Financial Frictions, Monetary Policy, and Exchange Rates. Roberto Chang May 2016

Transcription

1 Financial Frictions, Monetary Policy, and Exchange Rates Roberto Chang May 2016

2 Introduction and Motivation In our discussion of the NK model, we stressed the assumption of frictionless financial markets This assumption seems too strong Also, the global financial crisis and its aftermath have directed attention to distortions in the financial sector and their macro implications

3 Jan-10 Jan-02 Jan-01 Jan-04 Jan-03 Jan-06 Jan-05 Jan-08 Jan-07 Jan-09 Jan USA: Real Estate Price Index (S&P/Case-Shiller 20 City Composite Index) Source: MacroMarkets

4 Real Interest Rates, Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul Year 3-7/8% Treasury Inflation-Indexed Note. Source: FRED, Federal Reserve Bank of St. Louis

5 9/3/2006 5/3/2006 1/3/2006 9/3/2007 5/3/2007 1/3/2007 5/3/2008 1/3/2008 5/3/2009 1/3/2009 9/3/2008 5/3/2010 1/3/2010 9/3/ Lehman Northern Rock Bear Stearns TED Spread (LIBOR Versus T-Bill, percentage points)

6 Total Asset Backed Financial, Non Asset Backed Non Financial, Non Asset Backed Commercial Paper Market (Millions US$)

7 Jan-10 Jan-09 Apr-09 Jul-09 Oct-09 Jul-08 Oct-08 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Apr Jan US: GDP Growth (% last 12 months) Source: FRED, St. Louis Fed

8 Why Financial Imperfections May Be Crucial Large changes in relative prices are often seen and create winners and losers Examples: real estate prices, stocks and bonds, exchange rates Conventional macroeconomics has largely ignored these, believing that redistribution has negligible aggregate effects That belief is appropriate if financial markets are perfect

9 Fisherian Deflation

10 Fisherian Deflation Irving Fischer (1932): redistribution can have large aggregate effects In particular, if debts are written in nominal terms, deflation increases their real value The resulting redistribution matters in the aggregate because debtors have a higher marginal propensity to spend than creditors

11 A modern rendition of Fisher s argument: Eggertsson-Krugman The basic idea: there is a set of debtconstrained agents, whose consumption falls sharply if their debt limit is reduced While debts may be denominated in dollars, debt limits may be set in real terms Aggregate demand can then fall if there is deflation

12 The AD-AS diagram Recall the AD-AS diagram from undergraduate Macro courses It can be obtained from basic NK models, too

13 π s AS AD Y s Conventional Macro

14 Bizarre Macro When debts are denominated in nominal terms, price deflation redistributes wealth from debtors to creditors If financial frictions are substantial, debtors may reduce demand more than creditors increase theirs Deflation can then reduce aggregate demand a upward sloping AD

15 π s AS AD Y s Bizarre Macro

16 Consecuences AD curve can have a positive slope Paradox of toil Paradox of flexibility Inflation is very expansionary (and deflation very contractionary) Fiscal policy is particularly effective

17 The Paradox of Toil In a bizarre world, a productivity increase can lead to a fall in output This is because higher productivity leads to lower prices, which (under bizarre world assumptions) can reduce aggregate demand

18 π s AS AD Y s Conventional Macro

19 π s E AS E AS AD Conventional Impact of a Productivity Increase Y s

20 π s AS AD Y s Bizarre Macro

21 π s E AS E AS AD Y s The Paradox of Toil

22 Paradox of Flexibility Likewise, in a bizarre world, a fall in aggregate demand can be more contractionary if prices are more flexible This is because more price flexibility implies a steeper AS curve

23 π s AS fix AS flex AD Conventional: Price Flexibility Implies a Steeper AS Y s

24 π s E fix AS fix E flex AS flex AD AD Conventional: A fall in demand is less contractionary if prices are more flexible Y s

25 π s AS fix AS flex AD Y s In a bizarre macro world

26 π s AD E fix AS fix E flex AS flex AD..the opposite is true: Paradox of Flexibility Y s

27 The Effectiveness of Fiscal Policy In a conventional world, increased fiscal expenditure leads to inflation, which offsets some of the expansionary effects In a bizarre world, inflation reinforces the expansionary effects

28 π s AS AD bizarre AD conventional Y s Fiscal Policy

29 π s E E AS AD bizarre AD conventional Y s Fiscal Policy

30 The Open Economy: Balance Sheets, and Exchange Rates

31 Motivation: Dollarization and the Fixed vs Flexible Rates Debate Asian Crisis of 1990s: Exchange Rate depreciations were observed to be contractionary Explanation: Currency Mismatches To work, one needs financial frictions and balance sheet effects Intuition: Céspedes, Chang, Velasco

32 The IS y = α i i + α x x + α e e y: output demand There is a demand component that increases with e (real exchange rate) for usual reasons i : investment x : exogenous component of demand

33 LM The central bank is assumed to fix exchange rates, so there is no need to specify the LM

34 The BP The key relation Start with investment demand: i = - (ρ + η ) + γ e Similar to usual assumption, but: ρ: world interest rate η: a risk premium

35 The key aspect of the model is that the risk premium η depends on the value of investment relative to corporate net worth The idea, originally due to Bernanke and Gertler, can be derived from microeconomic models of debt contracts

36 Risk premia η = μ [(1-γ)e + i n] Can be derived from more basic models of financial frictions n: corporate net worth, in terms of domestic goods

37 Corporate Balances n = δ y y δ e e δ e depends on corporate debt and currency mismatches A highly dollarized economy is likely to have a larger δ e

38 The BP Combining two preceding equations, η = μ [(1-γ+ δ e )e + i δ y y] Inserting in investment demand, one gets the BP relation: (1+μ) i = - ρ + μ δ y y+ [ γ- μ (1-γ+ δ e )]e

39 Two types of Economies (1+μ) i = - ρ + μ δ y y+ [ γ - μ (1-γ+ δ e )]e If γ > μ (1-γ+ δ e ), we say that the economy is financially robust Otherwise, we say that it is fragile.

40 i IS BP y

41 Implications Consider the impact of an exogenous increase in demand (modeled as an unanticipated increase in x) This can be due to a fall in exports or government expenditure

42 i IS IS BP A A fall in Exports y

43 Note that balance sheet effects help amplifying the impact of an x shock

44 i IS IS A BP A y Without financial frictions, equilibrium would be at A

45 Now, consider an increase in the world interest rate ρ

46 i IS BP y

47 i IS BP BP y A An increase in the world interest rate

48 Contractionary Depreciation Finally, what happens if there is an exchange rate depreciation? Recall that in the conventional model, a depreciation is always expansionary Here, it can be contractionary instead

49 i IS IS BP y Depreciation

50 i IS IS BP A BP y Depreciation in a robust economy

51 i IS IS BP A y BP

52 i IS IS BP BP y A Depreciation in fragile economy

53 i IS IS BP y BP A Depreciation in fragile economy

54 Summary and Takeaway 1. In a small open economy with financial frictions, the cost of capital may depend on the real value of corporate net worth 2. An exchange rate depreciation can cause a steep fall in net worth, especially if the economy is dollarized 3. This can reduce investment and aggregate demand

55 Summary and Takeaway 4. Under such conditions, exchange rate depreciation can be contractionary rather than expansionary 5. Also, such effects can exacerbate the amplification and persistence of shocks

56 Some Further Implications This analysis may explain why central bankers in developing countries often suffer from fear of floating The analysis of exchange rates depends on the degree of financial development Rationale for de-dollarization, leverage limits, and other macro-prudential policies