Essays on the Role of Safe Assets in International Macroeconomics

Abstract

This thesis consists of 3 chapters on the role of safe assets in international macroeconomics.

Chapter 1 presents a model of a small open economy (Home) that issues uncontingent Home-currency denominated external debt and is subject to nominal rigidities in price-setting. Aggregate demand management considerations call for a risk-premium on the Home bond that is decreasing (increasing) in the covariation of the global business cycle with Home productivity shocks (demand shocks for Home exports). Insurance considerations call for a risk-premium on the Home bond that is increasing in the covariation of Home and Foreign output and decreasing in Foreign’s risk-aversion. Empirically, I find support for the model’s predictions with respect to aggregate demand management.

Chapter 2 provides a closed form solution to the benchmark small open economy model of Gali and Monacelli (2005) for a particular case: the optimal policy under the so-called Cole-Obstfeld specification where several elasticities equal unity. This allows for a tight characterization of currency risk-premia. I find that currency risk-premia are and increasing in the variance of shocks to world output and the world price level and decreasing in the covariance of Home productivity with world output and the world price level.

Chapter 3, coauthored with Fernando Mendo, investigates the consequences of global safe asset shortages for aggregate economic activity. We build a model with two countries (Home and Foreign) and emphasize two sources of heterogeneity: (i) Home has more developed financial markets and (ii) a smaller number of risk-averse agents compared to Foreign. We find that safe asset demand by Foreign causes a “safety trap” (liquidity trap in the market for safe assets) with depressed output in both countries. Under imperfect fiscal policy, there is a trade-off for safe public debt provision: it expands output everywhere but generates wasteful distortions in the issuing country. Finally, we show that Home has an incentive to close down its capital account. This has the upside of avoiding a safety trap, yet the downsides of paying higher debt servicing costs and foregoing net interest income on its asset position.