International Financial Markets, the Macroeconomy and Macroeconomic Policy

Brian Henry

There will be four sections to the project, and each will conclude with a major report, which will be suitable both as an input into academic conferences and for publication in full or in part in mainstream journals. In outline the four sections are as follows. Each report will be published on the website as it becomes available.

Financial Crises and the Macroeconomy.

A review of major theories and the prospects for a common testing framework. Theoretical models at present are limited to two-period simplified economic representations. Descriptive studies emphasise the role of government policy in creating moral hazard (Investment in South Korea, Foreign exchange risk bets in Russia), the importance of financial intermediaries and non rational expectations behaviour (e.g. contagion effects, herd instinct etc), but are short on testable implications and empirical results. The purpose of this exercise is to establish a framework, bringing together ingredients from each of these strands, aiming to determine what we do- and what we do not-know, and what can be established by new empirical tests.

Financial Crises and the Macroeconomy: A Critical Review.

Models of Cycles and Financial Crises.

This section will investigate non-linearity in models of the business cycle and extensions to these which attribute a major role to financial crises in producing real cycles. Critically, this section will evaluate the crucial role of rational expectations formation in the standard “second-generation” model of crises, including the issue of its apparent incompatibility with stylised data. We will set out the case for alternative models of multiple equilibria, with boundedly rational expectations as its main assumption. This will lead to models having the property of policy induced “adverse equilibrium” states, taking the sluggish economic performance of the Eurozone and Japan during the 1990s as examples.

On an Inconsistency in the Goodwin Model of the Growth Cycle

Volatility in International Financial markets.

Measures of volatility. This will use both statistical and other measures of volatility derived from derivative markets. It will estimate models of time-varying volatility. The final stage will seek to account for changes in volatility, using structural models of volatility and will identify the role of policy regimes in producing changes to measures of volatility.

Asset prices and the International economy.

The basic tests in this section will be concerned with the international linkages between financial asset price changes. This will use a variety of statistical methods; time-series analysis and structural econometric models of international linkages, at both high frequency and low frequency. The statistical models will feature dynamic spectral, and factor and principal components techniques. The structural models in turn, will estimate joint models of standard arbitrage relations using modern cointegration techniques to incorporate the major non-stationarities in the data. A variety of asset prices will be considered, including international interest rates (short and long), bond yields and equity returns.

Among the key questions to be tested will be evidence of long run equilibrium relations which accord with theory. We will also undertake econometric tests of macro and policy effects on international asset price spreads. Do changes in government debt have quantifiable effects for example?