Optimal Monetary Policy in a Sudden Stop

... Optimal Monetary Policy in a Sudden Stop with Jorge Roldos (IMF) and Fabio Braggion (Northwestern, Tilburg) 1

Modeling Issues/Tools Small, Open Economy Model Interaction Between Asset Markets and Monetary Policy Limited Participation Model of Money. 2

Motivation Asian Financial Crisis: Sudden Stop Current Account Swings Negative to Positive by 15 Percentage Points of GDP Output Drops 12 Percent, Consumption a Little More, Employment a Little Less Asset Prices and Exchange Rates Drop by Over 4 Percent Controversy: How Should the Domestic Monetary Authority Respond? Two Responses: Krugman-Stiglitz: A Crisis is a Time When Economies are Slipping Into Recession. Medicine Appropriate for US: Interest Rate Cut. If It s Good Enough for the US, then It s Good Enough for Thailand. IMF: A Crisis is a Time When Foreign Investors are Rushing for the Exits. Need High Rates to Stop Them. 1

Motivation... What Did They Do? Both! 35 SHORT-TERM INTEREST RATES 1/ 35 3 25 Thailand Korea M alaysia Philippines 3 25 2 2 15 15 1 1 5 5 Jan-97 Jan-98 Jan-99 Jan- Was Policy Erratic, Responding to Different Advice at Different Times? Our Argument: this Policy May have been Roughly Optimal. 14

Fig.9. Availability of Credit after the Crisis 5 more available same less available 3 domestic banks foreign banks other domestic financial institution 2.47 2.29 2.22 local money lenders 1.92 family/friends suppliers partner firms bond market equity market 2.54 2.44 2.1 2.13 2.6 1

Motivation... Analysis: Compute Optimal Monetary Policy in a Variant on Model in Christiano, Gust, Roldos (JET, 24) Model Highlights Key Features of Crisis Economies: General Evidence From Surveys of Credit Crunch Collateral Constraints on Loans in Crisis Economies Tightened Syndicated Loans to Emerging Markets (in billions of U.S. dollars) Year Total Secured Secured as % of Total 1993 47.5 7.9 16.5 1994 64.9 11.5 17.7 1995 93. 16.1 17.3 1996 14.3 22. 21.1 1997 143.7 61.4 42.7 1998 77.3 25.9 33.5 1999 73.1 26.3 35.9 Thailand: banks loaned 7-8% of collateral pre-crisis, 5-6% after crisis (Edison, Luangaram and Miller (2)) 2

Motivation... Analysis: Compute Optimal Monetary Policy in a Variant on Model in Christiano, Gust, Roldos (JET, 24) Model Highlights Key Features of Crisis Economies: General Evidence From Surveys of Credit Crunch Collateral Constraints on Loans in Crisis Economies Tightened Intermediate Inputs are an Important Component of Imports Thailand Year Total Intermediate % of Total 1995 7,718 25,61 35% 1996 72,248 24,874 34% 1997 63,286 21,86 35% 1998 42,43 14,744 35% 1999 49,919 18,25 36% 2 62,181 23,663 38% 21 61,847 22,978 37% 22 64,317 24,461 38% Korea Total Intemediate % of Total 135,119 64,611 48% 15,339 68,556 46% 144,616 69,361 48% 93,282 45,593 49% 119,752 57,253 48% 16,481 78,975 49% 141,98 71,929 51% 152,126 73,891 49% 22

Intermediate Goods Import vs. GDP (Index 1995 = 1) 14 Indones ia 14 14 Korea 14 12 12 12 12 1 8 Intermediate 1 8 1 8 1 8 6 6 6 GDP 6 4 GDP 4 4 4 2 2 2 2 1993 1995 1997 1999 21 1993 1995 1997 1999 21 14 12 Malaysia Intermediate 14 12 14 12 Philippines Intermediate 14 12 1 8 GDP 1 8 1 8 GDP 1 8 6 6 6 6 4 4 4 4 2 2 2 2 1993 1995 1997 1999 21 1993 1995 1997 1999 21 14 Thailand 14 12 12 1 Intermediate 1 8 8 6 GDP 6 4 4 2 2 1993 1995 1997 1999 21 Sources: CEIC; and WEO. Figure 2

Structure of Model Small, Open Economy with Traded and Nontraded Goods Imported Intermediate Inputs and Labor Must be Financed in Advance Trigger of Crisis: Collateral Shock. Sudden Tightening of Binding Collateral Constraints. We Do Not Explain Why this Shock Occurs We Only Hope to Explain the Consequences Labor Market Frictions Short Run: Labor Hard to Adjust in Tradable Sector Longer Run: Labor Everywhere Flexible 29

Outline Dynamic Model Simulation of Optimal Policy Comparison with Korean Data Draw Attention to the Unusual Nature of the Monetary Transmission Mechanism Welfare and Output Increased in First Period with Increase in Domestic Interest Rate Carefully Go Through A Highly Simplified (Non-Monetary, Static) Version of the Model to Better Understand Monetary Transmission Mechanism. 3

Outline... Flow of Goods and Labor in the Model Household Final Consumption Good Traded Goods Nontraded Goods Foreign Sector Labor Market 31

Outline... Model Agents: Households, Final Good Firms, Intermediate Good Firms, Foreign Sector. Households max c t,l t X t= β t h i 1 σ c t ψ 1+ψ L1+ψ t 1 σ P t c t W t L t + M t D t = R t (D t + X t )+Pt T π t + W t L t + M t D t P t c t M t+1 money chosen by household R t gross domestic nominal rate X t money injection by central bank π t profits D t deposits of cash with intermediary. M t+1 32

Outline... 33

Outline... Final Good Firms ( Retailers ): c =min (1 γ) c T,γc Nª. c N c T non-traded intermediate input traded intermediate input 34

Outline... Domestic Intermediate Good Firms: Technology, traded goods: y T = nθ [µ 1 V ] ξ 1 ξ o +(1 θ)[µ 2 z] ξ 1 ξ ξ 1 ξ, V = A K T ν L T 1 ν, Short Run Friction: ξ elasticity of substitution between V and z z foreign intermediate good Traded Good Firm Decides L T At Start of Period Technology, non-traded goods: y N = K N α L N 1 α. 35

Outline... 36

Outline... Objective of Intermediate Good Firms: X max β t Λ t+1 π t, t= π t = p N t y N t + y T t w t R t L t R z t r B t +(B t+1 B t ) Collateral Constraint: τ QN t S t K N + τ QT t S t K T R z t +(1+r )B t q i t = VMP Ki,t + λ t τ i q i t + qi t+1 1+ρ t,q i t = Qi t S t,i= N,T. Resource Constraints: y N = c N y T = c T + R z + r B (B B) 37

Outline... Parameters Values of the Model β.943 γ.3 ψ 3. R 1.11 R 1.6 r.6 α.36 K N 1 ν.5 K T 5 µ 1 1 µ 2 3.5 τ.8 θ.5 ψ.36 σ 2 A 1.5 ξ.1 ζ.6 Note : Here, β, R and R are expressed in annualized terms. 38

Outline... Timing Collateral Shock Monetary Action 1 2 t Traded Good Firm Decides Employment in Traded Sector Household Deposit Decision Production, Consumption Occur 39

Effects of Collateral Shock Economy in Steady State Until Period, Ignoring Collateral Constraint. Collateral Constraint Unexpectedly Imposed and Binding in Period Current Account Switches to Positive As Firms Pay Down Debt. Intertemporal Euler Equation of Firm 1=β Λ t+2 Λ t+1 (1 + r )(1 + λ t+1 ),t=, 1, 2,.... Λ t+1 multiplier on household budget constraint We Assume β(1 + r )=1, so Λ t+1 Λ t+2 =1+λ t+1,t=, 1, 2,... With λ t+1 >, Consumption Level Low, Growth High B t Falls Until λ t. 41

Effects of Collateral Shock... Response of Debt and Output to Collateral Shock In the Absence of Monetary Policy Response (Fixed Money Growth) B t Level of International Debt in Old Steady State High Shadow Value of Debt Induces Firms to Pay it D ow n Financial Crisis Level of Debt in New Steady State t Output Output During the Transition t 42

.4 current account Optimal and Constant Money Growth 5 real GDP.2-5 1 Employment -1-15 1 Consumption -1-1 -2 1 Imports -2 1 Asset Prices -1-1 4 Nominal Interest Rate -2 1.6 Nominal Exchange Rate (Price of Traded) 1.4 2 1.2 Inflation 1 6 4 2-2 Optimal Money Growth Constant Money Growth

.2 current account Optimal and Korea 5 real GDP.1-5 -1 1 Employment -15 1 Consumption -1-1 -2 1 Imports -2 1 Asset Prices -1-1 -2 4 Nominal Interest Rate 1.6 Nominal Exchange Rate (Price of Traded) 1.4 2 1.2 Inflation 1 6 4 2-2 Simulation Actual Korean Data

Heart of Analysis Raising Interest Rate Leads to Higher Employment, Asset Prices and Welfare Puzzle: Interest Rate is Like Tax on Labor Why Does Raising Tax on Labor Lead to More Employment and Higher Welfare? Asset Values Correspond to Inputs that Complement Labor Why Does Raising Tax on Labor Raise Value of Complementary Inputs? Answer: Higher Wedge on Labor Permits Reduction in Another Wedge, Collateral Constraint Will Work Through a Simple Example, Where Analytic Result is Possible 47

Simplified Model Economy Households Maximize subject to: u(c, L) =c ψ 1+ψ L1+ψ pc wl + π + T Firms: Final Good Technology: c =min (1 γ)c T,γc Nª. 48

Simplified Model Economy... Traded and Non-Traded Good Technology: Market Clearing y T = Az θ,y N = K α L 1 α. y T = c T + R z, y N = c N. Intermediate Good Firm Problem: maximize π = p N y N + y T q(k K ) w(1 + τ)l R z, s.t. τ N qk R z. 49

Simplified Model Economy... Timing 1. Labor Tax Rate, τ, Selected 2. Domestic Market in Physical Capital, with Price: 3. Production and Trade Occurs. q = αpn K α 1 L 1 α 1 λτ N. Labor Supply: ψ o L ψ = w p Labor Demand: p N (1 α) K α L α =(1+τ) w 5

Results Proposition: If there is a unique equilibrium in which the collateral constraint binds, then an increase in τ leads to an increase in Real Exchange Rate (p N ), Asset Values (q), Imports (z), Employment (L), Welfare. Rise in τ Increases Marginal Cost of Nontraded Goods Relative Price, p N, of Non-Traded Goods, Rises Value of Assets in Non-Traded Good Sector Increase. Relaxation of Collateral Constraint: Imports of Intermediate Good Expand Increased Production of Tradeable Good Inreased Demand (Leontieff Helps Here!) For Non-Tradable Good Supports Increased Employment in Non-Tradable Sector. 56

Results... Figure: Labor Market Equilibrium Labor supply w/p Labor Demand (p N,τ) + 57

Results... f(λ;τ) = τ N q(λ;τ)k - z(λ) λ(τ 2 ) λ(τ 1 ) 1/τ N λ τ 2 > τ 1 Figure 4: The Effect of An Increase in the Labor Tax Rate 58

Results... 6 Figure 5: Equilibrium Associated With Various Tax Rates p N q z 3 3.5 5 4 3 2 1.5 1 τ 2.5 2 1.5 1.5.2.4 τ 3 2.5 2 1.5 1.2.4 τ L λ.67 utility 1.6 1.5.665 1.4 1.66 1.2.5.655 1.2.4 τ.2.4 τ.65.2.4 τ 59

Results... Conclusion Identified Factors That Make Raising the Interest Rate in Immediate Aftermath of Financial Crisis Optimal Simulated a Model With These Properties (Inflexible Factors of Production in Short Run) and Found that Actual Interest Rate Response May Have Been Roughly Optimal. Broader Implications of Analysis: Monetary Transmission Mechanism May Be Profoundly Different When Collateral Constraints are Binding. Perhaps Binding Collateral Constraints are Binding More Often in Developing Countries, Where Collateral May Be in Short Supply Connections to Related Literature: Non-Keynesian Effects of Fiscal Policy, Expansionary Fiscal Consolidations (Giavazzi-Jappelli-Pagano, Perotti) Results in Financial Frictions Literature that Raising Interest Rates May Be Good When Borrowing Constraints Bind (Kocherlakota (AER, 22).) 64