In recent years three major developments have highlighted the important role that international financial markets play in macroeconomic events in open economies. These are:
(i) The rapid expansion (over the past 20 years) of gross cross-border balance sheet positions and gross financial flows.
(ii) The emergence (again over the past 20 years) of large and persistent current account imbalances.
(iii) The financial crisis of 2007-2010 has highlighted how a shock to the financial system in one country can rapidly be transmitted between countries. Large gross asset positions mean that financial institutions and countries have complex interconnections which create fragility and facilitate the transmission of shocks.
Until recently the study of many important aspects of these developments was hampered by the lack of appropriate models and methodologies to capture complex financial interactions between countries. Most models in international macroeconomics focused on very simple and stylised financial structures where portfolio allocation is either not relevant or not explicitly represented. The expansion of gross asset positions, the growth of current account imbalances and the international transmission of financial market shocks during the crisis, all require a much deeper analysis of international financial markets and portfolio allocation than has been possible in existing models of macro-finance.
Devereux and Sutherland have recently developed a solution method which allows substantial progress to be made in improving the modelling of international financial markets. This new methodology makes it possible to analyse more realistic asset market structures and to understand the interaction between macroeconomics and financial factors. These methodological developments have significant further potential for aiding the understanding of international financial markets and provide a vital new framework for analysing the recent crisis.
This project builds on the foundations provided by the Devereux-Sutherland approach and extends its applicability and scope. The aim is to build international macro models that can replicate key macro-finance facts and at the same time are suitable for policy analysis. The testable implications of these theoretical models will be analysed and compared to the data on gross portfolio positions, asset returns and valuation effects. The extent to which these new theoretical models resolve long-standing empirical puzzles in international macroeconomics will be assessed. The theoretical models will be used to analyse the ways in which financial markets create and propagate shocks and models will be developed which capture financial fragility, financial crises, financial interconnectedness and contagion. These theoretical models will be used to analyse the welfare impact of monetary, fiscal and macro-prudential policy. And rules for welfare maximising monetary, fiscal and macro-prudential policy in these models will be derived and analysed in these models. Lastly, the robustness and accuracy of the Devereux-Sutherland solution methodology will be tested and links to other solution methodologies will be explored.
CDMA researchers: Alan Sutherland, Ozge Senay (in collaboration with Michael B Devereux of the University of British Columbia)
Selected recent related papers by CDMA authors