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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 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 F i g u r e 6 . 1 S e i g n i o r a g e , R e s e r v e R a t i o , a n d t h e I n f l a t i o n T a x S = 0 * E S / = 0 S o u r c e : A d a p t e d f r o m B r o c k ( 1 9 8 9 , p . 1 1 3 ) . 14 Since generally > 0, there exists an optimal degree of financial repression. This is traded off with the optimal inflation tax in order to raise the demand for money---the inflation tax base. In practice, reserve requirements represent a large share of the revenue from seigniorage. Figure 6.2: Effective reserve requirements on bank deposits and decomposition of revenue from seigniorage in developed and developing countries. Reserve requirements on bank deposits are higher in developing countries. 15 F i g u r e 6 . 2 E f f e c t i v e R e s e r v e R a t i o a n d S e i g n i o r a g e ( A v e r a g e o v e r 1 9 8 0 9 6 , i n p e r c e n t o f G D P u n l e s s o t h e r w i s e i n d i c a t e d ) E f f e c t i v e R e s e r v e R a t i o o n B a n k D e p o s i t s { R e s e r v e c o m p o n e n t ( i n p e r c e n t ) B o l i v i a B o l i v i a B r a z i l B r a z i l C a m e r o o n C a m e r o o n C o l o m b i a C o l o m b i a F r a n c e F r a n c e G a b o n G a b o n G e r m a n y G e r m a n y I n d i a I n d i a I n d o n e s i a I n d o n e s i a I t a l y I t a l y J a m a i c a J a m a i c a J a p a n J a p a n K e n y a K e n y a L e s o t h o L e s o t h o M a l a y s i a M a l a y s i a M e x i c o M e x i c o M o r o c c o M o r o c c o N i g e r i a N i g e r i a P a k i s t a n P a k i s t a n P e r u P e r u P h i l i p p i n e s P h i l i p p i n e s S i n g a p o r e S i n g a p o r e S o m a l i a S o m a l i a S r iL a n k a S r i L a n k a T h a i l a n d T h a i l a n d U n i t e d K i n g d o m U n i t e d K i n g d o m U n i t e d S t a t e s U n i t e d S t a t e s V e n e z u e l a 0 C u r r e n c y c o m p o n e n t T o t a l S e i g n i o r a g e V e n e z u e l a 2 0 4 0 6 0 S o u r c e : C a l c u l a t i o n s b a s e d o n I n t e r n a t i o n a l F i n a n c i a l S t a t i s t i c s . 0 2 4 6 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 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 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 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. 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 F i g u r e 6 . 3 D e t e r m i n a t i o n o f O u t p u t a n d t h e I n f o r m a l I n t e r e s t R a t e i n v a n W i j n b e r g e n ' s M o d e l i L L ' Y L L ' ' E ' E L ' E ' ' L Y L ' ' y S o u r c e : v a n W i j n b e r g e n ( 1 9 8 3 b , p . 4 3 9 ) . 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 F i g u r e 6 . 4 a D e v a l u a t i o n , U n d e r i n v o i c i n g , a n d t h e C u r r e n t A c c o u n t t 0 T U n d e r i n v o i c i n g s h a r e S o u r c e : K a m i n ( 1 9 9 3 , p . 1 6 0 ) . 82 F i g u r e 6 . 4 b D e v a l u a t i o n , U n d e r i n v o i c i n g , a n d t h e C u r r e n t A c c o u n t 0 t 0 T O f f i c i a l c u r r e n t a c c o u n t S o u r c e : K a m i n ( 1 9 9 3 , p . 1 6 0 ) . 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, ) + zFp - 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 = (Es1-)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-1s. 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-1E - 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 + EFg. 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. 155 Increase in Lending Rates 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; 156 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 157 large wealth effects; 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. 158 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. 159 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. 160 This exerts positive effect on demand for home goods. 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. 161 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. 162