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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.