Download Capital Flows and Monetary Policy

Capital Flows
and Monetary Policy
Javier Guillermo Gómez
October 2009
Summary
• Model
– Capital inflows and outflows endogenous to
shocks to the country risk premium
– Equation for evolution of foreign debt
• Policy experiments:
– Floating and fixed exchange rates
– High, low debt
– Debt denominated in foreign and domestic
currencies
Motivation
• Capital inflows:
– Exchange rate appreciates, aggregate demand increases
– Inflation decreases (short term), inflation increases
(medium term)
• Capital outflows:
– Devaluation, recession, vulnerable balance sheets
– Inflation (short term) and disinflation (medium term)
• Repeated bouts of capital inflows and outflows:
–
–
–
–
–
1980’s debt crisis
Crisis of the end of the century
Doc com crisis in 2002
Global financial crises of 2008
Consumption and credit booms before these crises
Relation to the literature
• Vulnerable balance sheets
– Krugman (2000).
• Financial accelerator in the open economy
(shocks to the foreign interest rate):
– Céspedes, Chang and Velasco (2004)
– Gertler, Gilchrist and Natalucci (2001)
• Constraint on foreign borrowing that binds
– Mendoza (2004)
– Chari, Kehoe, McGrattan (2005)
Effect of sudden stops on output
mechanisms not transparent, lack empirical evidence:
- Firms borrow in advance to pay imported inputs or wage bill
- In cases this produces a shock to total factor productivity
Points of the paper
• Model of capital outflows and inflows
• Model of sudden stops and recessions
– Recessions depend on interest rate policy
Not necessarily on critical balance sheets
• Capital inflows and outflows obtained with shocks to the
country credit risk premium
• Equation for foreign debt
• Policy experiments:
– Interest rate defenses cause recessions
even in financially resilient economies
– Behavior of foreign debt not necessarily better (during sudden
stops) with a fixed exchange rate
– Resilience gained by shifting denomination AND floating the
currency
The model
• Trilema + capital mobility
= dilemma (fix or float)
• Policy interest rate either does not
respond to the shock or stabilizes the
exchange rate
The model
• Shocks to the country risk premium
Mr. Market: bouts of increase and decrease
in risk aversion
• Capital outflows
– Transfer
– Trade balance turns positive
– NFA improve
The model
• UIP augmented by the country risk
premium
• Source of volatility: shocks to the
country risk premium
– Price of risk not contemporaneously
related to advanced-country policy rates
The model
•
•
•
•
•
•
Two economies domestic and foreign
Domestic economy: small and open
Foreign economy: approximately closed
Each economy produces one good
Both goods are tradable
Agents in the domestic economy:
– Household
– Firm
– Central bank
• Assets in the domestic economy:
– Domestic bond
– Foreign bond denominated in foreign currency
– Foreign bond denominated in domestic currency
• Agent in the foreign economy
– Household
The model
• Domestic economy: nfa < 0
• Foreign economy nfa tend to 0
• Nominal and real rigidities
The household
• Solves three problems
– Chooses absorption and leisure
(here also chooses savings and net
foreign assets)
– Splits absorption between domestic and
foreign goods
– Splits domestic goods among a
continuum of goods
First order conditions
Spread on debt denominated in domestic currency
= spread on debt denominated in foreign currency
+ expected depreciation of exrate
Cost of servicing foreign debt denominated in foreign currency
= domestic interest rate + unexpected change in exrate
Cost of servicing foreign debt denominated in domestic currency
= domestic interest rate
The firm
• Phillips curve
• Christiano, Eichembaum and Evans
(2001):
– If firm does not re optimize the price
raises by a proportion of lagged inflation
The central bank
• Follows ad-hoc rule:
i = lambda * (spread + i* )
+ 0.00001 * gap
Foreign household
• Demands
foreign imports
= domestic exports
“Closing” the model
• Spread = 0.9 * spread (-1)
- coeff * nfa(-1) + shock to country
risk
Budget constraint
+ Balance sheet
=> evolution of net worth
•
Budget constraint:
absorption = output + ( 1 + r ) * domestic bonds (t-1) - domestic bonds (t)
- ( 1 + rstar ) * ( 1 + spread F ) * foreign bonds F (t-1) – foreign bonds F (t)
- ( 1 + rstar ) ( 1 + spread H ) foreign bonds H (t-1) – foreign bonds H (t)
•
Balance sheet:
domestic bonds + foreign bonds F + foreign bonds H = net worth
•
Law of evolution of net worth:
net worth (t) = ( 1 + r + alpha * valuation ) * net worth(t-1) + trade balance (t)
net worth (t) = ( 1 + alpha * valuation ) * net worth(t-1) + current account (t)
•
Valuation effect, cost effect, trade balance
•
Lane, Millesi-Ferreti (2005)
Complete model
• Price block:
–
–
–
–
–
–
CPI identity
Phillips curve (domestically produced goods)
Marginal cost (output gap, exchange rate, technology)
UIP
Policy rule
Spread
• Flow block:
– Aggregate demand
– Trade balance
– Absorption
• Stock block:
– Net foreign assets
Main flows
output = output(+1) – coeff * r
+ coeff * spread + coeff * rstar
trade balance = trade balance(+1) – coeff * r
+ coeff * spread + coeff * rstar
absorption = absorption(+1) – coeff * r
Results
Figure 1. The shock and the
policy response
B. Floating-exchange-rate policy
A. Fixed-exchange-rate policy
Country credit risk premium
Policy interest rate
Country credit risk premium
Policy interest rate
Nominal exchange rate
Nominal exchange rate
0,30
0,30
0,25
0,25
0,20
0,20
0,15
0,15
0,10
0,10
0,05
0,05
0,00
0,00
-0,05
-0,05
-0,10
-0,10
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Figure 1 (continued).
The shock and the main prices
D. Floating-exchange-rate policy
C. Fixed-exchange-rate policy
Country credit risk premium
Country credit risk premium
Real interest rate
Real exchange rate
Real interest rate
Real exchange rate
0,30
0,30
0,25
0,25
0,20
0,20
0,15
0,15
0,10
0,10
0,05
0,05
0,00
0,00
-0,05
-0,05
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
sudden stops + fixed
exchange rate = output
drops
r ≈ spread > 0
output = output(+1) – coeff * spread
trade balance = trade balance(+1) + coeff * spread
absorption = absorption(+1) – coeff * spread
• Drop in output, transfer, drop in absorption
sudden stops + floating exrate
= output increases
spread > 0, r ≈ 0
output = output(+1) + coeff * spread
trade balance = trade balance(+1) + coeff * spread
• Increase in output and capital outflow
Figure 2. The main flows
A. Fixed-exchange-rate policy
B. Floating-exchange-rate policy
Output
Output
Absorption
Trade balance
Absorption
Trade balance
0,150
0,150
0,125
0,100
0,075
0,050
0,025
0,000
-0,025
-0,050
-0,075
-0,100
0,125
0,100
0,075
0,050
0,025
0,000
-0,025
-0,050
-0,075
-0,100
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Capital inflow + fixed
exchange rate = output
increases
r ≈ spread < 0
output = output(+1) – coeff * spread
trade balance = trade balance(+1) + coeff * spread
absorption = absorption(+1) – coeff * spread
Increase in absorption > increase in output
=> capital inflow
Capital inflow + floating exrate
= output drops
spread < 0, r ≈ 0
output = output(+1) + coeff * spread
trade balance = trade balance(+1) + coeff * spread
Drop in output and capital inflow
• Note on calibration
– Closed: 0.1
– Opened: 0.5
– Otherwise: 0.3
– Not indebted: -20%
– Indebted: -100%
– Otherwise: -50%
Capital flows, monetary
policy and openness
• Fixed exrate: r ≈ spread > 0
trade balance = trade balance(+1)
+ ( cf / sigma ) * spread
• Flexible exrate: spread > 0, r = 0
trade balance = trade balance(+1)
+ ( cf + other ) * spread
Figure 3.
Trade balance and openness
B. Floating-exchange-rate policy
A. Fixed-exchange-rate policy
Trade balance in the relatively closed economy
Trade balance in the relatively closed economy
Trade balance in the relatively open economy
Trade balance in the relatively open economy
0,30
0,30
0,25
0,25
0,20
0,20
0,15
0,15
0,10
0,10
0,05
0,05
0,00
0,00
-0,05
-0,05
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Calvo, Izquierdo, Talvi (2003):
“the required change in exrate is larger the more closed the
economy is”
Given: size of the transfer
Question required depreciation of exrate
Answer: depends on openness
Here:
Given: increase in spread (risk premium shock)
Question: effect on trade balance
Answer: depends on monetary policy
Figure 4.
Factors impacting net worth
A. Fixed-exchange-rate policy
B. Floating-exchange-rate policy
Cost effect
Valuation effect
Cost effect
Valuation effect
Trade balance
Trade balance
0,2
0,2
0,1
0,1
0,0
0,0
-0,1
-0,1
-0,2
-0,2
-0,3
-0,3
-0,4
-0,4
-0,5
-0,5
-0,6
-0,6
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Figure 5. Resilience
and net foreign assets
B. Floating-exchange-rate policy
A. Fixed-exchange-rate policy
Fragile economy
Fragile economy
Resilient economy
Resilient economy
0,2
0,2
0,0
0,0
-0,2
-0,2
-0,4
-0,4
-0,6
-0,6
-0,8
-0,8
-1,0
-1,0
-1,2
-1,2
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
• Short run: valuation and cost effects
have about the same impact on debt
• Effect of the trade balance on net
worth depends on openness and on
the length of the shock
Figure 6. Net foreign assets
and liability dollarization
B. Floating-exchange-rate policy
A. Fixed-exchange-rate policy
Foreign debt denominated in foreign currency
Fogreign debt denominated in foreign currency
Foreign debt denominated in domestic currency
Foreign debt denominated in domestic currency
0,2
0,2
0,1
0,1
0,0
0,0
-0,1
-0,1
-0,2
-0,2
-0,3
-0,3
-0,4
-0,4
-0,5
-0,5
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
• Fixed-exchange-rate policy:
– Currency denomination “not an issue”
• Floating-exchange-rate policy:
– Currency denomination “matters”
• Feldstein (2003) “avoiding large amounts of
dollar denominated debt is probably the most
useful thing a country can do to avoid the serious
consequences of a currency fall”
• Resilience gained not only by shifting the
denomination but also by floating the currency
Extension: the financial
accelerator
• The financial cycle and the
accelerator,
financial booms and busts:
– Many assets and balance sheets
• Here:
– Price of one asset (exchange rate)
– One balance sheet (household)
• Aoki, Proudman, Vlieghé (2004)
– PI consumer
– Financially constrained consumer
• By UIP, household indifferent between
domestic and foreign finance
• Premium on foreign borrowing decreases
with financial condition of the household
• Financial condition of the household is nfa
Premium decreases with nfa
Figure 7. The accelerator and
output in resilient economies
B. Floating-exchange-rate policy
A. Fixed-exchange-rate policy
Output with accelerator in the resilient economy
Output with accelerator in the resilient economy
Output without accelerator in the resilient economy
Output without accelerator in the resilient economy
0,20
0,20
0,15
0,15
0,10
0,10
0,05
0,05
0,00
0,00
-0,05
-0,05
-0,10
-0,10
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Figure 8. The accelerator and
output in fragile economies
Floating-exchange-rate policy
Fixed-exchange-rate policy
Output with accelerator in the fragile economy
Output with accelerator in the fragile economy
Output without accelerator in the fragile economy
Output without accelerator in the fragile economy
0,20
0,20
0,15
0,15
0,10
0,10
0,05
0,05
0,00
0,00
-0,05
-0,05
-0,10
-0,10
0
2
4
6
8
10
12
14
16
18
20
0
2
4
6
8
10
12
14
16
18
20
Extension: the
government
• Public and private sectors
• Assumptions:
– Fiscal authority committed to solvency
– Government follows rule that targets
level of debt to GDP
– Taxes are lump sum
Budget constraint + balance sheet =
law of evolution of net worth
(government and private sectors)
• Valuation effect, cost effect and trade balance
(primary balance, private savings)
• Short term: cost and valuation effects
• Medium term: primary savings most important
(permanent) element in evolution of debt
Fixed exchange rate
=> transfer born by private sector
trade balance = output – absorption
private savings = output – taxes – absorption
government balance = taxes – expenditure
let gvt. expenditure = 0
note: taxes = 0.8 * output + other
private savings = trade balance – taxes
government balance = taxes
• sudden stops => private savings increase,
government balance decreases
• Transfer born by private sector
Floating exchange rate
=> transfer born by both sectors
Recall:
taxes = 0.8 * output + other
• output increases
=> disposable income increases
=> (absorption constant) private savings increase
• output increase
=> taxes increase
=> government balance increases
• Transfer born by both sectors
Figure 9. Primary savings and net worth: the household
Solid line: savings, dotted line: net foreign assets
A. Fixed exchange rate
3.5
B. Floating exchange rate
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
-0.5
-0.5
0
10
20
30
40
0
10
20
30
40
Figure 10. Primary savings and net worth: the government
Solid line: primary balance, dotted line: net foreign assets
A. Fixed exchange rate
1.6
B. Floating exchange rate
1.6
0.8
0.8
-0.0
-0.0
-0.8
-0.8
-1.6
-1.6
-2.4
-2.4
-3.2
-3.2
0
10
20
30
40
0
10
20
30
40
Extension: Flexible price
equilibrium
• More rigorous definitions of
– output gap
– real interest rate
Conclusions
•
•
•
•
Positive shocks to spread => capital outflow
Negative shocks to spread => capital inflow
Shocks to spread and capital flows: the same
Fixed exchange rate: drop in absorption > drop in output =>
transfer
• Flexible exchange rate: increase in output and in the trade
balance
=> transfer
• Case of Chari, Kehoe, McGrattan (2005):
Sudden stops and output increases
Only under a floating exchange rate
• Exchange rate rigidity => sudden stops and output drops
• Transparent aggregate demand channel
Unlike mechanisms surveyed by Chari, Kehoe and McGrattan
(2005)
• CKM (2005):
Sudden stops => increase in net exports and increase in output
• In this paper:
• Despite increase in net exports, drop in absorption causes an
output drop
• From the equilibrium conditions of the
model
Expression for evolution of nfa
• Policy experiments
– Fixed and floating exchange rate
– High and low debt
– Debt denominated in foreign and domestic
currency
Conclusions of policy
experiments
• Foreign debt not improved by fixedexchange-rate policy
• Resilience
– Not gained by shifting denomination of
debt
– Gained by shifting denomination and
floating the currency
Limitations
• Risk structure of interest rates
shock to rstar + rigid exrate
= no capital outflow
r ≈ rstar > 0
output = output(+1) – coeff * rstar
trade balance = trade balance(+1)
absorption = absorption(+1) – coeff * rstar
=> no transfer, recession
shock to rstar + flexible exrate
= capital outflow
r ≈ 0, rstar > 0
output = output(+1) + coeff * rstar
trade balance = trade balance(+1) + coeff * rstar
absorption = absorption(+1)
=> transfer, increase in output