Monetary Policy, Welfare and the Structure of International Financial Markets
Summary of research findings
The project analyses the implications of international financial markets for macroeconomic dynamics and monetary policy. It was conducted in collaboration with Michael Devereux of the University of British Columbia in Vancouver. The main results can be summarised as: (1) the development of a new solution methodology, which allows the analysis of portfolio problems in open economy dynamic general equilibrium models; (2) analysis of both the steady state and dynamic components of equilibrium portfolios; (3) analysis of the impact of portfolio choice on optimal monetary policy.
The solution is divided into two stages. In the first, a zero-order approximation is used to solve for the steady state component of portfolios. Then, in the second, a first-order approximation is applied to derive accurate solutions for all other variables of the model. The extension of the method to higher-order approximations of the model provides valuable insights into the fundamental factors that determine portfolio dynamics.
One of the main achievements of this project is to show that solution methods based on second-order approximation techniques offer a powerful and tractable approach for the analysis of asset markets and portfolios. This study demonstrates that they can be applied to any standard open economy model with any number of assets, any number of state variables, and complete or incomplete markets. The solution technique also makes it possible to obtain solutions for asset returns.
The size and composition of international portfolios of assets depend on the monetary policies that Central Banks use (among other things). However, it turns out that the effect on portfolios does not alter the case for price stability as an optimal monetary policy. Indeed, it may reinforce the case. Another very interesting finding is that exchange rate volatility may be a necessary part of optimal monetary policy because it facilitates risk sharing.
Further details of the project are to be found on Professor Sutherland’s website or the ESRC Today website.
Papers from the project were presented at major academic conferences and at many policy institutions, including the Federal Reserve Board, the European Central Bank, the Bank of England and the International Monetary Fund.
Recent publications:
Devereux, Michael B and Alan Sutherland (2008) "Financial Globalization and Monetary Policy" Journal of Monetary Economics, 55, 1363-1375.
Devereux, Michael B and Alan Sutherland (2009) "A Portfolio Model of Capital Flows to Emerging Markets" Journal of Development Economics, 2009, 89, 181-193.
Devereux, Michael B and Alan Sutherland (2008) "Country Portfolios in Open Economy Macro Models" NBER Working Paper No 14372. (Forthcoming in the Journal of the European Economic Association.)
Devereux, Michael B and Alan Sutherland (2009) "Valuation Effects and the Dynamics of Net External Assets" NBER Working Paper No 14794. (Forthcoming in the Journal of International Economics.)
Associated Papers:
Devereux, Michael B and Alan Sutherland (2006) "Solving for Country Portfolios
in Open Economy Macro Models" CEPR Discussion Paper No 5966.
Devereux, Michael B and Alan Sutherland (2006) "Country Portfolio Dynamics"
manuscript.
Devereux, Michael B and Alan Sutherland (2006) "Monetary Policy Rules and
International Portfolio Choice" manuscript.
Devereux, Michael B and Alan Sutherland (2006) "Monetary Policy and Portfolio
Choice in an Open Economy Macro Model"
Devereux, Michael B and Alan Sutherland (2007) "Monetary Policy and Portfolio Choice in an Open Economy Macro Model" Journal of the European Economic Association, 5 (Papers and Proceedings), 491-499.
Devereux, Michael B and Alan Sutherland (2007) "Country Portfolio Dynamics" CEPR Discussion Paper No 6208.
Devereux, Michael B and Alan Sutherland (2008) "Financial Globalization and Monetary Policy" Journal of Monetary Economics, 55, 1363-1375.
Devereux, Michael B and Alan Sutherland (2008) "Country Portfolios in Open Economy Macro Models" NBER Working Paper No 14372. (Forthcoming in the Journal of the European Economic Association.)
Devereux, Michael B and Alan Sutherland (2009) "A Portfolio Model of Capital Flows to Emerging Markets" Journal of Development Economics, 2009, 89, 181-193.
Devereux, Michael B and Alan Sutherland (2009) "Valuation Effects and the Dynamics of Net External Assets" NBER Working Paper No 14794. (Forthcoming in the Journal of International Economics.)
Researchers:
Professor Alan J Sutherland
University of St Andrews
Contact:
Professor Alan Sutherland
School of Economics and Finance
University of St Andrews
St Andrews
Fife
KY16 9AL
Tel: 01334 462420
email: ajs10@st-and.ac.uk
Duration of Research:
September 2005 - June 2007