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Financial Frictions, Monetary Policy, Exchange Rates Some Basic Issues Introduction • Large changes in relative prices are often seen and create winners and losers • Examples: real estate prices, stocks and bonds, exchange rates • Conventional macroeconomics has largely ignored these • The view is that redistribution has negligible aggregate effects Fisherian Deflation • Irving Fischer (1932): redistribution can have large relative and aggregate effects • In particular, if debts are written in nominal terms, deflation increases their real value • The resulting redistribution matters in the aggregate because debtors have a higher marginal propensity to spend than creditors • A modern rendition of Fisher’s argument: Eggertsson-Krugman • The basic idea: there is a set of debtconstrained agents, whose consumption falls sharply if their debt limit is reduced • While debts may be denominated in dollars, debt limits may be set in real terms • Aggregate demand can then fall if there is deflation Basic Model • Two types of agents, with different discount factors (β(s) = β > β(b) ) • Log utility • Endowment: (1/2) Y per period Budget Constraints Dt(i) = (1+rt-1 )Dt-1 – (Y/2) + Ct(i) (1+rt) Dt(i) ≤ Dhigh i = s, b Steady state • Impatient agent borrows as much as he can: Cb = (Y/2) – (r/(1+r)) Dhigh • Output = consumption: Y = Cs + Cb Cs = (Y/2) + (r/(1+r)) Dhigh • Patient agent is unconstrained: (1/Cts) = (1+rt) β Et (1/Ct+1 s) 1+r = 1/β in ss “Crisis” • A sudden and permanent reduction in credit ceiling to Dlow < Dhigh • In the long run, the impatient agent must increase consumption: CbL = (Y/2) – (r/(1+r)) Dlow = (Y/2) – (1-β)Dlow • In short run, borrower must reduce consumption to satisfy the new debt ceiling: Ds = Dhigh – (Y/2) + Csb • Key assumption: adjustment takes one period: Ds =Dlow/(1+rs ) Csb = Y/2 + Dlow/(1+rs ) - Dhigh • In long run, patient agent consumes: CLs = Y/2 + (1-β) Dlow • In the short run, CSs = Y – CSb = Y/2 - Dlow/(1+rs ) + Dhigh • But CLs = (1+rs)β CSs Negative interest rates • Combining, 1 + rs = (Dlow+Y/2)/β(Dhigh+Y/2) rs is negative if βDhigh - Dlow > (1- β)Y/2 Nominal debt and deflation • If debt is denominated in “dollars”, 1 + rs = (1 + is ) PS/P* • Here recall that is ≥ 0 If the shock requires a negative real rate, 1 + rs = PS/P* < 1, e.g. deflation More on Nominal Debt • If the debt is denominated in dollars but the debt ceiling is given in real terms, in the previous analysis Bhigh/PS must be less than or equal to Dhigh Deflation can exacerbate the adjustment problem Introducing Production, Etc. • One can introduce an aggregate supply curve in the usual way • See EK • The main point, however, is that aggregate demand can increase with inflation πs AS AD Ys Conventional Macro πs AS AD Ys Bizarre Macro Consecuences • • • • • AD curve can have a positive slope “Paradox of toil” “Paradox of flexibility” Inflation is expansionary Fiscal policy is particularly effective πs AS AD Ys Conventional Macro πs E E’ AS AS’ AD Ys Conventional Impact of a Productivity Increase πs AS AD Ys Bizarre Macro πs E AS E’ AS’ AD Ys The Paradox of Toil πs ASfix ASflex AD Ys Conventional: Price Flexibility Implies a Steeper AS πs Efix ASfix Eflex ASflex AD’ AD Ys Conventional: A fall in demand is less contractionary if prices are more flexible πs ASfix ASflex AD Ys In a bizarre macro world… AD’ πs Efix ASfix Eflex ASflex AD Ys ..the opposite is true: Paradox of Flexibility The Open Economy: Balance Sheets, and Exchange Rates Motivation: Dollarization and the Fixed vs Flexible Rates Debate • Asian Crisis: Exchange Rate depreciations were observed to be contractionary • Explanation: Currency Mismatches • To “work”, one needs financial frictions and balance sheet effects • Intuition: Céspedes, Chang, Velasco The IS y = αii + αxx + αee • Quite conventional • x can be interpreted as any exogenous component of demand LM • Not needed: fixed exchange rates. The BP • The key relation. • Start with investment demand: i = - (ρ + η ) + γ e Similar to usual assumption. Risk premia η = μ [(1-γ)e + i – n] Can be derived from more basic models of financial frictions Corporate Balances n = δyy – δee δe depends on corporate debt and currency mismatches. The BP • Combining two preceding equations, η = μ [(1-γ+ δe)e + i – δyy ] • Inserting in investment demand, one gets the BP relation: (1+μ) i = - ρ + μ δyy + [ γ- μ (1-γ+ δe)]e Two types of Economies (1+μ) i = - ρ + μ δyy + [ γ - μ (1-γ+ δe)]e • If γ > μ (1-γ+ δe) , we say that the economy is financially robust • Otherwise, we say that it is fragile. i IS BP y i IS’ IS BP y A A fall in Exports i IS’ IS BP A’ y A Without financial frictions, equilibrium would be at A’ i IS BP y i IS BP BP’ A y An increase in the world interest rate i IS IS’ BP y Depreciation… i IS IS’ BP’ A BP y Depreciation in robust economy i IS IS’ BP BP’ A y i IS IS’ BP BP’ y A Depreciation in fragile economy i IS IS’ BP y BP’ A Depreciation in fragile economy Some Implications • A strong connection between exchange rates and financial development • Rationale for de-dollarization, leverage limits, and other macro-prudential policies