Interest Premium, Sudden Stop, and Adjustment in a Small Open - - PowerPoint PPT Presentation

Introduction The Model Evaluation and Policy Conclusion

Interest Premium, Sudden Stop, and Adjustment in a Small Open Economy

Péter Benczúr István Kónya

Magyar Nemzeti Bank and Central European University

MNB/CEPR/BOI 2013

Introduction The Model Evaluation and Policy Conclusion

DISCLAIMER

The views expressed are those of the authors and do not necessarily reflect the official view of the Magyar Nemzeti Bank (the central bank of Hungary).

Introduction The Model Evaluation and Policy Conclusion

MOTIVATION

◮ The crisis of 2008-2009 hit many small open economies by

tightening their external conditions

◮ The CEE economies provide a good laboratory ◮ Important differences in initial conditions and responses

◮ NFA per GDP ◮ Exchange rate regime ◮ Currency mismatch ◮ Balance sheet adjustment ◮ Current account ◮ Traded-nontraded reallocation

NET FOREIGN ASSETS

−150 −100 −50 NFA, %GDP 1995 2000 2005 2010 Czech Republic Hungary Poland

Net foreign asset positions, %GDP. Source: Eurostat.

CDS SPREADS

200 400 600 CDS spread 2002q3 2005q1 2007q3 2010q1 2012q3 Czech Republic Hungary Poland

5−year sovereign CDS spreads. Source: Bloomberg. Back

DEBT AND CDS SPREADS

Hungary Romania Poland Czech Republic Slovenia Bulgaria

100 200 300 400 500 ∆ CDS spread, b.p. −120 −100 −80 −60 −40 −20 Net foreign assets, %GDP

Maximum increase in CDS spreads after 2008Q3. Source: Eurostat, Bloomberg .

FOREIGN CURRENCY LENDING

.1 .2 .3 .4 .5 .6 Foreign currency lending 2002 2004 2006 2008 2010 2012 Czech Republic Hungary Poland

Foreign currency MFI loans, % total loans. Source: ECB.

Introduction The Model Evaluation and Policy Conclusion

TABLE OF CONTENTS

Introduction The Model Evaluation and Policy Conclusion

Introduction The Model Evaluation and Policy Conclusion

THIS PAPER

◮ The crisis: a permanent tightening in the cost of foreign

borrowing (and a one-period drop in export demand)

◮ Calibrate the model to Hungarian data, evaluate

quantitative fit conditional on only two shocks

◮ Counterfactuals: exchange rate regime, initial indebtedness ◮ Is “optimal” policy conditional on initial conditions?

◮ Two-sector, flexible price model with money-in-the-utility

and debt-dependent interest rate

◮ Interest premium highly nonlinear, similar to credit

constraint

Go ◮ Downward nominal wage rigidity (internal devaluation) Go ◮ Currency mismatch

Introduction The Model Evaluation and Policy Conclusion

LITERATURE

◮ Nominal growth, model ingredients: Benczúr-Kónya (JIMF

2013)

◮ Real models of the current account and real exchange

rates: Kehoe and Fernandez de Cordoba (2000), Bems and Hartelius (2006)

◮ Small open economy models with money: Rebelo and

Vegh (1995) and Burstein, Eichenbaum and Rebelo (2007)

◮ Exchange rate regimes and financing frictions: Cook and

Devereux (2006), Gertler, Gilchrist and Natalucci (2007), Brzoza-Brzezina and Makarsky (2011), Heer and Schubert (2012)

◮ Sudden stops: Curdia (2008), Christiano et al. (JME 2009) ◮ Valuation effects: Tille (2005) ◮ Downward nominal wage rigidity: Fahr and Smets (2010)

Introduction The Model Evaluation and Policy Conclusion

MODEL

◮ Production: exports and nontradables, consumption:

imports and nontradables

◮ Sector-specific investment with adjustment costs ◮ Money-in-the-utility and non-linear, debt-dependent

foreign interest premium

◮ Endogenous labor supply, downward nominal wage

rigidity

◮ Monetary policy: degree of exchange rate flexibility ◮ Small open economy with downward-sloping export

demand

Introduction The Model Evaluation and Policy Conclusion

MECHANISM

◮ MIU implies households hold assets (money) in domestic

currency; foreign borrowing assumed to be in foreign currency ⇒ currency mismatch

◮ Higher premium makes HHs poorer, debt more expensive

◮ External rebalancing ⇒ exchange rate depreciates ⇒

mismatch exacerbated

◮ Fixed exchange rate protects HH balance sheets, but

hinders CA adjustment through exports

◮ In standard models, valuation effects for CB reserves

exactly offset this

◮ Here, premium depends only on unconsolidated HH

position

◮ CB reserves earn lower interest rate

Introduction The Model Evaluation and Policy Conclusion

THE CENTRAL BANK

◮ Per period budget constraint

St

• Bc

t − Rc t−1Bc t−1

• CB foreign reserves

+Dt − Rd

t−1Dt−1 + Tt = Ht − Ht−1 ◮ Policy rule in terms of exchange rate flexibility

Ht Ht−1 ρs St St−1 1−ρs = 1

◮ Reserve policy

Bc

t = ρh

Ht St

Introduction The Model Evaluation and Policy Conclusion

CURRENT ACCOUNT

◮ Private debt

Bh

t − Rt−1Bh t−1

= TBt − ρh Ht St − Rc

t−1Ht−1

St−1

• ◮ Total debt

Bh

t + Bc t Bt

−Rt−1Bt−1 = TBt − ρh

• Rt−1 − Rc

t−1

Ht−1 St−1

◮ Money is not neutral!

◮ Debt vs. reserves ◮ Interest rate on reserves

Introduction The Model Evaluation and Policy Conclusion

EXPERIMENTS

◮ We simulate the deterministic, nonlinear model ◮ Transition from an initial to a new steady state

◮ Long-run NFA per GDP (by = ¯

Bh/¯ Y): −1 ⇒ 0

◮ Unexpected, permanent shock ◮ (First period only: large decline in export demand)

◮ Counterfactuals

◮ Different exchange rate regimes ◮ Lower initial indebtedness

CALIBRATION

Parameters Notation Value Calibration target Discount rate β 0.96 Real interest rate Depreciation δ 0.06 Literature Imports share in C λ 0.36 National accounts Import share in I λI 0.44 National accounts Capital share in X αT 0.42 National accounts Capital share in NT αN 0.37 National accounts Labor supply elast. 1/ω 1/3 Literature Wage markup σw 3.5 Literature Wage adjustment function νw; ξw 1; 100 Literature

• Cap. adj. cost

φ 5 Literature

• Exp. demand elast.

η 0.5 HU DSGE model Importance of money γ 0.35 Euro Area M1/GDP Initial/new NFA/GDP b0,¯ b −1, 0 HU data, int. av. Linex parameters Go ν, ξ 0.01, 2 CDS ⇑ in HU, CZ Central bank reserves ρh 1 HU M1/Reserves Monetary policy ρs 0.2 Exchange rate resp.

2 4 6 8 10 0.04 0.05 0.06 0.07 0.08 0.09 Interest rate Baseline Data 2 4 6 8 10 1 1.05 1.1 1.15 Exchange rate 2 4 6 8 10 −1.4 −1.2 −1 −0.8 −0.6 NFA per GDP 2 4 6 8 10 0.7 0.8 0.9 1 Money stock 2 4 6 8 10 0.8 0.85 0.9 0.95 1 Non−tradable rel. price 2 4 6 8 10 0.8 0.85 0.9 0.95 1 1.05 Export 2 4 6 8 10 0.8 0.85 0.9 0.95 1 Consumption 2 4 6 8 10 0.7 0.8 0.9 1 Investment

Baseline simulations

2 4 6 8 10 0.8 0.85 0.9 0.95 1 1.05 Employment

Introduction The Model Evaluation and Policy Conclusion

BASELINE RESULTS

◮ Data points: pre-crisis trends removed ◮ Model captures relevant movements qualitatively, often

quantitatively as well

◮ Money drops too little, consumption too much, and NT

relative price too little

◮ Cumulative three period changes closer to data ◮ Portfolio adjustment costs, illiquid assets? ◮ Price rigidities?

◮ Employment, exports

2 4 6 8 10 1 1.05 1.1 1.15 1.2 1.25 1.3 1.35 1.4 1.45 Exchange rate Fixed Flexible Baseline 2 4 6 8 10 1.04 1.045 1.05 1.055 1.06 1.065 FT interest rate 2 4 6 8 10 −1.8 −1.6 −1.4 −1.2 −1 −0.8 −0.6 −0.4 NFA per GDP 2 4 6 8 10 0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 1.2 Tradable production 2 4 6 8 10 0.75 0.8 0.85 0.9 0.95 1 1.05 1.1 1.15 Employment

Alternative exchange rate regimes

2 4 6 8 10 0.86 0.88 0.9 0.92 0.94 0.96 0.98 1 Consumption

2 4 6 8 10 1 1.05 1.1 1.15 Exchange rate Fixed Flexible 2 4 6 8 10 1.041 1.042 1.043 1.044 1.045 1.046 1.047 1.048 1.049 1.05 FT interest rate 2 4 6 8 10 −0.75 −0.7 −0.65 −0.6 −0.55 −0.5 −0.45 −0.4 −0.35 NFA per GDP 2 4 6 8 10 0.8 0.85 0.9 0.95 1 1.05 Tradable production 2 4 6 8 10 0.8 0.85 0.9 0.95 1 1.05 Employment

Policy comparison with lower initial indebtedness

2 4 6 8 10 0.94 0.95 0.96 0.97 0.98 0.99 1 Consumption

Introduction The Model Evaluation and Policy Conclusion

COUNTERFACTUAL RESULTS

◮ Flexible exchange rate

◮ Employment falls less (DNWR), export sector declines less ◮ Consumption drops more, because of valuation effects

◮ Fixed exchange rate

◮ Employment falls more (DNWR), export sector declines

more

◮ Consumption falls less, because HH balance sheets are

protected

◮ Lower indebtedness: flexible regime better for consumption

Introduction The Model Evaluation and Policy Conclusion

CONCLUSION

◮ We built a simple two-sector model to quantitatively

evaluate the impact of the crisis of 2008-2009 in a small

• pen economy

◮ Key features are external interest premium, currency

mismatch, DNWR

◮ Model captures stylized facts well (even quantitatively) ◮ We highlight the interactions between the exchange rate

regime and initial indebtedness

◮ Export sector and employment vs. balance sheets and

consumption

◮ Exchange rate policy of central bank important for tradeoff

◮ Many things still to be explored! Regional comparisons

INTEREST PREMIUM: EXPONENTIAL

−1.5 −1 −0.5 0.5 1 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 NFA/GDP Interest rate The exponential specification Before the crisis After the crisis

INTEREST PREMIUM: LINEX

−1.5 −1 −0.5 0.5 1 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 NFA/GDP Interest rate The linex specification Before the crisis After the crisis

Back INTEREST PREMIUM: LINEX −1.5 −1 −0.5 0.5 1 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 NFA/GDP Interest rate The linex specification Before the crisis After the crisis

DOWNWARD NOMINAL WAGE RIGIDITY

0.94 0.96 0.98 1 1.02 1.04 1.06 1.08 1.1 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 Wage change Cost of wage adjustment (% cons.) Γ(πw) = (e−ξ(πw−1)+ξ(π

w−

1)− 1) ξ2

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