Download Stabilizing role of own currency in a small open economy

Is there a case for enlarging euro area?
Stabilizing role of own currency in a small open
economy
Introduction
After joining eurozone, a country no longer possesses its own currency and it thus
cannot affect exchange rate through FX interventions or let exchange rate float according
to market forces.
In my research, I will first evaluate FX interventions of specific kind conducted at
specific time: commitment of central bank to maintain exchange rate above declared exchange rate floor, supported by in principle unlimited amount of FX purchases with newly
created money, when the interest rate is at zero lower bound (ZLB). The main purpose
of exchange rate floor is to keep exchange rate at devalued rate and, unlike common discretionary FX interventions, it has predictable and persistent impact on exchange rate.
Recently, Switzerland and the Czech Republic successfully implemented this instrument
and exchange rate stayed always above the declared floor.
Second, I will determine extent to which exchange rate absorbed or amplified negative
shocks in the four Visegrad countries (V4)—the Czech Republic, Poland, Hungary, and
Slovakia—at the time when the shocks were largest, during the recent financial crisis. In
particular, I will compare flexible exchange rate with counterfactual fixed exchange rate
to euro in the first three countries and fixed with counterfactual flexible exchange rate in
Slovakia.
Increase in exchange rate, on one hand, boosts economic activity since domestic agents
purchase less imported foreign goods, which is now more expensive, and more domestic
goods and foreign agents purchase more goods imported from domestic economy, which
is now less expensive, and less goods from their own economy. On the other hand, higher
exchange rate dampens economic activity when net foreign liabilities are positive since
higher value of these liabilities in domestic currency leads to lower domestic demand. In
my research, I will first determine impact of devaluation with exchange rate floor in a
model calibrated for the Czech Republic, a representative small open economy. Second,
I will determine impact of depreciations in the three V4 countries with flexible exchange
rates and of no depreciation in Slovakia. I have addressed both research areas in my
diploma thesis and found significant positive impact of devaluation with exchange rate
floor and of flexible exchange rate during financial crisis in the Czech Republic. The
applied methodology was, however, far more basic compared to one suggested in this
proposal.
Literature review
To my best knowledge, there is no rigorous analysis evaluating impact of exchange
rate floor on real economic activity and prices. The most relevant study is an analysis in
CNB’s Inflation Report I/2014 [CNB (2014b)]. Using input-output tables, it estimates
24 percent pass-through to prices, when considering only imported consumption goods,
and 34 percent, when considering also imported inputs to production. Limitation of this
study is that it evaluates impact of higher nominal exchange rate only through higher
import prices and that it assumes instant and complete increase of these prices.
Regarding fixed exchange rate during crisis, Brzoza-Brzezina et al. (2014) conduct
such analysis for Poland and estimate GDP growth would have oscillated between -6%
and 9% instead of 1% and 7% and inflation between -1% and 7% instead of 2% and 4%.
Authors, however, use less advanced methodology than in this proposal with potentially
large negative effect on precision of results. Most importantly, exports consist only of
domestic production, what is inconsistent with around 30 percent import content of exports in Poland and would be also inconsistent with around 50 percent import content in
three other V4 countries [OECD (2011)]; domestic economy is just a one good economy
implying that inflation does not represent inflation of only consumption goods, which
is of most interest; financial frictions consist of collateral constraint, along the lines if
Iacoviello (2005), and not of financial accelerator of Bernanke et al. (1999), which is far
more widespread in DSGE literature and also shown in Brzoza-Brzezina et al. (2013) to
deliver superior data fit.
Methodology
For both research areas, the core of the model is built along the lines of medium-sized
New Keynesian DSGE model of Christiano et al. (2011). The model is therefore basically
be a standard closed economy model in tradition of Smets & Wouters (2003), which is
extended to a small open economy with multiple sectors and additionally includes financial
frictions of Bernanke et al. (1999).
The main intuition behind simulation of devaluation with exchange rate floor at ZLB
is as follows. Credible commitment of central bank to the exchange rate floor, supported
by FX purchases, increases both current and expected nominal exchange rate to the
floor. DSGE model is, however, built such that it explains relations between deviations
of real variables from trends and thus it also uses deviation of real exchange rate from
the trend. This deviation initially increases as much as nominal exchange rate but then
decreases because of higher domestic inflation and increasing trend. The model captures
this path of real exchange rate deviation by a one-off persistent shock in uncovered interest
parity (UIP) condition at the time of devaluation. Optimal interest rate is assumed to
be sufficiently below ZLB such that central bank does not respond with its increase to
devaluation and subsequent inflation. This is captured by employing an adjusted piecewise
linear ZLB algorithm of Guerrieri & Iacoviello (2015).
Exchange rate fixed to euro necessarily also implies interest rate equal to that in eurozone. These adjustments are incorporated into DSGE model by replacing UIP condition
with equation stating that change in real exchange rate is equal to difference between
foreign and domestic inflation and by replacing domestic Taylor rule with equality be-
tween domestic and eurozone interest rate. Under fixed exchange rate, risk premium and
monetary policy shocks thus disappear and propagation of other shocks is altered because
of adjusted model equations. Lastly, the simulation is altered such that it enables to
disentangle impact of fixed exchange rate from the impact of different interest rate rule.
Counterfactual path of economy for three V4 countries with flexible exchange rate
during crisis is simulated by exposing fixed exchange rate model to the exogenous shocks
identified by Kalman smoother for flexible exchange rate model using as dataset values
of main macroeconomic variables. On the other hand, path of economy for Slovakia with
fixed exchange rate during crisis is simulated by exposing flexible exchange rate model to
shocks identified by Kalman smoother for fixed exchange rate model; additionally, two
exogenous shocks not present in fixed exchange rate model, risk premium and monetary
shocks, are set to values identified for the three other V4 countries and these will constitute three different scenarios for Slovakia.
Expected contribution
In the proposed research, I will first estimate how effective the devaluation with exchange rate floor is in stimulating economy. Countries with interest rates already at ZLB
and in need of further stimulus could use these findings to make a more informed decision
whether to use this or to use rather other unconventional instruments such as quantitative
easing or negative interest rates on deposits.
Second, I will estimate counterfactual development for the Czech Republic, Poland,
and Hungary, if they had fixed exchange rate during crisis, and counterfactual development for Slovakia if it had flexible exchange rate. These estimations will be of some
interest to policymakers in the four countries and will also lead to more general conclusions about role of exchange rate in small open economies during crises. Further, these
four countries share many similarities as post-communist countries but are also different
in many respects, for example openness to foreign trade, ratio of net foreign liabilities
to GDP, and procyclicality due to different shares of agricultural sector and automotive
industry. Comparative analysis will shed more light on importance of these and other
structural features.
The two analyses will identify some costs or benefits of having own currency and
consequently some costs or benefits of becoming a member of eurozone. These results
could help both prospective and current members. Prospective members could compare
them with other costs and benefits and then better decide whether to join eurozone.
Current members can better evaluate to what degree losing own currency poses a threat
to stability of a new member and eventually to whole eurozone as crises tend to be highly
contagious. Lastly, recent decision of the UK to leave the European Union could trigger a
wave of referenda in other countries about staying in the European Union and also in the
euro area. Even the current members may again need to compare the costs and benefits
of membership.
Bibliography
Bernanke, B. S., M. Gertler, & S. Gilchrist (1999): “The financial accelerator in a
quantitative business cycle framework.” In J. B. Taylor & M. Woodford (editors),
“Handbook of Macroeconomics,” volume 1 of Handbook of Macroeconomics, chapter 21,
pp. 1341–1393. Elsevier.
Brzoza-Brzezina, M., M. Kolasa, & K. Makarski (2013): “The anatomy of standard DSGE models with financial frictions.” Journal of Economic Dynamics and Control 37(1): pp. 32–51.
Brzoza-Brzezina, M., K. Makarski, & G. Wesolowski (2014): “Would it have paid
to be in the eurozone?” Economic Modelling 41(C): pp. 66–79.
Christiano, L. J., M. Trabandt, & K. Walentin (2011): “Introducing financial
frictions and unemployment into a small open economy model.” Journal of Economic
Dynamics and Control 35(12): pp. 1999–2041.
CNB (2014b): “Inflation report i/2014.” Technical report, Czech National Bank.
Guerrieri, L. & M. Iacoviello (2015): “OccBin: A toolkit for solving dynamic models
with occasionally binding constraints easily.” Journal of Monetary Economics 70(C):
pp. 22–38.
Iacoviello, M. (2005): “House Prices, Borrowing Constraints, and Monetary Policy in
the Business Cycle.” American Economic Review 95(3): pp. 739–764.
OECD (2011): “Import content of exports.” OECD Science, Technology and Industry
Scoreboard 2011 .
Smets, F. & R. Wouters (2003): “An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area.” Journal of the European Economic Association 1(5):
pp. 1123–1175.