Essays on International Finance

Abstract

This dissertation studies how monetary policy, international capital flows, and fiscal financing constraints shape bond yields, exchange rates, and inflation in open economies. Across three chapters, it shows that financial prices in these economies are influenced not only by conventional policy and market forces, but also by the information conveyed by central bank actions, the balance-sheet exposures created by cross-border investors, and the fiscal incentives behind inflationary finance. Chapter 1 examines how monetary policy surprises affect the term structure of interest rates in advanced and emerging economies. Using a novel high-frequency dataset of sovereign nominal yield curves for more than 40 countries, together with information from inflation-indexed bonds, I show that a surprise monetary tightening lowers long-term nominal yields, term premia, and inflation expectations in advanced economies, but raises them in emerging markets. I also show that these contrasting responses are driven by differences in the informational content of policy surprises: in emerging markets, private agents extract relatively more information from unexpected policy decisions about future inflation. To rationalize these findings, I develop a preferred-habitat model with asymmetric information in which policy actions transmit not only through interest rates, but also through the beliefs they reveal about the economy. Chapter 2, joint with Pierre De Leo, Lorena Keller, Mauricio Villamizar-Villegas and Tomás Williams, studies how global investors in local-currency bond markets shape the joint dynamics of government bond yields and exchange rates. Using transaction-level data from Colombia’s bond and foreign exchange markets, we show that global investors’ purchases of local-currency government bonds are systematically accompanied by simultaneous transactions in the spot foreign exchange market, whereas this is not the case for local investors. We develop a model in which these cross-market flows alter intermediaries’ exposure to bond and currency risk, thereby affecting the joint behavior of bond and currency risk premia. The model accounts for the observed effects of foreign inflows on intermediaries’ positions, asset returns, and the comovement between bond yields and exchange rates, and it helps explain cross-country differences in these joint dynamics. Chapter 3 studies the optimal use of seigniorage in economies where agents can substitute away from domestic currency and into foreign money. Motivated by the fact that persistent fiscal deficits remain a central feature of high-inflation economies, I solve a multi-currency optimal taxation problem with and without foreign exchange controls. The analysis shows that restricting the use of foreign currency increases the government’s control over the monetary base and allows it to sustain larger fiscal deficits through inflationary finance. The chapter also implies that the Friedman rule is never optimal in this environment, that countries with weaker tax systems rely more heavily on the inflation tax, and that foreign exchange controls may become more desirable when foreign nominal interest rates are high.