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Motivation Credit market frictions Stylised model Long-run e¤ects The e¤ects of asymmetric information in an open economy Business cycle e¤ects Iris Claus Sensitivity analysis Summary and conclusion CAMA and RBNZ Conference 16-17 December 2010 CAMA and RBNZ Conference 1 / 27 Motivation Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Credit markets can have real economic e¤ects. Wicksell’s early writings on monetary dynamics Fisher’s “debt-de‡ation theory of great depressions” Distressed …nancial and banking systems (e.g. US, UK, Scandinavia, Latin America, Japan, east Asian countries) have rekindled interest in credit markets. CAMA and RBNZ Conference 2 / 27 Motivation Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Credit market frictions are caused by asymmetric information between borrowers and lenders. Borrowers know more about their investment projects than lenders do. Agency costs arise when lenders delegate control over resources to borrowers, and borrowers (agents) have an incentive not to perform in the best interest of lenders (principals). Agency costs increase …rms’cost of external …nance relative to internal funds. CAMA and RBNZ Conference 3 / 27 Motivation Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion The literature has focused on closed economies (e.g. Bernanke and Gertler, 1989, Carlstrom and Fuerst, 1997 and Bernanke, Gertler and Gilchrist, 1999). Credit market frictions may be more pronounced in small open economies than in large closed economies. This paper assesses the e¤ects of asymmetric information between borrowers and lenders in an open economy with access to international capital markets. It builds on Carlstrom and Fuerst’s closed economy model. CAMA and RBNZ Conference 4 / 27 Credit markets Motivation Credit market frictions Current theories of the role of credit markets build on the economics of imperfect information. Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Information is a public good. Less than socially optimal quantity of information may be produced. Financial intermediaries and markets can reduce the asymmetric information problem. But this is costly. CAMA and RBNZ Conference 5 / 27 Ex ante information asymmetry Motivation Credit market frictions Stylised model Lenders cannot di¤erentiate between borrowers with di¤erent credit risks before providing loans. Long-run e¤ects This leads to an adverse selection problem. Business cycle e¤ects Financial intermediaries are more likely to lend to high-risk borrowers. Sensitivity analysis Summary and conclusion Those who are willing to pay higher interest rates will, on average, be worse risks. CAMA and RBNZ Conference 6 / 27 Ex post information asymmetry Motivation Credit market frictions Stylised model Only borrowers can costlessly observe actual returns after project completion. Long-run e¤ects This leads to a moral hazard problem. Business cycle e¤ects Borrowers engage in activities that reduce the likelihood of a loan being repaid. Sensitivity analysis Summary and conclusion This type of asymmetric information is included in the model. CAMA and RBNZ Conference 7 / 27 Open economies Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Credit market frictions may be more pronounced in small open economies. Small economies tend to have a large number of small …rms and fewer large businesses. Small …rms are more a¤ected by asymmetric information because of economies of scale in acquiring and monitoring information. In open economies with access to international capital markets, domestic savings are not constrained to domestic (risky) investments. The cost of borrowing is in‡uenced by movements in the exchange rate. CAMA and RBNZ Conference 8 / 27 Six agents Motivation Credit market frictions Stylised model Long-run e¤ects Households Firms Financial intermediaries Business cycle e¤ects Entrepreneurs Sensitivity analysis Government Summary and conclusion Monetary authority CAMA and RBNZ Conference 9 / 27 Financial intermediaries Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Financial intermediaries help overcome an information asymmetry problem. They provide external …nancing to entrepreneurs. Entrepreneurs also use their own net worth. Instead of lending to risky entrepreneurs …nancial intermediaries can hold risk-free foreign bonds. Access to international capital markets increases the opportunity cost of lending to entrepreneurs, who may default on their debt. This increases the rate of return lenders demand for the use of their funds. CAMA and RBNZ Conference 10 / 27 Information asymmetry Motivation Credit market frictions Stylised model Entrepreneurs’production technology is subject to idiosyncratic shocks. Long-run e¤ects Only entrepreneurs can costlessly observe the shocks. Business cycle e¤ects The information asymmetry creates a moral hazard problem. Sensitivity analysis Summary and conclusion Entrepreneurs have an incentive to underreport the true value of their technology shock. CAMA and RBNZ Conference 11 / 27 Debt contract Motivation Credit market frictions Stylised model Long-run e¤ects Financial intermediaries lend to entrepreneurs via a debt contract. The optimal contract is structured so that entrepreneurs always truthfully report their technology shock. In the event of default, …nancial intermediaries monitor entrepreneurs and con…scate all returns from their projects. Entrepreneurs with larger net worth receive larger loans. Business cycle e¤ects Sensitivity analysis Summary and conclusion The size of loans …nancial intermediaries are willing to provide is in‡uenced by the opportunity cost of not lending internationally. CAMA and RBNZ Conference 12 / 27 Households Motivation Credit market frictions maximise utility Stylised model work Long-run e¤ects own …rms Business cycle e¤ects rent capital to …rms Sensitivity analysis Summary and conclusion can hold domestic and foreign bonds must hold demand deposits to purchase consumption and capital goods CAMA and RBNZ Conference 13 / 27 Firms Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion are monopolistic competitors hire labour and capital from households and entrepreneurs use commodity inputs, which they import at the beginning of each period produce output of consumptions goods pay dividends to households at the end of each period CAMA and RBNZ Conference 14 / 27 Entrepreneurs Motivation Credit market frictions produce the capital that …rms use in the production of consumption goods Stylised model Long-run e¤ects use their own net worth, which consists of their after-tax wage earnings and the market value of their capital stock Business cycle e¤ects obtain external …nancing from …nancial intermediaries Sensitivity analysis face idiosyncratic technology shocks Summary and conclusion who are still solvent after the shocks occur repay their loans and make their consumption decisions CAMA and RBNZ Conference 15 / 27 Government Motivation Credit market frictions Stylised model Long-run e¤ects collects taxes on households’and entrepreneurs’wage and rental incomes Business cycle e¤ects uses this revenue to purchase consumption goods from …rms Sensitivity analysis has a balanced budget constraint in each period Summary and conclusion CAMA and RBNZ Conference 16 / 27 Monetary authority Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis has an explicit consumer price in‡ation target adjusts the nominal rate of interest paid on domestic bonds follows a Taylor rule with interest rate smoothing Summary and conclusion CAMA and RBNZ Conference 17 / 27 Long-run e¤ects of asymmetric information Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion The stylised model is solved for a steady state with and without agency costs. The two steady states are compared. The information asymmetry problem disappears when entrepreneurs’production process is certain. Entrepreneurs no longer become bankrupt and default on their debt. They can obtain all external …nancing directly from households. They no longer need collateral or net worth. CAMA and RBNZ Conference 18 / 27 Agency costs in the open economy Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects capital investment output cost of external …nance Agency cost model 26.068 0.538 4.495 3.4 % No agency costs 27.151 0.559 4.552 0.0 % Di¤erence 4.2 % 3.9 % 1.3 % -3.4 p.p. Sensitivity analysis Summary and conclusion The cost of external …nance is higher than in Carlstrom and Fuerst’s closed economy (3.4 % compared to 2.4 %). CAMA and RBNZ Conference 19 / 27 Productivity shock output Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion 1.0 0.8 0.6 0.4 0.2 0.0 interest rate 0.03 0.00 -0.03 -0.06 -0.09 -0.12 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Agency cost model No agency costs 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 An appreciation of the domestic currency increases the relative return to foreign assets and reduces (domestic and foreign) lenders’willingness to provide funds to entrepreneurs. This raises further the cost of external …nance. CAMA and RBNZ Conference 20 / 27 Foreign demand shock Motivation Credit market frictions Stylised model output 0.04 interest rate Agency cost model No agency costs 0.03 0.02 Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion 0.008 0.006 0.004 0.01 0.002 0.00 0.000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 As in the case of the productivity shock, the presence of agency costs dampens the e¤ects on output and the central bank’s response. CAMA and RBNZ Conference 21 / 27 Reduced access to international capital markets Motivation Credit market frictions Financial intermediaries can only lend to entrepreneurs. Stylised model That is, they can no longer hold risk-free foreign bonds. Long-run e¤ects This lowers the cost of external …nance. Business cycle e¤ects The cost of external …nance no longer includes the opportunity cost of not lending internationally. Sensitivity analysis Summary and conclusion The reduction in the cost of external …nance raises steady state capital, investment, output and consumption. CAMA and RBNZ Conference 22 / 27 Productivity shock Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion output 1.0 interest rate 0.03 0.00 -0.03 -0.06 -0.09 -0.12 0.8 0.6 0.4 0.2 0.0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Agency cost model No agency costs Reduced capital mobility 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 A reduction in capital mobility lessens the e¤ects of agency costs following a supply shock. The exchange rate no longer a¤ects the cost of external …nance. CAMA and RBNZ Conference 23 / 27 Foreign demand shock output Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion 0.08 Agency cost model No agency costs Reduced capital mobility 0.06 0.04 0.02 0.00 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 interest rate 0.018 0.015 0.012 0.009 0.006 0.003 0.000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 The real exchange rate appreciation no longer raises the cost of external …nance. In fact, the cost of external …nancing falls ... as the positive demand shock leads to a reduction in investment to meet increased foreign demand. CAMA and RBNZ Conference 24 / 27 Summary and conclusion Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion This paper assessed the e¤ects of asymmetric information between borrowers and lenders in a small open economy with access to international capital markets. Only borrowers could costlessly observe actual returns after project completion. The ex post information asymmetry led to agency costs and a moral hazard problem. Financial intermediaries helped overcome the information asymmetry. They lent via a debt contract and monitored borrowers who defaulted on their debt. CAMA and RBNZ Conference 25 / 27 Main …ndings Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion Asymmetric information and agency costs have real economic e¤ects. They raise the cost of external …nance and lower steady state investment, capital and output. The long-run e¤ects are exacerbated in an open economy. Agency costs impact on the business cycle. Shocks to the economy a¤ect the cost of external …nance. In an open economy the cost of external …nance is also in‡uenced by the exchange rate. Whether agency costs dampen or magnify business cycle ‡uctuations depends on the degree of capital mobility and type of shock. CAMA and RBNZ Conference 26 / 27 Implications of …ndings Motivation Credit market frictions Stylised model Long-run e¤ects Business cycle e¤ects Sensitivity analysis Summary and conclusion The results underline the importance of well-functioning …nancial systems. Macroeconomic models that do not account for asymmetric information in credit markets provide an incomplete description of the economy. Credit market interactions are altered in small open economies compared to large closed economies. Credit market frictions may change with increases in international capital mobility due to …nancial liberalization and globalization. CAMA and RBNZ Conference 27 / 27