Implications of the Global Financial Crisis on the Algerian Economy

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1 Implicaions of he Global Financial Crisis on he Algerian Economy Implicaions of he Global Financial Crisis on he Algerian Economy Dr Ali DIB Bank of Canada-canada Absrac The global financial crisis may affec he Algerian economy hrough he following channels: () increase of coss of firms borrowing o finance heir invesmen, (2) decline in oil prices, and (3) he lower world ineres raes. This paper uses a small-open economy model wih financial fricions (he financial acceleraor) o examine he implicaions of he global financial crisis on he Algerian economy and evaluaes he imporance of he main ransmission channels. Firms operaing in Algeria borrow from domesic and foreign banks. The financing coss depend on firms balance shee posiions and on exernal finance premiums charged by banks for higher risks hey are facing. Main findings are ha he global financial crisis has subsanially and negaively affeced he Algerian economy and all channels are imporan in he ransmission of he financial shocks. Neverheless, he implemenaion of expansionary moneary and governmen spending policies can successfully help he economy avoid recession and hus offse he negaive implicaions of he global financial crisis. Keywords: Algerian economy; Global financial crisis; Transmission channel; Oil prices. JEL classificaion: E52; F3; F4; G. INTRODUCTION The ongoing global financial crisis, which was riggered by dysfuncional U.S. credi markes, broke ou in 27 when he subprime morgage defaul raes rose sharply afer he housing bubble burs in 26. Saring in he beginning of 2s, consecuive ineres rae cus and he flows of capial from he emerging and oilexporing economies allowed he U.S. banks o exend heir loans o low-income households wihou he need o exercise pruden conrol over he credi risks. In addiion, wih hisorical low ineres raes, The views expressed in his paper are hose of he auhor and should no be aribued o he Bank of Canada. Inernaional Economic Analysis Deparmen, Bank of Canada, 234 Wellingon S., Oawa (On), KA G9, Canada. Adib@bankofcaada.ca REVUE Des économies

2 Implicaions of he Global Financial Crisis on he Algerian Economy invesors could easily obain funds wih high leverage for invesmens. Consequenly, he housing crunch led o a chain of evens: he value of houses (collaeral for morgages) fell and was followed by mouning defaul raes, which caused sharp declines in he values of he underlying securiies and in urn he asse markes as a whole. The slump in he values of he asse-backed securiies led o a deerioraion in he balance shees of banks and firms, and sharp increase in he exernal finance premiums for firms. The deerioraion of he balance shees of banks and firms exacerbaed he impacs of he financial crisis and led o credi conracions in he financial and real secors. This resuled in deep recession worldwide. Thus, he failure o monior he loans and he decline in he collaeral values were wo of he main causes of he global financial crisis. The global financial crisis has affeced he oil-exporing counries, such as Algeria, hrough four main channels. Firs, wih ighening credi supply condiions, banks in developed counries have largely reduced heir loans. Thus, capial flows o finance foreign direc invesmen in oil exporing counries have been seriously affeced and coss of firms borrowing abroad widely increased, which incies foreign firms o cu heir direc invesmen in hese counries. Second, wih higher lending risks worldwide, domesic banks may ighen heir credi supply and raise he exernal finance premium requesed o compensae higher risks. Third, global financial crisis has induced subsanial decline in oil prices. Oil prices have dropped from abou $5 in he mid of July 28 o abou $5 in he mid of 29. This rapid and persisen decline resuled from he fall of global oil demand. Consequenly, revenues of oil exporing counries (from oil expors) have been largely declined, which is considered a major shock o heir curren accouns. Fourh, o simulae heir economies, developed counries cu heir nominal ineres raes. For example, he Federal Reserve Bank, cu he U.S. federal funds by 5 basic poin, from 5.25% o -.25%. Consequenly, revenues of reserves, which oil exporing counries were accumulaed during he boom, have dramaically fell leading o subsanial deerioraion of heir curren accoun posiion. 2 REVUE Des économies

3 Implicaions of he Global Financial Crisis on he Algerian Economy This paper aims o examine he implicaions of he global financial crisis on he Algeria economy and o analyze he role of he main previous four channels in he ransmission of he financial crisis. I also evaluaes he imporance of expansionary moneary and governmen spending policies in offseing negaive impacs of he financial crisis. Thus, we develop a small open economy model wih financial fricions and financial shocks. The model is a class of dynamic and sochasic general equilibrium (DSGE) models ha have been developed for policy and macro-economics analyses. The financial fricions are inroduced using he financial acceleraor mechanism à la Bernanke, Gerler and Gilchris (999) (BGG, hereafer), as used by Chrisensen and Dib (28). This financial mechanism focuses on he role of corporae (firm) balance shees in he amplificaion and propagaion of he differen shocks o he real economy. In his framework, households save by deposis a banks (financial inermediaries). Using deposis, banks provide loans o enrepreneurs, who are subjec o idiosyncraic produciviy shocks, o finance pars of heir invesmen. The presence of informaion asymmery beween banks and enrepreneurs creaes financial fricions and makes enrepreneurial demand for capial depends on heir financial posiion (leverage raio), which implies he exernal finance premium. 2 The model is calibraed o fi he main feaures of he Algerian economy, such as: () oil accouns for more han 95% of expors; (2) he counry is a ne credior o he res of he world and holds is reserves in he U.S. reasury bonds; and (3) is curren accouns highly depends on oil prices. Thus, we assume ha oil is he only expored good and oal impors are invoiced in he U.S. dollar. Similar models are used by Cespedes, Chang and Velasco (24) o examine impacs of he Asian financial crisis, by Dib, Mendicino and Zhang (28) o evaluae effecs of financial shocks on he Canadian economy, and by Bouakez, Rebei and Vencaachellum (28) o examine he impacs of oil price shocks in Africa.. 2 The enrepreneurs leverage raio is defined as he raio of deb o ne worh (equiy). 3 REVUE Des économies

4 Implicaions of he Global Financial Crisis on he Algerian Economy The model is solved numerically using Blanchard and Kahn (98) procedure. Then, i is simulaed using global financial, domesic financial, oil price, moneary, and governmen spending shocks. Main findings are ha foreign financial shocks associaed wih he global financial crisis have subsanial negaive implicaions on he Algerian economy and he four ransmission channels have large role in he propagaion of global financial crisis. Afer a negaive foreign financial shock ha ighs credi supply abroad, Algerian oupu and invesmen fall by more han % on impac, and hese negaive effecs persis for longer period. Similarly, drops of oil price enails significan decline in oupu, consumpion, and he curren accoun posiion. A fall of he world ineres raes negaively reduces he reurns on reserves held abroad and deerioraes he counry s curren accoun posiion. Neverheless, a decline in world ineres rae booss he domesic aggregae demand and incies he home counry o inves is reserves domesically. Ineresingly, he implemenaion of expansionary moneary and governmen spending policies can successfully help he economy avoid recession and hus eliminae negaive implicaions of he global financial crisis. The paper is organized as follows. Secion 2 describes he model. Secion 3 discusses he calibraion of he parameers. Secion 4 analyzes he simulaion resuls. Finally, secion 5 concludes. 2. THE MODEL We consider a small open economy populaed by households, producers of final goods, a coninuum of reailers and imporers, producers of capial, enrepreneurs, and a cenral bank. The counry s expors consis only of oil whose prices are se on he world markes and denominaed in he U.S. dollar. 2.. Households Households derive uiliy from consumpion, C, real cash money, m (holdings of money ouside banks), and leisure -h, where h is hours worked. Their preferences are described by 4 REVUE Des économies

5 Implicaions of he Global Financial Crisis on he Algerian Economy ( C, m h ) = E u, = U β, () where <β< is he discoun facor. The single-period uiliy funcion is u = log( C ) + υ log( m ) + η log( h (2) ( ) ), where υ> and η> denoe he weighs on money and leisure in he uiliy funcion, respecively. Toal consumpion depends on privae consumpion, c, and public consumpion, g, so ha γ γ γ γ γ γ γ C = a c + ( a) g, (3) where γ> is he consan elasiciy of subsiuion beween privae and public consumpion, and <a< is he share of privae consumpion in oal consumpion. For <γ<, privae and public consumpion are complemen. Households ener period wih real cash money, m -, real deposis a domesic banks, d -, and real ne foreign bonds, b, denominaed in he U.S. dollar. 3 During period, households may sell or purchase foreign bonds for prices ha depend on he counryspecific risk premium, κ, and he world ineres rae, R >. Furhermore, households receive revenues from exporing a fixed quaniy of oil, y o, for he oil price, p. Households also earn real wages, w, from supplying labour services and receive dividend paymens from he monopolisically compeiive reailers and imporers, Ω n + Ω f, as well as a lump-sum ransfer, T, from he cenral bank. The single-period budge consrain of he represenaive household is given by: d sb d sb m c + m w, h + s po yo + Ωn + Ω f + T R κr π π π (4) γ o 3 b is he sock of he real foreign deb if i is negaive, i.e. b <. 5 REVUE Des économies

6 Implicaions of he Global Financial Crisis on he Algerian Economy where s is he real exchange rae, he price of one U.S. dollar in erms of he Algerian dinars, R > is he domesic nominal ineres rae on holding deposis, and π > is he world inflaion rae. We assume ha oil prices, p o, are given in he world markes in erms of he U.S. dollar and evolve according o an AR() process, while he oil supply, y o, is a fixed endowmen. The world nominal ineres rae, R, and inflaion, π, are assumed o evolve exogenously according o AR() processes. The counry-specific risk premium, κ, which reflecs deparures from he uncovered ineres rae pariy, is decreasing in he foreign-asse-o-oal-oupu raio and given by: where φ> is a parameer measuring he risk premium, ~ s = exp b κ ϕ, (5) y ~ b > is he average real sock of foreign asses held by he domesic households, and y denoes oal oupu in he economy. The household chooses [c, m, h, d, b ] o maximize he expecaion of he discouned sum of is uiliy flows subjec o equaions (3) and (4). See Dib (28) for furher deails abou his opimizaion problem Firms Final-good producer The perfecly compeiive final-good producer uses domesic goods, y n, and impored goods, y f, o produce a final good, z, according he following CES echnology ν ν ν ν ν ν ν z = ( ω) yn + ω y f, (6) where ω> denoes he share of impors in he final good, and ν> is he elasiciy of subsiuion beween domesic and impored goods. Similarly, boh inpus are produced using he CES echnology ν 6 REVUE Des économies

7 Implicaions of he Global Financial Crisis on he Algerian Economy θ θ θ θ θ [ y ( j) ] θ n n and [ ( )] θ y = θ f,, y f j dj y =, dj (7) where θ > is he consan elasiciy of subsiuion beween inermediae goods in composie goods aggregaion. The final-good producer chooses y n and y f o maximize is profi. Is maximizaion problem is max { yn, y f } P z P n y n P subjec o (6). This implies he following demand funcions for domesic- and impored goods: ν ν Pn Pf ( ω z P and y f ω z P yn = ) =. (8) The zero-profi condiion implies ha he final-good price level, which is he consumer-price index (CPI), is linked o domesic- and impored-goods prices hrough: ν ν /( ν ) [( ω) P + ωp ] P. (9) = n f The final good is divided beween privae consumpion, governmen spending, and invesmen, so ha z = c + g + i Enrepreneurs The enrepreneurs' behavior is modeled following BGG (999). We assume ha enrepreneurs manage firms ha produce wholesale nonoil goods. Enrepreneurs are risk neural and have a finie expeced horizon for planning purposes. The probabiliy ha an enrepreneur will survive unil he nex period is τ, so he expeced lifeime horizon is /(-τ). This assumpion ensures ha enrepreneurs' ne worh (he firm equiy) is never sufficien o self-finance new capial acquisiions, so hey issue deb conracs o finance heir desired invesmen expendiures in excess of ne worh. A he end of each period, enrepreneurs purchase capial, k +, ha will be used in he nex period a he real price q. Thus, he cos of he purchased capial is q k +. The capial acquisiion is financed parly by heir ne worh, n, and by borrowing q k + -n f y f, 7 REVUE Des économies

8 Implicaions of he Global Financial Crisis on he Algerian Economy from domesic and foreign banks. We assume ha enrepreneurs borrow a fracion α from domesic banks and (-α) from foreign banks. Domesic banks obain heir funds from he households deposis. Borrowing from foreign banks is denominaed in foreign currency. The enrepreneurs' demand for capial depends on he k expeced marginal reurn, r +, and he expeced marginal exernal financing cos a +, E f +, which equals he real ineres rae on exernal (borrowed) funds. Consequenly, he opimal enrepreneurs' capial demand guaranees ha k r + + ( δ ) q+ E f+ = E, () q where δ is he capial depreciaion rae. The expeced marginal reurn k of capial is given by he righ-side erms of (), in which r + is he marginal produciviy of capial, and q + is he value of one uni of capial used in +. BGG (999) assume he exisence of an agency problem ha makes exernal finance more expensive han inernal funds. The enrepreneurs observe heir oupu coslessly, and oupu is subjec o a random oucome. Banks incur an audiing cos o observe enrepreneurs oupu. Afer observing heir projec oucome, enrepreneurs decide wheher o repay heir deb or o defaul. If hey defaul, he banks audi he loan and recover he projec oucome, less monioring coss. BGG solve a financial conrac ha maximizes he payoff o enrepreneurs, subjec o he required rae of reurn of loans. BGG show ha---given parameer values associaed wih coss of monioring borrowers, characerisics of he disribuion of enrepreneurial reurns, and he expeced life span of firms---he deb conrac implies an exernal finance premium, Ψ ( ), ha depends on he enrepreneurs' leverage raio. The underlying parameer values deermine he elasiciy of he exernal finance premium wih respec o he firm s leverage raio. Accordingly, he marginal exernal financing coss is equal o he gross premium for exernal funds plus he real opporuniy coss 8 REVUE Des économies

9 Implicaions of he Global Financial Crisis on he Algerian Economy ha is equivalen o he risk-free ineres rae. We assume ha enrepreneurs borrow a he same ime from domesic and foreign banks. They borrow a fracion α from domesic banks and (-α) from foreign banks. 4 Loans from foreign banks are denominaed in he foreign currency, so hey are convered o Algerian currency by muliplying by he real exchange rae s. The marginal cos of R borrowing from domesic banks is E Ψ( ) Γ and ha from π + R s + foreign banks is E Ψ( ) Γ. Thus, he oal exernal π + s financing cos is he sum of boh marginal coss of borrowing, so ha R R s + E f+ = α E Ψ( ) Γ + ( α) E Ψ( ) Γ, π + π + s () where Γ and Γ are domesic and foreign financial shocks, respecively. 5 Demand for capial should saisfy he following opimaliy condiion (). We assume ha hese financial shocks follow AR() processes, and he exernal finance premium is given by ψ qk+ Ψ( ) = Ψ, (2) n wih ψ< is he elasiciy of he exernal risk premium wih respec o he enrepreneurs leverage raio, and Ψ ( ) =. This elasiciy depends on he sandard deviaion of he disribuion of he enrepreneurs idiosyncraic shocks, he agency cos and he enrepreneurs' defaul hreshold. The exernal finance premium depends on he borrower's equiy sake in a projec (or, alernaively, he borrower's leverage raio). As q k + /n increases, he borrower increasingly relies on uncollaeralized borrowing (higher leverage) o 4 The oal enrepreneurs deb is (q k + -n ), so hey borrow α (q k + -n ) from domesic banks and (-α) (q k + -n ) from foreign banks. 5 For furher deails, see Dib e al. (28) ha analyze he impacs of hese shocks on he Canadian economy. 9 REVUE Des économies

10 Implicaions of he Global Financial Crisis on he Algerian Economy fund he projec. Since his raises he incenive o misrepor he oucome of he projec, he loan becomes riskier, and he cos of borrowing rises. 6 Aggregae enrepreneurial ne worh evolves according o n [ ( ) = τ fq k E f q k n ], (3) where f is he ex-pos real reurn on capial held a, and E - f is he cos of borrowing (he real ineres rae implied by he loan conrac signed a -.) 7 In his formulaion, borrowers sign deb conracs ha specify nominal ineres raes. The loan repaymen (in real erms) will hen depend on ex pos real ineres raes. Therefore, an unanicipaed increase (decrease) in inflaion will reduce (increase) he real cos of deb repaymen and increase (decrease) he enrepreneurial ne worh. To produce oupu y n, he enrepreneurs use k unis of capial and h unis of labor following a consan-reurns-o-scale echnology: α n α n y = A k h, (4) n where α n (,) is he share of capial in he non-oil oupu producion and A is a echnology shock common o all enrepreneurs. A is assumed o follow a saionary AR() process. Each enrepreneur sells is oupu o reail firms in a perfecly compeiive marke for a price ha equals is nominal marginal cos. The enrepreneur maximizes profis by choosing k and h subjec o he producion funcion (4). See Dib e al. (28) for furher deails Capial producers Capial producers use a linear echnology o produce capial goods sold a he end of period. They use a fracion of final goods 6 When he risk of loans increases, he agency coss rise and he lender's expeced losses increase. A higher exernal finance premium paid by successful enrepreneurs offses hese higher losses. 7 The cos of borrowing from domesic and foreign banks is ψ ψ R q k R s q k E = Γ + ( ) Γ. f E α α π n π s n REVUE Des économies

11 Implicaions of he Global Financial Crisis on he Algerian Economy purchased from reailers as invesmen goods i and he exising capial sock o produce new capial goods. The new capial goods replace depreciaed capial and add o he capial sock. Capial producers are also subjec o quadraic invesmen adjusmen coss 2 ha are specified as.5 χ ( i / i ) i, where χ> is he invesmen adjusmen cos parameer. The capial producers' opimizaion problem consiss of choosing he quaniy of invesmen o maximize heir profis. The opimal condiion is / q = χ ( i / i ) + βχe ( i + / i ), (5) which is he sandard Tobin's Q equaion ha relaes he price of capial o he marginal adjusmen coss. Noe ha, in he absence of invesmen adjusmen coss, capial price q is equal o. We inroduce invesmen adjusmen coss in he model o allow capial price variabiliy, which conribues o volailiy of enrepreneurial ne worh. The quaniy and price of capial are deermined in he capial marke. The inersecion of he demand and supply curves gives he marke-clearing quaniy and price of capial. Capial adjusmen coss slow down he response of invesmen o differen shocks, which direcly affecs he price of capial. Furhermore, he aggregae capial sock evolves according o k + = (-δ) k + i Reail firms Reail firms are used o incorporae nominal price rigidiy ino he economy. They purchase he wholesale goods from enrepreneurs a a price ha equals he nominal marginal cos and diversify hem a no cos. Then, hey sell heir goods in a monopolisically compeiive marke. Following Calvo (983) and Yun (996), we assume ha each reailer canno reopimize is selling price, unless i receives a random signal. The consan probabiliy of receiving such a signal is ( φ) ; and, wih probabiliy φ, he reailer j mus charge he same price of he preceding period, indexed o he seady-sae gross rae of CPI inflaion, π. If he reailer j receives he signal o reopimize, i chooses a price ha maximizes is discouned, expeced real oal profis for l REVUE Des économies

12 Implicaions of he Global Financial Crisis on he Algerian Economy periods, when i will no be allowed o reopimize. The reailer's opimizaion problem implies he following New Phillips curve: ( βφ )( φ ) πˆ ˆ ˆ n = β E π n + + ξ, (6) φ where π n is he gross inflaion rae in he non-oil secor, ξˆ is he real marginal cos, and variables wih has are log deviaions from he seady-sae values Imporers There is a coninuum of monopolisically compeiive imporers indexed by j [,] ha impor a homogeneous good produced abroad. Imporers can only change heir prices when hey receive a random signal. The probabiliy of receiving such a signal is ( φ). Also, if an imporer is no allowed o opimize is prices, i fully indexes hem o he seady-sae CPI inflaion rae. The presence of price rigidiy implies ha he response of he impored goods price o exogenous shocks is gradual. Thus, here is incomplee pass-hrough of exchange rae changes o he levels of prices. If imporer j is allowed o change is price, i ses he price ha maximizes is weighed expeced profis, given he real exchange rae, s. The maximizaion problem implies he following New- Phillips curve. ( βφ )( φ ) πˆ ˆ ˆ f = β E π f + + s, (7) φ where π f is he gross inflaion rae in he impor secor Moneary auhoriy We assume ha he moneary auhoriy follows a Taylor-ype moneary policy rule. According o his rule, he cenral bank endogenously adjuss he shor-erm nominal ineres rae, R, o response o changes in he CPI inflaion rae, π. Thus, R R = R R ρ π π r ρ π exp( ε ), (8) r 2 REVUE Des économies

13 Implicaions of he Global Financial Crisis on he Algerian Economy where ρ r is a smoohing-erm parameer, ρ π, is a policy coefficien measuring he cenral bank's response o deviaions of inflaion from is seady-sae level. The serially uncorrelaed moneary policy shock, ε r, is normally disribued wih zero mean and sandard deviaion σ r. We also assume ha he governmen consumes a fracion of he final goods and runs a balanced-budge financed wih lump-sum axes: g = T, where g follows an AR() process Shock processes A par from moneary policy shock, ε r, oher srucural shocks follow AR() processes: x ) ( )log( x ) + log( x ), log( = ρ x ρ x + ε x x = A g, Γ, Γ, p, R, π, x > is he seady-sae value, o where { } of x, ρ (, ) x, and ε x is normally disribued wih zero mean and sandard deviaion σ x. 3. PARAMITRIZATION We calibrae he model s srucural parameers using he convenional procedures. Some parameers are resored o calibraed values based on previous sudies [paricularly, Dib (28) ha develops a model for Algeria], while ohers are se o mach he model's seady-sae raios o hose observed in he daa. 8 See Table and 2. To calibrae he parameers in he financial secor, we se he elasiciy of he exernal finance premium, ψ, and he firms leverage raio, n/k, a.5 and.5, respecively. The probabiliy of enrepreneurs survival o he nex period, τ, is se a.983. These values are commonly used in he sudies ha use DSGE models wih he financial acceleraor à la BGG (999). The invesmen adjusmen cos parameer, χ, is se a. The discoun facor β is se a.992, implying an annual seady-sae real ineres rae on exernal deb of abou 4%. The parameer η, denoing he weigh pu on leisure in he uiliy 8 For example, Chrisiano e al. (29) and Dib (28). 3 REVUE Des économies

14 Implicaions of he Global Financial Crisis on he Algerian Economy funcion, is se a.47, so ha households spend roughly one hird of heir ime in marke aciviies. The elasiciy of subsiuion beween privae and public consumpion, γ, is se a.5, implying ha privae and public consumpion goods are complemen. The share of privae consumpion in oal consumpion, a, is.65 o mach he observed raio in he daa. The parameer υ, which deermines he seady-sae money velociy, is se a.2. The shares of capial in he non-oil producion and he capial depreciaion rae, α n and δ are assigned values of.27 and.25, respecively. These values are commonly used in open economy lieraure. The parameer θ ha measures monopoly power in domesic- and impored-inermediae-goods markes is se a 6, implying a seady-sae markup of price over marginal coss equal o 2%. The parameer φ, deermining he degree of nominal price rigidiy in reail and impor secors, is se a.66. Thus, on average he domesic and impored goods prices remain unchanged for 3 quarers. The parameer ν, measuring he elasiciy of subsiuion beween domesic and impored goods in he final oupu, is se equal o.5. Thus, domesically produced goods are only slighly subsiuable for impored goods. This reflecs he naure of Algerian impors ha consis of a large share of invesmen goods. The fracion of impored goods in he final goods, ω, is se a.22. Table also repors he calibraion of he sochasic process coefficiens. We assume ha boh financial shocks are highly persisen, bu moderaely volaile. Therefore, we se he auoregressive coefficiens, ρ Γ and ρ Γ, a.9 and heir sandard deviaions, σ Γ and σ Γ, a.2. The oil-price shocks are persisen and largely volaile. We se heir auoregressive coefficien, ρ p, and he sandard deviaion, σ p, a.8 and.97, respecively. These values are larger han hose assigned for forcing sochasic processes in he model. The sochasic processes of governmen spending, he world ineres rae, and world inflaion are persisen, wih he auoregressive parameers above.5 and sandard deviaions are ranging from.6 o.2. The seady-sae of he gross inflaion and nominal raes,π, π, R, and R, are se equal o.25,.7,.2, and.56, 4 REVUE Des économies

15 Implicaions of he Global Financial Crisis on he Algerian Economy respecively. The parameer in he counry-specific risk premium, φ, is se equal o.46 implying an annual risk premium of % ( basis poins). This value implies a seady-sae foreign-asse-o-gdp raio of 25%. Moneary policy coefficiens are calibraed as in Dib (28), so ρ r, ρ π, and σ r are se a.86,.7, and.5, respecively. Table 2 displays he seady-sae raios of key macro variables generaed by he model. 4. SIMULATION RESULTS To examine he implicaions of he global financial crisis, we simulae he dynamic response of he Algerian economy o foreign financial, domesic financial, world ineres rae, and oil price shocks. We also examine he responses of he cenral bank and governmen o financial shocks by adoping expansionary moneary and governmen spending policies. Therefore, we perform he impulse responses of he non-oil producion, consumpion, invesmen, employmen, impors, he domesic ineres rae, CPI inflaion, he real exchange rae, he curran accoun, firms ne worh, and he exernal finance premiums. Each response is expressed as he percenage deviaion of he variable from is seady-sae level. 4.. Responses o global financial shocks Figure displays he implicaions of he global financial shocks on he Algerian economy. I plos he impulse responses of key macro variables o a % global financial shock: an exogenous increase in he exernal finance premium when of loans conraced wih foreign banks (an increase in Γ ). This negaive shock reflecs ighening condiions of credi supply in he inernaional financial markes due o he decrease in he confidence level of foreign banks wih respec o he risks and he healh of he economy worldwide. Following his negaive shocks, foreign banks reduce heir credi supply and increase heir requesed exernal finance premium when lending o enrepreneurs. Wih a higher risk premium, enrepreneurs are facing a higher exernal finance coss, so hey reduce heir demand of loans and herefore invesmen declines. 5 REVUE Des économies

16 Implicaions of he Global Financial Crisis on he Algerian Economy Figure shows ha he foreign financial shock negaively affecs he enrepreneurs ne worh, which drops by abou 5% on he impac and persiss for few quarers. The decline of ne worh deerioraes firms balance shees and riggers an increase in he exernal finance premium paid o foreign banks. Therefore, he exernal finance coss increase, associaed wih a drop of firms values (equiies), leads o sharp decreases in invesmen and oupu and hus enailing a recession of he Algerian economy. The insananeous impacs of his shock on invesmen and oupu are very subsanial: Invesmen and oupu fall by.5% and %, respecively, on he impac and remain below heir seady-sae levels for many quarers. Ineresingly, he impulse responses also show ha afer his shock, he domesic exernal finance premium is lower few quarers afer he shock, implying subsiuion of borrowing from domesic banks for hose from abroad. We noe ha a foreign financial shock negaively affecs labour and impors. I also leads o he appreciaion of he domesic currency vis-à-vis he U.S. dollar and o moderae improvemen of he counry s curren accoun in he shor-erm. This curren accoun improvemen reflecs he decline in boh enrepreneurs borrowing from abroad and impors, resuling from he drop of invesmen. Finally, he simulaion resuls show ha he global financial shocks push down boh he inflaion and ineres raes. This allows he cenral bank o adop expansionary moneary policy (quaniaive moneary easing) o offse he negaive impacs of he global financial crisis Responses o domesic financial shocks To examine he implicaions of domesic financial shocks, we plo, in Figure 2, he impulse responses o a % increase in Γ. The qualiaive responses of macro variables o his shock are similar o hose of a global financial shock. Neverheless, he magniudes of he responses o domesic financial shocks are much lower han hose o global financial shocks. The insananeous impacs of his shock on oupu, invesmen, and ne worh are abou he half of hose generaed following a global financial shock. 6 REVUE Des économies

17 Implicaions of he Global Financial Crisis on he Algerian Economy In his case, an exogenous increase in Γ deerioraes credi supply condiions by domesic banks. This is a resul of he deerioraion of he domesic banks confidence level and he banks risk percepion: Domesic banks negaively perceive changes in crediworhiness of enrepreneurs. Therefore, a ighening domesic financial shock increases he exernal finance premium requesed by banks o be compensaed for he increase in risks of providing loans. A higher finance premium raises exernal finance coss of borrowing o finance invesmen, leading o a decline in enrepreneurs ne worh and significan drops of invesmen and oupu. Furhermore, following his domesic financial shock, employmen, impors, inflaion, and he nominal ineres rae jump below heir long run equilibrium values, while on he impac he counry s curren accoun slighly improves and he real exchange rae persisenly appreciaes Responses o oil price shocks The global financial crisis has negaively affeced he oil prices, which is he consequence of drops in oil demand caused by o he recession worldwide. The fall of oil prices is one of he main channels hrough which he financial crisis is ransmied o he oil exporing economies, such as Algeria. Therefore, we invesigae macroeconomic effecs of negaive oil price shocks, p ha reduce oil exporing revenues. Figure 3 plos he impulse responses o a % negaive oilprice shock (a decrease in he oil price by %). A negaive oil-price shock implies an insananeous and subsanial deerioraion of he curren accoun and very persisen and significan depreciaion of he domesic currency. Impors negaively, bu gradually, reac o his shock. Therefore, a fall in he oil price, which enails an insananeous decline in he Algerian expor revenues, implies a defici in counry's curren accoun. In addiion, following a negaive oil price shock, he enrepreneurs ne worh decreases. This riggers increases in boh domesic and foreign exernal finance premiums. So he coss of borrowing subsanially rise, which incies enrepreneurs o cu o 7 REVUE Des économies

18 Implicaions of he Global Financial Crisis on he Algerian Economy furher heir invesmen. This makes oupu, employmen, and impors declining. The oil-exporing counry is no richer afer a negaive oil price shock (negaive wealh effec), wha in urn reduces households consumpion. On he oher hand, he depreciaion of he domesic currency offses he effecs of he decreases in domesically-produced goods price on CPI inflaion and leads o a sligh increase in inflaion and he nominal ineres rae for longer periods Responses o world ineres rae shocks The drop of he world ineres rae during he crisis period is one of ransmission channel hrough which he global financial crisis affecs oil exporing counries. These economies had accumulaed large reserves during he boom period ha had preceded he financial crisis. The accumulaed reserves are invesed in foreign asses and mosly in he U.S. reasury bonds. The rae of reurns of foreign asses largely depends on he U.S shor-erm raes. Therefore, a fall in he U.S. shor erm raes lowers he reurns of foreign asses held by he exporing economies. This has direc effecs on he curren accoun posiion and may lead o is deerioraion. Figure 4 displays he implicaions of a basic poins drop in he world ineres rae. Following his shock, he counry s curren accoun falls by abou.75%, reflecing he decline in he reurns of invesed reserves in foreign counries. Therefore, he counry reduces is sock of foreign asses by selling a fracion of which in he inernaional financial markes and uses obained funds domesically. Therefore, he aggregae demand rises subsanially and he counry s currency appreciaes. Enrepreneurial ne worh is posiively affeced by he drop of he world ineres raes. Firs, a lower world ineres rae means a decline in coss of borrowing abroad for enrepreneurs. Second, he increase in he aggregae demand booss firms ne worh ha lowers he enrepreneurial leverage raios and hus reduces exernal finance premiums paid for borrowing funds. (See Figure 4). 8 REVUE Des économies

19 Implicaions of he Global Financial Crisis on he Algerian Economy 4.5. Responses o expansionary moneary policy shocks We now reurn o invesigae wheher he moneary auhoriy is able o reduce he impacs of shocks associaed wih he global financial crisis using an expansionary moneary policy. Sine prices are sicky, moneary policy is no neural in he shor erms. Thus, he cenral bank can neuralize he effecs of exogenous shocks by faciliaing he reallocaion of he resources in he economy. Figure 5 plos he impulse responses of he Algerian economy o a % expansionary moneary policy shock (a % decrease inε r ). This shock simulaes domesic aggregae demand and reduces he exernal cos of borrowing from domesic banks. Afer his shock, he nominal ineres rae, falls, while oupu, consumpion, invesmen, employmen, impors rise sharply on impac. Moreover, his shock enails a deerioraion of he curren accoun, because he counry reduces is foreign asses holdings o finance he increase of impors ha are boosed by posiive effecs on aggregae demand (consumpion and invesmen). The defici of he curren accoun leads o he depreciaion of he counry s real exchange rae, which faciliaes he increase in he inflaion rae. Also, his expansionary shock has a posiive impac on enrepreneurial ne worh, as i rises by abou 2% on impac, while domesic and foreign exernal finance premiums slighly increase, reflecing he rise in he enrepreneurs leverage raio o finance he expansion of heir invesmen. Therefore, adoping an expansionary moneary policy ha reduces he shor-erm ineres rae will increase he domesic aggregae demand, paricularly invesmen, and hus helps in offseing negaive impacs of differen shocks implied by he global financial crisis Responses o expansionary governmen spending shocks Here we examine he effecs of a % posiive shock o governmen spending (an increase in governmen expendiure by %). Figure 6 displays he impulse responses of he Algerian economy o his expansionary shock. The effecs of his shock are eviden, he implemenaion of governmen spending can successfully help he economy avoid recessions. Oupu increases by.2%, while consumpion, employmen, and impors rise by abou 9 REVUE Des économies

20 Implicaions of he Global Financial Crisis on he Algerian Economy.%. Neverheless, he increase in invesmen is marginal. This is explained by he crowding-ou effec of governmen spending on he ineres rae ha has increased afer he shock. The curren accoun posiion declines because of he increase in impors caused by a higher aggregae demand. We also noe ha enrepreneurial ne worh is posiively affeced by his expansionary shock, so firms balance shees are enhanced. Wih a lower leverage raio, he exernal finance premiums fall, which reduces coss of borrowing from banks o finance capial purchases. 5. CONCLUSION The ongoing global financial crisis was riggered by dysfuncional U.S. credi marke and spread o he mos of counries hrough differen ransmission channel. The financial crisis has affeced he Algerian economy hrough he following channels: () increase of coss of firms borrowing o finance heir invesmen, (2) decline in oil prices, and (3) he lower world ineres raes. The paper uses a small open economy model wih financial fricion à la BGG (999), price rigidiy, and financial shocks o examine he implicaions of he financial crisis and he imporance of he ransmission channels. The simulaion resuls show ha foreign financial shocks associaed wih he global financial crisis have subsanial negaive implicaions on he Algerian economy and he four ransmission channels have large role in he propagaion of global financial crisis. Neverheless, he implemenaion of expansionary moneary and governmen spending policies can successfully help he economy avoid recession and hus eliminae negaive implicaions of he global financial crisis. Fuure work consiss of developing a large scale small open economy model for Algeria by incorporaing opimizing bank secor using he microfounded framework developed by Dib (29) o model he supply-side of he credi marke. 2 REVUE Des économies

21 Implicaions of he Global Financial Crisis on he Algerian Economy REFERENCES. Bernanke, B., M. Gerler, and S. Gilchris, 999. The Financial Acceleraor in a Quaniaive Business 2. Cycle Framework. Handbook of Macroeconomics. Ameserdam: Norh Holland. 3. Blanchard, J.-O., and C.M. Kahn 98. The Soluion of Linear Difference Models under Raional Expecaions. Economerica 48, Bouakez, H., N. Rebei, and D. Vencaachellum, 28. Opimal Pass- Through of Oil Prices in an Economy wih Nominal Rigidiies. CIRPÉE Working Paper No Calvo, G. A., 983. Saggered Prices in a Uiliy-Maximizing Framework. Journal of Moneary Economics 2, Cespedes, L. F., R. Chang, and A. Velasco, 24. Balance Shees and Exchange Rae Policy. American Economic Review 94, Chrisensen, I., and A. Dib, 28. The Financial Acceleraor in an Esimaed New Keynesian Model. Review of Economic Dynamics, Chrisiano, L.J., Moo, R., and M, Rosagno, 29. Financial Facors in Economic Flucuaions. Norhwesern Universiy Draf. 9. Dib, A., 28. Oil Prices, U.S. Dollar Flucuaions and Moneary Policy in a Small Open Oil Exporing Economy: The Case of Algeria. Cahiers de Recherche du CREAD, Algeria.. Dib, A., C. Mendicino, and Y. Zhang, 28. Price Level Targeing in a Small Open Economy wih Financial Fricions: Welfare Analysis. Bank of Canada Working Paper No Dib, A., 29. Banks, Credi Marke Fricions, and Business Cycles. Bank of Canada Working Paper, forhcoming. 2. Lin, S., and H. Ye, 29. Does Inflaion Targeing Make a Difference in Developing Counries. Journal of Developmen Economics 89, Yun, T., 996. Nominal Price Rigidiy, Money Supply Endogeneiy, and Business Cycles. Journal of Moneary Economics 37, REVUE Des économies

22 Implicaions of he Global Financial Crisis on he Algerian Economy Table : Calibraion of he model's parameers Parameers Definiion ψ Elasiciy of exernal risk premium τ Probabiliy of survival n/k Firm s leverage raio β Discoun facor ρ r Smoohing coefficien in he moneary ρ π policy σ r Inflaion coefficien in he moneary ν policy γ Sandard deviaion of moneary policy a shocks φ Elasiciy of subsiuion beween home θ and impored goods χ Elasiciy of subsiuion beween ω privae and public consumpion α n Share of privae consumpion in oal δ consumpion φ Price rigidiy parameer η Elasiciy of subsiuion beween υ inermediae goods ρ Γ Capial adjusmen cos parameer ρ Γ Share of capial in non-oil producion ρ p Share of impors in GDP ρ A Capial depreciaion rae in he oil ρ g secor ρ R Counry-specific risk premium ρ π parameer σ Γ Weigh of leisure in uiliy σ Γ Weigh of cash money in uiliy σ p Auocorrelaion of global financial σ A shocks σ g Auocorrelaion of domesic financial σ R shocks σ π Auocorrelaion of oil price shocks Auocorrelaion of echnology shocks Auocorrelaion of governmen Values REVUE Des économies

23 Implicaions of he Global Financial Crisis on he Algerian Economy spending shocks Auocorrelaion of world ineres shocks Auocorrelaion of world inflaion shocks Sandard deviaion of global financial shocks Sandard deviaion of domesic financial shocks Sandard deviaion of oil price shocks Sandard deviaion of echnology shocks Sandard deviaion of governmen spending shock Sandard deviaion of world ineres shocks Sandard deviaion of world inflaion shocks Table 2: The model's seady-sae raios o GDP Exernal reserve Toal expors Toal impors Non-oil oupu Consumpion Invesmen Governmen spending Toal money sock REVUE Des économies

24 Implicaions of he Global Financial Crisis on he Algerian Economy Figure : Effecs of a % increase in he foreign exernal finance premium Oupu.5 Consumpion Invesmen 2 2 Labour.5 2 Impors 2 2 Curren accoun 2 Exchange rae 2 Inflaion.5 2 Ineres rae..5 2 Ne worh Domesic risk premium.2. 2 Foreign risk premium (Γ ) 2 Figure 2: Effecs of a % increase in domesic exernal finance premium (Γ ) Oupu.2 Consumpion Invesmen Labour Impors Curren accoun Exchange rae.5 2 Inflaion..5 2 Ineres rae Ne worh. 2 2 Domesic risk premium.5 2. Foreign risk premium REVUE Des économies

25 Implicaions of he Global Financial Crisis on he Algerian Economy Figure 3: Effecs of a % decrease in he oil price ( p o ) Oupu Consumpion Invesmen Labour. 2 Impors.4 2 Curren accoun Exchange rae Inflaion x Ineres rae Ne worh 2 5 x Domesic risk premium x Foreign risk premium Figure 4: Effecs of a % decrease in he world ineres rae ( R ).4 Oupu.5 Consumpion.4 Invesmen Labour Impors.5 2 Curren accoun.2 2 Exchange rae Inflaion.5 2 Ineres rae Ne worh Domesic risk premium. 2 Foreign risk premium REVUE Des économies

26 Implicaions of he Global Financial Crisis on he Algerian Economy Figure 5: Effecs of a % decrease in he domesic ineres rae ( ε ) r.4 Oupu.4 Consumpion.2 Invesmen Labour.5 2 Impors Curren accoun Exchange rae Inflaion Ineres rae.5 2 Ne worh x Domesic risk premium x Foreign risk premium Figure 6: Effecs of a % increase in governmen spending ( g ).2 Oupu. Consumpion.2 Invesmen. 2 Labour Impors.2 2. Curren accoun. 2 Exchange rae.5. 2 Inflaion.5. 2 Ineres rae Ne worh.5 2 x Domesic risk premium 3 2 x Foreign risk premium REVUE Des économies