The Credit Channel of Monetary Policy and Exchange Rate Flexibility in a Small Open Economy

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1 The Credi Channel of Moneary Policy and Exchange ae Flexibiliy in a Small Open Economy Yu-Ning Hwang a Fu-Min Yang b Deparmen of Economics Naional Chengchi Universiy Absrac The objecive of his sudy is o highligh he role of he banking secor in a small open economy. y including he banking secor in a dynamic sochasic general equilibrium (DSGE) model wih he small-open-economy seing, his sudy examines he significance of he banking secor in a small open economy and he implicaion of economic openness for he credi marke. The seady sae analyses show ha he inefficiency of he banking secor in a small open economy drives subsanial movemens of he EFP, same as is role in a closed economy, bu higher openness raises he EFP. Furhermore, in line wih he curren worldwide financial crisis, his sudy sresses he shock o he collaeral effeciveness for he loan services. In face of he financial shock, consumpion and oupu drop as hey do in a closed economy, accompanied by he appreciaion of he home currency. Thereby he home currency appreciaion resuls in lower expor as well as producion, and hus exacerbaes he impacs of shocks on he economy. Keyword:Credi Channel; Exernal Financial Premium; Flexible Exchange ae; Financial Crisis JEL Classificaions: F3; F4; F5 a Deparmen of Economics a Naional Chengchi Universiy, 64, SEC. 2, Tz-nan d., Wenshan, Taipei 6,Taiwan. Tel.: ex yuning@nccu.edu.w. b Deparmen of Economics a Naional Chengchi Universiy, 64, SEC. 2, Tz-nan d., Wenshan, Taipei 6,Taiwan. Tel.: ex @nccu.edu.w.

2 . Inroducion In he pas decade, here are considerable quaniies of sudies on he moneary policy under open economies, paricularly using he DSGE framework. However, mos of hese sudies neglec he banking secor whose imporance has been well recognized in a closed economy. On he oher hand, alhough he role of he banking secor in an economy has been examined exensively, hese sudies are conduced under a closed economy framework. Neverheless, he ongoing worldwide financial crisis which originaed from dysfuncional credi markes in he US has demonsraed how easily he credi marke shocks can be spread o oher counries under globalizaion of goods and capial markes. The crisis has cas srong doub for globalizaion. Therefore, i is crucial o invesigae he role of he banking secor in an open economy. The objecive of his sudy is o esablish a small-open-economy DSGE model wih money and banking o examine wheher he openness of goods and asse markes alers he role of he credi marke and helps dampen he macroeconomic impacs of he financial disress ha originaes from he credi marke. Inuiively, globalizaion may no affec he role of he banking secor qualiaively, bu exchange rae movemens driven by he ineres rae dispariy on he global asse marke due o financial shocks may influence he inernaional rades, and hus may aler he impacs of shocks on he producion and consumpion in an economy quaniaively. y using he model in Goodfriend and McCallum (27), we will conduc calibraions o examine he role of banking secor numerically. Equipped wih he loan marke, his sudy can also have some implicaions for he curren global financial crisis. The lieraure on credi channel such as ernanke and linder (988) and ernanke and Gerler (995), followed by many oher sudies places an emphasis on he implicaion of he banking secor for moneary policy ransmission. Insead of lumping

3 up all he ineres raes, hey disinguish various ineres raes on he marke and show ha he exernal finance premium (EFP), which is he spread beween he loan and deposi raes, can be counercyclical and plays he role of he financial acceleraor of moneary policy. The lower ineres raes caused by expansionary moneary policy help improve he balance shees of firms and hus firms can acquire more funds a lower loan raes. This will reduce he EFP and reinforces he effecs of moneary policy on producion. The credi channel has been examined exensively by Edwards and Vegh (997), Kiyoaki and Moore (997), Carlsrom and Fuers (997), Kocherlakoa (2) and ohers. However, sudies lised above neglec he role of money in he economy wih banking secor. Goodfriend and McCallum (27, henceforh GM (27)) includes he banking secor in a prevailing DSGE model. They emphasize he quaniaive imporance of money for an economy wih credi marke insead, and show ha money will be he financial aenuaor of moneary policy, couneracing he effecs of he financial acceleraor. The rising demand for deposis which is driven by an expansionary moneary policy raises he EFP. Moreover, by including he loan producion process in he model, hey can discuss he financial disress ha originaes from he credi marke. While hese sudies discussed above are conduced under closed economy frameworks and he examinaion of he credi channel under an open economy is absen, i is crucial o sudy his issue under a small open economy seing. Moreover, since he exchange rae movemens may aler he effecs of he credi channel, we have o include money in he model. Therefore, we exend he model wih money and banking in GM (27) by opening up he good and asse markes. All he goods are radable across counries under a monopolisically compeiive marke srucure. In addiion o he home bond issued by he governmen and held by domesic households only, here is he foreign bond ha can be raded inernaionally. Following he specificaion of GM (27), he

4 loan producion requires collaerals and monioring. The collaerals consis of he home bonds and real capials. The foreign bonds, however, can no serve as he collaeral. Thus, he foreign bonds require a liquidiy premium o compensae for he lack of he liquidiy services ha he home bonds can offer. Moreover, he loan process is subjec o wo shocks: he shock o he value of real capial as collaeral for loans and o he monioring. The credi shocks can characerize he curren financial crisis saring from he credi marke. y using his framework, we can see ha he banking secor does maer in an open economy and will play an addiional role for moneary policy ransmission, as he credi channel lieraure suggess. More efficien loan producion does help reduce he EFP in he seady sae analysis. On he oher hand, in he dynamics, a posiive uni shock o produciviy causes he EFP o rise, which serves as he financial aenuaor as in GM (27) due o he presence of money. The financial shocks also drive he EFP movemens. Furhermore, he calibraion resuls show ha higher degree of openness in he good markes raises he EFP in he seady sae by inducing greaer ransacions in bonds, and exacerbaes he impacs of he financial shock in dynamics. The remainder of his paper is srucured as follows. In Secion 2, we presen he specificaions of he model and he endogenous deerminaion of ineres raes is lised in Secion 3. The resuls of he seady sae are lised in Secion 4 o examine he quaniaive imporance of money and banking as well as he economic openness o he economy. In Secion 5, we conduc he dynamic analyses o examine how he EFP may behave differenly upon shocks in a small open economy, and how he openness may reinforce or dampen he impacs of shocks hrough exchange rae movemens. Secion 6 concludes. 2. The model

5 2. The model 2.. The goods marke Consider a small open economy operaes under floaing exchange raes and perfec capial mobiliy in a DSGE srucure. There are households, firms, banks, and governmen. The ypical household owns a monopolisically compeiive firm and a perfecly compeiive bank. All he goods are raded across counries by using capial and labor as inpus which are immobile across counries. The consumpion bundle of he counries includes he domesic goods and impors. The consumpion bundle in he counry consiss of he domesic and impored goods: c = ( ) ( ) ( ν ) ( ) ( ) ( ν ) ( ν ν ν ) d d m m α c ν + α c ν ν The associaed price index of he composie goods, and he associaed demands for each ype of goods are shown below: i P = P s ds i = d m ν ν i ν d d m m ( ),, P α ( P ) α ( P ) ( ) θ = +, i i i c = α P / P c, i = d, m () α α are he percenage of he domesic (impor) good in c, wih d m where ( ) d m d m α, α, α + α =. ν and θ are he price elasiciy of each individual goods and each ype of goods in he aggregae consumpion. P i is he price of goods associaed wih he firms of he counry. The goods of ype d and m presen he domesic goods and impored goods respecively. The consumpion demand and he price index in he res of he world follow he similar fashion:

6 ν x = ( / ), wih ( / ) ( ) ( ) c s P s P c x x x c = P P μ () where ν ( ν ) x( ) ( ν ) ν x x and ( ) x c = c s ds ν P = P s ds ( ν ) Here, x P is he home counry s expor price index denominaed in he foreign currency and P is he aggregae price index for he res of he world. We assume ha he law of one price holds for he home goods and hus P = P e where e is he d x nominal exchange rae The represenaive household The ypical household s preference is described by s s β ψ log ( ) + ( ψ) log( ) (2) E c l n = where β (,) is he subjecive discoun rae, and c is he period consumpion bundle. a The ime ha he ypical household own is normalized o one, l and n s are s he labor supplied in he good producion and banking secor separaely. ψ characerizes he imporance of he uiliy generaed by consumpion. The ypical household obains income from he salary of working, revenue from producion, receip of financial asses, and ne sales of capial goods. So he budge consrain can be wrien as a I is a Dixi-Sigliz consumpion bundle, in advance for always lending o consume.

7 x ( ) ( ) ( + ) ( s) d ν θ d M e s s d P P A ( δ) ( ) α d P P P P P q K w l + n + c + x ν μ x P s ep s P M ( ) x w l + n qk+ T P P P P e e c P( ) + + P = (3) Here, q is he value of he capial in erms of consumpion goods, δ denoes he depreciaion rae of capial, K represens he capial sock in he period. w is he real wage rae and is idenical across secors. l is he labor demanded by firms in he producion secor, while n is he labor demand of banks. M is nominal holdings of high-powered money a he end of. T sands for he real lump-sum ax paymen in he period. + is he bonds issued by he home governmen and denoes he associaed ineres rae. We assume ha he home bonds are circulaed wihin he counry only. On he world asse marke, here is one inernaionally radable bonds, +, wih he ineres rae. Following he specificaion in Kollmann (22), we assume here is a world ineres rae ha prevails on he global asse marke and he relaionship beween he world ineres rae and he bond rae paid by he individuals in he small open economy is saed as below: ( ) ( ) ( + ) + = + -φ / P / χ (4) Eq. (5) capures he fricion in he global financial marke wih φ as he degree of capial mobiliy. Higher φ represens lower capial mobiliy and hus he bond rae faced by he home individual will be lower, closer o he world bond rae. χ is he x seady-sae value of expors ( / ). P P μ

8 2..2 The goods marke clearing condiion Goods are sold in he domesic marke or are expored o he res of he world. Under monopolisically compeiive markes, oupu is deermined by he demand. Therefore, he marke clearing condiion holds as follows: θ d x ( ) P ( ) d ν ν μ x η l d P s η A P s P ( ) α d x P P = P P K Al c (5) where c = c + δ q K and A l is he echnology shock o he goods producion. A To simplify he model, we will assume ha he capial remains a is seady-sae level all he ime, following GM (27). Therefore, in he following calibraions, he invesmen expendiure is compleely refleced by he movemens of he capial value, q anks Aside from he real secor, here is a banking secor in he economy o supply he liquidiy services, including deposis and loans, o he marke. If he ypical household wans o consume goods, hey need o hold money in he period for he paymen. Therefore, he consumpion is subjec o he credi-in-advance consrain as follows: where c VD = (6) P D is he nominal deposis, and V sands for he velociy of deposis. a The bank as he financial inermediary receives deposis and creaes loans. Thus he bank s asse is composed of he oal reserves M and loans L, while he liabiliy a The concep comes from he equaion of exchange( MV = PY), similar o he urnover rae of money per year.

9 consiss of he demand deposi D. The balance shee is shown below: where M = τ D wih τ as he bank s reserve raio a. M + L = D (7) To offer loans, he bank has o hire labor for he loan managemen (such as evaluaing cusomers, monioring loan repaymens, and so on), as well as he acquisiion of capial and he home governmen bonds as he collaeral. The inernaionally raded bonds are no effecive o serve as he collaeral for loans. The loan producion is assumed o follow he Cobb-Douglas form: L P ( k α n ) ( ) + + α = Z b + A Θq K A n < α< (8) where Z is he consan measure of he loan producion efficiency. ( b k + + A ρqk+ ) is he collaeral wih / ( b+ + P ) = +. k A and A n are shocks o he efficiency of capial as he collaeral and he effeciveness of monioring respecively. The financial disress ha originaes from he credi marke can be characerized by negaive shocks o k A and A n. Θ is a consan which manifess he inferioriy of capial han he governmen bonds for collaeral uses. b 2.2 Firs-order condiions efore obaining he firs-order condiions, we le k ( ) Ω= α c / b + + A Θq K+ (9) Since all he agens are symmeric, prices of goods in he same caegory will be idenical. The firs-order condiions wih respec o l, l, n, K, +, +, P are s s a Tha is o say, τ is he reserve requiremen plus excess reserves. b ecause capial requires higher monioring cos and has lower liquidiy.

10 lised as follows: w ψ l n ψ = cλ = w λ ( α ) n c () () ξ l K w = A ( η ) l λ Al η (2) ψ c l η k λ+ λ+ ξ+ A+ l+ A ΘqΩ q + β( δ ) E q + βηe = λ λ λλ + K (3) λ P c ψ + Ω + β E ( + ) = λ λp+ ( ) + λ Pe + = + + β E λp+ e (4) (5) ξ P = (6) d ν λ ν P ( ) / b + = + P + (7) ( ) / b = e P + (8) + + P x d P = (9) e M M g T = + + P P P P ( + ) (2) The difference beween Eq. (5) and Eq. (6) is he liquidiy service offered by he home bonds o serve as he collaeral for loans. Therefore, he ineres rae of foreign bonds has o be high enough o offse is failure o serve as he collaeral for loans. Eq. (2) is he law of one price condiion and Eq. (2) is he governmen budge consrain. The governmen does no hold any inernaional raded bond, bu finances is

11 expendiures by levying ax, issuing high-powered money and bonds. In he symmeric, flexible-price equilibrium, Eqs.(), (2), (4) - (2) deermine he values of weny endogenous variables, clnw,,,, λ, Ω, LDq,,, d,, b, e, P,, A P c, ξ, T and, given he processes of exogenous variables and governmen policies M, b and g. For simpliciy, we assume he governmen spending g equals o zero hroughou. 2.3 Exogenous variables Now we urn o he exogenous variables. There are he world s price index, impor good price, and world ineres rae for he res of he world which have o be specified exogenously, because he small open economy does no have he power o affec he res of he world. Following Kollmann (22), we assume all of hese exogenous variables follow he A () process: a Π = ( ρ ) Π + ρ Π + ε, ρ < (2) Π Π Π Π m m m m m m m ρ Π ρ Π ε Π ρ Π Π = ( ) Π + Π +, < (22) = ( ρ ) + ρ π + ε, ρ < (23) where Π = / and Π m = P m / P m. P P Moreover, he exogenous shocks also obey he A() process: l l ( ) l l l l l A = ρ A + ρ A + ε, ρ < (24) k k ( ) k k k k k A = ρ A + ρ A + ε, ρ < (25) n n ( ) n n n n n A = ρ A + ρ A + ε, ρ < (26) where m Π Π ε, ε, ε, ε, ε, ε l k n are i.i.d. disribued. a We accep he mos sandard formula; I hink i is bes o say close o he mainsream of his heory.

12 In addiion, we assume ha he growh rae of high-powered money follows he similar evoluion process: h h h h = ρ h + ε, ρ < (28) where h = log M log M. y assuming he moneary policy as he conrol over he sock of high-powered money, insead of he ineres rae rule, his model can generae he ineres raes endogenously. 3. Ineres rae 3. ineres rae relaionship Various ineres raes are deermined endogenously in he model. To compare wih he convenional models, we inroduce an uncollaeralized loan rae, T, as he benchmark ineres rae. Wih he specificaion of he household opimizaion problem above, T mus saisfy he condiion below ha resembles he Euler equaion in he convenional lieraure: λ P + = E (29) T + βλ+ P The link beween Eq. (29) and Eq. (5) T and he governmen bond rae + ψ = T Ω + cλ could be obained from (3) From he equaion above, we can see ha hese wo raes would be idenical when Ω = or ( ψ / λ ) =. The far righ erm of Eq. (29) could be viewed as he c

13 liquidiy premium of bonds. The inerbank rae I is he mos common ool of he cenral bank s moneary policy. Equipped wih he reserve marke, banks can obain funds a he cos I and loan hem ou o households wihou requiring he collaeral a he uncollaeralized rae T. So here mus be a no-arbirage condiion beween he inerbank rae and loan rae for he compeiive banks. The marginal cos of he loan making is equal o he wage divided by he marginal produc of labor. The combinaion of Eqs. (7), (8), (9) yields he wage w. The relaionship beween hese wo ineres raes mus saisfy he condiion below: + = + + ( ) ( ) Vw n T I ( α)( τ) c (3) On he oher hand, households can also obain loans wih collaerals. The relaionship beween and L should follow he similar fashion. Since he collaeral can help I reduce he monioring effor by he share of α, he marginal cos of he collaeralized loans can be muliplied by ( α ). Therefore, he difference beween he collaeralized loan rae and he inerbank rae can be saed as below: + = + + ( ) ( ) Vw n c L I ( τ ) (32) Lasly, since he bank holds he fracion τ of deposi as he reserve. I is naural for and D o differ in reserve raio under he perfecly compeiive seup. Thus, he I relaionship beween he deposi and he inerbank rae is: D I = ( τ ) (33) The disincion of various ineres raes allows he endogenous deerminaion of EFP.

14 Here EFP can be deermined by L I which reflecs he real marginal cos of managing and monioring effor muliplied by he nominal wage of he loan producion. Since he EFP would influence he bank loan sraegy, he following analysis will emphasize is movemens. 4. Seady sae 4. Seady sae In his secion, we will examine he deerminisic seady sae wih zero inflaion. In he seady sae, we assume ha he price of capial q = and he nominal exchange rae is d m x equal o. Moreover, o simplify he analysis, we assume ha P= P = P = P = and he world price index for he res of he world P =.67. The inernaional ineres raes, and are specified as., following Kollmann (22). Moreover, according o GM (27), gb is he consan share of he governmen bonds o consumpion and is assumed o be.6 in he seady sae. As a resul, Eqs. () & (2), (4) - (2) will be degeneraed o nine equaions for nine endogenous variables,,,, λ, Ω,,,. clnw Kb The seady-sae condiions can be saed as below. Firsly, he combinaion of Eq. (7), (8), (9) V ΘqK n = Z gb+ τ c c α α (34) Then Eqs. () (4), (6) can be saed as follows: Ω= α qk gb + Θ (35) c

15 ψ = wλ l n ( α ) (36) ψ c w = ( ) (37) cλ n ( ν )( η) K w = ν l η ( ν ) (38) η ψ η K Θ Ω + β δ + = (39) cλ ν l x μ d A P c η η K n α = P (4) Afer hese seven seady-sae variables are obained from Eqs. (33) o (39), we can derive and b from he Euler equaions associaed wih he home and foreign bonds, and he curren accoun balance by combining Eqs.(4), (6), and (2). ( ) ψ Ω+ β = (27) cλ b ( P / P ) = α c (28) m A x Afer solving he core model, we can easily solve he seady-sae level of T I L D,,, and he EFP from he ineres rae condiions Eqs. (28) (3). μ 4.2 Model Parameerizaion Now we calibrae he model wih he appropriae specificaion of parameer values. In paricular, we will emphasize he imporance of he banking secor and how much he economic openness maers. Firsly, we se he quarerly discoun facor β o.99, and δ =.25 for he quarerly depreciaion rae as he convenional seing. ψ is assumed o be.48 o generae he reasonable labor inpu in he producion secor which is approximaely

16 m /3 of he oal ime endowmen. α =.3 is specified so ha he seady-sae impors/gdp raio is 3%, consisen wih he Germany and U.K. daa. The seady-sae price-marginal cos markup facor for goods produced by he domesic firms is se a ν /( ν ) =., and he price elasiciy for all goods in he economy and he res of he world is chosen θ = μ = 5. Following GM (27), we choose η =.36 o reflec he relaive shares of capial and labor in he goods producion. Then here are he parameers relaed o money and banking secor need o be deermined. The velociy of moneary urnover rae is specified as V =.4, and he bank reserve raio is equal o.5. a The parameers in he loan producion are Θ, Z, α, and are assumed o be.2,,.65, following he specificaion in GM (27). In he seady sae, we le he bond rae =.. φ=.2 is he value of panel regression for 2 OECD counries by Milesi-Ferrei & Lane (2). 4.3 Numerical resuls The seady-sae resuls of he baseline model are summarized in Table. Since he seady sae is in he zero inflaion condiion, all he ineres raes are in he real erm. Firsly, he oal labor l+ n 33.69% is a reasonable value close o /3 ha is generally acceped in he business cycle lieraure. ecause we se he world ineres rae = % as he normal level, oher raes are deermined accordingly from he ineres rae relaionships in Secion 3. As shown, he loan rae L is abou.56% quarerly, he inerbank rae is.32% and consequenly he EFP is a he level around a V =.3 in Goodfriend & McCallum(27), bu he ineres raes will be negaive in his sudy wih he same velociy.

17 m Table: enchmark model ( Z =, α =. 3) Variable c A c l n w K b b Seady Sae Variable I L T D λ Ω EFP Seady Sae %. While various ineres raes in he model are in differen levels, if he cenral bank uses only one ineres rae for he moneary policy making, i may lead o misjudgmens. Furhermore, we calibrae wo more cases o examine he significance of banking secor and economic openness in an economy. Firs, we consider a highly efficien financial marke by specifying Z o be imes higher han he benchmark model. The calibraion oucomes are lised in Table 2. Under he assumpion of perfecly compeiive bank indusry and he bank which could produce loans in a highly efficien way, all he ineres raes converge o. Therefore, he EFP is driven down o a level close o zero and so is he labor in he banking secor. Indeed, he high efficiency of he banking secor can successfully reduce he EFP in a small open economy as in a closed economy, which signals he worsening of he asymmeric informaion problem on he credi marke. The oher case is he lower openness of he counry by leing m α o be equal o.. The calibraion oucome is presened in Table 3. y comparing Table 2 and 3, we can see ha consumpion rises wih he openness of rades, bu capial drops. The mos significan change is he rise in he seady-sae real curren accoun balance as shown by b. As shown in Eq. (39), he accumulaion of he inernaional bonds mus be accompanied by excess impors. While he rade defici rises wih he degree of openness, he bonds needed are greaer. Furhermore, sronger consumpion demand

18 m Table2: Highly efficien banking sysem( Z = 9, α =. 3) Variable c A c l n w K b b Seady Sae Variable I L T D λ Ω EFP Seady Sae m Table3: Less open marke( Z =, α =. ) Variable c A c l n w K b b Seady Sae Variable I L T D λ Ω EFP Seady Sae due o greaer openness induces higher demand for deposis, and hus causes lower ineres raes in he seady sae. However, his resuls in a higher level of EFP. 5. Dynamic Analyses In his secion, we will discuss he impacs of produciviy and financial shocks on he economy. The numerical examinaion of dynamic analyses will focus on wo pars. One is he quaniaive imporance of credi channel in a small open economy. The ineres rae movemens caused by inernaional ransacions will have an addiional influence on he EFP movemens. Furhermore, while curren credi channel sudies are examined in a closed economy, our sudy will invesigae he implicaions of a small open economy on he financial secor. Since shocks aler he demand and supply for deposis

19 and loans in an economy, closely relaed o he consumpion which is alered by he inernaional rades, he exchange rae movemens and rades drive he ineres rae dispariy across counries which furher affecs he ransacion of inernaional radable bonds as well as he EFP. The following calibraions are conduced under highly persisen shocks. We assume l k n m he A() coefficiens of shocks, ρ = ρ = ρ = ρ =.99, while he persisence of he prices, Π ρ m Π = ρ =.8 and ρ =.95. Moreover, we assume ha prices are rigid in he shor run and ha firms adop he Calvo saggered pricing as he pricing sraegy. To avoid furher complicaion of he model, he price adjusmen process is characerized as follows: where κ > and Π = β EΠ + κσ + u (2) + Π = log log (2) P P which sands for he inflaion rae of he aggregae price level. marginal cos of goods producion and can be idenified as: κ is assumed o be.5 for calibraions. σ denoes he real σ = ξ λ (22) 5. Posiive produciviy shock: A l =. Figure shows he impacs of posiive produciviy on he economy. Similar o he convenional wisdom, oupu rises which is accompanied by lower labor inpu resuling from he echnological improvemen. The expansion in he home producion leads o lower expor prices and exchange rae appreciaions, which lowers he impor price, causing greaer impors. Therefore, he domesic consumpion increases.

20 .4 Consumpion Oupu Employmen Liquidiy yield Exchange rae - 2 x EFP Governmen bond -.4 x Foreign bond -3 x Inerbank rae Governmne bond rae -.5 Foreign bond rae x Loan rae Figure : A posiive uni shock o produciviy: A l =. On he oher hand, he domesic bond rae declines upon shock, bu rises above he normal level wih ime, while he foreign bond rae drops below he seady-sae level all he ime and will urn negaive in he end. The relaive change of ineres raes shrinks he spread beween he home and foreign bond raes over ime. This implies ha he benefi from he liquidiy service offered by he home bond declines gradually and hus drives greaer demand for he foreign bonds, causing he home currency o depreciae over ime. The home depreciaion dampens he ineres rae difference across counries, bu fails o compleely offse he dispariy. The lower benefi from he loan resuls in lower demand for loans and hereby drives down he loan rae. However, he cenral bank also reduces he inerbank rae in reacion o he deflaion due o he echnological progress and causes he srongly procyclical EFP, in conras o he counercyclical EFP in he convenional credi channel lieraure which excludes money and is conduced in a closed economy. This

21 .5 x -3 Consumpion.5 x -3 Oupu - x -3 Employmen -4 Liquidiy yield -3 x Exchange rae x EFP Governmen bond -3 4 x Foreign bond -5 x Inerbank rae Governmen bondrae x -3 Foreign bond rae x -3 Loan rae m A =, α =.3 n Figure 2: A uni shock o monioring:. resul prevails no maer how persisen he growh rae of he high-powered money is. This coincides wih he financial aenuaor of moneary policy in Goodfriend and McCallum (27) which essenially demonsraes he imporance of money in credi channel. I is because he expansionary money supply direcly increases he demand for consumpion, hereby deposis, which drives up he EFP. 5.2 A uni shock o he monior of loans: A n =. In line wih he curren financial crisis, shocks o he credi marke would be criical o he economy and he openness of he capial marke has made he crisis spread all over he world rapidly. The widespread crisis has cas srong doub on globalizaion. In addiion o he examinaion of he financial crisis which originaes from he inefficiency of monioring for he loan making process, we also wan o discuss wheher

22 .5 x -3 Consumpion.5 x -3 Oupu - x -3 Employmen -4 Liquidiy yield -3 x Exchange rae x EFP Governmen bond -3 4 x Foreign bond -5 x Inerbank rae Governmen bondrae x -3 Foreign bond rae x -3 Loan rae m A =, α =. n Figure 3: A uni shock o monioring under a less open economy:. globalizaion helps reduce he spread of he financial shock. However, insead of invesigaing he ransmission mechanism of he financial disress, we will focus on wheher he financial shock o a small open economy can be dampened by he openness of he economy. Figure 2 demonsraes he impacs of he shock o he monioring for he loan on he economy. While he loan making lacks monioring, i requires greaer amoun of collaerals for making he loans. Therefore, he demand for he home bond increases sharply, induced by he rising bond rae. The reducion of he liquidiy services ha he home bonds generae leads o greaer demand for foreign bonds, accompanied by falling foreign bond rae. While he spread beween he foreign and home bond raes urns negaive, he home currency appreciaes. On he oher hand, inernaional rades also cause he exchange rae movemens. The home appreciaion, ogeher wih he financial disress, causes he home

23 producion o drop while he consumpion rises, benefiing from cheaper impor prices. Oher ineres raes, on he oher hand, fall upon shocks. In paricular, he cenral bank has o reduce he inerbank rae o help he economy recover which has encounered declining oupu and deflaion. The loan rae also drops due o he lower supply of loans. The failure of monioring riggers he asymmeric informaion problem in he model causes he EFP o rise, same as he EFP movemen in he closed-economy framework in GM (27) under he financial shock. The divergen movemens of he bond rae and oher ineres raes place an emphasis on he imporance of he disincion of ineres raes in an economy wih he financial secor. This effec is absen from he convenional credi channel lieraure. The home currency appreciaion seems peculiar for an economy experiencing financial crisis, bu ineresingly, i coincides wih he movemens of he US dollars since he subprime crisis broke ou in 27. No only ha he US dollars did no experience significan depreciaions, bu also here seems o be a grea demand for he currency of he counry where he crisis originaed. The model here offers an explanaion for he srong dollar: he demand for he US asses remain high o offse he loss in he collaerals for he loan making. a Moreover, we have seen ha he exchange rae movemen has reinforced he impacs of he ineffeciveness of he loan monioring on he economy. The home appreciaion caused by he financial shock leads o higher expor prices, hereby lowers he home producion furher. The calibraion resuls of he model under lower degree of openness are shown in Figure 3. The comparison of Figure 2 and 3 demonsraes ha he impacs of he financial shock on oupu increase wih he openness. a The small-open-economy seup here may no be consisen wih he US economy. We assume ha foreigners do no hold home bonds, and he currency of he small open economy is definiely no he inernaional currency as he US dollars.

24 5. Conclusion In his paper, we examine he credi channel in a small open economy by using a small-open-economy DSGE model wih he banking secor. The discussions cener on wo aspecs. One is he role of he credi channel in a small open economy and he oher is he implicaions of economic openness for he banking secor. The seady sae analyses show ha he banking secor remains a significan role in he small open economy as in a closed economy. Moreover, he openness of rades drives down he ineres raes, bu raises he EFP. The analyses on dynamics, driven by he produciviy and financial shocks, are consisen wih he seady-sae resuls, bu addiionally demonsrae ha he exchange rae movemens may reinforce he impacs of financial shocks on he economy.

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