Monetary Policy In a Financial Crisis

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Monetary Policy In a Financial Crisis

with Jorge Roldos (IMF) and Chris Gust (Fed), Fabio Braggion (Northwestern)

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Modeling Issues/Tools

• Small, Open Economy Model

• Interaction Between Asset Markets and Monetary Policy

• Limited Participation Model of Money.

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Motivation

• Asian Financial Crisis: ‘Sudden Stop’

– Current Account Swings Negative to Positive by 15 Percentage Points of GDP

– Output Drops 12 Percent, Consumption a Little More, Employment a Little Less

– Asset Prices and Exchange Rates Drop by Over 40 Percent

• Controversy: How Should the Domestic Monetary Authority Respond?

• Two Responses:

– Krugman-Stiglitz:

∗ A Crisis is a Time When Economies are Slipping Into Recession.

∗ Medicine Appropriate for US: Interest Rate Cut.

∗ If It’s Good Enough for the US, then It’s Good Enough for Thailand.

– IMF: A Crisis is a Time When Foreign Investors are Rushing for the Exits.

Need High Rates to Stop Them.

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• What Did They Do? Both!

S H O R T - T E R M I N T E R E S T R A T E S 1 /

0 5 1 0 1 5 2 0 2 5 3 0 3 5

J a n - 9 7 J a n - 9 8 J a n - 9 9 J a n - 0 0

0 5 1 0 1 5 2 0 2 5 3 0 3 5

T h a i l a n d K o r e a M a l a y s i a P h i l i p p i n e s

• Was Policy Erratic, Responding to Different Advice at Different Times?

• Our Argument: this Policy May have been Roughly Optimal.

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• Analysis: Compute Optimal Monetary Policy in a Variant on Model in Christiano, Gust, Roldos (2004)

• Model Highlights Key Features of Crisis Economies:

– General Evidence From Surveys of ‘Credit Crunch’

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were higher in large firms and local firms than in SMEs and foreign controlled firms, respectively. It is particularly remarkable that the proportion of large firms rejected for loans rose dramatically from 21% in the first half of 1997 to 61% in the same period of 1998. This does not concord with the general belief that SMEs suffered more severely from the credit crunch.

Fig.9. Availability of Credit after the Crisis

D. Transparency and Disclosure

Even before the financial crisis began unfolding, the East Asian financial system, not excluding Korea’s, had often been criticized for its insufficient transparency and disclosure of financial information. Concerning this issue, we asked firms whether their financial statements were audited by outside accounting firms, whether they needed audited statements to receive a bank loan, and whether they had to secure their loan with collateral.

On the issue of audited statements, about two-thirds of surveyed firms answered that they were audited by outside accounting firms. Almost all of the large firms and about 60% of SMEs affirmed this. In order to qualify for a bank loan, approximately 62% of firms needed audited statements, specifically, about 95% of large firms and 56%

of SMEs. Thus, judging from this, it can be inferred that there is sufficient transparency and disclosure of financial information in Korea. Therefore, the actual problem in Korea is neither whether firms are audited by outside accounting firms nor whether they provide audited statements to receive a bank loan, but it is how much credibility the audited statements hold and how much importance banks attach to them in determining loan provisions. Unfortunately, this information cannot be obtained from our survey.

Meanwhile, on the issue of collateral, 86% of firms answered that they had to provide collateral to receive bank loans. This reflects the fact that Korean banks

1.92 2.01

2.54 2.44

2.13 2.06

2.29 2.22

2.47

1 3 5

domestic banks foreign banks other domestic financial institution

local money lenders

family/friends suppliers partner firms bond market equity market

more available

same

less available

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– Collateral Constraints on Loans in Crisis Economies Tightened Syndicated Loans to Emerging Markets

(in billions of U.S. dollars)

Year Total Secured Secured as % of Total

1993 47.5 7.9 16.5

1994 64.9 11.5 17.7

1995 93.0 16.1 17.3

1996 104.3 22.0 21.1

1997 143.7 61.4 42.7

1998 77.3 25.9 33.5

1999 73.1 26.3 35.9

∗ Thailand: banks loaned 70-80% of collateral pre-crisis, 50-60% after crisis (Edison, Luangaram and Miller (2000))

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– Collateral Constraints on Loans in Crisis Economies Tightened – Intermediate Inputs are an Important Component of Imports

Thailand

Year Total Intermediate % of Total 1995 70,718 25,061 35%

1996 72,248 24,874 34%

1997 63,286 21,860 35%

1998 42,403 14,744 35%

1999 49,919 18,205 36%

2000 62,181 23,663 38%

2001 61,847 22,978 37%

2002 64,317 24,461 38%

Korea

Total Intemediate % of Total

135,119 64,611 48%

150,339 68,556 46%

144,616 69,361 48%

93,282 45,593 49%

119,752 57,253 48%

160,481 78,975 49%

141,098 71,929 51%

152,126 73,891 49%

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Malaysia

1996 78,426 52,201 67%

1997 79,036 51,922 66%

1998 58,293 40,901 70%

1999 65,389 48,321 74%

2000 81,963 61,233 75%

2001 73,856 53,271 72%

2002 79,881 56,939 71%

Indonesia

Total Intermediate % of Total 1995 40,921 29,610 72%

1996 44,240 30,470 69%

1997 46,223 30,230 65%

1998 31,942 19,612 61%

1999 30,600 18,475 60%

2000 40,367 26,073 65%

2001 34,669 23,879 69%

2002 24,118

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Philippines

1996 32,427 14,015 43%

1997 35,933 14,663 41%

1998 29,660 11,586 39%

1999 30,726 12,596 41%

2000 34,491 16,747 49%

2001 33,058 15,121 46%

2002 35,427 14,791 42%

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– Intermediate Inputs are Closely Correlated with Output During Crisis.

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Intermediate Goods Import vs. GDP (Index 1995 = 100)

Sources: CEIC; and WEO.

Indonesia

GDP

0 20 40 60 80 100 120 140

1993 1995 1997 1999 2001 0 20 40 60 80 100 120 140

Intermediate

Korea

GDP

0 20 40 60 80 100 120 140

1993 1995 1997 1999 2001 0 20 40 60 80 100 120 140

Malaysia

GDP

0 20 40 60 80 100 120 140

1993 1995 1997 1999 2001 0 20 40 60 80 100 120 140

Intermediate Philippines

GDP

0 20 40 60 80 100 120 140

1993 1995 1997 1999 2001 0 20 40 60 80 100 120 140 Intermediate

Thailand

GDP

0 20 40 60 80 100 120 140

1993 1995 1997 1999 2001 0 20 40 60 80 100 120 140

Intermediate

Figure 2

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– Intermediate Inputs are Closely Correlated with Output During Crisis.

– Informal Evidence Suggests (Trade) Financing Important for Intermediate Inputs.

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Structure of Model

• Small, Open Economy with Traded and Nontraded Goods

• Imported Intermediate Inputs and Labor Must be Financed in Advance – Trigger of Crisis: Collateral Shock.

– Collateral Shock: Sudden Tightening of Binding Collateral Constraints.

• Labor Market Frictions

– Short Run: Labor Hard to Reallocate Across Sectors – Longer Run: Labor Flexible

• Non-neutrality of Money: Limited Participation Assumption

• Question: What is Optimal Dynamic Monetary Policy In Response to Collateral Shock?

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Basic Idea in the Analysis

• Collateral Constraint:

Q

SK ≥ R^∗z + (1 + r^∗)B

• Two Scenarios By Which Cut in R Affects Domestic Activity, In Principle:

– Balance Sheet Mismatch Scenario (IMF):

∗ Depreciation (i.e., S ↑) Reduces Left Side of Collateral Constraint.

∗ Firms Must Reduce z.

∗ Lack of Substitution Between z And Domestic Activity Brings on Recession.

– Asset Inflation Scenario (Krugman-Stiglitz):

∗ Q Jumps Because Real Interest Rate Falls

∗ ^Higher z Rationalized by Higher Q Raises M P_K, Justifying Higher Q.

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Findings of Earlier Analysis

Q

SK ≥ R^∗z + (1 + r^∗)B

• Asset Inflation Scenario

– More Likely If Factors that Complement z Can Be Brought Quickly Into Production

– Example: z is Computer Chips

∗ If Workers Can Be Brought In Quickly to Handle More z, Then M P_K ↑, Promoting Asset Inflation Scenario.

• Balance Sheet Mismatch Scenario

– More Likely if Resources are Slow to Move.

∗ Extra Computer Chips Do Nothing for M P_K If they Just Sit In a Warehouse.

• This Analysis: Assume Resources Move Slowly In Short Run.

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F lo w o f G o o d s a n d L a b o r in th e M o d e l

H o u s e h o ld

F in a l C o n s u m p tio n

G o o d

T r a d e d G o o d s

N o n - tr a d e d G o o d s

F o r e ig n S e c to r

L a b o r M a r k e t

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Model

• Agents: Households, Final Good Firms, Intermediate Good Firms, Foreign Sector.

• ^Households

maxc_t,L_t

X∞ t=0

β^t h

c_t − _1+ψ^ψ⁰ L^1+ψ_t i1−σ

1 − σ P_tc_t ≤ W^tL_t + ˜M_t − D^t

M˜_t+1 = R_t(D_t + X_t) + P_t^Tπ_t + W_tL_t + ˜M_t − D^t − P^tc_t M˜_t+1 ∼ money chosen by household

R_t ∼ gross domestic nominal rate X_t ∼ money injection by central bank

π_t ∼ ^profits

D_t ∼ deposits of cash with intermediary.

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• Final Good Firms (‘Retailers’):

c = min©

(1 − γ) c^T, γc^Nª . c^N ˜ non-traded intermediate input c^T ˜ traded intermediate input

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• Domestic Intermediate Good Firms:

– Technology, traded goods:

y^T = n

θ [µ₁V ]^ξ−1^ξ + (1 − θ) [µ2z]^ξ−1^ξ o_ξ−1^ξ , V = A ¡

K^T¢^ν ¡

L^T¢¹_−ν ,

ξ ˜ elasticity of substitution between V and z z ˜ foreign intermediate good

– Short Run Friction:

Traded Good Firm Decides L^T At Start of Period – Technology, non-traded goods:

y^N = ¡

K^N¢^α¡

L^N¢¹_−α .

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• Objective of Intermediate Good Firms:

max X∞

t=0

β^tΛ_t+1π_t,

π_t = p^N_t y_t^N + y_t^T − w^tR_tL_t − R^∗z_t − r^∗B_t + (B_t+1 − B^t)

τQ^N_t

S_t K^N + τQ^T_t

S_t K^T ≥ R^∗z_t + (1 + r^∗)B_t q_tⁱ = V M P_Kⁱ_,t + λ_tτⁱq_tⁱ + q_t+1ⁱ

1 + ρ_t, q_tⁱ = Qⁱ_t

S_t, i = N, T.

• Resource Constraints:

y^N = c^N

y^T = c^T + R^∗z + r^∗B − (B⁰ − B)

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Timing

Collateral Shock

Household

Deposit Decision

Monetary Action

Production,

Consumption Occur

0 1 2 t

Traded Good Firm Decides Employment in Traded Sector

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Effects of Collateral Shock

• Economy in Steady State, Ignoring Collateral Constraint.

• Collateral Constraint Unexpectedly Imposed and Binding (λ_t > 0).

• Intertemporal Euler Equation of Firm 1 = βΛ_t+2

Λ_t+1(1 + r^∗)(1 + λ_t+1), t = 0, 1, 2, ... . Λ_t+1 multiplier on household budget constraint

• ^{We Assume} β(1 + r^∗) = 1, so Λ_t+1

Λ_t+2 = 1 + λ_t+1, t = 0, 1, 2, ... .

• ^With λ_t+1 > 0, Consumption Level Low, Growth High

• B^t Falls Until λ_T = 0.

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L e v e l o f I n te r n a tio n a l D e b t in O ld S te a d y S ta te

Bt

F in a n c ia l C r is is

H ig h S h a d o w V a lu e o f D e b t I n d u c e s F ir m s to P a y it D o w n

t L e v e l o f D e b t in

N e w S te a d y S ta te

R e s p o n s e o f D e b t a n d O u tp u t to C o lla t e r a l S h o c k I n th e A b s e n c e o f M o n e t a r y P o lic y R e s p o n s e ( F ix e d

M o n e y G r o w th )

O u tp u t D u r in g th e T r a n s itio n

t O u tp u t

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Parameters Values of the Model β 0.943 γ 0.3

ψ 3.00 R 1.11 R^∗ 1.06 r^∗ 0.06 α 0.36 K^N 10 ν 0.5 K^T 5 µ₁ 1 µ₂ 3.5

τ 0.08 θ 0.5 ψ₀ 0.0036 σ 2

A 1.5 ξ 0.1 ζ 0.6

Note : Here, β, R and R^∗ are expressed in annualized terms.

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Optimal and Constant Money Growth

0 0.02

0.04 current account

Optimal Money Growth Constant Money Growth -15

-10 -5 0

5 real GDP

-20 -10 0

10 Employment

-20 -10 0

10 Consumption

-10 0

10 Imports

-20 -10 0

10 Asset Prices

0 20

40 Nominal Interest Rate

1 1.2 1.4

1.6 Nominal Exchange Rate (Price of Traded)

-20 0 20 40 60

Inflation

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Korean Data

-0.2 0

0.2 Current Accounts scaled by Trend Nom GDP

-20 -10 0

10 Real GDP: percent deviation from pre-crisis trend

1996 1997 1998 1999 2000 2001 2002

-10 -5 0

5 Employment: percent deviation from pre-crisis trend

-20 -10 0

10 Consumption: percent deviation from pre-crisis trend

3.5 4 4.5

5 Log Share Prices

0 10 20

0.5 1

1.5 Nominal Exchange Rate

0 5 10

15 inflation

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Optimal and Korea

0 0.1

0.2 current account

Simulation

Actual Korean Data -15

-10 -5 0

5 real GDP

-20 -10 0

10 Employment

-20 -10 0

10 Consumption

-10 0

10 Imports

-20 -10 0

10 Asset Prices

0 20

1 1.2 1.4

1.6 Nominal Exchange Rate (Price of Traded)

-20 0 20 40 60

Inflation

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Conclusion

• Identified Factors That Make Raising the Interest Rate in Immediate Aftermath of Financial Crisis Optimal

• Simulated a Model With These Properties (Inflexible Factors of Production in Short Run) and Found that Actual Interest Rate Response May Have Been Roughly Optimal.

• Broader Implications of Analysis:

– Monetary Transmission Mechanism May Be Profoundly Different When Collateral Constraints are Binding.

– Perhaps Binding Collateral Constraints are Binding More Often in Developing Countries, Where Collateral May Be in Short Supply