Financial Heterogeneity and Monetary Union

Financial Heterogeneity and Monetary Union S. Gilchrist R. Schoenle 2 J. Sim 3 E. Zakrajšek 3 Boston University Brandeis University 2 Federal Reserve Board 3 MEFM, NBER SI B J, 25

Disclaimer The views expressed should not be interpreted as reflecting the views of the Federal Reserve System or its staffs.

Eurozone Crisis (29?) Classic balance-of-payment crisis: The mix of overvalued RERs and cheap credit fueled by economic optimism led to over- and mal-investment. After the Global Financial Crisis came a sudden stop. Resolution of the crisis: Realignment of overvalued RERs. The mix of deflation in the south and reflation in the north. Surprisingly hard to achieve why?

Inflation and Output Dynamics in the Eurozone 992-28 29-24 Core GIIPS Core GIIPS Avg. inflation (%).58 3.34.22.66 Avg. output gap (%).32.8 -.38-4.88 Panel-version of the NK Phillips curve: π it =.449 (.5) E t π i,t+ +.533 (.49) π i,t +.4 (.48) (y it ȳ it ) + ˆη i + ˆɛ it AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT Annual data: 97 24 (unbalanced panel, Obs. = 429) Is lack of deflationary pressures related to financial strains?

Inflation Dynamics and Financial Strains Sample Period: 28-24 3 GIIPS 2 Core Inflation Residuals at t+ (pct.) - -2.5 5 2 Sovereign (5-year) CDS Spreads at t (pps., log scale)

Lessons from the Financial Crisis in the U.S. Gilchrist, Raphael, Sim & Zakrajšek [25] Empirics: Theory: Firms with strong balance sheets slashed prices. Firms with weak balance sheets raised prices. Develops a GE model that can replicate such patterns. Emphasizes the interaction between financial market frictions and firms pricing decisions in customer markets. Extend our framework to a two-country GE setting ( North and South ).

Preferences Two countries: home (h = south) and foreign (f = north) Continuum of households in each country: j N c [, ] { home goods (h) : c j Two types of goods: i,h,t, i N h [, 2] foreign goods (f ) : c j i,f,t, i N f [2, 3] CRRA in habit-adjusted consumption basket x j t : E t β s U(xt+s j δ t+s, ht+s j ); j [, ] s= δt = persistent aggregate demand shock labor (h) is immobile

Deep Habits Ravn, Schmitt-Grohe & Uribe [26] Armington-Ravn-Schmitt-Grohe-Uribe aggregator: x j t = [ k =h,f [ ] /ɛ ] /(/ɛ) ( ω k c j ) /ηdk /η i,k,t N sθ i,k,t k η = elasticity of substitution within a type of goods ɛ = elasticity of substitution between types of goods θ > governs the strength of deep habits < ωk < governs the degree of home bias in consumption Law of motion for deep habits: s i,k,t = ρs i,k,t + ( ρ) c j i,k,t dj; N c k = h, f Keeping up with the Joneses at the good level.

Technology Continuum of monopolistically competitive firms producing variety of differentiated goods of type h and type f. Production function (labor input, fixed operating costs): ( ) α y it = c i,h,t + ci,h,t = At h a it φ; i N h ( < α ) it At = persistent aggregate technology shock ait = i.i.d. idiosyncratic shock w/ log a it N(.5σ 2, σ 2 ) φ = servicing cost of fixed coupon long-term debt Heterogeneity in financial capacity: φ > φ =

Frictions Financial frictions: costly external equity financing New shares sold at a discount because of asymmetric information claim raises only ( ϕ t ) of funds Lemons premium ϕt AR() financial shock Makes expected shadow value of internal funds, E a t [ξ it ] > Nominal rigidities: quadratic cost of adjusting nominal prices Local currency pricing: law of one price does not apply

Beggar Thy Neighbor at the Micro Level Deep habits make investment in market share profitable: Investment takes the form of low markups, which exposes firms to liquidity risk. Optimal pricing strategy strikes the right balance. Price war: Liquidity crisis in the South is a good time for firms in the North to steal market share by undercutting their competitors prices. Mr. Marchionne and other auto executives accuse Volkswagen of exploiting the crisis to gain market share by offering aggressive discounts. It s a bloodbath of pricing and it s a bloodbath on margins, he said. The New York Times, July 25, 22

Optimal Pricing without Deep Habits Assume flexible prices and no customer markets. When α =, optimal pricing (home market) p i,h,t = η η }{{} Ea t [ξ it a it ] E a t [ξ it ] accounting markup }{{} economic markup [ ] wt /p h,t A t }{{} real marginal cost Financial frictions E a t [ξ it a it ] E a t [ξ it ] = + Cov[ξ it a it ]

Optimal Pricing with Deep Habits Bring back customer markets (still flexible prices!) Growth-adjusted, compounded discount rate: s β t,s m h,s+ /s h,s ρ s,s+ ρ s t [ ρ + χ s h,t+j /s h,t+j ρ ρ j= Optimal pricing η E p i,h,t = a [ ] t [ξ it a it ] wt /p h,t η E a t [ξ it ] A t χ η E t [ s=t+ β t,s E a s [ξ i,s ] E a t [ξ i,t ] ] m t+j,t+j ( p h,s w ) ] s /p h,s A s

Calibration Key Model Parameters Value Preferences & Technology deep habit (θ).9 persistence of deep habit (ρ).9 elasticity of substitution b/w and w/in goods (η, ɛ) 2.,.5 fixed operating costs (φ, φ ).8,. Nominal Rigidities price adjustment cost (γ p ). wage adjustment cost (γ w ) 3. Financial Frictions equity dilution cost (ϕ), E a [ξ i ] =.2,.3 idiosyncratic volatility, a.r. (σ). persistence financial shock (ρ ϕ ).9

Implications of a Financial Shock in the South In a monetary union (φ =.8, φ =.) (a) GDP, pct (b) consumption, pct.5.5 2 2 4 2 4 (c) hours, pct 2 2 2 4 2 (d) int rate, pp 2 4 (e) RER( ), NER(.), pct 3 2 2 2 4 2 (f) inflation, pp 2 4 2 2 (g) exports, pct 2 4.5.5 (h) CA, pct of GDP 2 4 Red = Foreign (North), Blue = Home (South) NER ( ) and RER ( ) are Home/Foreign

Implications of a Financial Shock in the South Under floating exchange rates (φ =.8, φ =.) 2 (a) GDP, pct 2 4 (e) RER( ), NER(.), pct 3 2 2 2 4.5.5 2 (b) consumption, pct 2 4 (f) inflation, pp 2 4 2 2 3 2 2 (c) hours, pct 2 4 (g) exports, pct 3 2 4 2 (d) int rate, pp 2 4 (h) CA, pct of GDP 2 4 Red = Foreign (North), Blue = Home (South) NER ( ) and RER ( ) are Home/Foreign

Heterogeneity As a Propagation Mechanism Alternative calibration: φ = φ =.8 Financial shocks in both North and South. In a monetary union.5 (a) Home GDP, percent.4 (b) Home consumption, percent.2.5.2.4.5.6.8 2 2 3 4 2 3 4.5 (c) Foreign GDP, percent.6 (d) Foreign consumption, percent.4.2.5.2.5.4.6 2 3 4.8 2 3 4 Alternative = ( ) and Baseline = ( )

Fiscal Devaluation We consider a simple VAT-payroll subsidy swap rule: VAT(τ V t ) + payroll subsidy(ς P t ) FD rules that are linear in the resource gap of the home country: ( ) yt τ V t = α FD log ȳ Is there a parameter region that is mutually beneficial to both home and foreign countries?

Welfare Difference in welfare from the baseline w/o FD.9.8.7.6.5.4.3.2. ΔW ΔW * 5 5 α FD

Concluding Remarks When firms engage in market share competitions, differences in financial capacity across countries imply strong amplification mechanism: beggar-thy-neighbor at the micro-level. Monetary union impedes adjustment of RERs and exacerbates the downturn in response to an adverse financial shock. Unilateral fiscal devaluation by periphery may be welfare improving for both periphery and core.