Financial Heterogeneity and Monetary Union S. Gilchrist 1 R. Schoenle - - PowerPoint PPT Presentation

Financial Heterogeneity and Monetary Union

• S. Gilchrist1
• R. Schoenle2
• J. Sim3
• E. Zakrajˇ

sek3

Boston University1 Brandeis University2 Federal Reserve Board3

Cambridge University

April 19th, 2016

Disclaimer

The views expressed should not be interpreted as reflecting the views

• f the Federal Reserve System or its staff.

Eurozone Crisis (2009–?)

Classic balance-of-payment crisis:

◮ The mix of overvalued RERs and cheap credit fueled by economic

• ptimism led to over- and mal-investment.

◮ After the Global Financial Crisis came a sudden stop.

Resolution of the crisis:

◮ Realignment of overvalued RERs. ◮ The mix of deflation in the “south” and reflation in the “north.” ◮ Surprisingly hard to achieve—why?

Lessons from the Financial Crisis in the U.S.

Gilchrist, Raphael, Sim & Zakrajˇ sek [2015]

Empirics:

◮ Firms with strong balance sheets slashed prices. ◮ Firms with weak balance sheets raised prices.

Theory:

◮ Develops a GE model that can replicate such patterns. ◮ Emphasizes the interaction between financial market frictions and

firms’ pricing decisions in customer markets.

Producer Price Inflation

• 24
• 16
• 8

8 16 24

• 30
• 25
• 20
• 15
• 10
• 5

5 Percentage points Peak: Jan1980 Peak: Jul1981 Peak: Jul1990 Peak: Mar2001 Peak: Dec2007

Months to and from business cycle peaks

Core producer prices*

* Deviations from a linear trend estimated over the 24 months preceding the specified recession.

• 24
• 16
• 8

8 16 24

• 30
• 25
• 20
• 15
• 10
• 5

5 Percentage points Peak: Jan1980 Peak: Jul1981 Peak: Jul1990 Peak: Mar2001 Peak: Dec2007

Months to and from business cycle peaks

Industrial production*

* Deviations from a linear trend estimated over the 24 months preceding the specified recession.

Relative Inflation

Financially unconstrained vs constrained firms

2005 2006 2007 2008 2009 2010 2011 2012

• 6
• 4
• 2

2 4 Percent Low liquidity firms High liquidity firms 3-month moving average

Note: Weighted average monthly inflation relative to industry (2-digit NAICS) inflation.

Inflation Response to Liquidity

2006 2007 2008 2009 2010 2011 2012

• 0.08
• 0.06
• 0.04
• 0.02

0.00 0.02 0.04 Coefficient

Estimate +/- 2 S.E.

Quantile Response to Liquidity During Crisis

• 1.0
• 0.8
• 0.6
• 0.4
• 0.2

0.0 0.2 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 Quantile Estimate 95% confidence interval OLS estimate

Inflation Response to EBP

• 10
• 8
• 6
• 4
• 2

2 4

• 3.5
• 3.0
• 2.5
• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5

12-month PPI inflation and financial conditions

By industry-specific indicator of financial constraints

Coefficient on EBP (4-digit NAICS) Median Size-Age Index (4-digit NAICS) p < .10 p >= .10 ^ β = 1.11 |t| = 4.88 R-sq = 0.29 Note: Smaller values of the size-age index indicate a smaller likelihood of financial constraints.

Output Response to EBP

• 12
• 10
• 8
• 6
• 4
• 2

2 4 6 8

• 3.5
• 3.0
• 2.5
• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5 Median Size-Age Index Coefficient on EBP

p < .10 p >= .10 ^ β = -1.88 |t| = -3.77 R-sq = 0.22

Inflation and Output Dynamics in the Eurozone

1992-2008 2009-2014 Core GIIPS Core GIIPS

• Avg. inflation (%)

1.58 3.34 1.22 0.66

• Avg. output gap (%)

0.32 0.81

• 1.38
• 4.88

Panel-version of the NK Phillips curve: πit = 0.449

(0.051) Etπi,t+1 + 0.533 (0.049) πi,t−1 + 0.104 (0.048) (yit − ¯

yit) + ˆ ηi + ˆ ǫit

◮ AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT ◮ Annual data: 1970–2014 (unbalanced panel, Obs. = 429)

Is lack of deflationary pressures related to financial strains?

Inflation and Output Dynamics in the Eurozone

1992-2008 2009-2014 Core GIIPS Core GIIPS

• Avg. inflation (%)

1.58 3.34 1.22 0.66

• Avg. output gap (%)

0.32 0.81

• 1.38
• 4.88

Panel-version of the NK Phillips curve: πit = 0.449

(0.051) Etπi,t+1 + 0.533 (0.049) πi,t−1 + 0.104 (0.048) (yit − ¯

yit) + ˆ ηi + ˆ ǫit

◮ AUT, DEU, BEL, FIN, FRA, NLD, GRC, IRL, ITA, ESP, PRT ◮ Annual data: 1970–2014 (unbalanced panel, Obs. = 429)

Is lack of deflationary pressures related to financial strains?

Inflation Dynamics and Financial Strains

Sample Period: 2008-2014

• 2
• 1

1 2 3 Sovereign (5-year) CDS Spreads at t (pps., log scale) Inflation Residuals at t+1 (pct.)

GIIPS Core

0.5 1 5 10 20

Heterogeneity as Propagation Mechanism

In this paper, we extend the theoretical framework to two-country GE. Study the consequences of forming a currency union among countries with heterogeneous financial conditions. Price War During periphery’s liquidity crisis, core has a strong incentive to slash markup to gain market share both home and abroad. In contrast, periphery is forced to raise prices to secure cashflow, cannibolizing its own future market share. Self-Reinforcing Crisis Possibility of RERs to appreciate for periphery rather than for core, a feedback loop that reinforces the liquidity crisis of periphery.

Policy Options

Fiscal Union:

◮ Trading state-contingent bonds among heterogeneous countries. ◮ Highly beneficial to periphery but requires large transfers from core. ◮ Are the costs of fiscal union bearable by core countries?

Fiscal Devaluation:

◮ Certain mixes of fiscal instruments replicate the devaluation. ◮ When can a unilateral fiscal devaluation be beneficial to core? ◮ Depends on the strength of externality created by financial friction.

Preferences

Two countries: home (h = south) and foreign (f = north) Continuum of households in each country: j ∈ Nc ≡ [0, 1] Two types of goods:

• home goods (h):

cj

i,h,t, i ∈ Nh ≡ [1, 2]

foreign goods (f ): cj

i,f ,t, i ∈ Nf ≡ [2, 3]

CRRA in habit-adjusted consumption basket xj

t:

Et

∞

∑

s=0

βsU(xj

t+s, hj t+s);

j ∈ [0, 1]

◮ labor (h) is immobile

Deep Habits

Ravn, Schmitt-Grohe & Uribe [2006]

Armington-Ravn-Schmitt-Grohe-Uribe aggregator: xj

t =

• ∑

k=h,f

ωk

• Nk
• cj

i,k,tsθ i,k,t−1

1−1/ηdk 1−1/ǫ

1−1/η

1/(1−1/ǫ)

◮ η = elasticity of substitution within a type of goods ◮ ǫ = elasticity of substitution between types of goods ◮ θ > 0 governs the strength of deep habits ◮ 0 < ωk < 1 governs the degree of home bias in consumption

Law of motion for deep habits: si,k,t = ρsi,k,t−1 + (1 − ρ)

• Nc

cj

i,k,tdj;

k = h, f

◮ “Keeping up with the Joneses” at the good level.

Deep Habits

Ravn, Schmitt-Grohe & Uribe [2006]

Armington-Ravn-Schmitt-Grohe-Uribe aggregator: xj

t =

• ∑

k=h,f

ωk

• Nk
• cj

i,k,tsθ i,k,t−1

1−1/ηdk 1−1/ǫ

1−1/η

1/(1−1/ǫ)

◮ η = elasticity of substitution within a type of goods ◮ ǫ = elasticity of substitution between types of goods ◮ θ > 0 governs the strength of deep habits ◮ 0 < ωk < 1 governs the degree of home bias in consumption

Law of motion for deep habits: si,k,t = ρsi,k,t−1 + (1 − ρ)

• Nc

cj

i,k,tdj;

k = h, f

◮ “Keeping up with the Joneses” at the good level.

Technology

Continuum of monopolistically competitive firms producing variety

• f differentiated goods of type h and type f .

Production function (labor input, fixed operating costs): yit = ci,h,t + c∗

i,h,t =

At ait hit α − φ; i ∈ Nh (0 < α ≤ 1)

◮ At = persistent aggregate technology shock ◮ ait = i.i.d. idiosyncratic shock w/ log ait ∼ N(−0.5σ2, σ2) ◮ φ = servicing cost of fixed coupon long-term debt

Heterogeneity in financial capacity: φ > φ∗ = 0

Frictions

Financial frictions: costly external equity financing

◮ New shares sold at a discount because of asymmetric information

e1 claim raises only e(1 − ϕt) of funds

◮ “Lemons premium” ϕt ∼ AR(1) ⇒ financial shock ◮ Makes expected shadow value of internal funds, Ea

t [ξit] > 1

Nominal rigidities: quadratic cost of adjusting nominal prices Local currency pricing: law of one price does not apply

“Beggar Thy Neighbor” at the Micro Level

Deep habits make investment in market share profitable:

◮ Investment takes the form of low markups, which exposes firms to

liquidity risk.

◮ Optimal pricing strategy strikes the right balance.

Price war:

◮ Liquidity crisis in the South is a good time for firms in the North to

steal market share by undercutting competitors’ prices in the south.

“Mr. Marchionne and other auto executives accuse Volkswagen

• f exploiting the crisis to gain market share by offering

aggressive discounts. “It’s a bloodbath of pricing and it’s a bloodbath on margins,” he said.” – The New York Times, July 25, 2012

“Beggar Thy Neighbor” at the Micro Level

Deep habits make investment in market share profitable:

◮ Investment takes the form of low markups, which exposes firms to

liquidity risk.

◮ Optimal pricing strategy strikes the right balance.

Price war:

◮ Liquidity crisis in the South is a good time for firms in the North to

steal market share by undercutting competitors’ prices in the south.

“Mr. Marchionne and other auto executives accuse Volkswagen

• f exploiting the crisis to gain market share by offering

aggressive discounts. “It’s a bloodbath of pricing and it’s a bloodbath on margins,” he said.” – The New York Times, July 25, 2012

Optimal Pricing without Deep Habits

Assume flexible prices and no customer markets. When α = 1, optimal pricing (home market) ⇒ pi,h,t = η η − 1

accounting markup

× Ea

t [ξitait]

Ea

t [ξit]

• economic markup

× wt/ph,t At

• real marginal cost

Financial frictions ⇒ Ea

t [ξitait]

Ea

t [ξit]

= 1 + Cov[ξitait] ≥ 1

Optimal Pricing with Deep Habits

Bring back customer markets (still flexible prices!) Growth-adjusted, compounded discount rate: ˜ βt,s ≡ ms,s+1 sh,s+1/sh,s − ρ 1 − ρ ×

s−t

∏

j=1

• ρ + χsh,t+j/sh,t+j−1 − ρ

1 − ρ

• mt+j−1,t+j

Optimal pricing ⇒ pi,h,t = η η − 1 Ea

t [ξitait]

Ea

t [ξit]

wt/ph,t At

• −

χ η − 1Et

• ∞

∑

s=t+1

˜ βt,s Ea

s[ξi,s]

Ea

t [ξi,t]

• ph,s − ws/ph,s

As

Optimal Pricing with Deep Habits

Bring back customer markets (still flexible prices!) Growth-adjusted, compounded discount rate: ˜ βt,s ≡ ms,s+1 sh,s+1/sh,s − ρ 1 − ρ ×

s−t

∏

j=1

• ρ + χsh,t+j/sh,t+j−1 − ρ

1 − ρ

• mt+j−1,t+j

Optimal pricing ⇒ pi,h,t = η η − 1 Ea

t [ξitait]

Ea

t [ξit]

wt/ph,t At

• −

χ η − 1Et

• ∞

∑

s=t+1

˜ βt,s Ea

s[ξi,s]

Ea

t [ξi,t]

• ph,s − ws/ph,s

As

Calibration

Key Model Parameters Value Preferences & Technology deep habit (θ) 0.90 persistence of deep habit (ρ) 0.90 elasticity of substitution b/w and w/in goods (η, ǫ) 2.00, 1.50 fixed operating costs (φ, φ∗) 0.08, 0.00 Nominal Rigidities price adjustment cost (γp) 10.0 wage adjustment cost (γw ) 30.0 Financial Frictions equity dilution cost (ϕ), Ea[ξi] = 1.12, 0.30 idiosyncratic volatility, a.r. (σ) 0.10 persistence financial shock (ρϕ) 0.90

Implications of a Financial Shock in the South

In a monetary union (φ = 0.08, φ∗ = 0.00)

20 40 −1 −0.5 0.5 (b) consumption, pct 20 40 −2 −1 1 (a) GDP, pct 20 40 −2 2 (c) hours, pct 20 40 −1 1 2 (d) int rate , pp 20 40 −2 −1 1 2 3 (e) RER(−), NER(−.), pct 20 40 −1 1 2 (f) inflation, pp 20 40 −2 −1 1 2 (g) exports, pct 20 40 −1 −0.5 0.5 1 (h) CA, pct of GDP

Red = Foreign (North) , Blue = Home (South) NER (·−·) and RER (−) are Home/Foreign

Implications of a Financial Shock in the South

Under floating exchange rates (φ = 0.08, φ∗ = 0.00)

20 40 −1 −0.5 0.5 (b) consumption, pct 20 40 −2 −1 1 (a) GDP, pct 20 40 −2 2 (c) hours, pct 20 40 −1 1 2 (d) int rate , pp 20 40 −2 −1 1 2 3 (e) RER(−), NER(−.), pct 20 40 −1 1 2 (f) inflation, pp 20 40 −3 −2 −1 1 2 3 (g) exports, pct 20 40 −1 1 (h) CA, pct of GDP

Red = Foreign (North) , Blue = Home (South) NER (·−·) and RER (−) are Home/Foreign

Prices and Market Shares

Figure: Financial Shock, Relative Prices and Market Shares

20 40 −2 −1 1 2 (a) relative price home markets, pct 20 40 −1 1 (b) relative price foreign markets, pct 20 40 −1 1 2 (c) market share, home markets, pct 20 40 −1 −0.5 0.5 (d) market share foreign markets, pct 20 40 −0.5 0.5 (e) wage inflation, pp 20 40 −2 2 4 6 (f) markup, pct home, floating foreign, floating home, union foreign, union

Some Evidence: Market Share Dynamics During the Crisis

2010Q1=1.0

0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 08 09 10 11 12 13 14 Portugal Export to Germany GDP Germany Export to Portugal GDP 0.7 0.8 0.9 1.0 1.1 1.2 1.3 08 09 10 11 12 13 14 Italy Export to Germany GDP Germany Export to Italy GDP 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 08 09 10 11 12 13 14 Greece Export to Germany GDP Germany Export to Greece GDP 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 08 09 10 11 12 13 14 Spanish Export to German GDP German Export to Spanish GDP

Heterogeneity As a Propagation Mechanism

In a monetary union

Alternative calibration: φ = φ∗ = 0.08 Financial shocks in both North and South.

10 20 30 40 −2 −1.5 −1 −0.5 0.5 (a) Home GDP, percent 10 20 30 40 −1 −0.8 −0.6 −0.4 −0.2 0.2 0.4 (b) Home consumption, percent 10 20 30 40 −1 −0.5 0.5 1 1.5 (c) Foreign GDP, percent 10 20 30 40 −0.8 −0.6 −0.4 −0.2 0.2 0.4 0.6 (d) Foreign consumption, percent

Alternative = (·−·) and Baseline = (−)

Monetary Union under Complete Risk Sharing

Dramatic reduction in consumption volatility Requires large wealth transfers from the north to the south.

Figure: Financial Shock, Monetary Union and Complete Risk Sharing

20 40 −2 −1.5 −1 −0.5 0.5 1 1.5 (a) GDP, pct 20 40 −1 −0.5 0.5 (b) Consumption, pct 20 40 −1.5 −1 −0.5 0.5 (c) RER, pct 20 40 −1.5 −1 −0.5 0.5 1 1.5 (d) Contingent TR, pct Home, baseline Foreign, baseline Home, Complete Foreign, Complete

Gains vs Losses of Fiscal Union

Table: Costs and Benefits of Complete Risk Sharing Welfare Con Equiv MU (A) Risk Sharing (B) Percent Home country

−274.86 −253.21 10.28

Foreign country

−217.86 −236.96 −9.13

Joint welfare

−492.82 −490.17 − Note: The consumption equivalent is the required minimum increase in average consumption per period holding labor hours constant to make the representative agent living in the economy under the floating exchange rate regime no worse off by transitioning to the currency union.

Fiscal Devaluation

We consider a simple VAT-payroll subsidy swap rule: VAT(τV

t ) + payroll subsidy(ςP t )

FD rules that are linear in the resource gap of the home country: τV

t = αFD × log

yt ¯ y

• Is there a parameter region that is mutually beneficial to both home

and foreign countries?

Fiscal Devaluation vs Flexible Exchange Rates

αFD∗ = arg maxαFD{U(xt − δt, ht) + βEt[V(st+1)]}

Figure: Monetary Union w/ and w/o optimal FD vs Floating

10 20 30 40 −4 −3 −2 −1 1 2 3 (a) Monetary Union w/o FD 10 20 30 40 −4 −3 −2 −1 1 2 3 (b) Optimal FD 10 20 30 40 −4 −3 −2 −1 1 2 3 (c) Flexible Home, y Foreign, y Home, c Foreign, c

Welfare

Difference in welfare from the baseline w/o FD

−15 −10 −5 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 αFD ∆W ∆W*

Welfare for the Core

As financial frictions in the periphery change

−10 −8 −6 −4 −2 0.5 1 1.5 2 2.5 αFD ∆W* (a) The effect of fixed cost φ=0.00 φ=0.05 φ=0.10 φ=0.15 −10 −8 −6 −4 −2 −0.4 −0.2 0.2 0.4 0.6 0.8 1 αFD ∆W* (a) The effect of issuance cost ϕ=0.00 ϕ=0.10 ϕ=0.20 ϕ=0.30

Concluding Remarks

When firms engage in market share competitions, differences in financial capacity across countries imply strong amplification mechanism: “beggar-thy-neighbor” at the micro-level. Monetary union impedes adjustment of RERs and exacerbates the downturn in response to an adverse financial shock. Unilateral fiscal devaluation by periphery may be welfare improving for both periphery and core.