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Chapter 6
Financial Markets,
Capital Mobility,
and Monetary Policy
© Pierre-Richard Agénor and Peter J. Montiel
1
Differences in structure of financial systems in
developing countries compared to developed
countries:
 Assets are limited to cash, demand deposits, time
deposits, and government securities.
 Financial system is limited in size and geographic
distribution.
 Many private individuals have limited access to
commercial banks.
 Secondary securities and equities markets are either
nonexistent or very limited in scope.
 Commercial banks operate under government-imposed
restrictions.
 There are restrictions on the degree of capital mobility.
2

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
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
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Financial Repression: Macroeconomic Effects.
Financial Repression, the Inflatoion Tax, and Capital
Controls.
Capital Mobility: Empirical Evidence.
Models of Informal Credit and Foreign Exchange
Markets.
Monetary Policy with Informal Financial Markets.
A Simulation Model with Informal Financial Markets.
3
Financial Repression:
Macroeconomic Effects
McKinnon (1973):
 Financial system in most developing countries is
“repressed” by government interventions.
 This keeps interest rates that domestic banks can offer
to savers very low.
 Motivation for these interventions is a fiscal one:
 government wants to promote development;
 but it lacks the direct fiscal means to do so, due to
either a lack of political will or administrative
constraints.
 It uses financial system to fund spending in two ways:
 By imposing large reserve and liquidity requirements
on banks, it creates a captive demand for its own
instruments.
5
It can finance its own spending by issuing debt.
 By keeping interest rates low, it creates an excess
demand for credit.
 It then requires the banking system to set a fixed
fraction of the credit available to priority sectors.
Combination of low nominal deposit interest rates and
moderate to high inflation has resulted in negative rates
of return on domestic financial assets.
This has an adverse effect on saving and the financial
intermediation process.
Interest rate ceilings introduce a wedge between the
social and private rates of return on asset accumulation,
thus distort intertemporal choices in the economy.




6





Savers switch from the acquisition of claims on the
banking system to accumulation of real assets, assets
traded in informal markets, and foreign assets.
Response of policymakers has been to declare illegal
the holding of both foreign assets and assets in the
informal sector.
But, these restrictions have met with limited success.
Investment level is not high since prospective investors
will be unable to secure financing.
There are income distribution consequences of financial
repression because this system transfers resources
 from actual and potential savers, and excluded
borrowers,
 to favored borrowers (most importantly public sector).
7
Financial Repression,
the Inflation Tax,
and Capital Controls


Financial Repression and Inflationary Finance.
A general Public-Finance Approach.
9
Financial Repression
and Inflationary Finance




Brock (1989): illustrate tradeoff between the inflation tax
and the degree of financial repression.
Consider a closed economy in which private agents
hold cash balances and bank deposits, with the former
asset bearing a zero rate of interest.
Output is taken as given and is normalized at zero.
Banks are subject to a fractional reserve requirement on
deposits.
10

Asset demand functions for cash m and bank deposits
d:
- +
m = m(i, i - id),
+ d = d(i, i - id),

i: nominal lending rate
id: deposit rate.
If banks face no operating costs, the zero-profit
condition yields
i = id /(1-),
0 <  < 1,
: required reserve ratio.
11

Assume that the asset demand functions take the form
ln m = 0 - i,



ln d = 0 - (i - id) = 0 - i.
Assume that the real interest rate is constant and set
equal to zero.
Thus, i = , where  is the inflation rate.
Policymaker's objective is to maximize inflation tax
revenues:
Srev = (m + d),
with respect to  and .
12

Solving this maximization problem yields
Srev/ = 0   = 1/,
(6)
Srev/ = 0   = (1/) + (d/m)[(1/) - ].
(7)




(7): when  is zero, the revenue-maximizing  is equal
to 1 / .
If both instruments are used, the optimal  may be
either higher or lower than 1 / .
Figure 6.1: determination of the optimal values of both
policy instruments.
These are obtained at the intersection of the two curves
defined by (6) and (7).
13
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 In practice, reserve requirements represent a large
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Figure 6.2:
 Effective reserve requirements on bank deposits and
decomposition of revenue from seigniorage in
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 Reserve requirements on bank deposits are higher in
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
15
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16


Seigniorage levied on required reserves represents a
large component of total seigniorage revenue in many
developing countries.
Another source of revenue from financial repression is
 implicit subsidy from which the government benefits
by obtaining access to bank financing at belowmarket interest rates,
 implicit tax on private sector bank deposits that are
remunerated at below-market interest rates.
17
A General Public-Finance
Approach




Financial repression of the domestic financial system is
always accompanied by controls on international capital
movements.
Reason: prevent restrictions on domestic financial
intermediaries from being bypassed by recourse to
foreign intermediaries.
If restrictions on capital mobility forces agents to hold
domestic-currency balances, capital controls may be
viewed as imposing a tax on asset holders.
Costs and benefits of this tax must be traded off with
other taxes.
18
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Thus a model, which unifies financial repression, capital
controls, and the inflation tax, requires policymakers to
be faced with constraints on the use of regular taxes.
Assume portfolio structure similar to that described
above, with the addition of imperfectly substitutable
foreign bonds.
Capital controls can be modeled as an explicit tax on
foreign interest income or as a tax on purchases of
foreign assets.
In taxation system, there are collection and enforcement
costs which are assumed to be an increasing and
convex function of the level of revenue.
Other forms of taxation (financial repression tax,
inflation tax, and capital controls) has low collection
costs.
19
Aizenman (1987) and Végh (1989b):
 Government's problem is maximizing either inflation tax
revenue, an overall revenue target in order to finance
”minimum” level of public expenditure.
 Representative consumer's indirect utility subject to its
budget constraint.
 Conclusion: capital controls, financial repression, and
the inflation tax must be used with regular taxes when
collection or enforcement costs on the latter are large.
 Increase in collection costs reduces the use of regular
taxes relative to other tax instruments.
 Increase in the deficit target leads to a more intensive
use of all taxation instruments.
 Optimal tax structure: highest tax rates are imposed on
20
activities that carry the lowest collection costs.
Implications of this approach:
 Decision to impose a high degree of financial repression
may be the outcome of an optimally determined taxation
structure.
 In such conditions, successful financial liberalization
requires the simultaneous implementation of
appropriate fiscal reforms.
Giovannini and de Melo (1993):
 Evidence on the revenue generated by controls on
capital flows and financial repression of the domestic
financial system.
 Capital controls coupled with restrictions on domestic
interest rates yield a positive differential between
domestic and world interest rates.
21
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This provides an implicit subsidy for the government on
domestic debt financing.
Government revenue from financial repression and
capital controls:
 spread between the foreign and the domestic cost of
funds,
 times the domestic stock of central government debt.
Capital controls/financial repression tax rate varies
across developing countries.
About 4% in Thailand, 6% in Korea, 25% in Costa Rica,
45% in Mexico, and 55% in Turkey.
Revenue from repression of the financial system and
capital controls amounts to 2% of GDP and 9% of
government revenue in developing countries.
22
Capital Mobility: Empirical
Evidence
Effectiveness of capital controls:
 If economy is completely closed and controls are
effctive, external financial intermediation is ruled out.
 Marginal cost of funds in the economy becomes the
interest rate in the informal credit market.
 Thus the marginal cost of funds are influenced by
domestic monetary, fiscal, and other shocks.
 If controls are completely ineffective and perfect capital
mobility prevails, interest rate in informal credit market
must be equal to the uncovered-parity foreign rate.
 Marginal cost of funds is given by the uncovered
parity rate.
 They are unaffected by domestic phenomena, unless
expected rate of depreciation of the domestic
24
currency is not affected.
Which of these situations is relevant in the developing
world?
 They tend to be treated as
 either completely closed to capital flows or
 completely integrated with world financial markets,
with domestic interest rates determined by uncovered
interest parity.
 In spite of controls, evidence suggests that many
developing countries are far from being financially
closed.
25
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The Magnitude of Gross Flows.
Tests of Interest Parity Conditions.
Tests of Monetary Autonomy.
Saving-Investment Correlation.
Summary.
26
The Magnitude of Gross Flows


Evidence on episodes of substantial capital movements
in and out of developing countries.
In Latin America, several episodes of large capital flows
in both directions:
 substantial external debt accumulation during 19741982;
 large short-term capital inflows associated with the
Southern Cone stabilization programs in 1978-1982;
 gross private capital outflows associated with the
“capital flight” phenomenon during the first half of the
1980s;
 resurgence of capital inflows, primarily to the private
27
sector.
Implications of the capital flow episodes can be seen by
measuring gross stocks of financial claims between
developing countries and external financial markets.
 Montiel (1992): for the group of fifteen heavily indebted
developing countries, stock of gross external debt as of
1988 amounted to about 75% of GDP.
Rojas-Suárez (1990):
 For the same year estimated that the total external
claims overwhelmingly acquired in the form of private
capital flight.
 This was about two-thirds of their external debt, or
about half of GDP.
 High correlation between the stock of flight capital and a
measure of default risk.

28

Thus the gross-flow evidence have shown a substantial
amount of financial openness.
29
Tests of Interest Parity
Conditions


Tests of interest parity conditions are the most common
approach to the measurement of financial integration for
industrial countries.
Differential return between holding the domestic and
foreign assets, without hedging the exchange risk in
forward markets, is
d = i - i* - ,
i: domestic interest rate;
i*: interest rate on foreign asset;
30
 :expected rate of depreciation of the domestic currency.




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
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Under perfect capital mobility, expected returns on
domestic and foreign assets should be equalized, so d
should be zero.
This situation is referred to as one in which uncovered
parity holds.
But, d is not directly observable; it depends on the
unobserved expectation .
If that expectation is formed rationally, then uncovered
interest parity implies that E(d/) = 0.
: information set used in forecasting .
Thus, d should not be correlated with any information
contained in .
Thus joint tests of uncovered interest parity and rational
expectations entail testing whether d is correlated with
31
variables in .
Lizondo (1983):
 Tests of both covered and uncovered interest parity for
Mexico.
 Reject the joint hypothesis of uncovered interest parity
and rational expectations.
 Either the one-month forward rate or the one-month
interest differential is used as the predictor of the future
spot rate.
 Because of the “peso problem” he did not interpret
these rejections as necessarily invalidating this
hypothesis for Mexico.
 In testing covered parity, he used methodology of
Frenkel and Levich (1975) to compute neutral bands
around the covered parity interest rate.
32
 He found that percentage to be extremely high.
He accounts for this rejection of covered parity
consisting of
 prior deposit restrictions on forward transactions;
 taxes on foreign exchange capital gains.
 Although unexploited profit opportunities were absent,
domestic rates could depart substantially from their
covered parity in Mexico.
Khor and Rojas-Suárez (1991):
 During 1987 to 1990, yields on dollar-indexed Mexican
government bonds were cointegrated with yields to
maturity on Mexican public external debt traded in the
secondary market.
 So Mexico's degree of integration with external financial
markets may have increased in recent years.

33
Phylaktis (1988):
 Argentina during 1971-1984.
 83% of the quarterly variance of the differential between
the three-month domestic deposit rate and its
uncovered-parity counterpart through
 use of standard portfolio variables;
 step dummies for capital controls.
Implications:
 While the Argentinean economy was financially open,
foreign and domestic assets were imperfect substitutes.
 Certain types of capital controls proved to be effective in
increasing the differential between foreign and domestic
rates of return.
34
Edwards and Khan (1985):
 Actual domestic interest rate can be expressed as a
weighted average of
 external rate
 domestic interest rate that would prevail in a
financially closed economy.
 The latter was a function of the excess money supply
and the expected rate of inflation.
 This approach uses domestic monetary variables to
explain the “risk premium.”
 If uncovered parity holds continuously, such variables
should have no explanatory power in the reduced form.
 If the economy is completely closed, the uncoveredparity variable should not enter.
35
For Colombia, both external and domestic variables
mattered, making this economy “semi-open”.
 For Singapore, only the foreign interest rate explains
the domestic interest rate due to strong financial
integration with international capital markets.
 Interest parity tests have not been widely applied to
developing countries.
 Reason: published interest rates for the formal financial
system do not refer to assets with market-determined
rates of return.
Haque and Montiel (1991):
 Assumption: domestic market-clearing interest rate is a
stable weighted average of the autarky rate and
uncovered parity.

36




They estimate the relevant weights by
 substituting the resulting expression for the marketclearing rate into the money demand function;
 estimating the resulting nonlinear function of
observable variables.
In this estimation, the weight is uncovered parity
emerges as the coefficient of this variable in the
estimate of the money-demand function.
This coefficient indicates the degree of financial
integration, with values approaching unity being
indicative of perfect financial integration.
In ten of the fifteen cases, the weight could not be
statistically distinguished from the perfect capital
mobility value of unity.
37
For Brazil, Jordan, Malta, and Turkey, an intermediate
degree of financial integration prevailed.
 The financial autarky value of zero failed to be rejected
in only Indian case.
 Edwards-Khan and Haque-Montiel methodology was
applied to Korea and Taiwan by Reisen and Yeches
(1993) and to Thailand by Robinson (1991).
 Results: these countries are among intermediate group.
Faruqee (1992):
 Tests for changes in the degree of financial integration
due to domestic financial liberalization in Pacific Basin
countries.

38


Differentials between money-market interest rates in
Korea, Malaysia, Singapore, and Thailand and the
three-month Japanese yen LIBOR rate during the
period from September 1978 to December 1990.
Conclusion: degree of financial integration increased in
these countries over the 1980s.
39
Tests of Monetary Autonomy



Under perfect capital mobility, the “offset coefficient” that
relates
 changes in the stock of domestic assets of the
central bank
 to changes in reserve flows
normally takes a value of -1.
Reason: any expansion of the domestic assets of the
central bank will give rise to an offsetting capital outflow.
This leaves the stock of money unchanged and implies
a loss of monetary autonomy.
40
Cumby and Obstfeld (1983):
 During the 1970s perfect capital mobility did not hold
between Mexico and the United States.
 Slow portfolio adjustment and imperfect asset
substitutability permitted Mexico to retain at least some
short-run monetary autonomy during that period.
 Recent approach: assessing the degree of monetary
autonomy is based on causality tests.
 In the absence of monetary autonomy under fixed
exchange rates, domestic financial aggregates should
not Granger-cause movements in nominal income.
41


Montiel (1989): Money or credit was found to Grangercause nominal income
 in Bolivia, Chile, Ghana, Indonesia, Mexico, Morocco,
Peru, and Sierra Leone;
 not in India, Pakistan, Turkey, or Sudan.
Dowla and Chowdhury (1991): some domestic financial
aggregate Granger-caused domestic real output
 in Greece, Côte d'Ivoire, Jordan, Korea, Malawi,
Mexico, Singapore, and Tunisia;
 but not in Bangladesh, India, Israel, Malaysia, or
Pakistan.
42
Saving-Investment Correlation
Feldstein and Horioka (1980):
 Degree of capital mobility among industrial countries
could be tested by examining the degree of correlation
between saving and investment rates.
 Reason: under perfect capital mobility domestic saving
and investment rates should be uncorrelated.
Dooley, Frankel, and Mathieson (1987) and Summers
(1988):
 Included developing countries in their cross-section
samples and considered the effect of including such
countries on their results.
 This reduced the strength of the saving-investment
43
correlation in their samples.
Unexpected because these countries were perceived as
less integrated with world capital markets.
Wong (1990):
 Cross-section sample of forty-five developing countries,
using annual data averaged over the period 1975-1981.
 Saving ratio has no statistically significant effect on the
investment ratio.
Montiel (1994):
 Integrate the disparate tests of capital mobility.
Results:
 Degree of financial integration differs across developing
countries.
 Financial links with the world capital markets can be
documented widely for such countries.
44

Summary




Few developing countries can be considered to be
financially closed.
For countries such as Argentina, Colombia, Indonesia,
Korea, Mexico, Morocco, and Thailand, tests of
arbitrage relationships indicate that
 external interest rates play an important role,
 but not necessarily exclusive role
in affecting domestic interest rates.
Result: while these economies should be regarded as
financially open, perfect capital mobility has not held.
Although gross flows have been large in Argentina,
Colombia, and Mexico, all these countries have
45
maintained some degree of monetary autonomy.


Although arbitrage tests cannot rule out perfect capital
mobility in Indonesia and Morocco, domestic financial
aggregates are Granger-cause domestic activity.
Guatemala, Malaysia, and Singapore may represent
instances of perfect capital mobility.
46
Models of Informal Credit
and Foreign Exchange
Markets


Models of Informal Credit Market.
 Stagflationary Effects of Monetary Policy.
 Interest Rate Policy and Output.
Models of Informal Currency Markets.
 Illegal Trade and Parallel Markets.
 Portfolio and Currency Substitution Models.
48
Models of Informal Credit
Markets



Macroeconomic implications of financial dualism
induced by government regulations on interest rates
have been highlighted by new structuralist economists.
Van Wijnbergen (1983a, 1983b) and Taylor (1983,
1990) are important.
Contribution: in the presence of informal credit markets,
“orthodox” monetary policy prescriptions lead to results
that differ significantly from those anticipated.
49
Stagflationary Effects of Monetary Policy
“New structuralist critique” of orthodox monetary
policy:
 In developing countries, credit plays a predominant role
as a source of funds for firms,
 for short-term working capital purposes;
 for long-term fixed capital formation.
 With rationing in official credit market and thriving
unorganized loan markets, transmission channel
between
 monetary instruments,
 and the supply side of the economy via credit
financing of working capital requirements
provides a critical link for gauging the effects of
stabilization policy.
50

This transmission channel gives a stagflationary bias to
restrictive monetary policies.
How does it work?

Restrictive monetary policies lead to expensive credit
from informal loan markets.

This leads to an increase in input costs.

This leads to higher prices and less output than would
obtain without the supply-side credit channel.

This effect is Cavallo-Patman effect (Cavallo, 1981;
Taylor, 1991).

If credit extended through the official and parallel
markets has a short-term maturity, the stagflationary
impact of a tight credit policy will work quickly.
51
However, the demand-restraining impact works
gradually:
 aggregate demand will fall,
 then output will fall and unemployment will rise.
 This will ease real wage pressure and thus inflation.
 Response to a one-shot tightening of monetary policy is
 initial acceleration of the inflation rate,
 then slowdown in inflation rate due to demand effects.
Van Wijnbergen (1985):
 Econometric model for South Korea.
 Both effects have a negative impact on output.

52
Interest Rate Policy and Output
“New structuralist critique” has controversy also on
interest rate policy.
McKinnon (1973) and Shaw (1973):
 Rise in interest rates on savings and time deposits will
increase the saving rate in developing countries.
 This raises the rate of economic growth.
 Increase in interest rates will lead to an inflow of
deposits into commercial banks, raising their capacity to
lend and finance investment.
 Kapur (1977): increased credit leads banks to increase
financing of working capital; this leads to a higher
growth rate.

53
van Wijnbergen (1983b):
 If informal loan markets are prevalent, a rise in official
interest rates may
 lead to a reduction in financial intermediation;
 have an adverse effect on output in the short and
medium run.
 Reason: informal credit markets are more “efficient” at
providing financial intermediation than the official
commercial banking system.
 Consider a closed economy in which there are four
categories of agents: households, firms, commercial
banks, and the central bank.
 Due to financial repression, an informal credit market
exists and allows households to channel funds directly
54
to firms.







Commercial banks lend only to firms and do not operate
in the informal market.
Central bank sets interest rates and reserve
requirements on commercial banks' loans, and does not
provide direct credit to banks or the public.
Households allocate their wealth among cash holdings,
time deposits, and loans to the informal credit market.
While doing this, they take into account their level of
income and the rates of return on alternative assets.
Rate of return on currency is the negative of the
expected inflation rate: - a.
Rate of return on bank deposits is the real deposit rate:
id - a.
Rate of return on informal market loans is the real
55
parallel interest rate: iL - a.

Assuming unit wealth elasticities, portfolio allocation:
+a
C
h (- ,
- a
- a +
CU/A =
id -  , iL -  , y),
-a + a
- a +
p
D
D /A = h (- , id -  , iL -  , y),
-a
- a + a p
L
L /A = h (- , id -  , iL -  , y),
hCk(·) + hDk(·) + hLk(·) = 0,
(8)
(9)
(10)
k = 1,…4, (11)
hC(·) + hD(·) + hL(·) = 1,
CU: currency holdings;
Dp: households' deposits in the banking system;
Lp: loans to the informal market;
y: real income.
(12)
56

A: nominal wealth defined as
A = CU + Dp + Lp.



(13)
(8)-(10): assume that assets are gross substitutes,
 positive functions of their own rate of return;
 negative functions of the rate of return on alternative
assets.
Negative income elasticity of the supply of parallel
market loans due to
 assumption of a positive relationship between income
and both currency and time deposits
 constraint (11).
(12) is the adding-up portfolio constraint.
57



Because the central bank does not provide credit to
commercial banks, households' deposits are the only
source of funds for the banking system.
Nominal interest rate for these deposits is id and
reserve requirement ratio is .
Credit supply function by commercial banks:
Ls = (1-)Dp, 0 <  < 1.

Commercial banks lend only to firms, whose demand for
credit is for the purpose of financing cash holdings
related to working capital needs.
58

These needs depend positively on the real product
wage, , and the level of output:
Df




+ +
= f( , y).
Firms absorb all credit provided by commercial banks.
Excess demand is satisfied in the informal market, at a
rate of interest higher than the official rate.
The total amount of loans to firms (Lp + Ls in equilibrium)
is implicitly held as high-powered money.
Monetary base is the sum of cash in circulation and
banks' reserves held in the central bank:
M = hC(·)A + Df + Dp.
59



Two market-clearing conditions in this model:
 equilibrium between supply and demand for highpowered money;
 equilibrium condition for the informal credit market.
Due to Walras law, focus on only one of them.
Using the informal credit market equilibrium condition
yields, using (10):
hL(-a, id - a, iL - a, y)A = f(, y) - Ls,
using (9) and (14):
hL(·)A = f(, y) - (1 - )hD(·)A.
60

Differentiating (17) and using (11):
L
diL
dy


=
LL
D
fy - (hy + (1-)hy)A
L
D
L
L
> 0.
[hi + (1-)hi ]A
This determines the slope of the credit market
equilibrium locus denoted LL in Figure 6.3.
Assume that output is demand determined and depends
only on the real interest rate in the informal loan market:
y = -(iL-a),  > 0.
61
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.
62

This yields
diL
dy



= - 1 /  < 0.
YY
This determines the slope of the commodity market
equilibrium locus denoted YY in Figure 6.3.
LL and YY: combinations of the informal interest rate
and real output that simultaneously yield equilibrium in
the informal credit market and the goods market.
Equilibrium point: E.
63
What happens when the official interest rate on bank
deposits is raised by the central bank?
 Increase in id does not change the position of YY
because aggregate demand is independent of the
deposit rate.
 It leads to a portfolio reallocation because it changes
the real rate of return on bank deposits and the relative
attractiveness of alternative assets.
 Households attempt to reduce their holdings of currency
and the supply of informal market loans, and increase
their holdings of bank deposits.
64

Net effect of the change in deposit rates on the position
of LL:
diL
dy
_
LL, y=y
=
hLi - (1-)hiCd
d
hiC+ hiD
L


 0.
L
This is ambiguous.
Net impact of the change in the interest rate on time
deposits depends on the relative elasticities of demand
for the two alternative assets
 cash holdings;
 informal market loans
to changes in id.
65

This condition can be written as
sg

{
diL
dy
_
LL, y=y
}
C
= sg {hi d- (1-)hid } .
L
As a result of the rise in id, households shift away mainly
from informal market loans, so that hiL / hiC > (1-) / .
d
d
Consequence of this shift is a decline in the overall
supply of funds to firms.
Reason:
 Informal credit market was providing “one-for-one”
financial intermediation.
 Funds deposited in commercial banks lead only to
partial intermediation due to financial regulations.

66

So informal interest rate rises and economic activity
falls, moving the economy from E in Figure 6.3 to E’.

Assume: rise in id leads households to shift to bank
deposits, hiL / hCi < (1-) / .
d




d
This shift entails an increase in real lending by
commercial banks to firms.
Reduction in excess demand in the official market leads
to a fall in interest rates in the informal credit market and
an increase in output.
Equilibrium position of the economy moves from point E
to point E ’’ in Figure 6.3.
High-interest-rate policies can have an adverse effect
on growth because of their “disintermediation effect”.
67




Increase in id may lead to results that are opposite to
those expected.
Financial structure is a critical factor in accounting for
this effect.
In the presence of informal credit markets, and central
bank regulations on reserve requirements, it is crucial to
gauge the pattern of substitution among the different
assets.
Financial liberalization may thus entail risks.
68
Models of Informal Currency
Markets



Early literature emphasized the effect of taxes and
smuggling activities on illegal transactions in foreign
exchange.
Recent emphasis has been on the portfolio balance
approach.
This stresses the role of asset composition in the
determination of supply and demand for foreign
exchange in the official and parallel markets.
69
Illegal Trade and Parallel Markets
Parallel market for foreign exchange in “real trade”
models is specified as reflecting
 on the demand side, foreign currency needed to
import illegal goods,
 on the supply side,
 foreign currency obtained from illegal sources,
 resale of officially allocated foreign exchange.
 These models neglect interactions of the parallel market
for foreign exchange with the rest of the economy.
Macedo (1987):
 Assume small open economy in which risk-averse
domestic importers and exporters face given world
70
prices.






In each period both categories of agents must choose
 quantities of goods to be transacted through official
channels;
 quantities to smuggle inside the country or outside.
Government operates a customs agency whose
purpose is to catch and prosecute offenders.
Due to prohibitive administrative costs, the agency
cannot prevent smuggling.
But detection technology is available such that the
probability of catching smugglers is an increasing
function of the smuggling ratio.
Offenders, when caught, are subject to a penalty that
consists in confiscating a proportion of the value of
smuggled goods.
71





Consider first the representative importer.
In official market, importer obtains foreign exchange at
the fixed official exchange rate, but must pay an ad
valorem tariff.
In parallel market, he acquires foreign exchange at a
more depreciated exchange rate and face a probability
 of being caught.
In this case a proportion  of smuggled goods is
confiscated.
Rational importer determines first the optimal amounts
of the good to be imported legally and illegally so as to
maximize profits, for given values of
 tariff rate m,
 parallel market premium ,
72
 price mark-up charged to domestic consumers.






Domestic price mark-up: weighted average of  and m.
Weight on the latter falls monotonically as  increases.
Necessary condition for the existence of a solution with
smuggling is  m > .
So smuggling activity takes place only if m is so high
that it pays to purchase foreign exchange in the parallel
market at a premium.
Risk-averse exporters face a similar problem.
They determine the proportions of exports to sell abroad
through legal and illegal channels, taking into account
 possibility of being caught;
 cost of producing export goods;
 export tax rate x .
73






Rational exporter determines the levels of legal exports
and smuggled exports so as to maximize profits.
Resulting domestic price of exports is a weighted
average of x and  and .
Necessary condition for a well-defined solution:  x < .
Flow equilibrium of the parallel market for foreign
exchange is obtained by equating aggregate flow
supply and demand.
Equilibrium value of the parallel exchange rate equates
total demand and supply.
First-order optimization conditions for importers and
exporters determine the long-run relation between the
premium and smuggling ratios.
74

Parallel market premium:
~
+
_
 = (m, x; , ).



When legal exports equal legal imports and smuggled
exports pay for planned smuggled imports in the long
run, premium is determined by
 structure of tariffs,
 penalties,
 risk of getting caught.
Increase in m raises demand for illegal foreign
exchange, raising the premium.
Fall in x reduces the premium.
75
Limitations of real trade models:
 Only purpose of parallel market transactions in foreign
exchange is to allow smuggling to take place.
 Thus there is no account portfolio motive (important in
determination of the parallel market demand for foreign
currency).
 There is no mechanism to explain short-run behavior of
the premium.
Macedo (1987):
 Extension of the model.
 Although the premium is determined in the long run by
the structure of trade taxes, it is given in the short run
by the requirement of portfolio balance.
76
Portfolio and Currency Substitution Models




Dornbusch et al. (1983) develop portfolio-balance model
of the parallel market for foreign exchange.
It stresses the role of portfolio composition in the
determination of parallel exchange rates.
General assumption: foreign exchange is a financial
asset held by agents as part of a diversified portfolio,
both as
 hedge
 refuge for funds.
Followings lead to changes in the demand for foreign
currency:
 loss of confidence in domestic-currency denominated
assets;
77
low real domestic interest rates;
 uncertainty about inflation, taxation, and the political
environment.
 Forward-looking expectations play a key role in
 determining short-term supply and demand shifts
 accounting for exchange-rate volatility.
 Essential features of the approach are best highlighted
in a “currency substitution” framework.
Kamin (1993) model:
 It incorporates interactions of the parallel market for
foreign exchange with production side of the economy.
 Domestic money stock depends on
 changes in central bank reserves;
 rate of growth of domestic credit.
78

Current account determines the change in the stock of
foreign currency held in private agents' portfolios.
 Flow supply of foreign exchange in the parallel market is
derived from under-invoicing of exports.
 Propensity to under-invoice depends on premium level.
 Probability of detection rises as fraudulent transactions
increase.
 This leads to a rising marginal under-invoicing share.
When devaluation is unexpected:
 Parity change causes a decline in the flow supply of
foreign currency to the private sector because the
premium falls.
 To maintain current account balance, a depreciation of
the parallel rate is required.

79
When devaluation occurs, the parallel rate depreciates
sharply.
 Current account losses of foreign currency drive the
unofficial exchange rate up until it reaches a new longrun equilibrium.
When devaluation is anticipated:
 Parallel exchange rate jumps upward (smaller jump),
and foreign-currency holdings begin rising.
 After the initial jump, the parallel rate continues to
depreciate while private agents accumulate foreign
currency in their portfolios.
 This happens until the economy reaches its new
equilibrium path at the instant devaluation actually
occurs.

80






Parallel rate continues to depreciate while foreigncurrency holdings decline.
Reason: unofficial current account deteriorates after
devaluation.
At the date of the announcement of future devaluation,
under-invoicing share jumps upward and grows as the
parallel market rate depreciates.
When devaluation is implemented, premium and underinvoicing share fall sharply.
Then they recover partially, because the parallel market
rate continues to depreciate.
Figure 6.4: behavior of the under-invoicing share and
the official current account.
81
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82
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83
Long-run impact of a once-and-for-all official
devaluation on the parallel exchange rate depends on
 degree to which fraudulent transactions react to
changes in the premium;
 rationing scheme imposed by the central bank;
 elasticity of export volumes to changes in relative
prices.
Empirical evidence:
 Prior to an official devaluation:
 growth rates of exports and imports decelerate;
 official current account balance and foreign reserves
deteriorate.

84





After official parity change:
 exports rebound strongly and current account
improves;
 imports continue to fall recovering only in the second
year after the devaluation.
Behavior of current account differs from predictions of
J-curve theory.
Kamin's (1993) model can explain these evidences.
Expansionary fiscal and monetary policies after
devaluation lead to an appreciation of the real exchange
rate and increases in the parallel market premium.
This leads to a reduction in the volume of exports, an
increase in under-invoicing, and a deterioration of the
officially recorded current account.
85
Fall in exports leads to growing reserve losses, forcing
authorities to tighten foreign exchange allocations to
imports.
 Following the devaluation, parallel market premium falls,
reducing the propensity to under-invoice and leading to
a sharp increase in officially measured exports.
 Gradual recovery of reserves allow the authorities to
increase sales of foreign exchange, leading to a
recovery in imports.
Evidence on effect of devaluation on parallel market
premium:
 Parallel market rates depreciate less than proportionally
in response to a devaluation of the official exchange
rate, so that the premium falls initially.

86

But reduction is temporary if fiscal and credit policies
are maintained on an expansionary course.
87
Monetary Policy with Informal
Financial Markets


The Analytical Framework.
Changes in Monetary Policy Instruments.
 Credit Expansion.
 Changes in the Administrated Interest Rate.
 Change in the Required Reserve Ratio.
 Intervention in the Parallel Foreign Exchange Market.
89
Informal markets for credit and foreign exchange
markets coexist in many developing countries.
Assumptions:
 There are no markets in which private agents can trade
domestic securities or equity.
 Capital controls are in place, but the private sector has
been able to evade these sufficiently well in the past to
acquire foreign-currency-denominated assets.
 These are traded among private agents in a free
exchange market and which are imperfect substitutes
for domestic assets.
 Thus movements in foreign interest rates influence
domestic financial markets.

90



Economy is a small open one with four types of agents:
 households;
 government;
 central bank;
 rest of the banking system.
Authorities maintain an official exchange rate for current
international transactions but prohibit private capital
movements.
Private households have access to four assets:
 bank deposits;
 curb market loans;
 foreign assets;
 bank credit.
91



Bank credit and curb market loans are perfect
substitutes in household portfolios.
Monetary authorities have four direct policy instruments:
 level of administered bank interest rates;
 required reserve ratio;
 amount of credit extended by the central bank to the
commercial banking system;
 intervention in the parallel exchange market.
Beside to conventional channel of transmission of
monetary policy, there are other mechanisms of
transmission:
 wealth effects induced by changes in the degree of
financial repression;
92

effects that operate through the exchange-rate
premium in the parallel foreign exchange market.
93
The Analytical Framework

Value of households' financial portfolios:
A = Dp + sFp - Lp,
Dp: bank deposits;
Lp: curb market loans, bank credit;
Fp: foreign assets.
s: domestic-currency price of foreign exchange traded in
the parallel market.
94

Portfolio balance requires:
+
0
(23)
Dp/P = hD(iL, a; id, s^a),
- + - -^
-Lp/P= hL(iL, a; id, sa), 0< hL2 <1 (24)
+
+
^a
p
F
sF /P = h (iL, a; id, s ), 0 < hF2 <1 (25)
iL, id: interest rate on curb market loans and interest rate
on bank deposits;
s^a: expected rate of depreciation of the parallel market
exchange rate;
P: domestic price level;
a: real private wealth.
95

Partial derivatives satisfy standard constraints:
hDk(·) + hkL(·) + hkF(·) = 0,
k = 1, 3, 4
h2L(·) + h2F(·) = 1.

Private absorption c depends on the real loan interest
rate and the level of household resources:
-a +
c = c(i- , a),

a: anticipated inflation rate.
Household resources consist of real financial wealth a
and real factor income.
96





Since real output is taken as constant, level of real
factor income is omitted from the function c(·).
Implicit taxes and subsidies imposed on households by
financial repression are taken into account as follows.
ic: controlled interest rate on bank credit.
Individuals with access to such credit receive a subsidy
of (iL-ic)Lp.
Present value of this subsidy is (iL-ic)Lp/iL, and this
represents a net addition to household financial wealth.
97

Degree of financial repression:
 = (iL-ic)/iL,

: present value of the subsidy, per unit of bank credit,
implied by the prevailing interest rate ceilings.
Present value of the tax on households as depositors:
~
(id-id
)Dp /
~
id
~
id: deposit interest rate corresponding to a loan interest
rate of iL under the banks' zero-profit condition.
98

This condition can be used to show that
~
(id-id

)Dp /
~
id = .
Taking these taxes and subsidies into account,
households' real financial wealth can be expressed as:
a = (Dp + sFp - Lp + Lp - Dp)/P,
(28)
= [(1-)(Dp-Lp) + sFp]/P.
99






Wealth effects of financial repression depend on
whether households are net creditors (Dp-Lp > 0) or
debtors (Dp-Lp < 0) of the banking system.
When Dp-Lp > 0, increase in  reduces household
wealth.
Reason: implicit tax imposed on households by interest
rate ceilings on deposits exceeds the subsidy received
by favored borrowers.
Banks' assets consist of reserves held at the central
bank RR and credit extended to households Lp.
Their liabilities are the deposits held by the public, and
credit received from the central bank Lcb.
Balance sheet of the banking system:
100

Balance sheet of the banking system:
RR + Lp = Dp + Lcb.


Banks hold no excess reserves.
Given a required reserve ratio of , reserve holdings:
RR = Dp, 0 <  < 1.


(29)
(30)
Reserves at the central bank pay no interest, but credit
extended to the banking system by the central bank
carries an interest charge.
It is equal to ic.
101

Zero-profit condition for the banking system:
ic = id /(1-).


The central bank pegs the official exchange rate at a
value E.
Stock of foreign exchange reserves evolves:
.
ER = PT(z),
(32)
R: central bank's stock of foreign exchange reserves;
T(z): trade balance;
z = E/P: real exchange rate.
102

Central bank's balance sheet:
ER + Lcb = RR.


(33)
Central bank's interest income is transferred to the
government.
Government budget constraint:
Pg = iLcb,

g: real government spending on domestic goods.
Market for domestic goods clearing condition:
y - c(iL-a, a) + g + T(z) = 0.
y: domestic real output:
103


 = s /E: (1 plus) the parallel market premium.
Using (23) - (25), (29) and (30), equilibrium conditions in
informal loan and foreign exchange markets:
hL(iL,
^a
a; id,  ) +
zFp

-
zlcb
+
hF(iL,
^a
D
(1-)h (iL; id,  )
a; id,  ) = 0,
^a
= 0,
(36)
(37)
lcb = Lcb / E;
^a
 = - s^ a: expected rate of change of the parallel market
premium.
Using (29) and (33) in (28), real household wealth:
a = [E(Fp+R) + (Lcb-RR)] /P.
104



Wealth effects of financial repression depend on the
excess of central bank lending to the banking system
over reserves held by commercial banks.
Reason: Lp can exceed Dp only if Lcb exceed RR.
Using (23), (30), and (32) and letting a* = A /E, a will be:
a = za*
= z[F +
(-1)Fp]
+
{zlcb
(38)
-
hD
^
(iL; id, a)},
F = R + Fp: economy’s total net foreign assets.
105

Commodity market equilibrium condition:
y - c(iL+z^a, za*) + iczlcb + T(z) = 0,




z^a: expected rate of depreciation of real exchange rate.
Monetary policy variables: id, , lcb, and central bank
intervention in the free market.
The last one is captured by Fp, which can be altered by
the central bank subject to the condition dR = -dFp.
Endogenous variables in the system are: iL, , R, z, .
Effects of the monetary policy instruments on aggregate
demand are captured by their effects on z, and changes
in P.
106
Changes in Monetary Policy
Instruments
Credit Expansion




Consider an increase in lcb.
Increase in credit provided to households by the
banking system creates an excess supply of loans in
the curb market.
Loan interest rate falls.
As households switch out of the informal loan market
and into foreign assets, the premium rises.
107




This influences private demand through
 standard interest rate effects;
 wealth effects;
 effects in changes in government consumption.
Interest rate effect: direct influence exerted by the curb
market rate on private spending (positive).
Wealth effect has two sources:
 increase in the value of the private sector's holdings
of foreign assets (due to increase in the premium);
 reduction in the informal market interest rate reduces
degree of financial repression.
Base of the financial repression tax is affected, both
because of
 expansion of credit, which reduces the base;
108
higher demand for deposits resulting from the
reduction in the curb market interest rate, which
increases it.
Base may rise or fall depending on the properties of
 asset demand functions;
 required reserve ratio.
Increase in the base exerts a negative wealth effect.
Increase lcb increases revenues for the public sector
because
 interest charges on the larger stock of credit;
 this additional revenue is spent by the government on
home goods so demand rises.




109
Changes in the Administrated Interest Rate






Increase in id will result in an excess supply of foreign
exchange.
Reason: funds are attracted into the domestic financial
system and away from the holding of foreign assets.
But net asset demand for curb market loans may rise or
fall.
Bank lending will rise as deposits increase.
But household lending will fall as asset holders shift
funds away from the loan market and into deposits.
If households move funds out of the loan market into
domestic financial system, it reduces supply of loans.
110
Reason: banks hold reserves while private lending
agents operating in the informal market do not.
 But, if funds attracted to banks come out of foreigncurrency holdings, supply of loans rises.
 Thus effect of changes in id depends on whether loans
or foreign-currency holdings are better substitutes for
deposits.
“Dollarization” case:
 Foreign currency and domestic money are close
substitutes.
 Increase in id result in an excess supply of loans in the
informal credit market, causing interest rates there to
fall.
 Effect on the premium will be negative, which has an
111
adverse wealth effect on demand for goods.




Since degree of financial repression falls, there is also a
positive effect on wealth.
Fiscal effect is always positive; central bank income
increases when administered interest rates are raised.
Thus, partial-equilibrium effects of an increase in id on
aggregate demand are ambiguous.
112
Change in the Required Reserve Ratio






Increase in  creates an excess demand for curb
market loans and thus raises the portfolio-equilibrium
loan interest rate.
This exerts negative effect on demand.
Premium on foreign assets falls.
Reason: individuals switch out of such assets into
lending on the informal credit market.
Degree of financial repression increases.
Reason: Proportionate increase in the loan interest
rate exceeds that of the interest rate on bank credit for
small initial values of the required reserve ratio.
113



Wealth effect arising from
 increase in the degree of financial repression;
 reduction of the premium
is negative.
But due to increase in the rate charged by the central
bank on its loans, fiscal revenue and government
spending increase.
This partially offsets the negative demand effects.
114
Intervention in the Parallel Foreign Exchange
Market





Monetary authorities can cause an increase in private
sector holdings of foreign assets by selling their foreign
exchange reserves in free exchange market.
Effect of an increase in this stock is to create an
excess supply of foreign exchange.
Thus reduction in the premium is required to restore
equilibrium.
Because this reduces the value of asset holders'
portfolios, the scale effect causes the asset demand
for loans to decrease.
This puts upward pressure on curb market interest
rate.
115



Negative wealth effect due to
 increase in the degree of financial repression;
 reduction in the premium.
This can be offset by the reduction in the base of the
financial repression tax.
This depends on
 initial degree of financial repression;
 elasticity of the demand for bank deposits with
respect to the interest rate in the informal credit
market.
116
A Simulation Model
with Informal Financial
Markets


Structure of the Model.
 Aggregate Supply.
 Aggregate Demand and the Disposible Income.
 Asset Accumulation and Financial Wealth.
 The Current Account and the Balance of Payments.
 The Banking System.
 Financial Deficits and Domestic Credit.
 Calibration of the Model.
Effects of Stabilization Policies.
 Government spending on Home Goods.
 Central Bank Credit to Commercial Banks.
 Increase in Lending Rates.
 Devaluation of the Official Exchange Rate.
118
Structure of the Model






Consider a small, open economy with five categories of
agents: producers, households, the government, the
central bank, and the commercial banks.
Economy produces two goods:
 home good (for final domestic consumption);
 export good.
Capital stock in each sector remains fixed.
Labor is perfectly mobile across sectors.
Households consume home goods and imported final
good that is imperfectly substitutable for the home good.
Producers import an intermediate input.
119




Financial system is characterized by
 existence of trade and exchange controls;
 legal ceilings on bank borrowing and lending rates;
 absence of organized markets for securities and
equities.
Informal credit and foreign exchange markets coexist
with official markets.
Commercial transactions of the private sector are
settled partly in the official market for foreign exchange
at a fixed exchange rate.
But rest of the commercial transactions and all capital
transactions are settled in the parallel market at a
market-clearing exchange rate.
120





Exports are in part smuggled out and imports of final
goods are in part smuggled in due to existence of
 tariffs,
 foreign exchange controls,
 positive exchange-rate premium.
Sales of foreign exchange to households for purchases
of imports are rationed by the central bank.
But foreign-currency sales for imports of intermediate
goods by domestic producers and government imports
are not subject to restrictions.
Interest rates on assets and liabilities of the banking
system are fixed.
Interest rate on curb market loans is determined by
market conditions.
121
Aggregate Supply

Production function of home and export goods:
L O 1-L -O
yh = Lh Oh Kh,
L, O < 1, h = N, X,
yh: output of sector h;
Kh: capital stock;
Lh: employment;
Oh: imported inputs in sector h.
122

Supply equation relating sectoral outputs yN and yX to
real product wage in home goods sector and relative
price of imported inputs:
s
yN =
e(1-)
-1 
-O
PN PO
s
yX =

w-L ,  = L + O < 1,
-1 
e(1-)
-O -
PX PO w n ,
PN: price of the home good;
PX: domestic price of exports;
PO: domestic price of imported intermediate goods;
w: nominal wage rate.
Under the small-country assumption, domestic price of
intermediate imports is exogenously determined by
123
world prices.



Price of the home good, domestic price of final imports
and domestic price of exports is determined
endogenously.
Since PX* (foreign export price) is fixed in the world
market, the foreign demand for exports is infinitely
elastic and volume of exports is supply determined.
Domestic supply price of exports is defined as an
average of
 price of smuggled exports sPX*, weighted by
proportion of smuggled exports 0 <  <1;
 after-tax price of official exports E(1-X)PX*
(0
< X < 1: tax rate on exports) weighted by proportion
of exports legally sold abroad, 1 - :
PX = [s + E(1-X)(1-)]PX*.
124


Labor contracts last one period and are negotiated one
period in advance, so that the wage rate is known by
firms at the beginning of the period, that is, before
output and home good prices are realized.
Nominal wages adjust slowly to their equilibrium value:
 ln w = (ln w* - ln w-1),

0 <  < 1.
Market-clearing wage w* is derived from the labormarket equilibrium condition:
w* = L(PNyN+PXyX)/ns,
ns: exogenous supply of labor.
125


Demand functions for real imports of intermediate goods
are derived in both sectors from the first-order
conditions for profit maximization.
Total imports of these goods:
O = O(PNyN+PXyX)/EPO*.

Net aggregate output at factor cost Z is obtained by
substracting real imports of intermediate goods from
recorded gross aggregate output:
PZ = PNyN = (1-X)(1-)EPX*yX - EPO*O,
P: domestic consumer price index (numéraire).
126

Index of domestic consumer prices is defined as a
geometric average of price of the home good and
domestic price of imported consumer goods:
P=

 1-
PNPI,
0 <  < 1.
Domestic-currency price of imported consumer goods
depends on the world price of imported goods PI* and
on weighted average of the official and parallel
exchange rates:
PI = (Es1-)PI*,
0 <  < 1,
where the weight on the official exchange rate is related
to rationing rule followed by the authorities in the official
127
market for foreign exchange.
Aggregate Demand and Disposible Income




Households hold four categories of assets in their
portfolios:
 domestic-currency notes CC;
p
 deposits with the banking system D ;
p
 foreign-currency denominated assets F ;
 loans extended through informal credit market.
CC bears no interest and are held only for transactions
purposes.
Holdings of all assets are financed from agents' net
worth or by borrowing through the banking system.
Bank credit Lp and curb market loans are perfect
substitutes in households' portfolios.
128

Total expenditure by households depends
 positively on real disposable income Ydisp and real
wealth A-1/P;
 negatively on the real interest rate:
a ),
ln TEp = h1 ln Ydisp + h2 ln(A-1/P) - h3(iL-+1
where 0 < h1 < 1;
real interest rate: difference between the nominal
interest rate in the informal credit market iL and the oneperiod-ahead expected rate of inflation a+1.
129

Real disposable income:
p
p
PYdisp = (1-)PZ + sPX*yX + qiL[L-1 - (1-)D-1]
(50)
where
q = (iL-ic)iL,
0  q  1;
(1-)PZ: after-tax factor income derived from legally
recorded production activities;
sPX*yX: income derived from the smuggling of exports;
last term of (50): implicit subsidies and taxes received
by households resulting from the existence of interest
rate controls.
130


Disposable income depends on the level of the financial
repression tax, q.
Demand for the home good:
d
yN = PTEp/PN + gN.
131
Asset Accumulation and Financial Wealth

Households' financial wealth:
A = CC + Dp + sFp - Lp.

Flow changes in financial wealth:
A = P(Ydisp
-TEp)
+
p
idD-1
+
p
if*sF-1
-
p
icL-1
+
p
F-1s.
132

Desired holdings of foreign-currency denominated
assets:
ln (sFp / (A-CC)) = 0 - 1iL - 2id + 3if,
where
if = i* +
a
^
s
+1,
if: perceived rate of return on foreign interest-bearing
assets;
i*: world interest rate;
a : expected rate of depreciation of the parallel
s^+1
exchange rate.
133

Desired holdings of bank deposits:
ln (Dp / (A-CC)) = 0 - 1iL + 2id - 3if.

Demand for CC:
ln (CC/P) = 0 + 1 ln (z) + 2 ln (PxyX),
 = s/E: parallel market premium.
134
The Current Account and the Balance of
Payments


Distinguishes between official current account and
unreported current account.
Total household demand for imported consumer goods
Imp :
Imp = (1-)PTEp/PI.

Central bank provides unlimited access to foreign
exchange for the government and producers, but
satisfies only a fraction  of private demand for
imported final goods.
135

Total sales of foreign exchange:
FS = PO*O + PI*gI + PI*Imp, 0    1.

Officially recorded current account:
CA = (1-)PX*yX +


g
i*(F-1+R-1)
- FS .
Capital account surplus: negative value of changes in
net holdings of external assets of the public sector Fg.
Change in net foreign assets of the central bank:
R = CA - Fg.
136

Leakage coefficient depends positively on the
exchange-rate ratio  and X:
 = 1 - [(1-X) / ],



 > 0,
0    1.
The higher the tax rate on exports or the higher the
premium, the higher will be the under-invoicing share.
Magnitude of these effects is inversely related to
 perceived implicit and explicit costs of engaging in
illegal transactions;
 degree of enforcement of exchange restrictions.
Even if the parallel market premium is zero, the
existence of an export tax would still provide an
incentive to under-invoice.
137

Change of private stock of foreign-currency
denominated assets:
Fp
= PX
*y
X
+
p
i*F-1
-
p
(1-)PI*Im.
138
The Banking System



Commercial banks' assets:
 reserves held at the central bank RR;
 credit extended to households.
Their liabilities:
 households' deposits;
p
 credit received from the central bank, L .
Balance sheet of the commercial banking system:
RR + Lp = Dp + Lb.

Banks' willingness to accept deposits is infinitely elastic.
139

Banks hold no excess reserves but are subject to
required reserves on deposits:
RR = Dp,




0 <  < 1.
Reserves held at the central bank pay no interest.
Credit extended to commercial banks by the monetary
authorities carries an interest charge.
It is set equal to interest rate banks charge their
customers for loans, ic.
Zero-profit condition for the banking system determines
interest rate paid on bank deposits:
id = (1-)ic.
140

Balance sheet of the central bank equates the monetary
base to the sum of international reserves and stock of
domestic credit extended to the government and
commercial banks, minus central bank's net worth:
CU + RR = ER + (Lg+Lb) - .

Total domestic credit L:
L = Lp + (Lg+Lb).
141

Changes in the central bank's net worth:
 = -1 + i*ER-1 +
g
ic(L-1+Lb-1)
+ R-1E - g,
g: net transfers to the government budget.
142
Fiscal Deficits and Domestic Credit


Government's revenue:
 income taxes on households;
 taxes on recorded exports;
 interest income from holdings of foreign-currency
denominated assets;
 transfers from the central bank.
Spending:
 purchases of both home and imported goods;
 interest payments on the domestic public debt.
143

Government deficit:
g
i*EF-1
GD = PZ +
+ X(1-)EPX*yX + g
g
- PNgN - EPI*gI - icL-1.

Deficit is financed by borrowing either from the central
bank or from world capital markets:
Lg


=
g
L-1
- GD + EFg.
Government expenditure is exogenous and ceiling is
imposed on foreign financing.
Deficits are therefore financed by central bank credit.
144
Calibration of the Model





Strategy adopted by Montiel, Agénor, and Haque (1993)
is to calibrate it.
Parameters used are based on available econometric
estimates where possible.
This approach is “theoretical simulation.”
Model is solved using the Fair-Taylor iterative technique.
Some key parameters were subjected to sensitivity
analysis, in order to determine the robustness of
observed patterns in the behavior of the model.
145
Effects of Stabilization Policies


Central bank retains five direct instruments of policy:
 level of controlled bank loan interest rates;
 required reserve ratio;
 amount of credit it extends to the commercial banking
system;
 proportion of private final imports satisfied in the
official foreign exchange market;
 official exchange rate.
Fiscal authority determines
 income tax rate;
 rate of taxation of exports;
 levels of spending on home and imported goods.146




Effects of 10% increase in government spending on
home goods, in central bank credit to commercial
banks, and in official lending rate, and of 10%
devaluation of official exchange rate are investigated.
Results of the simulations are reported in Montiel,
Agénor, and Haque (1993).
Assumption: policy measure is announced five periods
before implementation and carries full credibility.
This allows to consider dynamic behavior of the
economy in the transition period between
announcement and effective implementation of the
shock.
147
Government Spending on Home Goods





Consider first a one-period, fully anticipated 10%
increase in government spending on home goods,
financed by central bank credit.
Price of home goods begins rising prior to the policy
change.
Because nominal wage is maintained at its baseline
level, real product wage falls and this stimulates supply
of home goods.
Last effect is rather weak initially, but increases in the
period preceding the implementation of spending shock.
Increase in domestic money supply leads to
 anticipated future depreciation of parallel exchange
rate;
148
increase in expected rate of return on foreigncurrency denominated assets.
Agents thus switch away from domestic assets and
toward foreign-currency assets before the shock occurs.
As a consequence, parallel exchange rate depreciates,
raising domestic price of imported goods.
Rise in the premium induced by the increased demand
for foreign exchange reduces the private sector's
demand for bank deposits.
This causes households to shift assets into the informal
loan market, leading to a fall in curb market interest
rate.
These exert income and wealth effects that increase
private demand prior to implementation of the shock.






149






Expected future rise in domestic prices reinforces the
drop in nominal interest rate, causing real rate of
interest to fall.
In turn, the fall in real rate further stimulates private
expenditure, contributing to increase in domestic prices.
Implementation: rise in government spending is
expansionary both directly and through its monetary
effects.
Increase in money supply reinforces direct
expansionary impact of the fiscal shock.
It operates through informal market for foreign
exchange.
Although curb interest rate falls when the policy is
implemented, real interest rate actually rises.
150






Reason: removal of fiscal stimulus in the next period
produces an expected price decline.
Thus transitory nature of the shock diminishes its
expansionary effect with forward-looking agents.
After the shock is removed, the system returns to its
initial equilibrium only gradually.
Reason: monetary effects of increase in credit take time
to dissipate through balance of payments.
Smuggled exports increase flow of foreign exchange
channeled illegally into the economy.
But this is more than offset by a rise in smuggled
imports, implying that stock of foreign currencydenominated assets decreases.
151

Portfolio implications tend to sustain initial rise in curb
interest rate, keeping upward pressure on premium and
prolonging return to initial steady state.
152
Central Bank Credit to Commercial Banks




Fully anticipated, transitory increase of 10% in central
bank credit to the commercial banks.
During transition period between announcement and
implementation:
 output and prices rise;
 parallel exchange rate depreciates;
 informal interest rate falls.
When increase in central bank credit actually occurs,
loans to private sector by commercial banks expand.
As a result, demand for credit in informal market falls,
and curb interest rate drops sharply.
153





Reduction in financial repression tax lowers the implicit
subsidy provided by controls on interest rates, therefore
reducing disposable income.
This has a negative effect on private spending.
But fall in informal interest rate also reduces real
interest rate, which has a positive effect on private
expenditure.
Net effect is an expansion of private spending, which
stimulates domestic output and raises prices.
Due to fall in curb market interest rate, agents switch
toward foreign-currency denominated assets, leading to
a sharp spike in the premium.
154



Since foreign assets held by private sector rises during
transition period, undoing of the credit expansion leaves
private sector with a portfolio more heavily weighted
toward foreign exchange.
Parallel exchange rate appreciates beyond its initial
level in the process of restoring portfolio equilibrium.
Appreciation of free exchange rate
 reduces propensity to under-invoice exports;
 increases flow of foreign exchange channeled
through official market;
 reduces rate of accumulation of foreign-currency
denominated assets.
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Increase in Lending Rates
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Anticipated, temporary increase in bank lending rates by
one percentage point.
Key channel in transmission mechanism: through
portfolio reallocation effects.
Increase in bank lending rate also raises interest rate
paid on bank deposits, through zero-profit condition.
Rise in deposit rates leads households to move funds
away from both informal loan market and foreigncurrency assets and to increase bank deposits.
As a result:
 informal interest rate rises when the measure is
implemented;
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parallel exchange rate appreciates, both on impact
and when the measure is first announced.
As parallel exchange rate appreciates, domesticcurrency value of financial wealth falls depending on
weight of foreign-currency assets in private portfolios.
Reduction in nominal value of wealth causes a
secondary reallocation of portfolios.
Reason: demand for interest-bearing assets is linearly
homogeneous in financial wealth.
Because of this wealth effect, demand for bank deposits
may rise or fall in net terms.
Combination of high substitution elasticities between
domestic deposits and foreign exchange and important
share of foreign assets in private portfolios leads to
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 large wealth effects;
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reduction in domestic bank deposits at the
announcement period.
Factors explaining contractionary effects on output
and prices resulting from rise in lending rates:
 Appreciation of parallel exchange rate reduces real
value of households' wealth.
 Exchange-rate appreciation reduces producer price for
domestic exports.
 Implicit subsidy provided by financial repression falls, as
rise in deposit rates exceeds rise in informal loan
market.
 Consequence: output and domestic prices fall when the
measure is implemented, and immediately after
announcement.

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Devaluation of the Official Exchange Rate
Permanent, fully anticipated 10% devaluation of official
rate in the presence of informal financial markets.
 This causes
 net contractionary effect on domestic output upon
implementation;
 expansionary effect during transition period.
Channels through which official devaluation affects
real output:
 It raises real price of imported inputs, generating a
negative supply shock.
 It increases domestic price level directly through its
impact on domestic price of imported goods, thereby
increasing demand for domestic currency.
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This causes households to shift funds out of deposits,
curb market loans, and foreign-currency assets.
Result: higher informal interest rate and appreciation of
parallel exchange rate.
Rise in informal interest rate has a direct contractionary
effect on private spending.
Output of export good falls because increase in demand
price of exports is dampened by appreciation in parallel
exchange rate.
Supply price of exports bears the full impact of increase
in price of imported intermediate goods.
Increase in informal interest rate raises implicit financial
repression subsidy and thus real private disposable
income.
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This exerts positive effect on demand for home goods.
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Positive supply effect also arises from reduction in real
wage.
Given the set of parameters used, these expansionary
effects are outweighed by contractionary effects.
Although devaluation itself has a net contractionary
effect, anticipation of an official parity change is
expansionary.
Output rises in the period preceding the enactment of
devaluation.
Reason: anticipated increase in prices and parallel
exchange-rate appreciation upon implementation
combine to lower the real interest rate.
Anticipated appreciation of the parallel exchange rate
lowers the rate of return on foreign-currency assets.
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This causes households to increase their lending
through informal credit market, leading to an initial
reduction in informal interest rate.
This lowers real interest rate and increases domestic
demand in the period preceding the policy shock.
These effects become weaker as one moves backward
in time before devaluation is implemented.
They are outweighed at the announcement period by
negative wealth effects resulting from the appreciation
of the parallel exchange rate.
Reason: induced price level change in this period is
much smaller than price level jump induced by the
devaluation in the subsequent period.
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