the medium term will depend on a structural improvement in private savings.
Mr. Gian M Milesi-Ferretti and Mr. Philip R. Lane
This paper highlights the increased dispersion in net external positions in recent years, particularly among industrial countries. It provides a simple accounting framework that disentangles the factors driving the accumulation of external assets and liabilities (such as trade imbalances, investment income flows, and capital gains) for major external creditors and debtors. It also examines the factors driving the foreign asset portfolio of international investors, with a special focus on the weight of U.S. liabilities in the rest of the world's stock of external assets. Finally, it relates the empirical evidence to the current debate about the roles of portfolio balance effects and exchange rate adjustment in shaping the external adjustment process.
Mr. Enrique G. Mendoza
The performance of macroeconomic indicators of capital mobility is examined in the context of an intertemporal equilibrium model of a small open economy. Recursive numerical solution methods are used to compute measures of consumption smoothing, savings-investment correlation, and the variability and output-correlation of investment that characterize the model in the presence of income disturbances. None of these statistics is a reliable indicator of capital mobility unless information regarding differences in preferences, technology, and the nature of stochastic shocks can be taken into account.
Mr. Philip R. Lane and Mr. Gian M Milesi-Ferretti
We construct estimates of external assets and liabilities for 145 countries for the period 1970-2004. We describe our estimation methods and present key features of the data at the country and the global level. We focus on trends in net and gross external positions, and the composition of international portfolios, distinguishing between foreign direct investment, portfolio equity investment, official reserves, and external debt. We document the increasing importance of equity financing and the improvement in the external position for emerging markets, and the differing pace of financial integration between advanced and developing economies. We also show the existence of a global discrepancy between estimated foreign assets and liabilities, and identify the asset categories that account for this discrepancy.
Paul R. Masson

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