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Demand Imbalances, Exchange-Rate Misalignments, and Monetary Policy Giancarlo Corsetti IUE, Roma III & CEPR Luca Dedola European Central Bank & CEPR Sylvain Leduc Federal Reserve Bank of San Francisco Reserve Bank of New Zealand December 16-17 2010 Exchange Rate misalignments and demand/trade imbalances I Concerns about ER misalignments and associated imbalances are recurrent in the policy debate — e.g. recent G-20 meeting I Motivation for cooperative (monetary) policy to mitigate them I Can misalignments in asset prices like the ER and ensuing imbalances cause trade-o¤s with traditional stabilization objectives? I NOEM literature has focused on the impact of nominal price rigidities in goods markets: I I Emphasize e¤ects of ER misalignments on relative price of goods What about misalignments arising from the ER dual role as good and asset price in incomplete markets economies? What does this paper do? I Understand trade-o¤s when asset markets support allocation far from e¢ cient one I Standard incomplete markets model yielding misalignments and demand imbalances even with ‡exible price I I I Misalignments re‡ect suboptimal wealth movements across countries Ine¢ cient adjustment, although ER is driven by fundamentals only Allowing for alternative pricing mechanisms (PCP vs LCP), characterize optimal policy trade-o¤s Monetary policy trade-o¤s with incomplete markets I Analytic quadratic loss functions under incomplete markets I Numerical analysis of Ramsey policy implications for in‡ation, output gap, real exchange rates, net exports,... I Focus on "news” about future productivity to stress ER dual role in goods and asset markets — But also look at standard AR shocks Main results I I I Welfare trade-o¤s between domestic as well as external distortions: I Output gaps and in‡ation, but also misalignment and cross-country demand (consumption) gaps I External distortions depend on openness, trade elasticities Low trade elasticity: I Sizable ine¢ ciencies as currency misalignments and large demand imbalances I Optimal policy delivers close to …rst-best allocation under LCP Policy leans against misalignment, reducing domestic and trade imbalances Workhorse NOEM model I 2-country, cashless economy with sticky prices I All goods are traded I Both producer currency pricing (PCP) and local currency pricing (LCP) I No capital, technology linear in labor I Complete markets domestically, incomplete markets internationally: only one short-term, risk-free, nominal bond I Encompass Clarida-Gali-Gertler, Obstfeld-Rogo¤, Devereux-Engel, Benigno-Benigno, and other NOEM contributions Preferences 1 σ + κ (1 L t )1 + η 1 +η I Per-period utility: ζ C ,t C1t I Consumption consists of Home and Foreign tradables: C = CH,t I Z 1 0 " φ 1 1/φ φ aH CH σ φ φ 1 #φ 1 1/φ φ + aF CF θ θ 1 θ 1 θ Ct (h) dh Trade elasticity: φ CF,t φ>0 , Z 1 0 Ct (f θ 1 ) θ df θ 1 θ Welfare-relevant gaps in open economy: ER misalignments I I As in closed economies, output gap relative to …rst-best allocation bH ,t Y eHfb,t . Y gap = Y International-price gaps provide welfare-based concept of misalignments: bt RER gap = Q TOT gap = Tbt I b H,t = Ebt + P bH ,t ∆ e fb Q t fb e Tt bH ,t P A “misaligned” real exchange rate is one that is not equal to its e¢ cient level: I No guarantee that e.g. ‡exible exchange rates will deliver an e¢ cient real exchange rate Welfare-relevant gaps in open economy: Demand imbalances I Deviations from e¢ ciency condition under complete markets: bt = σ C bt Q b ζ C ,t bt C result in cross-country demand imbalances: b tgap = σ(C bt D I bt ) C bt Q b ζ C ,t b ζ C ,t b ζ C ,t ?0 General feature of multi-agent economies, sounder foundations than using current account or trade balance measures Gaps enter the Open-Economy Phillips curves... I NKPC is a function of output gaps, markups, misalignment, and imbalances ...: π H ,t I I = βEt π H ,t +1 8 > > > > > > > < +κ (1 > > > > > > > : b gap (η + σ) Y H ,t h aH ) (σφ (1 aH ) h gap b gap 1) Tbt +Q t b H,t ∆ b tgap D b H,t =0 under PCP, but not under LPC ∆ b tgap =0 under complete markets, but not under IM D i 9 > > > > > > = i > > > > > > > > ; ... and characterize the loss function under cooperation and LCP 1 b gap f(σ + η ) Y H ,t 2 ∝ + (1 2 +Ψ 4 θα αβ) (1 (σφ where Ψ = α) 1) σ 4aH (1 2 b gap + (σ + η ) Y F ,t aH π 2H ,t + (1 bH ,t Y 2 aH ) π 2F ,t + aH π F2,t + (1 e fb Y H ,t bt bt + D φ ∆ 2aH (1 aH ) aH ) (σφ 1) + 1 bF ,t Y 2 e fb Y F ,t 2 + 3 5g aH ) π H2,t CM and PCP: Divine coincidence in open economy Optimal policy in two targeting rules: global (sum) h i b gap Y b gap b gap Y b gap 0= Y + Y + θ π H ,t + π F ,t H ,t H ,t 1 F ,t F ,t 1 and relative (di¤erence) h b gap Y b gap 0= Y H ,t H ,t 1 b gap Y F ,t b gap Y F ,t 1 i + θ π H ,t π F ,t I International variables matter only if they in‡uence output gap and in‡ation I Same as in closed economy: strict in‡ation targeting is optimal against all – current and anticipated future – e¢ cient shocks (preferences technology) I correcting output gaps coincides with closing misalignments (as in DE) But divine coincidence breaks with incomplete market With …nancial autarky and PCP, global targeting rule is the same as with CM, but relative rule is h i b gap Y b gap b gap Y b gap 0 = Y Y (σ + η ) H ,t H ,t 1 F ,t F ,t 1 +θ (σ + η ) + 2 +4aH (1 + I ( 1 aH ) ( 1 1 2aH (1 aH ) (σφ 1) 4aH (1 aH ) (φ 1) 1 2aH (1 φ) σ) φ) gap [t TOT b tgap D π H ,t π F ,t gap 1 [t TOT b gap D t 1 Trade-o¤ between stabilizing relative Y gap and π, and gap b tgap . [ t and D correcting TOT Trade-o¤s and e¤ectiveness of optimal policy I By making the ‡exible price allocation ine¢ cient, incomplete markets may induce relevant policy trade-o¤s I Relevance of misalignment/imbalances in trade-o¤s depends on size of incomplete market distortions: I I Structure of …nancial markets, nature and number of the shocks, economic features like trade elasticity E¤ectiveness of optimal policy also depends on type of nominal distortions: I I b gap and relative output all With PCP terms of trade (RER), D t proportional b t , but LOOP deviations With LCP no longer true because of ∆ costly Trade-o¤s and e¤ectiveness of optimal policy: PCP I With PCP, terms of trade (RER) and relative output are proportional to each other: Tbt = bH ,t Y bF ,t Y bt = D bH ,t Y bF ,t Y 1 1 2aH (1 φ) σ (2aH φ 1) (2aH 1 2aH (1 φ) 1) Trade-o¤s and e¤ectiveness of optimal policy: LCP 1 1 2aH (1 2aH φ 2aH (1 φ) Tbt = bH ,t Y bF ,t Y bt = D bH ,t Y bF ,t Y bt ∆ 1 b t aH +∆ 2aH φ) σ (2aH φ 1) (2aH 1) 1 2aH (1 φ) 1 + φ (2σ (1 aH ) 1) 1 2aH (1 φ) Technology: News shocks vs Autoregressive AR Values of key parameters I θ = 0.75 I θ = 6 : implying a 20% markup I aH set to generate a 10% import share I κ set so that households spend 1/3 of their time working I φ = f0.45, 6g Understanding misalignment and demand imbalances: ‡ex-price allocation and CM Anticipated Home productivity increase with High trade elasticity / good substitutability Understanding misalignment and demand imbalances: ‡ex-price allocation, gaps between CM and IM Anticipated Home productivity increase with High trade elasticity / good substitutability Understanding misalignment and demand imbalances: larger gaps with low elasticity Anticipated Home productivity increase with low trade elasticity / good complementarity Large imbalances: role of low trade elasticity I Following an increase in Home tradable output, with a low trade elasticity, income e¤ects are large I If TOT worsen (as in the e¢ cient case): I I Home demand falls (large negative income e¤ect) With enough home bias: world demand for Home goods falls I TOT must improve to bring the goods market in equilibrium (and RER appreciates) I These movements amplify cross-country (relative) demand imbalances Optimal cooperative policy I Jointly maximize welfare under commitment and timeless perspective I High elasticity: near divine coincidence, PCP versus LCP I Low elasticity: optimal policy corrects misalignment and imbalances I I moderate success (short run) with PCP higher degree of success with LCP ‘Near divine coincidence’with high elasticity and PCP Optimal policy arbitrarily close to strict in‡ation targeting (‡ex-price) Low trade elasticity and PCP Correcting Dgap via consumption: e¤ective in the short-run Low trade elasticity and PCP Correcting Dgap via consumption: e¤ective in the short-run Low trade elasticity and LCP Leaning against misalignment has persistent e¤ects on imbalances Optimal policy with low trade elasticity and LCP Considerable improvement over ‡ex-price allocation: 0.36% of steady state consumption Anticipated AR shocks: low trade elasticity and LCP Conclusion I Asset-price misalignments pose relevant trade-o¤s for monetary policy when they lead to wealth and demand imbalances even for reasons independent of nominal frictions I Optimal policy should generally use monetary stance to redress misalignments in these cases I The success of optimal monetary policy in doing so depends on the structure of the economy, including the form of nominal rigidities – PCP vs. LCP in our case Conclusions Further exercises/directions: I Implementation I Domestically and international incomplete markets I Cooperative vs Nash Conclusions I Misalignments and wealth/demand imbalances — ine¢ ciencies that generally arise independently of monetary and nominal distortions — raise relevant policy trade-o¤s I Examples of economies where inward-looking strict in‡ation targeting, rather than correcting, results in signi…cant misalignments I I Even when the latter only re‡ects fundamental-based valuations Generate suboptimal demand and current account imbalances I Monetary policy should address misalignments in the foreign exchange market I Degree of success of optimal monetary policy depends on the structure of the economy, including the form of nominal rigidities – PCP vs. LCP in our case Conclusions Further exercises/directions: I Implementation I Domestically and international incomplete markets I Cooperative vs Nash Welfare and optimal (cooperative) policy I Planner chooses world allocation that maximizes: Welfare = W0 + W0 2 subject to households and …rms FOCs and resource constraints I Commitment and timeless perspective Experiments: focus on news shocks Linear technology with standard (ξ) shocks and news (ξ ν ) shocks: Yt (h) = Zt Lt (h) , Ut = 0.95Ut Zt = Ut Vt 1 Vt = 0.9Vt I + ξ t + ξ tν 1 + ξ tν Focus on a positive shock in the Home country Households V (st ) = max C H ,C F, L,B H,t +1 ζ C ,t Ct1 σ (1 Lt )1 +κ 1 σ 1 η η + β Ct , Lt EV (st +1 ) subject to: PH,t CH,t + PF,t CF,t + BH,t +1 Wt Lt + (1 + it )BH,t + Z 1 0 Π(h)dh BH,t : risk-free nominal bond that pays in unit of domestic currency ‘Near divine coincidence’with high elasticity and LCP Some correction, but ine¢ cient gaps remain open